The discussion around tariffs often gets caught up in political rhetoric, but if we take a step back and analyze the mechanics from a macroeconomic perspective, there are two key points that often get overlooked. Understanding these nuances requires thinking through the lens of post-Keynesian, Modern Monetary Theory (MMT)-influenced macroeconomics—an approach that sheds light on how tariffs impact financial flows, growth, and inflation.
The Recent Tariff Announcement and Market Reaction
Last Friday, Trump announced the implementation of tariffs on Canada, Mexico, and China—25% on Mexico, 25% on Canada, and 10% on China. The announcement created immediate market turmoil over the weekend, leading to significant drops in futures markets when they opened on Sunday night. However, by mid-afternoon on Monday, Trump had paused tariffs on Canada and Mexico after discussions with both nations, leading to a near-full recovery in the markets.
Despite the volatility, the S&P 500 remains only 2% off its all-time highs. This resilience underscores an important point: while tariff-induced uncertainty can cause short-term disruptions, the long-term macroeconomic impact is what really matters. That’s why it’s crucial to break down what tariffs actually do in an economy and how they might affect growth and inflation.
Tariffs: A Tax That Slows Growth
At their core, tariffs are just another form of taxation. When the government imposes a tariff on imported goods, the importer—typically a domestic business—has to pay the tax to bring those goods into the country. This revenue shows up on the U.S. Treasury’s daily statement under customs and excise taxes.
Some argue that tariffs create a new revenue stream for the government, even suggesting that they could replace income taxes. But from an MMT perspective, this is a mischaracterization. Tariffs, like all taxes, don’t create new financial assets; they simply transfer money from the private sector to the government. The first-order effect of this is a drag on economic growth because financial assets that would have otherwise been spent, invested, or saved by private entities are now removed from circulation.
In short, unless the government offsets tariffs with higher spending, the economy will experience a net contraction. The 2018 Trump tariffs provide a useful case study: following their enactment, GDP growth slowed, suggesting that tariffs acted as a headwind to economic expansion.
Will Tariffs Cause Inflation? It Depends.
A common belief is that tariffs are inherently inflationary because businesses will pass the added costs onto consumers. However, this isn’t always the case. Whether tariffs lead to inflation depends on how firms handle the increased costs.
A widely cited HBS & NBER study examined the effects of the 2018 tariffs and found that they did not significantly increase consumer prices. Instead, firms absorbed the added costs by reducing their profit margins. This had a secondary negative effect on growth: lower profit margins mean firms have less incentive to expand production, invest in new projects, or take on additional credit to fund growth.
This creates a double hit to economic growth:
- Direct effect: Tariffs remove financial assets from the private sector (like any tax).
- Indirect effect: If firms absorb the cost rather than passing it on to consumers, their profit margins shrink, reducing their willingness to expand investment and production, which further slows growth.
The Inflationary Scenario: What If Firms Pass the Costs Along?
Now, let’s consider an alternative scenario—one in which firms decide to pass the tariff costs onto consumers rather than absorbing them. In this case, tariffs would lead to an immediate, one-time inflationary effect as businesses increase prices to maintain their profit margins.
If consumers have enough income to absorb these higher prices, firms will maintain profitability and could even continue to expand investment and production. In such a scenario, we could see an ongoing economic expansion despite tariffs, as businesses continue borrowing and reinvesting—a key dynamic in the credit-driven economy.
A Counterintuitive Take: Why Inflationary Tariffs Might Be Good
Here’s where it gets interesting: if you want the economy to keep growing, you should hope that tariffs are inflationary. Why? Because if firms can pass on costs and maintain profitability, they won’t cut back on investment. This would allow the economy to continue its upward trajectory.
If, however, tariffs are not inflationary—meaning firms simply absorb the cost—then the economy is at greater risk of slowing down. This is what happened in 2018-2019: the economy cooled, partly due to the tariffs, as firms opted to reduce margins instead of raising prices.
What Happens Next?
Right now, we have a 30-day pause on new tariffs, with a decision coming in March. If tariffs are reinstated, the key question will be: Do firms pass the costs along, creating a one-time inflationary adjustment? Or do they absorb them, leading to reduced profits and slower growth?
If the latter occurs, the bullish macro environment that has driven markets higher could start to falter. On the other hand, if firms can maintain profitability despite tariffs, the economic expansion could continue.
Final Thoughts
Tariffs are often presented as either good or bad, but the reality is more nuanced. Their impact depends on how financial flows adjust, how firms react, and whether the economy can absorb the changes without stalling. The debate over tariffs isn’t just about trade policy—it’s about the fundamental mechanics of money, investment, and growth.
For more in-depth discussions, be sure to check out my latest video on tariffs, where I break this down even further. Watch it here.