Beyond the Brink: Escalation and Conflict in U.S.-China Economic Relations

Executive Summary

As the United States and China mark their 40th anniversary of formal diplomatic relations in 2019, the world’s most important bilateral relationship is increasingly defined by mistrust, competition, and uncertainty. After four decades of deepening economic integration, the talk in Washington today is about the extent to which the two economies will “decouple” over the years ahead. On July 6, 2018, the United States imposed tariffs of 25 percent on $34 billion worth of Chinese imports, launching the largest trade war in the post-war era. A year later, more than three-quarters of the $660 billion in two-way goods trade—an amount roughly the size of Thailand’s economy—was subject to tariffs. During that time, the United States also announced export restrictions for dozens of Chinese companies and designated Beijing a currency manipulator; both of these actions were met with swift retaliation. The potential economic costs of the conflict, and any decoupling it prompts, are enormous, not only to the United States and China but to the entire global economy. Moreover, the trade war has elevated the potential for spillovers into other aspects of the relationship and the risk of great-power conflict.

Despite these risks, the United States entered the trade war relatively unprepared for such a confrontation, with only a vague sense as to how it could unfold. Without an appreciation of where the trade war may lead, the United States may find itself weakened in economic, diplomatic, and security terms, without achieving significant policy changes in China. Most importantly, policymakers risk miscalculating and stumbling into a new Cold War—or worse.

We launched this project to help U.S. policymakers navigate the complexities of a trade war with China. We drew on several different academic disciplines to help us model how an economic conflict between the United States and China could escalate and eventually de-escalate. Although the real U.S.-China trade war quickly escalated over the course of this 18-month project, our theory-based approach provided valuable predictive power, as well as a basis for understanding the strategic logic of the other side.

We began by developing a model for the likely dynamics of how a trade war might escalate, applying game theory, bargaining theory, and the concept of “escalation dominance” from nuclear deterrence theory. Our model simplifies the variables in a negotiation to isolate those affecting escalation. The predictions of our model depend on several factors,  including each country’s appetite for risk and perceived knowledge about their adversary’s willingness to endure pain. Second, we inventoried and analyzed the tools of economic statecraft available to policymakers in the United States and China. A more complete understanding of these tools, including associated costs and use cases, will help U.S. policymakers better apply strategic pressure and understand Chinese responses. Finally, we tested and refined our model and the assumptions underlying it through two one-day simulations of a U.S.-China trade war involving experienced experts and former policymakers. The simulations helped us understand how Washington and Beijing approach economic conflict, which tools had the most strategic value, and possible escalatory pathways of a prolonged trade war.

Despite the challenges inherent in modelling economic conflict, our model was validated to a surprising extent by both our simulations and real-world developments. The project produced several findings that were both unexpected and relevant to policy:

• Game theory is useful to model the dynamics of escalation in U.S.-China economic conflict. Generally, our simulations confirmed our model’s central causal mechanism: an agent that has a high appetite for risk and underestimates its counterpart’s willingness to endure pain will launch an escalatory spiral. This helps explain the current impasse in the trade war. Beijing believes the costs of fundamentally reforming their economy as part of a deal are greater than the costs of the current conflict. Washington is determined to continue the conflict because it believes the costs are higher for China.
• A successful U.S. negotiating strategy must establish “dual credibility” about resolve and willingness to compromise. Our model and simulations found that an optimal U.S. strategy of pressure toward China credibly demonstrates both resolve and willingness to compromise. Washington must continually persuade Beijing that the United States is willing to absorb enormous costs for longer than China and that the United States would accept a compromise agreement that both addresses its own major concerns and yields benefits for China.
• China has an impulse to reach out and seek partners and is sensitive to multilateral pressure. In both of our simulations, China displayed an impulse to reach out and seek allies. Beijing’s tendency to use significant resources to attract partners— successful or not—suggests U.S. efforts to work with allies to isolate China have value. Beijing places a high priority on outreach, but Washington has a natural competitive
  advantage thanks to its network of alliances. By eschewing multilateralism and threatening tariffs against traditional allies, the United States is denying itself a stronger hand in negotiations with China.
• Economic statecraft—if well-targeted—can pressure China to make meaningful concessions. In our simulations, the China team felt most threatened when the United States banned exports to critical Chinese technology companies. Comparatively, they felt less pain from broad-based tariffs. As a result of this pressure, the China team in our simulations was willing to make concessions on what they perceived as non-core issues, including intellectual property protection and goods purchases. Applying our model, to reach a deal on fundamental structural issues, the United States will have to apply massive pressure to make the costs of conflict unbearable to China, which may be impossible without multilateral support.
• China prefers to use informal tools of economic statecraft. In our simulations, China often did not implement equivalent countervailing measures but used “qualitative” tools to retaliate to U.S. actions. These were not used at random but targeted politically salient interests. Use of informal tools allows China to pressure the United States while simultaneously passing laws that notionally liberalize its economy to
  attract other foreign investors. Still, this “silent” trade retaliation by Beijing is prone to miscalculation.
• Economic conflict generates pressure for a larger government role in the economy. Wide-ranging economic conflict pressures governments to more actively intervene in the domestic economy. For one thing, they may seek to prevent certain companies from trading with an adversary. They will face pressure to compensate interest groups harmed by escalation to maintain domestic support for continuing the conflict. And they will face broader incentives to stimulate growth to offset the pain of escalation, since neither side will want the other to perceive it as weak or damaged as a result of escalatory actions.
• Selective decoupling is an inevitable consequence of economic escalation once a threshold is crossed. This is arguably the most significant finding of our project. We found that escalation dynamics will push two countries apart once a certain threshold is crossed even if neither side had an initial goal of decoupling. Aggressive use of escalatory tactics erodes mutual trust, limiting the credibility that either side will negotiate in good faith or keep their promises. This is exacerbated when a country crosses certain “red lines” or if there are broader strategic concerns. Even if a deal is reached, memory of the conflict will influence public- and private-sector decisions. All of this suggests that economic conflict is likely to be an enduring feature of the U.S.- China relationship for many years to come. Until perceptions of relative costs in the two countries shift, Washington and Beijing seem set on a path of continued escalation, no substantial trade deal, and at least partial decoupling of their economies.

Reflecting on the findings of our project in light of the real-world U.S.-China trade war, we derive a few recommendations for U.S. policymakers seeking to engage in successful economic bargaining with China:

1. Establish “dual credibility.” Whether it wants to win narrow economic concessions or more fundamentally change Chinese policies, Washington must persuade Beijing that it is willing to both: (a) impose and maintain penalties—and bear the associated costs; and (b) follow through on its own commitments if a mutually beneficial deal is reached.
2. Set clear goals and assess the cost and benefits of achieving them. The first step in successful bargaining, with China or any other country, is to set clear objectives and ensure that everyone on the U.S. negotiating team understands them.  Once the negotiating objectives have been set, it is critical to have an accurate assessment of the costs and benefits of achieving them, including the impacts of using different tools and tactics. This should begin with the collection, analysis, and distribution of data on the benefits and costs of U.S.-China commerce, in absolute terms and relative to other policy challenges.
3. Enhance decision-making processes. An administration wishing to strengthen its bargaining position with China should work to maximize procedural strengths, including institutional experience and stakeholder input, and remedy challenges of coordination and regulatory-capture risks. Potential solutions include establishing a “China policy czar” in the White House charged by the president with developing and implementing strategy and ensuring coordination across the U.S. government. More transparent and standardized consultations with industry and consumer groups would also be valuable.
4. Build multilateral coalitions. No strategy toward China can succeed without extensive coordination with U.S. allies and partners. With the spread of China’s economic relationships around the world, access to the U.S. market alone no longer provides the kind of bargaining leverage for Washington that it once did. However, mobilizing the U.S. network of allies and partners can play on Beijing’s fear of isolation. As a first step, the Trump administration should deepen its trilateral work with the European Union and Japan.
5. Invest in economic strength at home. Beyond short-term interventions to improve the U.S. tactical position or offset costs to domestic stakeholders, the United States can and should strengthen its bargaining position vis-à-vis China by investing in the domestic underpinnings of its long-term economic competitiveness. This means upgrading the country’s physical infrastructure, preparing the American workforce with the skills and resilience needed in the twenty-first century economy, and investing more in research and development.

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