THE POLITICAL ECONOMY OF TARIFFS: CALIBRATION.

Let the record show that Our President has revised his ukases on tariffs.  "Trump temporarily drops tariffs to 10% for most countries, hits China harder with 125%."  It might take most of the ninety days for those negotiations with other countries to achieve some sort of agreement, and there is a line from a Tom Clancy novel about the, um, endowment of the Chinese regime that is rattling around in my mind.

Let us also note that it is folly to expect trade flows involving a country whose currency is a reserve currency for international settlements to balance.  Somebody who does not live in that country has to obtain that reserve currency somehow, which means selling goods to obtain the currency, either to hold qua currency (I once knew how many dollars were circulating outside the United States without turning up in the domestic velocity calculations) or to hold securities denominated in that currency.  One reason that Tom Clancy line keeps buzzing in my mind is that as of this afternoon, China's bankers have not been offloading all the Treasuries they hold.

But both Our President and his noisiest critics are in error alike about wanting to balance the current accounts.

American Economic Liberties Project's Rethink Trade director, Lori Wallach, declared that "the businesses that profiteered from our old broken trade system should pay for the necessary transition to more balanced trade, not American workers and consumers. President Trump must take immediate action to stop corporations from using the pretext of these tariffs to price gouge the very Americans already slammed by decades of bad trade policy and corporate greed."

Wallach was among those who pointed out that tariffs can be a vital tool. She explained that "Trump's announcement goes much broader, but tariffs against mercantilist countries like China, Germany, Korea, Taiwan, and Japan to counter systemic trade abuses can help restore America's capacity to produce more of the critical products needed for American families to be healthy and safe and for our country to be more resilient and secure."

"But to deliver more American production and good jobs, the goal must be to balance trade, not equalize tariff rates, and tariffs must be consistent," she stressed. "Tariffs must be accompanied by other industrial policies like tax credits to build demand for U.S.-made goods, incentives for investment in new production capacity and bans on stock buybacks, and easier union formation so gains go to wages, not just profits."

"Industrial policy" might present itself in the form of tariffs or quotas as well as in other ways of generating and dissipating rents: and I can see yet another mini-dissertation coming.  Today's theme is calibration, and we might as well start with Our President's calculations of the initial tariffs.

Welp, there goes the economy. Guess I'll have to wait another decade to be able to afford a house. pic.twitter.com/2pgpncUr5o

— Aaron Reichlin-Melnick (@ReichlinMelnick) April 2, 2025

That chart gave Paul Krugman, who knows a thing or two about strategic trade policy, the impression of something hurriedly put together.  But, as is often the case with political economy, the madmen in authority have academic scribbling rattling around in their brains.  The author of a Substack called "Tree of Woe" might have found the scribbler.

The theoretical basis for the Liberation Day tariffs can be found in the book Balanced Trade: Ending the Unbearable Cost of America’s Trade Deficits. Written in 2014 by three economic professors, Jesse Richman, Howard Richman, and Ryamond Richman, the book challenges the orthodox theory that free trade is always beneficial and argues for an alternate policy they call balanced trade.

The linked post is long, and it raises the possibility that in a world of countries practicing different levels of mercantilism, a country without trade barriers of its own is worse off, only in that post there are no second-best arguments involving representative agents dancing on the pivot of a price scissors.

We'll get to the calibration.

Now, let’s compare the Richmans’ approach to the Liberation Day tariff formula that Surowiecki called “extraordinary nonsense”. The Liberation Day tariff formula takes the US trade deficit with that country and dividing it by the value of the country's exports to the United States, then divides that value in half. For instance, if China had a trade deficit with the US of $298 billion, and exports of $427 billion, then 0.5 x $298 billion / $427 billion) ~ 35%.

Do you see? Trump’s Liberation Day tariffs are are caculalted with the exact same formula as the Richmans’ scaled tariffs.

In fact, if you read Trump’s executive order, it reads as if it was written by the Richmans - or at least by someone with a copy of their book on their desk as they typed the executive order. If you compare Trump’s executive order to pages 8-11 of Balanced Trade you’ll see it for yourself. Rarely in the history of presidential policy has a scholars policy formulation been so precisely followed.

The only difference is that Trump has also included a national strategic tariff of 10% as a baseline. Trump trade policy is simply Ian Fletcher’s Free Trade Doesn’t Work combined with the Richmans’ Balanced Trade!

Note, again, that it is a fool's errand to expect trade to balance for a country whose currency is a reserve currency.

Moreover, the academic scribbler might have been Chicago's Brent Neiman, rather than the Richman Brothers (didn't they once make suits?) or Ian Fletcher.

A top economist was shocked to learn the Trump administration used his research to justify its hefty tariffs — insisting the White House got his formula “very wrong” and grossly miscalculated the levies for each country.

Brent Neiman, a University of Chicago economics professor, said in a New York Times op-ed that President Trump’s sweeping tariff regime should have been roughly four times less if Neiman’s study had been followed correctly.

The economic expert, who co-wrote the research with three other renowned economists, noted that his first question when Trump unveiled its tariff rates was: “How on earth did it calculate such huge rates?”

“The next day it got personal. The Office of the U.S. Trade Representative released its methodology and cited an academic paper produced by four economists, including me, seemingly in support of its numbers,” he wrote.

“But it got it wrong. Very wrong,” he said.

“I disagree fundamentally with the government’s trade policy and approach. But even taking it at face value, our findings suggest the calculated tariffs should be dramatically smaller — perhaps one-fourth as large.”

It's all in the calibration.

Though in effect the formula for the tariff placed on the United States by another country is equal to the trade deficit divided by imports, the formula published by the Office of the US Trade Representative has two additional terms in the denominator that just so happen to cancel out: (1) the elasticity of import demand with respect to import prices, ε, and (2) the elasticity of import prices with respect to tariffs, φ.

The idea is that as tariffs rise, the change in the trade deficit will depend on the responsiveness of import demand to tariffs, which depends on how import demand responds to import prices and how import prices respond to tariffs. The Trump Administration assumes an elasticity of import demand with respect to import prices of four, and an elasticity of import prices with respect to tariffs of 0.25, the product of which is one and is the reason they cancel out in the Administration’s formula.

However, the elasticity of import prices with respect to tariffs should be about one (actually 0.945), not 0.25 as the Trump Administration states.

Our President has since recalibrated, at least with respect to every government other than Red China's.

Correcting the Trump Administration’s error would reduce the tariffs assumed to be applied by each country to the United States to about a fourth of their stated level, and as a result, cut the tariffs announced by President Trump on Wednesday by the same fraction, subject to the 10 percent tariff floor... [T]he tariff rate would not exceed 14 percent for any country. For all but a few countries, the tariff would be exactly 10 percent, the floor imposed by the Trump Administration.

Now, our view is that the formula the administration relied on has no foundation in either economic theory or trade law. But if we are going to pretend that it is a sound basis for US trade policy, we should at least be allowed to expect that the relevant White House officials do their calculations carefully. Hopefully they will correct their mistake soon: the resulting trade liberalization would provide a much-needed boost to the economy and may yet help us stave off a recession.

The fun will continue. Matt Bernius of Outside the Beltway notes,

I am curious how this clear decision to back away from the edge strengthens the mercurial Trump Administration’s position. They just used a lot of soft power to extract talks and promises from nations we’ve previously had positive relationships with.

What happens 90 days from now if those nations are not willing to participate in negotiations with Trump and his zero-sum game approach to tariffs? Once you’ve established that you are willing to blink first when the political cost appears too high, it’s hard to regain the “he’s so crazy he might go through with it bargaining chip.”

It's supposedly all in Art of the Deal. We'll see. Professor Neiman makes the closing argument.

Trade imbalances between two countries can emerge for many reasons that have nothing to do with protectionism. Americans spend more on clothing made in Sri Lanka than Sri Lankans spend on American pharmaceuticals and gas turbines. So what? That pattern reflects differences in natural resources, comparative advantage and development levels.”

And differences in peoples' propensities to hold dollars as the reserve currency.