Meixin Guo, Lin Lu, Liugang Sheng, Miaojie Yu
Trade disputes between the United States and China greatly intensified recently as the two countries announced a 25 percent tariff hike on $50 billion worth of products imported from each other, raising the risk of a trade war between the two giant trading economies. Based on a standard multi-sector, multi-country general equilibrium trade model with input-output linkages, we evaluate the cost of a trade war in which the United States and China both increase their tariffs to 45% for all imports from each other. We find that the United States would be more likely to be the bigger loser and that the cost for China would be moderate.
The world trade system has been facing grave danger in 2018 ever since U.S. president Donald Trump threatened a 25 percent import tariff on $50 billion worth of products from China, and China threatened to retaliate with a tit-for-tat tariff on imports from the United States. These two countries, which are the economic engines for the world economy and the largest exporters and importers in the world, are heading towards a high-stakes trade war. The risk of a U.S.-China trade war has significantly depressed global financial markets as increasing volatility has shadowed the economic outlook.
In our recent work (Guo et.al, 2018), we evaluate the possible impacts of a U.S.-China trade war on trade, output, and real wages by using a multi-sector, multi-country general equilibrium model with intersectional linkages. The model is an extension of Eaton and Kortum (2002), and the specific setting follows Caliendo and Parro (2015). The quantitative trade model provides a parsimonious approach to evaluating the quantitative consequences of changes in trade policy, and is an alternative to the traditional Computational General Equilibrium (CGE) model, which requires fully specified preferences, technology, and trade costs with many ad hoc parameters.
Our model covers 34 sectors in 62 economies including 34 OECD countries, 17 non-OECD emerging economies, and the rest of the world. We consider a hypothetical trade war in which the United States imposes a 45 percent import tariff for all imported goods from China. We choose this number because Trump proposed imposing 45 percent import tariffs during his meeting with the editorial board of The New York Times in January 2016. One important limitation of quantitative trade models is that a country’s aggregate trade balance (not bilateral trade balance) is usually exogenously determined by assumptions (Ossa, 2016). Countries with trade deficits receive a net income transfer from countries with trade surplus. For simplicity, we consider two possibilities: the trade war restores trade balance or maintains the current trade imbalance. The reality would be in between, but these two possible scenarios explain why the United States is at a disadvantage: it will lose the net income transfer from its current trade deficits if trade rebalances after a trade war.
We consider three possible scenarios of a U.S.-China tariff war in the model simulation. In the first scenario, the United States increases its import tariffs to 45 percent on all imports from China and all countries achieve balanced trade after the trade war. Balanced trade might well be one of the goals of a trade war as the U.S. government has for a long time blamed China for its large trade surplus. In the second case, we assume China retaliates by increasing its tariffs to 45 percent on its imports from the United States as well, again evaluating the impacts under the assumption of balanced trade. In the third case, we consider a situation in which both China and the United States impose 45 percent tariffs on each other, but trade imbalances remain unchanged for all countries. For simplicity, we name these three cases: 1) Unilateral U.S. tariffs with balanced trade, 2) U.S.-China reciprocal tariff war with balanced trade, and 3) U.S.-China reciprocal tariff war with pre-existing trade imbalance, respectively.
Our exercise shows that in all scenarios, high import tariffs lead to a catastrophic collapse in bilateral trade between the U.S and China. In the first case, China’s exports to the United States plummet upon the unilateral U.S. tariff hike, while the effects on U.S exports to China is rather moderate. In the second and third cases of a tit-for-tat tariff war, the bilateral imports between the two countries slump in all sectors, with half of the 18 sectors considered dropping by more than 90 percent. The collapse of bilateral trade is particularly pronounced in the sectors in which each country has a comparative advantage: U.S. exports of agricultural goods, wood, paper, and computers, and China’s exports of textiles and computer and electrical products.
A U.S.-China trade war would generate substantial losses in output and social welfare measured as real wages. The United States is likely to be the biggest loser in all scenarios. In the worst case, its output and real wages would drop by 1.08 percent and 0.75 percent respectively (case 2 in Table 1). The losses for China in the first two cases with balanced trade would be very small. The comparison between the first two cases also indicates that China would be better off if it takes retaliation when the U.S. increases its tariffs against China. In the third case with unbalanced trade, China and the United States would experience similar losses in social welfare, i.e., the real wage in the two countries would decrease by 0.37 percent and 0.32 percent respectively (case 3 in Table 1). In all cases, some Asian countries may gain slightly from the trade diversion, while many advanced economies would experience collateral damage due to spillover effects through input-output linkages and general equilibrium effects.