The best response to Trump tariffs is to drive up inflation in America

It's time to sell, baby, sell!

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As President Trump threatens the world with sweeping tariffs, he is trying to change the fundamental laws of economics through force of will. He shouldn’t succeed. Reciprocal tariffs will hurt developing countries more than the USA; they should instead sell off U.S. debt.

The Austrian American economist Ludwig von Mises once said that ‘the balance of payments theory forgets that the volume of trade is completely dependent on prices.’

The United States has such a gigantic trade deficit, at over $1 trillion each year, because it can buy foreign goods cheaper than it can produce them domestically. Some countries subsidise production to lower prices for export advantage while others export goods further down the value chain.

But, the U.S. dollar is so powerful, that it renders American exports more expensive, irrespective of the distortions and disadvantages of its trading partners. This is part of the exorbitant privilege in which the U.S. dollar remains the world’s leading reserve currency, amounting to 58% of total reserves.

Foreign countries put their capital into the U.S. precisely because it is a stable and safe, raising the price of the dollar on exchange markets because demand is always high. A strong greenback makes imports cheaper and that helps manage inflation in America.

President Trump clearly wants to boost his support in the blue collar heartlands of America, driving job creation in traditional American industry that has been undercut by foreign imports over many years.

But he can’t have two cakes and eat them both.

He can’t simultaneously slash the huge U.S. balance of payments deficit – helping blue collar workers – while at the same time maintaining the U.S. as the destination of choice for foreign capital.

That would be to defy the logic of economics.

To oversimplify slightly, America has built its bloated Federal apparatus on the back of cheap imports. The huge current account surpluses that exporting powerhouses like China, India, some European and ASEAN countries run produces a torrent of easy capital that props up the U.S. state.

The U.S. has a debt mountain of around $35 trillion which is roughly the equivalent sum of debt held by foreign investors. Of that debt, around $8.5 trillion is in the form of U.S. Treasuries, literally loans to the U.S. government, with a similar amount invested in corporate debt and the rest largely in equity.

That’s why Trump is going in so hard with Elon Musk’s DOGE initiative. He’s desperate to reduce the size of the U.S. state apparatus because he knows that the Federal house of cards is built on fiscal quicksand. He probably figures that the political benefits of promoting employment among among the working class are higher than cutting the federal workforce. If his plan works.

Because the real challenge to the U.S. is not the federal debt itself but its ability to service its debt. The exorbitant privilege, coupled with the massively disinflationary tidal wave of the global financial crisis, ushered in a period of historically low inflation and low interest rates.

That era has ended, as ratings agency Moody’s pointed out this week. U.S. interest rates are now higher, at 4.25-4.5% driving up the costs of servicing the country’s enormous debt mountain. The threat to the U.S. right now is inflation and what that means for its debt servicing bill, if interest rates are held or, even, forced higher.

That’s why the idea of a BRICS currency is so terrifying to Trump, because BRICS now accounts for 41% of the global economy by purchasing power parity. A BRICS currency (a highly speculative idea, frankly, at this stage) might pose a longer-term risk of making the dollar less appealing and, therefore, weaker, driving up inflation.

There are parallels here for the 1970s, when rampant inflation, triggered by a number of factors including the oil crisis and America’s move to a fiat currency, led U.S. interest rates to soar at one point to 20%. During this period, foreign countries withdrew their investments, and the dollar slumped to 45% of total global foreign exchange reserves.

And herein Trump’s challenge. He can’t export more without a weak dollar, and a weak dollar will make U.S. debt harder to services.

Tariffs are simply his attempt to bully less developed economies for America’s political and economic advantage. They impose a cost on foreign exporters that is unrelated to the price of the goods, as determined by the rate of exchange at any time. And there is little value for an individual country in responding with reciprocal tariffs, precisely because they export more to the U.S. than they import. On the escalation ladder of tariffs, developing countries will always lose out.

And economic war, like real war, hinges on which belligerent can accept the most pain and continue to fight on.

But developing countries have more power than they realise. Countries that export more than they import, build up stocks of foreign exchange that they invest overseas. If you look at the size of countries’ trade surpluses with the U.S. it is insightful. China’s surplus runs out at almost $300 billion each year, for the EU and ASEAN it’s over $220 billion. These countries/blocs all park significant volumes of their capital in the U.S.

Rather than fighting a losing tariff, the should accelerate the divestment of long-term debt holdings in U.S. treasuries and corporate debt, undermining the strength of the dollar and adding inflationary pressure.

U.S. exports may rise. Exporting countries may need to seek to reinvest in other jurisdictions or repatriate capital (as Russia did in 2014, following the imposition of sanctions). However, and as happened in the 1970s, inflation would become an increasing risk to the U.S. economy over a period of years, as the price of foreign imports rose in the face of a weakening dollar. That would force up interest rates, as the U.S. government sought to shore up demand for the dollar to reduce inflationary pressure. And that would raise the cost of servicing America’s debt mountain.

In the art of the deal, threatening to crash the U.S. economy would bring Trump to the table far quicker than a tariff war. As the U.S. President himself might say, ‘sell, baby, sell.’