US–China rivalry: The macro policy choices

• Date: 01 September 2020
• Author: Rod Tyers,Yixiao Zhou
• DOI: http://doi.org/10.1111/twec.12992
• Published date: 01 September 2020

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wileyonlinelibrary.com/journal/twec World Econ. 2020;43:2286–2314.

© 2020 John Wiley & Sons Ltd

Received: 5 March 2020

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Revised: 28 April 2020

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Accepted: 22 May 2020

DOI: 10.1111/twec.12992

ORIGINAL ARTICLE

US–China rivalry: The macro policy choices

RodTyers1,2

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YixiaoZhou2,3

1Business School, University of Western Australia, Crawley, WA, Australia

2Research School of Economics, Centre for Applied Macroeconomic Analysis (CAMA), Australian National University,

Canberra, ACT, Australia

3Crawford School of Public Policy, Australian National University, Canberra, ACT, Australia

KEYWORDS

China, general equilibrium analysis, macroeconomic policy, numerical theory, trade policy

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INTRODUCTION

The dispute between the US and China over tariffs and exchange rate policy has been the most notable of

a rising number of international economic conflicts in recent years.1 The conflict stems primarily from the

implicit threat to returns from US R&D perceived as emerging from China's drive to upgrade the sophis-

tication of its manufacturing sector, as embodied in ‘Made in China 2025’ (State Council of the People's

Republic of China, 2015). Related to this is the set of hangovers from the Uruguay Round of trade nego-

tiations and the conditions under which China originally acceded to the WTO, which grant concessions

over trade, investment and intellectual property protection in both goods and services sectors and which

are seen by the US to unfairly advantage the now more modern Chinese economy (Autor, Dorn, &

Hanson,2013; Brown,2019; Office of the US Trade Representative, 2018; Pierce & Schott,2012). More

generally, the considerable efforts on the part of the US since WWII to underwrite the institutions essen-

tial to orderly global commerce have come increasingly to be seen in the US as facilitating free riding by

other large economies, leading to a more unilateralist US approach.2 Indeed, a great power rivalry is

emerging, with a likely subdivision of the globe into zones of influence (Mearsheimer,2018).

While the trade dispute originated in 2018, the seeds of the macroeconomic policy dimension of

that rivalry go back decades, with an enduring focus on ‘currency manipulation’. Strategic bargaining

power was used against Japan in the 1980s and against China since the early 2000s to appreciate their

currencies against the USD (McKinnon,2006).3 The expectation that rapid economic expansion in

China might deliver an appreciating currency stems in part from the Balassa–Samuelson hypothesis,

1Other recent international trade conflicts underlie the renegotiation of North America Free Trade Area (NAFTA), European

retaliation against surviving US steel and aluminium tariffs and a US threat to impose a 25% duty on motor vehicle imports

from the EU, pending the outcome of continuing negotiations.

2This is a widely presented point in international politics. See, for example, Mearsheimer (2018).

3An early manifestation of the pressure from the US was the Exchange Rates and International Economic Policy

Coordination Act of 1988, then directed at Japan.

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which predicts that economies with rapidly expanding tradable sectors would experience strong wage

growth, higher prices of little-traded services and therefore real appreciations. This pattern was not

borne out until the early 2000s in the case of China because of the offsetting effects of trade reforms

in the lead-up to its accession to the WTO and very high saving rates during its subsequent growth

surge.4 Growing strategic tensions were therefore supplemented during China's growth surge by the

failure of the RMB to appreciate significantly,5 by the tendency for China's excess saving to reduce

long maturity rates and by the contribution China's excess supply made to rising deflationary pres-

sures worldwide.6

While the US choice to implement bilateral tariffs against China may have originated as a tactical

step in the rising great power conflict, it has also been justified on economic grounds. The most widely

quoted economic case is that China has a large bilateral trade surplus with the US. While bilateral

imbalances have no particular economic significance, they are seen by some as an indicator that the

gains from trade are being manipulated to the advantage of one partner. Yet the China–US bilateral

imbalance is inflated by China's role as an assembly point for wider Asian component manufacture,

via recently emerging global value chains, leading to a mismatch between the balances of trade value

and value-added content.7 There are, however, substantive concerns in the US over non-compliance

with rules relating to investment, property rights protection and enforced state domination of key

markets. Following US bilateral action in 2018, the government of China responded with domestic tax

changes and import tariffs of its own, along with a demonstration that it might exploit its hitherto re-

sisted option of RMB flexibility.

In this paper, we use a six-region global general equilibrium model with money that captures in-

ternational flows of financial capital as well as final and intermediate goods, along with their depen-

dency on direct and indirect tax rates. Each region has three different households, with capital owners

managing global portfolios of variably differentiated regional assets, and central banks that mostly

target inflation, thus anchoring expectations over consumer prices. Using this framework, we offer a

broad examination of the macro and trade policy options facing the US and China. The policy options

include rates of taxation on capital and other sources of income, the distribution of additional tariff

revenue between spending and tax relief and, for China, the option of a currency float and therefore a

significant depreciation.

Two types of solutions are obtained, one under short-run assumptions, with varying unemploy-

ment levels and fiscal deficits but fixed capital use, and another in which time is allowed for financial

flows to redistribute productive capacity across countries, for labour markets to adjust and for fiscal

balance to be retained via changes in tax rates or government expenditure. In either length of run trade

distortions alter the relativities between consumer, producer and GDP prices, wage rates and capital

returns. Because all regions are modelled as ‘large’, unilateral increases in protection by any one

region can raise domestic welfare at the expense of other regions, though such protection can shrink

output both domestically and globally. Alternative policy scenarios reflect possible trajectories of the

conflict. These include reforms affecting capital income tax rates in both economies, unilateral pro-

tection by the US against Chinese imports, bilateral liberalisation or retaliatory protection by China,

4See, for example, Tyers and Zhang (2011).

5See Tyers and Zhang (2014).

6For estimates of yield and deflationary pressures associated with 2China's growth surge, see Aurora et al. (2015), Tyers

(2015), and Tyers (2016).

7See the now extensive literature from Athukorala (2011) and Koopman et al. (2014).