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The International Economics program aims to explain developments in the international economy, and influence policy. It does so by undertaking independent analytical research.

The International Economics program contributes to the Lowy Institute’s core publications: policy briefs and policy analyses. For example, the program contributed the Lowy Institute Paper, John Edwards’ Beyond the Boom, which argued that Australia’s transition away from the commodities boom will be quite smooth.


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Is Australia wise to pick sides in US-China trade war?

The US-China trade war is viewed by many as a dark cloud over the global economy. So why is Australia’s ambassador to the US, Joe Hockey, seemingly urging Trump to go harder, and not settle for a “pyrrhic victory” that fails to resolve long-term differences between the US and China?

In October, the International Monetary Fund warned that the trade war risked making the world a “poorer and more dangerous place”. IMF Managing Director Christine Lagarde said that an all-out trade war would have “devastating effects”. This view was reflected in share markets, with analysts expressing fears that it raised the risk of a financial market “flash crash”.

With such dire warnings, there was an almost palpable sense of relief in November when over dinner at the G20 meeting in Buenos Aires Donald Trump and Xi Jinping agreed to a pause in the trade war. In particular, Trump held off imposing additional tariffs on $200 billion of Chinese imports to the US, pending further negotiations. The cease-fire lasts until 2 March and the markets fluctuate with reports regarding progress with the talks.

Is it prudent for Australia to be advocating that an unpredictable leader such as Trump, without a consistent view as to what he is seeking to achieve and what is achievable, should go harder in the US trade war with China?

Against that background, a story this week in the Australian Financial Review seemed to come from left field, with its headline of Hockey warning against Trump accepting a “pyrrhic” win with China. The Interpreter has asked the Department of Foreign Affairs and Trade about Hockey’s comments as reported, and will update with any response. What has been reported appears to be at odds with the calls made by Treasurer Josh Frydenberg at the IMF annual meeting last year on the need for cool heads as the world stares down the barrel of a global trade dispute. Specifically, Frydenberg called for an end of the US-China trade war.

Hockey’s views also seem to clash with the campaign being launched by a coalition of 200 US trade associations spanning agriculture, manufacturing, retail, technology, and oil, aimed at ending the trade war and even claiming it may be endangering babies.

Hockey’s comments were reported to have been made at a closed-door round table discussion in Washington DC. It reflected his apparent concern that Trump may do a deal with China that focuses solely on measures to reduce the US trade deficit with China, without tackling such structural issues as China’s intellectual property “theft” and corporate governance and subsidies to China’s state-owned enterprises.

If Hockey is concerned that the end of the trade war is based on Trump doing a “deal” whereby China agrees to buy more US products will not achieve much, then he is right. This, notwithstanding that Trump would no doubt claim it was the greatest trade deal “ever”.

Even if Trump was successful in reducing the bilateral trade deficit with China, unless the US improves its saving-investment balance, then there would be an increase in the US deficit with another country (ies) to an equal amount.

But the US dispute with China is generally considered to involve much more than reducing the size of the US-China trade deficit. The US allegations levelled against China include forced technological transfer, discriminatory investment acquisitions, state enterprises having all manner of unfair advantages over foreign competition, along with espionage and cyber-attacks. Former advisor Steve Bannon says Trump is engaged in a sophisticated form of economic warfare aimed at “uniting the west against the rise of a totalitarian China”. On this view, Trump is seeking to stop China’s economic and political rise.

Does Hockey want Trump to go harder on stopping the rise of China? As Stephen Grenville has observed (US versus China: the economic model), it would be over-reach for Trump to see China’s detailed planning for technological progress as somehow an illegitimate product of an authoritarian system. And John Edwards has noted (US-China trade: joke’s over) that China is not going to relinquish its ambition of becoming a global leader in advanced technological industries, which is central to its economic progress.

Hence the stakes are high depending on the US objective in its trade war with China. True to form, however, the Trump administration seems confused as to what are its objectives. Former State Department official Kurt Campbell has identified three schools of thought in the Trump administration: the “traditionalists”, who would be content if China merely bought more goods from the US; the “structuralists”, who are demanding that China change the structure of its economic system; and the “decouplers”, who believe that the US and Chinese economic systems are irreconcilable and are encouraging US firms to pull out of China.

Who knows which school Trump favours, but going by his actions to date, he will not have a coherent position nor a strategy and will flip flop between all three approaches.

Notwithstanding Trump’s views on his capacity as a deal maker, is it prudent for Australia to be advocating that an unpredictable leader such as Trump, without a consistent view as to what he is seeking to achieve and what is achievable, should go harder in the US trade war with China?

Australia, along with all other countries, would benefit if China showed greater respect toward intellectual property rights and curbed the preferences awarded to state-owned enterprises. It is doubtful, however, whether the best path towards achieving these outcomes is through entering into a fully-fledged trade war with China.

More generally, the world would be a more stable place if all countries adopted the policy that regardless of the objectives, the answer is unlikely to be found in increasing tariffs.

Bottom line, Australia should not be a cheerleader for Trump in his trade war with China.

Why the gloom? Global economic prospects

“Winter is coming” warned Indonesian President Joko Widodo in his address at the October meeting of the International Monetary Fund and World Bank Group in Bali. He wasn’t talking of Game of Thrones feuds but instead was warning about the global economic outlook. Many commentators seem to share this view. Why the gloom?

There are three main concerns: tightening of United States monetary policy, Donald Trump’s trade war, and China’s slowing.

Financial markets have been volatile ever since the “normalisation” phase of US monetary policy began with the “taper tantrum” in 2013 (see: The sky is not falling on Asia’s central banks). The prospect of each well-telegraphed increase since December 2015 has caused hand-wringing among commentators. The December rate increase – again just as the Federal Reserve foretold – had the extra excitement of Trump pressure. Would the Fed defy the president’s call not to increase rates? Of course, they would, if they wanted to retain their reputation for independence. So they did.

It’s time to squeeze a few more concessions out of China, declare victory, and move on. Globalisation is robust and will quickly adapt to any residual distortions.

Untidy as it is, none of this is cause for gloom. American GDP is at full capacity, as indicated by low unemployment, rising inflation, and wage growth. The economy has been growing faster than capacity, so has to slow if it is to avoid running into capacity problems.

Can the Fed engineer a soft landing? Does an inverted yield curve (where the long-term interest rate is lower than the short-term rate) make recession inevitable? Does the length of this cyclical expansion make a downturn inevitable? Former Fed Chair Janet Yellen noted that “expansions don’t die of old age”, with her successor commenting that they are “murdered” by policy mistakes. Australia’s 27-year expansion suggests that, with competent policy, expansions can last.

There is a good chance the Fed will do whatever is needed to maintain steady growth, albeit a bit slower than in 2018.

Trump’s trade measures have been endlessly debated, but not all that much has happened so far: minor skirmishes rather than a full-out trade war. The IMF estimates that the initial announced actions might take around half a percent off growth in the US and China, but even these measures have not been fully implemented: the threatened hike in tariffs on $200 billion of imports from 10% to 25% has not yet occurred.

Trump promotes himself as the master of deals. If these measures are just part of a negotiation strategy aimed at bringing China to heel on intellectual property and the bilateral balance, the time may be coming when the tariffs have served their purpose.

Persisting is painful. Soybean farmers have lost their market as the Chinese applied a politically-targeted response. Tesla and other auto manufacturers are expanding production in China. American steel is benefiting, but each of the 8,500 steel jobs created costs $650,000. By pushing up the price of domestic steel by nearly 50%, all steel-using industries are disadvantaged. The much-vaunted renegotiation of NAFTA brought trivial advantage. America’s withdrawal from the Trans-Pacific Partnership is universally judged as self-inflicted damage. As for Trump’s muddled concern with bilateral balances, these are determined by domestic saving/investment balances, which Trump’s measures do not address.

It’s time to squeeze a few more concessions out of China, declare victory, and move on. Globalisation is robust and will quickly adapt to any residual distortions.

Lastly, there are concerns about China’s growth, which has provided one-third of global growth in recent decades. Debt is uncomfortably high. For decades, the dynamism of the private sector has offset the deadweight of inefficient state-owned enterprises, but this beneficial transition seems to be reversing under President Xi Jinping. There are other imbalances which need correction: investment is still unsustainably high. 

Without a doubt, these are valid concerns. But so far the doom-merchants have been wrong, or at least premature (see: China’s economic gloom merchants and China’s looming financial crisis). China has demonstrated both resilience and capacity to correct imbalances (such as the excessive current account surplus in the mid-2000s).

There are two reasons for remaining positive. Crises are typically unforeseen – recall the unanticipated shock of the 2008 global financial crisis. In China, however, almost all these problems are not only recognised, but the solutions are underway, even if the process is slow. Here, China’s second advantage is its authoritarian capacity to implement.

The inflection point in China’s growth path was a decade ago, in 2008, when spectacular double-digit growth of the previous quarter-century became unsustainable. Expansion was temporarily sustained in 2010-2011 by massive stimulus but then settled back to the sort of pace seen in many emerging economies (including, for example, the previously chronic under-achiever India). Until China’s production techniques approach the technological frontier, the potential for catch-up growth remains. If China can manage these challenges as well as it has done in recent decades, then growth at around the current pace seems quite sustainable for a decade or more.

Economic forecasting is a mug’s game, with many opportunities to be wrong. Any of these three concerns could prove to be well-founded and unanticipated problems may arise. Gloomy stories seem to make more interesting news. The IMF’s new forecasts are universally reported as unhappy news but the Fund forecasts global growth to fall only slightly in this year and to rise a little in 2020. Reality, when it arrives, may turn out to be boringly routine ­– more-of-the-same, or at least a mild winter.

Could Ivanka Trump become the next World Bank President?

Will Ivanka Trump become the next World Bank President? There is speculation that the President’s daughter is among the names thrown into the mix to replace the current president, Jim Yong Kim, who recently announced his departure.

The idea of Ivanka Trump taking over as head of the World Bank was met with some scorn, with comments such as “this is among the most ridiculous proposals I have heard”.

But who takes over as President of the World Bank is not within the sole prerogative of Donald Trump. The position is not, as some commentators have suggested, the gift of the White House. Trump can nominate Ivanka Trump, Jared Kushner, or even his favourite rap star Kayne West. Whether they become World Bank President will depend on whether Trump’s nominee is supported by World Bank Executive Directors with at least 50% of the Bank’s voting power.

Departing World Bank chief Jim Yong Kim with Ivanka Trump (Photo: World Bank/Flickr)

Over the 75 year history of the World Bank, its President has always been an American. But the nationality of the President is not prescribed in the Bank’s articles. It has been an informal “gentlemen’s agreement” since the creation of the Bretton Woods institutions in 1945 that the head of the World Bank would be an American and the leader of the International Monetary Fund (IMF) a European.

However, with the changing structure of the global economy, and the increasing importance of emerging markets and developing countries, there has been growing pressure for the governance structures of these institutions to similarly change, both in terms of voting power and also the convention on the nationality of their leaders.

Trump’s nominee will need to be supported by World Bank Executive Directors with at least 50% of the Bank’s voting power.

The need to reform the governance of the World Bank and IMF has been a major topic on the G20 agenda. In 2009, the communique from the London G20 Summit said: “we agree that the heads and senior leaders of the international financial institutions should be appointed through an open, transparent and merit-based selection process”. While this wording was in response to pressure from other countries, the US (and many Europeans) opposed the inclusion of the phrase at the end of the sentence “regardless of nationality”.

To date, neither the US nor Europe has been prepared to abandon the convention on the nationality of the heads of the World Bank and IMF. And they need each other to maintain the convention. The US has just under 16% of the voting power in the World Bank. Taken together, however, the US World Bank Executive Director and those from the European Union have a combined voting power of nearly 50% – enough to appoint the President. The reality is that the US nominee for the position of World Bank President will require the support of EU countries, but this has been forthcoming for in return the US has always supported the European candidate to head the IMF.

It is only in recent years, however, that there has been some semblance of a contest for these positions. When Dominique Strauss-Kahn was forced to step down as IMF Managing Director in 2011, the two candidates were Christine Lagarde, the French Finance Minister, and Agustin Carsten, the Mexican Central Bank Governor and former finance minister. Lagarde had the backing of Europe, a number of other countries and the US. Australia, Canada, and Mexico were the only major countries to support Carsten – mainly on the basis that it was damaging for the institution if there was no support for a highly credentialed candidate from an emerging market.

When the position at the World Bank became vacant in 2012, the US nominee, Kim, was opposed by two former finance ministers (Ngozi Okonjo-Iweala from Nigeria and José Antonio Ocampo from Colombia). Many considered Kim’s credentials (a health professional and president of Dartmouth) to be weaker for the position than the other two candidates. Nevertheless, Kim was well regarded and the Obama Administration engaged in an aggressive campaign of arm twisting, in the end receiving support from South Korea, most of Europe, Canada, Australia, Russia, and reportedly, China, India, and Mexico.

The big step forward was that the process was open and not the outcome of deals in the back rooms of Washington and Europe – as had been the case in the past.

The key point, nevertheless, is that a US nominee will only be successful if supported by other countries and the US has had to work hard to ensure its candidate is successful. Consequently, while there is considerable hand-wringing about the potential damage to the World Bank if Trump nominates a candidate that supports Trump’s “America First” approach, his views on climate change, and apparent opposition to multilateralism, such a candidate would only take the mantle if supported by other countries, particularly from Europe.

Where to from here?

Instead of focusing on the machinations of Trump when it comes to US candidates, the rest of the World Bank membership should follow to the letter the agreed selection process for the position of President. Namely, this is to nominate highly qualified candidates who meet the agreed criteria ( a track record of leadership in a large organisation, international exposure, familiarity with the public sector, ability to articulate a vision for the World Bank, a commitment to multilateral cooperation, and effective and diplomatic communication skills).

They can then select the “best” candidate regardless of nationality in an “open, merit-based and transparent process”.

Money talks, and Australia doesn’t have a G8 voice

British think-tank, the Henry Jackson Society, recently released its Audit of Geopolitical Capability, which it describes as providing the “fullest picture of who’s up and who’s down on the international stage”.

According to the 2019 audit, Australia was up, ranked eighth in terms of geopolitical capability. Russia, meanwhile, was down, coming in at number 10. These results prompted headlines in the Australian press with reports such as “Case for Australia to take Russia’s seat on elite G7”.

Whether or not Australia it is included as a member of such groupings will not depend on assessments of its ‘international presence’, but what it can offer to the group.

Is there any prospect of Australia replacing Russia and restoring the G7 to the G8? In short, no. Among the challenges facing Prime Minister Scott Morrison in the coming months, he does not have to include the possibility of an invitation to the 45th G7 summit in France in March 2019. Similarly, whoever is prime minister after the forthcoming Australian general election will not have to fit in attendance at G8 summits among their future international commitments.

Notwithstanding the complex formula derived by James Rogers from the Henry Jackson Society to assess and rank geopolitical capability, there are no membership criteria for forums such as the G7/8 or G20. Furthermore, there is no appetite in the G7 to expand membership. The more immediate challenge is whether the forum can survive President Donald Trump.

The G7 emerged in the early 1970s as an informal gathering of finance ministers from the US, West Germany, France, and the United Kingdom to discuss how to deal with the energy crisis. In 1976, a French initiative was to host a summit of leaders from these countries and France also invited Italy. In 1976, the US extended the invitation to Canada and the G7 was formed. In 1997, Russia joined the leader level grouping to form the G8 (but G7 finance ministers continued to meet without Russia).

Russia was always the odd man out in terms of the original grouping of “like-minded” major industrial economies and Russia was suspended from the G8 when it invaded the Ukraine in 2014.

Australia is already a member of the G20, formed in response to the Asian Financial Crisis in the late 1990s. The rationale was that the crisis had its origins in the emerging markets and as such the emerging markets should be at the table when it came to discussions on how to prevent future crises. The G20 was elevated from a finance minister’s forum to a leader-level summit following the Global Financial Crisis in 2008 on the rationale that the membership of the G7/8 was too narrow to deal with a global crisis.

It was speculated that the G20 would usurp the G7/8, however, the effectiveness of the G20 has waned, in part a reflection of its unwieldy membership.

There was no criteria for G20 membership beyond the description that it was a gathering of “systemically significant” economies. The G20 membership was determined in 1999 during a telephone conversation between Timothy Geithner from the US Treasury, his counterpart at the German Finance Ministry, Caio Koch-Weser, and the Canadian finance minister Paul Martin.

Nigeria was originally selected as a member but domestic turmoil in the country just prior to the first G20 meeting resulted in its invitation being withheld. Rather than complex calculations assessing a country’s global “presence”, it appears that a major consideration was to achieve an appropriate spread of members in terms of geographic representation.

Larry Summers, who was the US Treasury secretary at the time of the formation of the G20, subsequently told me that when it came to selecting members, the position of Australia was not clear-cut because it did not represent a region. Australia’s membership of the G20 was not guaranteed and it took a significant diplomatic effort to ensure that Australia was at the G20 table.

Australia was not included in the 2017 audit of geopolitical capability prepared by the Henry Jackson Society and this was the first time the ranking covered all G20 members. Countries are ranked relative to the US which is deemed the “leading” country in terms of geopolitical capability. The UK came in second and this resulted in headlines in the UK press such as “UK ranked second most powerful country in the world”.

The audit is based on a range of attributes and capabilities for each country which are then weighted in to form a composite index, but the indicators selected and weight given to them is a matter of judgement. Such a ranking is more a case of judgement than science. Ultimately, money talks and a country’s international influence will be related to the size of its economy.

In terms of nominal GDP (current prices, US dollar) Australia is currently the 13th largest and in terms of GDP based on purchasing-power-parity (PPP), it is the 19th largest economy. But Australia’s relative economic importance is projected to decline, with the PWC’s World in 2050 projecting Australia’s economic position falling to 28th by 2050. This resulted in other headlines that Australia would be lucky to qualify for the “G30” in 2050.

Rankings by think tanks of a country’s international importance may flatter or disappoint countries, but they have no relevance to the membership of international groupings such as the G7, G20 or subsequent iterations. Whether or not Australia it is included as a member of such groupings will not depend on assessments of its “international presence”, but what it can offer to the group. Australia must concentrate on being an active and constructive contributor across all forms of international engagement.

Stepping up on Pacific infrastructure

Australia has decided it is going to do a lot more infrastructure financing in the Pacific.

This is a welcome development. The Pacific faces some of the most difficult development conditions in the world and has huge financing needs, especially due to the effects of climate change. It is also important that the Australian response to Chinese development finance in the region move beyond criticism and towards something that looks more constructive to the developing countries it is trying to work with.

Ultimately, the Pacific is an aid dependent region and most countries need far more grant financing, not loans.

The recently announced Australian Infrastructure Financing Facility for the Pacific (AIFFP) will provide $2 billion in funding ($1.5 billion in loans and $0.5 billion in grants). There are still more questions than answers about how the AIFFP will work. Nonetheless, one can begin to frame the main issues and, more importantly, key choices at hand.

A common concern is that it may divert funding away from other worthy priorities besides infrastructure, such as health and education. This is possible but needn’t be the case, even without increasing the overall aid budget.

The advantage of using concessional loans is that the grant funding Australia currently provides can be leveraged into a much larger loan amount. That appears to be the intention by combining loans and grants in the facility. With Australia typically giving around $100 million each year in infrastructure grants to the Pacific, the entire $2 billion figure could theoretically be reached in five years just by leveraging this up to the maximum extent possible while still qualifying as aid (though more realistically it will probably take much longer to scale up).

A second criticism is that more loans will simply add to debt sustainability problems in the region. This is a valid concern. The Pacific is an aid dependent region and half of all Pacific countries are already at high risk of debt distress.

Yet, with some prudence, the AIFFP needn’t cause debt-related problems. The total $2 billion package would constitute about 5% of the region’s GDP – not insignificant but very manageable, especially as it is the largest Pacific economies (PNG and Fiji) that have more room to take on additional debt. Moreover, many infrastructure projects are intended to generate financial returns, making this more suitable for debt financing than other areas.

Perhaps the most critical question is whether the Department of Foreign Affairs and Trade (DFAT) has the capability to run the AIFFP effectively. The integration of the Australian aid program into DFAT generally weakened its aid management capabilities, especially in more specialised areas. Yet, even prior to this, Australia traditionally relied on channeling funds to the World Bank and Asian Development Bank when it came to major infrastructure projects, given their more technical capabilities.

One approach would be to basically continue this strategy by channeling most of the AIFFP funds to the multilateral development banks (MDBs), while retaining an ability to directly finance strategic projects. This would give Australia the improved tactical ability to compete with China directly on specific projects where needed while relying on working through the MDBs to do the heavy lifting on the longer term issue of sustainable infrastructure development.

Such an approach though would forfeit some of the (hoped for) broader ability of the facility to compete with China. While the MDBs are good at ensuring quality, this typically comes at the expense of speed and responsiveness – creating a key gap that China has been able to fill.

Equally though, it is not clear that a DFAT-managed facility would be able to do a better job than the MDBs (particularly at scale) while still maintaining the high standards that Australia and other Western donors hold as their comparative advantage over China (notably, regarding economic sustainability and environmental and social safeguards). Ultimately, if DFAT is to successfully manage the AIFFP in-house, it will have to not only rebuild lost capabilities but also develop significant new ones that not only match but even surpass that of the MDBs. Other parts of government might be able to assist, but the challenge would still remain.

Something in between this and out-sourcing to the MDBs might thus be the best way forward – with more funding shifting over time to projects managed directly by government as this capability is gradually built up and proven to work effectively.

The fundamental development task ahead should also not be underestimated, whether Australia works through the MDBs or not. In particular, it will require considerable upfront work to identify and prepare a sufficient pipeline of “bankable” infrastructure projects. In the Pacific, these are neither readily nor easily available due to a host of issues ranging from land acquisition problems to non-economic cost recovery and the fundamental difficulties imposed by the region’s remoteness, diseconomies of scale, and lack of economic dynamism. Yet, there will be a heightened need to ensure these projects are indeed economically sustainable, given loans will need to be repaid but also as the viability of these projects may well be increasingly marginal.

Reflecting this, ensuring Australian loans are as concessional as possible is a higher priority than leveraging up our grants as much as possible (as more leverage reduces concessionality). This will also be necessary to compete effectively with China which, despite much criticism that its loans are more expensive than the MDBs, still provides quite concessional loan terms.

Even better would be simply providing more grants (something China itself may start to do more of) and a larger overall aid budget (especially after years of stagnation). Ultimately, the Pacific is an aid dependent region and most countries need far more grant financing, not loans. Without this, there will always be a pressing need for more development finance from somewhere.

US-China tensions: is this about economics or security?

The administration has recognised that the true challenge China presents is not fundamentally one of a rising power threatening to replace an established power. Instead it is the challenge that China poses to the fundamental principles embraced by market democracies globally: free trade and open markets, freedom of navigation, and good governance. Elisabeth C. Economy, Council of Foreign Affairs

With headlines dominated by President Donald Trump’s tariff war and bellicose rhetoric about “unfair” economics and stolen intellectual property, the challenge might seem to lie in China’s economic behaviour rather than old-fashioned power rivalry. But closer examination suggests otherwise.

Just how different – and incompatible – are the two economies?

Beginning with Deng Xiaoping’s “Southern journey” in 1992, the Chinese economy has been guided by market forces. Without this market-driven dynamic, China would not have achieved its decades of spectacular growth and produced a world-beating crop of billionaires. Instead, it would have been weighed down by the plodding inefficiencies of a planned economy. China is now a mixed economy, with two-thirds of output produced by the private sector.

Just as China is far different from the sort of centrally planned system seen in the USSR, America is far from the free-market paradigm.

China has its “Made in China 2025” industry policy; America had John F. Kennedy’s moon-landing commitment in the 1960s, and now Trump’s adviser Peter Navarro’s plan to make America self-sufficient in security-related production. Anyone doubting the extent of government intervention in the American economy might examine the policy response to the 2008 financial crisis.

In China’s state-capitalism system, Beijing directs industry; in America’s economic model, industry directs Washington through lobbying and political pressures. The interplay is different, but both countries have a symbiotic relationship between state and industry.

China’s development strategy doesn’t differ in principle from the successful development model of Japan, South Korea, and Taiwan. Competitive exchange rates and industry protection were used to establish viable scale in manufacturing, disciplined by a strong export sector. Singapore might be seen as a small-scale prototype for China, and who disputes its success or claims unfairness?

What, then, is the basis of Trump’s complaints about China’s economic rule-breaking?

The danger in Trump’s rantings lies in the confounding of economic issues with the real and serious security issues that should be at the heart of the debate.

The most straightforward explanation is that he hopes his arm-wrestling can achieve a better international deal for America. This involves repeating his NAFTA renegotiation with other trade deals. With China, he hopes to increase imports from America, allow more American investment, and encourage China to pay more for intellectual property (they paid US $26 billion in 2017).

He misunderstands the advantage of multilateral trade and the irrelevance of bilateral trade balances. His objective, however, is rational enough: to reset America’s trade relations more favourably. We might even take him at his word that he wants zero tariffs, eventually.

In this, he may be cruder than his predecessors and more confused: but the objective is not so different. Each American president has, understandably, tried to shift the rules in America’s favour. Whoever won in 2016 was going to move towards protection.

There will be some damage from Trump’s behaviour, mainly to America, but the tariff war is less harmful than the headlines imply. If “decoupling” means a return to pre-Nixon isolation of China, this is infeasible. Globalisation is robust and can operate with imperfect rules. When the arm-wrestling is over, the “fundamental principles” of free trade and open markets will remain a utopian ideal, observed by none, but good-enough general guidance for all countries to benefit.

The danger in Trump’s rantings lies in the confounding of economic issues with the real and serious security issues that should be at the heart of the debate.

We see this confusion in the intellectual property discussion. The commercial imperative to maximise IP earnings is incompatible with the security imperative to keep secrets. Security-critical technology (including dual-use technology) shouldn’t be part of the IP discussion. It has to be kept secret, not sold under license in the futile hope that it won’t be copied. When national security is misused to justify steel tariffs against allies, this muddle makes it harder to identify true security risks such as Chinese investment in Silicon Valley’s high tech.

At the heart of the security debate is some simple but uncomfortable arithmetic. China’s population is four times America’s. Even if China gets only half-way to matching America’s per-capita income, China would by then have twice the US gross domestic product.

Leaving GDP to one side, China’s military capabilities will remain far behind America’s for many years, but already, in this inferior position, China has been able to effectively seize the South China Sea, with no viable retaliation from more powerful forces. This was not about economics: it was about the crude exercise of power.

China’s dominant scale seems almost inevitable: growth at double the American rate seems likely for a decade or more. Attempting to delay this through “decoupling” makes no sense. The critical issue, then, is intent: what will China do with this power? This is an old-fashioned security issue, akin to Russia’s current clashes with Ukraine.

The starting point for sensible policy is to distinguish between security and economics, and between objectives and instruments. The response to a security threat may well involve economic instruments, such as sanctions. But let’s keep this analytically separate from sensible economic objectives, which include a multilateral trading framework with minimal trade distortions and enough well-functioning international institutions such as the World Trade Organisation to make globalisation work for the benefit of all.

“America First” and global economic governance

President Donald Trump’s stated objective is “America first”. What might this isolationist mantra mean for global economic governance, which is the economic component of the “rules-based order”?

Trump might have left the Paris climate-change accord and the Trans-Pacific Partnership, but there has been no blanket departure from the international institutions that are still useful in the pursuit of American interests. America retains membership of the UN, the World Bank, and the International Monetary Fund. Even within the World Trade Organisation, Trump’s disruptions are best interpreted as bullying efforts at reform rather than an attempt to pull down the temple.

That said, something has changed since the halcyon days when the US was constructively building international institutions that would benefit all and foster globalisation.

At Bretton Woods in 1944, America was prepared to give others a role in global institution-building, even if it retained a veto and a loud voice. Contrast this with the first great period of globalisation ­– the century before the First World War – when the colonial powers forced their presence on weaker nations for their own narrow economic advantage. Bretton Woods brought a different vision of globalisation, in which the preeminent economy asserted its position in a more refined manner.

Based on their own market-oriented beliefs, America established global guidelines that came to be called the Washington Consensus. Its core elements – free international trade, reliance on markets, fiscal rectitude – were conducive to international integration and enabled the outstanding period of global growth following the Second World War.

The success demonstrates how little global governance is needed to foster international trade and integration.

Of course, this rule-lite free-market orientation suited America: opening up new markets for trade and capital flows provided the incumbent industrial superpower with profitable opportunities. It also made good sense for the rest of the world, including the emerging economies (Taiwan, South Korea, Singapore and, in due course, China all did well).

The success demonstrates how little global governance is needed to foster international trade and integration. Global rules can be light-touch, with national rules often sufficing. Where global coordination is needed, it is often provided by ad hoc agreements covering the practical details: in aviation, shipping, telecommunications, financial stability, and taxation.

The WTO has laboured largely in vain since 1995 to improve the rules. Where progress was made, it was in smaller plurilateral or bilateral agreements that were, in principle, inferior to multilateral deals. Much production remains isolated from international competition – for example, the European Common Agricultural Policy. Perhaps no country (certainly not the US) has done away with protectionists policies.

There have been sporadic attempts at international policy coordination, with debatable success: the Plaza and Louvre accords in the mid-1980s addressed exchange-rate misalignments. It is hard to point to much governance rule-making coming out of ten years of G20 meetings. The continued presence of the G7 reflects the realities of power; it maintains its own interests and priorities.

There is little capacity to address the various global “tragedies of the commons” such as climate change and biosecurity or to provide global public goods in the form of effective international dispute-settlement, sovereign insolvency or equitable company tax. Sensitive sovereignty and vested interests get in the way of a more complete set of rules.

Despite these gaps in governance, the current structure is robust, with a great capacity to deliver widespread benefits. Even when the optimal rules are not observed by all – or any – of the participants. Globalisation has continued apace (some would say too fast) even in this rules-lite environment.

In part, this reflects other factors driving world integration. Technology boosted growth in general, and boosted globalisation in particular – the fall in transport costs (containerisation) and communications produced an almost “flat world”.

In short, Trump arrives on a world stage of highly-integrated economies operating an imperfect but “good enough” system of rules and understandings, loosely held together by talk-shops such as G20 and deeper networks of ad hoc technical agreements.

If Trump’s presence prevents these meetings from issuing a joint communique, not much is lost.

Trump’s rhetoric is a departure from the Bretton Woods ideals and his America First could do some damage at the margin. It is one thing to take America out of the TPP; it is another to use America’s heft to curtail other countries’ trade deals with third countries. If he collapses the WTO, by design or accident, a constraint on protectionism will be removed. With global financial fragility still an issue, the US Federal Reserve may not be able to repeat its crisis-averting injection of US $500 billion into a collapsing global banking system in 2008. But none of these adverse prospects seems likely to derail the powerful self-generating momentum of integration.

As usual, history provides a note of caution.

Charles Kindleberger, a masterly chronicler of business cycles and recessions, attributes the trade contraction of the between-wars period to America’s unwillingness to assume its leadership responsibilities during the Great Depression. Britain was too weakened by war, while America was too new in its role as the global superpower. The world economy was left without mechanisms to constrain competitive protectionism.

Will geopolitics trump trade?

Geopolitics may be rapidly moving to the forefront in deciding how the US-China trade war will play out. If so, the odds of a rapprochement are dwindling fast.

The trade conflict has always been about many things, clouding how different analysts understood it. Initially, it seemed best understood as part of the populist backlash against globalisation. According to Donald Trump, China was “raping” the American economy and stealing its manufacturing jobs. On the campaign trail, he promised to impose 45% tariffs on all Chinese imports. Protectionism was the name of the game.

Once in office, however, the agenda morphed to paradoxically reflect the concerns of America’s policy and business establishment (the very globalists seen by populists as complicit in offshoring US jobs). The chief complaints against China came to focus on its investment restrictions, abuse of intellectual property rights, industrial policies, and nationalist technology ambitions. Such “unfair” practices undermined US commercial interests and, it was argued, America’s national interest as well.

This created an internal inconsistency, clouding how the trade conflict might play out. If Trump “won” the trade war by forcing China to open up its economy, it would only increase trade and investment between the two countries. If anything, this would reinforce the offshoring of manufacturing jobs even if it boosted US profits and created jobs elsewhere, such as in services. The US-China trade deficit (a key complaint of Trump’s) may not necessarily even go down, particularly as the overall US trade deficit is set to widen anyway.

Trump’s ability to sell nearly anything to his political base, however, provided the key path to a deal. Take the revisions to both the US-Korea Free Trade Agreement and the North American Free Trade Agreement. The US forced through a few protectionist changes to each but largely left both agreements intact. The changes won’t do much for US prosperity or shift its distribution towards the working class. But Trump can claim the wins and everyone else can largely move on.

A rapidly deteriorating geopolitical narrative in the US might stand in the way.

The situation with China was always more complicated. Still, one can envision a deal where China liberalises its economy in some important ways and perhaps forcibly buys more US goods to help reduce its trade surplus with America. China has previously offered to do this to no avail. But perhaps more favourable timing (e.g. after the US mid-term elections) and/or a more substantial offer would do the trick.

Getting allies such as Europe and Japan to help pressure China has also been seen as key to achieving a meaningful deal. And very slowly, the Trump administration has been coming around to this as it dials down (though doesn’t necessarily drop) its various trade grievances with key allies.

This is the basic scenario for an eventual solution to the trade war. Yet, this view sets aside how a rapidly deteriorating geopolitical narrative in the US might stand in the way.

Signs of this have now mounted significantly. In a bluntly worded speech last week, US Vice President Mike Pence articulated what can only be seen as a clear reset of US policy towards China, essentially moving towards an overtly adversarial strategy. A similar message was also conveyed directly at a Chinese embassy event by a top US national security official.

The week also saw two unsettling developments, including a dangerously close encounter in the South China Sea and a Bloomberg report that the Chinese military had installed hidden microchips in hardware destined for major US tech companies, whose clients include the US government. The first provided a vivid example of how China is now challenging US power. The second brought into the public domain deep anxieties about the national security vulnerabilities created by today’s complex global supply chains and China’s central role within them, reinforcing a Pentagon report making similar warnings.

Pence’s remarks left the door open to a trade deal, saying: “we continue to demand an economic relationship with China that is free and fair and reciprocal”. This suggests that the Trump administration’s goals in this domain might still be on the core issues of concern to US commercial interests.

But another deep policy inconsistency has now emerged, this time with the rest of the national security agenda as it is now being articulated.

Chinese liberalisation would only enmesh the two economies further together – reinforcing vulnerabilities in US supply chains and creating broader opportunities for China to use economic leverage with US business interests in its political influencing activities, which the Trump administration has also identified as a major concern. It would also ultimately aid China’s economic and technological rise, without necessarily spurring the kind of political liberalisation many in the US seem to need in order to be comfortable with this. For them, economic “decoupling” is the objective not a mutually prosperous economic relationship. 

Thus, when it comes to the US-China trade war, there is an increasing alignment between the populists and the national security establishment. Free traders and businesses appear to be the odd ones out.


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