What Game Theory Says About Trump's Trade Strategy

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by: Mohamed El-Erian

Under one scenario, the tensions with China could lead to changes in the global economy that favor the U.S.

Financial markets were of two minds last week about the impact of mounting trade tensions between China and the U.S.

On the one hand, the escalating tit-for-tat tariffs still affect only a relatively small part of the two countries' economies. The consensus baseline remains that the measures should not have a significant and lasting downward impact on the economy and stocks and, ultimately, may help bring about trade that is still free but fairer.

On the other hand, each escalation (the latest is the July 10 announcement by the Trump administration of its intention to impose import duties on an additional $200 billion of Chinese products) increases the market's downside risk scenario of slipping, either on purpose or inadvertently, into a full-blown trade war that would significantly damage corporate earnings and the overall growth outcome.

And there is a third possible scenario for international trade that hasn't yet captured the attention of markets: A "Reagan moment" that has an upside, though it is less probable than the downside scenario, that goes beyond tweaks to the existing system by delivering changes in the overall global economic landscape that favor the U.S. in both relative and absolute terms.

Making firm predictions on the probability distribution of these three possible outcomes is challenging. The answer will depend on a lot more than just economics and finance. Domestic politics also play an important role, and the current polarized environment adds to the complexity of reconciling competing expectations with reinvigorated global harmony.

Here are some insights from game theory on what to watch and expect.

  1. An inherently cooperative game is increasingly played uncooperatively: The Trump administration is taking a disruptive approach to trade, and several other areas, by shaking things up as a means to fix what it views as asymmetrical components that undermine the fairness of the system and harm the U.S. It has resorted to unilateral tactics that combine actual tariff actions with threats of escalation, instead of continuing to rely on the rules-based system that has underpinned the post-World War II international economic order.
  2. In game theory terms, the Trump administration has introduced a notable "uncooperative" element to the inherently "cooperative game" of international trade. Most economists worry about the implications for individual countries and the system as a whole.
  3. Trade wars tend to create a strong stagflationary impulse, disrupting growth and increasing costs and prices. The conflicts complicate domestic policy management and increase the risk of financial instability. They also risk causing serious fractures to the international economic and financial architecture, with consequences that can extend well beyond economics and finance.
  4. Given all this, the major question today is whether the current round of mounting trade tensions is a means to a better end - still-free but fairer trade - or an end in itself. Until now, the markets have attached a considerably higher probability to the former, more positive possibility, though every escalation in the tit-for-tat tariffs erodes some of the confidence in that outcome.
  5. Further escalation is the most likely outcome for now: For trade tensions to be a means to a better end, individual country behaviors must change in a manner that is visible, verifiable and durable. This is particularly true of China's approach to intellectual property, market access limits and joint venture requirements, which are a longstanding source of friction with the U.S., as well as other countries. Until there are indications of durable change, the most likely American strategy will be to increase the pressure on China, even though that carries significant risks for all. The U.S. stance is intended to leave no doubt about the administration's resolve and its commitment to affecting change, almost regardless of the domestic costs. But the U.S. could end up pushing China too far, too fast. That would threaten not just a full-blown trade war, but also increased geopolitical strains and financial disruptions (including because China is a large holder of U.S. government securities and a major participant in the dollar market).
  6. The game is inherently unbalanced: Whether by accident or design, the U.S. is now playing in an uncooperative game that it is well placed to win in relative terms. For many reasons, trade tensions are less damaging for the U.S. than for China, whose growth model is still notably dependent on foreign markets. This relative advantage is already evident in the performance of the equity and currency markets of the two countries. While this advantage certainly isn't protection against some absolute damage, it gives the U.S. a stronger hand to play.
  7. The situation resembles the 1980s, when President Ronald Reagan embarked on a military spending race with the Soviet Union, a contest America was destined to win, albeit with costs and at considerable risk. This is an approach the Trump administration will be tempted to press further when it shifts its attention back to the modernization of existing trading arrangements with other countries, including some of its closest allies.
  8. China will likely ultimately agree to some U.S. requests: Because the game is unbalanced, China's least costly strategy over time will be to seek a return to a cooperative approach to trade, even though the country is making gains on regional arrangements. This may only be possible by acceding to some U.S. requests. It may not be a first best outcome for China, but it's a lot better than a full-blown trade war.
  9. Public accusations and counter-accusations make trust difficult: Restoring greater trust between China and the U.S. is key to re-establishing a durable cooperative game. This requires behind-closed-door meetings that set aside accusations currently being levied by both sides, and focus on immediate confidence-gaining steps as well as framework for resolving the inevitable misunderstandings and misperceptions that are likely to arise. The sooner these meetings resume in earnest, the lower the risks the current uncooperative game will turn into a very costly global trade war.
  10. You can get there faster through coalition-building: Given that America's genuine grievances against China are shared by other countries, it would be in the U.S. interest to build coalitions early on. Although the alliances could complicate the bilateral negotiations the U.S. wishes to pursue with those countries, they would help accelerate the effectiveness of its approach toward the bigger issue of China and reduce the risk of costly global economic fragmentation. This would also impart more of a multilateral tone to a notably unilateral approach, helping to safeguard an international architecture that, while it needs modernizing reforms at several levels, still serves the U.S. and the world well.
  11. Implementation is trickier than design: These steps are very difficult to calibrate. Trust is low, both in terms of domestic politics and between countries. A good understanding of other nations' reactions is essential, as well as an openness to course correction as an uncooperative game becomes increasingly unpredictable. Moreover, on the domestic front, well-communicated, timely and coordinated White House decision-making is key to maintaining the needed buy-in from broad segments of the population and Congress.

These eleven insights are key to assessing the benefits, costs and risks of the Trump administration's unconventional approach to international trade. They go beyond the arguments underpinning the markets' consensus baseline view that the tit-for-tat measures should not have a significant and lasting downward impact on the economy and stocks and, ultimately, may help bring about trade that is still free but fairer.

They also trace a fuller distribution of possible outcomes that includes a rather fat left tail (a full-blown trade war) and a smaller right tail - that is, a more fundamental realignment of the global system that favors American interests, counters the multi-year erosion of its international standing and allows it to benefit more from its core position in the international economy.

This article originally appeared on Bloomberg View.