Game theory and trade wars
It is never going to bring out an outcome with crystal-clear end results
It’s never going to bring an outcome with crystal-clear end results
Financial markets were of two minds about the impact of mounting trade tensions between China and the US. On the one hand, the escalating titfor-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 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 favour the US 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 polarised 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.
■ An inherently cooperative game is increasingly played uncooperatively
The Trump administration is taking a disruptive approach to trade 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 US. 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.
■ Further escalation is the most likely outcome for now
For trade tensions to be a means to a better end, individual country behaviours 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 long-standing source of friction with the US, as well as other countries. But the US could end up pushing China too far, too fast. That would threaten not just a fullblown trade war, but also increased geopolitical strains and financial disruptions.
■ The game is inherently unbalanced
Whether by accident or design, the US 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 US 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 US a stronger hand to play.China will likely ultimately agree to some US requests.
■ Public accusations and counter accusations make trust difficult
Restoring greater trust between China and the US 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 a framework for resolving the inevitable misunderstandings and misperceptions that are likely to arise.
■ 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 US interest to build coalitions early on. Although the alliances could complicate the bilateral negotiations the US 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.
■ 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.
These seven 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 favours 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.