The raison d’être of Davos is intelligence gathering. Hedge funds go to chat up CEOs, CEOs go to chat up politicians, politicians go to chat up donors, and journalists go to chat up everyone.
This year, all that chatting is yielding distressingly little intelligence, and that helps to explain why the mood here, and indeed over the world economy, seems so dark.
Here are the questions people here most want answered: How will Brexit be resolved? No one knows, certainly not British parliamentarians or cabinet ministers. When will the federal government shutdown ends? Nobody knows. Will the U.S. and China reach a deal to avoid all-out trade war by March 2? Nobody knows. This isn’t because no one from the Trump administration is here; if they were, they wouldn’t know, either (or so the people here who have dealt with Trump have concluded).
In the economy uncertainty is, of course, a constant. Businesses, markets and investors are used to working with probabilities rather than certainties, whether it’s the outlook for profits or interest rates. But with today’s problems you can’t even assign probabilities. Since Mr. Trump himself does not seem to know what he wants out of the China trade talks, how can you judge the odds and provisions of a deal?
How do you assign a probability to Mr. Trump or Democrats breaking a promise to their bases, as would be necessary to end the partial federal shutdown? Shutdowns used to treated as localized natural disasters, Harvard economist Ken Rogoff noted on a panel moderated by Journal editor Matt Murray: painful for those involved but without national repercussions. This shutdown, he said, is like one local disaster after another, each worse than the one before. In such a situation, “We don’t know what happens.”
As for Brexit, French finance minister Bruno Le Maire, asked about reopening the European Union’s deal with Britain, shrugged: “It’s up to the British people and British politicians to decide what they want.”
“Nobody knows anything,” screenwriter William Goldman once said of making hit movies. Too bad he died last year; he could have taught Davos a thing or two.
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.