Can tariffs have a deflationary impact?
Before I read Deirdre McCloskey, I had a rather primitive view of methodology. Economists should develop hypotheses and then test these theories using real world data. Models were mathematical and empirical tests used regression analysis.
Today, I have a more eclectic view. A macroeconomist uses basic economic concepts, stylized facts and financial market reactions to news in order to develop a framework for understanding important macro phenomena. Influential economists utilize more than just formal tests; they develop coherent stories that use powerful metaphors to persuade those with an open mind (i.e., the young.)
In my book on the Great Depression, I challenged the prevailing view that tariffs have an inflationary impact. Free trade advocates tend to see tariffs as a negative supply shock, and assume the impact will be inflationary. Keynesians admit that tariffs have modest efficiency costs, but also argue that they can boost demand for domestic goods, especially in a severely depressed economy. They also see tariffs as having an inflationary impact, for both supply and demand-side reasons.
I argued that the Smoot-Hawley tariff had a deflationary impact. This tariff interacted with monetary policy to reduce aggregate demand, which more than offset the inflationary impact of reduced aggregate supply. The response of asset markets to news about Smoot-Hawley further supports that view. Deflation accelerated after Smoot-Hawley was enacted in June 1930.
I don’t think my book will convince many people, partly because hardly anyone read it and partly because I don’t use standard methods. Nonetheless, I believe my explanation will eventually be accepted.
A recent issue of The Economist had a special essay on the causes of the global trend toward low inflation. This caught my eye:
Ironically, the recent incremental reversals of globalisation provide good examples of the importance of global financial conditions to inflation. In theory tariffs should boost inflation in the country that sets them. But as the trade war between America and China heated up during 2019, it sparked fears about global growth and triggered a rush into safe assets such as Treasury bonds. Long-term bond yields fell to new depths and the dollar surged. In response the Fed has cut rates and the ECB has restarted QE.
The deflationary impact of a change in global risk appetite has proved far more significant than the modest inflationary impact of the tariffs themselves.
Just to be clear, tariffs do not always have a deflationary impact; it depends on how they interact with the monetary regime. It is possible that the Fed’s recent rate cuts will prevent any significant fall in inflation (although TIPS spreads have declined). But the fact that they needed to cut rates is itself telling. In 1930, we were on the gold standard and central banks had less ability to engage in monetary offset.