How to think about the US-China trade war: A long-read Q&A with Derek Scissors

With the United States and China trading threats of escalating tariffs, the world waits to see whether these barbs become a full-fledged trade war between the two largest economies. The Trump administration claims its actions are necessary to deter China from continuing its predatory trade behavior — an objective today’s guest, Derek Scissors, agrees is a worthwhile pursuit — but he doubts whether the means Trump has chosen can achieve this end.

Over the course of our conversation we discuss the likely impact of Trump’s promised tariffs, the different ways China cheats the global trading system, whether the US should have allowed China to join the WTO in the first place, and much more. Derek Scissors is a resident scholar here at AEI, the chief economist of the China Beige Book, the author of the China Global Investment Tracker, and an all-around expert on US-China relations.

Below is a lightly-edited transcript of our conversation. You can also subscribe to my podcast on iTunes or Stitcher, or download the podcast here.

James Pethokoukis: As we were preparing this podcast, the president had promised $50 billion of tariffs against China, and then as we were beginning this podcast we hear there is a new threat: Trump now wants $200 billion more against China. You are in favor of getting tough on China, but you oppose this ever escalating tariff strategy. Why is this a bad strategy to get China to do what we want them to do? Though I’m not exactly sure what we want China to do.

Derek Scissors: Yeah so there are two problems there. What is our goal? In conversations with the administration for months and months and months they have never answered that. And that doesn’t mean that individual members of the administration have not answered the question. They do have a goal, it’s just the goal clashes from member to member. There’s been a lot of talk about how Secretary of Treasury Mnuchin and US Trade Representative Lighthizer don’t agree, so if you don’t have people within the administration agreeing on a goal, you don’t have a clear goal.

So it’s not that there’s no goals, it’s just the goals don’t necessarily sync together.

Exactly. If Lighthizer were sitting right here he’d have a goal; the problem is that is not the administration’s goal. So then with regard to the action last night, this comes out of Section 301, which is a section of one of the US trade acts. And this investigation was started in August, I was there at the beginning, and it was supposed to be about Chinese intellectual property violations. So that’s a real trade practice problem that harms the United States. We’re a very innovative country, China just takes that innovation away and doesn’t give us credit for it, and so comparative advantage doesn’t work because we’re good at innovation and then we don’t get any benefit out of it in trade with China.

But what we’ve moved to is, we’re not punishing companies that stole IP, or used stolen IP — we’re punishing everybody. It doesn’t say tariff on some companies it says tariffs on everything, and that means you have no incentive to change your behavior. If I stole IP or I didn’t steal IP, I get the same punishment, so I might as well steal it. So we’ve lost the plot on what we were originally going to do; that’s problem number one.

And problem number two is, for somebody following China, we know what really hurts the top of the Communist Party. It’s big, centrally-controlled Chinese state-owned enterprises (SOE) and we have an example right in front of us: ZTE. We’re not targeting them either, we’re targeting companies in China which export; some of those companies are American companies. So getting angry at China, I’m all in favor of it, but this isn’t going to do what we need it to do.

So these tariffs, they’re focused on different products and some of those products are technology products, they are the kinds of things that they are trying to get better at; you have the Made in China 2025 emerging technology initiative. So is there any kind of rhyme or reason to how these tariffs are being applied?

Well, we started off with $50 billion which was supposed to minimize impact to US consumers, which wasn’t the goal; the goal was to go after IP violators. Then we switched to minimize impact to US consumers but target exactly what you just said, the Made in China 2025 technologies. For the $200 billion announcement last night we don’t have any guidance at all and there’s no way that the Made in China 2025 product consists of $200 billion of exports to the US.

The reason the Chinese are emphasizing that is because they are not really competitive in those areas; they are not exporting a lot. So it’s hard to see the rhyme or reason in the tariff list so far; it comes from what the president said before: “trade wars area easy to win.” What he means by that is we can apply tariffs to more goods than the Chinese can apply tariffs to because we import more from them. That’s really the motivation there: we can go higher than they can. It’s not targeting technologies or IP violators or anyone else.

There are some people in the administration that are interested in the technology aspect — China is stealing IP and forcing technology transfer — but while the president may have mentioned that from time to time his focus is really on the very simple metric that there is a trade deficit, therefore we are losing, therefore we need to close it or eliminate it. That seems to be his focus. How do tariffs play into that?

Well if you think that a bilateral trade deficit is a legitimate target — which I don’t, but the president clearly does — the tariffs are going to shrink the trade deficit. It’s going to make it more costly for goods and services made in China to come here. That doesn’t mean that we will start making them all here; we’re probably going to buy them from other countries so it may not affect the overall trade deficit at all. But the bilateral trade deficit with China may decrease. This is just a tax. We’re taxing the bilateral trade deficit with China, and when you tax something you get less of it, and that’s what we’re going to get, less exports from China.

But can we eliminate that so there’s balanced trade between the two countries? It’s a big number.

We could, but the goods and services trade deficit last year was $337 billion. We’d have to take much stronger action then we’re doing now. I mean one of the attacks on China is they subsidize their products. Okay so you put a 10% tariff on, they raise their subsidies 8%, they’re still more competitive than other goods and we get nothing whatsoever. So yes we could eliminate the trade deficit but that’s not what these tariffs are going to do. And actually I don’t think that the president wants to do that. I think he wants to show that he took an action no one else did and the trade deficit shrank — not that it went away, but instead of 337 it was 287, something along those lines.

Right so he can say hey, maybe it’s not perfect but I just got you $50 billion. So the behavior these tariffs are going to change is what? What will China be doing differently because of these tariffs that will be to our advantage or help us?

We’ve gone away from trying to get them to change their IP behavior because we’ve gone away from targeting those companies. I guess we could say what we want is to change your Made in China 2025 policies but as you just said, that’s not what the president wants. The president wants the bilateral trade deficit to change. Made in China 2025 is about the future for China, not about the present.

Right and with that plan, they’re spending a lot on investment, they’re subsidizing industries, all in the effort to have leading companies in all these new technologies: artificial intelligence, aircraft engines, et cetera. If they want to move up the economic ladder and not be just a middle income country, they need to do that. So it would be very difficult to dissuade them from doing those subsidies. Is that possible, that they’re going to abandon this plan?

They’re not going to abandon the plan. China has had industrial strategies before 2025 and they always have; this is just a label that has got people’s attention because they are moving into areas that they weren’t into before, as you just said. So they’re not going to abandon it. Could we get them to modify it? Sure. If we kept tariffs on Made in China 2025 products for ten years, that reduces their export incentives. If the biggest market in the world isn’t available it kind of shifts their policies, but it doesn’t help now; that’s a future game. If we wanted to really push them off those policies now you’d have to take much more dramatic action.

The president is right that the US has leverage. China needs the foreign currency it gets from its trade with the United States. But we’d have to take very dramatic action. We’d have to say something like, “You exported 500 and change in goods and services to the United States last year and next year the quota is 400 billion — we just took 100 billion off your surplus.” Of course they would retaliate against that, but that’s the kind of thing that would make them change now.

And this is the problem that you are suggesting: Made in China 2025, well, it’s not 2025. If we’re acting against that, we’re trying to deal with a future problem. But the president doesn’t want to deal with a future problem, he wants to deal with a current problem. And these tariffs could have an effect over five years if we stuck with them for five years, but for now, they’re not going to be enough to get the Chinese to change their policies.

Right and the president won’t be able to say that it’s worked. If you said to him this will work in five years he would say you’re trying to scam me — this isn’t a real policy, real policies have immediate impacts.

Right and so I think this leads to a natural conclusion, which is the president wants to negotiate with the Chinese for immediate changes, using this threat of long term tariffs. When he put the $50 billion on, the Chinese didn’t start to negotiate they retaliated, and he’s trying to tell them you’re not going to win this war of retaliation, you better come to the table with a better offer than you’ve made so far. So the way we connect these two is the president says we can hurt you in the long term, and try to get the best deal in the short term.

But there will be retaliation in the short term, with an immediate impact on American companies and American consumers.

If you want to get the best deal and push the Chinese as far as they’ll go, you have to suffer some pain first, and I said that to members of the Cabinet when we started. I said if you’re not going to stick with this for at least three years and accept some pain and some political loss then just don’t bother. We haven’t seen the administration do that yet.

The Chinese are not just going to say, well okay the US threatened us with more tariffs so we’ll just give in. To get the most from the Chinese you have to have some retaliation against American companies, some retaliation against American exports, meaning jobs here. If you want to give in before that and have no tariffs and just have talks beforehand you’re not going to get that much. So the president has got a choice here of get a deal right now that isn’t very impressive or put up with some pain, including pain for constituents who voted for him, like farmers.

When I read about this it seems the consensus is that China believes that they have greater ability to absorb that pain than the United States. Do you think that’s right?

I think it’s right so far. We were talking earlier about our lack of a clear plan; we have not stuck to anything. We started this investigation, then had tariffs different than the investigation, then Secretary Mnuchin said the war is on hold — we keep bouncing around and if you’re China it’s very frustrating because you don’t know what US policy is going to be. But you see no sign the US willing to put up with pain.

So this is one of those funny situations. We can inflict more pain on the Chinese than they can inflict on us. That’s just true. But if we’re not willing to put up with any pain then we don’t have a strong negotiating position, and so far we haven’t shown that willingness.

Your concern about the technology issue — how serious of an issue is this? People point to IP theft and forced technology transfer, but what is really the impact of these two practices? And are our concerns more economic or are they national security related?

So it’s multidimensional question. The concrete economic impact is hard to measure because you got to figure out, well what would’ve been the value of something if the Chinese hadn’t stolen it, and that is really difficult. But you’re certainly talking about at least tens of billions of dollars every year. And you could be talking about in the low hundreds of billions.

Sticking with the economic side, what bothers me most is the number one American comparative advantage is in innovation. We have some great agricultural producing states, but the whole country is good at innovating and not just in big advanced technology, but little innovating, little tweaks that people come up with in their garages. And if the Chinese are going to take that away from us, the theories that we have about trade don’t work. If you can’t get your comparative advantage out of trade, the relationship doesn’t work for you anymore.

And so the whole idea of China stealing innovation to me is a fundamental threat to the benefits of the US-China economic relationship, and how much they’re stealing is secondary. We need to get them to do less, otherwise we’re not benefiting —

And did we not care as much before just because they weren’t as big an economy, they weren’t as rich? And now all of a sudden we see them as a true military, economic, and ideological rival?

Yes. I mean, there’s no question that’s a factor that as China has gotten bigger, there’s a national security element in this as well. Whereas before they were never stealing technology that could actually be competitive on a military basis and now they’re getting to that point. Their telecom equipment is only a little behind ours. Telecom equipment is really important in military operations. So there’s a national security element.

There’s an economic size element. To be blunt, I think the president deserves credit. I think President Obama should have done this. I think President Bush probably should have done this now. Maybe not the way President Trump is doing it because I don’t like tariffs, and maybe not in this kind of very alarmist fashion, but the US is overdue to respond to Chinese behavior. And as you said, size, national security, that’s pushing us to act now when 10 years ago we didn’t act.

We mentioned endgame earlier. The end game is not going to be that China is no longer a technologically advanced country — or do you think maybe that is the end game? It seems to me they’re a very big country. They graduate a lot of engineers. People can call them a communist country, but they are a very entrepreneurial country as well. It seems like they are going to be an economic and technological rival no matter what we do.

That’s right. So you have a group of people that really wants to basically destroy the Communist Party. That’s a very big goal. You have a group of people like me who say, look, China is going to be an important player on the global scene across all the dimensions you talked about, but we need to get them to cheat less. They’re not little anymore. They can’t get away with cheating —

Is that because it will really have that big of an impact, or is it because we’re worried about them suddenly having a breakthrough in some technology that changes the defense-economic equilibrium, or is it because if we don’t do anything, there’s just not the political support in the United States for free trade and openness?

So I think it’s the second one, but I’m not a military expert. If you had somebody else from AEI on they might say they are really worried about a Chinese breakthrough in this technology or this technology and then we could get a war over Taiwan or whatever — that may be true, but I don’t know enough.

What I’m more worried about is your second point, which is it’s not just the US. There’s a lot of anti-trade rhetoric around the world. The WTO stop moving forward in the middle of the last decade. We tried the TPP (though I didn’t think it was a very good agreement and it had no chance of passing the Congress). President Trump is a populist. It’s not just him. Hillary Clinton reversed herself on the TPP. Senator Sanders is anti-trade. So we’ve seen a lot of weakening for trade support around the world and in the US. And if the second largest economy and arguably the largest trading country is still cheating and there’s no pushback, of course Americans are going to say, I’m not supporting this. I’ll support free trade with Canada even though the president’s mad at them, but I’m not supporting free trade with China. And if you push the second largest economy out of the world trading system, the system may fall apart.

What will happen is some countries will go with the US, assuming that we treat them well, and some countries will go with China, and we’ll get a segmented world trading system instead of a global world trading system. So for me the problem is the Chinese are undermining global open trade by their behavior. There may be a military problem too, but I don’t know about that.

Was it a mistake to open up to China like this and let them join the World Trade Organization in 2000? What was the alternative? You’ve had these studies come out saying it’s hurt certain segments of US workers badly. Did we make a mistake bringing China into the world trading system?

Whenever I answer this question, I get angry phone calls from all my friends, including people at AEI. I think it turns out we made a mistake but I don’t think that was clear at the time at all.

Was the goal to turn this country capitalist through trade? We were opening them up and maybe they weren’t going to be Vermont tomorrow, but eventually they would end up being like South Korea, a relatively free, democratic, capitalist country.

That’s certainly what people like President Clinton said in the nineties. I didn’t have that view back then and I don’t think you need to have that view. What you wanted was a country that was going to move toward being a good trade and economic partner. And that’s where they were moving. China restarted reform after Tiananmen (a reminder of what kind of government they have), but they restarted reform after Tiananmen. They made big important changes as part of their negotiations with the US and the WTO. And it looked like when we agreed to let China in that they were really continuing to move in that direction.

So it seemed like the right call. This is a very big country with the world’s largest population. You don’t want to cut them out if they’re trying to do the right thing. Then what happened was a new government came in and China, after they got in the WTO, went backward. And they went backward slowly but consistently. They’ve been going backward in my opinion for 15 years. So we had a China that was going forward to be a better economic partner. We let them in the WTO, and since then they’ve been going backward.

Backward as just an economic partner, or as far as being a more market-oriented economy internally?

Both. For example, the main Chinese corporate reform now is not saying, hey, we like state-owned enterprises, but we’re going to limit them to certain sectors. It’s saying we want one gigantic state-owned enterprise to dominate this entire sector and be competitive for China around the world. And of course it’s never allowed to go out of business, so that’s the biggest subsidy of all. So in the nineties with the Chinese negotiating to get into the WTO, they were shrinking the state sector. Since then they’ve been expanding it. And so how are they moving backward? It’s domestic reform in China. It’s China’s trade practices with the US. And it’s China’s investment overseas.

Why do you think they changed directions like that? Was it just a political response, where they saw too much freedom and too much challenge? Because fundamentally that’s the ultimate policy filter: How does this impact the power of the Communist Party? If it’s bad for the Communist Party, then they are not going to pursue it.

People will accuse them of planning the whole thing in advance, like give the US as many concessions as they need just to get into the WTO and then reverse course. I don’t think that was the case. I think you had difficult structural adjustment kind of reforms that we always say countries should make — we need to make some in this country with regard to entitlements.

And then when that government left, the new government came in and just kind of coasted. It was like, great, thanks for doing all the work; we’re not going to do any of that. The government that took over in 2002 and was in charge for 10 years is very corrupt. And this government in China, which replaced it in 2012, is a populist anti-corruption government, and they want strong tools in the hands of the state, including economic tools. So I don’t think there was a conspiracy on the Chinese side. I think they got lazy and started to live off previous reforms, which many countries have done, and now what we have is a Maoist kind of dictator and he is not going to let the state’s power over any dimension of society wither.

No, it looks like they’re also creating not only a less market-oriented economy, but also a really kind of dystopian surveillance state, the kind people worry we have here in the US but we don’t — that’s exactly what they’re trying to create in China.

 So when you look at the direction of the economy, I thought that kind of economy wasn’t supposed to work, that kind of centrally planned, directed economy. They weren’t supposed to be innovative, but they seem super innovative. How is that possible? It seems like a challenge to what Americans think about how you run an innovative, growth-oriented economy.

Well, I’d say two things. I think China’s debt position shows it’s not working. But with regard to innovation, there are three pillars of innovation. One is competition: the Chinese don’t have it. They don’t like it. They suppress competition. In a lot of sectors they have some but they don’t have enough. Another is government direction: we talk about the moon project and DARPA creating the internet; the Chinese have a lot of that, a lot of government intervention. And then the third thing is they take stuff. Two out of the three pillars work in China. Are they going to ever be as innovative across the board as the United States? No, but they can be innovative in certain sectors.

They get a lot of government subsidies and then they’ll have some companies that are international companies that are also innovative. They’re not going to be 95% as innovative as we are, but they could easily be 70. So that’s why: Innovation is not just about competition. Where it’s about competition, China falls short, but where it’s about resources and copying others, they do very well.

It seems like President Xi is now going to be president for life. Was that an eye opener? I think for the average person, to the extent they follow China, they still may have thought there was some hope that China was going to go in a more democratic direction. Is that just not going to happen?

Well, it certainly doesn’t look like it. On the economic side we had people thinking the previous government was very corrupt and this government was going to be more efficient: They were going to engage in brave reforms because they were bolder and stronger and all that. None of that has happened. And in fact, as I said, this is a 21st century version of Mao. They’ve moved decisively in the other direction on politics. So I think it’s very difficult. Xi Jinping has a lot of power so he can change direction if he wants, but I think it’s very difficult to see what in his behavior says he wants to have a more market-oriented economy or a freer society. There’s nothing.

Right. Some people have said it’s a unique threat: China is a combination of Japan in the 1980s and the Soviet Union in the 1980s, where they’re both an economic and a military threat. It’s not really a kind of threat — or challenge if you prefer — that we’ve ever faced before, is it?

I think that’s right. I mean, the Japanese were an economic challenge, not a security challenge, and the Soviets were a security challenge, not an economic challenge. And the Chinese, you know, they’re not perfect; as I said, they’re running up a lot of debt. But they are a challenge on both dimensions. We have not faced this kind of multifaceted challenge while in the postwar era. And of course, there are problems with their large population. They’re aging —

Right we tend to treat them like they are being run by these superhuman, super intelligent engineers taking advantage of us and, boy, what are we going to do? But they have problems.

Yeah, they have serious problems. I mean, we are at AEI. I don’t think anyone in their right mind thinks that the US federal government borrowing over the last 10 years has been wonderful, but the Chinese have borrowed much more than us. They used to have a very simple, trivial debt position. They now have a larger debt burden than the United States. And that’s occurred all over the last 10 years. That’s how much they’re borrowing.

People are probably aware that China is aging very rapidly because of the one child policy and lack of replacement. So when you’re an indebted older country, you don’t want to be middle-income. China’s not rich. So those are fundamental economic problems that they face. They’re not geniuses. They’re not marching through history to inevitable victory. Unfortunately, that doesn’t help us right now. President Trump wants something to change right now. He’s not happy that in 2040 China will be stagnant or whatever.

So you would prefer not going the tariff route. You would like to — if we can show that a company has forced another company to give them technology or stolen IP — we should go after those companies. How do we go after those companies?

We have a model which is based on sanctions, which is the ZTE model. So ZTE broke American law and then was threatened with the stop sale of American components which will put the company out of business. And that got China’s attention because it’s essentially a state-owned enterprise. So you look for companies where you say hey, you didn’t have this technology a year ago, you didn’t say you were researching, and suddenly you have it? You take those companies and you say you can’t do any business in United States at all with any American firm, can’t raise money in the United States, and can’t use US banks to clear financial transactions. And then if what you’ve done is bad enough, if you really harmed American workers and American industry, well we’ll look at global financial sanctions and will go get you overseas.

And that goes right at Made in China 2025, because the whole idea is the Chinese are creating these global champions. So you have to attune it to how bad the problem was. But if you target five very large Chinese state-owned enterprises this way, you’re going to get China’s attention really, really fast, and you’re not hurting American consumers at all by your own actions. Retaliation might hurt, but your own action isn’t going to hurt.

The example you gave as the model, ZTE, that’s not working because we really don’t want to bring the hammer down — at least as hard as you would like to bring the hammer down on that company. So you must have seen that we have a perfect example that we can then translate to other instances, and now we’ve kind of backed off on this company.

The president’s famous tweet in May where he says too many jobs in China are being lost so we have to back off on ZTE — I really, if I had an opportunity to speak to the president, I would have said, sir, what do you think you’re trying to do with your tariffs? So that was very strange. You’re right. We have the president take an action that really put pressure on the Chinese, then we walk away from it. Congress on the other hand recognized that that action was appropriate.

The president likes tariffs and he’s focused on the trade deficit. It’s very hard to get them to think about bringing the hammer down on individual companies because it’s more complicated to explain and it’s not going to shrink the trade deficit very much. But if we want to get the Chinese to change their behavior, that’s what you do. So we have this trade off of do we want to sell this domestically as a political move or do we want to actually get China to change?

How do you think this has been perceived by China? Because I would assume that Beijing looks at what happened to ZTE and is thinking never again; we need to become more independent so the United States doesn’t have this kind of leverage over us. I would assume this would make them want to double down on this 2025 plan and more broadly not be dependent on the United States for technological components that their countries need.

Now that’s true. I would say, look, Xi Jinping is a rather hard-nosed dictator. He didn’t come into power in 2012 thinking, “I’m fine with being dependent on the United States” and then go, “Oh, ZTE, I’ve totally changed my view.” They had been trying — the whole point of Made in China 2025 was to spend their way out of being dependent on the United States. They’re not going to do anything different than they were before. You could say maybe the US window is going to close over time and we should act now.

The number one thing the US has going for it over China is actually not technology dependence, because there are the Germans and other places the Chinese can go. It is money. The Chinese are dependent on the dollar. They’re dependent on money coming from the United States to maintain their balance of payments and so on, so the Chinese are absolutely going to try to be technologically independent of us. Over time they’ll make progress on that. They were doing that before. We still have the opportunity now to act. And as I said before, global financial sanctions will work because the dollar is the world’s currency. You can’t do business if the US doesn’t want you to.

Should we let American companies open up research in China? If China wants to be advanced in AI and you have American companies opening up AI research centers in China, is that a good idea?

I really, and I know you feel the same way, don’t want to be telling American companies they can’t do things. So I would give ground to the Defense Department here and say, if you have a real national security point now, not someday in the future, but if there is a national security related technology issue now, then you can tell American companies they can’t take those actions. And that’s what export controls are supposed to do. Other than that, I don’t want to go the route of just saying anything China does is automatically a loss to us. If there’s a national security threat, you stop those companies from acting. Otherwise you let companies pursue their own interests because that’s the way you get rich.

This is the big ask. How does this current round of escalating tariffs potentially end? Does it end with just some deal that is struck which on paper would reduce the trade deficit but doesn’t really address these kind of core technological issues? One that lets the president say he got a deal that will lower the trade deficit by some $70 million, so we win?

Yes. I think that’s where we’re headed. I don’t think the administration has shown the patience and the unanimity to stick with a policy over years that’s going to change Chinese behavior. You’re not going to do that in 2018. You got to stick with it through 2021 or whatever. So I think what the president is trying to do with these threats is bring the Chinese to the table with a better offer on closing our trade deficit.

But similar to maybe their previous offers but more?

That’s right. We did this. We did the $50 billion threat. They said $50 billion. We went to $150 billion, which we didn’t implement or we just said we’re going to. We go to the table, we try and negotiate with the Chinese. The Chinese are like, well, you know, we’ll buy more. And it wasn’t specific enough for the president to agree to. So we went back and now we said, okay, we’re going to go to 250, which we can do and you can’t.

So that’s right. We’re trying to get a better result from the negotiating process than before so the president can come back and say, I got $100 billion and even AEI thinks this is a real $100 billion. It’s not fake. That’s what he’s looking to get. That’s where I think we end up because the Chinese know that in a low-level confrontation, they’re fine. The worse it gets, the more advantage goes to the US.

So it sounds like you would have liked to have not seen any of this tariff stuff done but get tough on ZTE, rather than the opposite.

Yeah. The ZTE case is just one case. They broke American law. They violated Iran sanctions. The president wants to re-impose Iran sanctions. I would rather set the precedent of, “we’re going to hurt your most high profile, most important companies” than “we’re going to restrict trade, which may not involve violators of IP or Chinese companies at all because it might be foreign companies exporting out of China.” So yes, I would much rather have gone the ZTE route than a tariff route.

Derek, I think we’re going to have to have you back on at some point because this is going to be an ongoing issue, but thank you for your time today.

I’ve enjoyed it. I’d be happy to be back on and just hope something new doesn’t happen tonight.