The Bear’s Lair: Lashed by dragon tails

In ancient Chinese mythology, dragons live in the center of the earth, and when they awaken and shake their tails, earthquakes result.  The Chinese economic dragon has very clearly awakened; dealing with the lashings of its tail will be no mean feat.

A conference at the American Enterprise Institute Thursday looked at the sustainability of China’s rapid economic growth.  The overall conclusion (with which I only partially agree because of the bad debt problems in China’s unreformed banking system) was that China’s rapid economic growth is sustainable. However, the economic and political implications of continued rapid Chinese growth for the rest of the world are very considerable indeed.
 
First, there is the increasing competitiveness of Chinese products in Western markets.  The abolition of textile quotas in January 2005 has caused a surge of Chinese textile exports into Western markets, which in turn has been met with increased called for protectionism.  The protectionist bill introduced by Senator Charles Schumer (D.-NY), which would levy a 27.5 percent tariff on Chinese goods, has been promised a hearing by Senate Finance Committee Chairman Charles Grassley (R.-IA) and seems likely to pass, according to the AEI conference, albeit with an amendment that would allow President George W. Bush to certify that China was making progress towards liberalizing its currency markets and thereby suspend the new tariff.
 
More ominously for U.S. workers’ living standards, DaimlerChrysler announced Friday that it would begin importing Chinese-made automobiles into the United States.  Traditionally, the Chinese automobile industry has not been cost-competitive by international standards, because the network of parts suppliers necessary to produce top quality automobiles at low cost does not yet exist in China.  If DaimlerChrysler believes that Chinese costs may now be internationally competitive, then a huge new sector of U.S. manufacturing, representing close to 5 percent of factory output, is about to come under attack. Thus continued Chinese progress in manufacturing appears very likely to lead to an outbreak of protectionism in the West more severe than any seen since World War II.
 
The other still more disturbing factor in China’s economic emergence is its demand for energy.  According to Mikkal Herberg of the National Bureau for Asian Research, the majority of China’s energy demand to 2020 will be met by increased coal consumption, for use in China’ s power stations.  This is bringing the inevitable squawks from environmentalists, who have detected increased carbon deposits in Seattle from Chinese coal burning, but in practice it seems likely that a combination of the use of modern “clean coal” techniques in Chinese power stations and reduced burning of filthy domestic coal to heat Beijing will minimize the adverse environmental impact of Chinese coal usage.
 
However, China’s increased demand for oil is another matter. Herberg projects that in the period to 2020, Middle East oil exports will increase by more than 50 percent, and that around 80 percent of the additional 9 million barrels per day exported from the region will flow to Asian users (around half to China.) Lack of investment in Middle Eastern production capacity in the last 20 years, rather than any potential exhaustion in oil reserves, has caused steadily increasing world oil demand to bump up against production capacity, with a consequent sharp rise in oil prices to over $50 per barrel, a level Herberg expects to be sustained or exceeded over the medium term.
 
China’s policymakers take this impending oil shortage extremely seriously, and have been moving in a number of areas to counter it.  The AEI conference believed that much of the recent aggression in Chinese foreign policy stems from this factor, and in particular from Chinese concern about perceived U.S. attempts to control Middle East oil reserves. 
 
If affairs continue on their present trajectory, therefore, the world runs a risk of a Manichean struggle between the United States and China, in which U.S. protectionism against Chinese exports is matched by Chinese attempts to recruit client states in the Middle East through arms supplies and sabotage of U.S. embargoes on trade in nuclear materials. This would produce a very gloomy world, both economically and politically, with the likelihood of a major world recession caused by protectionism and oil shortages combined with the probable emergence of a number of rogue nuclear states.
 
To avoid this thoroughly unpleasant outcome, it’s worth examining U.S./China relations from first principles, to determine whether a way forward can be found.
 
Traditionally, in the United States, conservatives have pointed out the undemocratic nature of China’s regime, its continuing Communist elements, and have suggested a policy of containment similar to that practiced against the Soviet Union from 1945 to 1991.  Liberals, on the hand, at least those of the free trading variety, have pointed out China’s economic dynamism, and suggested that it be treated like Japan or Western Europe, a stable partner in the world trading system that simply has the misfortune to be not yet a democracy.
 
Neither approach seems to me quite right. The old Soviet Union could be isolated because it was of little economic importance; trade with the Soviet Union and its satellite states was a tiny fraction of the world total.  On the other hand, Japan and Western Europe, even France, share with the United States assumptions and constraints that do not apply to a non-democratic state whose origins are rooted in the Thoughts of Chairman Mao as much as in Confucius. Smaller non-democratic states, such as those in the Middle East, can be bullied (though this approach has not worked particularly well, to say the least) but China has grown too big to bully.
 
China thus represents a problem that has not existed since 1945: a major power that operates by assumptions quite different to those of Western democracy and yet is closely tied into the world economic system through international trade and investment, to which China has recently been remarkably open.  To find an analogy, it is necessary to go back to the last economically exuberant major power which was nevertheless not a democracy and was thus difficult to deal with: the pre-1914 Germany of Kaiser Wilhelm II.
 
Wilhelmine Germany was economically enormously successful; between 1870 and 1914 it far outdistanced its economic rivals Britain and France and remained second only to the somewhat isolated United States.  At the same time, it was not a democracy; political decision making was divided between the Chancellor, directly appointed by the Kaiser, and the General Staff, while economic policy was devised “from the shadows” by the great Jewish merchant banker Gerson von Bleichroder. It was mercantilist in its trade policy and followed an industrial policy of developing huge heavy industry cartels. Thus in a semi-democratic and free trading era it followed the dictates neither of democracy nor of free trade. Nevertheless, it was a major export power, and immensely successful in its economic diplomacy.
 
As the melancholy fate of relations with Wilhelmine Germany indicates, the problem of how to deal with such an entity is not an easy one.  Certainly the solution chosen in 1894-1914, of surrounding it with hostile rivals and hoping to overpower and thwart its ambitions led to two immensely destructive wars. Nevertheless China and Wilhelmine Germany differ from the Soviet Union in two essential respects: they are economically rational entities, and their fortunes are inextricably linked with the world economy as a whole.
 
If isolation is impossible and encirclement is too dangerous, the only remaining option is constructive engagement, building on the areas in which the United States and China, as major participants in the world economy, have interests in common. 

In the trade field, this is already being done. China’s membership of the World Trade Organization imposes obligations on it in terms of opening its economy, particularly the service sector, which offer immense opportunities to U.S. business and suggest that losses by the United States in manufacturing can readily be made up in services.
 
There are two requirements for success. First, the United States and China’s other trading partners must make sure that China adheres to its WTO obligations, and does not engage in excessive market distortion. Second, the protectionist instincts of the sillier U.S. Congressmen must be resisted, except to the extent that they can be used as a helpful lever to ensure the continued opening of the Chinese economy and in particular the freeing of the Chinese financial sector from its twin evils of state-enforced lending and draconian exchange controls.
 
On the energy front, the position is trickier: there are a finite number of oil sources, and both the United States and China are heavily dependent on foreign oil controlled by unpleasant regimes. If both countries attempt to control oil sources unilaterally there is the potential for a destabilizing “oil race” similar to the Anglo-German Naval Race of 1898-1914.

However, both countries share an overriding need for a Middle East that is politically stable, economically coherent, and determined to pump as much oil as possible. Hence if a mechanism for dialogue can be found, cooperation should be possible.

To cooperate, both parties must agree on objectives, and pursue policies that are non-threatening to the other.  Recent U.S. policy in the Middle East has failed this test with respect to China.  Of the possible objectives of the Iraq war, both the threat of Saddam Hussein’s weapons of mass destruction and his regime’s links to Al-Qaida, would even if real have been of only minor importance to China, and in the two years since the invasion the reality of both has been called in question (although not wholly disproved.)  Going to war to establish democracy, as the Bush administration now proclaims as its objective, is both incomprehensible to China and threatening to it, since China itself is not a democracy.

Hence to China it appears that the Iraq war was about oil, either to bring Iraqi oil production back to its pre-1991 level, an objective China would favor, or to secure control of Iraqi production to the United States, an objective China would vehemently oppose.
 
Viewed in this light, U.S. Middle East policy over the last 30 years appears completely irrational.  The 1991 invasion of Iraq was justified by Saddam’s seizure of Kuwaiti oil production, but why then did the George H.W. Bush administration halt the war without removing Saddam, thus hugely hindering Iraqi oil from reaching the world market (and increasing the likelihood of a rogue Saddam supporting terrorists and developing weapons of mass destruction?) Why was it necessary to invade Iraq in 2003, when it had not been thought necessary in 1991? 

Conversely, why did the United States not invade Saudi Arabia in 1973, when the Saudi seizure of its oil production from the U.S. companies that had discovered the Saudi oil fields and were developing them endangered U.S. oil security and plunged the Western economy into recession for a decade? To rational Chinese eyes, U.S. policy in the Middle East appears both naïve and dangerous, and the basis for cooperation in the region does not currently exist.

To ensure that the nightmare scenario of U.S./Chinese diplomatic and even military competition for Middle Eastern oil does not occur, U.S. policy must take a form that China can respect and live with.  Avoiding nuclear proliferation and suppressing terrorism are important U.S. objectives with which China can reasonably cooperate, provided her own overriding objective of secure access to Middle East oil is met. Military intervention in the Middle East needs to be carried out on a bipartisan basis, with China’s strong military and huge manpower being welcomed as an important addition to Western forces that are already overstretched and may be politically unable to intervene again should that prove necessary.

China should thus be invited to send peacekeepers to Iraq and should be granted a long term offtake contract for a substantial part of Iraq’s oil. It should also be invited to join with the United States in scenario planning for a joint invasion in the Middle East, to secure oil supplies in the event of instability in Saudi Arabia or anarchy in Iran, the two most dangerous oil-producing trouble spots. It might even be desirable to sign a contingent treaty, to come into force in the event of oil supply disruption, (ideally including the other huge oil-short Asian power, India) guaranteeing China its share of the restored oil supplies and guaranteeing to the United States that its efforts to impose democracy would not be misunderstood. In return, China must be made to liberalize its exchange rate regime, to cease supporting nuclear proliferation and to avoid exacerbating flashpoints such as Taiwan and Japan-China relations.

Negotiating with the Kaiser was never easy; negotiating with China is not easy. But until the disastrous Anglo-French Entente Cordiale of 1904, British and U.S. diplomacy proved readily able to reach agreement with Germany on mutual objectives, even when public opinion, as in the Boer War and the Boxer Rebellion of 1900, would have driven the countries apart. 

Similarly by understanding China’s overriding economic objectives and ensuring that U.S. policy is adapted to allow their fulfillment, the U.S. can safeguard world economic wellbeing and allow China to achieve its full potential in a world of peace and economic growth.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long ‘90s boom, the proportion of “sell” recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
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Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005)—details can be found on the Web site greatconservatives.com.

Posted by karlmagnus on Monday, April 25, 2005 at 10:51 AM in Business & Industry,  Economics & Finance,  Globalisation,  History,  U.S. Politics,  World Affairs
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