Pricing the China Shock: The Unintended Consequences of Sectoral Trade Protectionism

Synopsis: The China Shock can be measured in terms of import flows or, alternatively, as a price effect. Adopting the latter perspective, i.e., pricing the China Shock, helps explain, through a wage-price mechanism, why industrial policy attempting to protect specific sectors ends up, in reality, penalizing those same sectors.

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Today, US narrative is that trade is unfair and unbalanced, and harms American businesses and workers. Thus, trade needs to be adusted by protectionist policy. Additionally, for reasons of national security, resilience, or geopolitical objectives, industrial policy might be called for as well. The two, trade protectionism and industrial policy, can gainfully work together.

The typical objection to this is that protectionism creates inefficiency, even if industrial policy might well do the right thing. I argue here that beyond just inefficiency, such policies have the unintended consequence of immiserising the very industry being protected.

Two mechanisms matter:

1. (A trade-price effect) Whether trade is unfair and unbalanced or otherwise, trade always changes relative prices. Whatever happens to the magnitude of imports, that change in relative prices has real effects. When prices shift, someone somewhere will feel disadvantaged. Unless those people see their loss sufficiently compensated somehow, they will exercise what political leverage they can against trade. This has nothing to do with trade being unfair or unbalanced, and is independent of whether the bilateral trade balance is in surplus or deficit;

2. (A non-tradeable price effect) If policy erects barriers so that a certain part of the economy is protected from trade, that creates a non-tradeables sector. This might arise because of industrial policy, say, that seeks to reshape the landscape of industrial activity. In this case, a version of the Balassa-Samuelson effect kicks in: Improvements in the technology of the newly-created non-tradeables sector reduces price there and harms businesses. This reduces the incentive to innovate. The more advanced is technology in the non-tradeables sector, the worse is the downward impact there from ever more successful exchange in the traded goods sector. But for trade in particular my point here is that as long as labour markets continue to operate, any price shock due to trade propagates to downward pressure on prices of non-tradeables as well, through wage effects in labour markets.

The implication of the trade-price effect is that even when trade is fair and balanced, and comparative advantage theory applies to make for win-win outcomes, there can still be political opposition against trade. The implication of the non-tradeable price effect is that protectionism directed at specific sectors—because of an industrial policy approach, say—does not, in actuality, protect those sectors.

The trade-price effect might seem, at first, unusual, but it is just a generalization of a different idea, now considered conventional. In economic analysis comparative advantage can coexist with trade increasing inequality. A rise in inequality can engender escalation in populist activity and political opposition to trade.

Connecting this with the trade-price effect, observe that while there might be variety in the different possible mechanisms underlying political opposition to trade, one simple unifying idea connects them all. This is that trade changes relative prices. And, when relative prices change, someone somewhere in the economy is disadvantaged.

When prices happen to move against the poor, this is a rise in inequality. Thus a special case of the trade-price effect is simply the trade-inequality relation. But, depending on initial conditions and factor proportions, prices might move not agains the poor but can instead against the rich. Even if that reduces inequality then, the rich who are disadvantaged by trade can marshal even greater political opposition to trade. When prices move against large national champions in industry, nationalism will arise to oppose trade. When prices move against smaller but emerging industries, opposition to trade can emerge from infant-industry proponents. Depending on where national elites have invested, the change in relative price can either line the pockets of those elites or engender opposition from their political rivals.

The Figure shows perhaps the largest of such price disruptions over an extended period of time. The data graphed are timeseries, over 2003-2024, of price indexes important for assessing US trade. The three rising graphs are, respectively, the US Consumer Price Index and the price indexes for imports from Canada and Mexico. Over the last quarter century, US consumer prices have risen 65%; Canadian import prices by 68%; Mexico import prices, 49%. Thus, Canadian imports have kept pace with US consumer prices, while Mexican imports have become marginally cheaper.

It is the fourth line in the Figure that is most critical: this is the price index for imports from China. Its graph shows, in essence, zero change for the entire last quarter of a century. Even as Chinese exports to the US have transitioned from primarily low-tech manufactures and plastic toys to high-quality frontier technologies, they have remained as cheap for the US consumer today as they were over two decades ago.

However, those same features in the graph show also the intense competition faced by US businesses and workers in those industries for which these exports substitute. Why would US consumers buy goods whose prices have risen by 70% over others that are comparable or of even better quality?

Protectionism Punishing Those Sectors Being Protected

The significance of the non-tradeables price effect is that the impact of a severe price shock, such as in the Figure, is not confined to just the traded-goods sector. Suppose that policymakers act to ringfence some sector of the economy, therefore creating a new non-tradeables sector.

The negative price shock in the trade goods sector, for a given level of technology, will put downward pressure on wages in traded goods.

But in an integrated labour market, that reduces wages in the newly-created non-tradeables sector as well. This is the wage-price mechanism. Unless technology in the non-tradeables sector compensates, the price of ringfenced-non-tradeables will fall.

(In symbols the argument uses the fact that in equilibrium $w = p \times \theta$, where $w$ is wage, $p$ is price, and $\theta$ representing technology—with one such equation for the traded goods sector and one for the nonetradeables sectors. A functioning labour market equalizes wages. Then for fixed $\theta$, one each in the traded and non-traded sectors, a reduction in $p_T$—the price in the traded goods sector—translates into a proportional reduction in $p_{NT}$, with constant of proportionality equal to $\theta_T / \theta_{NT}$. The greater the separation between technology levels in trade and non-tradeable sectors, the larger the multiplier effect on prices in the non-tradeables sector. A more extended and mathematically visible argument appears as a version of the Balassa-Samuelson effect that I used in “Why Small Nations Unexpectedly Succeed”, 2024.)

Pricing the China Shock—rather than just looking the size and direction of imports—helps explain an unintended consequence of industrial and trade policy. Raising protectionist barriers in specific sectors does not, in actuality, protect those sectors from the price shock that is trade.

References

Kennedy, Scott and Mazzocco, Ilaria. 2022. “The China Shock: Reevaluating the Debate,” Big Data China, Center for Strategic and International Studies, October 14, 2022, last modified 11 Apr, 2024 https://bigdatachina.csis.org/the-china-shock-reevaluating-the-debate/

Quah, Danny. 2024. “Why Small Nations Unexpectedly Succeed: Trade, Technology, and the Washington Consensus”, LKYSPP Working Paper, Mar https://DannyQuah.github.io/working-papers/2024-02-small-nations-succeed/

Quah, Danny. 2025. “Correlated Trade and Geopolitics Driving a Fractured World Order”, Ch. 5, pp. 54-66, in Ing, Lili Yan and Rodrik, Dani (eds.) The New Global Economic Order, New York: Routledge.
https://DannyQuah.github.io/publications/2025-04-Danny.Quah-Correlated-Trade-Geopolitics-Fractured-Order-NEO/

Quah, Danny. 2025. “Response to Ricardo Hausmann by Danny Quah: The Trade-Technology Relation in Small and Poor Economies”, in Besley, Tim, Bucelli, Irene, and Velasco, Andres (eds.) The London Consensus: Economic Principles for the 21st Century, London: LSE Press, pp. 181-193 https://DannyQuah.github.io/publications/2025-03-Danny.Quah-Small-Poor-Trade-Technology-TLC