My Favorite Policy for Dealing with China
The biggest problem with only writing two of these per week is that every now and then something will happen, and it sparks a thought for me that I realize might be useful for y’all to read about. Then, somebody whose job is to write full time writes something pretty close to what I was planning to write before I can write it.
Well, here is one of those things from
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But the good news is he only covered about half of what I was thinking on the topic. This came up when I was having a conversation with a friend about a potential trade war with China. Because Noah Smith pretty much covered the ending of my trade war thoughts—that it would be good to think about moving jobs from China not just back to the United States, but also to other allied countries—I’ll just talk about the trade war part, and the policy mechanism that I keep thinking about when reshoring and friendshoring jobs from China.
At the moment there is no trade war with China. Both Trump and Biden have been ramping up their “firmness”, for lack of a better word, in trade policy toward China. To be clear about what I mean by firmness, I really can only tell you what the last two administrations are not doing. They are not really being aggressive or hostile toward China (though Biden seems to be tiptoeing that line), in that they are not attempting to use trade policy to defeat China economically. For a couple decades China has been less than circumspect in their treatment of trade, and the US and global policy for this has basically been “Well, they make cheap stuff that we want, so let’s just sort of look the other way and kinda let them get away with it?” But this isn’t happening nearly as much any more. Rather, the US is now being less squishy toward China when it comes to the international expectations of trade—thus I chose firmness as the correct word. The US is no longer just looking the other way.
Donald Trump did two big things toward China with trade policy. First, he implemented some import taxes on certain Chinese goods. This essentially makes Chinese imports more expensive. Now, this doesn’t directly hurt China because China doesn’t directly pay for these taxes—instead, like most businesses, they just pass them on. To pay the tax China just charges importers more for their stuff, and then those importers have to charge customers more for their stuff. In the end, this just means you and I pay more for Chinese imports; meaning we pay for the tax. Some estimates by free trade groups put the bill as high as $2,000 per family per year in increased costs because of the tariffs.
But these taxes indirectly hurt China as well. If these Chinese imports are more expensive then it becomes easier for non-Chinese firms to compete. If a Thing costs $15 from China, and $20 from a friendlier nation, you are probably gonna buy the Chinese Thing. But, if the taxes make the Thing cost $18.50 from China, you might be much more likely to buy the $20 thing. Maybe the $20 thing is higher quality; maybe $1.50 is well worth it for you to stick it to China; maybe the Chinese Thing runs out of stock and you decide the extra $1.50 is fine so you don’t have to wait for the Chinese Thing to be on the shelf again. No matter what the avenue of decision is, this hurts China if you decide to buy the $20 Thing—even though it is costing you more.
President Biden has left the Trump tariffs in place. There is a lot of discussion among economists about whether these tariffs are a good thing, but I won’t get into the details here. Most economists tend to think it would be better if the tariffs went away, but there is some disagreement. Not all the debate revolves around actual impacts of the tariffs—some of the arguments are theoretical and some are ideological, but it’s complicated, and this would be a huge tangent. So, for now, I’ll just leave it at that and go to the next Trump thing.
Trump also labeled China as a currency manipulator. Essentially China has been using secrecy, smoke, and mirrors to keep their currency cheaper than it would be on a natural competitive trade market. This makes Chinese things cheaper to buy. If a Yuan is trading at 5-1 for the Dollar, then a Yuan is basically worth about 20 cents. But, suppose the natural rate of trade for the Yuan without manipulation would be 2.5-1 (a Yuan is worth 40 cents). Well, in this competitive market trade rate you have to give Chinese companies twice as many dollars to get the same amount of stuff. That’s an extreme hypothetical, but if China is artificially deflating the Yuan by even 20% the Thing that only costs $15 would be $18.75 on a competitive market.
Labeling China a currency manipulator is more symbolic than substantive, and the label was lifted after a short time. But, at the very least, it sent a signal to China that the US was going to be serious about getting firmer on trade.
Biden took the firming up against China a huge step further. Chinese companies have been clearly stealing technology and spying on foreign firms for quite a while. This is made more simple by the advanced computer chips China brings in from the US and other counties. Biden banned the export of these chips, and equipment that could manufacture them, to China. This cuts off Chinese access to the technology they need to keep up their spying and stealing. If they can’t just buy this tech, they have to independently develop it, which will take quite a bit of time and cost a lot of money.
This firmness is still, despite headlines, not the same thing as an all out trade war. So, what if a trade war did happen?
I’ve heard a lot of people say that a trade war with China would completely devastate the US economy—after all, China is America’s factory.
I disagree.
Yes, a trade war would be painful, but I think it is a “war” that would hurt China a whole lot more than the US. The fact that tariffs, currency manipulator labels, and an export ban haven’t really changed much for ordinary Americans in the way of economic behavior is a good sign that China knows it needs us a lot more than we need it. I think a trade war, though painful, would be heavily slanted in favor of the United States.
What an actual trade war might look like is difficult to predict. Every trade war looks different because every country in every time is different. Much like WWII looked very different than WWI, even though many of the same countries participated. On top of this, The US used nuclear warheads in WWII, but not in Korea or Vietnam, or any subsequent war. This tactical choice is a parallel to a trade war as well. Both the US and China each have different “arsenals”, and the tactics each country chooses depends on the situation and the expected outcome. That is the long way of saying that I don’t know what a trade war might actually look like, but to illustrate my point about who might win, suppose all trade of any kind between the United States and China stopped overnight. The US loses access to all Chinese imports, and all Chinese exports go to zero. The same thing happens to China.
This undoubtedly hurts China worse than the US.
The US would only lose 8.6% of all it’s exports, while China would lose 17.5%. The US would lose access to about 18% of its imports, while China would only lose access to about 6% of its imports. But in this situation, China is in deep trouble. Both the United States and China can—fairly quickly—replace the imports they have lost access to. Other countries that are not part of the trade war will gleefully fill orders these two countries no longer give to one another. I would also argue that this would be quite a bit easier for the US to do than China. For example, about half of what the US imports from China are tech gadgets. These are fairly substitutable, and certainly delayable. People desperate for a phone or computer can buy a Japanese Sony, a Korean Samsung or LG, or any other foreign-non-Chinese gadget. People who insist on buying only Chinese made products will need to wait until a new factory can be built outside of China for their gadget. This will certainly mean Apple customers are annoyed, and even Japanese and Korean companies do some manufacturing in China so there will be some adjustment period. But, in the long run, this is much easier for the US to replace than the high tech and pharmaceutical goods China imports from the United States.
But, the much more difficult question is where does each country go to rebuild its export base? A very large number of jobs, both in the US and China, depend on exports. Chinese exports to the US are roughly 3% of its entire GDP. It is doubtful that China could find that many new customers anywhere in the world. This would be a very large, long term hit on the Chinese economy. On the other hand, US exports to China are about $155 Billion, or just about 0.7% of our GDP. That would be a painful loss, but not nearly as painful as the body slam China’s economy would take.
But imports and exports are not the only loss. Foreign direct investment would also go away. This is $123.9 Billion in China’s $18 trillion economy, but only $38 Billion in the US’ $23 Trillion economy. Again, China pays a higher cost. Intellectual property would also be similar. In fact, this is basically the case for a number of major resources. China relies on us more than we do on it.
Now, I’m massively oversimplifying this. The global economy means this would ripple out into so many additional areas, and additional trading partners. But, here again, the US has the advantage. Most of the trading partners China would need to mend its losses from a trade war are much closer allies to the US than to China. The big exceptions here are oil producing nations and OPEC. Many of these countries seem to be really close to China (although the US and Canada are massive producers of oil). But, these other countries also have to consider their long term future. If they refuse to sell oil to the US and our allies, not only do they lose most of their sales, they also speed the transition to green energy, making themselves less important and more insecure much sooner than the natural market would do.
Again, I want to emphasize that nobody really knows what a trade war might look like, and I am making this much more simple than it would be in real life. But I think the simple illustration is enough to see that China doesn’t want a trade war. If this weren’t the case, they would have had a much larger reaction to the firming of trade that has already taken place.
So, maybe China is the factory for the US—but we can always build another factory.
How would the US build another factory? This is where I get really excited because I get to talk about taxes.
The biggest tool the US could use to incentivize a new non-Chinese production would be depreciation.
Suppose a company buys a new truck to do its business for $50,000. This is a cost to the company, and so it doesn’t have to pay taxes on this cost. But, since this truck will be used for many years, the US does not let the company take all $50,000 off of its taxes this year. Instead, the IRS sets a depreciation schedule for certain types of equipment. It is usually not quite this simple, but let’s just pretend the IRS says the company can take $5,000 of cost deductions on its taxes for 10 years. This way the cost of the truck comes off of taxes as the truck gets used, and likely as it gets paid for because capital expenditures are often financed.
If the US wanted to incentivize disinvestment in China, or win a trade war, it could use depreciation to reward countries who move production out of China. Money now is always better than an equal amount of money later because money later is worth less. The value of $50,000 in 10 years is not the same as it is today because of inflation. On top of this, I could do other things with that $50,000 now to make it worth more. I could invest it both in an asset like the stock market, or in more capital so my business can generate more revenue. So, waiting 10 years makes my money worth less.
The US could speed up depreciation schedules for any company that moves a factory or lab out of China. This way companies get their money quicker. This can be designed to both bring jobs back to the US and to give more to our allies—the friendshoring Noah Smith talks about. Maybe, for the example of the truck, the depreciation schedule gets accelerated to just 3 years for friendshoring, and could be same year for US reshoring.
The details could be hammered out in DC, but this would pretty quickly generate a lot of Chinese disinvestment. Many companies are already looking to do this sort of thing without an incentive because Covid made it clear that supply chains are much more fragile than we realized. Having everything sourced from China is a bad strategy regardless of a trade war because one single kink in the supply chain means 100% of supply gets delayed—and this is a big cost. So, rather than Apple making all its iPhones in China, maybe it would like to move some production to Korea, some to Malaysia, some to Vietnam, and maybe it would like to invest in a more emerging market like Ghana. If something happens to take one of these supply hubs offline, the kink no longer results in a delay of 100% of production output.
Multiply this by every major company that currently relies heavily on Chinese manufacturing, and China loses a trade war pretty quickly.
I have definitely oversimplified all of this. To really cover the complexities of a trade war and its long reaching ripples it would require a thick book. Rather than a complete theoretical framework for what might happen, I just wanted to point out that China has more to lose, and the US has good and simple tools to use. Yes, a trade war would still create a great deal of pain in the US, but there is a reason China has not seriously retaliated against US action.
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I wrote my Master's thesis on China-Taiwan relations and US trade with China was a big part of that, and you are right that a trade war would be no fun for the US, but devastating for China. The US would certainly "win", and one can make an argument that Washington should start hammering Beijing on trade; the whole reason China was able to skyrocket its economy beginning in the 80s is because Washington was so insistent that Beijing be allowed in the WTO, even if they didn't follow a bunch of the rules everyone else had to. Sure, that was mostly for self-interest on Washington's part, but also because the US wanted China to become a strong and stable international partner. That is not what has happened, and Chinese authorities have acted with bad faith at almost every step of the way. If China had the chance, in a heartbeat they would rewrite the post-war economic order that they used to develop so rapidly in the first place.
The problem, however, is that a weak and economically declining China is a dangerous China. The CCP derives every drop of their domestic legitimacy from its economy, and that is already wobbling. Should Xi be made to feel even more insecure, Beijing would increasingly lash out in the South China Sea, at its neighbors, China would almost certainly support Russia in Ukraine, and the PLA would likely try to take Taiwan in an attempt to hold on to that legitimacy. Obviously most people in DC know this, which is why the possibility of a trade war is something the Biden administration is fairly cautious about. They know diversification and ending reliance on China would be useful, both as a cudgel and as wise economic policy, but the consequences could get scary. Let's hope both DC and Beijing move slowly and carefully.