Streetwise Professor

The tariff tremor has subsided, though the aftershocks linger. Again, most of the discussion is off-point because it is framed in strictly, or at least primarily, economic terms when in fact this policy is first and foremost an economic weapon in a much deeper great power conflict, one between the US and China/the CCP.

It is not correct to say that Trump started this war. The reality is that he has decided to fight back in a struggle for supremacy that China has been waging quite openly for years, especially during the Xi years. All the blather about Trump destroying the “American dominated rules based international order” is utterly ridiculous because China (seconded by Russia) has been quite blunt in its expressions of dissatisfaction with that order, and its intent to overturn it.

The genius behind the CCP strategy is that it has used, judo like, the order’s institutions against it. Most notably, it has ruthlessly exploited the WTO to advance its geopolitical objectives. It is quite sickening to read what the uniparty said about China’s ascension to the WTO. It was gonna make China all open and democratic, dontcha know. When admitted to the trading system, they would become just like us! Kumbaya! The End of History!

Wrong.

The desolation of industries outside of China, rampant IP theft, aggressive actions in Asia, Covid, and (if anything) an increase in domestic repression is what the gauzy sentiment about the “rules based international order” actually achieved. Perhaps too late, Trump is fighting back.

Then why not just tariffs on China then? Why impose punitive tariffs on the rest of the world, including our alleged allies, the Europeans?

Trump wants to isolate China and stem, and indeed reverse, the inroads it has made around the world, most notably Europe. The threatened tariffs on Europe (and other countries) are a way of forcing them to choose to cooperate in countering China, or kowtowing to it.

The Europeans, morons that they are, are leaning towards kowtowing. Even though they recognize that an avalanche of Chinese goods heretofore destined for the US will descend on Europe.

Lenin said that capitalists would sell communists the rope by which they will be hanged. The Europeans say: “That’s nothing! Watch this! We’ll buy from the communists the rope by which they hang us!”

All that said, I don’t think all of the measures Trump is adopting make sense. One about to go into effect is the special fee imposed on Chinese built and/or operated ships visiting US ports. The alleged purpose for this is to restore US commercial shipbuilding. As I wrote some weeks ago, this is a forlorn hope, and US efforts should focus on fixing its dysfunctional military shipbuilding rather than diffusing its resources with little (or no) chance of success.

Another downside of the monomaniacal focus on China is that it means that other areas that have greater potential to rejuvenate the American economy may be slighted. Two stand out.

The first is the T Rex in the living room–the budget and the national debt. The administration has made some encouraging moves in that direction, but those efforts appear to be slipping, and such as they were, they strike at the edges of the problem at best.

Musk promised that DOGE would save trillions. He has since faded those promises, and recent indications are that the realized savings will be 10 percent or so of those initially promised.

That’s so Elon. His business MO from Day 1 has been to overpromise and underdeliver. Remember the Solar Roof? Yes, Tesla eventually sort of caught up to his hype, but years after the promised delivery date. The lesson is–and I should have heeded it myself: always discount Elon’s promises.

I further remark that Musk’s prominence has faded noticeably in the last couple of weeks. No doubt there are multiple reasons for this. One is likely not wanting to be called out on his overpromising. Another is that his Face of DOGE routine unleashed hell on Tesla and he wants to tamp down those fires. Another is that he has no doubt tread on many toes and bruised many egos–including Trump’s.

Even a DOGE as promised would unlikely be enough to address the staggering budgetary issues confronting the country. Without confronting entitlements and effectively reversing the Covid spending splurge those issues will continue to pose an existential threat.

The second issue is regulation. One could reasonably argue that matastasizing regulation is one blade of a scissors that has cut American economic performance, China being the other.

Yes, the administration is making inroads here. Lee Zeldin’s zealousness at EPA is a particularly encouraging sign. As are Trump’s efforts to seize control of the “independent agencies” (a constitutional oxymoron). But these forays are being vigorously contesting in the courts, courts that harbor numerous intense Deep State/Administrative State partisans. Ultimately these battles will wind up in the Supreme Court, which is unlikely to resolve them definitively, let alone definitively against the bureaucracy. (Note that my prediction that the Court would dodge ruling on substance by deciding on narrow procedural grounds proved true in the first immigration case that reached it came true. Expect that to become a pattern).

The newest front in the battle for institutional control involves the Fed, with Trump ratcheting up his attacks on Chairman Jerome Powell. On the day that Trump announced the tariff salvo, I told a friend that he had to worry most about an internal foe–Powell and the Fed. My reasoning being that Trump is antithetical to the Powells of the world, and that the latter would therefore be highly likely to adopt policies that hurt the economy, just out of spite for Trump.

Powell’s remarks on Wednesday–which are what triggered Trump’s outburst about “terminating” him–confirm, or at least do not contradict, that suspicion.

Powell’s rationale for not cutting interest rates (something that the ECB has done and continues to do) is that Trump’s tariffs will be inflationary. That conclusion, if based on the simplistic reasoning that dominates discussion of this topic, is wrongheaded.

Tariffs affect the prices of imported goods relative to other goods. I repeat: they affect relative prices. Inflation relates to the level of prices. It is possible to have relative prices go up and the price level go down. Or the reverse. You cannot–I repeat, cannot–argue that there is a direct line between relative price changes and the price level.

Here I am reciting John Cochrane’s catechism about the sin of mistaking relative price shocks and price level shocks. I recommend reading the original in more detail: here is a good start.

There are causal channels that connect tariffs to the price level. But they are indirect. Both go through the effect of tariffs on real income.

The monetarist/neo-Keynesian channel is that tariffs reduce output, which reduces the demand for money, which leads to an increase in the price level.

The Fiscal Theory of the Price Level (my current preferred theory) is that tariffs reduce real income, which reduces tax receipts, which reduce primary surpluses, which causes an increase in the price level (since the real value of debt equals the present value of real primary surpluses). One wrinkle in this story is that tariff revenues affect primary surpluses, though I consider it likely that at least the punitive levels initially announced are not revenue maximizing, especially when taking into account their effect on income and corporate taxes.

But note: these causal stories are implicitly based on a projected final outcome in which the high tariffs persist for some time. That is by no means clear. The initial salvo is, as I opined at the very outset, likely a negotiating tactic that could result in reduced trade barriers, at least for countries other than China. The pause and announcements of numerous countries approaching the administration to negotiate certainly supports the art-of-the-deal interpretation.

And if it does, the same arguments that could be used to argue that the tariffs, if they remain in place, would be inflationary would be turned on their head: tariff threats that resulted in reduced trade barriers would be anti-inflationary.

Which brings me back to my earlier observation (which has achieved some resonance): tariff threats as a negotiating strategy don’t work unless there is uncertainty about whether they are a negotiating strategy. This creates uncertainty about the ultimate result, which creates uncertainty about ultimate effects on inflation.

Regardless, the legitimate potentially inflationary channels relate to the effects of tariffs on real incomes. And here perhaps the best analogy is with Fed policy responses to oil price shocks. An oil price shock is a relative price shock, just as tariffs are a relative price shock. As documented Bernanke et al, in the past the Fed has responded to this relative price shock by tightening policy, and that tightening has caused the recessions and stock market declines that Hamilton (and others) had documented previously.

Will Powell–unless Trump defenestrates him–follow the old–and discredited–Fed playbook of tightening in response to a relative price shock? I consider that likely, either because of intellectual error (compounded by institutional biases), political spite, or both.

If Trump indeed “terminates” Powell, it will have effects on the economic impact of tariffs, whatever they end up being, and will have potentially seismic consequences for America’s governing institutions (going well beyond the Fed). Thus, we are witnessing yet another game of chicken for high stakes. Does Powell think that his cause is so righteous that he will trigger this potentially cataclysmic collision?

Another imponderable that just compounds the uncertainty.