I must say that the commentary surrounding Sunday’s so-called trade agreement between the US and EU has been almost universally “Trumpian” in its analysis.

Nearly every commentator emphasises that Trump has “won” whilst the EU has capitulated. From Frankfurt to Paris, from Dublin to Copenhagen, the narrative is one of European defeat in the face of American economic bullying.

So let’s examine the facts instead of the rhetoric.

The Pre-Trump Baseline

Before Trump’s return to the White House, there was widespread free trade between the EU and USA, save for a handful of selected goods. The average US tariff on EU imports stood at a mere 1.2%—a testament to decades of trade liberalisation.

This was an excellent situation. Economists have known since Adam Smith’s Wealth of Nations in 1776 that free trade trumps protectionism. David Ricardo subsequently taught us that the value of trade lies in each country producing what it is RELATIVELY best at—the principle of comparative advantage that has underpinned global prosperity for two centuries.

Prior to Smith, mercantilism dominated economic thinking. According to mercantilist doctrine, the purpose of trade policy was to maximise the trade surplus—or exports. This is precisely how Trump thinks about trade.

But the lesson from Smith and Ricardo is that we should focus on the division of labour and the consumer, not on crude trade balance arithmetic.

The New Reality: A 15% Baseline

When Trump threatened to impose tariffs, the EU had limited options. The deal, which imposes a 15 percent tariff on most European goods, came after a private meeting on Sunday between US President Donald Trump and European Commission President Ursula von der Leyen in Scotland. Yes, this disrupts the division of labour. But this was also the situation BEFORE Sunday’s “agreement” (we still don’t know the full details—as always with Trump, there’s more bluster than substance).

What would the perfect agreement look like? If we’re to heed Ricardo and Smith, it would be zero tariffs—both ways.

We haven’t achieved that, but here’s what’s remarkable: Announcing the agreement, Trump said the E.U. will not impose a tariff on U.S. imports. In other words, the EU has moved towards MORE free trade, not less. The bloc has committed to maintaining zero tariffs on American goods whilst accepting a 15% levy on its own exports.

This is, all else being equal, GOOD for European consumers and producers.

The Asymmetry That Matters

What isn’t good, naturally, is Trump’s 15% tariff on European exports to the USA. This certainly affects European exporters. But let’s be clear about who bears the greatest burden here: American consumers and producers will pay the lion’s share of these costs through higher prices and reduced competitiveness.

It’s worth remembering that trade is a positive-sum game, not a zero-sum contest. When I hear commentators proclaim that Europe has “lost,” it sounds eerily like Trump himself, who persistently misunderstands trade as a win-lose proposition.

The EU could have escalated the trade war. Brussels had prepared a long list of retaliatory tariffs targeting everything from beef and beer to Boeing aircraft and car parts. That would have been a replay of the 1930s trade catastrophes when global commerce collapsed.

We’re not getting that. Instead, we’re getting LOWER EU tariff rates—indeed, zero tariffs on US goods. Yes, we face tariffs on our exports. That’s not ideal, but it’s primarily American consumers who will foot the bill.

The Numbers Tell a Different Story

Consider what Trump initially threatened versus what materialised:

• Initial threat: 30% tariffs on all EU goods
• April position: 20% “reciprocal” tariffs
• Final agreement: 15% baseline with significant carve-outs

A “zero-for-zero” scheme will apply to aircraft and related components, semiconductor equipment, critical raw materials and some chemical and agricultural products. Moreover, For the auto industry, for which the current tariffs of 27.5% were almost halved to 15%.

I’m genuinely pleased that the EU has let reason prevail and avoided escalating a trade war. It would have been economically senseless and would have led to inflation and stagnation across Europe. Now we get to maintain ZERO import tariffs—likely contributing to lower inflation in the coming period.

The Broader Economic Context

We must also remember that the USA today consumes excessively—both publicly and privately. A correction is inevitable. Americans must pay higher taxes to close the massive federal budget deficit.

Tariffs are an absurdly inefficient way to raise revenue, but the alternative would have been lower public spending combined with the introduction of a federal VAT (which would have been my recommendation). Regardless, Americans must consume less. And they will. Yes, this means reduced European exports to the USA.

The Investment “Promises”

What about the EU’s “pledges” to “invest” in the USA? Trump, the deal also includes that all European Union countries will be “opened up for U.S. goods” at 0% and the bloc will invest $600 billion in the U.S. Frankly, I doubt this will amount to much. This is vintage Trump theatre. We saw the same performance with the Japan trade agreement—Trump announced massive Japanese “investments” that Tokyo couldn’t recognise in the actual agreement.

The Bottom Line

So what should we conclude? We’ve secured an agreement that leaves European consumers BETTER off than before. We’ve avoided or postponed a trade war. American consumers will bear the cost of Trump’s tariff folly.

All told, whilst everyone claims the EU has “lost,” European consumers have actually WON. Credit to the EU’s negotiators for this outcome. They may not even realise it, and they’ll be savaged in the press, but this is actually a good day for Europe.

We must lament that Trump behaves like an economic illiterate, attacking international trading systems and attempting to dismantle the liberal world order. But escalating the trade war would have been monumentally stupid.

The Path Forward

The EU should continue down this path—we need ZERO tariffs on even more goods and with even more countries. “We have a deal. We have a trade deal between the two largest economies in the world, and it’s a big deal, it’s a huge deal,” she said. “It will bring stability. It will bring predictability.” The EU must urgently begin negotiating with major trading partners—Japan, South Korea, and the UK—for zero-tariff agreements.

And again, let’s stop thinking about trade like Trump does. It’s not about maximising exports. It’s about the division of labour and lower prices for consumers. The mercantilist obsession with trade surpluses died with Adam Smith in 1776. Let’s not resurrect it now.

A Final Thought on Economic Literacy

What’s most disturbing about this entire episode isn’t the tariffs themselves—it’s the economic illiteracy they reveal. When supposedly sophisticated European commentators adopt Trump’s zero-sum view of trade, we’ve truly lost the plot.

The gains from trade don’t come from running surpluses. They come from specialisation, from competition, from the creative destruction that forces firms to innovate. When we impose tariffs, we don’t protect jobs—we protect inefficiency.

The EU’s negotiators may have just pulled off one of the cleverest moves in recent trade diplomacy: maintaining completely open access for American goods whilst accepting temporary tariffs that American consumers will largely pay. It is not perfect (that would be complete free trade), but it is much, much better than European consumers would pay massive higher prices than today.

The Hidden Third Mandate

The Federal Reserve Act may soon create serious problems for Jerome Powell – or perhaps I should say “Too Late” Jerome Powell, as President Trump has taken to calling him.

Most economists discuss the Federal Reserve’s “dual mandate”—to secure both “stable prices” and “maximum employment”. The Fed has interpreted this more specifically as a 2% inflation target, with room to support employment so long as it doesn’t conflict with price stability.

But here’s the truth: the Fed doesn’t have a dual mandate—it has a triple mandate. The actual language in the Federal Reserve Reform Act, dating from 1977, states that it’s the Fed’s responsibility “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

There it is – a third goal: to ensure “moderate long-term interest rates”.

This has rarely commanded much attention, as economists generally assume that low inflation automatically leads to low inflation expectations, which in turn ensures moderate long-term interest rates.

When Goals Collide

What’s striking is that the law doesn’t discuss what the Fed should do when these three goals conflict.

There’s now consensus amongst economists (less so in 1977) that monetary policy cannot permanently hold unemployment below the “structural unemployment” rate, and attempting to do so will cause inflation to spiral out of control.

That’s why the Fed has interpreted the law for at least 30 years such that the inflation target takes precedence over the employment goal.

But for the past three decades, there hasn’t been a test of the interest rate goal. What happens when long-term rates begin rising sharply, so we can no longer say they’re “moderate long-term interest rates”?

The Warning Signs Are Flashing

This is hardly a hypothetical scenario. The 30-year Treasury yield today rose above 5%.

This could happen if markets lose confidence in the US government’s willingness and ability to repay its debt. Given how the Trump administration (and previous ones) and both Democrats and Republicans seem utterly indifferent to public debt dynamics, the risk of a sudden and severe spike in interest rates is increasing.

What then?

The Fed could argue that rising rates reflect irresponsible fiscal policy and do nothing. Just as they’ve never assumed “maximum employment” means zero unemployment, recognising structural labour market conditions.

But they’ve only been able to take this position because monetary policy genuinely can control inflation long-term but cannot control unemployment long-term (which is structurally determined).

Interest rates are different. When fiscal policy becomes unsustainable, what economists call “fiscal dominance” emerges – where expectations arise that unsustainable public finances will eventually force the central bank to “rescue” the government by monetising the deficit.

In this situation, expectations of monetisation cause inflation expectations to explode, and it’s fiscal policy, not monetary policy, that effectively determines inflation.

If the central bank attempts to tighten policy, it merely exacerbates the fiscal problem and potentially increases inflation expectations further.

This is typically what happens in countries where massive public finance problems create expectation dynamics leading to hyperinflation.

Thankfully, the US isn’t there yet. But we’re moving in that worrying direction.

The question now is: when can we say the Fed isn’t meeting its “triple mandate”? What if rates rise to 6% or 7%? Or 10%?

The Fiscal Dominance Trap

In that situation, there are certainly good grounds to claim the Fed should buy US Treasuries to push down government bond yields.

But in that situation inflation expectations would explode – and the dollar would weaken markedly. And yes, actual inflation would shoot up dramatically.

The Fed would thus be forced to abandon its inflation target – even though it all stems from irresponsible fiscal policy over which the Fed has no influence.

We see here that economic gravity determines the hierarchy of the three goals.

Under normal conditions, the Fed can focus on ensuring low inflation and, when there’s room, support employment – and interest rates will remain “moderate”.

But if fiscal policy becomes truly unsustainable, the Fed essentially loses control. Expectation formation will completely undermine the Fed’s ability to control inflation. And worse – according to the Federal Reserve Reform Act, it’s actually the Fed’s obligation to ignore inflation (which it can’t control in this situation anyway) and focus on keeping rates low.

Trump’s Dangerous Game

This is an extremely worrying scenario, and one must say it’s becoming increasingly likely given that US fiscal policy is clearly completely unsustainable, there’s no political will to address it – and yes, it’s simultaneously clear that President Trump believes it’s the Fed’s job to solve the problem by cutting policy rates.

President Trump recently suggested that the Federal Reserve should substantially cut policy rates to help lower the mounting interest rate cost associated with servicing the massive government debt. Last week, the president sent Powell a handwritten note: “You should lower the rate — by a lot! Hundreds of billions of dollars being lost!”

Trump hasn’t yet focused on long-term rates, but with continued rises in Treasury yields, it’s surely only a matter of time before he realises the Federal Reserve Reform Act might be used to twist Jerome Powell’s arm.

The conditions for fiscal dominance — when a central bank’s ability to control inflation through monetary policy is effectively negated by a government’s high debt and deficits — are falling into place.

The Independence Illusion

That said, the Federal Reserve Reform Act also guarantees the Fed’s independence, and there are no sanctions in the law against the Fed if it doesn’t meet the “triple mandate”.

What’s frightening, however, is that we even need to discuss these matters, but it would be deeply irresponsible to ignore these risks.

The bond market is already sending warning signals. Moody’s downgraded the U.S. government’s credit rating earlier this year, citing the increasing burden of financing the government’s ballooning budget deficit.

The Price of Recklessness

We’re witnessing the early stages of what could become a full-blown fiscal dominance crisis. The Fed may soon face an impossible choice: follow its triple mandate and facilitate fiscal irresponsibility, or maintain its inflation-fighting credibility and risk being accused of violating the law.

This is the price of decades of fiscal recklessness. And I fear we’re only beginning to pay it.

As a classical liberal economist, I ought to be thrilled about Javier Milei. A self-proclaimed libertarian winning the presidency of Argentina on a platform of radical economic liberalisation? It sounds like something straight out of a classical liberal dream.

And to be fair, there’s plenty to like about Milei. He’s an economist — not just another lawyer or career politician. I agree with perhaps 95% of what he says on economics.

But I must admit: I prefer the Friedman-Hayek approach — radical in substance, conservative in method. Milei’s theatrical style may be effective (at least in the short term), but it’s not my cup of tea.

Let me also be frank: I’ve previously spoken favourably about Milei and his reform agenda. I still hope his reforms succeed. Argentina desperately needs them. The country needs structural reforms to break with decades of economic mismanagement.

But concern has gradually crept in. Not over Milei’s results per se — they are what they are — but over how we classical liberals around the world may have overestimated him. That we’ve allowed ourselves to be dazzled by rhetoric and short-term wins, while ignoring a fundamental truth: He’s not delivering the lasting reforms Argentina needs.

Let me be absolutely clear: I didn’t buy the hysterical warnings from the left about Milei — and I still don’t. That criticism has largely been ideological and overwrought.

My concern is not that he’s doing too much — but rather that he’s doing far too little. That much of it is political theatre.

When I take a closer look at what has actually happened in Argentina since December 2023, I get worried. Not so much because of Milei’s outcomes — but because we classical liberals have constructed a narrative that has surprisingly little to do with reality.

Then there’s the matter of character. The shitcoin scandal of February 2025, in which Milei promoted a cryptocurrency called $LIBRA that collapsed within hours and wiped out $250 million in investor value?

That raises serious questions about judgement and integrity. Even if he was misled, as he claims, it suggests a troubling naïveté for a head of state. Yes, he was formally cleared of legal wrongdoing — but the episode still casts doubt on his judgement.

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The Uncomfortable Truth About the Reforms

And here’s the crux: Milei’s style and rhetoric are one thing. Implementing lasting reforms is something else entirely.

Real reform work is difficult — and often boring legislative work. It requires patience, political craftsmanship, and coalition-building. This is where Milei falls short.

In fact, Argentina saw more far-reaching market-oriented reforms during the 1990s under Carlos Menem. Those reforms were far from perfect, but they were largely enacted through the legislative process and institutionally anchored via Parliament — not simply decreed from the presidential palace.

Let’s begin with the facts: Milei’s most high-profile campaign promise was to dollarise the Argentine economy. That hasn’t happened. His promise to shut down the central bank? Abandoned.

What about privatisation? Of the 41 state-owned enterprises originally targeted, only between 2 and 8 have actually been approved for sale. Major SOEs remain firmly in state hands.

His flagship reform package — the so-called Ley de Bases — was trimmed down from 664 articles to just 232.

His labour reforms were declared unconstitutional. With just 15% of seats in the lower house, Milei simply lacks the political capital needed to push through serious structural reform.

So what has he actually achieved?

The key result is, in fact, quite simple: Through decree, he has frozen nominal public expenditure. With inflation running above 200%, this results in massive real cuts — up to 35% reductions in pensions and public sector wages.

It’s a clever trick — and yes, it worked. Argentina recorded its first primary budget surplus in 123 years.

But let’s be honest about what that is: It’s not structural reform. It’s not legislation. It’s effectively an inflation tax applied to the state itself. And it’s certainly not sustainable in the long run.

Lower Inflation, But Deep Structural Problems

Even these headline “successes” come with major caveats. Yes, inflation has dropped dramatically — from 25.5% monthly to around 1.5% in May 2025.

Annual inflation now stands at 43.5% — which sounds impressive until you realise that’s roughly where Argentina was back in 2019–2020. In other words, we’re merely back where we started 4–5 years ago.

The economy is indeed showing signs of recovery, but that comes after a sharp recession — with GDP contracting by 3.5% in 2024. More worryingly, unemployment is rising — now at 7.9%, the highest since 2021.

The peso remains another weak spot. Rather than stabilising the currency, Milei has presided over continued depreciation. If that trend continues, any disinflation gains will eventually be reversed. It’s basic macroeconomics: a persistently weakening currency will feed back into prices.

And then there’s the method behind the “miracle cuts”. Milei exploited a particular institutional quirk: If Parliament fails to pass a new budget, the previous year’s budget is automatically extended — but in nominal terms. In a high-inflation environment, this effectively creates sharp real cuts without lifting a finger. Clever? Yes. Sustainable? Hardly.

The Echo Chamber

And yet, what do we hear from classical liberal and libertarian commentators globally?

“Milei’s miracle!” they proclaim. Reason Magazine, the Cato Institute, and a chorus of free-market advocates celebrate his “shock therapy” as a triumph of market economics. And yes, I too have been among those praising the results.

We highlight falling inflation, the budget surplus, and a 160% rally in the stock market as signs of success. We talk about renewed growth — but fail to mention that it’s growth from a deeply depressed base.

This is dangerous for several reasons:

First, it simply overstates the extent of reform. To call Milei’s programme a “libertarian revolution” is misleading when most structural reforms were never enacted, and most changes were made by decree, not legislation.

Second, it ignores how fragile the methods are. Decrees can be reversed as quickly as they were issued. Without legislative backing, nothing is durable.

Third — and perhaps most importantly — we risk discrediting the entire case for liberal reform by overselling the Milei experiment.

The Risk of Overselling

Here’s my greatest concern: What happens when reality catches up with the narrative?

What if the Argentine economy — as it has many times before — collapses under the weight of an overvalued currency, rising unemployment, and unfulfilled reforms?

If we classical liberals have spent years celebrating Milei as a free-market hero and his policies as a miracle, who will take us seriously the next time we argue for market reform?

We risk becoming the ideological boys who cried wolf — too eager to claim victory, too blind to the obvious weaknesses.

A More Honest Assessment

Let me be clear: Many of Milei’s spending cuts were both necessary and sensible. I would have voted for them all.

Argentina urgently needed to regain control of its public finances. Fighting inflation remains essential. Reducing the chronic fiscal deficit was a vital step. And I genuinely hope Milei finds a way to implement the structural reforms Argentina so desperately needs.

But let’s not confuse emergency crisis management by decree with long-term structural reform through legislation. When the next president can undo everything with a stroke of a pen, we haven’t achieved change — we’ve merely delayed the reckoning. Perhaps not for long.

The real problem isn’t that Milei cut spending — it’s that he did so without securing the institutional foundations to make those changes permanent. Without parliamentary support, broad political consensus, or legislation that binds future governments, nothing is truly anchored.

What We Should Learn

The real lesson from the Milei experiment is likely more nuanced than either supporters or critics admit:

1. Decrees are not reform: Real structural change requires legislation. Without parliamentary backing, it’s all temporary.
2. Argentina’s root problem is constitutional: The country lacks the institutional framework to deliver long-term reform. What’s really needed is constitutional reform — a Herculean task Milei hasn’t even attempted.
3. Timing isn’t enough: Crisis may make reform possible, but that doesn’t make it lasting.
4. Institutions cannot be bypassed: The attempt to govern by decree shows exactly why institutional anchoring is essential.

A Warning to My Classical Liberal Friends and Colleagues

So here is my appeal to my fellow classical liberals around the world: Let’s be honest about what is happening in Argentina.

Let us acknowledge both the successes and the shortcomings. Let us not oversell the results or exaggerate the scale of reform.

Because if we elevate Milei as a free-market champion, and the Argentine experiment fails — as it very well might — then we haven’t just damaged our own credibility.

We’ve also made it harder for future reformers to make the case for the market-based policies so many countries desperately need.

The truth is, Milei has delivered something — but almost entirely by decree. The economic results are mixed, not miraculous. And without institutional anchoring, even the positive changes are extremely fragile.

Let’s tell that story instead. It may be less sexy, less ideologically gratifying — but it is honest. And in the long run, honesty serves the cause of economic liberty better than propaganda ever will.

Because if we truly believe in free markets and classical liberal reforms, we should also believe in the importance of strong institutions and democratically grounded change — not just quick-fix decree solutions that can vanish as easily as they appeared.

Argentina needs constitutional reform to lay the foundation for long-term economic policy. That’s the truly difficult task.

It requires political courage, broad cooperation, and long-term thinking. And that, quite frankly, is what Milei has failed to deliver.

And perhaps most importantly: we should insist on character and judgement in those we elevate as champions of liberty. A president promoting dodgy cryptocurrencies? That’s not the example we need.

After Trump announced “Liberation Day” on 2 April, US government bond yields began to rise – and even after the announcement on 9 April of a “pause” in the implementation of Trump’s massive tariff increases, yields continued to climb.

It was especially the 30-year Treasury yields that rose to alarmingly high levels, reaching just above 5% by the end of May.

However, in June, things seemed to calm down somewhat – partly because the economic data turned out slightly better than expected, keeping the door open for further interest rate cuts from the Federal Reserve.

Now, though, we are once again approaching the 5% mark on the 30-year US yield, after several weeks during which long-term interest rates have ticked upwards – not only in the US, but also in Japan, the Eurozone, and the UK.

So far, the equity markets have largely ignored the renewed rise in yields, but I firmly believe there’s good reason to keep a close eye on interest rates. Given that Trump and US politicians seem unwilling to take the country’s enormous fiscal challenges seriously, there is every reason to believe that we may be heading for a fresh wave of market turmoil. This could trigger a drop in US stock prices, a further weakening of the dollar – and yes, we might well see the 30-year Treasury yield rise above 5% again within the next few days.

The question is whether calm can be restored as easily as it was in May–June, or whether we’re in for a much rougher ride this time.

And yes, Trump’s tariff circus is also playing a role again – we are, as I’ve noted in recent days, effectively heading towards 1 August, when tariff levels could return to those originally announced on Liberation Day.

The Unpleasant Arithmetic Returns

Regular readers will recall my May post “The US Consumer Goes to Fiscal Reality Mart: Tariffs or VAT?” about what I’ve termed the “unpleasant arithmetic.” With US federal debt held by the public now at 100% of GDP, the United States has crossed a critical threshold where traditional monetary policy tools become dangerously constrained. The maths are brutally simple: with total US federal debt at $36 trillion, each percentage point rise in rates adds approximately $360 billion to annual interest costs.

This creates what economists call “fiscal dominance” – a situation where monetary policy becomes subservient to fiscal needs. When the US Court of International Trade struck down Trump’s Liberation Day tariff programme in April, they didn’t just deliver a legal judgement; they exposed the fundamental fiscal constraints facing the US administration.

As I wrote then, once you breach the 7-8% threshold on government borrowing costs, you enter an explosive feedback loop. Higher rates generate larger deficits, which require more debt issuance, which pushes up term premiums, which drives rates even higher. It’s a self-reinforcing spiral that, at 119% debt-to-GDP, becomes mathematically impossible to escape through conventional means.

Why This Time Is Different

Back in 2013, I argued in “Be right for the right reasons” that 5% yields on the 30-year US Treasury would signal the end of the Great Recession and a return to the nominal GDP growth rates of the Great Moderation. But context, as they say, is everything. Then, 5% yields meant healthy growth expectations; now, they signal something far more ominous – the stirring of the bond vigilantes.

The temporary calm in June shouldn’t fool anyone. Yes, US inflation expectations dipped from 6.6% to 5.1% according to the Michigan survey, and yes, some economic data surprised to the upside. But these are merely ripples on the surface whilst the underlying currents grow stronger.

Consider the global nature of the current yield surge. It’s not just US Treasuries – Japanese, European, and UK yields are all rising in tandem. This isn’t a story about relative growth differentials or monetary policy divergence. It’s about a fundamental reassessment of sovereign credit risk in an era of fiscal profligacy.

The August Deadline Looms

US Treasury Secretary Bessent’s announcement that tariffs will “boomerang back” to Liberation Day levels by 1 August for countries without trade deals represents more than diplomatic brinkmanship. It’s an acknowledgement of fiscal desperation dressed up as trade policy.

As I demonstrated in “The US Consumer Goes to Fiscal Reality Mart: Tariffs or VAT?”, even revenue-maximising tariffs at 33% would generate only 2.3% of GDP whilst creating deadweight losses of 1.14% of GDP. For every dollar collected, the economy loses an additional 49 cents. It’s fiscal madness masquerading as “America First” economics.

The court’s April ruling was clear: the US president cannot simply declare economic emergencies to impose tariffs at will. Yet here we are, three months later, with the administration attempting to achieve through negotiation what it couldn’t accomplish through executive fiat. The markets aren’t impressed, and neither should they be.

What the Markets Are Telling Us

The renewed talk about Trump potentially firing Powell is particularly troubling. Over the weekend, National Economic Council Director Kevin Hassett said the administration is “looking into” whether Trump has the authority to fire the Fed Chair, suggesting the $2.5 billion renovation of Fed headquarters could provide “cause.” This comes as Trump faces mounting pressure from his MAGA base over the Epstein files debacle, with many calling for Attorney General Bondi’s resignation.

When US presidents face political heat, they often create diversions. And with Trump defending Bondi while his base revolts – the first major split we’ve seen in the MAGA movement – firing Powell would certainly change the subject. It would also be catastrophically stupid from an economic perspective.

Through the lens of MV = PY, such a move could trigger the velocity shock I’ve been warning about. When central bank independence is questioned, households and businesses reduce their money holdings. Velocity accelerates, creating inflation without any increase in the money supply. It’s the mirror image of 2008, when velocity collapsed and the Federal Reserve struggled to prevent deflation.

The Fed now faces an impossible trilemma: they can’t simultaneously maintain price stability, fiscal sustainability, and financial stability. Something has to give. Powell’s recent comments about “staying the course” on inflation ring hollow when everyone knows that above 7-8% rates, the US fiscal arithmetic explodes.

This is why US equity markets’ current complacency strikes me as dangerously misguided. They’re pricing in a Goldilocks scenario where the Fed defeats inflation without triggering a fiscal crisis. The bond market, always the adult in the room, is telling a different story. And now we have the added risk of Trump doing something monumentally foolish to distract from his domestic political troubles.

What Happens Next

The risk I highlighted in May remains very real and is growing: the US could face a multi-phase crisis where rising term premiums lead to capital flight, forcing Fed intervention that sparks surging inflation and ultimately results in de facto debt restructuring. The probability of this scenario is increasing.

The approach to 5% on the 30-year US Treasury yield is the canary in the coal mine. Cross that threshold decisively, and we enter the danger zone where fiscal mathematics overwhelm monetary policy. The June respite bought time, nothing more. Unless US politicians suddenly discover fiscal religion – and Trump’s weekend theatrics defending Bondi whilst his own base calls for her resignation suggests otherwise – the unpleasant arithmetic will assert itself.

For investors, the message is clear: don’t mistake temporary calm for permanent resolution. The bond vigilantes are stirring, and they have mathematics on their side. When US sovereign debt reaches 100% of GDP, 5% long-term rates aren’t a sign of healthy growth expectations; they’re a warning that the game is nearly up.

As I’ve said before, whilst politicians debate, mathematics calculates. And right now, the sums are looking increasingly brutal. The question isn’t whether we’ll see fresh market turmoil, but when – and whether this time, the traditional policy tools will be enough to restore calm.

I suspect we’ll have our answer soon enough. The 1 August tariff deadline may prove to be about more than trade policy. It might just be the date when fiscal reality finally trumps political rhetoric.

The sheer mathematical impossibility of American fiscal policy never ceases to amaze me.

Here we have the world’s largest economy, blessed with extraordinary dynamism and innovation, yet trapped in a consensus so delusional it would make a Danish politician from the 1970s blush. And I should know—I lived through Denmark’s fiscal crisis as a child, watching inflation destroy savings and unemployment ravaging communities.

The latest “One Big Beautiful Bill Act” perfectly encapsulates this delusion. Americans want Scandinavian-style social insurance programmes whilst maintaining Hong Kong-style tax rates. It’s rather like insisting you can fly by vigorously flapping your arms—the physics simply doesn’t work, no matter how fervently you believe.

As a classical liberal economist, I’m hardly advocating for Nordic-style income redistribution on a large scale—even though, ironically, Norway and Sweden have more dollar billionaires per capita than the US, and we actually had more income equality in Scandinavia BEFORE we expanded the public sector in the 1960s.

But my work on “The Free Enterprise Welfare State: A History of Denmark’s Unique Economic Model” for the Fraser Institute in 2023 reinforced something I already knew: fiscal mathematics is utterly indifferent to political preferences.

Following the current American debate over the “Big Beautiful Bill” has made me increasingly aware of just how delusional American fiscal discourse has become. When Social Democratic Danish Finance Minister Knud Heinesen declared in 1979 that Denmark stood at “the brink of the abyss,” he wasn’t being dramatic. He was doing arithmetic.

America’s Extremist Centre

Here’s what most commentators miss: America’s fiscal extremism isn’t found on the political fringes—it’s the mainstream consensus.

The supposed “middle ground” combines two fundamentally incompatible demands: expansive social programmes and low taxes for most Americans. This is the real extremism, far more dangerous than any fringe ideology.

Consider the numbers. According to the Congressional Budget Office, federal debt held by the public has reached 100% of GDP in 2025, with projections showing it will hit 118% by 2035 and 156% by 2055. Interest payments alone consume $952 billion annually—exceeding the entire defence budget. The Peterson Foundation calculates America borrows $2.6 billion daily just to service past borrowing.

The deficit for fiscal year 2025 is projected at $1.9 trillion, or 6.2% of GDP. By 2035, CBO projects the deficit will still hover around 6.1% of GDP. This isn’t a temporary pandemic aberration—it’s structural. And the CBO likely is far too optimistic.

Yet AP-NORC polling from 2023 shows 79% of Americans oppose any cuts to Social Security or Medicare. Simultaneously, they’re convinced someone else should foot the bill. And here’s where American fiscal discourse becomes truly fantastical.

Trump insists foreigners will pay through tariffs—as if Chinese exporters, not American consumers, bear the cost of import duties. Tax Foundation analysis shows even a 10% universal tariff would raise merely $2.2 trillion over a decade, whilst federal income taxes generate over $2 trillion annually. The Peterson Institute projects such tariffs would actually shrink GDP by 0.8-1.3% whilst eliminating up to 1.1 million jobs.

Meanwhile, self-proclaimed “democratic socialists” like New York’s Zohran Mamdani propose billionaires will pay through 2% wealth taxes and higher corporate rates, projecting perhaps $10 billion annually for New York—a rounding error against federal entitlement spending of $2.7 trillion.

These are the same fantasy dollars, just with different imaginary payers. Trump wants foreigners to pay. The ‘progressive’ left wants billionaires to pay. Both are peddling the same delusion: that someone else—anyone else but the broad middle class—can fund the government Americans want.

It’s fiscal fantasy of the highest order. Only the middle class has the numbers and income to generate the revenue needed, but in US, they don’t pay. And both parties promise they never will.

The Perfect Illustration: Opposition to the “Big Beautiful Bill”

Nothing illustrates America’s fiscal delusion better than the opposition to the “One Big Beautiful Bill Act.”

The primary critics aren’t fiscal conservatives alarmed by the $4 trillion in the mostly funded tax cuts over a decade.

No, the loudest opposition comes from Democrats attacking the bill’s modest attempts at entitlement reform – work requirements for Medicaid, restrictions on benefits for non-citizens, and efforts to reduce waste and fraud.

The Congressional Budget Office estimates the bill would cut federal spending on Medicaid and CHIP by $1.02 trillion, removing 10.5 million people from the programmes by 2034. Democrats decry this as cruel, yet these are precisely the kinds of reforms Denmark implemented decades ago—and more stringently. Our unemployment benefits require active job searching and participation in activation programmes. We means-test aggressively. We’ve raised retirement ages systematically.

Speaking of retirement ages, the contrast is stark. Denmark has followed a policy since 2006 that ties the retirement age directly to the average life expectancy of its citizens. The retirement age will increase in steps: to 68 by 2030, then to 69 by 2035, and finally reaching 70 by 2040. This isn’t arbitrary—it’s automatic, linked to life expectancy projections and reviewed every five years. By 2100, the retirement age is expected to be 77 if current trends continue.

Meanwhile, the current full retirement age is 67 years old for people attaining age 62 in 2025 in America, with no automatic adjustment mechanism. Some Republicans propose raising it to 69 or 70, but even these modest proposals face fierce opposition. The difference? Denmark’s reforms are systematic, mathematical, and depoliticised. America’s are sporadic, emotional, and paralysed by politics.

The bill would add $2.3 trillion to the deficit over 10 years whilst triggering automatic Medicare cuts of $490 billion—yet even these modest savings provoke hysteria. Meanwhile, the few remaining fiscal conservatives in the Republican Party have essentially capitulated, accepting massive tax cuts without corresponding spending reductions. The Tax Foundation estimates the bill would reduce federal tax revenue by $4 trillion between 2025 and 2034, with spending cuts offsetting less than half.

This perfectly encapsulates America’s bipartisan fiscal delusion: Republicans promise tax cuts without spending cuts, Democrats promise spending increases without tax increases on the middle class, and both attack anyone suggesting mathematical reality might intrude on their fantasies.

The Scandinavian Reality Check

Let me explain how Denmark actually works, since American politicians of all stripes seem incapable of understanding it. Denmark isn’t socialist – it’s fiscally conservative with redistribution. Following our near-catastrophe in 1982, when inflation hit double digits and government bond yields exceeded 20%, we implemented genuine reforms.

The 1982 government of Poul Schlüter broke with the failed Keynesian experiments of the 1970s through three key measures:

• Significant fiscal consolidation via spending cuts and tax reform
• A “hard” currency peg to the Deutsche Mark (now the Euro)
• De-indexation of wages and benefits to break the inflation spiral

These weren’t popular measures. But they worked. Inflation fell from over 10% to under 2%. Bond yields normalised. The economy recovered. Most importantly, they established a new consensus: fiscal responsibility isn’t optional.

Denmark’s approach to fiscal policy became significantly less Keynesian than America’s, focusing much more on the medium to long term.

We were remarkably instructed by our experience in the 1980s when fiscal contractions actually worked expansively—the Danish fiscal contraction had not hurt economic expansion. This “expansionary fiscal contraction” flew in the face of traditional Keynesian thinking but proved that credible fiscal consolidation could boost confidence and growth.

I know this because I lived it. As a policy analyst in the Danish Ministry of Economic Affairs during the second half of the 1990s, I worked for a coalition government led by Social Democrat Prime Minister Poul Nyrup Rasmussen, which included smaller centre-right parties.

That coalition government – with Social Democrats at the helm – implemented more entitlement reforms AND marginal income tax reductions than any Republican congressman could fantasise about. The Nyrup government tightened unemployment benefits, introduced activation requirements, reformed early retirement schemes, and actually cut top marginal tax rates. A Social Democratic-led coalition did this – because they understood fiscal reality and because that is what the Danish public demanded.

Today, Denmark operates under our 2012 Budget Law that basically semi-constitutionally mandates a structural public budget balance. It was a Social Democratic Finance Minister, Bjarne Corydon, who implemented this law. A Social Democrat enshrining fiscal discipline in law! When Social Democrats return to power, they don’t undo these reforms. They’ve learned.

The Danish Paradox: High Taxes, High Economic Freedom

Here’s what confounds American political discourse: despite our high taxes, Denmark consistently ranks as free or more economically free than the United States in many crucial areas.

The Heritage Foundation’s 2024 Index of Economic Freedom scores Denmark at 78 points—well above America’s historically low 70.1, placing the US at 25th globally. The Fraser Institute’s 2024 Economic Freedom of the World report ranks the United States 5th, with Denmark tied for 6th.

This isn’t a contradiction—it’s a lesson in what economic freedom actually means. Denmark excels in:

• Rule of law and property rights: Our courts are relatively efficient, contracts are enforced, and corruption is minimal
• Business freedom: Starting a business in Denmark takes hours, not weeks. We rank consistently in the top 5 globally for ease of doing business
• Labour market flexibility: Yes, we have strong unions, but also flexible hiring and firing rules—our “flexicurity” model
• Trade freedom: As a small open economy, we maintain minimal trade barriers
• Sound money: Our currency peg provides stability and predictability

What Americans fail to grasp is that economic freedom isn’t simply about low taxes – it’s about the ability to engage in voluntary exchange, enforce contracts, start businesses, and operate free from corruption.

Everyone Pays in Scandinavia

The fundamental difference between American and Scandinavian fiscal models is breathtakingly simple: everyone pays in Scandinavia. OECD data shows Denmark’s tax-to-GDP ratio at 46%, compared to America’s 27.7%. But it’s the structure that matters most.

Our 25% VAT ensures universal contribution—you pay every time you buy anything. Income taxes are genuinely broad-based: the top rate of 55.9% kicks in at just 1.2 times average income—around $60,000. In America, top rates only apply above $626,350.

According to the Tax Policy Center, 40-45% of American households pay no federal income tax whatsoever, whilst Tax Foundation data shows the top 1% pays 40.4% of all income taxes.

Here’s the crucial point Americans miss: Denmark has no wealth tax (Poul Nyrup Rasmussen’s Social Democratic government did that in 1997). Our corporate tax rate of 22% is actually lower than America’s 21% federal rate plus state taxes (the combined corporate tax rate in New York is for example 27-30%).

America’s problem isn’t that it doesn’t tax the rich- it’s that it doesn’t tax the middle class. The American left’s obsession with “soaking the rich” is mathematically futile. There simply aren’t enough millionaires and billionaires to fund a Scandinavian-style welfare state, even if you confiscated every penny they earned.

The mathematics is inescapable: you cannot fund universal programmes on the backs of a minority. Denmark learned this the hard way. In the 1970s, we tried funding expanding welfare programmes through narrow, progressive taxation. The result? Capital flight, economic stagnation, and near-fiscal collapse.

Compare Danish revenue sources with American ones:

• Denmark: Income taxes (40%), VAT (20%), Social contributions (20%), Other (20%)
• USA: Income taxes (50%), Payroll taxes (36%), Corporate (7%), Minimal consumption taxes (7%)

America’s reliance on volatile income taxes from high earners makes revenue unstable and politically vulnerable. Denmark’s broad base ensures everyone has skin in the game.

The Power of Automatic Stabilisers

Here’s another crucial difference American policymakers fail to understand: Denmark’s broad-based tax system creates powerful automatic fiscal stabilisers. Our VAT and comprehensive income taxes mean that when the economy slows, tax revenues automatically decline, providing stimulus without politicians having to pass emergency spending bills. When the economy booms, revenues automatically increase, cooling inflation without requiring discretionary tightening.

This is why Denmark rarely needs the kind of massive stimulus packages America deploys during every recession. Our fiscal system adjusts automatically. When consumption falls, VAT revenues drop immediately. When incomes decline, tax receipts fall across the entire income distribution, not just from a handful of high earners. The system breathes with the economy.

America’s narrow tax base—dependent on volatile capital gains and income taxes from the wealthy – provides weak automatic stabilisation. When markets crash, revenues collapse disproportionately. When they boom, windfalls create pressure for tax cuts rather than deficit reduction.

The result? Denmark maintains fiscal stability through the cycle. America swings wildly between deficits that are too large in good times and stimulus that arrives too late in bad times. Our system is boring but effective. America’s is exciting but dysfunctional.

A Classical Liberal Alternative for America

My preferred solution for America’s current fiscal crisis combines fiscal responsibility with individual ownership – learning from Denmark’s experience whilst avoiding our mistakes.

Introduce mandatory pension savings of 12-15% of income, funded partly by a new federal VAT of 10-15%. These would be genuine individual accounts, professionally managed but privately owned. Phase out Social Security over 30-40 years as these accounts mature. Similar approach for healthcare: mandatory health savings accounts, catastrophic insurance, and gradual Medicare phase-out.

The mathematics works: 10% VAT (with perfect compliance and no exemptions) could theoretically raise about 6.8–7.0% of GDP. Combined with mandatory savings, Americans could build substantial private assets. Chile’s pension reform, despite its flaws, shows the transition is feasible. Singapore’s CPF demonstrates how mandatory savings can replace traditional welfare.

This isn’t radical – it’s what most developed countries did before embracing pay-as-you-go systems. It avoids both America’s unfunded liabilities and Scandinavia’s work disincentives. Most importantly, it’s honest: genuine funding rather than intergenerational Ponzi schemes.

To be clear: I’m not suggesting this for Denmark, where I’d pursue different reforms (our pension system is already nearly fully funded and the fiscal house is in order). But for America’s specific circumstances – a culture of individual responsibility, entrepreneurial dynamism, and deep scepticism of government – this approach aligns with national values whilst addressing fiscal reality.

The Reform Imperative

America faces three possible paths:

1. Implement broad-based taxation: A 15-20% federal VAT, middle-class income tax increases, carbon taxes, financial transaction taxes. This could stabilise the fiscal situation but requires political honesty about who pays.
2. Genuine entitlement reform: Raise retirement ages, means-test benefits, shift to private accounts, introduce real healthcare competition. Painful but mathematically necessary.
3. Financial crisis and forced adjustment: Continue current path until markets lose confidence. Then face all the above reforms simultaneously under crisis conditions.

Denmark chose a combination of options 1 and 2 after nearly experiencing option 3. We implemented broad taxes whilst simultaneously reforming our welfare state—activation requirements for unemployment benefits, pension age increases, partial privatisation of services.

The result? Danish government gross debt stands at 30% of GDP, compared to America’s 100%+.

But here’s what American politicians don’t grasp: Denmark’s net financial position is actually positive—the Danish state has net assets, not net debt. Trump once spoke of creating an American “Sovereign Wealth Fund.” Such funds require actual wealth. America has none; Denmark does.

Lessons from 45 Years of Danish Reforms

What America should learn from Denmark isn’t our welfare state—it’s our fiscal discipline. Since 1982, every Danish government, left or right, has accepted certain realities:

• Budgets must balance over the cycle
• Debt must remain sustainable
• Everyone must contribute
• Reforms must be continuous

We’ve raised pension ages systematically through our life expectancy linkage and tightened unemployment benefits. We’ve maintained fiscal surpluses in good years to prepare for bad ones. We’ve resisted the temptation to buy votes with unfunded promises.

The result? Denmark has seen GDP comparable to the US but without fiscal irrisponsibility.

The Coming American Reckoning

The Penn Wharton Budget Model warns that financial markets face limits in sustaining current deficit levels. Social Security’s trust funds deplete in 2034, Medicare’s Hospital Insurance fund in 2033, according to the 2024 Trustees Report. CBO projects net interest costs will reach $1.8 trillion by 2035—consuming 22.2% of federal revenues.

These aren’t distant abstractions. When trust funds “deplete,” benefits automatically cut by 20-25%. When interest costs crowd out other spending, hard choices become unavoidable. When markets lose confidence, borrowing costs spike overnight.

I’ve seen this film before. In Denmark in 1982. In Sweden in 1992. In countless countries that thought arithmetic was negotiable. The crisis always comes suddenly, after years of warnings ignored.

America possesses enormous advantages: reserve currency status, deep capital markets, entrepreneurial dynamism, vast resources. But these advantages aren’t permanent. They’re eroding with each trillion added to the debt, each year of fiscal irresponsibility, each political cycle that prioritises fantasy over mathematics.

My childhood in 1970s Denmark taught me that fiscal crises aren’t academic exercises. They’re lived experiences of inflation eating savings, unemployment destroying communities, and political systems failing their citizens. But Denmark’s subsequent 45 years of reform also taught me that recovery is possible – through genuine fiscal conservatism, not political fantasies.

America would do well to learn not just from Denmark’s mistakes, but from our hard-won reforms. The lesson isn’t to copy our welfare state – heaven forbid – but to understand that fiscal reality eventually asserts itself.

You can have a generous welfare state with high taxes, or a minimal state with low taxes. You cannot have generous welfare with low taxes, no matter how beautiful the bill promising otherwise.

Mathematics, unlike politics, doesn’t negotiate. And that’s a lesson best learned voluntarily, rather than having it imposed by markets that have lost patience with beautiful delusions.

The US economy added a stronger-than-expected 147,000 jobs in June, and the unemployment rate ticked down to 4.1%, according to this morning’s Bureau of Labor Statistics report.

As has become depressingly predictable, this release was immediately followed by political noise from both sides of the aisle.

The Trump administration has been proposing rules that would make it easier to fire federal workers, including BLS economists, raising concerns about potential political pressure on data reporting.

Meanwhile, Democrats continue to point to Trump’s baseless claims from August that the Biden administration was “fraudulently manipulating job statistics” as evidence of his willingness to undermine trust in official statistics.

But here’s the thing: I don’t care about the politics. I care about the data. And more importantly, I care about what an independently estimated econometric model tells us about the reliability of that data.

Let me walk you through the model I’ve estimated.

This is a straightforward OLS model of monthly changes in US private-sector employment (USPRIV). I focus on the private sector because it’s less susceptible to policy-driven discontinuities than total employment, which includes government hiring.

The model specification is:

​Δ₁m USPRIVₜ = α + Σᵢ₌₁¹² βᵢ Δ₁m USPRIVₜ₋ᵢ + γ₀ Δ₁m ADPₜ + γ₂ Δ₁m ADPₜ₋₂ + εₜ

Where:

• The dependent variable is the monthly change in private employment (in thousands).
• The model includes 12 lags of the dependent variable to capture persistence and momentum.
• It incorporates changes in ADP private employment: contemporaneous (t) and two months lagged (t-2), reflecting both immediate and delayed payroll effects.
• The model is estimated on data from January 2010 through December 2019 and January 2022 through December 2024.
• All forecasts from January 2025 onwards are fully out-of-sample.

The Results Are Statistically Stable and Economically Intuitive

The model performs well:

• Root MSE is approximately 80,000 jobs, indicating tight forecast precision.
• Key predictors include:
  • ADP lag 2 with a stronger coefficient than contemporaneous ADP, highlighting delayed effects in payroll data.
  • A positive constant, consistent with the underlying trend in private-sector job growth.
• The 12 lags of USPRIV capture the typical momentum and reversal patterns in monthly employment dynamics.

The model tracks the evolution of employment remarkably well and closely matches actual BLS data through both the Biden and Trump administrations.

What About Forecast Accuracy Under Different Administrations?

To assess whether employment figures under either the Biden or Trump administrations exhibit signs of manipulation or structural breaks, I’ve analysed forecast errors across three distinct periods: the pre-COVID decade (2010–2019), the post-COVID Biden term (2022 to January 2025), and the early months of Trump’s second term (February to June 2025).

The model tracks actual employment changes with impressive consistency.

Under Biden, the average forecast error is virtually zero. Under Trump, the model slightly underpredicts job growth, but the deviation remains modest and statistically insignificant.

Crucially, the errors observed during both administrations fall well within the range seen during the stable, pre-pandemic decade.

There is no evidence of systematic bias and no indication of data manipulation. The BLS figures continue to behave exactly as one would expect based on long-standing empirical relationships.

The June 2025 Divergence: ADP vs BLS

This morning’s employment report offers a fascinating snapshot of how different data series can tell distinct stories—without suggesting any manipulation.

ADP reported that private-sector payrolls fell by 33,000 in June—the first decline since March 2023. In contrast, the BLS establishment survey recorded a gain of 74,000 private-sector jobs.

My model, which combines ADP data with lagged private-sector employment dynamics, predicted an increase of 71.6k. With the actual coming in at 74k, the forecast error was just 2.4k—well within the model’s expected range.

The gap between ADP and BLS isn’t a sign of data inconsistency or foul play.

It reflects different methodologies: ADP is based on a single payroll processor’s clients, while BLS surveys a broader swathe of employers and applies different seasonal adjustments.

But here’s the twist: the real surprise in June wasn’t the private sector at all—it was the public sector, which added 73,000 jobs. That surge came mainly from state and local government hiring in education and healthcare—categories that ADP doesn’t cover at all.

So despite political rhetoric about shrinking government or civil service freezes, public employment continues to grow—even under Trump. If the plan was to slow down hiring via executive order or DOGE-themed disruption, it hasn’t shown up in the numbers yet.

By blending the signal from ADP with historical labour market persistence, the model offers a more stable and comprehensive benchmark.

And once again, the results are clear: no anomalies, no bias—just a labour market evolving along predictable, statistical lines.

Visual Evidence: The Model Tracks Reality

The chart above tells the story better than any statistical test.

There’s no structural break, no sudden deviation, no evidence of systematic bias under either administration. The data continues to evolve exactly as the model would predict based on historical relationships.

Trust the Process, Not the Politics

Former BLS Commissioner Erica Groshen warns that proposed civil service reforms could “open the door” to political pressure on statisticians.

She’s right to be concerned about institutional safeguards. But the empirical evidence shows that, so far at least, the data integrity remains intact.

The accusations flying from both political camps – whether Trump’s claims of Biden “fraudulently manipulating job statistics” or current concerns about Trump undermining the BLS – simply don’t survive contact with the data.

My model provides a neutral benchmark. It doesn’t know or care who’s in the White House. It simply captures the statistical relationships between different employment measures over time. And it continues to track the official data with remarkable accuracy.

The labour market might actually be softening a bit

And the markets don’t seem particularly rattled by the data either.

Yes, June’s jobs number came in well above the ADP estimate, but the market reaction has been muted. Bond yields are up slightly, but in the context of this year’s volatility, a 5bp move in 10-year Treasuries barely qualifies as news.

What deserves more attention, however, is the trend captured by the model—based on both BLS and ADP data. This combined signal offers a more stable and perhaps more reliable indicator of the true trajectory of the US labour market than either source alone.

And here’s what stands out: while the model was broadly flat to up through the second half of 2024, it has clearly begun to trend downward since February 2025.

That shift points to a moderate but persistent softening in private-sector job growth—entirely consistent with a labour market that remains resilient, but is gradually cooling.

So while the Trump administration may be celebrating today’s headline beat, and Fed hawks might use the data to argue against further rate cuts, the underlying message is more nuanced.

According to the data that actually tracks labour market fundamentals, momentum is easing—not accelerating.

Conclusion: Economics, Not Politics

Good policy requires good data. But good data requires trust – trust that the numbers reflect economic reality, not political convenience.

The evidence from my model is unambiguous: that trust remains justified. Neither the Biden administration nor the Trump administration has successfully “cooked the books.”

The Bureau of Labor Statistics continues to produce reliable, professional statistics that pass the test of independent validation.

For years, I’ve argued that central banks fundamentally misunderstand their own monetary policy transmission mechanism. They believe the federal funds rate drives nominal variables, when increasingly it’s the other way around.

In this blog post, I present empirical evidence through a structural VAR analysis spanning 1973 to 2025 that demonstrates this complete reversal of causality.

The results in my view are nothing short of remarkable. The federal funds rate – the Fed’s supposed primary policy instrument – has transformed from a leading indicator that once shaped economic outcomes to a lagging variable that merely follows market-determined nominal developments.

This analysis stems from my repeated attempts over the past few weeks to re-estimate interest rate policy rules for both the Fed and the ECB. Perhaps intellectually dulled, I’ve been “playing along” with the New Keynesian game of estimating Taylor rules.

Paradoxically, this “betrayal” of market monetarist thinking has only strengthened my conviction about the need to examine causality in the monetary transmission mechanism.

The conclusion: we market monetarists have been right, and we may have convinced both the Fed and the markets – even though no one has officially acknowledged it. This analysis is presented below.

The Methodology: Letting the Data Speak

I’ve conducted a structural Vector Autoregression (VAR) analysis using monthly data from January 1973 to June 2025, examining five key macroeconomic variables:

1. Trade-weighted US Dollar Index (nominal, combined series)
2. M2 Money Supply
3. Personal Consumption Expenditures (PCE) — my proxy for NGDP
4. Federal Funds Rate (FFR)
5. 10-Year Treasury Yield

The analysis employs a Hodrick-Prescott filter (λ=129,600) to extract cyclical components after log-transforming the level variables.

I then estimate a VAR(3) model and conduct Granger causality tests to identify which variables lead and which follow.

The Smoking Gun: Federal Funds Rate as Follower, Not Leader

Look at the FFR row in the table below – it’s a sea of statistical insignificance!

The federal funds rate fails to Granger-cause any variable except the 10-year yield at conventional significance levels. Meanwhile, look at the FFR column – it is caused by nominel spending (PCE) and 10 year yields!

Figure 1 below adds up these results.

The federal funds rate exhibits:

• Low out-degree: Causes only 2 variables significantly (M2 and 10-year yield)
• High in-degree: Is caused by 3 variables (PCE, 10-year yield, and indirectly through other channels)
• Net causality score of -1: Negative, indicating follower status

But the real story is PCE’s dominance:

• Highest out-degree: PCE causes 4 out of 4 variables
• Moderate in-degree: Only caused by 2 variables (M2 and Dollar)
• Net causality score of +2: The clear leader of the system

This reveals the complete inversion of monetary transmission. PCE – our proxy for nominal spending -drives everything including the Fed’s own policy rate.

The federal funds rate doesn’t lead nominal developments; it follows them. Meanwhile, PCE acts as the system’s true anchor, causing movements in money supply, exchange rates, interest rates, and even monetary policy itself.

A true policy instrument should lead the system as PCE does. Instead, the FFR is relegated to follower status – validating the nominal path that PCE has already determined. The supposed conductor of monetary policy is actually just another instrument in PCE’s orchestra.

The Historical Transformation: The Rise and Fall of FFR Leadership

Perhaps most striking is how the federal funds rate’s role has completely reversed over our sample period.

Table 2 and figure 2 provide an overview of these changes.

In the 1970s-1990s, the FFR led the dance. It Granger-caused movements in money supply, nominal spending, exchange rates, and bond yields. This was the era when the Fed moved first and markets reacted.

But something fundamental shifted around 2000 (I suspect it actually started with the introduction of Treasury Inflation Protected Securities (TIPS) in 1997 – thank you Bob Hetzel).

The federal funds rate increasingly became a follower – reacting to developments in nominal variables rather than causing them.

By the 2010s, the transformation was complete: the FFR had become almost entirely endogenous.

Variance Decomposition: Who Explains Whom?

The Forecast Error Variance Decomposition (FEVD) at 24 months provides another perspective on this transformation:

Table 3 reveals a striking truth: the Federal Funds Rate (FFR) explains almost none of the variation in key nominal variables. It accounts for just 1.7% of dollar movements, 4.8% of money supply, and 2.4% of PCE — our proxy for NGDP.

By contrast, PCE alone explains over 20% of the FFR’s own variance, with the 10-year yield contributing another 6%. In other words, the Fed’s policy rate follows the nominal economy; it doesn’t lead it.

PCE and M2 exhibit far more explanatory power than the rate central banks claim to control. The conclusion is unavoidable: interest rate policy is no longer a tool – it’s a follower. The FFR reads the temperature of the economy but no longer changes it.

Why Did the FFR Lose Its Leadership?

The transformation from leader to follower wasn’t accidental – it emerged from the very evolution of modern central banking itself.

The Taylor Rule trapped the Fed in endogeneity. Once markets understood that the Fed systematically responds to inflation and output gaps, they began anticipating these responses.

The federal funds rate became endogenous by design, transforming the Fed from active leader into predictable follower of economic conditions.

Forward guidance paradoxically accelerated this transformation. Greater transparency and communication, intended to enhance policy effectiveness, instead completed the endogeneity circle.

When central banks telegraph exactly how they’ll react to future data, they’ve effectively announced that their policy rate is a dependent variable, not an independent force.

The 2008 crisis delivered the coup de grâce. When rates hit the zero lower bound, the Fed’s resort to quantitative measures exposed the federal funds rate’s fundamental limitations. Monetary aggregates briefly assumed leadership during this period, shattering any remaining pretense that interest rates represented an all-powerful policy tool. The emperor wasn’t just naked—he was powerless.

Today’s high-frequency financial markets represent the final stage of this evolution. Information flows instantly, expectations adjust continuously, and nominal variables shift before the FOMC can even convene.

Markets no longer wait for Fed decisions; they anticipate, price in, and effectively determine where rates must go. The Fed arrives at each meeting to find markets have already done the heavy lifting, leaving only the ceremonial announcement of what everyone already knows must happen. By the time the FOMC meets, markets have already moved nominal variables to where they “should” be, and the Fed merely validates these moves.

This isn’t a bug in the system – it’s the inevitable feature of a transparent, market-based monetary regime operating without explicit nominal anchors. The Fed engineered its own irrelevance through the very reforms meant to enhance its effectiveness.

The Uncomfortable Truth About “Monetary Policy”

What does it mean for monetary policy when the federal funds rate has transformed from leader to follower?

Our VAR evidence reveals that nominal variables and market rates drive the federal funds rate, not vice versa. The FOMC meetings have become theatrical performances – committee members debate quarter-point adjustments whilst markets have already determined where rates must go based on nominal conditions.

The federal funds rate now functions as a thermometer rather than a thermostat. It reads the temperature of nominal conditions but cannot change them.

Since the FFR follows rather than leads, actual monetary influence must operate through expectations. Markets coordinate around implicit nominal targets, and the Fed’s role has been reduced to validating these market-determined paths.

This reality is deeply inconvenient for the monetary policy establishment. Central bankers imagine themselves as maestros conducting the economic orchestra, yet our analysis demonstrates they’re dancing to the market’s tune. The Federal Reserve believes it conducts policy through rate adjustments; the data shows it merely reacts to developments beyond its control.

Conclusion: The New Monetary Reality

The transformation from leader to follower is complete and irreversible. Rather than attempting to restore the federal funds rate’s lost leadership – a futile endeavour in modern financial markets – we must design institutions that acknowledge how monetary systems actually operate.

This follower status isn’t inherently problematic. Markets excel at processing information and coordinating expectations. The danger lies in maintaining the illusion of active policy whilst passively rubber-stamping market outcomes. Every quarter-point debate at the FOMC perpetuates this charade, wasting credibility on decisions that markets have already made.

When nominal expectations drive outcomes and policy rates follow, the path forward requires embracing market-based nominal targeting with the credibility that shapes those very expectations. As I’ve long argued, effective monetary policy works through nominal expectations, not mechanical rate adjustments.

This VAR analysis confirms that even the Fed’s primary tool has become subordinate to the market forces it once commanded.

The emperor has no clothes. It’s time we designed monetary institutions that acknowledge this reality.

Postscript: When Fiscal Dominance Destroys Market-Based Nominal Targeting

The VAR analysis reveals that markets now effectively coordinate nominal expectations, with the Fed merely following.

This could be benign – markets are rather good at implicit NGDP targeting. But as I’ve warned in my latest post “The Fiscal Dominance Trap,” we’re approaching the point where this market leadership transforms from feature to catastrophic bug.

The unpleasant monetarist arithmetic is brutal: with US federal debt at 119% of GDP, each percentage point rise in rates adds $350 billion to annual interest costs. The fiscal dominance threshold – where raising rates to fight inflation becomes self-defeating – sits around 7-8%. Above this level, higher rates create larger deficits, more debt issuance, higher term premiums, and an explosive feedback loop that no amount of Fed credibility can break.

We’re witnessing the Carter-Burns-Miller nightmare in real time, but with constraints that make the 1970s look like a monetary picnic. When Carter pushed out Burns for Miller in 1977, federal debt was 35% of GDP. Volcker could take rates to 20% because the fiscal arithmetic still worked. Today, with debt at 119% of GDP, the Volcker solution is mathematically impossible.

The terrifying irony is that just as markets have learned to coordinate nominal expectations efficiently, fiscal dominance threatens to turn this virtue into catastrophe.

When velocity accelerates – as it did 4% within months of Miller’s appointment in 1978 – markets will still lead, but they’ll be leading us into an inflationary spiral. The Fed will still follow, but it will be following markets as they price in fiscal insolvency.

The window for avoiding this fate is maybe measured in months, not years. Either we achieve fiscal adjustment of 5-6% of GDP – politically impossible in any democracy – or we learn that even the most sophisticated market-driven monetary arrangements cannot overcome basic arithmetic. When governments spend beyond their means indefinitely, something must give. What gives is always the currency, and this time, there’s no Volcker waiting in the wings to save us.

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Hodrick, R.J. and Prescott, E.C. (1997). “Postwar U.S. Business Cycles: An Empirical Investigation.” Journal of Money, Credit and Banking 29(1): 1-16.

Sims, C.A. (1980). “Macroeconomics and Reality.” Econometrica 48(1): 1-48.

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