Europe and China would be foolish to retaliate to US tariffs

Trump’s protectionism can only spiral into a trade war if other countries react rashly. If they do, they will lose out financially and will also lose the high moral ground, says Dani Rodrik.

DEFYING common sense and 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 $34bn 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 car imports from Europe. And he may withdraw the US 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 elected him. Disaffected congressional Republicans and unhappy corporations may yet rein him in, despite having supported him on other matters. 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, we need to consider other countries’ incentives. 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.)

Another scenario focuses on the so-called terms-of-trade effects of tariffs. By restricting trade volumes, a large country or region can manipulate to its advantage the prices at which it competes in world markets.

An import tariff 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 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 favour 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 authorisation 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 $100bn, and Shawn Donnan, of the Financial Times, reckons that this figure could soon reach $1trn, or 6% of global trade. This is a large number. But it assumes retaliation, which need not occur.

What matters are 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 favour 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 minimise 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 decry the tendency to overlook the beneficiaries on the export side. They should not fall for 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.

Dani Rodrik is professor of international political economy at Harvard University’s John F. Kennedy School of Government.

He is the author of The Globalisation Paradox: Democracy and the Future of the World Economy, Economics Rules: The Rights and Wrongs of the Dismal Science, and, most recently, Straight Talk on Trade: Ideas for a Sane World Economy.