What follows is the preface of the paper A Model for Understanding Trade Stability Dynamic Equilibrium in International Reciprocal Tariffs by Richard W. Rahn, Ph.D. and Lawrence A. Hunter, Ph.D. To read the full paper, click here.
International trade in April 2025 faced escalating tensions as the United States, under President Donald J. Trump, implemented reciprocal tariffs to tackle a $1.2 trillion trade deficit, a $1.8 trillion fiscal deficit and a 120% debt-to-GDP ratio. This paper models the tariff-adjustment process between two countries, A and B, to determine if a stable equilibrium of tariffs is possible or if escalation triggers divergence or cycles in tariff changes.
It is important to understand that – especially where trade policy and tariffs are concerned – we are confronted by policymakers (heads of states and their bureaucracies) operating in a political marketplace separate and distinct from the general economic marketplace.1 These two marketplaces, however, directly interact and affect the economic marketplace.
Actors in the political marketplace are not necessarily, indeed frequently are not driven by the same market forces that drive individuals.2 In today’s world, it is the political marketplace that largely determines what trade policies and tariffs are adopted by a country, and those actors, by and large, have become obsessed with the imbalance of trade, which leads them to focus on the trade deficit and tariffs as the main policy lever at their disposal.
But the trade deficit, economically speaking, is the wrong target. This true assessment does not, however, detract from the very real truth that in a world of managed trade by state-firms and other asphyxiating economic policies churned out by governments, the primary actors have come to view trade deficits much as they view budget deficits (remember the “twin-deficit” obsession a couple of decades back) – as a manageable variable they can manipulate to solve the underlying economic problems besetting the country. Not so. Nor does our view on trade deficits obviate the truth that when politicians and self-interested factions (state-firms and their clients) come to believe fallacies, they behave as if they are true.
For that reason, we believe trade deficits, while not the market force driving economic growth and sound money, are indeed the force driving the actors in the state-firm setting trade and tariff policies. Therefore, it is reasonable to model tariff policy as being driven by trade deficits in today’s world of state-firms maximizing their objective (utility) function.
President Trump is a curiosity. On the one hand, he appears to believe in managed trade in pursuit of higher government revenues, revitalization of the manufacturing sector, faster overall economic growth and greater prosperity for everyone. At the same time, his actions on trade policy seem more targeted at breaking up the world of managed trade – which operates through oligarchic central planning at the World Trade Organization (WTO) – in the belief that tariffs will settle to some low, stable and symmetric level, which will both produce more revenue than the currently dysfunctional tax system and remove from the world the sodden blanket smothering it, woven of destructive tax, regulatory and monetary policies, managed trade and central planning generally.
To the extent the trade deficit really is a major concern, it is largely a political concern rather than an economic concern. Every country should be concerned about an imbalance of trade in certain products and commodities essential to national security, which also includes other items essential to the nation’s health and safety. In this sense, a trade deficit can be viewed as a marker of dependency and vulnerability. If countries become inordinately dependent on other countries for these items, especially its adversaries, it poses a dangerous political problem. So, to the extent an imbalance of trade arises, the important questions to address are not so much the magnitude of the trade deficit but rather the make-up of the deficit: who and what components of a trade deficit impact these critical areas? A blindness to the danger of trade dependency on adversaries or countries that have market power in certain products and commodities that are essential to the well-being of the nation is as bad as a blind dismissal of the gains from trade and a resulting insistence on autarky.
1 James Buchanan, a Nobel laureate in economics, viewed the political process as a “marketplace” similar to economic markets, where individuals and groups engage in a process of exchange and negotiation to achieve their goals. He and his co-author, Gordon Tullock, famously argued in their book The Calculus of Consent, a foundational work in the theory of Public Choice, that both political and economic markets follow the same rules, with dollar votes and ballot-box votes operating under similar principles. Also see Jon Murphy, “The Problem with Tariffs,” citing Buchanan.
2 In an Appendix of The Calculus of Consent, Tullock addresses this matter with a comparison between general economics and the theory of the firm: “General economics proves that a certain social organization [the market] will maximize the degree to which individual desires are met. The theory of the firm investigates how individual businessmen or corporations achieve their ends.” We are in an analogous situation here where heads of state and their bureaucrats take on the role of the firm – let’s call it “the state-firm” – and “the theory of the state-firm” investigates how individual politicians or the state achieve their ends.
The general economics marketplace, driven by its own economic laws (e.g., supply and demand) can determine the extent to which individual desires can be met given the constraints (e.g., economic distortions) created by the state-firm. Our dynamic model for understanding trade and tariff stability assumes: 1) politicians and their bureaucrats (the state-firm) have their own objective (utility) functions that they attempt to maximize; and 2) they are driven and constrained by the notion that “trade imbalance,” and resulting trade deficits/surpluses are the product of bad intentions and ignorance of foreign state-firms and ignorance and bad judgement of domestic actors. Given that heads of state and their bureaucrats are playing a game of tariffs, this is probably a very reasonable operating assumption. Actors in the “state-firm” go wrong, however, when they engage in group-think, allowing every problem created by world-wide state-firms’ disruptions of the general economics marketplace to be boiled down into a single concept, namely, trade-imbalance causing trade deficits/surpluses.