The State of Play: A Trade War Begins
On April 2, 2025, the White House issued an executive order imposing sweeping reciprocal tariffs on imports from all U.S. trade partners, citing concerns over “large and persistent annual United States goods trade deficits.” Tariff rates range from 10 percent on countries like Australia and the United Kingdom, to 20 percent on the European Union, and 24 percent on Japan. Canada and Mexico, though excluded from this particular order, were already hit with 25 percent tariffs on February 1 under a separate executive order. Some countries face even steeper penalties—China, for instance, was targeted with a 145 percent tariff and has already retaliated. Other nations are considering how to respond.
This escalation marks a serious rupture in the global trading system. Goods trade, which accounts for roughly 75 percent of global trade (the remainder being services), is being upended by a rapid and sharp departure from previous norms. As recently as 2023, average U.S. and Chinese tariff rates on imported goods stood at just 3.3 percent and 7.5 percent, respectively.
The Problem—As Framed by the Administration
The April 2 executive order lays out the Trump Administration’s fundamental grievances with the international trading system. Chief among them is the claim that “[l]arge and persistent annual U.S. goods trade deficits” have “hollow[ed] out [the U.S.] manufacturing base” and result from a “lack of reciprocity in [U.S.] bilateral trade relationships.” The Administration asserts that most countries fail to “play by the rules,” often protecting inefficient domestic producers through tariff and non-tariff barriers.
While it’s true that many trade partners engage in some form of protectionism, the United States is not exempt from this charge. U.S. trade policy also includes import restrictions aimed at shielding domestic industries from foreign competition.
At the heart of the Administration’s approach is a mercantilist worldview in which trade is viewed as a zero-sum game: countries that export are “winners,” while those that import are “losers.” By this logic, bilateral trade deficits are inherently bad and must be eliminated. But this perspective overlooks fundamental economic realities. A trade deficit for one country is, by definition, a trade surplus for its partner. It is mathematically impossible for all countries to simultaneously run trade surpluses.
Moreover, in a system with floating exchange rates, such as the USD, the flip side of a trade deficit is a capital surplus, or an inflow of investment. If the goal is to reduce trade deficits, that would require a reduction in capital inflows, seemingly at odds with calls to boost domestic investment. Conversely, policies that attract more foreign investment into the United States, such as building more factories, will almost inevitably increase trade deficits due to the associated rise in imports (e.g., of materials and equipment).
Why Tariffs?
The Trump administration has chosen import tariffs as its primary tool to rebalance trade and gain leverage in negotiations over both trade and non-trade issues. However, tariffs are, at their core, a tax on imports—typically paid by importers, which in this case are U.S. firms purchasing goods from abroad. These imported goods are then sold either directly to consumers or passed through wholesalers and retailers before reaching the final buyer.
How the burden of a tariff is distributed depends on how much of the added cost can be passed along the supply chain—from foreign exporters to U.S. importers, to wholesalers, retailers, and, ultimately, consumers. Recent academic studies suggest that American firms are likely to shoulder most of this cost.
When consumers do face higher prices, demand for imported goods tends to fall, potentially reducing the U.S. trade deficit, all else being equal. The Administration also hopes that, over time, high tariffs will push foreign firms to relocate production to the United States, thereby boosting domestic investment and job creation, further reducing imports and trade imbalances.
However, all else is rarely equal. Retaliation from trade partners is a real and growing risk. As mentioned earlier, China has already imposed retaliatory measures, and other major partners are expected to follow. While a trade war may reduce U.S. imports, it will also suppress exports, making the net impact on the trade balance uncertain.
The Administration appears to be banking on tariffs to both shrink trade deficits and raise substantial revenue. But for this to succeed, the percentage increase in tariff rates would need to exceed the percentage drop in import demand. Given how broadly and indiscriminately the tariffs have been applied, that outcome seems unlikely.
More plausibly, U.S. consumers will respond to higher prices by reducing their consumption of imported goods, leading to lower import volumes and diminishing any revenue gains from tariffs. Taken to its logical extreme, if retaliatory measures escalate far enough, tariff rates could become so prohibitive that both trade flows and the revenue they generate collapse to nearly zero.
The Impact of Tariffs
By artificially raising domestic prices, tariffs impose two fundamental costs on the U.S. economy. First, as noted earlier, consumers are unable to purchase as much with a given income, effectively reducing their purchasing power. Second, tariffs shield inefficient domestic firms from foreign competition, encouraging them to expand production. This can divert scarce resources, such as labor and capital, away from more efficient domestic firms, undermining overall economic productivity.
The United States’ recent pivot toward mercantilism runs counter to one of the most well-established principles in economics: comparative advantage. This principle holds that countries should specialize in producing goods they are most efficient at making and import the rest, thereby allowing resources to be allocated to their most productive uses. Even in a world of restricted trade, comparative advantage suggests that trade deficits or surpluses are not inherently “bad” or “good” but simply outcomes of international specialization and investment flows.
While there is a case for protecting inefficient industries deemed strategically important, such as steel or aluminum, the Trump Administration has imposed tariffs on a much broader range of products, many of which appear to lack clear strategic or national security significance.
Unintended Consequences
U.S. tariff policy is likely to generate a range of unintended and counterproductive consequences.
Currency movements play a crucial role in determining the international competitiveness of exporters. If higher U.S. tariffs successfully boost domestic investment and production relative to other countries, the USD is likely to appreciate as global capital flows into U.S. assets. Consequently, foreign-made goods will become cheaper for U.S. consumers, while U.S. exports will become more expensive abroad, partially offsetting the intended effects of the tariffs.
Additionally, if higher tariffs and a resulting global trade war generate uncertainty and dampen global economic growth, the USD may appreciate further. In times of crisis, international investors tend to seek out U.S. assets, particularly government bonds, as safe havens, regardless of the source of the disruption.
If this historical pattern holds, U.S. producers may suffer a loss of competitiveness as imports become more affordable, potentially widening the trade deficit. On the other hand, if the U.S. loses its safe-haven status, resulting in declining demand for the dollar and U.S. government bonds, the country could face not only a weaker currency but also significantly higher borrowing costs on international markets. While this might reduce the trade deficit, it would do so at a potentially devastating economic cost.
Further complicating matters, if tariffs and trade tensions fuel higher U.S. inflation, the Federal Reserve may have limited room to lower interest rates in response. In that case, yields on U.S. financial assets would remain elevated, once again reinforcing dollar appreciation and undermining the competitiveness of U.S. exports.
The Path Forward
Despite the concerns outlined above, tariffs can play a legitimate and strategic role in trade policy, especially for large economies like the United States that have the capacity to influence global prices. However, realizing this potential requires careful and nuanced design. The current U.S. approach, by contrast, appears to reflect a broad-based backlash against all trade partners and goods, rather than the selective industry- and country-specific application of what economists call optimal tariffs.
Optimal tariffs are designed to strategically reduce domestic demand for imports to such an extent that global prices fall, thereby lowering the tariff-adjusted domestic price of imported goods. This is known as the “terms-of-trade” benefit. But achieving this effect requires a delicate balance: tariff rates must be set just high enough to reduce demand and shift global prices, without imposing greater costs on domestic producers and consumers than the potential gains. The current U.S. tariff policy, however, lacks this precision and appears to have been implemented in a haphazard manner. Moreover, the administration’s warnings to trade partners not to retaliate suggest that retaliation was not fully accounted for in the tariff design.
In practice, any theoretical welfare benefits from optimal tariffs tend to evaporate quickly once trade partners retaliate. As history has shown, trade wars leave all parties worse off.
The United States should return to the drawing board, not necessarily to abandon the use of tariffs altogether, but to recalibrate and tightly target them in response to specific grievances with individual countries and particular products. A more credible and effective approach would begin with the roughly 130 cases before the World Trade Organization (WTO) in which the United States is the formal complainant, as well as the approximately 60 investigations by the U.S. International Trade Commission (USITC) into unfair trade practices by foreign producers.
In addition to leveraging these existing mechanisms, the United States could pursue new WTO complaints and encourage more U.S. companies to bring cases to the USITC. Where there is strong prima facie evidence of unfair trade, the United States might consider launching preemptive punitive tariff responses while investigations are ongoing, despite the fact that such measures are not WTO-compliant and would likely provoke retaliation.
Nevertheless, this approach would send a clearer message: that the U.S. turn toward protectionism is grounded in specific, documented trade grievances, not in a generalized rejection of the global trading system. While controversial, the preemptive use of punitive tariffs could potentially accelerate the resolution of long-standing disputes and restore some measure of credibility and coherence to U.S. trade policy.
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Mark Melatos is an Associate Professor in the School of Economics at the University of Sydney. His research, which focuses on international trade theory and policy, has been published in leading international academic journals. He has consulted for the Organisation for Economic Co-operation and Development’s Trade and Agriculture Directorate and has been invited to advise Australian Government inquiries on matters related to international trade and investment.
Image Credit: Official White House Photo by Shealah Craighead, CC0 license, via Raw Pixel
