Donald Trump has famously promised tariffs—20 percent on imports generally, and as high as 60 percent to 100 percent on Chinese goods. During the campaign, many economists described such plans as inflationary. They made simple calculations to translate the rising costs of imports to American consumer and producer prices. Such easy conclusions surely reflected political motivations more than principles of sound economic analysis.
The effects of tariffs are more complicated, being dependent on how consumers respond to higher import prices and, importantly, how foreign exchange markets react. These considerations certainly came into play when Trump last raised tariffs in 2018 and 2019. In those cases, secondary effects seemed to erase any inflationary impact.
The simple (and political) assessment of Trump’s proposed tariffs emerged from what can only be described as a highly mechanical process. The economists making these analyses assumed that the cost of imports would rise by the amount of the tariffs. They then applied that higher cost to the current mix of imports in the U.S. economy. From that straightforward calculation, the analysts concluded that Americans’ cost of living would increase.
This answer served a political purpose during the campaign, but the economics involved are more complex. When tariffs increase import costs and prices, people change their behavior, and markets react. Analyses that don’t account for these secondary effects are meaningless. H. L. Menken’s old saw comes to mind: “Every complex problem has a simple answer, and it is wrong.”
One of the crucial secondary effects concerns how consumers and businesses respond to the higher costs of imports: they choose to do their buying elsewhere, presumably from domestic sources. Doubtless, the imports before the tariffs had a lower price than the domestic alternative, which is why the country was importing in the first place. But after the tariffs, the imports have a higher cost than the domestic alternative. The difference between this new, higher cost of imports and the cost of domestic alternatives blunts the overall impact of the tariffs on U.S. inflation, even if it cannot erase it.
Another consideration is the response of exchange rates. If the tariffs cause the Chinese yuan to lose value against the U.S. dollar, then the dollar price of Chinese goods will fall, erasing some or all of the tariffs’ burden on American buyers. Indeed, this is what happened when Trump first raised tariffs on Chinese goods in 2018 and 2019. Back then, the tariffs prompted a steep 10 percent decline in the Chinese yuan against the U.S. dollar, enough to offset roughly two-thirds of the costs imposed by the tariff increases. American buying of Chinese goods, accordingly, remained high. Imported volumes of Chinese goods rose some 12 percent a year on average in 2018 and 2019.
Thus, these foreign exchange effects not only erased most of the inflationary effect of the tariffs; they also thwarted Trump’s aim to reduce the flow of Chinese imports. Because the foreign exchange moves meant that Chinese producers received fewer dollars for their products than before, the burden of the tariffs fell on them. Their revenues and profits suffered, even as sales volumes continued to rise. Trump noted this fact at the time, announcing that the Chinese were paying for the tariffs. The media roundly mocked him for this statement, but he was right.
This time, the Trump tariffs will almost certainly be higher, so a similar offset would require a bigger yuan move. A yuan drop of 18 percent to 20 percent against the dollar would probably be sufficient. That would put the exchange rate at about 8.5 yuan to the dollar, taking it back to its cheapest level since 2005. Beijing might resist such a yuan depreciation. Chinese authorities have resisted yuan declines of late out of fear that it will prompt capital outflows. But China’s economy needs to sustain export volumes, which may prompt a change in Beijing’s stance once these new tariffs go into effect. Such a move would bring on some or all of the offsets present in 2018 and 2019.
There is no telling what mix of reactions will develop once the new Trump tariffs go into effect. They may create a one-time jump in the cost of living, but likely not as high as politically motivated analysts suggested during the campaign. They may slow the flow of Chinese imports into the United States, but not nearly as dramatically as the new administration likely wants. Whatever happens, the outcome will be anything but simple.
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