Trade Tariffs Won't Crash The World Economy, Monetary Policy Will
As the Trump administration announces 25% tariffs on over $50bn of Chinese goods, and Europe and China prepare retaliation measures, The Economist concludes that “Rising tariffs are the worst of many threats to the world economy”, because, among other things, “Tariffs temporarily push up inflation, making it harder for central banks to cushion the blow.”
This statement displays a deeply entrenched confusion—if not utter misunderstanding—of some basic economic concepts. Most important, many people fail to correctly distinguish between the causes and effects of price inflation and those of monetary inflation.
Monetary inflation is the increase in the quantity of money in an economy. This inflation causes the purchasing power of money to fall, which brings about price effects—a general rise in prices of goods and services—which we can refer to as price inflation. However, this general rise in prices following monetary inflation is disproportionate and staggered: prices will rise at different times and to different extents as money reaches a lower purchasing power.
But monetary inflation also has non-price effects. One of these is the transfer of wealth between the last receivers of the new money toward the first receivers.
Another—and even more important—is the distortion of the pattern of investment and production, as the new money being created through credit expansion reaches stock markets and businesses—thus artificially reducing the interest rate. This latter effect explains the occurrence of production booms misaligned with consumer preferences, and the later, inevitable economic bust or crash. These price and non-price effects of monetary inflation are general and underline every possible economic activity.
Trade tariffs, on the other hand, affect only some markets and bring about increases in some prices in the economy. As this happens, our consumption patterns change: if we consume fewer imports, prices of domestic substitutes will rise. If our consumption of imports rises or does not change, we will have a reduced income to spend on other goods, whose prices will now fall. Whatever the result, it does not engender a ‘general’ rise in prices, or a depreciation of the currency as a result.