After decades of growing trade and current account imbalances in the United States, the new administration has set out to change this equation with nothing less than a rebalancing of the global economy.
Today, a new mercantilism, rooted in tariffs and trade protection, is emerging. We define mercantilism as the explicit state policy that seeks the accumulation of wealth and power through favorable trade balances.
While we still prefer a framework for trade that results in a general increase in welfare, it is clear that policies across the large, advanced economies are moving in another direction in an effort to confront China.
Now, as Trade War 2.0 between China and the U.S. begins, investors, firm managers and policymakers should expect an expansion of currency manipulation and a possible return to beggar-thy-neighbor devaluations should the trade tensions spill over into other economies.
Clash of the titans
Already, China has retaliated against the 10% across-the-board tariffs imposed by the U.S. with 14% tariffs of their own on selected goods. We also expect China to diminish the value of the yuan to partially offset these tariffs.
The tit-for-tat trade war has begun.
The irony is that the markets, seeing the evolution of the two economies, had already taken a posture that supports depreciation of the yuan. After all, the U.S. economy is growing faster than China’s, which is mired in the early stages of a long-term deleveraging process.
As would normally be the case with two diverging economies, the yield differential between the U.S. and China has widened.
That widening implies a depreciation of the yuan toward 8 per dollar or above this year from the current rate of 7.3. This forecast, though, might be optimistic given the deep differences between the U.S. and China.
Currency manipulation
Foremost in the success of the pre-China global economy has been the emergence of floating exchange rates.
The free-floating of the U.S. dollar was the catalyst for the development of the global financial system and Western economic growth in recent decades. Included in this group are the economies of North America, the European Union, and the Asia-Pacific alliance of South Korea, Japan, Australia and New Zealand. All have free-floating exchange rates.
The same cannot be said for the emerging markets that have at times pegged their currencies to the dollar, causing devaluations to maintain competitiveness.
A case in point is the destructive currency volatility and hyperinflation of Argentina.
In the case of China, the renminbi (or yuan) lost 14% of its value each year between 1981 and 1994, including a devaluation in 1993.
The renminbi was pegged from 1994 to 2005, and finally allowed to appreciate, but only at an average rate of 0.6% per year despite the strength of China’s economy.
In real, or inflation-adjusted, terms and using 2014 as a base period, we can see the effect of economic growth on the value of the U.S. dollar and Indian rupee compared with other currencies.
Canada’s economy and the Canadian dollar, for example, have muddled along while the British pound has lost ground after the self-imposed shocks of fiscal austerity and Brexit.
Germany’s production sector has been losing ground because of competition from China, with the euro’s real value moving lower.
The outlier among this group has been China, whose growth has propelled it to the top tier of industrial nations, but whose currency value has been sinking in real terms.
To some observers, this suggests that China has been engaged in currency manipulation. Put another way, it is selling the renminbi to keep Chinese-produced goods more competitive than goods made elsewhere.
You would expect a consistent relationship between real economic growth and real effective exchange rates. The U.S. economy has grown at an average annual rate of 2.5% since 2014, which is in line with its average real currency appreciation of 3% per year.
Part of the dollar’s strength can be attributed to its comparative advantage of its financial assets and the dollar’s use in trade and investment.
At the other end of the spectrum is Japan, with low growth and a deterioration of the yen.
Compare that to the current powerhouses in Asia. India has had average annual growth of slightly over 6% since 2014, and China has grown at just under 6% per year.
But while the real effective exchange rate of the rupee has grown by 1.8% per year, the renminbi has lost an average of 0.3% per year.
The Bank of India has said that it is active in the currency market only to smooth out occasional spikes. To that point, the de-facto peg of the rupee by the Royal Bank of India was effectively ended in October and the central bank has moved toward what one might call a “dirty float.”
As for China, the actions of its monetary authority are opaque, opening itself to claims of manipulation.
Dumping
A 2016 article in the Annual Review of Economics found that “China’s economic size, speed of growth and import penetration were all of an order of magnitude different from previous waves of imports from Japan or Mexico or others.”
And while the U.S. has imposed hundreds of anti-dumping and countervailing tariffs, the wave of cheap imports from China has simply overwhelmed companies, even as it has gained manufacturing prowess.
The trade rules were not up the task of coping with the flood of goods from China, leading to the conclusion by the United States trade representative in 2022 that China did not comply with the rules of the World Trade Organization.
We point to the dissembling of the U.S. solar panel industry by imports from China as one example among many of the need to protect infant industries.
It’s not only U.S. manufacturing that has been affected by China’s dumping practices. The Economic Times reports that India’s steel industry is also under attack from China: “From solar panels to electric vehicles, various Chinese goods head to overseas markets where they kill the local industry due to their ultra-low prices made possible by Chinese state subsidies and various other incentives.”
To be sure, dumping is not limited to China. A report in November 2024 by the Commerce Department found that one of the two producers/exporters of hot-rolled steel flat products from Japan, Nippon, had sold merchandise in the U.S. at below market value from October 2022 through September 2023.
Inconsistent responses
The global economy has endured a series of shocks over the past 15 years, capped by the pandemic shutdown, the war in Ukraine and the inflation that followed.
Underlying all of this, however, was the stripping of productive centers from the U.S. and Germany in what is called China Shock 1.0.
So how should the U.S. and its allies respond?
For now, the response is to embrace mercantilism and trade protectionism that targets friends and foes alike.
The U.S. and its trade bloc are trying to rebalance the global economy through unilateral measures organized around the use of tariffs that raise the cost of accessing the American market.
Read more of RSM’s insights on the economy and the middle market.
If this approach does not work, there is an alternative which would involve a program of cooperation with other democratic, market-driven economies.
That alternative approach relies on the creation of a trade and currency bloc that includes the U.S., Canada, Mexico, Britain, the European Union, Japan, South Korea and Australia. Together, these markets comprise over 90% of all global currency reserves and control the global institutions that are committed to free and fair trade.
Creating this kind of trading bloc implicitly acknowledges that a return to unfettered global trade and the free flow of capital will remain inhibited for now.
This might be called “defensive mercantilism,” or an extension of the industrial policies already in place to finance the rebuilding of the domestic infrastructure and foster essential industries.
Implicit in this approach is the strict enforcement of WTO rules on all trading partners. It requires universal recognition of the problems facing the West and then the formality of uniformly applied tax incentives and industrial programs.
From mercantilism to free trade and back
There is no disputing the role that free trade played in the success of the postwar world. This did not come about by accident.
Because of the obvious damage caused by tariffs and isolationism during the Great Depression and before, the United States provided the means to rebuild the devastated economies of Europe and Japan after World War II. In doing so, it created the international markets for goods, services and financing that created the vast store of wealth and the means for innovation that continue today.
In the 80 years since the end of the World War II, there have been three major disruptions to the system of free trade: the oil embargoes of the 1970s, Japan’s dumping of steel in the 1970s, and the rise of China.
- Oil—The embargo by the Middle East in 1973 disrupted the American way of life, not to mention spurring inflation and ultimately a series of recessions. But in the end, American industry adapted, improving the fuel efficiency of its cars and developing new ways of extracting oil and gas. Today, the U.S. is the world’s largest exporter of petroleum.
- Steel and automobiles—Japan’s dumping of steel in the 1970s was met by tariffs, restoring U.S. competitiveness, but only for a time. The damage to the steel industry had been done and now China is accused of dumping as well. At the same time, Japanese and German automakers have invested in production in the U.S. Southeast.
- China—China has become an antagonist rather than the partner that the West had hoped. What worked after the rebuilding of Germany and Japan, in creating an open society and open markets, has not worked for China. As it turned out, expectations for including China in the World Trade Organization may have been naïve.
Rebalancing the global economy
“There is nothing so likely to produce peace as to be well prepared to meet an enemy,” George Washington wrote in a letter in 1780.
The first rule of setting trade policy is to understand that the success of the West is based on its evolution away from the inefficiency of mercantilism toward the efficiency of free trade and market-based decision-making.
We would point to North America as a leading example of the efficiency that regional production among neighbors can bring. Intermediate goods travel back and forth among U.S., Canada, Mexico. Canada ships 95% of its crude oil to the U.S. refineries. Mexico supplies the U.S. with fresh fruit and vegetables and autos.
In Europe, the success of the free flow of trade and people within the European Union is the opposite of the conflict it had last century.
The modern economy is based on the premise that businesses need to be profitable. But that only works if the government insures the safe operation of those businesses and workers. Doing so prevents the political and societal distortions in Europe between the world wars. Today, the de-industrialization in both Europe and the U.S. calls for a similar response.
We can think of the trade war of 2018-20 as proof of the consequences of tariffs, resulting in the manufacturing recession that gripped the world economy.
And we can think of the pandemic as highlighting the need to diversify supply chains. The West should no longer rely so heavily on China for many of its goods.
The pandemic highlighted the need to diversify supply chains.
Businesses cannot be blamed for buying the cheapest goods available. But that should not at the cost of destroying the livelihoods of a whole segment of society or compromising national security.
China has made no secret of its goal to become the world’s pre-eminent economy. While the West is not engaged in military conflict with China, there is the danger of an economic rivalry turning into something a lot worse.
The West’s bargaining chip is that China needs consumers in the West to buy China’s over-production and to finance its debt. The redundancy of state-run enterprises has resulted in a real-estate bubble and an over-abundance of goods with insufficient domestic demand.
A unified response from the West could help rebalance the global economy. To begin with, the West should adopt tax incentives to protect and promote its essential industries while also promoting trade among its bloc of democracies.
A case study
Given how disruptive tariffs are to trade patterns, even temporary ones can generate lasting effects. These were the findings of a paper in 2023 on the negative impact of tariffs and quotas on the steel industry.
For a vivid example, consider the U.S. soybean industry, which was a casualty of the 2018 trade ward.
In that case, the U.S. imposed tariffs on imports of steel and aluminum products, setting off a chain reaction of tariffs on U.S. agricultural products by China, Canada, Mexico, the European Union, Turkey and India.
Perhaps more important, America’s trading partners looked to other suppliers of foodstuffs in what has become a global market for most commodities.
Not only did China impose retaliatory tariffs, targeting U.S. soybeans, but it also added to the damage on American farmers by shifting soybean purchases to Brazil.
The result is a diminished market for American growers. Since 2017, U.S. exports of soybeans have dropped by 2.4% per year, in what appears to be an unrecoverable loss of share.
To counter the loss of revenue, the Department of Agriculture found that subsidy payments to farmers ballooned from just over $4 billion in 2017 to more than $20 billion in 2020. These payments were driven largely by ad hoc programs meant to offset the effects of the trade war.
Trade is not a zero-sum game
In ancient history, a nation’s wealth was determined by its exports minus its imports. That is, if Holland sold more tulips to England than England sold to Holland, then Holland was the richer nation.
Having ignored Adam Smith, this linear thinking of maximizing exports and minimizing imports has captivated generations of policymakers. The Smoot-Hawley tariffs of 1930, for example, pushed the country deeper into the Great Depression and the U.S. trade war of 2018-20 led to a manufacturing recession.
There are many reasons to encourage both trade and the regionalization of nations and economies.
At its simplest, trade is the opportunity for consumers to choose which products to buy. Some households might prefer Italian to French wines, or maybe California products.
Today, North America is essentially a single, highly efficient economy, able to move intermediate and final products across borders.
In terms of trade, that means that countries offer different skills or products, with the trade of dissimilar products the balancing act among nations.
You would expect advanced economies to specialize in high-skill-intensive products and to export the capital derived from their wealth. In return, the developing countries would export the low-skill-intensive products needed by the advanced economies.
Today, North America is essentially a single, highly efficient economy, able to move intermediate and final products across borders in a mutually advantageous manner. Canada ships its crude oil to U.S. refineries. Mexico assembles autos. And the U.S. provides access to its services and to its financial system.
We can see that in the increased purchases of U.S. Treasury bonds over time. U.S. purchases of imported goods send cash overseas, which is then invested in the safety of Treasury securities or in the U.S. stock market.
The takeaway
In the end, the U.S. trade deficit represents the excess demand of U.S. households and business consumption compared to the level of U.S. production.
As nations begin to address these imbalances, investors, firm managers and policymakers can expect the adoption of protectionist trade policies and a rise in currency manipulation if these trade tensions spread across the global economy.
