“China vs US” tariff wars – A repeat of “David vs Goliath”

Global markets rattle amid escalating US-China tariff wars

The world is in the middle of an escalating tariff war between the US and China. The reverberations have been felt in most markets worldwide, and with no signs of a backdown by either country, the road ahead appears murky. However, that is only if one does not understand the principles of trade, currencies, and economics.

As I see it, there is only one way this war will end – By China replacing the US as the dominant economic force on this planet and the US Dollar being replaced by Gold as the world’s reserve asset. The competitive advantage that China has created will stay for decades, similar to the US enjoying the dominant position during the entirety of the 20th century.

Another definitive consequence of the trade wars is going to be downgrading of US treasuries from what is seen as the safest asset on the planet today to several notches below the current grade. The end game would be when the treasuries get downgraded to “near junk” status, but that is still a few years away.

The decline of the US – both the economy and the Dollar – started almost very early in the 20th century, i.e., 1913, with the formation of the US Federal Reserve. But there was so much momentum and lead that the US had built up over the previous century under the classical gold standard that the decline was hardly noticeable. Similar to what Max Weber outlines in his chronicle of the decline of the Roman Empire, the culture of rugged individualism and liberty that the US was known for was conquered from within.

The seeds of the precipitous part of the decline were sown much later in 1971 with the closure of the Gold Window. This ability to create “currency out of thin air” provided a carte blanche to the US Government to expand its powers within and outside the US. This growth in government came at the expense of the private sector, which is the productive part of the economy. This restraint of gold on the government was first unshackled in 1913 with the formation of the Federal Reserve, and eventually removed entirely in 1971.

Many readers may not be aware that the US government was funded almost entirely through tariffs on imports until 1914. Income Tax was introduced as a “soak the rich” plan to eliminate tariffs that were paid for by everybody, and instead, a small fraction of the population would pay Income Tax.

Donald Trump is right when he says Tariffs were used to fund the government entirely at some point. But what he doesn’t know, or at least doesn’t reveal, is that government expenses as a percentage of the economy used to be less than 2% at that point in time and not 24% as they are today.

Trade – Who benefits?

With so much misinformation, it is better to start from the basics. At the outset, a trade benefits both parties involved in the transaction. When one buys a cake of soap from a retailer, it is because one prefers the soap to the currency used to purchase it. Similar is the case with the retailer who prefers your currency to the cake of soap. This is an immutable truth that trade benefits both parties involved, as otherwise, it would not happen. The trade occurs even in extreme cases of ransom/ extortion because both benefit.

A trade doesn’t imply that both parties benefit equally or even near equally. This is not only valid for the extortionist case above but also for legitimate transactions. For example, many customers have railed against NVIDIA for the exorbitant pricing using its “temporary” monopoly power in a specific category of chips. But in all these cases, it is indeed a voluntary transaction as NVIDIA is not forcing any company to buy its chips. Customers are buying ONLY because they are better off with these “overpriced” chips than without.
Similarly, the US imports products from China only because the citizens/residents/users benefit. The follow-on question should be obvious at this stage: If trade benefits both parties, does it stand to reason that “tariffs” hurt both parties? Of course, yes. But in very unequal ways, as I will explain in this article.

Now, before getting into the details of tariffs, it’s good to correct certain misperceptions regarding the popular biblical fable of “David vs Goliath”. The usual narrative of a “victory of the underdog” is a complete misrepresentation. The truth is that Goliath never stood a remote chance of defeating David in this battle. Before explaining, think of how to defeat Bruce Lee in a one-on-one duel: the answer is simple. While Bruce Lee might come with his karate paraphernalia, you go with a loaded rifle that has a 100m range, and shoot before Bruce Lee gets anywhere near you. Another example, how can one defeat Messi? Simple again: engage him in a game of chess. The path to victory lies in making the opponent’s strengths irrelevant in the battle. Change the frame of reference.

That’s what happens in David Vs Goliath as well. The latter, Goliath, is a lumbering giant figure who comes to the battle with heavy armour, shields, and swords – essentially prepared for short-range combat. David is an expert at defending his flock of sheep from lions and wolves using his sling with devastating effect. David can very accurately aim from hundreds of yards away, and that’s exactly what happens in the famed battle. Goliath lasted all of a few seconds and did not stand a chance of getting anywhere near David to use his sword.

For somebody who understands military warfare, Goliath is the real underdog in the battle, who had no chance of winning. If there is any lesson to be learned, it is the misperception of the overwhelming favourite as the underdog. This is as true today for the China Vs US trade war as it was for David Vs Goliath. For somebody who understands economics and trade wars, the US is the real underdog with a near “0” probability of winning the tariff war with China. Or to use a terminology that Trump would understand, “China holds all the cards”.

The US-China trade equation

For starters, China exports 200% more than it imports from the US. So, the bigger loser is going to be the US, as they will pay substantially higher for these products than they are paying today. In many cases, not only would it be a question of a higher price but also much longer lead times and lower quality, even assuming there are manufacturers outside China for these products. For example, about 80 to 90% of all iPhones are assembled in China. It is not possible to replace China in the short to medium term for many products, and tariffs simply would imply a higher cost of products and reduced demand.

The way forward for China

The tariffs might as well be a blessing in disguise for China. For a long time, the US consumer has been taking advantage of the Chinese manufacturer, who not only makes these products at a low price but also lends money to the US consumer to buy them. Over the decades, China’s accumulation of treasuries has lent strength to the US dollar, allowing the US consumer to live way beyond their means.

Sure enough, the disruptions in selling to the US consumer today is going to require China to rewire the supply lines as well as retool the manufacturing infrastructure to cater to the needs of other consumers, more particularly the local Chinese consumer. The transition is going to render tens of millions unemployed in the interim. However, the key is that they have the manufacturing infrastructure and the skills/discipline to operate the same.

The solution to the Chinese problem has to necessarily come from a strengthening of the Chinese Yuan vis-à-vis the US Dollar. Another way to achieve the same outcome would be to launch the BRICS gold-backed currency and use it for all International transactions and also as a Reserve Asset. Under the Gold Standard, China’s trillion-dollar trade surplus would have automatically ensured this without having these massive trade imbalances built up over decades. China has to realize that its 1.42 billion people are capable of consuming what 350 million Americans do today. The purchasing power of the Chinese consumer that would allow this can and will come from a currency revaluation. That will also ensure that the Chinese GDP will become larger than the US GDP.

Over the last 25 years, China has developed extensive trade networks and is now the largest trading partner for most countries. Quite unlike at the start of this century, when the US was the predominant exporting destination for Chinese manufacturers, today, China has become an established trading partner worldwide, as seen from the figure below. The revaluation of these other currencies vis-à-vis the US Dollar will also permit a greater share of Chinese exports to these countries.

What does it mean for the US?

Quite independently of what Trump does with these tariffs, the US consumer will see empty retail shelves in the months ahead. Trump’s tariffs are merely accelerating the decline of the US consumer, as the lifeline extended by other countries, particularly China, is unlikely to be revived. Maybe Trump is drawing inspiration from Nietzsche’s quote, “That which is falling deserves to be pushed,” and is hastening the downfall of the US.

Most US consumer-focused industries – Retail, health care, banking and financial services, housing, etc. are looking at a downturn that will last for decades to come. If something appears as light inside the dark tunnel over the next few years (or “green shoots” as the media would like to call it), it is very likely to be an oncoming train and not the light at the end of the tunnel.

The US has to build the manufacturing infrastructure all over again. For that to happen, the culture of savings that has been destroyed by reckless monetary policy starting from the days of Greenspan has to be re-created. The US government has to return to the basics – limited government, sound money (or at least balanced budgets), “trade with all and entangling alliances with none,” and if possible, a return to the “Republic” form of government as envisaged by the founding fathers. That the US will be a declining power for decades is a given. The steps listed above will permit a re-emergence from the ashes that the US Dollar will literally become.

As in the famed David-Goliath battle, the perceived underdog, China, will surely emerge victorious. But once the economic fundamentals are understood, it is easy to see that the sinking ship in this war is the US economy. The fatal crash happened in 1971, and the US can never really engage in a battle with that monumental handicap. It can also never restart a meaningful recovery without a return to sound money en route.

What does it mean for India?

“Enlightened self-interest” should be the guiding principle in choosing sides in the China vs. US trade war. At all costs, we should avoid moralistic-sounding arguments like “supporting democracies,” etc. We also cannot afford to take the “Side of Peace” as we did in the Ukraine-Russia conflict.

At this stage, being a friend of the US is far more dangerous than being its enemy. The US is a sinking ship, and if we tether with it, we will also sink. Our economy is not meaningfully strong enough to alter the outcome of the trade wars, and we are better off siding with the winners and extracting a meaningful proposition for the support.

Note:
1. Text in Blue points to additional data on the topic.
2. The views expressed here are those of the author and do not necessarily represent or reflect the views of PGurus.

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