Controlled and Uncontrolled Exports of Knowledge Capital

This post is me simply thinking out loud. So if you like tidy posts with a beginning and an end, just skip this one.

I’m thinking about cross-border flows of knowledge capital, which really screw up our interpretation of the trade statistics. In particular, the cross-border flows of knowledge capital make it really hard to understand the real meaning of our trade deficit with China.

Take this situation. An unnamed U.S. manufacturer, with fairly advanced technology,  wants to produce airplane parts in China where the manufacturing costs are cheaper. In order to do this, the manufacturer must transfer proprietary knowledge about the design of the parts, the materials, and the manufacturing process to the Chinese factory.  The parts are then shipped back to the U.S. , showing up as an import of airplane parts.

There are two extreme  possibilities (and plenty in between)

a) The factory is owned by the U.S. manufacturer. The knowledge capital is exported to the Chinese factory, and then imported again, as embodied in the airplane parts. There is no spillover of knowledge capital to the broader China economy.

b) The factory is owned by a Chinese manufacturer who is sophisticated enough to learn from the knowledge capital, and apply it to the production of other aerospace parts, to be sold on the broader export market. Moreover, the knowledge capital becomes part of the knowledge set of all the companies in the region. In this case, the imported knowledge capital fully spills over to the Chinese economy.

In case (a), call this a controlled export of knowledge capital. It looks like we are importing airplane parts, but in fact we are mostly importing our own knowledge capital. If we correctly accounted for knowledge capital in the trade accounts–i.e. if the Chinese factory paid full royalties for all the U.S. knowledge capital being used–it would look like our trade deficit was a lot smaller. The difference would also show up as a combination of a higher profit margin for  domestic airplane manufacturers, higher profit margins for airlines, and lower costs for air travellers. Presuming perfect competition in China, all of the gains from the shift overseas are captured by the downstream members of the supply chain.

In case (b), call it an uncontrolled export of knowledge capital. The imports of airplane parts would look exactly the same, but the rest of the economic system would be very different. Chinese manufacturers would become effective competitors to U.S. manufacturers in the market for airplane parts. This would drive down the prices that U.S. manufacturers could charge–not just for the original part, but for other parts as well.

In case (b), we would still have the original flow of knowledge capital to the factory, and the flow back in imports. Additionally,  it’s as if we gave a gift of knowledge capital to the Chinese economy for which we were not paid.

What happens when you give a gift of knowledge capital? In a world of monopolistic competition, if you give a gift of knowledge capital to one of your competitors, your profit margin unambiguously falls. In this case, the sum of corporate profits and improvements in consumer welfare would drop.

So in order to assess the true trade deficit  with China, we need to know (1) the value of the goods we are importing, (2) the exports  of knowledge capital from the U.S. to China necessary to produce those goods, and (3) whether those exports of knowledge capital are controlled or uncontrolled.

The iPhone is probably an extreme case, where Apple does a good job of keeping its exports of knowledge capital under control. Other companies? Not so much.

I welcome any and all comments and criticisms. My goal is to build up a more sophisticated framework for thinking about global trade, including knowledge capital flows.



Chinese-U.S. Exchange Rates and Knowledge Capital Flows:Why We Feel Poorer

The short summary:   The Chinese policy of buying dollars can be best understood as an indirect purchase of U.S. knowledge capital–technology and business know-how.  That, in a nutshell, is why we feel poorer today. Unless the Obama Administration understands the link between the undervalued yuan and the global  flows of knowledge capital,  negotiations with China are doomed to fail.  

Viewed in the usual economic light, Chinese exchange rate policy in recent years looks like a gift to the U.S..   By buying up dollars to keep the yuan low, China–still a poor country– is effectively lending money to the U.S.–still a rich country–to buy Chinese products.  According to the official statistics, the U.S. has run a cumulative $1.4 trillion trade deficit with China since 2005. But over the same period, Chinese ownership of  dollar-denominated financial assets in the U.S. has risen by $1.3 trillion.

To put it another way, the conventional statistics seem to be saying that  the U.S. is getting $350+ billion a year in cheap clothing, electronics products, and toys at no real cost today.  What’s not to like? 

But if this explanation was really correct–if  that purchase of dollars  was a gift from China–the U.S. would  be feeling happy and prosperous right now.  We have received all of these cheap goods and services, without having to give up very many of our own resources.  

But of course, the U.S. doesn’t feel rich and happy right now–we feel poorer, while the Chinese are feeling more prosperous. How can we explain this?

The  reason why the Chinese purchase of dollars seems like a gift is  because we have a 20th century statistical system trying to track a 21st century  global economy. We can do a decent job tracking the flows of goods and services and a passable job tracking financial flows.  But there is no statistical agency tracking global knowledge capital flows–and that’s where the real story is. Take a look at this diagram.

The first three boxes represent the conventional view: The U.S. gets cheap goods and services, and then pays for them by selling financial  assets.

But that leaves out the  the transfer of knowledge capital  from the U.S. to China. In effect, the Chinese purchase of dollars is a mammoth subsidy for the transfer of technology and business-know into China.  

Consider this. When China keeps the yuan low, that’s an inducement for U.S.-based companies to set up factories and research facilities in China, both for sale in China and for imports back to the U.S. .  And that, in turn, requires a transfer of  technology and business know-how from the U.S. to China.

My favorite example is furniture makers.  Over the years, U.S. furniture makers had accumulated this vast storehouse of knowledge–for example, how to make  coatings on dining room tables that are less likely to chip or discolor from heat or liquids. That’s one of the differences between a low-quality and a high-quality table.

As the manufacturing of furniture was offshored to China, the knowledge capital had to be transferred as well.   And that, in turn, helped turn the Chinese furniture industry into a global exporting powerhouse.

Now, let’s stop and make  three points here. First, we need to compliment China. It is not easy to absorb knowledge capital from the outside and make good use of it.  Frankly, all sorts of other countries could have tried the same exchange rate trick, and it wouldn’t have worked for them.

Second, the transfer of knowledge capital to China doesn’t mean that the same knowledge capital  disappears in the U.S. However, our knowledge capital  does become less valuable because there is more global competition–and that’s why we feel poorer. (see my earlier post on the writedown of knowledge capital)

Third, what’s needed from Washington is a sophisticated  response that both focuses on rebuilding our own knowledge capital, while at the same time slowing down the exchange-rate knowledge capital pump. More to come on this.

Knowledge Capital Writedown at Boeing?

According to a story from the Seattle Times, Boeing’s Dreamliner is bogged down in problems.

A top Federal Aviation Administration (FAA) official 10 days ago warned Boeing that without further proof of the plane’s reliability, it won’t be certified to fly the long intercontinental routes that airlines expect it to serve.

Meanwhile, on the production side, one veteran employee on the 787 said he’s witnessing “the perfect storm of manufacturing hell.”

The global supply chain is at a standstill, and outside the Everett factory the rows of partly finished jets will take many months to complete.

But really, what’s going on here is a breakdown of Boeing’s outsourcing strategy, and a possible breakdown of Boeing as well. As the story notes,

[Read more…]

A Massive Writedown of U.S. Knowledge Capital

In his column this morning, Paul Krugman gets it half-right:

America’s economy isn’t a stalled car, nor is it an invalid who will soon return to health if he gets a bit more rest. Our problems are longer-term than either metaphor implies….The idea that the economic engine is going to catch or the patient rise from his sickbed any day now encourages policy makers to settle for sloppy, short-term measures when the economy really needs well-designed, sustained support.

So far, so good.  But then Krugman goes off the rails:

The root of our current troubles lies in the debt American families ran up during the Bush-era housing bubble…What we’ve been dealing with ever since is a painful process of “deleveraging”: highly indebted Americans not only can’t spend the way they used to, they’re having to pay down the debts they ran up in the bubble years.

No, no, no. The build-up of debt was a symptom of  the real underlying problem:  A massive write-down of U.S. knowledge capital over the past 10-15 years, combined with anti-innovation policies on the part of the government.

U.S. prosperity has always depended far more on our accumulated store of knowledge capital than on our physical investments. Knowledge capital includes accumulated education, research and development, and business-knowhow–all the intangibles that underly a modern economy.

The value of knowledge capital depends, in part, on how rare it is. The more companies or countries that possess the same knowledge (say, about how to make a commercial airliner), the less valuable that knowledge is.  This is just Economics 101, applied to intangibles.

Over the past 10-15 years, the strengthening of information flows into developing countries meant that knowledge capital was being distributed much more quickly around the world.  As a result, the normal process of knowledge capital depreciation greatly accelerated in the U.S. and Europe–beneath the radar screen, because no statistical agency constructs a set of knowledge capital accounts.

What we should have been doing is boosting our investment in knowledge capital creation–education, R&D, business innovation.   Instead, we borrowed to support consumption.  Instead, we got Republican and Democratics administrations that  were more concerned with punishing innovative industries and ladling on additional security and economic regulations.

We still have some major knowledge capital advantages–in communications, in the biosciences, in the rapidly growing area of digital education–that we can build on for the future.   But this is the moment where we should be focusing on rebuilding our knowledge capital base rather than supporting debt-led consumption.

Added 12/15: Tyler Cowen agrees that knowledge capital may be depreciating more rapidly, but disagrees on the cause.

I agree with the conclusion but I am not sure that globalization was the mechanism.  I sometimes think of an imaginary economy with two sectors: music and bathtubs.  I believe that my bathtub is over thirty years old, yet for me it works fine and I have no desire to buy a new one.  When it comes to music, most people want to listen to what is new and hot, not Bach’s B Minor Mass.