The macro­eco­nomics of trade war

The Philippine Star - - OPINION - By PAUL KRUG­MAN The New York Times

Will Trump back down from his urge to start a trade war? No­body knows; the thing is, he’s been an ig­no­rant trade hawk for decades, he’s feel­ing be­lea­guered on many fronts, and word is that his doc­tor has told him to eat fewer burg­ers. So there’s surely a lot of pent-up rage that he’s all too likely to take out on the world trad­ing sys­tem, es­pe­cially when he tweets stuff like this:

So it’s worth ask­ing what would hap­pen if Trump re­ally did try to close the trade gap – it’s ac­tu­ally $500 bil­lion, not $800 bil­lion, but who’s count­ing – by im­pos­ing tar­iffs.

The trade gap is cur­rently run­ning a bit shy of 3 per­cent of GDP, while im­ports are 15 per­cent of GDP:

If the price elas­tic­ity of im­port de­mand is around 1, which is a typ­i­cal es­ti­mate for the short-to-medium run, a 20 per­cent across the board tar­iff might, other things equal, be enough to close the gap. But other things would very much not be equal.

Leave aside the is­sue of for­eign re­tal­i­a­tion/em­u­la­tion, al­though that would be a very big deal in prac­tice. As­sume in­stead that the U.S. gets away with it, with no for­eign re­sponse. Even so, this wouldn’t work out the way Trump imag­ines.

You see, di­vert­ing de­mand equal to 3 per­cent of GDP from for­eign to do­mes­tic prod­ucts would not in­crease US out­put by 3 per­cent rel­a­tive to what it would have been oth­er­wise, let alone the 4.5 per­cent you’d ex­pect if there’s a mul­ti­plier ef­fect. Why? Be­cause the US is close to full em­ploy­ment. Maybe – maybe – we have an­other half-point of un­em­ploy­ment to go. But a 3 per­cent rise in out­put rel­a­tive to trend would re­duce un­em­ploy­ment about 3 times that much, 1.5 per­cent­age points. And that just isn’t go­ing to hap­pen.

What would hap­pen in­stead is that the Fed would raise rates sharply to head off in­fla­tion­ary pres­sures (es­pe­cially be­cause a 20 per­cent tar­iff would di­rectly raise prices by some­thing like 3 per­cent.) The rise in in­ter­est rates would have two big ef­fects. First, it would squeeze in­ter­est-sen­si­tive sec­tors: Trump’s friends in real es­tate would be­come very, very un­happy, as would any­one who is highly lever­aged (hello, Jared.)

Sec­ond, it would drive up the dol­lar, in­flict­ing se­vere harm on U.S. ex­port sec­tors. Greet­ings, farm­ers of Iowa!

So pro­tec­tion­ism wouldn’t do very much to re­duce the trade deficit, even if other coun­tries didn’t re­tal­i­ate, and would in­flict a lot of pain across the econ­omy. And that’s with­out get­ting into the dis­lo­ca­tions caused by dis­rup­tion of sup­ply chains.

Add in the fact that other coun­tries would re­tal­i­ate – they’re al­ready draw­ing up their tar­get lists – and the fact that we’d be alien­at­ing key al­lies, and you have a truly ter­ri­ble, dumb pol­icy idea. Which makes it quite likely, as I see it, that Trump will in­deed fol­low through.

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