In the "Trade Wars" Saga, We're Still in the Prequel

For this episode of Motley Fool Answers, Robert Brokamp and Alison Southwick wanted to consider one of the biggest macroeconomic dangers facing Americans today: the full-blown trade war President Trump seems determined to heat up with China. To help, they brought in an outside expert: Scott Kennedy, the director of the Project on Chinese Business and Political Economy for the Center for Strategic and International Studies -- a nonpartisan, foreign-policy think tank.

In this segment, Kennedy digs into the history of U.S. economic protectionism and the causes of today's trade deficit; contrasts the facts about our current trade imbalance with the misstatements coming from the president about it; and considers the recent changes in Chinese politics and policy that have poured oil on the flames of what had for years been a simmering conflict. He also considers our options and the risks we face if we do nothing in the face of China's enhanced brand of economic aggression.

A full transcript follows the video.

This video was recorded on April 24, 2018.

Alison Southwick: We're going to get into investing more generally in Chinese businesses and companies and what the climate is like out there. Learn from what you've learned over there interviewing businesses. But for now, let's focus on what's been in the headlines and that's, of course, been the threat of a trade war. For a brief history should we talk about Smoot-Hawley? That was in the 1930s, so I can't tell if that was the last trade war, or if people just like to talk about it because it has such a fun name? Is it relevant for us to talk about?

Robert Brokamp: Wasn't it in Ferris Bueller's Day Off, too?

Southwick: It was. "Bueller. Beuller."

Brokamp: There you go.

Southwick: Is it relevant for us to talk about this in light of what we're going through now, or is it not a history-repeating-itself sort of situation?

Scott Kennedy: I think we've got something that's a little bit different. I think people like to talk about Smoot-Hawley because it came in the early 1930s just after the stock market crashed. We were looking for ways to revive the economy, and so we had the very smart idea of restricting government spending [along with a monetary policy of] putting up trade barriers to help us against trading partners, and the combination of those things didn't help. Quite the opposite.

This situation is a little bit different because we're in a moment when the American economy and the global economy is growing relatively fast, partly because we've had tax cuts, but generally because we've figured out how to get beyond the global financial crisis of a decade ago.

But we've got other challenges. We've got the challenge of globalization and the effect that it's had on manufacturing, on income gaps between rich and poor, and the rise of China at the same time [and the thought that China's rise is a factor affecting the gap between rich and poor, and manufacturing]. The reason that we're talking about [and perhaps going to launch into a trade war] has a different type of origins than we had in the 1930s and I'm happy that it's a different environment.

Southwick: Trump is saying that Chinese companies have an unfair advantage over Americans. A trade deficit of $500 billion a year. Intellectual property theft of $300 billion a year. Can you explain exactly what he's accusing China of doing?

Kennedy: It's probably not going to surprise most listeners that occasionally the president engages in some hyperbole, and so the specific numbers you just mentioned [which he has mentioned on occasion] aren't exactly true...

Southwick: But I read it on Twitter!

Kennedy: ... and so it must be true.

Southwick: I read it on the internet!

Kennedy: Let's take the listeners of the podcast down a crazy road of some alternative facts that they might want to listen to and then weigh it against what they see on Twitter. I would say yes, largely the president is right in spirit that we have an unfair relationship with China.

It hasn't always been that way. I think when China joined the WTO [World Trade Organization] it made a genuine effort to adapt and modify its tariffs, reduce non-tariff barriers, and it spent about a decade trying to do that. It didn't do it perfectly, of course. It tried to learn the rules of the system [both the good ones and the bad ones] that help you game the system, but since Xi Jinping came into power in late 2012 [five and a half years ago], China's been on a path to figure out a way around these rules.

[Xi] is a very nationalistic leader. Chinese people don't have a middle name, but if they did "control" would be Xi Jinping's middle name. He's very much interested in controlling domestic political environment, China's economy, increasing Chinese global influence, and he's not really interested in what the existing rules of the game are.

The Chinese have very loyally moved away from their commitments and, given the size of China and the size of their financial system, they have gone headlong into industrial policy focused exactly on the areas in which the U.S. has comparative advantage; in high tech and the most important parts of our economy that provide productivity growth.

The two economies used to be primarily complementary. Now they're increasingly competitive, and China's competing using unfair practices. President Obama and others tried to use an approach of patiently pulling China into a rules-based order in hoping that they would be socialized into that system. It hadn't really worked out as planned and Trump ran on the campaign promise that he'd be a lot tougher. We are seeing him implement that campaign pledge and it's, of course, generating a lot of anxiety among everybody.

Southwick: It sounds like you're saying his concerns are legitimate, but is he going about this the right way? Economists hate tariffs. That's what I've been reading in everything. Right in principle, wrong in execution?

Kennedy: Sure. I think he's got the general picture right that things have been unfair, and that there are consequences for the American economy and the global economy because they have been unfair. We have a bilateral deficit with China that's not $500 billion. It's about $375 billion in trade and goods. If you count services, the U.S. has a big surplus in services with China, so the deficit would be closer to about $335 billion a year. It's still a big number. It's been getting bigger and this year it's been getting even larger.

Now the source of that deficit isn't really unfair practices. It's primarily the fact that the U.S. consumes a lot more than it saves and it's got to consume from abroad when that's out of balance. We consume a lot internationally and China's a big provider. Also, manufacturers have all moved to China. Many things are assembled in China. All of the value of those products -- even if only part of the value was created in China -- are counted in China's export column. In our imports, as well.

Nevertheless, things are genuinely unfair because China uses industrial policy that promotes domestic Chinese companies ahead of foreign companies that are exporting to China or that are investing in China, and the scale of China's effort means that it has effects not only on individual companies that are competing for market share in China, but on global markets.

A great example would be the solar industry. A little over a decade ago China decided that it wanted to go into the sector and threw scads of money at the sector. The result of its bottomless pit of money being invested is that no one else could survive, so it destroyed the rest of the global supply chain in solar and dumped solar on the global market.

This, for some consumers who want cheap solar panels on their roofs was good, but for the rest of the competition it was highly destructive, and we ended up locking in a type of solar energy system which wasn't ideal. Actually, there's much better types of ways you could translate sun power into electricity than the type that is commercialized now.

And there's a chance that China could do that in many other industries: in semiconductors, in electric cars, in robotics and AI; all the things that we are betting our future on, the Chinese also could use that bottomless well of money and protectionism to crowd out good investors. That's what I'm worried about. I'm not worried about so much any individual company, although I know investors are, but I'm worried about the health of those business sectors and the vibrancy of the business models, which everyone depends on.

So, using pressure to try and get China back into the fold is definitely risky, because China's strong. China's got lots of resources. Their president, Xi Jinping, does not have protesters out on the street telling him or lobbying him to say, "You know, gee, this trade war is really going to hurt us if you retaliate against the United States." There's no Motley Fool podcast equivalent in China..

Southwick: Not yet. I should really get on that!

Kennedy: ... raising worries and concerns about how China might respond. Media is very controlled in China, now, particularly compared to before Xi Jinping came into power. So, Xi Jinping's domestic political situation allows him, basically, to whack back without major consequence.

That's a big challenge for the U.S., and so taking China head-on like this is quite risky, but I guess I just wanted to emphasize not doing anything is also risky. We know if we end up in a world dominated by the China model [where state funding replaces private sector funding and these business models are deeply damaged], that's not good for anybody, either. So, we are in a very difficult position.