Contrary to what President Trump thinks, trade wars are neither good, nor easy to win. But ultimately, as in any war, there are winners and losers. In that respect, the U.S. president is probably right in his implicit assumption that the U.S., not China, is likely to come out ahead in its steadily intensifying trade conflict with Beijing—at least in the short term, until China can wean itself off its export-led mercantilist growth model. This is not to say that there will not be collateral damage in the U.S., although it is interesting to note that even as the conflict has intensified, the Dow Jones index has continued to hit new historic highs, while China’s Shanghai SE Composite Index is down more than 17 percent year to date. So clearly there are some implicit bets being placed on the outcome of this particular conflict in favor of the U.S. Are these bets rational?

The roots of this conflict and, indeed, much of the basis for Trump’s presidency lie in trade—or, more precisely, the outcomes of trade, globalization and the unimpeded offshoring of American manufacturing.

As I have written before, these phenomena in aggregate have created the effect of a “synthetic” open borders immigration policy, as American manufacturers have relocated to low-cost (especially with regard to labor) jurisdictions in China under the assumption that pre-existing free trade arrangements would safeguard the ease of shipping these cheaper goods back to the U.S.

The “Chimerica” nexus has imparted deflation in two ways:

1. The threat of offshoring (or the actual implementation of it) has moderated demands for higher pay to workers in the U.S., and

2. The importation of cheaper Chinese goods has also kept prices lower, thereby nipping incipient inflationary pressures in the bud.

Trump’s goal is to disrupt this “Chimerica” nexus and induce bringing supply chains back to the U.S. However, one potentially adverse outcome is that this policy may be inflationary, by creating short-term bottlenecks as the flow of cheap Chinese imports is disrupted. Furthermore, a tariff, like a devaluation, is expansionary as it diverts demand from foreign to home producers, thereby further contributing to potential inflation.

For Trump, this might be a reasonable trade-off. But if the president is successful in securing these objectives, he might well find himself winning a trade battle with China, but losing the inflationary war.

Unlike the Great Depression, this is an economy currently running much closer to full capacity and hence, is more at risk of rising inflation, which could erode any real wage gains for the workers that the policy is ostensibly designed to help. Furthermore, Trump’s growth objectives could be undermined by the U.S. Federal Reserve as it continues to hike rates to offset the rise in incipient inflationary pressures. Given the fact that private debt levels among households remain relatively high, an increased interest burden could well abort the economic recovery.

One of the supporting factors for the markets’ comparatively benign view of U.S. prospects relative to those of China is the period of the Great Depression and its impact on U.S. economic growth. History shows that creditor nations end up as the biggest losers in a trade war. By the time of the Great Depression, the U.S. was the world’s largest creditor nation (the China of its time), and exports represented 7 percent of GDP by 1929. The infamous Smoot-Hawley tariff, introduced in June 1930, caused U.S. exports to fall by 1.5 percent over the next two years, contributing to a further 2 percent loss in GDP.

Without minimizing the impact of a 2 percent decline in GDP directly attributable to the decline in U.S. exports, on the face of it, the imposition of Smoot-Hawley does not appear to provide much support to the view that protectionism per se caused the Great Depression. Especially when one considers that from 1929 to 1933, real national income fell by almost 40 percent, unemployment rose to 25 percent, and real Gross Domestic Product collapsed by 30 percent.

On the other hand, note economists Theodore Phalan, Deema Yazigi, and Thomas Rustici:

“Two percent of GNP does not sound like a big change, but if it’s concentrated in one-fifth to one-third of the states, it’s very large indeed. The tariff dramatically lowered U.S. exports, from $7 billion in 1929 to $2.4 billion in 1932, and a large portion of U.S. exports were agricultural; therefore, it cannot be assumed that the microeconomic inefficiencies were evenly distributed… “Agriculture was not the only export sector destroyed by the tariff. The worldwide retaliation against U.S. minerals greatly depressed income in mining states and can be partially blamed for the collapse of the Wingfield chain of banks (about one-third of the banks in Nevada, with 65 percent of all deposits and 75 percent of commercial loans). U.S. iron and steel exports decreased 85.5 percent by 1932 due to retaliation by Canada. The cumulative decrease in those exports below their pre-tariff levels totaled $369 million. Is it any wonder that Pittsburgh saw 11 of its largest banks, with $67 million in deposits, close in September 1931? How about U.S.-made automobiles? European retaliation raised tariffs so high that U.S. exports declined from $541 million per year to $97 million by 1933, an 82 percent drop! Thus there was a cumulative export decline of $1.57 billion from the pre-tariff volume to 1933. Is it any wonder that the Detroit banking system (tied to the auto industry) was in complete collapse by early 1933?”

As one of the world’s leading creditor nations today, this history is germane to China, even though its current account surplus as a percentage of GDP was only 1.7 percent at the end of 2017 (after averaging around 2.2 percent from 1980 to 2017). But its exports to the U.S. last year totaled $507bn and the total net trade surplus with Washington was $375bn. So from a simple arithmetical angle, the U.S. has much further scope to impose tariffs on Chinese goods than vice versa. True, economists such as Dean Baker note, Beijing is not devoid of countermeasures:

“It can encourage domestic Chinese companies to make millions of copies of Windows-based computers, without paying a penny to Microsoft. It can do the same with iPhones and Apple. In fact, it can encourage Chinese companies to export these unauthorized copies all over the world, destroying Microsoft’s and Apple’s markets in third countries. “It can do the same with fertilizers and pesticides, making Monsanto and other chemical giants unhappy. And, it can do this with Pfizer and Merck’s drugs, flooding the world with low-cost generic drugs. Even a short period of generic availability may do permanent damage to these companies’ markets.”

Those are not insignificant countermeasures, but unlike the time of Smoot-Hawley, the economic backdrop in the U.S. remains comparatively benign. Fiscal stimulus remains relatively robust (even though much of the benefits of the recent tax cuts is being directed to the wealthiest consumers with the highest savings propensities), and unemployment remains fairly low by historic standards (even if unduly flattered by lower worker participation rates).

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Being a net importer, the U.S. is therefore not nearly as dependent on exports to sustain growth as China is. So the market participants’ relative assessments of U.S. prospects relative to China are not irrational. This would also explain why the U.S. stock market has remained so resilient in the face of this intensifying trade battle between Trump and China.

What about the U.S. bond market? What is invariably discussed in the context of this mounting trade war is China’s huge stock of U.S. Treasuries. The risk often cited is that China will dump these Treasuries en masse, and thereby create a huge financial discontinuity in the U.S. economy as its actions crater the bond market. There are numerous inconsistencies in this argument.

First, China will continue to receive U.S. dollars (with which it has historically bought treasuries) so long as it exports to the U.S. market. Restrict its exports, and it has correspondingly fewer dollars with which to purchase said Treasuries.

It is true that China can dump its existing stockpile of Treasuries. But what does that actually mean? Recall that these instruments are recorded as electronic entries at the Bank of China’s foreign custody account held at the NY Fed. So here’s how the sale would work: the Federal Reserve would debit the Bank of China’s securities account (the central bank equivalent of a “savings account” where the Treasuries are held), and will simultaneously credit its reserve account (aka the “checking account”). All of this is done electronically, via computer keystrokes—just as you or I would do when we transfer funds from our savings account into our checking account—which means that China’s Treasury holdings are now converted to a large stock of dollars held in the central banking equivalent of a checking account.

China may well choose to sell those dollars and, say, immediately convert them into other currencies, such as the euro. This could potentially elevate the euro relative to the RMB (all other things being equal), leaving Europe to face an additional import onslaught from Chinese goods. It’s hard to believe that the EU (still suffering from much higher levels of unemployment than the U.S. and far less prone to unconditionally accepting free trade dogma) would not follow the U.S. lead and restrict their domestic market to Chinese exports in response (as it has done in the past).

Furthermore, no less a figure than Nobel Laureate Paul Krugman has argued that “if Chinese sales somehow put a squeeze on longer maturities, the Fed could just engage in more quantitative easing and buy up those bonds. It’s true that such actions could possibly depress the value of the dollar. But that would be good for America!” Not only good for America (by making its goods more competitive relative to foreign competitors), but also for emerging economies, whose economic health is somewhat dependent on the ready access to dollar liquidity (and any potential reduction in the external value of the U.S. dollar eases the funding pressure for nations such as Turkey, which have huge amounts of U.S.-denominated debt).

Bigger picture: bonds may well fall for reasons of inflation (which erode the real value of the interest payments), but this has little to do with any potential buyers’ strike by China (or widespread sales of its pre-existing stock of Treasury holdings). It certainly would not create a deflationary tsunami. The important fact here is that it will be the actions of the U.S. Federal Reserve, not China (or the so-called “bond vigilantes”), which will ultimately set the level of American interest rates. (See here for more explanation.)

All of these scenarios highlight a broader problem created by Beijing’s decision to emulate its Asian counterparts by embracing an export-driven growth model, despite having a domestic market of almost 1.5 billion people. Export-driven growth strategies have two fundamental flaws: One is that they turn the exporting country into a “Blanche Dubois economy” in which the exporting nation becomes dependent on the “kindness of strangers” to buy its goods. A foreign government can unilaterally choose to restrict the flow of said goods (as Trump is seeking to do against China right now via tariffs) or simply diminish the country’s capacity to buy by embracing fiscal austerity, which curbs the capacity of its citizenry to purchase imports, no matter how cheap. An unemployed or marginally employed worker (who has latent purchasing power) has less capacity to buy such goods from China.

Another problem is that export-driven strategies lead to a global “race to the bottom” as far as wages go, insofar as the exporting nation is under constant pressure to retain global market competitiveness, and generally does so by squeezing labor costs. Everybody works just as hard (if not harder). But there is less purchasing power on the part of the workers to consume the fruits of their own labor. As trade competition intensifies globally, eventually this creates an adverse feedback loop, as all workers get paid less in order to remain globally competitive (but also have less money to buy foreign goods). Maximizing current consumption means purchasing the lowest-priced goods at any particular level of quality, but this becomes self-defeating when pursuing a mercantilist trade policy. Ultimately, it endangers the country’s growth prospects both externally (via trade shocks) and domestically (via wage deflation to sustain the export market share).

Even one of the early advocates of export-led growth, the late former German Chancellor Helmut Schmidt, reflected in a 2010 interview with Handelsblatt on the shortcomings of this model in the Monthly Bulletin of the Official Monetary and Financial Institutions Forum (OMFIF) (quoted and translated into English by economist and professor Bill Mitchell):

Handelsblatt: I remember you saying many times, if the Germans keep the D-Mark we will make ourselves unpopular with the rest of the world; our banks and our currency would be the Number 1, all the other countries would be against us and that was why we should have the euro to embed us in a larger European undertaking. It’s all rather ironic, because people are saying that Germany has profited a great deal from the euro because the D-Mark has been kept down and this helps German exports … Schmidt: I ask myself whether this profit really is a profit? I wonder whether running perpetual current account surpluses really amounts to a profit. In the long run it is not a profit. Handelsblatt: Because in the long run these assets will have to be written down because people won’t pay them back … Schmidt: Yes—it means that you sell goods and what you get back is just paper money and later on it will be devalued and you will have to write it off. So you are withholding from your own nation goods that otherwise they would like to consume.

In essence, China gets a raw deal because it exports the fruits of its economic output to the U.S., rather than consuming it at home. In return it gets paper, whose real value could be eroded by inflation, as Schmidt noted.

Even though less flexible, command economies tend to be more resilient than free market economies because the state faces fewer impediments to curbing the free market’s “boom-bust” cycle, but at a cost of economic dynamism and preserving state white elephants. How do they overcome this drag? Traditionally, Beijing has done this by buttressing its big, inefficient state-owned enterprises, simultaneously creating new trade relations from which it can increase the resultant exports (the “Belt and Road” initiative). Judging from the way Beijing has allowed its managed currency, the RMB, to fall against the U.S. dollar (the decline roughly corresponding to the size of the tariffs imposed by Washington), Beijing is finding it hard to break from its export model, although its “Made in China 2025” plan represents an explicit program of import substitution.

Any trade shock brought about by U.S. protectionism will intensify the strains on an economy already weighed down by a historically unprecedented capital expenditure bubble. As the export channel is cut down, China will accelerate policies that shift the emphasis to consuming its output domestically. This could prove disruptive in the short term, but when 1.5 billion people are consuming the fruits of their own labor, rather than exporting it to other countries, the comparatively benign period of disinflation could be well be over.

Imagine a China aggressively competing for scarce foodstuffs, minerals, or energy. Globalization produced a deflationary cycle. Trump undoing that via tariffs may help him win a trade battle against China, but lose an inflationary war, as bond yields rise to reflect the new reality and abort America’s economic recovery in the process. In the end, therefore, Trump’s “trade victory” may well prove pyrrhic.