Arthur Waldron

July 2019

The current tariff war between China and much of the world has a history, which is fundamentally one of Beijing’s overestimation of its own economic power. This overestimation continues. The objective situation changed fundamentally when, to the total surprise of the Chinese government, the United States imposed tariffs on Chinese exports that did real damage.

Two questions are particularly important. First, how have the new tariffs and other measures affected the vaunted Chinese economy, regularly touted as second in the world? Second, how have the changes in the regulation of trade produced follow-on effects in seemingly unrelated areas.

Our story can begin last year (2018) when, seeking to balance trade, Trump began to impose substantial tariffs on imports from China even as negotiations to find a permanent solution got under way.

Many months of conscientious negotiation between American and Chinese experts. By early this year an agreed draft for a new economic agreement was near fruition.

Evidently the Chinese leadership had not followed closely what their own negotiators were sweating over, for the draft was almost instantly deemed unacceptable. The most important points were simply inked out by the leadership, thus eviscerating the agreement. Were they unaware of what was being discussed?

The version with the important and binding provisions removed was then sent to Washington. There on May 10, 2019 the Trump administration deemed the diluted version unacceptable, leaving US-China trade in a policy vacuum.  A range of genuinely punitive tariffs was imposed. These almost certainly caught Beijing by surprise, for this was tough behavior, something that the Americans, over forty years, had taught the Chinese we would never adopt.

One can speculate that any of the three previous American administrations would have said, “goodwill is what is really important. So let us accept this in the short term in order to promote better relations in the future.” This is almost certainly the reaction the Chinese expected, for effectively all American administrations since the 1970s when relations with the People’s Republic of China were established (1979) has reacted that way. Long term “engagement” and toleration of Chinese abuses, they believed, was the way eventually to bring China into the world system.

Donald Trump, however, saw things differently. In the tough world of real estate, the only area of which he has expert knowledge, the rule is pretty much “a deal is a deal.” Of course quite often a long negotiation will fail, but in such cases the owners, the real powers, will have been following things closely, coordinating with their lawyers and others from day one.

Trump’s people had been negotiating in good faith. Top American specialists vetted each successive draft agreement. The hard work of negotiators on both sides had been discarded with the same ease with which Xi Jinping had made himself potentially ruler for life. He simply inked out parts of the Constitution of the People’s Republic of China and added new language. This casual dismissal of months of careful work was an insult to both the American and the Chinese negotiators.

Most importantly, Trump felt betrayed. As is common in business he had tried to develop a personal relationship with his counterpart, Xi Jinping. He put a lot of confidence in the power of good personal chemistry to overcome technical problems. Now it turned out that Xi was not really his friend in that sense. Accustomed to manipulating American politicians, the Chinese assumed that as always in the past, Washington would bend.

This belief was already fraying and ready to snap, the Chinese should have understood. Their poor understanding of American history as well as cumbersome decision making process made it difficult for China to imagine that the always agreeable United States of forty years might change, though anyone knowing American history realizes that is a recurrent pattern: an abrupt reversal of a policy if it is finally agreed the United States is  being manipulated or not taken seriously or in danger.

So Trump did what people in real estate do. He stopped talking and economic pain on his erstwhile negotiating partner. These unexpectedly tough actions did damage. China’s economy today is suffering in a way that of the United States is not. A new consensus has developed that trade must be fair. This is perhaps clearest in the Congressional vote 16 July 2019, to nullify certain concessions Trump had made to the Chinese military intelligence organization Huawei (it is certainly no “private corporation.” Such things do not exist in China).

For Trump these concessions were sweetners, designed to indicate to the Chinese that the United States was reasonable, even generous. The Congress had a different view. If Huawei was stealing American technology and installing listening devices in her internet systems, both the case, then they should take the maximum hit. That meant immovable, leak-proof sanctions. These as well as investigations that revealed the links that made Huawei, like at least half of China’s economy, effectively part of the government.

*

With this brief historical background, we can now turn to the question of the nature of Chinese economic growth and its effects.

China is a paradox. It is the third largest state in the world (after Russia and Canada) but it has adopted export led growth as its economic policy. This will work for a Singapore or a Taiwan, for the world market is large enough not to be greatly distorted by the huge proportion exports occupy in their gross national products (70% in the case of Taiwan. Japan is about 11%). This fact reflects the lack of a large local market. Countries having larger populations and thus more domestic buying power, tend to develop industries that produce for local consumption, ideally improving productivity, thus creating more buying power, more domestically focused investment, and the sort of virtuous cycle that has brought Taiwan’s gross domestic product per capita from US $900 in the early 1970s to nearly $26,000 today  (nominal—i.e. using amounts of money and exchange rates to judge, rather than the infinitely flexible Purchasing Power Parity or PPP)

The lack of privately held wealth in China meant that no domestic private demand existed when, after Mao Zedong’s death in 1976, Beijing decided that the economy needed to grow. Everything from shoe retailing to steel production was already run by the government. Land was all owned by the government (as it still is) farmed impoverished peasants, scarcely a reservoir of demand. (Today China boasts of lifting millions out of poverty—but that is perhaps less impressive than it sound when one realizes that poverty in China is defined as an income of less than roughly US$500 per year).  Like the small states just mentioned,. China had to rely on foreign demand to drive growth, until she somehow rearranges her society so that it has a popular wealth not derived from the state. As it stands, less than half of China’s population accounts effectively for all her wealth.

Rather than in effect abolishing the planned economy and state ownership of everything, which would have meant the end of communist rule as well as of the highly inefficient state controlled economy, the path of least resistance would be to depend on foreign demand to lift the Chinese economy, without fundamental structural reform. That plus the cheapness of Chinese labor.

So manufacture for export became the order of the day, with Chinese products began to flood foreign markets, including that of the United States. Of course China remained a large country so simply by dint of her huge population, more than half of her GDP was domestic in origin, though consisting in most cases of locally necessary goods, for which no international market exists.

Development was fastest in the Southeast, around Guangzhou (Canton) which benefited from proximity to the rich free economy of Hong Kong as well as a long tradition of trade. Soon the area around Dongguan was filled with ramshackle factories, producing in high volume for, among others, vast American discount merchants such as Walmart.

Rarely did foreign customers understand either the true provenance or low quality of what they procured. As the American China-trader and author Paul Midler has shown in his books, based on his own innumberable first hand factory visits (see Poorly Made in China 2011) the ingredients in beauty products imported from Dongguan and other factories bore no relationship to the description: “luxury aloe cream” for example, had never been near an aloe, but was rather a counterfeit produced  under filthy conditions.

At the same time, for reasons difficult to understand in retrospect, foreign producers began moving their own production to China. Much of this was high-technology—e.g. optical fibers, computers, etc.—not the sort of Christmas lights and sometimes toxic toothpaste that might have made sense. The Americans were shocked when their proprietary technologies, the products of billions of dollars in research, were simply stolen without acknowledgment. This of course was partly because of Chinese duplicity, but also owed to quite stunning American ignorance and stupidity.

The result was the devastation of foreign production of a range of goods, closure of factories, unemployment in the middle classes, and so forth.  This is where Trump came in.

*

Trump’s election victory was driven by the many Americans whose standards of living had been destroyed by waves of imports, not from a small island state, but from one of the world’s giant economy. Trump’s actions were decisive as well as unexpected by the Chinese. They have contributed to a general crisis for the Chinese economy.

China has claimed that her economic growth has been little short of a miracle. In fact China’s GDP per capital today is US$450 or so (nominal) which puts it in the bottom forty percent of the world, behind Brazil, a bit more than half of Uruguay, but ahead of Paraguay. This is better than where China was under Mao’s regime, but it is no miracle that should strike awe into the hearts of other countries.

The problem is that the Chinese leadership is simply not familiar with previous examples of growth: the “economic miracle” of post World War II Germany, the development of Japan into one of the world’s most capable and advanced economies (the Western consensus post War was that Japan would subsist indefinitely on foreign aid), not to mention South Korea, Taiwan, Hong Kong, and Singapore among others.

Within a short distance of President Xi’s office work hundreds of academic economists who are as good as any in the world, who understand this. The communist party, however, does not consult them. Hence the lack of fundamental reform that would make China’s growth truly self-sustaining.

To list some of the problems that must be addressed, for no more is possible in a short essay: Capital allocation must be determined by market interest rates, or else over time misallocation will lead to a deformed and dysfunctional economy. Private ownership of land and production is essential, for the party has shown itself incompetent. Chinese money must be convertible—otherwise no one knows what it is really worth, an impediment to trade—and perhaps most importantly, the financing of what appears to be growth by state borrowing must end. Or perhaps one should say, “will end” for with debt perhaps 400% of gdp, the debt will liquidate itself, though inescapable bankruptcies, bank failures, etc. China has several times pumped her economy up by profligate lending, leaving banks technically insolvent, but bailed out by the government. Today, with the situation at its worst ever, China continues to pour government created money into the bottomless pit of impending crisis, which today is no longer even postponing the reckoning.

This reckoning is natural, because state run or communist economies do not function over the long run, but rather eventually destroy themselves. Surgery is needed, not transfusions, steroids, and rouge on the face. Politically, however, China’s government seems to believe that they can continue, which means that periodic economic crises and ineffective or destructive reactions will become the norm.

Although the weaknesses are inherent in the communist system, China could manage as long it China could pump exports into unregulated American markets, at the cost of American jobs, while pumping in billions of dollars in foreign direct investments from advanced countries (one wonders who makes these strange decisions). Trump did not create the deformed Chinese economic system, but his unexpected insistence on fairness, balance, and legality, brought to China the kind of sudden shock felt by gamblers when police unexpectedly enter their illegal casino from all directions.

*

So what will be the consequences for China and the world?

Chinese diplomacy has long been based on the assumption of limitless funds with which to bribe foreign officials or lend to impoverished government, which often leads to recipients being trapped. Unable to repay, they must transfer assets, such as ports, to China. Estimates are that at least $100 billion have been so expended. Without considering why that money is not invested in capital-hungry China (much is probably disguised expatriation of funds), one can be certain that Chinese yuan diplomacy will run into trouble.

Likewise China’s immense military building program, the ostensible purpose of which is to make China the most powerful country in the world by 2049. A good question is how one understands “power” in a world where an attempt to coerce almost any other country would lead to hideous, perhaps suicidal, war. China has already made immense investments in a military establishment that contains some real excellence and thus danger for the rest of the world, making it known by ever more distant naval voyages all over the world. The cost of maintaining such a military is already vast, even without including research and development. Chances are good that given the fatal risks associated with using it, this great military folly will simply rust.

Most pressing, however, are domestic problems. Foreign investment is being withdrawn, factories closed, source chains for other countries rearranged, for in fact China has nothing to offer that distinguishes it from any number of countries with whom she competes to export.

A huge population has been promised a certain standard of living and retirement by the government (this is in the urban sector. Peasants are effectively on their own). No one knows how these promises can be kept, any more than those of such American programs as Social Security and Medicare, except by inflating the currency so that the promised amounts are delivered, but in currency having no buying power.

The probable result of this insoluble problem will be unrest, followed by the gradual fracturing of the party into competing factions promoting different solutions. This is not unlike the situation that Gorbachev faced on taking power in the USSR. The end of that country is in the West usually called a “collapse” but neither the Russians nor the Chinese, who arguably know best, use that word. Rather the word in Russian is распад “raspad” and in Chinese jieti 解體 or in both languages,  “disintegration.” How China can avoid such a gradual pulling apart of its component pieces, even if all remain Chinese, is hard to say. One may recall the prescient words of Hu Shih 胡適 （1891-1962） China’s most important early twentieth century intellectual, that left alone and loose China stayed unified, but that attempts to unify and standardize (such as those of Xi Jinping) lead to division and disintegration. As the head of the KGB, the USSR was like a chocolate bar, held together by thin scorings, designed to be broken. One can see the lines of separation already inscribed on the map of China.

 Now we must mention Hong Kong. The unprecedented mass demonstrations against China’s attempt to force an unwanted law on the population, are perhaps a first sign of this problem. They were entirely unanticipated and look to be less possible to defuse than thought. This is the case, even according to Beijing-leaning politicians, unless the basic demand for universal suffrage is met. China has little to fear. An elected chief executive would be at pains to keep good relations with Beijing.

Beijing evidently does not share this view, though the complete lack of action, at time of writing, by the central government, suggests that they have no idea what to do. Many will say that ultimately “resort to force” will be required. This will likewise be more difficult than, for example, the Tiananmen Massacre of 1989, where the naïve protesters did not believe the People’s Army would fire on them. Indeed the People’s Liberation Army was profoundly opposed we have learned this just passed thirtieth anniversary, when Beijing finally admitted that yes, something had happened. Furthermore, Hong Kong is worth trillions of dollars to China. To destroy it would be worse than crippling Shanghai.

This author was told much the same thing, in an indirect manner, during a social visit to a now-deceased former PLA general of the highest rank. This means that the army cannot be relied upon by the party, which is a recipe for possible real trouble.

*

How, then, does the tariff war end? Rather than seek compromise China has unwisely nailed her flag to the trade flagpole, so rather than some sort of modus vivendi, we can expect increasingly embittered strike and counterstrike, with China unable to control the situation.

The incompatibility of the Chinese system with the world trading system has always meant that China could only swim in the deep economic water if special exceptions were made for her, such as pretending to recognize her currency as more than paper. Although China imports and imitates foreign goods in a way the USSR never did, her fundamental economic structure—the girders that support the structure—are still Soviet 1950’s in arrangement. Free economies cannot interact with such systems at any level of depth, for one cannot connect then, any more than one can screw together pipes having different threads, or mix AC and DC current. China will face a choice of either so remodeling as to be a genuinely free market economy, or gradually falling behind.

President Trump is famous for The Art of the Deal (1987). This is what he knows, not international politics. China, however, is educating him. His hopes for a “really great” settlement between China and the United States were once common. Now he seems to have cooled on his friendship with President Xi, who has shown himself untrustworthy. He has also come to understand better that even if Xi wanted to make the Chinese economy compatible with that of the rest of the world, he might well be unable to do so. Trump will likely then impose more tariffs and general restrictions on illegal Chinese activity, while pushing cooperation, by no wish of his own, into the distant future.

Tariffs are not optimal solutions to trade problems. They do, however, radically change incentives and trading patterns. In this case they are hurting China, which has no effective way to deal with them. The longer problems go unsolved, the more the world economy will change its structure, making China more marginal. Her “rise” will be seen as a bit of outdated rhetoric from a time of unjustified but overweening confidence.

As that happens, it will become clear that Trump’s tariffs (and it is difficult to imagine the Democrats lifting them) did more than protect American steel and other products. They provided a nudge that accelerated basic clarification and change of the world economic system, one hopes in the direction of fairness, legality, and transparency.

（This paper was written on 18 July.）