Tuesday, May 21, 2019

Trade War: Who is Vulnerable?

Trade Wars. Easy to initiate, but challenging to terminate. As the trade war escalates between China and the United States, many economists have provided their insight to this international trade war. Of course, the overall analysis would not be complete unless I provide more insight into this situation. Please note: My perspective has nothing to do with my personal political views for any politician, as I am analyzing this from an economics framework.

This article, Who is Most Vulnerable In A Trade War?, analyzes which side, China or the US, is the most vulnerable in this conflict. I have a perspective, and I will use economic logic to support it. I will also look at the position of the allegations of China’s intellectual property theft of US firms and if that is a proper reason to raise tariffs on US Imports.

Who is Really Vulnerable?

First of all: The question is built upon a faulty presupposition: “Who is the most vulnerable in a trade war?” The question is framed from a collective: China or The United States. This needs to be made clear: Trade does not happen between two countries, but individuals. Individual firms, in China and the United States, engage in voluntary trade with each other. It is not about which country will be hurt the most with this “trade war”; rather it is about the individuals who will be impacted from the increased economic cost forced upon their distribution process.

For example, if a Chinese steel manufacturer sells his steel to a United States supplier, and tariffs are raised in the United States, the supplier, in the US, is impacted. Depending on the price elasticity, namely, how sensitive the consumer is to price increases, the supplier will stop purchasing Chinese steel. Or the firm may continue to purchase the steel, and absorb the price increase, or raise his prices. There are many variables here to consider. In the case of the US Supplier is unable to purchase Chinese steel, the domestic firm may go out of business if he can not absorb the cost, or if he can not sell his product at a higher price. In this scenario, the smaller US Suppliers are vulnerable, along with the Chinese steel maker.

As an aside: With any tax increase, it is always subject to elasticity. With regards to tariffs, this is no exception. For example, if tariffs are raised to 100% on all imports, the possibility of the tax revenues generated, from the tariffs, will be close to zero. If the tariffs are set at 0%, it is obvious that the revenue generated from tariffs will also be zero. In between the minimum and maximum, the Federal Government will set the tariff rate. This is done to optimize all factors: elasticity, tax revenues, and etc.

Secondly, simply stating, “Oh well, the Chinese will lose here, and the US will be able to absorb the tariffs”, is specious statement. This is framed in a means that the “wins and losses” can be accurately quantified, in order to “keep score”. Economics is not a quantitative science, but it is a qualitative one. It is built upon the fact that human beings act, and their actions are driven to obtain “happiness”, as these economic actors utilize subjective means. It is possible to attempt quantify some things within economics, but that explicit analysis will never capture all the economic costs, as that feat is impossible.

Back to the specious statement...if we could actually keep score, how is it done? Can the United States’ economists analyze the potential economic impact of billions of people (China), as compared to the hundreds of millions (United States). This means, to capture this data, the economists would need to determine the needs of all the citizens in both nations, and figure out all the preferences of the individuals involved in the entire supply chain process. This too is impossible.

To state following: "Who is the most vulnerable" simply is a derivative of the "us vs them" dynamic, which is a common theme in sports. Voluntary exchange is not a "football game" where there are winners and losers, yet it is about both sides benefiting from the mutual exchange. Once intervention by fiat takes place, e.g. from the Government, the economic costs are raised. In this event, all sides are "vulnerable"; mainly the smaller firms in China and the United States.

“But, China is stealing from the US Firms!”

There is always a risk of asset theft in any market. Theft happens in the American market. To propose it never happens is quixotic, and to propose it happens 100% of the time, is equally nonsensical.

However, let us suppose this is true. Let us suppose that it is true 100% of the time. Questions would need to be raised to address this claim. For starters, why would any firm do business in a market that has an absolute risk of Intellectual Property theft? If the risk is that high, no firm would do business in China. Not one. Yet, it is evident US firms still do business in China, despite the risk of IP theft. The risk of that IP theft is built into the marginal cost of every product sold on the retail market. If the firms' marginal cost exceeded the marginal benefit, based upon this risk, they would seek alternatives. The fact that some US Firms still engage in the Chinese market means this allegation is not an absolute, but a percentage...which is all about a probability of risk. Due to the fact is about a probability of risk, US firms conducting business in China must determine the means to manage this specific risk.

If every single firm is a victim to the nefarious Chinese US IP theft cabal, and tariffs are the solution to mitigate the IP theft, the American people are paying the insurance for the US firms doing business in China. As previously mentioned, since it is not an absolute risk, this means there is a probability of risk. Since the rationale of the use of tariffs acts as a response to Chinese IP theft, this means the tariffs revenues collected act as “insurance”, to indemnify the US firms’ stolen IP assets (allegedly). If this is true: How are the premiums calculated? This process would require an evaluation of the IP assets of every single US firm, doing business in China. Also: The Government would need to factor in all the risk factors calculating the premiums. This assumes those tariff revenues actually go to the firms that file claims for IP theft. In the event this happens, this creates a moral hazard involving the US Firms. Those firms would have little to no incentive to internalize the risk (cost) of doing business in China. They will simply conduct business as usual, seeking Government funded protection from the risk of IP theft in China.

Conclusion

Firms must absorb all risk associated with their projects and endeavors. The costs, related to the risk, along with other costs, are factored into the development of the product as it is brought to the marketplace for sale. If that risk, is mitigated with the use of Tariffs, then that risk is passed on to the American consumers via higher taxes or tariffs.

Back to the earlier portion of this analysis, smaller firms would not be able to compete properly, due to the increased economic cost of the tariffs. The larger firms would be able to absorb the costs, yet would they actually be indemnified due to a loss? Furthermore, will the revenues from the tariffs be held in some sort of “reserve” account for these firms who need to file a claim from stolen IP assets from the Chinese?

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