What are the long-term costs of the China-U.S. trade war?

Dark times loom for the U.S. economy in the aftermath of President Trump’s latest threat on Aug. 1 to levy 10% tariffs on some $300 billion of imports from China. In response, China allowed the yuan to weaken against the dollar and thereby cushion the impact for Chinese exporters. In a tweet, Trump accused China of “currency manipulation” and called upon on the Federal Reserve to respond.

Two signposts, one reads Made in China, pointing left, directly beneath it reads Made in USA, pointing right, symbolic of the U.S. China trade war crossroads.

The Aug. 5 yuan-dollar rate of 7-to-1 was at its lowest since 2008. “[The] trade war has now become a currency war, which raises the potential economic harm to another level,” The Wall Street Journal noted in an editorial.

On Monday, Aug. 5, the Dow Jones and the S&P indices fell 3% and stock markets and currencies in emerging markets weakened, and an economic downturn seemed closer than before. The spread between the 3-month and 10-year Treasury yields—an indicator of recessions—inverted to its widest level since 2007.

Trump said on Thursday, Aug. 1, the U.S. would impose 10% tariffs on $300 billion worth of imports from China effective Sept. 1, amid signs that talks between the two countries over the past year or so were yielding little progress. That tariff move would be in addition to the higher tariffs already in place for $250 billion worth of imports from China, thereby covering all U.S. imports from that country. 

The Penn Wharton Budget Model (PWBM), which analyzes the longer term implications of policy moves, has identified two primary effects of the trade war with China. One is lower output for the U.S. economy, and the other is a shift toward households in the financing of U.S. debt, says Efraim Berkovich, director of computational dynamics at PWBM. As the escalation in the trade war reduces foreign capital inflows into the U.S., it would provide a short-term boost to GDP as domestic households would pick up the slack and provide more labor, but GDP will fall the long-run, Berkovich says.

Wharton’s Berkovich and Marshall W. Meyer, along with Syracuse’s Mary E. Lovely, discuss the long-term implications of the escalating trade war on electronics, produce, and debt domestically, and U.S. global competitiveness.

Read more at Knowledge@Wharton.