The game theory and Trump’s trade strategy

Financial markets were of two minds last week about the impact of mounting trade tensions between China and the US.
On the one hand, the escalating tit-for-tat tariffs still affect only a relatively small part of the two countries’ economies. The consensus baseline remains that the measures should not have a significant and lasting downward impact on the economy and stocks and, ultimately, may help bring about trade that is still free but fairer.
On the other hand, each escalation (the latest is the July 10 announcement by the Trump administration of its intention to impose import duties on an additional $200 billion of Chinese products) increases the market’s downside risk scenario of slipping, either on purpose or inadvertently, into a full-blown trade war that would significantly damage corporate earnings and the overall growth outcome.
And there is a third possible scenario for international trade that hasn’t yet captured the attention of markets: A ”Reagan moment” that has an upside, though it is less probable than the downside scenario, that goes beyond tweaks to the existing system by delivering changes in the overall global economic landscape that favor the US in both relative and absolute terms.
Making firm predictions on probability distribution of these three possible outco-mes is challenging. The answer will depend on a lot more than just economics and finance. Domestic politics also play important role, and the current polarised environment adds to the complexity of reconciling compe- ting expectations with reinvigorated global harmony.
Here are some insights from game theory on what to watch and expect.
An inherently cooperative game is increasingly played uncooperatively: The Trump administration is taking a disruptive approach to trade, and several other areas, by shaking things up as a means to fix what it views as asymmetrical components that undermine the fairness of the system and harm the US. It has resorted to unilateral tactics that combine actual tariff actions with threats of escalation, instead of continuing to rely on the rules-based system that has underpinned the post-World War II international economic order.
In game theory terms, the Trump administration has introduced a notable “uncooperative” element to the inherently “cooperative game” of international trade. Most economists worry about the implications for individual countries and the system as a whole. Trade wars tend to create a strong stagflationary impulse, disrupting growth and increasing costs and prices. The conflicts complicate domestic policy management and increase the risk of financial instability.
Further escalation is the most likely outcome for now: For trade tensions to be a means to a better end, individual country behaviours must change in a manner that is visible, verifiable and durable. This is par-
ticularly true of China’s approach to intellectual property, market access limits and joint venture requirements, which are a longstanding source of friction with the US, as well as other countries. Until there are indications of durable change, the most likely American strategy will be to increase the pressure on China, even though that carries significant risks for all.
The game is inherently unbalanced: Whether by accident or design, the US is now playing in an uncooperative game that it is well placed to win in relative terms. For many reasons, trade tensions are less damaging for US th-an for China, whose growth model is still notably depen-dent on foreign markets. Th-is relative advantage is alre- ady evident in the performance of equity and currency markets of two countries.
While this advantage certainly isn’t protection against some absolute damage, it gives the US a stronger hand to play. The situation resembles the 1980s, when President Ronald Reagan emba- rked on a military spending race with the Soviet Union, a contest America was destined to win, albeit with costs and at considerable risk.
Public accusations and counter-accusations make trust difficult: Restoring gre-ater trust between China and US is key to re-establishing a durable cooperative game. This requires behind-closed-door meetings that set aside accusations currently being levied by both sides, and focus on immediate confidence-gaining steps as well a framework for resolving the inevitable misunderstandings and misperceptions that are likely to arise.
You can get there faster through coalition-building: Given that America’s genuine grievances against China are shared by other countries, it would be in the US interest to build coalitions early on. Although the alliances could complicate the bilateral negotiations the US wishes to pursue with those countries, they would help accelerate the effectiveness of its approach toward the bigger issue of China and reduce the risk of costly global economic fragmentation. This would also impart more of a multilateral tone to a notably unilateral approach, helping to safeguard an international architecture that, while it needs modernizing reforms at several levels, still serves the US and the world well.
Implementation is trickier than design: These steps are very difficult to calibrate. Trust is low, both in terms of domestic politics and between countries. A good understanding of other nations’ reactions is essential, as well as an openness to course correction as an uncooperative game becomes increasingly unpredictable. Moreo- ver, on the domestic front, well-communicated, timely and coordinated White Hou-se decision making is key to maintaining the needed buy-in from broad segments of the population and Congress.
These seven insights are key to assessing benefits, co-sts and risks of Trump administration’s unconventio- nal approach to global trade.

— Bloomberg

Mohamed A. El-Erian is an Egyptian American businessman. He is chief economic adviser at Allianz, the corporate parent of PIMCO where he served as CEO and co-chief investment office