There is a long held belief that free trade is the guarantor of world peace. But Japan’s dispute with China over a small group of islands in the East China Sea puts this idea to the test. Over the last twelve months, there was been a drop in trade by 14.1 percent as each of the countries ramp up the bellicose rhetoric against the other.

On the ground, Japanese car-makers have found their showrooms in China vandalized as the government plays the jingoist card. Car sales have dropped by as much as a third, and it is starting to affect the Japanese economy.

Japan is no innocent bystander in this unofficial trade war; exports of Japanese machine tools, which China needs to run its factories and feed its global supply chain, have dropped by 29.1 percent.

The World Trade Organization (WTO) was supposed to stop such trade wars. China has cleverly got around its rules by surreptitiously encouraging its State Owned Enterprises to boycott Japanese goods. These enterprises are able to do as they please, arguing that they are private entities whose commercial decisions are beyond the jurisdiction of WTO. Such actions make a mockery of the WTO, and if China is allowed to get away with such measures, the world trading system faces a major crisis.

This is not the first time that China has flexed its muscles. In 2010, Beijing limited rare earth mineral exports to Japan to punish the country over its claims that it owns the Senkaku Islands in the East China Sea, which China has claimed.

There is data to back the thesis that politics affect commercial decisions made by State Owned Enterprises. Two academics at the University of Goettingen published a report that showed that Beijing punished those countries whose governments held official meetings with the Dalai Lama.  The authors found that the offending country’s exports to China fell by 16.9 percent and remained depressed for two years after such a meeting.

The China-Japan dispute flies in the face of the theory put forward by liberal economists who argue that where goods cross borders, armies won’t go.

In 1909 the British journalist Norman Angell published a book called The Great Illusion. Its thesis was that the integration of the European economy, and by implication the global economy, had become so all-embracing and irreversible that future wars were all but impossible.

Angell’s timing couldn’t have been worse as he published his ideas on trade and peace five years before the First World War.

This idea was revived by Thomas Friedman whose books and columns in the New York Times enthusiastically promote globalization. His theory is called “The Golden Arches Theory of Conflict Prevention,” which argues that no two countries with a McDonald’s franchise had ever gone to war. Friedman skips over history and argues that the world has grown up and asserts that globalization is now the underwriter of world peace.

This dispute may well prove that the promise of greater prosperity, through cooperation, will not be sufficiently strong enough to overcome the base emotions stirred up by nationalism.

As the Chinese and Japanese economies account for about a fifth of the world’s economic output, pursuing trade brinkmanship threatens not only the stability of the two countries involved, but the world’s economy. The timing could not be worse as the world is trying to recover from the greatest financial crisis since the Second World War.

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