How has the trade war respectively impacted the US and Chinese economies? What are the surprises neither side anticipated?

My economist friends say there is a discernible, but not catastrophic, impact on both economies through the trade war. In a macro sense, neither economy will fail because of the trade war tensions and the new trade war restrictions that have come into play. But that doesn't mean that there are not severe impacts on a more local level in small pockets. For example, US small businesses have a lot less flexibility than larger US businesses do in terms of dealing with tariffs on goods that are a part of a supply chain to China. If the trade war goes on long enough, we will start to see the strain on those small businesses, which is very problematic.

Economists say that US consumers drive the growth in the US economy. If the next round of $156 billion of tariffs is enacted, it will hit consumer goods, which could have a significant ripple in the US economy. That could have some economic ramifications, but more importantly, it might have political ramifications on the 2020 elections. On the Chinese side, China is not critically dependent on trade with the US. The statistics are that 12% of China’s exports are exports to the US. That's not a death blow by any means. More complicated, however, is when you look at issues like technology, or various other potential interdependencies.

In terms of surprises, China initially did not anticipate that Trump would escalate the way he did. That tension eventually caused them to sit down and put issues on the table that they had been stalling on, or hadn't been willing to fix prior to Trump’s aggressive moves. A lot of these issues are not new issues, and there had been incremental progress on a number of them, but in terms of China understanding that the US was serious about getting something done, that was a surprise for China. And that was a very interesting opportunity for the United States.

There is also the question as to whether China made a mistake in taking as long as they did to come to the table, and whether it might have made sense for them to get the trade war off the table and make a quicker deal. It's complicated trying to anticipate what this story is. But you do wonder whether they could have controlled the response a little bit more last May, or even earlier, in terms of cutting a deal.

On the US side, it feels like the US is conducting an experiment. It's improvising because it’s in a territory it’s never been in before. The US initially may have overestimated its leverage, and may have not understood that China will not be cowed or crushed by US tariffs. They did not understand that China will not make changes in its economy if those changes run counter to President Xi's overriding goal of ensuring that the CCP maintains total control over the Chinese economy.

What are the factors that have prevented the two sides from reaching a satisfactory deal?

What happened is that the constituencies on both sides of the Pacific, at different times, created blockages that were unanticipated. Also, it’s incredibly difficult to try to create a credible, enforceable, politically sellable deal. The US environment right now is much more skeptical of China, and it would be easy for any deal, no matter how extensive, to be criticized for not doing enough. It's tricky on the US side. On the Chinese side, they will not lose face. The idea of a weak China being victimized by the West is one to which Chinese leaders react viscerally. They will not cave. Those sensitivities can be emotional at times.

For example, on the US side, the initial focus of the trade war involved buying more US goods because Trump was so focused on the trade deficit. There was a deal that came back to the US spearheaded by Treasury Secretary Minuchin, but when it was leaked to test the waters, the US congressional  response was extremely hostile. And not just from Democrats--which you might expect with a Republican president--but also from Trump's right. Trump easily could have been in trouble, because apparently the deal on the table would not have addressed any of the structural problems in China's economy. It wouldn't have addressed technology transfers, IP theft, or China's industrial policy that distorts global markets.

That deal went down in flames--but the Chinese were experimenting at that point too, to see what they could get that Trump would like. I think they have since recognized that they need to do more, and they need to address some of the substantive issues. And while I have no inside sources on this, I think they decided that they might be ready to make some more substantive changes, for pragmatic domestic reasons. There is a large US demand for change, interestingly for changes that Chinese reformers themselves had been pressing for. Xi Jinping himself signaled in 2013 that he might be heading in this direction to make the Chinese economy less corrupt and more fair and efficient. If you were inside the Chinese system, you could make the argument: why not take advantage of this external pressure to move China towards a stronger economic position, as it would be a better functioning economy.

But then the pendulum of ambivalence swung to the Chinese side. Apparently, when the US thought they were getting close to a comprehensive deal, the conservative constituency inside China balked. Apparently, the fact that the draft agreement had specific provisions saying what Chinese measures would be changed, and what dates those changes would be enacted was politically unacceptable. These constituencies within China saw this as interfering in China's internal affairs, and saw it as losing face. That then cracked the deal that the pragmatists inside China had thought would work, because it was going to help China create a more efficient economic system.

This put the onus on the Chinese side to get the talks back on track, because their objections crossed a political-emotional red line for the US. The United States expects consistency and precision with regard to enforcing any agreements that are made, or the deal does not look credible on the US side. Otherwise, you just have published another ten commandments: 'Thou shalt not steal technology.' That plus five dollars gets you a latte at Starbucks. That's not good enough.

Donald Trump has historically maintained a public friendship with Xi Jinping, but in recent months he has expressed frustration with both China and Xi over the trade relationship. What is behind Trump’s change of tone in recent months?

Trump changes his tone by instinct, and it depends on what's on his mind at any given point. But if you look at all of his positions throughout his presidency, it was striking what he said very recently in the context of Hong Kong. He said he simultaneously stands with Hong Kong and the forces of freedom, and in the same sentence, said that he was also friends with President Xi and trying to negotiate a trade deal. He has not said if he will sign the Hong Kong Human Rights and Democracy act the House and Senate passed by an overwhelming majority, even though the bill itself is mild because it only says there will be oversight to see whether Hong Kong is maintaining the one country two systems with the integrity that was the premise of giving Hong Kong special status in the first place. If it does not, and it's overtaken by Beijing, we would no longer give them separate special status. It's not an automatic guillotine. Trump’s comments, to me, indicate that Trump continues not to be interested in the broader policy context, but in much more micro and pragmatic issues and so remains focused on what he wants until he can’t ignore a larger issue.

US and Chinese officials have hinted that a “phase one” deal might be signed in December of this year, most likely near the December 15 deadline when $156 billion dollars of Chinese goods are expected to be subject to tariffs. What do you anticipate a “phase one” deal could look like, and how do you expect that deal would help translate to a complete deal?

If there is a deal, and it is possible that there will be one, it is likely that it will be in part because Trump does not want to impose the tariffs in December. But Trump is also someone who does not like to let leverage dissipate. If there is a deal, China would have to make enough compromises to allow that deal to happen. The rumors are that China wants not only an agreement to not go forward with the December tariffs, but also wants to roll back the tariffs put on in September. So things are up in the air, and it’s going to depend on what happens.

In order for the deal to be credible, it would have to be more than agriculture purchases. There would also be potential changes to intellectual property enforcement and protection, which are feasible if they are in areas where China too would like those changes. For example, China recently announced an increase in intellectual property penalties. This has been a longstanding tension with the US--if you were sued or found guilty in terms of stealing someone’s IP, the cost has been the cost of a traffic ticket. We need to increase the penalties until they make people decide not engage in IP theft.

In tech transfers, again, China has already taken steps. Recently it published draft regulations to implement their foreign investment law. There is a famous provision in their foreign investment law that states that Chinese administrative agencies will not require transfer of technology in contexts of licensing or other administrative actions. These draft regulations are designed to put more meat on the bones of the vague statements in the foreign investment law. Now there are still problems with the scope of the regulations. I don't know if the US will view them as enough, as a lot of tech transfer does not occur in the context of administrative action.

But again, one of the beautiful things for the US political situation is that any deal can be described as just phase one of an ongoing process: we’re just getting started, showing good faith bilaterally and engaged in a trust building exercise with some immediate upfront changes being agreed. On the Chinese side, I predict that there will be nothing controversial in a phase one deal. No sectors opened where China's vested interests would oppose it, even if these are situations where China should be fixing its actions.

In terms of whether going with a phased approach would help get the US to a strong complete deal, some would say that splitting up the negotiations is a problematic approach in terms of maximizing leverage. If there is a truce now which allows China not to face these tariffs, and it allows them to kick the can down the road and have conversations about the hard stuff they don't want to change, that's good for China. It also kicks the can down the road in terms of waiting until after the 2020 US elections. However, China shouldn't assume that the Democrats would give them an easier time should Trump lose, although the Democrats might not break as many rules as Trump has. That's another risk for China.

On the other hand, China may feel like time is a friend, and it may be easier for them to wait a year or more. So it's hard to say if this approach will result in a complete deal or not.

Given the deep distrust between Beijing and Washington and enormity of the challenges in normalizing their trade relations, what may be realistically the best possible outcome for both sides regarding the trade war?

If you look at the trading relationship between China and the United States now, you really need to decide what 'trading relationship' means. It's really the overall economic, and maybe strategic relationship which is changing. And that change is not necessarily the result of Trump winning the White House. No matter who came in in 2016, the skepticism about China and its intentions would have been there, and the sense that the old ways of dealing with China--the efforts to get incremental steps forward--really dried up. China was not willing to do much in the traditional contexts any more. We also need to factor in Xi Jinping, who decided he was no longer going to follow the philosophy of hiding China's light and biding China's time, as past Chinese leaders have said was the way to go. Instead, he has been much more aggressive.

It's not like trade sits in its own bubble, unconnected from the other dimensions of the relationship. Investment is another part. When we talk about the trade relationship, for example, we also talk about changes to Chinese banks--some of those have to do with opening the markets to allow for investment in China's economy and some of this has to do with the macro stability long term of China’s financial system. So it's really trade and investment and the economy. Then you start thinking about what else the economic interactions implicate in certain situations, such as national security, and where you need to be careful on the broader strategic plane.

China has been paranoid for a long time about foreign investment. They have a very broad national security law, which could make anything down to a local choir school the subject of a national security probe. Anything investment in China can be classified as a security threat. But we do have to understand that whatever the deal is on the trade side, there are paradigm shifts in how the world views China. The US was skeptical and wants to be more careful about trade relationships, and that is spreading to the rest of the world. Ideally, if we were to take the best approach, it might be for the US to get China to make as many changes as feasible to reduce market access barriers to China and other market distortions where it can, and ensure that China is obeying global trading rules.  Then the US would work at home and with other open market economies to create safe harbors of open trade with comprehensive fair rules and mutual benefit.

What are the consequences for the global trading system and supply chains if the US-China trade war drags on without a resolution?

The uncertainty is really problematic. It makes it hard for businesses to plan, and hard for businesses to decide where to invest. But you are going to see some opportunistic behavior by other countries' businesses coming in if they see a space where China has to reduce its reliance on US sources. On the other hand, on the US side, if you are a large company, China has 1.4 billion consumers. In order to not let that go, you are going to have to make more complex supply chains. And that's expensive, which makes your life more complicated, and that's going to make you less efficient. Economists have modeled some of this, and have said this will make the global trading system a more unstable environment. 

Finally, a broader and more skeptical view of what China's goals are comes from some of China's rhetoric: we will be dominant, and will throw out the foreigners after we have gotten the benefit of what they can teach us. That kind of attitude is problematic. It means that like-minded and open market economies might want to think about getting together and trying to create an economic environment where they can strengthen each other and trade and invest more freely. As well, it would help them identify common economic national security threats with each other on some basis.