The worst of the trade war is probably behind us. US President Donald Trump is not a black box, as is often claimed. There are different blocs within the administration, as in all coalitions, which is why the administration has conflicting goals. The markets ultimately forced Trump to settle for more moderate import tariffs, and the most intense phase of the trade war lasted only 40 days. With the shorter duration, lower tariffs and calmer markets, a recession is no longer the most likely scenario, as it was during the darkest days. However, tariffs will increase prices and harm economic growth. Security policy has become an established part of trade policy. The reason for this is the strong rise of the Chinese economy, which has enabled China to challenge the US.
Trump revealed
The core principle of economics analysis is the revealed preference principle. It means that talk is cheap. If you want to know what someone likes, don’t ask them. Rather watch what they end up choosing. Choices, not words, reveal preference.
Trump revealed his preference when after a whole week after Liberation Day he maintained that he was willing to stand short term economic pain for long term economic gain. After a week, which began with stocks entering a bear market and culminated in the US bond market starting to panic, he raised the white flag by implementing the 90-day pause on tariffs.
The pause was the first real indication that he was not willing to stomach significant economic or financial market pain. A month later, he cut a very lenient trade deal with China, which validated the hypothesis that Trump was moving on from the trade war.
Markets expect little damage from tariffs
Stock markets are back to where they were before tariffs. Trump caving in and making a deal with China means that the tail risk scenarios, where extreme trade war grinds US and China trade to a halt and thrusts the US and the global economy into recession, are now unlikely.
Figure 1: Stock markets have recovered from Liberation Day
It’s remarkable that markets are pricing no damage from tariffs despite the US having quadrupled its effective tariff rate from roughly three percent. Tariffs are now set at rates last seen before the World War II.
One explanation is that if markets perceive that the weakening of the global economy will be temporary, then markets will look through the slow down, much like they would look through the earnings fall of a company suffering a one-off legal expense.
Figure 2: US tariff rates set to revert to pre-World War II levels
Assessing trade war damage
One needs a lot of humility in assessing potential trade war damage since we have not seen this level of tariffs in modern history.
The first source of tariff damage concerns supply chains. China’s share of global manufacturing is a third and it is crucial producer of key components. In the event of trade war escalation, it could have used export restrictions to hurt the US economy. In particular, China could have restricted the export of rare earth elements. China produces 70 percent and manufactures 90 percent of global rare earth elements supply. With the de-escalation of tensions damage to supply chains is no longer a large concern.
The effect of uncertainty on investment
During the most intense period of the trade war, Economics Nobel laureate Paul Krugman replied in a Goldman Sachs interview that the direct effect of tariffs on prices would not cause a recession. However, he stressed that the impact of uncertainty on investment would cause a recession. So, the bulk of economic pain comes from forgoing investment and durable consumption due to uncertainty and not from the tariff-based price increases.
The intense phase of the trade war only lasted 40 days. During this phase, firms most likely froze investment plans. However, it may be that the intense period of the trade war was simply too brief to result in firms cancelling significant orders or jettisoning investment plans. In any case, the amount of damage will be less than what seemed likely during the darkest days of the trade war.
The direct effect of tariffs
The over ten percent tariff will increase prices and lower economic growth directly as consumers and firms have less spending power. Exactly how much, depends on the flexibility of the economy. To what degree will consumers and firms be able to find substitutes to those products hit by tariffs?
Tariffs mean a less efficient economy, where consumers and firms will substitute for second best products. This means less welfare for consumers and less efficiency for firms as they reconfigure their consumption. However, the government receives tariff income and domestic suppliers receive higher demand. Net there is a loss, but the loss is smaller than a traditional macroeconomic shock that causes unemployment and hence demand.
The caveat to the idea that tariffs cause limited damage is the sheer magnitude of the current tariff shock. Previous tariff incidents in modern history involved either a segment of goods such as washers, steel and aluminium or were between two countries such as the 2018-19 US-China trade conflict. Presently the US is set to establish an effective universal tariff of over ten percent. Much also depends on how high the retaliatory tariffs will be. Presently, it seems that most countries will “eat it” in Trump parlance and impose limited tariffs.
One big, beautiful bill and the Fed
Trump’s other policies stimulate the economy and soften the blow. The Trump administration has pushed through congress a major bill that will stimulate the economy. It will increase the budget deficit and is causing significant bond market anxiety. But the bill will counteract some of the damage done by the tariffs. His other policies on regulation will likely have less short-term macroeconomic impact.
Recession no longer the likely outcome
In summary, Trump tried to push through as much tariffs as he could. The market balked and Trump retreated. The tariffs will still be historically high, and they will raise prices and hit economic growth. But most likely they will not cause a recession.
