Retaliation: Why raising tariffs becomes a food fight

I’ll trade my Fruit Roll-Up for your Oreos

My daughter tells me that the boys in her 8th grade routinely dump their food in the middle of the lunch table and each kid takes what they want. There’s surprisingly little fighting – they’ve worked out a system of compatible demand and supply. You could say this is a crude from of voluntary exchange – you barter your food for someone else’s that you want more or for something your mom doesn’t buy.

Outside the lunchroom, this happens every day, but it’s governed by more predictable methods of exchange like commercial contracts. Either way, the point of voluntary exchange is that it works because everyone involved perceives they are better off. When government steps into these transactions, there are often unintended consequences.

In the lunch scenario, let’s say that one of the dads is upset that his kid traded a bag of Oreos for one measly Fruit Roll-Up. So instead of letting the kids work it out, he emails the dad of the Fruit Roll-Up kid, demanding that from now on his son should get two Fruit Roll-Ups for each bag of Oreos. Now Fruit Roll-Up dad gets upset and decides to fix the “price” of each Fruit Roll-Up so his kid can get at least one bag of chips and two granola bars for each Roll-Up he trades. The inevitable consequence will be a bunch of upset kids who can no longer trade for what they want.

It’s not lunchroom Lord of the Flies – there are rules for retaliation

Middle school kids have their own social rules for sorting out disputes. WTO members have the Dispute Settlement Understanding. When members of the WTO believe another member has imposed measures that are WTO-inconsistent — and therefore diminish in some way the benefits they receive from their trading partner’s adherence to WTO agreements – the aggrieved members can take their case to the WTO’s Dispute Settlement Body. (Read Bruce Hirsh’s Essential for more detail on this.)

If they win their case, the dispute settlement mechanism of the WTO provides for three types of remedies for breach of WTO law. First, the losing party may withdraw the WTO-inconsistent measure or modify the measure to make it WTO-consistent, in which case, the basis of the dispute is effectively removed. The parties to the dispute may agree on what constitutes a reasonable period of time for the losing party to implement this kind of solution.

Sometimes there’s ongoing disagreement as to whether the replacement or modified measure is itself WTO-consistent, or perhaps the losing party simply fails to take any action within a reasonable timeframe.

Pay out or pay up

In these situations, the second or third remedies — compensation or retaliation — may be applied on a temporary basis in favor of the party or parties that won the case. Compensation, offered and accepted voluntarily, is the outcome in relatively few cases. It is more common for the complaining party to seek authorization from the Dispute Settlement Body to retaliate (formally referred to as the “suspension of concessions” or “suspension of benefits”).

The terminology “suspension of benefits” isn’t a gloss. WTO members use dispute settlement and retaliatory measures to restore market access benefits they lost. The WTO-inconsistent measure they complained about is said to have caused the “nullification or impairment” of benefits. Retaliation is designed to withdraw the equivalent value of trade benefits from the party that lost the dispute.

Even though retaliation is meant to offset lost benefits, it has significant economic and political drawbacks for all parties involved. Return to the lunchroom example: the Fruit Roll-Up kid probably had to give up some of his sales of Fruit Roll-Ups and give up some of his consumption of Oreos as a result of his retaliatory action – the fixed prices were too high. Ultimately, higher tariffs tend to lower both exports and imports. For this reason, retaliation is considered a last resort.

Get ready for a food fight

Although the steel and aluminum tariffs are promoted by the Trump administration as a strategy to seek fairness for those industries, the tariffs will incite retaliation by our trading partners, imposing significant costs on large numbers of US producers and consumers who have nothing to do with these industries’ grievances. One way that happens is through higher prices for steel and aluminum. But another way this happens is through “cross-retaliation”.

The WTO’s Dispute Settlement Understanding provides that the complaining party should first seek to retaliate against goods, services, or intellectual property within the same sector under the same agreement involved in the dispute. However, if that’s not practical or effective, the complaining party can “cross-retaliate.” Effectively, that means that if other countries successfully win a case against US steel tariffs, they could retaliate by applying tariffs on US-made apparel, machinery, or agricultural commodities.

In response to President Trump’s new tariffs, the European Union has already published a list of hundreds of American products that it would target for retaliatory tariffs. As one news story quipped, the list includes “everything including the kitchen sink.” Europe is seeking stakeholder comments on its list of items worth 2.8 billion Euros and includes US exports of sweet corn, rice, peanut butter, cranberries, orange juice, bourbon (here’s looking at you, Senator Mitch McConnell from Kentucky), make-up, motorcycles, and washing machines, in addition to an array of steel and aluminum products.

It’s about to get more complicated

More countries affected by the US steel and aluminum tariffs may decide to retaliate, compounding the impact for US exporters. Half of the steel that US producers export goes to Canada. What if Canada raises tariffs on US steel? According to Chad Bown of the Peterson Institute, if the sources of all U.S. steel and aluminum imports were to retaliate, we could be looking at new tariffs on US exports of as much as US$14.2 billion a year.

And the situation is about to get more complicated.

The Trump administration is preparing to propose US$60 billion worth of tariffs against products imported from China as a result of an entirely separate investigation into China’s technology transfer requirements that may violate US intellectual property rights. Beijing could respond in a number of ways that would hurt US exporters.

Retaliation in international trade is a messy, unsatisfying approach to solving disputes. When it is sanctioned as the result of a WTO dispute settlement case, retaliation is designed to inflict harm toward exporters in an attempt to get governments to quickly remove the measures that ran afoul of the trade rules in the first instance.

Given this boomerang effect of applying new US tariffs, we could soon find ourselves in one of the largest lunchroom food fights the trading system has seen in years.

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