
Tariffs: Game of Economic "Chicken"
Nov 8, 2024
A tariff is a tax on goods produced by a foreign nation. The goal of a tariff is to push buyers to choose domestic products over foreign products. Currently the United States is at a severe disadvantage to China, for example, because China charges tariffs on U.S. goods to price them out of the Chinese market. Goods that suffer from tariffs include steel, aluminum and autos.
Newly elected President Donald Trump says he will impose tariffs on goods produced by foreign countries with tariffs on U.S. goods. His opponents have characterized this policy as inflationary, but that could not be farther from the truth.
U.S. tariffs would ignite a game of economic "Chicken" whereby the opposing tariffs would careen into each other like two cars streaking towards a head-on collision. Like cars, when the tariffs are about to collide to cause a crash in the foreign economy, the foreign country will swerve out of the way by eliminating its tariff. The United States, meanwhile, will declare victory by eliminating its tariff, resulting in lower prices, not inflation.
True, the initial effect of U.S. tariffs on foreign goods will lead to higher prices, but once the economic deterioration takes hold, the foreign country will fold, and prices will be lower than before.
The key is monetary theory, which follows the equation MV = PQ. M is money supply, V is the velocity of money, P is prices, and Q is the quantity of goods produced. Q must decline if M and V are stable, but P will increase because of the new tariffs. This means the goods sold under the dueling tariffs will plummet. Both countries will suffer, but the one with the initial tariffs will suffer the most because it will no longer have the price advantage. The United States, meanwhile, will already have survived under this structure since it has long suffered with the tariffs without imposing any of its own. Under the weight of the economic decline, the foreign country will be forced to eliminate the tariffs, opting for a free market where it can achieve some market share rather than losing money on every good it produces.
For the United States, this means more goods will be made here and sold globally. Our manufacturing industry, which has long suffered under the weight of unfair foreign trade policy, will grow, and our economy will achieve more balance away from its dependence on service industries.
Tariffs will also have substantial effects on markets. Bond prices still need to figure this out. They are pricing Trump's policies as inflationary, and yields are rising. This is a buying opportunity for bonds because these yields will eventually come down sharply once economic effects become clearer. With lower rates, inflation, and corporate taxes, the United States' economic growth should be strong. And the Trump tariff policy will be vital to building and maintaining that strength.
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