The risks of economic coercion

| April 12, 2021

In December 2020, China blocked Australian coal imports after an increasingly tense political confrontation between the two countries. In August 2019, Japan strengthened restrictions on exports to South Korea following a South Korean Supreme Court decision on disputed historical issues between the two countries. This economic coercion inflicts mutual harm because it disrupts economic exchange.

China’s measures against Australia create uncertainty and increase the costs of doing business. Japan’s restrictive measures largely backfired after Japanese companies shifted production to South Korea and Europe to supply the South Korean market. The deployment of coercive economic measures might appear impractical in the face of these costs.

Economic coercion can be best understood through the lens of game theory. The famous Coase theorem suggests that people won’t pass up an opportunity to cooperate through a mutually advantageous exchange. In this world, cooperation and settlements are (almost) always possible without major dispute.

Yet the doyen of market optimisation, Pareto, argued ‘the efforts of men are [used] in two different ways: they are directed to the production or transformation of economic goods, or else to the appropriation of goods produced by others’. The economist Hirshleifer said that seizing what others have produced is consistent with Machiavelli’s golden rule ‘he who gets to rule will get the gold’.

International relations are framed in a world of tension between the Coasian world, where legal protection of property and enforceable contracts are available, and the world of Machiavelli, where ‘might makes right’. It is difficult to enforce contracts in international relations because there is limited supra-national power capable of holding powerful states to account. The multilateral trade rules provide constraint if the superpowers back them and the system can impose costs on those countries that breach the rules.

Without rules that are strictly enforced by an outside authority, states are incentivised to skirt rules to produce outcomes that favour them. Game theorists call such devices strategic moves — one example of which is economic coercion.

Take the Australia–China trade conflict. Assuming that Australia chooses not to use Huawei’s 5G network infrastructure for security reasons and that China imports Australian products, China will still remain better off importing from Australia, even if it loses it Huawei market in Australia. The least preferred outcome for Australia occurs when Australia uses Huawei and China does not import Australian products. In this instance, Australia will be clearly worse off than China in the long run.

Australia always prefers the case in which Huawei is not used. The best outcome for China occurs when Australia uses Huawei and China imports Australian products. The worst outcome occurs when Australia does not use Huawei and China does not import.

Both countries have dominant strategies — regardless of the other’s choice, Australia will choose not to use Huawei and China will choose to import. When China imports and Australia does not use Huawei, Australia has no incentive to make another strategic move. Still, China has one it can try — the threat of economic coercion — to achieve a better outcome for itself.

Yet, China must make the threat of economic coercion — and its willingness to carry it out — credible. If Australia continues to ban Huawei, China might be tempted to refrain from carrying out the threat of banning Australian imports because China is clearly worse off under the scenario with a reciprocal import ban.

If blocking imports was China’s best response to Australia’s Huawei ban, then China would have no incentive to make the threat in the first place. Because the threat of economic coercion remains a viable option to China in the bargain, it locks China into punishing Australia to possibly make itself relatively better off in the long. Economic coercion is still costly for China to carry out because it inflicts mutual harm.

The use of strategic moves and their credibility in practice is fraught with difficulty.  Making them work in practice depends on the context and tactics used.   As Dixit warned, ‘use such strategies at your own risk’.

This article was published by the East Asia Forum.