Trade Wars – When Nash Equilibrium meets Deglobalization

Trade warnoun ­– “a situation in which countries try to damage each other’s trade, typically by the imposition of tariffs or quota restrictions.”.

The US-China trade war, despite the looks of being surging now, it has already started by 2016 when Donald Trump was fighting for presidency: “Any country that devalues their currency to take unfair advantage of the United States and all of its companies that can’t compete will face tariffs and taxes to stop the cheating.”. It started out as steel and aluminium tariffs for every United States imports, it later escalated to threats about taxing imports of European Union fabricated cars, then the official exemptions began with the NAFTA countries and lastly extended to the EU as well, making tariffs for EU’s finished products very unlikely at this stage.

As game theory suggests, just like any repeated game with consecutive turns, each player in the game has room for retaliatory actions that punish the other player’s “bad behavior” and, inevitably, both will reach to a Nash equilibrium where they can’t improve their payoffs given the other player’s predictable choices, even if this equilibrium is considerably worse that it would be if both players had assumed a cooperative approach. And, of course, when we say “players” we say “U.S.A.” and “China”. However, when the issue involves two of the most critical nations in geopolitical terms, political pressures arise and create expectations on other players’ behaviors – which sides will they take and what retaliatory measures will they impose? Needless to say that, regardless the future equilibrium of this strategic game, the markets often prepare to assume the worst when a period of uncertainty ascends, translating into high volatility and high values of the trade-policy uncertainty index.

Chart 1: New-based index of trade policy uncertainty, 2006-2017

Source: Retrieved from Voxeu

 

For now, it is viable to assume that large capital investment decisions are being suspended due to the uncertainty regarding future tariffs and their respective global effects, and equity investments have become much riskier, causing an immediate hit to the current GDPs of the main involved players. The Dow Jones average is on its way to the worst March since 1980, when it decreased 8.97%, and the S&P500 to the worst March since 2001, when it declined 6.4%. This happens because investors are concerned about the eminent trade war while the Federal Reserve attempts to normalize the monetary policy during dramatic circumstantial changes.

It is still too soon to predict China’s answer to the announced tariff plans for up to $60 billion in Chinese imports, but this tit-for-tat game will certainly give the opportunity to the most important emergent nation in the world to hit the USA’s economy where it hurts the most, possibly jeopardizing the monetary policy plans by messing with inflation targets and costs of living. The immediate guaranteed consequence will be felt for national companies from both sides that have been built based on the long-term planning, which have already established ways of doing things: strategic roots, logistic choices, production mechanisms, workforce training, and so on. The change in taxing circumstances may lead these companies to rediscover all these processes in a different geography and postpone the natural rate of growth.

Investment-wise, the equity related risk has gone up, and if the social media communication about the international trade issues keeps providing negative outlooks, then Treasury yields could be going lower in the near future. The relative risk of emerging markets has also decreased, incentivizing equity lovers to allocate their resources to better fits for the momentaneous risk-reward company profiles. The VIX index should be far from converging to a mean as well, while the United States, the European Union and China will be facing with the higher doses of uncertainty: how will China react, how will the EU position itself, what will be the damage to the US economy and how will it affect the planned monetary policies? Only time will tell the next Nash equilibrium.

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