Following is the testimony of Ralph E. Gomory, Research Professor, Stern School of Business, New York University, New York, N.Y., before the U.S. – China Economic and Security Review Commission, Hearing on China’s Five-Year Plan, Indigenous Innovation and Technology Transfers, and Outsourcing on June 15, 2011.
Thank you for the opportunity to take part in this hearing of the China Commission. The subjects that we are discussing today are closely related to the topics to which I have devoted much of my working life. For almost 20 years I was the head of the research effort of a major international corporation, (IBM). For the next 18 years I was the head of a major foundation (Alfred P. Sloan) deeply interested in science and technology. In addition I have been a director of several major corporations and for the last two decades I have devoted considerable energy to understanding and writing about the economics of trade.
Many of the questions you have proposed to this panel relate to China’s efforts to move its people into more productive jobs where they can create more value for each hour worked, and to the means, ranging from foreign direct investment to direct acquisition of knowledge abroad, that China has used and will use to acquire the technical knowledge that is needed to produce that result. Explicit or implicit in many of the questions is also the question of the impact of these actions on the U.S. and the likelihood of their success in the future. A further implicit question posed is this: What can the U.S. do when these impacts are detrimental to the U.S.?
I will state here in short form what I will say in a more detailed way below. What we can expect in the future is simply more, and probably much more, of what we have seen to date.
What we have seen to date is this: rapid economic growth in China, coupled with a major negative impact of the imports of Chinese goods on the productive capability of this county. We have seen an enormous imbalance of trade as these imports are not balanced by a sufficient counter-flow of exports. In the U.S. we have seen greater corporate profits, accompanied by downward pressure on wages and employment.
While the inflow of cheaper consumer goods has been a benefit. That benefit, as we will show below, has come at too high a price.
It is also clear that U.S. global corporations, in their normal pursuit of profits, are strongly aiding these developments. Therefore it is time to realize that the interests of our global corporations and the interests of our country have diverged.
Without a major departure from current U.S. government policies, we can expect that that divergence too will continue.
Confusion Over Free Trade
Why is this happening when there is a strong and pervasive belief, especially among many of the most educated and influential, that free trade benefits everyone; that when you lose manufacturing¸ it is because your comparative advantage is somewhere else, and that it benefits everyone to allow market forces to shift you in the direction of your comparative advantage rather than struggle to keep what you once had.
This view represents a fundamental confusion. In most standard economic models countries have fixed capabilities. In this situation market forces will sort themselves out in the way described and the free market free trade result is beneficial. Unfortunately that does not answer or even address the question we are interested in: we are interested in the effect of changes.
What is the effect when a trading partner, in this discussion China, does not hold its capabilities fixed, but rather improves them? Let me state clearly here that economic theory does not say that when your trading partner improves its capabilities, and then market forces act on these new capabilities, that the new free trade result is better for your country than where you were before the change. In fact it can be harmful.
What standard models involving change do show, and this is the work that Professor Baumol  and I have been engaged in for many years (References 1 and 8), is this: That the initial development of your trading partner is good for you, but as your trading partner moves from a less developed to a more developed state, things turn around. Their further development becomes harmful to your country. Its impact is to decrease your GDP.
And this result takes into account all the effects. It includes the benefit to consumers of cheaper goods from the newly developed partner (in this case China) as well as the negative impact of losing productive industries in the home country (USA).
Consequently we cannot take refuge, as many do, in simply asserting, is spite of the evidence before their eyes, that China’s development is good for the U.S. In fact it is more reasonable to say that theory expects it to have a negative impact with further economic development, and it is further development that is being discussed here.
China’s Form of Mercantilism
China’s approach to trade cannot be described as free trade. It is traditional mercantilism, a pattern of government policies aimed at advancing Chinese industries in world trade, an approach that has many precedents.
The effect of mispriced currency, subsidies, and the rapid appropriation of foreign know-how allows many Chinese industries to appear on the world scene with prices and capabilities that would have taken decades (if ever) to attain without the aid of these practices. Professor Shih, who is testifying here today, has well described the destructive effect of these efforts on American industries in some of his writings (Reference 2).
A More Detailed Description
If we look more closely at the development of China we can see what U.S. corporations contribute. We see U.S. corporations, either alone or in joint enterprises with Chinese corporations, building plants in China that enhance both that country’s’ productive abilities and its technical know how. We have seen the goods imported from these enterprises contribute largely to the enormous imbalance of trade since these imports are not balanced by a sufficient counter-flow of exports from this country. We see that today this has resulted in 2 to 3 trillion dollars at the disposal of the Chinese government for the purchase of more treasury notes etc. as in the past, or, as is more likely in the future, for the acquisition of companies and their technology.
In addition, we see U.S. corporations increasingly locating their research and development in China. This is a further and very direct way for China to acquire the necessary know how.
While many economists have been slow to realize that all is not well, we now have this from the Nobel Prize winning economist Michael Spence writing in a widely noticed paper: (Reference 3)
Until about a decade ago, the effects of globalization on the distribution of wealth and jobs were largely benign… Imported goods became cheaper as emerging markets engaged with the global economy, benefiting consumers in both developed and developing countries.
But as the developing countries became larger and richer … they moved up the value-added chain. Now, developing countries increasingly produce the kind of high-value-added components that 30 years ago were the exclusive purview of advanced economies.
The major emerging economies are becoming more competitive in areas in which the U.S. economy has historically been dominant, such as the design and manufacture of semiconductors, pharmaceuticals, and information technology services.