ExplainSpeaking: Why Trump loves tariffs, and why he shouldn’t

Since tariffs alter the effective prices of goods and services, a move of such a global scale by the world’s largest economy — whose currency is the default global currency — can potentially lead to upheavals in prices of different assets, be it the stock markets, gold, currency exchange rates and even real estate. Depending on the severity of the move, it can affect economic growth, inflation and interest rates across the world. The turmoil in global markets — especially in the US — since Trump took over is a good precursor.

The obvious question is: What is the problem that Donald Trump is trying to solve?

The problem

On the face of it, the US’ trillion dollar trade deficit — the gap between the value of its imports and exports — is the trigger. But the underlying cause for this, as explained in last week’s ExplainSpeaking column, is the “over-valuation” of the US dollar. The dollar has been “over-valued” because it is the default currency for the world and as such its demand never falls, not even when the US economy struggles.

The real world implications of the dollar’s peculiar problem have been quite dire.

In a paper written in November 2024 after Trump won the election, Stephen Miran, a Harvard economist who has now been appointed as the Chairman of Council of Economic Advisors at the White House, explained the problem as follows:

‘The deep unhappiness with the prevailing economic order is rooted in persistent overvaluation of the dollar and asymmetric trade conditions. Such overvaluation makes U.S. exports less competitive, U.S. imports cheaper, and handicaps American manufacturing. Manufacturing employment declines as factories close. Those local economies subside, many working families are unable to support themselves and become addicted to government handouts or opioids or move to more prosperous locations. Infrastructure declines as governments no longer service it, and housing and factories lay abandoned. Communities are “blighted.”’

Of course, the dollar’s strength and status also has many advantages such as a strong purchasing power to import goods from anywhere in the world, the ability to borrow at very low interest rates, as well as the ability to sanction and shut out any foreign country from the international financial order dominated by the US.

Then why doesn’t Trump simply address the overvaluation of the dollar? Why impose tariffs?

The solution

In the past, the US has got together with its trade partners to orchestrate a devaluation of the dollar (the Plaza Accord of 1985). Many expected a similar exercise this time around as well — the Mar-a-Lago Accord. However, Trump is more favourably inclined towards the use of tariffs.

It is true that conventional understanding from mainstream economics is that tariffs are paid by domestic consumers, and that they will, as a result, lead to inflation.

Trump and his advisors, however, argue that tariffs are paid for by foreign countries and, as such, they will not be inflationary.

In the paper, Miran wrote: “… rather than attempting to end the use of the dollar as the global reserve currency, the Trump Administration can attempt to find ways to capture back some of the benefits other nations receive from our reserve provision. Reallocation of aggregate demand from other countries to America, an increase in revenue to the U.S. Treasury, or a combination thereof, can help America bear the increasing cost of providing reserve assets for a growing global economy.”

Who pays the tariffs: Conventional view vs Trump’s view

The nub of the current debate — the desirability, or the lack of, imposing tariffs — is the issue: Who pays the tariffs?

The conventional view is as follows: Suppose an American wants to buy a Chinese fountain pen that is priced at 10 yuan in China. Suppose, the going exchange rate is 10 yuan for a US dollar. Without tariffs, a US customer pays $1 to import a pen that is worth 10 yuan. Now suppose, the US slaps a tariff of 10%. The price of the pen goes up to 11 yuan or $1.10 for the US customer. The 10 extra cents go from the US customer’s pocket to the US government treasury. In this case, the US tariff has only managed to increase prices in the US and essentially penalised the US consumer.

However, implicit in this example are two crucial assumptions.

One, that neither the Chinese producer/seller nor the US importer/re-seller takes any hit on their profit margins; they simply pass through the effect of tariff to the end consumer (who in this case is a US citizen). It is easy to imagine a scenario, for instance, where the Chinese seller fears losing the sale to some Japanese seller and, thus, cuts his own profit margin to stay in the market.

The second assumption is that the dollar-yuan exchange rate doesn’t change. To be sure, when any two countries trade, the exchange rate between their currencies does alter because it is essentially determined by the relative demand between the two currencies. If the goods of Country A are more in demand by people of Country B than the goods of Country B are demanded by the people of Country A then the currency of Country A will strengthen/ appreciate against the currency of Country B.

It is important to note here that this traditional logic doesn’t always work with the US because of the original problem: The forever high and rising demand for dollars, regardless of trade.

The view among Trump supporters is well articulated by Miran in his paper, titled “A User’s Guide to Restructuring the Global Trading System”. Miran used the data from the first round of tariffs against China during the first Trump term to show how they were essentially paid by the Chinese and had very little effect on US inflation.

CHART 1 (sourced from Miran’s paper) shows how this came about. While the effective tariff rate on Chinese imports increased by 17.9 percentage points from the start of the trade war in 2018 to the maximum tariff rate in 2019, the after-tariff US dollar import price rose by 4.1%. This was made possible because the yuan depreciated — or lost value — against the dollar by almost 14%.

Chart.

In the pen example above, imagine yuan depreciating by 10% as soon as the US imposed a 10% tariff. A dollar now is equal to 11 yuan. Put differently, only 0.9 dollars are now needed to buy the same pen (which is made using 10 yuan only). But the US customer still pays $1. She is not facing higher prices but she is also not benefitting from the depreciation because the last 10 cents are pocketed by the US government as tariffs.

In this case, there is no inflation in the US, no hit on trade volume and yet the US government gains tariff revenues. All of this has been made possible by the depreciation of the yuan, which is another way of saying that the Chinese have lost purchasing power relative to the US because now it takes 11 yuan (instead of just 10 earlier) to buy (import) something that is worth one dollar from the US.

Upshot

The Miran evidence is deeply contested by several mainstream economists who have studies to show how the first round of tariffs led to higher inflation. For instance, a 2020 study led by Mary Amiti of the Federal Reserve Bank of New York, finds that “U.S. tariffs continue to be almost entirely borne by U.S. firms and consumers”. Nobel laureate Paul Krugman has been scathing in his Substack piece, stating “Their (economists supporting Trump) arguments are being used the way a drunkard uses a lamppost, for support rather than illumination”.

The TABLE below shows how the two extreme cases can pan out. The reality is likely to fall somewhere in the middle. But either way, Miran and Trump might have got it wrong because even if one accepts Miran data and evidence, and the exchange rate offsets the tariffs and they are non-inflationary as a result, it would leave the US with an even more overvalued dollar — which was the root cause to begin with. In other words, tariffs just made the problem worse.

Table.

If, on the other hand, the currency offset does not happen, then, as Miran himself admits, “American consumers will suffer higher prices, and the tariff will be borne by them.”

Lastly, this is all based on an analysis of tariffs on just one country. The apprehension is that when Trump unveils tariffs on all major trading partners, several more factors will come into play, creating confusion and threatening to stall the global economy.

Share you views and queries at udit.misra@expressindia.com

Take care,

Udit