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The U.S.-China Competition Conundrum

The U.S.-China Competition Conundrum

Public-private partnerships are needed to compete with China’s state-driven model—all the while embracing the free market.

Theodore L. Leonhardt

The attempted $765 million loan that the U.S. International Development Finance Corporation (DFC) offered to the Eastman Kodak Company in July 2020 to jumpstart production of critical pharmaceuticals exemplifies the competition conundrum complicating the American strategic rivalry with China: How can the United States reconcile the requirements of a free-market economy, in which the government does not own or control major corporations, with the need to marshal American economic and political resources to compete with China?

The Trump Administration had billed the DFC’s loan to Kodak as an American answer to Chinese mercantilism. For strategists, the loan would provide a playbook for “selective decoupling” in order to reduce American dependence on China for strategic supplies. “If we have learned anything from the global pandemic, it is that Americans are dangerously dependent on foreign supply chains for essential medicines,” White House advisor Peter Navarro declared in announcing the transaction. Pharmaceutical ingredient manufacturing by Kodak could spur further investment in American production and ease pressure on the Strategic National Stockpile.

For the DFC, this first domestic transaction would validate the agency’s creation in 2018, as well as President Donald Trump’s expansion of its authority to collaborate with other agencies on domestic transactions that address COVID-19 under the Defense Production Act. Kodak, for its part, would exorcise its 2012 bankruptcy by expanding its nascent pharmaceuticals segment. Embattled by the pandemic, President Trump could nostalgically herald “a historic agreement with a great American company” from “the good old camera age,” in keeping with his promise to Make America Great Again.

Instead, the transaction’s collapse leaves the United States in suspended confusion about how to approach U.S.-China competition. Kodak previewed the loan to local news outlets in Rochester, New York, which leaked the deal before the official announcement on July 28, 2020. Kodak’s stock price fleetingly flew from $2 to $60 per share. Simultaneously, Kodak’s executives received large stock option grants, and one board member made a record charitable donation of securities. The Securities and Exchange Commission, the DFC’s inspector general, and congressional committees began investigating. The DFC temporized, placing the transaction “on hold.” Kodak’s share price plummeted. “What happened at Kodak was probably the dumbest decisions [sic] made by executives in corporate history,” Peter Navarro fumed, distancing himself from a deal that he had once proclaimed as “one of the greatest second acts in American industrial history.”

What will be America’s second act in attempting to resolve the competition conundrum? Subsequent investigations indicate that the Kodak deal sunk primarily at the hands of the company’s executives, yet the episode is nonetheless illustrative of the looming challenge: The United States will not win a strategic competition with China by making a few good stock picks or clever loans. Rather, overcoming the competition conundrum requires an intellectual framework that is pro-market but not anti-government. The United States must balance “defensive” economic measures against Chinese exploitation of open markets with creative “offensive” reforms to improve competitiveness. And while the Trump Administration successfully implemented numerous defensive initiatives, offensive measures have been lacking.

In designing the latter, the United States must not lapse into statism. Successful free-market policies during the Cold War and Japan’s earlier economic challenge suggest that the United States should redouble its commitment to competitive markets while reforming military procurement, research, and investment policies. The “generational effort” against China will require American leaders to call forth the political will for a patient, long-term approach to implementing nuanced reforms.

The Limits of Lending

The Kodak transaction’s implosion exposed the limits of government lending for countering China. Insufficient financial firepower, execution risk, conflicts of interest, and investment risk all undermine the efficacy of government stakes in strategic businesses.

Financially, government lending to individual businesses cannot meaningfully alter the strategic balance with China. While the DFC’s investment war chest of $60 billion is welcome, that financial scope is best suited to the agency’s main mission of financial assistance to developing countries.  Even sixty billion dollars cannot reshape America’s strategic industries.

For perspective, consider that global capital markets total roughly $120 trillion in debt securities outstanding as of September 2020. With regard to the Kodak example, the American chemical products manufacturing industry generates $37 billion in sales annually, while U.S. generic pharmaceutical manufacturers book nearly $50 billion in yearly sales. Even if government investments were the right means of implementing strategic decoupling from China, doing so would require more financial firepower than the DFC currently offers.

The Kodak debacle also highlights the challenges of executing government investments. The risk of a failed transaction is ever-present for the private equity firms that the DFC seeks to emulate. For investment firms whose raison d’être is generating returns, this risk is a tolerable cost of doing business. However, the costs of poor execution are much greater and more varied for the government, as the distracting investigations of Kodak demonstrate. Misfires like Kodak damage the government’s reputation and, accordingly, hinder the DFC’s primary mission, which remains international development. Walter Russell Mead has eloquently explained the sometimes-abstract advantages of republican governance for conducting foreign policy, but acting with “secrecy” and “dispatch,” in Alexander Hamilton’s words, to close a deal is not one of them.

Aligning public and private incentives in partnerships like the Kodak loan remains difficult. This dilemma is not new: Adam Smith complained about conflicts of interest between corporations, investors, and the state in his own time, and the Founding Fathers also grappled with industrial policy. If COVID-19 has accelerated the “return of geopolitics” to markets and corporate decision-making, too many investors and individual executives still myopically focus on quarterly returns and personal projects, as with the Kodak director’s charitable donation. The difficulty of convincing private partners to reform corporate governance for greater alignment with the government may preclude many strategic investments.

The DFC confronts the same challenge as all investors: picking winners. Some losses are acceptable in development finance, where the aim is as much diplomatic as financial. The stakes are higher in strategic industries like telecommunications, where “picking the wrong horse” could cede American control of the global infrastructure to China.

Further, under the U.S. Bankruptcy Code, bankruptcy filings by recipients of government loans can result in federal ownership of companies and their physical plants. Kodak, for example, could have lost ownership of its pharmaceuticals subsidiary if the latter were to have defaulted on the loan. Additional problems present themselves when the government partners with private investors.  The DFC’s recently approved $590 million loan to ApiJect Systems—which had been partnering with government on the Operation Warp Speed vaccine effort—to increase manufacturing capacity for prefilled COVID-19 vaccine injectors is boosted by capital from the investment bank Jeffries Financial. In bankruptcy, such a transaction could cause protracted court conflicts over restructuring plans between the government and private investors, especially when the government has separate commercial contracts with the borrower.

Reducing such risks by sufficiently diversifying the government’s “portfolio” would require an unrealistic capital commitment from Congress. Unprofitable investments would prompt further congressional inquiries: Instead of “who lost China,” the question would become “who lost to China” in core industries.

An Offensive-Defensive Framework

Rather than directly picking winners, the U.S. government must foster the conditions for successful markets in strategic industries with a mix of defensive and offensive measures. Defensive measures protect the rules-based U.S. economy from what business historian Thomas McCraw has described as “a closed system exploiting open ones.” This succinctly captures how China exploits the American-led, open global economic system through state-owned enterprises, forced technology transfers, predatory infrastructure investments, and other tactics. Offensive measures to bolster strategic U.S. industries improve American competitiveness, which management scholar Michael Porter has defined as “the capacity of [a country’s] industry to innovate and upgrade.”

Policymakers must recognize the interplay of offensive and defensive measures, as well as domestic policies. For example, antitrust laws may have improved American international competitiveness in the twentieth century. Anticipating outcomes is difficult, but a coherent combination of offensive and defensive measures can buttress American economic and technological leadership.

During the Trump Administration, the United States prioritized defensive measures. Key steps included reforming the Committee on Foreign Investment in the United States, an international campaign to exclude Huawei’s products from 5G telecommunications infrastructure, and initiatives to de-list dodgy Chinese companies from American stock exchanges. Decoupling also falls into the defensive measure category. As Derek Scissors has explained, decoupling reduces American susceptibility to Chinese leverage, curtails funding for China’s Belt and Road Initiative, prevents technology transfers, and restores some measure of competitiveness to markets stunted by Chinese subsidies. But that increase in competitiveness may still fall well short of Porter’s requirement for offensive measures that industries have the “capacity … to innovate and upgrade.” The United States has made some important strides in its defensive measures, and it will no doubt continue to refine them as the bipartisan consensus on competing with China solidifies.

Unfortunately, the United States has not yet developed truly offensive measures to enable U.S. industries to compete with, or even reduce reliance on, strategic Chinese industries. The Kodak loan and American overtures to the Scandinavian telecommunications manufacturers Nokia and Ericsson fell flat. Meanwhile, the U.S. budget deficit has ballooned to 24 percent of GDP throughout the COVID-19 pandemic, signaling no end to expanding entitlements and likely reductions in defense spending. In the strategic competition with China, U.S. policymakers have yet to play by the old athletics adage that “the best defense is a good offense.”

On to Offense

The hardening of U.S.-China relations during the COVID-19 pandemic recalls the onset of the Cold War in 1946–47. Then, cold warriors also confronted the competition conundrum, as Aaron Friedberg has articulated it: “State ownership of the means of production and other extraordinary interventions in the civilian economy might be acceptable in a short-term emergency, but in a protracted ‘twilight struggle’ of unforeseeable length they ran the risk of undermining the foundations of the nation’s economic system, perhaps even transforming it over time into a replica of its competitor.” On Thomas McCraw’s spectrum from “substantial laissez faire” to “systematized state management,” American policymakers resolved the competition conundrum by favoring free-market policies throughout the Cold War. “[G]overnment officials had no intention of replacing the [corporate] managers as coordinators of current demand and allocators of resources for the future,” business historian Alfred Chandler concluded. That broadly free-market approach provides lessons for the strategic competition with China.

American leaders flirted with central planning during the Korean War, when legislation like the Defense Production Act (which later enabled the Kodak loan) recalled industrial policy during the world wars. However, industrial planning bodies like the National Security Resources Board (NSRB) never endured; indeed, the NSRB was the only institution created by the famed National Security Act of 1947 that did not survive the Cold War.

Contrarily, the Cold War accelerated the privatization of military production and development that began during World War II. This shift capitalized on American technological prowess and competitive incentives. Successive administrations eschewed concerted industrial policy. The Eisenhower and Reagan Administrations both rejected subsidized loans to strategic industries, and the former disfavored dubious proposals tying tariffs to national security. Ultimately, what Friedberg has termed policymakers’ “widespread animosity to statism” exceeded the allure of state planning, even during defense buildups in the 1950s and 1980s.

The United States must tailor procurement to enlist commercial firms as contractors and researchers while enhancing competition. Famously, government agencies such as the Defense Advanced Research Projects Agency (DARPA) accelerated American technological leadership in key industries during the Cold War, producing “positive externalities” through the civilian application of new technologies like the internet. Just as important as “spinoffs” like the internet are “spin-ons” of civilian technology for military means, such as cybersecurity software.

Fostering commercial collaboration can be challenging. As defense industry scholar Jacques Gansler detailed, commercial enterprises are wary of defense contracting. Among other issues, they fear the byzantine Federal Acquisition Regulations and calculate that export controls on defense-related technology might foreclose sales to foreign markets. Many large commercial enterprises, such as Ford and IBM, sold their medium-sized defense subsidiaries as military spending declined in the 1990s. Other companies, like Hewlett Packard and Corning, historically shunned contracting altogether, further reducing innovation and civil-military cross-pollination.

Policymakers must recognize the interplay of offensive and defensive measures to properly balance protecting American technology and encouraging commercial collaborators. A “Buy NATO” mandate could reconcile these competing objectives. President Dwight D. Eisenhower recognized that the Buy American Act of 1933, requiring domestic procurement contracts, inhibited alliance politics. Ike thus proposed amending the act to allow reciprocal procurement arrangements with allies. In 2021, a Buy NATO mandate could open sufficient overseas markets for commercial firms to enter defense contracting without fearing export controls, while also revitalizing the transatlantic alliance. It could even reduce redundant military spending by establishing a “division of labor” and international supply chains within the defense pact.

Today, another defense buildup is overdue, but procurement policy is far from simple. Procurement policies should enhance competition in defense contracting. Awards to multiple corporations should replace unwieldy “sole-source” contracts, which center production of a weapons system on a single “prime” contractor. The most famous example of financial savings and superior results through contracting with multiple producers is the “great engine war” for the F-16 fighter plane, which saved $3 billion to $4 billion over twenty years. Engendering competition can be as simple as awarding large prizes for useful innovations; DARPA has emulated the British government’s famous 18th-century cash prize for measuring longitude. Government ownership of intellectual property from such competitions can enable licensing arrangements that rapidly expand production, as exemplified by American aircraft manufacturing during World War II.

The United States must commit to reforms and investments that will embody and ingrain a long-term, competitive perspective. Competitiveness must be a national mindset. In adopting that mindset for confronting China, the economic competition between the United States and Japan during the 1980s may be even more instructive than the Cold War, since the Soviet Union was primarily a military adversary, not an economic rival.

In 1992 Michael Porter posited that three “determinants of investment” influence long-term national competitiveness: the macroeconomic environment, capital allocation mechanisms, and local conditions such as skills, technology, and infrastructure. At a macroeconomic level, the United States must reform entitlements to reduce its budget deficit while encouraging a higher savings rate. For capital allocation mechanisms, the “short-termism” of American markets may derive not from companies themselves, but from performance metrics for the fund managers who now invest most American savings. Converting Wall Street to a long-term view for challenging China may require reforms that concede other priorities, such as a lower capital gains tax rate on investments exceeding five years. Finally, Alfred Chandler’s sweeping studies of American and European business in the 19th and 20th centuries show that reinvesting profits in worker training and research can create favorable local conditions over time to avoid forfeiting technological advantages.

To encourage research, the government should increase contracts and grants to address the “collective action problem” of inadequate scientific funding. Vannevar Bush, who led American scientific efforts during World War II, famously found that private enterprises lacked sufficient incentives to undertake basic scientific research at the onset of the Cold War. The government thus began a massive research spending program accounting for 1.86 percent of GDP in 1964. In 2017 that figure sat at 0.61 percent. Federal funding amounted to well over half of all research spending throughout the Cold War, compared to just 22 percent today.

Government funding for research and development at corporations and universities during the Cold War prompted companies to supplement government grants. Two professors at the Massachusetts Institute of Technology found that each government dollar spent on defense research between 1987 and 2009 in OECD countries brought between $2.50 and $5.90 in private capital. This “crowd-in” effect resembles how increasing American defense spending spurs allies to boost their own commitments. The Cold War experience shows that jumpstarting research spending should be the federal government’s guiding paradigm. In Alfred Chandler’s words, the federal government should again expand research funding as the “coordinator and allocator of last resort.”

Walter Russell Mead has compared a republic’s foreign policy to a raft: slow and soggy, but less prone to sinking than an autocratic “ship.” Similarly, America’s capitalist economy may endure occasional setbacks in strategic industries, but the system can prevail over time in a strategic competition with China. Americans should take solace in the “basic resilience of the free market system” during the Cold War. That resilience includes democracies’ responsiveness to technological change.

Winning a long-term economic competition with China will not require a wholesale reimagination of American capitalism; there need not be an “industrial policy” per se. Instead, the government can play a constructive role through often technical reforms that enhance competition and innovation in fields from defense procurement to securities regulation. Most important, the United States must conjure the national will to compete by reducing the budget deficit, increasing savings, and investing in research and development. Policymakers, companies, and citizens face a long road ahead toward economic and strategic leadership. Sharing sacrifices and playing to our free-market strengths, not statism, will sustain American primacy.

Theodore L. Leonhardt is a research analyst at the Henry A. Kissinger Center for Global Affairs at the Johns Hopkins School of Advanced International Studies and a former investment banking analyst. He is co-author of Divine Fire: Groton School and the American Century (Martin and Lawrence Press, 2014).