Thread by @itskhoki

*Trade war: my theory of the case*
1. What is the goal/ideal outcome/trump admin hopes: 10% tariff across the board with no retaliation + direct non-tariff favors from other countries to settle this at 10% + a possible full-scale bilateral trade war with China. (1/n)

Indeed, a major financial win for the US which would justify a financial market optimism. Trump proxies are essentially begging other countries to call him and negotiate this scenario. (2/n)

2. While this scenario is possible with some probability, it is an unlikely outcome: a) US is 23% of world GDP and less than that as a share of global trade, and has much more to lose from a trade war against all of the rest of the world, so this is a bluff. (3/n)

b) Such outcome requires not only cold calculation by other countries, but also a political process in other countries to accept this unfair outcome, highly unlikely. (4/n)

c) Recent cases of Canada and Mexico show that smart retaliation (with delayed implementation) according to WTO rules and targeted to specific final products from the US is quite effective at facing off the trump tariff. (5/n)

3. Once other countries threaten/implement retaliatory tariffs, there are 2.5 possibilities. i) trump admin rolls back settling with some sparce idiosyncratic tariffs against certain country-industries. (6/n)

This would be like first-term trump, truly not worth the global financial and economic turmoil of the last month, so perhaps markets do not believe in this easy exit. (7/n)

Then possibility ii) full-scale first round with retaliation by most countries. This is clearly not a lasting equilibrium, so either it rolls back to (i) or US needs to respond with a second round. And this is where shit hits the fan. (8/n)

There could be more tariffs, or could there really, 50-100%? I fear the more likely scenario is the use of the financial tool, some kind of financial sanctions against countries that retaliated. (9/n)

And this scenario justifies the full-scale financial panic that we are observing, with financial outflows from the US and USD unfamiliarly depreciating as measures of financial uncertainty are at historical maximums. (10/n)

4. Even if the probability of case (ii) is not very high, this is the moment for international long-term investors to re-evaluate their positions in US assets, including US Treasuries - the global safe asset. (11/n)

Retaliatory financial sanctions can range from asset freezes to blocking countries from the US financial and payment systems, a disastrous state for foreign investors even if not a very likely one. (12/n)

5. Perhaps this is exactly why we seeing capital outflows from the US and USD depreciating. This is how the end of dominance and “privilege” looks like. Who would have thought that it is not because of debt or inflation, but because of a trade war. (13/n)

6. It is not enough to sell off US assets, investors need to buy something instead - another pilar of dominant currency. (14/n)

Good time to expand European sovereign debt market and raise funding to pay for the economic and financial decoupling from the US and European security without the US, which is long overdue. (15/n)

7. Rarely we witness the end of a dominant currency, but this is how it may look like, a lot of forces coming together at once to break the secular US dollar equilibrium. (16/n)

8. If this happens, new equilibrium will feature: i) weaker US dollar, ii) higher funding costs in the US and in USD generally, iii) decline in consumption and investment in the US, and... (17/n)

... iv) US current account rebalancing and even possible trade surpluses under weaker dollar and lower consumption and investment demand with higher interest rates. And no longer any need for tariffs to fix the imbalance. (18/n)

This outcome is of course still less likely than more likely, dominant currency equilibrium is not easy to break, and USD is still a central node in many other respects, but arguably we never came this close to the end of dominance. Not a boring simulation. (19/19 END)

or perhaps we are already on that less likely branch of the tree with waning dollar:

https://x.com/HannoLustig/status/1912602928243962231