Some, but much less than you might assume.

Let’s focus on the current trade dispute with China. I often read that Chinese exports to America represent only 3% of Chinese GDP. This is supposed to demonstrate that the US doesn’t have much leverage over China. The conclusion is correct, but the reasoning is flawed. That’s because 3% of GDP is huge. China would really, really hate to lose a foreign market equal to 3% of its GDP.

The correct arguments are very different:

1. A complete ban on Chinese exports to America would have an absolutely massive impact on the US economy. Think about the impact on American automakers that rely on Chinese components. Think about the impact on Walmart–what would they sell? Think about how long it would take for Apple to get Foxconn to recreate its massive Zhengzhou complex in some place like Vietnam or Indonesia. (Samsung would be smiling.) I could go on and on. The total loss of Chinese imports would devastate the US economy, and also cause a stock market crash. China knows this, and hence knows that at the end of the day its exports to America will still be roughly 3% of Chinese GDP. Any tariffs imposed by America will knock less that 10% off its exports, and probably more like 1%. And 1% of 3% of GDP really is a small number.

I do think the US has enough leverage to get some sort of symbolic win, some sort of deal where China agrees to crack down on piracy, and perhaps lower a few of its tariffs. Maybe allow a bit more US investment into its banking and insurance industries. (We’ve had such successes in the past.) But don’t forget that more US financial exports to China mean more Chinese manufacturing exports to America. I’m sure that unemployment steelworkers in West Virginia will be thrilled to hear that Steven Mnuchin is working hard to make sure that American financial firms get even richer, at their expense.

2. There is enormous misunderstanding in the media regarding the concept of “retaliation”. Pundits try to use game theory to figure out whether there will be a “tit-for-tat” trade war. Please, just stop wasting your time. There is always retaliation for trade barriers, regardless of what other governments do. That’s because the most fundamental principle of trade theory is that trade involves . . . trade. If we buy less from them, they will buy less from us. Always. Yes, it’s that simple. China is not giving us all these goods, we must pay for them with exports. If you think there is some sort of “deficit” then you have left something out.

Foreign individuals always “retaliate” when their home country exports less.

3. It is true that, in any given year, other countries may send us more stuff than we send to them. But the opposite will be equally true in other years. In the long run, trade balances out. Do less importing and you will equally reduce your exports. It’s also true that other countries may send us goods, and we may send them intangibles, like expertise, but that’s still “trade”.

4. Even though trade can be imbalanced in any given year, tariffs do not cause that imbalance to be “corrected.” Thus if the US imposes tariffs on China, it will not cause our deficit to change by any significant amount, because the deficit is caused by a saving/investment imbalance. More specifically, a trade deficit is domestic investment minus domestic saving.

5. The policies of the Trump administration will cause the trade deficit to become bigger, because his economic regime is somewhat anti-saving. Trump’s policies, particularly the ballooning budget deficit, will cause domestic saving to decline, and the trade deficit to get “worse”. I use scare quotes, as a larger trade deficit is not in any meaningful way worse than a smaller deficit. Indeed the trade deficit has already started to grow:

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In fairness to Trump, although he will likely fail to reduce the trade deficit (especially the actual deficit–the measured deficit might fall a bit do to the effects of tax reform, which will encourage multinationals to re-label foreign production as domestic production), this “failure” will not actually be a problem. I believe it likely that Trump’s policies will lead to slightly faster RGDP growth, at least for a while (again, partly mismeasurement due to tax reform, but partly actual). Of course in the long run there will be a price to pay in terms of much higher taxes, and that will eventually slow growth.

To use the familiar metaphor, the Trump administration might be foolish enough to shoot off one of its small toes, but it won’t take a shotgun and amputate two of its own feet. And the Chinese know this. I’m often critical of Trump, but he does have one slightly positive quirk, an intense interest in how the stock market views his policies. That’s not a very good way of setting public policy (think clean air), but in this particular case it’s actually very helpful.