Local Trade Wars

Modern protectionism has increasingly taken the form of decentralized trade coercion rather than multilateral escalation. What tariffs prevail in such local trade wars? How are welfare consequences shared between participants and bystanders? And can targeted economies credibly deter unilateralism? Using a multi-country, multi-sector Armington model that distinguishes the elasticity of substitution between domestic and imported goods from that across foreign varieties, we show that bilateral tariffs generate substantial third-market leakage. Applied to recent U.S. trade policy, this leakage magnifies U.S. losses and bystander gains under Trump 1.0, with bilateral Nash tariffs that are lower but more costly than those implied by standard models with a uniform trade elasticity. Trump 2.0's Liberation Day tariffs reverse these patterns by largely shutting down third-market leakage through broad-based tariff escalation. In a dynamic setting, no individual trading partner can credibly deter U.S. unilateralism: bilateral retaliation is either too weak or too costly. Only a near-universal coalition, broadly resembling the WTO membership, can flip U.S. incentives.