Who will win the trade war?

This map shows in blue how the US was the biggest trading partner for most countries in 2001. But, as the years progress, we see the map turn red as China quickly overtakes the US as the world’s biggest trading partner.

No wonder the US escalated an unprecedented trade war against China. But, is it too late? Or can the US actually contain the rise of China?

Many economists have come out and written that Beijing has escalation dominance and the US will lose against China.

World famous macro investor Ray Dalio is even convinced that what we are seeing today is a classic pattern, of how a rising power displaces an old hegemon. First, through trade, and then by replacing its currency as the global reserve currency.

If that happens, the Dollar will collapse, and the US will find itself much poorer, unable to pay for its global military presence, while China will suddenly see its power multiply.

And, yet US treasury secretary Scott Bessent has said that:

If you look at the history of the trade negotiations, we are the deficit country. So what do we lose by the Chinese raising tariffs on us? We export only one-fifth to them of what they export to us. So that is a losing hand—for them.

And, actually, Bessent may be correct. People like Dalio, who argue for the rise of China, often don’t take into account how unique the role of the US Dollar is today—now that it’s no longer backed by gold. On top of that, when I studied the rise and fall of hegemons over 400 years, I found plenty of cases where dominant powers managed to contain rising rivals. For example, Britain contained an industrially superior Germany in 1914 and the US arguably contained a rapidly rising Japan in the late eighties through tariffs and a currency deal.

So, who actually has the stronger hand today to win this trade war and become the new global hegemon? The only way to answer that question is to do a proper deep dive into

The rise and fall of global hegemons

In this book, principles for dealing with the changing world order, famous macro investor Ray Dalio attempted plot the relative economic and military power of the world’s most powerful countries into a single index.

It looks like this. It shows us that in the 17th century the Netherlands quickly rose to become the world’s most powerful nation, overtaking Spain and China. Then, it shows that the United Kingdom overtook the Netherlands to become the dominant hegemon in the 19th century. The US’s rise in the 20th century, and, finally, now we see the rapid rise of China.

Based on this research Dalio argues there is a detailed pattern that can explain why empires rise and fall.

In the past, I’ve argued that his detailed theory does not hold up very well. However, the pattern that a great power first tends to become an industrial power and then later obtains reserve currency status. That, it not very controversial.

For example, while the UK overtook the Netherlands as main trading nation in the late 17th century, it was only in 1784 that the Dutch Guilder lost reserve currency status to the Pound.

Similarly, the UK pound only lost its crown as the global reserve currency in the 1950s. Well, after the US had overtaken it.

Why is that the case? Why do rising nations take the industrial crown before taking the reserve currency crown?

To answer that question, we need to talk about gold. You see, for most of the period Dalio studies, all national currencies were directly tied to gold. So, one Dutch guilder, British Pound, and US Dollar could be exchanged for a certain weight of gold. Because gold is pretty heavy and impractical to divide and carry around, people ended up favoring currencies that were convertible into gold, rather than holding gold itself. However, this did of course mean that currency issuers needed to convince holders that they had enough gold in their vault to back up all the paper they had issued. So, logically, the nations that were able to issue the most currency, where those that had the most gold. And, how did nations earn gold? Well, by exporting more than they import, of course.

This can explain why —historically— rising powers needed to become an exporting powerhouse first. Once their superior industries became a gold magnet, it would slowly but surely attract gold from the reigning Hegemon. Of course, the reigning hegemon’s currency had a big advantage, it was already used by everyone. But, at some point, once the gold in the hegemon’s central bank would be low enough, that power would face a run on its currency, which would cause it to collapse, after which, the rising power’s currency would take over.

This sequence of events is roughly the dynamic that Dalio talks about in his book.

In a gold standard world, I think Dalio’s analysis holds up pretty well. The Dutch lost the export crown to the British in the late 17th century. But, it took roughly a 100 years for Dutch gold to run so low that the Bank of Amsterdam faced a run, and collapsed. Similarly, the US surpassed Britain’s industrial might in the late 19th century. But, it took the US’s superior industry slowly but surely collecting all the world’s gold, and a major war before the US Dollar could fully displace the Pound in the 1950s.

Dalio’s model can also explain why some challenger powers never made it. For example, while Napoleon tried to break British industry when he formed the so-called ‘continental system,’ the British used the power of their reserve currency to borrow money to fund a war against it’s weakest link: Denmark. In this case Napoleon lost the trade war because he had not yet surpassed Britain in industry. The next challenger, Germany fared slightly better, as it hit the first milestone, surpassing Britain’s industry around 1870. However, then it mistakenly started a massive war before it has surpassed Britain financially, and ultimately found itself unable to borrow much, while Britain used its incredible financial power not just to finance itself, but also key Allies such as France and Russia.

However, today, we no longer live in a gold standard world. Therefore, Dalio’s framework cannot tell us much about whether or not China can displace the US today.

After all, the US DID already run out of gold in the 1970s. And, rather than perishing like the UK Pound and Dutch guilder did before it, the US Dollar became more valuable than ever. After that, US trade deficits became bigger than ever

During this period, the US has faced three challengers that exported way more than they imported. The first was Japan, an innovative rising export powerhouse, which prioritized exports over all else. In the 1980s many predicted that Japan would overtake the US. And yet, if we look at Dollar GDP, this is what actually happened.

Next, we have the European Union, which had a significantly bigger population than the US, overtook US manufacturing output in 2003, and had an export surplus.

No wonder that some expert economists predicted it could overtake the US Dollar as early as 2015.

However, much like Japan, after a significant challenge to the Dollar, Europe’s Dollar term GDP stagnated.

The reason that exporting powerhouses can no longer simply displace the Dollar is that it is no longer tied to gold. But, if it not backed by gold, then why do countries around the world want to keep using the Dollar as their preferred reserve asset? Well, according to central bank reserve managers themselves, they choose the Dollar over other assets for two main reasons. The first is safety. Safety from getting your assets confiscated and safety from major volatility, as the Dollar is one of the most stable currencies in the world. The second main reason is liquidity. Liquidity comes from central banks easily being able to borrow dollars, from either the IMF, World Bank or Fed. But, for many developing countries is also comes from having access to the US consumer. You see, the most stable ways to obtain Dollars, is to export to the US. By making this easy, the US has essentially given developing countries an extremely strong incentive to plug into the Dollar system.

However, as you can imagine, this is no charity. The Dollar’s reserve currency status has given the US a tremendous advantage. It can now keep a military presence of over the world even though it does not have the industrial might to back that up.

And yet, as MAGA economists have emphasized, an expensive Dollar does make exporting from the US very costly, leading to de-industrialization. This may become a problem if there is a ever a total war. This is why the US escalated this trade war.

So, I would argue that winning the trade war for the US means, taking back the industrial crown from rising power China. On the other hand, winning the trade war from the perspective of China would mean ending US hegemony once and for all, taking reserve currency status away from the Dollar.

If China could pull this off, it could become the new reining hegemon in one fell swoop. After all, if we purely look at the value of all goods and services, if the Dollar wasn’t so strong, we would get this graph. Showing that, officially, in terms of raw output, China’s economy is already bigger than that of the US.

Now, at this point, I do have to mention that there are very legitimate concerns about the quality of official Chinese GDP data. But, despite that, the point remains that the increased value of the Dollar, despite high inflation in the US, made US GDP and therefore military might much higher than it otherwise would have been.

Displacing the US Dollar. Is that even possible? After all, before Trump started his trade war, China’s Dollar value GDP graph was starting to look an awful lot like that of Japan and Europe… going flat

Well, yes, I think there is a plausible scenario in which

China becomes the global hegemon by replacing the Dollar

You see, after freezing Afghani reserves in 2021 and Russian reserves in 2022, many countries are looking for an alternative reserve currency to the US Dollar. This has only gotten worse now that Trump has made the Dollar much more volatile, and now that it is threatening to close American markets, thereby robbing many developing countries of a safe and stable way to accumulate Dollars.

In this scenario, the Chinese leadership recognizes this vulnerability and also recognize that their current policies have kept the Renminbi’s usefulness as a reserve currency way down.

Therefore, Xi Jinping now starts following the advise of economists that have written about this for decades and takes 3 steps to make the Chinese Renminbi an irresistible alternative to the Dollar.

First, the Chinese recognize that for foreign central bankers safety and predictability are key. So, while Trump keeps bashing the Fed, China’s leadership moves to make its central bank completely independent. It also changes the rules to freely allow money in and out of China. Finally, it gives foreign asset holders complete guarantees that its leaders cannot sanction you, let alone move in to confiscate your reserve assets, if you speak out against China globally. This instantly gives the Renminbi an edge over the Dollar for relatively developed countries with lots of reserves like the Gulf countries, South Korea, and Japan.

Second, China’s leaders realize that they need to make it attractive for developing countries as well to use the Renminbi rather than the Dollar. Therefore, they make the unprecedented step of opening up their consumer markets to developing nations. This means they copy the US cold war tactic of allowing these nations to protect their own markets somewhat from Chinese producers.

Finally, the Chinese leadership removes policies to subsidize industry, suppress wages, and control the value of the Renminbi.

Seeing their wages go up, the Chinse economy finally sees an increase in consumption, allowing for further growth in China. Increased reserve currency usage means that the Chinese renminbi rises, giving the Chinese consumer far more purchasing power globally. This then makes the Renminbi extra attractive for developing nations, as they can now re-orient their export growth strategy from the US to China.

Finally implementing these long overdue measures makes the Renminbi instantly more attractive than the Dollar for both advanced exporters and developing countries that need a big consumer market to export to.

So, why hasn’t this happened yet? Well, the most convincing two arguments I’ve heard are about (1) ideology, and (2) power. You see, ideologically speaking, Xi has apparently developed a real passion for exports, and not so much for consumption and allowing some industries to move overseas. Second, there’s politics. This entire plan involve ceding a lot government power to independent institutions that protect foreign money in China. So far, Chinese leadership has done exactly the opposite, seeking more power, rather than less.

This means that, sadly for China, and frankly for the world, this scenario has a really low probability of actually happening. Despite Trump’s chaos, China is unlikely to win the trade war and displace the US as the new hegemon because its leadership is unlikely to implement the reform needed to do so.

That is great news for Trump. But, does he himself actually stand a chance to win? Let’s now explore the scenario that

The US holds of yet another challenger and remains the global hegemon

Honestly, until Trump came along, it looked like this scenario would happen. China’s GDP was going exactly the same way as that of Japan and Europe.

But, as I’ve said in a previous video, I do understand that the Trump team still viewed China’s industrial subsidies, and recent dominance of new industries as a national security threat.

However, in contrast to listening to his smartest advisors, who recommended going slow and predictable with the tariffs, while copying some of China’s industrial subsidies, Trump decided to go with hard line advisors, while sprinkling in his own chaos. As a consequence, the Dollar has been really volatile, and the development model of many nations is now in danger, both weakening the attractiveness of the Dollar as a reserve currency.

To reverse this, in this scenario, Trump does three things. First, he focusses more on playing golf and less on Tariffs. This means that he lets his most competent advisors implement a moderate and predictable tariff, and subsidy program to slowly but surely bring SOME strategic industry back to the US. Second, he re-establishes the trustworthiness of the Dollar by strengthening, rather than undermining, the rule of law, by ensuring that the Federal Reserve remains independent and by refraining annexing or threatening to annex territories that belongs to allies. Finally, he recognizes that to grow a bigger economy than China, the US needs talented, hard working people. So, while he restricts illegal immigration, he makes legal immigration a viable alternative.

In this scenario, China continues on its current path of failing to rebalance its economy. This ensures that while imperfect, the US Dollar remains the only serious reserve currency. On top of that, Trump is helped by the fact that developing countries will sooner or later impose tariffs on China on their own, as their markets are flooded with subsidized products.

Sadly, I think again that this scenario is pretty unlikely because it requires that Trump completely changes the way that he operates.

This is why I think, in the end, sadly, we have to answer our main question: who will win the trade war by talking about the most likely scenario:

Nobody wins the trade war

In this scenario, Trump’s chaos will continue to make the Dollar less attractive. But, because Xi is unwilling to rebalance the Chinese economy, there won’t be a credible alternative. Therefore, we get stuck in a world where there are essentially 3 big global export clusters: China. the European Union, and the US. In this scenario, China remains the biggest exporter, but it is not dominant enough to set the rules of the game for everyone.

In this scenario there also remain 3 big import clusters. But, again, while the US remains the biggest, it’s not big enough to allow it to convince all other countries to join it in completely blocking out China.

Sadly, while this may sound like a continuation of the global order that we have right now. A new field of economics, geoEconomics teaches us that Trump’s trade war is a sign that the hegemonic power of the US is now in question. We are moving to a multipolar world and that has major implications for what the global economy will look like when it comes to investments, inflation, currencies, trade wars, and more.

But, what the multipolar global economy, in which nobody actually wins the trade war, will look like? That will be the topic of my next video. So, subscribe and hit the bell icon if you want to make sure you don’t miss it.

To get an idea about the new global order before that, I highly recommend you check out the following three articles from our advertising sponsor: the Economist.

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