November 22, 2019

Escalation of the China-US Trade War Could Lead to an Economic Crisis

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Chinese cars waiting to be loaded on a ship in Lianyungang, Jiangsu Province. Chinese imports and exports declined more than expected in September this year due to US tariffs and declining global demand.
Chinese cars waiting to be loaded on a ship in Lianyungang, Jiangsu Province. Chinese imports and exports declined more than expected in September this year due to US tariffs and declining global demand.

The future of the World Trade Organization is not rosy.

Trade relations between China and the US have been tense for decades, but the trade war rose to new peaks in early 2018. As this conflict has profound economic policy implications and is part of a broader global power struggle, any agreement currently being negotiated is unlikely to bring about a lasting solution to the tensions between the two countries. The combination of immense international economic friction and personality-centred factors could lead to a full-scale global trade war and financial crisis in the short term. In the long run, the tug-of-war between the two superpowers threatens to bring about the complete marginalisation of the World Trade Organization (WTO). Unavoidably, this war also affects the European Union, which must carefully balance its economic interests, security considerations, and values.

The Roots of a New Wave of Protectionism

One of the root causes of the current direction of US trade policy is the globalisation of the international economy, the profits from which have not been equally shared by all sections of society. From the point of view of economics, the removal of customs and other trade barriers helps to increase the financial well-being of a country, whether due to specialisation, economies of scale or innovation. However, these benefits might not be shared equally in society either. In the US context, the main losers from globalisation are unskilled workers, whose real income (i.e. given the simultaneous rise in prices) has remained unchanged for 30 years.1 This has been made possible by the employment of hundreds of millions of Asian and Latin American workers, whose salary levels are significantly lower. While the technological development and the gradual automation of production have also led to job losses in the industrial sector, it is much more impressive in political rhetoric to blame other countries. Thus, international trade has played an essential role in the economic success of the US, but for a specific social group it poses an existential threat to their habitual way of life and income.

The media coverage of the US-China trade war has so far remained primarily focused on president Donald Trump, although the turn towards protectionism would probably have taken place without him too. For example, in the run-up to the 2016 presidential election, Democratic Party candidate Hillary Clinton said she would not support US involvement in the Trans-Pacific Partnership (TPP), which she had advocated as Obama’s secretary of state. Although Clinton justified her change of mind by pointing to substantive shortcomings in the final agreement, this decision was probably also due to a change in public opinion on free trade. Ironically, trade policy has become one of the few topics on which the current president’s principles resemble those of his biggest political opponents. Like Trump, earlier US trade agreements—such as NAFTA—and their destructive impact on the working class have also been criticised by “democratic socialists” such as Bernie Sanders and Alexandria Ocasio-Cortez. Thus, pulling the brake on the liberalisation of international trade in the US seems an inevitable trend, not a one-person solo project.

Trump’s Trade Policies

However, to a large extent, Trump’s personality is a major factor in the way the US tries to address current trade-policy issues. Typically, as a businessman, Trump began bargaining right at the start of his presidency. While the TPP was abandoned without further ado, the new president wanted to have NAFTA (dating from 1994) and the trade agreement with South Korea (2012) amended, justifying this by the need to reduce the US trade deficit and bring jobs back to America. At least in formal terms, he was successful because the partners in both treaties met the US halfway, but it remains questionable whether there was any substance to the changes. The opportunity to show off his deal-making skills and to send a message to the public about prioritising US interests was perhaps even more important than the new content of the treaties.

Trump’s style and the focus of his messages have influenced the emphasis of the entire US-China trade war. At first glance, the problem is straightforward: China exports more to the US than vice versa, causing the US to lose both profit and jobs. At the same time, one might ask: why not import the goods that consumers want and can afford? The global value chains that have emerged over recent decades, employing cheaper offshore labour, have made available to the average US and European consumer a variety of products that would previously have been considered luxury items.

Through his rhetoric, as well as by imposing duties and other restrictions, Trump is trying to attract investors to the US economy and draw finance away from China. Here, he has put forward both national security arguments and the fight for human rights to justify his actions. Nevertheless, with all this activity, it is clear that, in economic terms, the US needs China and China needs the US; the countries are like yin and yang, complementing each other. This interdependence was well illustrated by the bans imposed on Huawei and their subsequent relaxation. Even the president of the US is not capable of a loss-free rupture of the value chain that has evolved. At the same time, Huawei cannot do without high-tech components manufactured in the US.

While the American economy as a whole is still doing pretty well, the message is mixed in some states that will play a crucial role in Trump’s re-election, such as Michigan, Pennsylvania and Wisconsin. On the one hand, the Chinese countermeasures and high customs tariffs have hurt American agricultural companies that export directly to China. US farmers have been particularly hit by the trade war, as a whopping one-quarter of their exports go to China.2 On the other hand, customs duties on China have made US companies that use Chinese input in their final products less competitive, such as the automotive industry which is based on Chinese steel.

China’s Dishonest Commercial Practices

However, China may also be subject to legitimate trade-policy-related reprimands. In China, intellectual property theft and state aid issues are a significant source of controversy. The first of these, industrial copying, has been one of the pillars of China’s economic miracle, because the Chinese have not had to bear the costs of creating new technologies themselves. Intellectual property theft is not only the result of cutting-edge industrial espionage but also a widespread practice whereby foreign companies set up joint ventures with local enterprises and essentially transfer their technology to them. The problem of state aid arises in the face of global market competition, with regulation by or injections of money from the Chinese central government giving local businesses an advantage over their competitors.

This is where we finally come to the real problem of trading with China, which is not unique to the US—Europe, the other innovation centre, faces identical risks. As security partners, the US and the EU also share more specific concerns, such as over-reliance on China’s ICT infrastructure or other future technologies. Given the rise in Europe of political populism, whose supporters are broadly similar to those of Trump in socio-economic terms, the broader trade-policy concerns of the US and the EU appear almost identical.

Impact of the Trade War on the EU and the World

Instead of transatlantic cooperation, president Trump has favoured a unilateral approach to China, which coincides with his “America First” policy principles. What is more, the US and the EU are also facing a limited trade conflict. Bruno Le Maire, the French Minister of the Economy and Finance, hit the nail on the head by saying that the winner in the EU-US trade war was China. However, it is difficult for Europe to choose sides in the trade war between Beijing and Washington. Supporting China seems inconceivable because the US and Europe share similar concerns and are security allies. At the same time, endorsing the US approach would run counter to EU principles founded on a rules-based and multilateral trading system. In addition, China is one of the most promising foreign markets that it would be better not to aggravate. To take a neutral position, there is the hope that, with the mutual Sino-US sanctions, European products will become more competitive in both the Chinese and the US markets. On the other hand, the EU must consider the possibility of diverting some of the goods moving between the two hostile sides to the European market, the over-saturation of which could cause problems for local producers.

In summary, the economic effect of the trade war between two of the world’s largest countries is complicated and has a global impact. In simple terms, imposing trade restrictions inevitably brings about an economic recession. Even if customs duties fill the coffers of one country, collecting them requires additional resources. Non-tariff barriers to trade—from quotas to unreasonable product standards—may stop trade completely. At the same time, trade sanctions imposed by one country are likely to provoke a similar reaction from the other. Thus, one of the possible short-term consequences of the escalation of the trade war is an economic crisis, as (intermediate) products and services can no longer cross national borders, and the complex clockwork of the international economy stops. Various economic growth forecasting agencies, such as the World Bank, the International Monetary Fund and the OECD, have already reduced economic growth indicators for the coming years.

The Role of the WTO in Resolving Trade Conflicts

To prevent prisoner dilemmas in the international economy, the General Agreement on Tariffs and Trade (GATT) was signed in 1947. Negotiations over the agreement led to a decrease in international tariffs: while after World War II the average customs duty rate was close to 40%, in 2017 it was 1.66% in the US, 1.79% in the EU and 3.83% in China.3 With the emergence of new trends in international trade in the 1980s and the lack of dispute settlement measures, the GATT increasingly began to justify its humorous alternative name—the General Agreement of Talk and Talk. The need to address issues such as foreign investment, trade in services and the protection of intellectual property led to the establishment of the WTO in 1995, which had more dynamic dispute settlement mechanisms than the GATT, recognised in practice by member states.

In its turn, the WTO is now in trouble. One of the obstacles to the development of the multilateral trading system is the initial justification for its creation: to bring almost all countries to a common negotiating table. As trade negotiations are conducted on an all-or-nothing basis, the Doha Round (which was initially development-oriented) has been dragging on since 2001. A stalemate has emerged between developed industrial countries, their allies and developing countries. It is simply no longer possible to push for a solution if dozens of developing countries oppose it. As a result of the Doha Round being delayed, many countries have decided to enter into bilateral trade agreements, which are allowed under WTO rules as long as they do not lead to an increase in trade barriers with third countries.

A New Rise in the Bilateral Approach

The conclusion of bilateral agreements entails both opportunities and risks for the multilateral negotiating system. There are economists who believe that such agreements support the liberalisation of global trade. For example, recent EU FTAs with Canada and Japan might be examples for the rest of the world. Compared to earlier agreements, they lead to significantly closer economic integration and include new areas, such as the protection of geographical indications and human rights, on which it would be extremely difficult to reach consensus multilaterally. Other countries’ desire to share the benefits of trade liberalisation may, therefore, also motivate them to join existing trade associations. But there are also a large number of experts who believe that the conclusion of bilateral agreements leads to fragmented and polarised world trade, which hinders any multilateral development. The WTO will then become a bystander in which countries just talk but nothing can be agreed.

In the light of the US-China trade war, however, bilateral approaches seem to have prevailed in both trade negotiations and trade wars. By contrast, the WTO seems to gain the attention of the major powers only if it benefits them. As president, Donald Trump has repeatedly criticised the WTO for treating the US unfairly. Based on this allegation, Washington has blocked the appointment of new members to the WTO’s Dispute Settlement Body (DSB). Since only one judge will continue to serve in this body from December but three judges are needed to make decisions, the DSB’s activity may be suspended altogether. At the same time, Trump welcomed the WTO’s decision in early October to allow the US to impose 7.5 billion dollars’-worth of customs duties on EU goods after European countries were found guilty of illegal state aid to the aircraft manufacturer Airbus. EU aeronautical products were subjected to 10% customs duty and EU agricultural exports (such as selected cheeses and wines) to 25%, both of which are rather hefty in the context of developed countries.

At the same time, the Airbus state aid case is an excellent example of a WTO failure. The trade dispute over the aeronautical industry began as early as 2004, when the US accused the EU of subsidising Airbus, to which the EU responded with a complaint about US state aid for Boeing. In 2010–11, the WTO ruled that both parties were guilty of the unfair subsidisation of their aeronautical companies, but the exact extent of countermeasures allowed by the arbitration has only now been determined. The US was authorised to impose customs tariff countermeasures in early October, and the EU is likely to impose tariffs of the same magnitude in a few months. All in all, both sides are winners and losers at the same time.

In addition to the slowness of the decision-making mechanism, the WTO as it stands seems incapable of resolving trade problems with China. True, statistics show that the US has won 19 of the 23 complaints against China since joining the WTO.4 (The remaining four complaints are still pending.) At the same time, China has won five of the 15 complaints filed against the US, while six are currently pending. However, problems with China are more fundamental. In fact, even the intellectual property issues have been in the air since Bill Clinton’s presidency, but recently there has been a move towards more advanced imitation rather than just copying CDs. In practice, the issue has not been resolved by legally binding commitments or obligations taken on when joining the WTO (details of which can be found, for example, in the US Trade Representative’s report to Congress).5 Although the arguments are likely to continue on both sides, the contradictions fundamentally boil down to a different understanding of the role of the state in the economy. China is willing to compromise on many details, but certainly not in the fundamentals of its economic model.

The Future of International Trade

As we look to the future of the WTO, we will once again come to the much-discussed point of the need for reform. Although the political will of major powers is a prerequisite for reform, systemic changes in the global economy must be taken into account in finding a new solution. According to Richard Baldwin, a respected economist, the WTO was fit to regulate 20th-century trade, which was based on cross-border product sales and market access.6 But 21st-century trade is a two-way flow of goods, services, knowledge, investments and professionals. Instead of simple market access, developed countries are, figuratively speaking, providing developing countries their factories, thereby enabling them to industrialise. At the same time, developing countries are expected to implement reforms to protect the tangible and intangible assets of private companies. A universal solution to all 21st-century problems seems unrealistic, which is why Baldwin also suggests that the WTO could remain in place for the resolution of old-fashioned disputes, but that more complex issues should be resolved through bilateral agreements.

At the same time, China has wanted to exchange access rights to its market in return for Western factories and technology without further reforms. This contradiction has led to more conflict. In general terms, two paths have been proposed thus far in respect of China: either the West or China needs to change. In the first case, it is recognised that the Chinese economy is so vital to the West that it must be treated exceptionally. The second option means trying to punish China and deprive it of the benefits of closer economic integration.

In this context, on 27 October a remarkable joint statement was published by 37 US and Chinese economists, including five Nobel laureates (among them Joseph Stiglitz and Michael Spence). They argued that the current understanding of resolving a trade conflict involves a choice for China of following all the rules of multilateral trade and integration or facing being decoupled from the global trade system. The parties making the joint statement consider that a third way—a compromise that respects the WTO’s rules but is more flexible in interpretation—is necessary and possible.

“We believe this approach preserves the bulk of the gains from trade between the two economies, without presuming convergence in economic models,” the statement said.7

They also argued that this would be in line with the current multilateral trading system, although it would extend the rights of both the US and China arising from the existing WTO rules. The statement illustrates the complexity of implementing the current WTO rules on China, and also seeks to formulate more general principles on how to add flexibility to the WTO system. Overall, this seems to be in line with the ideas of Harvard professor Dani Rodrik, who has advocated giving countries more political space to pursue and defend their domestic economic priorities. China has its own development logic, which cannot be broken by force; rather, the trade relations framework needs to be made more flexible.

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1 “The Economic Drivers Behind the US Trade Deficit with China”, Euromonitor, 10 June 2013.

2 “China Tariff Effect on US Agriculture and Food Industries”, Euromonitor, April 2018.

3 “Tariff rate applied, weighted mean, all products (%)”, The World Bank, 2018. data.worldbank.org/indicator/tm.tax.mrch.wm.ar.zs.

4 Jeffrey J. Schott and Eujin Jung, “In US-China Trade Disputes, the WTO Usually Sides with the United States”, Peterson Institute for International Economics, 12 March 2019. www.piie.com/blogs/trade-and-investment-policy-wat….

5 “2018 Report to Congress On China’s WTO Compliance”, United States Trade Representative, February 2019. ustr.gov/sites/default/files/2018-USTR-Report-to-C…

6 Richard Baldwin, “The World Trade Organization and the Future of Multilateralism”, Journal of Economic Perspectives, Vol. 30 No. 1 (Winter 2016), pp. 95–116. www.aeaweb.org/articles?id=10.1257/jep.30.1.95

7 “US-China Trade Relations: A Way Forward. The US-China Trade Policy Working Group Joint Statement”, 18 October 2019 (published 27 October 2019). cdn.shanghai.nyu.edu/sites/default/files/_us-china…