Ostrich Policy: escalating the tariff war with China

The present Administration wants to talk and act tough with China and has deployed various tariff and other economic tools to induce China to change some of its most important trade policies. China currently requires the transfer of American technology as the price of a firm’s “admission” into China. We don’t think that our campaign for IP protection offers a good prediction on how the Chinese will ultimately respond to our charges. We think that “selling that story” to the U.S. voter will make it much harder to achieve the goals we have set for ourselves in this current commercial policy war.

Economic War and Military History

Those familiar with military history know that the ”fog of war” conceals the likely responses by one side when the other belligerent ups the ante in a battle. This is particularly the case when military authorities report to the political wing of a government. An unexpected outcome on the battlefield often leads political authorities to order a severe retaliation, and then the other side retaliates. The escalation of violence becomes the game theory solution of “tit for tat.” The usual outcome is that many boots on the ground don’t come home when the war finally ends.

One only needs to recount the sequence of events in America’s colonial conflicts with the British and again in the war of 1812 repeated once again in our later war with Mexico. This untoward sequence of one-sided strategic change leading to retaliation by the opponent and then reciprocal conflict escalation was also evident in the Viet Nam war. It is a common history in many military conflicts.

Economic war often has a similar pattern of escalation. This seems particularly relevant in the current dispute between China and the U.S. In the military sphere, much more damage results from mutual episodes of escalation without the hoped for shortening of the war. In economic conflicts, similar concerns apply. Escalation becomes its own reward and policy makers find it hard to get back to ground zero.

In the China-US dispute, each side has tried to make its point by escalation tactics while economic damage to both increases. We are all familiar with the initial thrust of the Trump international trade agenda: (1) abandoning multilateral treaty efforts in favor of bilateral negotiations (TPP, NAFTA); (2) direct, one nation centered tariff raises (Mexico on metals and chemicals); staged tariff increases regarding China, and finally a leveraged attack on a particular Chinese business sector (telecom producer Huawei). The recent escalation prohibits sales to Huawei by U.S. tech suppliers.

In each of these sequences, the escalation is reciprocal, making it far more likely that the costs to each side will outweigh any particular short run mercantile gain. The China-U.S. commercial war focuses on damage infliction, not damage control. This parallels military-political history that demonstrates escalation acquiring a life of its own far beyond any strategic gains that the initial escalation was intended to achieve.

Politics trumps Economics

The real danger in the China-US tariff war is that leads first to a decline in trade and services on both sides; second, a relocation of longer-term purchase and supply arrangements and finally relocation of China-based U.S. company production and marketing in China as well as closure to China investment in the U.S. While the likelihood of an escalation into an outright military engagement is low, when countries practice these escalations, getting back to ground zero becomes almost impossible. Collateral damage increases over time and too much face would be lost on both sides by throwing in the towel.

The only respite in a sequence like this is a complete change in the political organization on both sides. While the U.S. has an election in 18 months, even replacement of the President or a Republican defeat in the Senate is unlikely to create a path to zero. To get there, both political establishments would have to be dramatically altered. Is that a likely outcome? We judge it unlikely.

The Time Dimension

Economics is a long-term affair. A major alteration in the commercial relationship between two major trading partners primarily affects long term micro economic relationships, but it may well trigger changes in macro-economic policy as well. Those changes take time, while undoing them takes even longer because both sides will have a memory of policy makers failing to find a peaceful solution. That is even more likely to be the case in the China-U.S. dispute.

China points to its history and uses the unfortunate outcomes in the 19th and early 20th century as a Magic Wand to motivate the current population to support its anti-U.S. measures. The alleged hurt to American firms due to IP theft in China has now become a bi-partisan rallying cry in the U.S. That sets up a barrier to constructing a peaceful backdown from current economic policy-making that will be hard for any Chinese administration—-even in the unlikely outcome of a shuffle in Chinese Communist Party leadership while it sets a high barrier to an American retreat as well. That is a very poor environment for reasonable compromise. This is not an optimistic forecast as to where the China-U.S. dispute is likely to be headed, not just over the next 18 months, but even on a horizon that extends well beyond the next Presidential election. Even a change in the Administration in 2020 will not undo all the damage. If China is willing to incur even more economic damage until our election, the barrier to a reasonable compromise rises even further.

Economics has often influenced foreign policy, and sadly the reverse is also true. The current impasse features the irreconcilable goals of each party over the theft of intellectual property. The U.S. position draws great popular support even on a bi-partisan basis. The U.S. insists that IP theft be explicitly punished by China and that Chinese laws and judicial practices embed such a punishment. China sees that demand as an affront to its sovereignty and then waves its magic wand to gain public support for its opposition. That makes a Chinese backdown a threat to the current regime, just as a failure by the Americans to come away with an IP “victory” also will be seen as a loss.

The IP issue is far less transparent to most Americans than is realized. American firms are not unaware that Chinese policy has always been require the transfer of technology. If a U.S. firm moved production to China, clearly, U.S managers were aware of the risks of IP theft. We can infer they frequently chose to take advantage of the largest, growing market in the world and risk their current innovations. It also seems reasonable to assume that American management understood that it was risking IP theft because the benefits of expansion in China were seen to be greater. It might have even stimulated U.S. Companies to innovate even more quickly to offset potential IP thefts in China. It is hard to locate American investors who punished American managements for making that choice. U.S. companies complained vigorously but entered China nonetheless.

The American Claim

The current Administration has conflated the loss of manufacturing in the U.S. with China’s IP theft. While this is powerful political claim, the economics are far less clear. The current claim that U.S. negotiating tactics are bringing firms “home” to the U.S. is also a sleight of hand argument. What the tariff strategy has done is to deliberately raise uncertainty over when and how this commercial war will end and deliberately confuses the public over who “pays for the (tariff) war.” The real costs of the tariff war are borne by both sides, as all serious economists know. The normal case of the “gains from trade” is that expanded trade almost always results in shared gains, and almost never that only one side is the beneficiary. The reverse is also true. The costs of trade warfare are borne by both sides, almost never just by one side. But, calculating the costs of reduced trade, reduced international changes in production location and a relatively free movement of capital is complicated and hard to explain to the public by slogans. It is far easier to claim that “we win, the other guy loses.” Stories of re-locating American production from China either back to the U.S. or to other competitive countries are characterized as “wins,” even if unit costs rise in another location and even when rising “uncertainty” is the likely true driver of such changes.

The foregoing analysis leads to the conclusion that this war is not likely to end quickly. It is also far less likely that it will end in a “victory” to the U.S. in real economic terms. It also suggests that if a “peace breaks out,” it will be far less beneficial than advertised. Reducing trade and international capital movements always seems like such a good idea to many politicians until they try it. In the long run, we will not be dead as Keynes once admonished. In the long run, our economic benefits will be outweighed by our losses (even if they are now miscalculated for political purposes).

Tariff negotiations that feature rising restrictions or costs to international trade are akin to letting the Genie out of the bottle. Once out, it is hard to force the Genie back inside. Further, if in the short run, the current strategy is accepted to be “winning,” it will likely spread to other regional areas of world trade. Sooner or later Mr. Market will make a more precise calculation of lost profits.

Investors should expect that uncertain outcome will not be a “win-win” despite the current political sloganeering. Trade and capital movement expansion, the twin icons of globalization, was a win for many countries, in spite of the current political identification with job loss and hollowing out manufacturing in the U.S. Changes in trade and investment rules always cause economic dislocation, particularly in the short run and adjustment is clearly painful. The larger economic change now ongoing is the massive expansion of the Gig Economy and we can’t legislate against that via a tariff war. An ostrich-like tariff war will only make that very fundamental adjustment harder.