By Joseph Bruseulas, RSM US LLP

Trade friction represents the natural state of international economic affairs. While the benefits of free trade are unassailable, from time to time, distributional impacts to distribution caused by comparative advantage and specialisation move to the forefront of economic diplomacy. The U.S.-China trade spat marks the opening salvo in a period of increasing friction within the global trade system.A bipartisan consensus in Washington contends that China should be confronted over its international trade practices. That said, some alternative strategies to those being deployed by the Trump administration can avoid upsetting global asset markets, disrupting the flow of goods and risking escalation to a trade war.

Trade Friction, Trade Spats & Trade Wars

Since the trade wars of the 1930s upended a prior period of nearly forty years of globalisation, there is little U.S. memory of a trade war. Amid today’s brazen media reports, it is important to separate reality from hyperbole. There are major differences between trade frictions, tradespats and trade wars. Policymakers, investors and firm managers need to understand those differences.

Trade Friction

For 30 years, the World Trade Organisation has been the primary vehicle preventing trade friction from spilling over into a trade spat, usually the first indictor an economy could be on the road to a trade war.

An agricultural trade dispute between the United States and Japan demonstrates the WTO’s importance. In the 1980s, Japan’s efforts to protect its upscale apple market through a series of non-tariff barriers to prevent entry of cheaper American apples led to bi-lateral friction. The Japanese, claimed it was attempting to prevent fire blight bacterium from entering the U.S. ecosystem, convened a panel to mediate. Japan and the U.S. reached a mutual agreement in September 2005, and a trade spat was avoided.

Trade Spats

A trade spat is best defined as tit-for-tat retaliation involving industrial or tradable service products between two or more trading partners.. Trade spats are typically short; they end with the withdrawal of tariffs by the instigating party after losing in the WTO courts or following domestic economic impact associated with tradeoffs that lead to job losses and higher prices.

Examples of tariff spats include actions taken by the George W. Bush and Barrack Obama administrations. Bush imposed 20 percent tariffs on steel imports in 2001, resulting in retaliation by the WTO, which ruled the actions were illegal under existing treaty obligations. The European Union followed up by imposing $2.5 billion in retaliatory tariffs. The Bush administration quietly withdrew its import taxes in 2002.

The Obama administration imposed taxes of 35 percent on the import of tires in 2009 to ostensibly save jobs. The move resulted in a net increase of about 1,200 jobs at a cost of roughly $1.1 billion or $900,000 per job. After a rigorous economic analysis, the Obama administration, quietly backed away from the tariffs, withdrawing them in late 2012.

The prospective tariff war the Trump administration intends to start with China will likely look like the Obama experience. Outsizedretaliation by China on industries beyond steel and aluminum such as agricultural, including the symbolic targeting of products politically important to Trump such as Harley Davidson motorcycles, Levis jeans and Kentucky bourbon, has made for high-profile optics. However, we would need to observe more far-reaching actions before characterising the ongoing friction as a trade dispute.

Trade War

A trade war occurs when countries move beyond WTO involvement and issue punitive taxes against a country or economic bloc.The first sign isa period of disruption and devolution in global trade:dissolution  of the global trading regime through the repeal of multilateral trade treaties such as NAFTA; aggressive erection of non-tariff barriers; caps on capital flows and the expropriation of foreign-owned firms and property. Such conditions portend sharp currency devaluations such as those of the Great Depression of the 1930s.

Over the last 75 years the United States has provided the foundation and framework of the global trading system. While current US-China trade friction can still be fairly categorised as a trade spat, the decision by the Trump administration to impose tariffs on allies and adversaries alike has stimulated fears that the United States is on the cusp of bringing that era to an end.

Partial Equilibrium Model of a Trade Spat

One way to illustratea trade spat’s potential damage to the international economy is by viewing a partial equilibrium model that treats the import market as one for a specific product in a much larger global economy. The diagram below illustrates demand for imports as a function of their relative domestic price. Imposing a tariff causes the trade equilibrium for the product at the global price to deviate. Thus, the price of the good following the tariff shifts up and the quantity of the good provided shifts to the left from the global price to that following the trade spat with the blue shaded triangle representing the deadweight loss caused by the imposition of the new tariff policy.

How large would the deadweight be? It would depend on the size of the tariff regime imposed and the relative elasticity of demand for the good negatively impacted by the new policy. The tariffs on steel and aluminum are quite small with relatively modest elasticities.

Then why has the response in financial markets been so large? The answer lies in the pace of globalisation over the past thirty years and the construction of supply chains spanning various global economic blocs during that time. While a relatively contained trade spat between the United States and China would likely only shave 0.02 to 0.03 percent from U.S. gross domestic product, it would also force Chinese and U.S. firms to seek supply chain alternatives, devaluing the businesses that depend upon them and reducing the value of investments in non-liquid assets that have been made over the extended period of globalization.

 Washington Consensus

Despite multiple diplomatic and commercial agreements with China, the past thirty years of economic interaction has not produced the outcome desired by the United States, European Union or its allies—to integrate China into the existing global trade framework. It’s not clear whether China ever desired to be part of that order or is interested in fostering its development. Whatever the case, as the United Statesenters a period of relative decline, that order is going to change and with it policy from Washington regarding China.

That policy shift is being driven by relative changes in growth and financial conditionsin each economy. As a result, the new bipartisan consensus in Washington has formed to both challenge and accommodate China’s economic rise. For now, the consensus remains that China must be confronted onits overproduction and dumping of supply into global markets as well as its appropriation of intellectual property from western firms operating in its country.

State of Play

While at this time the diplomatic and economic interaction between the Trump administration and China could be described as open mouth operations well short of a trade war, the potential economic impact and price distortions to the global economy are significant.

It’s possible the Trump administration will slap an additional $100 billion in tariffs on Chinese exports to the United States, bringing the total to $150 billion (larger than the $136 billion in U.S.exports to China). The risk is that China will respond in an asymmetrical fashion through non-tariff barriers and expansion of the tariffs beyond manufacturing and agriculture.

Although it must be stated that appropriation of IP is largely a private sector problem for firms that produce for China and is not a cause of US domestic distributional issues. Thus, there is clearly an opportunity to address these issues immediately without significantly disrupting the global trade system. The irony that the Trump administration which has campaigned against US based firms producing in foreign companies is now on the verge of launching a trade war on behalf of firms that choose to produce in China is not lost here.

Alternative to Undermining Multilateral Trade Institutions

The first round of the trade spat has not been beneficial to the Trump administration. The administration is now considering a rapprochement with the eleven signatories of the Trans Pacific Partnership, which was the geo-economic entity agreed upon by the 12 countries accounting for over forty percent of global economic activity on how to challenge China over its economic policies. The re-entry of the U.S. into the TPP would reduce current tensions and provide a better alternative to the general global economic uncertainty and upset in global asset markets that has accompanied the first salvo launched by the Trump administration. Moreover, the Chinese have signaled to all that it would be easier for them to make concessions within an integrated regional and global framework for discussions.

The U.S.-Sino economic relationship is complex and predicated on a growing global supply chain across a diverse universe of products, services and investment. The ability of the two countries to negotiate the problems surrounding the implementation of rules governing intellectual property and the dumping of commodities in international markets would be far more successful if done via the WTO and with the United States under the Trans-Pacific Partnership.

Trade conflicts are the ultimate wars of choice. They are easy to start, difficult to end and typically result in losses to both sides. The future of trade between the United States and China will be defined not by manufacturing and agricultural trade. Rather, it will be organised around the rules and framework governing the coming era of artificial intelligence and machine learning. That period of interaction will likely be defined by how the current trade friction and trade spats are settled.