Recent announcements regarding tariffs have raised eyebrows—particularly due to the formula behind them, which most economists deem nonsensical:
Upon further investigation, it appears that even if one were to entertain the logic of the formula, the underlying calculations were flawed due to an incorrect estimate of elasticity. A report from the American Enterprise Institute authored by Kevin Corinth and Stan Veuger provides clarity:
The essence of the formula is that the response of the trade deficit to increasing tariffs hinges on how import demand reacts to tariffs, which in turn relates to how import prices adjust to tariffs. The Trump Administration adopted an elasticity of import demand with respect to import prices of four, coupled with an elasticity of import prices regarding tariffs set at 0.25. This curious multiplication leads to a product of one, essentially nullifying the impact in their formula.
However, the true elasticity of import prices concerning tariffs should hover around one (specifically 0.945), rather than the claimed 0.25. The administration’s miscalculation stems from relying on the elasticity of retail prices rather than import prices. As highlighted in a study by Alberto Cavallo and colleagues, tariffs are almost fully passed through to U.S. import prices, while retail price responses are significantly more variable. Thus, it’s fundamentally flawed to conflate the elasticity of import demand with respect to import prices with that of retail prices concerning tariffs.
If we rectify this error, the tariffs expected from each country would drop to roughly a quarter of the initially stated levels. Consequently, tariffs announced by President Trump could be similarly reduced, subject to a minimum threshold of 10 percent. According to Table 1, no country would face a tariff exceeding 14 percent, and most would see a uniform 10 percent rate—thanks to the floor established by the administration.
The Cavallo study is behind a paywall, but a tweet from Cavallo appears to support their analysis:
Interestingly, the stock market initially responded positively to the tariff announcement, seemingly reassured by the prospect of a blanket 10% tariff across the board. However, this optimism quickly evaporated as traders realized that major trading partners would face significantly higher tariffs. The fallout? A staggering $5.4 trillion in wealth seemingly obliterated by a bureaucratic blunder. While this formula has numerous flaws, this particular miscalculation is particularly egregious.
It’s worth noting that the administration may have already been predisposed to high tariffs, using this formula as a convenient cover. This conjecture could explain why the EU is slapped with a 20% tariff, China a whopping 34%, and Vietnam a staggering 46%. As the saying goes, mistakes have consequences!
This situation invites comparisons to the Chinese Cultural Revolution (1966-76), when seasoned experts were exiled in favor of youthful zealots.
To be fair, anyone can make a mathematical error. Yet in an administration that boasts a cadre of skilled economists, one would expect such oversights to be promptly identified, especially when the final figures appear questionable. The previous administration fell short in this regard as well; Larry Summers cautioned the Biden administration about the risks of excessive fiscal and monetary expansion leading to inflation. The current administration, however, seems even more dismissive of economic expertise, with many talented individuals either having exited government service or keeping a low profile to avoid entanglement in the current chaos.
Now, the administration finds itself at a crossroads with three potential paths:
- Admit the erroneous figure was used and adjust the tariffs accordingly.
- Admit the erroneous figure was used while also acknowledging that the formula was not the true justification for the tariffs—essentially admitting to dishonesty.
- Refuse to acknowledge any mistake in the formula.
In previous times, option #3 would have been utterly unthinkable. Yet, we now find ourselves in a landscape where just weeks ago, the administration dismissed the specifics of a leaked battle plan as not constituting “classified information.” Indeed, and the sun rises in the west.
My wife, who experienced the Cultural Revolution, had hoped to leave such absurdities behind when she moved to America.
PS. When I reflect on the Cultural Revolution, I often think of a poignant moment from the 1994 Chinese film To Live:
Months later, during Fengxia’s childbirth, her parents and husband accompany her to the county hospital. All doctors have been sent to do hard labor for being overeducated, leaving only students in charge. Wan Erxi locates a doctor to oversee the birth, but he’s frail from starvation. The family provides him with seven steamed buns (mantou), and they decide to name their son Mantou after the buns. However, as Fengxia begins to hemorrhage, panic ensues among the nurses, who admit their ignorance. They seek the doctor’s advice, only to find him semiconscious from overeating. The family is rendered powerless, and tragically, Fengxia succumbs to postpartum hemorrhage.
