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 Date:3/26/2009

 

News & Views
Shrugging Off European Hypocrisy
Self-interest governs G20 reluctance to alter trade policy, argues William R. Hawkins.

In the wake of the G-20 finance ministers meeting held just outside London March 13-14, British Prime Minister Gordon Brown called for expanding free trade as a way for countries to “support thy neighbour.” The United Kingdom is the chair of the G-20 for 2009. The final communiqué issued at the close of the summit included the pledge, “We commit to fight all forms of protectionism and maintain open trade and investment.” Yet, three days later, the World Bank reported that 17 members of the G-20 have put in place measures to restrict trade at the expense of other countries. They are acting to protect their interests, while opposing any effort by America to correct its debilitating deficit. What could be better, from their perspective, than have Americans be the ones piling up debt to stimulate economies overseas?

The United States has been supporting its neighbors, indeed the entire world, by running trade deficits that averaged $706 billion each year from 2005 to 2008. The G-20 include 12 of America’s top trading partners: Brazil, Canada, China, France, Germany, Italy, Japan, Mexico, Saudi Arabia, South Korea, the United Kingdom and the European Union (which double counts the individual European member states in the G-20). Among these, the U.S. ran a trade deficit with all but Brazil in 2008. It is self-interest, not high principle, which motivates the G-20 to oppose any changes in American policy. An examination of the policies of foreign governments on trade reveals considerable hypocrisy.

Prime Minister Brown called on the European Commission to fight protectionism, but opposed an EC proposal for a new Euro-regulator with powers to supervise banking. Brown has strong ties to The City (London’s Wall Street) and does not want new controls that would weaken London as a major financial center whose appeal is its open access and weak oversight.

Prime Minister Brown also called on the World Trade Organization to root out “covert forms of protectionism.” Yet, the Europeans locked into WTO rules the use of value added taxes (VAT) which have become a substitute for protective tariffs. The VAT is a sales tax levied on production. It is a major source of revenue for many of the 137 countries that use it, but it is not used by the United States.

This is how the VAT system works to distort trade. When an American company exports to Germany, it will pay the 19 percent German VAT in addition to all the U.S. taxes to which it is subject at home. When a German company sends its products to America, it is not subject to any U.S. taxes and has its home VAT refunded. Without these tax burdens, German firms can sell their products in America for much less, gaining a competitive advantage. The VAT works both as a tariff on imports and as an export subsidy. The Europeans have been substituting the VAT for tariffs, seemingly liberalizing trade but in reality protecting the continental economy. In 1968, the average EU member tariff was 10.4 percent with an average VAT rate of 13.4 percent making a trade barrier against U.S. goods of 23.8 percent. By 2006, the average tariff rate had declined to 4.4 percent, but the average VAT rate had climbed to 19.4 percent, keeping the trade barrier against U.S. products at 23.8 percent!

Attempts to offset the VAT effect by U.S. law have been declared illegal by the WTO, and the EU has refused to negotiate any changes in a system that so clearly benefits them.

The European Union has led the foreign criticism of “Buy America” provisions in the U.S. economic stimulus package. But the EU does not approach the question of how government spending should be directed to domestic industry with anything like clean hands. In late January, I spoke at an international trade conference in Ankara, Turkey where European hypocrisy on procurement issues was on full display.

The subject of the conference was how governments use offsets to manage their public spending to ensure maximum return to their home economies. Most of the participants were government officials, swapping ideas on how better to exploit trade with the United States to bolster their own concepts of economic nationalism.

Offsets occur when governments require foreign bidders to kick back industrial compensation to the home economy in order to win a contract. Offsets can include co-production, licensed production, subcontractor awards, technology transfer, counter-trade, local investment, and help in promoting exports. Neil Davies, chief economist at the British Ministry of Defence put it concisely in Ankara: offsets are about the “transfer of economic activity from the supplier nation to the purchaser nation.”

The U.S. is the world’s largest exporter of defense products. The Pentagon spends four times as much on research and development as the EU. America has a clear comparative advantage in the arms trade. Academic trade theory holds that countries are to specialize in sectors where they have a comparative advantage and exchange goods with those who have an advantage in other sectors. Americans are constantly told they must respect the international division of tabor, and not try to shape trade flows or protect key industries even in the face of massive deficits. Yet, there is no foreign respect for the American advantage in military equipment. When foreign governments buy U.S. systems, they demand offsets to deny America the full benefits of the export.

The Commerce Department reports to Congress annually about the offsets demanded of U.S. firms exporting military products. According to the December, 2008 report, for the period 1993-2007, offsets averaged 72 percent of the sale price. The 2007 report found that in Europe, offsets often totaled 100 percent of the export price, and sometimes exceeded the full cost of the original contract. Almost two-thirds of the offsets demanded are for commercial products (called indirect offsets), not for military development (called direct offsets).

In the commercial sector, the use of offsets is considered an illegitimate distortion of normal trade practices. The 1994 Government Procurement Agreement (GPA) explicitly prohibits the use of offsets. However, matters affecting national security are exempt from the GPA, so governments have been skirting the commercial ban on offsets by tying them to defense procurement.

A major objective of foreign government policy is to gain American technology. Though not mentioned specifically at the Ankara conference, at other meeting in which I’ve participated a top priority has been placed on gaining American pharmaceutical and medical equipment technology. These are other sectors of U.S. comparative advantage where foreign rivals want to close the gap and not simply accept their role as consumers. Trade is a dynamic form of competition, where the division of labor is constantly being redefined by firms and governments who want to improve their position in the global hierarchy.

In Ankara, Martin Sticha of the Czech Ministry of Industry and Trade talked of “causality,” a policy to generate economic activity in his country that would not have otherwise taken place in a free market. Peter Taal of the European Defense Agency said the EU seeks “less dependence on non-European sources for key defense technologies” while “working to strengthen the European Industrial and Technological Base.”

Prime contractors can develop long-term supplier relationships with overseas subcontractors based on short-term offset requirements. These new relationships endanger future business opportunities for U.S. suppliers.

The official U.S. government position is that offsets are purely a private matter. Firms are free to offer whatever package they deem necessary to win overseas contracts, on which they will earn a profit regardless of how much work they must outsource. Foreign governments use their leverage to play prime contractors off against each other to maximize offsets.

In 2004, an Interagency Team chaired by the Defense Department was created to study the impact of offsets and discuss their use with foreign governments. Nothing has come of this diplomatic effort. When Sen. Christopher Dodd became chairman of the Senate Banking Committee in 2007, he said he would consider legislation to control offsets which he believes cost the American economy a net 10,000 jobs annually, but nothing was done on this issue in the 110th Congress.

The 111th Congress has opened with a heightened concern about the economy and trade in a world in which recession is making global competition ever more contentious. The Buy America provision in the stimulus bill was meant to keep matters from getting worse. Now it is time to address the much larger, underlying problem of a massive, persistent trade deficit that drains the economy of money, jobs and productive capacity. America’s “trading partners” are of no mind to help solve what they see as a benefit to them, not a problem. The United States will have to take action on its own to balance its trade account and redirect economic activity back home. When it does so, it can easily shrug off the criticism of those whose own behavior gives them no credibility as “free trade” idealists.

William Hawkins is a consultant specializing in international economic and national security issues.