Reader, it is difficult to overstate just how incredibly bad the “Liberation Day” tariff scheme is. Top to bottom, it is incoherent. When the plan was announced on April 2 with Donald Trump holding up a board of seemingly-random numbers, economists had to scramble to figure out what, exactly, these figures came from. They seemed utterly divorced from reality and had nothing to do with reciprocity. Folks figured the numbers were the bilateral trade deficit divided by imports to that country. This prompted the USTR to deny that claim and release their actual calculations. Somehow, it was worse than what people thought.
One would think that a model on “reciprocal” tariffs would include tariffs from the other country. Indeed, there are already well-established methods in US law and economic theory in determining what reciprocal tariffs should be in the face of unfair trading practices. Section 301 of the Trade Act of 1974 lays out various remedies, as does the Reciprocal Tariff Act. Countervailing duty calculations already exist; this new model serves no purpose when it comes to reciprocity or even correcting “unfair” trade practices since it doesn’t take into account any tariffs or nontariff barriers.
Rather, the model treats bilateral trade deficits as per se evidence of unfair practices. One could make an argument that overall trade deficits are bad (but even that is a stretch as such an argument is conditional, not per se, and made even weaker when a nation is the international reserve currency). But bilateral? Absolutely not. There is no reason to think that trade between any two partners would be equally balanced; we do not live in a barter economy. The entire point of money is to facilitate these bilateral trade imbalances. I have a trade surplus with my employer. That is not per se evidence that I am ripping them off. Likewise, I have trade deficits with the grocer, the butcher, the brewer, and so on. That is not per se evidence that Rouses Supermarket, Bourgeois Meat Market, nor Abitia Brewing is ripping me off. If it weren’t for money, we would have to have bilateral trade balance: I would need to find exactly what Rouses wants for my daily meals (I am willing to bet they do not want economics research). So, the premise of the entire model fundamentally misunderstands the very foundations of monetary economic exchange.
But, for the sake of argument, let us assume that the model’s premise is valid. Let us take a look at the model itself. The USTR reports the model as the balance of trade with a given country divided by price elasticity of imports (ε) times tariff passthrough (φ) times imports. This model means nothing; it hides this meaninglessness behind Greek letters, but there is no interpretable meaning to this model. It’s not obvious it will even do what the authors want it to do. Reader, you will not find this model in any economics textbook or paper and, at least as of this writing, no one has released an in-depth report on the logic of the model. So, even if the premise was valid, there is no prima facie reason to think the model itself has anything to do with the premise.
But, for the sake of argument, let’s assume that the model is valid. The model parameters chosen are illogical. For ε and φ, the USTR chose the same values for each country. But there is no reason to assume ε and φ would be identical for each country, or even for each good within each country. Both ε and φ depend on exchange-specific factors. For example, goods with many substitutes, ε will be higher (or lower if the good has few substitutes). Consequently, this implies that the calculated tariff rate is likely incorrect; it may be too high and it may be too low.
But, for the sake of argument, let us assume that every country in the world has the exact same ε and φ. The numbers chosen for these parameters are incorrect. The authors state:
Recent evidence suggests the elasticity is near 2 in the long run (Boehm et al., 2023), but estimates of the elasticity vary. To be conservative, studies that find higher elasticities near 3-4 (e.g., Broda and Weinstein 2006; Simonovska and Waugh 2014; Soderbery 2018) were drawn on.
Those are some estimates, sure. But, despite the statement that ε of 4 is “conservative,” it’s actually not. Many studies find that ε is upwards of 5-7, especially after a trade shock (see, eg, here). Furthermore, they just set φ at 0.25.* No citation given. The only justification given is:
The recent experience with U.S. tariffs on China has demonstrated that tariff passthrough to retail prices was low (Cavallo et al, 2021). [link added]
But retail prices are not the relevant measure here. We need total passthrough. Here is what Alberto Cavallo et al actually say (emphasis added):
At the border, import tariff pass-through is much higher than exchange rate pass-through. Chinese exporters did not lower their dollar prices by much, despite the recent appreciation of the dollar. By contrast, US exporters significantly lowered prices affected by foreign retaliatory tariffs. In US stores, the price impact is more limited, suggesting that retail margins have fallen. Our results imply that, so far, the tariffs’ incidence has fallen in large part on US firms.
The authors of the report get Cavallo et al exactly backward. Rather than showing low passthrough, they actually show nearly complete passthrough and that the tariff passthrough was borne by Americans. This is a horrific case of cherry-picking by the USTR. Oh, and by the way, research shows φ is closer to 0.8, not 0.25. Consequently, both ε and φ are underestimated, indicating the tariff calculation is systematically too high.
But, for the sake of argument, let us assume that their choices for ε and φ are accurate. We get to the real kicker. The authors write:
“Assuming that offsetting exchange rate and general equilibrium effects are small enough to be ignored…”
This assumption is huge. Their whole model falls apart if the assumption does not hold. Here’s the problem: The entire point of the tariffs is to have exchange rate and general equilibrium effects! They state so multiple times in their report and the Trump Administration’s economic advisors have said so as well. Thus, the core necessary assumptions of the model never held, meaning the whole thing is bunk ab initio. Indeed, not 24 hours after the tariff scheme was released, the stock market had its worst two days on record and the dollar depreciated. I don’t think I’ve ever seen a model get proven wrong so fast. 24 hours has got to be some kind of record. Even the COVID lockdown models, as bad as they were, took a few months to blow up.
I repeat again: it is hard to overstate just how bad this model is. Start to finish, it is incoherent and rife with bad assumptions, bad parameters, and no logic. This is not the result of reasoned thinking. It is a shameful display of scientism.
*By the way, this is why folks initially thought that the model was just the trade balance divided by imports. If ε = 4 and φ = 0.25 and the denominator is ε * φ * imports, then ε * φ = 1 and the whole denominator reduces to just imports. The fact the USTR didn’t see that is problematic.
