China—Not Trump—Could Lose Most in a Trade War With U.S.

Xi Jinping delivers a speech at the Great Hall of the People on November 15, 2012 in Beijing, China. Lintao Zhang/Getty

It was a master class in public relations, and one that may have stopped a trade war. For now.

While U.S. President Donald Trump stewed about Beijing on Twitter, Chinese President Xi Jinping played the role of the grown-up and struck a softer tone. On April 10, Xi said his country was committed to becoming a more "open" market. As evidence, he offered to reduce tariffs, particularly the 25 percent levy China slaps on imported automobiles, as well as the limits on foreign ownership of auto plants.

The American president liked what he heard. "Very thankful for President Xi's kind words on tariffs and auto restrictions," Trump tweeted. After weeks of declines, U.S. stock prices soared in relief.

Xi may have been relieved too. The conventional wisdom about a trade war between the world's two largest economies is that both sides would lose, bigly. The standoff, in this view, is a lot like two people aiming guns at their own heads, shouting, "Do as I say, or the idiot gets it!"

The reality is a bit more complicated. In a trade war with China, the U.S., if it's smart about it, could "win," or least make sure that China loses more. In fact, as Michael Pettis, a professor of finance at the elite Peking University in Beijing, explains, "the dirty little secret of trade is that for diversified economies with large deficits (such as the U.S.), a trade war can actually be positive for growth, at least in the short run, as long as the intervention is done correctly." (He and others argue that the U.S. should focus on reducing the amount of money from abroad that flows into the country to rectify trade imbalances.)

When it comes to trade wars, many reflexively invoke the infamous Smoot-Hawley tariff of 1930. That measure helped bring on the Great Depression by accelerating a contraction in global trade. The reason this tariff was so monumentally stupid: The United States ran massive trade surpluses—much like China does today. Its domestic economy could not absorb everything it produced. So it exported the difference. At the time, Pettis notes, "the U.S. had the highest absolute trade surplus in history."

Today, that surplus is long gone, and the United States is the world's economic "shock absorber," as Pettis puts it, taking in half of all the globe's excess savings. It's the only economy in the world big enough, and with sufficient capital markets, to absorb those inflows. All that foreign money has to go somewhere, and a decent chunk of it winds up in real estate or the stock market, leaving Americans suddenly feeling richer and more willing to spend than they otherwise would be. This extra consumption helps fuel the trade deficit.

The U.S. can respond in two ways. It can allow an increase in unemployment, as foreign producers take market share away from domestic companies. But that, obviously, creates political problems. Or it can increase government spending to keep overall demand high and unemployment relatively low. Guess which it chooses?

Donald Trump signs a presidential memorandum, aimed at what he calls Chinese economic aggression, at the White House on March 22, 2018. Mark Wilson/Getty

Would tariffs of the sort Trump has proposed—as opposed what Pettis and others believe would be more effective—actually reduce the trade deficit? Probably not. But if the U.S. chooses that route anyway—and Trump has long expressed an affinity for tariffs—the conventional wisdom is that China will retaliate. It's widely assumed that Beijing has significant weapons with which to do so—weapons that could seriously damage the U.S. and global economy.

But Xi knows better. His ability to retaliate is limited. One thing Beijing could do is stop buying U.S. Treasury debt. Hillary Clinton invoked this possibility on the campaign trail

in explaining why the United States was in no position to get tough with China. But that outcome is unlikely. If China did not buy American debt, it would have to repatriate the money it earns from trade, which it receives in dollars. To do so would require selling those dollars and buying the renminbi. That would drive up the value of the Chinese currency significantly, putting the exporters who generated the surpluses at risk. As Pettis puts it, selling U.S. debt "is a completely empty threat."

Xi, of course, does have one advantage in a trade war: He doesn't have to worry about voters. Trump does, and many of his constituents live in states that could be affected by Chinese tariffs on agricultural products or Boeing airplanes. Beijing could try to intimidate Trump and hope he folds.

Yet China's hand isn't that strong. Yes, import restrictions on specific U.S. companies could be painful to them, their suppliers and shareholders. Boeing, for example, is very vulnerable. A sales ban on U.S. products assembled and then sold in China (hello, Apple) would also hurt. But Beijing's ability to inflict pain on the overall U.S. economy is limited, some analysts believe. U.S. soybean producers, for example, could suffer, but we're not talking about another Great Depression.

Boeing Dreamliner 787 planes sit on the production line at the company's final assembly facility in North Charleston, South Carolina, on December 6, 2016. Travis Dove/Bloomberg/Getty

Beijing, on the other hand, could suffer greatly because of its surpluses. "To the extent that Chinese retaliation encourages greater trade intervention by the U.S. and the rest of the world," Pettis argues, "China is hugely at risk. Any forced contraction in their surpluses requires either more debt or more unemployment."

And though Xi doesn't have to worry about voters, he does have to worry about protesters in the streets. He sounded reasonable in early April because he can't really want any part of this game of chicken. Which means it's possible that the specter of a trade war might ultimately vanish and stop haunting the global economy.