How To Avoid a Trade War
Economists typically argue against focusing excessively on the losers from freer trade, and they decry the tendency to overlook the beneficiaries on the export side. They should not be prone to the same fallacy now, by ignoring that US protectionism surely will generate some beneficiaries as well in other countries.
CAMBRIDGE – Defying common sense as well as business and financial elites, US President Donald Trump seems to relish the prospect of a trade war. On July 6, his latest trade restrictions – 25% tariffs on about $34 billion of Chinese imports – took effect. They were promptly met by retaliatory tariffs on an equivalent volume of US exports to the Chinese market. Trump has threatened further measures against China, as well as tariffs on automobile imports from Europe. And it remains possible that he will withdraw the United States from the North American Free Trade Agreement if Mexico and Canada do not agree to amend it to his liking.
Trump’s kneejerk protectionism does little to help the working class that helped elect him. Disaffected congressional Republicans and unhappy corporations that have supported him on other matters may yet rein him in. But those who, like me, thought Trump’s bark would be worse than his bite on trade are having second thoughts about where all of this might lead.
But before we get too carried away with doomsday scenarios on trade, we need to consider other countries’ incentives as well. Trump may well want a trade war, but he cannot have it on his own. A trade war requires other economies to retaliate and escalate. And there are compelling reasons why they should not do so.
In the usual scenario, trade retaliation occurs because countries have economic reasons to depart from low tariffs. The canonical historical experience unfolded during the early 1930s, when countries were caught in the Great Depression with high unemployment and inadequate policy remedies. Counter-cyclical fiscal policy was not yet in vogue – John Maynard Keynes’ General Theory was published only in 1936 – while the Gold Standard rendered monetary policy worse than useless.
Under the circumstances, trade protectionism made some sense for each country on its own, as it shifted demand away from foreign goods and thus helped support domestic employment. (Of course, for all countries taken together, protectionism spelled disaster; one country’s expenditure shift was more than offset by others’ own shifts.)
Economists also consider another scenario that focuses on the so-called terms-of-trade effects of tariffs. By restricting trade volumes, a large country or region can manipulate the prices at which it competes in world markets to its advantage. An import tariff, in particular, would tend to depress the world prices of imported commodities, while raising their tariff-inclusive prices – with the home treasury reaping the difference in tariff revenues.
Neither scenario makes much sense today. Europe and China are not particularly interested in depressing world prices of their imports or in the resulting revenue. Employment considerations are not a major issue, either. While some countries in the eurozone suffer from high levels of unemployment, there is nothing that protectionism can do for these countries that expansionary fiscal or monetary policy (the latter by the European Central Bank) cannot do better.
If Europe, China, and other trade partners were to retaliate in response to Trump’s tariffs they would simply reduce their own gains from trade without reaping any of the advantages of protectionism. And they would be doing Trump a favor by lending surface plausibility to his complaints about the “unfairness” of other countries’ trade policies vis-à-vis the US. For the rest of the world, raising trade barriers would be a case of cutting off one’s nose to spite one’s face.
Besides, if Europe and China want to uphold a rules-based multilateral trade regime, as they say they do, they cannot mirror Trump’s unilateralism and take matters into their own hands. They need to go through the World Trade Organization and wait for formal authorization to reciprocate, without expecting a quick resolution or that Trump will have much respect for the eventual ruling.
In short, both self-interest and principle counsel restraint and no (immediate) retaliation. This is the time for Europe and China to stand tall. They should refuse to be drawn into a trade war, and say to Trump: you are free to damage your own economy; we will stick by policies that work best for us.
Provided other countries do not overreact, Trump’s protectionism need not be as costly as many accounts make it sound. The value of trade covered by the measures and countermeasures resulting from Trump’s trade policies has already reached $100 billion, and Shawn Donnan of the Financial Times reckons that this figure could soon reach more than $1 trillion, or 6% of global trade. This is a large number. But it assumes retaliation, which need not occur.
More important, what matters is incomes and welfare, not trade per se. Even if the volume of trade takes a big hit, aggregate economic performance need not suffer much. Some European airlines favor Boeing over Airbus, while some US airlines prefer Airbus over Boeing. Trade restrictions may result in a total collapse in this large volume of two-way trade in aircraft between the US and Europe. But the overall loss in economic welfare would be small, so long as airlines view the two companies’ products as close substitutes.
This is not to minimize the costs that specific European and Chinese companies may incur as the US market becomes more closed. But for every exporter forced to seek alternative markets, there may be another domestic firm presented with a new economic opportunity. As US trade shrinks, there will be also fewer American competitors and less US competition.
Economists typically make the point in reverse, when they argue against focusing excessively on the losers from freer trade, and they decry the tendency to overlook the beneficiaries on the export side. They should not be prone to the same fallacy now, by ignoring that US protectionism surely will generate some beneficiaries as well in other countries.
Trump’s protectionism may yet result in a global trade war, with eventual economic consequences that are far more serious than the self-harm it entails at present. But if that happens, it will be as much the result of miscalculation and overreaction on the part of Europe and China as of Trump’s folly.
A “Reagan Moment” for International Trade?
In the 1980s, US President Ronald Reagan initiated a military spending race with the Soviet Union that ended up altering the global balance of power in ways that affected many countries worldwide. Could Donald Trump's tariff race with China lead to a similar outcome?
NEW YORK – The latest round of tit-for-tat tariffs by the United States and China has intensified the ongoing global debate about whether the world is facing a mere trade skirmish or heading rapidly toward a full-blown trade war. But what is really at stake may be even more fundamental. Either accidentally or by design, US President Donald Trump’s administration may have paved the way for a “Reagan moment” for the international trade regime.
In the 1980s, US President Ronald Reagan initiated a military spending race with the Soviet Union that ended up altering the global balance of power in ways that affected many countries worldwide. Today, Trump has launched a tariff race with China, an economic superpower, perhaps with similarly far-reaching potential consequences. Like under Reagan, the US is better placed to win the current competition with China – but the risks are sizable.
In the latest escalation of the trade dispute, the US imposed levies on $34 billion worth of Chinese imports. China immediately implemented retaliatory tariffs, spurring the US to threaten even more protectionist measures. These actions exacerbate tensions over the Trump administration’s imposition of tariffs on imports from other countries, including some of America’s closest allies (such as Canada), and its threats to withdraw from the World Trade Organization, which undergirds the rules-based system regulating cross-border flows of goods, services, and capital.
Many existing trade agreements would benefit from modernization. And most economists agree that the US has genuine trade grievances against China, including intellectual property theft, asymmetrical technology transfers, and non-tariff barriers, such as the requirement that foreign companies enter joint-venture agreements with domestic firms to access the Chinese market.
But most economists also agree that competitive tariffs are a risky way to address these grievances. Because tariffs transmit stagflationary pressures (that is, they encourage simultaneous economic contraction and inflation), they risk undermining a global recovery that is already facing challenges. And they complicate long-overdue monetary-policy normalization, while increasing the likelihood of global financial instability. The resulting systemic cracks could jeopardize the entire rules-based multilateral trading system at a time when there is no good alternative.
Many economists hesitate on precisely what lies ahead. For example, one group, while recognizing that the current tensions increase the risk of a policy accident or mistake, views them as part of a process of posturing and negotiation. When push comes to shove, they argue, the world’s major trade powers will avoid a mutually destructive approach, opting instead for negotiations that yield a still-free but fairer regime. Reinforcing this view are preliminary indications that the European Union may now be willing to consider a zero-tariff automobile initiative.
Another group, citing historical precedent, warns that beggar-thy-neighbor trade measures can quickly spiral out of control, taking a heavy toll on living standards. At a time of pronounced political polarization, anti-establishment anger, and mistrust of expert opinion – owing to economic disappointments and widespread fear of cultural and technological change – heightened protectionism would likely fuel even greater nationalism, populism, and inward-looking policymaking.
But the comparison to Reagan suggests that there may be other, broader implications. By forcing the Soviet Union into a military spending race that only the US could win (at the cost of rising debt and a higher risk of conflict), Reagan accelerated the demise of what he called the “evil empire.”
It was a bold and risky strategy that ultimately changed the political map of Europe. Even before the Soviet Union’s demise, resulting in 15 new countries, its European “empire” had collapsed. The Berlin Wall had fallen, bringing German reunification, and Yugoslavia was disintegrating. Soon after, Czechoslovakia’s “Velvet Divorce” gave rise to the Czech Republic and Slovakia, which – together with other Central and Eastern European countries (including Hungary and Poland) – then anchored themselves firmly in the West by joining NATO and the EU.
Today, a trade war would damage all economies. But the US – which is relatively less dependent on foreign markets, possesses deeper domestic markets, and is generally more economically resilient than other countries – would do better than most others in a contracting world economy. Already, Chinese financial markets have suffered, while those in the US have held their own.
Game theory suggests that rational actors, recognizing how damaging a trade war would be for them, would see the merit of abandoning a retaliatory strategy, and instead accede to many US demands. All of this could leave the US more able and willing to halt the multi-year erosion of its global economic influence and standing.
But the success of this approach is far from guaranteed. Its execution will require more mutual trust than is currently on offer. A divided US public will need to be kept on board throughout the retaliatory phase, which will lead to higher prices and, in some cases, greater job insecurity.
Furthermore, the Trump administration will need to avoid actually pushing other countries (especially China) too hard too soon, thereby threatening the entire global economy with a possible recession and markets with disorderly declines. Already, the US Federal Reserve, relying on its contacts in the domestic business community, has warned that corporate investment plans could be “scaled back or postponed” because of uncertainty over global trade relations. And let us not forget that China holds a massive volume of US Treasury bonds which, if pushed too hard, it could use to try to destabilize the US government bond market, which is essential to the health of the global financial system.
It is too early to say whether a “Reagan moment” on trade will play out and deliver more than a fairer system. After all, such an approach would require careful strategic design and skillful implementation – not to mention plenty of good luck – guided by a nuanced understanding of economic, political, and geopolitical factors. That is why we must move beyond the question of whether this is a trade skirmish or a trade war to develop real strategies for the “Trump trade moment,” should it arrive.
The Economic Consequences of Trump’s Trade War
For those who observe that the economic and financial fallout from US President Donald Trump’s trade war has been surprisingly small, the best response is that a lagged effect is exactly what we should expect. Just wait.
BERKELEY – US President Donald Trump’s phony, blowhard’s trade war just got real.
The steel and aluminum tariffs that the Trump administration imposed at the beginning of June were important mainly for their symbolic value, not for their real economic impact. While the tariffs signified that the United States was no longer playing by the rules of the world trading system, they targeted just $45 billion of imports, less than 0.25% of GDP in an $18.5 trillion US economy.
On July 6, however, an additional 25% tariff on $34 billion of Chinese exports went into effect, and China retaliated against an equivalent volume of US exports. An angry Trump has ordered the US trade representative to draw up a list of additional Chinese goods, worth more than $400 billion, that could be taxed, and China again vowed to retaliate. Trump has also threatened to impose tariffs on $350 billion worth of imported motor vehicles and parts. If he does, the European Union and others could retaliate against an equal amount of US exports.
We are now talking about real money: nearly $1 trillion of US imports and an equivalent amount of US export sales and foreign investments.
The mystery is why the economic and financial fallout from this escalation has been so limited. The US economy is humming along. The Purchasing Managers’ Index was up again in June. Wall Street has wobbled, but there has been nothing resembling its sharp negative reaction to the Smoot-Hawley Tariff of 1930. Emerging markets have suffered capital outflows and currency weakness, but this is more a consequence of Federal Reserve interest-rate hikes than of any announcements emanating from the White House.
There are three possible explanations. First, purchasing managers and stock market investors may be betting that sanity will yet prevail. They may be hoping that Trump’s threats are just bluster, or that the objections of the US Chamber of Commerce and other business groups will ultimately register.
But this ignores the fact that Trump’s tariff talk is wildly popular with his base. One recent poll found that 66% of Republican voters backed Trump’s threatened tariffs against China. Trump ran in 2016 on a protectionist vow that he would no longer allow other countries to “take advantage” of the US. His voters expect him to deliver on that promise, and he knows it.
Second, the markets may be betting that Trump is right when he says that trade wars are easy to win. Other countries that depend on exports to the US may conclude that it is in their interest to back down. In early July, the European Commission was reportedly contemplating a tariff-cutting deal to address Trump’s complaint that the EU taxes American cars at four times the rate the US taxes European sedans.
But China shows no willingness to buckle under US pressure. Canada, that politest of countries, is similarly unwilling to be bullied; it has retaliated with 25% tariffs on $12 billion of US goods. And the EU would contemplate concessions only if the US offers some in return – such as eliminating its prohibitive tariffs on imported light pickup trucks and vans – and only if other exporters like Japan and South Korea go along.
Third, it could be that the macroeconomic effects of even the full panoply of US tariffs, together with foreign retaliation, are relatively small. Leading models of the US economy, in particular, imply that a 10% increase in the cost of imported goods will lead to a one-time increase in inflation of at most 0.7%.
This is simply the law of iterated fractions at work. Imports are 15% of US GDP. Multiply 0.15 by 0.10 (the hypothesized tariff rate), and you get 1.5%. Allow for some substitution away from more expensive imported goods, and the number drops below 1%. And if growth slows because of the higher cost of imported intermediate inputs, the Fed can offset this by raising interest rates more slowly. Foreign central banks can do likewise.
Still, one worries, because the standard economic models are notoriously bad at capturing the macroeconomic effects of uncertainty, which trade wars create with a vengeance. Investment plans are made in advance, so it may take, say, a year for the impact of that uncertainty to materialize – as was the case in the United Kingdom following the 2016 Brexit referendum. Taxing intermediate inputs will hurt efficiency, while shifting resources away from dynamic high-tech sectors in favor of old-line manufacturing will depress productivity growth, with further negative implications for investment. And these are outcomes that the Fed cannot easily offset.
So, for those who observe that the economic and financial fallout from Trump’s trade war has been surprisingly small, the best response is: just wait.
The Global Economy’s Uncertain Future
At this time last year, the global economy was experiencing strong, widespread growth, with even the long-stagnant European Union staging a robust recovery. But with key indicators of trade and investment now weakening, a new crisis – not least a global trade war – could quickly bring the global upturn to a halt.
LONDON – At the start of 2018, most of the world economy was experiencing a synchronized cyclical recovery that seemed to herald a longer period of sustainable growth and an end to the decade-long hangover from the 2008 slump. Despite the shock of Brexit, storm clouds over the Middle East and Korean Peninsula, and US President Donald Trump’s unpredictable behavior, rising investment and wages, alongside falling rates of unemployment, appeared to be in the offing.
Yet, as I warned in January, “the global mood [had] shifted from fear about political risks to obliviousness, even though many such risks still loom large.” Moreover, while my preferred global indicators were all looking up, I worried about whether that would continue after the first half of 2018, given foreseeable complications such as monetary-policy tightening across advanced economies, especially in the US.
Lo and behold, we are now halfway through 2018, and some of those same indicators are no longer looking quite so rosy. While the US Institute for Supply Management’s June Purchasing Managers’ Index (PMI) remains very strong, other comparable surveys around the world are not nearly as robust as they were six months ago. Most important, business activity has slowed in both China and Europe.
Another key indicator is South Korea’s trade data, which is published monthly and before that of any other country. On July 1, we learned that South Korean exports had fallen year-on-year in June 2018. Whereas 2017 was a record-setting year for the country’s nominal export strength, 2018 has ushered in several months of decelerating performance. Ironically, this slump coincides with improved relations with North Korea, while the strong performance last year occurred in spite of nuclear brinkmanship on the Korean Peninsula.
The weakening of South Korean exports calls for careful follow-up analysis, both of other major economies’ trade data and of South Korea’s July data, when it is published on August 1. Given the worrying escalation of Trump’s import tariffs and the retaliatory measures being pursued by China, the European Union, and others, one should not be surprised if the weakening of global trade persists.
That said, one also should not assume that falling trade numbers are a direct result of tariffs. We do not yet have a full regional breakdown of export performance. But from the data that are available for the first 20 days of June, we can see that South Korean exports to the US and China were actually rather strong; the weakness was in exports to Association of Southeast Asian Nations countries and the Middle East. If this remains the case, there is less reason to worry that the strong global-trade performance over the past 12-18 months is being thrown into reverse.
After all, we are in a decade in which the world economy is dominated by activity in the US and China. According to my calculations, 85% of the growth of nominal GDP worldwide since 2010 is due to these two countries, with the US accounting for 35% and China accounting for 50%. So, as long as China and the US are doing fine, the global economy can be expected to sustain annual output growth of around 3.4%.
As for the rest of the world, economic indicators from this time last year through early 2018 seemed to suggest that many previously weak performers were finally on the mend. In nominal dollar terms, Brazil, the EU, Japan, and Russia all experienced slight declines since 2010, but showed signs of improvement in 2017.
For example, at this time last year, the EU looked as though it was on the cusp of a robust, widespread cyclical recovery. But that no longer seems to be the case. Key economies such as France and Germany have experienced a slowdown, perhaps owing to fears of a global trade war. And, of course, the plodding Brexit negotiations, Italy’s new anti-establishment government, and an intra-EU political crisis over immigration have all created more economic uncertainty. The immigration crisis, in particular, could have severe consequences both for German Chancellor Angela Merkel’s government and for EU cohesion.
To be sure, Europe’s economic softening could prove temporary, and PMIs for eurozone countries did strengthen somewhat in June, following a couple of months of marked decline. But it would be foolhardy to rule out the worst.
Still, as we have seen, the sustainability of global growth depends largely on the US and China. Obviously, if these two economic giants are going to start trading blows with tit-for-tat tariffs, both will lose – and so will the world economy. For the US, where consumption accounts for around 70% of GDP, positive international trade and a stable, friendly investment climate are essential for sustainable growth. One hopes that someone close to Trump can turn him around before his policies derail the world’s long-awaited recovery.
Trump’s Protectionist Rube Goldberg Machine
The Trump administration is offering some countries a reprieve from US import tariffs in exchange for self-imposed export quotas, while allowing domestic producers to apply for tariff exemptions. Because this approach will weaken competition and cause delays, the predictable result will be higher costs and reduced quality control.
WASHINGTON, DC – To avoid the Trump administration’s 25% tariff on imported steel, some countries have agreed to accept export quotas on 59 varieties of steel products. At the same time, the administration has declared that US manufacturers that use steel as an input may apply for tariff exemptions from the Department of Commerce if they are unable to source the specialized products they need domestically.
Trump would like to think that forcing quotas on exports and providing exemptions to domestic importers is good for the United States both politically and economically. Nothing could be further from the truth. Politically, the Trump administration has already done serious damage to America’s international standing by justifying tariffs against allies’ exports on the grounds of “national security.”
But the economic fallout of Trump’s tariffs has been no less alarming. US manufacturers that rely on steel inputs are already facing higher costs, and could soon face shortages, with the price of steel in the US having risen 50% above that in China or Europe. In fact, citing higher costs, the iconic motorcycle company Harley-Davidson recently announced that it was moving some of its production out of the US, to avoid the European Union’s retaliatory tariffs.
As US manufacturers’ costs rise above those of their overseas competitors, American consumers will also face higher prices. As a result, they will limit or delay purchases and shift at least some of their consumption to foreign-made products that the tariffs have now made relatively cheaper. The Peterson Institute for International Economics estimates that the levy on steel alone could destroy 195,000 jobs in the auto and auto-parts industry over the next three years.
Beyond the obvious fallout from tariffs, the introduction of export quotas and exemptions will also have an insidious impact. For example, South Korea has agreed to limit its steel exports to the US to 70% of 2015-17 levels, raising the question of how such quotas should even be administered. Either the South Korean government or the US Customs Service will have to monitor and limit each of the 59 categories of steel.
Supposing that the South Koreans take on the task, US customs officials will either have to trust their numbers, or incur the costs of duplicating the monitoring efforts needed to enforce the quota. Either way, higher costs and delays will follow, because each South Korean exporter will have to request approval for each type of steel shipment.
If this system of export licensing operates on a first-come, first-served basis, then US importers and South Korean exporters will be left with no choice but to rush out their orders early in the year. Alternatively, if the South Korean authorities decide to allocate quotas among firms, they will probably have to benchmark each firm’s allotment to its share of exports in the 2015-2017 period.
But with a fixed-quota arrangement, there would be no competition among South Korean steel exporters in the US market. Based on past experience with quotas around the world, the predictable result would be reduced quality control and longer delivery times, because exporters would have no reason to compete for new customers.
Tariff exemptions, too, can have a similarly damaging effect. By the end of June, the Department of Commerce had already received 21,000 applications for exemptions, and it expects that number to double this year.Processing these applications takes time and introduces further complications, all the more so because companies seeking exemptions must apply separately for each type of steel (with the only difference sometimes being the component’s shape), and because exemptions must be renewed annually.
The Department of Commerce has hired around 30 people to process applications within 90 days. But applications are also made public for 30 days, and if a domestic steel producer indicates that it can produce the steel type in question, the application is denied. As of June 21, 9,000 of the initial 20,000 applications had been posted for review, 42 had won exemptions, and 56 had been rejected.
In practice, this system will allow any domestic producer to block duty-free imports of steel components that it believes it can produce. When this method of administration has been used elsewhere around the world, it has resulted in firms asserting dubious capabilities without regard to quality, price, or the timeliness of deliveries. And in the case of the Trump administration, there is every reason to doubt that those examining these claims will have the necessary qualifications.
In this new age of protectionism, US firms that receive tariff exemptions and South Korean firms that receive quota entitlements will be gaining valuable property rights at little cost. That will give firms all the more reason to lobby and otherwise pressure licensing authorities, further complicating the process, and raising the possibility of corruption. And even if decision-making is handed over to independent bodies to prevent abuse, doing so will make the process even more complicated and time-consuming.
Trump’s “America First” trade policies will result in more misrepresentation on the part of domestic suppliers, reduced quality control, bureaucratic delays, and higher barriers for potential new competitors. Moreover, once tariffs or quotas are imposed, other producers will start demanding equal protectionist attention, which may be why Trump is now threatening additional tariffs on cars. Once this contagion takes hold, there is no telling where it will stop.
The Trump administration has cut taxes and slashed regulations in the hope of boosting productivity growth. But by subjecting US manufacturers and the world to a system of tariffs, quotas, and exemptions, it will achieve the opposite effect: lower competition, higher prices, poorer service, and less innovation.