Global markets dropped on September 2, after the US and China kicked off a new round of tariffs in their ongoing trade war. MSCI’s world index, which tracks shares across 47 countries, was down 0.1% on that day. The latest studies suggest that the tariffs will cost US households up to $1,000 a year, hitting a considerable number of basic consumer goods.

There is no doubt that Sino-US relations are passing through the toughest phase in history as both countries pursue divergent interests with different means to reach their goals. This change in the relationship has been due to US President Donald Trump’s policy of protectionism. Each nation is preoccupied with a different set of policies with different goals and agendas. The US today under the Trump administration has a long list of unconventional policies, which it regards as protecting America’s core interests.

But this ongoing trade fight between the two world superpowers has impacted the global economy in unexpected ways. Recently, Trump urged US companies to look for other markets after China slammed a new round of retaliatory tariffs on US products.

Impact on the global economy

Because of the US trade pressure and low domestic demand, factory activity in China shrank in August for the fourth consecutive month. The Purchasing Managers’ Index (PMI) fell to 49.5 in August, versus 49.7 in July, below the mark of 50 points that separates growth from contraction on a monthly basis.

Recently the International Monetary Fund (IMF) reported that the current US-China trade war could impact global gross domestic product by 0.5% or about $455 billion in 2020. It has predicted global growth of around 3.6% in 2020 but said this outlook is vulnerable to trade tensions, Brexit and uncertain recoveries in some stressed economies such as Argentina and Turkey. Also, there is extreme pressure on emerging economies’ currencies mainly due to trade tensions.

Currency war

The US has always pursued a policy of a strong dollar and has accused its trade partners of keeping their currencies undervalued. But the current US administration has been moving away from the decades-long strong-dollar policy in order to boost exports and narrow the trade deficit. To counter America’s monetary-easing policy, China has allowed the yuan to weaken below the rate of 7 to $1, the lowest in a decade. This has prompted the US Treasury Department officially to brand China as a currency manipulator, a designation last used against China in 1994. These actions seem to present a clear picture of a currency war in play between these two economic giants. Such wars can last for 10 or 15 years.

In an interconnected global economy, it is important to have a better understanding of the costs and benefits of such unilateral economic actions. Most of the analysis of the effectiveness of economic sanctions suggests that they have limited utility for changing the behavior or government’s policy of the targeted country. A better way to understand this is through the gravity theorem of international trade, which states that international trade between the two countries is influenced by geographical proximity, economic size of the respective countries and similarity in consumer preferences and economic development. The gravity model and OLS (ordinary least squares) technique (which helps to investigate issues that are cross-sectional in nature) permit us to analyze the indirect as well as direct effects of economic sanctions across a large number of countries.

Currently nine of the major economies around the world, including the UK, Germany, Russia, Singapore and Brazil, are on the brink of recession or already there. But apart from that the US too is facing the heat of the trade war. There is a large amount of data to support the claim that a recession has already arrived in the US economy. Fresh data show that US trade declined during the first six months of the year as exports flattened out. Also, a recent US GDP report shows that gross private domestic investment tumbled 5.5% in the second quarter, the worst since Q4 in 2015.

The US stock market plunged on August 14, with the Dow Jones Industrial Average booking its worst single day of trading for the year, as new data suggest that the US Treasury yield curve inverted, with the two-year yield above the 10-year Treasury yield for the first time since 2007. An inverted yield curve occurs when long-term government debt yields fall below rates on short-term notes and bills. It’s one of the most reliable recession indicators in the market. The yield curve has inverted before every US recession since 1963, suggesting that an economic downturn is coming.

Moreover, the US tariff move also upset the global supply chain by forcing both countries to look for alternative sources for their imports. None of those sources or countries have the capacity or the infrastructure to fulfill the two giants’ demands. New data reveal that in the first seven months of the year, the US trade deficit grew, with the shrinking gap with China more than offset by a rising gap with other countries acting as a drag on the US economy.

The US trade gap narrowed in July as manufacturing weakness held down the import of business equipment and supplies, one of the latest signs of slowing investment due to the trade war and a weak global growth. According to a report by Bloomberg Economics, uncertainty over trade could lower world gross domestic product by 0.6% in 2021, relative to a scenario with no trade war. Tariffs from both sides have a direct impact equivalent to $585 billion, considering the world GDP to be around $97 trillion in 2021, as quoted by the IMF.

Find a solution before it’s too late

Neither country is in any mood to backtrack from its original position. Much of the reason behind this tariff war is politics. Trump has been quite successful in using the trade war as a tool to boost his approval rating and make an excellent case for the next presidential election with a strong America as the main agenda, while the Communist Party of China has used the same tool to nationalize sentiment among Chinese to blame the US for the loss of millions of jobs, the problems in Hong Kong and a slowing economy.

These two superpowers are using foreign policy as a tool to distract their populations from the inefficiency of their economies. It is highly unlikely that Trump will backtrack from the tariff war against China until the next election or his goal is achieved, and neither does China wish to bend to the US demands, as that would not help its case for a Chinese-led world order. But the trade friction between these two nations has already put the global economy into a tailspin.

Historical data suggest that currency and trade wars don’t work in the long term. Sooner or later they morph into shooting wars or military conflict. Economic failure always results in political failure. That’s what happened in the 1920s, 1930s and up to 1939. There was a currency war in the 1920s and early 1930s, then a massive trade war in the ’30s. And then World War II broke out at the end of the 1930s.

The current situation is more or less the same, as are such problems as rising inequality, too much debt and nationalist sentiment across the world. There is an urgent need to have a meaningful dialogue between these two superpowers so as at least to have a minimal consensus on certain key issues to avoid a repeat of the mistakes of the past.