A Litmus Test for the State of the World

The future of a once-great American icon is up for grabs. It's time to take The Sniff Test.

The State of the World

The world started changing about a decade ago. At that time the prevailing view of China in Washington shifted. A country that US authorities thought they could deal with became one to be contained.

This is not easy to do. The economies of the world are intertwined and the Americans designed it that way. Unpicking the threads that bind countries together is a laborious process. It may also be counterproductive.

In the last week, the private equity giant Apollo has offered to invest $5 billion in Intel, America’s last sizable semiconductor fabricator. It’s rival Qualcomm, which designs chips that are made in Taiwan, has floated the idea of buying Intel. How this plays out will tell us a lot about the state of the world.

Accelerating the Inevitable

China joined the World Trade Organisation in 2001. It was given non-market economy status, meaning it had open access to the West while being able to protect its fledging industries. This lasted for 15 years and has been in dispute since then.

What is not in dispute, is that the US no longer believes economic growth will allow China to open up and democratise. This is not Japan or South Korea. China is the main economic and military counterweight to the US.

On Wednesday, China tested its first intercontinental ballistic missile for 44 years. Its navy conducted drills with the Russians in the western Pacific. It also surprised markets with an economic stimulus package, which may indicate a desire to reduce dependence on trade with the West.

In the US, the presidential candidates fall over themselves to talk tough on China. Trump imposed tariffs during his first term and promises many more if he wins in November. This may accelerate the inevitable, in terms of creating a bipolar world and slower economies.

Can’t Get the Staff

Western companies prefer to source goods from the cheapest supplier. Often this is China and manufacturing capacity has headed East on the grounds of both efficiency and promoting global growth. The primary reason is promoting profits.

This creates an interdependent world. China imports food, fuel and technology and exports the industrial goods the world requires. The US owns much of the intellectual property to use those goods and is by far the largest consumer of finished products.

This is a gross simplification and everyone imports and exports a bit of everything. Semiconductors illustrate this. China controls the critical raw materials needed to make them. US companies have the know-how and designs for state-of-the-art chips, which are fabricated in Taiwan and South Korea.

The US denies China access to the latest chips and the machines to build them. The Chinese therefore increase investment in their domestic industry and do some sabre rattling near Taiwan. The Taiwanese try and build wafer fabs in the US, but can’t find the staff. That’s what happens when you stop building something. You lose the ability to build it.

The scales tilt more in China’s favour in green technologies. Not only does it control the necessary materials, both at home and internationally, it has a head start making solar panels and wind turbines. Slapping tariffs on green goods stalls the transition to clean energy. To address this, Microsoft is investing to restart the infamous Three Mile Island nuclear power plant in Pennsylvania.

Given this global interdependence, why would anyone think tariffs are a good idea?

An Uneven Playing Field

A tariff is a tax on goods and services entering a country. The original purpose was to raise money. In the centuries before income tax, trade levies were the most reliable way for monarchs to raise cash. Customs refer to taxes on international trade and excise to those on goods made at home.

Tariffs raise the price of foreign goods. In theory this reduces demand and allows domestic companies to compete. Tariffs have been justified to protect young industries, strategically important ones, and declining ones that employ a lot of people. Trump’s rhetoric captures all of these justifications and it happens that the fading industries are in swing states.

In practice, consumers pay higher prices for the goods, meaning individuals shoulder the tax burden. This is the case with most taxes and a cautionary note for those who think companies should pay more tax to address budget deficits. Furthermore, many companies can move profits offshore with the stroke of a pen.

Tariffs are also popular when other countries are considered to be cheating. Dumping means selling goods below the cost of production, to get rid of surplus and put rivals out of business. It is made possible by industrial subsidies by foreign governments and occasionally slave labour.

Again, everyone subsidises something, it’s just that China does more of it. It is also more reliant on trade for growth than the US and hence unlikely to escalate a tit-for-tat tariff battle too far. At least that’s the thinking.

Subsidies as % of the economy (source: DiPippo et al. 2022)

Why shouldn’t China subsidise its preferred industries? Large, well-funded US companies often run at a loss using predatory pricing to drive competitors out of business. Think of Uber and taxis, or the early days of Amazon.

Is this behaviour justified when funded privately, but not when state sponsored? As the US has the deepest capital markets, under these rules no one can catch up. It’s little wonder China has no time for these arguments.

Tariffs are the crudest way to protect companies. Try charging your Galaxy phone with an Apple charger, or calling your sparkling wine Champagne. Non-tariff barriers are everywhere, but less obvious and less political than tariffs.

A Decent Wine

Tariffs distort free trade, which is assumed to be for the benefit of the everyone. The argument is based on comparative advantage. When England made cloth and Portugal wine, it made sense for each to focus on making and trading a single good.

The theory holds even when one country is better at producing both goods. The best outcome is when each focuses wherever it has the greatest relative advantage. Therefore, even were China the cheapest place to make everything, it should still only make goods where its cost advantage was greatest.

This assumes we all get along nicely. Portugal is England’s oldest ally. In these circumstances, it’s a benefit of free trade that our inefficient industries either improve or go bust. They consume resources that are better used in areas where we have an advantage.

There is a joke in which an economist is asked to assess policy. They reply that it’s fine in practice, but does it work in theory. Economic arguments rely on simplifying assumptions and do not reflect the real world.

Governments want to keep people in employment and develop new technologies. No country has a perpetual advantage in any area. Even some English wine is decent.

The stakes are raised significantly when national security is at stake. A popular argument is that the US must sustain heavy manufacturing to supply the components for strategic industries. Two world wars were won by the ability to build faster than the enemy, but now the US is in a position of weakness. It must be able to scale up.

This argument kicked up a notch with the attacks on pagers and walkie-talkies in Lebanon. The FBI announced that it has dismantled a network of connected devices used by China to launch cyber attacks in the US and Europe. The US has long tried to banish Huawei components from its infrastructure.

Maintaining minimum capacity is a poor argument. Small suppliers cannot be scaled and don’t earn the profits to invest in modernisation. Industry must be run full throttle and even then can become obsolete. Which brings us back to Intel.

The Technological Battlefield

One reason the US builds fewer tanks and boats is that warfare is increasingly about technology. US tech firms are defence contractors, which is why there are Gaza protests outside the Apple Store. The firms also project US power.

Microsoft and Blackrock are raising money to invest in data centres and supporting energy infrastructure worldwide. They are roping in Middle East investors to bring oil money onside. The promise is that whoever controls the hardware will own AI.

In contrast, China subverts its tech companies, preferring government-to-government projections of power. It offers huge loans that Western banks can’t match, not needing to be paid back when that allows seizure of mines, ports and communications networks. This is a poor version of US soft power and is meeting rising resistance.

Yet China looms large over Taiwan. When it finds a means to push the US back behind the second island chain, then it will have the hardware to invade, even if it doesn’t right now. That will turn everything on its head and gift China victory in the AI race.

Intel once dominated semiconductors, but it underestimated the importance of graphic chips, first for gaming then for AI. The world moved on and Intel headed the way of Motorola, Blackberry and Blockbuster.

Then suddenly there’s renewed interest. Is this an attempt to rebuild domestic chip capacity as a strategic asset? Will a deal with Qualcomm be fast-tracked?

If so, do new owners do what’s profitable, and shut down Intel’s manufacturing, or what’s political, and ramp it up?

The answer will tell us how worried the US is about the threat from China.