The Unwinnable Trade War

In late June, the leaders of China and the United States announced at the G-20 meeting in Osaka, Japan, that they had reached a détente in their trade war. U.S. President Donald Trump claimed that the two sides had set negotiations “back on track.” He put on hold new tariffs on Chinese goods and lifted restrictions preventing U.S. companies from selling to Huawei, the blacklisted Chinese telecommunications giant. Markets rallied, and media reports hailed the move as a “cease-fire.”

That supposed cease-fire was a false dawn, one of many that have marked the on-again, off-again diplomacy between Beijing and Washington. All wasn’t quiet on the trade front; the guns never stopped blazing. In September, after a summer of heated rhetoric, the Trump administration increased tariffs on another $125 billion worth of Chinese imports. China responded by issuing tariffs on an additional $75 billion worth of U.S. goods. The United States might institute further tariffs in December, bringing the total value of Chinese goods subject to punitive tariffs to over half a trillion dollars, covering almost all Chinese imports. China’s retaliation is expected to cover 69 percent of its imports from the United States. If all the threatened hikes are put in place, the average tariff rate on U.S. imports of Chinese goods will be about 24 percent, up from about three percent two years ago, and that on Chinese imports of U.S. goods will be at nearly 26 percent, compared with China’s average tariff rate of 6.7 percent for all other countries.

The parties to this trade war may yet step back from the abyss. There have been over a dozen rounds of high-level negotiations without any real prospect of a settlement. Trump thinks that tariffs will convince China to cave in and change its allegedly unfair trade practices. China may be willing to budge on some issues, such as buying more U.S. goods, opening its market further to U.S. companies, and improving intellectual property protection, in exchange for the removal of all new tariffs, but not to the extent demanded by the Trump administration. Meanwhile, China hopes that its retaliatory actions will cause enough economic pain in the United States to make Washington reconsider its stance.

The numbers suggest that Washington is not winning this trade war. Although China’s economic growth has slowed, the tariffs have hit U.S. consumers harder than their Chinese counterparts. With fears of a recession around the corner, Trump must reckon with the fact that his current approach is imperiling the U.S. economy, posing a threat to the international trading system, and failing to reduce the trade deficit that he loathes.

Trump may back away from his self-destructive policy toward China, but U.S.-Chinese competition will continue beyond his tenure as president. Much of the coverage of the conflict makes it seem like a clash of personalities, the capriciousness of Trump against the implacable will of Chinese President Xi Jinping and the Chinese Communist Party. But this friction is systemic. The current costs of the trade war reflect the structural realities that underpin the relationship between the U.S. and Chinese economies. It’s worth tracing that dynamic as the two great powers try to find a new, fitful equilibrium in the years ahead.

CONSIDER THE LOBSTERS

The trade war has not produced the desired results for the United States. Washington first raised tariffs on Chinese imports in 2018. In the same year, Chinese exports to the United States increased by $34 billion, or seven percent, year-over-year, while U.S. exports to China decreased by $10 billion, or eight percent. In the first eight months of this year, China’s exports to the United States dropped by just under four percent compared with the same period in the previous year, but U.S. exports to China shrank much more, by nearly 24 percent. Instead of narrowing the trade gap, the tariffs have coincided with a widening of the U.S. trade deficit with China: by nearly 12 percent in 2018 (to $420 billion) and by about another eight percent in the first eight months of this year.

There are at least two reasons why Chinese exports to the United States have not fallen as much as the Trump administration hoped they would. One is that there are no good substitutes for many of the products the United States imports from China, such as iPhones and consumer drones, so U.S. buyers are forced to absorb the tariffs in the form of higher prices. The other reason is that despite recent headlines, much of the manufacturing of U.S.-bound goods isn’t leaving China anytime soon, since many companies depend on supply chains that exist only there. (In 2012, Apple attempted to move manufacturing of its high-end Mac Pro computer from China to Texas, but the difficulty of sourcing the tiny screws that hold it together prevented the relocation.)

Some export-oriented manufacturing is leaving China, but not for the United States. According to a May survey conducted by the American Chamber of Commerce in Shanghai, fewer than six percent of U.S. businesses in China plan to return home. Sixty percent of U.S. companies said they would stay in China.

Much of the manufacturing of U.S.-bound goods isn’t leaving China anytime soon.

The damage to the economy on the import side is even more pronounced for the United States than it is for China. Economists at the Federal Reserve Bank of New York and elsewhere found that in 2018, the tariffs did not compel Chinese exporters to reduce their prices; instead, the full cost of the tariffs hit American consumers. As tariffs raise the prices of goods imported from China, U.S. consumers will opt to buy substitutes (when available) from other countries, which may be more expensive than the original Chinese imports but are cheaper than those same goods after the tariffs. The price difference between the pre-tariff Chinese imports and these third-country substitutes constitutes what economists call a “dead-weight loss” to the economy.

Economists reckon the dead-weight loss arising from the existing tariffs on $200 billion in Chinese imports to be $620 per household, or about $80 billion, annually. This represents about 0.4 percent of U.S. GDP. If the United States continues to expand its tariff regime as scheduled, that loss will more than double.

Meanwhile, Chinese consumers aren’t paying higher prices for U.S. imports. A study by the Peterson Institute for International Economics shows that since the beginning of 2018, China has raised the average tariff rate on U.S. imports from 8.0 percent to 21.8 percent and has lowered the average tariff rate on all its other trading partners from 8.0 percent to 6.7 percent. China imposed tariffs only on U.S. commodities that can be replaced with imports from other countries at similar prices. It actually lowered duties for those U.S. products that can’t be bought elsewhere more cheaply, such as semiconductors and pharmaceuticals. Consequently, China’s import prices for the same products have dropped overall, in spite of higher tariffs on U.S. imports.

Beijing’s nimble calculations are well illustrated by the example of lobsters. China imposed a 25 percent tariff on U.S. lobsters in July 2018, precipitating a 70 percent drop in U.S. lobster exports. At the same time, Beijing cut tariffs on Canadian lobsters by three percent, and as a result, Canadian lobster exports to China doubled. Chinese consumers now pay less for lobsters imported from essentially the same waters.

THE INESCAPABLE DEFICIT

Beijing has proved much more capable than Washington of minimizing the pain to its consumers and economy. But the trade war would be more palatable for Washington if its confrontation with China were accomplishing Trump’s goals. The president thinks that China is “ripping off” the United States. He wants to reduce the United States’ overall trade deficit by changing China’s trade practices. But levying tariffs on Chinese imports has had the paradoxical effect of inflating the United States’ overall trade deficit, which, according to the U.S. Census Bureau, rose by $28 billion in the first seven months of this year compared with the same period last year.

The uncomfortable truth for Trump is that U.S. trade deficits don’t spring from the practices of U.S. trading partners; they come from the United States’ own spending habits. The United States has run a persistent trade deficit since 1975, both overall and with most of its trading partners. Over the past 20 years, U.S. domestic expenditures have always exceeded GDP, resulting in negative net exports, or a trade deficit. The shortfall has shifted over time but has remained between three and six percent of GDP. Trump wants to boost U.S. exports to trim the deficit, but trade wars inevitably invite retaliation that leads to significant reductions in exports. Moreover, increasing the volume of exports does not necessarily reduce trade deficits unless it is accompanied by a reduction in the country’s spending in terms of consumption and investment. The right way to reduce a trade deficit is to grow the economy faster than concurrent domestic expenditures, which can be accomplished only by encouraging innovation and increasing productivity. A trade war does the opposite, damaging the economy, impeding growth, and hindering innovation.

Even a total Chinese capitulation in the trade war wouldn’t make a dent in the overall U.S. trade deficit. If China buys more from the United States, it will purchase less from other countries, which will then sell the difference either to the United States or to its competitors. For example, look at aircraft sales by the U.S. firm Boeing and its European rival, Airbus. At the moment, both companies are operating at full capacity. If China buys 1,000 more aircraft from Boeing and 1,000 fewer from Airbus, the European plane-maker will still sell those 1,000 aircraft, just to the United States or to other countries that might have bought instead from Boeing. China understands this, which is one reason it hasn’t put higher tariffs on U.S.-made aircraft. Whatever the outcome of the trade war, the deficit won’t be greatly changed.

A RESILIENT CHINA

The trade war has not really damaged China so far, largely because Beijing has managed to keep import prices from rising and because its exports to the United States have been less affected than anticipated. This pattern will change as U.S. importers begin to switch from buying from China to buying from third countries to avoid paying the high tariffs. But assuming China’s GDP continues to grow at around five to six percent every year, the effect of that change will be quite modest. Some pundits doubt the accuracy of Chinese figures for economic growth, but multilateral agencies and independent research institutions set Chinese GDP growth within a range of five to six percent.

Skeptics also miss the bigger picture that China’s economy is slowing down as it shifts to a consumption-driven model. Some manufacturing will leave China if the high tariffs become permanent, but the significance of such a development should not be overstated. Independent of the anxiety bred by Trump’s tariffs, China is gradually weaning itself off its dependence on export-led growth. Exports to the United States as a proportion of China’s GDP steadily declined from a peak of 11 percent in 2005 to less than four percent by 2018. In 2006, total exports made up 36 percent of China’s GDP; by 2018, that figure had been cut by half, to 18 percent, which is much lower than the average of 29 percent for the industrialized countries of the Organ-ization for Economic Cooperation and Development. Chinese leaders have long sought to steer their economy away from export-driven manufacturing to a consumer-driven model.

The resilience of the Chinese economy helps explain why Beijing has stiffened its negotiating position.

To be sure, the trade war has exacted a severe psychological toll on the Chinese economy. In 2018, when the tariffs were first announced, they caused a near panic in China’s market at a time when growth was slowing thanks to a round of credit tightening. The stock market took a beating, plummeting some 25 percent. The government initially felt pressured to find a way out of the trade war quickly. But as the smoke cleared to reveal little real damage, confidence in the market rebounded: stock indexes had risen by 23 percent and 34 percent on the Shanghai and Shenzhen exchanges, respectively, by September 12, 2019. The resilience of the Chinese economy in the face of the trade war helps explain why Beijing has stiffened its negotiating position in spite of Trump’s escalation.

China hasn’t had a recession in the past 40 years and won’t have one in the foreseeable future, because its economy is still at an early stage of development, with per capita GDP only one-sixth of that of the United States. Due to declining rates of saving and rising wages, the engine of China’s economy is shifting from investments and exports to private consumption. As a result, the country’s growth rate is expected to slow. The International Monetary Fund projects that China’s real GDP growth will fall from 6.6 percent in 2018 to 5.5 percent in 2024; other estimates put the growth rate at an even lower number. Although the rate of Chinese growth may dip, there is little risk that the Chinese economy will contract in the foreseeable future. Private consumption, which has been increasing, representing 35 percent of GDP in 2010 and 39 percent last year, is expected to continue to rise and to drive economic growth, especially now that China has expanded its social safety net and welfare provisions, freeing up private savings for consumption.

The U.S. economy, on the other hand, has had the longest expansion in history, and the inevitable down cycle is already on the horizon: second-quarter GDP growth this year dropped to 2.0 percent from the first quarter’s 3.1 percent. The trade war, without taking into account the escalations from September, will shave off at least half a percentage point of U.S. GDP, and that much of a drag on the economy may tip it into the anticipated downturn. (According to a September Washington Post poll, 60 percent of Americans expect a recession in 2020.) The prospect of a recession could provide Trump with the impetus to call off the trade war. Here, then, is one plausible way the trade war will come to an end. Americans aren’t uniformly feeling the pain of the tariffs yet. But a turning point is likely to come when the economy starts to lose steam.

If the trade war continues, it will compromise the international trading system, which relies on a global division of labor based on each country’s comparative advantage. Once that system becomes less dependable—when disrupted, for instance, by the boycotts and hostility of trade wars—countries will start decoupling from one another.

China and the United States are joined at the hip economically, each being the other’s biggest trading partner. Any attempt to decouple the two economies will bring catastrophic consequences for both, and for the world at large. Consumer prices will rise, world economic growth will slow, supply chains will be disrupted and laboriously duplicated on a global scale, and a digital divide—in technology, the Internet, and telecommunications—will vastly hamper innovation by limiting the horizons and ambitions of technology firms.

SILVER LININGS

Trump’s trade war does not seem to simply seek to reduce the trade deficit. Rather, his administration sees the tariffs as a means to slow China’s economic rise and check the growing power of a geopolitical competitor. At the heart of this gambit is the notion that China’s system of government involvement in economic activities represents a unique threat to the United States. Robert Lighthizer, the U.S. trade representative, has insisted that the purpose of the tariffs is to spur China to overhaul its way of doing business.

Ironically, it is China’s private sector that has been hardest hit by the trade war, as it accounts for 90 percent of Chinese exports (43 percent of which are from foreign-owned firms). If the trade war persists, it will weaken the private sector. China may well agree to commit to purchasing large quantities of U.S. goods as part of a settlement. But such purchases can be made only by the government, not by the private sector. The United States should recognize that securing such a commitment would basically compel the Chinese government to remain a large presence in economic affairs. The trade policy of the Trump administration threatens to undermine its own stated objectives.

U.S. officials should reconsider their analysis of the Chinese economy. To think that there is a unique “China model” of economic development, which represents an alternative and a threat to liberal market systems, is ahistorical nonsense. China has achieved rapid growth in the past 40 years by moving away from the old system of state control of the economy and embracing the market. Today, the market plays a dominant role in resource allocation, and the private sector accounts for more than two-thirds of the economy.

However, the government-controlled sector remains too big, inefficient, wasteful, and moribund, more of a bane than a boon to the economy. It is also a source of growing friction between China and the West, which fears, with good reason, that Chinese government subsidies and support unfairly advantage state-owned firms. This arrangement needs to change, both for China and for its trading partners.

Chinese leaders have long sought to steer their economy toward a consumer-driven model.

China can maintain its economic momentum only by structurally reforming its economy to move in the direction of a freer, more open market. If it fails to do so, its growth will hit a ceiling and its rise will be curtailed. U.S. negotiators should push China to further trim its state-owned sector, to guarantee equal access to its market for trade and investment, and to develop a better regime of intellectual property protection. These measures would accelerate the trajectory of reform that China embarked on 40 years ago, which has led to the rise of a vibrant private sector in China and the country’s economic integration with the global market. Speeding up this process will not be painless and will be resisted by vested interests in China. But such changes will benefit China as well as its trading partners, including the United States. Beijing and Washington should share these objectives in their trade negotiations. If they succeed in meeting these goals, both sides will win the trade war.

It is in the best interests of both countries to move away from zero-sum thinking and put an end to the ad hoc decoupling that the trade war has threatened. The best path forward is not to close but to tear down existing barriers and further open up trade. To maintain its global primacy and technological leadership, the United States needs China—the biggest and fastest-growing consumer market in the world. To sustain the momentum of its economic ascent, China needs to further its reforms and continue opening up to the world market. Ultimately, a mix of cooperation and competition within a rules-based system will lead to the greatest prosperity for both countries and for the world economy, as all trading nations have learned throughout history.