The Sword of Damocles

If you are stumped like I am about the tariffs or if you are confounded by the math behind them, fear not! We are not the only ones floundering. If you dig enough, you will find an explanation akin to a bowl of entangled spaghetti. I spent time detangling the strands and here is what I found.

The chief characters in this saga are national debt and trade balance.

Let's tackle the national debt first.

9.2T of the national debt (now at a whopping 36.22T) is maturing in 2025, 6.5T maturing in June. The country doesn’t have 6.5T, let alone 9.2T to pay back. Every time we stare at a maturity, we find a way to refinance the part that is maturing, meaning we take a new loan to cover the payment. At the moment the interest rate is high and that is not good for refinancing.

Why not lower the interest rate? The Fed doesn't want to do this yet given that Covid-related inflation isn’t fully under control. Previous administrations have simply refinanced at the available rate and we have grown used to an exponentially mushrooming national debt.

Status quo is not this President's strength though and he has used tariffs to control the debt.

The tariffs have shocked Wall Street and is causing global stock markets to melt. When investors flee stocks, they gravitate toward US Treasuries which are bonds, notes and bills issued by the US Government. Foreign countries hold a significant amount of Treasuries because of the strength of the US dollar. To make up for spending deficits, US sells Treasuries with the promise of an interest. A lower interest rate on the Treasuries means less obligation for the government to bond holders who are financing the deficit.

This is why Trump screams in upper case at Jerome Powell, the Fed chair, to cut the interest rate. Since Powell won’t do it, Trump has spooked the market with tariffs hoping that investors will be forced towards Treasuries. The more Treasuries people buy, the more the interest or yield on these will drop, which will help with management of the national debt.

Mission accomplished, then? Nope.

Lower yield on Treasuries inevitably coincides with higher prices and recession. This is where the trade balance comes into play along with the value of the US dollar.

We know that US imports more than we export, creating a trade imbalance. Exporting countries understand our insatiable appetite for inexpensive foreign goods and control their currency's exchange rate with the US dollar to make their exports more expensive than they should be.

Let’s say a pair of shoes costs ¥100 to make in China. Hypothetically, let us also say that in the open market, ¥100 should be $20. The reality is that through currency manipulation, the Chinese government fixes the price of the shoe at $30. The US does not "fix" the value of the dollar which makes it the most reliable currency in the world. So now, when the shoe is exported from China to the US at $30 instead of $20, China overcharges and the trade balance tilts in its favor. This is not good for the US but the consumer doesn’t care, because the shoe would cost a lot more if it was made in the US. On imports from the US, other countries tax what is coming in and that puts our products at a disadvantage. No doubt, there is a real problem.

Back to our example: what does the 54% tariff on China do to our shoe? It shoots up the price from $30 to $46.

Three things can happen now.

First, the consumer pays the higher cost or the consumer refuses to buy the shoe. This causes inflation or opens the door to recession. Neither is good.

Second, China adjusts the exchange rate appropriately and the shoe costs $20 as it should. Add the tariff and the shoe is $30.8 to the US consumer, near the same value as before. Alternately, China drops tariffs on imports and we reciprocate by dropping tariffs on them. This gives Trump a huge political win of bringing China to its knees on currency manipulation and tariffs.

Third, China manufactures the shoe in the US. Notwithstanding a higher price for the shoe, this gives the MAGA world a different kind of win with an uptick in employment.

If the tariff-ed countries blink, Trump’s strategy will pay off in some form. If they don’t, the US consumer is in dire trouble. Everything will cost more, 401Ks will be eviscerated, venture funding will freeze, the AI boom will screech to a grinding halt, unemployment will tick up and the door to recession could crack open.

In order to buffer against this possibility, Elon Musk has arrived with a chain saw. A 2T cut in government spending will help balance the budget. If the gamble on the tariffs fails, a balanced budget will likely preserve the conservative party's chance of holding on to the House in 2026.

Is this brazen, bold, brilliant or ignorant, disastrous, catastrophic?

Nobody knows because global trade has never been tested like this before.

The approach is unprecedented and fraught with extreme risk. In this game of economic chess, you and I have everything to lose and our kids may have a lot to gain. We should never bet against the country but we will continue to hyperventilate under the sword of Damocles, not knowing when it will drop.

Deep breath in, long exhale out.

Image source: https://www.meisterdrucke.us/fine-art-prints/French-School/924034/The-Sword-of-Damocles.-In-%27Beautes-de-l%27histoire-ancienne-ou-faits-et-dits-memorables-des-grands-hommes%27.html