US government is pinning its tariff hopes on some unlikely to be realised assumptions

Last week, the US President honoured his election promise, indeed his long-held commitment, to increase tariffs on imported goods and services to the US. The formula they came up to differentiate between countries was bizarre but I don’t intend commenting on that here, except to say, the imposition of tariffs on the – Heard Island and McDonald Islands – which are an ‘Australian external territory’ that is a ‘a volcanic group of mostly barren Antarctic islands, about two-thirds of the way from Madagascar to Antarctica’ (where penguins live) ranked up there with their Signal chaos. These guys have access to the ‘red button’ after all. That’s the scary thing. Anyway I was sent a document that seemingly is the theoretical rationalisation for the tariff decision (thanks Mahaish, appreciated) and so I thought I would give it some time.

The Heard and McDonald Islands fiasco brings home the fact that the US Administration is making rapid decisions, using flimsy data and poor analytical reasoning.

Given the seriousness of these decisions in relation to global stability and the like, we are going through a very dangerous historical period.

In the case of the Islands above – they are uninhabited and very remote.

There is some research equipment there and not much else.

The UK Guardian article (April 4, 2025) – Not that Norfolk! Mislabelled shipments led to Trump tariffs on uninhabited islands and remote outposts with no US trade – tells us that according to the current US Administration the US imported “Aquarium systems, Timberland boots and recycling plant parts” from these islands.

The US relied on the World Bank data apparently which claims that “the US imported US$1.4m (A$2.23m) of products from Heard Island and McDonald Islands in 2022, nearly all of which was “machinery and electrical” imports.”

Hilarious, which also demonstrates why the World Bank should be dismantled and replaced with a more progressive and competent mission.

All economists seem to agree that the decision by the US President to impose these varied tariffs will undermine American prosperity.

That is what is taught in undergraduate and graduate programs all around the world.

Just this morning (April 7, 2025), the Melbourne Age newspaper carried analysis from its Senior economics editor – Trump’s trade war is bad, but how bad is up to the rest of us – that said among other things that:

So, while Trump’s tariffs – import duties – will hurt the countries it imports from to an extent, it’s the American businesses and consumers now having to pay more for their foreign purchases that will be hit hardest.

What he’s done will increase US prices and discourage growth in his economy – an unusual combination – increasing the risk of a US recession.

That is the standard line.

His article continued to analyse the direct and indirect impacts on Australia, which I will leave for another day.

I did a radio interview the other day and was asked about this conventional view.

Rather the conventional view was asserted by the interviewer with the question: “we all agree with that”.

To which I responded: “Not quite, it all depends on what happens to the exchange rate”.

While that view is not conventional it reflects, to some extent what we have observed in the past when looking at the aftermath of tariff decisions.

The problem is that most of the tariff dynamics historically have been associated with the fixed exchange rate period and like a lot of mainstream macroeconomic monetary theory, which was based on that period, the conventional wisdom about tariffs might be askew.

Indeed, there is evidence that during Trump’s first term, the imposition of tariffs did create exclusive burdens for US domestic residents.

More on that in a while.

It is important to understand that the nominal exchange rate regime in use at the time of the change in tariffs matters.

In a fixed exchange rate system, a tariff will increase domestic prices without offset and thus will deliver results that most economists are predicting now about Trump’s tariffs.

However, the analysis has to be different when there is the possibility of nominal exchange rate movements coinciding with relative price level movements between nations.

Then the issue is less than clear cut.

The document I mentioned in the Introduction was written by one – Stephen Miran – who is now the Chair of the US – Council of Economic Advisers – and an economist at a US-based hedge fund.

The Council of Economic Advisors is part of the Presidential Executive Office and “provides much of the empirical research for the White House and prepares the publicly-available annual Economic Report of the President.”

In other words it is influential.

His PhD was supervised by none other than Martin Feldstein at Harvard.

I have written about Feldstein’s capabilities before, for example – Martin Feldstein should be ignored (May 3, 2011) and more recently – I make a prediction about the relationship between US government debt and impending crisis (July 1, 2024).

Miran’s document (published November 2024) – A User’s Guide to Restructuring the Global Trading System – appears to be the conceptual blueprint for what Trump is up to at present.

It suggests that the President is seeking:

… to reform the global trading system and put American industry on fairer ground vis-à-vis the rest of the world …

The problem he cites is the “persistent dollar overvaluation that prevents the balancing of international trade, and this overvaluation is driven by inelastic demand for reserve assets”.

A major contention in the document is that:

Tariffs provide revenue, and if offset by currency adjustments, present minimal inflationary or otherwise adverse side effects, consistent with the experience in 2018-2019. While currency offset can inhibit adjustments to trade flows, it suggests that tariffs are ultimately financed by the tariffed nation, whose real purchasing power and wealth decline, and that the revenue raised improves burden sharing for reserve asset provision.

In Chapter 3 of the document, this argument is spelt out in detail.

The argument goes like this:

1. Tariffs are a tax which is paid in this case by the exporting entity to the US Federal government on every imported good or service that falls within the tariff regime.

The price charged by the foreign exporters for the imported item from Australia to the US, as an example, is Px (that is, it is in Australian dollars).

The Exchange rate between the US and Australia in this example is e and the tariff rate on the good is t.

Which means that the $US price for the good is Pm:

Pm = e times (1 + t) times Px

If the foreign price is $A10 and the exchange rate is 0.6 ($A1 buys $US0.60) then the imported price in local currency in the absence of a tariff would be $US6.

Impose a 10 per cent tariff on all Australian goods and the $US price rises to $US6.6 with the $A price unchanged at $A10.

The following table shows some workings for you to understand the relationships.

From periods 1 to 4, the $A is appreciating as it can purchase more and more US dollars per $A1.

With no tariff, the $US price for the good quoted at $A10 starts to rise as the nominal exchange rate appreciates (or from the US side, the US depreciates against the AUD).

Scan across to the last two columns and now we have a 10 per cent tariff imposed and the impact at each nominal exchange rate would be to increase the USD price for the same good quoted at $A10.

From periods 5 to 7, the AUD is depreciating and the impact is to lower the USD price of the good quoted at $A10 irrespective of the tariff regime.

Now, if at the same time as 10 per cent tariff is imposed the currency appreciates against the currency of the exporting nation then there might be no impact on the domestic price of the good in question.

See the following table for the example.

In Period 2a, the tariff of 10 per cent increases the USD price of the quoted $A10 good by 60 US cents at an unchanged exchange rate of 0.6.

In Period 2b, however, the nominal exchange rate falls to 0.546 (that is, the AUD has depreciated by just under 10 per cent) and the tariff of 10 per cent has no impact on the USD price of the imported good.

This is the argument that underpins the advice that Trump is getting from the Council of Economic Advisers.

The document cited states it:

In other words, the exchange rate move and the tariff almost completely offset each other … The after-tariff price of the import, denominated in dollars, didn’t change. If the after-tariff import price in dollars doesn’t change, there are minimal inflationary consequences for the American economy (but not so for the exporting country).

Then the caveats are presented:

1. The nominal exchange has to appreciate by “the right amount”.

2. There is essentially no value-added being produced for the good or service in the domestic economy – so all costs embedded in the quoted price (in foreign currency) are foreign.

3. There is full “passthrough from exchange rates to exporter prices” – this becomes a problem for the US because often traded goods are not quoted in foreign prices at the instantiation of the contract but in USD.

In that case, the USD appreciation would just boost the “exporter profit margins” and not alter the price US consumers pay.

4. “Passthrough from wholesale import to retail consumer prices is complete.”

The Chair of the CEA admits that “these assumptions may not hold perfectly”, in which case the offset justification may fail.

Why would the currency appreciate after a tariff was imposed?

The assumption is that the current account (Balance of Trade component) changes in favour of US exports and against US imports, which combined boost relative demand for US dollars.

This is because the rising US dollar price of imports shifts domestic demand away from them to substitutes such as import-competing goods and services.

Evidence: Flimsy and where exchange rate effects on trade balances do occur in this direction they take some time to work through.

The document writes:

In the macroeconomic data from the 2018-2019 experience, the tariffs operated pretty much as described above. The effective tariff rate on Chinese imports increased by 17.9 percentage points from the start of the trade war in 2018 to the maximum tariff rate in 2019 … As the financial markets digested the news, the Chinese renminbi depreciated against the dollar over this period by 13.7%, so that the after-tariff USD import price rose by 4.1%. In other words, the currency move offset more than three-fourths of the tariff, explaining the negligible upward pressure on inflation. Measured from currency peak to trough (who knows exactly when the market begins to price in news?), the move in the currency was 15%, suggesting even more offset.

When there is a ‘complete’ offset, the burden of the tariff then falls on the exporting nation that is subject to the tariff because its real income is now lower because their exchange rate has depreciated.

The document claims that the impact on world trade is minimal in that case.

But isn’t the competitiveness of US exporters reduced by the nominal exchange rate appreciation?

The document claims that this impact can be minimised by:

… an aggressive deregulatory agenda, which helps make U.S. production more competitive.

So there is the ideology coming in.

The authors are claiming that the external competitiveness loss can be alleviated because government regulations can be aggressively eliminated which then allows the exporter to quote at lower prices for a given profit margin.

They obviously discount the exporters taking the unit cost reductions in higher profit margins (which is likely should such cost reductions occur).

They are also assuming productivity doesn’t change (or is enhanced) and if the deregulations impact on labour pay or conditions then that is a heroic assumption (unlikely that is!).

I decided to exam the shifts in the real exchange rates (which are provided by the Bank of International Settlements).

The Bank of International Settlements – Effective exchange rates – About – page tells us that:

Nominal effective exchange rates (NEER) are calculated as geometric trade-weighted averages of bilateral exchange rates. Real effective exchange rates (REER) are derived by adjusting the NEER by relative consumer prices.

Specifically, changes in the REER take into account both nominal exchange rate developments and the inflation differential against a basket of trading partners. An increase in NEER indicates an appreciation in nominal terms, whereas an increase in REER corresponds to an appreciation in real terms.

So what happened in the first Trump term.

The – Tariffs in the first Trump administration – were first imposed from January 2018.

The following graph shows the movements in Real Effective Exchange Rates (REER) for the US against selected trading nations for the period January 2017 to January 2021 – that is, the span of Trump’s first term in office

The results are interesting and I haven’t time today to fully analyse them.

But in summary:

1. Over Trump’s entire term, the external competitiveness of the US increased by around 6.6 per cent.

2. However, over the period between January 2018 and January 2021, US external competitiveness declined by 1.89 per cent, which means US consumers were disadvantaged (probably by the tariffs on Chinese imports).

3. The tariffs on Chinese imports appear to coincide with a deterioration in US external competitiveness and an improvement in China’s competitiveness.

But then both nations move in the same direction (falling competitiveness) after 2019.

4. Australia improved its position relative to the US.

5. The other nations shown didn’t experience significant declines in their external competitiveness and thus improved relative to the US.

So inasmuch as this was a US vs China affair, those nations appear to have experienced the larger negative effects.

The following table summarises the shifts in international competitiveness over the course of Trump’s first four-year term post the tariff impost in January 2018.

The data shows that when we take into account exchange rate movements and shifts in domestic inflation rates, only Australia improved its external competitiveness as measured by the real exchange rate.

The rest in the list lost international competitiveness overall and China and Japan lost out relative to the US.

Change in Real Exchange Rates – January 1, 2018 to January 1, 2021

Country	Index January 2018	Index January 2021	Change (per cent)
Australia	100.0	97.3	-2.70
China	100.0	103.5	+3.52
France	100	100.1	+0.14
Germany	100.0	101.9	+1.86
Japan	100.0	103.1	+3.11
UK	100.0	100.22	+0.22
US	100.0	100.1	+2.07

Conclusion

There is a lot more to write about all this.

But the message is that I doubt the hopes that the CEA chair is transmitting will work out in the way he thinks.

In part, it will depend on how much activity is shifted onto US soil from the large foreign exporting corporations and I will write about that another day.

That is enough for today!

(c) Copyright 2025 William Mitchell. All Rights Reserved.