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‘Liberation day’: or start of a Trump slump?

On April 2nd, Donald Trump announced sweeping new ‘reciprocal’ tariffs. These would be in addition to 25% tariffs on imports of cars, steel and aluminium already announced and any other tariffs in place on individual countries, such as China. The new tariffs would apply to US imports from every country, except for Canada and Mexico where tariffs had already been imposed.

The new tariffs will depend on the size of the country’s trade in goods surplus with the USA (i.e. the USA’s trade in goods deficit with that country). The bigger the percentage surplus, the bigger the tariff. But, no matter how small a country’s surplus or even if it runs a deficit (i.e. imports more goods from the USA than it sells), it will still face a minimum 10% ‘baseline’ tariff.

President Trump states that these tariffs are to counter what he claims as unfair trade practices inflicted on the USA. People had been expecting that these tariffs would reflect the tariffs applied by other countries on US goods and possibly also non-tariff barriers, such as the ban on chlorine-washed chicken or hormone-injected beef in the EU and UK. But, by basing them on the size of a country’s trade surplus, this meant imposing them on many countries with which the USA has a free-trade deal with no tariffs at all.

The table gives some examples of the new tariff rates. The largest rates will apply to China and south-east Asian countries, which supply low-priced products, such as clothing, footwear and electronics to the US market. In China’s case, it now faces a reciprocal tariff rate of 34% plus the previously imposed tariff rate of 20%, giving a massive 54%.

What is more, the ‘de minimis’ exemption will be scrapped for packages sent by private couriers. This had exempted goods of $800 or less sent direct to consumers from China and other countries from companies such as Temu and Alibaba. It is also intended to cut back on packages of synthetic opioids sent from these countries.

The US formula for reciprocal tariffs

As we have seen, reciprocal tariffs do not reflect countries’ tariff rates on the USA. Instead, rates for countries running a trade in goods surplus with the USA (a US trade deficit with these countries) are designed to reflect the size of that surplus as a percentage of their total imports from the USA. The White House has published the following formula.


where:

When the two elasticities are multiplied together this gives 1 and so can be ignored. As there was no previous ‘reciprocal’ tariff, the rise in the reciprocal tariff rate is the actual reciprocal tariff rate. The formula for the reciprocal tariff rate thus becomes the percentage trade surplus of that country with the USA: (exports – imports) / imports, expressed as a percentage. This is then rounded up to the nearest whole number.

President Trump also stated that countries would be given a discount to show US goodwill. This involves halving the rate from the above formula and then rounding up to the nearest whole number.

Take the case of China. China’s exports of goods to the USA in 2024 were $439bn, while its imports of goods from the USA were $144bn, giving China a trade surplus with the USA of $295bn. Expressing this as a percentage of exports gives ($295/$439 × 100)/2 = 33.6%, rounded up to 34%. For the EU, the formula gives ($227bn/$584bn × 100)/2 = 19.4%, rounded up to 20%.

Questioning the value of φ. Even if you accept the formula itself as the basis for imposing tariffs, the value of the second term in the denominator, φ, is likely to be seriously undervalued. The term represents the elasticity of import prices with respect to tariff changes. It shows the proportion of a tariff rise that is passed on to consumers, which is assumed to be just one quarter, with producers bearing the remaining three quarters. In reality, it is highly likely that most of the tariff will get passed on, as it was with the tariffs applied in Donald Trump’s first presidency.

If the value for φ were 1 (i.e. all the tariff passed on to the consumer), the formula would give a ‘reciprocal tariff’ of just one quarter of that with a value of φ of 0.25. The figures in the table above would look very different. If the rates were then still halved, all countries with a tariff below 40% (such as the EU, Japan or India) would instead face just the baseline tariff of 10%. What is more, China’s rate would be reduced from 54% to 30% (the original 20% plus the baseline of 10%). Cambodia’s would be reduced to 13%. Even if the halving discount were no longer applied, the rates would still be only half of those shown in the table (and 37% for China).

Are the tariffs justified?

Even if a correct value of φ were used, a percentage trade surplus is a poor way of measuring the protection used by a country. Many countries running a trade surplus with the USA are low-income countries with low labour costs. They have a comparative advantage in labour-intensive goods. That allows such goods to be purchased at low cost by Americans. Their trade surplus may not be a reflection of protection at all.

Also, if protection is to be used to reflect the trade imbalance with each country, then why impose a 10% baseline on countries, like the UK, with which the USA has a trade surplus? By the Trump administration’s logic, it ought to be subsidising UK imports or accepting of UK tariffs on imports of US goods.

But President Trump also wants to address the USA’s overall trade deficit. The US balance of trade in goods deficit was $1063bn in 2023 (the latest year for a full set of figures). But the overall balance of payments must balance. There were thus surpluses elsewhere on the balance of payments account (and some other deficits). There was a surplus on the services account of $278bn and on the financial account of $924bn. In other words, inward investment to the USA (both direct and portfolio) and the acquisition of dollars by other countries as a reserve asset were very large and helped to drive up the exchange rate. This made US goods less competitive and imports relatively cheaper.

The USA has a large national debt of some $36 trillion of which some $9 trillion is owed to foreign investors (people, institutions or countries). Servicing the debt pushes up US interest rates. This helps to maintain a high exchange rate, thereby making imports cheaper and worsening the trade deficit. The fiscal burden of servicing the debt also crowds out US government expenditure on items such as defence, education, law and order and infrastructure. President Trump hopes that tariffs will bring in additional revenue to help finance the deficit.

Effects on the USA

If the tariffs reduce spending on imports and if other countries do not retaliate, then the US balance of trade should improve. However, a tariff is effectively a tax on imported goods. It is charged to the importing company not to the manufacturer abroad. As we saw in the context of the false value for φ, most of the tariff will be passed on to American consumers. Theoretically the incidence of the tariff is shared between the supplier and the purchaser, but in practice, most of the higher cost to the importer will be passed on to the consumer. As with other taxes, the effect is to transfer money from the consumer to the government, making people poorer but giving the government extra revenue. This revenue will be dollars, not foreign currency.

As some of the biggest price rises will be for cheap manufactured products, such as imports from China, and various staple foodstuffs, the effects could be felt disproportionately by the poor. Higher import prices will allow domestic producers competing with these imports to raise their prices too. The tariffs are thus likely to be inflationary. But because the inflation would be the result of higher costs, not higher demand, this could lead to recession as real incomes fell.

American resources will be diverted by the tariffs from sectors in which the USA has a comparative advantage, such as advanced manufactured goods and services, to more basic products. Tariffs on cheap imports will make domestic versions of these products more profitable: even though they are more costly to produce, they will be sold at a higher price.

The tariffs will also directly affect goods produced by US companies. The reason is that many use complex supply chains involving parts produced abroad. Take the case of Apple. Even though it is an American company which designs its products in California, the company sources parts from several Asian countries and has factories in Vietnam, China, India, and Thailand. These components will face tariffs and thus directly affect the price of iPhones, iPads, MacBooks, etc. Similarly affected are other US tech hardware manufacturers, US car manufactures, clothing and footwear producers, such as The Gap and Nike, and home goods producers.

Monetary policy response. How the Fed would respond is not clear. Higher inflation and lower growth, or even a recession, produces what is known as ‘stagflation’: inflation combined with stagnation. Many countries experienced stagflation following the Russian invasion of Ukraine, when higher commodity prices led to soaring inflation and economic slowdown. There was a cost-of-living crisis.

If a central bank has a simple mandate of keeping inflation to a target, higher inflation would be likely to lead to higher interest rates, making recession even more likely. It is the inflation of the two elements of stagflation (inflation and stagnation) that is addressed. The recession is thus likely to be deepened by monetary policy. But as the Fed has a dual mandate of controlling inflation but also of maximising employment, it may choose not to raise interest rates, or even to lower them, to get the optimum balance between these two targets.

If other countries retaliate by themselves raising tariffs on US exports and/or if consumers boycott American goods and services, this will further reduce incomes in the USA. Just two days after ‘liberation day’, China retaliated against America’s 34% additional tariff on Chinese imports by imposing its own 34% tariff on US imports to China.

A trade war will make the world poorer, especially the USA. Investors know this. In the two days following ‘liberation day’, stock markets around the world fell sharply and especially in the USA. The Dow Jones was down 9.3% and the tech-heavy Nasdaq Composite was down 11.4%.

Effects on the rest of the world

The effects of the tariffs on other countries will obviously depend on the tariff rate. The countries facing the largest tariffs are some of the poorest countries which supply the USA with simple labour-intensive products, such as garments, footwear, food and minerals. This could have a severe effect on their economies and cause rapidly increasing poverty and hardship.

If countries retaliate, then this will raise prices of their imports from the USA and hurt their own domestic consumers. This will fuel inflation and push the more seriously affected countries into recession.

If the USA retaliates to this retaliation, thereby further escalating the trade war, the effects could be very serious. The world could be pushed into a deep recession. The benefits of trade, where all countries can gain by specialising in producing goods with low opportunity costs and importing those with high domestic opportunity costs, would be seriously eroded.

What President Trump hopes is that the tariffs will put him in a strong negotiating position. He could offer to reduce or scrap the tariffs on a particular country in exchange for something he wants. An example would be the offer to scrap or reduce the baseline 10% tariff on UK exports and/or the 25% tariff on UK exports of cars, steel and aluminium. This could be in exchange for the UK allowing the importation of US chlorinated chicken or abolishing the digital services tax. This was introduced in 2020 and is a 2% levy on tech firms, including big US firms such as Amazon, Alphabet (Google), Meta and X.

It will be fascinating but worrying to see how the politics of the trade war play out.

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Questions

  1. What is the law of comparative advantage? Does this imply that free trade is always the best alternative for countries?
  2. From a US perspective, what are the arguments for and against the tariffs announced by President Trump on 2 April 2025?
  3. What response to the tariffs is in the UK’s best interests and why?
  4. Should the UK align with the EU in responding to the tariffs?
  5. What is meant by a negative sum game? Explain whether a trade war is a negative sum game. Can a specific ‘player’ gain in a negative sum game?
  6. What happened to stock markets directly following President Trump’s announcement and what has happened since? Explain you findings.
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Investment set to fall as business is baffled by Trump

Economic growth is closely linked to investment. In the short term, there is a demand-side effect: higher investment, by increasing aggregate demand, creates a multiplier effect. GDP rises and unemployment falls. Over the longer term, higher net investment causes a supply-side effect: industrial capacity and potential output rise. This will be from both the greater quantity of capital and, if new investment incorporates superior technology, from a greater productivity of capital.

One of the biggest determinants of investment is certainty about the future: certainty allows businesses to plan investment. Uncertainty, by contrast, is likely to dampen investment. Investment is for future output and if the future is unknown, why undertake costly investment? After all, the cost of investment is generally recouped over several months or year, not immediately. Uncertainty thus increases the risks of investment.

There is currently great uncertainty in the USA and its trading partners. The frequent changes in policy by President Trump are causing a fall in confidence and consequently a fall in investment. The past few weeks have seen large cuts in US government expenditure as his administration seeks to dismantle the current structure of government. The businesses supplying federal agencies thus face great uncertainty about future contracts. Laid-off workers will be forced to cut their spending, which will have knock-on effect on business, who will cut employment and investment as the multiplier and accelerator work through.

There are also worries that the economic chaos caused by President Trump’s frequent policy changes will cause inflation to rise. Higher inflation will prompt the Federal Reserve to raise interest rates. This, in turn, will increase the cost of borrowing for investment.

Tariff uncertainty

Perhaps the biggest uncertainty for business concerns the imposition of tariffs. Many US businesses rely on imports of raw materials, components, equipment, etc. Imposing tariffs on imports raises business costs. But this will vary from firm to firm, depending on the proportion of their inputs that are imported. And even when the inputs are from other US companies, those companies may rely on imports and thus be forced to raise prices to their customers. And if, in retaliation, other countries impose tariffs on US goods, this will affect US exporters and discourage them from investing.

For many multinational companies, whether based in the USA or elsewhere, supply chains involve many countries. New tariffs will force them to rethink which suppliers to use and where to locate production. The resulting uncertainty can cause them to delay or cancel investments.

Uncertainty has also been caused by the frequent changes in the planned level of tariffs. With the Trump administration using tariffs as a threat to get trading partners to change policy, the threatened tariff rates have varied depending on how trading partners have responded. There has also been uncertainty on just how the tariff policy will be implemented, making it more difficult for businesses to estimate the effect on them.

Then there are serious issues for the longer term. Other countries will be less willing to sign trade deals with the USA if they will not be honoured. Countries may increasingly look to diverting trade from the USA to other countries.

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Data

Questions

  1. Find out what tariffs have been proposed, imposed and changed since Donald Trump came to office on 20 January 2025.
  2. In what scenario might US investment be stimulated by Donald Trump’s policies?
  3. What countries’ economies have gained or are set to gain from Donald Trump’s policies?
  4. What is the USMCA agreement? Do Donald Trump’s policies break this agreement?
  5. Find out and explain what has happened to the US stock market since January 2025. How do share prices affect business investment?
  6. Which sector’s shares have risen and which have fallen?
  7. Using the Data link above, find out what has been happening to the US Policy Uncertainty Index since Donald Trump was elected and explain particular spikes in the index. Is this mirrored in the global Policy Uncertainty Index?
  8. Are changes in the Policy Uncertainty Index mirrored in the World Uncertainty Index (WUI) and the CBOE Volatility Index: VIX?
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‘Tariff is the most beautiful word.’ Not for economists!

In an interview with Joe Rogan for his podcast, The Joe Rogan Experience, just before the US election, Donald Trump stated that, “To me, the most beautiful word – and I’ve said this for the last couple of weeks – in the dictionary today and any is the word ‘tariff’. It’s more beautiful than love; it’s more beautiful than anything. It’s the most beautiful word. This country can become rich with the use, the proper use of tariffs.”

President-elect Trump has stated that he will impose tariffs on imports of 10% or 20%, with 60% and 100% tariffs on imports from China and Mexico, respectively. This protection for US industries, combined with lighter regulation, will, he claims, provide a stimulus to the economy and help create jobs. The revenues will also help to reduce America’s budget deficit.

But it is not that straightforward.

Problems with tariffs for the USA

Imposing tariffs is likely to reduce international trade. But international trade brings net benefits, which are distributed between the participants according to the terms of trade. This is the law of comparative advantage.

In the simple two-country case, the law states that, provided the opportunity costs of producing various goods differ between the two countries, both of them can gain from mutual trade if they specialise in producing (and exporting) those goods that have relatively low opportunity costs compared with the other country. The total production and consumption of the two countries will be higher.

So if the USA has a comparative advantage in various manufactured products and a trading partner has a comparative advantage in tropical food products, such as coffee or bananas, both can gain by specialisation and trade.

If tariffs are imposed and trade is thereby reduced between the USA and its trading partners, there will be a net loss, as production will switch from lower-cost production to higher-cost production. The higher costs of less efficient production in the USA will lead to higher prices for those goods than if they were imported.

At the same time, goods that are still imported will be more expensive as the price will include the tariff. Some of this may be borne by the importer, meaning that only part of the tariff is passed on to the consumer. The incidence of the tariff between consumer and importer will depend on price elasticities of demand and supply. Nevertheless, imports will still be more expensive, allowing the domestically-produced substitutes to rise in price too, albeit probably by not so much. According to work by Kimberly Clausing and Mary E Lovely for the Peterson Institute (see link in Articles below), Trump’s proposals to raise tariffs would cost the typical American household over $2600 a year.

The net effect will be a rise in inflation – at least temporarily. Yet one of Donald Trump’s pledges is to reduce inflation. Higher inflation will, in turn, encourage the Fed to raise interest rates, which will dampen investment and economic growth.

Donald Trump tends to behave transactionally rather than ideologically. He is probably hoping that a rapid introduction of tariffs will then give the USA a strong bargaining position with foreign countries to trade more fairly. He is also hoping that protecting US industries by the use of tariffs, especially when coupled with deregulation, will encourage greater investment and thereby faster growth.

Much will depend on how other countries respond. If they respond by raising tariffs on US exports, any gain to industries from protection from imports will be offset by a loss to exporters.

A trade war, with higher tariffs, will lead to a net loss in global GDP. It is a negative sum game. In such a ‘game’, it is possible for one ‘player’ (country) to gain, but the loss to the other players (countries) will be greater than that gain.

Donald Trump is hoping that by ‘winning’ such a game, the USA could still come out better off. But the gain from higher investment, output and employment in the protected industries would have to outweigh the losses to exporting industries and from higher import prices.

The first Trump administration (2017–21), as part of its ‘America First’ programme, imposed large-scale tariffs on Chinese imports and on steel and aluminium from across the world. There was wide-scale retaliation by other countries with tariffs imposed on a range of US exports. There was a net loss to world income, including US GDP.

Problems with US tariffs for the rest of the world

The imposition of tariffs by the USA will have considerable effects on other countries. The higher the tariffs and the more that countries rely on exports to the USA, the bigger will the effect be. China and Mexico are likely to be the biggest losers as they face the highest tariffs and the USA is a major customer. In 2023, US imports from China were worth $427bn, while US exports to China were worth just $148bn – only 34.6% of the value of imports. The percentage is estimated to be even lower for 2024 at around 32%. In 2023, China’s exports to the USA accounted for 12.6% of its total exports; Mexico’s exports to the USA accounted for 82.7% of its total exports.

It is possible that higher tariffs could be extended beyond China to other Asian countries, such as Vietnam, South Korea, Taiwan, India and Indonesia. These countries typically run trade surpluses with the USA. Also, many of the products from these countries include Chinese components.

As far as the UK is concerned, the proposed tariffs would cause significant falls in trade. According to research by Nicolò Tamberi at the University of Sussex (see link below in Articles):

The UK’s exports to the world could fall by £22 billion (–2.6%) and imports by £1.4 (–0.16%), with significant variations across sectors. Some sectors, like fishing and petroleum, are particularly hard-hit due to their high sensitivity to tariff changes, while others, such as textiles, benefit from trade diversion as the US shifts demand away from China.

Other badly affected sectors would include mining, pharmaceuticals, finance and insurance, and business services. The overall effect, according to the research, would be to reduce UK output by just under 1%.

Countries are likely to respond to US tariffs by imposing their own tariffs on US imports. World Trade Organization rules permit the use of retaliatory tariffs equivalent to those imposed by the USA. The more aggressive the resulting trade war, the bigger would be the fall in world trade and GDP.

The EU is planning to negotiate with Trump to avoid a trade war, but officials are preparing the details of retaliatory measures should the future Trump administration impose the threatened tariffs. The EU response is likely to be strong.

Articles

Questions

  1. Explain why, according to the law of comparative advantage, all countries can gain from trade.
  2. In what ways may the imposition of tariffs benefit particular sections of an economy?
  3. Is it in countries’ interests to retaliate if the USA imposes tariffs on their exports to the USA?
  4. Why is a trade war a ‘negative sum game’?
  5. Should the UK align with the EU in resisting President-elect Trump’s trade policy or should it seek independently to make a free-trade deal with the USA? is it possible to do both?
  6. What should China do in response to US threats to impose tariffs of 60% or more on Chinese imports to the USA?
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Should train companies scrap peak-time fares?

In many countries, train fares at peak times are higher than at off-peak times. This is an example of third-degree price discrimination. Assuming that peak-time travellers generally have a lower price elasticity of demand, the policy allows train companies to increase revenue and profit.

If the sole purpose of ticket sales were to maximise profits, the policy would make sense. Assuming that higher peak-time fares were carefully set, although the number travelling would be somewhat reduced, this would be more than compensated for by the higher revenue per passenger.

But there are external benefits from train travel. Compared with travel by car, there are lower carbon emissions per person travelling. Also, train travel helps to reduce road congestion. To the extent that higher peak-time fares encourage people to travel by car instead, there will be resulting environmental and congestion externalities.

The Scottish experiment with abolishing higher peak-time fares

In October 2023, the Scottish government introduced a pilot scheme abolishing peak-time fares, so that tickets were the same price at any time of the day. The idea was to encourage people, especially commuters, to adopt more sustainable means of transport. Although the price elasticity of demand for commuting is very low, the hope was that the cross-price elasticity between cars and trains would be sufficiently high to encourage many people to switch from driving to taking the train.

One concern with scrapping peak-time fares is that trains would not have the capacity to cope with the extra passengers. Indeed, one of the arguments for higher peak-time fares is to smooth out the flow of passengers during the day, encouraging those with flexibility of when to travel to use the cheaper and less crowded off-peak trains.

This may well apply to certain parts of the UK, but in the case of Scotland it was felt that there would be the capacity to cope with the extra demand at peak time. Also, in a post-COVID world, with more people working flexibly, there was less need for many people to travel at peak times than previously.

Reinstatement of peak-time fares in Scotland

It was with some dismay, therefore, especially by commuters and environmentalists, when the Scottish government decided to end the pilot at the beginning of October 2024 and reinstate peak-time fares – in many cases at nearly double the off-peak rates. For example, the return fare between Glasgow and Edinburgh rose from £16.20 to £31.40 at peak times.

The Scottish government justified the decision by claiming that passenger numbers had risen by only 6.8%, when, to be self-financing, an increase of 10% would have been required. But this begs the question of whether it was necessary to be self-financing when the justification was partly environmental. Also, the 6.8% figure is based on a number of assumptions that could be challenged (see The Conversation article linked below). A longer pilot would have helped to clarify demand.

Other schemes

A number of countries have introduced schemes to encourage greater use of the railways or other forms of public transport. One of these is the flat fare for local journeys. Provided that this is lower than previously, it can encourage people to use public transport and leave their car at home. Also, its simplicity is also likely to be attractive to passengers. For example, in England bus fares are capped at £2. Currently, the scheme is set to run until 31 December 2024.

Another scheme is the subscription model, whereby people pay a flat fee per month (or week or year, or other time period) for train or bus travel or both. Germany, for example, has a flat-rate €49 per month ‘Deutschland-Ticket‘ (rising to €58 per month in January 2025). This ticket provides unlimited access to local and regional public transport in Germany, including trains, buses, trams, metros and ferries (but not long-distance trains). This zero marginal fare cost of a journey encourages passengers to use public transport. The only marginal costs they will face will be ancillary costs, such as getting to and from the train station or bus stop and having to travel at a specific time.

Articles

Questions

  1. Identify the arguments for and against having higher rail fares at peak times than at off-peak times
  2. Why might it be a good idea to scrap higher peak-time fares in some parts of a country but not in others?
  3. Provide a critique of the Scottish government’s arguments for reintroducing higher peak-time fares.
  4. With reference to The Conversation article, why is it difficult to determine the effect on demand of the Scottish pilot of scrapping peak-time fares?
  5. What are the arguments for and against the German scheme of having a €49 per month public transport pass for local and regional transport with no further cost per journey? Should it be extended to long-distance trains and coaches?
  6. In England there is a flat £2 single fare for buses. Would it be a good idea to make bus travel completely free?