Trump’s Threatened Mexico Tariffs: Credible, Irrational, Doomed

(Bloomberg Opinion) -- It’s unclear how President Donald Trump’s announcement of new across-the-board tariffs on Mexico will achieve their stated goal of stopping illegal immigration. But they could help the president in his ongoing disputes with the U.S. Federal Reserve and China.

For months, Trump has engaged in an unprecedented public feud with the Fed. He has complained bitterly that its policies are not providing enough stimulus to the U.S. economy and has repeatedly called for the bank to lower interest rates. He even considered nominees for the Fed’s board of governors whose main qualification was loyalty to the president rather than economic expertise.

The response? The Fed has mostly ignored the president. Unfortunately, it faces a dilemma beyond presidential meddling: The global economy is weaker than the Fed had expected, and some members have begun to question whether the interest rate increases at the end of last year were too much. Lowering interest rates, however, creates risks of its own.

First, there is a chance that the weakness in the global economy would not spill over into the U.S., and that an interest rate decrease would end up stimulating the economy more than some members think prudent. Second, cutting interest rates might spook the financial markets into thinking the Fed now is now certain that worse economic conditions are ahead. Third, cutting interest rates before the U.S. economy actually starts to weaken could make it appear as if the Fed were capitulating to the president’s demands.

Trump’s tariff announcement relieves all of those concerns. It’s a virtual certainty that the fallout from the tariffs, which has already rattled markets and prompted a fall in both interest rates on U.S. Treasury bonds and the value of the Mexican peso, will weaken U.S. economic growth. Thus the Fed can cut interest rates without fear of either being too stimulative or sending the wrong signal to the markets.

Paradoxically, Trump’s tariffs could also relieve any concern that the Fed might be giving in to his demands. In fact, by lowering rates it would be acting to contain the damage he is causing. If the only way that a president can get the Fed to cut rates is by hiking tariffs, there is little chance that the economy will be overstimulated.

Which brings us to one of the reasons Trump has been so adamant about lowering interest rates: because he thinks current interest rates put him at a disadvantage in negotiations with China. Never mind that this isn’t actually true. But the imposition of tariffs on Mexico is likely to help Trump’s position vis-a-vis China.

Not necessarily because the tariffs on Mexico show China that the president is willing to consider harsh measures in order to get his way, though this is probably what Trump had in mind. The more subtle reason is that Trump’s actions give Chinese officials a face-saving way to come to negotiations.

The current impasse between China and the U.S. was sparked by the Chinese government’s decision to withdraw some of the concessions it had previously agreed to. Officials were betting that Trump, looking to boost U.S. growth in the run-up to next year’s election, would be eager to sign a deal. When he called their bluff, it created a delicate situation for the Chinese.

Chinese negotiators cannot admit to having made this miscalculation without embarrassing the Communist Party and President Xi Jinping. This has led to Chinese efforts to paint the U.S. as unreasonable. Once that happened, China could not concede to U.S. demands without appearing weak. In fact today it announced sweeping new restrictions on foreign firms.

Now Trump’s sudden imposition of tariffs, just after he negotiated a free trade agreement with Mexico, makes him appear unreasonable. It also means that if Xi can just get Trump to sign an agreement and stick to it, then Xi can cast himself as a strong negotiator who tamed an international madman.

Of course, it’s important to remember that Trump has positioned himself to get his way only by imposing tariffs that will damage his own country’s economy.

In economic game theory, this type of behavior is known as a credible threat to be irrational. It can be a powerful strategy — if only one player adopts it. If two or more players do, the result is inevitably catastrophe. Right now Trump is benefiting from being the most irrational player. It remains to be seen whether he is setting up the global economy for catastrophe.

To contact the editor responsible for this story: Michael Newman at

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Karl W. Smith is a former assistant professor of economics at the University of North Carolina's school of government and founder of the blog Modeled Behavior.

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