The theory is that the surplus economy, as a result of the increase in foreign exchange, will have a strengthening currency which leads to a loss of export competitiveness which then gives the deficit economy a chance to compete and recover its external trade position.
This does not usually happen in the now of China and in the past of Japan where their respective currencies are being held down deliberately either by maintaining low domestic interest rates or by managed foreign exchange policy.
It is a long-held belief that an external trade surplus is indicative of good economic health.
Of course, it is better to have a trade surplus than a trade deficit.
But it is not good to always maintain a trade surplus which means than other economy or the rest of the world has to run a trade deficit forever which it clearly cannot.
(If the trade surplus economy is small, then the problem is not that serious, as in the case of Singapore.)
By maintaining a sustained trade surplus, it means that the domestic industries are deliberately keeping down the cost of production especially wages and the benefits to workers while profits are ploughed into machinery to keep increasing productivity.
A social and political policy question arises: What is the benefit of a sustainable trade surplus when the working population does the enjoy much of the fruit of the surplus? Are people meant to work the machinery and hence work like machines as well?
Of course, the trade surplus has also the effect of flooding the domestic economy with liquidity. The local banks choose to direct their new loans at real estate which seems to the practice all round the world in the last few decades. The problem with real estate is that it is also a good collateral for banks for their loans, so as real estate prices increase, asset inflation escalates new loans to real estate again, thus accelerating asset inflation.
The banks think they have good collateral so when the asset price bubble bursts, as it is happening now, the banks will end up owning the real estate themselves. In asset deflation, the banks will be loaded with bad loans enough to send them into insolvency due to lack of reserve provisions as the directors have pocketed the profits (which had encouraged them to be reckless in their lending).
Now, what should the surplus economy do when faced with tariff imposition by the deficit economy? A non-economist will think that it is war, call it economic war, and retaliate. Even at war, one probably does retaliate but possible try to defend.
To retaliate means that: since you are hurting my industries, I too will do the same to hurt your industries.
To defend means that: since you are hurting my industries, I will do my best to ensure that my industries are not hurt too much. How can you do that?
One is to provide subsidies to the hurt industries. This may not be a good move because you will be accused of further distorting fairness of trade.
Two is to negotiate to see which aspects of the trade is deemed to be unfair. It has usually got to be concerned with the (allegedly) suppressed exchange rate, the too low cost of production such as excessively low wages, poor worker welfare and all those things dealing with labour which the deficit economy has been doing to improve human welfare in society. To undertake a negotiated worker welfare programme for the labour force may be a good first step.
Of course, what has happened with the surplus economy is that it has tried to spend its surplus in third world countries to try to secure raw materials for future growth. This diversion of the trade surplus could probably have also weakened the force of adjustment for the benefit the deficit economy. This is like a three-body problem which means that there is no possible stable working equilibrium to be established between the surplus economy and deficit economy (which the conventional theory espouses) because there is a third party economy involved to which the equilibrating energy is diverted. With no equilibrium in sight, it is natural that the deficit economy wants to put a stop to its deficit run and start rebuilding its economy with a new paradigm. The same goes for the surplus economy which will now have to find its new working model without the prevailing deficit economy.
If the now surplus economy now wants to circulate around its own orbit, it will have to find another economy with a big deficit to fund its desired surplus. This is unlikely to happen firstly because of the deficit size to be replaced but because it will then have to accept a new currency for its foreign currency reserves. At the moment, there is no such single currency that could be deemed acceptable.
There has been an apparent drive to sell the US dollar for gold which can be kept as reserves. When you keep gold in your vaults, gold does nothing as it sits there collecting dust. In the end, you may try to issue your currency as a receipt to an actual amount of physical gold. It would be much better than bitcoin which is an artificial digital construct on an arbitrary basis.
The problem with a currency on the gold standard is that if you allow the gold to be redeemed, you may end up with no physical gold and lots of paper money.
There is no way in a money-using economy that you can do away with money as a unit of final settlement. It is the ability of the fractional banking system that allows money to be created through the expansion of loans, and when the new loans are properly vetted and used, that money creation helps to expand the real economy. It is a fact that the expansion of the US money supply helps to raise the China economy as new US loans were spent on investing and building factories in China and in the process built up the foreign reserves of China.
For China now to discard the US dollar as its foreign reserves by divesting into monopsony and gold, is an attempt now to play the economic game with the US. It is therefore logical that the US should stop this bilateral economic understanding and enforce a structural break even just for the sake of trying to reduce the deficit problem. Like everybody when we try to reduce our debt, we consume less output thereby causing a recession.
A tariff war ends up in recession. This is a fact.
