The U.S. Missed Its Chance to Make China Play Fair

(Bloomberg View) -- Generals, the old saying goes, always fight the last war. A similar (though less pithy) principle is that politicians always propose solutions to the last decade's problems. In the U.S., there are two main areas where we see this principle at work. The first is immigration -- net illegal immigration stopped a decade ago, but President Donald Trump and his supporters are still up in arms over it. The second is China.

The standard story is that Chinese competition is devastating U.S. manufacturing. According to this tale, China's unbeatable cost advantage, driven by cheap labor, cheap energy and lax environmental protections, is siphoning jobs and investment away from the U.S. at a tremendous rate, exacerbated by China's artificially undervalued currency.

This narrative was essentially correct in the 2000s. Chinese competition devastated large swathes of American industry, leaving shattered careers and major economic dislocations in its wake. And the Chinese government was complicit -- with its steady purchases of U.S. dollar assets, China was holding down its currency to flood the U.S. market with cheap goods.

The People's Currency

But that was the 2000s; how true is the story today? A few parts of it still hold -- China's currency, the yuan, is still undervalued. The Economist has a quick and easy way to measure currency undervaluation -- just compare the price of a Big Mac hamburger in multiple countries. Here is what that it shows:

So the yuan is still too cheap. But something important has changed. The Chinese government is no longer buying U.S. assets to try to keep its currency weak. In fact, during the past few years it has been selling its fabled stock of foreign-exchange reserves at a fairly rapid clip:

But there's another, even bigger reason why the old China story isn't accurate in the 2010s. Chinese wages have risen a lot. A decade ago, a Chinese worker made less than a 10th of what his or her U.S. counterpart did; today, it's about a quarter:

The trend is also important. Chinese wages have been rising so quickly and steadily that most multinational companies and investors must expect them to continue going up. That means that anyone who invests in China not only pays a much higher wages than 10 years ago, but is also signing up to pay even higher wages down the road.

Of course, these pay numbers don't tell the whole story. Businesses that look beyond the headline numbers will think about unit labor costs -- i.e., costs adjusted for productivity. Since Chinese workers have been getting more productive as their employers get more and better technology, China can still be a cheap place to produce things.

But here too, China's advantage has eroded substantially. A recent study by consulting firm Oxford Economics found that China's unit labor costs were only 4 percent lower than those in the U.S. According to that study, it's actually now cheaper to produce things in Japan, Mexico or (especially) India. Boston Consulting Group puts the difference at only 1 percent -- not nearly enough to motivate companies to shift production from the U.S. to China.

One reason for that is energy costs. Although hydraulic fracturing has lowered the price of power in the U.S., China has struggled to increase its production of coal, its main fuel source. China's coal boom was truly spectacular, but nothing can grow without limit -- various supply bottlenecks started to bite several years ago. Meanwhile, China's air pollution reached truly apocalyptic levels, forcing the government to start favoring renewable energy over dirty coal. As a result, Chinese coal consumption has actually fallen since 2013. And electricity in China, though still cheap, is now only about a third less expensive than in the U.S.

So China's legendary cost advantage, so potent in the 2000s, have mostly eroded in the 2010s. And the trend will probably continue. This means that although the U.S. lost lots of jobs and industry to China in the previous decade, the bleeding has stopped. Chinese companies are even starting to build some factories in the U.S.

This means that just like on immigration, the Trump administration is living in the past when it comes to China. If the U.S. had taken the China threat seriously 15 or 20 years ago, it might have been able to cushion the blow by forcing China to stop making its currency artificially cheap. But it's now too late for that -- the damage to U.S. workers' careers and to U.S. industrial know-how has already been done. The great China Shock is over.

What U.S. leaders need to do now is stop focusing on the last decade's problems, and start thinking about those of the next decade. Rebuilding U.S. industry and the careers of American workers will require hard work -- infrastructure investment, retraining and education initiatives, smart regulation and other policies aimed at creating the new instead of protecting the old. Bashing China might have done the U.S. some good long ago, but it will achieve little or nothing now.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

To contact the author of this story: Noah Smith at nsmith150@bloomberg.net.

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net.

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