War over Taiwan would be financial disaster for US, China Opinion by Bloomberg

Bloomberg has published an opinion piece claiming that a conflict between the two superpowers would trigger mutually assured financial destruction. Caliber.Az reprints the article.

“Mutually assured destruction” was one of those blood-chilling concepts that emerged from the game theory approach to nuclear strategy. For my generation, the initials MAD summed up the surreal nature of the global contest between the US and the Soviet Union that I now think of as Cold War I.

“Assured destruction” (the initial formulation) was a concept born in the 1960s, as the Soviets began to catch up with the US in terms of warheads, launchers and throw weight. As defence secretary, Robert McNamara embraced the theories of the Harvard economist Thomas Schelling about a “stable” balance of terror. This was based on the combination of an American capacity for a vastly destructive retaliatory attack on the Soviet Union, and an American vulnerability to such an attack by Moscow. As Henry Kissinger later put it, the strategy President Richard Nixon inherited from President Lyndon Johnson was based on the belief “that vulnerability contributed to peace, and invulnerability contributed to war.”

To a surprising extent, this “MAD” idea proved durable. Some even believe that it was the reason World War III did not occur, despite moments of acute tension between the superpowers.

Today, in the early stages of Cold War II between the US and China, an equivalent concept exists. To be sure, this conflict also has a nuclear dimension, now that the Chinese have massively enlarged their own nuclear arsenal. But not many people seem terribly worried about that aspect of the Sino-American rivalry. Rather, it is mutually assured financial destruction that constrains today’s superpowers and most clearly distinguishes Cold War II from Cold War I.

True, a faint scent of détente has been in the air this year. According to Kurt Campbell, the head of Indo-Pacific on the National Security Council, President Joe Biden’s administration is “seeking careful, productive, strategic interactions with China. … a more predictable, judicious set of interactions across a variety of spheres.” On her recent visit to Beijing and Shanghai, Commerce Secretary Gina Raimondo secured a commitment to set up new “working groups” on commercial issues and another on export controls.

Yet Raimondo rebuffed a Chinese request to reduce US tariffs on Chinese goods. There was no discussion of the October 2022 Commerce Department rules that limit Chinese access to high-end semiconductors and the machines that make them. In early August, the White House announced new restrictions on investments in Chinese artificial intelligence, quantum computing and semiconductors by US private equity and venture capital firms.

Partly because of these measures, and in anticipation of more to come, economic decoupling is happening quite rapidly. China’s share of US imports has fallen steeply since 2017. Foreign investors sold $12 billion worth of Chinese stocks in August, the biggest downward shift since offshore trading in Shanghai- and Shenzhen-listed shares began in late 2014. US private equity and VC investments in China, which seemed to be recovering in 2021, have since plunged. Most China-focused private equity funds are now raising mostly in Chinese currency.

Yet both sides have economic weaknesses that undercut these drives to reduce interdependence. On the Chinese side, recovery from the regime of “zero Covid” has been lackluster.

The mounting problems of the Chinese real estate sector and the reluctance of consumers to spend suggest at least some parallels with the Japanese economy after the bubble burst in 1989. China’s problems can be summed up as diminishing returns from fixed-asset investment, insufficient consumer demand, and a lack of fiscal room for manoeuvre attributable to excessive reliance in the past on local government financial vehicles and sales of land to developers. Meanwhile, the country’s demographics go from bad to worse.

The problems of the US are in some ways a mirror image. To European eyes, the US economy is doing wonderfully well, with full employment, consumers continuing to spend, and inflation coming down after its spike in 2022. This apparent health conceals a severe structural weakness on the fiscal side, however.

Recent years have witnessed a succession of excessively large federal deficits, in substantial measure financed by enlarging the Federal Reserve’s balance sheet. What was a $19.9 trillion debt when Donald Trump was inaugurated is now close to a $32.3 trillion debt. The Federal Reserve’s balance sheet more than doubled in size between January 2020 and its peak last April, from $4.2 trillion to just under $9 trillion.

Agatha Kratz of the Atlantic Council envision that in a “maximalist scenario … at least $3 trillion in trade and financial flows, not including foreign reserve assets, would be put at immediate risk of disruption.”

In the case of a war, moreover, the US has long intended to impose a blockade on China to shut down the flow of essential goods, including oil and food, through the Strait of Malacca, the key chokepoint between the Malay Peninsula and the Indonesian island of Sumatra. Some experts doubt that such a “far blockade” could be effective because of the familiar incentives for neutrals to evade the blockade as well as China’s capacity for self-sufficiency in certain areas. But even the attempt at a far blockade would cause significant disruption to global markets, driving up prices in ways similar to those we saw last year after Russia invaded Ukraine, but on a much larger scale.

The economic implications of such a scenario are very difficult to foresee with precision, but the word “catastrophic” suggests itself. Cuba was and remains economically trivial. Its principal export is cigars. Taiwan leads the world in the manufacture of the most sophisticated semiconductors. Even the elevated probability that Taiwan Semiconductor Manufacturing Co.’s massive fabs might be destroyed would send microchip prices through the roof.

Note, too, the uncertainty of the outcome of a US-Chinese war. According to a recent report in Politico, “in every [recent war game] exercise the U.S. uses up all its long-range air-to-surface missiles in a few days, with a substantial portion of its planes destroyed on the ground.” Representative Mike Gallagher, who chairs the House Select Committee on the Strategic Competition Between the US and the Chinese Communist Party, says the US urgently needs more Joint Air-to-Surface Standoff Missiles (JASSMs), Long Range Anti-Ship Missiles (LRASMs), Harpoon anti-ship missiles, Tomahawk cruise missiles and other munitions. Stocks of a number of these weapons have been heavily depleted as a result of the Biden administration’s support for Ukraine.

In addition, there is a widening naval gap. The PLA Navy passed the US Navy in fleet size in around 2020. China now has some 340 warships and is expected to reach 400 by 2025, according to the Pentagon’s 2022 China Military Power Report. Under the 2018 National Defense Authorization Act, Congress required the Navy to increase the number of its combat ships to 355 (from fewer than 300 now) “as soon as practicable.” But the Pentagon’s current building plans would not achieve that target for years — perhaps not until the 2050s. The US is currently building only 1.2 submarines a year on average, despite a congressional mandate for two a year.

It would therefore be fair to conclude that, even if the US has a strategic concept for war with China — the favoured term is “Distributed Maritime Operations” — it lacks the ships and submarines to make those operations practicable in the near term. It needs to invest in hundreds of drones for reconnaissance, as well as integrated systems to manage drone swarms. It needs to modernize its submarine fleet and move on from anachronisms such as easily sinkable warships, helicopters, large drones and towed artillery. And, to achieve all this, it urgently needs to reform its cumbersome defence acquisition process — in particular, the 61-year-old Planning, Programming, Budgeting and Execution system, which was recently described by former Google CEO Eric Schmidt as an “outdated, industrial-age budgeting process” that “creates a valley of death for new technology.”

How does this all get paid for? The problem is obvious. With the rapid rise of interest rates, the very large federal debt accumulated in recent years is no longer a free lunch in terms of debt service. Many years ago, I advanced the hypothesis that a great power or empire that spent more money on interest payments than on defence was likely on the verge of decline and fall.

During the most hectic phase of Cold War I, from 1947 until 1969, defence on average cost the US five times as much as debt service. Between 1970 and 1990, debt service rose in relative terms from 21% the size of the defense budget to just above 70%. The two lines met briefly in 1997 and 1998, when military spending was slashed for the supposed “peace dividend,” only to diverge again as interest rates declined and the defence budget grew again after 9/11. In the second quarter of this year, however, the two figures were almost identical. Next year it is almost certain that interest payments will exceed defense spending. It is not difficult to foresee a sustained divergence thereafter.

In this context, the possibility of a war between the US and China raises the spectre of mutually assured financial destruction. It is not clear that either the US or China can afford even to sustain their current arms race. It is surely out of the question that they could cope with the adverse financial consequences of a war over Taiwan.

What Moritz Schularick and I christened “Chimerica” back in 2007 — the symbiotic economic relationship between China and the US — is not dead yet, even if trade and investment have receded from their peaks at that time. The US annual trade deficit with China remains in excess of $300 billion. More than 80% of US smartphone imports continue to come from China, as the Wall Street Journal recently noted.

China has accumulated a substantial stock of international reserves, including what Brad Setser of the Council on Foreign Relations calls “shadow reserves” not counted in the $3.12 trillion that the State Administration of Foreign Exchange reported in December 2022. The true total is probably closer to $6 trillion. In an attempt to reduce its exposure to potential US sanctions, China has clearly reduced its net holdings of US Treasury bills by 3.1% — to $776.4 billion in June, down from $801.5 billion in May — the biggest reduction in percentage terms since October 2000.

From the point of view of China, however, a complete exit from US-dollar denominated assets is an unattainable goal, so the vulnerability to a partial freezing of reserves — similar to that inflicted on Russia last year — remains.

From the point of view of the US, the declining willingness of investors to hold Treasury securities can only imply higher long-term interest rates, just as China’s willingness to accumulate dollars prior to 2008 was one of the reasons for the “anomaly” of low long-term rates in the period before the financial crisis. Note that China is not the only seller of US debt this year: Saudi Arabia has also been cutting its exposure to US Treasuries.

So, in the case of a showdown over Taiwan, the US might impose financial sanctions on China — but the effect would be to impose a form of secondary financial sanctions on itself. I cannot estimate precisely what the effect of all this on global stock, bond and currency markets would be, but it would not be small.

In Cold War I, it used to be argued, the prospect of mutually assured destruction had averted the nightmare of World War III. In Cold War II, it is tempting to conclude, mutually assured financial destruction (MAFiD) may have a similar deterrent effect on the two superpowers.

Yet it would be wrong to regard MAFiD as a sufficient guarantee against Armageddon. Did financial considerations deter Britain and Germany from going to war in 1914, at a time when their economies were almost as interdependent as the American and Chinese economies in our time?

Did Cold War I stay cold, as Schelling hypothesized, because of MAD? Or did we just get lucky? Increasingly, historians of the first Cold War incline toward the latter view. A major crisis over Taiwan would have immediate and dire financial consequences before a shot was even fired. But to assume that this prospect will prevent an escalation from Cold War II to World War III risks making the same mistake as the nuclear theorists of the 1960s — who were blissfully unaware of just how close mutually assured destruction had come over Cuba.