Right now tariffs and evolving policy are top of mind. Used as a tool for protectionism, retaliation, or revenue generation, tariffs have long played a role in shaping the U.S. economy. But under the Trump administration, their role has evolved into something more complex and sometimes controversial.
In a recent webcast hosted by Dimensional Fund Advisors, Professor Douglas Irwin, a leading expert on international trade, dissected the historical, economic, and geopolitical implications of tariffs, explaining how they function, why they are imposed, and what impact they may have on both the U.S. and its closest trading partners.
For those who want to watch the full discussion, you can do so (linked here). But if you’re short on time, this piece provides a comprehensive summary of the session, covering all key insights, economic perspectives, and audience Q&A.
A Brief History of Tariffs in the U.S.
Long before the federal government relied on income taxes to fund operations, tariffs served as one of its primary revenue sources. In the early days of the republic, U.S. tariffs averaged around 40%, a level that would be unthinkable today. These high tariffs were necessary at the time, as the government had few other ways to generate income.
However, as the U.S. economy modernized and diversified, the purpose of tariffs shifted. Instead of merely collecting revenue, tariffs became a strategic tool for:
Protecting domestic industries from foreign competition.
Influencing trade agreements by imposing pressure on other nations.
Punishing countries for unfair trade practices or geopolitical conflicts.
By the 20th century, the role of tariffs had changed dramatically. The creation of free trade agreements (FTAs) and organizations like the World Trade Organization (WTO) ushered in an era of lower global tariffs, promoting economic interdependence.
Yet, in the 21st century, tariffs have re-emerged as a political and economic battleground, with the Trump administration leading a renewed push for trade protectionism.
Why Do Countries Impose Tariffs? The Three R’s
Professor Irwin framed the use of tariffs around what he called the “Three R’s”—Reciprocity, Revenue, and Retaliation.
1. Reciprocity: Using Tariffs as a Negotiating Tool
Reciprocity refers to the strategy of matching another country’s trade policies in order to pressure them into lowering their tariffs or opening their markets. The logic is straightforward:
If another country imposes a high tariff on U.S. goods, the U.S. may respond with its own counter-tariff to force a renegotiation.
This approach is commonly used in trade agreements, where nations reduce tariffs together in a mutual compromise.
2. Revenue: The Original Purpose of Tariffs
While tariffs were once a significant source of government revenue, they have largely been replaced by income and corporate taxes in modern economies. Today, revenue generation is a secondary consideration, though it still plays a role in some policy decisions.
3. Retaliation: The “Trade War” Tactic
When a country feels that another nation is engaging in unfair trade practices, it may impose retaliatory tariffs as a means of economic punishment. This can include:
Targeting industries where the rival country is heavily dependent on exports.
Applying tariffs strategically to pressure political leaders (e.g., tariffs on goods produced in key voting districts).
What Makes Trump’s Tariffs Unique?
Historically, most administrations focused on one of these three reasons when imposing tariffs. However, the Trump administration has done something unusual: they are using tariffs for all three reasons at the same time, making their trade policy a mix of strategy, politics, and economic uncertainty.
Why Impose Tariffs on Canada and Mexico?
One of the more perplexing aspects of recent U.S. trade policy is the decision to impose tariffs on Canada and Mexico, two of the largest and closest trade partners of the United States.
During his first term, Trump repeatedly criticized NAFTA (the North American Free Trade Agreement), calling it “one of the worst trade deals ever.” However, when NAFTA was renegotiated into the USMCA (United States-Mexico-Canada Agreement), the core tariff structures remained largely unchanged.
Most of the updates in USMCA were not about tariffs but rather modernizing the agreement (from the 90s) to reflect technological advancements, digital commerce, and intellectual property protections. In many ways, the updated deal closely followed the framework of the Trans-Pacific Partnership (TPP), an agreement that the U.S. withdrew from in 2017 but that set many of the same trade standards.
Trump’s Justification for Tariffs on Canada and Mexico
The stated reasons for these tariffs were:
Curbing immigration – Despite Canada having little to do with U.S. immigration issues, it was lumped into the same category as Mexico.
Combatting fentanyl trafficking – Many of the precursor chemicals for fentanyl originate in China, yet tariffs were extended to North American partners.
Increasing domestic manufacturing – A push to reduce reliance on foreign steel and aluminum.
Why Economists Are Skeptical
Professor Irwin and many trade experts argue that these tariffs are counterproductive for several reasons:
Steel and aluminum tariffs disproportionately harm U.S. car manufacturers, raising production costs for American-made vehicles.
Consumers may simply switch to alternative imports, such as Korean vehicles from Kia or Hyundai, which remain tariff-free under existing trade agreements.
Canada and Mexico are not economic threats, yet they are being treated as adversaries in this tariff policy.
The result? Higher costs for American businesses and consumers without a clear long-term benefit.
Trade Deficits: Should We Be Concerned?
One of the most commonly misunderstood aspects of trade policy is the trade deficit, the difference between what a country imports versus what it exports.
Many politicians argue that a trade deficit is inherently bad, but Professor Irwin suggests otherwise.
A Wall Street Journal editorial once joked:
“The best way to think about the trade deficit is not to think about it.”
Why Trade Deficits Aren’t Necessarily a Problem
As individuals, we all run trade deficits in everyday life.
You buy groceries, but the grocery store doesn’t buy anything from you, that doesn’t mean it’s a bad economic transaction.
Bilateral trade deficits are largely meaningless, a country may have a deficit with one nation but a surplus with another.
When Do Trade Deficits Become a Concern?
While normal trade deficits aren’t alarming, large and persistent trade deficits (exceeding 3% of GDP) can be problematic. When this happens, something will eventually correct the imbalance, such as:
A recession that weakens the U.S. dollar.
Government intervention to reduce imports or increase exports.
Foreign investment shifts, causing economic uncertainty.
Thus, while trade deficits are not inherently bad, policymakers should be cautious if they grow too large.
The China Tariffs: Are They Effective?
A major focus of the Trump administration’s trade policy has been tariffs on Chinese goods, particularly those over $800 in value. These tariffs have been justified as a way to:
Combat fentanyl production, as many of its precursor chemicals originate in China.
Deter intellectual property (IP) theft, a longstanding issue in U.S.-China trade relations.
But Do These Tariffs Work?
According to Professor Irwin, tariffs rarely force behavioral change. Instead, they:
Lead to Chinese retaliation, making American goods more expensive for Chinese consumers.
Increase costs for U.S. consumers, who ultimately bear the brunt of higher prices.
Would a Ban Be More Effective?
Instead of tariffs, some argue that the U.S. should completely ban certain Chinese imports (e.g., semiconductors) if national security is the primary concern.
This aligns with Adam Smith’s principle that, “Defense is more important than opulence.”
If national security is at risk, the U.S. may need to accept economic sacrifices, but should carefully evaluate how much trade it is willing to forgo.
The Push for Reciprocal Tariffs: Is It Fair Trade or Just Politics?
Recently, Trump has announced a move toward “reciprocal trade tariffs”, a concept that on the surface appears to be about fairness. The idea is simple:
If another country imposes a 10% tariff on U.S. exports, the U.S. should match it with a 10% tariff on their imports.
This approach assumes that other countries have higher tariffs than the U.S., but that isn't always the case.
Where Reciprocal Tariffs Get Complicated
Professor Irwin pointed out several flaws in this approach:
Many countries already have lower tariffs than the U.S.
For example, Japan imposes a 0% tariff on U.S. autos. If the U.S. truly wanted reciprocity, should it lower its own auto tariffs to 0% as well?
New Zealand has no tariffs on dairy products, would the U.S. open its dairy market completely in return?
True reciprocity would mean 0% tariffs across the board, which is effectively a free trade agreement. However, Trump has not been satisfied with 0% reciprocity in past agreements.
The process will likely be highly discretionary. Since each country’s tariff structure is different, the government will have to pick and choose which tariffs to adjust, leading to uncertainty and unpredictability in trade policy.
Ultimately, reciprocal tariffs may end up being more about political messaging than actual trade policy.
The Economic Impact: What Happens If These Tariffs Take Effect?
Professor Irwin emphasized that tariffs don’t exist in a vacuum, they have ripple effects across the economy.
Scenario 1: Tariffs on China
The economic impact would be significant but manageable.
The main burden would fall on U.S. consumers and businesses that rely on Chinese imports.
Over time, companies might move supply chains out of China, but that doesn’t necessarily mean they’ll relocate to the U.S., they could shift to Vietnam, India, or Mexico instead.
Scenario 2: Tariffs on Canada & Mexico
This is where the biggest risks lie. Canada and Mexico are the largest U.S. trading partners, and a full-scale tariff war would create major disruptions in:
Automotive manufacturing (Canada/Mexico supply large amounts of steel and parts).
Agriculture (U.S. exports significant crops to Mexico).
Energy markets (Mexico is a key trading partner in energy products).
Projected GDP & Inflation Impacts
Economic research groups, such as the Peterson Institute for International Economics (PIIE) and the Tax Foundation, have estimated:
A 3% reduction in U.S. GDP if tariffs escalate.
A 50 basis point increase in inflation due to higher import costs.
Certain industries could face recession-like conditions, particularly agriculture and manufacturing.
While tariffs alone won’t cause a recession, their compounding effect, when combined with higher interest rates, supply chain disruptions, or consumer sentiment shifts, could tip the economy toward contraction.
How Would Canada & Mexico Respond? Retaliation or Recalibration?
If these tariffs move forward, Canada and Mexico would likely respond. The question is: how?
Economic Fallout for Canada & Mexico
Unlike the U.S., which has a large and diversified economy, Canada and Mexico are heavily dependent on U.S. trade.
Canada is much smaller than the U.S. and doesn’t have many options to reorient exports toward Europe or Asia.
Mexico’s economy is deeply linked to U.S. demand, factories and supply chains have been built specifically for U.S. consumption.
If tariffs disrupt these industries, it could push both countries into recession.
Would Retaliation Make It Worse?
A common saying in trade policy is, “Don’t shoot your other foot just because your partner shot yours.”
Professor Irwin noted that even if avoiding retaliation would be the more rational economic response, it may not be politically viable. Just as the U.S. has economic nationalists advocating for tariffs, Canada and Mexico also have domestic pressure groups that will demand action. Voters are unlikely to accept inaction in response to aggressive U.S. trade measures, meaning some level of retaliation is almost inevitable.
What Would Retaliatory Tariffs Target?
If Canada and Mexico do retaliate, they will likely:
Select products that are politically sensitive,industries that will create pressure on U.S. policymakers.
Focus on cash crops (corn, soybeans, wheat), which impact key U.S. farming districts.
Target U.S. brands with political connections (e.g., Canada has targeted Harley Davidson and whiskey in past disputes).
By being strategic, Canada and Mexico could create political pressure within the U.S. without necessarily escalating into a full trade war.
How Would Tariffs Affect the Stock Market?
Investors always seek predictability, and tariffs create uncertainty, which markets dislike.
Overall Market Impact
Historically, tariffs tend to have a negative impact on stocks, as they increase costs for businesses and reduce global trade efficiency.
The resolution of uncertainty (whether good or bad) is what ultimately determines market reactions.
Which Companies Would Be Most Affected?
Large U.S. exporters
If retaliatory tariffs target American agriculture, automotive, or consumer goods, these companies will be hurt.
Industries that rely on imported components
Sectors like automobiles, electronics, and manufacturing will face higher costs.
Companies with U.S.-only operations
Some purely domestic firms might benefit by facing less foreign competition.
However, these gains are usually limited to niche industries.
It’s important to understand markets have already taken in the available information we have at this time and reflect current expectations of potential outcomes. It is already priced in. As new details emerge in real time markets will absorb them immediately and they can be positive or negative, they are yet to be revealed.
Do Tariffs Cause Inflation?
A common misconception is that tariffs lead to sustained inflation. Professor Irwin clarified:
“Tariffs do not create inflation, but they do raise prices on affected goods.”
Inflation is a sustained rise in prices across the economy.
Tariffs create one-time price increases for goods that are directly affected.
Consumers may see higher prices on certain products, but this does not necessarily cause year-over-year inflation growth.
The Risk of Political Favoritism in Tariff Exemptions
One overlooked aspect of tariffs is how exemptions are granted.
Are Certain Companies Getting Special Treatment?
During Trump’s first term, tariffs were selectively applied, with some businesses securing exemptions through the Commerce Department.
Companies with political connections often fared better in getting relief.
What Would Happen with Expanded Tariffs?
If tariffs are applied broadly across Canada, Mexico, and China, the Commerce Department will likely be flooded with exemption requests.
Industries will argue that certain materials (e.g., rare chemicals, steel components) have no viable alternatives.
The bureaucracy will be responsible for deciding who gets relief—creating an environment ripe for political favoritism.
Professor Irwin cautions that this creates incentives for businesses to lobby for special treatment, rather than competing based on efficiency.
Final Thoughts: Where Do We Go from Here?
Tariffs are not inherently good or bad, but they create winners and losers.
The trade-offs must be weighed carefully, protecting certain industries may come at a steep cost to consumers and other businesses.
If tariffs escalate, we could see real economic damage, particularly if Canada and Mexico are significantly impacted.
Want to Learn More?
For deeper analysis, check out:
If you have time, watch Professor Irwin’s full lecture for additional insights.
DISCLOSURE:
The views expressed in this piece reflect the perspectives shared by Professor Douglas Irwin during his presentation and do not necessarily represent the views of Altruist Wealth Management. This content is for informational and educational purposes only and should not be construed as personalized financial, legal, or investment advice. While Altruist Wealth Management is a Registered Investment Advisor (RIA), this discussion is intended to provide general insights on trade policy and economic trends and does not constitute a recommendation to buy or sell any particular investment or security.
The information presented is based on sources believed to be reliable at the time of publication, but Altruist Wealth Management makes no representations or warranties as to its accuracy or completeness. Readers should evaluate how this information applies to their personal circumstances and consult directly with a qualified financial professional before making any investment or economic decisions.
Altruist Wealth Management is not affiliated with Dimensional Fund Advisors or Professor Douglas Irwin.