Industrial policy in an era of a changing political economy

The death knell of globalization and free trade has been sounded over the past several years as nations have imposed tariffs and embraced industrial policies to protect vital industries.

For the past five decades, the economics of efficiency has dominated the trade and financial framework.

The logic of free trade was given primacy over localized distributional concerns when it came to jobs, wages and wealth creation.

That time has clearly passed, and industrial policy will be the primary organizing framework for trade, technology transfers and global finance.

Today, a new framework is emerging around a type of political economy that puts localized concerns around jobs and wages first and then expects those who participate in international trade to accommodate those concerns, primarily through the absorption of higher prices that come with such arrangements.

While we have significant reservations around the deviation from free trade and movement of capital—the result will be suboptimal, leading to a permanent increase in prices and inflation and, we would argue, less overall wage growth—that framework is the new political economy.

But reports of free trade’s demise have been greatly exaggerated. Free trade isn’t dying; it’s just changing.

Global exports increased at an average annual rate of 9% from 1969 before peaking in 2022, according to the International Monetary Fund.

Since then, the volume of global exports has declined, in no small part because of the decline in China’s exports of manufactured goods.

China needs its trading partners as much as they need China. The idea that there should be a total retreat from global trade or from trade with China is misplaced.

Globalization and trade will continue, but within constraints imposed because of national security concerns and the rapid shift in technology.

Economies in the West will continue to benefit from lower-cost imports, with smaller economies in Asia picking up the slack in those products as China moves up the economic ladder.

Still, the tariffs imposed in recent years show how much global trade has evolved, from the doctrine of free trade to the embrace of industrial policies today.

For a few decades, the West fostered the free flow of capital as a way to promote economic growth and efficiency. But that dynamic has shifted toward a more protectionist stance as political and economic pressures have changed.

But this new reality does not require sealing off our borders. Abandoning trade would be as catastrophic for the U.S. economy as it would be for the global economy.

Instead, we view friendshoring of production, tariffs on China and the freezing of Russian financial assets as essential for national security as they are for the competitiveness and growth of the U.S. economy. 

The devolution of free trade

There are two defensible reasons to impose tariffs: national security, and protecting infant industries from the dumping of cheap goods.

The ideal of the global economy, with minimal tariffs and a free flow of goods and services, has devolved into the reality of two geopolitical trading blocs: the liberal democracies in the West engaged in the rules-based framework embodied by the World Trade Organization, and the authoritarian regimes engaged in the mercantilism of state-run enterprises.

To put it in simpler terms, we are talking about how to deal with China. Russia has removed itself from the global economy with its invasion of Ukraine, and the member nations of OPEC are trying to diversify away from oil.

China, though, will remain an important trading partner. To declare economic war on the world’s second-largest economy would be as disastrous for the global economy as it would be for China itself.

The goal, then, is to prevent China from undermining the self-sufficiency of the West through its dumping practices, and to protect U.S. national security interests.

But the framework provided by the World Trade Organization has been ineffective. It did not prevent Japan’s dumping of steel in the 1970s and ’80s and, more recently, China’s dumping of steel and solar panels. 

We think that the Western economies need to better coordinate industrial policies to promote the production of essential products and disallow the use of dumped products.

For example, rather than the U.S. simply slapping tariffs on imports of Mexican steel products, Mexico said on July 10 that it had agreed to require importers of steel to provide more information about a steel product’s country of origin. The new rule is intended to prevent countries that do not participate in free trade agreements from evading import restrictions. 

At the same time, the United States will implement new requirements on the manufacturing process to further protect U.S. manufacturers.

For the United States, the transition should not bring that much of a change. Since late 2022, its largest trading partners have been the euro area, Mexico, and Canada, followed by China, which has taken on a decreasing role.

U.S. trade with the democracies in North America, Europe and Asia accounts for roughly 60% of all American trade.

China’s reduced role in recent years is because of its “zero-COVID” policy and the realization of the West that it could no longer rely so heavily on China as a manufacturing center.

Finally, Western economies can assure China that they have no intention of cutting off all ties, but rather aim to promote self-sufficiency by protecting access to essential goods.

What could go wrong?

Research by the economists Ben Bernanke and Olivier Blanchard shows that the inflation shock of recent years was initially caused by the abrupt disruption to the supply chain during the pandemic shutdown.

So why would the West risk cutting itself off from the largest producer of cheap goods?

After all, it took 50 years of trial and error to come up with the World Trade Organization in 1995. And the impact of the haphazard imposition of tariffs in 2018 and 2019 should be reason enough to think twice about disrupting North American trade, much less global trade.

In addition, we should not lose sight that, according to the Economic Innovation Group, median hourly wages grew by 35% once one adjusts for inflation from the free trade era of 1980 to 2023, and they grew fastest for women.

There are significant reasons why the U.S. should move carefully as it gives industrial policy primacy in trade and global finance.

There are a host of reasons to maintain the status quo or to tinker around the edges and hope for the best.

Here are three examples of why policy changes need to be carried out carefully.

The cost of tariffs

Limiting the supply of goods through tariffs or import restrictions merely shifts the additional cost to households and businesses. There is no cost to producers, which simply pass along the higher costs. Instead, tariffs become a tax on household and business consumption.

Take, for instance, the 100% tariff on China’s electric vehicles, which sell for as little as $15,000. A Chevy Bolt costs about $30,000. So, after applying the tariff, U.S. households would pay an additional $15,000 no matter which vehicle they choose.

Tariffs are taxes that firms and consumers pay. Over time, they result in a higher inflation rate.

A slower transition from fossil fuels

If the goal is to end the West’s dependence on fossil fuels, why cut off the cheapest source of solar equipment and battery-powered vehicles?

Arguably, the West could reduce its carbon emissions more rapidly by embracing the cheaper green energy products from China.

The counterargument is that relying on the decision-making of autocratic regimes leaves democracies open to the threat of shortages and price controls. Just as the oil embargoes of the 1970s brought on soaring inflation, the trade disruptions during the period of China’s zero-COVID policy should be reason enough not to put our inflation rate in someone else’s hands.

The likelihood of workarounds

Telling the smaller economies that they must restrict trade with China might be a difficult sell for those who would benefit.

For instance, the boycott of Russian oil by the West following its invasion of Ukraine has had mixed results, with India and China willing buyers of discounted Russian oil.

Closer to home, asking Mexico to refuse Chinese investment in assembly factories, which turn Chinese parts into electric vehicles or solar panels for sale in the U.S., puts Mexico and U.S. policymakers in a difficult position.

For Mexico to forgo the benefit of Chinese investment, the U.S. would have to either impose crippling tariffs on our largest trading partner or counter China’s investment with investment by the U.S auto industry.

The first option would impose significant costs on U.S. households; the second option is a large-ticket item for U.S. labor unions and politicians to accept.

The return of dumping

According to the World Trade Organization, a product is being dumped if it is introduced into another country at less than its normal value.

The dramatic shifts in the price of steel over the years offer evidence of severe drops in price that appear unrelated to normal shifts in supply and demand.

The prime example is the dislocation caused by Japan’s steel dumping of the 1970s and ’80s that affected mill towns from Pennsylvania to Indiana and is being replayed 45 years later, this time with China as the protagonist.

The Treasury Department has found that international trade in steel has been plagued by unfair trade practices and excessive worldwide steelmaking capacity.

In addition, the failure of existing trade statutes to deal effectively with unfairly traded steel imports had led to the deferral and cancellation of many investment projects.

We would add that allowing the consolidation of the steel industry was a policy failure that played a role in the lack of investment in U.S. steel in the postwar era, the nation’s loss of industry competitiveness and its eventual loss of market share.

Today, it is not just the U.S. steel industry that’s concerned. China is accused of dumping steel throughout Southeast Asia, most likely in response to the lack of demand from its slumping real estate market.

As for green energy, the wide swings in the price of silicon seem unrealistic with regard to supply and demand. China’s dumping of solar panels and basic commodity inputs can be looked on as advantageous for efforts in the West to eliminate carbon emissions. 

The return of industrial policy

The West abandoned its zero-sum belief in mercantilism with the creation of the World Trade Organization to foster a system of rules-based free trade.

In the process, the West abandoned currency controls and fostered the financial order needed to fund private development.

Globalization peaked around 2015. Tariffs were minor and trade associations proliferated. China and the United States were linked by extensive flows of trade, capital and labor. As noted by the economist Gordon Hanson, supply chains spanned dozens of countries.

But this hyperglobalization began to erode in 2018, when the U.S. raised tariffs on imports of Chinese solar panels and washing machines. Those tariffs led to a trade war that devolved into a global manufacturing recession.

Now, the Biden administration has upped the ante, raising tariffs mostly without criticism.

Has the concept of a global economy succumbed to the reality of geopolitically inspired protectionism? Or are the Biden tariffs a necessary response to China’s efforts to corner markets? According to the Biden administration, this latest round of tariffs was designed to protect the U.S. supply chain and to shield government and private investments in critical industries.

There is a segment of the political class that, as Hanson writes, still imbues manufacturing with near-mystical significance and sees trade deficits as the only metric that matters for evaluating trade agreements.

The recent embrace of industrial policies by the U.S. initially drew the concern of our allies. But these fears appear to have dissipated. We attribute this ambivalence to our allies protecting their U.S. investments, to joint defense concerns, and to the concern of China cornering markets.

If anything, the shift toward industrial policies will only accelerate, if the recent speech by the former European Central Bank President Mario Draghi is any indication.

In defense of industrial policy

In the second half of the 1990s, the U.S. technology sector brought the world into the era of personal computing. By 2002, the U.S. was running a trade deficit in advanced technology products. By 2020, during the pandemic, the American auto industry ran out of computer chips, which created a shortage of available cars and led to higher inflation.

Since then, Western governments have reconsidered their role in vital industries, like semiconductors.

The takeaway

Most economists will tell you that in an open economy, the government should have a minimal role in economic decisions—that the market will dictate what is produced and what is consumed. The government should step in only in the case of market failures.

As it turned out, putting all our production eggs in China’s basket was OK until it wasn’t. The pandemic became a harsh reminder that market failures exist and that our national security requires access to essential industries.

It is easy to understand the importance of the aerospace industry. It should be just as easy to understand the necessity of maintaining the ability to produce semiconductors, solar panels, electric vehicles and medical equipment.