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  March 13th, 2018 | Written by

Trump’s Trade War: How Aggrieved Countries Should Respond

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  • A trade war where tariffs rise 10 percent would cost the US 1.3 percent of GDP and China 4.3 percent of GDP.
  • A trade war with a 40-percent change in tariffs would cause a deep global recession.
  • Foreign debt subsidizes a US economy which encourages consumption beyond its means.

Many analysts are assuming that aggrieved economies—such as the European Union and China—around the world will respond to Trump’s tariffs by imposing tariffs of their own on United States exports. That might be their knee-jerk reaction, but a scholar at the Brookings Institution argues for a very different kind of response.

His argument is premised on the fact that “leaders of the major countries…have advisers who have completed economics 101” and would therefore understand the consequences of such a reaction. Research by this same scholar, Warwick McKibbin, who is also a professor at the Australian National University, indicates that a “minor global trade war” where tariffs rise 10 percent, would cost the US 1.3 percent of GDP and China 4.3 percent of GDP, while a 40-percent change in tariffs would cause “a deep global recession.”

The alternative response, for McKibbin, is to sell their holdings of US government securities. Why? Foreign debt also drives down the costs of government and corporate borrowing, which in effect encourages them to take on more relatively cheap debt. All of this subsidizes a US economy which encourages consumption beyond the means of its citizens and its companies.

What would be the consequences of such an action? “The US would quickly discover the fundamental error in the economic logic underpinning the Trump administration,” according to McKibbin.

“The US dollar would drop sharply,” he wrote, “US long bonds would rise by several hundred basis points until US savings rose and US investment fell so as to move the trade position closer to balance. US exports would rise and imports would fall. US firms, consumers and the government would be far worse off due to higher borrowing costs but they would sell more for cheaper prices to foreigners.”

In short, if the US no longer wanted access to an open global trading system, it would have to live within its means if it. “A country that leverages by borrowing for decades in order to sustain consumption and investment levels that are far removed from fundamentals eventually has to pay,” according to McKibbin. “Is it not surprising that many of the billionaires in the Trump administration don’t understand this logic because the US economy has mirrored their own financial strategies of borrowing heavily, subsidized by foreigners and leveraging those loans to generate enormous wealth.”

Meanwhile, the foreign debt holders would free up capital “to invest in infrastructure projects with much higher rates of return than offered by the US Treasury.”