Michael Waugh Monetary Advisor

Mike Waugh was supposed to be in China this fall. It’s a round trip economists have routinely made for decades, road-testing new research and networking with Chinese counterparts.

It didn’t happen. “Hong Kong was deemed OK, but I had mainland China invites,” Waugh said. This put his itinerary in tension with the current U.S. State Department advisory to “reconsider” travel to the world’s second-largest economy, citing “arbitrary enforcement of local laws” and “risk of wrongful detentions.” The academic chill appears to run both ways, with Chinese academics increasingly keeping their distance from the United States.

While our economic entwinement with China remains enormous, Waugh’s canceled trip is part of a broader backtracking in business, trade, and technology collaboration. “It’s just a different world now,” said Waugh, a Minneapolis Fed monetary advisor and Bank specialist on international trade. “Executives, too, are thinking twice about going to China.”

This doesn’t look like “the end of globalization”—the trending phrase Waugh confronted in our 2022 interview. But we certainly appear at the end of a long, China-driven era of flourishing trade, from the mutual dropping of many tariffs in 1980, to China’s auspicious entry into the World Trade Organization (WTO) in 2001, to Mexico and Canada recently topping China as our largest sources of imports (Figure 1).

In recent months, the two countries’ leaders have taken gradual steps to shore up their relationship. Yet President Biden has largely left in place the Trump administration trade war with China. Chinese President Xi Jinping offers little reassurance to U.S. companies freshly worried about safeguarding data, technology, and employees. And the trade numbers don’t lie—things have changed.

This moment coincides with signs of economic fragility across the Chinese economy, including a collapsing property sector, sluggish consumer spending, masses of unemployed young people, and a heavier government hand with the private sector. China-related factors are contributing to a lull in trade worldwide: The IMF projects global trade growth will plummet below 1 percent this year in the face of rising trade barriers.

I asked Waugh, who also maintains the China-focused website TradeWarTracker.com, about his major insights from this current moment with China.

Keeping the pullback in perspective

Any reversal in our trade relationship with China is a major deal. But to some extent, “you could look at what’s going on and say this is just the natural development process of China,” Waugh said. “China has grown so much. Their labor costs have risen a lot. Their comparative advantage isn’t what it was. When you look at Mexico or Canada now—factoring in their distance from us—they look pretty good relative to China, whereas 10 or 15 years ago China just dominated them.”

Even amid some decline, trade with China seems likely to remain substantial. U.S. imports from China have slipped around 25 percent from their highs in 2018, currently neck and neck with Mexico and Canada. But China remains three times larger than import partners No. 4 and No. 5 (Germany and Japan). Total U.S. exports to China have even grown slightly despite the trade war launched in 2018 (Figure 2). “Stepping back to consider China’s place in the world and in global trade, it’s such a huge component,” said Waugh. “It’s not going to vanish. China is just so big.”

So big, in fact, that to even talk about China as a single market can obscure important developments. “There are really two Chinas,” Waugh said. “There’s the Eastern Seaboard—Beijing, Shanghai, Shenzhen—and when you’re there, it’s amazing the scale and the modernness. But then there’s a whole other part of China that is still rural and agriculturally oriented. We would naturally expect that now that the Eastern Seaboard is more costly, production would start rotating into places where labor’s cheap, in the hinterland.” A recent Wall Street Journal article noted that China’s central and western provinces are seeing faster export growth than competitors Mexico, India, and Vietnam.

Implications for U.S. inflation and growth

The past two decades of strong trade with China contributed to our sustained low inflation. While major categories of consumer spending such as housing and core services have often run hotter than the Fed’s 2 percent inflation target, “historically, we’ve had deflation in core goods around -1 percent,” Waugh said. “This is about globalization in China, in particular. We’ve been able to benefit from continual decreases in the cost of goods coming from China,” balancing out other price increases (Figure 3).

For the moment, U.S. core goods inflation has returned to zero. But “when we think about a slowing China that is also becoming harder to do business with, that calls into question that component of inflation. It makes our goal, our target of 2 percent, harder to achieve.”

Waugh said slowing Chinese growth and the ongoing trade war have costs for U.S. soybean, pork, and other ag producers for whom China has become an important market. China is also a critical market for the U.S. aircraft industry (principally Boeing). What is harder to measure: The opportunity cost for U.S. export industries that might have benefited from a stronger, richer China, but won’t. “You go back to China’s 2001 WTO accession, and the idea was that as the China market develops, it would become—maybe not today or tomorrow, but in the future—an important market for U.S. exporters,” Waugh said. “It’s still an important market, but China’s slow growth makes that market smaller than otherwise.”

Waugh is thinking especially of the high-end legal and financial services at which the U.S. excels. “As China would get richer, all of a sudden the product mix they’re demanding would start aligning with our comparative advantage,” he said. “A bunch of American investment banks have been waiting around in China for a long time, hoping the financial system would open up and develop like the U.S. or Europe. It hasn’t. In fact, they’re coming to the conclusion that if it does develop, we’re going to be excluded from it.”

Also troubling: Concerns about espionage (such as the U.S. ban on technology by Chinese telecommunications firm Huawei) or military use (such as sanctions to prevent China from obtaining certain microchip production equipment) have spurred China to develop competing, incompatible technology standards. Huawei recently debuted Chinese versions of Wi-Fi and Bluetooth.

“It’s like Betamax and VHS back in the early ’80s,” said Waugh, “and that’s a bad outcome,” inhibiting the kind of network effects that facilitate technological innovation and business collaboration. The prospect of a world where our smartphones no longer work in each other’s countries would portend slower progress, needless economic inefficiency, and less growth for everyone.

Trending trade terms: From free trade to friendshoring?

Investment in China surged alongside a hope and presumption that the future of global trade would converge to a freer and freer state (albeit with inevitable fits and starts). The notion is hard to shake, rooted in one of the fundamental theories of economics, credited to David Ricardo in the early 1800s: In the long run, free trade makes everyone better off.

Waugh’s own research offers plenty of support for the 200-year-old idea of Ricardian gains from trade. In an American Economic Review paper with Jesse Perla and Christopher Tonetti, Waugh established how opening to trade raises the rate at which firms adopt new technologies, substantially increasing economic growth and overall welfare. Waugh’s new Minneapolis Fed Staff Report finds that reducing the costs of trade primarily benefits poorer households that gain the most from lower prices.

Today, however, the endgame looks less and less like the Ricardian ideal. Trade with China, Waugh says, has proven it cannot be severed from geopolitics. Nor have many aspects of the Chinese economy ultimately emerged from the shadow of state influence. “In a way, we were investing in China with the hope that Chinese political values would align with our values. We’re coming to the conclusion that this hasn’t happened, and it will not be happening for the indefinite future.”

The Russia-Ukraine war and worries about China have spawned new buzzwords—maybe more nuanced than “the end of globalization”—to capture the emerging state of trade: homeshoring, friendshoring, nearshoring—and a related trade-policy concept, “small yard, high fence.” I asked Waugh what these emerging terms mean to him.

Homeshoring

For Waugh, “homeshoring” is the most troubling of these trending trade terms. In a more innocuous sense, homeshoring can describe U.S. firms finding it economically advantageous to return some overseas production to the U.S.—either for cost-based reasons, or because of changes in the risk environment overseas.

In other contexts, however, Waugh worries homeshoring is becoming a friendlier-sounding name for classic protectionism: “We’re not going to buy stuff from abroad, we’re going to buy American, we’re going to orient policies so we are more closed. I would call that definitively bad. It goes back to the idea that in an ideal world, we want firms to source in a way that takes advantage of the fact that there are low-cost, productive firms out there in the world that can supply at low prices and benefit consumers here in the U.S.”

“Small yard, high fence”

This expression of U.S. trade and national security policy found its moment about a year ago when U.S. National Security Advisor Jake Sullivan declared it in a speech to be the new policy of the administration. “Strategic competitors should not be able to exploit American and allied technologies to undermine American and allied security,” Sullivan said.

The policy was prompted by concerns about Chinese access to advanced Western semiconductor technology. The pandemic also revealed the vulnerability of thin semiconductor supply chains that are especially dependent on Taiwan.

The “small yard” refers to a limited scope of products to which a severe form of protectionism (the “high fence”) is applied. But Waugh is skeptical that the yard can stay small, especially as the argument has already expanded to batteries and other green technologies. “That’s why economists have really strong ‘priors’ against these kinds of policies: Once you build that fence, the guy on the outside starts complaining, ‘Fence me in too.’ Where do you draw that line?”

Friendshoring

“Friendshoring” entered the parlance after a 2022 speech in which U.S. Treasury Secretary Janet Yellen endorsed “favoring the ‘friend-shoring’ of supply chains to a large number of trusted countries.” It has a nice ring, but Waugh finds it hard to pin down, making it a challenging concept for researchers and policymakers.

“Friendshoring gets into issues that are less related to economics, like are the political leaders of a country aligned with ours? From an economic standpoint, that’s a hard thing to evaluate,” said Waugh. “For example, India is as far away as China, and in some ways has a similar low-cost structure. But we’ve had a complicated relationship with India for a long time. Are they a friend? A foe?”

Also, “friends come and go,” Waugh said, making it a slippery concept on which to structure or try to understand trade relationships. “Suppose Apple steps into India at a large scale, and maybe that really starts to shape the relationship between the U.S and India in a way that hadn’t been foreseen.”

It is further unclear whether friendshoring is about concentrating economic relationships with existing friends (say, Canada), or using commerce to shore up ambiguous relationships for foreign policy reasons (such as President Biden’s recent visit to China’s neighbor, Vietnam). University of Chicago economist and former Reserve Bank of India Governor Raghuram Rajan warns against friendshoring as a cover for “resurgent protectionism” that will limit U.S. trade with poorer countries while “increasing production costs and consumer prices.”

Nearshoring

Mexico’s recent return as our top import partner suggests to Waugh that “nearshoring” might be the most tractable concept for economists seeking to understand the present and future of trade. With pandemic supply-chain woes barely in the rearview mirror—and with China looking less competitive and more off-putting—perhaps the world is less “flat” and geography matters more than we had come to think.

At the same moment, Waugh and other economists are taking a broader view of the goals of trade. “Suppose we have a social planner who cares about the fact that some people don’t eat as much as other people,” Waugh said. “How should we organize the pattern of trade to address those distributional concerns?” In Waugh’s upcoming research exploring what he calls “equitable trade,” he says something akin to nearshoring emerges as one answer to this question.

The intuition behind this finding is under development. “This is something I’m thinking a lot about right now. Check back in a couple months and I'll have some answers for you.” But Waugh’s early model shows him that more equitable outcomes come from concentrating more trade in partners who are productive, cost-competitive—and, it seems, closer. Waugh says we still need to trade for the same classic Ricardian reason: Specialization and exchange grow the size of the pie for everyone. But “rich and poor people are gaining differentially from trade, and one way to equalize things is to tweak the pattern of trade,” Waugh said.

Waugh’s initial insight intriguingly suggests that a future of nearshoring might not necessarily be a poor, second-best substitute for the free trade future many once imagined for the U.S. and China. For good or ill, global trade is undergoing a forced adaptation to the noneconomic tides of history, politics, and geography. Economists, like the rest of us, are working hard to keep up.