The Economic Impact of the Trade War

There is currently little doubt that the U.S. and China are in a trade war, where retaliation begets retaliation. Conflicts with Mexico, Canada, and the European Union are effectively in a temporary ceasefire, but remain unresolved. It’s unclear how long these conflicts will last and how far they will go. Yet, following President Trump’s decision last week to impose further tariffs on China, and China’s promise to retaliate, the stock market rose. This could simply reflect trade policy news fatigue, but more likely, the overall economic impact of trade policy disruptions has been minor and is projected to be limited even if trade tensions escalate. The longer-term effects are likely to be more consequential.

This summer, President Trump imposed 25% tariffs on $50 billion in Chinese goods ($34 billion on July 6 and $16 billion on August 23, mostly industrial inputs). China, which had warned of retaliation, responded with 25% tariffs on $50 billion in U.S. exports (agriculture and cars). In response, President Trump imposed 10% tariffs on an additional $200 billion in Chinese goods (intermediate goods, capital goods, and consumer goods) effective September 24, which will rise to 25% on January 1, 2019. The initial 10% was meant to limit the impact during the holiday shopping season. China indicated that it will respond with increased tariffs on U.S. exporters (including suppliers of inputs and capital equipment), but does not plan to weaken its currency. In turn, President Trump has threatened to impose tariffs on an additional $267 billion (effectively, all imports from China).

The focus on the U.S. trade deficit with China is misguided. Granted, China has been a bad player in global trade. However, the way to deal with that is through coordinated efforts with our allies (which is partly what the Trans Pacific Partnership was about). Our trade deficit with China is due to two key factors. The first is that the U.S. consumes more than it produces (or equivalently, we don’t save enough – and remember that the federal budget deficit, which has risen sharply, is part of national savings). The second is that China is generally an assembler, pulling in inputs from outside the country and exporting intermediate and finished goods. China’s current account surplus was 1.3% of GDP in 2017 – not large. The U.S. deficit with China is really a deficit with the rest of the world. Production (or assembly) may move to other countries, but China has massive capacity, and scale matters.

In recent decades, China’s economy has been centered on exports and infrastructure. It is now transitioning to a more balanced economy, developing more internal demand, especially consumption. The U.S. has a comparative advantage in services and has long maintained a surplus with the rest of the world, including China, in trade services. The current trade conflict threatens to leave the U.S. (and its companies) out of the growing Chinese market, potentially for a very long time. Trade policy has also created tensions with our key allies, Canada, Mexico, and the European Union.