Trade War: insights and understanding of macroeconomic issues

Prof. Luisa Lambertini, what is a trade war?

All countries engage in international trade, namely they export goods and services produced domestically and import goods and services produced abroad. According to the World Bank, world trade measured as the sum of exports and imports amounts to more than 50% of world gross domestic product. Tariffs and quotas are the main instruments of trade policy. Tariffs are taxes levied as percentage of the value of imported goods and services that ultimately raise the price paid by importers; quotas are limitations on the quantity of imports. Both trade instruments affect imports and restrain international trade. A trade war between two countries happens when country A raises tariffs or quotas on imports from country B, which then retaliates by raising its own tariffs and quotas against country A, which then responds by further raising tariffs against country B and so on. The current escalation of tariffs between the United States and China is an example of a trade war.

What is Donald Trump’s goal?

From an economic point of view, tariffs and quotas reduce trade and the economic-wellbeing of all countries concerned. The goal is most likely political. During his campaign, Trump promised to raise tariffs on goods imported into the United States, to renegotiate or end NAFTA (North American Free Trade Agreement with Canada and Mexico), and to cut the U.S. trade imbalances. These promises to engage in protectionism, which is the use of tariffs, quotas and other policies to protect domestic industries against foreign competition, played an important role in the 2016 election. Trump won in counties with a higher share of manufacturing employment by promising to restore coal, manufacturing and other type of jobs that moved outside the United States over the last few decades. Not surprisingly, the renegotiation of NAFTA required use of workers earning at least $16 as well as an increase in the North-American content of imported cars from Mexico. With mid-term elections approaching, this renewed emphasis on protectionism is not surprising.

What is the likely effect of Trump’s tariffs on the US trade deficit and the U.S. economy?

A country has a trade deficit (surplus) when its imports exceed (fall behind) its exports. Another reason why the United States are imposing tariffs on imports is that Trump promised to cut the U.S. trade deficits, which have persisted since the late 1970s. Trump and his administration believe that these protectionist measures will reduce U.S. imports and improve the U.S. economy thanks to the switch in demand toward U.S. produced goods and services. However, years and years of studies show that tariffs and quotas reduce trade but they do not necessarily improve the imposing country’s trade balance. If the other country imposes reciprocal tariffs, bilateral trade will fall but the trade deficit may not improve. Moreover, tariffs and quotas have many consequences on the rest of the economy. Consider for example the tariff on U.S. aluminum and steel imports. Trump believes this will shift demand toward U.S. producers and increase jobs. The necessary increase in aluminum and steel prices, however, will increase production costs of U.S. industries that use these raw materials, so that demand and jobs in these industries will fall. The increase in price of these products will hurt consumers.

What are the likely effects on world trade?

Tariffs and quotas unequivocally reduce trade. The years between World War I and II witnessed an escalation of tariffs and retaliatory responses that led to the collapse of world trade, with all countries being worse off relative to their initial condition. Looking into the future, world trade will suffer if tariffs persist and become widespread. Trump also threatened to pull the United States of the World Trade Organization (WTO), a move that would put an end to many years of trade diplomacy. Interestingly, this could potentially hurt U.S. exporters because the United States would lose the most favored nation status it enjoys with many other countries.

How is the rest of the world going to be affected and how it is going to respond?

Aggrieved countries are likely to retaliate and enter a trade war with the United States. Producers and consumers in these countries will be affected. Because so much of today’s production is global, consumers around the world are likely to see the prices of certain goods go up. For example, China may tax U.S.-based corporations, like Apple, that manufacture in China. This will lead to higher prices of their products around the world. In addition to the direct effects on trade and consumers, a trade war is going to have indirect effects of uncertainty and confidence, particularly on business investment. Emerging economies will suffer most – see the sharp depreciation of the Turkish lira after Trump announced he was doubling tariffs on steel and aluminum imports from Turkey. A multilateral trade war will end up in losses for all.

A better response by the rest of the world to Trump’s tariffs is to tackle the roots of U.S. trade deficits. For several decades, global savings have allowed the U.S. government to borrow at extremely low rates, reducing borrowing costs for everyone in the United States and making it cheap for the U.S. government to run large fiscal deficits. A reversal in this trend would depreciate the U.S. dollar, raise savings and reduce investment, closing the U.S. trade gap.