U.S. and China play Trade Chicken, and both are likely to win

Global markets are in the midst of another panic attack that appears to be the direct result of an escalating game of trade-war chicken between the US and China. Who's likely to win? I believe the odds are in favor of the U.S. winning, especially since a trade deal with China to Trump's liking is likely to end up being a win-win for all concerned.

The vast majority of economists would agree that the best trade policy is free trade, with no tariffs, barriers to entry, or subsidies. Free markets and global trade have proven to be the best way to promote global prosperity. Tariffs are best viewed as a tax on imports, with the cost being paid by the consumer, not by the producer. Taxes serve only to reduce private consumption in order to fund public consumption, which in the end is less efficient. The country that taxes its imports least is therefore the country that will benefit most from trade. By the same logic, countries that subsidize their exports only hurt themselves while benefiting those who buy their subsidized goods and services. (We should welcome any country's subsidies!)

The vast majority of economists would also agree that there are second-order effects that stem from tariffs. By making imported goods more expensive, countries that impose tariffs on imported goods give domestic producers a degree of "protection" to the extent domestic producers can charge higher prices and still compete with imports. But this only reinforces the argument that at least part of the cost of tariffs is born by consumers. Protectionists also argue that tariffs save jobs—and to some extent they do, in the "protected" industries—but only at the expense of consumers. Tariffs, in short, benefit a relative few at the expense of the many.

Trump understands this, and said so at the G7 summit meeting last year: "That’s the way it should be, no tariffs, no barriers … and no subsidies. ... that would be the ultimate thing." The only way to understand Trump's apparent love for tariffs today is that they are, as Larry Kudlow noted a few months ago, "a negotiating tool. They are part of his quiver." And tariffs are a policy tool over which Trump has direct control. That makes tariffs irresistible to deal-maker Trump.

A war of escalating tariffs between the US and China would be damaging to both countries. If carried to an extreme, a tariff war with China would most likely endanger the global economy by weakening both the huge U.S. and Chinese economies. Bad! And in that sense Trump is crazy to be engaging in a tariff war with China. Worse, he falsely argues that his tariffs are paid by the Chinese and that the money goes straight to the federal government's coffers. To his credit, Trump's economic advisor (and my good friend) Larry Kudlow yesterday correctly admitted that tariffs are in fact paid by U.S. consumers, not the Chinese. But he also correctly added that higher U.S. tariffs will hurt the Chinese as well. So the question then becomes, Who will suffer the most? Who will likely back off from this game of chicken the first?

Tyler Cowen is a well-respected economist at George Mason University who has a reputation for not having a partisan bias. Today he wrote a column for Bloomberg (which certainly does have a strong liberal bias) in which he argues persuasively that China stands to lose more from a trade war than the U.S. does, even though it is clear that Trump's higher tariffs on Chinese imports impose burdens on U.S. producers and consumers.

Here's Cowen's conclusion (read the whole thing for the important details):

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.

My argument isn’t about whether Trump’s policy toward China is correct. I am only trying to get the basic economics straight. Next time you hear that the costs of the trade war are simply being borne by Americans, be suspicious. In their zeal to make Trump look completely wrong, on tariffs or other issues, too many commentators pick and choose their arguments. A more fair and complete economic analysis indicates that China is also a big loser from a trade war. Trump’s threats are exerting some very real pressure on the country.

Markets are usually efficient at discounting the future, if only because they reflect the consensus of millions of participants with skin in the game. Right now they are saying that although both the U.S. and Chinese economies are hurting, the Chinese are hurting more.

Chart #1

Chart #1 compares the value of yuan vis a vis the dollar (blue) with the level of China's foreign exchange reserves (red). Here we see that since the beginning of the U.S.-China tariff war (March-April 2018) the yuan has fallen by about 8% vs. the dollar. That means that the amount of yuan that Chinese producers receive for each dollar of sales to the U.S. has fallen by 8%. This chart also shows that China's foreign exchange reserves have been relatively stable for the past 30 months, at just over $3 trillion. China's central bank is apparently targeting a stable level of reserves, and allowing the yuan to fluctuate in value as capital attempts to enter or leave the country (this is a legitimate monetary policy, though one not often used). The weaker yuan thus directly reflects weaker net investment in China and a loss of Chinese purchasing power. Bad!

As Cowen notes in his column, China's lack of "guarantees against espionage, intellectual property theft and unfair legal treatment ... makes investing in China less desirable for many multinationals, not just U.S. ones." If China were to agree to Trump's demands in these regards, its economy would almost certainly benefit from increased investment and a stronger yuan. Good!

Chart #2

Chart #2 compares the value of the MSCI China Index (in HK dollars) to the value of the S&P 500. Chinese equities have greatly underperformed their US counterparts since China's "opening" to the world in 1995. Moreover, since the US/China tariff war started last year, Chinese equities have fallen by almost 18% relative to US equities. Equity markets are clearly saying that China will be the biggest loser.

Chart #3

Chart #3 shows that Chinese exports to the US and imports from the US have both fallen since the beginning of Trump's tariff war (in dollar terms). This is the result not only of a reduced volume of trade but also the yuan's reduced value. US/China trade represents a far greater share of China's economy than it does of the US economy: China's exports to the US are roughly 4 times greater than China's imports from the US, while the US economy is roughly half again as large as China's. China thus stands to lose much more from any trade disruptions.

Chart #4

Chart #4 quantifies the market's renewed sense of unease over trade relations. Though not yet as acute as what we saw late last year, it's a similar pattern. Rising fears are driving down the value of equities.

Meanwhile, swap spreads and credit spreads remain relatively low. Liquidity conditions have not deteriorated, the Fed is not too tight, the dollar is not collapsing, and the US economy is likely to continue growing. What we see in the markets today is another panic attack which will likely be assuaged once the Chinese figure out a face-saving way of capitulating to Trump's demands. That shouldn't be too hard, since it ultimately will lead to a positive result for both the US and Chinese economies.