The US- China trade war is a short-term phenomena that will correct itself despite the warnings of some. The pessimists cite the classic Prisoner’s Dilemma model as the reason a trade war will have long-term consequences. This is wrong…
In the Prisoners Dilemma, two felons are confined separately and interrogated. They are offered the choice of snitching on their fellow culprit with the reward being freedom or clamming up and risking that their accomplice snitches. The equilibrium in the game is the (snitch,snitch) pair where they both fess-up and they both go to jail. The optimal strategy, on the other hand, is the (clam,clam) pair which ensures that they both go free.(1)
Despite its romantic left-wing appeal(2), it is a little known fact that the Prisoners Dilemma actually breaks down in a world where the fuzz can re-interrogate a prisoner – the so called ‘repeated game’. In this more realistic setting, snitching on your mate does not allow you to walk free – the police just pick you up again and you, too, go to jail. So the optimal strategy in the repeated game is to (clam,clam) thus ensuring that both felons remain free.
The reality is that trade wars are repeated games with the optimal strategy being the Free Trade choice. The US sanctions China and China responds tit-for-tat. This goes on for a few rounds, makes headlines, but eventually the sanctions are abandoned and we all live happily ever after. If the optimal strategy is Free Trade, why would the US impose sanctions and why would China respond? In the case of the US, there is always a saddle-point in mixed strategies and it may be advantageous to test your friend and opponent’s resolve. In the case of China’s response, the tit-for-tat sanctioning is a method for proving China’s credible threat point. But once the Punch and Judy show is over, it is in the interest of all parties to return to the Free Trade position as soon as possible.
(1) This was a major discovery in economic theory since, prior to John Nash’s Nobel prize winning insight, it had always been held that equilibrium strategies were simultaneously optimal and vice versa. Nash showed that the equilibrium could be sub-optimal
(2) Governments and other Left Wing entities use the Prisoner’s Dilemma to justify almost everything