Understanding Tariffs

An inordinate amount of attention and energy has been given to the subject of tariffs since the beginning of 2025. The stock market, all three branches of the U.S. government, the news media, indeed the entire world is in flux over the potential impact of tariffs on the global trading system and people’s lives. Fortunately, unlike with many other subjects debated by economists, tariffs are quite well-understood and something that economists are largely in agreement about.

To understand the current tariff debate, we must understand how tariffs work, who they impact, and the historical role they’ve played.

First, the basics: tariffs are taxes. When you tax something, in this case imports, you get less of it. Tariffs, like most taxes are redistributive: their costs fall primarily on consumers and businesses buying things that are made or have major components made outside the country, and on the foreign producers of these goods. Major benefits go to domestic producers of competitive products and their employees, and the government levying the tariff. Like sales taxes, they are also tough on those living from paycheck to paycheck, unlike an income tax - which falls disproportionally on those with higher incomes.

Tariffs in context

Tariffs are not nearly as straightforward as the government storyline or news media reports. To get a picture of how one country treats another economically, we need to realize that tariffs are but one of many weapons. Countries can devalue their currencies to give their companies a price advantage over the rest of the world, saddle countries with sanctions or import quotas, subsidize or give tax breaks to domestic companies/exporters, fail to enforce patent and copyright laws, make importing inefficient and expensive through licensing, paperwork, or other administrative impediments, or give foreigners little recourse in disputes. It also matters what tariffs are used for. If, e.g., they are used to fund ports, highways and other infrastructure, domestic business gains a double advantage (higher-than-otherwise demand and prices, along with lower logistics costs). The U.S., Germany, Japan and China have all done some of these at times.

Even if a country allows relatively unrestricted imports, it can greatly restrict what foreigners can do with the money they earn by taxing them, restricting them from taking their profits out of the country, or from making certain types of investments, or forcing them to enter joint ventures, or limiting them to minority ownership positions. For example, at the end of 2024 the U.S. had a 2.5 percent tariff on cars imported from Germany, and Germany had a ten percent tariff on cars imported from the U.S. But Germany also levied a hefty value-added (effectively a sales) tax on both German-made and imported cars. This would have been fine for purposes of leveling the playing field, but since they refunded this tax on exported German cars, far more Mercedes, BMWs, and Volkswagens are traveling on American roads than Fords or Chevies on the autobahn. The important point is that tariffs must be always be evaluated within the broader context and evaluated accordingly.

Tariffs, exchange rates, and interest rates

The impact of tariffs is also not limited to prices and the flow of goods. Because tariffs lower the demand for goods from a specific country, in a floating-exchange-rate world (like we generally have) they also exert downward pressure on the exporting country’s currency - which partly offsets the price increase associated with the tariff. The other side of this coin is the corresponding increase in the value of the tariffing county’s currency, which can harm its exporters. Tariffed countries also tend to retaliate with tariffs of their own. So, it is hard to suppress imports without also suppressing exports. This is why, for example, when the U.S. tried to tariff itself out of the Great Depression, total global trade volume (imports and exports) dropped by about 2/3, and U.S. exports dropped nearly 80% in three years. This is widely agreed by economists to be one of the main reasons the Depression of the 1930s will forever after be known as “Great.”

The impact of tariffs on exchange rates and interest rates depends on whether governments are trying to hold an exchange rate steady or allow it to float based on supply and demand. An analysis of this is beyond the scope of this article, but it is worth noting that in the twenty-year period that I received invitations to teach in China, they kept their currency from depreciating. China’s export-driven economy received a steady flow of surplus dollars from the mid-1990s to 2015, and the Bank of China issued Yuan to buy these dollars, accumulating around $4 trillion in reserves in the process. This massive increase in their domestic money supply drove interest rates down, spurred lending, and increased inflation. But to their credit, the Central Bank also sold bonds to sterilize this money supply increase and raised bank reserve requirements to over 20% to keep interest rates up. These policies slowed their economy, kept the Yuan stable, and made Chinese wages to go up relative to the rest of the world, giving them less of a competitive advantage than they would otherwise have had.

The current situation is different. With U.S. tariffs putting downward pressure on both their exports and the yuan, speculators will try to move capital out of China because of slowing growth and anticipated currency depreciation. Assuming China remains true to form, it will support its currency by selling its U.S. bond reserves and buying yuan with the dollars. This is likely to offset the appreciation of the U.S. dollar related to tariffs, which means the goods we import from China will be more expensive than otherwise and our interest rates will also go up substantially - raising our government’s fiscal deficit at a risky time to do so.

If all this erodes confidence in U.S. global economic leadership, other foreign investors will gradually exchange dollar-denominated investments for those in other currencies, further eroding the “safe haven” status of the U.S. dollar and increasing our interest rates. In a worst-case scenario, we lose the exorbitant privilege of hundreds of billions in interest-free loans from the people around the world who hold and use our dollars as well as the lower interest rates on U.S. government and private debt we have enjoyed for decades. And, of course, higher interest costs to the U.S. government means less money in the budget for the provision of services, and higher rates across the U.S. economy means American debtors have less money for other things, increasing the likelihood of a recession.

Recent events also remind us that tariff wars have the potential to significantly depress stock market values at the same time interest rates are increasing - as economic activity becomes riskier, forecasted profits decrease, and bonds are sold to raise cash or to pay back money borrowed to purchase stocks, further eroding confidence and economic activity.

History of Tariff Negotiations

The damage done by the Great Depression, coupled with the tariff realities articulated above, is the main reason the nations of the world came together to create the General Agreement on Tariffs and Trade (GATT) in 1947. The U.S. led this effort and reduced its tariffs more than its trading partners to accelerate the post-WWII economic rebuilding of the economies of both allies and former enemies. Now in its eighth round, having evolved into the World Trade Organization (WTO) in 1995 to also deal with broader trade barriers, it has successfully reduced tens of thousands of tariffs and trade barriers. Although imperfect, the WTO remains vital in upholding integrity across intellectual property and other trade and investment barriers.

Tariff reduction has arguably been the most successful diplomatic effort. According to the WTO, U.S. imposed “trade-weighted” tariffs had dropped from around 20% during the Great Depression to approximately 2% prior to the recent tariff brouhaha, and most other wealthy countries had similarly low trade-weighted tariffs on U.S. products at this time. Not incidentally, global trade has risen from $12 billion in the 1930s to over $20 trillion per year during this period. And, although the World Bank did not measure the percentage of the world’s population living in “extreme poverty” during the 1930s, the percentage of the world’s population living in extreme poverty has dropped from over 60% in the year of my birth (1950) to around 9% today.

We would do well to pay attention to these numbers as we attempt to find a way out of the current tariff controversy.