The Unexpected Chill: What History Tells Us About Tariffs, Inflation, and Unemployment

The recent increase in tariffs has sparked considerable debate about its potential impact on the US economy. Will it boost domestic industries? Will it lead to higher prices for consumers? And what will happen to employment? While the current economic landscape is vastly different from the past, a look back at historical tariff changes can offer valuable, if surprising, insights. In this Economic Letter, we explore the effects of tariff shocks over the past 150 years, revealing a counterintuitive relationship between tariffs, inflation, and unemployment.

A Historical Perspective

To understand the potential consequences of today’s tariffs, we delved into data stretching back to 1870, examining periods of significant tariff changes in the United States. Our goal wasn't to simply identify correlations, but to isolate the causal effects of tariffs – that is, to determine what actually happened because of the tariff changes, and not just alongside them. This is a crucial distinction, as policymakers often implement tariffs in response to existing economic conditions, making it difficult to discern the true impact. To achieve this, we focused on tariff changes that were driven by shifts in political priorities, rather than reactions to the current state of the economy. For instance, the passage of the McKinley Tariff in 1890, following Benjamin Harrison’s election victory, was largely motivated by a desire to protect domestic industries, irrespective of the prevailing economic climate. By focusing on such “policy-driven” tariff changes, we could better isolate their independent effects.

The Counterintuitive Result

Our analysis revealed a surprising pattern: historically, large tariff increases have been associated with lower inflation and higher unemployment. This is the opposite of what many economists initially expect. The conventional wisdom suggests that tariffs raise the cost of imported goods, leading to higher prices (inflation) and potentially boosting domestic production and employment. However, the historical data paint a different picture. So, what explains this counterintuitive relationship? We believe the key lies in the effects of uncertainty. Tariff shocks often coincide with periods of economic uncertainty, which can depress consumer and investor confidence, leading to reduced spending and investment. This decline in demand can then outweigh any positive effects on domestic production, resulting in higher unemployment and lower inflation.

Uncertainty and the Chill Effect

To investigate this further, we examined the impact of tariff shocks on stock market volatility as a proxy for uncertainty. Our findings support the idea that tariff increases tend to heighten uncertainty, leading to a drop in stock prices and a decrease in economic activity. This suggests that the “uncertainty channel” plays a significant role in explaining the observed relationship between tariffs and economic outcomes. Modern

Considerations

It's crucial to acknowledge that the economic landscape has changed considerably since the 19th and early 20th centuries. The share of imported inputs in production is much higher today, meaning that tariffs are more likely to directly impact the cost of goods and services. This could potentially lead to higher inflation than observed in the past. However, the uncertainty channel remains relevant. In today’s interconnected global economy, tariff shocks can disrupt supply chains and create widespread uncertainty, impacting business investment and consumer spending. The recent increases in tariffs, coupled with other sources of economic uncertainty, could therefore contribute to a slowdown in economic growth and potentially lead to higher unemployment.

Conclusion

Our analysis of historical tariff changes reveals a surprising and counterintuitive relationship between tariffs, inflation, and unemployment. While the modern economy is different, the lessons from the past suggest that tariff shocks can have complex and often unintended consequences. Policymakers should be mindful of the potential for tariffs to heighten uncertainty and depress economic activity, even if they are intended to protect domestic industries. The historical evidence suggests that a careful consideration of these effects is crucial for ensuring a stable and prosperous economy.