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Who is most vulnerable in a trade war?

Summary:
In a recent Bloomberg piece, Tyler Cowen argues that “China is probably in the more vulnerable position” in the current trade war with the US. While the overall argument is plausible, there are a few questionable points that are worth discussing: To see why the full picture is more complicated, let’s say the U.S. slaps tariffs on the industrial inputs (whether materials or labor) it is buying from China. It is easy to see the immediate chain of higher costs for the U.S. businesses translating into higher prices for U.S. consumers, and that is what the afore-mentioned studies are picking up. But keep in mind China won’t be supplying those inputs forever, especially if the tariffs remain. Within a few years, a country such as Vietnam will provide the same products,

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In a recent Bloomberg piece, Tyler Cowen argues that “China is probably in the more vulnerable position” in the current trade war with the US. While the overall argument is plausible, there are a few questionable points that are worth discussing:

To see why the full picture is more complicated, let’s say the U.S. slaps tariffs on the industrial inputs (whether materials or labor) it is buying from China. It is easy to see the immediate chain of higher costs for the U.S. businesses translating into higher prices for U.S. consumers, and that is what the afore-mentioned studies are picking up. But keep in mind China won’t be supplying those inputs forever, especially if the tariffs remain. Within a few years, a country such as Vietnam will provide the same products, perhaps at cheaper prices, because Vietnam has lower wages. So the costs to U.S. consumers are temporary, but the lost business in China will be permanent. Furthermore, the medium-term adjustment will have the effect of making China’s main competitors better exporters.

This paragraph alludes to two issues, supply elasticity and market size, which need to be examined more closely.  First, it is generally the case that industry supply curves are more elastic in the long run.  Indeed manufactured goods supply curves are almost perfectly elastic in the very long run.  This is why Vietnam would eventually be able to replace many Chinese exports, as Tyler suggests.  (Although keep in mind that Vietnam is a far smaller country, so it would probably take multiple countries to fully replace China.)

But the highly elastic nature of long run supply curves cuts both ways. Elastic supply implies flexibility, and this suggests that Chinese firms will also be able to transition to alternative markets.  Today, Chinese exports to America represent roughly 4% of Chinese GDP.  But just as Vietnam’s rise is quite likely to occur, so is the rise of Greater Asia, including big countries such as India, which are growing at 7% of year.  Thus is it almost inevitable that China’s exports will gradually shift from the US to Asia, even if the trade war ends tomorrow.  In the long run, Chinese manufacturers will be able to switch to alternative markets, as well as to the huge and growing Chinese domestic market. Because supply curves are elastic in the long run, both the US and China would eventually be able to adjust to higher tariffs, with only modest costs.

[As an aside, I don’t like it when people describe low wages as advantage, which can be misinterpreted.  Given Vietnam’s low productivity, low wages are needed to be cost competitive, which is presumably what Tyler means.  But I’m pretty sure that Tyler would agree that the rise of Vietnam won’t be “caused” by low wages, rather by market reforms that boost the productivity of the Vietnamese economy.  After all, the Congo also has low wages, but nobody is predicting an export boom from that country, which is plagued by low productivity caused by war, bad infrastructure, and a lack of education. Or North Korea, as long as they engage in central planning.]

A second issue alluded to in Tyler’s article is the small country/big country distinction.  Tyler refers to China as a relatively “poor” country, which is true.  However, it is not a particularly small economy.  Indeed in PPP terms it is the world’s largest economy, and it will surpass the US economy at market exchange rates within the next decade.  This is important, because trade theory suggests that smaller economies have more to gain from trade, and by implication more to lose from protectionism.

In my numerous visits to China, I’ve found that the Chinese think of themselves as much more vulnerable than Americans to a trade war. I think they are basically correct, mostly because China is a much poorer country with more fragile political institutions.

This may be true, but I’m not sure the Chinese leadership sees things this way.  They understand that President Trump is up for re-election next year and that Trump sees a strong stock market as a sign of success.  They may calculate that Trump will want to get a deal and not risk a major hit to the markets (and a possible recession) right before the election.

The poverty of China also cuts two ways.  While Americans have been spoiled by 70 years of prosperity, the Chinese have often been forced to “eat bitter”, to use a popular Chinese metaphor.  In the late 1990s and early 2000s, tens of millions of Chinese workers were laid off from state-owned enterprises being privatized.  No American politician would dare impose such pain on US citizens.  China is still growing at 6% a year, and a trade war with the US would only modestly slow that growth.  President Xi does not have to face re-election in 2020, and indeed will likely serve another decade.

That doesn’t mean Tyler is wrong about China being less stable than the US; indeed outsiders often underestimate the brittleness of the Chinese system.  In contrast, our democratic system is very messy, but the cultural and legal underpinnings are quite strong.  But is this how the fight is perceived in Beijing?  Consider that the biggest threat to Xi may come from nationalists in China who fear another Opium War-style humiliation.  Another capitulation to “Western bullies”.  Americans may view China as a bully, but I assure you that the history taught in Chinese schools presents a very different picture of world history. Xi won’t be brought down by economic “liberals” who wished that he would appease the US; the opposite is more likely.  Thus Xi may be in a stronger negotiating position than we assume.

In the end, I still expect a trade deal.  I suspect that both sides are posturing to appear “tough” to their home audiences.  Both sides want to convince domestic audiences that they “won” the trade war, before signing on to any deal.  In fact, both sides will very likely end up losing.  It was a mistake for the US to launch the trade war.

PS.  Josh Barro discusses this issue as well, although I don’t follow his argument.  He suggests that China might lose even if Americans paid 100% of the tariff.  But why?  Yes, they would lose sales, but if Chinese supply is perfectly elastic then where is the deadweight loss to China?  Perhaps I’m overlooking something.

PPS.  Here’s a picture of the ruins of the old Summer Palace in Beijing, looted and destroyed by British and French soldiers.  I never learned about this in school, but all Chinese learn about the many times that Western powers (including the US) humiliated China.

Who is most vulnerable in a trade war?

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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