Tariffs and Inflation

Not what some think

As an economist one of whose specializations in grad school in the late ‘60’s was international economics, I feel a certain obligation to discuss the Announcement by president elect Trump of a 25% tariff on goods and services imported from Canada and Mexico. For purposes of this discussion I will assume:

1. The tariffs are in fact levied.

2. The tariff revenues will not on the margin reduce the federal deficit. [I assume it will always be a big as he can get away with.]

3. The tariffs are large enough and are distributed among products differentially enough to require a significant redistribution of producing and consumption patterns.

I posted “Tariffs” (clever title, no?) two days before the election. Economics has not changed since then so I will quote some of that here.

In his very nice series of election issues, Nominal News today addresses tariffs. He points out the well-known fact that economists generally oppose tariffs. He also has a discussion of the distribution of the costs of the tariff between consumers being led to a mix of goods of lower value and additional cost of producing import substitutes. Correct but not new.

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[NN has a discussion of tariffs in the context of taxing net CO2 emissions that I commented on but will not repeat here.]

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Returning to “tariffs,” economists have been developing and refining arguments for and against import restrictions -- bans and quantitative restrictions are generally even worse than tariffs -- for decades.

In general, only two arguments pass muster. One is the "optimal tariff" (which would apply as well, generally better, as an "optimal export tax” -- a tariff or an export tax being equivalent macroeconomically). This works when imports/exports of item X by the imposing country are a large share of the world market for X, but X is imported/exported into/from the imposing country by many perfectly competitive importers/exporters. IFF the government of the imposing country, knowing the supply and demand curves of X can impose a tariff/export tax that will make the country an optimizing monopsonist of X imports/monopolist in the export of X, this will force down/up the international price of X and the imposing country will benefit.

I’ll here add that the “optimal” tariff/export tax will still have the same costs in terms of forcing changes in consumer behavior and tax/subsidize exports/untariffed imports as any other tariff/export tax, but the costs are more than compensated by the lower import prices/higher export revenues of X.

The other is a “Pigou tax” on a negative externality created by domestic use of the import. Examples would be a risk of disruption of supply that no one importer has the incentive to optimally diversify away from or (similarly) import of a "strategic material" whose supply disruption would cause damage greater than the damage to the importers themselves. The correct response here is a specific tariff on the strategic or risky good from specific sources, but it depends on the government having correct knowledge of the disruption risk from each importer.

NB these "Pigou tariffs" are not the same as "industrial policy" that seeks to increase domestic production of item X for some positive externality reason, including that production of X is an “infant industry. THAT calls for a subsidy on production, not restriction of imports. In the first case the negative externality is located with the _domestic use_ of item X from each source(s). In the second case, the positive externality is located with the _production_ of X.

An aspect of import restriction that is generally not understood is that they "tax" exports and "subsidize" non-restricted imports by raising the value of the domestic currency relative to foreign currencies. Formally this is the known as the “Lerner Equivalence” of tariffs and export taxes.

Also not generally understood is that fiscal deficits, by drawing in foreign capital, have the same effect of raising the value of the domestic currency and therefore taxing exports and producers of import substitutes as import restrictions.

One additional point to be addresses is the assertion by several pundits that the Trump tariffs woud be “inflationary.” This, technically, is mistaken.

The tariffs by virtue of assumptions 2 and 3 above constitute a (negative) supply shock to the economy of the same nature as COVID or the effect on petroleum prices from Putin’s invasion of Ukraine. As with any shock, relative prices in the economy need to change up and down but some prices cannot fall easily. The only way the relative prices can adjust is for the average level to rise: inflation.[1] To avoid markets not clearing due to non-adjustment of relative prices, we should expect the Fed to “flexibly” produce enough over-target inflation to permit the relative prices to adjust.

In this sense it is OK, if somewhat imprecise, to say _the tariffs_, with the Fed’s blessing, _produced inflation_.

Other pundits have assumed (or even recommended!) that the Fed NOT facilitate the shift in relative prices but rather “fight,” with higher interest rates, to keep inflation on target. Given the criticism the Fed has received for the over-target inflation of 2021-2023, there is some danger the Fed might take that path although employment and real income would suffer. Doing so, the Fed would be adding a macroeconomic cost to the microeconomic costs of the tariffs.

Image prompt: Group of people standing by a deflated balloon labeled “Inflation.” An air pump labeled “Tariffs” is attached to the balloon. The people seem undecided whether to inflate the balloon or not.

[Closer than I expected.]

[Standard bleg: Although my style is know-it-all-ism, I do sometime entertain the thought that, here and there, I might be mistaken on some minor detail. I would welcome comments on these views.]

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[1] If the Fed is running a Flexible Average Inflation Target (FAIT) regime, then everything is relative to those price trajectories.