The initial assessment of tariffs
The resurgence of Donald Trump has sparked a renewed fervor for tariffs, accompanied by a series of justifications: they promise to herald an economic “golden age,” are purportedly non-inflationary, are financed by foreign entities rather than American citizens, and serve as a potent tool in political confrontations. While a majority of economists hold differing views, one must ponder the extent to which their insights are heeded in contemporary discourse. To evaluate these assertions, it is essential to identify “natural experiments”: occurrences where the impact of tariffs remains untainted by extraneous factors such as proposed reductions in taxes and regulations. The 72 hours during which Trump appeared poised to impose 25% tariffs on Canada and Mexico exemplifies a notable experiment in trade policy.
The initial evidence suggests that the economic rationale for tariffs is weak: they appear to increase prices, hinder growth, are partially shouldered by Americans, and provoke retaliation that adversely affects exporters. Nonetheless, they serve as a formidable instrument in negotiations; Trump successfully secured commitments from Mexico and Canada to enhance border security. Enduring a setback to the economy, therefore, could be a cost worth incurring, provided that others bear a greater burden. Refer to it as the rationale of negative-sum economics.
From noon on Friday, just prior to the White House’s announcement of impending tariffs, to 10:40 a.m. on Monday, when Trump declared a 30-day suspension of tariffs on Mexico, the S&P 500 stock index experienced a decline of 2%. The Russell 2000 index, which tracks smaller companies primarily oriented towards the domestic market, experienced a decline of 2.1%. A suspension regarding Canada was announced later that day, coinciding with the implementation of the tariffs on China.
Inflation-indexed bonds have incorporated an extra 0.2 percentage point of inflation for the upcoming year, with approximately 25% of this attributed to gasoline, as noted by Michael Pond, who leads global inflation-linked research at Barclays. As inflationary pressures mount, investors have revised their expectations regarding the extent to which the Federal Reserve might reduce interest rates in the current year. Short-term bond yields increased more significantly than those at the longer end, resulting in a “flattening” yield curve that typically signals a slowdown in growth.
By Tuesday’s conclusion, the suspension of tariffs on Mexico and Canada had led to a significant reversal of many of those actions. This represents merely a brief period of market activity and offers little assurance that actual outcomes will align with investor expectations. The merit of this ruling lies in its impartiality: Investors are primarily motivated by profit rather than ideological assertions.
Should their assertions hold true, this undermines certain justifications for tariffs. Proponents contend that foreign entities are so reliant on the American market that they would prefer to reduce their prices and absorb the tariff rather than forfeit their market share. Tariffs represent a financial boon to the U.S. Treasury, courtesy of foreign entities. However, this contrasts with market expectations, as anecdotal evidence suggests that importers and their domestic rivals are either increasing or planning to increase prices. Although certain domestic firms may gain from reduced import competition, this advantage must be balanced against the potential harm to exporters resulting from retaliatory measures by Mexico, Canada, and China, as well as the implications of a stronger dollar.
Further insight was gleaned from the fluctuations in oil prices. Trump has declared a 10% tariff on Canadian energy, approximately $6 per barrel, a burden that Canadian producers are likely to shoulder, given their limited pipeline capacity for redirecting exports away from the United States. On Monday, Canadian oil experienced a decline, as reported by Platts, decreasing by $1.65 in relation to the U.S. benchmark. The market exhibited a lack of liquidity, complicating the interpretation of tariff impacts. However, the market dynamics indicate that a significant portion of the $6 tariff is likely to be borne by American refiners and consumers at the pump.
The market reaction was notably less pronounced compared to the responses observed during Trump’s imposition of tariffs on China in 2018 and 2019. Investors likely factored in certain tariffs prior to Friday, exhibiting skepticism regarding the likelihood of those announced on Saturday being implemented or remaining in place for an extended period. Nonetheless, the anticipated effect on the economy was unequivocal: detrimental.
However, what if the objective is not to bolster the economy but rather to coerce your partners into acquiescing to your demands—regarding trade, national security, and immigration? In such circumstances, it is acceptable for tariffs to inflict pain, provided that the adversary experiences greater detriment. This explains why, when Trump initially threatened tariffs last November, both Mexico and Canada swiftly acted to comply with his demands aimed at curbing the influx of fentanyl and migrants. However, when Trump escalated his rhetoric to the point of imposing tariffs, the positions of both Mexico and Canada became more entrenched. Both are poised to respond while encouraging their consumers to support local products. Following additional discussions, Trump consented to suspend the tariffs.
The inquiry, therefore, shifts from the efficacy of tariffs as a tool to their comparative effectiveness against other options available. In 2024, Mexico curtailed the influx of migrants to the border in response to a request from the Biden administration. In the aftermath of the September 11, 2001, terrorist attacks, Canada markedly enhanced its collaboration on border security measures. The U.S. refrained from imposing tariffs in both instances. Proponents of Trump argue that there exists a distinction between tariffs intended for negotiation—temporary by nature—and those aimed at diminishing the trade deficit and generating revenue, which are indefinite in scope. However, Trump himself does not draw such a distinction. On Saturday, he asserted that the tariffs imposed on Mexico and Canada were not merely a negotiating strategy: “It’s pure economic.” We are experiencing significant trade deficits with all three countries.
The majority of the tariffs implemented by Trump on China in 2018 were designed as a strategic maneuver in negotiations. Almost seven years on, these changes appear to be enduring, as the economies of the United States and China initiate a process of decoupling. They engage in reduced trade amongst themselves and have pursued alternatives to one another’s products and technologies. Over the past three decades, Canada and Mexico have staked their futures on the premise of North American integration. If they determine that, akin to China, they are subject to enduring higher tariffs, the process of integration will be reversed. Canada is currently engaged in discussions regarding the expansion of pipeline capacity to its coasts, aiming to liberate its oil and gas resources from dependence on American purchasers. Ultimately, a landscape characterized by elevated tariffs results in reduced trade for all parties involved, thereby eroding the advantages that the U.S. gains from economic integration.
