What’s the Fair Market Price of a Trade War?

In the latest crisis du jour—the trade war between the U.S. and China—the news media is maintaining its frenzy. There is widespread fear the global economy will slow down markedly as protectionist tariffs lead to a collapse in global trade, similar to what occurred in the aftermath of the Smoot-Hawley Tariff Act of 1930. While nothing is off the table at this point, worries tend to focus on worst-case scenarios which rarely, if ever, come to pass.

To get your arms around the current situation, it is critical to have a basic understanding of international trade. International trade exists because it is more profitable for a country to produce goods and services in which it has a comparative advantage than other countries, meaning the country is more productive and/or cost-efficient when producing such goods or services. This is not to be confused with absolute advantage, which is when a country has the ability to produce more of a good or service than other countries.

Correspondingly, a country with a comparative advantage may have an absolute advantage (or absolute disadvantage) at either or both goods.[1] For example, let’s say Country A and Country B can produce only two goods: apples and oranges. In any given year, Country A can produce 20,000 apples, 10,000 oranges, or any linear combination thereof. Similarly, Country B in any given year can produce 8,000 apples, 6,000 oranges, or any linear combination thereof. Country A has an absolute advantage in both goods because it can produce more of them. However, it has a comparative advantage only in producing apples because to produce 1 apple, it gives up only ½ an orange (i.e., 10,000/20,000), whereas Country B has to give up ¾ of an orange (i.e., 6,000/8,000) for each apple it produces. Conversely, Country B has a comparative advantage in producing oranges because it forgoes only 1 1/3 apples for each orange produced, whereas Country A forgoes 2 apples for the production of the same orange. Put differently, Country A is more efficient in producing apples, whereas Country B is more efficient in producing oranges. Both Country A and Country B will get richer by specializing in the good they can produce most effectively while trading surplus product to the other country.

Given this context, why would two countries launch a trade war when theory suggests it is suboptimal for both parties?

Implicit in this quandary is the assumption that both countries are “playing by the rules.” Meaning, countries are abiding by international trade regulations which prohibit any country from cheating to gain an advantage. Practically speaking, rule following is often not the norm due to what is known as the prisoner’s dilemma.

Put simply, in a prisoner’s dilemma, the joint optimal return from international trade comes from everyone cooperating, but because each country sees it in its best interest to betray the other countries for excess gains, everyone ends up worse off.[2] Examples of how countries cheat in international trade include:

1. Product dumping, in which countries underprice their goods to drive out the competition among domestic suppliers, ultimately allowing them to gain market share and monopoly pricing power.[3]
2. Export subsidies, whereby a country subsidizes government-owned companies in order to inflict excess pain on free-market competitors.
3. Subsidizing manufacturing via cheaper-than-market loans and inputs.
4. Ignoring environmental, health, and safety standards, allowing companies to cut costs and price products below market value.

In the end, all forms of cheating boil down to artificially altering the supply/demand dynamics to achieve short-term and/or long-term gains at the expense of another country. To date, there has been strong evidence of China cheating in many, if not all, of these categories. Recent administrations have not successfully confronted China’s predatory methods, leading to sharp imbalances in the global trade dynamic in terms of trade deficits/surpluses and domestic manufacturing bases.

The current administration’s attempt to address China’s practices is causing some indigestion in capital markets as they weigh the possible outcomes. While much remains to be determined, equities trading merely 2% from all-time highs suggest the market currently believes tariffs are not likely to be long-term structural implementations but rather a negotiating tactic for the Trump administration—much like we saw last week with the Mexico trade deal.

Lloyd Blankfein, the former CEO of Goldman Sachs, agrees in recent tweets:

“Tariffs might be an effective negotiating tool. Saying it hurts us misses the point. China relies more on trade and loses more. As in a labor strike where management and workers both get hurt, the process may demonstrate relative strength and resolve and where compromise needs to happen. As to who ultimately bears the tariffs’ cost: U.S. buyers may eventually switch their purchases to domestic or non-Chinese companies (and pay a bit more than now). Chinese companies lose the revenues. Not great but part of the process to assert pressure to level the playing field.”

Mr. Blankfein is asserting that the short-term pain on American consumers is likely a cost of making things better for the American economy in the long run. Because we cannot predict the future, we can neither confirm nor deny the validity of this perspective looking forward. However, we can say it is a valid approach to the potential outcome of the ongoing dynamic. This is especially the case since it can be argued U.S. consumers have disproportionately benefited from low inflation over the recent decade owing to the lower cost of products manufactured in China. As such, any short-term dents to consumers’ wallets could be viewed as merely paying some of what should have been paid in the past had the Chinese not been bending the rules.

Both sides in this tussle have things going for and against them. On the plus side for the U.S., we have a well-rounded economy that can prosper without Chinese imports, albeit with some collateral impact on consumers. Additionally, our economy is stronger than that of the rest of the world, giving us a cushion. On the downside, the U.S. is run by politicians who need to appeal to voters periodically; thus, political motivations may cause leaders to think short-term if voters cannot handle some of the pain.

The Chinese dynamic is quite the opposite: the downside is that it is an economy dependent on exports. As such, any collapse in U.S. exports will drive sharp declines in growth rates. However, its government is set up in a manner that allows politicians to disregard personal repercussions; thus, it is potentially able to hold off and squeeze opponents who may face the wrath of voters. The question is which of these factors will win out in this game of chicken.

If it becomes apparent these tactics are more than just the so-called “art of the deal,” we expect equity markets and bond markets (as evidenced by the yield curve) to price in more trouble than we are currently seeing. At this point, however, it appears China stands to lose more than the U.S. given the performance dispersion among the countries’ respective stock markets since the outset of the dispute.

[1] While international trade is the most common use of comparative advantage, the concept can be applied to any situation in which individuals want to trade labor and/or production. Suppose an attorney can spend an hour of labor billing $150 on client work, or she can spend the same amount of time mowing her lawn. If a neighborhood teen offers to mow her lawn for $50, it’s more profitable for the attorney to pay him to do so than to mow it herself for free. Instead, she can spend the hour billing while trading labor with someone who will mow the lawn, thus netting a profit of $100 for the hour.
[2] More information about the prisoner’s dilemma is available in Balentine’s 2016 Capital Markets Forecast.
[3] Product dumping is typically counteracted by the victimized country imposing countervailing duties.