Extensive new research sheds light on how China’s rise has driven innovation and evolution in Europe and the U.S., largely to the benefit of Western firms

The rise of China’s manufacturing sector is one of the most remarkable changes in global business this century. In 2020, Chinese exports of trade goods to the United States alone amounted to about $435B, a staggering increase from 1985 levels, when imports from China were about $4B. As China’s penetration into Western markets has grown, so too has Western wage inequality and unemployment in many parts of the U.S. 

Although much political and social rhetoric over the last decade has blamed the rise in Chinese imports for much of the negative labor impacts in the West, the general consensus among researchers has been that technology, and not trade, caused the biggest industry disruptions, wage inequality, and job losses. 

The volume of U.S. imports of trade goods from China from 1985 to 2020, in billion U.S. dollars. (Source: Statista)

New research, however, by Nicholas Bloom (Stanford), Stephen Terry (Boston University), John Van Reenen (LSE), and Paul Romer (NYU) suggests that this consensus may be wrong for three critical reasons:

  1. Most of the analysis of China’s impact used data only up to the mid-1990s, which largely predates the rise of China.

  2. The impact of trade through offshoring rather than end-goods has not been assessed.

  3. The impact that low-cost goods had on Western innovation has also not been defined.

To better understand China’s real impact, Bloom et al. looked at a decade’s worth of innovation, economic, and productivity data from across Europe. The analysis is extensive, including employment, capital, materials, wage bills, and sales information from almost every firm on the Continent. In addition, they also analyzed the rise in R&D and IT spend across the top 20 European markets as Chinese imports grew. 

A key underpinning of the researchers’ work is something they call the trapped-factor model. Trapped factors are “assets that incumbent firms have in place to create products (typically labor and capital).” When the price of the goods these factors create is high, they are “trapped” by the high opportunity cost of not working on those products. When the price of those same goods falls, however, the factors are “untrapped” and now free to innovate and create new products. 

The authors hypothesized that the arrival of low-cost Chinese goods, which threatened the lower-tech end of Western product sets, had a profound impact on Western industrial trapped factors. As they explain:

The basic idea is that firms can allocate factors to produce old goods or innovate and produce new goods. China can produce old goods, but cannot (as easily) innovate and produce new goods. At the beginning of the period there are factors of production employed in Northern firms making old goods (protected by trade barriers). These factors are “trapped” in the sense that workers have some firm-specific human capital and capital has firm-specific adjustment costs.

When import barriers are lowered, China starts exporting and the profitability of making old goods falls. Therefore, the opportunity cost of the trapped factors falls, reducing the costs of innovation. In addition, the fact that the opportunity costs of these factors fall means the cost of

producing new goods also falls. Both effects – the reduced costs of innovation and the reduced cost of producing new goods – increases the profitability of innovation.

If the theory of trapped factors is correct, the researchers would expect to find that in response to the arrival of low-cost, low-tech goods from China, European firms would divert labor and capital to innovate and to develop new products free from Chinese competition. This outcome is precisely what they find in the data.

First of all, European firms began to innovate at a higher rate in response to Chinese imports. Indeed, the researchers calculate that a “10 percentage point increase in Chinese import penetration is associated with a 3.2% increase in patenting.” This effect was not just companies increasing patents to protect previously developed IP [from Chinese incursion], the patents were for new innovations created after the arrival of low-cost Chinese goods. Chinese imports, conclude the authors, were actually a positive force for Western innovation, driving up the success of European R&D, as demonstrated by higher and better-quality patent production. Indeed, the authors “estimate that Chinese imports accounted for 13.9% of the increase in patents per employee over the 2000-04 period but 18.7% over the 2004-2007 period.” The reason for this acceleration is “clear” and directly tied to Chinese import growth, which “rapidly increased over this period.”

Correlated with the increase in innovation was a significant increase in IT spending by European firms to increase innovation and productivity in response to Chinese imports. As the authors note, “we examine IT intensity and find a positive and significant coefficient on Chinese imports.” This new competition spurred the “adoption of Enterprise Resource Planning, database software, and groupware tools”, all of which “also find positive coefficients on Chinese imports.”

The researchers found a third factor that helped European firms compete against their new Chinese rivals — China itself. As more and more suppliers opened to Western orders, there was reduced intermediate materials cost from increased offshoring. While “offshoring does not increase overall innovation (as measured by patents),” the authors conclude, “it does increase IT intensity and productivity, presumably since offshoring moves the less IT intensive and lower productivity parts of the production process overseas to China.” More offshoring to China, and better technology at home, made strong European firms more competitive, the data indicates, which in turn made them more competitive against their new Chinese rivals.

Overall, the authors find that total productivity and “absolute levels of patenting, R&D and IT have risen in firms who were more exposed to increases in Chinese imports.” Moreover, “in sectors more exposed to Chinese imports, jobs and survival rate fell in low-tech firms (measured by indicators such as IT and patenting intensity), but are relatively

protected in high-tech firms (the between firm effect).” In other words, China put many unsophisticated European firms out of business but left sophisticated companies largely undamaged (economically) and more innovative/competitive overall.

This research not only clarifies the impact that Chinese competition had on European producers, it also “supports theories arguing for an important role of trade on technical change.” This is a new and important perspective to add to the analysis of China-U.S. trade. However, as interesting as this paper is, it does not address the issue of all those lost jobs in places like the American Midwest. These states undoubtedly experienced a negative economic impact due to low-cost Chinese imports. To understand that phenomenon, we can turn to other research from Bloom,  Kyle Handley (Michigan), Andre Kurmann (Drexel), and Philip Luck (Colorado) that examines the impact that Chinese competition had in the U.S. during the same period. 

This research is not yet complete, but a published preview indicates that the arrival of low-cost Chinese goods had two different effects on U.S. companies. One group of industries (metal, machinery, computer and electronics, electrical, transportation equipment, and furniture manufacturing) bore the brunt of the unemployment effects. Another sector (wood, paper, petrol and coal, chemical, plastics and rubber, and non-metallic manufacturing) actually saw jobs increase with the arrival of Chinese imports. Moreover, many U.S. non-manufacturing companies also benefited because their businesses were complimentary with growing international trade. 

In those sectors that were impacted by China, companies reacted much as the first paper we examined predicted they would. They increased R&D and innovation and, most importantly, increased their focus on services. In other words, many large U.S. firms “with already established trade links – responded to the China shock by reallocating their activity away from manufacturing towards manufacturing-related non-manufacturing activities.” 

Here is where things get interesting, for the authors note that since services “activities are more skill-intensive, we conjecture that this reallocation should have benefited local labor markets with relatively high human capital to the detriment of local labor markets with relatively low human capital.” Markets with “high human capital” are places such as California, the Northeast, large parts of Texas and Florida. Places with low human capital are concentrated in the “rust belt” areas with old, low-tech manufacturing histories.

High versus Low Human Capital Commuting Zones (Source: Authors)

In short, in the most simplistic reading of both papers, while strong European firms generally innovated in response to China, strong U.S. firms pivoted to mon-manufacturing value-added activities, which shifted their workforces from old manufacturing centers to places where they could recruit high-skilled service employees. As the authors conclude:

The Good: The China shock had a significant positive effect on U.S. non-manufacturing employment concentrated in areas with high initial levels of human capital. The positive effect more than offset the negative effects on manufacturing employment in these high-human capital areas and led to overall improved labor market conditions.

The Bad: The China shock had a substantial negative effect on U.S. manufacturing employment on average, in particular in areas with low initial levels of human capital. Since non-manufacturing employment in these areas did not increase substantially, the negative effect on manufacturing was accompanied by an overall worsening of labor market conditions.

The Apocryphal: The China shock did not lead to a large-scale exit of firms. This is contrary to the popular view, at center stage in the current trade dispute between the U.S. and China, that Chinese import competition has not only decimated U.S. manufacturing employment but also had a negative effect on U.S. firms. Instead, we find that most of the manufacturing job losses are accounted for by large, importing firms that simultaneously expanded non-manufacturing employment and have on average not been affected negatively.

As Bloom noted in a recent interview:

The Chinese made computers and cellphones massively cheaper, which has hugely increased the reach of technology companies here. The market for their software has exploded. So if you’re Apple, you’ve got thousands of people here designing new phones, plus marketing and selling them. Apple’s total U.S. employment has almost certainly gone up, but its U.S. manufacturing employment has likely gone down.

As noted, the second paper referenced is still incomplete, but assuming its current general conclusions hold, we now find a more complete and descriptive picture of the effect that the “China shock” had on West manufacturers. On the one hand, it spurred their R&D, innovation, offshoring, and the growth of their services businesses (which tended to recruit talent in often privileged locations). On the other hand, it destroyed low-tech employment in areas that lacked the human capital that benefitted from the large-scale economic transformation China’s arrival on the world stage unleashed in the West.

All this research concludes that China’s union to the world economy in 2001 was a net plus to the West. Moreover, it suggests that the income inequality and job losses/gains experienced in Europe and the U.S. are more the consequences of decisions made in response to China’s arrival than anything Chinese manufacturers themselves did over the last two decades.

The Research

Nicholas Bloom, Paul Romer, Stephen J Terry, John Van Reenen, Trapped Factors and China’s Impact on Global Growth, The Economic Journal, Volume 131, Issue 633, January 2021, Pages 156–191, https://doi.org/10.1093/ej/ueaa086

Nicholas Bloom & Andre Kurmann & Kyle Handley & Philip Luck, 2019. “The Impact of Chinese Trade on U.S. Employment: The Good, The Bad, and The Apocryphal,” 2019 Meeting Papers 1433, Society for Economic Dynamics.

Posted by:Carlos Alvarenga