The China Challenge: Rebuilding Trust in the Global Trading System

Tariffs and sanctions on China won’t fix liberal international institutions, but unconventional, decentralized solutions might

Image Credit: Dan Matutina/Agent Pekka

By Christine McDaniel, Eileen Norcross and Weifeng Zhong

This year marks the 20th anniversary of China’s accession to the World Trade Organization (WTO) and the centenary of the Chinese Communist Party (CCP), whose global influence threatens the postwar liberal international order. President Biden in a recent interview summed up the China challenge as being about “whether or not democracy can function in the 21st century . . . [or] whether autocracy is the answer.” Taking on this challenge requires understanding what went wrong during China’s integration into the global economy and where liberal international institutions can still make a difference.

The past 20 years of engagement with China were largely based on an optimistic but failed vision that China would become “one of us.” Moving forward, a functioning global trading regime requires our liberal international institutions to find new ways to establish trust in the presence of authoritarian heavyweights such as China.

Expectations and Reality

Western countries had expectations for China upon its WTO accession that were inspired by long negotiations with Chinese officials. Once the global trading system welcomed the most populous country with open arms, existing WTO members anticipated they would enjoy a host of economic benefits from trade, such as lower import prices from China and greater access to Chinese markets. Meanwhile, China would enjoy greater access to world markets and experience income gains. It would also become more open and freer in its economic institutions, economic policies and perhaps even its political institutions.

There’s no question that economic gains from trade have been realized across the globe, albeit with adjustment costs (some quite severe) in Western countries. But China’s economic institutions and market practices have not become more open or market-oriented. Quite the contrary: With the CCP’s heavy hand in the economy, resources are allocated largely by the party’s orders instead of market forces. Moreover, domestic policy goals are implemented with little or no regard for fundamental principles of the world trading system: equal treatment of foreigners and locals, transparency and predictability. As for political institutions, the Chinese regime has become more authoritarian and more closed since President Xi Jinping came to power.

Economic and political practices coming out of China’s authoritarian regime create consequences that are spilling out to the rest of the world in troubling ways. Market-distorting government subsidies create large ripple effects in other countries, partly because of China’s sheer size. Active intellectual property and cyber theft continues as the CCP looks the other way, or in some cases even supports it. The CCP’s unwillingness to cooperate and be transparent can make it difficult, if not impossible, for international organizations to achieve their goals. Two recent examples include the possible pervasiveness of forced labor in anything “Made in China” with no way to verify cooperation with international labor standards, and the lack of cooperation in the realm of health research to identify the origin of COVID-19.

A Collision of Values

This raises the question: Why has Western engagement with China failed to deliver on the promise that increased economic openness would bring market and democratic reforms? The “end of history” expectation that free trade would lead inevitably to democracy failed to grapple with the deep cultural and historical roots of China’s governing institutions.

When it acceded to the WTO, China had only recently emerged from decades of being a relatively closed, communist society. But what China joined were liberal-democratic international institutions that it did not help set up, whose values it did not share and whose founding principles it did not appreciate.

Our international institutions are the bedrock of the rules of the game on the global stage. These post-WWII institutions were created by nations that shared the horrors of the bloodiest war in history and a desperate desire to rebuild societies and prevent future world wars. These nations sought to support postwar reconstruction, ongoing economic stabilization and organic growth through trade. By tying together the economic interests of buyers and sellers across borders, individuals would be disincentivized to support policies that restricted cross-border economic activities or induced conflicts. From the shared wartime experiences of Western nations and their hopes for the future emerged the trust whose importance cannot be overstated in today’s international institutions, including the WTO.

To be clear, tariffs, subsidies and even currency manipulations were not prohibited outright. Instead, tariffs were to be negotiated, and subsidies and currency manipulations were only prohibited to the extent they distorted trade or expressly created a trade benefit. Still, the WTO’s founding members established and committed to the fundamental principles of the global trading system: equal treatment of locally produced goods and imported goods, fostering freer trade through negotiations, and predictability and transparency in trade policy.

The problem is that China, now a global superpower with different history, institutions and values, was not at the table when those principles and rules were established. A nation’s cultural and institutional characteristics may become more resilient upon trade liberalization—though it may seem surprising—because they may provide a competitive edge and increase the gains from trade. But shortly after joining the WTO, China began to disregard, violate or manipulate agreed-upon international rules. Certain practices that China passively allowed in its pre-WTO years, including forced labor and the lack of intellectual-property protection—both benefiting China’s advantage in manufacturing—became formally institutionalized as part of China’s state-directed policies in the years after it joined the WTO.

The current Chinese policy regime was not the expectation, but it is the reality. Ineffective and self-defeating trade policy instruments such as tariffs are unlikely to change that reality. Neither should Western nations take a page out of China’s playbook and implement an interventionist industrial policy to boost certain industries. The answer to China’s threats to our principles of freedom and democracy is not further compromising those principles ourselves.

Trust Is the Basis of Trade

Our global trading regime, with its underlying goal of freer trade among nations, requires an intangible asset that is largely taken for granted and easy to destroy: trust. The need for trust is independent of whether China pursues democratic reform or continues to advance its interests with state-directed capitalist policies.

Nobel Laureate economist Kenneth Arrow observed that implicit in every commercial transaction is an element of trust. Trust is not only the basis of exchange, as M. Todd Henderson and Salen Churi note in their book “The Trust Revolution,” but it also undergirds a “virtuous cycle” in which exchange allows for specialization, increased productivity and even more exchange. Sustained and peaceful wealth creation is seriously undermined without trust.

The trading institutions that allow for low-friction and peaceful exchange emerged over many centuries as individuals, merchants and governments established rules of engagement. Among these innovations are contracts, trade laws, judicial systems and international dispute-resolution bodies. As global trade has increased in complexity, so too has the cost of monitoring treaties and activities, the complexity of regulations, and the sanctioning of violations of the spirit and letter of those agreements.

In “The Trust Revolution,” Henderson and Churi describe how trust is generated, and the sources of that trust can change without anyone fully realizing. Governmental and regulatory approaches have historically been suitable for providing trust in the industrial economy. But there are new competitors in the trust market: the platform economy (think Airbnb or Uber, where buyers and sellers can easily find each other digitally), prediction markets and peer-to-peer information networks. Corporate innovations, such as brand recognition, are also tested as the platform economy changes how we consume everything from real estate to food to vacations. Consumers and producers are relying increasingly on “digitalized” personal trust, which is at once both decentralized and global, and it gives them more power to make informed choices—far more quickly than governmental authorities could.

Some food and retail companies, for example, provide extensive information on the origin of inputs. And they can command a price premium for doing so, given consumer preferences. While the technology is available for digital distributed ledgers that can verify provenance of goods, using this technology will only become a widespread practice when there is sufficient consumer demand or when government regulations require it.

High levels of trust between nations, healthy governance structures and rules that facilitate trade are the goal. But new avenues for the provision of trust, including the use of new technologies, should be pursued if we are to preserve the global trading regime.

The Way Forward

The presence of an unlike-minded superpower in the global economy does not negate the importance of international institutions or the fundamental principles on which they were built. On the contrary, it means our institutions need to find new ways to achieve their goals despite the presence of such a superpower.

Governing institutions are crucial for preventing the “tragedy of the commons” in any community, and the global trading system is no exception. The framework of polycentric governance, developed by Nobel Laureate economist Elinor Ostrom, can be a powerful tool for the United States and its allies to develop their engagement strategy with China.

A polycentric order is one in which decision-making is distributed among different participants or entities. Economists Paul Aligica and Vlad Tarko describe polycentric systems, in which decision-makers are constrained by three key factors: the rule of law, a mutual understanding around shared goals, and rules on how to make rules for participation, exit, enforcement and sanctions. Further, polycentric systems allow for the revision of rules as circumstances and goals change. Ideally, polycentric systems are self-organized and self-correcting, like individuals.

Ostrom’s work, typically angled toward individual actors, has rarely been applied to international institutions in which members are sovereign states with different values. But in trade policy, the negotiations are at the state level. If the members of an institution such as the WTO are committed to sustaining a rules-based trading regime, they may have to find new ways to solve problems when one member, such as China, doesn’t want to follow the rules and other members don’t want to shoulder the cost of punishing rule-breakers.

When national-level negotiations are ineffective, new avenues should be explored. Recently, the world witnessed the efficacy of open-source, collective brainstorming on the origin of COVID-19. Investigation by a motley group, which calls itself DRASTIC, challenged the elites and those in authority, until President Biden eventually demanded an investigation by the U.S. intelligence community.

As for the “Made in China” link to forced labor, if national-level negotiations are lacking, then leveraging new technologies that harness the power of the individual could combat slow or incomplete information and verification. Digital distributed ledgers with trusted third-party auditors or customs brokers could be used to verify the provenance of goods. Policymakers with sufficient interest and willpower could impose disclosure requirements on companies, say, through the authority of the Securities and Exchange Commission, so that they would be required to disclose whether they do business in China with entities that use forced labor.

We are witnessing a global proliferation of subsidies and other trade policy instruments that prevent markets from efficiently allocating resources, disseminating information and communicating ideas. Large authoritarian governments that lack transparency are directing economic policy with ripple effects throughout the global economy, including the horrific fact that many of their imports are made with forced labor.

The more China operates outside international norms, the more pressure other countries feel to respond in ways that push themselves beyond those norms. The United States and other countries are using costly protectionism and overreaching industrial policy in an attempt to compete with China. Over time, if left unchecked, these developments will chip away at the ability of markets to function. And with that will come an erosion of trust.

Regardless of China’s path, we must find a way to self-preservation. Policymakers should work harder to correctly evaluate security risks in the economic engagement with China. That means distinguishing between legitimate national security threats and veiled calls for protectionism. It also means encouraging international institutions all the way down to civil society actors to leverage technologies and find new ways for buyers and sellers to share information and restore trust.

The China challenge is bigger than any unfair trade practice such as foreign steel subsidies or export restrictions on rare earths. Confronting this challenge means finding new ways to preserve our market functions and the institutions that make them robust.