Spaghetti-bowl trade deals could alter the global balance of power

It is worth going back to that note two weeks later, over which Trump has shifted course after a sharp reaction in financial markets saw US bond yields rise while the dollar lost value.

Also Read: Vivek Kaul: ‘Stupid, stupid, stupid’ is the only way to describe US tariffs

There are two statements in the USTR note that make for interesting reading a fortnight later. First, it says that the US government has assumed that “offsetting exchange rate and general equilibrium effects are small enough to be ignored." This means that there would be no significant second-round effect of US tariff hikes, which is akin to saying that there would be no ripples after a rock is chucked into a pond. Ignoring general equilibrium effects in an interconnected global economy is not what the doctor—or textbooks—ordered.

Second, the USTR noted: “While individually computing the trade deficit effects of tens of thousands of tariff, regulatory, tax and other policies in each country is complex, if not impossible, their combined effects can be proxied by computing the tariff level consistent with driving bilateral trade deficits to zero." 

Now, with each country expected to negotiate its own trade deal with the US and a growing list of items being exempt from the tariff hikes, US policy appears to be headed for a situation that would involve just the sort of complex calculations for different countries as well as different tariff lines that the USTR formula claimed to avoid.

Also Read: How Trump’s advisors got tied up in knots over his tariff obsession

There can be two potential consequences of Trump’s campaign to replace multilateral with bilateral trade deals, which would imply a shift from a cooperative to a non-cooperative system of international trade. As always, history offers some lessons. 

The insights of American economist Charles Kindleberger on financial meltdowns in Manias, Panics and Crashes: A History of Financial Crises, originally published in 1978, remained relevant even 30 years later during the North Atlantic financial crisis that began in 2008. Kindleberger also studied the collapse of international trade after an escalating series of protectionist tariff hikes plus competitive devaluations. How international trade almost withered away is beautifully captured in a diagram that is now known as the Kindleberger Spiral.

A similar collapse in international trade is unlikely today for several reasons (fingers crossed). First, international trade as a percentage of global output is now twice as large as it was in 1930. Second, modern exchange between nations is qualitatively different, dominated by trade in intermediate goods between companies, rather than in either raw materials or final goods that consumers buy, and hence tougher to disentangle. Third, rapidly expanding trade in services is far more difficult for governments to control through tariffs that are imposed at ports of entry, which is why they are outside the ambit of even Trump’s tariffs.

Also Read: Trump tariffs: The global bond market achieved what diplomacy couldn’t

There is one area of heightened risk as well. Today’s financial markets are far bigger than they were in the 1930s, with greater levels of leverage as well. Currency values are decided in markets through flexible exchange rates, rather than by central banks through fixed exchange rates. 

Such ‘financialization’ also means that there is now an additional financial channel through which the effects of a trade shock can be amplified. It is no surprise that Trump decided to pause his tariff campaign for 90 days immediately after turmoil in US financial markets.

Nobody can foresee how the future international trading system will look like once the shocks, course changes and negotiations proceed dynamically. History points to one option—a system of trade blocs in which there will be negligible tariffs between members but high tariffs for all countries outside the bloc. 

That was what the world saw in the 1930s. 

Also Read: Ajit Ranade: The decline of trade orthodoxy and rise of anti-free-traders

For example, the British got its dominions and colonies to sign a trade deal with London in 1932—the Ottawa Accord. This was a system of imperial preference that prioritized trade between countries under British rule. Other colonial powers such as the French and Spanish had similar arrangements. The Japanese came up with their own zone of influence, the Greater East Asia Co-Prosperity Sphere.

We no longer live in a world of colonial powers, but the experience of the 1930s suggests that groups of countries could build protective tariffs walls around themselves, with relatively free trade for those within these walls. This means markets will effectively become smaller than before, with all the attendant challenges in terms of division of labour, productivity and economic growth. There will be trade diversion as new supply chains are built, rather than trade creation.

A shift from the existing multilateral trade system to what Jagdish Bhagwati once described as a “spaghetti bowl" would not only be more complex, but also give immense power to larger countries that could use their heft to stare down smaller countries with little negotiating power. Each smaller country will then have a strong incentive to seek a protective umbrella from the most convenient big power, including China.

The author is executive director at Artha India Research Advisors.