Trump Tariffs and Global Outcomes (Part 2)
This is part two of this three part series. You can find part one here.
Tariffs and Debt Sustainability
Before jumping forward to reactive policies of China and the geo-politics of trade, we need to cover another underlying factor of trade dynamics — sovereign debt and government deficits. The sustainability of U.S. debt-to-GDP ratios is a pivotal concern in the context of tariffs. Currently, U.S. government spending accounts for approximately 35% of GDP, a figure that suppresses private investment through the well-documented phenomenon of “crowding out.”
What the three charts above show is that even though government spending as a percent of GDP has been normalized at above 30% since 1960, it has continued to increase since then and the sovereign debt curve has become parabolic as that spending gets compounded year over year. But the true nature and consequences of this spending becomes clear when one looks at the net domestic business investment as a percent of GDP which has been on a downward trend since 1980. This imbalance has restricted the potential for organic economic growth driven by private enterprise. High levels of government spending not only create fiscal challenges but also reduce the availability of capital for private investments. As federal expenditures dominate the financial landscape, businesses face constrained access to capital markets, limiting innovation and industrial diversification. This imbalance is most acutely felt in underdeveloped regions like the Rust Belt, where economic revitalization has lagged behind coastal states. It should then come as no surprise that the economically backward regions of the country constitute the greatest support for Trump whose policies aim to fix the imbalances that have hollowed out that part of the country economically.
Deregulation and Energy: Catalysts for Productivity Growth
To reverse the trend of declining domestic private investments, Trump plans to deregulate and make energy cheaper by drilling more. Deregulation plays a crucial role in freeing up markets and enabling private investment. By reducing the burden of compliance, risk capital can be deployed more effectively, not just across industries but also geographically. Middle America, characterized by its economic underdevelopment, offers significant opportunities for growth, particularly as it begins from a lower base.
However, to unlock this growth potential, cheap and abundant energy is essential. Energy costs form the foundation of production, and affordable energy reduces baseline capital requirements, increasing risk appetite across the economy. New industries, such as those focused on AI, robotics, and crypto, rely on energy-intensive processes. Ensuring cheap energy not only supports these industries but also enhances overall productivity, making inflationary pressures of tariffs more manageable.
Furthermore, Trump’s support of new technologies like Bitcoin will help monetize wasted energy from electrical grids, utilizing surplus capacity during low-demand periods. This not only increases grid efficiency but also generates revenue that can lower energy costs for consumers, creating a feedback loop of economic benefit. The result is a reduction in inflationary pressures over the long term, as greater productivity offsets the increased money supply.
Learning from History: Reagan-Era Policies and Today’s Challenges
The Reagan administration provides a useful historical precedent. During the 1980s, Reagan pursued a mix of tax cuts, deregulation, and targeted tariffs to protect key industries. While these policies revitalized certain sectors, they also contributed to significant fiscal deficits. However, Reagan’s strategy benefited from a much lower debt-to-GDP ratio (approximately 30% at the start of his presidency) than the 120%+ ratio seen today. That said, fiscal deficits and sovereign debts cannot be analyzed in a vacuum. While reducing government waste is as critical as it has ever been for the American economy, the dirty little secret of government financing is that no one pays off their debt. The debt simply gets refinanced. And as such, the key factor is not simply debt but economic growth in relation to debt. US debt will continue to rise but the challenge in front of the US is to grow fast enough to bring the debt to GDP ratio down. Often enough, driving growth from high levels of debt is accompanied by inflation and that will continue to be a threat to the US growth story in the coming years. But this discussion on debt, private investments, and growth should be helpful in understanding that not all inflation is created equal and the inflation I am talking about does not result from tariffs but from growth momentum.
China’s Economic Fragility: Exposed by Tariffs
Obviously, tariffs do not exist in silos. Just like 2018, China can respond to Trump tariffs with more of its tariffs. But US is much less dependent on the Chinese market for its exports than China is on the American economy and that is a key imbalance that Trump seeks to exploit. What worsens China’s position is their own debt situation and larger economic structure that is uniquely vulnerable to external pressures like tariffs, a reality that is deeply tied to its overreliance on manufacturing and weak domestic consumption. With Private Final Consumption Expenditure (PFCE) accounting for only 38% of GDP, China’s economy is heavily skewed toward production rather than consumption. This imbalance is not incidental — it is the result of decades of policy choices that suppressed wages, redirected household savings toward state-led investments, and prioritized export-driven growth.
Tariffs imposed by the U.S. further tilt this balance. As Chinese manufacturers lose access to key export markets, they face excess production capacity that cannot be absorbed domestically. Unlike the U.S., where economic imbalances can be mitigated through robust consumer spending and service-sector growth, China lacks a strong enough consumer base to offset declining exports. This weakness stems from structural issues: a middle class burdened by high precautionary savings for healthcare and education, limited wage growth, and underdeveloped social safety nets.
But the challenges for China go deeper. Its economic fragility lies in the self-reinforcing nature of its policy choices. When exports decline due to tariffs, the government is forced to intervene to support the manufacturing sector, often through subsidies or credit expansion. This intervention worsens China’s already precarious debt levels. State-led investments, which have historically driven GDP growth, now yield diminishing returns, leaving China in a cycle of increasing debt with weaker economic outcomes.
China has also used currency debasement as a tool to keep it’s exports cheap. From 1994 to 2005, China maintained a fixed peg of Yuan to the USD of 8.28 Yuan to USD. Post 2005 entry to WTO, China continued manipulating its currency with substantial impact on global trade. However, as more tariffs are imposed, China is pushed even further in resolving its monetary policy trilemma, i.e., it cannot prioritize Yuan’s exchange rate, impose capital controls, and also maintain an independent monetary policy. The easiest option for China here is to allow a free(r) float of the Yuan which could result in unprecedented depreciation in the Yuan. That will be devastating for an already weak consumer. As mentioned above, China’s PFCE as a % of GDP was 38% in 2023. By comparison, US was at 68% and India at 58%.
China’s low PFCE and using the average of US and India — 63% — as a benchmark for China, gives us a PFCE which is 25 points below the benchmark. In terms of nominal GDP (China’s GDP was ~$18T in 2023), that is loss of value for the Chinese citizens worth $4.5T. Some critics might call that stealth by the government. But without getting polemic, the larger point is that a free float of Yuan is not really an option for China. The Chinese consumer simply cannot take any more pain.
China can also not afford to remove capital controls. That will be the quickest way to an economic disaster as both foreign and domestic capital will seek safe havens — Gold, USD, Bitcoin. And finally, losing control over its monetary policy is obviously not a feasible solution as it would involve the end for PBoC, limited to no freedoms to use interest rates or reserve requirements, and in general high inflation accompanied with slow growth. So, what does China do? We will cover that in the next section but irrespective of China’s response to US tariffs, China is caught between Trump and a very hard place. And that is important context in understanding how trade negotiations between US and China are likely to evolve.
Japan a harbinger?
I think Japan is a unique case study and I don’t think the shoe fits in the case for China. But there are lessons for China from the Japanese experience. I don’t want to draw unnecessary parallels and as such before I get into what China might be able to learn from Japan, let me highlight two key differences between early 90s Japan and today’s China — a) When Japanese economic bubble burst in the early 90s, its demographics were still strong and it wouldn’t start declining until two decades later. It is an important point of distinction as China tries to manage its asset bubble in the face of collapsing demographics; and b) In the early 90s, Japan’s PFCE as a percent of GDP was at 55% while China stands at 38%. I keep coming back to PFCE because if Trump succeeds in bringing some balance to global trade, the immediate cascading impact for China will be the challenge of balancing its own economy between manufacturing and domestic consumption so as to grow fast enough to pay for its huge debts. However, the weak Chinese consumer will make create more economic pressures on China than it did for Japan.
With those two differences in mind, China’s predicament does draw striking parallels to Japan’s trade struggles following the 1985 Plaza Accord. Under U.S. pressure, Japan agreed to appreciate the yen to reduce trade imbalances. While the stronger yen narrowed Japan’s trade surplus with the U.S., it also undermined its export-driven economy, triggering decades of stagnation. Efforts to stimulate domestic demand through fiscal spending and monetary easing led to ballooning public debt and speculative bubbles, particularly in real estate. China finds itself at a similar crossroads. Like Japan in the 1980s, it must balance the need to maintain export competitiveness with the imperative to develop domestic consumption. However, China’s reliance on state-driven investments and mounting debt creates additional vulnerabilities. Unlike Japan, which entered its adjustment period with relatively strong fundamentals, China’s weaker consumer base and higher debt levels leave it with fewer options for a smooth transition. More significantly for the current world order, the US debt to GDP was far lower in the 80s than it is now, which means US is likely loathe to pay the price of any significant currency debasement. This, in my opinion, is the single biggest dynamic that will define the negotiations between US and China.
We will explore the how negotiations between US and China are likely to go and try to estimate an equilibrium solution, but there’s always a chance that negotiation might not be successful. I doubt that because both Trump and China seem to be eager to strike a deal. But if tariffs fail to bring China to the negotiation table, the outcome could devolve into a war of attrition. In this scenario, both the U.S. and China suffer, but China is likely to face greater pain. The U.S., supported by its reserve currency advantage and robust capital markets, can better absorb economic shocks. For China, the stakes are much higher: prolonged tariff pressures could exacerbate internal instability, from rising unemployment to growing public dissatisfaction.
China’s policy responses — whether through currency devaluation, subsidies, or credit expansion — are ultimately unsustainable. They deepen the structural weaknesses in the economy, erode consumer purchasing power, and make meaningful rebalancing more difficult. In the absence of an equilibrium solution, these dynamics are likely to persist, forcing China into increasingly reactive and costly measures. Whether through negotiations or attrition, the pressures created by tariffs will accelerate China’s need for economic reform, even if the path forward is fraught with challenges.
This is part two of a three part series. You can read part three here.
