trade war

What Does a Trade War Worst-Case Scenario Look Like?

Neither one’s backing down. Photo: Pang Xinglei/Xinhua News Agency via Getty Images

Ben: You wrote in a post today that China’s weakening of its currency reduces the cost of U.S. exports, which makes Chinese goods less expensive for American consumers. On the flip side, it makes American goods pricier and less appealing to foreign buyers. Does it seem to you that the hit to U.S. manufacturers is why the stock market is freaking out today (it closed down 767 points), or is it more because this latest move indicates that China isn’t backing down an inch?

Josh: It’s not specifically the hit to U.S. manufacturers. The outlook for them is mixed — some will benefit from protection from the tariff when selling to the domestic market (the weaker yuan offsets the tariff cost only partially), and for others that will be offset by greater difficulty exporting goods and by overall economic weakness.

But the escalating trade war is bad for a variety of other U.S. industries. It’s bad for companies, like retailers that buy Chinese goods — they may not be able to pass the whole tariff cost on to consumers, and consumers may buy less because prices go up and the economy is weaker.

It is even bad for casino companies — a lot of the casinos in Macau are owned by American companies, and they’re hurt by a weaker Chinese economy. They were even talking on CNBC earlier today about how baccarat revenue in Las Vegas is down because of problems with China. And of course, you have companies like Apple that rely on supply chains that run through China. Lots of parts of the economy are connected in one way or another — and then when worse performance and higher prices at these economies reduce overall growth, that has negative effects even on sectors with no direct connection to China.

Ben: You also wrote that Trump is trying to get the Fed to devalue the dollar as retaliation to China’s move, but that it probably won’t do so, since it’s an institution that tends to tread carefully in these scenarios. So what is the most likely counterpunch from Trump? More tariffs on more Chinese goods?

Josh: With these tariffs going into effect September 1, virtually all Chinese imports will be tariffed. But he could raise the tariff rates.
The Fed is likely to continue a modest pace of rate cutting, but probably not enough to keep pace with China. I would note that I think people are misunderstanding a little bit what happened with the Chinese currency yesterday and today. It’s not that China pushed its currency down. China stopped propping its currency up.

China has been managing the exchange rate to keep the yuan above seven to the dollar. It did that by using dollars to buy up yuan. Today, they stopped defending that level, and it was market forces that devalued the yuan.

There have been real events that provide good reasons for China’s currency to weaken —  they have domestic economic problems, and the trade war is making those worse. It is typical when a country has a weak economy for its currency to weaken, which allows the economy to become more competitive in global trade and sell more exports.
This of course is the opposite of what Trump wants. So, Trump can respond with more tariffs, which will do even more damage to the Chinese economy and create more downward pressure on the yuan.

Ben: Do you think Trump has misjudged the resilience of his foe on this one? As in, do you think he thought he would have won this battle by now?

Josh: Yes. I think his view was that a trade war does more damage to the Chinese economy than the U.S. economy, and the Chinese economy was already in more trouble than the U.S. economy, and so China would have to cave to him. He was right that they are more exposed. But he underestimated reasons they would dig in anyway.
Some of the demands the U.S. is making —  about opening up the Chinese economy more to U.S. firms, respecting our IP, not subsidizing their industries — go to the core of the Chinese economic model. It’s a big ask for them to change it.

Trump’s other main demand —  for China to somehow target the trade deficit —  is impractical. China just doesn’t have the capacity to consume the quantity of American goods they’d have to buy to meet the goal. So even though it is hard for China to endure the trade war, it’s even harder for them to meet U.S. demands. Trump is not the first president who has wanted these changes from China, and he’s running into the same reasons they’re reluctant to make them. It doesn’t help that he’s made the demands in a humiliating manner — which makes it politically harder for Xi to give in and politically easier for Xi to deflect blame for economic trouble to Trump and the U.S.

I also think even the sophisticated members of Trump’s team, like Robert Lighthizer, have been surprised by just how rigid the Chinese have been. I think they didn’t quite anticipate the extent to which Xi would be hemmed in by domestic political concerns.

Ben: So with the U.S. and China really dug in now, what does a worst-case scenario of this conflict look like for both sides, in, say, six months?

Josh: When I wrote about this back in May, I talked with Ernie Tedeschi from Evercore ISI about what a bigger trade war would look like. If Trump makes his next step to take all the China tariffs up to 25 percent, that would mean the China tariffs have gotten about five times as large as they were at the start of the year — roughly, applying to twice as many goods, at two and a half times the rate. So, rather than being good for a tenth of a point off GDP, it could be closer to half a point. And then there could be knock-on problems — how much does a weaker Chinese currency hurt economies in Japan and South Korea, for example, and how does that affect us? We could see weaker currencies in those countries too, and weaker demand there for American products.

I still don’t think this is likely to be a large enough problem to push the U.S. into a recession, but we could start talking about something like a point off GDP growth, a really material slowdown to the U.S. economy

Ben: If economic damage does mount with no material gain in sight, and with an election approaching, couldn’t Trump just give up and label the whole thing a win, even though he lost, the way he has when several other negotiations have faltered?

Josh: I think that would be challenging because the U.S. and China are so far apart in their negotiating positions.This is not like the USMCA, where the negotiating positions were not that far apart (and there were quite a few areas of shared desire to modernize the agreement) and so it was possible to come to a deal for small-bore changes.

If Trump agreed to back off pressure on China in exchange for very little change in their practices — practices that, unlike with Mexico and Canada, Trump has valid objections to that are shared by other U.S. political leaders — it will be a total cave and his Democratic opponent will say so. It would actually provide an opportunity for Democrats to be strong on what should be one of Trump’s strongest issues — accurately calling him “soft on China.” And while a late de-escalation likely would cause a pop in the stock market, any real economic damage that the trade war causes would take longer to unwind.

What Does a Trade War Worst-Case Scenario Look Like?