So last month the IGM Forum weighed in on the issue of supply chains and trade war — the issue that the current trade war, unlike previous trade conflicts, is taking place in a world where much trade consists, not of shipments of consumer goods, but of shipments of inputs used in production. The panelists more or less unanimously agreed that the prevalence of global supply chains increases the cost of trade war. But is the consensus right?
Well, although I yield to nobody in condemning the stupidity and corruption behind Trump trade policy, I’m a bit skeptical about the supply chain concern. Or maybe the best way to say this is that there are three possible stories about how supply chains might increase the costs of trade war, and while two of them are right, I suspect that many economists are buying into the third, which isn’t.
So, what difference does a supply-chain trading system make?
One thing it does is create the possibility that protectionism will be bad mercantilism — that even in its first-round effects it will actually destroy more domestic jobs than it creates, because it creates a competitive disadvantage for domestic downstream producers. Given the Trump tariffs’ heavy loading on intermediate goods, that looks right.
But what I think many economists have in mind is something more than that.
Standard trade theory tells us that the costs of a tariff — the reduction in real income — may be calculated, approximately, as
Real income loss = 0.5*tariff rate*reduction in imports
This formula suggests only moderate costs even from a major trade war. Suppose that worldwide tariff were to rise to 40 percent, and world trade were to fall by 15 percent of world GDP, a 50% reduction. Even so, world real income would fall only 3 percent.
Now, what I think many economists are suggesting is that this kind of analysis understates the losses when much of that trade is in intermediate goods. But I’m pretty sure they’re wrong, at least in the medium to long run.
Let me sketch out a model here.
Imagine two countries, Home and Foreign (my old trade theory roots are showing), both of which produce a final good using a large number — which we can represent as a continuum a la Dornbusch, Fischer, and Samuelson (1977) — of intermediate goods, which in turn are produced using a single factor of production, labor. In setting things up this way I’m assuming away distributional issues to focus on efficiency.
We can rank the goods in order of the ratio of Home to Foreign productivity in their production. Call this ratio A(z) for any good z. And let’s make a further simplification and assume that the countries are symmetric, so that the underlying situation looks the same if we reverse the countries’ identities. In that case wages will be the same, and under free trade Home will produce (and Foreign will import) all the goods for which A(z)>1, Foreign will produce and Home will import all the goods for which A(z)<1 .="" p="">
Now let’s have a trade war, which results in both countries imposing a tariff t. What happens?
The answer is, each country starts producing some of the intermediate goods it used to import for itself. Home becomes self-sufficient in goods for which 1 > A(z) > 1/(1+t), Foreign becomes self-sufficient in the goods for which 1+t > A(z) > 1. In each case efficiency goes down, because it takes more labor to produce these goods than it previously took to export stuff and import the goods instead.
What does this say about real income? Home’s loss from the marginal good it no longer imports is the excess resources required for Home production as compared with imports, namely, the tariff rate. The cost from all the inframarginal goods is less, down to zero at the last good it would have imported under free trade. The same is true for Foreign.
But this looks just like the logic of the standard estimates of the cost of protection: the average cost of a lost import is roughly half the tariff rate. So analyzing the costs of a trade war in a supply chain world isn’t any different from a conventional trade war analysis.
So where does the intuition that the costs of trade war must be higher in today’s world come from? I think it comes from the combination of two things. First, imagining a literal cutoff of imports, as opposed to a mere rise in their price; second, imagining a short run in which it’s impossible to develop domestic production to replace key inputs.1>
That said, a trade war in a supply-chain world would cause a lot of disruption, because it would lead over time to a major restructuring of industry. This would create a lot of losers, as well as some winners, perhaps more than a trade war would have in the past. But I don’t think the notion that the total loss in real income would be bigger than conventional analysis suggests holds up. Trump’s policy moves are destructive, based on ignorance, but we shouldn’t overstate their cost.