Tariffs are an instrument of trade war if they are used not to protect or, which is the same thing, favour a particular industry, but to coerce other nations to change their policy, trade or otherwise. So, trade war erupts when tariffs are not used for protection but for coercion. The success is measured not in the differential benefit but in the differential hurt. The end sought is a trade deal, akin to a peace agreement, which is beneficial to the more powerful side. The rhetoric is appropriately belligerent and nationalistically moralistic.
So, the question is whether tariffs as the instrument of choice in the trade war hurt in the way they should to lead to victory?
Who pays the tariffs? The importer. A tariff is like a cross-border sales tax. Selling the tariffed good to the final consumer cheaper than what the importer paid, after paying the tariff, would not make sense. So, the importer and then the final consumer of the imported and tariffed good pay the tariff. Which is why the tariff is used to protect the domestic producer from foreign competitors whose products are made more expensive because they are tariffed.
The tariff incidence may be different.
The exporters can change the selling price due to the imposition of the tariff. They may reduce the price that the importers pay to take account of the newly imposed tariff so that the price the importers and the final consumers end up paying will not change after the introduction of the tariff.
Assume that the pre-tariff price is set in the exporters’ currency, e.g. in yuan. After the tariff is imposed, the currency devalues just enough to neutralize the effect of the tariff on the price in the importers’ currency, e.g. in dollars.
So, the price the importers pay in their currency, dollars, does not change with the tariff, and the price the exporters charge in their currency, yuan, also does not change after the introduction of the tariff.
As the exchange rate does, so do the terms of trade.
The imports from the country with the newly imposed tariffs will become dearer, due to the appreciated currency. Approximately by the amount of the tariff.
So, if exports from China to the US are priced in yuan and exports from the US to China in dollars, US tariffs on Chinese imports will depress US exports to China after the yuan devalues.
If in addition China imposes retaliatory tariffs on imports from the US, exports from the US to China will decline further, except if the dollar price of US exports, with new tariffs, stays at the pre-tariff level. Which it might if the US exporters to China receive subsidies from the US budget. They could then lower their price just enough to compensate for the newly imposed Chinese tariffs.
Effectively, the US taxpayer would reimburse the Chinese importers for the tariffs they pay to the Chinese government.
Third countries will matter depending on their exchange rates. If they follow the yuan and depreciate against the dollar, their terms of trade with China will not change while they will deteriorate with the US. And the opposite will be the case for countries that are effectively on the dollar.
So, the third countries can be either like China or like the US or somewhere in between with respect to the change in their terms of trade.
In any case, US trade deficit with China will increase with the devaluation of the yuan after the imposition of the tariffs.
Enter cross-border value chains i.e. the globalization of markets.
If most of the exports are produced with inputs from abroad, a lot will depend on the currency they are priced in. If Chinese imports of intermediary goods are priced in yuan, the foreign suppliers will effectively be in the same position as the Chinese final exporters. The same goes for the US foreign suppliers.
Competing producers, however, lose out to the Chinese exporters, if they do not price in yuan, while those competing with the US for the Chinese market do better. With pricing in euros or any other third country currency things change depending on the movements of e.g. the euro exchange rate.
Why would the yuan devalue?
Assume that Chinese exporters face competition within China, but also in the US and in the third countries.
(Realistically, the competition is monopolistic, but nothing much hinges on that except the precision of the exchange rate adjustment. For devaluation that fully compensates for the newly introduced tariffs, price taking has to be assumed. But given that the dynamics can turn out to be complicated, with possible overshooting and all that, I will stay with what is essentially an exercise in comparative statics. Alternatively, dynamics may be in expectations that adapt quickly to perfect foresight as everybody learns the rules of the game being played and the available strategies.)
Assume also that value chains are not just within countries or neighbours but global – it is the world trade war. So, pricing is important, and political geography to the extent that it interferes with it (with national currencies or trade policies).
(That diminishes the role of geography and thus qualifies the importance of the gravity equation, but that is also not all that consequential. Globalisation increases the competition with lower transportation costs even with the proliferation of cross-border value chains. All that increases the quantitative precision of e.g. the movements of the exchange rates, but apart from messy dynamics it does not change the comparative statics or the game of trade war.)
Then Chinese exporters face competition in the US market and can either charge US consumers with the newly imposed tariffs, to the extent that they have monopoly power, or will need to lower costs to be competitive at the given price in the US market. Reducing the costs in yuan would be deflationary in China, so the central bank will react with supportive monetary policy, e.g. with lower interest rates or with increased supply of money. That will support devaluation.
Symmetrically, Chinese tariffs on imports from the US will influence FED’s policy with consequences for the dollar exchange rate. Thus, monetary authorities will be drawn into the trade war.
The difference is the US trade deficit with China, or rather with the rest of the world, which keeps the demand for dollars. So, overall, the exchange rates will adjust so that they at least keep their dollar exchange rates where they were or lower.
The logic of the trade war is to generalise. So, businesses in the US will be pressured to cut costs (real devaluation), FED will address deflationary pressures with monetary easing, and then one or another type of sanctions on doing business with China and the rest of the world may be in store. Investments and technology transfers are discouraged and may very well be prohibited. And global value chains broken.
The strategy being to rebuild the world trade system with bilateral agreements of the US with other countries – e.g. Mexico and Canada, Japan, UK, South Korea, and then with European economies, once the EU breaks down. In the end, national economies would trade and generally do business which is bilaterally balanced (advertised as fair and reciprocal).
Tariffs cannot achieve that, so the dilemma is to give up or mobilise.