26 October 2018

What Goes Around Comes Around

I attended a dinner last week where the topic of the United States-Canada-Mexico Trade Agreement (USMCA) came up, with the central question focused on the significance of the agreement. One guest put it in the “did no harm” category—a lot of constructive tweaks on digital trade, intellectual property, state-owned enterprises, and other “upgrades” I’ve discussed in previous columns, and compromises on most of the more unsettling administration demands like a sunset clause. However, others, including me, offered a more ominous interpretation—USMCA, along with some other initiatives, essentially heralds a return to managed trade, albeit a soft one, at least so far.

For those of you who did not live in the pre-WTO era or who were there but not paying attention, “managed trade” is the idea that governments in some cases should control trade levels through mechanisms like quotas and tariffs in order to achieve politically desirable results. It is not exactly a rejection of market principles, though it certainly contradicts them. Rather, it is the suggestion that sometimes the market does not work properly, and government needs to step in to set things right. Sort of guiding Adam Smith’s “invisible hand.” Some will argue that managed trade is just an elegant term for protectionism, and they would have a point, but the concept is a bit more sophisticated than that if done right. I’ll discuss the merits below, but first a word about why I think we are heading down that road.

First, no one should be particularly surprised. In an earlier column, I referred to Ambassador Lighthizer as “lost in the ‘80s” because of his enthusiasm for voluntary export restraints and other instruments of managed trade, which he employed against Japan at that time. (This, by the way, is still 30 years ahead of President Trump, who remains lost in the ‘50s.) Both the president and the ambassador have signaled their fondness for trade restraining mechanisms, although they usually justify them as a tactic to get us to freer trade at the end of the day. The fact that we have yet to get to the end of the day in most of these efforts tends to be forgotten.

The USMCA heads us toward managed trade in the automobile sector. In addition to more onerous content requirements, side letters attempt to address the possibility of companies deciding to ignore the requirements and simply import their autos and pay the 2.5 percent tariff, a strategy that makes sense if compliance costs and supply chain shift costs would exceed the amount of the tariff. To head that maneuver off at the pass, the side letters impose quotas on that alternative. The restrictions are modest—they are relevant only in the event the president imposes additional tariffs on autos for national security reasons, which he has not done (yet)—and the quota levels are set significantly above current import levels. So, there is no immediate impact, and any effects are likely to be modest and a good way down the road.

But the principle of managed trade has now been established. The three countries have agreed that quotas are an acceptable means of managing trade in this sector, which leaves the U.S. administration with the opportunity to try to ratchet down the quotas later on in a separate negotiation. Further demonstrating this trend, there is now a serious discussion about converting the steel and aluminum tariffs on Canada and Mexico to quotas, just as we did with South Korea. That is also a signal to Japan and the European Union to expect the same in their impending negotiations with us. If quota agreements are reached, we will have a significant portion of the global economy accepting the principle of managed trade, at least in these sectors.

It is easy for economists and trade philosophers to condemn this approach as fundamentally anti-market, protectionist, and growth limiting, and we will no doubt hear a lot of that as the administration’s policy becomes more obvious. However, I think the issue is more complicated than that, at least in steel. In that case, we have a problem with global overcapacity primarily caused by a single large producer—China. This is also not a surprise. In economies where credit is allocated by the state for political reasons and no one is reading market signals, overcapacity is inevitable.

Since China has thus far been unwilling or unable to take the hard steps necessary to correct the global problem it has caused, the world’s other steel producers have little choice but to take matters into their own hands if they want to survive. The U.S. tariffs, clumsily imposed and administered, have nevertheless been the catalyst for others to consider similar restraints. The effect, if it is done properly, will be to make the Chinese eat the surplus they have created rather than dump it on the rest of the world and thus put the burden of adjustment where it belongs. That also means we end up in a world of managed trade in steel, but it will be because of genuine market failure due to Chinese subsidized overcapacity.

Can you generalize that argument, and, particularly, can you apply it to autos? Almost certainly not—it is hard to find the same kind of market failure in autos or many other sectors. That is why managed trade coming around again is an ominous development—not because it is always a mistake but because the current administration does not know where to stop.

William Reinsch holds the Scholl Chair in International Business at the Center for Strategic and International Studies in Washington, D.C.

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