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MANUFACTURING A TRADE POLICY IN AN ERA OF CHANGE (Senate - July 11, 1989)

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Mr. DANFORTH. Mr. President, last fall, the distinguished Senator from Pennsylvania [Mr. Heinz] wrote an article for the Journal of International Affairs entitled `Manufacturing a Trade Policy in an Era of Change.'

Few among us have been as actively involved as the Senator from Pennsylvania in the deliberations on U.S. trade policy in recent years. Certainly no one is as well versed as he in the intricacies of our antidumping and countervailing duty laws, or has as extensive an understanding of the President's steel program. He has devoted an immense amount of time and energy to understanding our trade laws, and I am honored to have had the opportunity to work with him in shaping major trade legislation during the past decade.

`Manufacturing a Trade Policy in an Era of Change' is an important article. Delving beyond the surface images of a healthy U.S. economy, it offers a sobering review of our current competitive position. Relying on extensive new research by the Office of Technology Assessment, the article highlights the important contributions of the manufacturing sector to our trade balance and describes the extent to which the competitive position of this sector has deteriorated in recent years. It also includes a substantive explanation of the rationale underlying the Omnibus Trade Act of 1988, and emphasizes the critical point that trade and commercial considerations must be given a prominent place in our policymaking process. Finally, the article offers some specific prescriptions for change--in both attitude and policy--so as to come to grips with our persistent trade imbalance.

Everyone may not agree with each of the proposed solutions, but this article certainly represents a worthwhile contribution to the ongoing debate about U.S. trade policy. I commend my distinguished colleague from Pennsylvania for his work, and ask that the text of the article be printed in full in the Record.

The text of the article follows:

From the Journal of International Affairs, Fall 1988

[FROM THE JOURNAL OF INTERNATIONAL AFFAIRS, FALL 1988]

Manufacturing a Trade Policy In an Era of Change

(BY JOHN HEINZ)

With the era of eight years of Ronald Reagan drawn to a close--which no doubt fills some with gloom and others with enthusiasm--there is an opportunity to stop to take measure of where the United States is economically and where President George Bush will have to lead us. Determining the proper direction, not to mention exercising the leadership, is no small task, since there remains fundamental disagreement among economists and those who claim to be economists over the state of the American economy, how we got here (wherever it is that we are) and where we go from here. Respectable prescriptions range from more of the same--an updated version of `stay the course'--to radical change.

This article will provide one perspective on those questions by arguing that the United States has some fundamental long-term problems despite the surface good news; that we have reached this point through years of poor management and concentration on the wrong issues; and that we need a new, more coherent approach. My recommendations will not represent a radical departure, but will require a new, more precise calculation of our interests and, most importantly, will insist that we act with those interests in mind rather than with an idealized view of a world trading system that fits our fantasies rather than reality.

WHERE WE ARE AND HOW WE GOT THERE

On the surface, at least as of this writing, the economic picture is suffused with good news. Unemployment is down to levels not seen in fourteen years. At the same time, inflation has stayed low and interest rates, while up from their trough, are not rising rapidly. We stand in stark and favorable contrast to the European Community (EC) in our job-creating ability.

Digging beneath the surface, however, reveals a few slugs and other undesirables crawling around. The high standard of living we enjoy and the consumer buying binge that has been such an important part of it, have produced the largest budget and trade deficits in our history--the former, ironically, a piece of Keynesian pump priming in supply-side clothing that the most liberal of economists would not have thought possible ten years ago.

Maintaining this pleasant but inevitably unstable equilibrium has required a massive inflow of foreign investment that has kept us afloat but has had two more ominous consequences. First, foreign investors give signs of beginning a move out of financial instruments and into equity, including real estate and some high profile industries that are causing many in Congress to have second thoughts about the unqualified benefits of foreign ownership. Japanese interests now own about 40 percent of the office space in downtown Los Angeles. 1

That may or may not be bad, but it should make one think abut the direction in which our economy is heading.

1 Footnotes at end of article.

The second result of our twin deficits is a debt greater than any nation's in the world. Americans will pass this debt on to their children and grandchildren for payment, payment which will come in the form of harder work for lower wages and a lower standard of living than we have enjoyed.

As our debt grows, we are losing our capacity to control our own destiny. We are facing constraints on our scope of action due to our dependence on the continued inflow of foreign funds. We have been told, primarily by the Reagan administration, that the cost of pressng Japan or Europe too hard on other bilateral matters could well result in the redirection of foreign funds to other areas, a consequence that would force us to pay our own debts.

It is understandable that this would be an unwelcome development for the administration in power, since it would lead to a significant reduction in demand and/or increases in productivity, which translates into, at best, working harder for less and, at worst, into a recession. Yet extricating ourselves from our debt burden will inevitably mean the same sooner or later. Is it better to begin that process now when it is manageable or later when it is not?

The Reagan administration's benign neglect of the international economy from 1982 to February 1985, followed by its frantic efforts to control this process, led to the roller coaster ride the dollar has experienced over the last six years. First forced to the economic equivalent of Mt. Everest by foreign demand, the administration has now plunged into the Grand Canyon in a vain effort to reverse the tide of imports that led to the rise in the first place. This ride, lasting more than three years, has treated the public to one of the more abstruse policy debates in many years. This debate has concerned the `J-curve,' the function which is supposed to demonstrate how exports will recover with the dollar's decline. More than a year ago, in my comments in the Finance Committee report on the Senate trade bill, I mentioned that the `J-curve' in fact was more like an `L,' and little has happened since then to change that view. 2

The reason for this discrepancy is rather simple. When the dollar began to fall in late 1985, foreign producers reacted in a perfectly rational way, but not the way economic textbooks predicted. Instead of predictably raising prices to accommodate the currency devaluation, foreign producers kept prices down and sacrificed profits to maintain market share. The result was a continued influx of imports and the rather sad spectacle of the administration's bragging that the monthly trade deficit had fallen first to `only' $12 billion and more recently to $9 billion, figures that might have represented an annual tally fifteen years ago.

Recently, there appears to be some evidence that exports are increasing, thanks to the low dollars, but there is still no evidence that imports are declining. Because this is a necessary part of the equation, the result has been a string of monthly deficits that remain at historic levels.

Another crippling impact of the high dollar is that during the mid-1980s it stimulated the movement of manufacturing offshore. Moving manufacturing back to the United States in order to benefit from a relatively lower dollar, of course, is not so easy. We have been forced to learn to live with the internationalization of our production as well as our consumption, a development, as will be discussed below, that by itself requires a sharp shift in perspective.

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THE MANUFACTURING SECTOR 3

Just as some animals were more equal than others in Animal Farm, some economic sectors are more equal than others when it comes to measuring our overall health. The manufacturing sector is arguably the most important, both in its contribution to our current problems and in the role it must inevitably play in their solution. Discussing solutions requires a detailed understanding of what has been going on in this sector, and it is precisely this question that has been the subject of greatest controversy.

In my judgment, the manufacturing sector has suffered particularly severely from the macroeconomic changes I have discussed, although elaborating on that statement requires both careful definition and a look at some new data.

Careful definition means avoiding labor's mistake of defining a sector's health solely in terms of the number of jobs, and the economists' mistake of defining it solely in terms of gross output or share of GNP. It also means use of appropriate data. Everything looks better compared to 1982, for example, but for precisely that reason the snapshot is not very revealing.

In terms of jobs, the real picture is mixed. Manufacturing's share of employment has declined, as has the absolute number of jobs in the sector since the 1979 peak. In 1979, there were 21 million manufacturing jobs; by the end of 1987 there were 19.4 million jobs, more than in 1986 but still below the peak.

Some of this decline was due to productivity growth--an average of 3.5 percent per year from 1979 to 1986. At the same time, another part of the decline was due to imports, either directly or through their role in forcing the closure of inefficient plants. This was particularly true in industries where demand was flat or increasing slowly, like steel, textiles and autos. While the late President John F. Kennedy summarized a useful economic truth when he said, `A rising tide lifts all boats,' it is also true that when the sea is calm, some boats sink anyway--stagnant demand leaves an industry vulnerable to imports whether these are the result of fair or unfair trade practices--and the workers suffer inevitably because the industry shrinks, either through its lack of competitiveness or its improvements in productivity that allow it to shed workers.

Determining manufacturing's share of GNP, as a new Office of Technology Assessment (OTA) study points out, is fraught with difficulty. Measured in current dollars, the share dropped from 29 percent in 1960 to under 20 percent in 1986, with an increasing rate of decline since 1979. Current dollar analyses, however, fail to deal adequately with productivity improvements.

Constant dollar calculations, on the other hand, vary depending on the assumptions made and the years chosen. For example, the OTA study makes clear that in 1982 dollars, manufacturing has been a steady 21 or 22 percent of total output since the late 1940s; whereas, using 1972 constant dollars it has hovered around 24 percent; and with 1958 dollars around 30 percent. Each constant dollar revision appears to produce a reasonably straight line, but at a lower level.

This phenomenon is related both to the different weights given to industry inputs in different years that distort the actual structure of the economy in previous years, as well as the need to adjust for quality and performance improvements in products that are nominally the same from year to year. (A 1952 and a 1986 care are statistically the same thing, but in terms of actual performance or quality are light years apart.)

In addition, the 1982 results are skewed by the performance of the nonelectrical machinery sector, which included computers, whose gains were so great they offset losses not only in the rest of that sector, but also in the other sectors that make up manufacturing as well. The statistical result of this huge improvement in a portion of one sector is to prop up the share of GNP of all manufacturing. An OTA reassessment of the data, using 1980 constant dollars, showed that manufacturing's share of GNP declined from 23.3 percent in 1972 to 21.9 percent in 1984, with an accelerated rate of decline after 1979, as in the Commerce Department's analysis.

The OTA study suggests fairly clearly that domestic manufacturing production has been declining, but, as is always the case in these matters, production is only one side of the equation. What is unquestionably less controversial is that consumption of manufactured goods has outstripped corresponding domestic levels of production, leading to a growing gap that is reflected in the trade deficit. OTA estimates, for example, that the American share of spending on manufactured goods increased from 23 percent of GNP in 1948 to 27.7 percent in 1986. Meanwhile, manufacturing output in the latter year was 20.5 percent of GNP, a continuation of the declining trend that began in the early 1970s.

Some economists have compared this deterioration to that of agriculture, which over a longer period of time declined significantly as a percentage of the U.S. economy--from 22 percent of GNP at the beginning of the century to 2.2 percent in 1986. This change is used to justify the increased manufacturing share as an inevitable and healthy part of a transition to a postindustrial economy.

The analogy, however, is inexact. While agriculture's share of the economy has declined, its output has not only kept pace with demand, but has also consistently generated surpluses. In the case of manufacturing, not only has the sector failed to keep pace with demand, but demand itself also has increased, as previously noted. This is not the hallmark of an economy in transition, where demand for services is replacing demand for manufactured goods. In fact, from a consumer point of view, the manufacturing sector is alive and well. From a producer point of view, however, it has been seriously ill.

This is not a unique situation. According to OTA, it is reflected in the economies of all the major industrial nations, including Japan, although the sector's `downward slope' has been steeper in the United States.

`As a share of gross domestic product, the U.S. manufacturing sector shrank by 31 percent from 1965 to 1985. This compares to declines of 27 percent in Britain, 23 percent in Germany, and 14 percent in France. Japan, which was still in a stage of industrialization in 1965, saw a decline of only 7 percent over the period. As would be expected, the share of manufacturing in the economy rose in newly industrializing nations like South Korea, the Philippines, and Singapore.' 4

This extended discussion of manufacturing is necessary because analysts and policy-makers are increasingly coming to the conclusion that its health is the key to solving our macroeconomic problems. There is little doubt that events in the manufacturing sector are largely responsible for the trade deficit. In March 1988, when the merchandise trade deficit reached a several year low of $9.7 billion, manufacturing accounted for more than two-thirds of our exports and nearly 79 percent of our imports. Eighty-five percent of the 1987 current account deficit was in the manufacturing sector.

The obvious conclusion is that closing the trade gap depends upon some change in manufacturing. This would entail, most likely, both an increase in exports, which seem to be occurring, and a decrease in imports, which has not yet begun. Even the major improvement in March, which featured a 27.7 percent increase in exports over the 1988 average, simultaneously brought a 7 percent increase in imports over the 1988 average.

MANUFACTURING VERSUS SERVICES

Beyond the fact that manufacturing constitutes the major part of the deficit, and thus inevitably must constitute the major part of the solution, there is another reason why we need to focus our attention there. In its most simplified form, it is the premise that our economic strength rests on production, not consumption. As William R. Hawkins, assistant professor of economics at Radford University in Virginia wrote, `The long-run replacement of high value-added industry by low value-added industry will undermine the American economic strength. Wealth and power ultimately rests on the power of production, not consumption.' 5

This is not the place to resurrect the debate on whether service jobs are preferable to or as well paying as manufacturing jobs, but the link between the two is clear, computer hardware and software being the most obvious contemporary example. The OTA study concludes that some 8 million service jobs are directly linked to manufacturing; while research by Stephen Cohen and John Zysman at the University of California at Berkeley suggests that the number might be as high as 50-60 million. Advertising, law, banking, transportation, engineering and architecture would be particularly vulnerable to further manufacturing declines. 6 There is little question that most service jobs, whether they are hamburger flippers, architects or investment bankers, ultimately rest on the production of something, and it is by that production in the manfacturing sector that our strength must be measured.

MANUFACTURING AND FOREIGN INVESTMENT

The crisis in the manufacturing sector is not limited to short-term consequences for the health of our economy. The trade deficit and the Treasury Department's strategy of preserving a lower value of the dollar threaten to produce serious long-term consequences. Anecdotal evidence reflecting concerns about declining production and its impact on our security and independence of action is already beginning to surface, as is concern about foreign acquisition of U.S. property.

The Defense Department is developing a program to determine what procurement is `endangered' in the sense of insufficient domestic production to meet our needs--either presently or in the event of war. 7 Inquiry has focused on sectors such as machine tools, certain computers, specialty steel, forgings and castings, and ball bearings. Some of this concern has been stimulated by Congress, but much of it originated with the Defense Department, as its inability to meet its needs from the U.S. defense base has become obvious.

Likewise, increased foreign acquisition of U.S. companies, such as that proposed in the attempt of Fujitsu to take over Fairchild Semiconductor (although Fairchild was already owned by a different foreign company), has raised concerns both about the transfer of critical technology abroad and about our continued ability to meet our defense needs from secure sources. This concern led to the inclusion of the so-called Exon/Florio Amendment in the trade bill. This provision gives the president authority to block foreign acquisition on national security grounds. The challenge for the amendment's drafters, and for the administration that will ultimately implement it, is to insure that this new authority does not become transformed by the bureaucratic process into a formal investment screening process of all transactions based upon the pretext of an expanded definition of national security.

Sometimes the goals of adequate domestic production and domestic ownership of technology are in conflict. The Pentagon is increasingly finding cases where the best way to maintain U.S. production is to allow a foreign takeover, even at some risk to the technology involved:

`For years, the Pentagon discouraged substantial foreign investment in defense companies, for reasons still cited by opponents of such acquisitions. They say that allowing foreign companies to control vital defense weaponry would leave the U.S. vulnerable in the event of war. They add that a stake in a U.S. defense-electronics contractor could let a foreign company and a foreign government see potentially critical technology--strengthening foreign competitors and increasing the danger of espionage.

`The critics see yet another example of America's technological and industrial dominance slipping away. And their concern is all the deeper because of American defense contractors' increasing purchases of sophisticated parts from abroad.

`But with Frank Carlucci's ascension to the Defense Department's top job, economic considerations have gained ground in foreign-investment decisions. Many at the Pentagon--and in the industry--now say that preventing jobs from drifting overseas and remaining able to crank out weapons at home are more important than lessening the risk of espionage or a loss of face as an industrial power. With the right controls, they believe, the national interest can be protected as well. `We must not allow ourselves to use this issue as a shroud for protectionism,' says Robert B. Costello, who oversees Pentagon procurement.' 8

Anecdotal evidence, of course, is hardly dispositive, but in the political environment it carries great weight because it represents political, i.e. constituent, pressure for action. When machine-tool manufacturers complain about imports and lost market share, for example, they go first to their congressmen and senators. While that might produce protectionist proposals in the short run, they often are not intended to be enacted--and rarely are enacted--but rather serve as catalysts for a thorough examination of the problem through already existing procedures.

In the machine-tool case, for example, the industry ultimately filed a petition under section 232 of the Trade Expansion Act of 1962 seeking relief from imports on national security grounds. After a year-long investigation by the Department of Commerce and a two-year review by the White House (far too long, in the judgment of everyone associated with this case), the president decided under considerable pressure from Congress, that some action was warranted and directed the negotiation of import restraints to be held with key foreign producers.

This case, along with the 1984 steel section 210 case that was resolved by steel quota legislation, suggest that congressional agitation, though it might ultimately not produce a law, is an action-inducing device that a wise industry will seek to employ. A second conclusion, unfortunately, is that there are inevitably elements in the bureaucracy of any administration that prefer smooth relations with our trading partners regardless of the domestic cost and will oppose actions that might be viewed by our trading partners as disruptive.

Congressional pressure, however, is generally concerned with the short term and specific cases. The big picture is not alien to congressmen, but it is often put on the back burner by the force of current events. In addressing those events we de facto make policy more often by accident than design. A better means of focusing on that big picture is needed.

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GLOBAL CHANGES

It is precisely that bigger picture that must serve as a background for the changes I have discussed in the manufacturing sector and in foreign investment. These changes cannot be viewed in isolation but rather must be seen as part of a broader series of developments that are taking place world-wide and that have contributed to a decline in our relative position of strength in the world economy. Our share of the free world's GNP has declined in the postwar era from 60 percent to 25 percent and with it, inevitably, a degree of the influence we are able to exert internationally. Several of these changes are worth noting.

Permeable economies

The increasing speed and sophistication of transportation and communications systems have created a true world market for goods as well as services. Who would have thought even ten years ago, for example, that over half our daily supply of fresh carnations and chrysanthemums would come from overseas (Colombia, Israel and Europe)? Satellite communications systems and electronic financial systems now permit virtually instantaneous transfer not only of news, but also of data and business and financial transactions. Approximately $70 trillion of foreign exchange transactions occurred in 1986, more than $200 billion every working day, a volume of transactions that dwarfs trade flows by a factor of eighteen times. More recent figures suggest current financial transactions are more than twice that level. These developments have made virtually every economy accessible to every other and have made the movement of money more important than the movement of goods.

Growth of the trade sector

In part as a result of the permeable economies, foreign markets have become more important both for American producers seeking growth and for foreign producers seeking to take advantage of our open market to promote their growth. While in 1970 exports and imports of goods represented 7 percent of U.S. GNP, in 1987 they amounted to 15.1 percent. This figure, although significant, was still behind that of most European nations.

Demand for discipline

The increased importance of trade has created powerful constituencies for stronger international standards for the conduct of commerical activities and a better means of enforcing those standards. It is not longer only the import-impacted industries such as steel, footwear and textiles that are sensitive, but modern, technologically competitive industries such as machine tools, computers and semiconductors as well as growing segments of the agricultural sector that are joining the chorus of complaints about subsidized imports and access to foreign markets. These complaints translate into the newly popular term `fair trade.'

Failure of adjustment

The insistence on discipline in the trading system has also been aided by the almost unanimous failure of developed countries to successfully pursue and implement adjustment strategies for industries that are no longer competitive.

In steel, for example, the United States and the EC represent contrasting extremes of failure. The United States, having had virtually no policy, forced the steel industry to adjust in the most painful way possible. The result was abrupt reductions in employment (from 453,000 in 1979 to 163,000 in 1987--a decline of 64 percent in eight years!) and a series of corporate bankruptcies and mergers. The EC, in contrast, has regularly postponed the pain of adjustment by continuing subsidies and attempting to regulate levels of production between the member nations. The result has not been enough to stop exporting the responsibility for shrinkage to the United States. Parenthetically, it is worth noting that James Clifton of the Center for Industrial Competitiveness has done some preliminary analysis that suggests the United States leads other developed countries in downsizing its basic industries and that the gap in this country is being filled by imports from other developed countries rather than from lesser developed countries (LDCs). 9

Lack of consensus on rules

The world has witnessed the growing importance of non-Western trade players, whose standards, practices and ways of doing business are at variance with the essentially Western trade system drawn up by the United States and its European allies in the postwar era. The growing problem of counterfeiting, patent piracy and other forms of theft of intellectual property--books, recordings and tapes, for example--are manifestations of the fact that many of the LDCs and newly industrializing countries (NICs) do not accept or have not developed Western legal standards, and often regard them as instruments of Western economic exploitation. This spring the Thai government was threatened with collapse because of the nation's legislators' resistance to proposals to strengthen Thailand's copyright law.

Recognizing economic change

The United States has personal experience with the difficulty developed nations have in handling LDC industrialization. This is matched by the LDCs' difficulties in understanding the additional responsibility that comes with development. Admitting that a Korea or a Brazil can produce products of equivalent quality more cheaply than we can has been painful but necessary. Persuading a Korea or a Brazil that industrialization should mean a phasing out of the special benefits given LDCs and that a market-oriented system without subsidies offers the best hope of further balanced growth is equally painful, but equally necessary.

The debt bomb

Finally, we have to face the devastating effect of the LDC debt crisis. In recent years nearly 40 percent of U.S. exports went to Third World markets. This figure is greater than that exported by Europe and Japan combined. But LDC debt problems and an inability to finance previous levels of imports caused a $22 billion deterioration in U.S. exports to Latin America alone between 1981 and 1984. This loss in trade translated into the loss of 550,000 jobs in the U.S. export sector.

International Monetary Fund (IMF) action in 1983 and 1984 staved off catastrophe, and reductions in the dollar's value have brought the United States back to the point where exports to Latin America are now only 18 percent below 1981 levels. Nonetheless, there is a growing suspicion that we have at best abated the crisis, but not resolved it. In 1986 alone, the United States lost $70 billion in exports to LDCs compared to what would have occurred had the export growth rate of the 1970s continued; that amounts to 2.1 million jobs.

Most developing countries still find themselves in a slow-growth mode with per capita growth rates over the last five years half the average of the 1970s. Debtor nations, however, complain that IMF austerity programs have failed, and these countries continue to demonstrate growing sympathy for a more development-oriented set of policies with greater World Bank involvement. Secretary of the Treasury James Baker's plan to lend an additional $20 billion has been received skeptically by both LDCs and some U.S. banks. Growing private bank reluctance to provide new funds in the face of increasing LDC resistance to repayment shows clearly the difficulty of arriving at any long-term solution.

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The evidence of productivity. 10

There is no better evidence of the change in global terms of trade than productivity figures. The U.S. rate of productivity growth averaged less than 3 percent per year from 1960 to 1986, although since 1979 the record has been significantly better. Yet over the entire period, our improvement pales in comparison with that of Japan (8 percent), France, Italy, and Germany (5 percent) and Great Britain and Canada (over 3 percent).

It is the earlier years that are the most telling. While our productivity growth rate from 1960 to 1973 was 3.2 percent per year, European countries did significantly better, largely because they were still repairing war damage and investing in new equipment. Japan, which had substantial destruction as well as a lower base, enjoyed an average annual rate of 10.3 percent during this period.

These numbers reflect Europe and Japan's `catching up' to the United States from what amounted to a lower base. They were aided by an exceptionally poor U.S. performance from 1973 to 1979 (1.4 percent per year) that was probably attributable to a rapid expansion of the labor force as well as inflation and oil price increases (although the latter two factors affected other nations as well).

Since 1979, the U.S. performance has matched our trading partners, but the damage was already done. We are now competing on equal terms with Europe and Japan and in some respects may have fallen behind. As many other developments over the past thirty years, this one may be good for the system and is certainly good for our trading partners. However, it is clearly not so good for us, particularly when viewed in conjuction with other events that occurred simultaneously.

All these changes mean a very different trading system, one in which the United States is no longer the dominant player and in which there is no common agreement on the rules of the game. The consequences for American firms doing business internationally are no more clearly spelled out than in a speech by Cordell Hull, director and senior vice president of Bechtel Power Corp., a company on the cutting edge of large-scale engineering and construction technology. Commenting on the growing need for officially subsidized government support for exports, Mr. Hull said:

`In the 1960's, the U.S. engineering and construction industry did not need as much credit support from Eximbank with respect to other international activities because:

`This country held a commanding lead in technical know-how, equipment quality, and price position backed by strong project-management capabilities;

`Competition from the newly industrialized countries was virtually non-existent;

`Foreign exchange rates were stable and, for the most part, predictable.

`Moving into the 1970's, economic storm clouds gathered as:

`Host countries became more directly involved in project development and consequently required financing for their projects; in response, foreign engineering and construction competitors quickly emerged supported by subsidized government loans . . .

`Emerging foreign competition secured increasingly larger shares of the engineering and construction market with their government's subsidies and support. Further, some of these competitors were state enterprises, directly owned and backed by their governments, able to take extraordinary risks with impunity.' 1 1

SHUTTING THE WORLD'S DOORS

The other change that Mr. Hull alluded to that impacts directly on our policy and economic performance is the growth of market restraints and barriers abroad. It is common practice among nations, not to mention good domestic politics, periodically to accuse one's trading partners of protectionism. It is axiomatic that it is always easier to blame one's problems on someone else, and foreigners in particular are easy political targets since they do not vote in the United States.

At the same time, however, there is growing evidence, both anecdotal and statistical, that suggests an increasing portion of world trade is becoming subject to restraints of one form or another. The Reagan administration is pursuing more section 301 cases asserting violations of our General Agreement on Tariffs and Trade (GATT) rights or barriers to our products in other markets than in past years. News articles have fully covered our fights over citrus (EC), pasta (EC), beef (Japan), soybean oil (EC), apples (EC), almonds (India), oranges (Japan), informatics (Brazil), fish (Canada), semiconductors (Japan), tobacco (Japan, South Korea), chocolate (Japan, South Korea, Taiwan), insurance (South Korea), motion pictures (South Korea, Canada), ice cream (Canada), eggs (EC, Brazil), lawyers (Japan), telecommunications equipment (Japan), medical equipment (Japan), wood products (Japan) and aircraft (EC), and this is hardly a complete list.

In addition, we have been forced to cope with increasing penetration of our own market by dumped and subsidized goods or by fraud and circumvention of our laws. Those fights are also publicly chronicled: steel (over twenty countries), photo albums (South Korea), textiles and apparel (many countries), various electronic components (Japan and others), forklifts (Japan), raspberries (Canada), potatoes (Canada), lumber (Canada), pork (Canada), brass (several countries) and various chemicals (many countries) to mention only a few.

These specific cases constitute graphic evidence of what observers have begun to report in the aggregate--the growth of non-tariff barriers (NTBs) to trade as a way of life in most of the world. The World Bank summarized this trend with a table showing the proportion of trade covered by `hard core' NTBs by region: 1 2

TABLE 1: INDUSTRIAL COUNTRY IMPORTS SUBJECT TO `HARD-CORE' NTB'S 1981 AND 1986
[In percent]
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Importer                    Source of imports                               
                         Industrial countries      Developing countries     
                                         1981 1986                 1981 1986
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EC                                         10   13                   22   23
Japan                                      29   29                   22   22
United States                               9   15                   14   17
All industrial countries                   13   16                   19   21

[Footnote] Source: World Bank, `1987 World Development Report,' p. 142.

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The bank defines hard-core NTB's as those `most likely to have significant restrictive effects.' It lists among them import prohibitions, quantitative restrictions, voluntary export restraints, variable levies, Multifiber Agreement (MFA) restrictions (textiles and apparel) and nonautomatic licensing.

Table 1 leads to several interesting conclusions. First, it is clear that the overall situation is getting worse rather than better--barriers are increasing in virtually every category. Second, the United States lags behind its major counterparts in protection, although we appear to be getting worse at a faster rate that the others. Third, Japan is clearly the worst offender, particularly with respect to imports from industrial countries, which would include proportionately more manufactured goods and fewer raw materials; but it does not appear to be increasing its hard-core barriers. Fourth, with the notable exception of Japan, developed countries treat their LDC partners worse than their industrialized counterparts.

These conclusions do not suggest the smooth transition to free trade that economists would like to see. In fact, they suggest the opposite: the system is disintegrating rather than coalescing. The 1988 Omnibus Trade Act was intended to be a response to his process.

THE 1988 TRADE BILL

The trade bill, very simply, is a reflection of the congressional view that there is a discontinuity between the way we behave and the way others behave, and the realization that we can no longer afford to go our own way. It was acceptable in the immediate postwar era when the United States accounted for 60 percent of the world's GNP for us to act in ways that were system-reinforcing and that furthered our political or military goals, because the economic cost was small. Rebuilding Europe and integrating Japan into the Western alliance made political sense and there were few, if, any, short-term costs.

Now, however, the bill is coming due. Ironically, this is because from an economic rather than a trade policy perspective the playing field has already become level. For years our higher industrial base tilted it in our favor; now we are competing on more equal terms and not liking it.

The softness in our own system is reflected in a poor productivity performance and a troubled manufacturing sector, as discussed above, as well as in our collective inability to discipline ourselves to rectify either of our two budget imbalances.

Our competitors, on the other hand, have discovered short cuts on the road to comparative advantage through such means as the combined use of government subsidies and protection to nurture fledgling industries beyond the point where they are competitive, and the practice of businesses dumping in the U.S. market to capture market share at any price while sustaining themselves in the interim through a protected home market. Both of these practices are market-distorting deviations from free trade principles that in most cases are GATT-illegal. Clyde Prestowitz, author of Trading Places: How We Allowed Japan to take the Lead, commented on these tactics as applied by Japan:

`Just as the U.S. government orchestrated industry efforts to put a man on the moon, the Japanese government bent every effort to create world-class industries in such areas as steel, computers, and semiconductors. Critics say that government is no good at picking `winners' and `losers.' But the Japanese government hasn't picked aircraft, computers, telecommunications, biotechnology and advanced ceramics as `winners,' the market has. The government is just making sure that Japanese industries ride with the winners.

`In this context, Japanese companies can sometimes see a long-run strategic advantage in selling in a foreign market at a price below cost or below the price in the home market. Yes, such dumping can mean an immediate windfall for non-Japanese consumers, but it can also allow a Japanese industry to get or keep a lock-hold on an important market.

`For example, the conquest of the U.S. television market, partly by dumping, paved the way for Japan's lucrative monopoly in VCR's. Today U.S. entrepreneurs who wish to build improved VCR's or peripherals cannot, because Japanese suppliers will not provide the critical parts or licenses.

`Similarly, the driving of U.S. semiconductor producers out of key products has made U.S. electronics makers dependent on Japanese suppliers--their biggest competitors. And the Japanese will find it easier to block the entry of new electronic entrepreneurs into the market. Dumping can also protect market share while an industry adjusts to changing market conditions; during the recent rapid appreciation of the yen, Japanese producers held the line on prices, despite profit losses, to give them time to cut costs.

`From the point of view, far from being a gift, dumped products look more like the hot goods of a fence. Of course the consumers gets a low price and the fence makes a nice profit, but ultimately, legitimate producers get put out of business.' 13

The United States has historically been less reliant on subsidies than its counterparts and has only recently begun to increase its use of market-closing tactics, often as a response to others' trade distorting practices, as in the case of steel. The trade bill is an indication of congressional determination that our tougher line against market distorting practices should continue. It is ironic that it comes so late and is so weak that it simply amounts to little more than a validation of the somewhat more aggressive position the Reagan administration had already begun in 1986.

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WHERE WE HAVE TO GO

While the trade bill points the country in the right direction, no one has ever claimed it alone is a sufficient solution to all our problems. Indeed, action will be necessary on a far broader scale if there is to be any significant impact on the trade deficit, and such action will have to address both our attitude and our policy.

CHANGES IN ATTITUDES

One of the things we should have learned from the trade debate over the past few years is that competitiveness is, among other things, a state of mind and way of thinking; and there are a number of things we can do to recognize our thought processes for competitiveness.

Understand the real basis of our strength

The Reagan administration continued the historical tendency of American governments in the postwar era to define our strength in military terms--the size and credibility of our nuclear deterrent and our ability to project our strength and further our foreign policy goals around the globe. Recent poll data as well as media stories, perhaps inspired by books such as Paul Kennedy's The Rise and Fall of the Great Powers, reflect a growing awareness among the populace that the question is more complicated and that real strength at its core is a question of economic power and the industrial base of one's economy. In graphic terms it is the growing realization that a 600-ship navy is an irrelvant objective if you do not have the infrastructure to build it or the money to buy it. It is the suggestion that the issue is not necessarily guns vs. butter, but rather that in economic terms guns are butter, and vice versa.

All policy-making involves choices. Understanding the real nature of our strength means making different choices in the future--choices that nurture economic growth and productivity improvements, particularly in the manufacturing sector.

Reprioritize trade policy

This corollary is a logical consequence of the first principle. It is a sad but necessary fact of life in the bureaucracy that decisions are not made in isolation. A decision on whether to press Japan on any of its various agriculture quotas will be influenced by concerns of the Defense Department on possible Japanese reduction in defense spending, of the State Department on a range of pending political issues, of the National Security Council on Japanese political and military cooperation in the Pacific Rim, and so on.

The insertion of these not directly relevant concerns is neither surprising nor troubling; it is an inevitable part of a decision-making process. What is troubling is the fact that nontrade considerations consistently carry the day when trade policy decisions are actually made. The National Security Council, for example, delayed resolution of the machine-tool industry's request for import relief for more than two years, among other reasons because of concerns about the impact it would have on Japan's cooperation with us on strategic matters. Over three years ago, then chairman of the International Trade Subcommittee, Senator John Danforth, succinctly summed up this problem in a speech at the National Press Club:

`For years, trade policy has been the poor stepchild of our Government. It has been shoved to the back of the line, behind foreign policy and tax policy, behind antitrust policy and export controls, and behind any number of other considerations. For the sake of our own people as well as the international trading system itself, the era of second-class status must be brought to an end.' 1 4

The solution to this problem is not to eliminate these other considerations; nor is it to launch yet another reorganization that will leave the bureaucracy in chaos for another year. Rather it is simply to make decisions that properly reflect our real priorities.

Reevaluate the role of government in the economy

As discussed above, the international trend of events in the trade sector seems to be in favor of greater government direction of the economy, particularly the trade and export sector. The success of Japan in literally creating comparative advantage out of a mix of government subsidies, effective allocation of credit and selective protection has not been lost on its Pacific Rim competitors, beginning with Korea and Taiwan. There are signs that the lesson is also being learned farther south as well. Likewise in the LDCs, what has been heralded as a gradual shift to free market principles in the more successful countries may actually be little more than a shift to smarter subsidies.

That does not mean we should follow the same path. On the contrary, we should continue to do everything we can internationally to insist on free market principles, as the Reagan administration did. To the extent we fail in obtaining worldwide adherence to that standard, we may face over the long run little choice but to adopt some of the same tactics employed by our trading partners. In addition, our experience with the so-called Export-Import Bank `war chest' and with some of our recent agriculture programs suggests that sometimes the best way to deal with other nations' subsidies and market-distorting measures is to demonstrate graphically that we have deeper pockets and are prepared to use what is in them. This is the kind of tactical flexibility that is appropriate to changing global economic conditions and is something we need to keep in the forefront of our thinking as we confront new multilateral challenges.

CHANGES IN POLICY--TO BITE OR NOT TO BITE THE BULLET

The past eight years, if nothing else, have made clear the unwillingness of anyone--the president, the Congress, even the American people--to take decisive action in dealing with our twin deficits. The reason for that is simple: there are no pleasant choices; ergo, there is no one who wants to choose. This final section discusses the policy changes that the next administration will be required to make.

THE BUDGET DEFICIT

Reducing our federal budget deficit inevitably means either increases in taxes or cuts in spending, including defense, or, more likely, a combination of both. Politically speaking, announcing support for a tax increase is akin to announcing one has the plague. It is a ticket to a short political career. Likewise, trying to produce a public consensus on where to cut spending has been futile. As a result, Congress resorted to such ingenious steps as selling federal assets at a discount to raise money and changing the armed services' payday from September 30 to October 1, which had the effect of shifting a large expenditure into the next fiscal year and, in budget terms, freeing those funds for other spending in the earlier year. Sooner or later Congress and the president will run out of gimmicks and will have to face real choices.

THE TRADE DEFICIT

Reducing the trade deficit requires a similar hard choice we have resisted making. The essence of the dilemma is that it is rapidly becoming clear that the easy choice of increasing exports will not work. The dollar's decline in value--too little too late in my judgment--has helped increase exports (up 30.9 percent from third quarter 1986 to first quarter 1988), but as Albert Wojnilower pointed out in a prescient analysis:

`Trying to reduce the deficit rapidly through higher exports would produce overheating, draw in much larger imports, and culminate in recession. Even in the longer run, bringing down our deficit by export growth to the other members of the industrial establishment has its limits because it threatens their economies and a political as well as economic backlash. The only sustainable export market is among the developing countries. To increase sales to them quickly, we would have to import more industrial goods from them, pay higher prices for their raw materials, or forgive their debts. While we are doing some of all these things, it is by no means clear that we are ready to [do] so on the large scale required.' 15

The export increases that have occurred, however, have been accompanied by climbing imports. For the first four months of 1988, imports were running nearly 12 percent, or $15.7 billion, ahead of the same period last year. More to the point, they were more than $1.3 billion higher than the last four months in 1987. Subsequent data show some further declines in both exports and imports, but the change is at best glacial. Consumpton is not clearly declining, and until it does, the trade deficit will remain too high, and the increases in savings and investment necessary for our long-term competitiveness will have to be postponed.

It is a dirty little secret of the trade debate that those who pride themselves on being free traders do not like to mention that any effective solution requires reducing imports as well as increasing exports. To reduce the deficit only through the latter would require a more than $150 billion increase in our sales abroad--a level of domination of the global economy unprecedented in human history.

As Wojnilower also points out, however, the means of reducing imports are hardly fashionable:

`The three ways to reduce the deficit through lower imports are import substitution, reducing general demand, or protectionism. For the moment at least, import substitution--making things at home rather than importing them--has the same drawback as export increases, namely, heightening the inflationary pressure on domestic resources. Reducing demand is a euphemism for recession. With the United States accounting for 18% of the world's imports, recession here likely would mean recessions abroad and it is doubtful that anyone would come out ahead. One consequence would be certain: protectionism would mushroom everywhere. In fact protectionism is probably the only, though hardly a desirable, way to shrink the trade deficit in a hurry.' 1 6

This is not a choice members of Congress like to see. They will resist the obvious--some sort of across-the-board import surcharge or other restrictive device--and instead try to define the problem as that of `unfair' trade and fine tune our trade laws to deal with it. Of course, no analyst and no congressman has ever argued that opening closed markets abroad or stopping unfair trade practices will solve more than a fraction of the problem, but we politicians like to believe these problems can be `worked out' through negotiation. Obviously, they should be worked out for the reasons outlined by Clyde Prestowitz above, but we should not be under the illusion that doing so is by itself a sufficient answer to our economic problems.

Ultimately, meaningful progress will require both import-limiting action on our part and action to increase growth elsewhere in the world. Import-limiting action could be either general or targeted. In either case it will hit Japan the hardest. In the spring of 1985, I was among the first to propose an import surcharge on Japanese goods, a tariff increase that would both reduce imports and raise revenue. That idea has not found much favor, but it will return inevitably as the choices narrow.

One action that will probably not work is further reduction in the dollar's value. Although its 38 percent reduction from its 1985 peak (against a basket of currencies) has made a difference, it has not been nearly as great as textbooks would suggest, and there clearly is a limit to how much more juice can be squeezed out of that particular orange.

The reasons for this is simple. Foreign producers elected in many cases to reduce or even eliminate profits and kept prices low to retain market share. U.S. producers, who must have been reading different textbooks than the Japanese, often did the reverse, increasing prices to restore profits that had been missing in the early 1980s. At the same time, U.S. consumers have continued in their determination to buy foreign products regardless of price increases. In some situations, VCRs being the most conspicuous example, there is no significant U.S. producer, and yen appreciation goes straight into U.S. inflation. We have done well so far in reducing the dollar's value without stimulating inflation, but it does not appear that there is much more benefit to be gained from that strategy.

The other choice is increased economic growth elsewhere. Jim Baker, as Treasury Secretary, had pursued this policy with enthusiasm but with limited success. Japan responded, but not in a way that will produce rapid results here. Germany remains paralyzed by its fear of inflation--not entirely irrational in view of its history--and appears willing to live with less economic growth as a consequence. Many of the NICs are constrained by their debt burdens from making much of a contribution. That leaves Taiwan, South Korea and a few others--not enough to make a difference. It remains the right policy, but counting on others to solve our problems is at best naive and at worst foolish. In the end we will have to solve our own problems through our own actions.

Wojnilower's response to this dilemma is that `we must learn if not to love our deficit at least to become more relaxed about it,' 1 7 a reflection of his pessimism about a near-term solution.

The right response is for the private sector to understand the profound challenge we face and for labor and management to work far more realistically and cooperatively. Nevertheless, our government must recognize the urgency of creating a climate for the success of these efforts. We must go directly to the core of the problem and start with a comprehensive blueprint to support and encourage the revitalization of our manufacturing base. Following are some necessary parts of such a blueprint.

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Shift the tax system to favor savings and investment rather than consumption; provide tax incentives for research and development

The United States has consistently had the lowest savings rate in the developed world. This has both crippled our ability to make badly needed investments in research and development and infrastructure, but it has permitted the consumption binge that has created our trade and current account deficits.

Devise strategies to create targeted comparative advantage while facilitating adjustment

I first proposed a market facilitating adjustment strategy for industry five years ago. The best approach is not one that is government led or dictated, but one in which the government conditions its support on the industry--labor and management--cooperating to devise solutions to its problems. The government becomes a facilitator not a partner in the process.

Help develop a stronger export mentality among our manufacturers

It is axiomatic in any analysis of American economic history that Americans have ignored foreign markets in favor of the large domestic market. Even those who have sought to export have often not tackled the global market systematically and have gone to it only in times of surplus capacity, pulling back when domestic demand has increased. This has prevented the development of a true export mentality in the United States, in sharp contrast to so many of our trading partners who rely on exporting as an integral part of their economies.

We need to encourage more thinking about exports. The Commerce Department has launched several such initiatives, most recently its Export Now program, and the Export Trading Company Act of 1982 was intended to do the same thing for smaller businesses. We need to pursue these and other initiatives aggressively to help our manufacturers fully undestand the extent to which they are now part of a global market.

Aggressively defined the market system against competitors' unfair trade practices

Stopping dumped and subsidized imports makes economic sense over the long term for both the United States and foreign economies. In the short term, aggressive enforcement limits inports not only in the directly affected sector but more broadly because of the message it sends our trading partners about our determination to support market principles.

Another unfair practice gaining in popularity is patent/trademark piracy. America's lead in innovation is already under siege for legitimate reasons. Theft of technology and outright copying of our products make the problem much worse. The recently passed trade bill will help crack down on this activity, but international negotiation on stronger protection for intellectual property will also be necessary.

Indeed, the entire Uruguay Round can play an important role in the reduction of our trade deficit, not just by opening others' closed doors, but by further tightening the rules on unfair practices, particularly in the area of agricultural subsidies.

Lower the cost of capital by reducing the budget deficit

This has been discussed above, but it is worth reiterating to stress its relevance as part of a comprehensive approach.

Upgrade the capability of the work force through education and retraining

The trade bill takes some important steps in this direction by significantly increasing our job retraining and trade adjustment assistance funds. The decline in unemployment over the past year makes it tempting to put retraining on the back burner. That would be a grave mistake. Changes in the structure of our economy and the nature of our manufacturing sector are coming ever faster. Making sure our work force is prepared to adapt to them is critical.

Better manage our current account deficit by reducing energy imports through conservation and substitution and increasing defense burden-sharing by our allies

Obviously, reducing the trade and budget deficits will also contribute to better current-account control, but reducing our energy and defense bills would be two important steps beyond that, steps that are also justifiable on their own merits.

Following this blueprint is essential for both revitalizing our manufacturing sector and bringing our overall trade problems under control. There is a very real possibility, however, that in some specific cases we may be too late. To the extent that whole industries have already been decimated, recovery may be impossible. For example, the ability of the Japanese to understand interrelated end-use markets in the electronics sector has enabled them to take a commanding world lead in video recorders, video cameras, lens manufacturing, small precision electronic motor design, automatic camera focusing systems, 35 millimeter cameras, television sets, audio recorders, compact disk playback systems, video disk playback systems and high speed digital fiber transmission equipment. 18 The next battleground will likely be high definition television, where our industry faces the same technological, organizational and marketing challenge.

Related to that is the continuing struggle of our high-tech sector to maintain a full range of production of components and finished products, including dynamic random access memory chips. Our ability to develop new generations of products depends on investment in research and development, which in turn depends on earnings from sales of current generation products. Companies that abandon a product line are not just giving up present earnings; they are forfeiting their future.

Our success is also dependent on our ability to rise to the challenge. So long as a Japanese company can take a product from idea to pilot production in three and a half years while an American company takes over five years with about twice as many engineering hours, and so long as a Japanese company can use the same flexible manufacturing system to produce fifty products that our companies employ to make only fifteen, we will not make up the ground we have lost.

Our failure thus far to meet this challenge has meant thousands of jobs and billions of dollars in earnings surrendered overseas. We cannot get them back. We can, however, prevent the same thing from happening again, if we have the discipline and vision to follow the kind of blueprint laid out above.

Finally, President Bush must at all costs avoid a relaxed approach that hopes for favorable trends in the monthly deficit figures, a favorite media exercise. This ignores the real issues, including the serious and continuing erosion of the manufacturing sector that has been the focus of much of this article. While productivity improvements are welcome developments, they cannot substitute for the jobs lost that will not be regained, the factories closed that will not be reopened and most importantly the industries that permanently stopped producing in the United States. These consequences can only be addressed by a sea change in our thinking. Simply put, we have to understand the primary role that economics plays in our national strength; we have to define more clearly our economic interests, both short and long term; and we have to be prepared to act aggressively to further those interests, regardless of the complaints we might receive from our trading partners. The status quo works very well for them. Nobody should be surprised if they resist changing it.

But our obligation is to pursue policies that are in our interest, not theirs. We have not done that for some years, and it is long past time to make the switch. Nearly 150 years ago, Benjamin Disraeli said, `Free trade is not a principle. It is an expedient.' Free trade served the British well, and it served us well, but over the years we have forgotten Disraeli's advice and turned it into the eleventh commandment. It is past time to put it back in its rightful place--a sound policy to be pursued when circumstances and interests dictate--which may not be right now.

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FOOTNOTES

1 Clyde Prestowitz, `Let's Wake Up on Trade,' Washington Post, 12 June 1988, p. C4.

2 John Heinz, `Additional Views,' Senate Finance Committee Report on the Omnibus Trade Act of 1987, Senate Report 100-71, p. 269.

3 The data in this section are taken from Office of Technology Assessment, `Paying the Bill: Manufacturing and America's Trade Deficit,' draft report, June 1988.

4 Ibid, chapter 4, p. 11.

5 William R. Hawkins, letter to the editor, The American Spectator, October 1985.

6 Stephen S. Cohen and John Zysman, `The Myth of a Post-Industrial Economy,' Technology Review, February-March 1987, p. 58. (This article was adapted from Cohen and Zysman's book, Manufacturing Matters: The Myth of a Post-Industrial Economy.)

7 General Accounting Office, `Information Relating to Industries Critical to the Defense Industrial Base,' draft report, 7 March 1988.

8 Cynthia F. Mitchell, `Pentagon Eases Stand Against Foreign Stakes in U.S. Defense Firms,' Wall Street Journal, 28 April 1988, p. 1.

9 James Clifton, `Why Should the United States Unilaterally Downsize its Basic Industries?', unpublished monograph.

10 Office of Technology Assessment, `Paying the Bill: Manufacturing and America's Trade Deficit,' draft report, June 1988.

11 Cordell Hull, speech at the `Trade 1984' conference, U.S. State Department, Washington, DC, 25 October 1984.

12 World Bank, World Development Report 1987, p. 142.

13 Clyde Prestowitz, `Let's Wake Up on Trade,' Washington Post, 12 June 1988, p. C4.

14 John C. Danforth, speech at the National Press Club, Washington, D.C., April 1985. Reprinted in Congressional Record, 25 April 1985, p. 9428.

15 Albert M. Wojnilower, `A Trade Deficit for All Seasons,' remarks delivered to the Conference Board's 1988 Business Outlook Conference, New York, NY, 10 September 1987, p. 15.

16 Ibid., p. 15.

17 Ibid., p. 16.

18 Richard Elkus, Jr., `Towards a National Strategy: The Strategy of Leverage,' presentation at a conference on `Compete or Concede? CEOs Respond to the High-Tech Challenge,' sponsored by Rebuild America, American Electronics Association, Congressional Clearninghouse on the Future, 13 July 1988.

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