How does a trade war work? Is it possible that countries, not directly involved in the trade war, suffer?

In a recently published paper by Antoine Bouët and David Laborde entitled:

“US Trade Wars with Emerging Countries in the 21st Century Make America and Its Partners Lose Again”

The authors make poignant arguments in a context of the rising protectionist rhetoric by the Trump administration and the impact of trade wars initiated by a change in US trade policies. They consider that such trade wars can hurt developing countries and damage the global trading system without any gains for the United States. They use a static multi-country, multi-sector Armington trade model to evaluate 6 modalities of 3 potential trade wars—for a total of 18 scenarios—between the United States and China, between the United States and Mexico, and between the United States and both China and Mexico. In each case, trade retaliation is analyzed by a Nash equilibrium.

The conclusion of the paper is that “there is no scenario in which the US government benefits its domestic welfare or gross domestic product. The authors think that there may be sectoral gains in value-added in the United States, but they are small and to the detriment of other sectors. Losses for China would be small but potential losses for the Mexican economy are significant.”

There is no doubt that trade relations among nations made a hard turn after the British referendum so called Brexit supporting the departure of the United Kingdom from the European Union took place. Additionally, the election of Donald Trump, may be the seal on the coffin for a step backwards taking protectionist measures particularly threatening China, Mexico, and Germany with import duties. Trump said many times that he would “impose tariffs of 35 percent on Mexican imports and 45 percent on Chinese imports to protect American jobs from unfair foreign competition.” One of his first actions as newly elected President was to sign an executive order withdrawing the United States from the Trans-Pacific Partnership; however, this move was largely theater of the absurd because the deal had not been ratified by the US Congress.

The important fact to consider is that all three countries are members of WTO; the United States and Mexico have been members since the birth of the institution in January 1995. China became a full member in 2001. The two trade relationships--US-China and US-Mexico--are substantial, principally for Mexico, for which the United States represents 81 percent of total exports of goods and 47 percent of total imports.

However Trump doesn’t have a free hand on the issue of imposing tariffs for two important reasons:

1.-Under U.S. law he cannot target the imports of individual companies. Trump's threat, for instance, to impose a border tax on Chevrolet hatchbacks shipped from Mexico would be discriminatory if it applied only to GM.

2.-All three countries are members of WTO and must follow the rules stated in its charter. Therefore, in the absence of NAFTA, the average tariff on Mexican exports to the United States would be 3.7 percent, whereas the average tariff on US exports to Mexico would be 7.4 percent. About 25 percent of US exports would be subject to tariffs above 5 percent. On the other hand under WTO rules, only 15 percent of Mexican exports would be subject to tariffs above 5 percent.

In other words Mexico would have a lot of room to raise tariffs, up to its WTO bound rates of about 35 percent. In contrast, the United States has less room to adjust its tariff rates without breaching WTO rules because Normal Trade Relations (NTR) and/or the Most Favored Nation (MFN) the US tariff rates of about 4 percent are already at their bound rates. Furthermore, the US is China's largest trading partner, accounting for about 20% of China's export market

Under this scenario tariffs would be re-imposed on United States imports and exports. Manufacturing jobs would be exposed in many of the states that elected Trump president. Moreover, global supply chains would be disrupted, making American—Canadian—Mexican industries less competitive with European and Asian companies. A trade war between China and the U.S. represents the biggest risk to the stock market's record rally. Also, it would reduce real incomes around the world by 3.5 percent on average. For numerous U.S. companies, China is their number two market and revenue-generator in global trade. For many others US business, China is already number one, therefore, new barriers that surface from a trade war will have domino effect could devastate American enterprises and have a negative impact on the overall economy.