Trade Policy and the Risk of a Trade War

A Review of The Pros, Cons & Risks of a Trade War vs Open Trade

Posted 2 months ago

Key Takeaways

An all-out trade war could reduce U.S. GDP by 0.9% by 2027 and 5.3% by 2040, while wages could fall by 1.1% by 2027 and 4.8% by 2040.
A trade opening could increase U.S. GDP by 0.2% to 0.7% by 2027 and 1.3% to 4.0% by 2040, with wages rising by 0.3% to 0.8% by 2027 and 1.2% to 3.6% by 2040.
The downside risk of a trade war is significantly larger than the potential upside of a trade opening.

Introduction: U.S. Trade Policy and the Risk of a Trade War

On March 8, 2018, President Trump signed an executive order imposing 25% tariffs on steel and 10% tariffs on aluminum imports, with the new policy taking effect on March 23, 2018. The announcement quickly drew reactions from major U.S. trading partners, signaling potential retaliatory tariffs and sparking fears of a trade war.

Trade War vs. Trade Opening

President Trump suggested that these tariffs might ultimately lead to a reduction in foreign tariffs on U.S. exports, producing a trade opening instead of a prolonged trade war. While game theory supports the possibility of such an outcome, it does not guarantee it. The final resolution depends on how the U.S. and its trading partners value their trade relationships.

The economic impact of either scenario—trade war or trade opening—is significant, with long-term consequences for GDP, wages, capital investment, and labor services in the U.S.

Economic Impact of a Trade War

Short-Term Effects (By 2027)

In the event of an all-out trade war:

GDP would decline by 0.9%.
Wages would fall by 1.1%.
Capital services would drop by 3.0%, reducing overall investment in the U.S. economy.

Long-Term Effects (By 2040)

If a trade war continues, the economic consequences become more severe:

GDP would decline by 5.3%, a significant contraction relative to current policy.
Wages would drop by 4.8%, impacting household income and purchasing power.
Capital services would fall by 14.8%, further stifling investment and economic growth.

Economic Variable	2027 (Trade War)	2040 (Trade War)
GDP Change	-0.9%	-5.3%
Wage Change	-1.1%	-4.8%
Capital Services	-3.0%	-14.8%

Economic Impact of a Trade Opening

Short-Term Benefits (By 2027)

A trade opening—where tariffs are reduced globally—would lead to economic gains:

GDP would rise between 0.2% and 0.7%.
Wages would increase by 0.3% to 0.8%, benefiting workers across the U.S.
Capital services would grow by 2.3%, encouraging greater investment.

Long-Term Benefits (By 2040)

If global trade barriers were further reduced:

GDP would increase by 1.3% to 4.0% relative to current policy.
Wages would rise between 1.2% and 3.6%, improving standards of living.
Capital services would expand by 11.1%, driving economic growth and productivity.

Economic Variable	2027 (Trade Opening)	2040 (Trade Opening)
GDP Change	0.2% to 0.7%	1.3% to 4.0%
Wage Change	0.3% to 0.8%	1.2% to 3.6%
Capital Services	2.3%	11.1%

The Financial Account and Debt Dynamics

Impact on Debt Financing

A trade war would likely reduce the foreign purchase of U.S. Treasury debt, forcing the U.S. government to rely more heavily on domestic financing. This could:

Divert capital away from private investments that drive economic growth.
Lead to an increase in debt held by the public, further burdening the U.S. economy.

In contrast, a trade opening would allow the U.S. to sell more Treasury debt to foreign investors, freeing up capital for domestic investments and improving overall economic productivity.

Sensitivity Analysis: Different Levels of Trade Openness

50% Open Scenario

In a more moderate scenario, where the U.S. economy becomes 50% open to trade:

GDP would increase by 0.2% by 2027 and by 1.3% by 2040.
Wages would rise by 0.3% by 2027 and by 1.2% by 2040.

100% Open Scenario

In a highly optimistic scenario, where the U.S. is fully open to trade:

GDP could increase by 1.4% by 2027 and by 8.0% by 2040.
Wages would grow by 1.6% by 2027 and by 7.2% by 2040.

However, achieving 100% trade openness is highly improbable due to the size of U.S. capital markets and other structural limitations.

Economic Variable	50% Open (2027)	50% Open (2040)	100% Open (2027)	100% Open (2040)
GDP Change	0.2%	1.3%	1.4%	8.0%
Wage Change	0.3%	1.2%	1.6%	7.2%

Conclusion: Trade War Risks vs. Trade Opening Gains

Our analysis shows that the potential downside of an all-out trade war far outweighs the potential upside of a trade opening.

A trade war could reduce GDP by 5.3% and wages by 4.8% by 2040, significantly harming the U.S. economy.
In contrast, a trade opening could increase GDP by up to 4.0% and wages by up to 3.6%, but these benefits are still limited compared to the risks of a trade war.

Key Considerations:

Trade war results in long-term economic contraction, lower wages, and reduced capital investment.
Trade opening offers modest economic gains, but achieving full openness is unlikely.