Introduction
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The title of this paper has two questions that may have obvious affirmative answers to many or even most readers, but this paper questions common beliefs. Given media and policy attention on the US-China trade war and how the market seems to react to every bit of news, “yes” may be the answer for many people to the first question, “Does the trade war matter?” The answer to the second question, “Can the US win the trade war?” will also be “yes” if one bases the answer on President Trump’s early explanation that the war will be easily won simply because China exports more to the US than the US exports to China so China has the most to lose by tariffs. However, the US has discovered that this war is not so easily won, and herein I explain why. I also argue that the trade war would not matter to the aggregate economy if it were not for the fact that most people behave based on their belief that it does. Beliefs cause actions, even if they are faulty.
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The Problem with Trump’s Math
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So far, the US has enacted tariffs on $250 billion of imports from China. China retaliated with tariffs on US products, but to a lesser amount. Trump suggested that the trade war would be easy to win since the US runs a trade deficit. The US reported a $378.6 billion trade imbalance in 2018. While on the surface it appears logical that China has more to lose from tariffs, the import/export trade balance lacks important additional details.
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While the US runs a negative trade balance with China, US firms are heavily invested in China and US affiliates operating in China sell a comparatively large amount of sales to China ($481 billion in 2015 according to the BEA) versus sales of Chinese companies operating in the US ($26 billion). US firms operating in China had 82% of their sales in China and 6% of their sales back in the US. Because of this, the overall balance of trade is in favor of the US by $88 billion (see figure 1). The US advantage may grow even further if we include sales of US affiliates in Hong Kong. While sales of US affiliates in China is $481 billion, the figure rises to $630 billion if we also include Hong Kong. Using Trump’s logic on the trade balance but considering that the US has a positive balance, it appears the US has more to lose than China in this trade war. Maybe this is why China is not so easily willing to concede.
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For June 2019, Chinese imports of US goods dropped 31%, whereas US imports of Chinese goods dropped 8%, and the US import/export trade deficit widened. China has mitigated some of the damage of higher cost US products (due to Chinese tariffs on US goods) by lowering tariffs on other countries. The average tariff rate on US goods jumped from 8% at the beginning of 2018 to 20.7% in June, whereas the tariffs on imports from all other countries fell from 8% to 6.7% last November and is stable since then.
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Should the Trade War Even Matter?
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Keep in mind that this question, “Should the trade war even matter?” starts with “should.” In the last section, I will talk about the behavioral reasons the trade war matters. Here, I suggest that it should not matter, at least that much, because the total dollar value of trade is not high enough to cause significant damage to either country.
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Trump has threatened 25% tariffs on $325 billion more goods from China. This would mean that every import from China has a 25% tax. Back of the envelope (figure 2), this would cause US business profits to drop 9% if corporations absorbed all of the additional costs, or it would bump up inflation by 0.6% if consumers bore all of the costs. Keep in mind that the Fed has been worried about too low of inflation, so a boost in inflation could be welcomed, unless it makes the Fed more aggressive and it raises interest rates. The 9% drop in profits is not good, but it is only a little more than one year’s earnings. In a recession, earnings could drop over 50%. Although, the amount could be more or less depending on how China retaliates. It could be much more if China implements controls on US companies operating in China. Or, it could be much less if US companies find alternative supplies outside China to avoid the tariffs.
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The size of the trade balance is small versus the US and Chinese economies, so it does not provide much incentive to negotiate. The US economy is $20.5 trillion (current prices through April 2019, IMF). A roughly $400 billion trade gap is only 2.0% of GDP, and our economy is growing 4% or more nominal. Thus, if we lost all exports to China and ceased importing from China, the US would still grow 2%, or half of the annual rate of growth. Stated another way but from China’s perspective, if the Chinese lose their import/export advantage, this would only reduce growth by 2.8% (on $14.2 trillion in GDP). Given that China’s real GDP is growing 6% and closer to 8% nominal, this is not such a big deal relative to the cost of concessions. Of course, to overcome lost imports, the US and China would need to source supplies from other companies and countries which can be disruptive and costly. If they believe this is a dire outcome, the governments may assume tariffs will eventually lead to a negotiated solution, so the short-term pain is worth it. This assumption is either reasonable or optimistic. So far, it appears both sides are digging trenches in preparation for a long stand-off. President Trump does not appear to lack confidence, and overconfidence in negotiation could cause one to underestimate the opponent.
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The Slowing of the Chinese Economy was Planned – It was Initially Not Due to the Trade War
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China’s real GDP grew 6.2% in the latest quarter, the slowest in 27 years. Trump tweeted that this is due to the “major effect on companies wanting to leave China for non-tariffed countries.” This may be part of the story, but China’s slowdown began before the tariffs and it was orchestrated by the Chinese government to reduce debt growth.
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China’s debt has been growing quicker than GDP and its non-financial debt to GDP ratio is 254%, up from 213% in 2013. While this is similar to the US (250%), the US level has been flat since 2013, plus China’s level is higher than the average of all reporting countries (234%). China’s household debt has been growing quickly (52.6% of GDP, up from 33.1% in 2013), whereas the world is flat (at 60%). Much of this debt is in mortgages, and real estate prices have skyrocketed (up 9% to over 12% the last couple years). However, perhaps the mortgage debt is not too concerning since Chinese borrowers have to put more money down (20-30%+) and prices are up so their equity may be much higher, borrowers cannot walk away if they face foreclosure, and there is a restriction in China on owning more than one home. Non-financial corporations are also heavily indebted (152% of GDP compared to 74.4% for the US and 91% for all reporting economies) and I expect China wants to keep this ratio moving down (it is down 6.5% since 2017).
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China pulled back on many levers to manufacture the slowdown in credit growth which also slowed the economy. Figure 4 shows money supply growth relative to GDP growth, with a one year lead. If money supply growth is higher than GDP growth, then this is a sign of stimulate monetary policy. Money supply leads GDP by about a year, and figure 4 shows that growth was curtailed significantly from 2016 through the end of 2018.
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However, money supply growth is starting to pick up, perhaps to offset negatives from the trade war. This is occurring at the same time as the government is ramping up fiscal stimulus. The OECD suggest the fiscal deficit could be as high as 4.25% of GDP in 2019, up from 2.94% in 2018. The Chinese government can afford big fiscal deficits since government debt to GDP was 50% in 2018 compared to 99% for the US and 79% for all reporting economies. Thus, China has monetary and fiscal policy options to support the economy; however, if renewed economic growth leads to a greater pick-up in debt financed spending then the overall debt problem noted earlier may become even more worrisome.
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China’s Debt Problem is a Bonus to the US
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China’s debt problem is a bonus for the US. To grow, China may need more investment from the US and elsewhere since its corporations are already levered up. Even if the trade war did not occur, China may have slowly, or even quickly, been more nurturing of foreign investors. Maybe the country would have even changed its practice on technology transfers.
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However, I fear that being bullied by one country (US) into playing fair will not help. If the US joined forces with its European partners against technology sharing issues, instead of also attacking Europe for unfair trade practices and going it alone on China, then perhaps China may have been willing to level playing field by now. Maybe the US will be successful (I hope), but please keep in mind China’s point of view.
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Some time ago, I read an interesting rebuttal from China to the US’s position on its policies. In it, China said that the US did not have to sell to China, so US companies were not made to transfer technology. They have a point. US companies had a choice and decided that it was better to participate in China’s economic growth and prosperity (which China shared with foreigners) and give up some technology prowess than to sit it out. Since productivity improvement through “stolen” technology advancements and employment growth from foreign investment has improved China’s standard of living, China’s “unfair” policies have benefited its population. The policies were smart business on China’s behalf (they effectively bought the technology by sharing China’s growth), so China will not likely give up technology transfer rules to appease just one country (US). Plus, it wants to appear strong against US pressures.
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The US says the technology sharing policies are unfair because it does not require Chinese companies to share their technology with US firms to gain entry into US markets. However, remember, the US is growing more slowly so Chinese firms also gain less long-term growth by coming to the US (in the short-term, they may still gain plenty by displacing sales of higher cost US firms). Despite this, the US may win on the technology transfer issue because of the first point above – due to China’s debt problem, it may need more foreign investment than before and be willing to concede on technology transfer policies.
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This War is Not Easy to Win
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China has ample ammunition and big guns in the trade war.
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Some industries in the US have already been hurt, and the next round of tariffs will impact the US consumer more than the earlier tariffs. For instance, China accounts for 20% of Kohl’s goods. In a letter to Trump, 170 shoe retailers noted that a 25% tariff could mean some shoes in the US could have a 100% duty. Automobiles are being tariffed at a rate of 40% (up from 15%) in China. Soybeans are also being hit hard, as China is the largest importer.
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- As noted earlier, sales of US affiliates in China is about $500 billion. China could encourage its citizens to boycott US products. For instance, Apple is the largest US foreign affiliate operating in China by sales to China (about 20% of its 2017 sales) and six of the next seven largest firms are tech companies (China is 16% to 65% of sales of their firms). The technology sector has driven up US markets, so if China encourages boycotting these firms then the market could get really nervous really fast.
- China could limit US foreign direct investment; although, they may need it as noted above. Still, other countries could fill the void left by US companies which would miss out on China’s growth trajectory.
- China could selectively enforce laws and regulations against US entities.
- China could reduce its holdings of US Treasury securities. It is the largest foreign holder at 19%. However, selling securities could make the dollar decline and help the US trade balance, plus the Fed could buy those Treasuries to offset the distortion to interest rates.
- China could seek non-US suppliers of goods and services. For instance, this could include buying from Airbus instead of Boeing (13% of Boeing’s 2017 sales were in China). As noted earlier, China has lowered tariffs to other countries.
- China could ban critical minerals to the US. China accounts for 70% of the output of rare earths and has raised the threat of bans.
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Let’s use Apple as an example. What if China wants to really hurt Apple? That could scare markets as it is a trillion-dollar company. Apple assembles most of its iPhones through Foxconn, a Taiwanese company, in Shenzhen, China. What if China stops the supply of a critical part for the phone? Would that hurt China more or less than the US? Apple stated that it has created and supported 4.8 million jobs in China. While this appears to be significant, consider also that China has 1.4 billion people and then this is only 0.3% of the population, or a blip. Plus, many of these people may work at firms that sell to other firms besides Apple, some of which could be helped by Apple’s troubles. On the other hand, disrupting Apple’s supply chain could severely hurt Apple and the scare it causes could ripple through the entire US financial market and drive the US economy into a recession. Is this China’s silver bullet? Would China resort to firing it? Maybe, if the trade war gets bad enough. However, maybe not since it would also ripple through to other countries since many components to an iPhone are made outside China (it is assembled in China). Even if China would never penalize Apple, the threat of doing so provides China with ample negotiating power.
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Even if the Trade War Should Not Matter, It Still May if People Believe It Does
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For the reasons cited earlier, this trade war is not easily resolved. Both parties have ample negotiating power. Both countries, in aggregate, have little to lose in a full-blown trade war where trade drops to zero. Of course, certain industries will be hurt quite a bit until alternative sources of supplies or customers are found. However, in aggregate, the trade war really should not matter much, but I do believe it still does. The reason is due to human behaviors.
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If people believe the trade war is important, then they will act like it is important. Businesses may curtail spending, hiring, and wage increases. Consumers may also reduce spending if they are nervous about their jobs. The stock market may decline in response to the slowing economy (spending is the economy). This means that corporations will have a higher cost of capital, which may make them curtail spending more. A vicious cycle to a recession ensues.
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People act on their beliefs, and beliefs can be in error by the majority of a society. The internet and financial bubble were founded on people believing in a new economy and housing prices never coming down on a national basis. The stock market priced in the trade war being resolved or nearly resolved in May, and then corrected severely as it priced in a new more protracted war. Now, it is assuming that the Fed, with rate cuts, will come to the rescue.
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To herd and to go with the crowd is natural. Herding worked well when we lived in caves and hunted in groups, so we are genetically programmed as humans to want to be like others and tend to not question common “knowledge.” The crowd view regarding the trade war is that it is important and impacts the economy, and most people believe this even if they should not. To think differently, as the title of this article – “Does the trade war matter? – implies, invites disagreement and ridicule so people who believe it does not matter stay quiet. This is what I call rational irrationality, or doing something irrational (not speaking up for an unpopular opinion) to rationally go with the crowd and protect one’s job or reputation. So, one only hears one point of view – the trade war is important. The more one hears a view, the more likely one is to believe it since it is easy to believe what is readily available to recall. Thus, the belief that the trade war is important has become well-grounded in public opinion.
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Most people do not critically analyze their news. If they did, I expect fewer not-to-be named apparently pro-Trump and pro-democrat TV news outlets would have fewer viewers. Plus, even if one does not watch a certain news outlet to feed himself or herself what he or she likes, algorithms for news searches may anyway. People tend to look for confirming information to support their views since we do not like to be proven wrong, but this is dangerous to a well-informed opinion if you get your news from the internet. Earlier this year, I spent 30-40 minutes on YouTube searching for negative implications of the trade war. Soon, YouTube learned my pattern and led me to an Armageddon scenario (“Nearly 5,000 US Stores Closing Already in 2019! MASS Debt and Bankruptcy!”) in just five clicks (see figure 5).
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We can only hope that negotiators on both sides of the trade war try to understand each other’s point of views and realize the risks (to consumer and business sentiment) of “digging in.” Unfortunately, backing down is often considered being weak by supporters, and it is even harder to back down when one publicly announces one’s opinion (like Trump and China), so the most likely course is often an escalation of effort until the situation becomes dire enough that one is forced to negotiate. We are not there yet, and the Fed coming to the rescue with interest rate cuts to bolster the economy and China working to stimulate its economy may not help us get there any sooner.
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