By now, anybody who is anybody – and plenty who aren’t – has
had their say on the Trump tariffs and their possible implications. Much ink
has been spilled documenting the twists and turns of the Trump Administration’s
actions and the subsequent market movements. If there is one lesson to be
learned from recent weeks, it is not to overreact to latest events because
likely as not, there will be a rollback which renders the previous position
invalid. That is not to say markets are wrong to sell off/rally as Trump’s
whims dictate – after all, investors have to take a position based on available
information because each signal from the White House alters the landscape of
risks, costs and growth expectations. But it is no way to run an economy.
More than a game
One way to think of Trump’s strategy is through the prism of
game theory, and there are some elements which echo the main findings of Thomas
Schelling’s classic 1960 book, The
Strategy of Conflict – a seminal work in game theory and strategic
decision-making, particularly in the context of conflict, negotiation, and
deterrence. One of the key takeaways of Schelling’s work is that conflicts
are not merely power plays that pit one side against another, but are instead
contests that highlight strategic interdependence – in other words, the
actions of one player have an effect on the strategy of the opponent.
Schelling also highlighted the role of brinkmanship
in which pushing one party further outside their comfort zone forces them to
change their own strategy. This is very clearly the case in the context of the
US-China trade row which threatens to inflict significant economic damage
unless cooler heads soon prevail. China responded to the 145% levy on exports
to the US with a tariff of 125% on US imports, highlighting the impact of
brinkmanship. But the strategic interdependence element also came into play when
the US exempted Chinese-made smartphones from higher import levies – the number
one Chinese export to America by value – when the inflationary impact of
smartphone tariffs became clear. It was a small de-escalation in a much bigger
dispute but it highlights that there are some people in the US Administration
who appear to understand the risks of escalation.
Another game theory concept highlights what can happen if
actors in the dispute focus purely on the pursuit of their goals – Martin
Shubik’s dollar auction
problem which I originally used as a demonstration of the irrationality of
Brexit negotiations. In brief, the dollar auction problem is a two-person
thought experiment in which a dollar is initially auctioned off at a
substantial discount to its face value. In subsequent rounds the price is bid
up, with the highest bidder winning. But the twist is that the loser must also
pay their bid. Consequently, both bidders have an incentive to continue bidding
beyond the value of the prize in order to minimise losses, which results in a
lose-lose outcome.
In the trade context, neither China nor the US wants to
look weak in the eyes of the world leading to a cycle of escalating
tariffs, even when both countries incur economic losses. The rational solution
to this problem is to back down early or find a co-operative solution which
minimises losses for both sides. Unless this approach is adopted, the key
lesson highlighted by the dollar auction paradox is that once the bidding
process becomes entrenched, the competing parties lose sight of their original
goals and produces an outcome where the costs of winning outweigh the cost of
defeat.
Credibility and how to lose it
One aspect of Schelling’s work that has not been adhered
to is the principle of credibility. Schelling made the point that in
strategic interactions, the ability to credibly commit to a course of action
conveys a decisive advantage and that threats and promises must be credible to
be effective. In the case of trade, however, Trump has not acted credibly. He
has backtracked on his tariff policies on a number of occasions, leading many
to wonder whether he is bluffing. While Trump sets great store by the art of
the deal, the art of the bluff can take you a long way in life, love and poker.
But bluffing only works if opponents believe the bluffer will follow through.
While Trump has the power to impose tariffs, the question is whether doing so
is politically or economically wise. According to
a recent poll, 56% of respondents disapprove of his handling of the economy
while 75% believe tariffs will push prices higher in the short-term. If Trump
were attempting a further run for the White House, it would be politically
dangerous to go further with the tariff policy. But because he is not bound by
this constraint, further trade escalation cannot be ruled out, especially since
34% of poll respondents believe Trump's economic policies will pay off in the long
run (admittedly down from 41% at end-March).
We cannot continue in our game theory mode without talking
about a Nash equilibrium – a situation where
no player can improve their outcome by unilaterally changing their strategy,
assuming the other players keep their strategies unchanged. Since high US
tariffs hurt domestic consumers, the US might improve its welfare by lowering
tariffs — even without immediate Chinese reciprocity. This suggests that the
current position does not represent a stable Nash equilibrium. But since US
tariffs also make China worse off, China has an incentive to reciprocate by
reducing its own tariffs. Rolling this forwards, both sides engage in tariff
reduction until the point at which we reach a stable welfare position. Such a
strategy works because it builds trust gradually and is credible, even in the
absence of explicit cooperation.
Trust busting
Looked at from a logical standpoint, Trump’s trade policy
appears inconsistent because (a) it will make US consumers worse off and (b)
he has not followed through on his calls, undermining their credibility. Against
that, his policy could be seen as a form of calculated ambiguity or
strategic brinkmanship, with Trump attempting to pressure trading partners into
concessions and rallying domestic support by appearing strong on trade. By
merely postponing tariff implantation, Trump keeps everyone off balance, thus
enhancing his leverage and keeping his threats alive without fully committing.
Perhaps the best definition of the current situation is one
of strategic ambiguity, based on the goal of retaining flexibility in order to
exert pressure and manipulate expectations. Such a strategy might work if
the short-term volatility serves a longer-term purpose, but other than
putting maximum pressure on China, it is hard to see what the longer-term
plan is. At some point Trump has to commit on tariffs one way or the other
but when he does, he will have to accept the consequences. America’s putative allies
may be amenable to Trump’s threats but China most certainly is not.
Last word: Common sense is not so common
All of this may sound like obvious common sense – don’t escalate conflicts that hurt both sides, don’t bluff unless you’re willing to follow through, and don’t ignore the long-term consequences of short-term moves. Yet time and again, these lessons are ignored in the heat of political battles. This is where game theory proves its value: not as an abstract academic exercise, but as a practical framework for understanding strategic behaviour and anticipating outcomes. By highlighting the incentives, interdependencies, and likely responses of all players, the theory of games offers a rational lens through which to view even the most irrational-seeming policies.
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