Thermostats, Christmas cards, and the trade war

The recent escalation of the China-US trade war and its ripple effects have brought much uncertainty to the global economy. A recent rereading of Micromotives and Macrobehavior, a book written by Thomas Schelling, Nobel Prize Winner for Economic Sciences, has filled me with mixed feelings in light of the ongoing trade war.

People often assume that there is a motive behind every action, be it to show one's likes and dislikes or to attain certain goals. Beginning from infancy, others speculate on our motives, but it is not always right to assume that every behaviour is intentional or purposive. As Schelling points out in his book: "With people, we can get carried away with our image of goal seeking and problem solving. We can forget that people pursue misguided goals or don't know their goals, and that they enjoy or suffer subconscious processes that deceive them about their goals. And we can exaggerate how much good is accomplished when people achieve the goals we think they think they have been pursuing." Erroneous assumptions of others' pursuits and exaggeration of the good they have accomplished are common phenomena in international relations. China's industrial policy is one such example.

The leaders who led China's market reforms proposed the idea of "the state regulates the market and the market guides enterprises" roughly 30 years ago. The industrial policy, which was then considered a replacement for central planning, was adopted as the main tool to regulate the market. The government could use industrial policy to steer the direction of industrial development and to push for the upgrade of industrial structure, which is a common practice internationally. The problem was that, at the time, China's economy was smaller in scale and foreign trade linkages were less extensive. State regulations only applied to China's domestic market, and were directed at Chinese enterprises. However, when China became the world's second largest economy and the largest exporting country, its industrial policy began to affect the global market, creating a massive impact on enterprises in other countries. When that happens, there is a new wave of global interest in China's industrial policy.

Oftentimes, the government can over-regulate the market. In Micromotives and Macrobehavior, Schelling uses the metaphor of thermostats in old homes to explain overregulation. When outdoor temperatures dip, indoor temperatures follow suit. In response, the thermostat sets off the heating process, but the water in the furnace takes time to heat up before it can generate warmth. At this point, one might become impatient and raise the temperature a few degrees higher. Before long, the furnace generates warmth and reaches the new set temperature. The room then becomes too warm, leading those inside the house to lower the set temperature. This repeated overshoots or "overregulation" is due to the time lags in the thermostat's regulation of temperatures. Schelling believes that government policies are often similarly overregulated. When the Soviet Union launched the world's first satellite in 1957, the US was under tremendous pressure to keep up, not wanting to be left behind in the space race. There was alarm about a shortage of scientists and engineers in America. Subsidised programmes of all sorts sprang up to cultivate scientists and engineers. However, it takes time to nurture talent. At least five to six years are needed to stimulate high school students' interest in science and engineering, after which they must complete a degree or an advanced degree in these fields. Lag time tempts people to adjust the "thermostat", which in turn creates a surplus of scientists and engineers. Once news of this surplus is made known, university students rethink their career paths, resulting in a later deficit in this field.

China's industrial policies are often overregulated because these policies focus on picking winners, and their implementation lies mainly in the hands of local governments. Whenever the central government launches an industrial policy, local governments enthusiastically flock to cooperate. More than 3,000 Chinese local governments at all levels quickly respond with different forms of subsidies and incentives in their enthusiastic efforts to promote the policy's implementation. Due to the lag time from investment to production, ill-advised investments are initially well-hidden. However, such a misguided frenzy soon leads to numerous firms with overcapacity in production, resulting in a price war. These firms then suffer from financial losses, and may even go bankrupt. The majority of their loans soon become bad debts held by financial institutions. Some enterprises become "zombie enterprises" that survive solely on bailouts.

Professor Huang Shaoqing and his team from Shanghai Jiao Tong University studied the relationship between industrial policies and zombie enterprises and found that industries earmarked by the government as key industries received a greater proportion of government subsidies. A few years later, a higher ratio of these enterprises became zombie enterprises, and productivity decreased.

Mr Chen Qingtai, former Deputy Director of the Development Research Center of the State Council, believes that in the initial phase, industrial policies had a positive impact when planned economy was gradually phased out. However, the negatives eventually outweighed the positives. Current industrial policies are excessively interventionist, weakening the innovative spirit of enterprises, resulting in a state of inertia and over-reliance on the government, and even breeds corruption.

China's industrial policies have brought about a multitude of problems, pushing both the government and academics to reflect on the phenomenon of overregulation. It is obvious that the results of these policies have taken policymakers by surprise and have not achieved their intended goals. However, the West often perceives these policies as strategic tools used by the Chinese government to increase the competitiveness of China's manufacturing industries. Western observers note that when the Chinese government injects massive funds into an industry, its production capacity grows exponentially, leading China-manufactured goods to flood the global market. As a result, most non-Chinese enterprises are defeated in price wars. Chinese enterprises, especially state-owned enterprises that receive immense financial support from state-owned banks, become the ultimate winners. This scenario is constantly played out in various industries, including steel, glass, cement, photovoltaic products, and new energy vehicles. Hence, the common belief is that the Chinese government is making use of industrial policies to unfairly occupy market shares and monopolise the entire market. Like what Schelling would say, when one makes assumptions about the goals of the Chinese government, it is easy to exaggerate China's achievement of those supposed goals through its implementation of industrial policies.

Objectively speaking, it is difficult for policymakers in China's central government to foresee the results of any policy, since a policy's effect hinges on how well local governments cooperate with them. Due to huge differences between China's different regions, local governments enjoy a great degree of autonomy when implementing central policies. If local governments play up a policy, its results will surprise even the central government. If they downplay them, the policy fizzles out, and policymakers in Beijing lament the limitations of their control outside the office.

Many local governments are fervent in their implementation of industrial policies, as demonstrated by the photovoltaic industry. During the initial stages of a national policy launched to support this industry over ten years ago, virtually every province heavily supported it. As a result, the production scale of Chinese photovoltaic products grew rapidly, and China became the global leader in 2012. Most China-manufactured photovoltaic products were exported, creating a vicious price competition in the global market, which ultimately compelled the EU and the US to impose anti-dumping measures. Hit by new export limits, many Chinese photovoltaic enterprises were on the edge of collapse. The State Council was forced to provide subsidies to photovoltaic power stations in 2013 so that the domestic market could absorb this excess supply of products. Once subsidy policies were put in place, local governments quickly followed suit. In Zhejiang province, apart from the provincial government, eight municipal and 20 district governments likewise provided subsidies to photovoltaic power stations, with subsidies covering electricity costs and initial capital investments. Exactly how much in subsidies did the photovoltaic enterprises receive from various levels of the government? No one knows.

Subsidy policies have since created a craze over the installation of photovoltaic power generators. Compared to numbers worldwide, China's new power generators increased from 0.6% of the global share in 2008 to 45.7% in 2016. The rapid growth in China's market fueled the production of photovoltaic products even further. As of 2018, nine out of ten companies with the largest amounts of photovoltaic product shipments are from China. In such a short period of time, China has become the biggest manufacturer of photovoltaic products. Yet, the majority of photovoltaic enterprises are burdened with huge subsidies, huge investments, huge debt, low core technical skills, and unsustainable operations. In a bid to alleviate financial subsidies and curb excess supply, China's Ministry of Finance, the National Development and Reform Commission, and the National Energy Administration jointly announced last year a reduction in subsidies and a restrictive quota for the construction of photovoltaic power stations. This decision put the brakes on the blind enthusiasm and disorderliness of the photovoltaic industry. Many small companies collapsed, while big companies ceased production, retrenched their staff, and even sold their subsidiary companies and power stations.

How can local governments' overreaction to industrial policies be explained? We can get some hints from Schelling who described the traditional act of mailing Christmas cards as an "interactive process" and demonstrated the infuriating problem the practice eventually created. At first, he says, people feel obliged to send cards to people from whom they expect to receive them. Later, they know that they will receive cards only because the senders expect to receive reciprocal greetings. Therefore, people send cards early to avoid the suspicion that they were sent only after one had already been received. Next, people sometimes send cards only because cards have been sent for several years and cessation of the practice might signal something untoward. Even students start sending cards to teachers, believing that other students were doing so as well. Eventually, the list of sendees only gets longer, but the act of mailing cards is no longer motivated by holiday spirit and friendship; being done instead purely out of obligation. This act has become an absurd, ridiculous, senseless trap. Everyone is like those around them, lamenting the trap they have fallen into and cannot escape, yet, no one is courageous enough to stop sending cards, fearing the trouble and embarrassment it might bring. Fortunately, mailing Christmas cards has now become a thing of the past.

The attitude towards central policies and the mindsets of local governments in response to these policies are analogous to the practice of mailing Christmas cards. In a centralised political system, the people in charge of local governments are appointed by their superiors. Once the central government advances a new policy, it expects local governments to be in total alignment, anticipating no less than a firm implementation of the policy. The local governments are aware of this expectation and thus fully adhere to it. They are further pressured by other local governments and their execution of the policies. They fear that they are not complying closely enough or not adequately forceful in their implementation. They also fear being seen as passive followers of other local governments' actions. More importantly, industrial policies are advantageous to local governments. With central policies in place, investment projects are easily approved, bank loans easily acquired, and goals for GDP growth rate easily met. Even if support and aid for the chosen industry fails, local governments are not held responsible, since the policy was laid down by the central government. Moreover, the incentives associated with industrial policies (such as fiscal subsidies, tax incentives, or status as leading companies) give rise to rent-seeking behaviour, providing corrupt officials with opportunities for rent extraction.

In recent years, China's industrial policies have become controversial. Although supporters insist on their necessity, success stories of industrial policies are nowhere to be found. Yet, industrial policies are highly impactful overseas. Policymakers give them their full attention, be it filing litigations against the World Trade Organisation, countering industrial policies by imposing anti-dumping laws and coming up with countervailing measures, or establishing detailed terms in the Trans-Pacific Partnership Agreement to further address the problem. Industrial policies and state-owned enterprises are also the main topics of the China-US trade talks.

In the past, Schelling was greatly influential among policymakers. If he were still alive, what would his response to the current situation be? Perhaps he would warn the US government against false assumptions regarding the motives of others, or he might suggest that the Chinese government evaluate their industrial policy and deter overregulation to avoid being misunderstood. However, although it is easy to make mistakes, admitting and correcting them is difficult, and re-establishing trust is an even greater challenge.