Tag: industrial policy

Reducing CHIP Supply Risks

When semiconductors where invented in the U.S. in the late 1950 and began to replace vacuum tubes in electronic circuits, the world of electronic circuitry changed dramatically forever (from the computer I am composing this note on, to the mobile phone on which I might discuss it with you or the electronics in the car I might drive to meet you while listening to the radio these chips made possible, not to mention of submarines, planes, and satellites they empower).

American companies continue to lead the world in the design of the most sophisticate chips and semiconductor circuits. However, they have increasingly found it more economical to outsource their manufacture to facilities in foreign countries. Almost all the most sophisticated chips (still designed in the US) are now produced in Taiwan by TSMC, which produces about 56% of world output of semiconductors.  Especially given the increasing suggestion, even by the President of the United States, that the U.S. might renounce its acceptance of China’s claim to Taiwan, such reliance on TSMC for our most advanced chips is an economic and security risk we should reduce.

What is the best way to reduce the risk of our heavy dependance on Taiwan’s supply of such Chips? The rest of this note briefly compares the market approach with the government (socialist/industrial planning) approach to reducing that risk.

American and other firms concentrated the manufacturing of the chips they designed and/or needed where it was cheapest to produce (and deliver) them. Where China violated the WTO rules of fair trade via state subsidies, importing countries are allowed by WTO rules to impose tariffs at levels designed to neutralize such artificial advantages. WTO rules also allow the use of tariffs to diminish the risk to national security of dependance on foreign supplies.

The opposite approach is for a government to subsidize the otherwise uneconomical manufacture of semiconductors (or whatever) in their own country.  In the U.S., the CHIPS and Science Act of 2022 appropriated $280 billion in part to subsidize factories to produce such chips in the U.S. Why was so much needed to get firms to produce chips in the U.S.? “’It’s much cheaper to build the chips and the factories in Taiwan than it is in the United States,’ former Google CEO Eric Schmidt told Semafor. ‘Similarly, the workforce quality is not as good as it is in Taiwan.’” “Chip war-US-Taiwan”

The Biden administration’s industrial policy approach suffers all the well-known disadvantages of industrial policy. First, like China’s subsidies, it violates WTO trading rules, which the U.S. seems all too willing to do when it is the violator rather than someone else. Second, it, rather than market factors, must decide who gets the subsidies (and tax breaks), either by establishing the rules for access or by outright picking winners. Governments’ records at picking winners, especially picking technologies, have historically been poor compared with the search for profit by entrepreneurs, most of whom fail and quietly fade away without further cost or waste. Third, when governments pick winners, they establish an economic incentive for corruption by those seeking to be “picked”. Governments, like everyone else, tend to bend to such temptations.

Rather than paying hundreds of billions of American taxpayer’s money for more costly Made in American products, imposing tariffs on imported chips sufficient to reflect the existing sole source risk would leave it to the market to find the best alternative and more diversified sources (India, Korea, Japan, Viet Nam, etc.). The full cost of lower living standards from industrial policies will only be felt in the longer run. “The slippery slope”

The same economic forces and arguments apply to slowing or preventing further global warming. A carbon tax reflecting the global warming externality of carbon producing activities leaves to the market the search for the best technologies for reducing carbon emissions without loss or with minimal loss of output.

Buy American

In recent years the U.S. government has become more protectionist (protecting its domestic firms from foreign competition). Last year it even provided billions of dollars to subsidize chip production and other designated products in the U.S., an example of industrial policy (state directed development). The CHIPS Act passed last year will shell out over $200 billion over the next five years to subsidize domestic chip production.

To add insult to injury, the so called “Inflation Reduction Act” may violate World Trade Organization rules: “We have concerns about a number of discriminatory elements in this Inflation Reduction Act which puts requirement for local content, for local production,” Dombrovskis, who also is a European Commission vice president, told Bloomberg in Prague.” EU Is Assessing If US Inflation Act in Breach of WTO Rules – Bloomberg Did we really think that we could cheat and Europe and the rest of the world would just roll over and play dead.

President Biden has proclaimed that these expensive policies are needed to create jobs in American. This is bazar given that we are currently suffering from a labor shortage.  Manufacturing output in the U.S. is at an all-time high. U.S. employment in manufacturing has gradually declined in recent decades because our workers have become more productive. But that is surely a good thing, resulting in an increase in our standard of living. President Biden has taken steps to lower our standard of living in order to create American job. Take a deep breath. If we don’t significantly increase legal immigration, you can count on the continuation of long waits on the phone to talk to a real service person.

Where does the “Buy American” impulse come from? It seems that some people see American nationalism as keeping everything at home whatever the cost, while I see it as enjoying the fruits of our largely free society to work and innovate and flourish as we each see fit for the benefit of all.

Several years ago, Ito and I celebrated the 4th of July at the American Embassy in Roma at the invitation of our friend David Zimov, at that time Counselor for Economic Affairs at the U.S. Embassy in Rome. It was really a fun event overflowing with hot dogs and hamburgers. While listening to the Marine Band and waving the little American flags we were all given, I noticed that the flag had been Made in China (clearly tagged). I am guessing that the American nationalists I referred to above were appalled. I, on the other hand, was grateful that my tax dollars were being spent as carefully and wisely as possible—on this occasion at least.  https://wcoats.blog/2023/01/22/trade-once-again/

Trade once again

Everyone understands that without trade they would be dirt poor. If everyone had to be self-sufficient, they would be lucky to survive. It’s almost as obvious that the wider we can trade the more we can specialize in our comparative advantage raising the incomes of everyone. Where many stumble is at their national borders (though within national borders of large countries some regions restrict trade with other national regions to protect otherwise less efficient enterprises thus lowering incomes in general).

Why should trade be restricted across national borders? Three reasons stand out: two legitimate and one not. A potentially legitimate reason concerns national security. Requiring that products necessary for defense be domestically produced, even at greater cost, reduces the risk of supply chain disruptions. The risk is that this excuse is easily abused to the extent that such protection can turn illegitimate or corrupt.

A second legitimate reason also concerns resilience. The most efficient allocation of productive resources must take account of the risks of disruption to supply chains. We buy insurance for many assets and activities, thus incurring a certain cost, to protect our incomes from risks (large or small) of interruption and potentially larger losses. When buying goods or inputs from cheaper producers located far away, we are exposed to larger risks of supply interruptions. American manufacturers, for example, take these risks into account in deciding where to produce and purchase inputs to their products sold in the U.S.

A government bestowed financial favor on a firm or industry (trade protection, industrial policy) is always part of a quid pro quo. The firm delivers favors to the politicians who favor it.  Government protection of otherwise uncompetitive firms increases their viability and profits but at the expense of lower income for the rest of us. Countries that heavily indulge in such protection have suffered lower levels of income. “Trade protection and corruption”

Following World War II, and the establishment of what became the World Trade Organization, barriers to trade (domestic protectionism) were gradually reduced via bilateral and multilateral trade agreements. In the 62 years from 1959 to2021, real United States’ per capita personal income, when measured in constant 2012 dollars to adjust for inflation, increased 297.1%, from $13,971 in 1959 to $55,477 in 2021. This huge increase is the result of increased productivity per worker. But such productivity gains are only possible because of trade (within or across national borders).  “The case for trade”

Weaknesses in government programs to facilitate worker adjustments that are a necessary part of a dynamic, growing economy and other geopolitical factors are undermining the freest and most efficient trade (domestic and global) that our prosperity has depended on. “Geo Economic Fragmentation and the Future of Multilateralism”  “End globalization?”

The Economist magazine has argued that: “One problem [with protectionism and industrial policies] is their extra economic costs. The Economist estimates that replicating the cumulative investments of firms in the global tech-hardware, green-energy and battery industries would cost $3.1trn-4.6trn (3.2-4.8% of global gdp). Reindustrialisation will raise prices, hurting the poor most. Duplicating green supply chains will make it costlier for America and the world to wean themselves off carbon. History suggests that vast amounts of public money could go to waste…. Yet rescuing the global order will require bolder American leadership that once again rejects the false promise of zero-sum thinking. ”  “The destructive new logic that threatens globalisation”

Misinformation and corruption are undermining the basis of our incredible prosperity just when we need to pull together to deal with global warming. We must resist and fight back to restore and preserve our efficient market economies.  They would not exist without trade.

Competing with China

China is now our main economic and political rival. Our proper and honorable response should be to strengthen our side—to be the best that we can be—in the way that one athletic team would fairly compete with another. Instead, we seem to be following the Michael Corleone—God Father—script of knee capping the enemy. Worse still, rather than pulling China into compliance with the international rules of commerce, we are moving toward their failing system of central guidance (industrial policy) of investment.

Deng Xiaoping, who served as the “paramount leader” of the People’s Republic of China (PRC) from December 1978 to November 1989, ended Mao’s repressive economic policies thus freeing up much of the economy under policies dubbed “socialism with Chinese characteristics.” Deng became known as the “Architect of Modern China.” “Since China began to open up and reform its economy in 1978, GDP growth has averaged almost 10 percent a year, and more than 800 million people have lifted themselves out of poverty.” When Xi Jinping took the throne in 2013, China’s annual GDP growth rate was 7.8%. As he increasingly reversed Deng’s economic liberalizations, China’s growth rate has steadily declined and is expected to average 2.8% in 2022. “World Bank – China”

The dramatic economic growth around the world since the start of the industrial revolution is founded in private property and trade. Trade enables individuals (and families) to specialize in what they have a comparative advantage in producing and trade it for what their neighbors are better at. Both are wealthier as a result. “Econ-101-Trade in very simple terms”    “Benefits of free trade”

Following President Richard Nixon’s page turning first visit to the Peoples Republic of China in 1972, when China’s total exports had drifted down from 4.3% of China’s GDP in 1960 ($2.6 billion) to 3.25% ($3.7 billion), until the U.S. formally established full diplomatic relations with the PRC under Deng in 1979, when its total exports were 5.16% of its GDP ($9.2 billion), exports remained a small part of China’s economic output. U.S. diplomatic recognition opened the door to increased trade with China.

At the time, a friend asked me what China could possibly produce that we would want to buy (I swear). While Chica’s exports changed little over those 19 years as a share of its GDP, it increased threefold in dollar value as a result of Chica’s overall economic growth.

Over the next 19 years (1979-1998) following Deng’s economic liberalization, China’s exports rose to 18.34% of its GDP and to $188.8 billion in absolute terms (over 20 times its exports in 1979). Income growth in developing countries normally reflect investment in capital, but in China’s case the larger share of its spectacular growth after its liberalization resulted from the improved efficiency of its resource allocations (increased labor and capital productivity). According to an IMF study “Analysis of the pre- and post-1978 periods indicates that the market-oriented reforms undertaken by China were critical in creating this productivity boom…. Prior to the 1978 reforms, nearly four in five Chinese worked in agriculture; by 1994, only one in two did. Reforms expanded property rights in the countryside and touched off a race to form small nonagricultural businesses in rural areas.” “Why Is China Growing So Fast”

But to maximize the win-win feature of trade, each person/firm must make its decisions about what to produce and trade without distorting outside interference (taxes, subsidies, buy American, etc.). Thus, communities develop rules and norms for “fair” trade. When trade extended beyond the community to the entire world, individuals and countries could maximize the mutual benefits of trade by extending such rules internationally. The U.S. had high protective tariffs on some Chinese goods under the Smoot–Hawley Tariff Act of 1930 (the Reciprocal Trade Agreements Act of 1934 allowed the US President to negotiate bilateral tariff reductions). China had many restrictions on foreign investments in China and a variety of government interventions in its export markets. These restrictive measures needed to be addressed as part of granting China membership in the World Trade Organization (WTO).

From joining the WTO at the end of 2001, China’s $272.1 billion in exports exploded to almost $3,550 billion over the next 19 years (2020), an increase of 13 times (essentially the same share of its GDP as the result of its extraordinary growth in total output). China’s imports followed a similar, but modestly lower, path, raising from 4.4% of GDP ($2.6 billion) to 17.42% of GDP ($3.090 billion) in 2020.  Prior to China’s admission into the WTO what had historically been generally balanced trade (imports and exports generally balanced) rose to a trade surplus of 4.45% in 1997. China sold more abroad than it bought from abroad and bought U.S. debt and property with the resulting surplus. It was hoped and expected that China’s pursuit of an export promotion policy based on an undervaluation of its exchange rate would be reined in by its adoption of WTO rules.

The Peoples Bank of China requested technical assistance from the IMF with complying with WTO requirements. In July 2002 the IMF sent me to discuss and organize the assistance for what was one of my most enjoyable missions (VIP tours of the Great Wall and the Forbidden City and some fabulous dinners). They wanted an American banking supervisor. One of my conditions was that he be given an office with an open door with the rest of the Chinese supervisors. The Deputy Governor approved our agreement, but the Governor vetoed it reflecting the existence of conflicting views on China’s way forward. The primary difference with the officials I talked to was how fast China should liberalize. They all agreed on the direction. The IMF report cited above stated that: “By welcoming foreign investment, China’s open-door policy has added power to the economic transformation. Cumulative foreign direct investment, negligible before 1978, reached nearly US$100 billion in 1994; annual inflows increased from less than 1 percent of total fixed investment in 1979 to 18 percent in 1994.” Direct foreign investment in 1994 was $34 billion and in 2020 it was $253 billion.

China’s gradual liberalization of its restrictions on capital outflows have resulted in larger outflows than inflows since early 2020. Between February and July of this year (2022), China suffered a record net outflow of US$81 billion via the Stock Connect and Bond Connect mechanisms, according to data from the Institute of International Finance (IIF). 

As developing countries catch up to the developed country leaders, their growth rates are expected to slow. But China’s continued heavy government direction of investment, while producing impressive high-speed trains and many thousands of high-rise apartments, and the resulting level of wasteful malinvestment is increasingly taking its toll. After speaking at a People’s Bank of China and Reinventing Bretton Woods conference in Hangzhou in 2014, I continued West to participate in the Astana Economic Forum, in Astana, Kazakhstan, stopping overnight in Urumqi, China, to celebrate my 72 birthday and change planes. Driving from the airport into a lovely Sheraton Hotel in downtown Urumqi, I passed row upon row of empty high-rise apartments (it was evening, and they were all dark) now the source of a major real estate crisis.

When Xi Jinping took over as China’s leader in 2013, the unfinished project of economic liberalization was stopped and put into reverse. The slowing of China’s growth rate accelerated. Clyde Prestowitz reported that: “The CCP [Chinese Communist Party] has long operated the economy on the basis of five year plans. In 2015, the new five year plan included the objective of: Made in China 2025. It listed a range of hi technology items with a target for making them in China by the year 2025. Semiconductors were high on the list, and as an advisor at the time to Intel, I can say that China exerted enormous pressure on that company and many others to move their production of semiconductor chips to China” “Tom Friedman has Biden and China Backward”

We are competing with China just as every firm competes with every other firm. It is mutually advantageous for both economies to grow. It is win win. But neither of us fully plays by the rules of fair trade. What should we do? While adopting policies to strengthen our own economy, we should encourage China to fulfil its WTO obligations. We are doing the opposite. We are taking the God Father mobster approach. As Edward Luce put it in the Financial Times: “Imagine that a superpower declared war on a great power and nobody noticed. Joe Biden this month launched a full-blown economic war on China — all but committing the US to stopping its rise — and for the most part, Americans did not react”  “Containing China is Biden’s Explicit Goal”

German Chancellor Olaf Scholz declared that “Globalisation has been a success story that enabled prosperity for many people. We must defend it…. Decoupling is the wrong answer…. 

We don’t have to decouple from some countries,… I say emphatically we must continue to do business with China.” “Decoupling China wrong answer says German leader”

“Mr. Xi and President Biden should focus their efforts on the future they seek, rather than the one they fear…. If a peaceful — if competitive — coexistence is the ultimate objective, Washington and Beijing do not need to knock each other out to win.” Jessica Chen Weiss in NY Times

We are restricting and reducing trade rather than encouraging its expansion. Not only has President Biden left former President Trump’s unjustified and damaging steel and aluminum tariffs in place (including on Canada) on national security grounds, but we have also directly knee-capped Chinese industries (Huawei, semiconductor chip supplies, etc.). “On 7 October, the Biden administration imposed a sweeping set of export controls that included measures to cut China off from certain semiconductor chips and chip-making equipment. Under these rules, US companies must cease supplying Chinese chipmakers with equipment that can produce relatively advanced chips unless they first obtain a licence.” “What do US curbs on selling microchips to China mean for the global economy”

Historically, such measures, as well as tariffs and bans on certain imports, have been motivated by protecting domestic firms or industries. “The Reign of Polite Protectionism”  The Jones Act of 1917, which forbids shipping goods between US ports in anything other than US built ships, is one of the most useless and embarrassing such laws (ask Puerto Rico). Banning the sale of some items to China can have a military justification but drawing the line between justifiable security concerns and the protection of uncompetitive domestic firms can be difficult. Trump’s 25% tariff on Canadian steel was (but cannot honestly be) justified on national security grounds. Whither justified or not, such restrictions make China and the U.S. (and the rest of the world) poorer. “Next salvo in Biden’s tech war on China expected to aim at quantum computing parts and artificial intelligence software.”  “US mulling bans to stunt China’s quantum computing”  Such restriction are examples of the knee-capping approach to competing with our rivals. “Trade protection and corruption”

But worse still we are now increasingly adopting China’s approach to economic management by the state—so called industrial policy. The recently adopted Inflation Reduction Act, for example, along with measures to reduce carbon omissions, subsidizes the domestic production of solar panels, wind turbines, batteries, and the processing of some critical minerals. A good economic case can be made for encouraging the use of low or non-carbon emitting sources of energy such as with the carbon taxes imposed in Europe. But there is no good case for incurring the higher cost of subsidizing the manufacture of low carbon emitting energy sources in the U.S. The same applies to subsidizing the domestic production of semiconductor chips as is established in this Act. The historical experience with government selection and support of particular products or technologies is not good to say the least. The Trump administration’s promise to buy successful Covid vaccines was a much better and very successful approach to encouraging the private sector.

“French President Emmanuel Macron slammed US trade and energy policies for creating “a double standard” with Europe…. He complained that ‘they allow state aid going to up to 80% on some sectors while it’s banned here — you get a double standard…. It comes down to the sincerity of transatlantic trade….’ The EU has been chafing over the US stimulus package known as the Inflation Reduction Act, which provides subsidies for electric cars made in North America.” “Macron accuses US of trade double standard amid energy crunch”

The financial incentive for corruption in obtaining government financial support is obvious. But even without it, government agents are at best just as good at determining and funding the best new and promising technologies for the future as are private entrepreneurs. The difference is that the private entrepreneurs are risking their own money and the government is risking yours and my money. The vast majority of such undertakings fail. When funded by the government, however, there is less financial pressure to fold and move on when outcompeted by better products. The government landscape is littered with white elephants.  “Questioning industrial policy”

Our China related policies have become damaging to the US and the West in almost every respect. “The China Initiative, launched in 2018 by the administration of former US president Donald Trump, aimed to fight suspected Chinese theft of technical secrets and intellectual property as competition between the two countries intensified…. At least 1,400 US-based ethnic Chinese scientists switched their affiliation last year from American to Chinese institutions,… The US had been ‘losing talent to China for a while and particularly after the China Initiative’,” “1400 US based ethnic Chinese scientists exited American institutions”  Not only do they return with Western technical knowledge but they also return with a fondness for Western values and freedom. Many Chinese retain that fondness and the desire to import more of it into China. We should not kill off those desires.

Doug Bandow offers sound advice: “There is still much for the West to do. The future is not set, and contra Xi’s boastful rhetoric, freedom still is the better bet for the world. Washington should start by addressing its own weaknesses. Free and allied states can constrain the PRC when necessary while cooperating with Beijing when possible, addressing Chinese abuses without adopting the PRC’s authoritarian and collectivist strategies. Americans should continue to engage the Chinese people, especially the young, showing respect for a great civilization while making the case for a free rather than totalitarian society. America can remember the crises she has overcome in the past, and confidently confront the China challenge today.” “Xi plays Mao without the madness”