US-China growth divergence
From a Keynesian perspective, the outcome of a trade war depends on whether the players are experiencing full employment or demand deficiency. In recessionary times, tariffs can boost domestic demand and employment by eroding the substitution effect of imports, albeit at the cost of long-run efficiency and welfare. But in a full-employment situation, tariffs merely boost inflation and impoverish the consumer.
Today’s robust US economy is clearly close to, or even beyond, its sustainable production possibility frontier. US businesses will not only have to hire extra workers to boost output to supplant Chinese imports, they will also need to invest in new capacity. But the current lack of spare capacity suggests that this new investment will have to come at the expense of other investments that were more profitable and productive before the tariffs were implemented.
If the tariffs on Chinese imports are permanent, the US will suffer an efficiency loss, as the comparative advantage theory argues – goods that could have been bought cheaply from China may use up resources that displace more profitable activity where the US has a comparative advantage. The higher costs of domestically-produced and imported goods will also reduce the US consumer surplus. This outcome is more likely if the US imposes tariffs more broadly to prevent production from shifting to other low-cost producers from China.
If the tariffs turn out to be temporary, the investment in capacity for substituting Chinese imports will become obsolete later as output will eventually be undercut again by cheap tariff-free Chinese goods. In fact, anticipating that tariffs may be temporary, US businesses may not invest or hire new workers to replace imports from China.
Add in the Chinese
If the Chinese suppliers also know that US businesses will not invest in import substitutes in response to what might be temporary tariffs, they will not necessarily cut their export prices to the US despite the tariffs. This means that US importers will be left to pass the extra cost of tariffs onto the US consumer or accept a reduction in their retail margins, or a combination of both. Hence, the tariffs will simply act as a tax on the US consumer instead of a penalty on Chinese exports.
US household well-being will decline as a result of reduced hiring in sectors that face margin pressure exerted by the tariffs. There would be inadequately offset via increased hiring in sectors protected by the tariffs if indeed US companies choose not to expand production in response to what might turn out to be temporary protectionism. And as US importers pass on the tariff cost to the consumer, that will drive up US inflation and interest rates, ceteris paribus.
Impact on EM
To the extent that US tariffs do price China out of the US market, other EM producers may replace the Chinese exports unless the US imposes tariffs on all other imports. In this case, the overall US trade deficit will still remain, but with a different geographical import composition. In particular, US imports of low-end goods such as shoes, toys and textile may shift to Vietnam, India, Bangladesh and Indonesia. Imports of higher-value goods such as electronic equipment and machinery may shift to Mexico, Turkey or South Korea.
Contrary to the conventional wisdom of the Sino-US trade conflict hurting emerging markets, US tariffs may end up helping these countries by boosting their exports to displace Chinese goods. Meanwhile, if China increases its domestic stimulus to fight the trade war, it could also increase imports from EM. The combined trade diversion and Chinese demand effects will help offset some of the collateral damage on the region that the Sino-US trade conflict will likely bring.
The strategic implications
To the extent that President Trump wants to use tariffs to force US multinational companies to cut their investments in China so that the interdependence of the two rival economies can be reduced, the strategy may backfire on US national security. This is because since World War II, the US commitment to open markets through trade and investment has fostered an economic boom in Asia, which has created a benign economic interdependence between nations. This interdependence, in turn, has raised the cost of military conflict.
China has benefited from this system and thus should have an incentive to maintain stability and order. But if the US abandons its post-war economic engagement strategy, by corollary, it will reduce economic interdependence, lower the cost of armed conflict and possibly increase China’s incentive to become more aggressive to erode US power and influence. This should be seen by the Trump administration as a threat to US national security.