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The Price of Protectionism: Understanding the Economic Trade-offs of Tariffs

In recent years, tariff policies have resurfaced as a focal point in global economic discussions. With the new US administration’s promotion of tariffs as a policy tool, it is critical to understand their potential implications. This paper explores the broader implications of tariffs, underscoring the trade-offs inherent in tariff policy and their potential economic and financial consequences.

This piece is authored by Ramu Thiagarajan, Jennifer Bender and Michael Metcalfe.

Jennifer Bender, Ph.D.
Chief Investment Strategist

Tariffs: The Flip Sides to Intended Outcomes

The economic and financial impacts of tariffs are complex and multi-faceted, influencing both domestic industries and broader market dynamics. On the one hand, tariffs aim to protect domestic industries, address trade imbalances, and support emerging sectors, allowing them to develop and become competitive. They can also enhance national security by reducing dependence on foreign suppliers for critical goods and serve as leverage in trade negotiations and encouraging trading partners to adopt fairer practices.

On the other hand, while tariffs are intended to achieve these positive outcomes, their broader consequences can extend beyond their original objectives. By raising the cost of imported goods, tariffs can increase consumer prices, particularly in sectors reliant on global supply chains. Over time, they may reduce efficiency by insulating less competitive firms, misallocating resources and discouraging innovation. Additionally, tariffs can limit access to advanced technologies, slowing technological progress and hindering long-term economic development.

Although substitution effects can offset some costs by encouraging shifts to domestic alternatives or alternative trade partners, these adjustments often come with their own inefficiencies, such as higher logistical complexities, increased transportation costs, and supply chain disruptions.

The impact of tariffs on financial markets is more difficult to quantify. Markets generally experience heightened volatility in response to tariff announcements, particularly in sectors heavily integrated into global trade networks. Their effect on exchange rates is nuanced, shaped by factors such as trade flows, market expectations, and policy responses.

A Rise in Tariff Implementation

From an economic theory standpoint, tariffs are import taxes that alter the relative prices of imported goods compared to domestically produced ones. The downstream effects can be profound, impacting inflation, exchange rates, economic growth, industrial productivity, and long-term innovation.

Historically, there are limited precedents to guide us. Prior to 2018, tariffs were most prominently used in the US in the 1910s-1930s, notably with the Smoot-Hawley Tariff Act of 1930, widely regarded as a contributor to The Great Depression. In the modern era, significant tariff actions were initiated by the first Trump administration and continued under the Biden administration, targeting steel and aluminum (2018 onward), Chinese imports (2018 onward), European aircraft and agricultural products (2019-2021), and solar panels (2018 onward).

Exhibit 1 illustrates the historical decline in US effective tariff rates from approximately 1900 to 2023, with tariffs on dutiable goods and overall imports showing a sharp decrease over time due to trade liberalization and economic integration. This highlights the shift from protectionist policies to a more open trade environment, with a slight recent uptick reflecting renewed tariff policies.

Exhibit 2 illustrates the primary channels through which tariffs influence an economy. Arrows represent the direction of causality or impact, while text in parentheses highlights potential outcomes or intermediating factors.

Exhibit 2: Holistic Framework for Understanding Impacts of Tariffs

Protectionist Piece

Each node is examined in greater detail in the piece, starting with the more well-established economic channels and concluding with the less certain financial ones.

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Tariff policies are often intended to provide short-term protection to domestic industries, shielding them from foreign competition and potentially boosting employment and output. However, they can also introduce long-term inefficiencies and risks. We explore the complex cost/benefit puzzle that can arise from trade protectionism.

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