Trump's Tariffs: When One Policy Tool Is Asked to Do Too Much

Recently, many Indians have expressed surprise, and in some cases disappointment, over a perceived deterioration in US-India trade relations. After a period of increasingly closer economic and geopolitical ties, the imposition of steep US tariffs on Indian exports has raised questions about the direction of the relationship. While the political dynamics are complex and outside the scope of this article, the economics of such a policy can be assessed in a clear-eyed manner. 

Jan Tinbergen, a Dutch economist who pioneered the use of mathematical models to guide real-world decisions, shared the first Nobel Prize in Economics with Ragnar Frisch in 1969. One of his lasting contributions to economics was the observation that if a government has three separate goals, it must have at least three independent tools to achieve them, where each tool is selected carefully based on its capacity to influence the target. The logic is straightforward. 

A tariff policy under strain 

The recent US trade policy provides a textbook example of what happens when one instrument is asked to reduce large bilateral trade deficits, bring manufacturing jobs back to the US, retain investment capital at home, secure supply chains for national security and serve as a bargaining chip in trade negotiations. That is an extraordinarily broad range of ambitions for a single tool, particularly when many of these targets are only loosely connected to tariff measures.

For example, let us take the question of bilateral trade deficits involving specific goods. These are largely driven by the comparitive advantage of an exporting country in producing those goods relative to the price point where they can be produced in the US. 

The US can produce good-quality shirts, but not at the price Bangladesh or India can. Labour-intensive manufacturing moved abroad because others could produce such goods at far lower cost. Tariffs do not suddenly make domestic production competitive at prices Americans are willing to pay. 

The transformation of America from a low-skill, labour- intensive manufacturing nation of the 1950s into a highly-specialised service exporter underscores its technological revolution which helped propel it into one of the richest countries in the world. But, that structural transformation also helped expand The US’s trade deficit in goods vis-à-vis the rest of the world as its economy grew. 

In the aggregate, the current account deficit is macro-economically identical to an excess of expenditure over income, a fact that tariffs have little ability to change. So, even if tariffs reduce imports from one country, overall imports may simply shift to other suppliers, leaving the aggregate trade deficit much the same.

The point becomes even sharper when one considers the interaction of trade with fiscal policy. Under the national income accounts, the current account balance mirrors the difference between national savings and investment. A large fiscal deficit, driven by a major expansionary spending bill, will widen the savings-investment gap. Unless private savings rise to close the gap, which rarely happens, the result is a wider current account deficit. 

This is why the US fiscal and current account deficits (aka, the “twin deficits”), have often moved together over the past four decades. Hence, as long as the fiscal stance is pulling in the opposite direction, tariff policy alone cannot shrink the current account deficit. 

Reshoring manufacturing is another case in point. Location decisions hinge on infrastructure quality, workforce skills, productivity and market access. Tariffs may make foreign sourcing more expensive, but they cannot, by themselves, create a skilled labor force or modernise transport networks. 

The same misalignment is evident in the bid to retain domestic investment capital. Businesses choose to invest at home when they face stable demand, predictable regulation and competitive costs. Broad tariffs can increase uncertainty and raise input prices, which in turn can discourage rather than encourage investment. 

And, while tariffs can sometimes serve as a bargaining chip in negotiations, the approach risks inviting retaliation. Trading partners often respond with their own barriers to US exports, harming precisely the industries policymakers intended to protect.

The predictable trade-offs

When one instrument is made to pursue multiple, poorly aligned objectives, trade-offs become inevitable. Measures meant to shield domestic producers can raise costs for downstream manufacturers, undermining reshoring efforts. Targeting imports from one country can simply divert trade to others without improving the overall balance. Using tariffs as leverage in talks can erode export markets through retaliation. 

Another problem that is often overlooked involves the effective rate of protection. When tariffs on inputs are set higher than those on the final product, they tend to erode rather than enhance domestic value added. For example, when the United States imposed tariffs on imported steel, it raised costs for domestic auto manufacturers. The higher steel prices reduced value added in US automobile production and made American cars less competitive, whether sold at home or abroad. 

Tinbergen’s framework makes clear that these are not accidental outcomes. They are the logical result of mismatching the number and nature of instruments to the number and nature of goals. And when an additional macroeconomic reality, the savings-investment identity, is layered on top, the chances of success shrink further. 

Why does this matter for India?

The same lesson is equally relevant to India’s own policymaking. For instance, while high import tariffs have been used to protect domestic industry, policymakers have also been trying to make Indian industry more competitive in an effort to boost exports. 

Thus, the “Atmanirbhar Abhiyaan” and other inward-looking policies to curb imports will only have a limited effect if fiscal policy is pulling in the other direction. India also needs to ensure that tariffs are consistent across value chains; if inputs are taxed more heavily than outputs, initiatives such as Atmanirbhar Abhiyaan or the Production-Linked Incentive (PLI) schemes could end up discouraging value addition rather than promoting it.

In addition, industrial policy initiatives such as the PLI schemes are sometimes tasked simultaneously with boosting manufacturing, creating jobs, reducing imports, and fostering technological self-reliance. If these diverse goals are pursued with only one or two blunt instruments, disappointment is likely.

While retaliating against tariffs from a major trading partner may feel like the natural response, a trade war with the US is not in India’s interest as it has more to lose and is in a relatively weaker economic position than the US.

Instead, India should let trade relations stabilise and use the current tensions as an opportunity to push far-reaching economic reforms to further liberalise the economy, while also strengthening infrastructure and labour skills to enhance competitiveness at home. Liberalisation alone may not be sufficient, but without it, India risks remaining a high-cost, low-competitiveness economy. Tinbergen’s insight is clear: good policy requires matching the right policy instruments to the right targets. No country is exempt from that rule – neither the US nor India. 

Dev Kar is the chief economist emeritus at Global Financial Integrity and a Fellow at Yale University. Prior to this, he was a senior economist at the International Monetary Fund (IMF) where, in a career spanning nearly 32 years, he worked in various departments and visited many countries on missions.

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