China Changes the Calculus on Free Trade

"Subsidies and tariffs waste resources, burden taxpayers and politicize decisions best left to markets. No wonder economists extol free trade.

But there are exceptions, and the subsidies for semiconductor production contained in the bill passed by the Senate on Wednesday may be one. So might the tariffs that President Donald Trump imposed, and President Biden has maintained, on imports from China.

Allowing the production of semiconductors, and countless other products, to migrate to China may be economically efficient, but has a downside: the potential for China to leverage that dependence in some future conflict with the U.S. or its allies, much as Russia is now leveraging Europe's dependence on its gas to undercut support for Ukraine.

In a recent speech in South Korea, Treasury Secretary Janet Yellen, an economist, labeled this risk an "externality," which refers to a cost that an economic transaction imposes on others, such as pollution from a factory. Trade policy, she said, should take "into account externalities arising from concentration of supply chains, geopolitical concerns and value -- rather than overly focusing on cost."

Sen. Todd Young (R., Ind.), a leading sponsor of the Senate bill, which allots $52.7 billion to semiconductor manufacturing in the U.S. and billions more for research and development, concurred: "Real world circumstances are a lot more complicated than the economic models that I learned at the University of Chicago, and have become more complicated with the emergence of our near-peer rival, and its state capitalist economic model."

Subsidies and tariffs are usually intended to protect domestic industry and jobs from foreign competitors, or give them an edge in foreign markets. More than two centuries ago Adam Smith wrote "The Wealth of Nations" in part to discredit protectionism. But he made an exception for national security, defending, for example, laws that required British ships to carry British imports. "Defense is of much more importance than opulence," he wrote.

Events of recent years have cast new attention on the threat to supply chains. The pandemic led to acute shortages of semiconductors, impairing automobile production. Some countries limited exports of medical products or commodities.

Geopolitics was often a driver: the U.S. restricted the sale of sensitive technology to Chinese companies and, along with its allies, blocked the sale of key products such as microchips and aircraft parts to Russia for its invasion of Ukraine. Russia is retaliating in kind, withholding deliveries of natural gas to Europe. It isn't a stretch to imagine that in some future conflict over Taiwan, China may withhold critical supplies from any country thinking of coming to its aid.

Critics of aid to build semiconductor fabrication plants, or "fabs," in the U.S., such as Sen. Bernie Sanders (I., Vt.), note that its likely recipients, such as Intel Corp. and Taiwan Semiconductor Manufacturing Co., are immensely profitable. The hard reality is that almost every host country subsidizes fabs, none more than China. Without doing the same, the U.S. is more likely to lose out on future location decisions.

With industrial policy back in vogue, other industries will declare themselves deserving of aid. But the bar is high, judging by the circuitous, two-year journey of this bill. "Someone would have to make a strong case that other countries were subsidizing a particular industry and inhibiting the U.S. from having mission-critical components accessible to our businesses," Mr. Young said. Democrats in the House of Representatives at one point sought to add $45 billion in subsidies for other American industries. Senate Republicans including Mr. Young said no. The House is now expected to approve the Senate bill.

The European Union is also increasing semiconductor aid, raising the prospect of a subsidy war and capacity glut. In response, the U.S. and the EU say they'll coordinate. "We have a common interest in not having a subsidy race," Margrethe Vestager, the European Commissioner for Competition, said in an interview earlier this year. For both Europe and the U.S., self sufficiency in semiconductors "is a no-go," requiring funds and talent that don't exist, she said. "So we think that the only way forward is. . .EU-U.S. cooperation, probably with other partners as well."

The bill's biggest shortcoming is how little it reduces dependency on China. The attention on cutting-edge fields such as robotics and artificial intelligence obscures China's sway over mundane but critical products such as dyes used in magnetic resonance imaging and neodymium magnets. Even as the U.S. and its allies dominate advanced chips, such as those used in data centers, China is expanding its market share in low-end chips vital to numerous industries including autos. This will continue as long as China can ignore profits while Western companies can't and thus have no incentive to diversify toward more expensive suppliers.

Tariffs provide one incentive. While Mr. Trump placed tariffs on most Chinese imports in 2018 mainly to reduce the U.S. trade deficit, another goal was to force U.S. companies to "consider other options on where to manufacture those goods," said Matt Turpin, who served on Mr. Trump's National Security Council and is now affiliated with the Hoover Institution, a think tank.

Tariffs didn't shrink the overall U.S. trade deficit, just as free traders predicted. But they appear to have expanded U.S. imports from Mexico, South Korea and Vietnam, according to various studies, at China's expense -- which might have benefits that free traders don't consider."Bilateral tariff wars don't really accomplish much," Mr. Young said. "But . . . shifting of sourcing to a friendly country, that may not be a bad thing."” [1]

1.  U.S. News -- Capital Account: China Changes the Calculus on Free Trade
Ip, Greg. 
Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 28 July 2022: A.2.