Im­pact Se­ries: 01-20

Trade Wars
in the Global Value Chain Era

Emily Blanchard
Guest Professor at Kühne Center for Sustainable Trade and Logistics, Associate Professor at the Tuck School of Business at Dartmouth College and a Research Fellow with the Center for Economic Policy Research, joining the Center as a Visiting Fellow for the academic year 2019/20

Outline

The rapid proliferation of Global Value Chains (GVCs) has changed the nature of global commerce, and with it, the political contours and economic consequences of trade protection in the 21st century. Trade wars have always been costly, but they are particularity expensive in the GVC era.

This article shares insights from recent research in economics, and explains how protectionist policies could backfire.

Full Article

The na­ture of glob­al com­merce has changed dra­mat­i­cal­ly over the past 40 years, with the me­te­oric rise of Glob­al Val­ue Chain (GVC) trade.¹ Sim­ply put, coun­tries and com­pa­nies make goods dif­fer­ent­ly to­day than in the past. In the 21st cen­tu­ry, prod­ucts are “made in the world” as nev­er be­fore, as firms com­bine raw ma­te­ri­als, in­puts, la­bor, and ideas – the many sliv­ers of val­ue added that ul­ti­mate­ly make up a fi­nal prod­uct – each sourced from around the world ac­cord­ing to spe­cif­ic cost-ben­e­fit trade­offs for every com­po­nent part of the val­ue chain. This GVC phe­nom­e­non is made pos­si­ble by in­no­va­tions in com­mu­ni­ca­tions and trans­porta­tion tech­nolo­gies, to­geth­er with in­sti­tu­tion­al and mar­ket re­forms that have al­lowed scores of coun­tries to join an in­creas­ing­ly-in­te­grat­ed glob­al trad­ing sys­tem. GVC trade – mea­sured as a dra­mat­ic rise in the trade in val­ue-added sub­com­po­nents rel­a­tive to trade in fi­nal goods – is the quan­tifi­able man­i­fes­ta­tion of this “made in the world” glob­al pro­duc­tion rev­o­lu­tion.

In turn, the rise of GVC trade has re­shaped the eco­nom­ic con­se­quences and po­lit­i­cal con­tours of trade pro­tec­tion. Trade wars have al­ways been dis­rup­tive, but they are par­tic­u­lar­ly ex­pen­sive and di­vi­sive in the GVC Era.

This ar­ti­cle builds on in­sights from re­cent re­search to iden­ti­fy three crit­i­cal di­men­sions of GVC trade that promise to make to­day’s trade wars more eco­nom­i­cal­ly cost­ly and more po­lit­i­cal­ly com­plex than pre­vi­ous trade wars. Along the way, the dis­cus­sion high­lights dis­tinc­tive as­pects of the re­cent 2018 trade ac­tions that could car­ry ad­di­tion­al, un­in­ten­tion­al costs for the US econ­o­my.

The first point is ob­vi­ous but im­por­tant: GVCs am­pli­fy the ef­fects of tar­iffs. Be­cause tar­iffs are (typ­i­cal­ly) ap­plied to the gross val­ue of a good when it cross­es the bor­der, rather than just the “new” val­ue added, every bor­der cross­ing in­creas­es the to­tal tar­iff-bill as­so­ci­at­ed with pro­duc­tion.

Con­sid­er the ex­am­ple in Fig­ure 1. Sup­pose that a pair of blue jeans is made in three stages: first, raw cot­ton is grown in coun­try A and ex­port­ed to coun­try B; then coun­try B process­es the cot­ton into den­im fab­ric, which is ex­port­ed to coun­try C; fi­nal­ly, coun­try C cuts, sews, and fin­ish­es the jeans to be sold, ul­ti­mate­ly, in coun­try A. If each coun­try im­pos­es a uni­form 10% tar­iff on all im­ports, a tar­iff will be paid three times dur­ing the pro­duc­tion process, with es­ca­lat­ing costs as the gross val­ue of trade in­creas­es from raw cot­ton, to the cot­ton fab­ric, to the fin­ished prod­uct. Had the jeans been pro­duced start to fin­ish in coun­try C, the tar­iff would be paid just once (when the fi­nal prod­uct is shipped to the con­sumer in coun­try A), and the to­tal cost of pro­duc­tion, in­clu­sive of tar­iffs, would be low­er.

The im­pli­ca­tion is im­me­di­ate: the costs of high­er tar­iffs in trade war will be greater (po­ten­tial­ly many times over) in a trad­ing sys­tem with GVC-trade than in an oth­er­wise equiv­a­lent world with­out it. The corol­lary (dis­cussed fur­ther be­low) is that high­er tar­iffs in gen­er­al, and trade wars in par­tic­u­lar, may in­duce firms to short­en or oth­er­wise re­shape their glob­al sup­ply chains.²

The costs of higher tariffs in trade war will be greater in a trading system with GVC trade

The sec­ond dis­tinc­tion con­cerns not the to­tal cost of a trade war, but the dis­tri­bu­tion of that cost across dif­fer­ent stake­hold­ers. Fun­da­men­tal­ly, GVC link­ages mean that the bur­den of tar­iffs falls dif­fer­ent­ly among con­sumers, work­ers, and firms in­volved through­out the val­ue chain. As ex­plained be­low, some of the costs of trade pro­tec­tion may ul­ti­mate­ly be borne by up­stream pro­duc­ers in the coun­try im­pos­ing the tar­iff,³ while some of the pro­duc­er-side ben­e­fits from trade pro­tec­tion en­joyed by lo­cal im­port-com­pet­ing firms may be passed along to for­eign in­ter­ests.

The same ex­am­ple of blue jean pro­duc­tion serves to il­lus­trate (Fig­ure 2). Sup­pose now that coun­try A in­creas­es its tar­iff on all prod­ucts (in­clud­ing blue jeans) to 25%. If coun­try A’s con­sumers con­sti­tute a suf­fi­cient share of glob­al de­mand for blue jeans, then an in­crease in coun­try A’s tar­iff will push down the ex­port price re­ceived by the mak­ers of jeans in coun­try C. That is, the in­ci­dence of the tar­iff will be shared by con­sumers in coun­try A, who pay high­er prices, and pro­duc­ers in coun­try C, who re­ceive low­er prices, with the gov­ern­ment of coun­try A col­lect­ing the dif­fer­ence as tar­iff rev­enue. By the same log­ic, if coun­try C’s jeans-pro­duc­ers are an im­por­tant source of glob­al de­mand for den­im fab­ric, pro­duc­ers of jeans in coun­try C will be able to pass-on some of the fall in their rev­enue to pro­duc­ers of fab­ric in coun­try B, who would then re­ceive a low­er ex­port price. In turn, if coun­try B is a suf­fi­cient­ly im­por­tant mar­ket for coun­try A’s raw cot­ton, the price of cot­ton in coun­try A will also fall. Thus, ul­ti­mate­ly, the costs of coun­try A’s tar­iffs on im­port­ed blue jeans will be shared be­tween coun­try A’s con­sumers and all of the pro­duc­ers of val­ue added em­bed­ded in the im­port­ed blue jeans, in­clud­ing, in this ex­am­ple, the pro­duc­ers of raw cot­ton in coun­try A.

The effects of higher tariffs may extend well beyond the immediate “intentional” targets at the expense of the very country that imposed the new protection

Mean­while, if coun­try A had a pro­duc­er of blue jeans com­pet­ing head-to-head with im­ports from coun­try C, that pro­duc­er would gain from the ad­di­tion­al pro­tec­tion af­ford­ed by the 25% tar­iff. But if that lo­cal pro­duc­er was owned by a for­eign in­ter­est, or sourced its in­puts from abroad, part of the ben­e­fit of that trade pro­tec­tion would again be passed up the val­ue chain, out­side of coun­try A. GVC link­ages mean that coun­try A’s ben­e­fit from tar­iff pro­tec­tion may be erod­ed, even as it must in­ter­nal­ize more of the costs of its tar­iff hike.⁴

The ex­tent to which pro­duc­ers in each coun­try bear the costs of the tar­iff de­pend on a host of fac­tors, in­clud­ing mar­ket pow­er, bar­gain­ing re­la­tion­ships, in­put cus­tomiza­tion, trade vol­umes and more. What­ev­er the de­tails, the broad im­pli­ca­tion is the same: GVC trade means that the costs and ben­e­fits of high­er tar­iffs – and by ex­ten­sion, trade wars – may ex­tend well be­yond the im­me­di­ate “in­ten­tion­al” tar­gets to in­clude coun­tries and com­pa­nies around the world, even at the ex­pense of the very coun­try that im­posed the new pro­tec­tion at the out­set.

The third point rec­og­nizes that GVCs are them­selves de­ter­mined by mar­ket forces. Be­cause GVC struc­ture is the re­sult of strate­gic sourc­ing and for­eign in­vest­ment de­ci­sions of glob­al­ly-en­gaged firms, tar­iffs may have large, long-last­ing, and unan­tic­i­pat­ed con­se­quences for the pat­tern of glob­al pro­duc­tion. If ris­ing tar­iffs (or even just the threat of a trade war) caus­es firms to change how and where prod­ucts are made in the world, this ad­di­tion­al pro­duc­tion dis­lo­ca­tion will car­ry ad­di­tion­al ef­fi­cien­cy, job, prof­it, and wel­fare loss­es. More­over, giv­en the com­plex cal­cu­lus faced by firms re­spond­ing to changes in the glob­al eco­nom­ic land­scape, there is good rea­son to be­lieve that glob­al firms may not re­spond the way the im­port­ing coun­try wants or ex­pects.

Pro­duc­tion dis­lo­ca­tion is par­tic­u­lar­ly like­ly un­der a tit-for-tat tar­iff es­ca­la­tion, in which mul­ti­ple coun­tries raise tar­iffs at the same time. All else equal, high­er tar­iffs give firms an in­cen­tive to con­sol­i­date their glob­al sup­ply net­works into few­er coun­tries, bor­der cross­ings, and (thus) vul­ner­a­bil­i­ties. But where firms choose to con­sol­i­date that pro­duc­tion de­pends on a host of fac­tors, in­clud­ing prox­im­i­ty not only to ex­pect­ed con­sumers, but also raw ma­te­r­i­al, crit­i­cal in­put sup­pli­ers, lo­cal eco­nom­ic reg­u­la­tions, pol­i­cy cer­tain­ty, ac­cess to skilled and low-cost la­bor, and more.

To the ex­tent that some of the new US-im­posed tar­iffs in 2018 were de­signed to in­duce pro­duc­ers to “reshore” pro­duc­tion in the US, they may have the un­in­tend­ed con­se­quence of caus­ing firms to balka­nize their pro­duc­tion net­works some­where else. “Amer­i­ca first” could back­fire.

“America first”
could backfire

A note­wor­thy irony, giv­en Pres­i­dent Trump’s stat­ed goal to bring jobs back to US shores, is that the ad­min­is­tra­tion has im­posed new tar­iffs dis­pro­por­tion­ate­ly on im­port­ed in­ter­me­di­ate goods⁵— the very in­puts that are nec­es­sary for US man­u­fac­tur­ers to pro­duce and sell their prod­ucts com­pet­i­tive­ly in the US and glob­al mar­kets. If the in­tent is to in­duce US man­u­fac­tures to “re-shore” pro­duc­tion to the US (or to dis­suade US firms from mov­ing fi­nal as­sem­bly/down­stream pro­duc­tion over­seas), low­er tar­iffs on im­port­ed in­ter­me­di­ate goods would be in or­der. High­er tar­iffs on in­ter­me­di­ate goods – to­geth­er with in­creased un­cer­tain­ty over the fu­ture of US tar­iff pol­i­cy more gen­er­al­ly⁶ – seem all but de­signed to in­duce firms to shift their cur­rent pro­duc­tion pat­terns away from the US and into “fac­to­ry Asia” or “fac­to­ry Eu­rope”.

Glob­al firms seem to ap­pre­ci­ate the im­por­tance of these GVC link­ages and what they mean for the po­ten­tial es­ca­lat­ing and unan­tic­i­pat­ed costs of trade wars. The US Cham­ber of Com­merce has been a re­lent­less ad­vo­cate for a quick and am­i­ca­ble res­o­lu­tion of the 2018 trade fric­tions. At the same time, the Unit­ed Steel­work­ers union, which rep­re­sents near­ly 1 mil­lion US work­er-mem­bers in man­u­fac­tur­ing, met­als, forestry and be­yond – in­dus­tries that em­ploy work­ers up and down the val­ue chain across myr­i­ad trad­ed prod­ucts – was an out­spo­ken crit­ic of both rene­go­ti­at­ing NAF­TA and the US steel and alu­minum tar­iffs against Cana­da. Per­haps most no­tably, un­til re­cent­ly, many gov­ern­ments had been im­ple­ment­ing poli­cies con­sis­tent with a so­phis­ti­cat­ed un­der­stand­ing of the re­la­tion­ship be­tween GVCs and trade pol­i­cy. Ac­cord­ing to sev­er­al stud­ies, the con­tours of GVC link­ages and firms’ glob­al sourc­ing op­er­a­tions were re­flect­ed in trade pol­i­cy be­fore the 2018 trade war, not least in the US.⁷

How will firms shift, consolidate, and potentially balkanize their production to mitigate the costs of tit-for-tat tariffs and the uncertainty of future trade wars?

Ear­ly ev­i­dence sug­gests that even in the very short run, the 2018 trade war is tak­ing a toll on US firms and con­sumers.8 The key ques­tion in the months and years to come, is how, if these tar­iffs con­tin­ue, they be­gin to feed back through glob­al val­ue chains at the ex­pense of firms and work­ers in the US, Chi­na, and around the world. How, ul­ti­mate­ly, will firms shift, con­sol­i­date, and po­ten­tial­ly balka­nize their pro­duc­tion to mit­i­gate the costs of tit-for-tat tar­iffs and the un­cer­tain­ty of fu­ture trade wars? The con­se­quences of this trade war may be slow to un­fold, and long last­ing once they do.