Mental Models That Explain the ‘Liberation Day’ Tariffs—Their Causes and Consequences

The "Liberation Day" tariffs represent a significant shift in global economic policy, marking a pivotal moment in international trade relations. To fully grasp the underlying causes and far-reaching impacts of these tariffs, it is essential to employ robust mental models that clarify complex economic, political, and geopolitical dynamics. This document introduces key frameworks—such as Ray Dalio's Big Cycle and Aswath Damodaran's Crisis Effect—that provide structured lenses through which we can analyze and interpret the unfolding events. By applying these mental models, we can better understand the interconnected forces driving the tariffs, anticipate potential outcomes, and navigate the uncertainties of this transformative period.

References

It is important to understand that the mental models are not originated from me. I am just sharing the mental models that I found useful to understand the causes and impacts of the "Liberation Day" tariffs. Here are the references:

• Principles for Dealing With the Changing World Order by Ray Dalio
• Anatomy of a Market Crisis: Tariffs, Markets and the Economy! by Aswath Damodaran
• Investing Politics: Globalization Backlash and Government Disruption! by Aswath Damodaran
• 特朗普为什么急着俄乌停火? by 许哲
• 美国宣布国家紧急状态，对所有国家征收 10% 的「基准关税」，会对全球贸易带来哪些影响？ by 桃竹村
• Lee Hsien Loong on the impact of Trump's tariffs on Singapore
• Singapore PM’s Reality Check To Trump Amid Tariff War In Parliament

Ray Dalio's Big Cycle

The big cycle is a long-term, recurring historical pattern that Dalio describes as the rise and fall of empires and world orders, driven by predictable forces. Such major shifts occur roughly once in a lifetime but have happened repeatedly throughout history.

The big cycle is driven by 5 forces:

1. Monetary/Economic Order Breakdown
2. Domestic Political Order Breakdown
3. International Geopolitical Order Breakdown
4. Acts of Nature
5. Technological Innovation

The first 3 forces are the most important or relevant to the "Liberation Day" tariffs.

At a glance:

• Debt cycle strains household & fiscal cash flow.
• Internal cycle turns that strain into domestic conflict.
• External cycle turns domestic weakness into contested hegemony.

Debt powers an economy much like oxygen feeds a flame: in the early, low‑leverage phase new credit finances genuinely productive investment, productivity rises faster than interest costs, and living standards improve. Success breeds complacency; lenders loosen, borrowers stretch, and ever‑larger sums chase existing assets rather than new output, driving leverage and asset prices far ahead of income. When debt‑service burdens bite—often after only modest rate hikes—the cash‑flow gap widens, bubbles strain and a reckoning begins. Debts can shrink via repayment, restructuring, inflation or default; governments, unlike households, typically roll over principal and service only the interest, which can absorb a hefty slice of GDP. Central banks counter the squeeze by cutting rates and, where currency sovereignty allows, launching quantitative easing; combined with targeted write‑downs, transfers and some fiscal restraint, this can orchestrate the “beautiful deleveraging” Dalio describes. Overdone, however, easy money erodes credibility, stokes inflation and forces a new round of tightening, completing the cycle and setting the stage for the next one.

Domestic political orders often begin with a unifying leader or coalition that, after a rupture, forges fresh institutions and rules. A long spell of stability and broad‑based prosperity follows, but over decades wealth and opportunity concentrate, cultural values diverge, and trust in elites erodes. When economic stress or an external shock hits, these wealth and values gaps ignite populist backlash; the resulting disorder can range from messy elections to outright civil conflict. Renewal comes only when society—sometimes under a charismatic leader, sometimes through collective reform—reaches a new consensus and refreshes its rules, restarting the cycle.

An international order typically begins when a freshly victorious great power—armed with the world’s strongest economy, military, technology, and reserve currency—writes the rules and builds global institutions (e.g., Bretton Woods, the UN) that usher in decades of peace and commerce. Over time, success breeds over‑stretch: the hegemon shoulders costly commitments abroad, piles up debt at home, and political cohesion frays, even as its open markets and know‑how let other countries upgrade their education, technology, and military capabilities. Once a rising power’s composite strength approaches the incumbent’s—and the incumbent is distracted by internal problems—the status‑quo power tightens alliances or imposes sanctions to defend its position, while the challenger pushes for a bigger share of trade, tech, and influence. This rivalry ushers in a period of external disorder that can end in a negotiated power‑sharing, a financial‑currency shift, or, in the worst case, a hot war that resets the global hierarchy and launches the next cycle.

The cycles reinforce one another in both directions. As the long‑term debt build‑up pushes interest costs above income growth, governments juggle austerity, money‑printing, restructurings and wealth transfers; whichever mix they choose widens wealth and values gaps, fuels populism and erodes institutional trust. That domestic fragility signals to rising powers that the incumbent hegemon is distracted, encouraging them to contest trade, technology and security arrangements. The resulting sanctions, arms races and supply‑chain disruptions raise fiscal deficits and inflation at home, looping back into the long‑term debt problem. If a productivity surge or “beautiful” policy mix doesn’t break the spiral, simultaneous late‑stage readings across all three cycles raise the odds of a major geopolitical reset—or even hot conflict—that clears the slate for the next order.

Aswath Damodaran's Crisis Effect

Aswath Damodaran describes how crisis typically unfolds and how it impacts the real economy and its instrict values.

Collectively, these factors ultimately shape projected future cash flows and required rates of return, thereby determining the economy’s intrinsic valuation.

\[\text{Intrinsic value of S\&P 500}= \sum_{t=1}^{5} \frac{E(CF_t)}{(1+r)^t}+\underbrace{\frac{E(CF_6)}{(r-g)(1+r)^5}}_{\text{terminal value}}\]

Free Cash Flow to the Firm

\[FCFF = Revenue \times Operating Margin - Taxes - Reinvestment\]

Tariffs and broader trade conflicts suppress revenue growth, particularly for businesses that rely heavily on cross‑border sales. Operating margins also compress when global supply chains incur higher costs. Capital‑intensive firms that once counted on inexpensive offshore labour or components must now pay more for domestic inputs or invest in alternative production capacity, driving up both operating expenses and capital requirements.

\[ Value = \frac{FCFF}{WACC - g} \]

where $g$ is the growth rate of FCFF, and $WACC$ is the weighted average cost of capital.

A firm’s value is the present value of its expected free cash flows (FCFF), discounted at the weighted‑average cost of capital (WACC). WACC combines the required return on equity and the after‑tax cost of debt, weighted by their share in the capital structure. Heightened uncertainty increases the equity risk premium, while tariff‑driven inflation fears push up borrowing costs, raising both components—and therefore the overall WACC.

Big picture:

Tariffs and trade wars hit a firm on three fronts simultaneously:

1. Cash flows shrink (less growth, tighter margins, costlier reinvestment).
2. Discount rate rises (costlier equity and debt financing).
3. Failure risk rises (greater chance of business disruption).

The Context of the Liberation Day Tariffs

The Liberation Day tariffs cast a wide and deep shadow over global commerce: almost every nation feels their impact, with Russia and North Korea—already limited by separate sanctions—standing as rare exceptions.

Using the framework above indiscriminately may border on overfitting, yet it remains a valuable lens for navigating this unsettled landscape. Even so, readers should apply it with care and maintain a critical perspective.

Unsustainable US Debt (Debt Cycle)

Ray Dalio watches the following metrics in his quick glance dashboard:

The total deficit is -6.4% of GDP in 2024, according to the Congressional Budget Office. Also, interest payment exceeded a number of other budget categories

Data sources: Congressional Budget Office; Department of the Treasury; Office of Management and Budget.

The total interest bill is rising rapidly to 3.02% of GDP in 2024.

Below is a decade‑stacked view of U.S. federal interest outlays as % of GDP.
Each column is a 10‑year window; each row shows the offset within that window (0 = first year of the decade, 1 = second year, ...).
Blank cells mean data are not yet available for that offset.

* 2020‑29 column covers 2020‑2024 so far; later years are blank.

Data source: Fred

The debt-to-GDP ratio hits 120% in 2024.

* 2020‑29 column covers 2020‑2024 so far; later years are blank.

Data source: Fred

The average maturity as of April 2025 is 71 months. Approximately 33% of U.S. publicly held marketable debt will be maturing in the next 12 months

Data source: JEC Senate

The interest rate (R) is projected to exceed the economic growth rate (G) for the next 30 years.

When R > G, debt dynamics become more challenging as interest costs grow faster than the economy.

Data source: Peterson Foundation

Nearly one-third of U.S. debt relies on foreign lenders. The major foreign holders are Japan and China, which together account for about $2.0 trillion (Japan ~$1.1T, China ~$0.85T as of end-2024)

*Data Source: Peterson Foundation

While U.S. debt has not yet reached unsustainable levels, its trajectory is increasingly worrisome. Faced with that challenge, the administration pitches the “Liberation Day” tariffs as a way to make “foreigners pay our bills,” i.e., raise revenue and curb the trade gap without unpopular tax hikes or spending cuts. Customs duties have indeed risen but that is a fraction of the interest tab and far below the “billions a day” claimed in political rhetoric. In Dalio’s framework, this resort to import taxes is a late‑cycle reflex: a fiscally stretched hegemon turns to visible, voter‑friendly levies on external rivals rather than tackling the structural drivers of its unsustainable debt, even though such tariffs do little to change the debt trajectory and risk slowing growth that could otherwise ease the burden.

Deglobalization (Internal Order Cycle)

After World War II the United States emerged as the dominant global power, and the dollar became the world’s reserve currency. The post‑war order delivered decades of relative peace and prosperity with no serious challenger to U.S. primacy. Washington championed globalization and free trade—culminating in institutions such as the World Trade Organization (WTO)—and preserved the dollar’s reserve status by running persistent current‑account deficits, effectively paying for foreign goods with freshly created dollars.

Lower trade barriers benefited most economies by letting countries specialize in what they produced most efficiently. Yet America’s higher wages left its farmers and manufacturers vulnerable to lower‑cost foreign competition, leading to job losses and stagnant pay at home. U.S. industry responded by moving up the value chain into technology, finance, and healthcare. Aggregate productivity rose, but income and wealth disparities widened, and political views grew increasingly polarized. Donald Trump’s 2016 election crystallized that divide.

Once in office, Trump pursued protectionist “America First” policies. He withdrew from the Trans‑Pacific Partnership (TPP) and the Paris Climate Accord, favored one‑on‑one negotiations over multilateral frameworks, and imposed tariffs on nearly every major trading partner to shrink the trade deficit and bring jobs back to the United States. Trump’s team reached for a politically salable lever: import tariffs that punish an external “other,” promise to reshore jobs, and generate some customs revenue without touching domestic voters’ wallets.

Rising China (External Order Cycle)

Singapore former Prime Minister Lee Hsien Loong said that, "On the US side, fundamentally, they have made an assessment that China is a pacing challenge. That means it is something which they have to treat −not just as a partner, as a friendly country −but something which could pose a challenge, maybe even a threat to them."

China’s share of global GDP has risen more than twenty‑fold—from about 1.5 percent in the 1980s to nearly 18 percent in 2023—second only to that of the United States. This dramatic ascent positions Beijing as the principal challenger to Washington’s economic primacy. Over the past five decades China has sharply improved educational attainment, upgraded its technological base, and modernised its armed forces. The country now boasts the world’s largest cohort of university‑educated workers and is a frontrunner in areas such as artificial intelligence and 5G. Its defence budget, meanwhile, is the world’s second‑largest.

Washington has sought to slow China’s momentum by tightening export controls on advanced semiconductors, high‑end graphics processors, and other sensitive technologies. At the same time, the United States has deepened strategic ties with regional partners—including Australia, Japan, South Korea, Taiwan, and India—in an effort to build a coalition that can balance China’s expanding influence.

On the United States side, they suffer from internal political polarization and unsustainable debt as mentioned in the previous section. Also, the cost of maintaining the US's global primacy is too high, including military overstretch and trade imbalances. For example, Trump asked the US allies to pay more for the US's military protection.

Without question, China is the sole nation capable of contesting U.S. global primacy—and Beijing knows it. As a result, Washington increasingly regards China not as a partner but as a formidable strategic rival.

The Impact of the Liberation Day Tariffs

It is difficult to predict the exact impact of the Liberation Day Tariffs because the game is dynamic. Here are some of my predictions:

• Global GDP growth will likely decelerate as higher tariffs, supply‑chain reshoring, and broader geopolitical uncertainty curb trade volumes and erode productivity gains.
• U.S. economic policy is poised to remain structurally more protectionist—regardless of which party holds the White House—because ballooning public debt, widening inequality, and bipartisan skepticism of globalization create strong domestic pressure to shield home industries.
• In turn, other countries will deepen regional and plurilateral pacts (CPTPP, RCEP, EU‑Mercosur, AfCFTA, etc.), increasingly negotiating with Washington as a bloc or bypassing it altogether to secure market access and supply‑chain resilience.
• Strategic rivalry between the United States and China will intensify across trade, technology, and finance, exacerbated by Beijing’s role as a major holder of U.S. Treasuries and Washington’s export‑control regime.
• Elevated policy uncertainty will push risk premia higher: investors will seek safer assets, corporate capex and M&A will slow, revenue expansion will moderate, and equity valuations are likely to compress.
• U.S. multinationals reliant on offshore production will face higher input costs, supply‑chain disruptions, and a rising weighted‑average cost of capital—effects felt most acutely in capital‑intensive sectors such as semiconductors, autos, and industrials.
• Foreign companies that depend on U.S. demand will confront similar headwinds—tariff exposure, compliance costs, and tighter financing conditions—with capex‑heavy businesses particularly vulnerable.

Conclusion

The Liberation Day tariffs are more than a one‑off policy move—they signal a deeper turn in the long‑term debt, domestic political, and geopolitical cycles. By layering Ray Dalio’s Big Cycle and Aswath Damodaran’s Crisis‑Effect lenses, we see how fiscal strain, social polarization, and strategic rivalry converge to reshape trade, capital costs, and corporate cash flows. While exact outcomes will depend on how policymakers and firms respond, the direction is clear: volatility is the new baseline, and success will hinge on continuously tracking debt sustainability metrics, supply‑chain realignments, and shifting risk premia. Equipped with these mental models, investors and operators can turn today’s upheaval into a framework for clearer decisions amid the uncertainty ahead.