Mutual Assured Destruction (MAD) has prevented a global nuclear war. That was also true for international trade until the Administration raised tariffs on U.S. imports to levels not seen since 1909, igniting a trade war. Before the inauguration, the average tariff rate on U.S. imports was around 2.5%, but following the reciprocal tariffs announced on April 2 affecting almost every trading partner, it shot up to 22-24%. That is the highest U.S. average tariff rate since 1909, even greater than the 20% average tariff of the 1930 Smoot-Hawley Act, which deepened and extended the Depression. And that was when imports were a much smaller percentage of U.S. GDP: 3-4%, instead of over 11% now.
The 90-day pause on reciprocal tariffs provided hope that the Administration would back off, but it did not reduce the average tariff rate. The increase in tariffs to close to 150% on China, which amounts to a virtual embargo on a major source of U.S. imports, more than offsets the reductions elsewhere. The average tariff rate should move back down over time because the extreme skew toward China will cause imports to shift toward countries with lower tariffs. There is also potential for exemptions and negotiations, although negotiating trade deals with over 70 countries in the 90 days before the pause ends does not seem realistic. Individual trade agreements take many months under normal circumstances. In this case, many countries have close trade ties with China, making successful trade agreements with the U.S. much more difficult.
If average tariffs remain at 15% or higher for more than a few months, it would cause significant damage to the U.S. economy (as well as to most trading partners). U.S. inflation would increase, and economic growth would drop, most likely producing a recession.
Financial Market Volatility Is Already Testing Tariff Resolve
There are signs that the Administration might back off, as the volatility in financial markets has already generated alarm. It’s not just the sharp drop in the stock market; equities were expensive by almost every valuation metric, and current prices are nowhere near pricing in a recession. More worrisome was the surge in bond yields following the announcement of worldwide reciprocal tariffs on April 2, despite the elevated risk of recession, which usually causes interest rates to fall. This occurred as the value of the U.S. dollar continued to decline despite expectations of smaller trade deficits. A coincident drop in stock and bond prices along with the currency is typical for emerging market countries during times of crisis. Not so for developed countries, especially the U.S. The U.S. share of global equity market capitalization has already begun to decline.
Free Trade Has Been a Boon for the U.S.
The adverse reaction of financial markets and the recent plunge in consumer and business confidence in the biggest global trade war since the Depression reflects how beneficial free trade has been. Put simply, no one forces countries to trade, implying that it is inherently mutually beneficial. Tariffs are a barrier, and the enormous increases imposed by the Administration are upending the global trading system, which has become a critical conduit for the worldwide supply chain. Around 40% of U.S. imports are used as inputs to domestic production, and it would take many years for U.S. manufacturers to build domestic production facilities to make up for its loss.
Capital Flight Threatens U.S. Economic Exceptionalism
Recent capital flight is a significant concern because the capital account surplus that the U.S. has enjoyed for decades—foreigners buying more U.S. assets than Americans buy from them—has generated an enormous addition to the supply of loanable funds. The net dollars that leave the country due to trade deficits come back in the form of foreign purchases of U.S. stocks and bonds. Foreigners could instead sell the dollars for other currencies, but they invest in the U.S. because it has by far the largest, most liquid and safest financial markets in the world. Recent capital flight suggests that the safety feature is now in doubt in the minds of foreign investors.
Foreign capital inflow has kept interest rates lower than they would otherwise be and fostered a high level of investment. The U.S. has a relatively low savings rate, which usually implies less investment. But foreign inflows make up the difference, allowing for both a high consumption rate that boosts current growth and lots of investment that powers future growth and has propelled the U.S. to dominance in technology.
Tariffs Induce Retaliation
Aggressive tariffs have other negative effects besides disrupting the supply chain and the capital flowing into the U.S. They always generate retaliation that damages some of the industries the tariffs are meant to protect, such as manufacturing, agriculture and technology. China has already retaliated with a 125% tariff on U.S. exports and has also added U.S. companies to their Unreliable Entities list and set new export restrictions to the U.S., including metals necessary to produce microchips. The EU has delayed retaliation in response to the pause in reciprocal tariffs. Still, without a mutually acceptable trade deal it will likely enact tariffs roughly equivalent to the 20% rate announced by the U.S.
The Benefits of Free Trade Have More Than Offset the Cost
The exports from China and other developing countries have indeed hollowed out U.S. manufacturing and many cities that hosted them, and those are very visible and visceral costs. But it has also allowed hundreds of millions of Americans to buy goods for much less money than they could have otherwise. This allows them to spend much more money on services, such as travel, cell phone plans, streaming services, and going out to restaurants, gyms, salons, and entertainment venues. Empirical research shows that the net effect is greater output, more jobs, and lower prices. The U.S. has had trade deficits every year since 1975, and they have helped keep inflation relatively low even as economic growth has been strong.
U.S. Policy Reaction to Weaker Growth Is Constrained
If a recession occurs soon, U.S. policymakers would be constrained on how much and how quickly they could respond. The Federal Reserve normally reacts to signs of impending recession with huge interest rate cuts, having taken them to zero in the last two downturns. But the huge increase in tariffs amounts to a negative supply shock that means that a downturn in the economy will be accompanied by higher inflation, making the Fed more cautious.
Most macroeconomic shocks are on the demand side, which makes it easier for central banks to respond since prices and output move in the same direction. Countries outside the U.S. are facing a negative demand shock, which reduces both output and prices. As a result, some central banks like the ECB are already cutting rates.
With the Fed funds rate currently over 4 1/4%—considered by most economists to be restrictive—some reduction in Fed policy rates is still likely this year. And if bond yields continue to rise in response to capital flight, the Fed may well resume buying bonds, injecting liquidity to stabilize financial markets. On the fiscal side, the US is currently saddled with usually high debt levels, which would limit the size of any fiscal response.
The U.S. Economy Is on Solid Ground But Trouble Lurks Ahead
Fortunately, the U.S. economy has been quite resilient and is on solid footing, suggesting that it will take at least a couple of months for significant weakness to show up in the data. It also means that if the tariffs are temporary a prospective downturn is likely to be short-lived. The labor market is healthy, with strong job growth and an historically low unemployment rate. Jobless claims—which are released weekly and a good indicator of the health of the labor market—have remained quite low. In fact, payroll income has been running at nearly a 5% annual rate over the past 3 months, which—along with the sharp drop in energy prices—should mitigate the damage to household spending. Household and business balance sheets also look healthy: Household net worth increased by $14 trillion last year to a level of $169 trillion. Meanwhile, the debt service ratio—total debt payments divided by income—is on the low side at 11.3% (it reached almost 16% before the financial crisis and was trending around 12% before Covid). The corporate sector also looks healthy, with high net profit margins and a strong pace of business investment powered by AI.
While current economic data look solid, the outlook going forward has deteriorated. Business and consumer confidence have already taken large hits, and the April regional Fed surveys reveal a sharp drop in capital investment intentions. Household wealth has also begun to fall, reflecting lower stock and bond prices.
Tariff Policy Is Key to Where We Go From Here
Economic policy is typically overrated as a determinant of the business cycle. The economy’s performance is the product of decisions made by billions of consumers and companies around the world and is subject to numerous other influences. But the current Administration’s trade policies are so extreme that they have become a dominant factor. Further complicating matters are the frequent changes in tariffs, which have elevated uncertainty on the part of both consumers and businesses and are producing extreme volatility in financial markets.
The bottom line is that the extent to which U.S. economic growth slows and inflation increases is as much a political issue as an economic one. The Administration has already backed off some tariffs and increased others, and it’s difficult to know which tariffs will stick and how high they will ultimately be. There are also legal issues regarding whether the executive branch of the government has the power to enact these tariffs. If the current tariffs remain in place and the reciprocal tariffs are resumed, prices will rise and the economy will weaken significantly, with a recession a likely outcome. That said, the recent backtracking in response to a weaker dollar, lower stock and bond prices and the associated evidence of capital flight provides room for optimism that the current tariffs won’t last long.
