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How did the International Division of Labor between the U.S. and China in terms of
finance and manufacturing start?
By J.D. Han, King’s University College, Canada
Prepared for “Insight” (draft)
Behind the flows of money, there are flows of goods. A study of international finance cannot be
complete without looking at international trade and investment.
It seems that China manufactures, exports to the U.S., gets trade surplus and finally sends capital
back to the U.S. Alongside with the U.S. treasury, the U.S. financial firms do manage the capital.
As long as the this circular flows do not stop or leak, there is a happy equilibrium.
We wonder how this division of labor and the circular flows were created. It was about in 1995
that China started having trade surplus of a noticeable magnitude. Just prior to it, a treaty of
Most Favored Nations had been signed between the two countries.
What were the underlying forces? It is was not just a natural evolution of the market forces.
There were clearly a constellation of socio-political factors which have contributed the division
of labor.
Since the 1970s it became clear that the U.S. industrial sectors started showing different growth
paths: the manufacturing sector, which is heavily relied on unskilled labor forces, was losing the
ground of productivity and international competitiveness. The automobile industry was probably
the last manufacturing industry which was holding out for international competition while steels
and other heavy ‘smoke stake’ industries were gone for awhile. On the other hand, some
industries of the U.S. proved to be ‘innovative’ and continued to be the source of ‘value added’.
The U.S. financial industry evolving around the investment banking sector is the best example.
East Asian countries, such as Japan, Korea, Taiwan, and even China to a large extent, are
resource-poor countries. There are no massive investment opportunities, which would bring
immediate and certain positive returns. Trade surplus will flow out of the country. On the other
hand, the USSR has a vast undeveloped area with a rich reserve of resources in Siberia. Trade
surplus will be domestically invested.
One direct impact of the declining manufacturing sector was shown as a rising price level –
inflation- which resulted from remaining subsidies of the declining manufacturing sector, and led
to a declining per-capita consumption or the quality of life. That posed a real treat to the stability
of the U.S. society. The U.S. needed to step up mass consumption revolution for social stability.
The social unrests of the 1970s in major urban areas were attributed to the deteriorating level of
consumption goods. The only option was to bring in a large quantity of good quality
consumption goods at lowest possible prices. The U.S. looked at various candidates, including
the ‘enemy’ countries such as the USSR block and China. The U.S. started sponsoring these
‘enemy’ countries into the integrated world market. The U.S. wanted a partner which could help
the U.S. ‘s competitive industries such as the investment banking. The U.S. does not want a
trading partner which would keep all its trade surplus inside of its own country. In other words,
a country which has a large manufacturing capacity but a small domestic investment capacity is
the best partner: If the domestic investment needs are checked, under the level of savings, the
country will export capital, to the U.S. financial industry.
This division of labor cannot be sustained in the conventional international finance theory of
the‘Flow of Species’. In a world with a limited liquidity(money) somehow linked to a given
quantity of precious metal, trade-surplus country will eventually experience a swelling domestic
money supply and inflation, and the trade deficit country will have a declining money supply and
deflation. The terms of trade changes to the extent to reverse the flow of imports and exports,
and thus the international or external balance is to be achieved.
In a world with the key currency system, the correction does not have to be immediate. As long
as the key currency country, U.S., can get its currency accepted by the trading partner(s), it can
sustain trade deficits simply by printing money. If the trading partner loses confidence in the key
currency, then it will decrease the demand for the key currency in international trade and
investment, which will in turn threaten the status of the key currency. From the viewpoint of the
U.S., the best trading partner is a country which has a healthy appetite for investment in the U.S.
not in its own domestic economy.
In the world history after the 18th century, England, U.S. and Germany, and Japan have taken
turns in raking in colossal trade surplus from the rest of world: First, the front runner of England
recorded a large trade surplus starting in the late 18th century. However, it was not recessionary
or deflationary for the rest of the world. Here, by ‘deflationary’ we mean that the growth of
England was not at the expense of other countries. The main reason was that England invested
overseas such as in the U.S. , South Africa, India, Egypt, and Canada. The financial investment
as well as physical investment, which amounted to today’s terms of FDI or Foreign Direct
Investment, boosted the economy of those countries. It was rather the economic growth of the
U.S. of the later period, and Germany that had deflationary on the world economy as particularly
the colossal and territorially expanding U.S. economy could not really afford to invest overseas.
Of course, politically, the U.S. had the expediency of the Monroe doctrine as well. Precious
metal flowed in the U.S. from the rest of the world, and those countries in the world suffered
from a shrinking supply of their money which was directly related to the metal base system.
Today, we have no direct linkage between money supply and precious metal. And the key
currency can be controlled by the U.S. As long as the U.S. pumps liquidity into the world
economy, there would not a problem coming from a declining money supply. Still it would be
nice if the U.S. dollars that a U.S. trading partner gets through trade surplus are circulated out of
the country. That will reduce just one agony of the U.S.
The U.S. approaches to China and the USSR were fundamentally different. Unless Rubbles of
the USSR is deprived of the key currency status, the USSR has no incentive to work hard for the
U.S. consumers. Only when the USSR can buy only to the extent that it produces, sells, and earn
the key currency, the USSR would try to produce as much as it can so that it can also buy more
from the rest of the world. And eventually it happened but only after the complete breakdown of
the Soviet Union or Glanost. (Note: To many monetarists, it is puzzling why the USSR gave up
the key currency status of Rubbles in the Soviet and East European blocks. Here we can apply
what we have discussed about the advantage and requirement of the key currency country to run
a sustained trade deficit. One answer can be found in that the U.S.S.R became increasingly
uninteresting country for investment for those trading partners which were simply accumulating
a reserve of Rubbles. Therefore the fundamental reason for the collapse of the Soviet block or
the Easter European block was the failure of the U.S.S.R. economy to be the source of
innovation while keeping turning out liquidity. In a somewhat unpleasant but poignant parable,
at first elixir of vitality sprang out from the U.S.S.R. to its satellite countries in the 1950s to 60s.
All that vitality of technical innovation along with liquidity was overflowing from the U.S.S.R.
to the satellite countries. And investment flows back to the U.S.S.R. However, by the 70s, the
U.S.S.R. economy became a dead sea, oozing out puss of no vitality. The demand for Rubbles
fell, and so did the value of the key currency of Rubbles. The key currency system could not be
sustained any longer.)
Chinese currency was never a key currency. Thus if China wants to buy more for the rest of the
world, for consumption or for investment, she has to work hard and to produce more of output
for the U.S. consumers. It also happened.
However, the speeds at which China and the USSR transform themselves as suppliers to the U.S.
were vastly different. What would be the reason? There could be two different theories. One is
that compared the Russians and the East Europeans, the East Asians are more suitable for
assembly line of mass production as they are ‘docile’ and ‘respectful’ of the authority. The
authors of this line of argument take up the example of Japan, Korea, Taiwan, and other ‘NeoConfucian countries’ as use the commonality among them. There might be some truth to it.
However, we can come up with an alternative theory: China was eager to adapt itself for the
status of the manufacturing country as it did not have its own technology. In the process of using
American technologies, China wished to internalize some of the U.S. technologies. On the other
hand, the USSR insisted on using its own ‘traditional’ technology for the production of export
goods to the U.S. market.
The U.S. firms would not easily transfer technologies to China or any manufacturing countries
which do not have to pay for them by laws of intellectual properties. It would be Japan that gets
the U.S. technologies, and Japan will make sure to get its share for its value added to the U.S.
‘original’ technologies. Japan sells ‘machine’, not technologies, to Korea, Taiwan, and others,
which in turns produce parts with those Japanese machine, and sell them to the actual mass
manufacturing countries. And China belongs to the last category in this spectacular ‘Supply
Chain’. China is as far removed from the source of ‘technology know-how’ as it can be. This
supply chain of technologies running from the center to the periphery, or from the U.S. to China
is devised to protect the U.S. technologies from being “pirated”. The single large category of the
U.S. products to Japan is ‘technology’. Directly lending technology to China would be suicidal
for the U.S. industry.
It would not be far-fetched to argue that the current world order of economy is by the U.S. design.
The final result tells everything: the U.S. still remains to be the most abundant in terms of
consumption, and the most prospective in terms of investment. It has been the real winner who
whines a lot(over the Chinese trade surplus). For them, China is the perfect partner that can
produce the massive amount of consumption goods at low costs and, at the same time, make
financial investment, not FDI, back in the U.S. This will happen as long as investment in the
U.S. remains attractive, which in turns depends on technical innovation and social stability of the
U.S.