Following the recent summit between American President Donald Trump and China’s President Xi Jinping, Global Insight considers the reversal on protectionism and free trade, assessing the potential for a major trade war between the two global superpowers.

Before directing the White House National Trade Council, Peter Navarro directed, wrote and produced the documentary ‘Death by China’. Navarro’s may be the first documentary on trade policy to be promoted with a horror film poster. A serrated steel knife plunges into a map of the American heartland, painted with stars and stripes, spurting blood and bringing to mind posters for films like ‘Psycho’ – the marker of origin: ‘Made in China’. The official website leads with Donald Trump’s endorsement: ‘“Death by China” is right on.’

President Trump’s other leading trade adviser cuts a more conventional figure only superficially. United States Trade Representative (USTR) Robert Lighthizer is legendary for disposing of an unsatisfactory Tokyo trade proposal when he was Deputy USTR in the 1980s, by folding it into a paper aeroplane and launching it out the door. A long-time lawyer for US Steel at Skadden, Arps, Slate Meagher & Flom, he is willing to contemplate taking extreme steps against China with eyes wide open. ‘[W]here a trade relationship has become so unbalanced,’ he said in 2010, ‘[o]ne must ask whether potential retaliation from China really would or could even remotely offset the benefits to the United States of more aggressive trade measures.’

That’s about as close as a trade lawyer will come to saying that a trade war would be rational. And to those who treasure global economic stability, it’s just as horrifying as Navarro’s lurid imagery. As men like these have President Trump’s ear, some free traders worry that the sequel to ‘Death by China’ will be ‘Death by China Trade War’. On the hustings, Trump pledged to slap a 45 per cent tariff on Chinese imports, without specifying how. The trade lawyer Bill Perry, who writes the US China Trade War blog, takes Trump at his word. He expects the President to ‘start imposing tariffs willy-nilly’ on the pretext of national security.

Others, in surveying the landscape of US-China trade policy, foresee less a trade war than a Twitter war. The only result of Trump’s summit with Xi Jinping was ‘a plan to create a plan,’ says WilmerHale Senior International Partner Charlene Barshefsky. ‘It will not change the structural nature of the relationship. It will not change market access in a real sense. It will not engender particular areas of reform in China. It will be scattershot but tweetable.’

What’s the problem?

As the USTR under Bill Clinton, Barshefsky led the long talks that led to China’s 2001 World Trade Organization (WTO) entry. Before that tango began, in 1996, the US ran a $34bn trade deficit with China. Terry Stewart of Stewart & Stewart, who is a leading voice for fair trade, went back and studied the congressional debate during the period. Although $34bn was regarded as shockingly high, the conventional wisdom was that the US trade deficit would plummet after China joined the WTO. As Stewart drily observes, ‘The results obviously were not that.’

In fact, over the next 20 years, the deficit with China grew tenfold to $347bn. In 2016, China accounted for nearly 70 per cent of America’s global trade deficit of roughly $0.5tn in goods and services. (As if that weren’t staggering enough, President Trump prefers to cite the $734bn goods deficit, and ignore America’s surplus in services.

Trump and Navarro obsessively cite the trade deficit as the starting point for any discussion of US-China trade policy. For them, it’s a shameful scorecard that shows America to be the greatest loser in the history of commerce. Both Navarro and Commerce Secretary Wilbur Ross insist that China is an anchor on US growth, because gross domestic product (GDP) equals the sum of domestic economic activity (consumption, investment and government spending), adjusted by adding exports and subtracting imports.

Economists are apoplectic that Trump’s leading trade advisers misunderstand the definition of GDP. Imports are not subtracted from the equation because they are negative. Imports are subtracted because (unlike exports) they’ve already been counted as an aspect of domestic economic activity.

‘This is a conceptual error,’ says Barshefsky. ‘There is a very fringe group of economists that take the view that trade deficits are equal to or a sign of unfair trade but, if I had a guess, 95 per cent of the world’s economists do not believe that to be the case. Trade deficits in the US are a function of our lack of savings, and substantial capital inflows into the US.’

Of the capital inflows there can be no doubt. China holds more than $1tn in US Treasury bonds. And while China has a comparatively modest base of US direct investment, in 2016 it ploughed a record $46bn into American assets. These investments create US jobs.

Navarro and his allies retort that auctioning the US’s crown jewels to China is a problem in its own right. ‘While, from a mathematics point of view, obviously you offset trade deficits with inflows that come in, which can either be debt or investments,’ says Stewart, ‘the fact that you’re basically selling your country piece by piece ought to be of some concern.’

Navarro makes the same point less subtly. ‘Suppose,’ he writes, ‘that it is not a benign ally buying up our companies, our technologies, our farmland and our food supply chain, and ultimately controlling much of our defense-industrial base. Rather, it is a rapidly militarising strategic rival intent on hegemony in Asia and perhaps world hegemony.’

Although free traders find Navarro’s tone hysterical, they generally agree that Chinese bids for overseas tech firms merit close scrutiny given China’s record on cyber-espionage and forced technology transfer. Similarly, while most economists scoff at the notion that trade deficits are a net drag on growth, all concede that globalisation creates some economic losers in the US. As the Democrats belatedly discovered, those losers form Trump’s political base.

The bitter debate over trade deficits masks a consensus that China is a bad actor on trade. Even those who dismiss Trump’s general approach to economics, and the wider world, know that China plays dirty. ‘There’s no current or former US trade official I know of who’s going to defend China’s current trade practices,’ says Warren Maruyama of Hogan Lovells, who served as General Counsel to George W Bush’s US Trade Representative. ‘Not on the Hill, not in this administration, not in past administrations. There’s very little sympathy or good will.’

‘There’s no question about it,’ says Barshefsky. ‘The relationship is problematic and I don’t need deficit numbers [to tell me so]... China has embarked on a massive indigenisation effort... with increasingly less reliance, dependence or interest in foreign multinationals other than those that can bring technology... China has embarked on a zero-sum, very mercantilist strategy of import substitution to reduce the presence of multinationals in the market and ramp up the presence of local companies in the market by embarking on a series of highly prejudicial policies. Forced technology transfer, cyber-espionage, the resurgence of state-owned enterprises, the creation of champion companies, the heavy subsidisation of new [strategic] sectors... ’

China’s list of misdeeds on trade is endless. Among other frequently-cited offences are its internet ban, the use of health concerns as a pre-text to shelter agriculture, and (until recently) currency manipulation. Perhaps most notably, industrial subsidies and easy credit have created overcapacity on a huge scale in commodities like metals, cement, rubber and glass.

China is the Saudi Arabia of steel; it can forge unneeded tonnes by the hundreds of millions. Indeed, China’s excess steel capacity equals the full capacity of the US, the European Union and Japan put together. In aluminium, China’s overcapacity was five times America’s full capacity at the end of 2015 – and then Alcoa closed a smelter that drove US output down to 1950 levels.

Barshefsky calls these numbers astonishing. ‘China has pumped in massive amounts of government money to create and then sustain industries which are in substantial overcapacity,’ she says. ‘As the returns dry up because the market price has totally cratered as a result of overcapacity, the government is forced to pump more money into these companies, to keep the jobs. Those companies then pump out more product. And this is a vicious cycle.’

On this, the proponent of a free trade and the proponent of a fair trade are in total agreement. ‘What is clear is that the world faces serious economic challenges in many manufacturing sectors flowing from state activism by China,’ writes Stewart. Overcapacity on this scale ‘has never been seen before and could not have happened under market economy conditions’.

Trump solution one: rip up your old deals

Amidst all the attention given to the drama of Trump’s first 100 days, the promises he’s made good on sometimes get forgotten. Literally as the first order of business on his first day in office, the President theatrically signed an order withdrawing the US from the Trans-Pacific Partnership (TPP).

He told the cameras it was a great thing for the American worker, but didn’t elaborate on why. Michael Wessel -- a long-time advocate for United Steelworkers and a member of the congressional US-China Economic Security and Review Commission -- argues that the TPP would have empowered China. A new rule of origin would have seen ‘Made in America’ stamped on goods assembled from parts that were two-thirds made in China. The pact, he complains, had no effective provisions on currency manipulation, no discipline on state-owned entities, and no provisions on overcapacity. Of course, it’s also true that China was not one of the 12 signatories.

In Barshefsky’s view, cancelling the TPP was ‘first and foremost a repudiation of our partners and allies in the Asia Pacific where, quite independent from China, the US has substantial economic and security interests’. She also argues that TPP withdrawal tilts the Asian balance of power away from America. Obama USTR Michael Froman summed up this attitude in his exit memo: ‘If we step back from a global leadership role, it will be our loss and China’s gain.’

Intriguingly, Trump’s agenda for renegotiating the North American Free Trade Agreement (NAFTA) – ostensibly updated protections for trade in services and technology; stronger protections for labour and the environment – sounds remarkably like the TPP. ‘If the new administration is smart,’ says Barshefsky, ‘a new NAFTA would look a whole lot like the TPP, and that would be the first step in reconvening, if you will, the TPP countries on an, in quotes, “bilateral” basis, but essentially very rapidly putting TPP back together.’

However, if Trump wishes to start from scratch with each nation, says Barshefsky, that’s ‘not remotely realistic’. The USTR simply lacks the staff. In any event, she says, ‘the notion that Congress will vote on 11 separate trade agreements is political suicide. There is no member of Congress who will tolerate that number of trade votes in the current environment.’

Why not just cut a deal with Japan then, and recapture most of TPP’s benefit in one blow? ‘I suspect many blue collar workers who supported President Trump would dislike a Japan agreement just about as much, if not more, than TPP,’ says Maruyama. ‘One of the benefits of TPP from the Obama administration’s point of view was that it was a way to do a deal with Japan without it being overtly a US-Japan deal. So it would require President Trump to go against an important part of his political base.’

The upshot is that a Pacific pact won’t be reached any time soon. Trump’s first policy move may be among his most lasting.

Trump solution two: double down on trade remedies

The prevailing method to address unfair trade practices is to slap specific Chinese goods with dumping penalties or countervailing subsidy duties. Perry estimates there are nearly 200 orders in place against China, which effectively block $10bn to $20bn of annual imports.

Even so, Wessel says America needs to be more responsive to hurting industries. Obama would sit for a year on a winning aluminium case, and prolong futile dialogue on overcapacity. The trade deficit will never fade, he says, ‘if all we do is to say, “Gee why didn’t you fix this problem, why didn’t you fix that problem?” It may be time to simply load up the case chart.’

Without making huge headlines, Trump is bringing complaints urged by industry at an unusually high pace. He filed seven trade remedy cases in his first three months – including four against China, targeting aluminium foil, tool chests and cabinets, carton closing staples and cold-drawn mechanical tubing. ‘We’re seeing a wave of cases here,’ says Perry. ‘I was talking to one of my friends in a petitioner’s law firm and he said, “Bill, there are a lot more coming”.’

One danger in this strategy is that national trade remedy law is vulnerable in Geneva – home of the WTO –  but the main limitation of trade remedies is that they’re too piecemeal to matter economically. Targeting this or that subsector can’t make a dent in a $1bn-a-day deficit. For the world’s biggest trade partners, such fines are merely a token offering to the protectionist gods, a steam release valve for free trade. Of course, they still matter greatly to the targeted industries and their lawyers. ‘Yes, trade remedy cases are somewhat whack-a-mole,’ says Stewart. ‘But, for every worker whose future is shattered by unfair trade, we have to continue to pursue them.’

Trump solution three: risk a trade war by turning the tax system upside down

The US has griped for 60 years that the Value-Added Tax (VAT) other nations levy on US exports amounts to a trade barrier. This grievance has only grown over time, as every major economy except the US adopted a VAT, and the prevailing rates rose into the vicinity of 20 per cent.

Coincidentally, as the House Republicans worked early this year to design a tax cut that might pass Congress, they needed to make it revenue-neutral under the Senate rules. They lit on the idea of a VAT-like Border-Adjusted Tax, or ‘BAT’, that would raise $1tn plus over ten years. As the Harvard economist Martin Feldstein describes it, the BAT would effectively be a 20 per cent levy on imports combined with a 20 per cent subsidy for exports. Supporters say it would be VAT-like enough to qualify as an indirect tax that may be rebated under global trade law. And to the delight of Trumpist trade hawks, American exports would boom.

However, most card-carrying trade experts doubt a BAT would survive a Geneva challenge. That’s partly because the US lost challenges to similar tax schemes in 1981 and 1999.

‘There are 167 members of the WTO, and probably 160 of them would immediately join in a case challenging a US BAT,’ says former USTR General Counsel Maruyama. ‘The WTO consistency of BAT is extremely dubious because it’s basically a tweaking of the US corporate income tax as opposed to a real VAT. The only people I’ve seen who have said it would be WTO-consistent have been tax law professors.

‘There’s a reason international trade lawyers shouldn’t dabble in corporate tax advice,’ Maruyama adds with a wink, ‘and it probably goes both ways. At the end of the day, the amount of retaliation that could be authorised against US exports would be massive. Exports of things like aircraft, agriculture, hi-tech – basically you could kiss them goodbye.’

Reasonable minds can differ on the merits of the WTO analysis, Barshefsky says – but she agrees that the BAT would be begging for an immediate worldwide trade war. ‘If you’re a trading partner, and your product is going to the US and a 20 per cent tariff is slapped on it, are you going to wait two years for a WTO ruling? No way. You’ll retaliate now.’ The Peterson Institute for International Economics envisions an unprecedented $385bn in trade retaliation.

These fears seem to have halted the BAT’s momentum, with a big assist from the import-reliant retail and energy sectors, as well as the Koch brother kingpins of Republican campaign finance. The one-page tax plan released by President Trump before his one-hundredth day in office made no mention of border adjustment. Still, Trump’s one-pager is an opening position; the pressure to find new revenue remains, and House Republicans are pushing for the BAT.

Trump solution four: risk a trade war by hiking tariffs in the name of national security

National security in trade presented President Trump with a rare opportunity for bridge building. Everyone from Barshefsky to Wessel thinks that China’s aggressive policy of strategic mergers and acquisitions (M&A) in technology calls for strengthening the national security review of cross-border M&A deals conducted by the Committee on Foreign Investment in the United States (CFIUS).

Trump’s early big surprise in trade policy was to instead invoke national security as a grounds for the Commerce Department to broadly investigate raising tariffs on global steel and aluminium imports under an obscure Cold War-era law: section 232 of the Trade Expansion Act of 1962. Is this a way for the President to fulfil his protectionist pledges through the back door? Bill Perry of the US China Trade War blog foresees stiff tariffs on metal imports within the year, with more sectors to follow. ‘This could be the real beginning of a trade war,’ he says.

For starters, section 232 may appeal to Commerce Secretary Wilbur Ross as an end-run on the International Trade Commission (ITC). In ordinary trade remedy cases, Commerce can’t act without an injury finding by the ITC – a bipartisan body funded by Congress that is no one’s puppet. The ITC ‘will not be embracing any alternative facts,’ the Democratic ex-Commissioner Jennifer Hillman has tartly warned President Trump. In February, the ITC riled US industry by halting a $1bn dumping case against Chinese truck and bus tyres in its tracks. Perry, who worked at both agencies, estimates that the ITC finds ‘no injury’ close to a third of the time. By contrast, he thinks the Commerce Department, which is fully controlled by the executive, finds dumping at least 90 per cent of the time. ‘Section 232 is totally a creature of the Commerce Department,’ Perry argues, and ‘the Commerce Department is very protectionist.’

But, in Perry’s view, what really makes section 232 a game changer is that it could evade juridicaloversight. US courts might decline jurisdiction because the Trade Expansion Act does not expressly provide for judicial review. The WTO might take its national security clause to be self-judging. In either forum, jurists naturally tend to defer on national security.

‘We know Donald Trump wants to find a way to unilaterally impose tariffs on his own,’ Perry says. ‘In the campaign he always said, “I’m going to put a tariff on them!” Well, now he’s got a way to do so. And he’s going to do so with a friendly Commerce Department, no independent check at the ITC, no court review of the determination... And, [in] the WTO, [the only check is] a provision that’s never been used and gives a country wide latitude.’

However, Professor Robert Howse of NYU says it’s far from certain that Commerce will find a section 232 violation or that the executive would choose aggressive tariffs as the remedy. And it’s unlikely that such a tariff would survive review by the US courts and WTO.

Launching a section 232 investigation is good for a tweet or a soundbite, says Howse. ‘But it’s completely preposterous. I’d be very amused to see any reasoned argument that steel imports threaten US security.’ The logic seems to be that America lacks the means to supply its military, yet these industries are far from extinct. And, in any event, a tariff won’t magically build a new steel mill in Pittsburgh. In the end, Howse predicts, ‘we’ll hear a lot of belligerent rhetoric. But will there be any actions in obvious  violation of WTO treaty obligations? I don’t think so.’

Howse expects the US courts to read a reasonableness requirement into the Trade Expansion Act. He doubts the WTO would undermine its own system by giving members carte blanche to impose tariffs under the guise of self-assessed national security needs. And, at both levels, the decision-makers may feel a responsibility to act as a check on a President who openly campaigned in opposition to free trade, globalisation and the liberal world order. Even as he signed the section 232 orders, Trump was slinging protectionist slogans. ‘We’re going to fight for American workers and American-made steel,’ he proclaimed. ‘For decades, America has lost our jobs and our factories to unfair foreign trade... and we’re going to reverse that.’

Just as US judges read Trump’s ‘travel ban’ in light of his rage against Muslims, the WTO may read his ‘national security orders’ in light of his protectionist pledges. Ambassador Barshefsky says jurists aren’t deaf: ‘Look, there’s such sensitivity internationally because of all the rhetoric in the campaign, that as the administration takes action that looks like that rhetoric, it will be interpreted as fulfilling the rhetoric... I don’t think there’s any panellist in the world, just as there’s no judge in the world, who wouldn’t also say, I know [why] this was enacted the way it was.’

In any event, the stakes may stay low. Julia Ya Qin of Tsinghua University rejects the notion that the section 232 strategy will spread from steel to sector after sector. Trump has ‘realised that the economies of China and the US are so interdependent that neither side can afford a trade war,’ she says. And steel tariffs ‘would not trigger a full blown trade war’.

Trump solution five: make a new and better trade deal

One school of thought holds that the US President is merely aiming to intimidate China, and to win trade concessions before hostilities escalate. Wessel says that’s certainly his hope. ‘No one is looking for trade wars,’ says Wessel, ‘but if one steps back and looks at the composition of trade, the volume of trade and also the political situation in each country, I would argue China has a lot more to lose.’ The Communist Party’s hold on power, he stresses, depends on keeping their people employed. ‘And so I think China has to be very careful about how it approaches the US and needs to be much more responsive [to its] complaints.’

Exactly what concessions Trump would pursue in negotiations is anyone’s guess. In general, the administration is trying to make ‘reciprocity’ the new touchstone for equitable deals. Stewart, for one, would like to see managed trade. ‘Look,’ he would say, ‘we’re happy to accept as much from China as China is willing to accept from us, and we’ll give you five years to get there.’ Such an approach is the antithesis of free trade, but it would probably be WTO-compliant if it were negotiated bilaterally as part of a comprehensive deal.

If threatening a trade war is Trump’s negotiating strategy, Barshefsky is underwhelmed. Threatening a war only works if you’re willing to wage a war, she says, and the business community isn’t. ‘China may be more trade dependent than we are,’ she says, ‘but do you want to lop off a third of the growth in GDP? Can the US actually afford that? I don’t think so. So this notion, this talk about trade war, which I view as so much bravado, is completely undesirable.’

In practice, when he met with Xi, Trump seemed willing to subordinate the trade agenda he campaigned on to North Korean diplomacy. ‘I think it’s astonishing,’ says Barshefsky. ‘I think it’s astonishing to say to a country... you’re cheating us, you’re raping the US... but I won’t mind if you help me on North Korea.’ On the flip side, Howse was scandalised when then President-elect Trump voiced a willingness to subordinate Taiwanese diplomacy to his trade agenda. Trump quickly backed down on Taiwan so, in terms of trade, China won both skirmishes.

Professor Qin would remind us that China is no stranger to the art of the deal. ‘So long as it is a matter of making deals,’ she says, ‘China should be able to manage just fine.’

Coming to terms with China in the world trade system

If Charlene Barshefsky could reconvene the WTO talks of the late 1990s, she’d do it all over again. ‘So you have the world’s largest country, a nuclear power, a permanent member of the Security Council, the world’s largest standing army, the centre-pole of Asia, and it knocks on your door and says, “we want to reform our economy”. You don’t say no.’

As Bill Clinton’s US Trade Representative, her only regret is that the Republican Congress didn’t adequately assist displaced workers. She’d like both parties to pay more attention to trade adjustment policy. Wage insurance and apprenticeships in Denmark, Germany, Korea and Singapore should be emulated. Counselling for small businesses should be scaled up. ‘I think China has to be credited with a lot of the progress that it’s made,’ she says, ‘and it has to be criticised for a backsliding on reform.’

China has ‘reformed its economy substantially,’ she continues. It ‘so substantially opened its economy that, in fact, it’s the second-largest importer in the world... Its contribution to global growth has been exceptionally important... Where China fell off the wagon was beginning seven-ish years after WTO entry, when you saw, beginning 2007, a trickling down of economic reform and opening, and a ramping up of discriminatory measures, elevated to ideology almost by Xi Jinping.’

Professor Qin of Tsinghua wrote an influential paper on ‘The Impact of WTO Accession’ in The China Quarterly. From a Chinese perspective, she sees a different mix of blessings and curses. And she disagrees with the Western narrative of Beijing’s recent betrayal.

‘Everyone, including the Chinese government itself, underestimated the economic impact of China’s accession to the WTO,’ she says. ‘For China, it has brought economic prosperity for millions and made China a great economic power within a short span of a decade. It has also helped China to modernise its domestic governance. But, the amazing speed of China’s economic rise has come at the expense of severe environmental degradation, and has led to an enormous wealth gap, and created many other social problems.

‘Politically, outsiders may have had some misconceptions about the Chinese system and thought that China would gradually evolve into a market economy not fundamentally different from the prototype. In reality, the Chinese government has been very consistent in its policy of making the state sector stronger and more competitive -- this basic position has never changed. And the government has never indicated that it would give up using industrial policies in economic development. In this regard, I don’t see a fundamental shift in 2007.’ 

Whether or not they see China’s deviation from the Western model as consistent or forseeable, committed internationalists would address them within the WTO system.

Barshefsky would like to see the US bring a WTO case that attacks every facet of China’s programme to nurture a new field of technology through non-market practices. She’d also like the US to update China’s 1999 WTO agreement with a series of bilateral accords. It pains free traders that the liberal President of the future can’t build on the platform of a TPP. But, they are determined to complete their historic project. ‘When you need to see systematic change, the one thing you don’t do is throw out the agreement that would have pushed China to make systematic change, and that was the TPP,’ she says ruefully. ‘Now we have to do it area by area, negotiation by negotiation. But it has to be done.’

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Michael Goldhaber is the IBA’s US Correspondent. He can be contacted at michael.goldhaber@int-bar.org