Trade War Not Inevitable

VIDEO TRANSCRIPT:

Donald Trump calls tariff the most beautiful word in the dictionary

Unlike at the start of his first term, nobody is doubting the sincerity of his tariff threats

Trump believes tariffs can help finance America’s budget deficit and create more jobs in the US

Is he right? 

What can we learn from the results of his 2018 tariff war? 

What were the unintended consequences? 

How might it backfire this time? 

…..

Conventional wisdom since the economist David Ricardo is that trade between countries is a win-win for all. 

By extension, everyone loses in a trade war. 

However, some might lose more than others. 

For example, it is possible that in a trade war a country running a trade deficit loses less than a country running a trade surplus, especially if the former is not in full employment. 

This belief was the basis of Trump’s first trade war against China in 2018. 

The fact that the US exported much less to China than China exported to the US meant that, all else being equal, a reduction in trade would hurt the US less than China. 

Trump saw this as his leverage, and he correctly counted on China to make concessions to avoid a trade war with the US. 

Because of COVID, the Phase 1 trade agreement signed between the US and China at the start of 2020 never got implemented. 

As a result, Trump’s 2018 and 2019 tariffs on Chinese goods have largely remained in place. (Chart 1)

What impact have they had on world trade? 

 …..

Global trade has slowed noticeably since the introduction of Trump’s tariffs.  (Chart 2)

The indirect impact of the tariffs on the slowdown is likely greater than the direct impact.

There is no denying that the Trump tariffs have helped make protectionist policies more acceptable. 

In any case, world trade volume is growing 30% slower in this decade than the decade previously and 50% slower than in the 2000s. (Chart 3)

There has also been a change in the pattern of trade. 

Emerging and developing economies are now trading more among themselves than they are with advanced economies (Chart 4)

To a lesser extent, trade among advanced economies is likewise growing faster than their trade with emerging and developing economies (Chart 5) 

Given comparative advantage and specialization are the main benefit of international trade, these developments are unlikely to be welfare enhancing.

A big part of what these trends reflect is the transformation of how China trades with the rest of the world. 

During COVID, China managed to increase its share of the total imports of advanced economies by keeping its factories open (Chart 6)

This has since been completely reversed. (Chart 6)

Indeed, China’s share of the total imports of advanced economies recently fell to just 13%, the lowest level in 10 years (Chart 6)

China has offset the loss of market share in advanced economies by selling more to other emerging and developing economies (Chart 7)

More than 20% of imports of these countries now come from China (Chart 7)

This partly reflects the fact that Chinese exporters are using some of these countries as a back door to the US to avoid the Trump tariffs (Chart 8)

It is difficult  otherwise to explain the high correlation between China’s exports to Vietnam and Vietnam’s exports to the US  (Chart 8)

However, we should be careful not to exaggerate the magnitude of this much talked about back door phenomenon. 

Yes, Chinese exports to Mexico have increased but they cannot even begin to account for the surge in Mexico’s exports to the US in recent years (Chart 9)

…. 

It is not surprising that the Trump tariffs have had the effect of reducing US demand for Chinese goods. 

It is less obvious that they should also reduce China’s demand for the exports of other advanced economies. 

Yet this is exactly what happened. 

An unintended consequence of the Trump tariffs is that they forced China to accelerate its move away from producing price elastic, low margin, cheap consumer goods. 

The tariffs forced China to move into higher margin and higher value-added manufactured goods, including capital goods. 

As China moves up in the manufacturing food chain, export of countries like Germany, Japan and South Korea to China fell (Chart 10)

Given China was the largest export market for these countries, the shock has hit them hard. 

German manufacturing has already been shrinking for more than 2 years and there are no signs that it is coming out the other side. (Chart 11)

Forced to look elsewhere for growth, German exporters have been shifting their focus to the US which last year replaced China as Germany’s largest export market (Chart 10)

In a nut shell, Germany has become less dependent on China and more dependent on the US. 

The same has happened with South Korea (Chart 12) and to a lesser extent with Japan. 

So 5 years after Trump slapped punishing tariffs on China, who are the winners and who the losers? 

Which countries have seen their shares of global exports go up and which have seen their shares go down (Chart 13)? 

Ironically, China’s market share has gone up 15%. (Chart14)

The market share of the US has gone up 2%. (Chart 14)

South Korea’s market share has gone down 10%. (Chart 14)

Both Germany and Japan have seen their market shares decline by 15% (Chart 14)

As Henry Kissinger famously said “it may be dangerous to be America’s enemy, but to be America’s friend is fatal”

In this respect, a new trade war under Trump 2.0 could be deadly for these American allies, especially given their increased dependency on the US over the past few years. 

…..

Trump is right about one thing, though.

His tariffs on China did not lead to higher inflation. 

Prices of Chinese imports are back to where they were before the tariffs were introduced (Chart 15)

incredibly, inflation on Chinese imports has been zero over the past 5 years. (Chart 15)

It is difficult to imagine that either the Chinese government or Chinese exporters had the resources to subsidize US consumers for so long even if they had wanted to. 

More likely, continued low prices of Chinese goods are the result of sustained increase in productivity, through, for example, automation.  

 According to the data from the International Federation of Robotics, China installed more industrial robots than all of the rest of the world combined in 2022 (Chart 16)

What this says to me is that the Trump tariffs have made China manufacturers leaner and meaner (Chart 16). 

I suspect Elon Musk would not disagree. 

Musk said last year that his giga factory in Shanghai is not only the most efficient car factory in the world but that it also produces the highest quality Tesla. 

What does all this mean for Trump 2.0? 

Trump has been talking about a 60% tariff on China. 

But what will that accomplish? 

China’s share of US imports has fallen from 22% in 2018 to just 13%. (Chart 17)

This means new tariffs on China will neither raise a lot of revenue nor will it hurt China very much (Chart 17)

US trade deficit with China has also shrunk since 2018. (Chart 18)

China’s share of US trade deficit has declined from 50% to just 25%. (Chart 19) 

This means that tariffs on Chinese imports will have a more limited impact on the overall US trade deficit (Chart 19)

What it means is that if Trump really wants to hurt China, fund tax cuts with tariffs, and narrow the US trade deficit, he will have to wage a tariff war with the whole world. 

In addition to the 60% tariff on China, he has talked about a 20% tariff on everyone else. 

But that is a riskier proposition than a one-on-one trade war with China, especially given the rest of the world will likely join forces against the US in such a scenario. 

Following the US election last week, the EU ambassador to China said that “Trump’s victory is an opportunity for China and Europe to resume more normal business and investment relations.”

……..

Now some predictions

I am hopeful that cooler heads will prevail in good time to avoid a global trade war.  

A trade war between the US and China is not good for business.

Elon Musk knows that better than anyone else. 

China is not only Tesla’s second largest market, but Tesla is building a second factory in China. 

I find it difficult to believe that Musk would support a new trade war with China that will hurt his interest in China. 

Moreover, as I argued last week, a tariff war is dangerous game to play when you are running a budget deficit of 6% of GDP and with a debt to GDP ratio of 120%. (thumbnail: Can Trump diffuse the debt bomb)

Tariffs could easily backfire by driving up interest rates and further destabilize the fragile US fiscal dynamics.    

Whoever is going to be Trump’s treasury secretary will likely argue against them. 

Trump wants jobs back in the US. 

I think there are easier ways to make this happen than tariffs.  

For example, Trump can offer BYD and other Chinese car companies to build factories in the US to make cars for the US market. 

Just like Toyota, Hyundai, and BMW have done. 

BYD, which is building factories in Hungary and Turkey, will likely jump at the opportunity. 

The phase 1 agreement signed by the US and China was a major accomplishment of Trump’s first term

It was a good deal because it was a win-win for both the US and China. 

It makes sense that Trump would want to start where he left off. 

And with the Chinese economy in a doldrum, Xi Jinping should have every incentive to meet him half way. 

US and China will remain strategic rivals for the years to come

But this should not prevent them from exploring overlapping interests. 

Trump calls himself the dealmaker in chief

This is his opportunity to cement his legacy.