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The looming trade war is bigger than China and the US

Bloomberg logoBloomberg 4/13/2018 Peter Coy

Video by USA Today

By threatening a tariff war with China, Donald Trump has essentially thrown a deck of cards into the air. We don’t know yet where each will land. While it appears that both the U.S. and China would suffer in a trade war, “the pattern of loss is going to be very difficult to predict,” says Jamie Murray, Bloomberg Economics’ chief European economist.

One of the most powerful laws in economics is the law of unintended consequences. As formulated by the American sociologist Robert Merton in a 1936 paper called “The Unanticipated Consequences of Purposive Social Action,” it says that consequences “are occasioned by the interplay of forces and circumstances which are so complex and numerous that prediction of them is quite beyond our reach.”

The law of unintended consequences strengthens the case for free trade by explaining that interventions in markets such as jacking up tariffs, however well intended, can make matters worse in ways that no economist or computer model can foresee. That’s not a counsel for inaction, but it’s a brief for stepping forward carefully. “History has proven that centralized industrial policy is not the most efficient way to run an economy,” says Thomas Derry, chief executive officer of the Institute for Supply Management, an organization of purchasing managers based in Tempe, Ariz.

It’s well understood that tariffs on imported goods raise prices for domestic businesses and consumers. Even President Trump, who has said trade wars are good and easy to win against countries that run big surpluses with the U.S., acknowledged their short-term downside on New York talk radio in early April, saying, “I’m not saying there won’t be a little pain.”

What’s less familiar is that tariffs are blunt instruments that strike every nation in a supply chain, not just the ones being targeted. There are few interesting products anymore that can simply be labeled “American” or “Chinese.” According to the Organization for Economic Cooperation and Development, as of 2011 only two-thirds of China’s gross exports consisted of value that was added in China. Japan, the U.S., and South Korea supplied much of the value and therefore earned much of the profit (chart). The iPhone is an extreme example. Only about 1 percent of the retail price of an iPhone consists of Chinese labor costs, according to calculations for the iPhone 7 by Jason Dedrick of Syracuse University and Kenneth Kraemer of the University of California at Irvine.

Globalization almost guarantees casualties from friendly fire. Take the U.S. tariffs on steel and aluminum. Chinese producers buy iron ore for steel from Australia, Brazil, India, Iran, South Africa, and Ukraine, and bauxite for aluminum from Australia, Brazil, and the poor West African nation of Guinea. All will be affected.

It’s no easier for the Chinese to target their retaliation. Chinese tariffs on American-made cars seem like a hardship for Detroit. But General Motors, Ford Motor, and Fiat Chrysler make most of their cars for the Chinese market through joint ventures in China. In reality, the main victims of China’s tariffs would be the shareholders and American employees of two German companies, Daimler AG and BMW AG. They export cars to China from plants in the South—Mercedes-Benzes in Tuscaloosa, Ala., and BMWs in Spartanburg, S.C.

Or take soybeans. If China puts a 25 percent tariff on American soybeans, several things could happen. The Chinese could keep buying the American beans but pay more for them. Or they could switch to Brazilian soybeans. But Brazil wouldn’t be able to ramp up production enough to make up for all the missing American beans, says Vinicius Ito, senior vice president for derivatives at Ecom Trading, a Swiss-based commodity merchant. So American farmers might sell their soybeans to countries that used to be Brazil’s customers. Some American farmers might also switch some of their acreage to other crops, such as corn and wheat, which would put downward pressure on the world prices for those crops. American livestock producers could benefit from lower feed prices, says Wallace Tyner, a Purdue University agricultural economist.

As the soybean scenarios show, the global trading system is like a heart that adapts to damage. When one artery is blocked, collateral vessels grow to do its job. Computer models show that the harm of tariffs diminishes over time as suppliers and consumers learn to adjust. But the damage never goes away completely because the tariffs force commerce away from its ideal configuration. A tariff, like any other tax, creates a deadweight loss by stopping transactions that would benefit both buyers and sellers.

The Trump administration is correct that China charges higher tariffs on American products, such as cars, than the U.S. charges on Chinese ones. China unfairly forces American companies to license their valuable patents to Chinese venture partners as a condition for doing business in the country. And China erects nontariff barriers to foreign companies to give an edge to favored domestic ones in sectors such as tech and finance.

The question is what to do about it. On April 10, Trumpian toughness seemed like it might be paying off when Chinese President Xi Jinping pledged to cut tariffs on cars and further open the financial sector in his keynote address at the Boao Forum for Asia conference. But ratcheting up the pressure on China as publicly as Trump has done could backfire in the long run. China nurses a sense of national humiliation over the century of foreign domination that preceded the Chinese Communist Revolution in 1949. Bloomberg News reported on April 10 that Beijing has rejected a U.S. request to stop subsidizing industries related to its Made in China 2025 initiative.

While a trade war with the U.S. would be disastrous for China, national pride might impel Xi to fight on. The country has several levers remaining. It could block Qualcomm Technologies Inc.’s pending purchase of NXP Semiconductors N.V. as part of an effort to bolster Chinese chipmakers. It could keep life difficult for American financial institutions and other service providers, which collectively run a trade surplus with China. It could allow—or force—its currency to depreciate, which would make its products more competitive. In extremis, it could stop selling the U.S. rare earth elements, which are used in high-tech magnets among other devices and are produced mainly by China.

The list of Chinese products that the U.S. wants to slap 25 percent tariffs on is bemusing: malaria diagnosis kits, human blood antiserum, chain saws, pump-action shotguns, railroad tracks, and turbo propellers, to name a few. “It’s hard to pick up what the rhyme or reason is,” says Dartmouth College economist Robert Johnson.

Derry, the CEO of the Institute for Supply Management, says he thinks Trump is playing chess with the Chinese. “It’s to create maximum political pressure and get all these issues on the table,” he says. Maybe. But American business leaders are getting nervous about the consequences of Trump’s threats, intended or otherwise. Even the U.S. Chamber of Commerce, which has been cautious about inviting the president’s wrath, posted an essay on its website by its chief economist, J.D. Foster, that included this phrase about the state of the U.S. economy, directed to no one in particular: “This is a rare moment. Enjoy it, and don’t screw it up.” —With Keith Zhai, Tatiana Freitas, Gabrielle Coppola, and Toluse Olorunnipa

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