America’s policy toward China is misdirected, because it would actually strengthen China and weaken the United States

China’s industrial policy is a weakness, so why should the U.S. copy it or demand that Beijing abandon it?

U.S. political leaders have long tried to counter Chinese industrial policy. And now they seem to have decided that the best way to do that is to emulate it. But their agenda betrays a profound lack of understanding of the unique challenge posed by China’s coupling of an authoritarian political regime with a dynamic market economy.

Millions of Chinese firms, including some of the world’s most innovative, are occasionally asked to serve the regime’s political objectives – an unprecedented marriage of pioneering private companies and a Leninist one-party state. Western countries cannot match it, and should not begin to try. But much of the U.S. economic policy response to China is misdirected.

For example, the United States wants to curtail China’s support for state-owned firms, despite the overwhelming evidence that such assistance starves private Chinese businesses of resources. The real challenge to America comes from private companies such as Huawei and Alibaba, which produce goods that U.S. consumers eagerly buy. It does not come from state-owned firms like aircraft manufacturer COMAC, which has never made a profit and, more important, has prevented the emergence of a private-sector Chinese equivalent of Boeing.

Denationalizing under Zhu

In fact, the private firms that now dominate the Chinese economy took off only after former Premier Zhu Rongji closed or privatized hundreds of thousands of state-owned companies in the early 2000s. The closures released capital to private firms and cleared the way for them to grow. Does anyone seriously believe that the Chinese economy would be stronger if policy makers were to undo Zhu’s reforms and revive all the old loss-making state enterprises?

Or consider the U.S. obsession with the Chinese government’s so-called “Made in China 2025” plan, which channels subsidies to private firms in “strategic” sectors such as semiconductors. The jury is still out on whether the billions of renminbi CNYUSD, -0.02% spent to support such industries will prove effective, but the evidence so far is not encouraging.

The dominant global semiconductor manufacturer is Taiwan Semiconductor Manufacturing Co. TSM, -2.59%, not the Chinese champion Shanghai Semiconductor. And until now, the huge sums that China has plowed into this sector have resulted in spectacular failures such as the Hongxin Semiconductor, and the emergence of close to 60,000 new companies that have no technological expertise but are seeking to capitalize on the subsidies.

Such outcomes are all too common when governments subsidize industrial sectors, perhaps owing simply to a lack of accountability. After all, who is held responsible when billions have been wasted and the officials who allocated the funds have moved on to other posts?

Local support is vital

The growth of China’s business sector has been fueled not by support for state-owned firms or industrial policy, but by powerful local governments’ backing of private firms – including Hyundai 005380, +0.48% in Beijing, and Tesla TSLA, -3.86% and General Motors GM, -3.82% in Shanghai.

“The commercial goal of selling more GM Buicks and Chevrolets in China becomes a political and economic campaign to enhance the power and might of the city of Shanghai,” says one long-time observer of the car industry in China. “Think of it as Shanghai Inc., with the mayor as the chairman and CEO.”

The support of local governments is particularly crucial for private Chinese firms. For example, the East Hope Group became the largest private aluminum producer in China with the support of the small city of Sanmenxia in Henan Province, despite the fierce opposition of the state-owned giant Chinalco.

Chinese local governments also compete ferociously with each other to attract business – a crucial factor in allowing private firms to grow. This reflects the rivalry between the Communist Party of China’s powerful local secretaries, many of whom eventually become members of the CPC’s Politburo. In contrast, the central government ministers who run industrial policy and state-owned firms almost never make it into the party’s top tiers.

Emulating the worst ideas

If the U.S. forces China to dismantle its support for state-owned firms and roll back its industrial policy, it would succeed only in removing the shackles on the private sector, making it more likely that other innovative private companies, supported by local party secretaries, would emerge to challenge U.S. businesses. Although U.S. consumers would benefit, these Chinese firms – regardless of their intentions – have no choice but to comply when asked to advance the CPC’s political goals.

But U.S. strategy instead seems focused on emulating the worst aspects of Chinese industrial policy. One example is the Facilitating American-Built Semiconductors Act, recently introduced in Congress, which would provide investment tax credits to U.S. chip manufacturers. This follows the Senate’s approval in June of a $52 billion investment in the sector as part of the U.S. Innovation and Competition Act.

It is easy to understand why the U.S. semiconductor industry would welcome the $52 billion. But besides the questionable equity of subsidizing wealthy U.S. firms that use chips, the measure will produce the same result as the billions that China has poured into semiconductors. It will spawn companies that specialize in obtaining free money instead of investing in new technologies and products, causing the U.S. semiconductor industry to fall further behind the leading global players.

So, what should America do instead? Late in his life, the 20th-century U.S. diplomat George F. Kennan said that “the best thing we can do if we want the Russians to let us be Americans is to let the Russians be Russian.” His advice also applies to U.S. policy toward China today, with the added complication that the current authoritarian superpower also has a market economy.

The real business-related challenge the U.S. faces vis-à-vis China is the tradeoff between national security and the benefits of economic exchange, not China’s support for state-owned firms or its industrial subsidies. And the worst thing America could do is to enact industrial policies of its own.

Author: Chang-Tai Hsieh, MarketWatch

Chang-Tai Hsieh is professor of economics at the University of Chicago Booth School of Business.

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