Mr. Trump likes to think of himself as a free trader, but in his mind, free trade isn’t free (or at least mutually beneficial) when the other side is continually cheating.  I tend to be very skeptical of Mr. Trump’s trade policies, especially since his stated logic is grounded in fundamental fallacies, such as the harm of the large trade deficit with China.  Yet in this point I actually think Mr. Trump is at least half right, so let’s walk through some of the many facets of what’s going on.  Will we have a trade war?  Will China sell off our treasuries and destroy the value of the dollar?  Will we win or lose?  Here are my thoughts on this.

1. Mr. Trump is right to engage more forcefully with China in two areas:  China continues to both steal intellectual property from American companies as well as force them to give up their intellectual property as a precondition to do business in their markets.  This is unacceptable, and we’ve complained for years to no avail, so I think a more forceful approach is necessary.  But note that a more forceful approach does not need to be a public approach, and certainly not negotiation by twitter.
2. Mr. Trump’s abdication of global leadership on trade, specifically abandonment of the TPP, has reduced our leverage over China as that would have strengthened multi-lateral actions against China.
3. Discussion of China’s possible sale of treasuries is good for headlines, but exceedingly unlikely, as it would cause China far more problems than the U.S.  I wrote about this during my time at the Brookings Institution a decade ago here, and my take hasn’t changed.  First, China has these dollar reserves to serve their own internal purposes.  They currently are exercising capital controls to keep their own citizens from fleeing their currency and have lost ~$1T of their vaunted reserves already.  They can’t afford to lose more.
4. In part because the DAILY Forex market is ~$5T; even their entire stash of treasuries can be absorbed into the market.  And it won’t do to sell treasuries for simply another dollar-denominated asset, as the Fed could simply buy them all from China and put on its balance sheet and sterilize any effect.  They would have to sell them and buy assets denominated in some other currency.  Yet to drive down the value of the dollar vis a vis their own currency is precisely one of Mr. Trump’s objectives (to make Chinese exports more expensive), so it doesn’t seem a wise approach on their part.
5. Mr. Trump’s fixation on the trade deficit is unfortunate, as it is fallacious and obscures the real issue, which is their continuing theft of our intellectual property.  Re the trade deficit, think of it this way:  I run a massive trade deficit with Amazon.  I keep importing their goods; packages show up at my door several times a week, and they NEVER buy my economic’s lectures, so I must be losing in Mr. Trump’s logic, since I’m running a massive deficit with them.  Obviously we never have equal inflows and outflows with any particular trading partner; it is ludicrous to think that we should even try.  It’s what matters as a whole that counts (and that must include balance in the capital account, e.g., investment dollars that flow across borders).  The Balance of Payments MUST balance, and it always does.
6. Further, the trade deficit with China obscures the reality that much of China’s deficit with us reflects other countries input into final products.  Let me give an example to illustrate.  Let’s say that we make components for an iPhone here in the U.S., and we assign the value of those components as $300.  We send the phone to China, and Apple pays them $50 to assemble.  Then we import the assembled phone from China, and sell for $700 to give a 100% profit margin.  Yet when we bring the phone in from China, our national accounting will assign the entire $350 production cost of the phone to China, even though they only added $50 value.  Precisely because China is not the manufacturer of the world, but rather more appropriately is the assembler of the world, we must only expect China’s trade deficit with us to rise as we expand imports from Asia generally.
7. Retaliatory tariffs on our part are dangerous, and we will definitely lose (as well as our many trading partners that send components into China for final assembly), but they may be part of the solution.  Yet they are dangerous and can quickly go awry–Mr. Trump’s rhetoric gives me little confidence of his sobriety in dealing with China, and more importantly, markets don’t particularly like this.  While China has the world’s biggest credit bubble, we also have a very richly valued stock market.  If the market simply went to historical valuations in a panic of a global trade war, we could see on the order of a 35% stock market drop.  Is Mr. Trump really prepared for this?  Yet Mr. Trump is right on an economic point–China has far more to lose and is much more vulnerable than we are.  Yet make no mistake–if this goes badly we will lose big time, and it will be little solace that China will lose more.

Mr. Trump may end up winning on this issue, and if he can get China to actually respect our property rights then over the long term we will be better off.  Yet his negotiation in public gives a proud Chinese leadership little room to accede to his demands and save face.  Several administration officials (including Larry Kudlow–who I generally like) were walking back on a trade war this weekend, and that’s encouraging.  It’s better to speak softly and carry a big stick.