To understand President Trump’s Tughlaqian reciprocal tariffs decision on Thursday, let’s rewind to what JD Vance had to say in his address on March 18, 2025 at the American Dynamism Summit organised by a Silicon Valley venture capitalist firm.
The US Vice President remarked there that the governments of the last 40 years have failed to understand the implications of the core premise behind globalisation. That is, “we can separate the making of things from the design of things”. It was also assumed that the rich countries would move further up the value chain, when manufacturing is done by the poor nations.
Vance further mentioned that “as they (the poor countries) got better at the low end of the value chain, they also started catching up on the higher end. We were squeezed from both ends.” He also highlighted the fact that “cheap labor cannot be used as a substitute for the productivity gains that come with economic innovation.”
Labour arbitrage was never the solution to economic progress
It is true that labour arbitrage (the practice of companies reducing labor costs by employing workers in places with lower wages) cannot take a business or a society too far. We do want the labour cost to go up so that people can live a better life. Many of our business, economic and political leaders of the past have encouraged choices based on labour arbitrage and not engineering and human ingenuity, which I call the good old Toyota Way.
However, Vance is being unfair to people in poorer countries. We all know that the ability to learn and do better is neither confined to a geographical boundary nor is defined by the level of household earnings or riches of a nation. Riches, however, do help to take risks, and deal with uncertainty, particularly in business. But the US businesses have not been investing in areas that mattered the most for their economy, as Vance has mentioned in this address.
Impact of a global market-based system
A market-based system, by its very design, ensures that the relative benefits of increased economic activity are not shared equally among people and businesses. It prizes knowledge over skills and skills over pure physical effort. It benefits capital more than labour, as capital enables risk-taking. If business leaders can influence policies (e.g., weak consumer regulation, high barriers to entry, etc.) to their advantage, the households bear the cost either in the form of higher prices and limited choices and/or higher taxes.
Consequently, it is important that our business, economic and political leaders make choices that focus on helping households too. The US has not done that to the extent required. For example, the Chinese households have benefited from higher real wage growth (> 2.0% per annum for the last four decades) whereas the growth in the US real wage has been about 0.49% per annum. At the same time, all the leaders in the US and China knew, all along, that the households in their respective countries were benefiting differently. Both the countries have not paid adequate attention to the problem of inequity and inequality.
In a global market-based system, the businesses too benefit differently. A recent study by NBER estimated that the overall profitability of the US firms has increased significantly following China’s entry into the World Trade Organisation and the increase was driven by foreign profitability of S&P 500 firms that spend significantly more on R&D and sales and marketing. On the other hand, “the domestic profitability of US firms remained flat, and firms employed more capital to generate sales.”
However, the increased competition in the domestic market helps households with getting lower-priced goods from poorer countries and, thereby, maintaining their quality of life even when their real wages are not going up. Walmart, Dell, Apple, Amazon, along with many other large US firms, have helped the US households get cheaper products from China, Mexico, Vietnam, and many other countries. As a result, these firms are some of the most valuable firms in the world.
However, given that the median household earnings have not kept pace (for nearly half a century) with wealth and earnings for the upper quadrant of the US households, the US is having to use emergency provisions to create regulatory arbitrage for its businesses – both large and small and domestic and the global. It is hoping to solve a five-decade old problem through a unilaterally announced trade policy.
I am reminded of our own hastily implemented policy for eliminating corruption through demonetisation and the GST and improving investments and employment through Performance Linked Incentives. Neither has corruption been eliminated nor we have achieved accelerated employment growth.
The laziest form of arbitrage
The proposed US policy of raising tariffs is the ‘regulatory arbitrage‘ crutch that the US is offering its businesses. It is, in turn, expecting that these businesses will invest and create well-paying manufacturing jobs – five million of which were lost from 1997 to 2024. It is an attempt at unwinding policies that have helped the US as well as its partners – though not everyone in the US or among its partners was benefited. It is raising tariffs to a level not seen for nearly a century in the US.
Regulatory arbitrage has limited effectiveness even when compared with the labour arbitrage strategy that the US has used during the last few decades.
Regulatory arbitrage is the laziest form of arbitrage. It encourages businesses to game the system, as is being sought through selective exemptions. In addition, if the US can impose tariffs unilaterally, the partners can retaliate with tariff as well as non-tariff measures, as we have seen during the recent months. Not to forget that the consumers too can become activists, if the policy choices are seen as unfair. We are seeing that in parts of Europe, Mexico and Canada.
The probability of US success now depends on China, EU, Mexico and Canada’s policy decisions. If the US does not start the negotiation process immediately and if these countries choose to retaliate with higher tariff or non-tariff measures, we will end up with:
· Higher inflation resulting in lower consumption, lower savings and higher household debt, not only in the US but in its partner countries too. The second order effects will spread to countries like India, who are not even major global players. If higher inflation gets transmitted to wages, the businesses will face higher costs.
· Deep $ depreciation, one of the US policy objectives, will not only feed inflation but also cause flight of capital from the US. We must remember that the US runs a large current account deficit. If Europe is able to absorb some of this capital in accelerating their defence investment plan, the US may end with a smaller share of global capital.
· On the positive side, $ depreciation can help large export-oriented US firms report higher earnings, without an increase in volume. But that will help the same set of firms that have gained from globalisation. It would not help the households who will have to deal with higher cost of living or the businesses that sell to these households.
· Financial markets will have to deal with higher degree of uncertainty, causing increased volatility. Once more helping speculators and traders and not necessarily the households and businesses that the policy is intended to help.
· If the US partners choose to retaliate through tax and non-tax measures on the US service exports, the trade war can become uglier, hurting much larger number of people across the world.
