The formula behind Trump's tariffs

The S&P 500 fell 4.8 per cent on 3 April after the White House published a formula that ties each country's tariff rate to America's goods trade deficit with it. Every trading partner pays a 10 per cent baseline tariff, and the rate climbs automatically with the size of the bilateral deficit. National accounts, in other words, have become a schedule of penalties.

It was the index's worst day since the pandemic crash of 2020, and the Nasdaq Composite fell further. The baseline levy takes effect on April 5th and the higher country-specific rates a few days later. China faces an additional 34 per cent on top of the duties already imposed this year, the European Union 20 per cent, Japan 24 per cent and Vietnam 46 per cent. Canada and Mexico are left out of the new schedule, though they remain subject to earlier tariffs.

How the numbers were made

The calculation turned out to be simpler than the administration's charts implied. For each country, officials took America's goods deficit with it, divided that by America's imports from it, and halved the result, with 10 per cent as the floor. The published version wraps this in elasticities of import demand and of pass-through to prices, but the two parameters chosen cancel each other out. A country that sells America much more than it buys faces a high rate, whatever its own tariffs actually are.

The results expose the method. Lesotho, a small and poor kingdom whose exports to America are mostly clothing and diamonds, was assigned 50 per cent, because its people cannot afford many American goods. Territories with almost no trade at all appear on the list. Countries with low tariffs of their own but big surpluses in goods face higher rates than some with high tariffs and balanced trade. Tariffs, taxes and regulations, the barriers the policy was meant to measure, play no direct part in the formula.

Bad economics, by formula

Economists can find little logic in setting tariffs by bilateral deficits. Those balances reflect comparative advantage, how much each country saves and invests, and what its consumers like to buy. They say nothing about cheating. A country with a surplus against America often sends the money straight back into American financial assets. Penalising partners on goods flows alone also ignores the surpluses America runs in services, earned by its software, finance and entertainment companies.

The deeper problem is an accounting identity. A country's overall trade balance equals the gap between what it saves and what it invests. America's total goods deficit, which exceeded $1 trillion last year, reflects a national saving rate below domestic investment, driven in large part by persistent federal budget deficits. Tariffs can shift which countries America buys from, but unless they change saving and investment they will not close the overall gap. The trade war with China that began in 2018 showed as much: America's bilateral deficit with China fell, while imports from Vietnam, Mexico and elsewhere rose.

Why shares sold off

Markets fell hard because a formula leaves no room for presidential discretion or diplomatic give-and-take. If duties move automatically with the trade statistics, a multinational's cash flow depends on every quarterly swing in the national trade figures.

The selling was concentrated where exposure is greatest. Companies that make their products in Asia and sell them in America, such as makers of consumer electronics, clothing and footwear, fell far more than the index. Retailers that import heavily followed. Banks and energy producers dropped on fears of recession. The dollar weakened rather than strengthened, which is unusual for a tariff shock and suggests investors worry more about American growth than about the trade balance. Treasury yields fell as money sought safety and markets priced in more rate cuts from the Federal Reserve.

Relative winners were few. Companies that produce and sell mainly at home, such as utilities, telecoms operators and some health-care groups, fell less than the index. Holders of Treasuries gained as prices rose. The formula also hands an advantage to countries that received only the baseline rate, including Britain, Australia and Brazil, whose exporters can now undercut rivals from Asia in the American market.

Retaliation and precedent

Partners have begun to respond. Beijing announced on Friday that it would impose a 34 per cent tariff of its own on all American goods, matching Washington's rate. The European Union is preparing countermeasures, and other governments are weighing whether to retaliate or to seek a deal. Each response invites another, and a formula that punishes partners for buying less from America will only raise rates further if their exports to America fall more slowly than their imports from it.

The closest precedent is the 10 per cent import surcharge that Richard Nixon imposed in August 1971, alongside ending the dollar's convertibility into gold. It was explicitly a bargaining tool, intended to force trading partners to revalue their currencies. Within four months the Smithsonian Agreement delivered those revaluations and the surcharge was lifted. The difference now is that the demand, bilateral balance with every partner, is one no negotiation can realistically meet.

What could change the call

The strongest counterargument is that the formula is a negotiating device and the rates will be bargained down, country by country, as partners offer to buy more American goods or cut their own barriers. Several governments have already signalled interest in talks, and the administration has reversed tariffs before. If a string of bilateral deals emerges quickly, markets could recover much of their losses.

Semiconductors and pharmaceuticals are spared for now, pending separate reviews. Watch whether those carve-outs hold, any delay in the higher rates, and whether the administration defines what a partner must do to earn a lower one. A formula that is tied to deficits gives no clear route to relief, which is why its abandonment, rather than its fine-tuning, is what markets need.

Treating bilateral goods deficits as offences to be punished turns routine national accounting into an erratic tax, and investors will probably keep marking down the earnings of multinational companies until the formula is dropped. Expect analysts to cut profit forecasts for importers and consumer-goods makers through the April earnings season, and expect American shoppers to see higher prices on electronics and clothing by the summer.