Welcome Back, Divided Government

Last week I predicted:

the midterm wipeout is coming.

I predicted a ‘moderate red wave’ here in 2022. I predict a blue wave for 2026 that is bigger than the red wave of 2022, though not a ‘mega tsunami‘

That post looks good now with the exception of those last five words- it was in fact a blue ‘mega tsunami’ by Kalshi’s definition (Democrats hold 240+ House and 54+ Senate seats).

Polling from the WSJ backs up my assessment that this was mainly about the economy and prices:

This comes after a longtime WSJ editorial writer hoped for a big Republican loss, something I’ve never seen from the WSJ before. But if they speak for the markets, it makes sense- US stocks opened up 2% the day after the election.

Crypto and gold prices are also up, an odd combination. Oil prices are down, perhaps seeing an end to the Iran war as more likely. Polymarket shows the odds of a US invasion of Iran this year down 5%. John Ossoff and Ron Desantis saw their odds of becoming President in 2028 rise at the expense of JD Vance and Gavin Newsom.

What will we see change on economic policy? Congress may lower tariffs and take back some of the tariff power they have long delegated to presidents. The Federal Reserve board will feel more free to raise interest rates if they think it is warranted. Many state-level results mean data centers will get harder to build, which will hurt the ‘picks and shovels’ companies literally building them but not necessarily the frontier labs who won’t be able to spend as much on racing ahead. NVDA and Micron stock is down while Google, Meta, Anthropic and OpenAI are up.

But the fact that President Trump still has veto power will limit how many big changes we’ll see over the next two years for anything that would require a new bill. Welcome back to divided government, to gridlock, and to checks and balances.

Halloween candy quality has plummeted

There’s plenty of press about sticker shock on halloween candy prices this year, but the day having arrived and the candy now opened, I can tell you the biggest shock to me was how notably inferior it was to standard “full size” candy equivalents. The Kit Kats are thin and flavorless, the Twizzlers taste like bottom shelf generics. I had heard that chocalate products had reduced their cocao content, but Twizzlers? I tried a few other gummmy candies from other brands and they were inedible. As a livelong afficianodo of Halloween childhood sugar crashes and adult weight gain, this is a generational crime.

It’s a good reminder that shrinkflation often hits quality harder than quantity. Whether there is a direct tariff or not, the reality is that everything costs more to import than it used to. Cross product subsidies exist in every dimension when you’re trying to fill a cargo ship. Your kid’s candy haul this year is one of the purest ways to experience the thousands of sources of consumer surplus lost as we’ve crippled our own economy for no reason but spite and ignorance (all dusted with the unmissable taste of xenophobia and racism).

I used to worry about the first week in the office after Halloween and all the willpower that I was going to have to muster not to sample a Twix, Kit Kat, Snickers, or Twizzler every time I needed to get up from my desk.

Not going to be a problem this year.

Midterms: It’s The Economy

This is my last post before the midterms Tuesday. What will they bring?

Midterm elections are usually bad for the President’s party:

I don’t think this year will be an exception to the rule. I see many indicators pointing in the same direction.

The largest US prediction market Kalshi currently gives Democrats a 91% chance to take the House and a 66% chance to take the Senate. The international Polymarket and play-money Manifold currently give slightly higher chances, 93/67 and 94/69. Forecaster Nate Silver is higher still at 95/76.

The best odds I’m seeing for Republicans among the models I have followed for years is Ray Fair giving Dems only a 60% chance to take the House (he doesn’t forecast the Senate). In Fair’s model, the economy is working in favor of Republicans; inflation is a negative for them but economic growth is a stronger positive (including the 3.4% Q3 GDP estimate just released today).

In practice though I think economic issues are working in favor of Democrats. The economy is good in many ways, like 4.2% unemployment- but most people aren’t happy about it. Consumer sentiment is at record lows. Economic growth is solid but largely driven by the AI boom, which gives people plenty to be nervous about. Inflation is only a bit high (3.4% vs a 2% target) but easy to tie to administration policies like tariffs, war, and pressuring the Fed to lower interest rates. Ad spending indicates that politicians on both sides think tariffs have gone from a minor issue that voters have mixed feelings about to a major issue that voters don’t like:

Gas prices have long been especially salient, and are currently high because of the Iran war. I said here in March:

if the US administration wants to avoid a midterm wipeout driven by high gas prices, I see only 3 options:

  1. Get lucky and see the Iranian regime fall quickly
  2. Negotiate an end to the war quickly (which might itself be unpopular if they can’t get a good deal) or just declare victory and go home (but its not clear whether Iran would re-open the strait now just because the US stopped bombing)
  3. Restrict Exports

But they took none of those three options, and now it seems the midterm wipeout is coming.

I predicted a ‘moderate red wave’ here in 2022. I predict a blue wave for 2026 that is bigger than the red wave of 2022, though not a ‘mega tsunami‘. The main things Republicans have going for them are the Senate map (Dems need to win in multiple 2024 red states to win) and the possibility that angry anti-incumbent voters will take down some Dems too.

Tariffs Are Not Smart Industrial Policy

Economists overwhelmingly see tariffs as clearly welfare-reducing. Tariffs on imports result in higher prices, fewer imports, less consumption, and more domestic production. In fact, it is the higher prices that solicit and make profitable the greater domestic production. We don’t get the greater domestic output at the pre-tariff price. We can show graphically that domestic welfare is harmed with either export or import tariffs. The basic economics are very clear.

However, the standard model of international trade makes a huge assumption: Peace. That is, the model assumes that there are secure property rights and no threats of violence. All transactions are consensual. This is where the political scientists, who often don’t understand the model in the first place, say ‘Ah ha!. Silly economists…’ They proceed to argue for tariffs on the grounds of national security and the need for emergency manufacturing capacity. But is an intellectual mistake.  

Just as economists have a good idea for how to increase welfare with exchange, we also have good ideas about how to achieve greater or fewer quantities transacted in particular markets. This is not a case of economists knowing the ideal answer that happens to be politically impossible.  Rather, if it pleases politicians, economists can provide a whole menu of methods to increase US manufacturing, vaccine manufacturing, weapons manufacturing… Heck, we can identify multiple ways to achieve more of just about any good or service. Let the politicians choose from the menu of alternatives.

The problem with tariffs is that they reduce consumer welfare a lot, given some amount of increased production in the protected industry. Importantly, this assumes that the tariffs aren’t hitting inputs to those industries and are only being applied to direct foreign competitors. The below argument is even stronger against imperfectly applied tariffs, like the US tariffs of 2025.

What’s the alternative?

The alternative is a more focused tack. If the government wants more missile or ship production, then what should it do? There’s plenty, but here’s a short list of more effective and less harmful alternatives to tariffs:

Continue reading →

Do Tariffs Decrease Prices?

Much of what economics has to say about tariffs comes from microeconomic theory. But it’s mostly sectoral in nature. Trade theory has some insights. But the effects on the whole of an economy are either small, specific to undiversified economies, or make representative agent assumptions that avoid much detail. Given that the economics profession has repeatedly said that the Trump tariffs would contribute to inflation, it seems like we should look at the historical evidence.

Lay of the Land

Economists say things like ‘competition drives prices closer to marginal cost’. Whether the competitor lives abroad is irrelevant. More foreign competition means lower prices at home. But that’s a partial equilibrium story. It’s true for a particular type of good or sector. What happens to prices in the larger economy in seemingly unrelated industries? The vanilla thinking that it depends on various elasticities.

I think that the typical economist has a fuzzy idea that the general price level will be higher relative to personal incomes in some sort of real-wages and economic growth mental model. I don’t think that they’re wrong. But that model is a long-run model. As we’ve discovered, people want to know about inflation this month and this year, not the impact on real wages over a five-year period.

Part of the answer is technical. If domestic import prices go up, then we’ll sensibly see lower quantities purchased. The magnitude depends on the availability of substitutes. But what should happen to total import spending? Rarely do we talk about the expenditure elasticity of prices. Rarely do we get a simple ‘price shock’ in a subsector. It’s unclear that total spending on imports, such as on coffee, would rise or fall – not to mention the explicit tax increase. It’s possible that consumers spend more on imports due to higher prices, or less due to newly attractive substitutes. The reason that spending matters is that it drives prices in other parts of the economy.

For example, I argued previously that tariffs reduce dollars sent abroad (regardless of domestic consumer spending inclusive of tariffs) and that fewer dollars will return as asset purchases. I further argued that uncertainty makes our assets less attractive. That puts downward pressure on our asset prices. However, assets don’t show up in the CPI.

According to the above discussion, it’s unclear whether tariffs have a supply or demand impact on the economy. The microeconomics says that it’s a supply-side shock. But the domestic spending implications are a big question mark.

What is a Tariff Shock?

That’s the title of a recent working paper from the Federal Reserve Bank of San Francisco. It’s a fun paper and I won’t review the entirety. They start by summarizing historical documents and interpreting the motivation of tariffs going back to 1870. They argue that tariffs are generally not endogenous to good or bad moments in a business cycle and they’re usually perceived as permanent. The authors create an index  to measure tariff rates.

Here’s the fun part. They run an annual VAR of unemployment, inflation, and their measure of tariffs. Unemployment in negatively correlated with output and reflects the real side of the economy. Along with inflation, we have the axes of the Aggregate Supply & Aggregate Demand model. Tariffs provide the shock – but to supply or demand?.  Below are the IRF results:

Continue reading →

What Tariffs Mean For Your Finances

That’s the title of a talk I’ll be giving Saturday at the Financial Capability Conference at Rhode Island College. Registration for the conference, which also features personal finance speakers and top Rhode Island politicians, is free here.

A preview: after many changes, the average tariff on the goods Americans import has settled in the 15-20% range:

If the tariffs stay in place, which is far from certain, this will represent roughly a 2% increase in overall costs for Americans (a ~17% tax on imports which are ~14% of the economy predicts a 2.4% increase, but a bit of that will be paid by foreign producers lowering prices).

This is bad for US consumers, but not as bad as the Covid-era inflation, and likely not as bad as our upcoming problems with debt and plans to weaken the dollar. It is more valuable for most people to make sure they are getting the personal finance basics right than to think about how to avoid tariffs, though they may want to consider investments that hold their value with a weakening dollar.

The Supreme Court Case on Trump’s Tariffs

Today is a big day not only for Supreme Court watchers, but for everyone following economic policy: the Court will hear oral arguments for the case Learning Resources, Inc. v. Trump. The case concerns whether Trump’s tariffs imposed under the International Emergency Economic Powers Act are legal, which includes the famous “Liberation Day” tariffs from April 2025.

You should be able to livestream the arguments from the SCOTUS website starting at 10am ET (though it may start a little later). SCOTUS blog has a liveblog which should cover most of the legal arguments, but if you want to follow the economic arguments there are several people you can follow on Twitter, such as Scott Lincicome and Phil Magness (you can follow me too).

Does Trump Weaken the US Dollar?

Talk to some economists and they’ll tell you that exchange rates aren’t economically important. They say that exchange rates between countries are a reflection of supply and demand for one another’s stuff. So, at the macro, it’s a result and not a determinant of transnational economic activity.

For individual firms at the micro level, it’s the opposite. They don’t affect the exchange rate by their lonesome and are instead affected by it. If you have operations in a foreign country, then sudden changes to the exchange rate can cause your costs to be much higher or lower than you had anticipated. The same is true when you sell in a foreign country, but for revenues. This type of risk is called ‘exchange rate risk’ since it’s possible that none of the prices in either country changed and yet your investment returns change merely because of an appreciated currency.

Supply & Demand

Exchange rates are determined by supply and demand for currencies. Demand is driven by what people can do with a currency. If a country’s goods become more attractive, then demand for those goods rise and demand for the currency rises. After all, most retailers and wholesalers in the US require that you pay using US dollars. Importantly,  it’s not just manufacturing goods that drive demand for currency. Demand for services, real estate, and financial assets can also affect the supply and demand for currency. In fact, many foreigners  are specifically interested in stocks, bonds, US treasuries, and other investments. The more attractive all of those things are, the more demand there is for them.

Of course, the market for currency also includes suppliers. Who does that? Answer: Anyone who holds dollars and might buy something. Indeed, all buyers of goods or financial products are suppliers of their medium of exchange. In the US, we pay in dollars. Especially since 1972, suppliers have also included other central banks and governments. They treat the US currency as if it’s a reserve of value, such as gold, that can be depended upon if they need a valuable asset (hence the name, “Federal Reserve”). This is where the term ‘reserve currency’ comes from – not from the dollar-denominated prices of some internationally traded commodities. Though, that’s come to be an adopted meaning.  

Another major supplier of currency is the US central bank. It has the advantage of being able to print US dollars. But it doesn’t have an exchange rate policy. So, it’s not targeting a particular price of the US dollar versus any other currency. The Fed does engage in some international reserve lending, but it’s not for the purpose of supplying currency to foreign exchange markets.  

The US Exchange Rate in 2025

One of the reasons that the US has such popular financial assets is that we have highly developed financial markets and the rule of law. People trust that, regardless of the individual performance of an asset, the rules of the game are mostly known and evenly applied. For example, we have a process to follow when bond issuers default. So, our popularity is not merely because our assets have higher returns. Rather, US investment returns have dependably avoided political risk – relative to other countries anyway.

Continue reading →

The 2018 Tariffs in Many Graphs

Did president Trump’s first term tariffs, enacted in 2018, increase manufacturing employment or even just manufacturing output? Let’s set the stage.

Manufacturing employment was at its peak in 1979 at 19.6 million. That number declined to 18m by the 1980s, 17.3m in the 1990s. By 2010, the statistics bottom out at 11.4m. Since then, there has been a rise and plateau to about 12.8m if we omit the pandemic.

Historically, economists weren’t too worried about the transition to services for a while. After all, despite falling employment in manufacturing, output continued to rise through 2007. But, after the financial crisis, output has been flat since 2014, again, if we omit the pandemic. Since manufacturing employment has since risen by 5% through 2025, that reflects falling productivity per worker. That’s not comforting to either economists or to people who want more things “Made in the USA”.

Looking at the graphs, there’s no long term bump from the 2018 tariffs in either employment or output. If you squint, then maybe you can argue that there was a year-long bump in both – but that’s really charitable. But let’s not commit the fallacy of composition. What about the categories of manufacturing? After all, the 2018 tariffs were targeted at solar panels, washing machines, and steel. Smaller or less exciting tariffs followed.

Breaking it down into the major manufacturing categories of durables, nondurables, and ‘other’ (which includes printed material and minimally processed wood products),  only durable manufacturing output briefly got a bump in 2018. But we can break it down further.

Continue reading →

Tariff Tilly (Satire)

Satire news shows are, in my opinion, one of the higher forms of art that my country has produced (and an example of our exports). “Meet Tariff Tilly, the perfect replacement for the 37 dolls your kid does not need” from The Daily Show

“Tariff Tilly” builds. There is even a comment on interest rates (addressed in my previous post).

In this house, we believe in economists writing about dolls. You can find more at https://economistwritingeveryday.com/?s=barbie or https://economistwritingeveryday.com/?s=dolls