Offshored Production, Dysfunctional Diplomacy and Outsourced Policy: A Three-Part Analysis on America’s Trade Decline

American Manufacturing Slowly Rotting Away: How Industries Die

I wrote in a previous article about why America's manufacturing sector, despite record output, is actually in very deep trouble: record output doesn't prove the sector healthy when we are running a huge trade deficit in manufactured goods – that is, consuming more goods than we produce and plugging the gap with asset sales and debt.

But this analysis of the problem only touches the quantitative surface of our ongoing industrial decline. Real industries are not abstract aggregates; they are complex ecosystems of suppliers and supply chains, skills and customer relationships, long-term investments and returns.

Deindustrialization is thus a more complex process than is usually realized. It is not just layoffs and crumbling buildings; industries sicken and die in complicated ways.

To take just one example, when American producers are pushed out of foreign markets by protectionism abroad and out of domestic markets by the export subsidies of foreign nations, it is not just immediate profits that are lost. Declining sales undermine their scale economies, driving up their costs and making them even less competitive. Less profit means less money to plow into future technology development. Less access to sophisticated foreign markets means less exposure to sophisticated foreign technology and diverse foreign-buyer needs.

When an industry shrinks, it ceases to support the complex web of skills, many of them outside the industry itself, upon which it depends. These skills often take years to master, so they only survive if the industry (and its supporting industries, several tiers deep into the supply chain) remain in continuous operation. The same goes for specialized suppliers. Thus, for example, in the words of the Financial Times' James Kynge, “The more Boeing outsourced, the quicker the machine-tool companies that supplied it went bust, providing opportunities for Chinese competitors to buy the technology they needed, better to supply companies like Boeing.”

Similarly, America starts being invisibly shut out of future industries that struggling or dying industries would have spawned. For example, in the words of tech CEO Richard Elkus:

Just as the loss of the VCR wiped out America's ability to participate in the design and manufacture of broadcast video-recording equipment, the loss of the design and manufacturing of consumer electronic cameras in the United States virtually guaranteed the demise of its professional camera market…. Thus, as the United States lost its position in consumer electronics, it began to lose its competitive base in commercial electronics as well. The losses in these related infrastructures would begin to negatively affect other down-stream industries, not the least of which was the automobile…. Like an ecosystem, a competitive economy is a holistic entity, far greater than the sum of its parts. (Emphasis added.)

One important example of this is the decline of the once-supreme American semiconductor industry, visible in declining plant investment relative to the rest of the world. In 2009, the whole of North America received only 21 percent of the world's investment in semiconductor capital equipment, compared to 64 percent going to China, Japan, South Korea and Taiwan. The US now has virtually no position in photolithographic steppers, the ultra-expensive machines (among the most sophisticated technological devices in existence) that “print” the microscopic circuits of computer chips on silicon wafers. America's lack of a position in steppers means that close collaboration between the makers of these machines and the companies that use them is no longer easy in the US. This collaboration traditionally drove both the chip and the stepper industries to new heights of performance. American companies had 90 percent of the world market in 1980, but have less than 10 percent today.

The decay of the related printed circuit board (PCB) industry tells a similar tale. An extended 2008 excerpt from Manufacturing & Technology News is worth reading on this score:

The state of this industry has gone further downhill from what seems to be eons ago in 2005. The bare printed circuit industry is extremely sick in North America. Many equipment manufacturers have disappeared or are a shallow shell of their former selves. Many have opted to follow their customers to Asia, building machines there. Many raw material vendors have also gone.

What is basically left in the United States are very fragile manufacturers, weak in capital, struggling to supply [original equipment manufacturers] at prices that do not contribute to profit. The majority of the remaining manufacturers should be called shops. They are owner operated and employ themselves. They are small. They barely survive. They cannot invest. Most offer only small lot, quick-turn delivery. There is very little R&D, if any at all. They can't afford equipment. They are stale. The larger companies simply get into deeper debt loads. The profits aren't there to reinvest. Talent is no longer attracted to a dying industry and the remaining manufacturers have cut all incentives.

PCB manufacturers need raw materials with which to produce their wares. There is hardly a copper clad lamination industry. Drill bits are coming from offshore. Imaging materials, specialty chemicals, metal finishing chemistry, film and capital equipment have disappeared from the United States. Saving a PCB shop isn't saving anything if its raw materials must come from offshore. As the mass exodus of PCB manufacturers heads east, so is their supply chain.

All over America, other industries are quietly falling apart in similar ways.

Losing positions in key technologies means that whatever brilliant innovations Americans may dream up in small start-up companies in the future, large-scale commercialization of those innovations will increasingly take place abroad. A similar fate befell Great Britain, which invented such staples of the postwar era as radar, the jet passenger plane and the CAT scanner, only to see huge industries based on each end up in the US. For example, the US invented photovoltaic cells, and was number one in their production as recently as 1998, but has now dropped to fifth behind Japan, China, Germany and Taiwan. Of the world's 10 largest wind turbine makers, only one (General Electric) is American. Over time, the industries of the future inexorably become the industries of the present, so this is a formula for automatic economic decline. Case in point: nanotechnology is probably the first major new industry in a century in which the US is not the undisputed world leader.

America's increasingly patchy technological base also renders it vulnerable to foreign suppliers of “key” or “chokepoint” technologies. These, though obscure and of small dollar value in themselves, are technologies without which major other technologies cannot function. For example, China recently restricted export of the rare-earth minerals required to make advanced magnets for everything from headphones to electric cars. Another form this problem takes is the refusal of oligopoly suppliers to sell their best technology to American companies as quickly as they make it available to their own corporate partners. It doesn't take much imagination to see how foreign industrial policy could turn this into a potent competitive weapon against American industry. For another example, Japan now supplies over 70 percent of the world's nickel-metal hydride batteries and 60-70 percent of the world's lithium-ion batteries. This will give Japan a key advantage in electric cars.

The Obama administration shows no awareness of any of this, despite scratching a hole in its head over why job creation has stalled. (Hint: it hasn't stalled in the nations, from China to Germany, running trade surpluses with us in manufactured goods.) It is not yet too late to reverse these dynamics, but we are definitely running out of time. So, the sooner we start questioning the sacred myth of free trade, which is largely responsible for this mess, the better.

The Obama Administration's Clueless Trade Diplomacy

Obama clearly doesn't get it yet on trade agreements.

Despite the fact that every major American trade agreement since the North American Free Trade Agreement (NAFTA) has worsened America's trade balance, he actually seems to think he can improve America's export performance by going for more, starting with a free trade agreement with South Korea.

So, it's worth taking a hard look at why America's trade diplomacy is so chronically dysfunctional. I mean, if the trade agreements our government signs are so disadvantageous to the United States, why does it sign them in the first place?

The obvious answer is, of course, special interest pressures. Realpolitik in the name of the national interest is a joke; what we have is multinational corporations headquartered in the United States passing themselves off as American and calling the shots.

Even worse, many of the largest American companies are now so dependent on their overseas operations, and thus so vulnerable to pressures by foreign governments, that they have become outright Trojan horses with respect to American trade policy. As former Congressman Duncan Hunter (R-California) – for years one of the outstanding critics of trade giveaways in Congress – has put it, “For practical purposes, many of the multinational corporations have become Chinese corporations.”

At some point, the nationalists and the capitalists in the Republican Party will necessarily come to blows over this. Tea Party, are you listening?

The more profound answer, however, is that our government signs these treaties simply because it does not take their dangers seriously. Why? Because of its underlying economic assumptions about the universal benevolence of free trade. This is the deeper kind of special-interest corruption: when special interests are so entrenched in a society that the society has lost the power to distinguish their interests from those of society at large. The universities where America's diplomats, economists, politicians and journalists are trained are, of course, funded (and their boards of trustees filled with) the same corporate interests that also lobby directly for “free” trade. So what do you expect?

This corruption is often quite subtle, as befits a rich developed nation. It is not Soviet-style indoctrination. For example, the naive assumptions about economics that our trade diplomats have rarely consist in outright intellectual fanaticism about the economics of free trade. That is easy enough to find in academia and the strange wonderland of the editorial pages, but quite rare in our trade negotiators and diplomatic service generally. Instead, there is usually a hazy, almost undergraduate, sense that “economics says free trade is best” which renders our trade negotiators helpless in the face of corporate pressures for more trade agreements.

This helplessness is worsened by inexperience and a lack of institutional memory about past negotiations. And when our trade negotiators work to open foreign markets, they usually do so willy-nilly, with no sense that some industries are more strategic than others. This assumption is profoundly wrong, as it ultimately comes down to the idea that all industries are alike in their value for our economic future. This was epitomized by an infamous (and subsequently denied) comment by Michael J. Boskin, George H.W. Bush's chairman of the Council of Economic Advisers: It doesn't matter whether America exports computer chips, potato chips or poker chips! They're all just chips!

This is, of course, nonsense, as has been pointed out even by mainstream establishmentarian economists like Laura D'Andrea Tyson, chairwoman of Bill Clinton's Council of Economic Advisers, who observed that:

The composition of our production and trade does influence our economic well-being. Technology-intensive industries, in particular, make special contributions to the long-term health of the American economy. A dollar's worth of shoes may have the same effect on the trade balance as a dollar's worth of computers. But … the two do not have the same effect on employment, wages, labor skills, productivity and research – all major determinants of our economic health.

The Obama administration doesn't seem to grasp this. Apparently, it's just fine for America to sell Korea beef and they can sell us cars. Like a well-behaved colony, it's our job to be a captive market and supplier of raw materials.

More generally in our trade diplomacy, superficial attempts at hard bargaining occasionally reflect some well-organized industry that has managed to flag the attention of Congress, but are mainly just posturing. America's trade bureaucrats have little sense of loyalty to American industry or understanding that their efforts must ultimately be judged by quantifiable success in America's trade balances.

Supremely confident in its own brilliant trade performance, the US government spends billions trying to help other nations improve theirs. In 2008, the United States spent $2.3 billion on its various Aid for Trade programs, and it remains official US policy to be “the largest single-country provider of trade-related assistance, including development of trade-related physical infrastructure.” The 9/11 attacks intensified this effort; apparently what Osama really wants is to export.

American efforts to negotiate reasonable trade agreements are often handicapped by the fact that some American politicians have an unrealistic idea of international law. International law is not like ordinary civil or criminal law because there exists no sovereign to compel the obedience of nations. Instead, it is analogous to the rules of a game of stickball being played by children on a vacant lot: its rules only mean anything insofar as they are enforced by the players upon themselves. Obviously, as in the case of stickball, the players will enforce certain rules because that is the only way they can have a game. So, international law is not a completely vacuous concept, as some cynics suggest. But the players also won't enforce any rule grossly to the disadvantage of any particularly powerful player.

This means that the Anglo-American legal framework Americans tend to take for granted simply does not exist internationally, and therefore that a trading model based upon neutral and consistent enforcement of legal obligations is not feasible. There is no way to take power politics out of trade, which means that there is no way to leave everything in the hands of a neutral and rational free market once we but construct the right international legal machinery – otherwise known as the World Trade Organization (WTO).

On some level, I have to assume that many of the big power players are well aware of this, but, since this puppet show aggrandizes both the relentlessly power-accreting bureaucrats of the WTO and the multinationals, neither has any reason to let the cat out of the bag in public. So the game goes on, with a quasi-fictional legal order implementing fantasy economics.

And at the middle of it all, the president – who, despite being a serious scholar of such subjects as, say, constitutional law, appears to have no economic ideas of his own – seems blissfully unaware of all this. He just does what his Clinton-retread advisors tell him to do.

How appropriate that in the America of 2011, even our economic policy has been outsourced.

Currency Revaluation Won't Fix America's Trade Mess

It is sometimes suggested that our trade problems (job losses, international indebtedness) will go away on their own once currency values adjust. Bottom line? A declining dollar will eventually solve everything.

In the short and medium term, of course, foreign currency manipulation will prevent currency values from adjusting. But even if we assume currencies will eventually adjust, there are still serious problems with just letting the dollar slide until our trade balances.

For one thing, our trade might balance only after the dollar has declined so much that America's per capita GDP is lower, at prevailing exchange rates, than Portugal's. A 50 percent decline in the dollar from early 2011 levels would bring us to this level. And how big a decline would be needed to balance our trade nobody really knows, especially as we cannot predict how aggressively our trading partners will try to employ subsidies, tariffs, and nontariff barriers to protect their trade surpluses.

Dollar decline will write down the value of wealth that Americans have toiled for decades to acquire. Ordinary Americans may not care about the internationally denominated value of their money per se, but they will experience dollar decline as a wave of inflation in the price of imported goods. Everything from blue jeans to home heating oil will go up, with a ripple effect on the prices of domestically produced goods.

A declining dollar may even worsen our trade deficit in the short run, as it will increase the dollar price of many articles we no longer have any choice but to import, foreign competition having wiped out all domestic suppliers of items as prosaic as fabric suitcases and as sophisticated as the epoxy cresol novolac resins used in computer chips. (Of the billion or so cellular phones made worldwide in 2008, not one was made in the United States.) Ominously, the specialized skills base in the United States has been so depleted in some industries that even when corporations do want to move production back, they cannot do so at feasible cost.

Another problem with relying on dollar decline to square our books is that this won't just make American exports more attractive. It will also make foreign purchases of American assets – everything from Miami apartments to corporate takeovers – more attractive, too. As a result, it may just stimulate asset purchases if not combined with policies designed to promote the export of actual goods.

A spate of corporate acquisitions by Japanese companies was, in fact, one of the major unintended consequences of a previous currency-rebalancing effort: the 1985 Plaza Accord to increase the value of the Japanese yen, which carries important lessons for today. Combined with some stimulation of Japan's then-recessionary economy, it was supposed to produce a surge in Japanese demand for American exports and rectify our deficit with Japan, then the crux of our trade problems. For a few years, it appeared to work: the dollar fell by half against the yen by 1988, and, after a lag, our deficit with Japan fell by roughly half, too, bottoming out in the recession year of 1991. This was enough for political agitation against Japan to go off the boil, and Congress and the public seemed to lose interest in the Japanese threat. But only a few years later, things returned to business as usual, and Japan's trade surpluses re-attained their former size. Japan's surplus against the United States in 1985 was $46.2 billion, but by 1993 it had reached $59.4 billion. (It was $74.1 billion in 2008 before dipping with the recession.)

Relying on currency revaluation to rebalance our trade also assumes that the economies of foreign nations are not rigged to reject our exports regardless of their price in local currency. Many nations play this game to some extent: the most sophisticated player is probably still Japan, about which the distinguished former trade diplomat Clyde Prestowitz has written:

If the administration listed the structural barriers of Japan – such as keiretsu [conglomerates], tied distribution, relationship-based business dealings, and industrial policy – it had described in its earlier report, it would, in effect, be taking on the essence of Japanese economic organization.

We cannot expect foreign nations to redesign their entire economies just to pull in more imports from the United States.

In any case, the killer argument against balancing our trade by just letting the dollar fall comes down to a single word: oil. If the dollar has to fall by half to do this, this means that the price of oil must double in dollar terms. Even if oil remains denominated in dollars (it is already de facto partly priced in euros) a declining dollar will drive its price up. The United States, with its entrenched suburban land-use patterns and two generations of underinvestment in mass transit, is exceptionally ill-equipped to adapt compared to our competitors.

Fundamentally, allowing the dollar to crumble is a way of restoring our trade balance and international competitiveness by becoming poorer. That's not what Americans want, or should want. A tariff is a much better solution.