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How To Avoid a Trade War

Jul 10, 2018 DANI RODRIK

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.