Trump’s Most Chilling Economic Lie

Donald Trump has threatened to upend the post-World War II geopolitical order.  What he finds most vexing about that order is the rise of China. Today, China is the largest trading economy in the world. In terms of purchasing-power parity, it actually became the largest economy in the world in September 2015. Like it or not, there is simply nothing that Trump can do to change these facts. What he can do is make America’s economic position worse—possibly far worse.

President Trump sees the world in transactional and zero-sum terms—if something is good for China, it must be bad for the U.S.  By contrast, economists see the world in much more nuanced ways: if globalization is well-managed, it can be a positive-sum game, where both the U.S. and China gain; if it is badly managed, it can be negative-sum. So, too, for a retreat from globalization: the erection of barriers to trade and the movement of people and ideas more likely than not will be one in which the U.S. almost surely will lose. And depending on how China manages things, it is possible, even likely, for China to gain.

Behind Trump’s promise to “make America great again” lie many fallacies. The most important fallacy is that America’s place in the world can be restored to the one it occupied after World War II, when Europe was still recovering from vast devastation and most developing countries were still European colonies. It can’t be. Indeed, the U.S. will not even be able to maintain the place it held in the immediate aftermath of the fall of the Iron Curtain, in 1990. We inhabit a multi-polar world, and there is nothing that Trump can do about it.

Economists have explained that if we raise our tariffs and create other protectionist barriers to the goods and services of other countries, in violation of our trade agreements, those other countries could and probably would retaliate—propelling the world into the kind of downward spiral that occurred 87 years ago when another Republican administration again went isolationist.  Following that, U.S. exports fell by some 50 percent—contributing to our Great Depression.  At the most recent World Economic Forum, in Davos, it was disconcerting to hear rumors of the Trump team seemingly preparing for a trade war. As with a country thinking about launching a real war—calculating the number of tanks and troops relative to those of the enemy—the question they seemed to be asking was: who would lose more, who could better sustain the damage?   Of course, both sides lose in any war, including in a trade war. There are no winners.

Trump’s team may be tempted to conclude, naively, that because China exports so much more to the U.S. than the U.S. exports to China, the loss of a huge export market would hurt them more than it would hurt us. This reasoning is too simplistic by half. China’s government has far more control over the country’s economy than our government has over ours; and it is moving from export dependence to a model of growth driven by domestic demand. Any restriction on exports to the U.S. would simply accelerate a process already underway. Moreover, China’s government has the resources (it’s still sitting on some $3 trillion of reserves) and instruments to help any sector that has been shut out—and in this respect, too, China is better placed than the U.S.

China has already shown how it is likely to respond if Trump should launch a trade war. At Davos, President Xi Jinping came out as the great supporter of globalization and the international rule of law—as well China should. China, with its large emerging middle class, is among the big beneficiaries of globalization. Critics have said that China does not always play fair. They complain that as China has grown, it has taken away some of the privileges, some of the tax preferences, that it gave to foreigners in earlier stages of development. They are unhappy, too, that some Chinese firms have learned quickly how to compete—some of them even appropriating ideas from others, just as we appropriated intellectual property from Europe more than a century ago.

It is worth noting that, although large multinationals complain, they are not leaving.  And we tend to forget the extensive restrictions we impose on Chinese firms when they seek to invest in the U.S. or buy high-tech products. Indeed, the Chinese frequently point out that if the U.S. lifted those restrictions, America’s trade deficit with China would be smaller.

China’s first response will be to try to find areas of cooperation. They are experts in construction. They know how to build high-speed trains. They might even provide some financing for these projects. Given Trump’s rhetoric, though, I suspect that such cooperation is just a dream.

If Trump insists on an adversarial stance, China is likely to respond within the framework of international law even if Trump puts little weight on such agreements—and thus is not likely to retaliate in a naive, tit-for-tat way. But China has made it clear that it will respond.  And if history is any guide, it will respond both forcefully and intelligently, hitting us where it hurts economically and politically—where, for instance, cutbacks in purchases by China will lead to more unemployment in congressional districts that are vulnerable, influential, or both. If Boeing’s order book is thin, it might, for instance, cancel its purchases of Boeing planes.

Surprisingly for someone who prides himself on being an artful negotiator, Trump seems to have succumbed to several fallacies in negotiations (though he has intuitively grasped some of the lessons). The theory of negotiations has received a large boost from the development of a branch of economics and mathematics called game theory. Several Nobel Prizes have been awarded to those making significant advances in this field.

One of the central tenets of game theory is that the outcomes depend on the threat points—what happens to each side if an agreement is not reached. Trump seems to think that by insulting your opponent, you will make your opponent feel weaker—and you yourself will do better. He also seems to think that strutting like a peacock and explaining how great you are will likewise make your opponent feel weaker—and, again, you yourself will do better.

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Game theory was developed, however, on the assumption of two rational rivals interacting with each other, each of them thinking about what the other was thinking about his possible options—in an infinite recursion. Game theory also explained that a genuinely irrational player—a crazy man—may actually do better in negotiations. It is this part of game theory that Trump has intuitively understood.

Game theory was used to analyze nuclear deterrence. It was assumed that no one would rationally take an action that would lead to nuclear obliteration of both sides. But a crazy person might make a threat and actually execute it even if this meant his own destruction. What would under other circumstances be a non-credible threat thus becomes credible.  This may have served Trump well in his business and could explain some aspects of his behavior.

However, countries, and even people, are often different from the theoretical models of game theory. They are affected by pride and self-respect. Crazy or irrational behavior on one side may elicit similar behavior on the other—to the detriment of both. Citizens of one country will criticize their leaders if they are seen to give in to the temper tantrums of another country’s leaders. Seen from this perspective, what Trump has been doing has been particularly counterproductive. By belittling others, he makes it all the more imperative for them to show that they are strong.

One of the important lessons of international negotiations is never to put the other side in a politically unpalatable corner. Trump may believe that raising the issue of Taiwan strengthens his bargaining hand, by showing China that if it doesn’t make a deal on trade, the U.S. can make its life uncomfortable elsewhere. If this is what he believes, then he has badly misjudged China and shown impressive ignorance. Taiwan is not up for negotiation. It is a subject that cannot and will not be part of any trade negotiation; will not even be part of the backdrop to any trade negotiation. No Chinese government could make a concession in this arena. No Chinese government would think that it is a matter in which the U.S. has any say. Trump’s raising the issue does not strengthen his hand; it only increases distrust, making it perhaps more difficult to reach a deal. Trump finally seems to have realized this, and he has now reassured President Xi that he does not plan to upset the traditional U.S. one-China policy—a move widely viewed as giving to China the first-round victory in what Trump promises to be a long fight.

Just as problematic is Trump’s wall with Mexico. No Mexican government could endorse the idea, let alone agree to pay for it—that government would not survive. Trump has put himself in a corner where he must return from any negotiation with Mexico with an agreement that he characterizes as having Mexico pay for the wall. But Mexico will hear anything that Trump says to Americans, and if he so characterizes any agreement, the Mexican government will be quick to give its rebuttal.

The very Americans who have been among the losers of globalization stand to be among the losers of a reversal of globalization—including a trade war.  History cannot be put into reverse. Technology has proceeded in a certain way based on the premise of global supply chains. Disrupting the global supply chains would be costly and would increase the prices of goods that Americans buy—especially the mass-marketed goods that have kept prices so low for the goods purchased by ordinary Americans.

These global supply chains are complex, forged by the ever-changing realities of comparative advantage. The goods we consume—smart phones, say, are the product of contributions (parts, labor, ideas) from many countries. While the phone might be assembled in China, the intellectual property behind the phone—the research that made it possible—is largely American, while Japan may provide the largest “value added” in terms of components. As part of the largest consumer market in the world, American consumers are the big beneficiaries of these more-efficient supply chains. And there have been major macro-economic side benefits: because these efficiencies translate into lower prices means that inflationary pressures are reduced, which  allows central banks to take more expansionary stances. Alan Greenspan may have prided himself on containing inflation during the 19 years of his reign, but credit really goes to China and to the development of global supply chains.

An important question is: will a trade war create jobs?  Almost surely not. If we target our wrath on China, much of the production will simply shift elsewhere in the developing world. This is already happening. As China’s wages have increased, the country has become less competitive. Ethiopia is now a big shoe producer. Vietnam is a big textile producer. Firms have learned how to source their products in the cheapest possible way.

If we target imports more broadly, the exchange rate will adjust, largely undoing the impact of any protective tariffs—a higher dollar will largely offset the effect. Indeed, as a matter of basic macro-economic logic, the package of policies being pushed by Trump almost ensures that this will be so.

Trump has begun his interactions with China as a bully—or, should I say, like a bull in a China shop. China, of course, would prefer constructive engagement to a trade war. It could imagine helping America build the high-speed railroads it desperately needs—and perhaps even help to finance them. It could help build other infrastructure projects, like our airports or seaports. It might send more students to our schools. But this path of constructive engagement is far different from the one on which Trump has set forth.

Trump’s new protectionism—putting America first—will not help those he claims to speak for, and it will not help the economy as a whole. It will give us a country whose influence in the world is by far diminished. The world will become a less-friendly place, either in support of our values or of our interests. The U.S. was able to play the role of leader of the free world partly because of the size of our economy and of our military forces, but partly also because we were trusted. Others recognized that, in the end, we would do what was in our self-interest—no American president could do otherwise—but we took an enlightened and long-term view of what “self-interest” meant. In announcing his “America first” policy, Trump is, in effect, announcing that we will be selfish and shortsighted—a country that cannot be trusted to honor past commitments and therefore cannot be trusted to honor future ones.