The border adjustment tax is disruptive by its very nature. (I’m writing a series of articles about the good, the bad, and the ugly of this tax reform in Thoughts from the Frontline. Read Part 1 here).

In their defense, Paul Ryan and House Ways & Means Committee Chair Kevin Brady know everything I just said and probably agree with much of it. They believe the BAT’s negative effects will disappear quickly due to currency flows.

Border Adjustment Tax

As the trade deficit shrinks, fewer dollars will flow from the US to the rest of the world. That trend will make the dollar rise against other currencies. And that should nullify the higher prices we will pay for imported goods because of the border adjusted tax (BAT).

That’s the theory.

The Potential Financial Contagion Is Massive

Most economists do agree that the dollar is likely to rise significantly if this proposal is adopted. So, the theory is that Walmart shoppers really won’t pay higher prices, at least in dollar terms. I don’t think that things will work like that in practice… a least, not as quickly as they hope.

Here we see once again how debt keeps us from doing what might otherwise make sense.

To whom is all that emerging-market debt owed? Mostly to Western banks and bondholders, who are often themselves deeply indebted. The potential for financial contagion is massive.

The world economy is currently ensconced in the equivalent of a Nash equilibrium. What that means is that everybody has adjusted to the present rules by which the dollar is the world’s reserve currency. The US agrees to run large trade deficits, with dollars flowing to the rest of the world so that the USD can remain the reserve currency. And global trade is based around current global tax policies remaining largely stable.

The Problem Is Tit-for-Tat Economics

When you talk to Republican leaders and ask them why other nations wouldn’t react to the BAT by imposing larger tariffs or sanctions on US goods, they respond with a question of their own. And it’s a logical one: “But why would they? We’re only doing with the BAT what they’re already doing to us.” And they are right.

The problem is that other countries are simply not going to say, “Oh, the United States finally figured it out that we were taking advantage of its silly, complicated tax system. There’s really nothing we can do, so let’s just get on with the program.” No, they are going to protect their own businesses.

Game theory clearly shows that when one player interrupts the Nash equilibrium, the other players will respond. And the responses will go back and forth, tit for tat, until there is a new balance.

What worried me was a situation where the US, for domestic political reasons, pulled up the drawbridge and chose to pursue a current account surplus. Such an outcome was always going to be driven by Americans at large concluding that the global production system was being run against their interests.

The BAT Could Throw the World into a Global Recession

While I don’t think we are anywhere close to a policy as draconian as Herbert Hoover’s was in the late 1920s, it would behoove us to remember his Mexican Repatriation, by which somewhere between 500,000 and 2 million American residents of Mexican ancestry were forcibly returned to Mexico.

Many of these deportees were actually US citizens. And this was done without due process. I kid you not. By the way, this program was continued by Franklin D. Roosevelt for another four years. This program is a dark blot on American history. One that I think was even worse than the Japanese internment camps of World War II.

The expulsion was carried out in the name of “protecting American jobs” and putting America first. And then it was followed up with policies that were designed to make America productive again. Including the Smoot-Hawley Tariff Act, which was a contributing factor in the Great Depression.

The single thing that scares me more than any other potential economic event is a move toward protectionism and a resulting global trade and currency war.

I know this is going to offend a few of my friends, but I’m going to say it anyway. I am afraid that this border adjustment tax, if implemented, will throw the world into a global recession.

Understand, I’m a believer in free markets. I know that the American enterprise and entrepreneurial system, when given an opportunity, can respond and create growth in this country.

But the BAT is not the way to do it.

Subscribe to John Mauldin’s Investment Newsletter, Thoughts from the Frontline

Want to go beyond mainstream media hype and learn the economic trends and traps to watch out for? Join celebrated commentator John Mauldin as he uncovers macroeconomic truths every investor should know. Get it free in your inbox every Monday.