Why China Needs To End Its Economic Mercantilism

05/25/2011 12:25 pm ET

Recently, the World Bank published revised statistics on PPP (purchasing power parity) -- adjusted GDP--that suggest that the Chinese economy is 40 percent smaller than was previously estimated. After recently returning from two weeks in southern China, I have to say that the new picture of a poorer China did not surprise me. What struck me was not the building boom - which was evident everywhere - but rather the rampant levels of inefficiency and over-manning throughout the economy. Everywhere I looked, what's done in the United States by one or two workers, was done in China by a multitude of workers. Our hotel's front desk was staffed with 7 or 8 clerks, although I never saw more than 2 or 3 guests there. At the pool, 3 workers staffed the cabana, although this being December I only saw one hearty guest braving the unheated pool. At a nearby park 7 government workers were huddled together to weld one chain. At a local deli, 3 people handled paying for the sandwiches. One to put your sandwich in a bag, another to take your money, and a third to put money in the register and hand your change back to the second person. A particular street or "mall" might have 30 to 60 tiny shops all selling roughly the same item (toys, jewelry, electronics, etc). The examples could go on and on. All this is why, despite industrialization, output per Chinese worker is just 14 percent of U.S. levels.

This goes to the heart of the Chinese economic challenge. Instead of embracing growth policies to raise productivity in all the sectors of their economy, China, and indeed many developing nations, has erected neo-mercantilist policies designed to favor a few select export sectors. In The Wealth of Nations Adam Smith said that by favoring domestic goods and exports, "nations have been taught that their interest consisted in beggaring all their neighbors. Each nation has been made to look with an invidious eye upon the prosperity of all the nations with which it trades, and to consider their gain as its own loss."

This sums up China's economic policies. For they use a host of mercantilist actions to gain investments. Intellectual property theft is rampant. One electronics mall I visited in Guangzhou sold Mp3 devices that looked exactly like Apple iPods, and even had the Apple logo on them, but were illegal copies. A record store in a mall sold pirated DVDs and CDs. But China's mercantilism goes beyond IP theft to include tariff and non-tariff barriers to imports, subsidies to promote exports, forced technology transfer, and tax policies, like border-adjustable value-added taxes, that subsidize exports. And of course, their most effective mercantilist tool is to keep their currency, the yuan, significantly undervalued. In this way, exports are cheaper and imports more expensive.

What is especially perverse about this practice is that by running large trade surpluses, China is subsidizing American consumption while limiting their own. Journalist James Fallows notes that it's bizarre for a poor nation to reduce domestic consumption so that they can loan us money so that we can consume more than we produce.

Fallows and most China watchers argue that China is keeping the yuan low and running big trade surpluses in order to "keep Chinese-made products cheap, so Chinese factories will stay busy." But the notion that the only way to have low unemployment is to run ever-growing export surpluses contradicts basic macro-economics, which holds that a change in GDP equals the sum of the changes in consumer spending, government spending, corporate investment and net exports. So if the yuan were to appreciate, China would export less (and import more). But assuming that the government responded with an expansionary fiscal and monetary policy, growth in consumer spending, government spending and corporate investment should offset any loss of jobs from reduced exports.

So if full employment is not their motivation for rampant mercantilism, what is? To understand this, it's worth considering that if China were a firm (which in many ways it is, given the government's excessive involvement in Chinese economic organizations) it would be engaged in what economists call predatory pricing, where it prices below cost to gain market share. Why would a firm do this, since it would mean losing money on each sale? Firms price below cost in order to put one or more competitors out of business, after which they can charge even prices. This is why U.S. anti-trust limits predatory pricing.

China Inc. is engaged in the same practice, although in this case, it hopes to use its mercantilist policies to gain competitive advantage in a host of key industrial sectors, and by doing so, erode the production base of advanced industrial nations. They have done this already in some sectors, such as textiles, but they are now working to move into higher value-added sectors, including semi-conductors and other IT products. The end game for them is world leadership in most advanced industrial sectors.

Beside the simple fact that their rampant mercantilist policies violate the spirit, and often the letter, of international trade rules, there are two problems with this strategy. First, this strategy is not sustainable for the global economy. It was one thing for countries like Taiwan and Singapore, to grow this way, for they were quite small. It's quite another when the largest nation on earth (and many others, like India, Russia and Brazil), see rising trade surpluses as their growth engine.

Second, and more importantly, this strategy is actually not the most effective way to raise Chinese living standards. While mercantilism might lead to some higher paying jobs in a few relatively small export-based industries, they do nothing to raise productivity in the rest of the economy. If China (and other developing nations) want raise their living standards they would be much better off abandoning their mercantilist economic strategies in favor of a growth economics strategy. Growth economics is based on the view that the path to higher incomes is by raising domestic productivity by all firms in all sectors: including in unglamorous sectors like hotels, restaurants, retail distribution, and local government services. To take just one example, the use of information technology in all sectors of the Chinese economy was responsible for 38 percent of the increase in productivity growth over the last decade. Boosting efficiency in the economy, in part by using more IT but also by creating the competitive and market conditions for firms to become more efficient is the royal road to growth.

It's unlikely that China or other nations will readily abandon mercantilist policies, as they are much easier politically than engaging in the hard struggle of building productivity. They win the favor of powerful constituents (e.g., domestic producers seeking protection from foreign IT competitors; consumers who don't want to pay for software and other digital products; workers seeking policies to protect their jobs from competition). In contrast, supporting policies to boost productivity risks the opposition of powerful interests (of unions and workers who may be displaced; domestic producers who enjoy cozy relationships and low levels of competition; and government bureaucrats whose top-down control is challenged).

As a result, it's time to develop a new global consensus that domestic productivity growth should be the key focus on economic policy in every nation. This means means stronger enforcement by global bodies like the the World Trade Organization and the World Intellectual Property Organization against beggar-thy-neighbor mercantilist strategies. It means that development organizations like the World Bank and the IMF will have not only to stop promoting export-led growth as a key solution to development, they will have to tie their assistance to steps taken by developing nations to move away from such negative-sum mercantilist policies, thereby rewarding countries whose policies are focused on spurring domestic productivity, not on protecting the status quo. Doing this will result in the kind of win-win strategy that we can all support.