Tariffs have been in the news like never before recently. We did a detailed breakdown a few months ago of how governments track economic growth and activity, with an in-depth look at GDP and how it’s calculated. We noted that economic topics would be forefront in the public conversation with the Trump Presidential administration promising to rip up a sizable portion of the trade agreements between the U.S. and the rest of the world. As the world’s largest economy, the U.S. has the power to shake up international trade and foreign exchange in both deep and subtle ways.
The U.S. President has enormous personal authority to rewrite longstanding practices and reshape global trade, and therefore global economic outlooks. However, even the most bearish experts did not predict the scope of Trump’s promised trade overhaul. The world economy and monetary systems continue to reel from the impact of a slate of tariffs and other changes that will continue to cause disruption for years to come.
Today, we’re diving into an aspect of economics that many find perplexing but is increasingly relevant in today’s volatile political climate: tariffs.
You’ve likely heard more about tariffs—essentially taxes on imported goods—in the past few weeks than ever before. Don’t worry, though; it’s not your fault. For nearly a century, much of the world has largely agreed that tariffs were undesirable, and best phased out over time. Economists have long favored targeted subsidies (money invested directly or indirectly by governments) to instill economic growth and development, rather than the use of tariffs. We have been, for the better part of the lives of most of our readers, a world with few trade barriers left.
If even a portion of the proposed levies on goods imported into the United States are enacted, that will all change. It could mark the most significant disruption to international free trade since the U.S. became the world’s largest economy.
While tariffs themselves are straightforward to grasp, their effects are anything but. This post will provide you with essential background on what tariffs are and, more importantly, why their impacts are far more complex than the Trump administration’s claims suggest. Our goal here isn’t to make a political statement—it’s to educate. Whether you support the impending trade war or not, the fact is that it will have an impact on your life, if not directly with its implications to your employment, then by its impact on global asset prices, the availability of consumer goods, or the cost of currency exchange
Tariffs and Trade Balances
What Are Tariffs?
Despite many false claims and implications by politicians in recent years, tariffs are not taxes on foreign producers competing with domestic industries. They are taxes on the importation of goods—and ultimately, they are paid by the purchaser. For instance, if an item costs $10 to import and a 30% tariff is imposed on that category of goods, the importer pays an extra $3 per item, raising the total cost to $13. The foreign producer still receives $10; the added expense is absorbed by the importer (and ultimately by the consumer). The $3 is collected by the government that imposed the tariff – meaning the country where the goods are bought, not the country from which the goods are imported.
As we’ll discuss in more depth later, the objective of tariffs are: to make domestic production more competitive by making imports more expensive, to collect revenue to run the government, potentially to punish foreign governments, and to change consumer behavior, such as by making undesired imports prohibitively expensive. While certain countries enjoy so called “free-trade” relationships with much of the rest of the world, others have high import tariffs to incentivize the local production and consumption of goods. Developing countries also typically have higher tariffs, which make collecting revenue to run their governments easier, since unlike sales taxes or income taxes, tariffs can be more easily tracked and smuggling and duty evasion is relatively easier to prevent. In such cases, the higher tariffs tend to be on more luxury goods, such as imported cars, perfumes, alcohol and tobacco, among other things.
Source: Investopedia
What Are Trade Imbalances?
As we discussed in our previous post on GDP, a trade imbalance occurs when the value of a country’s imports does not equal the value of its exports over a given period. In simple terms:
Trade Deficit: When a country imports more than it exports, it experiences a trade deficit. This situation can lead the country to borrow funds or attract investments to cover the gap, with potential long-term economic implications. Typically the danger of trade deficits is that a country will lose its currency reserves and wealth will be drained from the country over time. If a country continually sells currency reserves, then its own currency will depreciate over time, making it harder to continue to buy foreign goods.
Trade Surplus: Conversely, if a country exports more than it imports, it enjoys a trade surplus. This typically results in a net inflow of money, which can strengthen the nation’s currency and overall economic position. One problem of a trade surplus is that a country’s currency may become too valuable over time, making the prices of its imports higher. A lower relative currency value is better for export industries, because it means foreign buyers can more easily afford their goods. If a country exports too much, this can also make it harder for other countries to be competitive.
Trade Deficit Example
Imagine two countries: Bakersville and Budgetistan. Bakersville is famous for its delicious donuts, bagels, and other sweets. In one year, Bakersville earns $150 billion from exporting these treats to Budgetistan. However, Bakersville also imports raw materials—such as butter, flour, sugar, and specialized pastry ovens—from Budgetistan, costing $200 billion. As a result, Bakersville runs a trade deficit of $50 billion with Budgetistan because its spending on imports exceeds its earnings from exports.
Over time, the result of such an imbalance can be that the industries of both Bakersville and Budgetistan lose competitiveness against each other. Budgetistan cannot sustain its own sweets industry, and Bakersville cannot produce its own raw ingredients, making both very vulnerable to any potential shortfall or disruption in the flow of trade. If Budgetistan is hit by a hurricane in one year, and cannot produce sugar, then Bakersville will have no internal sugar supplies, and may not be able to bake sweets. This may lead Bakersville to do one of several things: keep a strategic sugar supply to whether any shocks in supply chains, to impose subsidies on its own sugar production industry, or lastly, to impose tariffs on sugar from Budgetistan, in the hopes that its own industry will thus become more competitive.
Typically, tariffs are the least favored method of solving such supply imbalances. However, following the massive trade disruptions of the COVID-19 pandemic, the use of tariffs to “de-globalize” supply chains has gain in popularity with developed countries, each of which will naturally tend to blame its trading partners for the supply shocks that, in reality, all developed countries suffered at the same time.
A real-world example is the United States’ trade relationship with China. Over many years, the U.S. has imported a large volume of goods—from electronics to clothing—while exporting relatively fewer products to China. This persistent imbalance has led to a significant U.S. trade deficit with China, influencing economic policies, affecting exchange rates, and fueling debates over job creation and industrial competitiveness. It has caused local production of many cheap goods to cease in the United States, and it has also made China very dependent on the income it generates from selling these cheap goods to the US. China also has an over-reliance on certain US produced goods, especially in certain food products like pork and grain.
Fairness and Trade Imbalances
There have been persistent and confusing claims by Trump administration officials and others that trade imbalances are inherently “unfair” or that countries running a trade surplus are “ripping off” or “cheating” the United States. However, as our example illustrates, trade imbalances do not represent a simple win/loss scenario. Consider the following points:
Specialization and Beneficial Exchange
Trade is built on voluntary exchange based on comparative advantage. When Budgetistan imports donuts and bagels from Bakersville, it does so because Bakersville produces them at a competitive price and quality that its consumers desire. Likewise, Bakersville values the high-quality ingredients and equipment produced in Budgetistan. A trade deficit, therefore, simply reflects consumer preference for goods that offer superior value, variety, or quality—it’s a conscious decision, not an economic loss.
Economic Specialization
Countries tend to specialize in areas where they have a relative strength. Bakersville, for example, has many skilled pastry chefs, while Budgetistan boasts vast, high-quality farmland. This specialization drives overall economic growth, even if one side of the trade ledger shows a deficit. In fact, the money spent on imports circulates through the global economy, creating opportunities for investment and innovation.
Investment and Capital Flows
A trade deficit is often accompanied by capital inflows. Even if Bakersville runs a persistent trade deficit with Budgetistan, the resulting inflow of funds can help create a monetary foundation in Bakersville. Imagine that Budgetistan uses these funds to develop a strong finance and banking system—its banks could then finance an expansion of Bakersville’s economy into new sectors, such as gingerbread houses, peanut butter cookies, or chocolate cake. What began as a trade imbalance might eventually become an opportunity for both nations.
Consumer Benefits and Efficiency Gains:
The competitive pressure generated by trade imbalances can lead to lower overall costs and improved quality for consumers. Budgetistan’s people enjoy an ever-expanding array of tasty snacks, while Bakersville benefits from increased investment, enhanced job security, and continued innovation. In this way, trade imbalances contribute to greater economic efficiency and improved living standards for both countries.
The Dynamic Nature of Global Trade:
Trade relations are not static—they adjust over time. For example, as Budgetistan builds its financial empire, it might choose to invest in developing its own sweets industry. The resulting competition between domestically produced goods and Bakersville’s exports could lead to lower prices for consumers and more job opportunities at home.
In global commerce, the gains from trade are measured not just in immediate financial flows but also in long-term growth, technology transfer, and improved consumer welfare.
Foreign Exchange: How Bakersville and Budgetistan Trade
There is another wrinkle to the picture of international trade. It’s foreign exchange (Forex).
When Bakersville sends its famous donuts, bagels, and cookies over to Budgetistan, their respective currencies must interact. In this world, Bakersville uses “Bakersville Sprinkles” and Budgetistan uses “Budgetistan Bills.” Currencies exchange every time a trade happens. This process takes place in a global marketplace known as the forex market.
What Are Exchange Rates?
The exchange rate is simply the price of one currency in terms of another. For instance, if 1 Bakersville Dollar equals 1.25 Budgetistan Bills, that rate tells us how many Bills you’d get in exchange for a Sprinkle. These rates aren’t fixed; they change according to supply and demand. If Budgetistan’s economy seems extra savory one day—perhaps due to booming agriculture or innovative manufacturing—its Bills might become more valuable compared to Sprinkles. Conversely, if Bakersville’s pastries suddenly have an even higher global demand, Sprinkles could appreciate against Budgetistan Bills.
Central banks in both countries deal with reserves and exchange rates on a systemic level, day to day. A central bank may choose to print more Sprinkles, or to buy more Bills when they are cheaper, in order to maintain a stable rate of exchange. Rates of exchange that are stable help both countries plan for the economic future. When a country has a persistent trade imbalance, especially when it is unilateral with only one other country, it slowly loses the ability to maintain this stable rate of exchange, and may be forced to “debase” its own currency by printing more of it in the case of a trade surplus, or to cause its own currency to appreciate (grow in value), making it more difficult for the trading partner to buy its products.
In reality, both Budgetistan and Bakersville would have many other trade relationships with other countries, which would balance the appreciation and depreciation of their currencies, meaning trade imbalance might not be a significant problem. Thus it is not necessarily unhealthy for two countries to have a relatively large imbalance, as long as there are other trade relationships that help to balance them.
Influences on Forex
Forex is a highly complex market that doesn’t necessarily function in an intuitive way. Rather, it is a patchwork of complex business, tax, and central banking policies that are mostly intended to provide as stable as possible an environment for the functioning of trade relationships, banking, travel, and economic development.
Trade Flows and Imbalances:
Suppose for a moment that the tables are suddenly reversed between Bakersville and Budgetistan. Perhaps scientists discover a cure for diabetes. Suddenly donuts and cookies are flying off the shelves!
If Budgetistan now suddenly imports more delicious pastries from Bakersville than it exports raw materials, it may soon need to exchange more of its Bills for Sprinkles. Over time, such trade imbalances can affect the relative value of each currency. More demand for Sprinkles could lead to their appreciation and, in turn, might force Budgetistan to tweak its own monetary policy to keep up.
Tariffs and Their Ripple Effect:
Or suppose the opposite: something happens to drastically affect the trade relationship between the two states. Recall our discussion on tariffs: when tariffs are imposed, imported goods become pricier. If Budgetistan were to slap tariffs on Bakersville’s delicious confections, to fight obesity for example, then Bakersville might see less demand for its goods. That reduced demand might lower the need for Bakerville’s Sprinkles, subtly shifting the balance in the foreign exchange market. While in a complex world market, the demand from Budgetistan might be replaced by another trading partner, sometimes a single relationship is so important that a change can drastically affect both countries.
With this sudden reduction in demand, producers in Bakersville may slash their production, laying off workers, or attempt to lower their prices and reduce costs drastically. This produces more unemployment and economic uncertainty, as well as lower profits. Suddenly international investors are unsure whether the Bakersville Sprinkle is a solid investment. They may seek to buy more Budgetistanian currency in order to weather the economic change. As investors sell Sprinkles, the Sprinkle depreciates even faster against the Bill, precipitating yet more panic, and so on.
This systemic shock could then lead to political instability, with the government of Bakersville suddenly facing sharply higher unemployment, lower tax revenues, and more civic unrest. Soon a “Sugar Rebellion” might be underway, with Bakersville bakers fighting over the dwindling sugar supply.
It’s not overstating the case to say that this cycle can lead to catastrophe. In fact, it was a cycle very similar to this one that led to the infamous Weimar Hyperinflation in Germany in the 1920s, and, some say, to the political instability that led to World War 2 as a result. We might soon be talking about the great war between Budgetistan and Bakersville, precipitated by the trade war that decimated the Bakersvillian economy following the Sugar Rebellion.
If this seems like an unlikely scenario, consider that the American revolution itself, as well as the War of 1812, was originally fought over the issue of tariffs and taxes on mostly luxury goods.
Investors and Speculation: Investors and speculators view foreign exchange markets as opportunities. When economic news—be it better-than-expected GDP numbers or innovative trade policies—breaks in either Bakersville or Budgetistan, investors might start buying or selling the respective currencies. These moves, often based on perception and future expectations, can lead to big and sudden swings in exchange rates.
Economic Fundamentals: Beyond trade alone, broader considerations such as interest rates, inflation, and political stability play their parts. For example, if Bakersville faces rising inflation because imported raw materials have become more expensive (perhaps due to a weaker currency), its central bank might adjust interest rates, thereby encouraging its consumers to save and borrow less, thus reducing inflation. Such adjustments, in turn, influence investor confidence and the currency’s standing in the global marketplace.
The Broader Impacts
In our imagined economy, foreign exchange isn’t just a behind-the-scenes numbers game—it impacts everything from the price of your morning bagel to large-scale investment decisions. A stronger Bakersville Sprinkle might mean Budgetistan’s raw materials become cheaper for Bakersville’s pastry chefs. Conversely, if Budgetistan’s Bills appreciate significantly, then their high-quality ingredients might come with a steeper price tag for Bakersville manufacturers, potentially nudging domestic prices upward.
Ultimately, the foreign exchange market is a dynamic, ever-changing arena where even a small step—like a new tariff or a shift in trade balance—can lead to a cascade of adjustments across both nations’ economies. This interplay ensures that as Bakersville and Budgetistan refine their specializations, their currencies continue to reflect the underlying strength, innovation, and mutual benefits of their trade relationship. A sudden drastic change can imperil many years of specialization and economic development.
Continued in Part 2
Next time, we’ll discuss the reality of the current trade war situation, and how it’s likely to impact you.
