Armistice Signed in China-US Trade War – New Boundary Set at 53rd Parallel

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TLDR Up Front:

A trade deal between China and the US is closer to an armistice than a peace treaty. It calls off hostilities, exchanges some prisoners and establishes a new boundary that looks a lot like where we started. Many contentious issues are kicked-down-the-road to a future “treaty”, to be negotiated in November 2020. Not being in a trade war is better than being in a trade war, but not having started a trade war would’ve been better than this draw. Plus, we get to refresh our favorite example of economics, which is KFC fried chicken.

 

Full Context in Back:

President Trump of the United States and President Xi of China signed “phase one” of a bi-lateral trade deal aimed at ending the most contentious issues of the two year “trade war.”  The trade war began over two main causes, which as with all issues economic, bear some quick explanations.

The first cause is the misunderstanding by many on the right, led by President Trump, that a trade deficit between two countries is a bad thing. In simple terms, when people read the US has a -$336BN trade deficit with China in 2017, they assume a negative score is “bad” as it would be in sports. That there is a winner and loser and the winner is the one with the highest score.  But imagine, as I often do, that I am leaving a KFC outlet with a tasty bucket of hot Xtra Crispy chicken for me and my friends. Although my bank account may be reading -$26.99, I do have a bucket of hot and tasty chicken in my hands which I didn’t have before I bought it.(1)The -$26.99 “score” doesn’t reflect that I have received something in exchange for my money, a thing I didn’t have before. And this is how trade deficits (simply put) work. We have a trade deficit with China because the total value of the goods we bought from them, minus the total value of goods we sold to them, worked out to -$366BN; but in return we still have the goods we bought from them in exchange.

The second cause is a misunderstanding by many on the left, led by Paul Krugman, that the cause of China’s trade deficit with the US is a result of currency manipulation. The Krugman argument in KFC terms is that the $26.99 I did pay would’ve been closer to $30 if KFC wasn’t somehow manipulating the value of the currency I am buying in.  In this argument although a deficit isn’t bad, the extent of the deficit signals unfair currency manipulation that disadvantages KFC’s competitors. Because I could’ve bought tasty fried-chicken from competitors such as Popeyes, Mrs. Winners, ChikFilet, Zaxby’s, Bojangles, Churches, but I only bought at KFC because it was “unfairly” cheapre. There are three problems with this cassus belli for a trade war.  First, it’s hard to argue that at the consumer level I’m suffering for getting cheaper fried chicken, regardless the source. Second, Paul Krugman has not to my knowledge endorsed a trade war as an effective tool for righting that imbalance. But even if we accept the premise that there is a utilitarian or even national security argument to make domestic fried chicken production capability worthy of protection from unfair trade practices, and that trade wars are one way to do that, we still run into the problem that no one actually knows the real size of the deficit.

That’s correct. The deficit itself, which both President Trump and Paul Krugman cite in alternative versions of “something must be done” against China, is based off a measurement held over from the 1950’s.  This measurement counts the total value of a “good” as if it entirely originated from the company that was the final point of embarkation before it arrived in the US. This works in an earlier economy before globalization. But supply chains now stretch around the world and a significant portion of “value” is not generated in the physical components of something, like an iPhone, but in the engineering of how to put those components together. In our KFC example this would be as if the Colonel’s Recipe was worth $20 of value of the $26.99 purchase price, and a further $3 of value came from Tysons, a chicken farmer supplying all these stores. This leaves only $3.99, or ~11% of the “actual value” of a $26.99 bucket of Xtra Crispy KFC coming from KFC itself.  These ratios are not all that far off from contributed value of an iPhone, which we happen to ship a lot of from China, but the design and engineering comes from the United States and key components from Germany. China only performs the final assembly before packaging them up and shipping them off to trendy US retail stores.

Although there’s no good number of how big this delta is, it’s been estimated as high as 50% of the entire US-China trade deficit might be accounted for in this mismeasurement.(2)And going to war, even a trade war, over something that may be wrong by as much as half puts the entire endeavor on shaky ground.

There were other causes as well – concern of Chinese pirating of US technical IP rights, US crackdown on Chinese companies like Huawei for alleged national security breaches. But these were side shows to the main show which revolved entirely around the trade deficit. And like the Korean armistice, this deal does not mean the war’s over, but simply hostiles have ceased.
Technically it’s “phase one” of what is supposed to be a multi-phased process to realign US and Chinese trade interests. The phase one deal today involves a reported $200BN of Chinese purchases of US goods to offset previous losses, a reduction of some tariffs, and promises to work on additional issues in phase two.  It’s much like settling the location of territorial exchange at the point the armies were at when the armistice was signed, the 53rd Parallel of Korea, exchanging some prisoners, and setting up a DMZ. But it is far from root-cause reconciliation of the factors which brought the sides into conflict in the first place. And like the Korean War it may touch off again at any moment given moves by either China or the US. (3)

Some losses may not be as easy to reverse as cutting a purchase order. For example, US exports of wheat to China dropped during the trade conflict, while Canadian imports of wheat from Canada rose from what had been a third to two thirds of all Chinese wheat imports.(4) This dynamic plays out anytime politicians begin monkeying around with free markets, the markets adjust, new relationships and supply chains form, investments are made and distrust of political intervention increases. Even when an armistice is called – the net benefit of the new deal must exceed the price differential, sunk cost of creating the new supply chain, and accumulated distrust that political meddling earned.

And what happened to the trade deficit during the war with China? It actually increased. Despite all of the economic shooting, in 2019 China’s trade at an estimated $353BN, about $25BN higher than when we started in 2017.(5) And the overall US trade deficit, accounting for all trade wars being waged by President Trump is estimated to be higher now than it ever was.

As in most cases of ‘war’ the clearest winners are the politicians who, having started it, can now claim to finish it.  If much of President Trump’s actual support is based on the appearance of doing-something, then the trade war itself and the signing of the deal amount to a victory, regardless of the facts on the ground. And President Xi can claim to his domestic audience that Trump eventually came around to the terms China initially offered.  Both politicians will try to gloss over the cost these wins have come at, a .25% reduction in Chinese GDP and .3% reduction for the same in the US. In practical terms that is an estimated $580 reduction in household income for US consumers in 2018. (6)

 

Much like the Korean War’s Armistice, technically both sides are still at war with each other. Of the initial tariffs implemented by both sides, about 50% remain intact. These remaining tariffs still impact $360BN of Chinese trade and a $100BN of US trade.  However, with the agreement in place barring a new spat it’s unlikely the situation will escalate from here. That’s good news because the tariff escalation had reached its natural plateau midway through 2019. With no goods left to apply tariffs on there was concern of where the next escalation might fall as both sides sought to innovate new weapons. Although China ceasing to buy US debt is unlikely, as discussed in a previous InfoMullet post there are many leverage points where even slight Chinese pressures could cause dramatic pain. (7)

 

 

(1)KFC prices adjusted for inflation (2020) for 16 Piece Bucket Chicken Only. I only checked for research purposes. I swear.  Source: kfc.com

(2)https://www.brookings.edu/blog/up-front/2018/02/06/the-true-trade-deficit/

(3)  https://www.cnbc.com/2020/01/15/china-trade-truce-is-seen-as-fragile-with-analysts-still-seeing-more-tariffs-as-a-possibility.html

(4) https://en.wikipedia.org/wiki/China%E2%80%93United_States_trade_war

(5)https://www.thebalance.com/u-s-china-trade-deficit-causes-effects-and-solutions-3306277

(6) https://www.bbc.com/news/business-51025464

(7) http://infomullet.com/2019/08/06/simple-steps-around-a-fatal-embrace/

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