EuroFinance

On March 5, US President Donald Trump addressed Congress, opening his speech with the statement, “America is Back.”

During his address, Trump asserted that other nations have long imposed tariffs on the United States, and it is now America’s turn to respond in kind. He pointed to India, noting that the country applies tariffs exceeding 100% on automobiles, which he described as an unfair practice. Additionally, he criticised the European Union, China, Brazil, and several other countries for imposing significantly higher tariffs on US goods compared to what the US levies on them, calling the system “very unfair.”

But, the discussions surrounding President Trump’s tariff proposals have sparked intense debate about their potential impact on the US economy. According to Joseph E. Gagnon, a senior fellow at the Peterson Institute for International Economics, an independent nonprofit research organisation, historical evidence and economic models suggest that tariffs are unlikely to achieve their intended goal of reducing trade deficits. “Any reduction in the deficit is temporary at best,” Gagnon told EuroFinance.

Instead, they carry inflationary consequences, weaken productivity, and increase economic uncertainty—raising concerns about a possible recession.

Tariffs won’t reduce trade deficits

One of the key arguments often made in favour of tariffs is that they help reduce trade deficits by discouraging imports. However, Gagnon dismisses this claim, explaining that tariffs tend to appreciate the US dollar, making exports more expensive and imports cheaper in relative terms. While tariffs might temporarily shrink the trade deficit, any reduction is short-lived.

“Economic models and historical experience show that tariffs do not reduce trade deficits. They appreciate the dollar, which hurts exports and partly offsets the reduction in imports.”

According to a post from the Peterson Institute for International Economics and a blog by Gagnon, even tariffs as high as 30% are unable to prevent countries from running trade deficits much larger than the one currently experienced by the United States. The reason is that when tariffs reduce imports, they also reduce the supply of dollars needed to pay for those imports. A decreased dollar supply to foreigners drives up the value of the dollar, making US exports more expensive for foreign buyers. As a result, imports do not shrink as much as expected from the tariff alone, and exports decrease by an equal amount, leaving the trade deficit unchanged.

Inflation and productivity declines

Gagnon highlighted two major economic effects of tariffs: inflation and declining productivity. Tariffs raise the cost of imported goods, and domestic producers of close substitutes find it easy to raise their own prices too. Although tariffs have a deflationary effect on exporters, this provides only a small benefit to the prices consumers pay.

“Tariffs are inflationary, both on imported goods and on domestic substitutes… They are bad for productivity and real incomes because they shift activity away from more productive exports to less productive import substitutes.” Over time, Gagnon warns, this protectionist approach makes US firms less competitive globally, leading to stagnation similar to what happened in Argentina.

“Sheltering US firms from foreign competition causes them to fall behind best practices in the rest of the world and gradually the U.S. turns into Argentina.”

The global response: retaliation and isolation

If foreign countries retaliate with their own tariffs, the US could face even higher inflation with little to no change in its trade deficit. Gagnon explains that retaliatory tariffs reduce U.S. exports just as much as U.S. tariffs reduce imports, neutralising any intended trade benefits.

“The US ends up even more isolated from the rest of the world, with even larger reductions in productivity.”

Trade wars, he notes, tend to harm multinational corporations while benefiting companies that operate solely within domestic markets. This shift further isolates the U.S. economy and weakens its global economic position.

Tariffs and monetary policy

The Federal Reserve’s response to tariffs adds another layer of uncertainty. In normal times, a one-time tariff hike might not prompt an interest rate change, as it would be treated similarly to a temporary oil price shock. However, the current economic environment complicates this approach. “It is going to be hard to be sure that any tariff increase now is a one-off. Trump obviously likes tariffs and may be tempted to keep piling them on.”

Moreover, the Fed has spent the past three years battling inflation, and allowing prices to rise again could threaten its credibility. “Central banks will likely feel obliged to act in response to any uptick in inflation at this point because they value their credibility above all else.”

Post-election uncertainty and recession risks

Perhaps the most striking observation from Gagnon is that economic uncertainty has increased after the election rather than decreased, an unusual phenomenon. Typically, elections provide clarity on economic policies, but in this case, uncertainty surrounding tariffs, deportations, federal employment, climate policies, and tax rates has only grown.

“Nobody knows where tariffs or many other policies… are heading because they are all subject to complex future negotiations.” This uncertainty is already unsettling markets, and Gagnon warned that the risk of recession is rising.

“Markets are increasingly worried that some of the possible outcomes, as well as the uncertainty itself, are raising the risk of a recession.”

Conclusion

Gagnon’s analysis paints a concerning picture of the economic risks associated with Trump’s tariff policies. While tariffs may seem like a tool to protect domestic industries, they come with significant downsides: inflation, reduced productivity, weakened global competitiveness, and heightened economic uncertainty. As policymakers navigate these challenges, the key question remains—will protectionist policies strengthen the US economy, or will they push it toward stagnation and recession?

Joseph E. Gagnon will be speaking at EuroFinance’s 29th annual International Treasury & Cash Management Summit Miami on May 28th-30th. In his session he will model potential economic trends over the next year, around the statistically probable parameters for growth, inflation, and rates in US markets.

Find out more about this year’s event and book your ticket here