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The Strategy Of "Trade Wars"

There are reports of a “Trade War” between the U.S. and China.

CNBC reports: Trade tensions, which have recently been in the spotlight, continued to simmer: The U.S. Trade Representative's office published its proposed list of around 1,300 Chinese imports that could be hit with tariffs. In response, China said via an embassy statement it opposed the additional tariffs proposed and that "it is only polite to reciprocate," Reuters reported. China's ambassador to the U.S. also told CNBC on Wednesday that his country would "fight back" against the latest measures. "This trade tension story is the biggest uncertainty for China from the external perspective and the story is developing every day," Haibin Zhu, chief China economist at J.P. Morgan, told CNBC's "Squawk Box." "Trade war, or the tariffs, are never a zero sum game. It's actually a lose-lose situation. China will probably lose more, but the U.S. will also suffer," he added. (bold added)

There are three important propositions in Mr. Zhu’s statement.

They are: 1. There is something called a “Trade War.” 2. A “Trade War” is not a Zero-Sum Game. 3. A “Trade War” is actually a “Lose-Lose” Game, otherwise known as a Negative-Sum Game.

Let’s examine these, starting with #1: There is something called a “Trade War.”

Trade, no matter what the politicians say, is a Positive-Sum Game. It’s voluntary. It makes both sides better off, or it doesn’t exist. If one side doesn’t think they’ll benefit, they walk away. For trade to happen, both sides must believe they’ll benefit from the trade. Trade is a Positive-Sum Game.

Wars, on the other hand, are Zero-Sum Games. They’re conflict over something. Or someone. Or someplace. If one side wins something, the other side loses that thing. You can only add what is subtracted from someone else. When you add together the wins and losses at the end of the day, they add up to zero. Wars are Zero-Sum Games.

So what is a “Trade War?” Is it a Zero-Sum Game or a Positive-Sum Game or some combination?

The typical pattern of strategic games in politics is Positive-Sum Game followed by Zero-Sum Game followed by Positive-Sum Game:

But trade between nations is something different: It’s a Positive-Sum Game followed by a Positive-Sum Game.

It looks like this:

If there are only Positive-Sum Games and no Zero-Sum Games, why do people call it a “Trade War?”

That brings us to proposition #2: A “Trade War” is not a Zero-Sum Game.

At first glance, this seems correct. In trade between nations, there are only Positive-Sum Games, so no Zero-Sum Game exists.

Then you look within the Positive-Sum Game. Inside every Positive-Sum Game are rules. Some of those rules are formal, like in the case of contracts. Some of those rules are informal and cultural. Some of those rules might favor one side over the other. Taken together, the rules within a Positive-Sum Game are called “institutions” by economists like Douglass North.

If one side or the other doesn’t like the rules of the Positive-Sum Game, they have two options:

1. Walk away from the Positive-Sum Game; or 2. Re-negotiate the rules of the Positive-Sum Game.

If one side chooses to re-negotiate the rules and the other side doesn’t accept the offer, there could be a counteroffer. There could be posturing. There could be a refusal to negotiate. Or one side or the other side could threaten to take the first option: Walk away.

Conflicts over rules can have huge implications, but they're not "wars." They’re embedded in Positive-Sum Games. If either side doesn’t like the new rules, they can walk away. Which means the Positive-Sum Game is over.

Fighting over the rules of a Positive-Sum Game is nowhere near as important fighting over people, places or things (To see how little tension there is in a “Trade War” vs. a real war compare Star Wars Episode I to the rest of the Star Wars movies).

Conflict over the rules of the Positive-Sum Game is a kind of Zero-Sum Game, but it’s a different kind of Zero-Sum Game: It’s a Zero-Sum Game embedded in a Positive-Sum Game. Without the Positive-Sum Game of trade, the Zero-Sum Game of “trade war” doesn’t exist.

That brings us to proposition #3: A “Trade War” is actually a “Lose-Lose” Game, otherwise known as a Negative-Sum Game.

That proposition only makes sense if you’re absolutely sure no better Positive-Sum Game exists for both sides. After all, one side might find a better trading partner somewhere else. In the case of China and the U.S., that might be hard, but it’s not impossible.

And any “losses” aren’t real losses. They’re imaginary. The losses are gains that are foregone (which many people would not consider “losses”), and they might not happen. But if they do happen, they’re the notional loss that comes from getting some benefits but not as many benefits as you otherwise might have received.

It’s not a real Negative-Sum Game like Verdun, where both sides lost soldiers from conflict. It’s an imaginary loss about a future benefit foregone that might not have happened anyway (Although, it may become real to a stockholder because expected future events are priced into today’s stock price).

But if it’s a Positive-Sum Game and everyone is benefiting, why re-negotiate it?

Sometimes, you re-negotiate the rules not just to get better rules in the current Positive-Sum Game, but also to influence the rules of other Positive-Sum Games you’re playing.

"Does President Trump really not understand that a trade war is a lose-lose situation or is he playing a smart strategic game?" Leering said in a note published on Wednesday. "There are indications the latter is the case." "It is very well possible that other countries will also give in to Trump. Trade partners such as Canada, Mexico, but also China, depend much more on American demand for their products than the other way around," he said. "US demand for Mexican and Chinese products contributes respectively twenty and five times as much to their GDP as their demand for US products adds to US GDP. Also, Canada has much more to lose in a bilateral trade war with the US than the Americans."

Whether you think Trump is right or wrong, there’s a good reason to re-negotiate trade agreements.

There is a good reason to start the poorly-named “Trade Wars”:

To get more things for your Endgame out of Positive-Sum Games.

Which, in the end, is the goal of every trade strategy.


To read more about this strategic framework, pick up a copy of A Spy's Guide To Strategy at Amazon.

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