February 3, 2025 - 7:30pm

After Donald Trump announced large tariffs on Mexico, Canada, and China, financial markets sprung into action to price in these potentially enormous changes to the system of international trade. In response, the US dollar surged against the Canadian dollar and the Mexican peso. Earlier today, Mexican President Claudia Sheinbaum announced that her country was working towards resolving issues surrounding illegal migration and fentanyl by sending 10,000 Mexican troops to the border.

This episode shows clearly that Trump doesn’t use tariffs to rebalance American trade, but instead as a means of threatening friends and foes with the intention of pressuring them to comply with his demands. The White House knows that tariffs in themselves do not really work to reduce trade dependencies. In a lengthy document, Trump’s incoming chair of the Council of Economic Advisers, Stephen Miran, argues that when tariffs are imposed on a country like Mexico the exchange rate between the US dollar and the peso can move to cancel out the effect.

So, for example, if Trump put a 25% tariff on all Mexican goods, the peso could fall by 25% relative to the dollar to cancel out the cost differential imposed by the tariff. This would be a net negative for the US, whose exports to Mexico would become less competitive, increasing the trade deficit between the two countries. The surge in the value of the US dollar after the tariffs were announced confirms that the mechanism works — exactly as Miran predicted.

This is not to say that tariffs and other trade war mechanisms cannot cause an enormous amount of chaos in the short run – in fact it seems to be precisely this chaos on which the President and his team are relying. Sharp moves in the currencies themselves can create financial instability in the countries affected, making Trump’s trade war well-suited to pressure Mexico and Canada to comply with his administration’s demands on immigration and drugs.

But Trump can only push his trade war so far. The countries he targets are typically ones that run large trade surpluses with the United States. When a country runs a trade surplus it accumulates financial claims on the country with which it is running this surplus. In the case of America, this typically means that the country running the trade surplus accumulates vast amounts of US Treasury bills. That is another way of saying that these countries effectively finance US government borrowing.

It is not in their interest to start dumping these bonds en masse, as doing so would create financial instability. It would also weaken the US dollar, in which case the tariffs would start impacting the countries on which they are imposed. However, the fact that this option is on the table means that if Trump pushes the tariffs too far, countries can engage in aggressive action in response.

But so long as the President’s demands are relatively reasonable – such as forcing Mexico to exert more control over its own border – the path of least resistance is to simply comply with his demands. Since Trump has a robust economic team around him who understand these dynamics, it seems likely that the new administration will know how much is too much and pull back from the brink long before provoking an aggressive response from its international partners.

What we are watching is not so much an actual trade war as it is Trump’s “art of the deal”. The President is using the leverage he has to extract concessions from his international partners that they have been dragging their feet over for years. So far, the strategy seems to be working.


Philip Pilkington is a macroeconomist and investment professional, and the author of The Reformation in Economics

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