The broad US stock market gave up an early rally and fell over 5% after President Trump’s announcement of punitive tariffs of 25% on steel and 10% on aluminum, the highest in US history. US Steel, the country’s largest producer of the metal, rose 6.4% on the news and aluminum producer Nucor gained 2.4%, while the S&P 500 average lost 1%. General Motors fell almost 4%, Ford fell 3%, United Technologies fell 2.8% and Boeing fell 3.4%.
Raw materials prices have little to do with the erosion of America’s industrial base. Chronic underinvestment in capital-intensive manufacturing is the underlying problem, and American manufacturers avoid big capital commitments because they can’t compete with Asian subsidies for industrial plant and equipment. Asian economies view a $10 billion semiconductor fabrication plant the way Americans view a bridge, stadium or airport, as a public good that merits taxpayer support. China’s economy is so big that its subsidies distort capital investment around the world.
By protecting raw materials exporters while ignoring the decline of American high-tech capacity, the Trump trade policy nudges the US economy towards the economic profile of a Brazil: a producer and exporter of agricultural goods and raw or semi-finished materials with an atrophied industrial base.
Trump announced the tariffs in offhand remarks to reporters at the White House, after a day of conflicting signals. The White House had planned an announcement as of Wednesday night, but postponed it until this morning. Trump tweeted early Thursday, “Our Steel and Aluminum industries (and many others) have been decimated by decades of unfair trade and bad policies from around the world. We must not let our country, companies and workers be taken advantage of any longer. We want free, fair and SMART TRADE!”
As the equity market plunge suggests, Trump’s announcement is anything but smart. America’s greatest commercial challenge comes from China, which dominates many categories of high-tech manufacturing and has committed tens of billions of dollars to a campaign for supremacy in semiconductors. But China’s steel and aluminum exports to the US amount to less than 1% of the total; America’s main suppliers are Canada, Brazil, South Korea, Mexico, Russia, Turkey and Japan, in order of importance. China has been accused of depressing world prices of industrial metals, although aluminum prices have risen by 60% and steel prices have doubled since the Nov. 2015 low. US Steel’s stock price has jumped from $7 a share in early 2016 to $43 before Trump’s announcement.
US Steel’s 29,000 employees won’t determine the outcome of any major election, but the White House evidently believes that it needs to show the flag on trade to maintain credibility with its working-class supporters. If Trump’s trade announcement was a cynical political gesture with domestic politics in mind, the damage will be limited. But earlier this week, the president promoted trade warrior Peter Navarro to a rank equal to that of Economic Policy Council head Gary Cohn, which suggests that other shoes are likely to drop.
In two recent essays for the Journal of American Affairs, I examined the decline of innovation and productivity in the US, and the impact of this decline on US trade. Starting in the 2000’s, US venture capitalists stopped investing in manufacturing.
The reason has to do with return on capital. In the United States, return on equity is negatively correlated with capital intensity. In China, it is positively correlated, and strongly so. That is the result of government subsidies for capital investment.
The charts below show the capital intensity (total assets per unit of earnings before interest and taxes) vs. return on equity of each company in the China MSCI Index and the S&P 500 respectively.
As I wrote in the Journal of Economic Affairs, China dominates the key digital technologies:
- Liquid crystal displays, which are employed in a wide variety of products, with $100 billion in annual sales. South Korea controls 35% of the market, Taiwan 25%, and China 20%.
- Light-emitting diodes (LEDs) are produced mainly in China and Taiwan.
- China and Taiwan dominate the production of semiconductor lasers, the energy source for fiber optic communications.
- Solid state sensors, which generate images in digital cameras and related devices, are produced mainly in Taiwan and Japan.
- Flash memory is produced mainly in South Korea, Japan and China, with only 10% of world output coming from the United States.
- Integrated circuits are a $270 billion global industry. Most are produced in Taiwan and South Korea, and China has undertaken an aggressive investment program in the industry. Less than a quarter of world output is produced in the United States.
- Solar energy panels, a $30 billion industry, are dominated by China.
On several occasions the US Department of Defense has had to abandon high-tech research projects that require sophisticated micro-manufacturing because it could not find an American manufacturer capable of executing the task. Defense Department rules exclude the use of foreign manufacturers, and in some fields the only technical capacity is located in South Korea, Taiwan, or other countries.
Restoring the US industrial base would require a radical departure from past policies. Requiring domestic content for high-tech defense goods, for example, would compel US manufacturers to create onshore capacity, but the taxpayer would have to support the effort. The government would have to persuade US companies to restore the R&D capacity they abandoned during the 1990s, when Bell Labs, RCA Labs, GE Labs, IBM Labs and other major industrial facilities still functioned. The Federal R&D budget stands at half of its Reagan-era level in terms of GDP. Even if the government were to restore funding, it lacks the corporate and national laboratories who know how to spend it effectively.
The US share of global high-tech exports has fallen from just below 20% in 1999 to barely over 5% in 2014, while China’s share has risen from 3% to 26% during the same period.
The United States has never encountered a competitor like China. Old-fashioned remedies like tariffs are not effective. I wrote in the Journal of American Affairs:
Solar panels are a case in point. China decided to address its urgent pollution problem by shifting to solar power during the early 2000s. It also sought to exploit growing global demand for clean energy. The technology to manufacture solar panels was developed in the United States and Germany, and German production equipment was available on the open market. China meanwhile directed investment into the components of solar panels such as polysilicon and glass frames, dominating the supply chain for solar panel production. As a result the U.S. share of solar panel production fell from 50 percent in 2007 to 6 percent in 2011. The largest Chinese solar panel producers are unlisted and do not publish their financial data, so it is impossible to gauge their profitability. The United States responded by imposing stiff tariffs on Chinese solar panel imports, up to 239 percent in the case of some companies. The European Union, Australia, Canada, India, and Turkey also imposed tariffs against Chinese exporters. The Chinese responded either by absorbing the tariffs, or by shifting production to other countries.
There is no indication, though, that Trump will attempt to protect high-tech manufacturing, for the simple reason that it has already left, and there are few jobs left to defend. Instead, the president will concentrate on labor-intensive, low-tech industries. That’s the way to give America the economic profile of a Brazil.