Comparative Advantage and Middle-Income Traps: Decoding the US-China Conflict
What The Fact - Special Issue on China
The escalating tensions between the US and China are commonly portrayed as an existential battle between democracy (good) and autocracy (evil), or, alternatively, as an unjustified display of power by a hypocritical global hegemon intent on forcing its values on China, while frequently failing to uphold them itself. Caught in the crossfire are multinational firms who are trying to cope with multiple rounds of retaliatory sanctions, subsidies, tariffs, industrial espionage, and IP theft, reflecting the deep-rooted complexities of this geopolitical dispute.
The driving forces behind the geopolitical fireworks are complex. At the core lies the existential importance of economic development and growth to China's policymakers—not only for improving living standards and national security, but also for the survival of the party itself. In fact, unraveling the root causes of the US-China conflict hinges on two pivotal, yet frequently misunderstood, economic concepts: the so-called Middle-Income Trap and one of the most consequential ideas in all of economics: comparative advantage.
Few economic theories enjoy the same universal acceptance as David Ricardo’s theory of comparative advantage – i.e., the counterintuitive insight that unrestricted trade between countries increases total output, even if one country has an absolute advantage over the other, as long as each specializes in the goods it can produce at a relatively lower cost.1 Ricardo’s analysis has provided a powerful argument for free trade ever since its introduction in 1817. Indeed, it goes to the heart of recent U.S. complaints about China’s allegedly unfair trade practices and industrial policies.
Yet, while Ricardo’s logic is unassailable, it does rest on a set of simplifying assumptions that are not, such as perfect competition, full deployment of all available resources, and the ability of all countries to produce all goods. In addition, Ricardo assumes that labor and capital are immobile; that asset ownership, national borders, and security concerns are irrelevant; that technology levels are fixed; and that imports are perfectly balanced by exports, so that no country must finance a trade deficit.2
But what happens when these assumptions are relaxed? Tariffs may well be preferrable over free trade, if a country’s economy operates below full employment and domestic resources need to be put to their full use, instead of merely being re-allocated among alternative uses. And firm ownership may not matter much for a country’s economic development in perfectly competitive markets, but surely does – a lot - when competition is a function of monopolistic assets, as in steel, cars, and semiconductors.3
More fundamentally, Ricardo (wrongly) assumed Portugal had an absolute advantage over England in the production of both cloth and wine but would still benefit by specializing in the production of wine, for which it also had a comparative advantage. But what if the wine industry didn’t have the same growth and technological spillover potential as the cloth industry? Wouldn’t specializing in wine doom the Portuguese economy to fall ever further behind England’s and lead to lower Portuguese standards of living in perpetuity? Contrary to the conventional wisdom, a powerful case can be made that the imposition of free trade on Portugal killed off a promising textile industry, leaving behind a slow-growing export market for wine, while exports of cotton cloth led to the mechanization and productivity gains associated with the Industrial Revolution for England.4
Ricardo’s theory of static comparative advantage falls short when considering economic development and industrial upgrading over time. Instead, a more dynamic understanding is required. For example, the static version of comparative advantage does little to explain why only a few late-developing economies successfully industrialized, while the vast majority got stuck halfway along their journey from low to high income levels – a phenomenon known as the Middle-Income Trap. In fact, late-developing economies that adopted free trade policies early in their transition (e.g., South America), have tended to fall victim to the Middle-Income Trap, whereas those that didn’t (e.g., East Asia) have flourished.5
The rise of China over the last 40 years illustrates both the causes and strategies required to overcome a Middle-Income Trap. It also goes a long way towards explaining the underlying root causes of the growing conflict between the U.S. and China and why that conflict has become so intractable.
China’s economy was in terrible shape after Mao’s death in 1976. Still primarily rural, technologically backward, and effectively bankrupt, China was short of everything: capital, skilled labor, technology, and investment. The one thing China did have was a comparative advantage in people – lots and lots of people.
Under Mao’s successor, Deng Xiaoping, China embarked on a remarkably successful economic development and catch-up plan. In the early 1980s, land reforms freed up China’s huge supply of non-productive farmers from its vast interior regions, who were put to work as migrant workers in its coastal regions, where they were employed in low-skilled, labor-intensive, light manufacturing of goods that were exported around the world. In return, the Chinese economy received an automatic productivity bump as well as large amounts of foreign capital, which was invested in infrastructure and other capital investments that further enhanced productivity.
This created a virtuous economic development circle that lasted until the mid-2000s, when China’s supply of non-productive farm labor finally began to run dry, labor costs were rising quickly, and its ultra-low-cost advantage started to shift to other countries, such as Vietnam. In addition, traditional investments in infrastructure and real estate became increasingly less effective in raising productivity levels. Beijing’s policymakers realized that further productivity gains could only come from higher value-added activities – i.e., from manufacturing products for the world’s leading multinationals to competing head-to-head with them in China and eventually around the world.
But most Chinese firms were nowhere near ready to compete at the global productivity frontier with their far more experienced and capable global competitors. In other words, China was stuck, losing its traditional low-cost advantage to other late-developing economies while still unable to compete for higher value-added activities with developed countries in Europe, Japan, and, of course, the US. In addition, China’s population was rapidly ageing, in part due to the notorious one-child policy, making a great productivity leap forward all the more urgent.
In response, China, now under the leadership of Xi Jinping, embarked on yet another series of industrial policies and indigenous innovation initiatives that date all the way back to the post-Opium War Self-Strengthening Movement of the late 1800s.6 Most notable has been the “Made in China 2025” initiative that identified ten priority industries, including advanced information technology and robotics, that were deemed essential for China to successfully navigate the Middle-Income Trap and “comprehensively build a moderately prosperous society.”7 But those same industries also lie at the heart of technological and economic leadership in general. In addition, they carry significant national security implications.
And therein lies the rub. The U.S. allowed Japan, South Korea, and Taiwan to adopt protectionist economic development policies, because they were allies that furthered its post-WWII geopolitical interests while their economies were still relatively small. But China is an emerging superpower and ideological rival that already has a systemic impact on the global economy. Moreover, the US feels cheated in strongly supporting China’s entry into the WTO in 2001, in the mistaken belief that China would, over time, adopt Western principles of democracy and free trade. In reality, China’s economic development strategy has always been about modernization, not Westernization. Under Deng, China reluctantly accepted a Faustian bargain by allowing Western firms in to facilitate the transfer of technology and other crucial know-how required for upgrading its economy.
Beijing’s mostly Western-trained economists are well-versed in the Middle-Income Trap and convinced that embracing the static interpretation of Ricardo’s theory of comparative advantage, without some form of infant industry protection, could result in wiping out fledgling domestic firms in precisely those industries that are crucial to its economic development and national security. In other words, a strongly-held belief that embracing Western principles of unfettered free trade could result not only in “kicking away the ladder” of economic development but also put China’s domestic stability and national security at risk8 – especially vis-à-vis the US, which China perceives as a strategic rival who is trying to contain its rise and prevent it from reclaiming the global leadership position it held prior to the Opium Wars. In fact, much of what China does and fears can be explained through the lens of the Middle-Income Trap.
There is no obvious way to resolve this. Beijing will never give in, because it believes doing so would be detrimental to its economic development and national security. And neither will the US, as it aims to uphold the post-WWII world order, including its own position as the preeminent superpower and “exorbitant privilege” of the dollar’s status as the leading international reserve currency. In addition, domestic politics and nationalist ideology increasingly play an overriding role in both countries.
What will the future bring? Several scenarios are plausible as a function of domestic economic and political developments in both countries. It is certainly possible for China to successfully navigate the Middle-Income Trap and the US to choose a more accommodative geopolitical stance. It is equally possible that China will run out of time and “grow old before it grows rich” while the US continues with its current, more confrontational, approach. In between lie several muddling-through scenarios that represent perhaps the most likely outcome, as China’s size alone makes a total collapse unlikely.
Importantly, each scenario represents vastly different worlds for both foreign multinationals and domestic Chinese firms. Business strategies, financial investments, and operational decisions that make sense under one scenario can lead to major losses under another. C-Suite executives will need to be exceptionally thoughtful in thinking through the associated uncertainty, complexity, and risk – and expect a decidedly bumpy ride over the next few years.
1 “On the Principles of Political Economy and Taxation,” Ricardo, 1817
2 “The Process of Economic Development,” Cypher and Dietz, Routledge, 2009
3 “Does Firm Ownership Matter? POEs vs. FOEs in the developing world,” Amsden, Cambridge, 2009
4 “Aspects of Development and Underdevelopment,” Robinson, Cambridge, 1978
5 “Lessons from the East Asian Development Model,” Jullens, Strategy+Business, 2014
6 “Will China’s New Leaders Step Up to the Plate?,” Jullens, Strategy+Business, 2013
7 “The Four Modernizations,” Xi, 2014
8 “Bad Samaritans,” Chang, Random House, 2007