Did Cold War II break out last week while no one was watching? As the Kavanaugh confirmation battle raged, many Americans missed what looks like the biggest shift in U.S.-China relations since Henry Kissinger’s 1971 visit to Beijing... Denouncing what he called China’s “whole of government” approach to its rivalry with the U.S., Mr. Pence vowed the Trump administration will respond in kind... The speech sounded like something Ronald Reagan could have delivered against the Soviet Union: Mr. Xi, tear down this wall! Mr. Pence also detailed an integrated, cross-government strategy to counter what the administration considers Chinese military, economic, political and ideological aggression... Navy plans for greatly intensified patrols in and around Chinese-claimed waters in the South China Sea were leaked to the press... the recently-entered trilateral U.S.-Mexico-Canada trade agreement was revealed to have a clause discouraging trade agreements between member countries and China. The administration indicated it would seek similar clauses in other trade agreements... Congress approved the Build Act, a $60 billion development-financing program designed to counter China’s Belt and Road strategy in Africa and Asia... highlighting the danger that foreign-based supply chains pose to U.S. military capabilities in the event they are cut off during a conflict... Mr. Pence warned that even higher tariffs are on the way. The White House report highlighting supply-chain vulnerabilities could provide the basis for new and more far-reaching restrictions... Business and investors may still be underestimating both the Trump administration’s determination to challenge China and the amount of economic disruption that greater U.S.-China tension can bring... To the mix of longtime China hawks and trade hawks now driving U.S. policy, national security matters more than economic friction, and many of the protestations from the U.S. business community may fall on deaf ears... Both China and the U.S. are likely to move quickly, unpredictably and disruptively as they struggle for advantage; Wall Street should brace itself for further shocks... Democrats who have relished attacking Mr. Trump for allegedly being soft on Vladimir Putin will have a hard time explaining why a hard line on Russia is a patriotic duty but a tough China policy is a mistake.
.. Replacing the North American Free Trade Agreement, reshaping the Supreme Court, and launching a new Cold War in the same week is quite the trifecta. America may or may not be on the road to greatness under Mr. Trump, but it is certainly going somewhere, and at an accelerating pace.
In handicapping the US-China conflict, Keynesian demand management is a better guide than comparative advantage. In principle, China can avoid any damage at all from US tariffs simply by responding with a full-scale Keynesian stimulus.
The United States cannot win its tariff war with China, regardless of what President Donald Trump says or does in the coming months. Trump believes that he has the upper hand in this conflict because the US economy is so strong, and also because politicians of both parties support the strategic objective of thwarting China’s rise and preserving US global dominance.
But, ironically, this apparent strength is Trump’s fatal weakness. By applying the martial arts principle of turning an opponent’s strength against him, China should easily win the tariff contest, or at least fight Trump to a draw.
.. Comparative advantage certainly influences long-term economic welfare, but demand conditions will determine whether China or America feels more pressure to sue for trade peace in the next few months. And a focus on demand management clearly reveals that the US will suffer from Trump’s tariffs, while China can avoid any adverse effects.
From a Keynesian perspective, the outcome of a trade war depends mainly on whether the combatants are experiencing recession or excess demand. In a recession, tariffs can boost economic activity and employment, albeit at the cost of long-term efficiency. But when an economy is operating at or near its maximum capacity, tariffs will merely raise prices and add to the upward pressure on US interest rates. This clearly applies to the US economy today.
.. US businesses could not, in aggregate, find extra low-wage workers to replace Chinese imports, and even the few US businesses motivated by tariffs to undercut Chinese imports would need to raise wages and build new factories, adding to the upward pressure on inflation and interest rates.
.. With little spare capacity available, the new investment and hiring required to replace Chinese goods would be at the cost of other business decisions that were more profitable before the tariff war with China. So, unless US businesses are sure the tariffs will continue for many years, they will neither invest nor hire new workers to compete with China... Assuming that well-informed Chinese businesses know this, they will not cut their export prices to absorb the cost of US tariffs. That will leave US importers to pay the tariffs and pass on the cost to US consumers (further fueling inflation).. Thus, the tariffs will not be “punitive” for China, as Trump seems to believe. Instead, the main effect will be to hurt US consumers and businesses, just like an increase in sales tax.
.. Where will the competitively priced imports that undercut China come from?
In most cases, the answer will be other emerging economies. Some low-end goods such as shoes and toys will be sourced from Vietnam or India. Final assembly of some electronic and industrial machinery may relocate to South Korea or Mexico.
.. But this should have no effect on Chinese growth, employment, or corporate profits if demand management is used to offset the loss of exports. The Chinese government has already started to boost domestic consumption and investment by easing monetary policy and cutting taxes.
.. In principle, China can avoid any damage at all from US tariffs simply by responding with a full-scale Keynesian stimulus. But would the Chinese government be willing do this?1
This is where bipartisan US support for a “containment policy” toward China paradoxically works against Trump. China’s rulers have so far been reluctant to use overt demand stimulus as a weapon in the trade war because of strong commitments made by President Xi Jinping to limit the growth of China’s debt and to reform the banking sector.
.. But such financial policy arguments against Keynesian policy are surely irrelevant now that the US has presented the battle over Trump’s tariffs as the opening skirmish in a geopolitical Cold War. It is simply inconceivable that Xi would attach higher priority to credit management than to winning the tariff war and thereby demonstrating the futility of a US containment strategy against China.
.. This raises the question of how Trump will react when his tariffs start to hurt US businesses and voters, while China and the rest of the world shrug them off. The probable answer is that Trump will follow the precedent of his conflicts with North Korea, the European Union, and Mexico. He will “make a deal” that fails to achieve his stated objectives but allows him to boast of a “win” and justify the verbal belligerence that inspires his supporters.
Trump’s surprisingly successful rhetorical technique of “shout loudly and carry a white flag” helps to explain the consistent inconsistency of his foreign policy. The US-China trade war is likely to provide the next example.