Trading Predictions

Friday, February 7, 2025

Trading Predictions

One way to evaluate the legitimacy of a hypothesis is to see if it is capable of prediction. International economics—the theories behind trade between nations—predicts several things that result from more and less free trade, from taxes on imports and exports, that affect relative prices and monetary values.

Arnold Kling helpfully wrote down the basic outline of international economic theory in a blog post Do Tariffs Reduce Trade Deficits? He published it back on January 22, well before the past weekend’s threatened tariffs against America’s largest trading partners, and most punishingly against our neighbors north and south.

The general theory says that tariffs cause currency values to shift as a natural adjustment in very specific, predictable ways. That is, the value of the country’s currency that imposes the tariff increases, meaning that the taxed exporting country’s products become cheaper. If the intent is to make manufacturing more attractive in the taxing country, theory predicts it will backfire.

Kling’s post describes the theory in terms of China:

As China saves (and the U.S. borrows), China buys Treasury bills, which drives up the value of the dollar. That makes U.S. goods expensive and Chinese goods cheap, so that China runs a trade surplus. That trade surplus is the mirror image of their national savings surplus.

In the abstract, when countries trade, the one with surplus exports bids up the price of the other’s currency. That country’s production becomes relatively more expensive.

Best as I recall from basic international economics, the theory is based on straightforward if simplified models. Their assumptions are unrealistic: The model world only encompasses two countries and two goods traded. Nonetheless, the model predictions hold up well in real-world settings. Since Trump’s proposed tariffs were meant to be as broad as possible, the theory should describe what would be expected.

The expected outcome would not be to make American production more competitive worldwide, but instead less so due to relative currency appreciation.