The largest cause of shocks to worldwide stock markets in recent years – other than COVID 19 – has been the threat of the introduction and escalation of the trade war between the US and China. During this conflict, hundreds of billions of dollars have been wiped off the global economy, with the brunt of economic losses being felt by the US and China. In light of these losses, it is interesting to consider the economic rationale for China’s approach: is there any justification for what appears to be an act of large-scale economic self-harm? And to what extent is it necessary to invoke wider strategic aims to explain China’s behaviour?

The origins of the trade war were longstanding US complaints against China’s trade practices, including export subsidies, currency devaluation and unfair intellectual property terms. Trump started imposing tariffs in February 2018, and both sides introduced various new tariffs in retaliation to those imposed by the other until a limited de-escalation of tariffs was negotiated in January 2020. During this period, US tariffs were exclusively applied to a total of $550 billion worth of Chinese goods, while the total of US goods subject to exclusive tariffs was $185 billion. Although the volumes of goods affected were different, the trade-weighted averages were remarkably similar – from October 2019 until the phase one deal in January 2020 this trade-weighted average tariff was around 21% on imports from the other country.

These tariffs are likely to have caused great harm to both nations, though the extent is hard to quantify. A UNCTAD paper from November 2019 estimated the US tariffs caused a 25% export loss to China in the first half of 2019. Of these Chinese export losses, around two-thirds were diverted to other countries, while the rest was either lost or diverted to US producers. The main beneficiaries included Taiwan, Vietnam, Mexico and the EU. The study did not consider the effects of Chinese tariffs on imports from the US, but did suggest that the qualitative results were likely to be analogous. A White Paper by the Chinese government claimed that the US GDP could decrease by $1 trillion over the next ten years cumulatively if the US were to impose 25% tariffs on all Chinese goods.

In traditional economic theory, barriers to free trade are to be discouraged. 250 years ago, Adam Smith in his book ‘The Wealth of Nations’, argued that free trade is beneficial to both parties – contradicting the previous mercantilist view strongly favouring protectionism. His view is now widely accepted by economists – and is the basis for entities like the World Trade Organisation (WTO), the EU, and other regional bodies that work to promote free trade. However, even if free trade is unambiguously beneficial to countries and populations overall, there may be economic incentives on some countries to restrict it.

For example, economic theory shows that larger economies can gain a net economic advantage from optimally designed import tariffs, at the expense of trading parties. This requires the world price to be sufficiently depressed by the tariff (the ‘terms of trade effect’), which is only possible for a large economy with significant market power (Figure 1). The theory also suggests that the optimal tariff is proportional to the inverse elasticity of supply of the exporting countries, so tariffs will be higher on goods with inelastic supply.

So how can the behaviour of China and the US be explained?

In welfare terms, China’s export subsidies and currency devaluation, which makes exports cheaper for people to buy, are unlikely to be beneficial as there is no ‘optimal subsidy’. But this ignores the strategic benefits to China of establishing fledgling industries which may pay dividends in future. Such protectionism may well have been rational in an economic sense for China, so long as they could escape consequences and retaliatory tariffs, which until President Trump, they were able to do. Since China joined the WTO in 2001, the US has brought 23 challenges to China’s trade practices, of which the US has won 20, with 3 still pending. Although China has lost most of these cases, the WTO has largely been unable to address complaints about trade practices, and the cost of losing WTO cases was relatively modest. However, under President Trump, the US appeared to lose patience with the WTO process.

The subsequent trade war drew the two sides into a form of Prisoner’s Dilemma. The best position for both parties overall was free trade. If either side imposed optimal tariffs they could gain at the other’s expense – but in doing so they risked provoking retaliation from the other side, leaving both sides worse off. After the US first introduced retaliatory tariffs on Chinese goods, it might therefore have been prudent for China to back down and try to achieve a return to WTO-mediated negotiations. China did not.

One possible explanation for China’s willingness to get drawn into a trade war was suggested in a recent paper by Imad Moosa, who argues that China could have expected US trade barriers to be relatively ineffective because of the US demand for Chinese goods is largely inelastic. If this is the case, in response to tariffs, importers of Chinese goods need only increase their prices to absorb the extra cost, and the brunt of the tariffs is ultimately felt by the American consumer.

It has also been suggested that the trade war may have permanently reshaped global supply chains in a way that will help China regain its historic position of dominance in its regional sphere. Following on from this, China’s stance may have been influenced by the hunger of a nation to forget its ‘hundred years of national humiliation’ and regain the position of power that it had lost. For thousands of years, China was the dominant power in Asia, and, by many standards, the largest and richest country in the world. Even by 1820, China made up a third of the global economic aggregate. However, starting in 1839 with an embarrassing defeat in the ‘First Opium War’ against Britain, China underwent this ‘century of humiliation’, in which a number of foreign powers subjected China to extremely disadvantageous trade agreements – causing enough ill-feeling even now, that one government advisor remarked that the announcement of any trade deal with the US would spark a ‘day of national humiliation’ in China. China may thus be willing to risk a certain amount of economic harm, in return for reducing the power of the US, and increasing its own.

In summary, although certain aspects of China’s policy in this recent trade war can be explained in terms of rational economics, it is necessary to take China’s history into account – and what this may reveal about China’s desire to take back what was once its own, and recover its position of global dominance.