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How bad could a trade war be for the global economy?
Since the Trump Administration proposed the tariff policy against Chinese imports, there are all kinds of comments, good or bad.
China’s response to US tariffs has been measured but the end game is uncertain.
Chinese response to the Trump’s announcement was at the dovish end of the spectrum of possible retaliatory actions. If we have seen the first shots in a global trade war, then there are many rounds of escalation still to come, probably taking years to play out.
So, how huge the scale of the economic damage will be?
The IMF has published simulations on its global economic model, showing the impact of a 10 per cent extra US tariff on all imports of goods from the rest of the world. This cuts US GDP by about 1 percentage point in the long term, and it also reduces GDP in the rest of the world by 0.3 per cent. There is no transfer of output from one region to another: everyone loses.
The tariff increases are estimated to reduce global trade volumes by around 6 per cent, and real GDP is reduced by 1.4 per cent, with the US, China and Europe each suffering a drop-in output of 1.7-2.2 per cent. Since these trade and output losses are likely to be spread over several years, the size of this shock would seem manageable, and maybe a bit less than investors currently fears.
Other simulations are broadly similar. Goldman Sachs economists have published results that imply output losses of around 0.9 per cent over two years for the US and Europe in the case of a 10-percentage point increase in global tariffs, along with a 20 per cent drop in equity prices. China’s output loss is only 0.5 per cent. Inflation rises by a few tenths of a per cent, but then drops back to target as monetary policy tightens and unemployment rises.
There are two obvious ways in which the economic impact could be much worse:
1. The huge growth in global value chains early in this century (i.e. trade in parts and components rather than finished products) could leave the trading system vulnerable to much greater temporary disruption if there are bankruptcies and dislocations in companies within the GVCs. Tariffs could be imposed every time components crisscross a frontier, greatly increasing the effective costs of production in GVCs.
2. Uncertainty about future tariffs and their effects could lead to postponement of capital investment decisions, resulting in a much larger immediate hit to GDP than shown in the above simulations.
In summary, the available (though not very convincing) evidence suggests that the global output losses from a trade war might reach 1-3 percentage points over several years, with a left tail that could be much worse. But there are huge uncertainties, both economically and politically. If this strategic game gets stuck in a bad equilibrium, then markets might become disposed to assume the worst.
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