US innovation widens the trade deficit with China

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America makes software, which runs on hardware that has to be imported from somewhere. Photo: AFP

Protecting intellectual property and reducing the US-China bilateral trade deficit are entirely unrelated issues, yet the Trump Administration has lumped them together in its commercial confrontation with China.

American innovations add economic value, but they are more likely to increase US imports from China than they are to increase US export to China. In other words, US innovations on balance will increase the trade deficit. That’s because the pipeline of US venture capital investments tilts overwhelmingly towards software rather than hardware. America now imports $150 billion a year of electronic goods from China, by far the largest component of its overall $562 billion from China. Better use of software usually requires more hardware, which means more imports.

US venture capital investments

The chart shows the distribution of venture capital investments last year as reported by the National Venture Capital Association. Software consumed over $30 billion, while IT hardware drew only $2.7 billion of new investments. The more America invests in software, the more hardware it needs, and the more hardware it will import.

Cloud computing is one of the great software success stories, with global revenues up to an estimated $260 billion in 2017 from $210 billion in 2016. America doesn’t manufacture the hardware; it imports it from Asia, and mostly from China. Whether a computer bears a “Chinese” or other Asian label is largely irrelevant, because the major Asian economies share a common supply chain in electronic components. The more cloud computing services sold by Amazon or IBM, the more hardware they will import. Cloud computing adds economic value, to be sure, but it also increases the trade deficit.

Venture capitalists are putting money into medical devices, and the Chinese well might purchase some of these from the United States, although the volume of trade in such items is unlikely to have much impact on the overall deficit.

Protecting intellectual property safeguards the profits of US companies on existing technologies. The fact that US companies earn more profits, of course, has nothing to do with the size of the trade deficit. If US companies distribute their profits to shareholders through buybacks and dividends, they will increase consumption, which means more imports. In fact, S&P 500 companies have returned $1 trillion to their shareholders since 2010, more than their gross capital spending of about $630 billion. Of course, the US government has a responsibility to help US companies protect IP. That’s the right thing to do on its own merits. But it has no relationship at all to the trade deficit.

If the United States wants to reduce its bilateral deficit with China in electronics goods, it will have to fight against a global supply chain that US companies have built over the past quarter-century. One way to attack the problem, as Dr. Henry Kressel and I proposed in the Wall Street Journal in November 2016, is to require domestic content for defense electronics. That would require US manufacturers to rebuild plants in the United States, a sensible measure for national security reasons, although an expensive one: the US government would pay a great deal more than it does today.

At present, US trade policy is a complete muddle that mixes up different issues that have different solutions and different outcomes. As I wrote yesterday, President Trump brings to mind the old joke about the [insert an ethnicity] Godfather who makes you an offer you can’t understand.

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