The Time is Right for the U.S. to Aggressively Confront China

By: Justice Clark Litle

Mar 24, 2021 | News

A general tone of conflict with China is escalating now — not just in respect to China versus the United States, but China versus Western allies as a group (with the United States at the forefront).

This is ominous news for Western companies with significant business exposure to China (like Apple and Tesla). It is ominous news for countries with significant supply chain exposure to China (there are far too many to list). Plus, it is bad news for emerging markets (which are not an attractive buy at this time).

The conflict is escalating, in part, because the United States wants it to. Given the current state of things, the United States has a strong incentive to pick a fight with China now.

There is an element of “no time like the present,” meaning, it appears better to act now rather than later; but there are also powerful economic reasons for the United States to pick a fight with China right now, that we shall explain. 

The short version in terms of economic incentives is this: If a new trade war breaks out in short order, or a significant slowdown of international trade occurs, that development would likely disproportionately help the U.S. economy, while hurting China’s economy at the same time.  

The West, meanwhile, is rapidly approaching a kind of critical moment with China. On various fronts, China has been pushing hard to serve its own geopolitical interests, and has been doing so for years.

In all manner of areas, from technology to client-state relationships to ideological influence — call it the “digital authoritarian state” model versus the Western democracy model — China has been advancing a position, like pushing pieces forward on a chess board, that the West sees as adversarial.

In some ways this is “the Thucydides Trap” writ large. The Thucydides Trap is a shorthand description for what happens when a rising great power challenges an existing great power; most of the time, though not always, the ultimate result is war.

To avoid war, and resolve the situation peacefully, in such a way that the existing great power and the rising great power co-exist, is to avoid war and thus avoid the Thucydides Trap. To wage all-out war is to fall into the trap, as has happened so many times in the past.

But avoiding the Thucydides Trap is not just a matter of the existing great power and the rising great power being reasonable with each other, as we are starting to see now.

If a clash of worldviews and geopolitical interests turns into a clash of civilizations, some type of conflict resolution becomes inevitable. At that point, the question is whether the conflict is resolved with words and negotiations or violence and brute force.

We would argue that, from the perspective of the United States — and perhaps other allies in the West, too — this confrontation with China is coming whether anybody wants it or not.

The inevitability of confrontation creates an element of striking while the iron is hot, so to speak: If you have to confront an adversary who is growing stronger, better to do it sooner, rather than waiting for their power to grow.

Then, too, at the current point in time, the United States is in a much, much stronger position than China.

There is a popular narrative that says China won the pandemic because their economy bounced back faster in 2020; that China is stronger economically and politically than the United States; and that China is “winning” while the United States is on the back foot.

That narrative — that says China is beating the United States — is completely and utterly wrong.

The United States still holds huge, almost overwhelming macroeconomic advantages over China; the United States is far better positioned than China for what is going to happen over the next decade or two; and China’s projection of having won the pandemic is mostly a mirage, perpetuated by those who have ideological incentive to believe the United States is weaker than it actually is.

What we have noted, so far, is that the West has incentive to confront China sooner rather than later; that the United States has significant incentive to push back against China; that a trade war or slowdown in trade would disproportionately help the U.S., and hurt China, simultaneously; and that the overall position of the U.S. is far better than China, to the point where China “winning” is a mirage.

To understand why China is far weaker than it appears — and the United States is far stronger — we can start with the below chart, via the World Bank, showing China’s consumption as a percent of GDP over the past six decades (1960-2019).

Domestic consumption is also known as personal consumption or household spending. It represents the appetite for goods and services from consumers — individual citizens and their families — as opposed to government spending or business spending.

China’s greatest challenge is to increase its overall level of domestic spending. This means getting Chinese households to consume more — and buy more stuff — which in turn would make China’s domestic economy stronger and less reliant on exports.

In most Western countries, the level of domestic spending is significantly higher than it is in China; in the United States, domestic consumption has hovered around 70% of GDP for nearly 20 years.

A higher level of domestic consumption creates an advantage in economic and geopolitical terms. The more that an economy is powered by local spending, the less dependent it is on exports to sustain it.

In 2019, China’s economy was 56% more reliant on exports (as a percentage of GDP) than the United States. That means China is significantly more exposed to trade-war risk than the United States.

If international trade channels shut down, it will have a greater impact on China than America, because China relies more on shipping stuff abroad, whereas America’s economy is more powered by spending that goes on at home.

But that is only part of the story explaining why America is in a better situation than China.

Because China’s level of domestic consumption is low, China has to create economic growth through aggressive capital expenditure and supply-side business investment.

In plain English, this means that, if China wants its economy to grow at a certain rate, and households aren’t spending enough, the government has to build bridges, subway stations, “ghost cities,” highways to nowhere, and so on, in order to create jobs and economic growth.

At the same time, because China’s households don’t spend enough, China has to stimulate its economy with “supply-side” measures, meaning, it has to pump money into businesses to try and get them to ship more exports, build more factories, and so on.

Spending lots of money on infrastructure and business development may sound good, but it is possible to have way too much of a good thing. In order to create economic growth — the Chinese government is terrified of what would happen if a recession ever occurred — China has been pumping huge sums into infrastructure and state-directed business development for decades on end.

In fact, as a result of China’s aggressive spending on infrastructure — building all those ghost cities and highways to nowhere — China’s internal debt ratios are approaching catastrophic levels.

According to the International Institute of Finance (IIF), China’s domestic debt — not including foreign debt — rose to 335% of GDP in 2020. That is more than triple the debt-to-GDP ratio of the United States as of year-end 2020.

In addition to being far more leveraged than the United States — and not just by a little, but rather a huge margin — we can also say China’s economy is dangerously imbalanced.

The Chinese government is addicted to “supply-side” economic growth boosters — stuff like building infrastructure, expanding business capacity, and so on — while extremely weak on “demand-side” measures, which comes from boosting domestic spending (households supporting the economy locally).

One might ask, why doesn’t China just find a way to increase its level of household spending? Why don’t they just start building up their domestic economy, instead of relying so much on exports and non-productive infrastructure projects?

The answer there is because, first, China’s economy is already so maxed out on debt (note the 330% debt-to-GDP estimate) that the Chinese government is extremely worried; and second, because China has become addicted to supply-side spending at the regional and local level.

The Chinese government is not just a handful of bureaucrats in Beijing running everything; it has dozens of layers, filtering all the way down to regional and local entities — the equivalent of governors, mayors, local councils, and so on.

At the same time, the structure China has created is like a vast plumbing network that is incredibly hard to fix or change. The whole system is built to fund more infrastructure and more business investment, with regional and local officials taking a cut of the action; it has been this way for decades.

That is why China can’t just turn off the spending on the supply side; the existing structure won’t change that easily. Nor can China start spending on the household side to increase consumer demand.

The reason China has been talking about debt discipline lately is not out of fiscal prudence (though that is the image they like to project), but rather out of hidden panic at how bad the unproductive spending has gotten behind the scenes. 

In the United States, the picture is very different. Domestic consumption in the U.S. already hovers around 70% of GDP, which means local consumption powers the economy. Then, too, the United States is in the opposite position to China when it comes to infrastructure.

Whereas China has been overspending on infrastructure for years now — think ghost cities and bridges to nowhere — the United States has a number of productive infrastructure projects it can invest in (because U.S. infrastructure has been neglected, rather than overbuilt).

What this means is that, in a real trade war, or a sustained slowdown of international trade, China would be extremely vulnerable — far more so than most pundits realize.

China’s debt levels are terrifyingly high; its domestic spending levels are painfully low relative to rich industrial nations; and the situation is not easily fixed because Chinese government officials, at many levels below Beijing, are addicted to the non-productive supply-side projects that line their pockets.

Then, too, the picture gets worse for China when one considers inflation vulnerabilities. China has to import agricultural products to feed itself, whereas the United States is an agricultural superpower that produces more food than it can internally consume. China also has to import oil and gas, whereas the United States is an energy superpower thanks to the shale revolution.

The agricultural and energy angles mean that, were food or energy prices to rise sharply (a real possibility in the coming years), China’s economy would be exposed to painful inflation with no way around it — you can’t not have food or not have oil — whereas the U.S. would be significantly insulated via internal production of food and energy.

Then, too, another factor looms that favors a confrontational attitude from the United States.

The heavy fiscal stimulus being deployed by the United States is going to power an aggressive economic recovery; the more that the stimulus funds are spent domestically, the more powerful that the economic recovery will be. That gives the United States an incentive to restrict or discourage imports.

In economics, there is a concept known as “marginal propensity to consume,” or MPC for short. MPC is a measure of how much someone will spend on consumption if they come across new funds.

As a general rule of thumb, the MPC for a wealthy person is zero, because they already have enough cash to buy whatever they want. As such, if you give money to a wealthy person, they will likely invest it.

The MPC for lower-income individuals, on the other hand, tends to be very high. The greater the gap between what a family needs and what a family can afford, the higher the likelihood that family will spend with new funds that are coming in. This means buying the “stuff” that powers daily life: Diapers, peanut butter, a new air conditioner, school clothes, and so on.

So, the United States is going to experience blockbuster growth in 2021, in part, because lower-income individuals are going to do catch-up spending in huge amounts, even as middle-income and wealthy individuals spend aggressively in an embrace of normal life and all the things they missed in 2020.

But to the degree that American households spend money on imports — buying “stuff” that is produced abroad — that is the rough equivalent of the $1.9 trillion stimulus leaking out at the edges, helping to power the recoveries of other countries versus staying within the United States

And to the degree American households are encouraged to spend more money locally — meaning, to the degree they consume more goods and services produced domestically — the more that the impact of the stimulus will stay within the U.S. economy, strengthening in a feedback loop of local business profits and increased local employment.

The geopolitical implication here is that, if the United States were to start a trade war with China tomorrow, it might actually help the U.S. on balance — or at minimum would hurt far less — because spending that was directed toward imports would go toward local products instead.

And to the extent the U.S. further embraces “demand-side” spending — meaning, the government is sending money to consumers, which increases consumer demand — the U.S. has increased incentive to reduce international trade flows, to the extent that consumers spend more locally versus spending on imports.

China, again, is in the exact opposite position. The Chinese government is far more leveraged than the U.S. government — almost to the point of crossing over the edge — and China cannot rely on local domestic spending to power its economy. As such, were China to lose its export channels, it would seriously hurt.

Nor can China really afford to attack the United States economically by, say, dumping treasury bonds for example. That is because, were China to take actions that substantially weakened the dollar, those same actions could trigger an inflationary spike in food and energy prices — which could be potentially disastrous for China, a forced net importer of both.

When you put the whole picture together, the United States is in a very dominant position relative to China — and even has a natural incentive to push for confrontation, because a reduced flow of imports would only make the U.S. domestic economy expand faster. 

This may explain why, on Monday, March 22, the United States joined with Canada and the United Kingdom to announce new sanctions on China in relation to human rights violations. You can read the U.S. Department of State press release here

Our overall view is that the time has come for the West to start confronting China in a serious way, and that, at the same time, the United States has an economically dominant edge over China and is well aware of it.

For these reasons, we can expect U.S. pushback on China to increase — which means we can also expect general tensions to ratchet higher. That, in turn, has negative implications for U.S. businesses with exposure to retaliatory measures from China, and broader negative implications for emerging markets in the world.

To sum up with a poker metaphor: The U.S. has the strongest hand and the biggest chip stack at the geopolitical poker table right now; China likes to act as if its hand is strong, but China is actually bluffing. The U.S. knows this, and things are about to get intense.


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