POLICY BRIEF the Chinese, the tariffs raise the prices of consumer goods but 19-17 US-China Trade have less direct impact on producers, since the Chinese have exempted some intermediate inputs.1 For the United States, War: Both Countries both total exports and total imports decline under all three scenarios according to the CGE model. China, however, can Lose, World Markets successfully divert its exports away from the United States, expanding in other markets and increasing total exports. A Adjust, Others Gain chain reaction is then set in motion: China increases exports to Europe and countries in East and Southeast Asia, who in Sherman Robinson and Karen Thierfelder turn increase their exports to the United States. The United November 2019 States is less able to divert its exports and change sources of imports, many of which are part of supply chains that are Sherman Robinson is nonresident senior fellow at the difficult to relocate.2 There is a complex mix of direct and Peterson Institute for International Economics and a leading expert on computable general equilibrium simulation models. indirect effects at work, with different impacts in the two Karen Thierfelder is professor of economics at the US Naval economies. Global trade declines slightly. Academy. The views and opinions expressed in this paper are those of the authors and do not necessarily reflect the official In terms of aggregate welfare (or aggregate final demand) policy or position of the US Naval Academy or the Peterson both the United States and China lose from the trade war, Institute. with a larger percentage and absolute loss for China— although the numbers are small.3 All other countries gain © Peterson Institute for International Economics. All rights reserved. welfare, benefitting from indirect spillover effects on inter- national prices, once they have adjusted to the short-term disruptions associated with rebuilding supply chains and The continuing US-China trade war is already damaging shifting labor and capital to alternative activities. both countries, and its expansion by the United States will The trade war affects the structure of production in only increase the damage and reverberate across the world China and the United States in different ways. In the United economy. The potential impacts of the current and threat- States, in all the scenarios, relative production shifts away ened trade war scenarios are analyzed in this paper using a from agriculture, manufacturing, and traded services, and computable general equilibrium (CGE) simulation model of output of nontraded services increases relatively. For China, the global economy. The first scenario is the current situa- the relative shift is in favor of manufacturing and traded tion (as of June 2019), whose effects are already happening, services. The results for the United States reflect a “fallacy and two additional scenarios that add new proposed US of composition” in trade policy—attempts to protect many tariffs and Chinese responses. As of September 2019, the manufacturing industries simultaneously can hurt manufac- Trump administration’s proposed escalations were sched- turing as a whole. In the scenarios, China is more selective, uled to take effect on October 15 and December 15; at the excluding tariffs on some intermediate manufactured goods, time of writing, the administration has delayed the October tariff increase. The model projects the situation after the two countries and the rest of the world have adjusted, a time horizon of three to five years. 1. As noted in Bown (2019), 31 percent of US exports to China will not be affected by Chinese retaliatory tariffs even after The trade war is already reverberating across the world December 15. economy. For the United States, increased tariffs operate 2. See Lovely and Liang (2018). exactly like a broad, large, sales tax on imported goods that is paid by US consumers—increasing prices and reducing 3. Welfare is measured by the total of all goods and services available for use in the country, which equals aggregate demand—and by producers who see a rise in the cost of production (GDP) plus imports minus exports (which go to imported intermediate inputs, damaging competitiveness. For foreigners). 1750 Massachusetts Avenue, NW | Washington, DC 20036-1903 USA | +1.202.328.9000 | www.piie.com PB 19-17 November 2019 so manufacturing production overall increases relatively in trade. Such trade diversion imposes increased costs asso- all three scenarios and absolutely in the first two scenarios. ciated with shifting markets. n Productivity: A trade war that reduces both imports and SCENARIO ANALYSIS exports will likely harm productivity (e.g., unwinding If a country imposes a tariff on imports of a final good (e.g., high-productivity supply chains). The links between automobiles), the effect would be to increase the cost of participation in international trade and productivity at imported cars, resulting in increased sales of domestically the sectoral level have been widely studied.5 produced autos and increased prices on all autos. There n Capital reallocation: Shifting the structure of produc- would be little impact on other sectors and no indirect tion to respond to changes in tariffs involves reallocating effects at the macroeconomic level. If the tariff is imposed on capital across sectors. Such reallocation is costly, leading imports of intermediate inputs (e.g., steel and aluminum), to changes in capital utilization in affected sectors. the result would be the same, except that there would be n Intersectoral linkages: The effect of widespread tariffs indirect downstream effects on producers who use steel and will reverberate across the economy through a web of aluminum inputs. Their production costs would increase, intersectoral linkages involving traded intermediate they may suffer a loss of productivity, and they would be inputs. Through this web, import tariffs will damage all damaged by the tariff. sectors, and the indirect links are especially strong for In a bilateral trade war, with two countries simultane- manufacturing. ously imposing tariffs on many sectors, the results are more complex, with a web of direct and indirect forces coming The three scenarios for the US-China trade war are into play. These include: analyzed using a global computable general equilibrium 6 n World prices: The tariffs will affect world prices, as (CGE) model called GLOBE. These scenarios draw on work global markets adjust to divert trade around the warring at the Peterson Institute by Chad P. Bown that describes the countries. The international terms of trade facing coun- evolution of the US-China trade war in detail, based on tariff 7 tries (the world prices of their exports compared to the schedules proposed by both countries. The scenarios are: prices of their imports) will change, favoring some and n Scenario 1, June 2019: The current situation as of June damaging others. Changes in world prices depend on 2019. The United States imposes a 25 percent tariff the trade shares of the countries imposing the tariffs— on $250 billion in Chinese imports, and the Chinese i.e. how large the country is in the global market—as retaliate by raising tariffs on about $110 billion of well as supply and demand elasticities. imports from the United States, with rates differing by 8 n Real exchange rates: There will be induced changes commodity between 5 and 25 percent. China exempts in real exchange rates (the “price” of foreign exchange deflated by the domestic price index). A policy of 5. See the review of this evidence by Winters (2004). For across-the-board tariffs by a single country will reduce a recent example of a trade-productivity link that has been aggregate imports and induce an appreciation of the widely used in CGE models, see Melitz and Ottaviano (2008). real exchange rate that effectively taxes exports.4 The 6. The GLOBE model is described in McDonald and Thierfelder (2016). This type of model is widely used for effect will be to shift resources away from traded sectors analyzing the impacts of changes in trade policy. The model (e.g., manufacturing) toward nontraded sectors (e.g., variant used for this analysis is described in more detail in services). In a bilateral trade war, the mechanisms are Robinson and Thierfelder (2019). more complex and depend on comparative trade shares 7. See Bown and Zhang (2019), Bown (2019), and Bown, and country size. Jung, and Zhang (2019). The tariff schedules are available for products at the Harmonized System (HS) level 10 for n Trade diversion: Reacting to a bilateral trade war, all the United States and HS level 8 and level 10 for China. The countries will change the structure of their imports and tariffs are aggregated, using import weights to HS6 (which is a comparable level internationally) and then to the level of exports by countries of origin and destination, diverting the sectors used in this CGE model. See Li et al. (2018), who also use a global CGE model to consider various US-China trade war scenarios. Their scenarios were constructed before the trade war began and include much larger tariff changes than have been proposed in 2019. 4. With a fixed trade balance, a reduction in imports leads to a reduction in exports through appreciation of the exchange 8. Two earlier studies that considered only the impact of the rate. This macroeconomic mechanism is called the “Lerner earlier 10 percent tariffs imposed by the United States are effect” after the economist Abba Lerner who laid out the surveyed in the NBER Digest, National Bureau of Economic mechanism at work. Research, May 2019. These studies did not use CGE models. 2 3 PB 19-17 November 2019 some imported intermediate inputs from retaliation—its Trump administration’s hostile attitude toward imports. policy is strategic in that Beijing seeks to minimize the Were that hesitation to occur, the result would be supply impact of the trade war on Chinese producers.