Tariff Wars and Net Foreign Assets

This paper examines whether and how international financial claims can be honored without default once a trade war erupts. Using a two-country two-good model, we study how unanticipated tariffs revalue international assets and how the outcome depends on ex-ante gross asset positions. When gross positions are strictly positive (each country has claims on the other), sufficiently high bilateral tariffs zero out any ex-ante net debt. Conversely, this net debt cannot be zeroed out when the debtor holds no claims on the creditor. When a country has liabilities denominated in the other country’s goods (or prices), then a sufficiently large tariff levied by the second can immiserize the first, generating multiple equilibria if both sides have such liabilities. These results generalize to settings with an arbitrary number of goods, time, and uncertainty. In a dynamic version, under a severe trade war, domestic interest rates and the real exchange rate must decouple: interest rates align with their autarkic values, and international relative prices revalue net asset positions to zero. We calibrate a two-country model to the US net foreign asset position in 2023 and show that the welfare consequences of a tariff war that stops short of autarky depend critically on the US ex-ante gross portfolio composition.