It’s very possible that I’m missing something important, but right now I’m having trouble following the media discussion of the US-China trade war.  Let’s start with the obvious:

1.  China’s exports to the US are a modest share of their GDP (about 3.5%).

2.  The proposed tariffs apply to only a fraction of Chinese exports (roughly 50%).

3.  Chinese industries tend to be highly competitive.

4.  The US would have difficulty finding these goods from an alternative source, at least in the short run.

Put those facts together, and damage to China’s GDP will probably be less than 0.5% of GDP.  That’s not pocket change, but it doesn’t seem to explain why Chinese stocks have fallen so sharply.

Here it might be useful to review the basics of tax incidence.  One key idea is that the side of the market with the less elastic curve bears the largest burden of the tax:

When considering US imports from China, Panel A is clearly a better fit. Because China’s export industries are highly competitive, the supply of Chinese exports is highly elastic.

In many cases, it’s a disadvantage to have competitive industries.  Thus firms in countries like the US and Switzerland often have a great deal of market power, as they produce goods with a high level of intellectual content (think about pharmaceuticals and precision machines from Switzerland, or high tech goods and movies from the US).  This allows for a relatively high rate of profit on our exports.  Chinese firms making zippers or sneakers are in a ruthlessly competitive industry, where profit margins are slim.

But this negative (for China) turns into a positive as soon as another country tries to tax their output.  China’s producers cannot profitably export the goods at a significantly lower price, and hence the tax gets passed on to consumers in the importing country.  Thus it seems to me that tariffs would hurt the US more than China.

Of course, there are lots of other factors to consider:

1. Perhaps tariffs on Chinese goods would cause output to shift to other countries.  Obviously, consumers will still be going to Walmart and buying products like sneakers and Christmas ornaments.  But they’ll be made elsewhere.  The problem here is that in the short run there’s no one else to fill the gap.  While the tariffs on Chinese goods may divert production to some extent, the overall effect will be modest in the short run.  In addition, the Chinese yuan will depreciate, which will further mitigate the impact of tariffs.  Thus China will keep exporting the same stuff to America in the short run, and US consumers will pick up the tax.

2.  In the long run, the effects of tariffs could be much greater.  Output will shift to other regions as the US begins buying more from places like Vietnam (a process already underway due to rising Chinese wages.)  This certainly harms China to some extent, as their alternative sectors may not be as profitable as the foregone exports to America.  But it seems unlikely that the trade war will continue in the long run.  The Chinese surely know that President Trump is highly unpopular, and also that he likes symbolic “wins”.  In addition, tariffs on Chinese inputs would put US producers who rely on those inputs at a competitive disadvantage to producers in Germany, Japan and Korea, which also rely on Chinese inputs.  I don’t see why the Chinese would feel any need to negotiate with Trump, except perhaps to offer a few meaningless face-saving gestures.

The counterargument is that Chinese stocks have recently done poorly, which might be due to the threat of a trade war.  It’s not clear that this is solely due to tariff fears (there’s also concern about the recent government crackdown on the Chinese property sector), but it’s probably at least partly due to the tariffs.  So there’s a decent chance I’m wrong in my assumption that Chinese exports will hold up well.  Perhaps in higher end manufacturing it will be less difficult to source the goods from alternative countries (including the US), and hence Chinese exports might fall by more than I assumed.  But I’m skeptical that the US can wait long enough for these alternative supply lines to develop.

When Siamese twins get into a knife fight, it’s hard to envision either side winning.

PS.  The initial tariffs will be 10%, rising to 25% in January.  My hunch is that the trade war will be over by February—as the 25% tariff would be too disruptive to the US economy. I predict an outcome much like the Nafta renegotiation—not much change in current trading patterns.