President Donald Trump and First Lady Melania Trump pose for a photo with Chinese President Xi Jingping and his wife, Mrs. Peng Liyuan, Thursday, April 6, 2017, at the entrance of Mar-a-Lago in Palm Beach, FL.
Wikimedia Commons / The White House, Washington, DC

How serious is the possibility of a trade war  between the United States and the People’s Republic of China? The nonzero probability for such a trade conflict has been enough to cause American stock markets to swoon over the past several weeks. How big a hit can our economy expect, and what can we expect in the future?

How Imminent Is A Trade War with China?

Any contingent trade war with China  is not at all imminent, as President Trump’s new chief economics advisor, Larry Kudlow, notes in the Fox Business News video below.

In this video, Kudlow declares concerning Trump’s tariff proposals,

These are just the first proposals. In the United States at least, we are putting it out for comment. It is going to take a couple months. I doubt if there will be any concrete actions for several months.  We will see how that plays out. Nothing concrete has actually happened. These are proposals. But the message is clear: China has got to stop these unfair and illegal trading violations. They must. They have done it for years. … Trump’s putting his cards on the table, he’s standing up for this country, but he’s also standing up for better world trade.

That being the case, we will all have plenty of time to debate what the U.S.’ optimal and proper response to China’s mercantilist policies should be.

The Special International Problem of China

The world’s problems with China  are exacerbated by China’s motivations. The masters of China are using trade policy not just to increase their prosperity, but as a geopolitical tool to increase their political as well as economic dominance in the world. It is in this light one should view China’s “One Road, One Belt” project to build a Chinese economic land bridge across Asia and Russia toward Europe. It should also illuminate China’s attempts to dominate the South and East China Seas. According to Robert D. Kaplan, chief geopolitical analyst for Stratfor and a former member of the Pentagon’s Defense Policy Board, more than half the merchant ship tonnage every year passes through the South China Sea. The oil transported through this choke-point enroute to East Asia is three times what passes through the Suez Canal and fifteen times what goes through the Panama Canal. Achieving dominance over the South China Sea could give China a stranglehold over Western and allied Eastern economies.

For China the tool of foreign trade is for much more than just improving the economic well-being of their people. That being the case, how China sells and buys from the rest of the world is not necessarily decided by comparative advantages. In some — perhaps even many — cases, the Chinese government is subsidizing Chinese companies to sell at or below production costs to grab control of some markets. For example, European countries have had a long-running problem of China dumping steel on them.

In addition, in 2006 China made a strategic decision to change its economic development model. Instead of depending on ordinary foreign direct investment to get the capital for their development, they decided on a strategy of helping domestic Chinese firms at the expense of foreign companies. To achieve this end China adopted mercantilist policies to appropriate foreign corporate capabilities wholesale. In order for a foreign company to operate in China, they were required to build Chinese production facilities and to surrender intellectual property to Chinese partner companies in joint ventures. U.S. companies forced into such joint ventures include Ford Motor Co., DreamWorks Entertainment, and Fellowes.

One can see the results of this change in development strategy in a definite inflection in their GDP growth rate around 2006.

Admittedly, these values are measured by purchasing-power parity, which is not necessarily the best way to measure them. (In constant 2010 U.S. dollars, the Chinese GDP was $9.5 trillion in 2016, while that of the U.S. was $16.9 trillion, according to the World Bank.)  Nevertheless, this plot gives an indication of how China’s GDP is developing.

Another result of Chinese policies is shown by the ranking of China among the world’s largest exporters, as shown below.

Clearly, China has become the dominant exporter in the world.

In a related but separate problem, China is implicated as the world’s largest thief of intellectual property, accounting for 50% to 80% of global IP theft. Estimates of how much Chinese IP theft is costing the American economy vary greatly from a low of $50 billion annually to a high of $600 billion. Other Chinese mercantilist policies to advantage Chinese companies at the expense of foreigners include currency manipulation, onerous regulatory certification for foreign companies (causing those companies to be effectively excluded from China), discriminatory government procurement policies, and subsidies for state-owned companies.

In making their decisions on what to buy and sell to the rest of the world, the law of comparative advantage is not something the Chinese necessarily pay any attention to. To make sense of what this means, we need to reconsider the meaning of the law of comparative advantage.

The Law of Comparative Advantage and Its Violation

David Ricardo’s law of comparative advantage  is the universal justification for foreign trade. Uniquely among the four major neoclassical laws of economics (supply and demand, Say’s law of markets, Ricardo’s law of comparative advantage, and marginal utility), the law of comparative advantage possesses a simple yet rigorous mathematical proof.

What the law says in brief is that if country A has a comparative advantage in producing a particular good over country B, then both countries will profit if country A sells the good to country B. The proof of the law shows this is true even if the absolute costs of production for the good in country B are less! What does this mean?

The law is usually expressed in terms of the relative costs in the two countries of producing units of pairs of different goods. Whatever the goods are (e.g. wine and  clothing, airplanes and cars, etc.), I will abstractly give them the names α and β. Let the cost of production in country A for these two goods be given by  C_Aα and C_Aβ, respectively, with similar notation for the costs of production in country B. Then, take the ratio of the cost of A producing a unit of good α relative to that to produce good β. If this ratio, the relative production cost of α compared to that of  β, is less than the similar ratio for country B, country A is said to have a comparative advantage in producing α. As an inequality, this is expressed by the following.

C_Aα / C_Aβ  <  C_Bα / C_Bβ

Taking the inverse of this inequality yields

C_Aβ / C_Aα  >  C_Bβ / C_Bα

If country A has a comparative advantage in producing α, then country B must necessarily have a comparative advantage in producing β.  If A has a comparative advantage for a good over B, then an exporter in A can sell it to B for a greater profit than he could in his own country. Also, an importer in B can buy it for a smaller price than he would have to pay to any producer in his own country. This has to do with the fact each country will produce more economic wealth if it produces goods for which it has a comparative economic advantage. In a way, you can view it as an extension of the division of labor to the international markets. Consider the elementary explanation of the video below.

However, the law of comparative advantage is valid only so long as economic decisions are made according to economic reasons, i.e. consistent with the other three fundamental neoclassical laws, particularly supply and demand, and marginal utility. It is most certainly not a predictor of the behavior of governments and how they construct their trade policies. It is instead a predictor about how international trade will maximize world wealth production to the advantage of all if free-markets are allowed to do their thing. Comparative advantage shows the way in which international trade should be conducted. What happens when geopolitical power plays determine a country’s foreign trade policy?

As long as China does not raise prices on goods it has dumped on the international market, the importing markets are only transitorily harmed. The importers do not just enjoy cheaper goods. Their erstwhile domestic suppliers no longer have to lock up capital devoted to the production of the imported goods. Instead, those suppliers can take that released capital and invest it in producing things for which their country will have a comparative advantage. If this has not usually happened in the West in recent decades, that is because Western governments have over time made it increasingly hard for companies to make profits. With a declining profit incentive comes falling investments, and the supposedly transient losses of off-shored jobs become permanent. This part of the problem is not the fault of China and other mercantilist regimes. It is the fault of Western governments.

However, what happens when China drives most suppliers in a particular sector (such as steel manufacturing) out of business? China can not permanently supply goods at below cost. What happens when Chinese institutions stop using their hoarded dollars from unbalanced trade to buy U.S. government bonds? The Chinese are among the largest investors in U.S. government debt. A persistent and large trade deficit with China driven by Chinese mercantilist policies prepares us for a future economic and political catastrophe when the imbalances must inevitably rebalance. What will China demand of us to let us down easily?

To the extent countries like China are making trade decisions for reasons of political power, and to the extent they are making those decisions divorced from the law of comparative advantage, Trump has a point that we must hit back. He also has a point that we must find a way to halt wholesale Chinese theft of American intellectual property. We must change their mercantilist behavior, or we must drastically reduce our trade connections to insulate ourselves from them. The question is, is the imposition of confiscatory import taxes on them the optimal way to respond?

Who Would Have the Upper Hand in a Trade War?

So what happens  if Trump can not persuade the Chinese to change their behavior and we end up in the middle of a trade war? Which side (if any) will have the upper hand? To begin this inquiry, let us look at the relative economic strengths of the U.S. and China, beginning with their GDPs.

This  looks pretty impressive for China, given that at the beginning of the 2000s it ranked among the third world countries. However, notice that in recent years Chinese GDP growth seems to be saturating with China’s GDP around $11 trillion, while the U.S. continues to grow. Also, China has a very large population compared to the U.S., and to estimate their social fragility to economic adversity, we would do better to compare their per capita GDPs over time.

Suddenly, China begins to look a lot more vulnerable to adverse economic shocks. This suggestion is reinforced by looking at the levels of U.S. imports from and exports to China.

Clearly, American imports of Chinese goods are much larger than its exports to China. Apparently China would be more vulnerable to U.S. import tariffs than the U.S. would be to a Chinese increase in import tariffs on American goods. This interpretation is bolstered by the percentages of each country’s exports and imports to their respective GDPs.

This data is the clincher. Clearly, China would have been much more vulnerable to U.S. import tariffs around 2005 when their exports to the U.S. peaked at 10.7% of Chinese GDP. However, today when Chinese exports to the U.S are around four percent of their GDP, U.S. exports to China are less than half of one percent of U.S. GDP. China would feel the sting of increased American import duties much more than the U.S. would be hurt by increased Chinese import tariffs.

As President Trump has suggested in the past, the United States would very much have the advantage in any trade war with  China. However, this does not mean there would be no American casualties. In their reaction to Trump’s suggestions of new tariffs, the Chinese have cleverly targeted Trump’s political base. American farmers and ranchers would  be particularly harmed by increased Chinese tariffs. Nevertheless, one can unduly exaggerate the harm to the U.S. economy from a trade war. Adding U.S. imports from and exports to China in 2017, we get a sum equal to 3.3% of U.S. GDP. We would be hurt but not crippled. The same sum for China in 2016 (the latest for which I can find numbers)  is 5.2% of Chinese GDP.

The Vulnerability of China’s Social Contract to a Trade War with the U.S.

There is yet another factor  in assessing China’s vulnerability to a trade war. The ruling Communist Party is dictatorial and tolerates no dissent. The operational social contract in China (sometimes referred to as the “mandate of Heaven” in this context) is that in return for the people’s acceptance of this authoritarian control, the Communist Party will insure the people’s security and economic prosperity. This is a social arrangement of which Thomas Hobbes, the author of The Leviathan, would throughly approve.

Yet continuing prosperity for the Chinese people is looking increasingly doubtful. The Chinese economy is beginning to become a house of cards, ready to tumble down with a sufficient shove.

Even before the dissolution of the Soviet Union, China was seeing the writing on the wall for conventional socialism. It was universally known by the 1970s that socialist regimes had always failed in solving the “economic calculation problem.” That is the problem any economy has of deciding how to allocate scarce economic assets to their best uses. In a socialist economy all such allocation must be done by the government. In a completely free-market economy all allocation is done by Adam Smith’s “Invisible Hand.” So long as it is not interfered with by the state, the “Invisible Hand” has historically done a very efficient job of ensuring economic growth. The closest the communists came to solving the problem was with Oskar Lange’s  idea of “Market Socialism,” which was an immense failure.

Seeing that they had to change or decay away in the same way as the Soviet Union, the Chinese leadership under Deng Xiaoping resolved to become more like the capitalists, starting around 1979. By the end of the 1990s they had effectively changed to a market economy, complete with private companies and stock markets. Nevertheless, the Communist Party retained strong directive influence over major investment decisions. It was this conversion to a simulacrum of a free-market economy that kick-started their GDP growth in the mid-2000s, as you can see in the time-plots of their GDP above.

Alas, it is hard for the leopard to change his spots. Sometime in the late 2000s, the leaders of the Chinese Communist Party decided they just could not resist the siren song of government power. They retained absolute power over their economy by reserving the right to control investments. Capital allocation is a rather murky affair in China, with the Chinese government trying to direct capital flows through state-owned investment banks. It should be no surprise then that a great deal of wasted malinvestment of scarce Chinese economic resources were made. Approximately $6.8 trillions worth of waste. That is the amount estimated in a joint report by China’s National Development and Reform Commission and the Academy of Macroeconomic Research. That is about 40% of the U.S. GDP and two years of output for the entire German nation. This horrendous quantity of waste is approximately half of all Chinese investment in the years covered by the report between 2009 and 2013. Some of that bad investment went to build ghost cities, cities essentially without any population! One should not wonder that Chinese economic growth has been stagnating lately (see the first of the graphs above).

Because of their self-inflicted dirigiste wounds, China’s economy is not well-situated to face a large economic shock such as a trade war. The Chinese ruling elite must be very aware that their citizens could decide they have lost Heaven’s mandate. Should Trump march us into a trade war with China, he just might win it.  Even so, such a conflict would be far from painless.

Other Contingencies

The greatest question  has yet to be answered: What do we do about China? It is clear we can not continue to tolerate their theft of intellectual property. It is also crystal clear we can not continue to look the other way while the Chinese sow future international instability by their disregard of comparative advantage. It is dangerous politically as well as economically, as China attempts to become the world’s dominant hegemon.

Yet, is Trump’s preferred weaponry of import tariffs the best tool? A trade war can spread, especially if Trump includes other countries as targets for their disregard of comparative advantage. If trade war is not isolated to China, the situation could become far worse. I will speculate about all this in my next post.

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