Understanding Tariffs
What could the US be trying to do? Incentivise their local manufacturing base? Break the reserve currency feedback loop?
I haven’t been paying much attention to all this, but I got curious today after reading the tweet below.
The tweet seemed cryptic at first, so I created a diagram to try to understand it.
But before we dive into that, let me give a brief primer on tariffs:
Tariffs are taxes on imported goods.
So when the US imports something from China (say a Huawei phone), it would cost $1000 without the tariffs. Introducing a 40% tax, aka tariff, will increase the price to $1400.
Now, you might think, I’m not buying any Chinese products anyway, I don’t care.
Supply Chains
The above phone example was simple, but real life isn’t that simple.
From my time at SAP, I know that the BOM (a bill of material) is a complex list of parts that go into manufacturing something.
(source)
Takes this car.
BMW doesn’t put steel, rubber and oil into a factory to churn out fancy cars. No, they buy most of the parts already built to assemble the final product.
These parts reach from bolts to entire drive-trains or windshield wiper motors.
The supply chains for these goods are global, meaning stuff is sourced from various countries.
Most of the stuff needed for almost everything nowadays comes from China - the world’s factory.
(just look at where stuff that goes into an EV is made)
Imposing tariffs on China thus does not only increase the prices of products we directly associate with China.
They mostly come from indirect costs. Let’s say the windshield-wiper-motor and drive-train for a car increase its price by 40% when imported into the US. That will have some impact on the end price of the product.
Unless, of course, the manufacturer can source the product locally, and that local producer didn’t have to buy any parts from outside.
Tariffs, therefore, have the potential to make local manufacturing more competitive. To realise that potential, though, much of the supply chain would have to be in the US.
China wouldn’t be the world’s factory if the US could produce all of that stuff themselves.
Tariffs might be a good incentive, but it will take a lot of time and effort to really compete.
Ripple Effect on Currency & Trade
Here is where it gets interesting regarding the supply and demand of currencies.
To simplify, I’ll stick to the US, China, USD, and Yuan.
China is the world’s factory. That means that the US buys a lot more from China than China does from the US, which is called a trade deficit.
Put simply, China sends stuff to the US, and the US sends USD to China.
China uses these USD to
invest in the US by buying land, property and stock with those USD
buy US debt (treasuries) and get interest on their USD
As factory of the world, you want your currency cheap, so they would likely not spend so much on buying their own Yuan
Buy gold as a reserve to diversify (which they have been increasing in recent years)
Add the tariffs, and China will likely sell less stuff to the US. It will become more expensive for US consumers to buy China’s goods.
Say over the next year, the US is going to buy 30% less from China, meaning China will have 30% less in USD.
Let’s make up some numbers here.
I’m oversimplifying, but from an economics perspective, this means less demand for USD.
If supply stays the same, then the price of USD declines.
If the price of USD declines, it will buy Americans even less stuff from overseas.
It will also strengthen demand for US goods.
If the US imports stuff, it exports USD.
Right now, the biggest export of the US is USD. The whole world runs on USD.
When China buys oil from Saudi Arabia, it will likely be paid in USD.
The USD is the world’s reserve currency.
This is partially good for the US as it can print USD to buy tangible goods from other countries.
Because the U.S. dollar is in high demand globally, the U.S. can borrow in its own currency—cheaply and in massive amounts.
It runs persistent trade deficits to supply dollars to the world, and foreign buyers happily park those dollars in U.S. Treasuries. They trust the US and the demand for USD. This makes financing its debt easier than it would be for most other countries.
Guatemala couldn’t do the same, as its Quetzal is much less trustworthy and can’t be used in many places (it doesn’t have the same utility).
The flip side for the US, however, is that the dollar is quite expensive because of this great demand for the dollar.
An expensive dollar and the fact that the US can print money to buy stuff have led to a great decline in the US’s manufacturing capabilities.
When you can’t produce stuff anymore, you get dependent on others. More importantly, though, you lose the knowledge of building stuff.
My good friend Jason wrote a great piece on how China is no longer copying but innovating at scale.
Forgetting how to make stuff seems like an important problem for a nation.
Where is Trump going with this?
Running a trade deficit means relying on others to fund your lifestyle.
That may be sustainable for some time—but it comes at the cost of domestic capability.
Tariffs might be the first real signal that the U.S. is trying to reverse that trade-off.
This all starts to look like a feedback loop:
The world demands dollars
The U.S. supplies them through trade deficits
Other countries recycle those dollars into U.S. debt
The U.S. borrows, buys, and imports more — fueling the loop, piling up debt and forgetting how to make stuff as they go.
Tariffs might, therefore, be an attempt to break this loop.
By slowing trade and reducing dollar outflows, the U.S. could be giving up some of the benefits of reserve currency status in exchange for rebuilding domestic manufacturing and long-term economic resilience.
I’m barely qualified enough to guess here, but from what I’ve been reading, the topic of tariffs seems to be somewhat intentionally targeted in this direction.
That’s at least how I read this tweet.
#Gold? Well, this likely leans on the idea that something needs to replace the USD as reserve currency. Gold has been around for a long time and has played a role in the past. Who knows if it will do it again?