The Wrath of Xi

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In the 1982 sci-fi classic, Star Trek II: The Wrath of Khan, we learn that every Starfleet Academy cadet takes part in a simulation that centers around trying to rescue a ship called the Kobayashi Maru that has been damaged in a Klingon attack.

The test is a no-win situation. If the cadet attempts to rescue the Maru, they are attacked by an overwhelming force of Klingons and everyone dies rescuer and rescuee alike. If the cadet opts to leave the ship, it faces certain destruction. Cadet Kirk, “Doesn’t like no win situations,” so he reprograms the simulation before the test to change the scenario and becomes the first cadet to win the “no-win” scenario.

To make a tortured analogy, I think this is exactly the situation facing the US as we contemplate what to do about China’s aggressive trade practices. The Kobayashi Maru is our current international trading system and the solution is to reprogram it.

The Threat

Last week in Part 1 of this post, I wrote about the threat that China’s effort to dominate every advanced technology and manufacturing sector poses to the rest of the world. China wants to win what many call the 4th Industrial Revolution.

That means taking leadership in AI, semiconductors, robotics, EVs, clean energy production (solar, wind, nuclear, etc.), and many other areas. This is the Wrath of Xi who wishes to avenge the Century of National Humiliation during which China was weak and subject to Western predation. (I can picture him doing his best Ricardo Montalban impression.)

To do this China suppresses the wages and social safety net of its own people and the profits of its businesses and redirects all that into advanced technology investment. We’re seeing the results in Europe with EVs right now. China can wipe out entire industries around the globe. Eventually this leads to dependence on China and the Middle Kingdom has shown a fondness for coercion.

Alternatively China’s economic aggression will fracture the entire global trade system which will collapse unless the US takes leadership. I imagine auto company executives around the world saying this in response to Chinese subsidies:

Some people may think that I’m exaggerating or that the threat is in the future. I disagree. I think it is here and the time to formulate a response is now. While Trump’s original tariffs and the Biden Administration’s maintenance and expansion of them were key steps, they are ultimately ineffective. Those measures are like trying to plunge leaks in the dyke with your fingers. Every time you plug one leak another springs open. So far we’ve been typical Starfleet cadets. Trying a bunch of stuff and losing every time. We need to rebuild the dyke or in Star Trek terms reprogram the simulation.

The US Response

One of the leading scholars on modern China and trade, Michael Pettis¹ , has summarized the main policy options for the US in a recently published article for the Carnegie Endowment coauthored with Erica Hogan. Laying out the options, they write:

Each approach has its pros and cons.

1. Option One or Beat China by Becoming China. The US retaliates with our own industrial policies to subsidize domestic manufacturing, such as the recently passed Inflation Reduction Act and CHIPS Act. This option will protect US capabilities in the targeted sectors but has two downsides.

   First, since it only protects certain sectors, it doesn’t stop overall manufacturing from shrinking and if carried too far it will ultimately just create more global overproduction. How many EVs does the world need after all? In the end all this does is make everyone poorer and less efficient.

   I think we need to use industrial policy sparingly to ensure that key national security sectors can’t be wiped out before we adopt a better long term strategy. However, the last thing the world needs is another China.

2. Option Two or Status Quo. I laid out the issues with continuing to allow China to destroy the rest of the world’s advanced manufacturing capacity above and in the post last week so I’ll just leave it at this: Option Two is a dystopian nightmare that leaves China in the position to bend the US and the rest of the world to its will.

3. Option Three or Reprogram the Simulation. In this option the US would simply stop playing the game and reorder the global trade system either unilaterally or in concert with like-minded nations. There are only a handful of deficit countries that can absorb all the surpluses of countries like China and they are all US allies: Canada, the UK, Australia, and a few others. The US could organize with these deficit countries to force the surplus countries to rebalance.

   This could be done through a new tariff regime and/or by using capital controls. Tariffs would raise the cost of exporting overproduction from surplus nations like China but tariff policies are leaky. China has been avoiding them by shipping goods through non-tariffed third countries like Vietnam and Mexico. Alternatively, If you apply tariffs to everyone, you end up punishing all countries, not just the ones doing the surplus exporting.

   Capital controls would prevent those surplus countries from recycling the dollars they receive in return for their exports back into US assets. Essentially the US and other deficit countries could impose restrictions, taxes, etc. on foreign money coming into and out of the United States.

   Countries like China have to recycle their dollars back into US assets in order to keep their own currencies from rising against the dollar which would make their exports too expensive. Capital controls are much more targeted but Wall Street would hate them. They make a lot of money off recycling those dollars.

   Pettis and Hogan summarize the pros and cons well in this table from the paper:

Reprogramming the Simulation

I believe the US needs to develop a short and long term strategy to reorder the world trade system. In the short term, we would use industrial policy and tariffs to ensure key industries remain in the US.

In an ideal world, the US would then do what Kirk did and make the situation winnable by working with key allies to reshape the system for the long term. We should start with the other countries in the same boat as us: the UK, Canada, and Australia. We would establish a norm that trade must be balanced and that surplus countries must adjust. I would then admit countries who are willing to play by these rules into that system. Those that opted out would be subject to much higher tariffs and currency controls.

This is the ideal but I doubt it will happen that way. Many of our “allies” play a modified form of China’s game including Germany, South Korea, and Japan. Such a shift might destabilize these countries. Many of them are key in our military coalition that seeks to contain China. Forcing a full adjustment would raise howls of protest from domestic constituencies in the US as well: Wall St, large corporations, and the national security establishment.

I think we will pursue a modified version of Pettis’s proposal in which we would focus mostly on targeting China until it adjusted its policies by forming a trading block that would exclude China. That doesn’t mean that we wouldn’t trade with China but we would impose higher tariffs, place capital controls on Chinese currency inflows and outflows, and police the system to ensure that other countries weren’t acting as Chinese proxies.

The US would allow access to the dollar and to our markets to allies who will follow US rules. We would probably still allow allied countries to pursue export driven strategies as an incentive to stay in our system or we might give countries we are favorable to more time to adjust.

The options for countries outside the US system would be few as they would eventually just become Chinese vassals or have to resort to economic autarky like North Korea. I believe most would have no choice but to agree to US terms.

The Costs

Of course there will be costs to this to the US and other nations. We wouldn’t be just rebalancing other economies, we’d be rebalancing our own. Don’t forget that Kirk (now played by Chris Prine) gets brought up on charges for reprogramming the simulation in a better acted 2009 Star Trek movie:

The main costs will be:

1. Inflation: As we readjust supply chains and force countries to stop subsidizing exports or devaluing their currencies, the cost of many goods will rise. It’s inevitable but I think we could apply the policies gradually to allow businesses and supply chains to adjust and create exemptions and exceptions in cases where critical goods are in short supply.

2. Deficits: The US is currently running high deficits that are partially funded by foreign asset purchases. Under my suggested approach, one of the largest foreign funders, China, would be forced to stop making those purchases-at least at the level they are today. This could spike interest rates in the short term but in my view the deficits are largely caused by the inflows of foreign money. Once that flow is controlled, the deficits themselves will decline.

   Secondly, Japan is the largest purchasers of Treasury debt specifically. In my modified version of the system we could lessen the adjustment by granting Japan open access while denying it to China.

3. Global Instability: I don’t think we can discount the impact such a move would have on global stability. It’s possible that China might even try to respond militarily to what I think would be a devastating blow. Xi’s dream would pretty much go up in smoke just like Khan’s did.

   In the end, we have a choice, we either deal with this issue and take the risks or march down the road to becoming a vassal state. I don’t think that’s much of a choice so we’ll have to accept the risk. Just like Kirk did. Again, doing this gradually with a clearly communicated plan should help minimize the disruption but there is no way to avoid it.

On the whole the adjustment will lead to a much healthier US and global economy with less inequality and much more trade in the long run but the trip there won’t be without major disruptions. I’ll return to this subject repeatedly in The New Rules as I think it is the major challenge facing the world.

Until then, I’ll close with the words of the defeated Khan who inexplicably quotes the last words of Captain Ahab:

Keep learning,

Alan

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1  Pettis is a former Wall St trader and now expert at the Carnegie Endowment and professor at the Tsinghua School in Beijing. No one has done more to elucidate these issue than he has.

2  One of the impacts of such a system would be a reduction in the sue of the dollar in the international trading system. Wall St makes money off the dollars role, large multinationals get to trade in their home currency, and security elites can use the status as a threat to enemies. Those are all benefits but the downsides of dollar dominance are worse.