Bringing back the 1930s?

The Trade Representative's geometric logic

I proved with geometric logic that a duplicate key to the icebox existed.

—Captain Queeg in The Caine Mutiny

Let’s start with a few observations:

1. The tariffs will likely be scaled back. I will discuss the impact of the proposed tariffs, but these should NOT be viewed as unconditional forecasts of their impact on the economy. (FWIW, markets seem to expect a bit of stagflation.)

2. Most of our major trading partners have tariffs that are quite similar to previous US tariff levels. The claim that these new tariffs are “reciprocal” is nonsense.

3. The highest tariff increases were imposed on Lesotho and St. Pierre and Miquelon (both 50%). I don’t quite understand the latter, as (at least AFAIK) it’s actually a part of France. Overall, the list looks like something complied by a child: it’s just a bunch of random numbers, with no rhyme or reason. The explanation from the Treasury US Trade Representative is nonsensical drivel.

Here’s the opening paragraph in the Treasury report:

Reciprocal tariffs are calculated as the tariff rate necessary to balance bilateral trade deficits between the U.S. and each of our trading partners. This calculation assumes that persistent trade deficits are due to a combination of tariff and non-tariff factors that prevent trade from balancing. Tariffs work through direct reductions of imports.

Bilateral trade balance is equivalent to replacing a monetary economy with barter.

There are bilateral deficits between states and regions within the US that can last for years or even decades. Are they due to “currency manipulation” and tariffs?

And contrary to the Treasury claim, tariffs reduce both imports and exports and have little or no effect on trade balances (as we saw during the first Trump administration.) That’s not to suggest that the trade deficit cannot get smaller—deficits generally shrink during recessions. Trump should hope his plan once again does not “work”.

The Washington Post provides an example of the Trade Representative’s Treasury’s geometric logic:

There was a flurry of online searches for an Australian territory, the Heard Island and McDonald Islands, after it made the list of places facing import taxes under Trump’s plan. (Spoiler alert: There are no golden arches anywhere near these remote islands in the Southern Ocean, about 2,500 miles from the Australian mainland.)

They are unoccupied by humans and had zero trade with the U.S. last year, according to the latest available U.S. figures. That makes the 10 percent tariff imposed Wednesday somewhat moot.

Predatory penguins.

(I recently surprised some friends by picking out New Caledonia in a Worldle game, but even I had never heard of Heard.)

All the good people have either left the government or are laying low until sanity comes back to Washington. As a result, policy is now being made by clowns.

If these figures stay in place, there’s no real prospect that the impact on prices will be offset by dollar appreciation. The yen actually rose on the news, despite a 24% tariff rate on Japan. Do you expect the yen to go to 190? (The dollar fell even further this morning.)

Again, I’m not making any unconditional inflation forecasts here, as I expect the tariffs to be significantly watered down. How much? I have no idea, we elected Captain Queeg.

Stocks seemed to have declined around 3% on the news, and this will change as new information comes in. (I wrote this last night, it’s even worse this morning.) When thinking about the impact of the tariffs on stock prices, you need to take two factors into account:

1. The actual announcement compared to what was previously expected.

2. The announced policy compared to the expected final policy.

Let’s take these one at a time, beginning with the (admittedly unrealistic) assumption that the announced policy is permanent. It seems likely that markets already expected something along these lines, but the actual announcement was significantly worse than expected. In that case, the impact of these tariffs on stock prices is roughly:

3% times the ratio of the final tariffs divided by the unexpected portion of the tariffs.

Thus assume the markets expected the average tariff rate to be 16% but the actual average was 24%. In that case, the new tariff is 3 times larger than the unanticipated part of the tariff (24% vs. 8%) and thus stock prices were reduced by 9% by the policy. Alternatively, the market would have risen by 6% if the announcement had been no tariffs at all, and hence the 3% decline meant stocks were 9% lower than a counterfactual with no tariffs. Of course this is merely an illustration, I don’t know the actual figures.

And even the preceding calculation may understate the degree of damage that would occur if the policy were permanent. Markets are probably expecting a substantial rollback of the tariffs, so the stock market response is not to the announced figures; rather they reflect the expected impact of the anticipated final figures. (I know, with Trump nothing is final.)

Tyler Cowen suggested that this is the biggest unforced US economic policy error that he’s observed in his lifetime:

This is perhaps the worst economic own goal I have seen in my lifetime.

I’d say the same, at least for mistakes that could be clearly identified as having occurred on a single day. (Monetary policy mistakes like 1929-32, 2008 and 2021-22 play out over longer periods of time.) In my study of economic history, I am aware of only two worse cases: Hoover’s decision to sign Smoot-Hawley (which triggered the biggest one-day stock decline of 1930), and the President’s Re-employment Agreement, which led to an even bigger stock market decline in late July, 1933.

The indirect effects of tariffs may well be worse than the direct effects. I’d expect substantial retaliation from foreign governments, especially if the announced tariffs remain in place. The administration seems to believe that the US is not in a vulnerable position due to our trade deficit. But the flip side of that deficit is a capital account surplus; partly drive by extremely high US equity valuations. The US stock market represents roughly 60% of global market cap, despite the US having only about 25% of global GDP. That’s a tempting target for foreign governments. I could see the Europeans imposing aggressive taxes on the portion of US tech profits earned in Europe—what would they have to lose?

The distributional effects are also of interest. Older upper middle class people like me might benefit, as our foreign trips become slightly cheaper in real terms. (But only if we avoid recession, which is not a sure thing.) I mostly buy services, and spend relatively little on imported goods. WalMart shoppers will be hit hard. This is the MAGA base. Even in the unlikely event that a handful of manufacturing jobs are created, the vast majority of MAGA supporters will be worse off.

This FT headline made me smile:

Donald Trump baffles economists with tariff formula

Of course it could be worse, much worse. What if we also had a HHS head that didn’t believe in modern medicine? What if we had a FBI director that didn’t believe in the rule of law? How about a State Department that didn’t think Russia was to blame for invading Ukraine? How about a Defense Secretary that liked to leak war plans to the media?

Seriously, all this goes far beyond tariffs. The Trump administration is trying to stoke global nationalism, even going so far as to support far-right European parties opposed to rearmament. They are trying to create a new might makes right global order, where countries like Russia are rewarded with territory ceded by weaker countries. The goal seems to be to destroy any sort of multilateral organization like Nato that would provide strength through numbers, as these alliances are most useful to smaller nations. This could lead to a wave of smaller countries developing nuclear weapons. China no longer has anything to lose from military adventurism, at least in terms of American economic retaliation.

Overall, the goal seems to be to recreate the conditions of the 1930s, a global trade war and an aggressive nationalism where the strong prey upon the weak.

Have a nice day.