U.S. President Donald Trump, left, and Xi Jinping, China’s president, attend a news conference at the Great Hall of the People in Beijing, China. (Photographer: Qilai Shen/Bloomberg)

Using Game Theory to Explain the U.S.-China Spat

(Bloomberg Businessweek) -- Picking a fight with a trading partner seems like a bad idea, but it’s not necessarily irrational. Probing a partner’s weaknesses can be an effective way to get a better trade deal, according to game theory, the branch of mathematics that deals with strategy. It sometimes makes sense for countries to “test each other’s resolve,” says Ethan Harris, head of global economics at Bank of America Merrill Lynch. “The act of putting on tariffs teaches you something about the other side,” in particular its willingness to retaliate, Harris says. It worked for the U.S. when it threatened South Korea with steel and aluminum tariffs; the Koreans quickly made concessions to escape the tariffs.

The problem with tit for tat is not irrationality, but miscalculation. If each country keeps escalating in the mistaken expectation that the other side will eventually back down, the result will be high tariff barriers and a reduction in cross-border commerce that leaves both sides worse off. That’s the risk the U.S. and China are courting.

Tit: On June 15, President Trump said the U.S. would soon begin charging duties on $50 billion worth of Chinese imports in response to what he says are decades of theft of American know-how. Trump has also signaled he wants to reduce America’s $376 billion trade deficit in goods with China.

Tat: China’s Ministry of Commerce immediately responded with a statement saying it would counter Trump’s measure with “equal scale, equal intensity.” Beijing is targeting soybeans, corn, wheat, rice, sorghum, beef, pork, poultry, fish, dairy products, nuts and vegetables, and autos, among other products.

Tit: Unhappy with China’s reaction, Trump on June 18 asked his staff to produce a list of $200 billion worth of additional Chinese goods that he could subject to punitive tariffs.

Tat: China said that “if the U.S. loses its senses and publishes such a list, China will have to take comprehensive quantitative and qualitative measures.”

Experts surveyed by Bloomberg News lay out four scenarios for how the U.S. trade conflict with China could end: Both sides back down, which now seems unlikely in the short term; China blinks; the U.S. blinks; or both sides keep escalating.

The “China blinks” scenario assumes President Xi Jinping won’t want to endure a downturn in the Chinese economy, which showed signs it underperformed in May. The “U.S. blinks” scenario assumes China calls Trump’s bluff, knowing how much he enjoys a strong economy, rising stock market, and the support of voters in farm states that China could target.

The fourth scenario, in which neither blinks, is the most damaging. “We’re not there yet, but it’s scary, because it seems like we’re on a path toward major conflict, and it’s hard to see the offramp,” says Michael Smart, managing director at Rock Creek Global Advisors LLC in Washington and a former international trade director on the National Security Council.

The World Trade Organization was created to prevent exactly this kind of bluffing and brinkmanship. “Trade agreements are a way of escaping from a prisoner’s dilemma in which each country acting rationally is stuck doing something that is bad for it individually, but they can’t get out of it without a collective agreement,” says Dartmouth College economist Robert Staiger.

Trump is convinced he can do better. So far, U.S. stocks have held up pretty well, strengthening his hand. That may not last, though. “I’ve been amazed at the complacency of markets as Trump marches off to trade war,” Paul Krugman, a Nobel laureate economist, wrote on Twitter on June 19. Chinese stocks have been sinking: The Shanghai Composite Index fell almost 4 percent, to a two-year low, on June 19. It rose slightly the next day after People’s Bank of China Governor Yi Gang made reassuring remarks. “Things could get a lot worse if the trade war escalates and China fights back in an unconventional way,” says Hao Hong, chief strategist with Bocom International Holdings Co. in Hong Kong.

No one’s backing down yet. Says Merrill Lynch’s Harris: “China thinks they can wait it out longer. Trump thinks he can hit them harder. They’re not just beating each other up for the fun of it. They think they have an advantage, and they’re only slowly learning that maybe they don’t.”

©2018 Bloomberg L.P.