Market responses to recent U.S. tariffs suggest a potential global transition for the nation

President Trump’s tariffs, announced on April 2, disrupted the global economy in unprecedented ways.

“The financial crisis they triggered was remarkably notable,” stated Oleg Itskhoki, an economics professor. “The fluctuations in the stock market, shifts in bond yields, and the dollar exchange rate—all these aspects are interlinked. You can no longer investigate tariffs without analyzing corresponding impacts in the financial market.”

In a recent working paper, Itskhoki and his long-time collaborator Dmitry Mukhin from the London School of Economics delve into what they call “the optimal macro tariff,” or the import tax rate most advantageous to U.S. economic interests. The international macroeconomists are recognized for their studies on how the current global financial market affects currency values. Now they have broadened their methodology to analyze tariffs aimed at various U.S. policy goals.

The academic literature was overdue for a refresh. The most recent instance of tariffs at this magnitude was seen in the 1930s when nations, including the U.S., aimed to safeguard jobs amid high unemployment during the Great Depression.

“There was no significant surge in protectionism following the Great Financial Crisis of 2008 and ’09, when unemployment in the U.S. reached above 10 percent,” Itskhoki emphasized. “It appeared as though the developed world had entered a balance without tariffs.”

We recently conversed with Itskhoki about how tariffs operate in a realm of deeply interconnected trade and investment. The discussion was edited for brevity and clarity.

---

What precisely is an “optimal macro tariff”?

The economic literature concerning optimal tariffs usually poses the query, “Which policy provides a nation the best terms of trade with the rest of the globe?” This literature generally presumes trade equilibrium, but the last time the U.S. experienced balance in trade was in 1991 or ’92.

Concurrently, macroeconomists often contemplate trade imbalances while not carefully considering tariffs. What we do in this paper is integrate the two perspectives.

You’ve connected two distinct schools of thought within economics.

Indeed. Since we’ve witnessed not just the globalization of trade, but also the globalization of financial markets, where nations maintain substantial portfolios of foreign assets, this has significant implications for the optimal tariff.

Your paper concentrates on optimal macro tariffs for the U.S. What insights should we have concerning the country’s role in the global economy at this time?

Macroeconomic research over the last two decades has centered on what is sometimes referred to as the “exorbitant privilege” of the United States.

Despite maintaining a persistent trade deficit, the country has accumulated fewer assets than liabilities. However, its foreign assets have tended to be riskier, including direct foreign investments and portfolio holdings. These assets yielded high returns compared to the liabilities, which mostly consist of U.S. Treasuries.

Moreover, the federal government enjoyed offering low returns on U.S. Treasuries until recently, as they were perceived as the safest asset globally. This situation allowed the U.S. to sustain a trade deficit and enabled the government to run a significant fiscal shortfall without severe financial repercussions.

However, rising interest rates imply that the required yields on U.S. Treasuries are now considerably elevated, meaning the government can no longer borrow cheaply. Interest payments on federal debt account for approximately half of the country’s substantial fiscal deficit, which is itself larger than the trade deficit.

Typically, we observe developing nations experiencing significant trade and fiscal deficits. It is quite unusual to find the world’s leading country in this scenario.

What are the effects of introducing tariffs?

The dollar strengthened, aligning with theoretical expectations, following most prior tariff announcements. With tariffs in place, Americans tend to purchase fewer imports. This leads to a reduced demand for foreign currency to settle these purchases, causing an abundance of dollars to remain, thus fortifying the currency. This, in turn, adversely affects U.S. exporters, as American products become more costly abroad, resulting in diminished foreign purchases and a new balance characterized by decreased trade on both fronts.

Additionally, dollar strengthening acts as a financial transfer from the U.S. to those regions holding U.S. assets—the so-called “valuation effects.”

Hence, in a financially interconnected world, the ideal tariff for the U.S. is smaller than in previous times. Moreover, ownership of U.S. assets serves as effective protection for countries like China and Japan against a potential trade conflict with the U.S.

However, that wasn’t the scenario after April 2. Instead, we observed a declining U.S. dollar. What was the reason?

This was indeed unexpected. The dollar’s decline coincided with a significant crash in the U.S. stock market and escalating yields on U.S. Treasuries. Initially, there was a hypothesis that foreigners were selling off Treasuries. However, in reality, they had limited alternatives to invest in. Perhaps they considered swapping U.S. Treasuries for highly rated German Bunds. In reality, the options were tenfold fewer…
“““html

There are more German bunds available than U.S. Treasuries today, complicating the transition of portfolios away from U.S. assets.

Instead, we observed a distinct shift in the currency market. Historically, Asian investors—especially—but also some European investors, were inclined to purchase U.S. Treasuries without hedging against currency risk. The market had anticipated that the U.S. dollar would consistently gain value during economic downturns. However, April 2 marked the first instance of significant dollar depreciation in adverse conditions, as global markets turned pessimistic following the announcement of the trade war.

The U.S. dollar now mirrors the British pound post the 2016 Brexit vote. Prior to April 2, for instance, Japanese pension funds may have been prepared to hold U.S. assets without acquiring currency insurance. Now, they seek to offload that risk of U.S. dollar depreciation to the market. The necessary premium for mitigating that risk has led to a weaker dollar.

Has the U.S. gained anything from the trade war?

Indeed, the U.S. is generating tariff revenue. However, for these immediate and minor financial benefits, the government may have instigated a larger process that could diminish some of the advantages the nation has enjoyed. You could contact French President Emmanuel Macron or U.K. Prime Minister Keir Starmer for tariff negotiations, but you cannot reach out to the financial market and demand confidence in the dollar.

It doesn’t imply that the U.S. will instantaneously forfeit its pivotal role in the global financial market, but it is evident that the tariffs heralded the beginning of a genuine realignment. The discussion surrounding a tax bill designed to increase the deficit in this context is quite absurd.

What should the general public understand about the model you’ve developed to analyze optimal macro tariffs?

The model offers a structured environment to pose questions and receive coherent responses. You can experiment with different aims, such as raising revenue or enhancing manufacturing employment. We discovered that there is indeed an optimal tariff for the U.S. — somewhere between 25 and 35 percent — if one disregards the financial market.

However, this only holds if the government persuades the global community not to retaliate, as significant losses could occur if everyone implements tariffs. This scenario resembles the pre-World War II era, when collective efforts were made to reduce tariffs.

Suddenly, the shortsighted optimal tariff has regained favor. Once we consider the financial market, the optimal tariff is actually considerably lower, around 9 percent. This figure only accounts for direct financial losses from valuation effects, failing to capture the ramifications of the U.S. losing its preeminence in the global financial market.

You mentioned exploring various policy objectives. According to your model, what is the optimal tariff for enhancing employment in U.S. manufacturing?

We initially believed there would be an ideal tariff for manufacturing employment. It reflects our inherent bias. Make no mistake, tariffs are effectively a trade tax. They contract the size of the tradable sector, leading to a decrease in both imports and exports. While it is accurate that increased trade with China negatively impacted U.S. manufacturing, a tariff on trade with China would exacerbate these challenges.

If the objective is to boost tradable employment, what is truly needed are subsidies. Perhaps specific regions should be targeted. Certain industries may be deemed essential — for security, defense, or to uphold our technological leadership. Ideally, U.S. society would engage in a democratic process to determine which activities to subsidize within a balanced budget, especially considering the current high borrowing costs. Yet we are evidently far from achieving this ideal.