Free Market Tariffs
“No amount of sophistication is going to allay the fact that all of your knowledge is about the past and all your decisions are about the future.” — Ian Wilson
I covered tariffs extensively after Liberation Day and took a rather contrarian stance that more than addressing trade deficits, the tariffs were designed to get the rest of the world to buy and hold more US debt. I argued that the tariffs were a well planned way of breaking the structural 17 year bull market in the dollar and that the Eurodollars were at the center of the whole gambit. In the time since then, this thesis has played out well (see here and here), especially with Japan agreeing to invest over $500 bn at the direction of President Trump, which is another way of funding the US government, i.e., buying US debt. That said, all of my Liberation Day analysis was meant to highlight the reasoning behind tariffs, amid a freak-out in the markets and mainstream media alike. With the upcoming deadline for negotiated agreements, and the agreements that we have already seen, it has become quite clear that Trump plans to impose tariffs on every country. Given that, it is pertinent to understand the likely impact of these tariffs and how the long-term equilibrium of global trade might shift.
The conventional economic orthodoxy holds that tariffs are inherently anti-competitive tools that distort free markets and reduce overall welfare. This perspective, deeply embedded in mainstream economic theory and policy discourse, treats any trade barrier as a deviation from the ideal of unfettered global commerce. However, this analysis fundamentally misunderstands both the nature of contemporary "free trade" and the role that targeted tariffs can play in restoring genuine market equilibrium. Rather than representing protectionist interference, properly designed tariffs can serve as essential corrective mechanisms that counteract artificial market distortions and restore the decentralized competition that defines true free markets. Appreciating this under-studied impact requires a fundamental reconsideration of how we understand market efficiency, trade balance, and the role of government intervention in global commerce.
The Regulatory Foundation of Modern Trade
The World Trade Organization, bilateral investment treaties, and multilateral trade agreements are frequently cited as pillars of the global "free trade" system. Yet these institutions represent the opposite of true free trade. By definition, any agreement that establishes rules, procedures, and limitations on commerce constrains the natural flow of trade that would occur in genuinely free markets. The WTO alone oversees approximately 60 different agreements with the status of international legal texts. These agreements create complex webs of regulations governing everything from agricultural subsidies to intellectual property rights, from technical standards to dispute resolution procedures. Each agreement represents a departure from pure market mechanisms in favor of negotiated political arrangements between nation-states.
Consider the fundamental WTO principles: non-discrimination through Most Favored Nation treatment, national treatment requirements, binding tariff commitments, and transparency obligations. While these principles aim to create more predictable trade conditions, they also establish artificial constraints on how nations and companies can compete. The "binding commitments" that countries make in their schedules of concessions prevent them from responding dynamically to changing market conditions—a key feature that would exist in truly free markets. These commitments have also led to a spaghetti bowl of overlapping, sometimes contradictory trade rules. As of 2025, 375 regional trade agreements were in force globally. This complex web of agreements creates significant transaction costs for businesses, requires extensive compliance mechanisms, and often results in trade diversion rather than trade creation.
The complexity extends beyond simple tariff preferences. Different agreements have varying rules of origin, dispute settlement mechanisms, standards regimes, and harmonization requirements. A multinational corporation operating across multiple markets must navigate dozens of different regulatory frameworks, each claiming to promote "free trade" while actually constraining market-driven decision-making. This regulatory complexity contradicts the efficient market hypothesis, which suggests that prices should incorporate all available information quickly and accurately. When trade flows are governed by hundreds of pages of legal agreements rather than market signals, the resulting allocation of resources cannot reflect true comparative advantages or consumer preferences.
So, if these agreements are so anti free trade, why have them in the first place? The hope behind managed trade agreements is that they can mimic all the good aspects of free trade while removing/reducing the negative impacts of free trade. However, this approach contains a fundamental logical flaw: it is impossible to limit the negative aspects of any system without compromising its positive features. Economic inefficiencies become baked into the system when political negotiations replace market mechanisms as the primary determinants of trade flows. These inefficiencies manifest in several ways. First, trade agreements often protect politically influential industries while exposing others to competition, creating arbitrary winners and losers rather than allowing market forces to determine competitive outcomes. Second, the static nature of negotiated agreements prevents the dynamic adjustments that characterize efficient markets. Third, the complexity and transaction costs of compliance with multiple overlapping agreements create barriers to entry that favor large corporations over smaller competitors.
At the same time, it is impossible, yes impossible, to have a free market and free trade for a sustainably long period of time. To understand why, it is important to appreciate the self-consuming nature of free markets. True free markets are fundamentally characterized by decentralization—the distribution of decision-making authority among numerous independent actors. This decentralization is crucial because, as the efficient market hypothesis suggests, the larger the number of competitors, the more quickly information asymmetries are resolved and prices reflect available information.
In genuinely competitive markets, no single actor has enough market power to systematically influence prices or exclude competitors. This creates a continuous process of information discovery, where prices serve as signals that guide resource allocation toward its most valued uses. The theoretical elegance of this system has made it the foundation of arguments for free market policies across numerous economic domains. However, free markets contain the seeds of their own transformation and demise. Competition inevitably produces winners and losers, and successful competitors accumulate resources and market positions that can be leveraged to gain additional advantages. Over time, this process leads to market concentration as less efficient competitors exit and barriers to entry increase, thereby nullifying the decentralization. For me, this is the natural cycle of free market capitalism.
Initial Decentralization: Markets begin with numerous competitors and relatively equal access to resources and information.
Competitive Selection: Market forces identify and reward the most efficient producers while eliminating less competitive ones.
Concentration: Successful competitors grow larger and gain market power, leading to increased centralization.
Inefficiency Emergence: Centralized market power creates inefficiencies as monopolistic behavior replaces competitive discipline.
Innovation Pressure: Inefficiencies create profit opportunities that incentivize innovation and new entry.
Disruption: New technologies or business models disrupt existing market structures, restoring competitive conditions
It’s the final step of disruption that a concentrated market with powerful, vested interests can prevent, thereby scuppering the return to competitive conditions. The key here is that genuinely free markets cannot sustainably exist without mechanisms that prevent excessive concentration while still allowing competitive selection to operate. Antitrust enforcement represents one such mechanism—it deliberately introduces "inefficiencies" by preventing certain combinations or behaviors that might be profitable for individual companies but harmful to market competition overall. Recent antitrust initiatives have expanded this concept to include challenges to government regulations that create unnecessary barriers to competition. The recognition that both private monopolization and government-created market barriers can undermine competitive markets represents a more sophisticated understanding of what maintaining "free markets" actually requires. It is in this context, we must analyze the pre-Liberation Day trade regime to see if there are systemic barriers preventing competitive markets.
Identifying Structural Market Inefficiencies Through Trade Imbalances
The prevailing debate about trade deficits often focuses on whether bilateral imbalances are inherently problematic. Many economists correctly note that bilateral deficits can reflect natural differences in comparative advantage, development levels, and consumer preferences. The notion that all trade should be bilaterally balanced is indeed economically naive. However, this analysis misses a more fundamental point: persistent, large-scale imbalances across multiple countries and decades may indicate structural distortions that prevent markets from achieving their natural equilibrium. The issue is not bilateral balance but "proportionate balance"—a condition where no single country or small group of countries dominates either global production or consumption to an extent that suggests artificial rather than market-driven advantages.
The evolution of the US-China trade relationship illustrates this distinction clearly. The growth from a $6 billion deficit in 1985 to $295 billion in 2024 represents a 4,800% increase over four decades. This dramatic trajectory suggests the presence of structural factors beyond natural comparative advantage. I don’t need to spend much time arguing the imbalances in global trade but I will highlight that these imbalances create several problems that would not exist in more balanced trade relationships. First, it makes the global economy vulnerable to disruptions in either major production centers or consumption markets. Second, it creates political tensions as domestic industries in deficit countries struggle to compete with subsidized foreign production. Third, it prevents the natural price discovery that would occur if production and consumption were more distributed globally. Of course, it also artificially distorts savings and consumption leading to producers subsidizing consumers in countries like the US while consumers subsidizing producers in countries like China, a point Michael Pettis makes eloquently in his book Trade Wars are Class Wars.
The efficient market hypothesis holds that prices should reflect all available information. If global trade were operating efficiently, price levels should guide production and consumption decisions toward sustainable equilibrium. However, persistent and ever increasing large-scale imbalances suggest that current prices may not reflect true market conditions. China's role in driving global prices lower provides a clear example. Through currency manipulation in the 1990s, exploitation of cheap labor in the 2000s, and achievement of artificial economies of scale through government support, China has systematically created cost advantages that do not reflect natural market conditions. These advantages have compressed prices below levels that would exist in genuinely competitive markets. If the result of these imbalances is artificially lower prices, then the prices that would exist under proportionate balance must be higher. This suggests that policies designed to raise prices toward their natural market level—such as tariffs that offset artificial subsidies—could actually move the global trading system closer to genuine market efficiency rather than further from it.
I italicized the last sentence because that would make the minds of most economists blow up. Haha. But that is only because the field of economics, dominated by Keynesians, has come to rely on esoteric models more than real world realities found in economic mechanisms. These economists have also failed to question their assumptions and have failed to realize that fundamental theories upon which their analyses rely are no longer valid. Take, for example, Adam Smith’s Wealth of Nations and the much vaunted Invisible Hand of the market. The phrase “invisible hand” appears only once in the book and its context is crucial for understanding Smith's actual position. Smith uses the phrase while explaining why merchants would naturally prefer to invest in their domestic economy rather than foreign ventures: "By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention." This passage reveals a critical assumption: Smith expected that business investment would remain primarily domestic due to natural preferences for familiar markets and patriotic sentiment. His theoretical framework explicitly assumed limited international capital mobility—an assumption that has been thoroughly invalidated by contemporary global financial markets. It might even surprise some readers to learn that Smith also supported tariffs in specific circumstances, including protection for nascent industries and nationally important sectors. He recognized that the theoretical benefits of free trade required certain conditions to be met, and he endorsed government intervention when those conditions were absent.
Another foundational theory of global trade is Ricardo’s theory of competitive advantage. However, Ricardo himself explicitly warned that his theory would become invalid under conditions of free capital mobility—precisely the conditions that characterize the modern global economy. In his famous England-Portugal example, he noted that if capital could move internationally, "it would undoubtedly be advantageous to the capitalists of England, and to the consumers in both countries, that under such circumstances the wine and the cloth should both be made in Portugal, and therefore that the capital and labour of England employed in making cloth should be removed to Portugal for that purpose." This admission is devastating for modern applications of comparative advantage theory. With contemporary levels of capital mobility, production naturally gravitates toward locations with the lowest absolute costs rather than following comparative advantage patterns. The result, as Ricardo predicted, benefits capital owners and consumers but can harm workers in higher-cost locations. When capital can move freely between countries, the theory that trade will benefit all participants no longer holds. Instead, trade becomes a potentially zero-sum competition where gains for some groups come at the expense of others.
Free Market Tariffs as Corrective Mechanisms
The traditional argument against tariffs assumes that they represent government interference in otherwise efficient markets. However, this analysis ignores the extent to which existing trade patterns reflect government interventions that create artificial competitive advantages. When foreign governments provide subsidies, manipulate currencies, or create other market distortions, tariffs can serve as equalizing mechanisms that restore competitive balance. Quite simply, Chinese government subsidies drive prices lower which tariffs drive prices higher, as displayed in the chart below. By themselves, both of them distort trade and introduce structural inefficiencies. But together, they cancel each other out.
China's industrial policy provides extensive examples of such distortions. From 2009 to 2023, the Chinese government provided $231 billion in subsidies to the electric vehicle sector alone—equivalent to 0.2% of annual GDP in 2023. More broadly, China's industrial subsidies account for approximately 1.7% of GDP, three to four times higher than other major economies. These subsidies create excess capacity that allows Chinese producers to sell below true market costs, driving competitors out of business and creating artificial economies of scale. In this context, tariffs that offset the subsidy effect do not distort markets—they restore market-based competition by neutralizing government interventions.
Not to belabor the point, but efficient markets require accurate price signals to allocate resources effectively. When government subsidies suppress prices below their natural market level, they prevent the price discovery process that guides production and investment decisions. Corrective tariffs can restore price levels that reflect true comparative advantages and production costs. This perspective reframes tariffs from market distortions to market corrections. Rather than interfering with free trade, properly designed tariffs can restore the conditions necessary for genuine free market competition.
The ultimate goal of free market tariffs is not to protect domestic industries but to restore the decentralized competition that allows markets to function efficiently. By neutralizing government interventions that concentrate production in artificially advantaged locations, corrective tariffs can promote the geographic distribution of economic activity that would occur under genuine market conditions. This is one of the key reasons why I also think that US tariffs will not simply benefit US industry but also industries in other countries. Counterintuitively, this will benefit Chinese domestic growth as well because tariffs reduce Chinese savings by reducing Chinese trade surpluses. The corollary is that it increases domestic consumption because consumption is inverse of savings.
Towards Proportionate Balance
Irrespective of the assertions by President Trump, the realistic equilibrium of his tariff policy does not lie in bilateral trade balance but in restoring "proportionate balance"—a condition where no single country or region dominates global production or consumption to an extent that indicates structural distortions rather than natural comparative advantages. So what does this proportionate balance looks like? From my vantage point, this must be characterized by the following four characteristics:
Distributed Production: Manufacturing capacity spread across multiple countries and regions based on genuine comparative advantages rather than government subsidies or regulatory arbitrage
Sustainable Consumption: Import levels supported by domestic production and exports rather than unlimited debt accumulation or reserve currency privileges
Dynamic Adjustment: Trade patterns that adjust gradually to changing conditions rather than exhibiting extreme persistence that suggests artificial rigidities
Competitive Diversity: Multiple suppliers in most product categories rather than excessive dependence on single-country dominance
To achieve these characteristics, the tariff policy will have to ensure that it serves market-correcting rather than market-distorting functions. And while today the tariffs can create the conditions for market corrections, I am less certain of these trade deals delivering sustainable mechanisms to prevent future artificial competitive advantages. The trade deals that have been announced do not allow for dynamic adjustments and overtime these deals will produce inefficiencies of their own. This is also why I think the Trump administration has missed a trick. If they had extended their deficits based tariffs into these trade deals, we would have seen the rise of proportionate balances over time. Instead, we have the Japanese trade deal, where Japanese auto manufacturers will face a 15% tariff while American manufacturers have to deal with much higher tariffs for imports from Mexico and Canada. It’s not that these tariff disparities cannot be resolved—Trump can always renegotiate USMCA—it’s the lack of dynamic incentives and disincentives. Opportunity missed, although I do hold on to the hope that America will not have trade deal with every country and will impose deficit based tariffs on most of the world. As long as America remains the largest consumer in the world, that singular policy should drive proportionate balances across the world.
As global economic diversion and reintegration takes shape, the choice is not between government intervention and pure markets—both domestic and international markets require institutional frameworks to function effectively. The relevant question is whether these frameworks serve to enhance or diminish competitive market processes. That has always been the question—from Bretton Woods to the Plaza Accord, from GATT to WTO. Free market tariffs, properly designed and implemented, can play an essential role in preserving the competitive conditions that allow markets to serve their fundamental economic functions. The path forward requires moving beyond ideological debates about free trade versus protectionism toward a more sophisticated understanding of how policy tools can support genuine market competition in a complex global economy. This evolution in economic thinking offers the potential for trade policies that truly serve the goal of economic efficiency rather than merely reflecting political compromises between competing interest groups.