The U.S.-China Economic Cold War, With Sebastian Mallaby

LINDSAY:
Welcome to The President's Inbox, a CFR podcast about the foreign policy challenges facing the United States. I'm Jim Lindsay, director of Studies at the Council on Foreign Relations. This week's topic is the economic Cold War with China. With me to discuss the Biden administration's decision to bar China from obtaining cutting-edge semiconductor technology, is Sebastian Mallaby. Sebastian is the Paul A. Volcker senior fellow for international economics at CFR, and a contributing columnist for the Washington Post. Sebastian writes brilliantly and lucidly on all things economic. He has written five books, the most recent of which is the wonderful, the Power Law: Venture Capital and the Making of the New Future. Sebastian, thank you is always for joining me.

MALLABY:
Thank you, Jim.

LINDSAY:
Sebastian, I'd like to begin by having you explain exactly what it was that the Biden administration decided to do in October in terms of halting semiconductor technology from going to China. It made a lot of news. I'm not sure people understand exactly what it was the administration decided.

MALLABY:
Sure. Well, I mean, the first thing to understand of course, is that semi-conductors really are the lifeblood of the modern industrial economy. So anything which touches on them, the supply of semiconductors, it's kind of like what the oil embargo was in the 1970s when the Arabs used that economic weapon. We see it again in the Ukraine War with natural gas and the effect on Western Europe when Russia cuts off supply. So we're talking of something arguably at least as big as that, it's right up there. And what the Biden administration has done is said that for advanced semiconductors, and I think the definition of advanced may be a bit squishy still, but the idea is that not only will semiconductor supplies to China be cut off, but also that the wherewithal to make semiconductors will be withheld.

And so, more specifically, what the Biden administration has said is first, no advanced semiconductors can be exported by U.S. entities to China or by foreign entities that might be using American technology to manufacture semiconductors. And that pretty much means everybody, all suppliers are using American technology in some way. So that's level one, a cutoff of the actual devices. Then level two is the machinery to make them. And here the U.S. is saying no, U.S. machinery making company can supply its machinery to China and foreign makers of machinery can for the moment. But there is a big diplomatic push underway to persuade the other semiconductor powers. I'm talking about Holland, the Netherlands, which has the best, most advanced lithographic engraving equipment for semiconductors, for example.

LINDSAY:
That's the company, ASML?

MALLABY:
That's right, exactly. And so ASML for the moment is allowed to supply China, but it's under a lot of pressure not to do so. Level three of the embargo is equipment that might be used for making equipment. So the inputs to make software for making semiconductors or other kinds of engraving technologies. The equipment that goes into that is being embargoed. And then the fourth level is the personnel that make all this magic happen. And so, they're a U.S. sort of semiconductor equipment manufacturers that have staff in China helping Chinese fabs, and they've basically been told to down tools and stop. So anybody who is a U.S. citizen, including a lot of Chinese American engineers, are not allowed to pursue assistance to Chinese semiconductor industry. Any U.S. company cannot. Any U.S., I think it extends to green card holders. So it's a very, very broad ban and a very aggressive one.

LINDSAY:
So how does this differ from what President Trump did during his administration? He made a lot of news about getting tough with China on trade. Haven't these steps already been taken?

MALLABY:
No, this goes a lot further. It's a much more broad ban. What we saw in the past with respect to export bans particularly, was that particular companies, most notably Huawei, the leading maker of routers, was told you cannot import American chips. And that was a very effective measure in terms of retarding Huawei's ability to churn out state-of-the-art routers. And so, a specific company in that instance was targeted on the argument that it was a particular threat to Western security. This time, it's the entirety of the Chinese economy, civilian, military doesn't matter, everybody is banned from getting advanced chips.

LINDSAY:
So what's the rationale behind the decision, Sebastian? What is the Biden administration hoping to accomplish?

MALLABY:
Well, the argument is that the distinction between military and non-military semiconductor makers in China is spurious, because there's such a close alliance between the state and industry. The state has no compunction in telling industry what to do and how to help. And it's too easy for a military purchaser in China to operate through an intermediary and source U.S. equipment through that method. And therefore, there is a much more aggressive strategy now of a blanket ban on all Chinese purchases no matter what it says on the tin. And I think the logic is that we are now in a clear competitive race for military power fundamentally with China.

And that part of military power derives from state-of-the-art technology. If we think about AI weapons systems, for example, which we've seen deployed in Ukraine with drones and so forth, if that's the next wave of military technology, then the fact that the U.S. has been historically dominant in the last generation of technology is not a defense anymore, because we're going to leap to this new area of AI where the Chinese are very strong. And so therefore, it's judged to be really a matter of national security for the U.S. to deprive China of the chips it needs to make AI function. And it's worth being super aggressive much more than Trump was to hold China back.

LINDSAY:
So is there anything China can do, Sebastian, to get the policy reversed, agreed to arms control talks, stop its militarization of the South China Sea, press North Korea to denuclearize, or is this a policy aimed not at what China has done, but at what it is becoming?

MALLABY:
I think it is about what China is becoming and therefore, there isn't much room for negotiation. If China were to persuade the West that it was becoming an advanced technological power, but one of clearly benign intent, then we might be in a different position. But at this point, it would take so much for China to persuade the West that its intent on something like Taiwan is benign. And so, I don't see any scope for a negotiation.

LINDSAY:
So does this amount to a declaration of economic warfare against China?

MALLABY:
I think it does, and it's certainly not what the Biden administration's language would indicate. President Biden has repeatedly said, "There is no need for a new Cold War with China." But in my view, there is a de facto Cold War with China.

LINDSAY:
So let's take the negative case. How might this ban on advanced semiconductor chips, technology, equipment and people, backfire on the United States?

MALLABY:
Well, it creates an incentive for China to do anything and everything to somehow develop its own domestic chip manufacturing capacity. If you think about the analogy with Western Europe and Russian gas, the west Europeans were aware for a long time that there was a potential vulnerability in depending on Russian gas, but it was cheap. It was convenient. It was attractive, and they kind of put short-term economic interests ahead of long-term strategic calculations. And that's sort of where China has been with chips that it could see that it's dependent on the West for semiconductors. It doesn't like that. Therefore, it has been trying to develop its semiconductor industry for quite a long time. Back to 2000, I know people who helped the Chinese and advised them on how to build a domestic semiconductor industry. But fast forward 22 years from that time, and they still haven't got state-of-the-art semiconductor capacity.

So they have been in the position of Germany and Italy on natural gas. Now, you do that Russian embargo thing and you cut them off, then it forces west Europe to find other sources of energy, just like it's now going to force China to find other sources of getting semiconductors. And so, I think the risk here is that China becomes self-sufficient. It takes them two or three years to figure out how to do that, but ultimately, it gets one semiconductor power or another, whether it's South Korea, whether it's Taiwan, whether it's Japan, whether it's the Netherlands, and it finds enough external know-how to be able to develop its own domestic capacity.

LINDSAY:
Well, let me ask you on that particular question, Sebastian, do we have a sense of how difficult it is to close the gap between where China is today and where cutting-edge semiconductor technology is? Because some of the articles I read about this suggest that the gap is substantial and it's incredibly difficult to close, even if you got the cooperation of one or two other countries. Other things I read suggest that perhaps just with a lot of time, effort, internal ingenuity, China can close the gap on its own. Do we really know the answer to that question?

MALLABY:
I mean, we're speculating about the future pace of development of a technology, and that's always tough. But I would say that there's an instructive analogy in the case of U.S. industrial policy in the 1980s, where the U.S. government at that time, was concerned about Japan overtaking the U.S. in terms of its chip manufacturing excellence. And organized a thing called SEMATECH, which was a sort of industry consortium with government backing that was focused specifically on reducing the fault rate and increasing the yield rate when you make semiconductors, which is one of the big things you've got to get right. It's a game of immense accuracy when you're dealing with tiny, tiny circuits.

So what happened was that government money went into this industry, prestigious industry leaders got involved in it. Bob Noyce, the famous founder of Intel, was the leader of SEMATECH for a while. And after about six or seven years, I had to look these numbers up when I was writing my book about venture capital, but basically the default rate in American semiconductor manufacturing was indeed reduced by this industrial policy. It's just that over the same period, Japan also made progress. And so, the gap between Japan and the U.S. was not shrunk. So that's one sort of illustrative story about how difficult it is, you can improve. But my guess would be that China with its statist economic traditions would go at a government industrial policy with five times more determination and twenty-five times more money than the U.S. ever did in the 1980s. And so therefore, I think it's a complacent bet to think that China will not catch up.

LINDSAY:
Are there any lessons to be drawn, Sebastian, from the example of the Clinton administration's effort to block U.S.-Chinese cooperation on satellite launches?

MALLABY:
Yeah, absolutely. I mean, I think that's very instructive. What happened there was that there had been a tradition of cooperation between the U.S. and China in the 1990s on the launching of satellites. I think it worked that the Chinese had the rockets and the U.S. had the satellites, and they worked together to put them up in space. And at the time, the U.S. share of the global satellite export market was 73 percent. And there came a moment when there were a couple of accidents, these rockets blew up before they reached their destination. And in the postmortem investigations of where the engineering had gone wrong, there was a lot of joint information sharing between the U.S. satellite makers and the Chinese rocket makers. And suddenly, the U.S. Senate understood that a huge amount of American intellectual property was being leaked to China through this consultative postmortem. And so, there was a legislation called the Helms Act, as I recall.

And the Helms Act banned U.S. satellite exports to China. And again, because the U.S. had 73% or something of the global market, that felt like a pretty powerful embargo. But what happened was that the Chinese went to other makers of satellites and collaborated with them. And two things ensued. First was that non-American satellite makers got a big leg up because a very active launcher of satellites wanted to work with them. And in the process of servicing a client, you learn more stuff, you advance your own technology, you become more cutting-edge, and you overtake the U.S. And the second thing that happened was that China got to be very good at this. And its satellite abilities, first of all, matched the U.S., then overtook the U.S.. And I think it's only really with the rise of Elon Musk's SpaceX in the last five or ten years that the U.S. has been anywhere in terms of satellite launching. So that is an object lesson in how an embargo can backfire on you and the object of the embargo will turn around, become self-sufficient, and then surpass you.

LINDSAY:
So this makes it sound like the Biden strategy really hinges on the willingness of other major semiconductor technology countries to come in behind and support the U.S. embargo. You mentioned here we're talking about the Netherlands with as ASML, we're talking about Japan, we're talking about South Korea. So what is the likelihood that they're willing to join in this effort?

MALLABY:
Well, I think they're going to be under a lot of pressure from the U.S.. The strategy seems to have been that the Biden administration spent two years or whatever, a year and a bit maybe, because they haven't been in power quite two years yet.

LINDSAY:
Give them 22 months.

MALLABY:
Right. Trying to persuade allies to join in the embargo fully. The allies would not do it, which tells us something about where they would rather be. But neither the U.S. has done it. And it's a case of are you with us or are you against us? The diplomatic bet in Washington, DC, is the Netherlands would rather be on our side than not on our side.

LINDSAY:
So the administration's trying to force the issue?

MALLABY:
Yeah, exactly. I think on a couple of different levels, it's an open question as to what happens. It could be that the Netherlands, the South Koreans and the Japanese say, "We're just not going to cooperate." That would be extreme. It could be that they say, "Well, we'll cooperate," but their enthusiasm is pretty limited and there's a way of wiggling out of it. Something like the technology is hived off to a subsidiary in a different country, and then that subsidiary collaborates with China. Sanctions always generate creative ways of getting around the sanctions. There's a possibility that maybe the embargo is never joined by allies. It's also a possibility that it is joined initially, but that the compliance degrades over time.

LINDSAY:
So why wouldn't the allies want to join in? If I look at the Netherlands, it is greatly concerned about Russia's invasion of Ukraine. The United States is important as the leader of NATO. So I would think that the Netherlands would have an interest in wanting to sign off on the Biden administration policy. Likewise, when I go to northeast Asia and I look at South Korea and Japan, both countries are very concerned about growing Chinese power. Both countries rely heavily on the United States as their security guarantor. So why wouldn't they want to join this effort? What downside do they see to doing so?

MALLABY:
Well, I mean, the first point to make, Jim, as you know very well as a student and expert of the history of American foreign policy is the free rider instinct.

LINDSAY:
More a student than an expert. We'll, go ahead. Appreciate that.

MALLABY:
The free rider instinct amongst other powers is extremely pronounced, right? That's the first thing. So that's the sort of the cynical explanation. The maybe slightly less cynical explanation/excuses for not going along with the U.S. embargo might be, oh, if you embargo China and you create a de facto Cold War, you are more likely to create the conflict that you would like to avoid with China. Or another version of this would be our national security depends on ASML remaining at the absolute cutting edge of semiconductor lithography. And to do that, ASML has to be involved with the biggest semiconductor customers in the world, that includes China. If we don't get in there and work with Chinese companies, we will be deprived of an opportunity to advance our own technology and that will negatively affect the national security of the Netherlands.

LINDSAY:
So that's the argument that the strategy is shortsighted?

MALLABY:
Yeah, I mean, that's not a crazy argument if you're Dutch, that your great sort of national security asset is this amazing semiconductor lithography company and you want it to be the best company in the world for as long as possible. And your way of achieving that is to work with all customers. Now of course, there's a countervailing national security consideration, which is that China might be a threat to global peace. But you can see that a lot of these debates come down to the fact that the U.S. is big, the U.S. is a global superpower, and therefore, the U.S. internalizes a lot of global considerations in a way that smaller countries just don't. They have a much more parochial way of looking at problems.

LINDSAY:
Well, that takes us back to the free rider point.

MALLABY:
Yeah, exactly.

LINDSAY:
So how much of this discussion that's taking place now between Washington and The Hague and Washington and Tokyo or Seoul is less about the headline banning semiconductor chips and more about the details? As I understand it, and I think you alluded to this earlier, some of the fine print is still being written on this strategy of denying China advanced semiconductor chips because advanced is not an objective fact, it's a subjective calculation. Could we be seeing a deal being struck that really is about that fine print, about what can be allowed?

MALLABY:
That's a great question. And I guess from the Biden administration's perspective, there is a choice to be made, right? Do you want an aggressive embargo, which is their opening position, that's what they've announced, or would you rather trade away some of that aggression and dilute the sanction a little bit in order to bring allies on board and make it a more comprehensive strategy? And that second path would strike me as having some logic, because I think without the willing collaboration of these other semiconductor powers, it is going to backfire.

LINDSAY:
I will note that when the Biden administration released its strategy or its decision, it stated that there would be some exemptions to the bans. Though I guess there's a presumption of denial when those exemptions are being submitted, but I'm not really sure what the standard is for a presumption of denial.

MALLABY:
Yes, exactly. And I suspect that's something which is going to be defined only in the doing of it as time rolls on. All of these embargoes always have, under special considerations, you may actually export, and-

LINDSAY:
But we've seen that right now with the various bans being imposed on Russia, Russian gas, Russian oil.

MALLABY:
Exactly. So I think the use or non-use of that power to issue exemptions will be one of the things we have to watch in the future. I don't know how that's going to play out.

LINDSAY:
Is there anything Washington can offer to the Dutch, to the Japanese, to the South Koreans on other issues to bring them into the fold on this one? I mean, a lot of diplomacy is about giving in order to get, and I guess my question is, is there anything the Biden administration can give or is willing to give to get cooperation on what it considers to be foreign policy priority number one?

MALLABY:
I think there's certainly something it ought to give, and that is market access in the U.S., the prospect of a deeper trade relationship. It is a tragedy in my view that whereas every single president that I can think of since the World War II up until 2017 wanted to further trade agreements. That was not the case for President Trump and it is not the case thus far with President Biden. They are outside the post-World War II pattern. And I think that's a real tragedy. And if they were willing to issue enhanced market access to Europe and to the Asia Pacific region, it would be much more likely that they would get collaboration as a quid pro quo on semiconductors. Somebody said, and then this may be an exaggeration, but it's certainly a memorable phrase, that when the United States withdrew from the Transpacific Trade Partnership, which had been negotiated in the Obama years, that ditching that deal was the greatest U.S. foreign policy mistake in Asia since Vietnam.

LINDSAY:
That's a pretty big statement, Sebastian.

MALLABY:
That's a big statement, I know. I mean, I put it out there for discussion, but I certainly think... I mean, think it is a very big error to have left that trade deal. One of the interesting things here, Jim, which I think is worth thinking about, is that there was a period from roughly the fall of the Berlin Wall through to, let's say the advent in office of both Donald Trump and Xi Jinping. We assume that globalization could grow and deepen and continue to do so, and that geopolitics would not really get in the way. And in that period, in the economics profession and generally the trade policy area, it was taken as obvious that the best kind of trade liberalization was global. The World Trade Organization, global liberalization was superior than regional deals. And our former colleague, Jagdish Bhagwati, used to say that regional trade deals were just trade diverting, they were not trade creating. And-

LINDSAY:
Yes, I heard him say that many, many times.

MALLABY:
Indeed, indeed. And I think that argument really feels different today, because we're in a world where we are closer to being kind of in the late 1940s when the general agreement on tariff and trade was created, a much narrower trade liberalization effort, which was sort of about solidifying the West in the Cold War and having trade amongst allies. And the purpose was geopolitical as much as it was economic. And indeed, the origins of the European Union, of course, I think it was called the Coal and Steel Union, and initially was six countries in Europe, which were far more concerned with kind of knitting themselves together politically avoiding another disastrous world war and building solidarity against the Soviet block. And so, those sorts of geopolitical arguments for trade deals, which went out of fashion in the high period of globalization, I think they need to come back into fashion in a big way, right? We are de facto in a new Cold War, as I said, and we therefore need to think about trade in an entirely different way and recognize that it is part of deepening alliances.

LINDSAY:
Well, you seem to be talking about recognizing trade in an old way, because that was the approach the Truman administration certainly took in the late 1940s. And I'll just say, having gone to Southeast Asia last month, what I heard my conversations there was puzzlement and a bit of sadness from a wide array of people that the United States, in their view, has taken itself out of the economic competition in Asia by its refusal to participate in TPP, by refusal if it wasn't going to come back in the TPP offering up something substantial to sort of knit these countries together economically.

And I got the sense that no one regarded or regards the Biden administration's Indo-Pacific Economic Framework, IPEF, as a substantial offering. And I think you know well successive Japanese prime ministers have been advising the White House first with Donald Trump and now with President Biden that the best thing the United States can do to shore up its strategic position in Asia is to come into the comprehensive and progressive Trans Pacific Partnership. But again, that seems to just fall in deaf ears here in Washington.

MALLABY:
Yeah. So in that sense, I think that if the Biden administration wants to succeed with its undeclared Cold War on China and succeed with the semiconductor embargo, which as I said is a very aggressive policy, it needs to be willing to make an argument for deeper trade with allies. And that is not where the Biden administration's heart is, but I think it needs to have a change of heart.

LINDSAY:
Before we wrap up this conversation, Sebastian, I want to come back to one final question about the specific decision to impose an embargo on advanced semiconductor chips. And that question is, what other choice did Biden have? And I hear from many people, certainly people in the administration that President Xi fired the first shot in this economic Cold War with his China 2025 plan, with China's rampant theft of U.S. intellectual property and clear signals coming out of Beijing that they intend to win or dominate in AI. So wasn't the Biden administration's hand forced by Chinese policy?

MALLABY:
I think there's some truth in that, and I think you could even build on that truth by saying it's not merely that China is openly ambitious in its economic strategy, its desire to win in AI, its willingness to steal foreign intellectual property. Those are various kinds of economic competition. And I think if it was just that, the U.S. might say, well, we have our own system. We believe more in markets and in private industry and in private initiative, we think our system ultimately produces a stronger result. Let's have a competition. But it's not just that. The problem with China is it combines those kinds of economic ambitions with a determination to view Taiwan as a rogue state that needs to be reabsorbed into the motherland. And that is not acceptable and nor other expansionist sort of muscle flexing.

So it's that combination of threatening foreign policy with the economic and technological ambition, which I think did force some sort of response from Biden. But the thing is, one has to play the art of the possible and an embargo that ends up creating a more independent technological China is non-goal, and you don't want that. So I think you can almost construct a logical synergism, which says, China threatening, must respond, semiconductor embargo necessary, and therefore, what's the necessary next step? It's a new view of trade and a willingness to put more into building alliances.

LINDSAY:
Do you see the administration decoupling from China in any other areas or technologies? Can it?

MALLABY:
Yes, I think that there is a across the board sense in the private sector in the U.S. and in the government, that collaboration with China is a risky thing to be engaged in. And if you are Apple and you have grown used to having a large number of iPhones assembled in China, you better have an alternative assembly plant in Vietnam, and that's what they're doing.

LINDSAY:
So it sounds like there's a lot we have to talk about down the road.

MALLABY:
Indeed.

LINDSAY:
So I'll have to have you come back on.

MALLABY:
Okay. It's a deal. Thank you, Jim.

LINDSAY:
Okay. On that note, I'll close up The President's Inbox for this week. My guest has been Sebastian Mallaby, the Paul A. Volcker senior fellow for international economics at CFR. Sebastian, thanks for joining me.

MALLABY:
It's a great pleasure. Thank you, Jim.

LINDSAY:
Please subscribe to the President's Inbox on Apple Podcast, Google Podcast, Spotify, or wherever you listen, and leave us a review. We love the feedback. You can find a link to Sebastian's book, The Power Law, as well as a transcript of our conversation on the podcast page for The President's Inbox on cfr.org. As always, opinions expressed in The President's Inbox are solely those of the host, or our guests, not of CFR, which takes no institutional positions on matters of policy. Today's episode was produced by Ester Fang, with senior podcast producer, Gabrielle Sierra. Special thanks to Michelle Kurilla for her assistance. This is Jim Lindsay. Thanks for listening.