How Trade War Happens and Destroys Countries

This is what a real war usually looks like,
and this is what a trade war usually looks like. But the pictures don’t say it all as the
latter is not necessarily less costly and destructive. The most disastrous trade war in history actually
never really happened, a war without smoke. In 1985, due to an explosive US trade deficit,
a massive trade war between the US and its trading partners was looming large but was
eventually avoided. A peace agreement initiated by the US, known
as the Plaza Accord, was signed by the US, Japan, Germany, France, and the UK, which
were obliged to intervene in the currency market, helping devalue the dollar and revitalize
the US exports. The US trade deficit was almost gone within
the next five years. A happy ending for the US. But the story was completely different for
Japan. In the same 5 years, Japan was accidentally
triggered into what was referred to as the lost decades. Since 1990, its economic growth has plummeted
from around 5% per year to around 1% over the past three decades. The potential loss to Japan? Suppose Japan had been able to keep its growth
trajectory, this would be the potential loss to the Japanese economy, which is 122 trillion
dollars. The cost of a real war? The financial cost of WWII to Japan was 56
billion dollars, which enabled Japan to invade and occupy 22 countries and regions with a
population of around 400 million people. This cost, adjusted for inflation, would look
like this in 2005. So the potential loss caused by the trade
war is more than enough for Japan to launch the military attack as it did in WWII but
over 200 times more powerful. Although the Plaza Accord didn’t inevitably
lead to the lost decades, even if 1% of the loss could be attributed to it, it’s more
than enough to show that trade wars could be more costly than real wars. While the dust is yet settled for Japan, now
the US and China, the two largest economies in the world again, is on the edge of another
full-blown trade war. So why is this happening again? From the perspective of economists, since
trade happens voluntarily, it is supposed to be mutually beneficial for both trading
partners, but why do countries battle over trade? And why could ending trade be so costly and
destructive? Why do countries want to trade? For one basic reason, they are different. Suppose one country is good at producing one
product, the other country is good at producing another, without trade, if they don’t want
to have a boring meal, each country has to produce both products and bear the low quality
of the locally produced product. But with trade, the two countries can specialize
in producing what they are good at and trade with each other. As a result, both countries spend the same
effort as before, but are able to enjoy more of both products. A win-win situation. It really works like magic. Wait, no. Magic is an illusion, but this is real. The trick is that specialization enables both
countries to best utilize their resources and trade makes it possible to realize the
gains from specialization. But the story doesn’t end here, far from
it. One day after your meal you might get a bit
greedy and want to consume more without producing. Lucky you! With trade, this is possible, but you have
to borrow from the other country. You can do so by importing from the other
country, but instead of paying it with actual products made from your blood, sweat, and
tears, you can pay the other country with some golden, shiny, glittering money, which
is not consumable but with a big promise printed on it. This borrowing is called trade deficit, your
deficit through trade, the effort you owe to the other country through more imports
and fewer exports. The other country needs to produce more without
consuming more, but at the end of the day, its wealth increases because it can use the
money accumulated for future consumption. But is trade deficit a bad thing? As it is essentially a borrowing, not necessarily. It really depends on the purpose of borrowing. If it is used for profitable investment opportunities,
then it is a good thing and good luck! If it is due to too much eating, it is a bad
thing as the lack of enough saving will hurt your future. Watch out! But trade deficit may sometimes occur unintentionally
due to the lack of the ability to produce. The problem is: complete specialization is
an ideal situation that is too good to be true in reality. Each country will always have some people
producing what the country is not good at. They will have to be ready to take the gloves
off and compete with the foreigners who are superior to them in producing the product. In this case, trade will create winners and
losers within each country. Some people will make a loss and other people
will gain. This situation is often accompanied by a trade
deficit that comes from the loser’s industry as a result of the limited power to export. So is trade deficit a problem and should trade
be supported in this situation? Different people have different opinions based
on their different approaches to balance the winners’ gains and the losers’ losses. Economists treat everyone equally and compare
the total losses with the total gains. Surprisingly the total gains are almost always
greater than the total losses as trade gives each country more possibility, and hence the
country benefits as a whole. So their answer is: trade is potentially good
because the winners have enough gains to compensate the losers and everyone would say yes to trade. This is why economists usually support free
trade based on the potential gains from trade but do not touch on the issues of how to distribute
the gains, a job which politicians have to face. So politicians’ calculation is different. As the losers from trade tend to form a more
organized and stronger lobbying group, they usually have a disproportionally large weight
in the politicians’ calculation. Once the loss or trade deficit in the losers’
industry passes a certain threshold, politicians will tend to take sides with the losers to
launch a trade dispute or even a trade war. This is usually done through setting up trade
barriers to protect the losers, such as increasing tariffs on foreign imports. And this is exactly what has happened in the
history of the US trade wars. It’s like a game of mole attack. The US tends to launch trade wars against
countries that deliver a big deficit to it. Each whole pizza stands for a trade deficit
equivalent to 1% of the US GDP. The US had a very balanced trade with an almost
negligible trade deficit until the late 1970s, after which, its trade deficit soared rapidly
with the majority of it coming from Japan, especially in the auto industry. In 1981, the US imposed intense pressure on
Japan. In response to that, Japan agreed to a Voluntary
Export Restraint program, which means that it voluntarily imposed quotas on the number
of automobiles it exported to the US. In 1982, the US started the decades-long trade
dispute with Canada over wood products, as Canada was consistently the top contributor
to the US trade deficit in that category. In 1985, President Reagan raised the tariffs
by up to 40 percent on imported pasta from the European Economic Community, mostly from
Italy, retaliating the community’s discrimination against the US citrus. Since 1981, although the Voluntary Export
Restraint program effectively reduced the trade deficit in the auto industry, the US
still had a large trade deficit due to Japan. To make things worse, from 1980 to 1985, the
US dollar appreciated by around 50%, the trade deficit shot up accordingly. Major US exporters, including IBM, Motorola
and Caterpillar, devastated by their export numbers, launched a massive lobbying campaign
urging Congress to protect them by passing new laws. In addition, the White House initiated direct
negotiation with its trading partners, which was turned into the Plaza Accord. The US trade deficit was almost gone within
5 years. However, it caused huge turbulence to the
Japanese economy. Immediately after the Plaza Accord, the yen
appreciated sharply within the first year, causing exports and GDP to stall in 1986. In imminent danger of a serious recession,
Japan introduced an unprecedented macroeconomic stimulus. Within just one year, its central bank reduced
the policy interest rate from above 8% to below 4%, a level which turned out to be much
lower than what was needed. In addition, extra government spending designed
to increase GDP by 1-2 percent was introduced in 1987 to compensate for the loss of external
demand due to the yen’s appreciation. These policies quickly helped Japan recover
from the initial crash. But due to the excessive concern over the
impact of the unprecedented appreciation, the massive stimulus was not withdrawn until
1989 when it was too late. To make things worse, due to the on-going
financial deregulation in Japan, large firms gained the access to capital markets and didn’t
have to rely on banks for funding. As a result, banks had to lend to real estate
developers and buyers, leading to explosive credit growth in the real estate market. The share of loans to the real estate market
grew from around 6% in 1980 to around 12% in 1990. This combined with the massive stimulus helped
the formation of an extraordinary asset price bubble, followed by a very painful burst in
the 1990s. The Japanese economy hasn’t been able to
recover ever since. In 2002, due to a large trade deficit in steel,
the Bush Administration launched a trade war against the whole world by raising the tariff
on steel from 0% to between 8% and 30%. The action was withdrawn earlier than originally
scheduled after the sanction from the WTO and the retaliation from the European Union. In 2006, the US had the largest trade deficit
in history with China being its largest source. Time for another trade war? Not this time, due to the break-out of the
global financial crisis, the US consumption power deteriorated rapidly. The trade deficit was automatically reduced
during the crisis. But since the global economy recovered, the
US trade deficit problem reappeared. In 2018, the Trump administration initiated
a trade war against China. The two countries escalated the trade war
by raising tariffs one after another. As a result, imported products become more
expensive. Although local industries are protected, the
country as a whole cannot enjoy cheaper and better products from abroad. Apart from the affected industries, the trade
war also caused huge disturbance to both economies. Since the trade war started in January 2018,
both the US and China’s stock markets have experienced enormous volatility. The uncertainty will make it even harder for
the two countries to offset the negative impact of the trade war, as the stake has changed
from a few industries to the whole economy. This is especially important for China, which
has just experienced a growth rate of 6.6% in 2018, the lowest in 28 years, and is now
taking a series of expansionary measures to tackle the slowdown in the economy. Since 2018, its central bank has cut banks’
reserve requirement ratios five times, releasing 3.35 trillion yuans, or around half a trillion
US dollars, into the financial system. In addition, the government also cut over
1 trillion yuans, or around 150 billion dollars, in taxes for the private sector and promised
further tax cuts in the next couple of years. However, estimating the appropriate stimulus
package remains a challenging task. Just like in the case of Japan, designing
an appropriate policy response with massive uncertainty is extremely difficult and prone
to errors. Although the scale of the trade war itself
may not be large compared with the size of the economy, any error in the policy response
may cause an extraordinary disaster to the overall economy. Globalization and free trade have brought
us tremendous success for the global economy. The world average tariff decreased dramatically
during the past two decades and trade has become a main driver of the global GDP with
the trade to GDP ratio increased to more than 40%. We are currently in an almost complete free
trade environment. The transition from the current state to a
complete free trade environment can only bring 1% increase to the global GDP. As the gains from trade are depleting, trade
disputes are on the rise. Since 1995 alone, more than 500 formal trade
disputes initiated by over 50 countries have been brought to the World Trade Organization. Trade negotiations have also become harder
and slower, as now the negotiations need to not only talk about the country’s gains
as a whole, but also to balance the winners and losers within each country. Hope this is just a healthy correction for
globalization. Countries can take the chance to release the
tension and have further communication.

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