When Donald Trump was re-elected in November, tech stocks and cryptocurrencies received a massive boost. Bitcoin, Tesla, and MicroStrategy (now Strategy) were among the biggest winners. But now the party seems to be ending.

Bitcoin has lost momentum, and the downturn could soon accelerate.

Tesla has already fallen over 30% from its peak in January, and Strategy’s bet on Bitcoin can quickly go from being a stroke of genius to a financial disaster.

Strategy’s Bitcoin Strategy: A Speculative Engine That Could Explode

Strategy, formerly MicroStrategy, started as a business intelligence software company. But under Michael Saylor, the company has effectively become a leveraged Bitcoin ETF.

Since 2020, Saylor has issued debt and new shares to buy more Bitcoin. The company now holds over 330,000 BTC, making it one of the largest institutional Bitcoin holders in the world.

Saylor has argued that the US should establish a “Strategic Bitcoin Reserve” to strengthen the country’s position in a digital economy.

But the market doesn’t believe it. The prediction market Polymarket assesses the probability that Trump will actually establish a Strategic Bitcoin Reserve at just 11%.

If the Bitcoin market seriously reverses, Strategy’s extreme exposure could lead to a systemic crisis, where the company risks being left with a debt bomb that eerily resembles Enron in 2001 – a high-flying company that imploded due to financial distress.

From the Hunt Brothers to Enron: Bitcoin in the Silver Trap?

There is a striking parallel between Strategy’s Bitcoin strategy and the Hunt brothers’ attempt to corner the silver market in the late 1970s. Back then, Nelson Bunker and William Herbert Hunt purchased such large quantities of silver that the price rose from 6 dollars per ounce to nearly 50 dollars in January 1980.

But the party ended abruptly when regulators tightened margin rules and removed leveraging opportunities. The silver price collapsed, and the Hunt brothers were ruined.

The difference this time? Regulation won’t save Saylor – or bring him down.

On the contrary, he stands alone in his bet, and the Trump administration doesn’t appear to be rushing to the rescue. If the market turns, Strategy’s enormous Bitcoin position could quickly become a huge risk.

And if the debt behind the speculative strategy proves unsustainable, we could face an Enron-like situation, where a company that appeared to be an invincible market leader is torn apart by financial distress.

Tesla: The Next Domino?

Tesla has been another big winner in the Trump trade, but the stock has now already fallen over 30% from its peak in January. Elon Musk, like Saylor, has had a close relationship with the Trump administration and has benefited from political incentives and lenient regulations.

But Tesla is no longer a startup that can live on future visions. With a market cap of several hundred billion dollars, the company has become a systemic player, and the problems are beginning to become apparent:

• Sales are failing in key markets.
• Competition from Chinese EV producers is pressuring margins.
• Tesla’s valuation was based on continued growth, but those expectations look increasingly unrealistic.
• Like Strategy, Tesla is directly exposed to Bitcoin (though to a lesser extent than before).

If Tesla, like Strategy, has structured its financing in a way that only works in a market with rising stock prices, we could see a cascade effect where the downturn reinforces itself and creates a deeper crisis.

Trump’s Trade War and Inflation: A Bomb Under the Market

An important difference from previous speculative bubbles is that we no longer have low interest rates to keep the party going. Trump has just imposed 25% tariffs on imports from Canada and Mexico, which could cause inflation to rise significantly.

The problem? If inflation rises, it becomes impossible for the Federal Reserve to lower interest rates further. And that’s a game changer. Bitcoin, Tesla, and other risky assets have benefited from a market where money has been plentiful, and investors have chased returns in a low-interest environment.

If inflation forces the Fed to keep interest rates up, it could accelerate a real risk reduction in the market – and Bitcoin, Strategy, and Tesla are precisely the assets that risk being hit the hardest.

Are We Heading Toward a New Enron Crisis?

Strategy’s debt-financed Bitcoin bet and Tesla’s high valuation have long been symbols of a speculative market cycle. Now it appears that cycle is turning.

History shows that speculative purchases can drive prices up for a period, but when the first major player begins to sell, everything can collapse. We’ve seen it before – from the silver market in 1980 to the dotcom crisis in 2000.

But now we may be facing something even worse. If Strategy’s Bitcoin exposure proves unsustainable, it could become a new Enron case – an implosion that doesn’t just hit one company but spreads financial distress throughout the entire market.

How we transformed Market Monetarist theory into an interactive tool with Claude AI

Recently, I discussed the risks of political interference in monetary policy and the potential for a 1970s-style inflation scenario in my Market Monetarist articles. Today, I want to share how these theoretical concepts have been turned into an interactive simulation that allows readers to explore these relationships themselves.

From Theory to Interactive Simulation

The simulation model emerged from two recent articles:

“Trump’s Tariffs and the Fed: A 1970s Velocity Nightmare in the Making” – examining how the politicisation of the Federal Reserve under G. William Miller led to an immediate surge in money velocity, well before external shocks like the Iranian Revolution.

“The Trump Superspike: If Trust in U.S. Governance Breaks, Interest Rates Will Explode” – exploring how market confidence in institutions underpins bond market stability, and how quickly that confidence can unravel.

These rather complex macroeconomic concepts benefit greatly from visual and interactive exploration, which is why I decided to create a simulator.

How the Simulator Was Created

Rather than coding this from scratch myself, I experimented with Claude 3.7 Sonnet to transform these concepts into a React-based simulation. The process was surprisingly effective:

Claude analysed the articles and identified the key economic relationships to model – particularly the connections between Fed credibility, money velocity, inflation expectations, and interest rates.

Using the historical examples from my articles (like the 7% velocity increase following Miller’s appointment and interest rates jumping from 9% to 15%), Claude developed mathematical relationships that could replicate these dynamics.

The final product is a React component with adjustable parameters, scenario presets, and dynamic visualisations that readers can use to explore alternative scenarios.

The Market Monetarist Model Behind the Simulator

The simulator captures several market monetarist principles:

1. Credibility and Inflation Expectations

When central bank credibility erodes, both short-term and long-term inflation expectations become unanchored. This relationship is at the heart of the simulator – reduce the “Fed Credibility” parameter and watch inflation expectations drift upward over time.

This reflects a core market monetarist insight: market expectations about future monetary policy are central to current economic outcomes. When people begin to doubt the central bank’s commitment to price stability, their behaviour changes immediately.

2. The Velocity Effect

Perhaps the most important insight from my “Velocity Nightmare” article is how quickly money velocity can surge when monetary policy credibility is questioned. The simulator shows this relationship explicitly.

When Fed credibility falls below certain thresholds, particularly with high political interference, money velocity accelerates – mimicking the historical pattern observed after Miller’s appointment. This captures the essential market monetarist insight that money demand is sensitive to expected inflation.

3. Interest Rate Dynamics and Threshold Effects

The simulator models both gradual and sudden changes in interest rates. Under normal conditions, interest rates rise gradually with inflation expectations. But when credibility falls below critical thresholds, we see non-linear “jumps” in interest rates – similar to what happened in the Liz Truss scenario.

This feature captures how financial markets don’t just price in gradual changes but can exhibit discontinuous repricing when confidence thresholds are breached.

4. Tariffs and Supply Shocks

Following a market monetarist approach, the model distinguishes between demand-side and supply-side inflation. Tariffs represent a supply-side shock that monetary policy cannot easily offset without causing further distortions.

Using the Simulator

The simulator includes several preset scenarios for readers to explore:

• Baseline Scenario: Current economic conditions with moderate risks
• 1970s Miller Scenario: Recreates conditions with declining Fed credibility
• Market Confidence Crisis: Similar to the Liz Truss event
• Trade War Scenario: High tariffs with political pressure on monetary policy
• Stable Policy Scenario: Strong Fed independence and low trade barriers

Beyond these presets, readers can adjust individual parameters:

• Fed Credibility (0-100%)
• Political Interference (0-100%)
• Tariff Levels (0-50%)
• Starting Inflation Rate
• Time Horizon (1-10 years)

The results display in real-time through three main charts:

1. Interest Rates & Inflation Expectations
2. Money Velocity
3. Price Level (indexed to 100 at start)

Educational Purpose and Limitations

The simulator simplifies complex economic relationships for educational purposes. It’s meant to help readers understand the concepts from my articles, not to serve as a precise forecasting model.

Despite simplifications, it effectively demonstrates a core insight: monetary policy credibility can erode quickly, with severe consequences for inflation expectations, money velocity, and ultimately price stability.

AI-Assisted Economic Education

What’s particularly interesting about this project is how AI can help bridge the gap between economic theory and public understanding. By transforming market monetarist concepts into interactive simulations, we can make these ideas more accessible.

I expect we’ll see more AI-assisted economic education tools in the future. The conversational development process allows economists to focus on conceptual aspects while AI handles technical implementation.

I invite all Market Monetarist readers to explore the simulator, test different scenarios, and develop their own intuition about how monetary policy credibility, political interference, and trade policies interact to shape economic outcomes.

In an era of increasing challenges to central bank independence and rising protectionism, understanding these relationships is more important than ever.

You can try the Simulator here.

This entire article was written by Claude 3.7 Sonnet with input from Lars Christensen (LC@paice.io).

The Golden Opportunity—Squandered

Four years ago today, just as Biden had become president, I wrote the following on Facebook (in Danish):

“No more grumbling from here. How is the US economy doing? Today we got retail sales figures for January. They look extremely good—retail sales are now 10% higher than a year ago. That there is talk of fiscal stimulus in the US is somewhat of a puzzle to me, but that is nonetheless what is being proposed. Unemployment will plummet in the coming months and will soon be below 5%.

The graph below should illustrate what we can expect to happen with GDP growth in Q1. I wouldn’t be surprised if we exceed 5% growth in real GDP (year/year) in the first quarter. The US is long past the crisis.

And interest rates? Yes, I think it’s increasingly likely that the Federal Reserve will raise rates before the end of the year.“

The Reality of 2021’s Growth

Both fiscal and monetary policy had been eased to an extreme degree in 2020 under Trump and Fed Chairman Powell. Furthermore, lockdowns in American society were coming to an end.

While my prediction of 5% real GDP growth in the first quarter was overly optimistic—growth came in at 1.8%—the second quarter saw massive growth of 12.2%.

The Policy Mistakes

With such high growth rates, both fiscal and monetary stimulus should naturally have been rolled back.

But what did Biden do?

He implemented new fiscal stimulus packages that were just as large as Trump’s massive stimulus in 2020.

And what did the Fed do, despite clear signals that inflation was rising and monetary easing had gone too far? Nothing!

They kept interest rates unchanged and strongly signaled they had no intention of raising rates in 2021. Even as inflation showed clear signs of increasing early in the year, the Fed insisted that there would be no tightening.

The Predictable Outcome

The result was predictable (as I noted in multiple posts in April 2021 – see here) – U.S. inflation would likely approach 10%. And it did.

Only when very high inflation had become unavoidable did the Fed finally begin to raise interest rates, but by then, most of the damage had already been done.

Biden’s Compounding Errors

At no point did the Biden administration change course. There were no major reforms or attempts at fiscal tightening. Worse yet, Biden continued several COVID-related restrictions—such as mask mandates and school closures—despite clear evidence that the pandemic was no longer the same economic or public health threat it had been in 2020.

The Political Price

These missteps had political consequences. Four years later, the Democrats lost the presidency, and all indications suggest that high inflation was the key reason.

Imagine if Biden had used his strong political position in 2021 to push through reforms, tighten fiscal policy, and ease COVID restrictions. The U.S. could have experienced a non-inflationary boom, Democrats might have retained power, and geopolitically, the country would have been in a much stronger position to counter Russia’s invasion of Ukraine in 2022.

Trump’s Similar Mistakes

Now, in 2025, Trump has inherited a similar situation: inflation has finally come down, and growth remains robust. With control over both the Senate and the House, he could have introduced a long-term reform agenda to improve public finances while allowing the Fed to carefully cut rates.

But what is he doing instead?

• Implementing aggressive tariffs that harm the supply side of the economy.
• Failing to pass structural economic reforms that would ensure long-term stability.
• Pursuing short-term populist measures that will likely lead to the same inflationary mistakes as Biden.
• Seriously undermining the trust in US and global economic and financial institution and seriously increasing geopolitical risks.

A Deeper Democratic Crisis?

The fact that two consecutive presidents, from opposing parties, have made similar economic policy mistakes suggests a deeper crisis in the American democratic process.

The country appears to have lost its ability to embrace common-sense economic policies—the kind that both Reagan and Clinton understood.

To break this cycle and ensure a stable and growing economy, the following policies should be implemented:

• Significant fiscal consolidation through massive structural reforms, particularly entitlement reforms.
• Ensuring the independence of the Federal Reserve to guarantee nominal stability.
• Implementing reforms within a rule-based and constitutional framework to provide long-term economic predictability and growth.

The U.S. economy has proven resilient, but without responsible economic leadership, it remains at risk of repeating the same mistakes over and over again.

Until Washington regains a sense of economic discipline, the cycle of boom, inflation, and stop-go policy-making will continue, to the detriment of American democracy and economic stability.

I should start by noting that cultural analysis is not my area of expertise—I typically focus on economic policy and market-driven explanations. However, recent developments in American political culture have been striking enough that I feel compelled to address them, even if they fall outside my usual analytical framework.

As someone who has long felt aligned with American political culture, I find myself increasingly alarmed by its trajectory. The widening gap between my Nordic perspective and contemporary American governance is not just a matter of shifting rhetoric but of fundamental institutional changes. This shift deserves scrutiny, even from those of us who typically focus on economic rather than political matters.

The Breakdown of Anglo-Saxon Institutional Architecture and the Cultural Divide

Frank Knight, a key figure at the University of Chicago from 1927 to 1952, distinguished between governance based on rules and governance based on authority. Rules-based governance fosters stability and predictability, while authority-driven governance centralises decision-making and increases institutional fragility. Knight cautioned that excessive reliance on authority erodes trust in institutions and leads to arbitrary governance.

The United States, historically grounded in the Anglo-Saxon/Nordic governance tradition, has traditionally followed a rules-based system that values institutional stability, checks and balances, and technocratic competence.

However, the period following Trump’s re-election suggests that this is not just a cyclical political fluctuation but a structural transformation toward a more Latin-style model of governance—one that prioritises personal authority and executive discretion over institutional continuity.

The contrast between these traditions is stark. In Northern Europe and the UK, governance is designed to prevent excessive executive influence by embedding stability and decentralisation into political frameworks.

By contrast, Southern European and Latin American models, seen in countries like Italy under Berlusconi or Argentina under Perón, concentrate power in the hands of dominant leaders, frequently bypassing institutional constraints.

Hungary under Viktor Orbán provides a cautionary example of how executive power can steadily erode democratic norms.

This shift in governance has significant implications. The American system of checks and balances, historically a safeguard against power centralisation, is increasingly being replaced by a model where political success is determined more by personal loyalty than by institutional robustness or long-term policy vision. The volatility and discretionary decision-making that characterise Latin-style governance appear to be gaining ground in the U.S., with far-reaching consequences for both democracy and economic stability.

The Dangers of Centralised Power and the Yes-Men Syndrome

A key risk of power centralisation is the emergence of an echo chamber, where dissenting voices are suppressed, and decision-makers become insulated from reality. Leaders who surround themselves with yes-men—advisers who validate their viewpoints rather than challenge them—become vulnerable to perception bias, where they mistake agreement for legitimacy.

Hans Christian Andersen’s The Emperor’s New Clothes offers a fitting analogy. When authority figures are shielded from criticism, they risk becoming detached from practical concerns, leading to governance based on personal judgment rather than institutional expertise. The erosion of checks and balances accelerates, making it easier for executive overreach to become self-reinforcing, as each unchecked decision further legitimises discretionary rule.

This form of governance is incompatible with the Anglo-Saxon/Nordic tradition of institutional independence. Without robust institutions acting as counterweights, political leaders may disregard expertise in favour of ideological or loyalty-based appointments, weakening the very structures that ensure stability.

The Rise of Personality-Driven Governance and Executive Overreach

The American system, once thought resilient against personality-driven governance, now appears increasingly vulnerable. The dramatic surge in executive orders (EOs) is a clear indication of the shift toward a discretionary governance model, where political power is wielded unilaterally by the executive rather than balanced by legislative oversight.

Images of Trump seated in the Oval Office, signing executive orders on an almost daily basis—dictating policies ranging from tariffs on Mexico and Canada to bans on paper straws—illustrate the extent of this trend.

EOs, while legally valid presidential tools, were never intended to replace the legislative process. The U.S. Constitution mandates that EOs must be grounded in either constitutional authority or existing federal law.

However, the unchecked expansion of EO use erodes legislative power and weakens the role of Congress. Courts or future presidents may overturn them, but the damage to institutional norms is already done.

Trump’s governance style bypasses the deliberative mechanisms that ensure laws are crafted with input from multiple branches of government. Instead of engaging with Congress, he relies almost exclusively on executive decrees, further consolidating power within the presidency.

The Unprecedented Surge in Executive Orders

To illustrate the scale of this shift, I have compiled data from The American Presidency Project comparing the average annual number of executive orders issued by U.S. presidents in modern history.

For Trump, I have separated his first and second terms. While his first term already demonstrated an increased reliance on EOs relative to contemporary presidents such as Obama, Clinton, Reagan, and both Bushes, his second term has seen an exponential increase.

As the chart demonstrates, Trump is issuing EOs at an unprecedented pace, surpassing even Franklin D. Roosevelt, whose tenure was defined by the Great Depression and World War II. Even acknowledging that this projection is based on early data, the trend is unmistakable: the presidency is increasingly governing by decree rather than legislation.

This shift represents a severe erosion of checks and balances and a dangerous concentration of executive power. If left unchecked, it could establish a precedent for a quasi-autocratic presidency that governs without meaningful legislative input.

The Global Implications of Executive Overreach

This is not just an American problem. I have also been deeply concerned by similar trends in Europe. Hungary under Viktor Orbán provides a stark example of how democratic backsliding can occur through the gradual accumulation of executive power. The erosion of judicial independence, increasing media control, and the curtailing of parliamentary oversight show how a democracy can transition towards authoritarian rule in small, incremental steps.

Future Trajectories: An Uncertain Outlook

The fundamental question now is whether the U.S. can re-establish institutional resilience or whether it has embarked on an irreversible shift toward discretionary, personality-driven rule. If the latter proves true, the long-term consequences will extend beyond governance, affecting economic expectations, investment behaviour, and institutional trust for years to come.

Markets, as always, will respond accordingly, and the implications will be far-reaching.

Recent developments in US financial markets are painting an increasingly clear picture of rising inflation expectations, a phenomenon we might call ‘Trumpflation’. T

he evidence is mounting across various market indicators, suggesting we may be transitioning from a ‘goldilocks’ economy towards a more stagflationary scenario.

American consumers’ inflation expectations have risen sharply in January and February, and we’re observing clear signs of both businesses and consumers stockpiling goods in anticipation of potential future tariffs. This behavioural shift is accompanied by notable increases in US food prices and global commodity prices, particularly gold – traditional indicators of rising inflation expectations.

While bond markets initially seemed somewhat immune to these inflation fears, this is now changing significantly.

Looking at market-based measures of inflation expectations, the picture becomes quite telling. The 5-year breakeven inflation rate (reflecting market expectations for CPI inflation over the next five years) has been trending decisively upward since the turn of the year.

Meanwhile, the 5-year, 5-year forward inflation expectation rate (measuring expected inflation for the five-year period beginning five years from now) has remained relatively stable near the Federal Reserve’s 2% target since Trump’s election in November.

Particularly noteworthy is the dollar’s recent behaviour. Counter to what one might expect given the substantial tariff increases, the US dollar has actually weakened over the past month.

This development, despite relatively high US interest rates compared to Japanese or European rates, suggests investors are beginning to withdraw from US bond and equity markets – another indication of growing inflation concerns.

The dollar, which still appears significantly overvalued, continues to face downward pressure.

The shift in market sentiment is further evidenced by the underperformance of US equities relative to European stocks over the past month. This marks a significant departure from the initial Trump-era optimism, when markets focused on the administration’s deregulation agenda and its potential to boost growth without stoking inflation.

We appear to be witnessing the evaporation of this early optimism. While the transition from ‘goldilocks’ to stagflation isn’t yet dramatic, the trend is becoming increasingly clear.

The markets are signalling that the combination of trade tensions, increasing worries US federal debt, and monetary policy may be creating a more inflationary environment than initially anticipated.

The Federal Reserve will find it increasingly difficult to dismiss these signals as temporary noise, particularly given the broader context of economic developments.

The confluence of rising inflation expectations, weakening dollar, and shifting market dynamics suggests we may be entering a new phase in the economic cycle – one that requires careful attention from policymakers and market participants alike.

Today we got the US inflation (CPI) data for January.

Both headline inflation and core inflation (excluding food and energy prices) came in higher than expected. Headline inflation was 3.0% year-over-year, while core inflation rose to 3.3% year-over-year.
This is hardly good news.

However, we should be very careful about drawing too many conclusions from month-to-month changes.

This is why I’ve taken a broader view. I’ve looked at the 1-, 3-, 6-, and 12-month growth rates in both CPI and core CPI (annualized) and combined all of these into a single number. This approach should help filter out the noise in the data and capture the underlying trend.

You can see this in the graph above, where I show the Deep CPI Trend against the Fed’s 2% target, along with the range of 3-month moving average inflation rates.

What we observe is that what I call the “Deep CPI Trend” was falling after the inflation shock of 2021-22, but we never quite managed to return to 2%. Just as we were almost there about six months ago, the Deep CPI started moving upward again.

Now we’re almost at 4% – far above the Federal Reserve’s official inflation target. We’re seeing something similar in consumer inflation expectations – which have become stuck above 2% and have recently increased sharply.

If we look at Google searches for the word “inflation” in the US, we see the same pattern. We’ve never returned to pre-2020 levels. In fact, the data shows search interest running at about twice the pre-pandemic levels.

I find it hard to interpret this as anything other than an erosion of Federal Reserve credibility.

Some thoughts on Truflation – when the truth isn’t so truthful

Many of my readers have been asking me about the Truflation index, which, despite its name’s implications, might not be telling us the whole truth about inflation dynamics.

Truflation is a digital platform that calculates inflation in real time by gathering data from a wide range of sources. It uses blockchain technology to ensure transparency and accessibility for everyone. The goal is to provide a more dynamic and up-to-date picture of price developments in the economy.

The index is showing a rather different picture with inflation dropping sharply, but there are good reasons to be skeptical.

I’ve long been an advocate of using high-frequency indicators in monetary and economic analysis, and I was initially quite excited about Truflation and have often used the data. However, I’m becoming increasingly skeptical about its methodology.

The main problem is that Truflation adjusts the weights for different commodity groups monthly. This creates significant jumps in the data, particularly visible at the start of each month, when these weight adjustments take effect.

The UK data provides a particularly clear illustration of this problem. Since Truflation launched its UK series, we have seen large jumps at the beginning of multiple months throughout the year. While official UK inflation is trending down through 2024, Truflation shows the opposite pattern. These systematic jumps at the start of each month are clearly methodological artifacts rather than actual inflation dynamics – a problem that becomes very apparent when analyzing the UK data series in detail.

While I appreciate what the Truflation team is trying to do, and I think it’s still a potentially useful tool, I suspect the developers might not fully grasp all the economics aspects of what they’re measuring.

The broader picture

The broader point here is that the Federal Reserve’s credibility is being eroded.

When the US public loses faith in the central bank’s commitment or ability to maintain price stability, we risk inflation expectations becoming unanchored. As Milton Friedman taught us, expectations matter greatly for inflation dynamics.

The evidence for this erosion of credibility is mounting.

The latest University of Michigan Consumer Sentiment Survey shows short-term inflation expectations jumping to 4.3%, while long-term expectations continue drifting upward – a particularly worrying development that occurred even as actual inflation moderated through 2023-24. See also here.

This isn’t just survey data speaking – if we look at the Google Trends data shown below, we can see that public concern about inflation remains quite elevated.

The search interest in “inflation” is still running at about twice the pre-2020 levels, clearly indicating that inflation remains top of mind for the American public – and it likely was the key reason Donald Trump won the presidential election.

What’s particularly concerning is that this elevated level of inflation awareness has persisted long after the initial 2021-22 inflation shock. In a situation where monetary policy was credible, we would expect to see these indicators returning to their pre-pandemic levels. The fact that they haven’t suggests that the public isn’t fully convinced by the Fed’s commitment to price stability.

This is exactly what we’re seeing reflected in our Deep CPI Trend measure – inflation expectations becoming entrenched above target, making the Fed’s job increasingly difficult.

The combination of actual inflation readings, consumer expectations, and public interest in inflation all point in the same direction – a persistent credibility problem for the Fed. While we’re not yet in a 1970s situation, the warning signs are clear.

A Fiscal Crisis in the Making

The United States’ public finances are approaching a historic turning point.

With Donald Trump’s re-election to the presidency in November 2024, it is clear that American fiscal policy is moving towards a critical point.

In this article, I present an econometric analysis of the US budget deficit, which shows that we will soon reach a deficit of 10% of GDP – a level that would have been unthinkable just a few years ago.

To understand the gravity of this development, I have conducted an analysis of US budget figures from 1970 to 2024.

The results are disturbing. We are not merely seeing a temporary deviation from normal fiscal policy, but a fundamental transformation in how American fiscal policy functions.

The econometric model I have estimated isolates the structural changes from normal business cycle fluctuations. By including the output gap as an explanatory variable, we can distinguish between cyclical fluctuations and more permanent changes in fiscal policy.

The results show a markedly negative shift in the budget balance that began under Trump (version 1) and continued under Biden.

The hard numbers are unequivocal. Under the Trump administration (2017-2020), we saw a permanent decline in the budget balance of 3.1 percentage points of GDP.

This was not a result of economic downturn or external shocks – it was the consequence of deliberate political choices, primarily driven by major tax cuts and increased defence spending.

The Biden administration, despite promises to the contrary, worsened the situation by an additional 2.9 percentage points through expansionary fiscal policy measures.

The most remarkable finding in the analysis is that the financial crisis – often highlighted as the main cause of persistent deficits – actually plays a lesser role than assumed.

When the model includes dummy variables for the Trump and Biden periods, the post-2008 variable loses its statistical significance. This is a crucial result that fundamentally challenges the conventional narrative about the causes of US fiscal problems.

The graph speaks for itself. The blue line shows the actual budget balance, and the red dotted line represents the model’s estimates.

This indicates that the model has identified the main drivers behind the development in public finances.

This is not just another discussion about fiscal priorities. It is a fundamental change in how American fiscal policy functions. The traditional mechanism, where deficits grew in bad times and fell again when the economy stabilised, no longer exists. Instead, we see a persistent slide towards larger structural deficits, independent of economic cycles.

An Econometric Analysis of the Structural Transformation
To quantify the transformation in American fiscal policy, I have estimated a linear OLS regression model with the budget balance as the dependent variable. The model is specified as follows:

Budget_Balance(t) = β₀ + β₁Output_Gap(t) + β₂Budget_Balance(t-1) + β₃Trump_Dummy + β₄Biden_Dummy + β₅Post2008_Dummy + ε(t)

where Budget_Balance(t) is the public budget balance as a percentage of GDP, Output_Gap(t) measures the difference between actual and potential GDP, and Budget_Balance(t-1) is the lagged value of the budget balance.

Trump_Dummy and Biden_Dummy are binary variables capturing the respective presidential periods, while Post2008_Dummy controls for potential permanent effects of the financial crisis.

The regression results are remarkable.

The Output_Gap coefficient is statistically significant, confirming the well-known relationship between the business cycle and budget balance.

But it is in the political regime variables that we find the most striking results. The Trump dummy variable has a coefficient of -3.1 (statistically significant at the 1% level), while the Biden dummy variable contributes an additional -2.9 percentage points (also significant at the 1% level).

Particularly interesting is that the Post2008_Dummy variable loses its statistical significance when the political regime dummies are included.

This is a central finding that fundamentally challenges the common perception of the financial crisis as the main cause of persistent deficits. It is not the financial crisis driving the structural deficits – it is the political decisions made under Trump and Biden.

The estimated model reveals a marked deterioration in the structural deficit over time:

Before 2017: Structural deficit of 0.8% of GDP
Under Trump (2017-2020): Increase to 3.9% of GDP
Under Biden (2021-2024): Further deterioration to 6.8% of GDP

The lagged budget balance is highly significant in the model, indicating considerable persistence in the deficits. This means that once a high deficit level is established, it tends to persist.

The transformation of American fiscal policy under Trump was driven by specific political initiatives, including comprehensive tax cuts through the Tax Cuts and Jobs Act, increased defence spending, and a massive fiscal response to the COVID-19 pandemic.

Under Biden, the expansionary fiscal policy continued with the American Rescue Plan (2021), increased social benefits, and comprehensive infrastructure investments.

The econometric results are unequivocal: We are seeing a fundamental change in American fiscal policy that cannot be explained by business cycles or aftereffects of the financial crisis.

It is the result of deliberate political choices that have created a new fiscal regime with persistent high structural deficits.

Projections and Consequences
The empirical results from the econometric model provide a basis for projecting the development of the US budget balance.

The projections, based on the estimated relationships and current political course, paint a bleak picture.

The model predicts an acceleration in the negative trend with budget deficits that will reach:

8.2% of GDP in 2025
9.4% of GDP in 2026
Approaching 10% of GDP in 2027

In the projections, it is assumed that the output gap gradually closes (it is positive now) over the coming couple of years.

These projections are even based on a relatively optimistic assumption about stable interest rates on US government debt.

But herein lies a significant risk that markets seem to have underestimated thus far: If financial markets lose confidence in the American government’s willingness or ability to improve public finances, we could see a sharp rise in interest rates on US government debt.

Such an interest rate increase would have a self-reinforcing effect on the deficit. Higher rates mean increased interest payments on existing debt, which in turn worsens the budget deficit.

In such a scenario, the deficit could very quickly accelerate towards and beyond 10% of GDP – substantially faster than our baseline projections indicate.

We might even risk seeing a negative spiral, where rising deficits lead to higher interest rates, which in turn increase the deficit through higher interest payments. This will further weaken confidence in US public finances and drive rates even higher. This is precisely the type of dynamics that has historically led to financial crises in other countries.

The crucial difference from earlier periods is that these deficits are no longer cyclical. The mechanism where deficits grew in bad times and fell again when the economy stabilised no longer exists. The budget deficit should have fallen when the pandemic crisis policy ebbed away. But it didn’t. The deficit has become structural.

The US effectively has only three possible ways out of this situation:

• A continuation of the current debt spiral until it becomes unsustainable – a development that could be markedly accelerated by a sudden interest rate increase
• A drastic fiscal tightening, for which no one has yet presented a credible plan
• The classic way out for highly indebted economies: Let the printing presses run and let inflation eat away the debt

What is remarkable is not just the size of the deficits, but the speed at which they are growing.

The empirical results are unequivocal: US fiscal policy is no longer governed by economic cycles or temporary crises, but by a new political logic where neither Republicans nor Democrats show any will for fiscal discipline.

The interest rate risk constitutes the decisive wild card in this game. Thus far, financial markets have shown remarkable tolerance towards growing US deficits. But history shows that market patience can disappear quickly and unexpectedly.

When that happens, the adjustment could be both abrupt and painful.

Democrats and Republicans will continue to blame each other. But I look at the numbers. And they show one thing: US deficits have already run amok – and no one yet knows how it will end.

The latest University of Michigan Consumer Sentiment Survey delivers a stark warning about U.S. monetary stability.

Following Trump’s return to the presidency in the November 2024 election, inflation expectations have surged dramatically.

The short-term (one-year) inflation expectations have jumped to 4.3% – a level that should set alarm bells ringing.

Even more concerning is the steady drift upward in long-term (5-year) expectations, which have continued to creep higher even as actual inflation moderated through 2023-24.

To put this shift in perspective, we’ve only seen similarly dramatic surges in inflation expectations twice before in the survey’s history since 1978: following the 9/11 terrorist attacks in 2002 and during the late 1970s. The current surge suggests a fundamental shift in public confidence about future price stability – and the historical parallels are deeply troubling.

The Velocity Warning Signal

To understand why this surge in inflation expectations is so concerning, we need to look back at a crucial lesson from the late 1970s about how quickly monetary policy credibility can unravel.

The most telling indicator of monetary policy credibility is often found in the velocity of money – how quickly people choose to spend rather than hold money balances.

A particularly illuminating graph shows the percentage change in M2 velocity from December 1977, marking two crucial events: Miller’s announcement as Fed Chairman (December 1977) and the Iranian Revolution (February 1979).

What the data reveals is striking and crucial for understanding our current risks: The dramatic acceleration in velocity began immediately after Miller’s appointment was announced, well before the Iranian Revolution.

From a slightly negative trend in late 1977, velocity jumped by nearly 4% within months of Miller’s appointment and continued to accelerate steadily. By the time the Iranian Revolution hit in early 1979, velocity was already up by 7% from its pre-Miller level.

The Political Erosion of Fed Credibility

This timing is crucial – it wasn’t external shocks that initially triggered the velocity surge, but rather the market’s immediate reaction to the politicisation of the Federal Reserve.

When President Jimmy Carter chose G. William Miller, the CEO of Textron, to replace Arthur Burns in December 1977, it was widely seen as a political choice – Carter wanted someone who would prioritize his administration’s focus on employment over inflation fighting. Miller, lacking strong monetary policy convictions, was expected to be more amenable to the White House’s preferences than Arthur Burns.

The market’s response was swift and clear. The acceleration in velocity shows that Americans began reducing their money holdings almost immediately after Miller’s appointment was announced, well before he even took office in March 1978. This wasn’t a gradual loss of confidence – it was an immediate reaction to the perceived politicisation of monetary policy.

By the time the Iranian Revolution added its own inflationary pressures in 1979, the foundational damage to Fed credibility was already done.

The velocity surge continued and intensified, with the cumulative increase in velocity between 1977 and 1982 contributing to a 12% rise in the U.S. price level – a massive inflationary impulse that ultimately required Paul Volcker’s dramatic interest rate hikes to contain.

The Trump-Powell Dynamic

This historical episode holds urgent lessons for today. Trump has already demonstrated his willingness to publicly attack Fed independence, famously comparing Jerome Powell to China as an “enemy” during his first term.

Now, with his return to office secured and his promise to “bring down prices,” there are growing concerns that he will attempt to replace Powell with a more politically compliant Fed chair – essentially recreating the Miller scenario.

The risk is particularly acute because Trump has explicitly linked his anti-inflation promises with criticism of Fed independence. The market reaction to any move against Powell could be similar to what we saw with Miller – an immediate jump in velocity as people lose confidence in monetary policy independence.

The Compounding Risk of Trade Restrictions

Adding to these concerns is Trump’s proposed expansion of tariffs and trade restrictions. While these would be inflationary in their own right, the real danger lies in their combination with any erosion of Fed independence. Just as the Iranian Revolution’s inflationary impact was magnified by Miller’s compromised monetary policy, Trump’s trade restrictions would be far more damaging in an environment of questioned Fed credibility.

The Expectations-Velocity Nexus

The connection between inflation expectations and velocity is straightforward but powerful: When people expect higher inflation, they reduce their money holdings and spend more quickly, effectively increasing the velocity of money. Unless the Federal Reserve responds by reducing money supply growth, this acceleration in velocity translates directly into higher inflation – potentially creating a self-fulfilling prophecy.

The current surge in inflation expectations we’re seeing in the Michigan Survey could be the precursor to a similar velocity spike. Just as in 1977-78, markets appear to be pricing in the risk of political interference with monetary policy before any actual changes have occurred.

Looking Forward

The velocity data from 1977-79 serves as a stark warning: the markets don’t wait for actual policy mistakes when monetary policy independence is threatened – they react to the threat itself.

The immediate jump in velocity following Miller’s appointment shows how quickly confidence can erode when markets perceive political interference with monetary policy.

The current surge in inflation expectations might reflect similar fears – not just about Trump’s specific policies, but about the future independence of the Federal Reserve itself. The lesson from 1977 is clear: once the public believes monetary policy has been politicised, the impact on money demand is immediate, and the cost of restoring credibility becomes enormously high.

The combination of rising inflation expectations, threats to Fed independence, and proposed trade restrictions creates a risk scenario remarkably similar to the late 1970s.

The irony is that Trump’s anti-inflation rhetoric, combined with policies that undermine Fed credibility and create supply-side price pressures through trade restrictions, might create exactly the kind of inflation surge he claims to oppose.

In risk departments across Europe’s banks and pension funds, intense discussions are unfolding. The topic? Trump’s increasingly erratic behavior and what it means for financial stability.

At first glance, the immediate concerns seem obvious—tariffs, trade wars, and economic uncertainty. But that’s not where the real danger lies. European credit departments will, of course, start by assessing first-order effects: What happens if European exports to the U.S. get hit with fresh duties? What will be the impact on corporate borrowers?

These are valid questions, but they are not the question. Even if a U.S. recession spills over into Europe, most European banks would be well-positioned to absorb the shock.

The real risk isn’t about trade or growth. It’s about governance.

The Real Risk: Trump vs. U.S. Institutions

Financial markets don’t just price assets based on economic fundamentals. They price trust—trust in rules, institutions, and the predictability of policymaking.

That’s why Swiss or German bonds yield close to zero, while Turkish bonds trade at emerging-market risk premiums. It’s not just about whether a country can pay its debts—it’s about whether its institutions are strong enough to guarantee that it will.

Now, what happens if markets stop trusting the U.S.?

That’s where things get dangerous. If investors start questioning whether the U.S. will honor its debt commitments—or whether Trump might try to overtake the Federal Reserve—then the pricing of risk-free assets ceases to function. That’s when we could see a superspike in U.S. interest rates.

Trump vs. Powell: The Pressure Cooker

Trump has never been a fan of an independent Fed. In his first term, he relentlessly pressured Jerome Powell to cut interest rates, even calling him an “enemy.” Now that he’s back in the White House, he is explicitly demanding that the Fed loosen monetary policy.

If Powell resists, Trump could attempt to sideline him, install a more loyal figure, and directly interfere in Fed policy. If markets begin to question the independence of the Federal Reserve, confidence in U.S. Treasuries could unravel fast.

We have seen this before. Erdogan systematically undermined Turkey’s central bank, keeping interest rates artificially low, triggering an investor exodus, and ultimately causing bond yields to explode from 10% to nearly 50%.

If something similar happened in the U.S., rates could surge well above 20%. That has never happened before in the U.S., but it’s worth remembering that interest rates jumped from 9% to 15% in the late 1970s. The precedent is there.

The Liz Truss Warning

If that sounds far-fetched, just look at Liz Truss.

In 2022, she announced an unfunded tax-cutting plan, convinced that markets would cheer her “pro-growth” policies. Instead, markets panicked. The pound crashed, UK gilt yields surged, and the Bank of England was forced to step in to prevent a total meltdown. Truss lasted 44 days in office.

Now imagine that scenario playing out in the $25–30 trillion U.S. Treasury market. If investors decide Trump is a systemic risk, there won’t be a central bank in the world big enough to stop the fallout.

The Cracks Are Already Showing

Even before a Trump vs. Fed showdown, the U.S. credit system is under severe strain.

Commercial real estate loans are already underwater, with billions of dollars in debt coming due in 2025. The U.S. banking system is quietly accumulating losses, delaying the recognition of bad loans. Official data still paints a picture of relative stability, but beneath the surface, stress is building.

Counterparty risks for European banks and pension funds must not be underestimated. If the U.S. financial system experiences a liquidity crunch, those dependencies will be tested overnight.

Trump’s Erratic Behavior Is Accelerating

Trump’s return to the White House has been anything but predictable. His sudden tariffs on Canada, Mexico, and China—justified by vague claims about immigration and national security—are already straining trade relations. His decision to impose a 25% tariff on imports from Canada and Mexico and a 10% tariff on Chinese goods confirms what many already feared: economic policy under Trump 2.0 will be chaotic.

But it’s not just trade policy.

Trump has suggested that the U.S. should take over the Gaza Strip, arguing that it could be redeveloped into a resort destination—the “Riviera of the Middle East.” This kind of geopolitical adventurism has no basis in reality, but it spooks investors by signaling that the rules-based global order is no longer a constraint on U.S. decision-making.

Then there’s Greenland. Trump is once again pushing to acquire Greenland, describing it as a “strategic necessity.” Denmark has, once again, rejected the idea. But the fact that we are even talking about this again tells you everything you need to know about Trump’s priorities.

For markets, the signal is clear: the old rules do not apply anymore.

What European CROs Need to Consider

For European risk managers, the key question isn’t whether U.S. interest rates will rise—it’s whether the global financial system can continue to treat U.S. Treasuries as the ultimate safe asset. If that assumption breaks, we will see a violent repricing of risk.

A European bank cannot avoid U.S. exposure, but it can prepare for a scenario where the dollar collapses and interest rates spike. That means modeling:

• What happens if U.S. interest rates hit 10%?
• What happens if the dollar loses 50% of its value?
• What happens if U.S. banks experience a sudden funding crisis?

These are not baseline forecasts. But they are entirely possible scenarios that every CRO in Europe should be running now.

The Erdogan Scenario Is Not Free

Governance matters. Institutional credibility matters.

If those fundamentals are eroded, markets will demand a risk premium—and that means higher rates. The cost of debt will rise. Asset values will fall. The institutions that have underpinned global finance for decades will be questioned.

That is not free.

This is not an exercise in worst-case thinking. It is risk management. If U.S. institutions hold, we move on. If they don’t, those who failed to prepare will be the first to pay the price.

Be careful out there.

Yesterday, the Trump administration announced new tariffs of 25% on all imports from Mexico and Canada and 10% on all imports from China. In response to this announcement – which wasn’t entirely unexpected – US stocks fell and interest rates rose.

The simple interpretation is that higher import prices drive up US inflation, causing the Federal Reserve to raise the policy rate (pushing market rates up). This reduces economic activity (and therefore earnings in US companies, hence pushing stocks down).

While there’s certainly truth to this, it should be noted that firstly, an import tariff is a “one-off” increase in price level, and the resulting rise in inflation is only temporary – in a year, inflation will fall back (though the price level will remain higher). And the Fed shouldn’t really react to this.

The real story: America’s monetary superpower status at risk

However, in my view, there’s a more important mechanism at play that leads to PERMANENTLY higher rates if the tariffs are maintained. For decades, the US has enjoyed what’s known as an “exorbitant privilege” – a term coined by French finance minister Valéry Giscard d’Estaing in the 1960s when he was serving under President Charles de Gaulle.

He used this phrase to describe what he saw as America’s unfair advantage of having the dollar as the world’s reserve currency.

As American economist Barry Eichengreen later perfectly summarized: “It costs only a few cents for the Bureau of Engraving and Printing to produce a $100 bill, but other countries had to pony up $100 of actual goods in order to obtain one.”

This privilege has allowed the US to run persistent deficits in both its balance of payments and trade balance – importing more goods and services than it exports. The flip side of this is capital movements. The deficit means that the US has EXPORTED dollars (that’s what the deficit is paid with), and as the global reserve currency, these dollars are eagerly absorbed by foreign central banks and investors.

This “exorbitant privilege” means that China, for instance, has built up large foreign exchange reserves over the past 30 years.

These reserves are largely held in dollars – and dollar assets – such as US Treasury bonds and money market papers. This naturally means that the interest rate on these papers is LOWER than it would otherwise have been. Moreover, strong international demand for dollars means that the US can print more money without it becoming inflationary – essentially getting a “free lunch” from its reserve currency status.

Therefore, if Trump truly wants to significantly reduce the US balance of payments and trade deficit through increased tariffs, he may inadvertently kill this “exorbitant privilege.”

It will mean less EXPORT of dollars – and yes, this must, ceteris paribus, lead to higher US interest rates (both real and nominal) and increased inflationary pressure – not primarily due to higher import prices, but simply because there will be less global dollar demand (less money demand).

Crucially, these dynamics imply a higher so-called natural rate of interest. This means the Federal Reserve would HAVE to raise rates just to maintain a neutral monetary policy stance – regardless of any direct inflationary effects from the tariffs themselves. The alternative would be effectively running an expansionary monetary policy at a time when the economy’s natural interest rate has risen – a recipe for additional inflationary pressures.

All of this is probably too complicated for Donald Trump to understand, but markets can easily see it… and if Trump continues down this path, we might as well get used to falling stock prices and significantly higher interest rates as America’s “exorbitant privilege” begins to erode. And then it will suddenly be very, very hard to fund the US government budget deficit.

Note: Illustration created with fal.ai/FLUX.