Innovation Mercantilism's Dangerous Consequences for American Manufacturing

Over the last decade, a growing number of countries have come to embrace a new kind of protectionist trade policy that seeks to expand domestic innovation capacity and technology exports by manipulating the international trading system and subverting the intent of free trade.

ITIF calls these practices “innovation mercantilism,” and they cover a wide range of methods, including localization barriers to trade (LBTs), indigenous innovation, currency manipulation, and intellectual property theft. Together, these policies drastically inhibit the ability of U.S. enterprises to effectively compete.

For example, countries’ use of local content requirements reduced global trade by almost $100 billion in 2010.

Furthermore, in 2009 alone, Chinese theft or infringement of U.S intellectual property cost almost one million U.S. jobs and $48.2 billion in U.S. economic losses. And unfortunately for American manufactures, these policies are becoming more prevalent.

The World Trade Organization reported the number of such “technical barriers to trade” implemented by countries in 2012 reached an all-time high.

As ITIF argued in a recent report, among the most damaging and fastest growing of these mercantilist practices are localization barriers to trade.

LBTs are designed to pressure foreign enterprises to “localize” economic activity in order to create domestic jobs and promote local production in lieu of imports. Only in exchange for local production are foreign firms granted access to local markets. These practices include local content requirements, discriminatory government procurement, forced offsets, and forced technology transfer.

Effects of Localization Barriers to Trade

For example, in order to open automobile factories in China, the Ford Motor Co. was required to enter into a joint venture with Chinese automobile producer Chang’an Motors. Moreover, the Chinese government required Ford to open an R&D laboratory employing at least 150 Chinese engineers.

Elsewhere, India’s Preferential Market Access mandate imposes local content requirements for public procurement of information and communications technology (ICT) equipment, forcing American ICT manufacturers to produce in India to meet the local content stipulation.

While countries fielding LBTs may enjoy some short-term gains through increasing industrial production and employment, in the long run LBTs are incredibly damaging.

First, they increase the cost of production, often requiring firms to raise prices or reduce investment in innovation or capital stock. Second, in nations affected by them, such as the United States, LBTs can lead to facility closures, cutbacks, or diminished expansion, which costs jobs and economic growth. This occurs through first-order effects, such as the shift of original equipment manufacturer (OEM) production from the U.S. to other nations, and second-order effects, including reducing sales for lower-tier U.S. suppliers as U.S. companies localizing production also often buy inputs locally.

Thus, it’s no coincidence that the rise in the use of innovation mercantilist practices in the 2000s coincided with the worst decade for American manufacturing since the Great Depression.

Furthermore, LBTs harm the global economy by reducing R&D and new product development in innovation-based industries, such as information and communications technology, life sciences, clean energy, and aerospace.

In these fields, intellectual property protection and access to global markets are particularly important in enabling firms to recoup the high development costs of their innovations. But LBTs reduce incentives for intellectual property generation, decrease the free flow of information across borders, and introduce market balkanization that limits scale-up.

If we are to build on the green shoots of manufacturing renewal sprouting in the United States, it’s imperative for American policymakers to get much tougher on these innovation mercantilist practices, including LBTs, to ensure U.S. manufacturers can operate on a level playing field.

For too long U.S. trade policy has been about opening markets through new trade deals, not on ensuring that other nations play by the rules. As ITIF has noted, we need to use the negotiations surrounding the Trans-Pacific Partnership (TPP) and the Trans-Atlantic Trade and Investment Partnership (T-TIP) agreements, to transform this paradigm and create model trade agreements that properly address mercantilism and maximize innovation.

In addition, the Obama administration should press the World Trade Organization (WTO) to create stronger enforcement mechanisms to address innovation mercantilism. This includes extending the WTO’s dispute settlement process to cover all types of LBTs. Congress should also increase funding for enforcement operations within the office of the United States Trade Representative, an organization that is underfunded given the nature of the formidable task at hand.

For countries that persist in using LBTs, the United States should also seriously consider rescinding some of the trade or aid preferences it extends to these nations, such as participation in the Generalized System of Preferences (GSP) and the Millennium Challenge’s development grant program.

Finally, manufacturers need to raise their voices—not in favor of protectionist policy to close our markets, but in favor of strong enforcement that ensures free trade around the world. American manufacturing can thrive, but not if other nations are distorting the playing field. It is time to make trade enforcement a number one priority.