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The theory of comparative advantage is a concept that would be referred to as Economics 101 in the world of economics. Simply put, this means that each one of us is not best suited for the same job and there are specialists for each type. It is important that each person take up a career for which the person is best suited (abilities and temperament) and the sooner the understanding sets in the better for the person’s career.
A parallel can be drawn from the above in the big world of global trade and global economics. If the world was an open free society with each country producing what it is particularly good at, irrespective of its internal consumption and exchange the goods with countries that produce (competitively) what it consumes, then the world output is likely to be much higher. The entire theory of competitive advantage is about specializing in production of goods that one is most efficient at and importing other consumption requirements from other countries that have a comparative advantage is the most cost efficient. Although trade theory has gone through lots of innovations since long, this principle is considered the cornerstone of global trade flows and history of economic progress is replete with instances of countries accepting this as one of the primary drivers of globalization.
However, recent developments are turning this argument around on its head. There seems to be a widespread usage of various kinds of price and quantity based restrictions on free trade, which are being imposed by large countries. The ongoing confrontation between the US and China is at the heart of this development and has now earned the unfortunate moniker of “trade wars”.
The genesis of this entire confrontation is the fact that the US runs a large current account deficit (CAD- imports much more than it exports) historically. This is also to be expected as the US Dollar is the world’s reserve currency and through its CAD, supplies Dollars to the rest of the world. It so happens that it runs a significantly large deficit against China. One would think that this would be the case as China is likely to produce most things cheaper than the US, as among other things, labour costs in China are much lower than that of the US.
This brings up the allied issue of job losses in the US, as in a global world, producers can easily shift their production bases to places which have lower costs. This problem of widespread job losses has been a pet theme for the political parties in the US. The imposition of tariffs on imports makes the goods manufactured offshore more costly and the administration hopes that in time, if domestic industry receives “protection” and costs get leveled across borders then exported jobs could come back onshore, as producers shift their bases back home.
More manufacturing onshore would also imply that the substantial current account deficit starts to reduce and also the excessive dependence on particular trading partners such as China starts to correct. The other aspect of these confrontations are also on the currency front, where the US feels that trade agreements also had implicit currency agreements backing them, which unfairly keep partner currencies cheaper and tilted the cost matrix in favour of the partner countries. These are in brief some of the main reasons why the US Government seems to be following this path of rapid escalation of trade barriers.
So far, the US has imposed 25% tariffs on USD 250 bn worth of goods in 2018 and 10% tariffs on USD 120 bn worth of goods recently. The 10% tariff hike on USD 180 bn worth of goods has been postponed for the moment till December 2019. China too has retaliated and has imposed tariffs on goods worth USD 110 bn. More recently, countries have also started using their currencies as a tool to ward off the tariff increase resulting in the possibility of the trade war leading to a potential currency war where all countries jostle with each other to keep their currency value low in order to attract exports that has just got less attractive due to tariff imposition.
What then would be the end game? While the Countries continue to ponder, the impact on real economic variables and financial markets are likely to be substantial.
We break this up into two parts. In the short term, global trade flows would be affected and will trigger adjustments in export and import baskets for all countries affected by the policy changes. Worsening trade flows would weigh on business sentiment in traditional manufacturing hubs and trigger a further round of GDP growth slowdown. Investment decisions would be postponed as it is difficult to make long term decisions against a backdrop of so much uncertainty without any confidence in ascertaining locational advantages. For financial markets, the growth and investment slowdown would affect sentiment in stock markets as companies start feeling the heat of demand slowdown and currencies of the most adversely affected nations would start weakening.
Over a more medium to long term horizon, assuming the worst case scenario that this “protectionism” is the new order of the world, we would finally see production bases being transferred and some jobs would be created but at what cost? Goods were not produced there in the first place because it was more expensive. Then to make it sustainable, productivity of factors of production would have to improve dramatically, otherwise all costs would go up sharply both due to tariffs and loss of efficiency. This may lead to a return of global inflation, which so far over the last decade or so has been extremely benign.
Beyond this, the benefits of globalization have ensured that a particular finished product is not manufactured fully in any one country. Instead we have what are called global value chains. As I argued earlier, several countries across the world are interconnected in producing one item of consumption. These processes are now very well entrenched and have led to countries super specializing in certain products. A change in the world order would mean that all these well-established chains would be disrupted sharply and new alliances would have to be forged. It is also possible that new global trade heavyweights would emerge. All the same, it seems that when the dust settles, it is very unlikely that countries will choose to go it alone when collaboration clearly leads to better results.
How is this picture likely to end? Is it that after a painful readjustment process, currently accepted global alliances could change markedly and give way to different ones. Or is it possible that the World returns to the pre-trade war normalcy realising the effectiveness of the efficiencies of Globalisation. Will the unambiguous benefits of global collaboration, free flow of factors of production, policy certainty and the peace dividend be apparent to all. Only time will tell.
Trade War Repercussions – this note is written by Varshika, a 12th grade student.
About the Author
Grade XII, International Baccalaureate Diploma Program, Dhirubhai Ambani International School, Mumbai