Note from the editor
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Trade War, what is it good for?
With each passing day the US and China announce new tit-for-tat tariffs and other trade restrictions, bringing the world ever closer to a trade war. So far, the US administration has announced tariffs on steel (25%) and aluminum (10%) together with a plan for 25% tariffs on more than 1300 Chinese imports, worth between USD 50 – 60 billion. Of course, China has reciprocated. More recently, we hear talk of tariffs on Chinese imports worth another USD 50 – 100 billion, and further tariffs are an obvious possibility as the total US import bill is around USD 500 billion.
The olive branches extended by Xi’s China thus far, and to which stock markets respond positively, contain little new information, about giving better access to China’s financial and transportation markets. Even though these and other vaguely described measures, especially those on intellectual property rights, could form the basis for an agreement, there is little evidence of the more transformative measures that the US Trade Representative addressed in its most recent report to congress.
In short, what the US administration seems to be targeting is the pervasive use of industrial policies or, to put it bluntly, almost any state-led intervention in the economy. That said, the focal points of the US administration should nonetheless be areas pertaining to China’s pronounced objective to become “world leader in science and technology”; and which involves all aspects of modern manufacturing (robotics etc.) and new technologies (AI etc.). This objective, nota bene, has long been complemented by a policy called “indigenous innovation”, and which in practice has implied a “techno-nationalistic strategy to steal and transfer foreign technology under the pretext of a relevant policy”.
Put another way: There is, in my opinion, every reason to treat the current trade skirmishes with extreme caution. I have little faith that this will develop into the “cooperative game” many other economists hope for.
Show me the money!
How bad can a trade war be? – Well, aside from seeing this as a precursor to war, there are a number of recent and eye-catching economic takes on the subject. Nicita et al (2018), e.g., suggested that a full-blown trade war, but still inside the premises of the WTO, would result in tariffs being hiked according to market power, in their calculations equating to 32%. Others, such as Ossa (2014), are even more frightening and suggest the possibility of an average tariff increase of 60% (only taking into account market power).
However, to describe the effect of introducing tariffs, let’s start by reasoning in terms of a standard partial equilibrium model, where the downward-sloping line is the demand for imports as a function of their price, measured relative to the price of domestic goods1. We import anything that costs less to produce abroad than at home. After imposing a tariff, we only import products where prices are cheaper (than domestic), even including the tariff.
1For simplicity we assume that the supply curve is perfectly price elastic, i.e., horizontal.
The marginal good we import, then, is much cheaper to produce than a domestic product, and the marginal good we don’t import is a cost to the economy; equal to the tariff that we would have paid if we had imported it. The total costs – welfare loss – are represented by the area of the triangle: the reduction in imports caused by the tariff, multiplied by half the tariff rate.
Figure 1: Welfare (dead-weight) loss from a tariff.
Tariff hikes of the sizes mentioned above would, of course, have pronounced effects on trade and GDP, but if they are manageable or devastating depends not only on the scale, but also the scope, of tariffs. Standard estimates of price elasticities of import demand often produce rather modest effects on trade and incomes from tariffs. To a casual observer, this might come across as somewhat surprising considering how financial markets have been gyrating over the past few months in response to the announcements of measures and counter-measures from the world’s largest exporters and importers.
One thing to keep in mind though, as some of the analysis referred to above is suggesting, is that such standard estimates fail to fully take into account domestic interdependencies between different industries with imported goods and services. In the table below, these shortcomings have been addressed and, not unexpectedly, the size of welfare gains to trade increase, in many cases, dramatically.
|G10 + China||Welfare gain
Naïve trade model
(% of GDP)
Sectoral (GTAP) trade model
(% of GDP)
Sectoral (SITC-3) trade model
(% of GDP)
|Welfare gain since 2000*
Sectoral (SITC-3) trade model
(% of GDP)
*Note: Since no nation has demonstrated complete autarky in modern times I have ‘discounted’ the estimates from Ossa (2015) with the changes in the Heritage Foundation’s estimates of trade openness between 2000 and 2007 in order to get a ballpark estimate of what the last big WTO-round of negotiations (Doha) has added to real incomes for different countries. These distribution keys (from Heritage Foundation) are accessible in the Macrobond application can of course be replaced by other keys (e.g., change in trade volumes, tariff changes etc.).
Source: R Ossa (2015), Journal of International Economics 97 (2015): “Why trade matters after all” and Macrobond calculations
Figure 2: Large, but unevenly spread costs of scaling back on globalization
Going from complete autarky to 2007-levels of trade openness has apparently brought about massive welfare improvements, at least according to this oft-quoted study. However, since few countries can be said to ever have demonstrated complete autarky, in the last column I have performed a crude experiment adjusting for the improvement in trade openness that has taken place between 2000 and 2007 (before the start of the WTO’s Doha negotiating round and China’s WTO-accession). And the effects on real incomes from trade are still impressive. Admittedly, my adjustments probably exaggerate the actual effects from trade somewhat2 but it should at least serve as a warning signal for the world economy in general, and a few individual countries in particular (Yes, I am looking at you, Belgium). Another, more general observation from the above table is that smaller, more specialized, and, less developed, countries seem to have the most to lose from a reversal of globalization.
2Since the autarky premise in the original implies no access to foreign, vital, products.
Conclusion: The stock market is always right!
A related economic issue that should also be taken into account, especially from a stock market perspective, and which e.g. Paul Krugman has drawn attention to, is that re-introducing trade regulations in a world with global value chains risk displacing capital (again)3. Of course, to the extent such capital is debt financed, it might also give rise to knock-on effects on banks and the wider financial system.
3Krugman has also, and importantly, underlined that the same line of reasoning applies to labor; workers.
Now, to conclude, if the above discussions and information is anything to go by, the complacent reaction to current trade skirmishes demonstrated by many prominent economists’ and policy makers is anything but comforting. Instead, I find little to suggest that the US administration will settle for anything but very large concessions from important surplus countries such as China. Harmless as the sweeping measures announced thus far might seem, there is indeed a risk for stark, non-linear, economic effects, should access to vital import products be rationed. And obviously, as international specialization and the complexity of global value chains have both increased over the past few decades, so has the probability of such risks materializing.
— Stay tuned!
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