World trade - USA = ?

Question

Governance based on clear rules that apply to everyone has proved to be important over many centuries of history, not only in international trade but also in far broader contexts. The principle that kings and elites are not above the law, and cannot make arbitrary decisions about spending and taxation, has been found (by Douglass North and others) to be crucial in launching the modern era of democracy and growth.

    Rule-based systems help resolve prisoners’ dilemmas. Without them, pursuit of self-interest by countries, firms, and individuals can lead to a non-cooperative outcome that hurts everyone.

    Another force that helps resolve such dilemmas is leadership by the largest player. That player has most to lose from collapse of the system. Therefore it pays a disproportionate share of the cost of sustaining the norm or rule of good behavior, even tolerating some cheating by small players. Mancur Olson labeled this “the exploitation of the great by the small.” It was most evident in many decades of operation of the world trade system after World War II, when the US was such a leader. (Other examples of similar leadership are the US in NATO, and Saudi Arabia in OPEC.)

    Therefore the recent actions of President Trump are especially dangerous and costly to the world. He has turned the US away from the multilateral, most-favored-nation-based WTO system, and engaged in bilateral one-at-a-time bargaining with countries whose smaller economies rely on access to the US market. This is having some success in achieving deals more favorable to the US (although the magnitude of the difference from the status quo seems greatly exaggerated).

Such might-based bilateral deals will in time destroy the rule-based system. This will hurt the US also, in fact disproportionately so because it is the largest player, but it may serve Mr. Trump’s personal political interest by firing up his base of support. The cost to the rest of the world is even larger than the direct one of defection of the US: when the largest player abandons its leadership role in resolving the prisoners’ dilemma, it will be that much harder to discipline cheating by others. (Remember how the initial violation, albeit small, of the EU’s budgetary rules by Germany and France made it harder to discipline subsequent violations by Italy, Greece and other members.) World trade may collapse into a free-for-all, perhaps as in the 1930s.

Many countries try to evade the spirit, and even the letter, of WTO rules when they can. But only the US has gone so far as to act as if rules do not even apply to its actions.

The economy of the world minus the US is bigger than the economy of the world including the US was less than 20 years ago; even if the US has zero trade, the rest of the world is an economy large and diverse enough to continue reaping the benefits of rule-based trade.

Hence my question: Will the rest of the world fare better in a WTO without the US, preserving for the rest the rule-based system that has on the whole served the world quite well for a long time? To be sure, departure of a large country from world trade is costly, but retaining a rogue large player who undermines the rule of law is also costly. Calculating the balance – comparing the welfare of the rest of the world in two scenarios, a rule-based system without the US, and a rule-less free-for-all Nash equilibrium of trade barriers for the whole world including the US – should be an interesting empirical research program for trade economists.

The WTO has no direct mechanism for expelling a member. But if enough other countries decide that a US departure would be in their collective interest, an expulsion will not be needed. At the mere voicing of such a move, President Trump is sure to quit in a tantrum of tweets.

Comments

I had suggested that the rest of the world may fare better by expelling the US from the WTO (or provoking its withdrawal). This seems to be happening by a different route. “Globalization is Surviving Trump” (Bloomberg Business Week, January 21, 2019) lists several regional and plurilateral trade pacts that are already in effect or imminent, have intersecting memberships, and gives members deals as good as they get in their other agreements. For example, the EU-Japan deal that comes into effect on February 1 gives European beef access to Japan on the same advantageous terms as Australia gets in the new CPTPP (effectively TPP minus USA). The combination of these deals may therefore amount to a super-WTO on its own super-MFN terms. That would leave trading on WTO terms as a relatively disadvantaged second-tier status for the US (and post-Brexit UK?).

Answer 1

Dear Professor Dixit,

I am honored to be communicating with you over EconSpark. Your research in micro and game theory over the past decades have been an inspiration to me. You have been an eye opener to a lot of open research questions across the globe- including my own dissertation on the theory of competition in differentiated markets back in 2002.

If I  may attempt to skeleton a preliminary response, we can consider a typical 2x2 game with US and rest of world as the two players ("US" and "Rest") with the following strategies. For the US: (1) US retaining WTO status (even if marginally), and (2) Trumpian effective departure from WTO. For "Rest": (1) Rule-based WTO system, and (2) Bilateral bargaining with possibility of a temporary trade war.

The simple 2x2 payoff matrix would be:

                                        Rest of World
                                   (1)             vs.             (2)
US Strategy (1)   A, B                              C, D
US Strategy (2)   E, F                               G, H

Some ideas on the outcomes:
(1), (1):  A, B would be the base scenario (others are value-added benefits and costs relative to this scenario).
(1), (2):  B would include retaining a rogue leader who undermines the rule of law, which maybe costly for the Rest of World, hence D > B is a possibility. For the sake of a strong Nash argument, assume this possibility is binding in the short term. If this is true, then on the other hand, for the US, G would be > C, i.e. the benefits of Trumpian departure from WTO would exceed US marginally retaining its WTO presence. This is the case of domestic political win for Trump, if bilateral bargaining provide protection of domestic jobs and local business interests in a relatively imperfect market scenario of extra positive profits relative to the more open world market (less imperfect market scenario) in the case of "C"- also in the short run.
(2), (1): Since the departure of a large player from WTO will be costly for BOTH players, then A>E and additionally B>F. The latter condition (B>F) would logically assume that the rest of world is better-off if US stays in the WTO, i.e. no follow ups on Brexit on the global level. If Rest of World domestic politics become geared towards protectionism, then B>F will cease to exist. It is ironic that such a constraint is invariant to the short run Nash equilibrium outcome of (2,2) as prescribed below.
(2), (2): Trumpian departure from WTO will trigger bilateral trade negotiations, albeit after the possibility of short run trade war announcements or calculated protectionist moves by Rest of World. In this case, H>F for Rest of World in this scenario, conditional on US strategy (2), if the rest of world value trade with the US more than trade without the US. This is a critical constraint because the difference between H and F, i.e. (H-F)> delta is itself the world trade with (relative to without) the US in it. Delta will be the importance of US inclusion in world trade from the benefits side of Rest of World. Assuming that delta is positive due to high opportunity costs of not trading with the US for Rest of World, then (2,2) will yield H>F. If, however, the Rest of World can operate in world trade without the US in such a system, with relative positive returns, then delta could be negative yielding F>H.  

For the short term Nash solution: If delta is positive making H>F, along with G>C  as discussed in scenario {(1),(2)} above, then the dominant Nash equilibrium will be scenario {(2),(2)} with no incentive to deviate. The US will effectively choose Trumpian departure from WTO, and the Rest of World will choose bilateral negotiations after short term trade war possibility. This short run Nash solution is an equilibrium solution with no incentive to deviate in the short term-  albeit unless delta becomes zero or negative (i.e. value-added returns of world trade with US , becomes less than the returns of world trade without US). Notice also that this short run Nash equilibrium solution is invariant to B>F, since if F becomes >B, the short run Nash solution of {(2),(2)} persists.

The above can be extended on three fronts:
(1) inclusion of concrete costs for a trade war. In this case, G and H will be revised downwards by the respective negative trade war impacts on US and Rest of World, respectively. This makes the short run Nash solution of (G,H) relatively unstable in the longer term- the more is the severity of the costs of trade protection.
(2) inclusion of discounted future benefits due to a greater world trade pie from free trade (i.e. the extra benefits of mutual trade between US and Rest of World) in more concrete terms. This can be modeled either as additional benefits under free trade, or as additional opportunity costs without free trade. With inclusion of the dynamics of future opportunity loss due to non-free trade scenario, the short term Nash outcome of {(2),(2)} is likely to break down, since G and H will need to be revised downwards to accommodate such opportunity loss. However, (E,F) will also need to be revised, which makes the short run {(2),(2)} solution unstable.
(3) extension towards world trade simulation with impact on non-tradable services and structural job shifts affecting the political economy of the world trade system in the longer term.

It is important to note here that the (win,win) or (A,B) scenario will never converge to be the longer term Nash solution, even if G and H are revised downwards, since B must be >D for a win,win (A,B) Nash solution to persist towards the longer term. This essentially proves that stability of long term world trade system will hitherto be conditional on US domestic politics, as well as the valuation of Rest of World towards trading with the US. If such sentiment fuels the Rest of World to lower valuation of trade with the US, making F>H (delta negative), along with A>E as invariant to such an outcome, then the current trade system will never converge back to a (win,win) (A,B) as a long term Nash solution, and consequently a different fabric of world trade will be essential for the world economy moving forward.

The above are extremely preliminary thoughts on the open subject matter that Professor Dixit has introduced.

Respectfully,
Tarek H. Selim
Professor of Economics at the American University in Cairo,
and former Visiting Researcher at MIT Industrial Performance Center.
tselim@aucegypt.edu

Comments

Dear Professor Selim,

     Thank you so much for saying such nice things about me. And thank you even more for laying out the possibilities in such detail. In your terminology, what I wrote was basically posing the question "Is F > H or F <H"? You have extended the question / analysis to other possibilities and raised the additional question of what can be an equilibrium of the game. To further complicate it, the rest of the world is not a single player; it has to solve a collective action problem of its own if it is to confront the US. Trump of course wants to prevent it from doing so, and peel off one country at a time to negotiate with. Anyway, I hope others will pick up these questions, research them further, and produce useful answers. Thank you again. - Avinash Dixit

Answer 2

As the populism take form in Europe, because of the huge change from a manufacture industrial economy into a services economy, the huge problem concerning immigration from Africa, and the Great Recession or even the next economic crisis what I think is going to happen soon, extreme political parties will get the power in different countries. As it's happening already in Greece or Italy, or as can happen in France with Marine Le Pen.

This extremes ideologies will close their national economies and they are going to put barriers to free trade. The first reason is the high unemployment suffered after the Great Recession, where a huge number of low skilled workers got fired. Meanwhile in China the economy kept growing (with a lower amount of exports) as the principal industrial center of the world competing with Germany that suffered the Great Recession too.

What's the point here? The principal goals of globalization, like specialization, factors allocation, or knowledge spillovers will cease creating a slower development for the countries of the world. It's the change from cooperation into total nationalism what leave countries disconnected and vulnerable to any internal shock as happened in the Soviet Union.

Taking into account the question you made. I think that the US will earn an imaginary reward increasing internal employment with the cost of lose development and progress what can increase the unemployment in the future because of the development of other countries that can get rid off American exportations. Besides, the US will reduce their progress and it can end in the reduction of their position as the main and most advanced power on earth.

Anyway, the WTO should have a clause in order to stop exploitative countries like China because there are not playing the game fairly and this push other countries to cheat in order to maintain the quality of life of their workers that can't compete with the Chinese in hours of work or low wages. The Chinese miracle is a forced specialization based in low wages and a heavy workforce capable of working 60 hours per week.


Ryan McConnell.