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What Are the Long-term Costs of the China-U.S. Trade War?

By Wharton's Efraim Berkovich and Marshall W.

Dark times loom for the U.S. economy in the aftermath of President Trump’s latest threat on August 1 to levy 10% tariffs on some $300 billion of imports from China. In response, China allowed allowing the yuan to weaken against the dollar and thereby cushion the impact for Chinese exporters. In a tweet, Trump accused China of “currency manipulation” and called upon on the Federal Reserve to respond.

Monday’s yuan-dollar rate of 7-to-1 was at its lowest since 2008. “[The] trade war has now become a currency war, which raises the potential economic harm to another level,” The Wall Street Journal noted in an editorial.

On Monday, the Dow Jones and the S&P indices fell 3% and stock markets and currencies in emerging markets weakened, and an economic downturn seemed closer than before. The spread between the 3-month and 10-year Treasury yields – an indicator of recessions – inverted to its widest level since 2007.

Last Thursday, Trump said the U.S. would impose 10% tariffs on $300 billion worth of imports from China effective September 1, amid signs that talks between the two countries over the past year or so were yielding little progress. That tariff move would be in addition to the higher tariffs already in place for $250 billion worth of imports from China, thereby covering all U.S. imports from that country. Trump reportedly overruled resistance from within his administration in announcing the latest tariff move.

Worries are over the larger and longer-term implications of China allowing the RMB dropping below “the psychological barrier” of 7 to a dollar, said Marshall W. Meyer, Wharton emeritus professor of management. “People are wondering whether China will repeat what it did in 1993-1994 when it devalued the RMB sharply to turn around a recession, and the knock-on effect perhaps was the Asian financial crisis.” Back then, China devalued the yuan by 33% overnight to 8.7 to the dollar as it unified its dual exchange rates, hoping it would help its state-owned enterprises embrace a market-based economy.

The Penn Wharton Budget Model (PWBM), which analyzes the longer-term implications of policy moves, has identified two primary effects of the trade war with China. One is lower output for the U.S. economy, and the other is a shift towards households in the financing of U.S. debt, said Efraim Berkovich, director of computational dynamics at PWBM. As the escalation in the trade war reduces foreign capital inflows into the U.S., it would provide a short-term boost to GDP as domestic households would pick up the slack and provide more labor, but GDP will fall the long-run, Berkovich said in an article with Zheli He, an economist at PWBM.

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