Liberating the Downside

In a piece in Haver’s Viewpoints section earlier this week (Strategic Uncertainty and Market Pricing: A Game Theoretic Perspective on Recent US Policy Shifts) it was argued that markets are struggling to price a highly uncertain and rapidly evolving strategic environment, marked by the Trump administration’s shift from cooperative to non-cooperative global games—most notably via aggressive trade threats that represent a sudden break from past policy norms. While asset prices had been reflecting reduced US growth expectations, higher inflation risk, and a modestly higher cost of capital, the wide range of possible outcomes—amplified by geopolitical unpredictability—meant the path to a new global equilibrium was likely to be volatile and disruptive.

And this view has now been dramatically amplified following the decision by the US administration on April 2nd to announce a sweeping package of tariffs on a broad range of imports from key trading partners—including the EU, China, and several emerging markets. These measures were more expansive in both scope and scale than markets had anticipated, and they carry the potential for significant global economic disruption—particularly if targeted trading partners respond with retaliatory countermeasures, escalating the risk of a full-scale trade conflict.

How exactly this will reshape the world economy is still anyone’s guess. Will global supply chains fracture completely or merely bend? Will retaliatory tariffs hit US tech, agri-exports, or defence deals? Will capital flows seize up or simply redirect? Will monetary authorities act quickly enough to stabilize expectations?

But aside from game theory—which provides insight into the strategic logic of defection and retaliation—another useful framework for assessing the macroeconomic consequences of this shock is that of financial balances.

Financial Balances: An Accounting Identity with Predictive Power

Recall the national income identity in financial balances form: (Private Sector Balance) + (Government Balance) + (Foreign Sector Balance) = 0

That is: (S – I) + (T – G) + (X – M) = 0

Where: • (S – I) = private savings minus investment • (T – G) = government surplus (or deficit if negative) • (X – M) = net exports (i.e., current account balance)

If one of these balances shifts—say, a current account improvement via import compression—then either the private sector must reduce its surplus (invest more or save less) or the government must run a bigger deficit. The system must rebalance, always.

1. US Impact: From External Adjustment to Domestic Strain

The intention behind the tariffs is clear: compress imports, reduce the trade deficit, and ideally, bring back some production capacity to the US mainland. But as we've seen in past episodes, protectionism rarely leads to clean outcomes.

• If imports fall due to tariffs, and exports are simultaneously hit by retaliation, the net trade balance might not improve meaningfully. • That means the foreign sector balance (X – M) doesn't deliver the adjustment hoped for. So where does the pressure go?

It goes to the private and public sectors.

• Private sector balance (S – I) is likely to rise. Firms face greater uncertainty and may reduce capital spending, while households—facing higher prices on imported goods—could cut consumption. Net private saving rises. • This leaves the government to absorb the shock. With private retrenchment and a stagnant or worsening current account, the only way the identity can hold is via a widening fiscal deficit.

In effect, the tariffs may create an illusion of national self-reliance, but the reality is a fiscal offset to a trade-induced demand squeeze. Unless the US is willing to tolerate a deeper recession, fiscal stimulus becomes the balancing item.

2. Global Impact: Shock to Trade-Exposed Economies

Now consider the rest of the world—especially the major US trading partners. The tariffs strike at trade-dependent, export-surplus economies such as Germany, South Korea, and China. These countries have historically run external surpluses, allowing their private and government sectors to remain in surplus or near balance.

• If their exports to the US fall, their foreign sector balance deteriorates. • If they don't immediately offset that with stronger domestic demand (via fiscal or private sector action), then either their private sector must dis-save (less likely), or their governments must run larger fiscal deficits to compensate.

For surplus economies like Germany or China, this moment could trigger a major shift toward domestic demand rebalancing, but the scale and speed required are politically and economically challenging.

For emerging markets, the picture is more fragile. Weaker export revenues + capital outflows → tighter financial conditions → risk of pro-cyclical fiscal tightening, which worsens the downturn. Hence, EMs may become the shock absorbers of this global shift, through both growth and FX channels.

3. Inflation, Policy Recalibration, and Financial Markets

Tariffs act like a tax on imports. In the short term, that means higher prices, especially in sectors like electronics, consumer goods, and industrial inputs. If retaliation is met with further escalation, costs rise further.

At the same time, the private sector is pulling back—demand is softening, and investment is slowing. The result is a stagflationary impulse: higher inflation, but weaker growth.

• The Fed faces a credibility trap. Inflation is sticky, but growth is slowing. Cut too early and you risk fuelling inflation; cut too late and the downturn deepens. • The ECB and other central banks have a clearer path—softer inflation gives them cover to ease—but deteriorating global trade may limit the power of domestic stimulus.

Meanwhile, financial markets are struggling to find footing:

• Equities in global cyclicals, capex-heavy sectors, and exporters are weakening. • Bond markets are now arguably pricing a lower global neutral rate, with flattening curves and increased volatility. • FX markets are unsettled: EM currencies weaken, the USD fluctuates, and policy divergence risks new capital flow imbalances.

4. Strategic Rebalancing: A Slow-Motion Adjustment

The financial balances framework doesn’t tell us where policy should go—but it tells us where it must go if macroeconomic stability is to be preserved. If the external sector can’t deliver the adjustment, either the private sector must invest more (unlikely amid uncertainty), or the public sector must step in.

In the US, that likely means:

• A bigger deficit, at least in the near term; • A higher risk of longer-term fiscal sustainability debates; • And growing pressure for industrial policy, subsidies, and tax incentives to replace what trade used to deliver.

Globally, we are likely to see:

• Asynchronous policy cycles, with China and Europe stimulating more aggressively; • Ongoing FX pressure and fragmented capital flows; • And a world inching toward multi-polar demand models, where economies rely less on the US consumer and more on domestic engines of growth.

Conclusion: When Tariffs Shift the System

The new tariffs are not a policy tweak—they are a shock to the system. Through the lens of financial balances, we can already see how the global economy will be forced to rebalance: not by choice, but by accounting necessity.

In the short term, this means slower growth, higher uncertainty, and deeper fiscal footprints. In the long term, it may mean a less integrated world economy—with all the frictions and inefficiencies that implies.

The challenge now is not just to understand the game, but to read the scoreboard.