Lose-lose Reality

Game theory predicts trade wars, economists warn

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No one swerved. Source: Koji Sasahara/AP/dapd

If you’ve ever played chicken, you know a bit about game theory. It’s not just about what you decide in any given situation. It is also about what you think others will decide, and what they think you think they will do.

With tit-for-tat tariffs threatening to escalate into a trade war, world trade is increasingly resembling this kind of high stakes game. China’s new levies on US products are proof of a scenario that the European Union might also soon be facing.

As a result, German economists are turning to game theory, the study of conflict and cooperation using mathematical models, to figure out what the EU’s best strategy might be. Should the EU hit back at Donald Trump’s tariffs, as China has done, or would that just make a bad situation worse? Game theory predicts that a trade war is the most likely outcome and could stick around for a long time.

For Axel Ockenfels, one of the country’s leading economists who specialized in game theory, the situation is clear: “The trade conflict between the United States and the EU can be described with a classic game theory scenario: the Prisoner’s Dilemma.”

The Prisoner’s Dilemma describes a situation in which two suspects must independently decide whether or not to betray the other of a crime they’ve both committed. If they act cooperatively and both deny the offense, they both win. If one person acts on a presumption of hostility, and confesses to the crime and betrays the other, he or she will benefit by getting a reduced sentence. The other person will suffer, receiving longer prison time. However, if both decide to act hostile as a principal witness, they will both receive an equally long sentence. The dilemma: acting hostile, or snitching, only pays off when the other decides to deny the act, but both have a chance of higher rewards when they confess. The incentive is to snitch — and still face a long jail time.

Heads I win, tails we lose

Transferring this logic to trade policy would mean tariffs are of greatest benefit to country A, if country B takes no countermeasures. If B does respond in kind, A’s benefits fall, and B limits the damage done to them. But both still lose out. The best result for both? If neither takes aggressive action in the first place.

Things get a bit more complicated if one of the nations in question has a very large economy, whose actions can affect world market prices for the goods it imports. This logic underlies Mr. Trump’s actions. His administration is betting that while American consumers may pay more, domestic producers will benefit, not to mention the money the government gains from tolls.

Mr. Ockenfels put this in economic terms: “Cooperation and free trade do not create a very robust equilibrium,” he said. Without a culture and a legal framework of free trade, the temptation to go it alone – like the prisoner with his dilemma – can be very strong.

Karl Morasch, an industrial economist with Germany’s Armed Forces University in Munich, said game theory teaches that Europe must take robust countermeasures against the Trump tariffs. This is exactly what is happening between the US and China, and what Europe has threatened to do if the US slaps a levy on EU cars. Mutual tariffs will reduce trade and thus have a negative effect. But nonetheless, he said, counter-tariffs make sense: they will even out the negative price effects, and respond appropriately to America’s withdrawal from cooperation.

Christof Böhringer, an economics professor at Oldenburg University, agrees. His calculations suggest that US tariffs could increase American GDP by 0.13 percent. “America wins if only it imposes tariffs. But it is a clear loser if the EU and China hit back,” he said. His economic simulations suggest that the United States loses more in a trade war, giving up 0.49 percent of GDP, than the EU, which would lose just 0.1 percent. China loses most of all, minus 0.66 percent.

Don’t solve the problem – avoid it

But the problem is this: if a trade war breaks out, returning to a free trade environment could be very difficult. “In game theory terms, a trade war is a stable equilibrium,” Mr. Ockenfels warned. No country has an incentive to change strategy as long as others keep tariffs in place. This pernicious situation is referred to as a “Nash equilibrium,” named after the Nobel Prize-winning mathematician celebrated in the movie A Beautiful Mind.

Mr. Ockenfels said the Nash equilibrium is why the EU would actually be better off not taking counter-measures: “We should continue to cooperate, to avoid ending up in an equilibrium of confrontation.” Others disagree with this on political grounds, suggesting that not responding could fatally undermine the disciplinary structures of the World Trade Organization (WTO), which explicitly allow counter-tariffs.

How to square the circle? Roman Trötschel, a social psychologist rather than an economist, had one possible answer: offer Mr. Trump something he can present as a big win. The best solution, he said, would be a radical move — the EU should offer to completely abolish tariffs on both sides of the Atlantic. This is an option the US and Europe are considering, at least when it comes to the question of car levies.

Getting rid of tariffs would save free trade, while making Mr. Trump feel good about himself. Any other strategy could end up with everyone on the losing side. As we know from playing chicken, a collision can be awfully painful.

A version of this article was first published in Wirtschaftswoche, a sister publication of Handelsblatt Global. To contact the authors: m.fischer@wiwo.de and f.ritters@wiwo.de

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