Playing Trade War Chicken

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Economists are predicting that the next recession will occur in or around 2020, as the Fed increases interest rates to tamp down an overheated economy, and the U.S. engages in a series of trade wars. Notably, the Trump Administration has more control of trade policy than the degree to which the economy overheats. So why then, has it used that control to propel the country into a series of trade wars with the rest of our major trading partners? U.S. Treasury secretary Steven Mnuchin has had some difficulty providing an articulate answer to this question.

Steven Mnuchin, U.S. Treasury secretary, speaks during a House Financial Services Committee hearing in Washington, D.C., U.S., on Thursday, July 12, 2018. Mnuchin said U.S. tariffs and retaliation by major trading partners haven’t dented the domestic economy, as he sought to calm fears from Republicans in Congress that a trade war is hurting American consumers and companies. Photographer: Andrew Harrer/Bloomberg

Is the answer to this last question “loss aversion,” as Neil Irwin suggested in an article that recently appeared in The New York Times? As a behavioral economist, I would argue this suggestion is not quite correct. Below, I explain why, and then move to the more important question of: if not loss aversion, then what?

Metaphorically, President Trump’s trade war policy involves the U.S. playing games of “chicken” with multiple parties around the world. In the real version of chicken, two cars move towards each other at high speed, and the one to swerve first loses the game. The way to win at chicken is to signal strongly that you will not swerve, no matter what. Of course, this is risky.  If the drivers of both cars truly follow this strategy, then both lose big.

Back to psychology: Playing chicken is risky. One of the most important findings about the psychology of risk is that people who face the prospect of accepting a sure loss will be much more inclined to take risks than otherwise. This phenomenon is called “aversion to a sure loss.” That is, people will fight by taking risks to avert sure losses.

In his article, Irwin argues that people who have been on the losing end of freer trade are much more willing to fight than those who came out ahead, a trait he attributes to loss aversion.

Technically, loss aversion is the tendency to experience a loss more acutely than a gain of comparable magnitude. Psychologists suggest that on average, the pain of loss is between two and three times as great as the pleasure from gains of comparable magnitude. The thing is that loss aversion explains why people are reluctant to take risks that feature the possibility of both gains and losses. However, loss aversion does not explain why people take risks to avoid having to accept sure losses.

It is important to get the psychology right, especially in these days where truth is under attack.

I do believe that aversion to a sure loss is playing an important role in explaining why President Trump is taking the U.S. into a series of trade wars. Indeed in my previous writings, I have argued that aversion to a sure loss played an important role in the U.K. Brexit vote and in President Trump’s election victory over Hillary Clinton.

However, there is something else to understand about aversion to a sure loss, and it is this: People are not just willing to take risks to avert a sure loss; they are willing to take imprudent risks, meaning that risks that do not pay off on average. Therefore aversion to a sure loss induces people to behave by hoping to beat the odds.

The concern with President Trump’s trade war policy is that we, and our trading partners, are now engaged in a series of imprudent risks.

In an interview last week, Fed Chair Jerome Powell was clear to say that he is aware of the risks that these trade wars are imposing on the U.S. economy, and that he will employ the traditional Fed approach, presumably reducing interest rates, should the economy slow. Powell also acknowledged the existence of those who have lost from liberalizing global trade.

The Fed Chair is no doubt aware that the U.S. yield curve is almost flat, indeed as flat as it has been in over a decade. In recent memory, recessions have always been preceded by yield curve inversions. So although equity markets do not seem especially alarmed about the impact of a trade war on the overall economy, bond markets appears to be on the verge of sounding the recession alarm.

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