Paul Krugman: Supply Chains and Trade War: "There are three possible stories about how supply chains might increase the costs of trade war, and while two of them are right, I suspect that many economists are buying into the third, which isn’t...

...What difference does a supply-chain trading system make?... Create[s] the possibility that protectionism will be bad mercantilism–that even in its first-round effects it will actually destroy more domestic jobs than it creates, because it creates a competitive disadvantage for domestic downstream producers. Given the Trump tariffs’ heavy loading on intermediate goods, that looks right. Another thing the rise of global supply chains has done is to increase both total trade and the gains from trade. As a result, there is more to lose from a trade war than there was a generation ago.

But what I think many economists have in mind is something more than that. Standard trade theory tells us that the costs of a tariff–the reduction in real income–may be calculated, approximately, as: Real income loss = 0.5*tariff rate*reduction in imports. This formula suggests only moderate costs even from a major trade war.... I think many economists are suggesting is that this kind of analysis understates the losses when much of that trade is in intermediate goods. But I’m pretty sure they’re wrong, at least in the medium to long run....

Let’s have a trade war, which results in both countries imposing a tariff t. What happens?... Each country starts producing some of the intermediate goods it used to import.... Home’s loss from the marginal good it no longer imports is the excess resources required for Home production as compared with imports, namely, the tariff rate.... This looks just like the logic of the standard estimates of the cost of protection: the average cost of a lost import is roughly half the tariff rate. So analyzing the costs of a trade war in a supply chain world isn’t any different from a conventional trade war analysis. So where does the intuition that the costs of trade war must be higher in today’s world come from? I think it comes from the combination of two things. First, imagining a literal cutoff of imports, as opposed to a mere rise in their price; second, imagining a short run in which it’s impossible to develop domestic production to replace key inputs. Something like that combination has occurred in the past, notably in the former Communist economies after the fall of the Soviet Union. But it doesn’t seem to be where we’re going right now.

That said, a trade war in a supply-chain world would cause a lot of disruption, because it would lead over time to a major restructuring of industry. This would create a lot of losers, as well as some winners, perhaps more than a trade war would have in the past. But I don’t think the notion that the total loss in real income would be bigger than conventional analysis suggests holds up. Trump’s policy moves are destructive, based on ignorance, but we shouldn’t overstate their cost.