Where Does the Trade War Lead?

After months of lead-in and antagonistic posturing, the trade war between the United States and China formally kicked off with the July 6 implementation of a 25 percent tariff in the United States on $34 billion in imports from China. Beijing's response was swift and set up the basic cadence of how China would respond: proportionally and reactively. China immediately imposed its own equivalent tariffs on an equivalent slice of U.S. imports. Days later, the Trump administration in the United States signaled its intent to escalate by releasing a list of tariffs on $200 billion in goods. The descent into tit-for-tat protectionism is in full swing.

But another development in July signaled that whatever the course being pursued by the United States and China, not every country was ready to follow. On July 17, the European Union and Japan concluded a bilateral Economic Partnership Agreement– the largest bilateral free trade agreement in world history. The agreement eliminates 99 percent of all tariffs on Japanese exports to the European Union and 94 percent of tariffs on European exports to Japan. (Eventually, Japan will bring the amount of lifted tariffs on European goods to 99 percent as well.)

The signing came days after U.S. President Donald J. Trump described the EU as a “foe” for the United States following a disastrously precarious summit of the North Atlantic Treaty Organization (NATO) in Brussels. “I think the European Union is a foe, what they do to us in trade,” Trump said. “Now you wouldn't think of the European Union but they're a foe.” Similarly, Trump, while softer in tone during his time in office, has been critical of Japanese trade practices for practically three decades – a running trend dating back to his time in the New York real estate scene in the late-1980s, when Americans feared Japanese economic dominance.

July 2018, above all, might have best demonstrated a burgeoning decoupling in the fundamentals of the world economic system. As the United States and China descend into a mutually deleterious trade war, Japan, accompanied by Europe, is willing to bear the flag for liberalized trade. Prime Minister Shinzo Abe, in particular, has been willing to stand up for Tokyo's interest in continued trade liberalization. Even in early 2017, during his first visit to the United States to meet Trump, Abe lamented the demise of the Trans-Pacific Partnership (TPP), but nevertheless asserted Japan's interest in seeing a successor agreement through. And Tokyo followed up: the Comprehensive and Progressive Trans-Pacific Partnership, bringing the 11 remaining members of the TPP together, was signed earlier this year.

Bear in mind, too, that next year Japanese Prime Minister Shinzo Abe will assume the chairmanship of the Group of Twenty (G20) and France's Emmanuel Macron will lead the Group of Seven (G7). While the agenda-setting effects of their leadership at these multilaterals will largely bear symbolic effect, Abe and Macron – backed by other leaders, including Germany's Angela Merkel and Canada's Justin Trudeau – should be able to offer a considerable bulwark against the protectionist tide that's taken hold of the United States.

In the meantime, the effects of the U.S.-China trade war on the global economic order will remain uncertain. What's increasingly clear is that the effects will not be restricted to the U.S. and Chinese economies. Should the United States proceed with implementing tariffs on the list of $200 billion in Chinese goods – a list aimed primarily at disincentivizing large firms that source components for manufacturing from China – then Beijing's hand may be forced to retaliate asymmetrically. This would chiefly be because U.S. export volumes to China simply wouldn’t be large enough for a reciprocal and proportional reaction. That means that the People's Bank of China (PBoC) could be drawn into the trade war more than it already has been and the value of the renminbi could become a potent weapon. In short, the trade war could fulfill one of Trump's accusations from the 2016 presidential campaign: that China is an obsessive currency manipulator.

Should the trade war escalate to new heights, manipulating the value of the renminbi might be a tempting get-out-of-jail card for China, but it's far from free. China has long sought to disincentivize domestic capital flight and allowing the renminbi to collapse in value could cause disastrous uncertainty in its domestic capital markets. China's exports would become cheaper as a result of a depreciated currency, but the uncertainty that comes with manipulation may be too much to tolerate. American optimists about the wisdom of Trump's trade war point to the United States' comparative institutional strengths as a source of leverage; in their telling, China will be forced to acquiesce to U.S. structural economic demands and put an end to the trade war.

All this leads to a foreboding sense that in the U.S.-China trade war, the worst is yet to come. If there is an American theory of victory, it hasn't been articulated. The Trump administration's Comprehensive Economic Dialogue with China outlined a wish list on trade last year, but, at the U.S. president's behest, the tariffs came anyway. On one level, the trade war is punitive – a way for Trump and his protectionist advisers, including Peter Navarro, to take revenge on China for what they see as a persistent pattern of bad trade practices since the country's 2001 accession to the World Trade Organization.

To avoid heading into the abyss, it'll take more than a commitment to free trade from Japan and Europe. Even a Democratic Party landslide in the upcoming U.S. midterm elections may be insufficient to tip Trump's preferences on trade. Even if China works to dig in for the long haul, it might find itself unable to satiate the Trump administration's demands – at least not without irreversibly damaging its leadership's prioritized domestic economic plans. This trade war might be doomed to play out until the end of Trump's term.