Introduction: Why Monetary Policy Needs a Firm Theoretical Foundation

Monetary policy is fundamentally about stabilising nominal spending — nominal GDP — to support economic growth and maintain price stability.

For the euro area, this challenge is particularly complex given structural differences across member states, asymmetric shocks, and the unique institutional arrangement of monetary union without fiscal union.

Traditional frameworks have largely relied on interest rate rules — most notably the Taylor rule — which use inflation and output gaps as policy guides.

Whilst these rules have been influential, they often fail to account for the inherent instability and variability of money demand, potentially creating misalignments between policy settings and economic fundamentals.

The McCallum rule offers a theoretically robust alternative, firmly grounded in the quantity theory of money and nominal income targeting.

It provides a transparent, quantity-based framework for monetary policy that explicitly accounts for fluctuations in money velocity — a critical consideration in the euro area context.

The Origins and Development of the McCallum Rule

Bennett McCallum, the Carnegie Mellon economist who sadly passed away in 2024, developed his eponymous rule in the late 1980s as a direct response to the perceived shortcomings of both discretionary monetary policy and simple monetary targeting.

His seminal 1988 paper “Robustness Properties of a Rule for Monetary Policy” (Carnegie-Rochester Conference Series) introduced the rule as a way to operationalise nominal GDP targeting through monetary base control.

McCallum’s motivation was straightforward: whilst Friedman’s k-percent rule assumed stable velocity, and Taylor’s (1993) rule relied on difficult-to-measure output gaps, a rule that explicitly adjusted for velocity trends could provide more reliable guidance.

His subsequent work, particularly “Alternative Monetary Policy Rules: A Comparison with Historical Settings for the United States, the United Kingdom, and Japan” (NBER, 1999), demonstrated the rule’s superior performance across different monetary regimes.

The rule gained some attention during the 2008 crisis when interest rate rules hit the zero lower bound.

McCallum himself argued in “Nominal GDP Targeting” (Shadow Open Market Committee, 2011) that his quantity-based approach remained viable even when conventional interest rate policy became impotent.

The ECB’s Historical Relationship with Monetary Aggregates

It’s worth noting that the ECB began its operations with an explicit monetary pillar, including a reference value for M3 growth of 4.5% annually.

This two-pillar strategy — combining monetary analysis with economic analysis — reflected the German Bundesbank tradition and recognised the long-run relationship between money growth and inflation.

The ECB’s original M3 reference value was derived from the quantity equation itself: 2% inflation target plus trend real GDP growth (2-2.5%) minus trend velocity decline (0.5-1%). This was essentially a simplified McCallum rule without the feedback mechanism.

However, the ECB progressively downgraded the role of monetary analysis, particularly after 2003, citing velocity instability and the weak short-run relationship between money growth and inflation.

This abandonment of monetary analysis was in my view a grave error. By throwing out the monetary baby with the bathwater, the ECB deprived itself of crucial information about monetary conditions.

As the analysis below will demonstrate, the ECB’s neglect of monetary aggregates led to systematic policy errors: excessive M3 growth prior to 2008 (contributing to asset bubbles and imbalances) followed by a prolonged period of undershooting that hampered the recovery and kept inflation persistently below target.

Had the ECB paid proper attention to monetary aggregates and nominal spending growth — as the McCallum rule prescribes — these costly errors could have been avoided.

The McCallum rule, by explicitly incorporating velocity trends and feedback from nominal GDP, addresses precisely the shortcomings that led the ECB to abandon its monetary pillar. Rather than abandoning monetary analysis when velocity became unstable, the ECB should have adopted a more sophisticated framework that accounts for velocity changes.

The Quantity Theory of Money and Nominal Income Targeting

The McCallum rule builds on the classical equation of exchange:

M × V = P × Y

Where:

• M is the money supply
• V is velocity
• P is the price level
• Y is real output

In growth terms, this becomes:

Δm + Δv = Δp + Δy = Δx

Where:

• Δm is money supply growth
• Δv is velocity growth
• Δp is inflation
• Δy is real GDP growth
• Δx is nominal GDP growth

The key insight is that stable nominal GDP growth ensures balanced growth in real output and prices. Monetary policy’s role, therefore, is to adjust money supply growth to offset velocity fluctuations and guide nominal GDP toward its target path.

The McCallum Rule Formalised

Building on this framework, McCallum proposed a systematic policy rule:

Δmₜ = -vₜ + xₜ + λ(x*ₜ – xₜ)

Where:

• v*ₜ is the trend velocity growth — recognising that velocity is not constant but evolves structurally over time due to financial innovation, regulation, and behaviour
• x*ₜ is the target nominal GDP growth, set by the inflation target plus trend real output growth
• xₜ is actual nominal GDP growth
• λ is a policy reaction coefficient, modulating responsiveness to deviations from target

This rule has several compelling features:

First, it provides direct control over nominal spending. By targeting money growth to stabilise NGDP, the rule ensures policy responds to the key macroeconomic aggregate affecting economic activity.

Second, it incorporates velocity trends. Unlike the ECB’s abandoned fixed reference value, it adjusts for persistent shifts in money demand — crucial for modern economies where velocity exhibits some structural changes.

Third, the systematic feedback mechanism λ(x*ₜ – xₜ) enables proportional policy responses to deviations in nominal income growth, providing automatic stabilisation.

Why Use M3 Instead of the Monetary Base?

McCallum’s original formulation targeted the monetary base — reserves and currency directly controlled by the central bank. The base represents the foundation of money creation and is under tight central bank control.

However, in the euro area context, the monetary base is relatively small compared to broader aggregates, and its relationship with nominal GDP has become increasingly unstable, particularly during unconventional monetary policy episodes such as quantitative easing. As McCallum himself acknowledged in later work (see “Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates,” Journal of Money, Credit and Banking, 2000), the choice of monetary aggregate matters for practical implementation.

For empirical implementation, I therefore use M3 — the broadest monetary aggregate — which better captures the liquidity available to the economy and the monetary conditions affecting spending decisions.

This choice is particularly appropriate given the ECB’s historical focus on M3 and the extensive data available for this aggregate.

The trade-off is clear: M3 velocity is less directly controllable than base velocity, requiring careful estimation of velocity trends (hence our 10-year moving average approach) and interpretation of the McCallum rule as a policy benchmark rather than a mechanical target.

Empirical Implementation: Estimating Trends

Applying the McCallum rule requires careful estimation of trend velocity growth (v*ₜ) and trend real GDP growth (y*ₜ).

I employ 10-year rolling averages of quarterly growth rates, which smooth cyclical fluctuations whilst capturing gradual structural changes.

This methodology follows McCallum’s own empirical applications, where he typically used moving averages of 12-16 quarters to estimate velocity trends.

The inflation target π* is set at 2% annually (approximately 0.5% quarterly), consistent with ECB objectives.

The reaction coefficient λ is calibrated at 0.5, reflecting the balanced responsiveness recommended in McCallum’s original work and subsequent empirical studies.

To account for uncertainty, I incorporate bands of ±1 standard deviation of velocity growth. For the extreme 2020-22 COVID period, I fix the band width at pre-pandemic levels to prevent distortion from these exceptional circumstances.

This framework provides a theoretically grounded, empirically implementable guide for monetary policy — one that respects the fundamental relationships between money, velocity, and nominal income whilst remaining flexible enough to accommodate the complexities of modern monetary economics.

It represents what the ECB’s two-pillar strategy should have evolved into, rather than being unceremoniously abandoned. The cost of that abandonment — in terms of excessive monetary growth pre-2008 and persistent undershooting thereafter — has been substantial.

Historical Review Through the McCallum Lens: A Detailed Narrative

The journey of euro area monetary policy since the launch of the single currency in 1999 reveals a story of evolving challenges, shifting economic realities, and the consequences of abandoning systematic monetary analysis.

By examining actual monetary growth relative to the McCallum rule’s prescriptions, we gain a revealing window into how policy decisions aligned — or more often diverged — from theoretically grounded benchmarks designed to stabilise nominal GDP.

The Early Years (2000–2005): Caution and Relative Stability

The birth of the euro marked a historic moment. The ECB was navigating uncharted waters, crafting a monetary regime for a diverse economic union. During these formative years, the graph below reveals a reassuring picture: the orange line of actual M3 growth oscillated closely around the red dashed McCallum target, mostly staying within the grey uncertainty bands.

This alignment was no accident. The ECB still maintained its two-pillar strategy, with the monetary pillar providing discipline. When M3 growth briefly spiked above 4% in 2001, it quickly corrected back toward the 2% target range. The central bank was effectively following a McCallum-type rule, even if not explicitly.

This period demonstrates what monetary policy can achieve when it respects monetary aggregates and nominal income dynamics. The relative stability wasn’t luck — it was the result of systematic policy grounded in sound monetary principles.

The Expansion and Overheating Phase (2005–2008): The Prelude to Crisis

From 2005 onwards, the graph below tells a dramatically different story. The orange line of actual M3 growth breaks decisively above the McCallum target, repeatedly piercing the upper uncertainty band. By 2007, M3 growth was consistently running at 3% or higher — well above the rule’s prescription of around 2%.

This wasn’t a brief deviation but a sustained period of monetary excess. The ECB had by then effectively abandoned its monetary pillar, dismissing the warning signals from accelerating money growth.

During this period instead of focusing on M3 growth and nominal spending growth the ECB got fooled by an excessive focus on actual inflation that in the early stage of the period still remained fairly low and stable.

The graph shows the consequences: a widening gap between actual policy and what systematic nominal income targeting would have prescribed.

The McCallum rule would have called for tightening — reducing M3 growth back toward the 2% level.

Instead, the ECB maintained an accommodative stance, flooding the euro periphery with excess liquidity that fuelled housing bubbles and unsustainable debt accumulation.

The Crisis and Austerity Period (2008–2014): The Cost of Overcorrection

The 2008 crisis marks a dramatic inflection point on the graph. The orange line plummets from above 3% to below -1% by 2010, crashing through the lower uncertainty band.

While the McCallum rule (red dashed line) called for maintaining positive money growth around 1-2% to offset collapsing velocity, actual policy went in the opposite direction.

This visual evidence is damning. For nearly five years, from 2010 to 2014, actual M3 growth remained below — often far below — what the McCallum rule prescribed. The ECB was actively tightening monetary conditions during the deepest recession since the 1930s.

This is the crucial insight that the interest rate lens obscures. Yes, the ECB cut rates — but not nearly enough to offset the velocity collapse and generate the money growth required to stabilise nominal GDP.

The McCallum rule shows what should have happened: a significant expansion of M3 to compensate for plummeting velocity. Instead, M3 growth turned sharply negative.

This analysis reveals the tragedy of discretionary policy without a nominal income anchor. While the rule called for support, the ECB delivered austerity. The prolonged period below the lower band corresponds exactly with the euro area’s double-dip recession and lost decade.

The Recovery and Quantitative Easing Era (2015–2019): Gradual Realignment

The launch of Quantitative Easing (QE) in 2015 shows up clearly on the graph below. The orange line rises from negative territory back toward the McCallum target.

For the first time since the crisis in 2008, actual M3 growth converges with the rule’s prescription, oscillating around the 1% level within the uncertainty bands.

This visual convergence tells the story of belated recognition. The ECB had finally acknowledged (at least indirectly) that monetary aggregates matter and that supporting nominal income requires adequate money growth.

The graph validates what monetarist critics like myself had argued for years — proper monetary expansion was needed and, when finally delivered, it worked.

The Pandemic Shock and Response (2020–2021): Learning from Past Mistakes

The COVID period reveals a dramatic but ultimately vindicated policy response from the ECB as the graph below show.

The orange line (actual M3 growth) initially plunges to -11% in early 2020 as the pandemic struck, before surging to an extraordinary peak of 12% by mid-2020. The red dashed line (McCallum target) shows a more moderate pattern, rising from 3% to about 6% before falling to -4%.

The divergence is revealing. While actual M3 growth swung wildly — from -11% to +12% — the McCallum rule prescribed a much more measured response. When the pandemic hit and M3 growth collapsed to -11%, the rule was already signalling the need for expansion to around 6%.

As the ECB responded with massive stimulus, pushing M3 growth to 12%, the McCallum rule was already moderating, recognising that velocity was rebounding.

The crucial insight comes from examining the full period.

From 2020 to end-2022, the average quarterly M3 growth was approximately 0.41%, while the McCallum rule target averaged 0.71%. This means that despite the dramatic spike in 2020, the ECB’s overall monetary stance was actually more restrictive than what the rule prescribed.

This finding challenges the conventional wisdom — including my own initial assessment — that ECB policy had also become too easy during the pandemic, albeit less so than in the US.

The McCallum rule reveals a different story: the ECB’s monetary stance was actually tighter than “optimal” throughout the COVID period – at least compared to the McCallum rule.

This restraint becomes even clearer when compared to the Fed. While euro area M3 growth peaked at 12% year-on-year in 2021, US M2 growth reached an astonishing 25%. The ECB provided necessary crisis support but avoided the Fed’s monetary excess.

The inflation comparison graph below tells the story even more starkly. US inflation (red line) began accelerating sharply in early 2021, rising from near zero to over 5% by mid-year.

Crucially, US inflation had already reached nearly 9% by February 2022 — before Russia’s invasion of Ukraine — and was clearly on an upward trajectory driven entirely by domestic monetary and fiscal excess.

In sharp contrast, Euro area inflation (blue line) remained subdued relative to the US throughout 2021. But as war fears escalated in early 2022 in Europe inflation started to accelerate in the euro area.

While US inflation was already near its peak when the war began, European inflation shot up from 5% to over 10% in the months following the invasion. This timing difference is decisive evidence that US and European inflation had fundamentally different causes.

The graph reveals clear evidence of US monetary policy “leading” European inflation. The red line consistently runs 6-12 months ahead of the blue line throughout the cycle.

As US inflation accelerated through 2021, European inflation began a modest rise in late 2021 — consistent with spillovers from American monetary excess but nothing like the surge that would follow the war. When US inflation peaks at 9% and begins declining in mid-2022, European inflation continues rising to its 10.6% peak several months later.

This leadership pattern indicates significant spillover effects, but the magnitude tells the real story.

Before Ukraine, Europe was experiencing perhaps 2-3 percentage points of imported inflation from easy US monetary conditions. But the explosion from 5% to over 10% inflation came only with the war — a pure supply shock that the ECB could not (and should not) have prevented regardless of policy stance.

The fact that European M3 growth averaged below the McCallum target throughout this period confirms that European inflation was to a large extent supply-side driven (from 2022) — a consequence of war and energy shocks, with some imported US inflation primarily in 2021, rather than domestic monetary excess. The US, having already reached 9% inflation before any war effects, was clearly experiencing a classic demand-driven inflation that the Fed had created through excessive stimulus.

The Post-Pandemic Period and Recent Tightening (2021–2025): From Convergence to Renewed Risks

The graph below shows that through 2021, actual M3 growth in the euro area declines sharply to around 0.5%, converging with the rising McCallum target.

By late 2021 and into 2022, both lines track closely together between 0.5% and 1%, with actual policy closely matching what the rule prescribed.

During this period, the ECB maintained its deposit rate at -0.50%, providing continued support as the economy recovered.

This convergence vindicated both the ECB and the McCallum framework.

By moderating M3 growth from its pandemic peak while keeping it aligned with the rule’s prescription, the ECB avoided the Fed’s error of maintaining excessive stimulus.

However, the Fed’s procrastination in addressing its own inflation — keeping rates at zero until March 2022 despite inflation exceeding 5% by mid-2021 — created spillovers that complicated the European picture.

The velocity graph below illustrates the mechanism of these spillovers.

From early 2021, actual velocity growth (orange line) surges dramatically above its trend (red dashed line), jumping from 0.3% to over 1.2% by late 2021.

This acceleration continues through 2022, with velocity growth peaking near 2% — more than triple its trend rate of around 0.5%.

This surge in velocity reflects rising inflation expectations imported from the US, as markets anticipated that global inflation pressures would eventually reach Europe.

These US spillovers lifting velocity above trend present a genuine dilemma: when velocity rises due to imported expectations rather than domestic conditions, central banks must balance competing risks.

Some of the surge in velocity likely also have to be seen in the light of the communication from the ECB that during 2021 continued to signal a very easy monetary stance despite the need to normalise montary conditions.

The extraordinary gap between actual and trend velocity growth in 2022-2023 shows the magnitude of this external shock that the ECB had to navigate.

When inflation did surge in Europe following Russia’s invasion, it was overwhelmingly driven by war and energy shocks rather than monetary excess. The ECB raised the deposit rate from -0.50% to 4.00% by September 2023 — 450 basis points in 14 months. This aggressive response needs to be understood in the context of velocity running far above trend, providing additional monetary stimulus that needed offsetting.

The M3 growth graph shows actual M3 growth plunging to near zero from mid-2022, remaining there through 2023, consistently below the McCallum target.

However, this apparent tightness must be viewed alongside the velocity surge — the combination of near-zero M3 growth and velocity running 1-1.5 percentage points above trend meant the ECB was striking a reasonable balance between competing objectives.

By late 2023, the velocity graph shows a sharp reversal, with actual velocity growth plunging below trend and even turning negative in 2024.

This normalisation of velocity — from 2% back toward the 0.6% trend — justified the ECB’s decision to begin cutting rates.

The fact that M3 growth has started recovering, albeit gradually, suggests the ECB is managing the transition reasonably well.

Looking at both graphs together, the ECB appears to have navigated an extraordinarily difficult period with reasonable skill.

They avoided the Fed’s error of excessive stimulus, responded appropriately to the velocity surge driven by imported expectations, and began easing as velocity normalised.

While M3 growth remains somewhat below the McCallum target, this may reflect appropriate caution given the unprecedented nature of the shocks.

The ECB’s response — raising rates aggressively when velocity surged, then cutting as it normalised — represents a sensible application of the McCallum framework’s insights while adapting to exceptional circumstances.

The lesson is that even good policy rules require judgment in their application. The ECB’s performance during this period, while not perfect, demonstrates that systematic monetary policy based on nominal income targeting principles can successfully navigate even extreme external shocks and imported inflation expectations.

Where We Stand Today (June 2025): A Return to Equilibrium

As of June 2025, the euro area monetary landscape presents a remarkably different picture from the turbulence of recent years.

The annualised velocity and real GDP growth graphs below show a striking convergence: actual values (orange lines) have returned to almost perfect alignment with their long-term trends (red dashed lines), with both now comfortably within their ±1% uncertainty bands.

The velocity graph shows the dramatic journey from early 2023, when annualised velocity growth exceeded 8%. This has now normalised to around 2.5%, virtually identical to its 10-year trend. ‘

The sharp decline from the 2023 peak through mid-2024 represented the unwinding of inflation expectations, and the current stability within the grey band suggests these extraordinary monetary disturbances have finally worked through the system.

Similarly, the real GDP growth graph reveals the economy’s path from the volatile swings in 2020-2022 to a steady convergence around the 4% trend rate.

The wild oscillations of the recovery period have given way to stable growth, with actual GDP expansion now tracking its long-term potential. The absence of any significant deviation from the trend band indicates the economy is operating at equilibrium, neither overheating nor underperforming.

This dual convergence is crucial for monetary policy. When both velocity and real growth align with their long-term patterns — as they clearly do now — the McCallum rule provides its most reliable guidance.

With v = v* and y = y*, the fundamental drivers of nominal GDP are at their structural levels.

The ECB just cut the deposit rate by 25bp to 2.00% last week as expected, and market pricing suggests only one more 25 basis point cut in the coming months.

This cautious market expectation appears well-calibrated. With M3 growth now tracking the McCallum rule target, velocity at trend, and real growth at potential, the ECB is approaching neutral territory. Following the market’s guidance — one more modest cut to 1.75% — would likely achieve the appropriate stance.

This represents a remarkable achievement. After navigating extreme velocity swings from -1% to 8%, managing imported inflation from US policy errors, and weathering an energy crisis, the ECB has engineered a soft landing with all key variables converging to their equilibrium values.

The current alignment — M3 growth matching the McCallum target, v = v*, y = y* – suggests monetary policy is almost perfectly calibrated.

The lesson is clear: systematic monetary policy works.

Conclusion: The Visual Verdict and the Path Forward

A single graph can capture a quarter century of the euro area’s monetary policy journey—its successes, its missteps, and its crucial lessons.

The black line in the graph below represents the McCallum gap – the difference between actual M3 growth and the McCallum rule – while the red shaded area highlights medium-term trends through the 1-year centered moving average of this cap.

Periods where the gap remains close to zero—such as 2000-2005 and 2015-2019—reflect times when the ECB’s policy aligned closely with systematic principles, corresponding with economic stability and recovery.

Conversely, sharp deviations—excessive money growth from 2005 to 2008 and undershooting from 2009 to 2014—map precisely onto the eurozone crises.

The message is unmistakable: adherence to a rule-based framework akin to the McCallum rule fosters economic prosperity.

Departures into discretionary, untethered monetary expansions or contractions bring turmoil. This graph is far more than a historical record—it’s a clear indictment of the costs borne by abandoning systematic monetary policy, and simultaneously a roadmap for reform.

The pandemic years stand as a notable exception, where discretion arguably outperformed rigid rule-following – but even then, success hinged on embracing the McCallum spirit: adjusting appropriately to unprecedented uncertainty without the Fed’s overreach.

This exception, in fact, underscores the rule’s validity: systematic nominal income targeting delivers superior outcomes compared to unanchored discretion.

Now, as we approach equilibrium in mid-2025, with M3 growth aligned with targets, velocity and real growth steady on trend, and inflation near 2%, the moment is ripe for institutional reform.

As I have long argued, the ECB must adopt a comprehensive framework that remains within the inflation targeting mandate but is underpinned by:

• Systematic M3 growth guidance based on the McCallum rule, ensuring a quantity anchor in monetary policy
• Explicit monitoring of nominal GDP growth to align policy with sustainable nominal spending
• Ongoing market-based expectation analysis for real-time feedback on policy credibility

Had this framework been in place over the last 25 years, many policy errors could have been avoided.

The evidence is overwhelming: monetary aggregates matter, nominal income is the critical benchmark, and rules systematically outperform discretion.

The current alignment of key indicators presents the perfect opportunity to institutionalise these lessons.

Rather than waiting for the next crisis to expose the limits of pure inflation targeting, the ECB should act now and embrace the framework history demands.

The McCallum rule has proven its worth time and again. It’s time to make it a cornerstone of the ECB’s official toolkit.

Finally, if you would like to test the McCallum rule yourself, I have developed a ‘McCallum Rule Calculator’ where you can input different values for the variables in the McCallum rule. Try the Calculator here.

Introduction: A Nation of Spend First, Ask Questions Later

If there is any enduring law in fiscal economics, it is this: arithmetic always wins. Political rhetoric, on the other hand, is mercifully short-lived.

In Washington, talk of “fiscal cliffs” and “grand bargains” has become background noise, but the numbers keep moving regardless.

The US has long since abandoned the old-fashioned “tax and spend” tradition. Today, it’s simply spend – and leave the arithmetic to tomorrow’s bondholders.

Yet beneath the slogans, we find the same old constraint: debt compounding does not care for politics.

Each new round of tax cuts or entitlement expansion, if unfunded, is simply more grist for the inexorable mill of interest on interest.

Recently, even markets – for so long content to finance the world’s reserve currency on generous terms – have begun to adjust their expectations.

Auctions that would once have been routine now bring higher yields; rating agencies, even if usually last to the party, are finally marking the homework. None of this should be surprising. When arithmetic is neglected, it always finds a way to make itself felt.

Why an Interactive Model? Transparency Over Oracles

Commentary is easy, but transparent arithmetic is harder to find.

That’s why I have build a model for US debt dynamics – not as a forecast, but as a laboratory for disciplined thinking about fiscal sustainability.

It is not a black box and does not pretend to predict political cycles or market moods. It simply lets you interrogate the future with open assumptions, and see how far you have to go before the numbers push back.

You set the key parameters: real growth, inflation, the size of the primary deficit, and—if you wish—a path for new taxes such as a federal VAT.

The model then mechanically computes the evolution of US federal debt from 2025 to 2055, tracking how compounding works for or against you, depending on the scenario. You are free to be as optimistic or pessimistic as you like; the arithmetic doesn’t care.

The Engine: How the Model Works

At its heart, the model is a stylised version of the classic government debt identity.

The debt-to-GDP ratio next year equals last year’s, increased by the nominal interest rate (itself a function of real rate plus inflation), plus any primary deficit, all divided by nominal growth.

The basic relationship is brutally honest: if the interest rate on debt exceeds the economy’s growth rate, debt rises relative to GDP even with a balanced primary budget. If the government is running persistent primary deficits, as the US is, the process is all the more acute.

Real growth and inflation are your two levers for nominal GDP growth. Higher real growth is, naturally, the least painful way to contain the ratio, as the denominator grows faster. Inflation can “dilute” the debt, but only as long as markets do not fully adjust the nominal interest rate in lockstep. Unfortunately, in the long run, they tend to do just that.

The primary deficit is simply the fiscal gap before interest – spending minus revenues, net of debt service. Keep it permanently negative, and the debt snowballs; improve it, and the path stabilises or reverses.

This is the central variable, and, in practice, also the most politically sensitive.

Endogenous Real Rates: When Markets Update Their Expectations

Unlike many official projections, the model does not assume the real interest rate is fixed. Instead, it lets the real rate drift upwards as debt and deficits mount. The logic is that, as fiscal prospects darken, investors will rationally update their expectations about future taxation, inflation, or even default risk (though the latter is unlikely for the US, as long as it borrows in dollars). This higher risk premium feeds directly into interest costs, which then compounds the debt further.

This mechanism is not a forecast of “crisis”, but a sober recognition that the market will not ignore fiscal fundamentals forever. The real rate thus acts as the model’s automatic stabiliser – or, if left unchecked, as the system’s accelerant.

Policy Levers: Stabilising Debt via Tax or Inflation

The model does more than show you the standard path of doom. It also allows you to experiment with two stylised but revealing “solutions”: inflation and new tax revenue.

If you want to see how much inflation it would take to merely stabilise the debt ratio at its current (already high) level, you can do so.

The answer is, for all practical purposes, always uncomfortable – typically far above the central bank’s target, and sustained over decades.

This is not an attractive way out. The required inflation path only grows more extreme the longer fiscal inaction persists.

Alternatively, the model quantifies the fiscal gap—the improvement in the primary balance needed to put the debt back on a stable path.

In the US context, this could mean a broad-based VAT, which is still political kryptonite in Washington.

For perspective: to raise an extra 6-7% of GDP in revenue (enough to stabilise debt in the most plausible scenarios) would require a VAT rate not far off the European norm.

Scenario Analysis: Baseline, Fiscal Consolidation, and “Beautiful Bill”

To make these abstractions concrete, let’s walk through the three main scenarios pre-loaded in the model:

Baseline: Inertia as Policy

The Baseline scenario is “business as usual”. Real growth is set to a modest 1.8%, inflation is a respectable 2%, and the primary deficit trundles along at around 2% of GDP—roughly what the Congressional Budget Office now expects. The real rate, in this scenario, rises gradually as debt mounts.

The results are as sobering as they are predictable. Debt as a share of GDP climbs steadily, at first almost imperceptibly, but with compounding soon driving it towards 250% of GDP by 2055.

Interest payments alone, by then, absorb a colossal share of federal revenue. Fiscal space, in any real sense, disappears. If one is feeling generous, this path can be called unsustainable. A more accurate description is mathematically impossible to maintain for long.

Fiscal Consolidation: The Road Not (Usually) Taken

In the Fiscal Consolidation scenario, we allow for an outbreak of political discipline. New revenue—perhaps a broad-based VAT, perhaps entitlement reform—closes the primary deficit. The result is a flattening of the debt trajectory, followed by gradual improvement as compounding works in the government’s favour for a change.

The required adjustment, to be clear, is substantial.

Moving from a structural deficit of 5-6% of GDP to primary balance or surplus is no small feat, and there is scant evidence of the political appetite.

Still, the model shows that such a path would restore the government’s freedom of action, sharply reduce the interest bill, and lower the risk of future unpleasant surprises.

“Beautiful Bill”: The Populist’s Shortcut

Finally, there is “Beautiful Bill”—a scenario in which the government enacts large, unfinanced tax cuts and adds further to the spending tab, all in the name of growth or electoral convenience. No plausible increase in real growth materialises. Instead, deficits balloon, and the debt ratio follows suit.

Here, the model is merciless. Debt explodes well beyond the baseline, the real rate rises sharply as investors update their expectations, and the fiscal gap required to restore stability becomes almost insurmountable.

This is not so much a forecast as a warning: sooner or later, something must give—be it expectations for inflation, future taxes, or some combination thereof.

What the Model Leaves Out: The Limits of Arithmetic

For all its mechanistic clarity, the model is a simplification.

It assumes expectations adjust gradually and smoothly to fundamentals, but it cannot capture those “unpleasant monetarist arithmetic” dynamics that Sargent & Wallace warned of.

If policymakers persistently refuse to close the fiscal gap, expectations about future policy can, at some point, shift suddenly and en masse. Such an adjustment—where markets collectively realise that only inflation or new taxes can restore stability—can result in far more abrupt changes in borrowing costs, exchange rates, and the credibility of US institutions than any model of compounding can safely accommodate.

There are no sudden jumps in the model. No endogenous “expectations trap”, no capital flight, no regime shifts or market segmentation.

The special role of the dollar, the global search for safe assets, and international spillover effects—all are abstracted away. As such, the results here are likely to be on the optimistic side. The real world is never as forgiving as a spreadsheet.

Conclusion: The Arithmetic Does Not Negotiate

The point of this model is not to forecast the next bond auction or to warn of impending doom.

It is to lay bare the arithmetic: the simple, mechanical logic of debt, compounding, and expectations. Fiscal inaction will, sooner or later, force its own reckoning—not through market “panic”, but because the numbers themselves cease to add up.

You are invited to play with the assumptions, stress-test your own fiscal views, and see how quickly the US moves from mere discomfort to genuine crisis if nothing changes. The numbers do not negotiate, and the unpleasant arithmetic always gets the last word.

The model has been build using the Large Language Model Claude 4.0. You can test the model here.

Stanley Fischer has passed away at the age of 81.

For those of us who have followed monetary policy closely over the years, this is not merely the loss of a prominent economist. It marks the departure of one of the rare practitioners who truly understood what it means to safeguard nominal stability – and who, as I have repeatedly argued on this blog, delivered on that promise in a way few others have managed.

A Life Shaped by Economics and Public Service

Born in 1943 in Mazabuka, Northern Rhodesia (now Zambia), Fischer’s upbringing was cosmopolitan and intellectually rich. His family, of Jewish-Latvian and Lithuanian descent, moved to Southern Rhodesia, where Fischer became active in the Zionist youth movement. This early global outlook would later inform much of his thinking as an economist.

He won a scholarship to the London School of Economics, completing both undergraduate and master’s degrees there before moving to MIT for his PhD, which he earned in 1969.

Fischer went on to an extraordinary academic career – first at the University of Chicago, and later at MIT, where he supervised and inspired a generation of central bankers, including Ben Bernanke and Mario Draghi.

His subsequent public service career is the stuff of legend: Chief Economist at the World Bank, First Deputy Managing Director at the IMF during the Asian crisis, Governor of the Bank of Israel (2005–2013), and Vice Chair of the Federal Reserve (2014–2017). Fischer became an American and Israeli citizen, and his influence reached across continents.

The Master of Nominal Stability – My Own Assessment

Readers of The Market Monetarist will know that I have long held Fischer in the highest regard.

In fact, I have often cited him as the central banker who came closest to running a true NGDP target in practice. His time at the Bank of Israel was nothing short of remarkable.

While central banks across the world floundered during the Great Recession that started in 2008, Fischer kept Israel’s nominal GDP on an astonishingly straight path – barely deviating from trend even at the height of global turmoil.

In a 2013 post (“Stanley Fischer – this guy can keep NGDP on a straight line”), I pointed out that Fischer’s stewardship resulted in an Israeli economy that largely escaped recession, thanks to his willingness to innovate and act decisively.

When the crisis hit, Fischer deployed quantitative easing and FX intervention long before it became fashionable in the advanced economies. The result: Israel’s real economy slowed, yes, but quickly returned to trend as soon as global conditions stabilised.

As I have argued elsewhere (“How Stan Fischer predicted the crisis and saved Israel from it”), Fischer’s intellectual flexibility – the ability to move beyond orthodoxy and focus on the centrality of nominal demand – proved decisive. He was, in my view, running the closest thing the world has seen to a pure NGDP targeting regime.

Not Without Critique – But Always With Respect

I have not always agreed with Fischer, especially in his later years at the Federal Reserve, where I felt his focus shifted too much towards concerns about bubbles and imbalances, and away from a simple focus on nominal stability (“Did Bill Gross get some insight from this blog? Maybe but it might (unfortunately) be outdated”).

Even so, his pragmatism, his humility, and his deep knowledge of both academic and practical economics always commanded respect.

A Lasting Legacy

We do not see many Stanley Fischers in monetary economics. He combined academic rigour with practical wisdom and genuine humility. His legacy endures not just in the institutions he served, but in the lives and careers of those he mentored, and in the intellectual clarity he brought to some of the world’s most difficult economic challenges.

Rest in peace, Stanley Fischer. Central banking, and those of us who care about nominal stability, owe you a debt of gratitude.

Selected blog posts on Stanley Fischer:

• “Stanley Fischer – this guy can keep NGDP on a straight line” – December 2013
• “How Stan Fischer predicted the crisis and saved Israel from it” – April 2014
• “The monetary transmission mechanism – causality and monetary policy rules” – May 2014
• “Is Karnit Flug jeopardizing Stan Fischer’s ‘straight line policy’? Not yet, but…” – September 2014
• “Did Bill Gross get some insight from this blog? Maybe but it might (unfortunately) be outdated” – October 2015
• “Make America Keynesian Again” – November 2016
• “Our Global Monetary Conditions Monitor – what we write about Bank of Israel” – February 2017

While Europe slept last night, a legal bombshell exploded over Trump’s trade policy. The U.S. Court of International Trade—America’s specialist federal court with exclusive jurisdiction over trade disputes—delivered what can only be described as a devastating blow to presidential overreach. In simple terms, a three-judge panel told Trump: No, you cannot do this.

This is genuinely remarkable.

The Court of International Trade has traditionally shown considerable deference to presidential trade actions, making this unanimous rebuke all the more significant.

The court found that Trump had exceeded his constitutional authority under the International Emergency Economic Powers Act (IEEPA)—a 1977 law that grants presidents certain emergency powers but, as the judges made crystal clear, does not permit circumventing Congress’s constitutional role in setting tariffs.

The Magnitude of What Just Happened

The implications are massive. The court has blocked Trump’s entire “Liberation Day” programme announced for April 2nd: the 30% tariffs on China, the 25% tariffs on certain Mexican and Canadian goods, and the 10% universal tariffs that would have affected virtually all U.S. imports. The whole edifice has crumbled.

Importantly, however, the ruling does not affect the 25% tariffs on automobiles, auto parts, steel, or aluminium imposed under Section 232 of the Trade Expansion Act. These remain in force, as they were implemented under different legal authority with proper procedural safeguards.

For us Europeans, this is particularly significant. Trump announced 20% tariffs on all EU imports on April 2nd, subsequently suspended for 90 days while threatening to escalate them to 50%. Just two days ago, he was boasting about how his threats had encouraged accelerated EU trade negotiations. Well, that leverage has just evaporated.

Why This Matters Beyond Trade Policy

This ruling means, in principle, that Trump’s ability to arbitrarily adjust tariff rates is finished. If he wants permanent tariff increases, he must pursue legislation through Congress, where securing support for comprehensive trade barriers will prove far more challenging. This could spell the end of Trump’s trade war madness—the most destructive element of his economic policy.

Let me be clear: this is THE MOST POSITIVE DEVELOPMENT IN THE US THIS YEAR.

Market reaction was immediate, though perhaps more muted than one might expect — U.S. equity futures are up 1-1.5% as I write this, with similar gains across Asian markets this morning.

This relatively modest response likely reflects partial anticipation of the ruling and awareness that the Trump administration has already appealed.

But make no mistake—this is profoundly positive. Trump has been significantly constrained, dramatically reducing uncertainty about global trade policy. This doesn’t mean everything is rosy, and I predict markets will soon shift attention to the next problem: the gaping hole in the U.S. federal budget.

A Personal Note on Constitutional Victory

I’m especially pleased to note that my friend Ilya Somin played a pivotal role in this case. As co-counsel with the Liberty Justice Center, Ilya was instrumental in challenging these tariffs and defending constitutional limits on presidential power.

His argument was elegantly simple yet devastatingly effective: “If starting the biggest trade war since the Great Depression based on a law that doesn’t even mention tariffs is not an unconstitutional usurpation of legislative power, I don’t know what is.“

Following yesterday’s ruling, Ilya emphasised that the court “unanimously ruled against this massive power grab by the President.”

This wasn’t just a technical legal victory—it was a triumph for the principle that even presidents must operate within constitutional boundaries.

The Constitutional Economics at Stake

The case, V.O.S. Selections, Inc. v. Trump, consolidated with challenges from twelve states, produced a unanimous verdict from a politically diverse panel: Judge Timothy Reif (Trump appointee), Judge Gary Katzmann (Obama appointee), and Judge Jane Restani (Reagan appointee).

When judges appointed by three different presidents spanning four decades agree, you know the constitutional violation was egregious.

The court’s reasoning cuts to the heart of American constitutional structure. Congress alone has the power to “lay and collect Taxes, Duties, Imposts and Excises” under Article I, Section 8. No president—regardless of claimed emergencies—can usurp this fundamental legislative prerogative.

The judges explicitly rejected the notion that persistent trade deficits constitute the “unusual and extraordinary threat” required to invoke emergency powers.

What’s particularly satisfying from an economic perspective is the court’s recognition that trade imbalances represent “normal ongoing problems” rather than emergencies.

Average U.S. tariff rates had risen from 2.5% to 27% between January and April 2025—a tenfold increase that would make Smoot and Hawley blush. The court understood that accepting Trump’s theory would permanently transfer Congress’s trade powers to the executive branch.

Why Markets Should Celebrate This Constitutional Victory

Policy uncertainty—particularly trade policy uncertainty—acts as a poison for market expectations and business investment. Trump’s arbitrary tariff threats created precisely the kind of regime uncertainty that makes corporate planning impossible and freezes capital allocation decisions.

When businesses cannot predict next quarter’s input costs, they stop investing. When supply chains face constant disruption threats, efficiency collapses.

Yesterday’s ruling doesn’t just constrain Trump; it establishes precedent limiting all future presidents.

The application of the “major questions doctrine” to trade policy means executives cannot make sweeping economic changes without clear congressional authorisation. This return to constitutional order should reduce the trade policy volatility that has plagued global markets since 2017.

This is how constitutional constraints create economic value. By limiting arbitrary executive power, courts reduce the risk premium businesses must factor into every decision. Lower uncertainty means lower required returns, which means higher asset values and more investment. It’s not complicated—it’s basic finance.

What Happens Next

The Department of Justice has appealed to the U.S. Court of Appeals for the Federal Circuit, with the White House predictably declaring that “unelected judges” shouldn’t decide national emergencies.

Supreme Court review seems inevitable given the constitutional stakes. But even if the high court eventually hears the case, the immediate blocking of these tariffs provides crucial breathing room for the global economy.

Today, I celebrate with markets that the US still has checks and balances, that constitutional limits mean something, and that economic sanity can occasionally prevail over populist madness. The fact that my friend Ilya helped architect this victory makes it even sweeter.

Congratulations, Ilya—you’ve literally changed the world for the better. Sometimes David really does defeat Goliath, especially when David has the Constitution on his side

On Friday, Moody’s delivered a sharp warning to U.S. policymakers, downgrading the government’s credit rating from Aaa to Aa1.

While this is not yet the beginning of a full-blown fiscal crisis, it may very well represent the first spark that sets one in motion.

The bond market responded immediately. Today, the yield on 30-year U.S. Treasuries surged above 5% for the first time since October 2023, briefly touching 5.03% before settling just below that threshold.

This is not a trivial technical move—it signals that financial markets are starting to lose patience with Washington’s fiscal recklessness.

It’s the Level, Not Just the Change, That Matters

As most economists understand, it’s not merely the fact that yields are rising—it’s the relationship between interest rates and nominal GDP growth that determines debt sustainability.

The graph below illustrates this dangerous dynamic. When the interest rate on government debt rises above the nominal growth rate of the economy, the debt-to-GDP ratio starts to increase automatically. Without meaningful fiscal reform, this leads to an accelerating debt burden and, eventually, a loss of investor confidence.

This was precisely the trap that ensnared the PIGS economies—Portugal, Italy, Greece, and Spain—during the euro crisis from 2009 to 2015. Nominal growth collapsed, interest rates shot up, and debt burdens exploded. Fiscal austerity, IMF and EU bailouts, and a lost economic decade followed.

The United States is not there yet—but it is dangerously close to the critical threshold where markets will no longer tolerate inaction.

The Return of the Unpleasant Monetarist Arithmetic

Back in the 1980s, economists Thomas Sargent and Neil Wallace described the “Unpleasant Monetarist Arithmetic,” and it’s just as relevant today.

If fiscal authorities refuse to consolidate deficits, the central bank eventually becomes the only institution capable of preventing a sovereign debt crisis—by monetizing the debt. But that solution comes with a heavy price: higher inflation, currency depreciation, and the erosion of the central bank’s credibility.

This is not a theoretical concern. The Federal Reserve may soon face a brutal choice:

• Tolerate higher long-term interest rates and risk a fiscal doom loop.
• Cap yields through aggressive bond buying, risking a dollar crisis and elevated inflation.

Neither path is attractive. But unless fiscal policy changes dramatically, one of them will become unavoidable.

The Political Class Is Asleep at the Wheel

Rather than confronting the fiscal reality, the Trump administration is doubling down on pro-cyclical policies. The proposed “One Big Beautiful Bill Act” promises sweeping tax cuts that would add an estimated $3.3 trillion to the deficit over the next decade—with no serious spending reforms in sight.

Treasury Secretary Scott Bessent understands the risks, but he has failed to generate the necessary crisis awareness in Washington.

The Dollar’s Exorbitant Privilege Has Limits

The U.S. does have one major advantage over the PIGS economies: it issues the world’s dominant reserve currency and controls its own central bank. But that privilege is not unlimited.

If markets start to believe that the Federal Reserve will be forced into yield curve control (YCC) and large-scale debt monetization, the dollar will come under intense pressure. Capital will flee U.S. assets, the dollar will weaken sharply, and inflation expectations will rise.

A full-scale dollar crisis would likely unfold in five brutal phases:

1. Rising Term Premium and Yield Curve Steepening.
2. Sudden Capital Flight from Dollar Assets.
3. Forced Federal Reserve Intervention through YCC.
4. Surging Inflation and Loss of Dollar Confidence.
5. De Facto Debt Restructuring via Inflation.

This isn’t just theory—it’s the historical script from Latin America in the 1980s, the UK in the 1970s, and even the U.S. during the Great Inflation era.

We’re Not in a Crisis Yet—But the First Spark Has Been Lit

Let’s be clear: the U.S. is not yet in a full sovereign debt or dollar crisis. But the market signals are unmistakable, and the critical threshold is fast approaching.

The bond vigilantes have not fully reawakened—but they are stirring. And history tells us that when the bond market finally asserts itself, it does so quickly and mercilessly.

Washington still has time to avert this crisis. But that window is closing rapidly. If policymakers continue to ignore the warning signs, the fiscal reckoning may arrive far sooner—and hit far harder—than anyone expects.

Today, 17 May 2025, US President Donald Trump took to Truth Social and delivered yet another economically illiterate proclamation.

In a characteristically bombastic post, Trump lashed out at Walmart, the world’s largest retailer, for daring to suggest that his newly imposed tariffs would lead to higher consumer prices. Trump thundered that Walmart should simply “EAT THE TARIFFS” rather than pass the cost on to customers, warning ominously, “I’ll be watching, and so will your customers!!!”

For those of us who remember the tragic farce of Zimbabwe’s hyperinflation under Gideon Gono, this is depressingly familiar.

Back in 2007, Gono, as Zimbabwe’s central bank governor, physically threatened shopkeepers in Harare for raising prices in response to the collapsing Zimbabwean dollar.

He demanded they hold prices flat while the printing presses ran wild. The result? Empty shelves, a flourishing black market, and eventually a currency so worthless it had to be abandoned.

Now, Trump is playing a similar hand. Rather than accept the obvious—that tariffs are taxes on American consumers—he has resorted to blaming businesses for following the basic laws of economics.

This is not “America First.” It’s economic populism dressed up as patriotism, and it risks doing to the U.S. economy what Gideon Gono did to Zimbabwe’s.

Basic Economics 101: Tariffs Are Taxes on Consumers

Let’s be clear: tariffs are nothing more than import taxes. When Trump slaps a 30% tariff on Chinese goods or a 25% tariff on Mexican imports (or whatever the rates are this week…), it raises the cost of those goods by exactly that amount unless offset elsewhere.

And contrary to the magical thinking on display in the White House, businesses with razor-thin margins—like Walmart—cannot simply “absorb” those costs without severe consequences for profitability and investment.

Walmart’s net profit margin hovers around 3%.

A 10% tariff already eats through that margin, and Trump’s proposed tariffs are significantly higher. This isn’t rocket science; it’s Econ 101.

Yet, Trump continues to pedal the fiction that tariffs are somehow “paid by foreigners.” Empirical studies from the Peterson Institute and the Federal Reserve have shown that nearly 100% of the cost of previous tariffs during Trump’s first term was passed directly on to American consumers.

As Walmart’s CEO Doug McMillon bluntly told investors, “There’s only so much we can do before these tariffs hit the consumer directly.”

And hit they will. Expect significant price increases across essential categories—from groceries to household appliances—as these tariffs take full effect.

Déjà Vu: Populists Blaming Business for Inflation

Does this all sound familiar?

It should. Back in 2021–22, the left-wing populists, led by then-Vice President Kamala Harris, blamed rising prices on so-called “greedflation.”

Harris accused businesses of price-gouging and demanded regulatory crackdowns. Yet, as I wrote at the time, this was pure economic nonsense.

Greed doesn’t suddenly appear or disappear—it’s a constant. What changed was the policy environment: massive fiscal stimulus and extremely easy monetary policy created a tidal wave of demand chasing limited supply.

I correctly forecasted that the U.S. was heading for double-digit inflation before the end of 2021—an out-of-consensus view at the time but one that proved painfully accurate (See link to my post from April 2021 below.)

That inflationary surge wasn’t caused by greedy CEOs; it was driven by the largest fiscal expansion since WWII and a Federal Reserve asleep at the wheel, maintaining ultra-loose policy while the money supply exploded.

The result? Inflation peaking near 10% in mid-2022.

Now, we’re witnessing the same intellectual laziness from the populist right. Trump and his tariff czar, JD Vance, have resurrected the greedflation narrative, merely swapping out Kamala Harris for Walmart’s boardroom. This is the same fallacy, just in a different political costume.

The Real Culprit: Trump’s Self-Inflicted Supply Shock

Unlike 2021–22, the inflation pressure we’re seeing today in 2025 isn’t driven by excessive demand. This time, it’s a classic negative supply shock created by Trump’s own policies.

His sweeping tariffs are raising input costs across the board, from raw materials to finished consumer goods. And with global supply chains already fragile, this couldn’t come at a worse time.

Former Treasury Secretary Larry Summers recently warned that Trump is repeating exactly the same mistakes he accused Biden of making: engaging in policies that fuel inflation while denying responsibility for the inevitable consequences. As Summers put it, “Trump’s inflationary errors are on track to exceed those of the Biden administration.”

Indeed, we’re already seeing this unfold. The University of Michigan’s consumer sentiment survey shows a sharp uptick in inflation expectations, with over 75% of respondents citing Trump’s tariff policies as a direct cause for concern.

Bond yields are rising as the market begins to price in higher inflation and the likelihood that the Federal Reserve will be forced back into a tightening stance.

Nixon Redux: The Ghost of 1970s Stagflation

If all of this sounds eerily like the 1970s, that’s because it is. Richard Nixon famously imposed tariffs, pressured the Federal Reserve to maintain easy monetary policy, and capped it all off with wage and price controls.

Initially, it seemed to work. Inflation was suppressed temporarily, and Nixon won re-election in a landslide in 1972. But as Milton Friedman warned at the time, this was a temporary illusion. When price controls were lifted, inflation exploded. The result? A decade of stagflation, culminating in the brutal recessions of the early 1980s.

Trump is following Nixon’s failed playbook almost to the letter. He demands easy money from the Federal Reserve, imposes protectionist tariffs, and now bullies private companies to hide the inflationary consequences of his own policies. The parallels are so strong that we might as well call this economic agenda “Trumpflation.”

And the risks don’t end there. Trump is also politicising America’s regulatory institutions. The SEC, now headed by loyalists, is reportedly being used to harass companies that fall out of favour with the administration. This is a dangerous path toward market dysfunction and authoritarian control over the economy.

Conclusion: The Markets Are Not Wrong — Policy Is

When I predicted double-digit inflation in 2021, I based that view on sound monetarist principles. I saw the liquidity overhang, the explosion in broad money supply, and the refusal of the Federal Reserve to act.

Today, I see a different but equally dangerous dynamic: a negative supply shock engineered by reckless tariff policies, coupled with political interference in market processes.

The lesson remains the same. You cannot defy the laws of economics indefinitely. Prices will adjust. Markets will clear. And if policymakers refuse to accept that reality, they will face the wrath of both markets and voters.

Expect more volatility in bond and equity markets. Expect higher inflation prints in the months ahead. And unless there is a dramatic reversal of course, prepare for the possibility that the U.S. economy will once again flirt with stagflation.

Trump’s message to Walmart may have been “I’ll be watching,” but the real message from the markets should be this: We’re watching too. And we’re not buying the nonsense.

And let me add a final, more ominous warning. The real economic and political danger will surface when bond yields start to surge in earnest. Trump will not stop at blaming Walmart and other retailers. The financial sector will inevitably come under attack as interest rates rise and financial markets become more volatile.

Expect banks, asset managers, and financial institutions—those the MAGA movement derisively labels as “globalists”—to be the next scapegoats. Apple, Amazon, and other iconic American technology companies, already frequent targets of populist ire, will find themselves in the crosshairs again, accused of everything from offshoring profits to conspiring against American workers.

And it won’t stop there. If Trump and his economic enforcers truly follow the logic of their interventionist policies, we may soon see demands for not only price controls on groceries and essential goods but also capital controls to prevent financial outflows and currency weakness.

This is a dangerous road—one that risks undermining America’s standing as the world’s premier financial safe haven. Capital controls may start as temporary measures to “protect American jobs” or “stabilise the dollar,” but history teaches us that once such controls are introduced, they are politically difficult to unwind.

In short, the slide from protectionism to outright economic repression is steep and slippery. The populist rhetoric that begins with tariffs and scapegoating Walmart can quickly escalate to attacks on financial freedom and property rights. Investors, business leaders, and policymakers alike should be deeply concerned. History may not repeat, but it certainly rhymes—and the echoes from Zimbabwe and the 1970s are growing louder by the day.

Further Reading and Sources

• Trump’s Truth Social Post on Walmart (17 May 2025) – PBS NewsHour
• Walmart Earnings Call Transcript – CFO John David Rainey on Tariff Impact (May 2025)
• Peterson Institute for International Economics – Who Paid for Trump’s Tariffs? (2020)
• Federal Reserve Bank of Dallas Survey on Tariff Impacts (2025)
• Milton Friedman on Nixon’s Price Controls – Free to Choose Documentary (1980)
• Larry Summers’ Warning on Trump’s Tariff Policies (Politico, 2025)
• University of Michigan Consumer Sentiment Index – May 2025 Report
• The Great Inflation and Its Aftermath – Robert J. Samuelson (Book)
• Cato Institute: Why Price Controls Fail – Historical Analysis (2021)
• Market Monetarist Archive – Leavitt & Gono: When Amazon-Bashers Meet Zimbabwe’s Hyperinflation Houdini (April 2025)
• Market Monetarist – Heading for Double-Digit US Inflation (April 2021)

Introduction

(If you don’t want to read the whole article – you can instead do your own simulations of how much revenue tariffs vs VAT can bring in here.)

The United States is staring at a structural budget deficit of about 6.5% of GDP – roughly a $2 trillion annual gap.

In plain terms, the federal government consistently spends far more than it collects, even in good economic times.

With no political will to cut spending, the uncomfortable reality is that taxes will eventually have to rise to foot the bill. The only question is how and who pays.

Policymakers essentially have two broad options to raise such a vast sum: make Americans pay more for the goods they buy from abroad (tariffs), or make Americans pay more for everything they consume (a value-added tax, or VAT).

In either case, the American consumer is in the firing line, whether they realise it or not.

In this post I will explore these two tax approaches.

We start from the premise that the bill is inescapable – one way or another, American households will bear the cost.

We’ll compare a general import tariff versus a broad-based national VAT, examining how much revenue each could raise, what rates would be required, and the economic side effects (deadweight losses, inflationary impact, and overall efficiency). As we shall see, neither option is pain-free – but the magnitude of pain differs greatly.

The Inescapable Bill: Consumers Will Pay Either Way

There is a widespread political illusion that a tariff is somehow paid by ‘foreigners’—a misconception that becomes quite clear after just five minutes of listening to Donald Trump talk about tariffs

It might feel satisfying to imagine funding the US Treasury by taxing Chinese or European goods.

In reality, tariffs are simply a sales tax on imported products, and their costs are largely passed on to domestic buyers.

When the US imposed tariffs in recent years, studies found American firms and consumers bore the brunt through higher prices.

A trip to the store will confirm it: a tariff on imported appliances means higher sticker prices for U.S. shoppers, not a charity cheque from abroad.

A VAT, on the other hand, is more straightforward: it’s a general consumption tax added at each stage of production and ultimately paid by consumers on almost everything they buy (though often with some exemptions).

Unlike tariffs, a VAT doesn’t discriminate between foreign and domestic products – it taxes all consumption. In Europe, where governments are larger, VATs have become a fixture of life.

If US federal spending continues to grow unabated, American taxpayers may face “European-style” taxation in the end – meaning broad-based consumption taxes akin to VAT.

Either route – tariffs or VAT – leads to Americans paying more out-of-pocket. The key differences lie in how visible the tax is, how efficiently it raises revenue, and how much collateral damage it inflicts on the economy.

Option 1: Taxing Imports – The General Tariff Temptation

Imagine the US government slaps a uniform tariff on all imported goods – this is essentially what the Trump administration is now heading towards.

The appeal is obvious: at first blush it sounds like taxing “others” (foreign exporters) rather than U.S. citizens. Historically, tariffs did fund much of the U.S. budget in the 19th century – as Trump so often has been arguing.

Today, however, imports are a large share of the economy’s consumption basket, and any significant tariff would immediately translate into higher prices at Walmart, Target, and the petrol station.

In effect, it’s a consumption tax with a narrow base – only imported goods – and a heavy built-in distortion: it makes imported products more expensive relative to domestic ones.

How much money could an import tariff raise?

Currently, U.S. imports of goods and services are on the order of 13–15% of GDP. To raise revenue equal to 6.5% of GDP from that base in theory, you’d need a tariff of roughly 40–50% (since 0.15 × 45% ≈ 6.5%).

But that simple arithmetic assumes imports wouldn’t shrink. In reality, tariffs cause a collapse in import volumes – Americans would buy fewer foreign goods or find substitutes – shrinking the tax base.

This is the classic Laffer curve effect: beyond a certain point, higher tax rates erode the base so much that revenue gains stall or reverse.

I here assume a price elasticity of -1.5 (meaning a 10% price increase reduces imports by 15%). This I believe is a realistic assumption for the medium-term. In the short term the elasticity might be lower.

Laffer Curve Analysis with Elasticity of -1.5

The graph below shows the Laffer curve for an general tariff on all US imports assuming a -1.5 price elasticity.

With this higher elasticity assumption, our calculations show that:

• A 10% tariff would raise approximately 1.2% of GDP in revenue
• A 20% tariff would raise approximately 2.0% of GDP
• A 30% tariff would raise approximately 2.3% of GDP
• A 40% tariff would yield 2.2% of GDP (note we’re already seeing diminishing returns)
• A 50% tariff would only raise 1.8% of GDP as the import base significantly erodes
• By 70% tariff rates, revenue collapses to nearly zero as imports are almost completely choked off

The revenue-maximizing tariff rate under these conditions is approximately 33%, which would generate only about 2.3% of GDP in revenue – far short of the 6.5% target.

The sobering message is that with this elasticity of -1.5, tariffs cannot raise anywhere near 6.5% of GDP in revenue at any rate.

Even the maximum possible revenue (2.3% of GDP) falls far short of the target. The tax base simply evaporates too quickly before you get close to the revenue goal.

Collateral Damage

The collateral damage such tariffs would cause remains severe. Imports don’t exist in a vacuum – they are inputs for U.S. factories and retailers, and often essential goods for consumers.

A blanket tariff would send shockwaves through supply chains – as we already are seeing as a result of Trump’s tariffs on China. Domestic prices of many goods would jump (even domestic producers might raise prices, facing less foreign competition).

We’d see cost-push inflation, not just on imported consumer products but on capital goods and raw materials used by American businesses.

In fact, a study from Yale’s Budget Lab found the recent mix of U.S. tariffs already in place by 2025 has raised the overall price level by about 2.3% (costing the average household $3,800) – and those tariffs are nowhere near the magnitude we’re contemplating here.

Inefficient Revenue Generation

Economically, a tariff remains a highly inefficient way to raise revenue. It introduces a large distortion between imported and domestic goods. Consumers substitute towards (potentially more expensive or lower-quality) domestic products or forego purchases entirely.

This creates a deadweight loss – lost economic welfare that doesn’t even benefit the Treasury.

With a price elasticity of -1.5, a 33% uniform import tariff maximizes government revenue. At this rate, the deadweight loss can be calculated using standard economic welfare analysis.

Starting with imports at 14% of GDP, the 33% tariff reduces import volume by 49.5% (elasticity × tariff rate), leaving new imports at 7.07% of GDP. This generates revenue equal to 2.33% of GDP (33% × 7.07%).

The deadweight loss equals half the product of the price change and the quantity reduction:
0.5×33%×(14%−7.07%)=1.14% of GDP.

This is pure economic waste — benefiting neither consumers, producers, nor the government.

For every dollar of revenue collected, the economy loses an additional 49 cents in deadweight loss. The total economic cost is therefore $1.49 per dollar of revenue.

In the case of the U.S. economy, this translates to approximately $623 billion in tariff revenue and $305 billion in deadweight loss, costing the average household about $7,086 annually.

Foreign Retaliation

Furthermore, tariffs invite foreign retaliation. If the US tried to raise revenue via big tariffs, trading partners would almost certainly strike back with tariffs on U.S. exports – exactly as we have seen both the Chinese and the Europeans doing.

That would hurt American exporters (farmers, manufacturers) and could set off a trade war, reducing overall economic output. The tariff revenue itself could be partially offset by declines in income and other tax receipts due to a smaller economy.

The Hidden Tax

From a political perspective, tariffs have a sneaky advantage: the cost to consumers is somewhat hidden in the form of higher retail prices, rather than an explicit tax line on a receipt. Politicians might hope the public blames “greedy foreigners” or businesses instead of the tax.

However, the reality of who pays is inescapable – at the end of the day, it’s American shoppers and firms who foot the bill. And with the higher elasticity assumption, it becomes even clearer that a tariff-based approach cannot generate the target revenue of 6.5% of GDP.

Before we write off the American consumer as a cash cow to be milked via pricier imports, we should examine the alternative: a broad-based tax on consumption – essentially, bringing the U.S. in line with how most advanced economies fund their governments.

Option 2: Taxing Everything – A Broad-Based National VAT

The second approach is a national value-added tax (VAT), akin to what nearly every European country (and many others worldwide) employs.

A VAT is essentially a general consumption tax, collected in pieces along the production chain but ultimately borne by the final consumer.

It is broad-based, typically covering most goods and services, with a few exemptions or reduced rates for necessities.

Crucially, a VAT taxes domestic and imported goods equally (and usually zero-taxes exports), so it doesn’t favour home goods over foreign – it’s trade-neutral (despite what the Trump administration has argued).

This makes it WTO-compliant and avoids the retaliation problem: no foreign government is going to retaliate against the U.S. for adopting a VAT, since it’s not targeting any one country’s products.

How high would a VAT need to be to raise 6.5% of GDP in revenue?

The answer, surprisingly, is “not as high as you might think”. Americans already spend a lot on consumption – personal consumption expenditures are roughly 68–70% of U.S. GDP.

If all of that were taxed, a 10% VAT (with perfect compliance and no exemptions) could theoretically raise about 6.8–7.0% of GDP.

Of course, in practice no VAT covers absolutely everything consumers buy – most countries exempt certain items like basic food, healthcare, education, etc., or have reduced rates. Let’s assume a broad base but with some modest exemptions, such that the effective taxable consumption base is around 60% of GDP.

In that case, a VAT of roughly 11% would net 6.5% of GDP (0.60 × 11% = 6.6%).

Even with a narrower base (say only 50% of GDP effectively taxed), the required rate would be on the order of 13%.

In other words, a national VAT in the 10–15% range could plug a gap of 6.5% of GDP. This is very much in line with international experience.

European VAT standard rates today range from 17% to 27%, with an OECD average around ~21%.

Those VATs typically raise about 6–8% of GDP in revenue for those countries.

The U.S., by virtue of not having a VAT yet, actually has a relatively clean slate – it could design a broad base with fewer loopholes (for example, New Zealand’s GST/VAT is famously broad and efficient, 15% rate raising about 8-9% of GDP – or Denmark’s MOMS, which at a rate of 25% brings in a revenue of close to 10% of GDP).

In fact, if the U.S. implemented, say, a 15% VAT with minimal exemptions, it could likely raise on the order of 8–10% of GDP – more than enough to cover a 6.5% gap and then some. Even a 10% VAT, if broadly applied, would get very close to the target.

For context, Americans already pay state/local retail sales taxes that average about 7.5%, albeit on a narrower base; a federal VAT would layer on top of that, potentially bringing total consumption taxes in the mid-teens – still around the lower end of European consumption tax burdens.

The graph below shows a Laffer curve for a broad-based VAT, assuming consumption elasticity = –0.5 (relatively inelastic demand).

Even at a modest rate of ~10%, a VAT could raise roughly 6.5% of GDP.

The broad tax base (close to total consumption) means revenue scales up nearly linearly with the tax rate for moderate rates.

Unlike the tariff case, there is no sharp revenue-maximising point short of extremely high rates – revenue continues to rise with higher rates, albeit with increasing economic distortions. This illustrates that a VAT can achieve the needed revenue with a far lower rate and less risk of “tax base collapse” than a tariff.

As graph illustrates, the VAT’s strength is its fiscal efficiency: because the base (consumer spending) is so large, a relatively low rate generates a lot of revenue.

The assumed elasticity of –0.5 means consumers reduce their spending somewhat when prices rise, but not drastically.

Thus, the Laffer curve for VAT is gently upward-sloping with no quick peak – in fact, under these assumptions, there is no revenue peak at any finite rate; revenue would keep rising (in reality, very high VAT rates would encourage evasion and underground activity, but at the 10–20% range we’re well within normal international practice).

The key takeaway is that a VAT can raise the required 6.5% of GDP with a tax rate on the order of one-tenth of what the tariff would need. A 10% VAT vs an 80% tariff – that’s a night-and-day difference in terms of feasibility. And we can only do this calculation assuming a lower (-1.0) price elasticity of imports than assumed above (-1.5).

To make this concrete, let’s compare it to Europe.

The graph below compares the hypothetical “necessary” U.S. VAT rate to standard VAT rates in selected European countries.

The U.S. rate (15%) shown here is an estimate assuming a relatively broad base.

It is lower than the VAT in every EU country, where standard rates range from 17% (Luxembourg) to 27% (Hungary).

Many European countries sustain government revenues with VATs around 20–25%, which typically bring in 6–8% of GDP. This suggests the U.S. could fill its deficit with a VAT even lower than the European average – highlighting the fiscal potency of a broad consumption tax.

As the graph highlights, the U.S. would not be an outlier if it adopted a VAT in the low-to-mid teens – in fact, it would be at the low end by European standards.

The difference is that Europe uses those VATs in addition to steep income and payroll taxes to fund a somewhat larger public sector.

The U.S. would be using it primarily to compensate for chronic deficits. Politically, of course, introducing a VAT in America would be a seismic shift.

Past proposals for a federal sales tax or VAT have met with resistance from both left and right – seen as either regressive (hitting the poor proportionally more) or as a “money machine” enabling bigger government. Yet, faced with ever-mounting debt and deficit, the alternative may well be worse (massive future tax hikes or financial crisis).

In terms of economic impact, a VAT is generally considered more efficient and less distortive than most other taxes.

It doesn’t penalise savings or investment (unlike income taxes), and it treats all consumption equally, whether the good is imported or domestically produced.

There is still a distortion – any tax on consumption can discourage some marginal consumption (people might save a bit more or participate in the informal economy to avoid the tax).

But given our elasticity assumption (–0.5), the deadweight loss from a 10% VAT is relatively small – certainly much smaller, per dollar of revenue, than the deadweight loss from an equivalent revenue-raising tariff or highly progressive income tax.

Moreover, VAT revenue comes in with less drag on economic growth: studies find that consumption taxes are less harmful to growth than taxes on capital or highly progressive taxes on income.

A VAT would cause a one-time increase in the price level – essentially a burst of inflation in the year of implementation. For example, if a 10% VAT were introduced, one might expect roughly a 10% jump in consumer prices (assuming it’s fully passed on) spread over a short period.

Central bankers typically view this as a level shift rather than ongoing inflation – in other words, a VAT causes a one-off rise in the price index, but it doesn’t necessarily mean continuing inflation if money supply is kept in check. (The Federal Reserve could accommodate or offset this as needed.)

By contrast, a tariff-driven price increase is more piecemeal and can create ongoing inflationary pressure if tariffs ratchet up or if domestic producers repeatedly raise prices under protection.

One valid concern about a VAT is distributional fairness.

By itself, a VAT is regressive relative to income – poorer households consume more of their income, so they’d pay a larger share of income in VAT than richer households.

European countries mitigate this through exemptions or reduced VAT rates for necessities like food, children’s clothing, etc., and by using part of the revenue to fund welfare benefits or income tax credits for the poor.

The U.S. could do similarly: for instance, a federal VAT could be paired with an annual “VAT rebate” or prebate to all households (as was proposed in some FairTax plans) to offset taxes on basic consumption.

Alternatively, exemptions for basic groceries and utilities could be enacted, though that narrows the base and requires a higher rate to compensate.

In any case, VAT’s regressivity can be addressed within the overall fiscal system, whereas a tariff’s incidence is hidden and its burden could also fall disproportionately on lower-income families (who spend a higher fraction of their budget on tradable goods like food, clothing, and electronics).

Finally, consider administration. The U.S. has no federal VAT machinery currently, but implementing one is a well-trod path globally – the know-how exists.

Businesses would face new compliance costs (filing VAT returns, remitting tax on their sales minus credits for tax on inputs).

The federal government would need to coordinate with states (some of which might adjust their sales taxes). It’s a big shift, but not an insurmountable one – Canada introduced a national GST in the 1990s, for example, despite provinces having sales taxes.

A tariff, on the other hand, can build on the existing customs apparatus – the U.S. already collects tariffs at ports of entry. In that sense, tariffs might seem administratively simpler. But keep in mind: the U.S. currently collects only a few tens of billions in tariff revenue; scaling that up to trillions would likely spur a proliferation of avoidance schemes (smuggling, re-routing of trade through third countries, mislabeling of products to evade tariffs, etc.), requiring much more enforcement.

A VAT’s enforcement challenge is mainly ensuring businesses report sales – not trivial, but again, very familiar to tax authorities worldwide.

Tariff vs VAT: Weighing the Trade-offs

Bringing the threads together, let’s directly compare the two strategies for raising 6.5% of GDP. Table 1 summarises the key outcomes and characteristics of a broad tariff vs a VAT:

Table 1: Tariffs vs VAT – Summary of Outcomes

Looking at the comparison, the VAT emerges as the more efficient and effective tool for raising a large chunk of revenue.

The tariff route, by contrast, is riddled with economic landmines – it’s a bit like trying to fill a leaky bucket. You can pour more water (higher rates) in, but most of it spills out as the base leaks away, and you risk breaking the bucket (the broader economy) in the process. The VAT is a larger, sturdier bucket: it can hold the needed revenue with far less spillage.

Conclusion: Confronting Reality – and the Lesser of Two Evils

Facing a structural deficit of 6.5% of GDP, the United States must eventually confront a tough choice.

If spending isn’t reined in, then taxes must rise – that is arithmetical reality, not ideology. In fact I would personally favouring entitlement reforms to reduce the size of the US government, but realistically that seems very unlikely in the present political environment.

My exploration above has contrasted two very different ways of extracting more revenue from the economy, and how they ultimately boil down to American consumers footing the bill.

A general tariff might appeal to populist instincts, masquerading as a charge on foreigners but ultimately acting as a stealth tax on every American family.

It fails to raise the required revenue even when pushed to absurd extremes, and along the way it would distort markets, raise domestic production costs, and invite international reprisals.

As an economic strategy, it’s the fiscal equivalent of eating candy for dinner – seemingly satisfying in the short run, but unhealthy and unsustainable in the long run.

A national VAT, on the other hand, is an overt, broad-based tax.

It squarely admits: yes, everyone will pay a bit more on what they buy.

Politically, that’s a hard sell in a country long accustomed to low consumption taxes and skeptical of European-style solutions.

Yet, the numbers make a compelling case that a VAT is far more capable of raising big revenue reliably.

It does so in a transparent way and is a staple of tax systems in over 160 countries. While regressive on its face, it can be coupled with measures to protect lower-income households. It would align the U.S. with a more balanced tax mix (most other rich nations rely more on consumption taxes than the U.S. currently does).

In that spirit, one might quip with mild irony that Americans have a choice of how to pay for their dessert: either pay a visible service charge (VAT) or have it hidden in the cost of the meal (tariffs).

But either way, the dessert will be paid for.

There is no free lunch – and no free import or consumption binge – when the government’s bills come due.

In an ideal world, of course, the U.S. would address the fiscal gap from both sides: trim excessive spending growth and implement efficient taxes for what remains.

However, given the premise of political gridlock on spending cuts, taxes like a VAT may become not just an option but a necessity.

The experience of other nations suggests that broad-based consumption taxes are the workhorse for funding modern governments – not because politicians love them, but because they get the job done with relatively less economic harm.

The American consumer, in the end, will shoulder the cost of fiscal adjustment, either through higher prices at checkout or higher tax-inclusive prices on imported goods. The VAT path at least has the virtue of clarity and effectiveness: you’ll see it on your receipt, and it will reliably fill the Treasury’s coffers.

The tariff path is a roundabout maneuver that might feel like someone else is paying until you realise the costs have merely been passed along in disguise – and meanwhile, the plan didn’t even raise enough revenue to stop the deficit bleeding.

As unpleasant as new taxes are, choosing the lesser of two evils matters. A broad VAT is not a pain-free solution, but compared to sweeping tariffs, it’s a much sharper knife – cutting into consumers’ purchasing power, yes, but cleanly and predictably, rather than hacking away at the economic fabric.

In a world of unsavoury options, a VAT may well be the more sensible bitter pill for America’s fiscal diabetes, while a tariff overdose could send the patient into shock.

Bottom line: The U.S. can’t wish away a structural deficit of ~6.5% of GDP.

If spending isn’t curbed, taxes will rise. We’ve seen that tariffs simply can’t carry that load without collapsing the load-bearing structure (the import base), whereas a VAT can.

Ultimately, it’s the American consumer who will pay, so the aim should be to design the taxation in a way that raises the needed revenue with the least disruption and long-run cost to the economy.

In that respect, a broad-based VAT is the clear winner over a general tariff.

The sooner the political conversation in Washington shifts from whether Americans will pay for their government to how they will pay for it, the sooner we can have a serious, pragmatic discussion about solutions like a VAT—before financial reality forces the decision upon us.

Let me be clear: this is not because I like taxes. Frankly, I don’t. But it’s hard to ignore the facts.

Americans don’t seem particularly fond of cutting public spending, nor do they show much appetite for serious public sector reform—certainly not at the scale we’ve seen in the Nordic countries.

That leaves an inconvenient truth: sooner or later, Americans will end up paying European-style taxes. And frankly, that’s a far better outcome than sliding into economically destructive protectionism and tariffs.

…

Links you should have a look at

PAICE – the AI consultancy I have co-founded

“Globale tanker” – if you want to book me for a keynote speech, a lecture or a workshop

The American political circus continues.

Today, President Trump’s press secretary, Karoline Leavitt, lashed out at Amazon. The reason? Amazon was considering showing customers how much Trump’s own tariffs have made goods more expensive. This prompted Leavitt to call the initiative a “hostile and political action,” exclaiming:

“Why didn’t Amazon do this when the Biden administration hiked inflation to the highest level in 40 years?”

It’s almost like being back in Zimbabwe in 2007, where central bank chief Gideon Gono threatened shops if they raised prices in line with costs.

The parallels are striking – Leavitt, much like Gono, seems determined to shoot the messenger rather than address the underlying economic reality. Gono blamed shopkeepers; Leavitt blames Amazon. Different continents, same playbook.

Products disappeared in Zimbabwe, shelves stood empty, but the authorities just kept insisting that the price was wrong – not the policy. One wonders if Leavitt has been studying Gono’s press conferences for inspiration.

And here we stand in 2025, where Republicans during the campaign spent countless hours calling Kamala Harris both a socialist and a communist.

But as they say: “The pot calling the kettle black.”

For who is it really that’s behaving like a state-controlling price control fanatic? It’s Trump, with Leavitt as his Gono-esque spokesperson, pointing fingers at retailers instead of policies.

Threats against private companies, state intervention in the market, attempts to hide the real costs from consumers. This isn’t classic capitalism – it’s socialism disguised as patriotism.

And it probably won’t be long before JD Vance – whom Trump himself has appointed as “tariff czar” – starts running around Walmart and Costco threatening store managers to lower prices, completing the transformation to America’s very own Gideon Gono.

PS: Gideon Gono has, by the way, written an unintentionally hilarious book titled “Zimbabwe’s Casino Economy: Extraordinary Measures for Extraordinary Challenges” – perhaps future required reading for the White House press office?

In the past three months, I haven’t written much positive about market developments – especially not regarding American stock and bond markets and the dollar.

BUT the last 24 hours have brought positive news – and this brings some calm to the markets.

I want to highlight two very important statements from Donald Trump himself:

“I have no intention of firing him. I would like to see him be a little more active in terms of his idea to lower interest rates. This is the perfect time to lower interest rates. If he doesn’t, is it the end? No, it’s not.”

And secondly:

“The tariff on China won’t be as high as 145%. It’ll come down substantially, but it won’t be zero.”

These are two clearly important statements. The first is basically an announcement that Trump says he respects the Federal Reserve’s independence, and he cannot force the Fed to lower interest rates.

And the second is that he is prepared to substantially reduce tariff rates against China.

Both make good sense – and indeed are what any normally thinking economist would have urged Trump to do. And yes, all economists would naturally have told Trump to completely stop his tariff madness, but this is definitely a step in the right direction.

The financial markets reacted quite positively – and unsurprisingly – to yesterday’s announcements.

In fact, I’m a bit surprised that the reaction wasn’t even more positive. For what we’re actually seeing now is that those with some economic sense around Trump – probably primarily Treasury Secretary Scott Bessent – have convinced Trump that what he has been doing could potentially have catastrophic consequences for the American economy – and for Trump’s own ability to survive as president.

I simultaneously interpret this as a certain admission from Trump that he has thrown himself into a multi-front war – illegal deportations, war with the judicial system (including the Supreme Court), war with the Federal Reserve, Pete Hegseth’s total chaos in the Pentagon, etc.

And it’s becoming increasingly clear that investors are simply losing confidence in the USA. And in America’s institutions.

But Trump is backing down now. And this is actually the first time in three months.

And in this connection, it’s worth noting that following Tesla’s catastrophic financial report yesterday, Elon Musk also announced that he was on his way out of the Trump administration and DOGE.

All in all, I think we’re seeing rather clear signs of a retreat from Donald Trump. His own chaotic behaviour has simply defeated him.

And that is, in my opinion, quite positive for the American financial markets.

That said, the following should be emphasised:

1. It’s difficult to restore confidence once it has been destroyed.
2. Trump is and remains a “loose cannon” – if we see signs of “recovery” in the markets, Trump can quickly come up with something insane again. He loves tariffs (as he says himself), so he won’t stop talking about them.
3. Even without the Trump chaos, the American stock market – and partially the dollar – already looked overvalued.
4. The coming period will be characterised by extremely negative American economic indicators, which will hardly do much to lift the mood in the stock market.
5. The USA faces massive fiscal policy challenges, and there is nothing to suggest that the Republicans in the House and Senate intend to do anything about it, and Trump has no ideas about what to do (without breaking his promises not to touch pensions and the healthcare system).
6. The Trump administration is clearly marked by massive internal power struggles – and it could get much worse.
7. The prospect of rising inflation AND higher unemployment will significantly weaken popular support for Trump.

FINALLY, given the unrest that has been in the markets, something systemic may have been broken, so there is a risk that new news will emerge, for example losses in banks and financial institutions.

All in all, I believe that Trump’s announcement MUST be taken as fundamentally positive, and therefore it’s also possible that the “haemorrhaging” in American stock markets and in the dollar is over, but I find it very difficult to see much “upside”.

Trump has simply created too many problems for himself.

If I am to become more positive – then something of the following must happen:

1. Trump’s advisor Peter Navarro, Trump’s hyper-protectionist advisor, must be fired, and Treasury Secretary Scott Bessent’s role must be substantially strengthened. It must be clear that it is Bessent who leads economic policy.
2. Defence Secretary Pete Hegseth must be fired and replaced by a former general or similar, who actually has the experience and insight to be Defence Secretary.
3. There must quickly be a significant rollback of the tariff madness. Not just in trifles – but in relation to China, the EU, Canada, Japan and Mexico.
4. The Trump administration must present concrete and radical plans to permanently improve public finances.
5. The Federal Reserve’s independence must be guaranteed. It would be best if Trump announced that Powell will be reappointed in 2026.

It requires quite a bit, but this is the sort of thing that is needed – otherwise there is a risk that the markets will again go into meltdown mode. But Trump has created so much uncertainty that it now requires a lot to restore confidence.

What do you think? Will Trump go berserk again, or can Bessent control him?

…

Links you should have a look at

PAICE – the AI consultancy I have co-founded

“Globale tanker” – if you want to book me for a keynote speech, a lecture or a workshop

I have always considered myself a non-American American patriot. I grew up with a deep admiration for the United States — for its ideals, its energy, and its global leadership. But after the events of the past few months, I find it increasingly difficult to view the US as a friend of Denmark.

Jay Nordlinger’s piece in National Review — “America Rattles Denmark” — captures this shift with precision and gravity. It’s rare to see an American conservative describe, so clearly, how deeply disillusioned many pro-American Danes now feel.

The Trump administration’s reckless rhetoric about Greenland, the open threats towards an ally, and the abandonment of Ukraine — a country fighting for its survival — have left many of us stunned. But perhaps even worse is the silence. The lack of outrage. The apparent indifference from much of the American public.

What was once an alliance based on shared values now feels transactional, conditional, and hollow.

This is not a policy disagreement. This is a break in trust.

I urge my American friends to read Nordlinger’s article — not defensively, but reflectively. There is still time to repair the damage. But for the first time in my life, I’m no longer sure we’re on the same side.