Earlier this week, the Washington Post reported that the new Trump administration was crafting a foreign trade policy that would potentially limit the blanket tariffs imposed by the United States to only those from critical sectors instead of on all imports. Trump quickly denied that this was on the table, but it goes to emphasize how 1) tariffs will be a major theme in 2025 and 2) all sides recognize the economic risk that comes from taking such an all-encompassing approach to international trade.
I’ve gotten a number of questions lately regarding tariffs, how they’ll impact the global economy and what that means for recession and inflation risk going forward. I think it’s time to review a few scenarios.
The base case for how tariffs will impact the global economy in the short-term is pretty straightforward and the current consensus opinion. Tariffs are effectively a tax on consumers. If a U.S. company decides to import a Chinese product with a 25% tariff on it, the cost of goods for the importing company will rise by 25%. While that company may choose to eat a portion of the higher cost in order to remain competitive, in many cases it will choose to pass that higher cost on to the consumer. In a very rudimentary example, this Chinese import, which may have cost $1 before, will likely now sell for $1.25.
Of course, the exporting country would likely apply retaliatory tariffs of their own and suddenly the price of everything starts going up. That’s the risk that the global economy faces today and is a big reason why we’ve seen interest rates on the long end of the curve rising all across the globe.
But what about the longer-term ramifications? We’ve often heard the saying that the cure for inflation is inflation. Is that the case with tariffs as well?
I recently received an email from a subscriber who proposed a number of theoretical potential outcomes from a trade war. The email noted that “On the tariff/inflation narrative, the theme that you outline seems to be pretty consensus, but does that hold, both from a theoretical standpoint and historical evidence standpoint?”
Let’s break down a few of the points he makes.
“Assume at present supply and demand curves are at equilibrium. Adding a material tariff then artificially raises prices initially. On the supply/demand curve it’s like sliding the equilibrium point UP the demand curve and down the supply curve, with the gap between the new equilibrium points on the y axis being the tariff amount. Consumers see higher prices, but suppliers see less demand. Suppliers may try to lower prices some to offset and get demand back, but they can’t get back to the original point (unless there’s a productivity bullet that offsets the tariff amount in full).”
I think this is the correct take. The imposition of tariffs is essentially a disruption to global supply/demand and there’s no quick way to get back to equilibrium without a major change to the overall economic structure. Inefficiencies will be created, such as lower consumer demand and larger than expected built-up inventories. Those inventories probably need to sit in the warehouse for a while (or get deeply discounted as the email suggests) until they eventually get sold, but there will be less need to produce much more in the meantime until that oversupply gets dwindled down. Consumers will simply need to limit consumption because they won’t have the resources.
“Now there’s too much supply for the demand. So supply has to go offline. If it’s got nowhere to go, as in a relatively blanket tariff case, then it’s stranded and has to be written down/off. And then the (likely) debt behind it is destroyed. En masse this is deflationary as debt destruction is equivalent to money destruction, levered. A deflationary bust ensues. At least for the overseas suppliers. With the other item being that only the lowest cost suppliers with best debt access survive. Drifting prices overtime back to the original equilibrium point, if not last.”
This is a pretty insightful observation. After the initial inflationary reaction, the market would likely need to adjust. Assuming that tariffs get applied in both directions as a retaliatory measure, consumer demand is likely going to be way down and/or there’s going to be a huge supply glut of unsold inventory. That would need to be resolved in one of two ways. In the example above, either workers get a 25% pay raise to compensate for higher prices and bring demand back to original levels (highly unlikely) or oversupply needs to be dumped at fire sale prices or written off altogether. That, by definition, is deflation.
There’s another byproduct of this, which helps to explain why these situations can quickly turn into downward spirals. The destruction of debt is a reduction to the overall money supply, which is stealth quantitative tightening. QT would, at the margins, be helpful in getting inflation under control, but this could happen when the deflationary bust is already in progress. Instead of adding liquidity to the system to try to boost consumer demand, liquidity is being withdrawn from the system, turning a bad situation into something worse.
“Empirically, isn’t this effectively what happened in the Great Depression post Smoot-Hawley? The U.S. had already started a domestic deflationary bust with the ‘29 crash and subsequent bank runs / liquidity crisis events. But the tariff effectively acted to export this to the rest of the world via the mechanism above.”
I think historical evidence would support this claim, although I’d note that it’s unclear how much of the impact was a direct result of Smoot-Hawley. As you note, the 1929 market crash, bank failures and runs on liquidity also had their impacts, but Smoot-Hawley was unquestionably a contributing factor.
The global tariff war, which ramped up in the aftermath of events in the United States, effectively served to try to increase domestic demand and manufacturing, very much like what Trump is trying to accomplish today. The decrease in global trade coupled with collapsing demand at the time did help to export deflation worldwide.
Final Thoughts
While the financial markets focus on the inflationary impacts of protectionist trade policies, the subscriber above lays out a good case for tariffs are actually “inflation now, deflation later” tools.
If inflation arises as a result of higher consumer demand and greater financial resources (such as in the aftermath of the COVID recession and subsequent stimulus bomb), that’s one thing. If inflation arises as a result of higher costs without a coinciding increase in demand or resources, then it can become something far worse.
Fortunately, it sounds like the Trump tariff policy might not end up being as punitive as was originally being threatened. The inflation that could be avoided in that scenario would be great. The subsequent deflationary bust that could be avoided would be even better.
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