Who Loses in a Trade War? Both Sides!

There is this myth swirling around that the U.S. is winning our nascent trade war with China. The truth is, as is always the case with trade wars, both sides are losing. If the ultimate goal is to incent China and other nations to change their behavior, then a trade war is a very expensive option. And there is no guarantee that after incurring the expense, the other side will change. In fact, if history is a lesson, it is very likely they won’t.

Gains to Trade

Let’s review the harm inflicted on both sides by a trade war. Imagine that it is proclaimed everyone had to become self-sufficient in food production and that farmers and food processors would cease to exist as a result. Clearly each person’s standard of living would fall as virtually everyone would have to figure out how to produce food, since few have this skill set. This means everyone would spend more time in search of food at the expense of spending time doing their job.

Additionally, farmers and processors would be out of a job so their standard of living would also plummet.

Think of consumers as food importers and farmers as food exporters. By halting trade in food, both sides are hurt economically. That is, the gains to trade have evaporated as each side is no longer doing what they do best and, in turn, can no longer meet their consumption needs by trading with others.

Imagine taking this to the extreme of having to become self-sufficient in everything we consume. It is not a stretch to say that our standard of living would plummet to near zero. The U.S. standard of living is heavily dependent on trading with our fellow citizens and millions of others around the world. The key is to specialize on what you do best and then trade to meet consumption needs. In other words, the “magical” gains to trade.

Chipping Away

A trade war is not as dramatic as imposing the self-sufficiency declaration, but it leads to similar results. By imposing tariffs and non-tariff barriers (such as import quality standards), the cost of imports increases and so fewer imports are purchased. Domestically produced goods, which generally cost more, are substituted for reduced imports. This means resources are pulled into less productive companies that produce the item that is imported and away from more productive exporters. So, both consumers and producers collectively are worse off.

There’s little doubt the other side will retaliate with their own tariffs and non-tariff barriers, as China and other countries have recently done, and, as a result, both sides take a further hit. The risk is that ego and emotions take over, and the initial actions turn into a full-blown trade war.

The 1920s, ’30s, and ’40s provide a chilling reminder of what can happen if things get out of hand. Coming out of Word War I, only the U.S. returned to the gold standard for its currency. With European rivalries still at a boiling  point from the war, countries engaged in a series of currency wars in the 1920s, devaluing their currencies to make their exports more attractive.

These were followed in the late ’20s and ’30s by an intense trade war and the U.S. Smoot-Hawley Tariff Act, which, in turn, was a major contributor to the Great Depression.