Since early 2025, the U.S. president has been making good on a campaign promise that many observers expected to be watered down or scrapped. Market players are now left guessing whether the tariffs — which have reached as high as 145% on Chinese imports — represent a firm policy shift or merely a bargaining tool.
To make sense of this moment, we need to revisit the history behind the unfolding trade war, and understand how this new wave of economic confrontation could affect you directly.
Tariffs and Comparative Advantage - a History Lesson
Under the reign of Louis XIV, France’s finance minister Jean-Baptiste Colbert developed an economic theory that would come to carry his name into posterity. The idea behind Colbertism was that France would accumulate gold and other precious metals through international trade.
The theory is a kind of ‘mercantilism 2.0’ where a country strives to have a positive trade balance. The logic is that the national economy gains precious metals by exporting more than importing.
Colbertism compels the government to direct the economy: choose the industries to be promoted and take control of the production of goods that it deems critical.
All the while, firms must embrace the state vision. In other words, companies cannot solely pursue their own self-interests.
In the early 19th century, David Ricardo, a British economist, reversed this theory. He advocated for the Theory of Comparative Advantage which expounded if you are English, there is not much point in producing wine - it’s better to focus on something you’re good at making - like clothes.
You then trade those clothes for something you can’t manufacture cheaply, e.g., Porto, the fortified wine from Portugal, (Ricardo had Portuguese roots).
If we look at the supply side of the story, the theory talks about opportunity cost (the cost of doing one thing instead of something else). The British could produce Porto if they really wanted to, they have the technology to do so, but it would simply cost them more.
Therefore, the Portuguese have a comparative advantage here, whereas the British have it in the production of clothing. Overall, both countries' citizens are better off: the Portuguese get access to cheaper clothes and the British can enjoy a tipple of some very good red wine.
This principle is the cornerstone of the theory behind modern international trade.
Practical Consequences of the Trade War and How to Survive Them
As history repeats itself, it is useful to look at the potential consequences of a trade war and at how governments have wielded tariffs over time.
1. Freedom of Choice Is Restricted by Government
International trade allows the country to specialize in what it is good at producing and delegate the production and supply of other goods elsewhere. This idea is the essence of a Pareto improvement, whereby one person benefits from a change in resource allocation without anyone else being harmed. Indeed, countries have the freedom to develop an industry without losing the benefits derived from the other sectors.
According to the three-sector model, the more a country develops, the more it moves toward a service sector-heavy economy. Now consider a developed economy whose population is mainly involved in the high added-value service sector.
The population can transition from primary sector jobs (like agriculture1.) to services as long as there is ample food production. This transition can come from increased productivity from a variety of sources such as primary sector workers, improved technology, immigration, or international trade (among others).
Sometimes, international trade is the only option. If you live in Norway, you’re going to have to import exotic fruit. This has been the crux of globalization’s expansion in recent decades.
Free trade, however, comes with a caveat, namely dependence on other countries; globalization has made every country more dependent on each other. Stated clearly, the country producing food might realize that it can cease supplying its trading partners with food and start rent-seeking (abusing a dominant position).
However, this reasoning is more of a political vision (and, as an economic institute, we stay away from politics) rather than an economic line of thought. Why?
Consider the following three points:
- Trade and power dynamics: The blackmail scenario is perfectly illustrated by the ‘butter and cannons’ theory. Imagine a country producing only butter and another country producing only cannons. Who will eventually eat the butter? Exactly.
The takeaway is that blackmail does not appear anywhere in economic theory: it is the purview of a country’s military. It is irrelevant whether your country is emmeshed in global trade is irrelevant; what matters is having as many cannons as possible. - The cost of self-sufficiency: However, if a country decides to be self-sufficient in a particular sector, its market is no longer free. First of all, who decides what the economy should produce? Usually the central government (i.e., a planned economy). This removes the free forces of the market from the equation and creates distortions.
What if the British Parliament decided the country should mass produce Porto? In terms of Pareto efficiency, there is a loss. Suppose we decide agriculture is a sector of national importance like Switzerland did in WWII. The Alpine country found itself heavily dependent on others and thus decided to actively support its agriculture sector - a wartime decision taken by politicians rather than economists. Switzerland protected a sector through barriers (e.g., tariffs, quotas, etc.) and subsidies.
As a result, agricultural firms were not as competitive as before. With such barriers, people have to acquire skills that might no longer be needed once the obstacles are suddenly removed, i.e., imagine techies, teachers and truck drivers suddenly reverting to being farmers? This applies to firms and capital investments, as well. The end result is higher food prices and less selection on the shelves. Again, this is a political decision, but it comes with a cost.
- The ‘tit-for-tat’ game theory: If a country protects a sector, another country might wonder what is brewing and thus replicate the move. The situation becomes a ‘race to the bottom’ where all the players around the poker table are wondering who is bluffing and who will play the last move.
In this scenario, the only option is upping the ante – but will result in even less freedom to choose. When a government levies a tariff it distorts the economy and reduces the scope of possibilities for private enterprise.
2. You Can’t Win on Both Sides of a Tariff
Your government cannot collect tariff revenues forever without somehow impoverishing consumers. A tariff on foreign goods can either produce revenue for the government or protect the sector – not both. By design, a tariff on imported Chinese goods will lead to a decline in consumption of those goods and thus less tariff revenue for the government.
It will, for better or worse, ensure that domestic producers do not face competition. On the flip side, if a tariff generates revenue, it is because people are still buying foreign products (e.g., people continue to buy Chinese products and, thus, the local market is not protected), which defeats the point of the tariff in the first place.
3. Can You Do Without Certain Products?
Who will pay for tariffs: the importer or the exporter? It depends on the price elasticity of the good. In short, how much are you willing to pay for a good or service? Consider champagne. If the price of bubbly increases, people will consider alternatives like Prosecco. On the flip side, even soaring prices of rare prescription medications will not scare away the consumer who needs those pills to stay alive.
Now, suppose country A puts a tax on French champagne. The seller (French producer) will most likely absorb the tax as they cannot pass it on to the consumer of country A. The producer has two choices: reduce their profit margin or sell elsewhere. In the first scenario, the government that has imposed the tariff collects the tax. In the second, it does not (see tip no. 2). In the second scenario, the consumer will not celebrate with champagne.
If, instead, we levy a tax on a pharmaceutical product, the producer will have no difficulty passing it on to the consumer. People will pay the tax and the government will collect the revenue. Put simply, the elasticity is the percentage of the tax paid by locals and the percentage paid by exporters. The more rigid the demand, the more the tax flips back to locals.
4. Powerful Countries Stand to Gain From Tariffs
After WWII, British economist John Maynard Keynes proposed the creation of an international currency. The U.S. representative in subsequent talks was a banker, Mr. White, who insisted on using the U.S. dollar as an international currency.
To oversimplify a bit, this produces three effects. First, countries around the world need to obtain dollars somehow. Trading with the U.S. is one way.
Second, the Fed needs to ensure that the dollars are used for the domestic economy and the international system. Again, if not only U.S. residents use the U.S. dollar, but also the whole world, the Fed has to consider it in its supply. Moreover, if the money is “printed” to pay for imports, this affects the balance of payments.
Third, U.S. buyers enjoy a lower exchange rate risk, i.e., if I am a European farmer selling internationally my agricultural products in U.S. dollars, I may suffer a loss in revenue if the U.S. dollar depreciates against the euro. The American farmer may not be exposed to such risk. Unless the world stops needing U.S. dollars, Americans are free to run a colossal current account deficit.
5. A Trade Deficit Is Not Necessarily a Problem
We might be tempted to think that imports are bad and exports are good, and that tariffs can right this wrong. However, a country does not have to always run a positive trade balance. The U.S. has had a large trade deficit over the last 40 years.
There are arguments in favor and arguments against it. (The U.S. has a huge surplus vs. the world in terms of services.) The practical takeaway is that the “yes or no” vision is a heritage of the past and risks skewing the analysis.
Consider an extremely poor country with one big desert and few resources. How can it progress? One option is through education. It can import education from other countries and build upon that know-how to create a knowledge-based, high-added-value economy.
The trade balance will be in deficit for many years but this might become a way to fuel economic growth, e.g., t. For instance, the Marshall Plan rebuilt Europe by borrowing money to recover and invest in long-term growth. Back then, it was perfectly alright for Europe to run a huge trade deficit.
6. A Trade War Comes With Inflation...
If the trade war succeeds in protecting the targeted industries, then those industries will face little competition and most likely raise their prices. If the sectors are created from the ground up, prices will be higher than what we would have initially paid for the imported goods (see comparative advantage). If the trade war does not protect the targeted industry because of elasticity (see point no. 3), prices will skyrocket.
...Or Even Stagflation
If the increase in price is not on the final goods but on intermediary goods, there will be a further contraction of supply. This leads to potential stagflation (a sputtering economy but rising prices). See the example of Japan’s Lost Decades (1991-2021).
7. Long-Term Growth Could Be Jeopardized
If the trade war involves technology or human capital, it might endanger technological advancement and, thus, economic growth. If the United States becomes reverts to an agrarian state then it can no longer drive global technological innovation. If it returns to its roots as a world-leading manufacturer wouldn’t its service sector (80% of GDP) suffer? Even on a smaller scale, this shift in priorities can have a major impact on people’s lives.
8. Knock-on Effects
Let’s channel Prof. Joseph Stiglitz and say that we are an industrialized country. The economy is highly capitalized. Trump wants to bring back jobs in agriculture. We might be tempted to tax agricultural imports. Imagine we succeed, and we discourage imports and stimulate local production.
To cut costs, U.S. farmers will continue to mechanize production instead of hiring workers. As a capitalized country, we might end up giving jobs to robots, which could increase the demand for high-tech components. Where are those components made? Domestically - hopefully!
9. Unexpected Consequences in Unrelated Sectors
A trade war creates instability and uncertainty. The problem is that once a tax is put in place, it is rarely removed. Politicians have a hard time eliminating taxes they’ve grown fond of. How does this relate to Germans’ love of U.S.? You’ll have to read for yourself but suffice to say that sometimes retaliatory tariffs stay in place even when we don’t remember why they were levied in the first place.
10. There Is Hope!
A trade war is a war. It creates tension and mistrust among trade partners. But don’t despair. A deal can usually be made and then the tariff might be eased or scrapped altogether binned entirely. Power dynamics can shift swiftly. Once the U.S. gets what it wants, will tariffs become less of a priority? If markets tank will politicians take heed and change course? The political winds of change are fickle so don’t lose hope!
Between Uncertainty and Resolution
Higher prices, acrimonious relations and the fear of what comes next are all consequences of tariffs that have set nations on edge. Trade wars impact people and businesses in ways that are both material and psychological, but history also shows us that negotiations follow escalations. While uncertainty looms, so too does the possibility of resolution. For now, staying informed may be our best protection.
If you’d like to explore how these dynamics are already affecting a key industry, this article on the impact of tariffs in the hospitality sector offers further insight.
