How to Meet the Strategic Challenge Posed by China

China poses a formidable strategic challenge to America, but we should keep in mind that it is in large part motivated by insecurity and fear. America has inherent strengths that China does not. And the greatest danger to America is not a lack of strength, but complacency.

China is a phenomenon unlike anything in economic history. The average Chinese consumes 17 times more today than in 1987. This is like the difference between driving a car and riding a bicycle or between indoor plumbing and an outhouse. In an incredibly short period of time, this formerly backward country has lifted itself into the very first rank of world economies.

Over the same period, China has moved approximately 600 million people from the countryside to the cities—the equivalent of moving the entire population of Europe from the Ural Mountains to the Atlantic Ocean. To accommodate those people, it built the equivalent of a new London, plus a new Berlin, Rome, Glasgow, Helsinki, Naples, and Lyons. And of course, moving people whose ancestors spent millennia in the monotony of traditional village life and bringing them into the industrial world led to an explosion of productivity.

Where does America stand in respect to China? By a measure economists call purchasing power parity, you can buy a lot more with $100 in China than you can in the United States. Adjusted for that measure, the Chinese economy is already bigger than ours. In terms of dollars, our economy is still bigger. But the Chinese are gaining on us, and in the next eight to ten years their economy—unlike the economies of our previous competitors—will catch up.

China, on the other hand, is an empire based on the coercion of unwilling people. Whereas the United States became a great nation populated by people who chose to be part of it, China conquered peoples of different ethnicities and with different languages and has kept them together by force. Whereas our principle is E Pluribus Unum, the Chinese reality is E Pluribus Pluribus with a dictator at the top.

China is inherently unstable because all that holds it together is an imperial culture and the tax collector in Beijing. It is like a collection of very powerful, oppositely charged magnets held together by super glue—it looks stable, but it isn’t.

Within the living memory of older Chinese, China underwent an era of national division, warlordism, civil war, starvation, and degradation. The Century of Humiliation, as the Chinese call it—which began with the opium wars in 1848 and ended with the success of the Communist Revolution in 1949—was a century in which civil war claimed untold millions of lives, and the terror of a return to those conditions is a specter that haunts the Chinese leadership.

Along with ensuring internal stability at all costs, China’s leaders are determined to make China impregnable from the outside. We hardly hear the term South China Sea these days, because that sea has become a Chinese lake. It has become a Chinese lake because the Chinese have made it clear they will go to war over it. There’s a Chinese proverb: “Kill the chicken for the instruction of the monkey.” China has an even greater concern over Taiwan. The Chinese Communist Party is terrified that a rebel province like Taiwan can set in motion centrifugal forces that the Party will be unable to control. So the adhesion of Taiwan to the Chinese state—the imperial center—is for the Chinese government an existential matter. They will go to war over it. By demonstrating their willingness to fight over the South China Sea, they are demonstrating that they will fight all the more viciously over Taiwan.

Turning back to our two economies, consider the three graphs above. China does something that Japan, Korea, and other Asian nations do—it massively subsidizes capital investment in heavy industry. From the Chinese standpoint, a steel mill or a semiconductor fabrication plant are public goods—the Chinese look at these things the way we look at highways and airports. And as a result of Chinese subsidies for heavy industry, America has been pushed out of any major capital-intensive manufacturing. Thirty years ago the Japanese were doing this, which is why the Reagan administration took steps to force the Japanese to build car plants in the U.S. But Japan’s economy was very small compared to ours. Because China’s economy is roughly the same size as ours, the impact of Chinese subsidies is huge.

The first graph shows the capital intensity of the companies in the major Chinese stock index (MSCI) versus their return on equity. The more capital-intensive, the higher the return. In the United States, on the other hand, if you look at the S&P 500 on the second graph, the slope is in the other direction. More capital-intensive industries are less profitable. This distortion of global investment by Chinese subsidies for heavy industry has led to a stripping out of capital from American heavy industry. It’s not that Americans prefer financial assets to real assets—it’s that the Chinese have pushed us out. That’s why we’ve lost so much ground in terms of industry.

As the third graph shows, China’s share of high tech exports has risen from about five percent in 1999 to about 25 percent at present, while America’s has plummeted from about 20 percent to about seven percent. That’s not a sustainable situation. What it means in practical terms is that America can’t build a military aircraft without Chinese chips. That’s a national security issue.

The impact of what China is doing is felt all over the world. Former allies of the U.S., including former NATO members, are orienting towards China. Russia—which has become totally dependent on China—has quadrupled its energy exports to China, providing China with land-based energy imports in case the U.S. tries interfering with seaborne energy traffic.

China has an extensive high-speed rail network, with trains going 200 miles an hour. This has had huge productivity effects, and the Chinese are proposing to build these trains all over Southeast Asia. Thailand, an agricultural country, sees that with high-speed trains built by China, it can become the source of fresh fruits and vegetables for China. So Thailand—which used to be an American ally—is being absorbed into the Chinese economy. And so on.

One of the most dangerous misconceptions Americans have about the Chinese is that they can’t innovate. Who do you think invented gunpowder, the magnetic compass, the clock, and movable type? Yes, China’s culture is much more conformist than ours. And on average, Chinese are less likely than Americans to be innovators. But there are 1.38 billion Chinese, and their research and development (R&D) spending is quickly catching up with ours. They’re producing four times as many science, technology, engineering, and mathematics (STEM) bachelor’s degrees and twice as many STEM Ph.D.s as the United States. Granted, some of them are of low quality—but many are excellent.

The single most troublesome deficiency we have in the United States is not the industrial base, which is relatively easy to deal with. It is the lack of scientific and engineering education. Six or seven percent of U.S. college students major in engineering. In China that number is 30-40 percent. That’s our biggest problem. Second to that is the fact, already mentioned, that there is a massive distortion of the global economic system caused by Chinese industrial policy.

Virtually all of American investment in R&D today goes to software. This means that we’ve conceded to Asia, and especially China, the actual manufacturing, to the point that—this bears repeating—we can’t put a warplane in the air without Chinese chips.

So what do we do about China? The answer is not to adopt an industrial policy. As Americans, we believe in individual liberty. We are not good at being collectivists. China and Germany have industrial policies. Culturally they can deal with it. We cannot. If we’re going to compete with China, we’ve got to do it the American way. And what we are best at is innovation.

In the 1970s, all the smart people thought Russia was going to win the Cold War. Economists at the CIA and in the universities believed that Russia had a great economy. But by 1989, we realized that the Russian economy was a piece of junk. It actually had a negative worth, because the cost of environmental cleanup exceeded the value of whatever Russia was producing.

What happened in the interim was the greatest wave of industrial innovation in American history. We invented fast, light, small, inexpensive microchips. We invented sensors that didn’t exist before. We invented the semiconductor laser. And we did virtually all of this through the Defense Advanced Research Projects Agency and NASA, in cooperation with the great corporate laboratories.

The U.S. turned the Russian economy into junk by creating an economy that hadn’t existed before. That was the Reagan economy. During this creation, the Fortune 500 lost employment. The monopolies were all ruined. New companies no one ever heard of sprang up to commercialize the new technologies, and corruption declined because we had challengers taking market share away from the entrenched interests.

We have failed to continue this innovation in recent decades. Starting with the Clinton administration, we came to believe we were so powerful that we didn’t have to invest in national defense and new technologies. Investment went into the Internet bubble of the 1990s, as if downloading movies was going to be the economy of the future.

I’m a free marketer. But the one thing markets cannot do is divorce themselves from culture. It is when we have a national security requirement, forcing us to the frontier of physics to develop weapons that are better than those of our rivals, that we get the best kind of innovation. So the government has a role—a critical role—in meeting the Chinese challenge.

If the Chinese are spending tens of billions of dollars to build chip fabrication plants and we come up with a better way of doing it, suddenly they’ll have a hundred billion dollars’ worth of worthless chip manufacturing plants on their hands. But you can’t predict the outcome in advance. You have to make the commitment and take a leap of faith in American ingenuity and science. We can meet the strategic challenge of China, but we have to meet it as Americans in the American way.