US versus China is here and Australia is unbelievably exposed

Bloomberg kicks us off:

U.S. President Donald Trump continued to hit out at China days after announcing another round of tariffs, signaling the trade war won’t end any time soon.

“It’s time to take a stand on China,” Trump said in an interview late Thursday with Fox News. “We have no choice. It’s been a long time. They’re hurting us.”

“We have a recent survey of our membership, and three quarters of our companies are going to be hurt by the U.S. tariffs,” American Chamber of Commerce in China Chairman William Zarit said Friday in an interview on Bloomberg Television.

“We’re seeing that — in terms of the supply chains, which are being so disrupted — that about a third of the companies are looking for new supply chains from the U.S., about a third of the companies looking for new supply chains from China, and about a third of the companies are putting off investment decisions until they see the dust settle,” Zarit said.

That kind of split would probably please the White House. Steven Bannon appeared in the SCMP:

US President Donald Trump’s strategy is to make the trade war with China “unprecedentedly large” and “unbearably painful” for Beijing, and he will not back down before victory, former White House chief strategist Steve Bannon said in an exclusive interview.

Bannon said the aim was not just to force China to give up on its “unfair trade practices” – the ultimate goal was to “re-industrialise America” because manufacturing was the core of a nation’s power.

He also took aim at the “Made in China 2025” plan – an attempt by Beijing to catch up with the West in 10 key technology sectors, saying China was using generous government support to reduce its reliance on the West for future technology.

Bannon, who claimed to have helped Trump draw up the trade war plan, said that in the past, tariffs had been limited to imports of between roughly US$10 billion and US$30 billion but the sheer magnitude of the more than US$500 billion in question this time had “caught Beijing off guard”.

“It’s not just any tariff. It’s tariffs on a scale and depth that is previously inconceivable in US history,” Bannon said.

He said Beijing had relied on “round after round of talks” to take the momentum out of the US punitive measures, but the delaying tactics would not work.

“They always want to have a strategic dialogue to tap things along. They never envisioned that somebody would actually do this.”

He and Trump were convinced the US would win – and there were signs the Chinese elite were too, with “so many senior Chinese officials exhausting all channels” to move their money out of China and into real estate in San Francisco, Los Angeles and midtown Manhattan.

“Why [does there have] to be massive capital controls placed on Chinese money? Otherwise all will flee to midtown Manhattan … They want to buy real assets in the US. That shows you a dramatic lack of confidence in their own economy.”

“Re-industrialise America”. Whoa. Even if the American goal is mostly targeted at China, that goes far beyond a bi-lateral trade war. If Bannon is to believed, and his basic outlook appears to be shared by President Trump if Bob Woodward’s Fear is to believed, then we are at the threshold of a paradigm shift led by the world’s super power. It may begin with the US but it will spread to allies and enemies alike over time.

Is the “re-industrialisation” of America even possible? Not in any traditional sense. Wage and land costs will prevent it. Though energy is an advantage. Where it will be possible is in robotics and automation, areas in which intellectual property and technical superiority are the competitive advantages. That may mean new well paid US manufacturing jobs but it also means less of them.

Which brings us back to the “Made in China 2025” plan. Clearly the two paradigms are now locked in a titanic struggle and Trump’s full range of tariffs is inevitable. To wit, from Goldman:

That does not seem likely, also from Bloomie:

China has called off planned trade talks with the U.S. and is unlikely to sit down with Washington until after the mid-term elections, according to people familiar with the situation.

Beijing has withdrawn a planned delegation to Washington next week, the people told Bloomberg. The Wall Street Journal earlier reported that China had scrapped plans to send Vice-Premier Liu He and a mid-level delegation.

Then there is this, via Al Jazeera:

China summoned the United States ambassador on Saturday after the US imposed sanctions on a branch of its military, according to Chinese state media.

China’s Deputy Foreign Minister Zheng Zeguang summoned Ambassador Terry Branstad and “lodged solemn representations” in relation to the sanctions, state media reported.

On Thursday, Washington imposed sanctions on the Equipment Development Department (EED) of the Chinese defence ministry, and its director Li Shangfu, over the purchase of missiles and fighter jets from Russia.

The sanctions triggered a visa ban and prohibited the EED and its director from conducting transactions with the US financial system.

The US state department said the Chinese procurement of S-400 surface-to-air missiles and Sukhoi SU-35 jets from Russia breached a US sanctions law targeting Russia for its alleged meddling in the 2016 US election and its activities in Ukraine.

US officials said the imposition of penalties against China was the first time a third-party country was punished under the Countering America’s Adversaries Through Sanctions Act, the sanctions law passed in 2017.

It’s not altogether obvious that Trump wants a deal with China. His goals and its are mutually exclusive. We can turn here to a little history lesson from Ray Dalio:

While the purpose of this chapter has been to examine the debt and economic circumstances in the United States during the 1930s, the linkages between economic conditions and political conditions, both within the United States and between the United States and other countries—most importantly Germany and Japan—cannot be ignored because economics and geopolitics were very intertwined at the time. Most importantly, Germany and Japan had internal conflicts between the haves (the Right) and the have-nots (the Left), which led to more populist, autocratic, nationalistic, and militaristic leaders who were given special autocratic powers by their democracies to bring order to their badly-managed economies. They also faced external economic and military conflicts arising as these countries became rival economic and military powers to existing world powers.

The case is also a good example of Thucydides’s Trap—where rivalries between countries lead to wars in order to establish which country is more powerful, which are then followed by periods of peace in which the dominant power/powers get to set the rules because no country can fight them until a rival power emerges, at which time they do it all over again.

To help to convey the picture in the 1930s, I will quickly run though the geopolitical highlights of what happened from 1930 until the official start of the war in Europe in 1939 and the bombing of Pearl Harbor in 1941. While 1939 and 1941 are known as the official start of the wars in Europe and the Pacific, the wars really started about 10 years before that, as economic conflicts that were at first limited progressively grew into World War II. As Germany and Japan became more expansionist economic and military powers, they increasingly competed with the UK, US, and France for both resources and influence over territories. That eventually led to the war, which culminated in it being clear which country (the United States) had the power to dictate the new world order. This has led to a period of peace under that world order and will continue until the same process happens again.

The economic/geopolitical cycle of economic conflicts leading to military conflicts both within and between emerging powerful countries and established powerful countries is obvious to anyone who studies history. It’s been well-described by historians, though those historians typically have more of a geopolitical perspective and less of an economic/market perspective than I do. In either case, it is well-recognized as classic by historians. The following sentence describes it as I see it in a nutshell:

When 1) within countries there are economic conflicts between the rich/capitalist/political right and the poor/proletariat/political left that lead to conflicts that result in populist, autocratic, nationalistic, and militaristic leaders coming to power, while at the same time, 2) between countries there are conflicts arising among comparably strong economic and military powers, the relationships between economics and politics become especially intertwined—and the probabilities of disruptive conflicts (e.g., wars) become much higher than normal.

In other words economic rivalries within and between countries often lead to fighting in order to establish which entities are most powerful. In these periods, we have war economies, and after them, markets, economies, and geopolitics all experience the hang-over effects. What happens during wars and as a result of wars have huge effects on which currencies, which debts, which equities, and which economies are worth what, and more profoundly, on the whole social-political fabric. At the most big-picture level, the periods of war are followed by periods of peace in which the dominant power/powers get to set the rules because no one can fight them. That continues until the cycle begins again (because of a rival power emerging).

Typically, though not always, at times of economic rivalry, emotions run high, firebrand populist leaders who prefer antagonistic paths are elected or come to power, and wars occur. However, that is not always the case. History has shown that through time, there are two broad types of relationships, and that what occurs depends on which type of relationship exists. The two types of relationships are:

a) Cooperative-competitive relationships in which the parties take into consideration what’s really important to the other and try to give it to them in exchange for what they most want. In this type of win-win relationship, there are often tough negotiations that are done with respect and consideration, like two friendly merchants in a bazaar or two friendly teams on the field.

b) Mutually threatening relationships in which the parties think about how they can harm the other and exchange painful acts in the hope of forcing the other into a position of fear so that they will give in. In this type of lose-lose relationship, they interact through “war” rather than through “negotiation.”

Either side can force the second path (threatening war, lose-lose) onto the other side, but it takes both sides to go down the cooperative, win-win path. Both sides will inevitably follow the same approach.

In the back of the minds of all parties, regardless of which path they choose, should be their relative powers. In the first case, each party should realize what the other could force on them and appreciate the quality of the exchange without getting too pushy, while in the second case, the parties should realize that power will be defined by the relative abilities of the parties to endure pain as much as their relative abilities to inflict it. When it isn’t clear exactly how much power either side has to reward and punish the other side because there are many untested ways, the first path is the safer way. On the other hand, the second way will certainly make clear—through the hell of war—which party is dominant and which one will have to be submissive. That is why, after wars, there are typically extended periods of peace with the dominant country setting the rules and other countries following them for the time it takes for the cycle to happen all over again.

We’re not there yet. But some of the symptoms are obvious.

So, how does Australia prepare in a policy sense? The first question to ask is will it last? The one area that Trump and Democrats do agree is on China so hoping for a regime change back to a happy globalisation is pretty naive. Nonetheless, that’s where we find the AFR:

It’s not surprising, therefore, that the political and media focus is largely on the domestic here and now. Behind the scenes, however, there are tentative signs of a thaw in Australia’s crucial relations with China. This is after 18 months of ties being in the deep freeze, although in the last weeks of the Turnbull-led government there were moves for a “reset”.

The new Foreign Minister, Senator Marise Payne, tells AFR Weekend she hopes to meet her Chinese counterpart, Wang Yi, on the sidelines of the UN General Assembly in New York during the coming week. Further, Payne is well advanced with plans to attend a revived Australia-China Foreign and Strategic Dialogue meeting in China “once suitable dates are agreed”. According to the minister’s office, this should be some time this year.

It’s also on the cards that Morrison will be visiting Beijing before the end of this year. There is a flurry of activity on this matter currently under way in Canberra. No formal announcement has been made, but, as one member of the PM’s press office put it: “There’s no reason why he’s not going.”

All good to be friendly. But in reality the reset looks more like this, at The Australian:

Australia’s intelligence and analysis agencies believe that the South Pacific now presents the greatest strategic threat to Australia, as a result of what they believe is Beijing’s intention to establish a military base in the region.

This marks the first time since World War II that the South ­Pacific has been of such intense strategic concern to Canberra.

China’s growing influence in the Pacific has prompted a warning from the former head of the NSA, America’s largest and most secretive intelligence agency, that Beijing is ­engaged in a deliberate power play to gain “advantage” across the ­Pacific.

In an interview with The Weekend Australian, Admiral Mike Rogers, regarded as an intelligence leader of the highest calibre, said closer strategic ties between Australia and Papua New Guinea, including a possible joint naval base on Manus Island, would be a “win-win”.

…Admiral Rogers said China was “clearly trying to create relationships that generate advantage for them. I’m not trying to argue it is inherently evil but on the other hand it’s a conscious strategy. Nobody should think this is just being done on a whim or ‘Oh I wonder why they are interested in — pick the island — in Oceania today?’ — there is a reason, guys, it’s not by chance.”

It won’t matter much which party is in power. Both will have to protect the Pacific from Chinese hard power incursion. If not then ANZUS is dead, so is Australian sovereignty with democracy soon to follow.

Indeed, if a Chinese naval base does arrive then it could trigger a great power crisis immediately to our north not dissimilar to the Cuban missile crisis. With Australia sitting right at the tail end of the Asian archipelago and somewhat out of the way this is a logical place for China to press its power projection goals once satisfied that the South China Sea is secure. If it succeeded then the Western Pacific would be book-ended and Asia itself become a Chinese lagoon. It could very deliberately test the resolve of ANZUS. It’s not imminent by any stretch but it is visible as a possible escalation as Chinese naval power grows over the next two decades.

What are our next steps, then? Can we sail on oblivious towards an ever greater economic integration with China as our great power protector makes the shift towards strategic rivalry?

It is true that choosing one side over the other is not in the national interest. But to ignore the rising possibility that that choice will be thrust upon us would be downright reckless. Trump will pass but the great power contest won’t. As evidence think of Obama’s “pivot to Asia”, the TPP and marines in Darwin. Imagine as well if Bernie Sanders were now US president. Exactly the same conflict would be unfolding only he would be more obviously friendly to the US alliance network. When the Democrats win the White House again that’s what will happen.

We need to make a shift now so that as the struggle intensifies, we are as prepared as we can be. That does not mean choosing sides. That means seeking economic balance, political durability and strategic clarity. At the moment we have only made a start on the latter two and have done almost nothing on the former.

Where are our vulnerabilities?

In our strategic outlook we need a complete overhaul of our soft and hard power objectives. We should seek to promote democratic alliances wherever possible. Engage with ASEAN, India, Japan, Korea and European Union heavily. Governance in the Pacific is now central to everything that we do. It must be woven into a watertight strategic alliance in our favour before it is done against. This does not mean getting into an open contest with Beijing. But it does mean doing it anyway.

Australia needs to prepare a national defense strategy that is both integrated with the US but can also operate without it if need be. A nuclear debate is hard to avoid for both sustained power projection and continental defence.

It’s the economy where the hardest battle looms. Here the Chinese state already has a very strong foothold. If Beijing has any sense it will keep throwing easy dough our way. We should take it within reason and use it to hedge our bets. Blocking the sale of strategic assets is only the most obvious place to start. Thankfully the Chinese government has shut down the housing trade so we’re off the hook there. But the real battle is to shift the national growth engine from urbanisation industries to tradeables. The former is a pure figment of utopian globalisation, reliant upon exporting citizenship and importing capital, both of which now represent emerging national security threats.

We need to cut immigration sharply to shift away from building houses and roads and work instead towards a productive economy powered by exports and import competers, including especially manufacturing. Re-industrialising Australia is hardly something that will come easy. Industry policy can be used to promote it. More important is that we focus on our competitiveness instead of the easy debt-driven growth triggered by mass immigration. Then industry will grow again anyway. Critical is the breaking of the east coast gas cartel. Industry will die without that. Other reforms like changes to negative gearing are an excellent way to deflate house prices and lower the currency.

Cutting immigration also comes with the upside that it implicitly limits the channels of influence coming from Beijing. We should not use discriminatory immigration policy. That way lies disaster. Once any one ethnicity is singled out, all are at risk and Australia’s internal stability will destabilise. It is simply anathema to modern Australia and the values of humanism that underpin what makes Australia worth fighting for. We just halve the intake.

There is no need to resort to resource nationalism or other martial policies. These are wartime in nature and should be eschewed.

The political battle might be just as hard to win. The obvious measures of combating bribery and the influence of Chinese-sympathetic money is underway. A good start has been made on pushing back via the foreign influence bills but more is needed. We need a federal ICAC. We need to ban political donations and introduce public funding for political parties.

More difficult is we need a new form of leadership. One that recognises the paradigm shift and throws out happy notions of a liberalising China, as well as a self-sacrificing liberal overlord in the US. China is a burgeoning dictatorship. The US is an angry superpower riven by class structures severely exacerbated by the nature of Chinese catch-up growth. Australia is “tip of the spear” for both and that position should be leveraged to find compromise wherever possible but do so with the full preparedness for failure.

The US versus China is now the defining struggle of our time. We need to recognise it openly without endorsing it. Yet Labor is still kneeling at the alter of the Asian Century doctrine in thrall to dated Keatingism. The Coalition is the lapdog of corporations such that it will agree to pretty much anything that they want in thrall to dated Howardism. Both operate under vestigial open border’s rubrics that will further entrench a Chinese economic dependence now clearly running directly contrary to our strategic interests.

We don’t know the worst case will unfold. The odds still favour that it won’t even though we are a few footsteps down the Dalio path. But the US versus China contest has arrived and Australia is unbelievably exposed. It’s time we dealt with that fact.