This Is What A Trade War With China Would Actually Look Like

think I know what you're talking about. It's trade, right, Yeah, But you're actually right that we're in this moment for markets where there just seems to be a lot going on again, lots of different cross winds and narratives and themes, whether it's anxiety about rising inflation, concern about the FED, the changing leadership in the market with regards to text docs, and now, as you say, trade has really come to the fore as a major thing that people are trying

to wrap their heads around. Right. So, what we've seen just over the past couple of weeks is the Trump administration unveiled a big set of tariffs on goods imported from China, and then China retaliated. They announced I think it was tariffs on about fifty billion dollars worth of goods including aircraft parts, soybeans, and cars, which are some

big ones for the market and for the economy. Right because a few days earlier, China had announced some retaliatory tariff measures, but they were on pretty minor stuff like jensing exports, which I doubt the U S exports a lot of jensing too China, or macadamia nuts and stuff like that, or wine earlier. Stuff that's kind of a

little bit more marginal. But when they announced the tariffs on soybeans, given that that's a major crop in the US, and given how much China consumes of soybeans, then people are like, WHOA, this is maybe a little bit more serious than we expected. Right, this is the week that everyone decided that soybeans were actually very very important. Um, we are sort of dancing around one issue, Joe, that we've been speaking a lot about internally, and that what

do we call this? Are we calling it a trade war? Right? We've had this discussion internally because I kind of get the impression that trade war is one of these things that doesn't have a very crisp definition. It's kind of like you know it when you see it. So some people are using that term, others aren't. But that's obviously something we have to figure out. And are we just seeing sort of a standard early stage negotiation or is

this a serious thing? And that's sort of what we're all trying to uh wrap our heads around, right, And some people are being really cute about it and calling a trade skirmish or a trade standoff, or a trade tiff, any number of trade war. All right, So for the purposes of this podcast, can we just agree that we're going to call it various things and no one can get mad at us. That sounds good. Well, I think we actually have the perfect guest to tell us exactly

what we're seeing right now. We're going to be speaking with Brad Setser. He's the stephen A. Tannenbaum Senior Fellow for International Economics. He's written for years about trade and other macroeconomic issues. He blogs. He used to be at the Treasury. Anyone who follows this space has has surely seen his work. He's here with us now, Brad. Thank you very much for joining us, my pleasure. So, Brad, uh, what is a trade war? I think a trade war

is a series of measures. I guess a significant set of trade restrictive measures by one country that prompt an equally significant response from another country. And you could call that a trade war. You could say you need another round of escalation before you have a trade war. I wouldn't use the term trade war if you're playing in what you might call the standard trade remedy space, a

standard dumping case, a standard safeguards case. But the US is doing a three oh one case, which is a tool that hasn't been used for a long time, and fifty billion is it's not enormous relative to the size of our economy, but for a trade measure or it's quite large. So if we proceed to the stage where we actually implement the tariffs, which we haven't done, and if China proceeds to implement the tariffs in response, I think for all intents and purposes, that would meet a

reasonable standard for a trade war. So we want to focus on what actually happens to the international economy when such a trade war is underway. But before we do, this is a big question that's currently hanging over markets and people who are watching this entire spat unfold. What are the prospects, in your opinion, that we get some

sort of compromise before the tariffs are actually enacted. I'm having a hard time getting a clear read on that particular issue, in large part because I don't quite know what the Trump administration views as an acceptable compromise. There's been a lot of criticism that the Trump administration hasn't really articulated what trade peace would look like, what set

of concessions would be enough. I think the Chinese are willing to offer some modest concessions, and maybe they will go beyond the more modest concessions that they've been signaling, But I don't know that the US has decided on what would constitute an acceptable offer. Can I just say before we go on that I am very relieved, And then I'm actually excited that you say that if the current measures went into effect, we could call it a trade war, because I was worried that you're gonna say, oh,

everyone needs to be less hysterical about this. So it's nice to talk to an expert who has given us the green light to use the exciting language. So I just want to say thank you. Right, And a trade war is not a shooting war. A trade war is a period of economic hostility. Tell us, you mentioned the difference between the standard trade remedies, the anti dumping stuff, stuff like that in a threal one case. Just walk us through the differences between those two things. So you know,

a standard emmedy, a safeguard, or a dumping comes. When a sort of specific product is flowing into, say the US, the industry petitions for relief either on the grounds that there's been a surgeon imports, which is a safeguard, or on the grounds that the other country is dumping or unfairly subsidizing its products, in which case there would be a dumping duty or countervailing duty. All these things go

through a standardized process with lags. At the end of the day, the President has to authorize the tariffs in the case of a safeguard, but they are approved within the rules remedies that are available, and after the fact people will litigate whether the dumping criteria or used correctly and whether there really was a subsidy. So they maybe be cases in the w t O, but these are sort of the within the system safety valves relief measures.

A three oh one in this particular case, is aimed at practices which the U S tr argues imphurt the U S economy that fall outside the scope of China's w t O commitments, and because of that, the US is essentially unilaterally imposing tariffs and other sanctions on China in order to change policies where there where there isn't really an argument that China's already agreed in the w t O to get rid of them. So do the

three oh one measures? Do those have a different impact than the sort of more standard anti dumping measures would Well, in a dumping case, you're going to target the sector where the dumping takes place. In a three oh one, you're essentially choosing the sectors where you want to impose tariffs to impose pain in order to try to convince your trading partner to remove measures that you judge to

be unfair. So it's a US determination that China's actions constitute something that impedes American exports and impedes American firms, And as a result of that unilateral judgment, the US will decide on its own what sectors at targets. So there's a lot more freedom and flexibility to broaden out the set of sectors that are covered by the tariffs when you're not responding to a specific concern of a

specific industry that is seeking relief from a flood of imports. Now, President Trump seems very fixated on the bilateral trade deficit with China. He's always growing around that number, I think billion or whatever it is, and he just wants to

see it lowered. And typically the response from economists is that looking at the trade deficit in isolation like that is not a particularly productive way to think about our trading relationship with any given country, or even the idea that a trade deficit with all countries is per se a bad thing, most economists argue, is not a particularly

useful way to think about the scoreboard. So can you, for the average listener, sort of explain why that is generally not viewed as a useful way to think about the relationship. So think about the following set of trading patterns. Say the US is exporting a lot of construction equipment to a third party, which is mining a lot of iron, which is shipping that iron to I guess a second party. I got my math a little wrong. That is taking iron and then selling consumer goods. It is quite possible

that that three way trade would be entirely balanced. I think of it as the US selling construction equipment to Australia, Australia selling iron to China, China selling consumer goods to the United States could be a perfectly balanced trading relationship, but the US would be running a bilateral deficit with China. So there's there's no particular reason why trade should balance between any individual country pair, And when you look at

simply the bilateral balance, that can be quite misleading. The global trade deficit is, I think a little bit different. The global trade deficit indicates that you're either receiving equity investment from the world or borrowing from the world. In the US case, we've been borrowing for from the world for a long time, and the trade deficit represents both you know, we're importing more than we export, but also

that we are building up our external debt. And there's always a question about whether or not that build up of external debt is fueling unhealthy economic expansion, fueling a lot of investment, or whether it's some sense unhealthy that it reflects an excess of spending and excess of consumption, and that we are borrowing from our future wealth. And I would say the US trade deficit is right at

the edge of being a problem. That's my personal view, So I don't I don't view that the any trade deficit is a problem, but I do think that trade deficits can be a problem. Okay, Well, as Joe mentioned, Donald Trump clearly has his own views about the desirability trade deficits. So let's say that all these various tariffs go through and we have an actual trade war on our hands. Walk us through the real world effects that we would likely see, you know, from day one, how

does it actually play out? Well, before we jump to the implementation of the tariffs, I think it's important to recognize that there's a period of comment and the immediate next step will be essentially a review of the U s tariffs, where industries that are believe they're adversely affected will lobby U s DR to change the list, and then after that there's a period of time for negotiations.

Tariffs don't have to be introduced at the end of the common period, so we're not necessarily going to implement tariffs tomorrow. It could come with a significant lag, but let's assume there isn't an agreement that the tariff list stays pretty much as it is. The US was put tariffs on fifty billion roughly of Chinese goods. Some are more final stage consumer goods like TVs. Some are more intermediate inputs into production various categories of parts, parts for

air conditioners, parts for various mechanical devices. In some cases there may not be any possibility to substitute, in which case American consumers will see an increase in price. In the US government was see an increase in revenue. Fifty is ballpark a quarter of a point of US GDP, so the tariff would be, if if fully paid, would be in the order of magnitude of a little over you know, five basis points of GDP, so you know,

meaningful but not giant. In some product categories, though there may be opportunities to substitute, be it US production, or be at production of parts from Europe or Mexico or elsewhere in Asia, in which case you would see trade diverted away from China toward the untariffed parts of the global economy. Then the economy would react to the Chinese tariffs, and there I think it really depends on the sectors China went after the Big Three, or threatened to go

after the Big three. US export categories to China aircraft, soybeans, and autos. With air craft, I think they were pretty they may have been playing it a little cute. They clearly have exempted wide bodies from the tariffs. They may have exempted most of the new seven thirty seven line. There's a debate about whether the seven seven eight Max has a weight that would exclude it from the tariff

or not. They clearly have tariff used seven seven for what it's worth and golf streams, So I think you can argue that that it was designed to avoid immediately whacking Chinese airlines that have large orders on the books for Boeing, And I think what probably matters more going forward is will those airlines continue to buy Bowings or

will they tilt towards air Bus. There's an interesting side note there, which is that China has always tried to play Bowing against Airbus, both to get about our price, of course, but also to induce both companies to shift more production to China, to do offsets, to buy more parts, and to help build up China's own aviation industry. If there isn't a threat of buying Boing, China loses a little bit of leverage in future negotiations with Airbus. So I think China is in some ways constrained in the

aircraft sector. There's another important note though, which is China has its own narrow body aircraft to see nine one nine, and undoubtedly Chinese airlines are going to be buying one nine rather than seven thirty seven s. Or does China have ambitions to have a homegrown aviation company that is on the same scale and capabilities as a Boeing or an air Bus and is that plausible in the medium term future In your view, China unambiguously has that ambition.

China has been working over time to build up in domestic aviations. Whether or not they will succeed at building planes that can compete with the latest generation from Airbus and Boeing, I think, remains an open question. But I I suspect that China won't give up. It's too important, it's too central to the China Plan and to China's own vision of what it wants to become. This China Plan, I don't think, is something that a lot of Americans

are particularly familiar with. The ambitions the country has to sort of develop its own homegrown champions in all these different spaces like medical technology and aviation and semi conductors. Can you just explain to US a little bit about what this plan is and how they've gone about implementing

it so far. So China Dinner fies a set of advanced manufacturing technology sectors, generally you know, medical equipment, semiconductors, aviation, next generation vehicles, and it sets out targets for Chinese production and Chinese market share, Chinese firm and Chinese production inside China to meet the Chinese market. A lot of these sectors are sort of cutting edge sectors where China now is a large buyer of goods made in the rest of the world, So there certainly is a component

in the targets of import substitution. These are products that China now imports, and China has articulated a goal of being able to meet its own demand with its own production and to do so with technology developed and owned by China. So there is a very legitimate trade complaint around these industrial real policy goals. I think the tools

that China uses vary from sector to sector. So how much do the U S tariffs actually play into China's long term ambitions of import substitution, Because you know, if if the US slaps teariffs some things like aerospace equipment and China has ambitions to build up its own industry in the space, then that seems almost like a benefit

to them. Well, I'm not sure that's the case. China and say aerospace needs to develop its capability, and as I mentioned earlier, in order to develop its capability, China likes to play Bowing against Airbus. It got Airbus to build a three twenty line in China. And if the US is saying more or less, if Boeing subcontracts from China, it faces a tariff on anything at imports that would discourage Bowing at the margin from shifting production to China.

Are shifting some of is contracting towards Chinese sub subcomponent manufacturing. And if China is not going to buy any Boeings going forward because of the Chinese retaliation, airbuses incentives change. They don't have to produce aircraft in China to celt to China. They're the only supplier. There's not that competition.

So I think that's the sense in which China is in some ways still constrained by the fact that in some of these sectors it is not yet at the cutting edge of technology and it still needs to play European and US firms off against each other to help it progress up the technological ladder. One of the things you hear, and I think the Trump administration has frustrations about it is the degree to which China demand some sort of transfer of technological know how from these companies

that want to participate in the Chinese market. So I don't know exactly what it does with aviation this idea that these big companies, if they want to access to the Chinese market, have to have some mechanism to give their technology to the local players. Can you walk us through what exactly China does with that and how much that deviates from sort of typical international norms. So this is uh the substance of the three oh one complaint. This is what the US is saying that China is

doing that warrants the unilateral u S tariffs. China, under its w t O obligations cannot condition approval of investment on technology transfer as a matter of policy. So that is one of China's w t O obligations. But there are an awful lot of things that China still can do. So China is not required on the w t O to allow investment into any sector that's a choice that

China makes. In many cases, China can require does require that any US firm wanting to produce in China set up a joint venture, and if the joint venture partner and most of the plausible joint venture partners will be stayed owned firms, given the nature of China's economy, and if the joint venture partner says that as a commercial matter, we will only enter into this joint venture if you agree to transfer technology to our subsidiary where we will

have control, then you have to kind of transfer the technology. It's part of the conditions of the deal. But it is not a matter of government policy. Is a matter of commercial negotiations between two companies. Similarly, saying the electric vehicle space, if you want to qualify for the subsidies for new energy vehicles, well you're much better off if you have a Chinese partner and if the technology has

been moved to China. So you know, there's a there's a lot of sources of pressure given the nature of China's economy, that don't come in the form of formally conditioning as a matter of government policy approval of investment on technology transfer. But have nonetheless created de facto requirements that if you want to supply the Chinese market, it's

pretty hard to do that without producing in China. And if you want to produce in China, you pretty much need a state firm as your joint venture partner, and that state firm can, as a matter of its own policy, so to speak, ask for tech transfer, because if it doesn't get that tech transfer, it will lose out because you know, the joint venture with the European company has agreed to do something a little bit more in China.

So there's there's certainly are many pressure points, and I don't think very many people challenge the core truth of the three oh one complaint. I want to talk about something that comes up whenever we talk about the US China trade deficit, and that is the idea of China retaliating by basically boycotting the US is biggest export, which has to be US treasuries. This always always comes up the idea that China is going to retaliate in a trade war by selling off some of its vast treasury holdings.

How realistic do you think that actually is? And I know there are strong opinions on either side I personally think I was one of the first to use the line that the US's biggest export was treasuries and agencies ten years ago, when the US is running a five percent of GDP trade deficits. It's been one of my favorite lines for a long time. I've definitely borrowed it since then, so thank you. I'm not sure I can claim original credit, but I like the phrase. Let's stipulate

a couple of things. Let's stipulate that Chinese holdings of treasuries are typically a function of China's reserve holdings. Private Chinese investors tend not to buy treasuries. They tend to put money in bank accounts are in real estate, so the vast bulk of the Chinese holdings of treasuries are

a reflection of Chinese reserves. Second point to stipulate is that over time, the amount of treasuries that China holds has tended to move in line with the evolution of China's reserves, been a pretty constant share of China's portfolio over time. And third point is that China's reserves are right now not growing very fast, so you would not normally expect China to be a big buyer right now.

In fact, if you look at kind of the global flow of funds, China's current account surplus, so the aggregate amount that it is lending to the world is smaller than that of Japan, certainly smaller than that of the Euro Area, and well below the combined current account surplus of the Asian newly industrialized economies Korea, Taiwan, Singapore, and you know, just for the sake of argument and not

I would throw in Thailand into that category. So much or even the majority of the financing that the US is getting to support its trade deficit and current account deficit is not right now coming from China. So I think those are kind of important background pieces. This is not two thousand seven, when China's current account surplus was the biggest in the world, and when China was adding six billion to its reserves every year and two thirds

of that ballpark was flowing into US bonds. China, though, of course, does have a large outstanding stock of treasuries, biggest in the world, probably a little bit bigger than it is then shows up in the data the Treasury releases, and China, if it wanted too, could move its portfolio around. We know that during the crisis, China shifted its portfolio. It's sold agencies and it bought treacheries. And by selling agencies, it put pressure on the agency market, so China can

affect spreads in them. Just for the terminology the agency market. There's like Fannie and Freddie, the housing agencies issued a lot of no I just you know, just for the sake of people. The terminology that went into funding a lot of American homes and stuff. That's right, and that was you know, before the crisis, everyone spoke of China's being a big buyer of treasuries, when actually before the crisis,

China was the biggest buyer of agencies. It's it's like one of those little details that is actually quite important that tends to get glossed over. But during the crisis, China shifted its portfolio out of agencies and into treasuries. That undoubtedly caused problems in the agency market. But remember that in Quee one, the started buying agencies and that stabilize the market. I think there's a little bit of a lesson there. If China sells treasuries a it has

to put its money somewhere. It may sell long term treasuries and buy short term bills, which would raise long term rates relative to short term rates. It may sell treasuries and then sell dollars and move into euros or yet that would weaken the dollar, and I think it would cost more problems for Japan and Europe, which would see their currencies appreciate and have difficulty exporting. Or it could just move within the US market moved to the short end of the curve, which is probably the most

plausible option. If it did that, I think it would have a short term impact on the market, but I don't think you should think of it as a one round game. If it's impacting the market in a way that adversely impacts the U S economy, the Fed should logically respond, either by adjusting the pace at which it tightens or by adjusting the pace of the balance sheet

roll off. I think at the end of the day, there should be no question that the Federal Reserve has a much bigger impact on the U. S. Treasury market than China. So, just to sort of some up what you're saying, a lot of interesting points there is that this sort of naive way you hear people talk about it is we borrow a lot from China, one day they might not want to lend to us, and then

we're in trouble. Whereas the more subtle point is, yes, China could change its policies and change the market, but the response would be not as clear cut, it's not as binary, and the moves into some ways could harm them or harm others. It's just it's not as simple as say, your bank no longer willing to extend your credit.

That's right. If you work through all the the reactions and the counter reactions, what eventually happens is the FED is up easy and the dollar ends up weakening, which isn't actually necessarily a bad thing for the U. S. Economy. It's a bad thing, much worse thing in some ways for those who have lent money to the US and dollars and so it's uh. It is hard to imagine

how China could cause a a funding crisis for the U. S. Treasury. Actually, China's greatest leverage comes, at least in my view, when it is buying things other than treasuries, when it was buying agencies, or if it's buying corporate bonds, it's buying things that in the normal course of monetary policy, the FED doesn't typically buy, and so it is much easier for China to influence credit spreads or the agency treasury spread, and a little bit more difficult for the FED to respond,

although obviously we did respond by extending our purchases of assets to agencies. So I think there are subtle ways that China can put pressure on the US market, but that at the end of the day, this isn't China's most powerful source of leverage. So once a trade war is well and truly underway, what stops it? Like? What is the resolution? I guess? My other question is how how much of our existing tariffs stem from trade wars that started, you know, ten, twenty, maybe even fifty years ago.

How long do these effects actually linger? There are interesting quirks in global trade that reflect the legacy of past trade fights. So the very high US tariff on light trucks apparently stems from a fight in the nineteen sixties. So we have a two point five percent tariff on cars, but a tariff on light trucks, and that that's now

enshrined in our w t O commitments. And da da da dada back a long, long time ago, the Europeans agreed to as an concession to the US to get rid of tariffs on soybeans but not grain, which is why soybeans sort of emerged as the globally traded animal food and became a much more traded commodity than say corn, given that both can be used as a source of animal feed. So you know, there certainly are permanent scars

in the trading system that reflect past decisions. I think there are three ways the current three oh one tariff threat could play out. One is, after the list is refined, there's a period of negotiation in the US and China come to a deal that either permanently removes the threat of tariffs or leads the Trump administration to, let's say, put the tariffs on hold on ice to allow more time for negotiation. We will withdraw this current petition and

we will refile it if necessary. But we don't have full agreement, but we have enough progress us to allow us to have confidence that we will get to agreement with more time. That's possibility. One possibility, too, is that the US imposes its tariffs, China imposes its tariffs, and more or less that's the end of it. There are tariffs on soybeans, there are tariffs on US auto exports.

Interestingly enough, the biggest at least in my view, exporters of cars from the US to China are the two German transplants, so the BMW factory in South Carolina and the Mercedes factory in Alabama. So the global economy is integrated. And then it sort of stops there that there's no further escalation, and then there will be ongoing negotiations over the conditions that would allow both sides to step back down,

but there wouldn't be a threat of further measures. And China of course would challenge the U S tariffs of the w t O because the RIO one's legality under the w t O is very unclear. The US is violating it's w t O commitments by raising tariffs against Chinese goods, at least in the Chinese few. Third option is that it continues to escalate and that the US comes up with an additional a round of tariffs, and then China responds with another round of tariffs, and so

we go from fifty billion to a bigger number. And there are other ways that either China or the U S could escalate, so China could retaliate against US firms operating inside China, the US could take steps that adversely affect Chinese interests in the U S. Alright, so then we gotta put you on the spot here of the scenarios, what is your guests and what is the trading relationship between the US and China look like a year from now. If I had to guess right now, I would say

we both implement the tariffs and then it stops. That seems like a plausible equilibrium. I think it will be hard for the Trump administration to get enough from China to convince the President, who seems personally animated by this, to step back. I also don't see any other major legal process underway that where the U S would initiate another type of complaint that would extend tariffs to new sectors. The highest probability is that we new round one of

a trade war, but then we don't. There isn't further escalation, but of course that has knock on impacts throughout the global economy. Red said Sir Stephen A. Tannembaum's Senior Fellow for International Economics at the Council Foreign Relations. That was awesome. I learned a lot from that discussion, Thank you very much, Pleasure, Joe. I enjoyed that conversation so much, not least because I continued to learn more about soybeans with every passing day

this month. Yeah, I definitely did not predict that the big commodity at the heart of the biggest economic story this month would be soybeans. But it's kind of a pleasant surprise, and I guess we should have seen it coming, because, as Brad mentioned, there's the big three aviation autos and soybeans, So if we were a little more knowledgeable, we could have seen that coming. Nonetheless, now you have to learn

something new all the time. Yeah. The other thing I liked about that conversation obviously a really really nuanced a series of thoughts from Brad, But I also like that we have to go ahead to use the term trade war essentially, or we're one round of escalation away from it. Yeah. I agree, it's right if the if the tariffs actually go into places planned and we have the green light

to use that colorful language. I'm glad that you brought up the treasury issue is and the theoretical threat of China not buying our treasuries, because when you think about various ways that if things deteriorated between the two countries, and deterioration could transmit themselves to the market, you always hear about the treasury angle, and so I like that it's not that there's nothing there, but that it's just far more complex and subtle than perhaps most of us

think of it. Yeah, I suppose in retrospect it's not a major surprise that talk about China's selling off it's US bond holdings tends to descend into a lot of rhetoric on either side rather than having a realistic conversation about it. But there we are. But Brad definitely walked us through all the details of that, which was fantastic. Um. The other interesting thing, Joe and I know you've been talking about it, but the market reaction to the trade

wars that we've been seeing so far. Yeah, I love the way in which people's perception of how the trade war is going or the trade tensions. We're not there yet, how the trade tensions are going seemed to invariably be dictated by the market. So on days when markets are green, it's like, oh, people are optimistic that they're gonna be talks, and some of the rhetoric is easing, and then that afternoon stocks turned red and suddenly everyone is afraid of

imminent trade warriors. It's a good reminder then our business price always leads to narrative. We like to pretend that we construct these stories and then the market digest them and then reprices. But I'm pretty sure it's the exact opposite. The market does its thing and then we construct stories expost facto to explain it. And it would be nice to get away from that, but I'm not sure that's gonna happen anytime soon. Good thing we don't host a

narrative markets podcast or anything like that. We would never do that, and we would never like do articles about these subjects day after day, trying to explain market movies. I'm glad we never do anything like that. Okay, I think we better stop here. This has been another edition of the Odd Lots Podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway, and I'm Joe

wi Isn't though. You could follow me on Twitter at the Stalwart, and you could follow Brad on Twitter at Brad Setzer with an underscore between Brad and Setzer, and you could follow our producer tofur Foreheads at Foreheads t and follow the bloomberg head of podcast, Francesco Levie at Francesco Today. Thanks for listening,