The Impact of Trade Conflicts on Innovation

Rising popularity of isolationist policies and a more prominent role of geopolitical arguments in policy making have led political scientists to conjecture a possibility of globalization backsliding. We take that assessment as motivation to study the potential effects of increased and persistent trade conflicts on global economic growth and technological innovation. We do so by building a multi-sector multi-region general equilibrium model with dynamic sector-specific knowledge diffusion. Idea diffusion is mediated by the input-output structure of production, such that both sector cost shares and import trade shares characterize the source distribution of ideas. Using this framework, we explore the potential impact of a ``decoupling of the global economy,'' a hypothetical scenario under which technology systems would diverge in the global economy. We divide the global economy in a U.S.-based bloc and a China-based bloc based on scores of geopolitical differences with the U.S. and China from the political science literature. We model decoupling through an increase in iceberg trade costs (full decoupling) or tariffs (tariff decoupling) between the U.S. bloc and the China bloc. Results yield three main insights. First, the projected welfare losses for the global economy of a decoupling scenario can be drastic, being as large as 15% in some regions. Second, the described size and pattern of welfare effects are specific to the model with diffusion of ideas. Without diffusion of ideas the size and variation across regions of the welfare losses would be substantially smaller. Third, a multi-sector framework exacerbates diffusion inefficiencies induced by trade costs relative to a single-sector one.