The Meaning of Tariffs

It is important to understand the meaning of tariffs to President Trump.  To him, they are a source of revenue, a bargaining chip, and something largely within his control. 

To lower income taxes, President Trump is making an all-out effort to cut government costs and raise government revenues.  The DOGE department and Elon Musk are given the task of terminating personnel while the President seeks to substantially reduce or eliminate entire government departments and their personnel.  He also seeks to stop the distribution of funds allocated by Congress for various purposes.  Finally, he is using tariffs to raise income by themselves, as well as get foreigners to build factories and increase employment and productive capacity in the United States.  Ending the wars in Gaza and Ukraine is also clearly intended to stop the expenditures for support of Israel and Ukraine, and he wants half of Ukraine’s revenues from its mineral wealth. Simply put, increase the income and cut the costs.

Now that we can see what he’s doing, we can make better judgments about the economic consequences of his policies:

Policy #1: Close the Border and Deport Illegal Aliens: This is a two-edged sword.  While it may save federal, state and local governments the cost of supporting immigrants with health care and education, it also prevents the growth that comes from having more economically productive units.  Many of the jobs in farming, transportation, construction, and services will go unstaffed. Thus, this policy will be inflationary as labor costs rise and may lower GNP by the amount these immigrants would otherwise contribute to “production” as well as consumption.  Rising labor costs will be the most apparent cost.

Policy #2: Impose Equal Tariffs on Anyone Who Subjects the US to Tariffs: We have some sympathy for this use of tariffs. Historically after WWII the US allowed the defeated nations to protect their industries while exporting to the US.  That policy was established 80 years ago and

has been eroding steadily under the World Trade Organization.  Seeking a level playing field makes some economic sense, but as is usually the case there are some negatives to it.

We believe that President Trump is making the same mistake as President Xi.  Both appear intent on becoming totally self-sufficient.  However, President Xi has the additional motive of not wanting Western ideas to impact his political power.  But in the end, the populations of both countries will lose the benefit of global trade and the competitive advantage that one country may have because it can produce a good or service more cheaply than the same could be produced by the country that would otherwise import the good or service.  If President Trump is only seeking equal terms of trade, that would be one thing…

 But it is clear that he looks at tariffs as a revenue source.  Imports of both goods and services in the US in 2024 amounted to $4.1 trillion.  If the effective tariff rate becomes 10%, then we are looking at a maximum additional revenue of $410 billion; if 20%, $820 billion. A nice chunk of revenue.  However, total GDP last year was $29.2 trillion; adding a tax of $4.1 billion on it represents a one-time 1.4% to 2.8% boost to inflation.  Neither the Federal Reserve nor the American population would be happy!  Particularly if the primary purpose was to provide tax cuts for the wealthy.  One could expect interest rates to rise accordingly – bad for bonds and stocks.

Finally, we view the use of tariffs as a bargaining chip somewhat ambivalently.  If it is effective in cutting off the supply of fentanyl and the materials that make it, perhaps the end justifies the means.  If they encourage greater investment in the US, that is a good thing for jobs and growth. However, if the purpose is to protect industry at home, as in the case of the steel tariffs, we are again concerned that steel prices in the US would rise because there would be no competition from imports, thus more inflation.

In any event, a significant increase in trade tariffs will be inflationary, the American people will pay the tax, not foreign countries, and since tariffs will cause prices to rise, they will also depress economic growth.  Unless demand for goods is inelastic, as the price rises, the demand falls and with it the growth rate of our economy will slow.  This is why many think we are headed into recession.  A further damper on US growth will be the additional tariffs foreign countries put on our exports to them with the same adverse effect on growth.

Policy #3: Cut the Size of the 3-Million-Man Government Bureaucracy: The idea may be good, but the implementation has been a horrible joke.  The random firings including essential personnel is using a sledgehammer to drive a nail.  Selective evaluation of employees and following proper federal procedures might have accomplished something relatively soon, but as it is, virtually all of it is being litigated, which at best will only slow the job, and therefore, we don’t believe it will be effective during the first several years of President Trump’s second term.  At any rate, the fears that it creates among the government’s employees are already affecting public morale and spending. 

WHAT TO DO?

The effect of all these policies is, at one and the same time, to raise costs while lowering growth! It is for this reason so many are anticipating a recession and/or stagflation, and it is reflected in the financial markets.  Last quarter, stock indices fell about 8% and the Magnificent Seven, responsible for so much of past year’s market performance, fell 20% and other members of the technology sector have fallen more.

We have expected such an event for a long time and that is why we have substantial amounts of “cash,” i.e. money market funds and US Treasury bills, in your accounts.  We think the President is a bit giddy with his power as he talks about buying Greenland or thinking he can push Putin into a peace deal or insisting that Ukraine give up half its mineral wealth to the US.

Whether we end up in recession depends upon how much he insists on raising tariffs and for how long. Because he thinks they are useful for revenue raising and deal making, we expect him to make them higher and keep them on longer than the optimistic, but nervous investor community thinks.

Having said that, we expect eventually his policies will backfire as interest rates rise and the stock market and economy decline.  Even he recognizes there is going to be some pain and has said so.  But President Trump has an uncanny way of dodging bullets, and we respect his ability to pivot.  Many recognize this fact and therefore simply say the market will be choppy.

It is our expectation that growth will slow.  The tax bill will not be affordable, and if it passes, the bond vigilantes will cause a sharp selloff in longer term bonds unless the Federal Reserve steps in and raises short term rates.  As the market begins to anticipate recession more fully, we may, given our contrarian bent, put some of your cash to work on the thesis that the politicians won’t be able to take the pain of their policies and will change.  In the meantime, the Federal Reserve, facing stagflation will be torn between increasing interest rates to fight inflation and lowering interest rates to fight economic decline.  At the margin, we think Chair Powell will be inclined to lower rates.

In the near-term, growth may not slow as much as feared, as the accelerated purchases of foreign goods in anticipation of the tariffs before now result in a sharp drop in imports which in turn contributes positively to US GDP growth.  But the ultimate impact, until new factories can be set up and workers hired, is a significant economic slowdown.  Near term, the important economic indices are not likely to be good.  The question is how bad they are and how much has already been anticipated in stock and bond prices.