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This a rudimentary game of ‘chicken,’ which is often referred to in ‘game theory’ made famous by John von Neumann and Oskar Morgenstern. Now, let us put names to the players. A is Donald Trump, who has made his intentions clear. B is a combination of various countries that have been targeted by the US President.
Trump has imposed higher import tariffs to correct uneven trade relationships with Canada, Mexico and China already. The EU, UK and India can also be clubbed with this group. Trump has also said that if the Brics bloc tries to deal in currencies other than the dollar, then he would drastically raise tariffs on US imports from its member countries.
With “America first” as its slogan, Uncle Sam is calling the shots. How would economic theory describe this situation?
Trump made some strong statements while campaigning. As part of the famous ‘announcement effects’ in economics, markets reacted to his spoken policy proposals right after he got elected in November 2024. US bond yields rose and the dollar rallied, for example, leading to disruptions.
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Are markets efficient? The ‘efficient markets’ hypothesis says that if information is known to all market players (in this case, Trump’s set of policies), then it gets reflected in market prices. Therefore, markets are efficient. It is just that markets are mostly still awaiting actual policy changes in the US.
What would the B group of nations do? Is A’s threat credible? Yes, as A has already slapped Mexico, Canada and China with tariffs. But what about others? Is it just ‘cheap talk’? The answer may depend on how B countries respond. Canada and Mexico have announced retaliatory tariffs.
While US implementation time-lines have not been spelt out in other cases, signals of its trade policy shift are clear. This is the ‘signalling effect’ of game theory. As it is based on moves initiated, it is firmer than the ‘announcement effect.’
Game theory is all about each party conjecturing how the other one reacts to any move made. China is still trying to digest the US move, while the EU may be bracing for action too.
Here, we should look at US trade numbers. Based on data for 11 months of 2024, its trade deficit is around $ 1 trillion. Of its imports of around $3 billion in those 11 months, 62% came from Canada, Mexico, the EU, China and the UK. These goods face higher tariffs that would hurt the economies of exporters. American’s tariffs aimed at Canada and Mexico cover imports worth an estimated $900 billion.
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The American exports picture is equally interesting. Of its exports of a little less than $2 trillion during the 11-month period, Canada, Mexico, the EU, China and the UK accounted for 55% of the total.
Therefore, game theory suggests that instead of swerving left under A’s threat, all B countries could take a counter call to impose retaliatory duties on imports from the US, as Mexico and Canada plan to do. If such signals of retaliation are sent, the US might reconsider its approach.
If the US faces weak resistance, it will get to call others “chicken” as it ploughs its way through.
Interestingly, the Bureau of Economic Analysis in the US shows that total outward US investment outstanding as of 2023 was nearly $6.7 trillion. Out of this, the EU accounts for about $2.6 trillion, the UK almost $ 1.1 trillion and the three others $720 billion. So if this group of countries decides to also impose, say, a higher corporate tax rate on American companies, then their message to A would get even stronger.
Game theory would advocate ‘collusion’ among all the exporters targeted by A, as a common strategy would serve their interests better. In other words, B countries need a single voice that sends counter messages to A, indicating the actions that would be taken by all in response to A’s raising of import barriers through higher tariffs.
In this strategic game, conversations between the potentially affected countries are necessary. Such talks would send the US a strong message. But this collusion has to be credible, and this is where the challenge lies. Political and ideological differences could come in the way of such an alliance, as every participant would have an individual agenda.
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Alternatively, countries may choose to individually negotiate with the US in a manner that serves their particular interests. This approach has already injured the World Trade Organization, which has more or less become irrelevant as countries have shifted to forging bilateral or multilateral agreements that keep out the rest of the world.
For strategic collusion to work, with both A and B swerving eventually to avert a clash, a credible collective retaliatory signal will have to be sent that might make the US rethink its path. Canada and Mexico appear to have acted together, while others may be mulling their options. If the US faces weak resistance, it will get to call others “chicken” as it ploughs its way through.
These are the author’s personal views.
The author is chief economist, Bank of Baroda, and author of ‘Corporate Quirks: The darker side of the sun’.
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