The adjustment problem
Yet even if cooperation remains possible, the transition from one equilibrium to another poses serious difficulties. It took decades of negotiations under GATT/WTO rules to move from the high-tariff world that emerged during World War II to a new, low-tariff era. Its two key pillars, reciprocity and nondiscrimination, served the trading system well by helping governments move from a noncooperative to a cooperative equilibrium.
What are the consequences for the trading system of the eruption of geopolitical rivalry today? Governments that care about relative power threaten to impose higher tariffs to hurt their rivals. The old agreement no longer reflects the new reality. A new cooperative equilibrium is needed. The question is how government can get there.
Two paths are possible. The first is what we call “war and redemption.” Countries allow the old agreement to collapse, triggering a trade war that pushes tariffs higher. Eventually, governments negotiate a new agreement through traditional reciprocal tariff reductions. This path is economically costly and would likely require lengthy negotiations but fits within the existing framework of multilateral trade rules.
The second path is more efficient but requires institutional innovation. Countries negotiate an immediate transition, avoiding economic disruption. But this adjustment involves moving along the frontier of possible efficient outcomes (see box). To sustain cooperation, the country for which the geopolitical shock is less severe must make concessions that reduce its welfare relative to the status quo. This is neither reciprocal nor mutually advantageous in the traditional sense, and the WTO’s foundational principle of reciprocity cannot accommodate it.
The challenge deepens in the multilateral world. Along with reciprocity, the principle of nondiscrimination might not facilitate adjustment, as it requires that any trade benefit extended to one member be extended to all. But when two rivals need to transfer economic benefits between each other, third countries are excluded and face consequences.
The 2020 Phase One agreement between the United States and China illustrates the problem. The deal, intended to ease trade tensions, included Chinese commitments to buy specific quantities of US goods. World Bank research at the time of the agreement predicted that although both countries would have gained relative to continued escalation, exporters in Europe, Latin America, and elsewhere would have been hurt if China had redirected imports from those regions to the US. The fact that the agreement was struck outside multilateral trade rules points to a deeper problem: The current system cannot accommodate the adjustments that geopolitical rivalry demands.
A geopolitical exemption
If the multilateral trading system is to remain relevant, it must create space for geopolitical adjustment while protecting third countries. In our research, we propose a geopolitical exemption to the fundamental principles of reciprocity and nondiscrimination that would allow strategic rivals to make discriminatory tariff adjustments under strict conditions.
There is a precedent for such an exemption. The trading system already accommodates certain forms of discrimination—for instance, allowing members to form preferential trade agreements, such as through free trade areas. These agreements advance the goal of liberalizing trade as long as they meet strict conditions: They cover “substantially all trade” among members and do not raise barriers against nonmembers. A geopolitical exemption would serve a different purpose: accommodating rivalry between strategic competitors while minimizing damage to the broader multilateral system.
The exemption would require that any discriminatory adjustments between rivals leave world prices between the rivals and third countries unchanged, thus limiting trade diversion. Implementing such a rule would be technically complex. But the alternative is worse: Geopolitical adjustment happens either outside the multilateral framework, undermining existing trade rules and imposing costs on neutral countries, or doesn’t happen at all, leaving the world trapped in destructive trade conflicts.
Preserving cooperation
We argue that the return of geopolitics does not eliminate the economic case for cooperation. Even countries engaged in strategic rivalry can benefit from negotiated agreements. The fundamental logic that sustained decades of trade opening remains intact. But new mechanisms are needed if geopolitical rivals are to adjust their trade relationships without engaging in disruptive trade wars or imposing undue costs on third countries.
The trading system has adapted before when circumstances changed—adding new agreements as the global economy evolved during multiple rounds of negotiations. The challenge today is to undertake a similar adaptation for geopolitical realities, preserving the core functions of the system while updating its rules for a changed world. The geopolitical exemption we propose would provide such a mechanism, establishing safeguards that maintain the integrity of the multilateral system while acknowledging the reality of strategic competition.
