Has President Donald Trump finally made some real progress in the ongoing trade war with China? Bloomberg reported over the weekend that indeed, this is perhaps so. According to officials familiar with the ongoing negotiations between the U.S. and China trade delegations, China has made a generous offer to increase its imports from the U.S. by $1 trillion over six years. The goal is to zero out China’s trade surplus with the U.S. by 2024.
Now, one can certainly criticize this development in many ways, but let’s leave all the criticism aside for the moment and give the Trump and Xi administrations the benefit of the doubt. Let’s assume they have solved the so-called trade imbalance problem, and that President Trump’s aggressive tariff-ridden trade strategy with China has worked. Let’s assume that by 2024, U.S.-Chinese trade has been balanced. What happens then?Â
If China were to import $1 trillion more of American products than it is currently importing, it will have to pay for those products in U.S. dollars, of course. It will have to get dollars from somewhere. The most obvious source is the $3 trillion Chinese stash of U.S. Treasuries, which they buy with the dollars they get from the current trade surplus with the U.S. Those surplus dollars are sent back to the U.S. Treasury to fund the federal deficit, with the added benefit of lower interest rates than otherwise.
Now let’s imagine the situation is reversed. U.S. trade with China is now balanced. That means China has fewer extra dollars to buy U.S. Treasuries with, which in turn means that interest rates will rise higher than they would otherwise. It also means that in order to buy all the extra stuff, China will have to sell some of the U.S. Treasuries that it does have in order to fund the extra purchases. That could even make China a net seller of U.S. Treasuries at a time when federal deficits are near $1 trillion annually.
So one obvious consequence of balanced trade with China is higher interest rates in the U.S. But there is another consequence, and that is higher consumer prices. In other words, higher inflation.
The idea is pretty simple. If the U.S. is exporting $1 trillion more of goods to China, those exports can come from three possible sources. First, existing exports can be redirected from other countries to China. Second, products could be redirected to China from existing domestic U.S. customers. Third, the U.S. could simply increase production.
Let’s reasonably say that the $1 trillion will come from a combination of these three sources. How would each affect prices? Redirecting exports from other countries to China would not ease the global U.S. trade imbalance, and so would also not affect the supply of goods within the U.S. itself. Domestic prices would remain unaffected on the supply side. However, redirecting products from existing U.S. customers to China would shrink the supply of goods available in the U.S., constricting supply and raising prices. The third source, increasing production and exporting the difference, would also leave the existing supply of domestic goods unaffected.
Therefore, from the supply side we have two factors that will not affect prices, and one that will push them higher, meaning prices will rise overall. But there’s one more thing to consider, and that is the monetary side of the equation. Exporting $1 trillion of products to China by definition means importing $1 trillion more in currency, literally, to the U.S. Instead of all that inflation sitting sterile in Chinese vaults in the form of U.S. Treasuries, those Treasuries will be sold for dollars, and those dollars exported to the U.S. from China. The domestic money supply will rise more than otherwise, raising consumer prices overall.
So what will the effect of balanced U.S.-China trade be? Through a $1 trillion Chinese buying spree, the U.S. will see higher interest rates and higher inflation than they would otherwise.
Disclosure: No positions.
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