China, Issues, Trade

Free trade requires rules

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“Agreements are worthless without enforcement… [T]he [World Trade Organization] WTO involves a long list of commitments by the member countries, as we have seen above.  But without some mechanism to enforce these agreements, countries will depart from them whenever they perceive it in their interest to do so, which it often will be.”

That was World Trade Organization (WTO) proponent Alan V. Deardorff in 1996, warning — astutely as it turned out — that world trade rules and free trade agreements were rather fragile arrangements. That to be long-lasting, the structures, such as the proposed 12-nation Trans-Pacific Partnership, would certainly require enforcement when parties to the organization broke the rules and raised trade barriers.

The Deardorff paper, from very early in the WTO period (the organization convened in 1995), makes the critical observation that every country has an individual incentive to raise trade barriers to protect domestic producers. But if everyone uses them, everyone winds up worse off as global trade grinds to a halt. Likening it to a worldwide prisoner’s dilemma — a hypothetical where two prisoners are held separately, both with an incentive to confess to the crime and testify against the other first — Deardorff proposes a mechanism where parties can come to agree, if not to rat each other out, then not to harm each other in global trade.

Free trade requires rules. Otherwise, they lack the necessary incentives to remain within the agreement’s framework.

Mind you, the paper was in favor of the WTO, lowering trade barriers, reducing tariffs and the like. But enforcement and dispute resolution were always anticipated as a means of keeping the agreement intact. Assuming strict compliance is the realm of philosophy, if not fantasy. In the real world, agreements require work to be sustainable.

Since that time, China entered the WTO in 2001. And in that time, Beijing has devalued its currency and stockpiled a horde of U.S. dollar-denominated assets including treasuries, mortgage-backed securities, corporate debt and equities, now at almost $1.7 trillion, in a bid to reduce the cost of Chinese exports to the world and to increase price of imports.

China does so by gradually reducing the value of the yuan below the dollar using its peg, which can be viewed quite transparently on the Bank of China’s website. The value since 1994 has ranged from 1 dollar equaling on a fixed basis as many as 8.62 yuan to about 6 yuan in 2014.

Now, in the wake of the massive economic correction in the Pacific, China is engaged in another massive devaluation, down 3 percent against the dollar in 2016 alone. Now, one dollar is worth about 6.69 yuan (and rising).

There is little question this affects the prices of exports and imports globally. An Oct. 2015 World Economic Outlook from the International Monetary Fund (IMF) study of 60 economies including China found that “A depreciation in an economy’s currency is typically associated with lower export prices paid by foreigners and higher domestic import prices, and these price changes, in turn, lead to a rise in exports and a decline in imports. Reflecting these channels, a 10 percent real effective exchange rate depreciation implies, on average, a 1.5 percent of GDP increase in real net exports,” which much of the increase happening in the first year.

So, China is again devaluing its currency once again to boost exports — a de facto subsidy on its exports and a major tariff against everyone else’s. So where is the WTO in enforcing the agreement?

Nowhere.

As noted by the Congressional Research’s Jonathan E. Sanford in 2011: “The International Monetary Fund (IMF) has jurisdiction for exchange rate questions. The World Trade Organization (WTO) is responsible for the rules governing international trade. The two organizations approach the issue of ‘currency manipulation’ differently. The IMF Articles of Agreement prohibit countries from manipulating their currency for the purpose of gaining unfair trade advantage, but the IMF cannot force a country to change its exchange rate policies. The WTO has rules against subsidies, but these are very narrow and specific and do not seem to encompass currency manipulation.”

In fact, the entire body of world trade rules — after decades of negotiation — somehow failed to foresee the obvious impact exchange rates might have on the prices of exports and imports.

But not so fast, the apologists for China interject. Neither the U.S. nor the WTO or anybody else should act against China, because China — by dumping, hording foreign exchange reserves, expanding global market share and devaluing the yuan thus subsidizing exports and taxing imports — is actually acting in our interests. After all, we get cheaper goods in the process and the goal of trade is to have imports.

Take noted George Mason University Professor Donald Boudreaux, who in response to a piece by this author in April wrote, “If and to the extent that Beijing’s policies allow Americans to buy Chinese-made goods at artificially low prices, we Americans should feel pity not for ourselves (for we are artificially enriched by such policies) but, instead, for the Chinese people.  It is they, if your premise is correct, who are losing.  The Beijing government (again, assuming your premise to be correct) is waging war, not against us, but against its own subjects.”

The Boudreauxs of the world say to simply ignore the rules that might punish China and other currency manipulators, apparently even in venues such as the WTO, because then everyone is worse off. We would be deprived of the cheap goods and worse, it might provoke a trade war. And in any event they are harming themselves, not us.

Of course, that defies the very premise of free trade agreements and entering organizations like the WTO on a mutual basis — with the goal of lowering trade barriers and because if everyone enacts trade barriers then everyone is harmed.

So, let’s take non-enforcement on its face. Inaction on the part of the WTO and trading partners on the issue of currency incentivizes other countries to raise trade barriers by devaluing their currencies, too.

By the free traders’ own logic that makes everyone else worse off. Weakness is more provocative than enforceable rules.

It’s like not fixing a broken window after a break-in and then expecting the rest of the neighborhood to continue behaving.

Or, it might be akin to having an international convention against nuclear weapons, but then failing to enforce it, making it more likely that one party will break the agreement with others following rapidly.

Similarly, free trade requires rules. The world lacks a single governing authority, currency and other trappings of a sovereign state — thank goodness. So for this to work requires a treaty framework of some sort and cooperation among trading partners not to harm one another.

Lacking that, turning a blind eye to trade cheaters in international venues like the WTO and the IMF on the issue of currency is already resulting in an increase in trade barriers, not a decrease. Other countries are getting in on the currency games, too, dwarfing prior tariff regimes by orders of magnitude not seen, as noted by a study of several nations by the Peterson Institute in 2012.

Those who are saying “do nothing” in the face of obvious trade barriers have actually made a trade war more likely, since they actually encourage others to raise trade barriers as well thanks to inaction.

Nobody ever argued for the WTO or NAFTA or any other trade agreement on the basis that it would not be followed when one side broke it. If such a proposition had been put to Congress — or any other country which has never enacted a zero tariff in modern economic history — to lower its tariffs but the rest of the world will not, it would have been soundly defeated.

If we want to have free trade, let’s have it — with enforceable agreements. By ignoring trade barriers like currency manipulation, the WTO and IMF are pushing the world further away from the goal of free trade and justifying actions by individual nations to protect domestic producers, which becomes the most likely outcome. Escalation seems inevitable. In the end, everyone will lose.

This is a guest post by Robert Romano senior editor of Americans for Limited Government.

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