The economics of a new Cold War

How dangerous is the China/US trade dispute? Most studies suggest the economic effect is quite modest. For example, a recent Bloomberg modelling exercise found that the current level of tariffs imposed by both sides will lower China’s GDP by a cumulative 0.5% and US GDP by just 0.2% by 2021. Not very much, really. And if President Trump extends the 25% tariffs to all imports from China, as he threatens, and assuming China retaliated in kind, the effect would still be only to cut China’s GDP by 0.8% and the US’ by 0.5%. Note that these figures are cumulative over about 18 months so the annual impact on growth is only about 2/3rds of them.

But it really depends on business confidence.

The problem is that these studies don’t take account of the full effects on business confidence. The Bloomberg study tries adding a 10% fall in stock markets to the tariffs and finds another tenth of a percent of growth or so is lost, but this may still be missing the point. The problem is that business has been banking on free and open global trade for decades. Supply chains, distribution partnerships and indeed whole business models are based on free trade. And it doesn’t just affect large companies. Lots of small companies either themselves export or are suppliers to large exporters, often foreign companies. If Trump’s trade delivers a serious hit to business confidence investment will fall. And a sudden hit to investment is often a cause of recession.

The confrontation is not just about Trump, or trade

My guess is that the US and China will reach a ‘truce’ on trade in the next few weeks because it is in both their interests. But tensions between the US and China have risen sharply over the last two years and it is not just about President Trump, nor is it just about trade. The American establishment in general, including the Democrats and business have become suspicious of China. On China’s side, President Xi has pursued a much more assertive diplomatic and military stance than his predecessors. And the 30 year trend to open up China’s economy to the private sector that began with Deng in 1978, has been made subservient to creating national champions to challenge on the world stage. This challenge is particularly in the technology area, with all its defence and security implications.

Two economic blocs again?

Even if a trade truce is agreed, the genie may be out of the bottle. What if the tension and competition between the two nations gets worse, and economic and political relations decline to the point that the world again divides into two camps? In one camp the US, Europe, Japan, Canada, Mexico, India, Australia, Saudi Arabia, Israel and Singapore to name the major players. In the other would be China, Russia, Iran, probably some of South-East Asia (but Thailand, Indonesia and the Philippines would be contested) and various commodity producers in the Middle East and Africa.

Just as in the 20th century Cold War, there would be major jockeying to ‘win’ countries. Arguably Europe has much less interest in confronting China than does the US. Could Europe try to remain open to China? The experience this year of the resumption of US sanctions against Iran suggests that this would be hard and, forced to choose between the US and China Europe will choose the US. In contrast Russia will stay with China unless a major rapprochement with the West could be engineered (ironically, rather like Nixon and China in 1972). Asia and the wider Middle East would be the key contested areas.

China is the biggest loser

The biggest loser in this would be China, with reduced access to markets and technology. There is a danger of a (hot) war because, like Japan in 1940, China may fear losing access to raw materials. Also, the Chinese government might pursue nationalist rhetoric and actions to deflect popular attention from poor economic performance. Most likely a new Cold War then would further weaken an economy which is already set for low growth in the 2020s in my view. It would likely also become even more autocratic though there is also the possibility of a political convulsion at some point.

Impact on the West

A sudden, total separation into economic blocs is unlikely but rather a decade long process in that direction involving trade tariffs and barriers, sanctions, disinvestment, discrimination and popular boycotts of companies and goods. Realisation that this really is the direction could bring a major stock market decline and, possibly, a recession as business confidence evaporates. Arguably it is fear of this scenario that has been playing in the markets in recent weeks. But more likely it will bring a painful slow adjustment

There would be dislocation as Western companies scramble to re-jig supply chains to produce outside China. Most large Western companies are globally-oriented today, with many relying on China for assembly and/or sales. If they have to move production, they will face capital costs and (probably) ongoing increased production costs. The loss of sales in China will hurt many too, especially those with a physical presence in China. Discrimination would hurt them while appropriation cannot be ruled out.

The net effect of all this then could be fourfold. First, a period of uncertainty with low investment, and slow growth or potentially a recession as the new order emerges. Secondly, new strong investment in cheap labour countries within the Western bloc, notably Mexico, India, perhaps Thailand, Indonesia and Philippines. Thirdly, re-shoring to advanced countries with a rise in automation. Fourth, a negative impact on overall efficiency hitting living standards.

Conclusion

How likely is this scenario? We believe the full-blown ‘cold war’ with separate autarkic blocs is unlikely. In the near-term President Trump has an election to win and we think he will back off at some point to help the economy. So, a recession over the next year with this as the cause is still unlikely. But ‘trade wars’ and other kinds of confrontation between the two nations may become the norm. That means the trend towards deglobalisation is likely to continue, hurting business confidence and keeping economic growth slower than it might otherwise be.