The Stage is Set: Familiar Playbook, Different Starting Point

As President-elect Trump prepares for his second term, we are entering a period that bears striking similarities to 2016, but with crucial differences.

Back then, I wrote about how Trump’s fiscal expansion plans, combined with the Federal Reserve’s willingness to tolerate higher inflation, created a unique alignment of fiscal and monetary policy. Markets reflected this dynamic, with rising inflation expectations and strong equity performance. See here and here.

Now, the stage appears set for a repeat performance—or at least a variation on the theme. Trump’s vocal opposition to debt ceiling constraints (see his post on ‘Truth Social’ from yesterday below) suggests that fiscal policy will again tilt towards expansion.

While details remain unclear, tax cuts and a push for deregulation seem likely to feature prominently (and higher tariffs). This aligns with the fiscal playbook of Trump’s first term, though the environment today is much less forgiving.

The Fed’s New Context

Yesterday, the Federal Reserve cut rates by 25 basis points, bringing the federal funds rate to 4.25-4.5%. However, their projections for 2025 signal a more restrained approach, with fewer rate cuts than previously anticipated.

Inflation remains above target, and Powell’s Fed is keenly focused on maintaining its credibility. This stands in stark contrast to the Fed of 2016, which welcomed fiscal stimulus as a way to lift inflation closer to its target.

This is clearly illustrated in the graph below – back in 2016 inflation expectations were well-below the Fed’s 2% inflation target. Today, we are closer to 2.5% inflation – hence slightly above the inflation target.

The Bond Market Speaks

The bond market is already reflecting this tension. The 10-year Treasury yield yesterday rose to 4.5%, but inflation expectations have remained largely flat.

This suggests that markets believe any inflationary impulse from fiscal policy will be neutralised by the Fed’s actions. Rising real yields, rather than nominal ones, are driving this dynamic—a clear sign that monetary policy will act as a counterweight to fiscal expansion.

Why 2024-25 Is Not 2016

In 2016, fiscal and monetary policies worked in tandem to boost below-target inflation and support nominal growth. Today, however, we begin from a situation with elevated inflation and higher rates. This changes the entire framework for how fiscal and monetary policies interact.

As Trump’s fiscal plans become clearer, the interplay between fiscal ambitions and the Fed’s inflation mandate will define the economic landscape. The market reaction so far underscores the limits of fiscal policy in a world where monetary vigilance remains paramount.

The Fed’s Balancing Act

The Federal Reserve’s rate cut yesterday, bringing the federal funds rate to 4.25-4.5%, underscores the central bank’s cautious approach to managing a challenging environment.

Unlike in 2016, when fiscal expansion and monetary accommodation worked in harmony, the Fed now faces a very different scenario. Inflation remains above target, and Powell’s primary focus is to ensure price stability while carefully navigating the pressures of fiscal expansion.

What’s particularly striking is the Fed’s revised outlook for 2025. By reducing projected rate cuts from four to two, the Fed has sent a clear signal that its easing cycle will be far more constrained than markets might have anticipated.

This adjustment reflects hard-learned lessons about inflation dynamics and suggests a central bank unwilling to repeat the mistakes of the 1970s, when monetary policy succumbed to fiscal pressures.

The Shadow of Fiscal Expansion

The potential for further fiscal expansion under President-elect Trump (or at least lack of fiscal consolidation) adds another layer of complexity. Trump’s remarks about the debt ceiling and his administration’s likely push for tax cuts signal a return to fiscal looseness. However, the Fed’s stance indicates it will not allow these policies to undermine its inflation-fighting credibility.

This reflects the essence of the so-called Sumner Critique: fiscal policy cannot sustainably drive aggregate demand if the central bank is committed to its nominal target. Powell’s Fed, by maintaining its focus on inflation stability, is ensuring that fiscal expansion under Trump will be met with monetary discipline.

Unlike in Trump’s first term, the Fed’s monetary stance is now operating from a position of relative high and maybe even rsing real rates. This means then Fed must walk a fine line, easing just enough to support the economy while ensuring that fiscal-driven inflation pressures remain firmly under control.

Markets Anticipate Monetary Restraint

The bond market’s reaction confirms this interpretation. While 10-year yields surged yesterday, inflation expectations have remained flat. This stability signals that investors trust Powell to counteract any inflationary impulses from fiscal policy. Instead, the rise in real yields is driving tighter financial conditions, adding downward pressure on equity markets.

The Fed’s Independence on Trial

The current environment places Jerome Powell’s leadership in sharp relief. The Fed’s independence has long been tested by political pressures, from Nixon’s influence on Arthur Burns in the 1970s to Trump’s public critiques during his first term. Powell’s cautious stance suggests he is determined to avoid the mistakes of the past, prioritising the Fed’s credibility even as fiscal ambitions grow.

As fiscal plans take shape, the Fed’s ability to manage this delicate balance will be crucial. Markets are already pricing in a central bank that is prepared to stand firm—a dynamic that will shape the interplay between monetary and fiscal policy in the months ahead.

Equity Markets Adjust to Real Yields

The rise in real yields has also filtered through to equity markets, contributing to the broad sell-off. Higher real yields increase the discount rate applied to future corporate earnings, reducing valuations and driving stocks lower.

Following the revised Federal Reserve outlook, the Dow Jones Industrial Average plummeted 1,123.03 points, or 2.58%, to close at 42,326.87. This marked the index’s 10th consecutive day of decline, its longest losing streak since 1974, and set it on course for its worst weekly performance since March 2023.

Meanwhile, the S&P 500 dropped 2.95% to 5,872.16, and the Nasdaq Composite sank 3.56% to 19,392.69, with losses in the tech-heavy index accelerating toward the end of the trading session.

Both the Dow and the S&P 500 recorded their largest single-day declines since August, a period marked by market turbulence triggered by the unwinding of the yen carry trade.

The Fed’s Path Forward

Markets are now pricing in a scenario where fiscal expansion will face firm limits imposed by monetary policy.

Over the past month, there has been a significant shift in market expectations for interest rate movements in 2025, as reflected in the CME FedWatch Tool (see below).

While the market previously anticipated deeper rate cuts below the 375-400 basis point range, expectations have now become more restrained. The dominant probability now centers around the 400-425 basis point range, signaling a forecast of gradual and moderate easing rather than aggressive rate cuts.

This shift aligns with FOMC statement, which highlighted solid economic growth and continued, albeit slow, progress toward the 2% inflation target.

Although inflationary pressures are easing and the labor market is showing some signs of cooling, the Fed emphasized ongoing economic uncertainty, limiting the likelihood of swift and substantial easing. As a result, the market has adjusted its outlook, anticipating a more cautious approach from the Fed, driven by data and balanced risk assessments.

Bessent’s “3-3-3” Framework Faces Reality

The nomination of Scott Bessent as Treasury Secretary adds a twist to this equation.

His “3-3-3” framework—targeting 3% growth, a 3% deficit, and increased oil production—presents a vision of fiscal responsibility that conflicts with Trump’s clear preference for aggressive fiscal measures.

Markets are already questioning the credibility of Bessent’s framework, particularly in light of Trump’s dismissive comments about debt ceilings.

This tension between the Treasury’s stated goals and Trump’s fiscal instincts further complicates the policy landscape. The Fed, however, remains the ultimate arbiter of aggregate demand, and Powell’s cautious stance ensures that any fiscal expansion will face meaningful limits.

Lessons from Historical Misalignments

The parallels to historical episodes of fiscal-monetary misalignment are clear. The Bundesbank’s reaction to German reunification in the early 1990s provides a particularly relevant example. Faced with massive fiscal expansion, the Bundesbank tightened monetary policy aggressively to maintain price stability, even at the cost of a sharp economic slowdown. See more on this here.

Today, Powell’s Fed faces a similarly challenging environment, though its tools differ. Instead of raising rates aggressively, Powell may demonstrate monetary restraint through a slower-than-expected pace of rate cuts.

The Political Tensions of Fiscal and Monetary Policy

The dynamics between fiscal and monetary policy are not just economic; they are inherently political.

President-elect Trump’s fiscal ambitions, as evidenced by his dismissive remarks about debt ceilings and focus on tax cuts, could bring renewed political pressure on the Federal Reserve.

This recalls the 1970s, when President Nixon famously pressured Fed Chair Arthur Burns to loosen monetary policy to support his fiscal agenda—a decision that ultimately undermined inflation control and the Fed’s credibility. I have written about the this unfortunate episode in US monetary policy before – see here.

Jerome Powell, however, appears determined to avoid such pitfalls. His leadership of the Fed has consistently emphasised independence and a commitment to price stability.

Powell’s resolve surely will be tested, but his actions so far indicate that he is unlikely to repeat the mistakes of the past, but that might ultimately end in a major confrontation with the Trump administration.

Trump’s populist Keynesianism will test the Fed’s independence, while Powell’s cautious approach will likely frustrate those expecting rapid monetary accommodation.

This emerging dynamic highlights the fundamental constraint on fiscal policy: the central bank’s commitment to price stability. As in the past, monetary policy will dominate fiscal outcomes, ensuring that any fiscal expansion operates within the boundaries set by the Fed.

Trump will only win the battle against Powell’s commitment to price stability is Powell is replaced by a Arthur Burns type central bankers. Lets not hope it comes to that.

The Sumner Critique in Practice

The unfolding situation serves as a real-world demonstration of the Sumner Critique. Fiscal policy, however ambitious, cannot sustainably boost aggregate demand if the central bank is committed to its nominal target. Powell’s cautious approach, coupled with the Fed’s measured pace of rate cuts, ensures that fiscal expansion will not lead to runaway inflation or unanchored expectations.

The Bottom Line

The months ahead will provide a critical test of the balance between fiscal ambitions and monetary discipline. The Fed’s cautious approach, combined with the market’s clear signals, reinforces the limits of fiscal policy in a world of vigilant monetary oversight.

As I have long argued, monetary policy ultimately dominates fiscal policy in determining nominal outcomes. Powell’s Fed seems prepared to uphold this principle, ensuring that monetary credibility remains intact even in the face of aggressive fiscal measures. The market reaction so far tells us the story: fiscal policy will not run unchecked, and the Fed will remain the anchor of nominal stability.

Note: The illustration above was created with fal.ai/FLUX.

PS: I want to acknowledge that my use of the term “Keynesian” here may not align with how serious (New) Keynesians would define their approach. In this context, I use “Keynesian” to describe the type of demand management policies that proved problematic in the 1970s. While these policies were inspired by Keynesian economic thought and can be labeled as such, this does not imply that modern Keynesians would necessarily endorse or agree with these strategies. I might also have used the term vulgar supply side economics.

———————

If you want to know more about my work on AI and data, then have a look at the website of PAICE — the AI and data consultancy I have co-founded.

Yesterday, Donald Trump shared a rather remarkable post on “Truth Social” about his meeting with the International Longshoremen’s Association, where he strongly criticised automation at American ports.

The message reveals Trump’s economic thinking as fundamentally aligned with that of a 1970s New York union leader: opposing immigration, free trade, and now technological advancement.

This is not a growth agenda – it is basically militant socialist thinking.

Trump’s open stance against automation is entirely consistent with his broader economic philosophy. AI and robots serve the same economic function as free trade and immigration – they enhance productivity and competition.

This is precisely why economists generally champion immigration, free trade, and technological progress. Trump, however, appears to oppose all three.

The logic follows that Trump must oppose AI in general terms. After all, if automation is to be restricted in American ports, where exactly should it be permitted?

This in my view presents a significant risk to US stock markets and should Trump continue down this fundamental anti-growth path, it must eventually have rather negative implications for growth and earnings expectations.

It would be prudent to monitor Trump’s future statements regarding AI carefully. While he may be hanging out with Elon Musk, Trump secured power by appealing to American working-class voters who fear competition from immigrants and imported goods. Given this context, it seems entirely natural that he might eventually launch a fundamental attack on AI.

Indeed, Trump’s economic thinking appears in many ways closer to Bernie Sanders than Ronald Reagan and his latest statement demonstrates a clear preference for protectionist policies over market-driven innovation, further confirming a significant departure from traditional Republican free-market principles.

The profound irony is that while Trump claims to put “AMERICA FIRST”, his opposition to automation and technological advancement could ultimately leave American ports – and by extension, the broader American economy – at a competitive disadvantage in the global marketplace.

So, if stock markets tank, you know who to blame.

Note: Cartoon created with FLUX/fal.ai

Today, the Russian ruble has weakened significantly – 7-8% against the euro and dollar. This is quite substantial – even for an Emerging Markets currency.

I am generally very sceptical about shouting “collapse” every time economic news (often just rumours) comes out of Russia, and I would also emphasise that the ruble market is virtually non-existent.

Or rather, you cannot call your normal bank anywhere in the Western world and ask to buy or sell rubles. At the same time, there are, in practice, very significant restrictions on Russian companies’ and citizens’ ability to buy and sell rubles in the market.

For the same reason, it would be wrong to overestimate most movements we see in the ruble. However, at this precise moment, I don’t think we can ignore this movement.

The graph below shows the movement in USD/RUB over the past five years. When the curve rises, the number of rubles you can buy for a dollar increases. In other words, an increase is a weakening of the ruble.

If you zoom in a bit, you’ll see that the weakening of the ruble began (this time) around August, but the weakening really took hold around 21 November.

And on precisely 21 November, the US Treasury announced new sanctions against Russia focusing on Gazprom and the energy sector.

The sanctions hit Gazprombank with financial restrictions and asset freezes, limiting the bank’s transactions and Gazprom’s revenues.

Additionally, over 50 Russian financial institutions, energy companies and defence producers are affected by restrictions, while sanctions against officials and oligarchs include travel bans and asset freezes to increase pressure on the Kremlin.

Having said that, the Russian ruble – given the extensive capital and currency restrictions – doesn’t “just” automatically weaken.

This is by no means a freely floating currency. So in that sense, there is to some extent a “deliberate” devaluation of the ruble by the Russian authorities.

But it’s probably also a choice that couldn’t have been different, and in a time of clearly rising Russian inflation, a weakening of the ruble is hardly something that delights the broader Russian population.

‘Butter crisis widens’

And if you’ve been following news from Russia lately, there has been quite a focus on food prices in particular rising sharply recently – and in the Russian media, there have been plenty of stories about supermarkets around Russia starting to put locks on refrigerated displays because the extent of “butter theft” has increased dramatically.

These problems should furthermore be seen in light of the fact that Russia is militarily challenged. There are reports of very high Russian casualty numbers – particularly in the Kursk area, where Ukraine has occupied part of the Kursk region since summer, and where North Korean troops have apparently most recently been deployed in the fighting.

None of this strengthens Putin – and I particularly believe that the sharply rising food prices (and they will now rise further) will increase dissatisfaction with the situation.

But the question is as always – who will get the blame? Putin or the evil Americans and Europeans? Finally, I should warn against concluding that Putin is about to be overthrown any time soon.

We simply don’t know, but we can say that regarding Putin’s ability to finance his war of aggression, there are fewer and fewer means to do so day by day.

* Cartoon created with fal.ai/FLUX

I had an interesting exchange on Bluesky yesterday sparked by Scott Bessent’s recent comments on tariffs and inflation.

It started with Leslie Ehrlich sharing a story about a cab driver in Indianapolis who in the 1980s said something quite profound: “Inflation is a money problem. Do away with money and you’ll do away with inflation.”

The cabbie was exactly right – echoing what I wrote in a blog post last year about inflation being a monetary phenomenon (see here)

In fact, both the cabbie’s insight and Bessent’s recent comments touch on key aspects of what I discussed in that post, though Bessent’s analysis is incomplete.

In a radio interview with Larry Kudlow, Bessent stated that “tariffs can’t be inflationary because if the price of one thing goes up — unless you give people more money — then they have less money to spend on other thing, so there is no inflation.”

Let’s use the equation of exchange MV=PY (where M is the money supply, V is velocity, P is the price level, and Y is real GDP) to understand where Bessent is both right and wrong – just as I did in analyzing the general case in my earlier post. We can rearrange this as P=MV/Y.

The Part Bessent Gets Right

If we assume constant nominal spending (MV) AND unchanged real GDP (Y), then Bessent makes a valid point – tariffs would indeed only affect relative prices. When one price goes up, other prices must come down to maintain the same overall price level (given by MV and Y).

We can illustrate this with a simple two-good economy. The equation of exchange becomes:

M•V = Pa•Ya + Pb•Yb

In a barter economy (where M=0), this reduces to:

0 = Pa•Ya + Pb•Yb
Pa•Ya = -Pb•Yb

This shows that in a barter economy, if the price of good A rises relative to good B, the price of good B must fall relative to good A. We can only have relative price changes, not inflation. Here, prices are merely exchange ratios rather than monetary prices. This is similar to what happens in an economy with constant MV (and a constant Y).

The Part Bessent Misses

However, tariffs also create a negative supply shock that reduces Y (real GDP). Looking at our equation P=MV/Y, we can clearly see that for a given level of MV, any reduction in Y must mathematically result in a higher price level (P).

This is the crucial part that Bessent overlooks – even if relative prices adjust as he suggests, the overall price level will still rise due to the reduction in real GDP caused by the tariffs, for a given nominal income (MV).

The Monetary Policy Dimension

But here’s the key point for monetary policy: whether this initial price level increase turns into sustained inflation depends entirely on the central bank’s response. As I noted on Bluesky, this effect “will not continue forever if the Fed reduces M or the growth rate of M.”

If the central bank maintains a strict inflation target, it would need to reduce M to offset the negative impact of lower Y on P. However, this might not be the optimal policy response during a negative supply shock.

The Broader Lesson

This analysis demonstrates why we must always think about inflation in monetary terms.

While supply shocks like tariffs can affect the price level through their impact on real GDP, sustained inflation is always and everywhere a monetary phenomenon – it requires accommodation from the central bank.

Understanding these mechanisms – how supply shocks affect both relative prices and the price level, and how monetary policy determines whether price level changes become sustained inflation – is crucial for sound economic policy. Bessent’s analysis captures an important piece of the puzzle but misses the crucial supply-side channel through which tariffs affect prices.

A Final Note on Policy Framework – and a Warning About Protectionism

Given that President-elect Trump’s administration seems determined to pursue destructive protectionist policies – with promises of across-the-board tariffs that would significantly harm American consumers and businesses (not to mention the global economy) – it becomes even more crucial that we get the monetary policy framework right.

The negative supply-side effects of such protectionist policies would be substantial. Tariffs don’t just change relative prices – they reduce productive capacity, distort international trade patterns, and lower real GDP.

This is Economics 101, and I am quite certain that Bessent understands these effects perfectly well. His partial analysis of tariffs and inflation likely reflects political constraints rather than economic confusion – after all, it wouldn’t be wise for a Treasury Secretary nominee to publicly challenge the president-elect’s core economic agenda.

In this environment, it would be far better if the Federal Reserve operated under a nominal GDP level target rather than an inflation target. This would allow the Fed to better handle the supply shocks that inevitably come with protectionist policies, avoiding the need to tighten monetary policy in response to negative supply shocks that reduce real GDP. While NGDP targeting wouldn’t prevent the real economic damage from protectionist policies, it would at least ensure that monetary policy doesn’t amplify the negative effects.

Bessent’s politically cautious analysis of tariffs and inflation is understandable given his prospective role as Treasury Secretary. While he publicly focuses on the relative price mechanism, I suspect he privately understands the full economic costs of the protectionist agenda he would be asked to implement. Let’s hope his market experience and economic knowledge will help moderate some of the more destructive protectionist impulses of the incoming administration.

The Decade-Long Warning Signs

For more than a decade, I have consistently argued that China’s economic model is fundamentally unsustainable. This perspective, which I first articulated publicly in my August 2014 blog post titled “China might NEVER become the biggest economy in the world,” has proven increasingly prescient as we watch China’s structural weaknesses manifest in real-time. The roots of China’s current challenges can be traced back to a pivotal moment in 2006 when China’s workforce peaked and began its subsequent decline. While this demographic turning point wasn’t immediately apparent in the growth figures, it marked the beginning of a fundamental shift in China’s economic trajectory that would have far-reaching implications for the country’s future development.

The Marxist Foundation of Chinese Economic Thinking

What makes China’s situation particularly fascinating is that its economic thinking remains fundamentally Marxist. This isn’t merely a political observation – it has profound implications for how the Chinese leadership approaches economic challenges. In the Marxist view, wealth creation is primarily driven by capital accumulation. This mindset has led Chinese authorities to respond to any growth slowdown with more investment, particularly in housing and infrastructure, creating a self-reinforcing cycle of diminishing returns.

The results of this approach have been striking. China’s investment rate has reached approximately 40% of GDP, a level that is two to three times higher than what would be normal for a country in a developmental catch-up phase. When we compare China with other emerging markets like Brazil or South Africa, the scale of overinvestment becomes starkly apparent, revealing a fundamental imbalance in the country’s economic structure.

The Growth Slowdown Reality

The consequences of this model are now becoming increasingly evident. From trend growth rates of 14-15% in the mid-2000s, we’ve seen a steady decline to 4-5% in recent years, with periods of zero or negative growth. This isn’t merely a cyclical downturn – it represents a structural break in China’s growth model that signals a fundamental transformation in the country’s economic trajectory.

The reliability of Chinese economic data has become an increasingly important consideration in analyzing these trends. While there have always been questions about Chinese statistics, I believe we could generally trust the growth figures until about ten years ago. Having worked with emerging markets data for many years, I’ve learned to cross-reference official statistics with other indicators like electricity consumption, car sales, and transportation data. However, in recent years, the reliability of Chinese data has become increasingly questionable, making it harder to assess the true state of the economy.

The End of An Era

What we’re witnessing isn’t just a temporary slowdown but the end of China’s catch-up growth phase. This transition is particularly challenging because, unlike Japan or South Korea at similar stages of development, China lacks the institutional framework and market mechanisms to manage this transition effectively. The implications of this structural slowdown are profound, not just for China but for the global economy.

In many ways, this situation reminds me of Japan in the late 1980s, when many predicted it would become the world’s largest economy. However, China’s case is more concerning because of its political system and the way its leadership responds to economic challenges. While China may continue to grow, the era of double-digit growth rates is definitively over, and the transition to a more sustainable economic model will be far more challenging than many observers anticipate.

As we look to the future, it’s becoming increasingly clear that China’s economic challenges are intertwined with its political structure and leadership decisions. The next phase of China’s economic development will be marked by slower growth, increasing domestic challenges, and potentially significant global ramifications. These developments warrant careful attention from economists, policymakers, and business leaders worldwide, as they will likely shape global economic dynamics for decades to come.

The Fundamental Market Contradiction

At the heart of China’s economic challenges lies a critical weakness in how capital is allocated throughout the economy. While China has embraced market principles in many areas, allowing prices to be set by market forces in retail and many industries, the financial sector remains heavily regulated and controlled. This partial liberalization creates a fundamental contradiction in the Chinese economy that undermines its long-term stability and growth prospects.

The State-Controlled Financial System

China’s banking system operates fundamentally differently from those in market economies. State-controlled banks, both at the national and provincial levels, dominate lending decisions. These decisions aren’t made based on market principles but rather follow what I would characterize as Marxist capital allocation principles, where political directives often override economic considerations. The result is a financial system that consistently misallocates resources, directing capital toward state-favored projects rather than their most productive uses.

The Property Market Dilemma

The average Chinese household faces severely restricted investment options, creating a dangerous overreliance on real estate investment. Without a well-developed capital market or private pension system, property has become the default investment vehicle for most Chinese citizens. This has created a situation where household wealth is disproportionately tied to property values, making the entire economy vulnerable to real estate market fluctuations. The government’s attempts to manage this situation through various stimulus measures have only served to delay and potentially exacerbate the underlying problems.

Provincial Financial Stress

A particularly concerning aspect of this system is the growing financial stress at the provincial level. While the central government maintains relatively sound finances, regional governments face significant financial difficulties. This is partly because local banks, which are often semi-state-controlled or state-supported, are struggling with deteriorating asset quality. The recent attempts by the central government to prop up these local institutions through various stimulus measures highlight the severity of the problem while failing to address its root causes.

The Singapore Contrast

When considering alternative paths for China’s development, Singapore provides an interesting contrast. While Singapore maintains significant state control, it has developed sophisticated financial markets and allows for relatively free flow of capital and information. This has enabled Singapore to achieve remarkable economic success while maintaining political stability. Xi Jinping could have chosen this path for China, but has instead moved in the opposite direction, tightening control over both the financial system and information flows.

The Reform Paralysis

The challenges in China’s capital allocation system are deeply intertwined with political considerations. Effective market-based capital allocation requires free flow of information, open discussion, and debate about economic policies and their effects. However, this level of openness could lead to questioning of government policies and leadership, something the current regime seems unwilling to risk. The declining influence of the reform-oriented “Shanghai clique” within the Chinese Communist Party symbolizes this broader retreat from market-oriented reforms.

The implications of these capital allocation problems extend far beyond China’s borders. Foreign direct investment, which played a crucial role in China’s development, is declining as international companies reassess their exposure to Chinese markets. This isn’t just about economics – it’s increasingly about geopolitical risk assessment and the recognition that China’s financial system may be fundamentally incompatible with global market integration.

Without significant reforms to how capital is allocated and managed, it’s difficult to see how China can maintain sustainable economic growth. However, such reforms would require fundamental changes to China’s political system, as efficient capital allocation ultimately requires transparency, rule of law, and free flow of information – elements that seem increasingly at odds with the current leadership’s direction.

The Japanese Echo

China is increasingly facing a deflation problem that bears striking similarities to Japan’s experience in the 1990s. However, there’s a crucial difference that makes China’s situation potentially more dangerous: while Japan was and remains a robust democracy with established institutions capable of managing long-term economic challenges, China’s political system makes addressing these issues significantly more complex. The implications of this structural difference cannot be overstated when considering potential solutions to China’s deflation problem.

Currency Management and Its Consequences

For many years, China maintained a fixed exchange rate against the dollar. While they moved away from this strict peg about a decade ago, the exact nature of their current currency regime remains deliberately opaque. What’s clear is that Chinese authorities remain extremely reluctant to allow significant currency weakness. This ‘fear of floating’ has created a fundamental problem: when an economy’s trend growth rate declines, its currency typically needs to weaken to reflect this new reality. By preventing this natural adjustment, Chinese authorities have effectively chosen the path of internal devaluation, leading to deflation.

The Self-Reinforcing Deflationary Cycle

The deflationary pressure in China has created a dangerous cycle that becomes increasingly difficult to break. As prices fall, it becomes harder for borrowers to service their debt, since their nominal incomes decline while debt obligations remain fixed. This leads to reduced consumer spending and difficulties in real estate debt servicing, which in turn creates stress in the financial sector and generates further downward pressure on prices. The situation is evidenced by China’s money supply growth, which has turned negative in the past year and a half – a concerning indicator that historically precedes sustained deflation.

The Political Constraints on Economic Solutions

Chinese authorities have attempted to address these issues through various stimulus measures, but these increasingly resemble Japan’s ineffective efforts of the 1990s. The fundamental problem remains: they’re unwilling to address the core issue of currency valuation. This reluctance isn’t purely economic – it’s deeply political. A weaker currency would signal to the Chinese population that something is fundamentally wrong with the economy. Given that the Communist Party’s legitimacy is heavily tied to economic performance, this presents an unacceptable political risk.

The Regional Government Crisis

The deflationary environment is particularly challenging for China’s regional governments and their banking systems. While the central government maintains relatively healthy finances, provincial governments face severe financial stress, complicated by their reliance on struggling local banks. This creates a complex web of financial interdependencies that makes addressing the deflation problem even more challenging, as any solution must consider the potential impact on already-stressed local government finances.

Global Implications and Future Prospects

The way China handles this deflation challenge will likely determine not just its economic future but also its political stability and role in the global order. A sustainable solution would require significant reforms, including greater currency flexibility, development of domestic capital markets, reduced reliance on property investment, and more transparent monetary policy. However, such reforms would necessarily involve some short-term pain and uncertainty, which the current leadership appears unwilling to accept.

Without addressing the underlying currency and monetary policy issues, China risks entering a prolonged period of economic stagnation similar to Japan’s “lost decades.” However, unlike Japan, China’s political system makes it much more difficult to maintain social stability during such a prolonged downturn. The combination of deflation, debt, and demographic decline creates a challenging environment that will test the resilience of China’s economic and political model in the years ahead.

The Transformation Under Xi

One of the most profound developments of the past decade has been how China’s economic challenges have become intertwined with increasingly assertive geopolitical ambitions under Xi Jinping’s leadership. The Chinese Communist Party has traditionally maintained a system of collective leadership that, while certainly not democratic, provided some internal checks and balances through different factions representing varying viewpoints. Xi Jinping has effectively dismantled this system, concentrating power in ways that make addressing economic challenges significantly more difficult.

The Economics of Authoritarianism

Through my recent work with Professor Mikkel Vedby Rasmussen on geopolitical simulation models using machine learning, we’ve identified a concerning pattern in authoritarian regimes facing economic slowdown. When confronted with declining trend growth, these regimes typically face two choices: liberalize and give up some control, or become more repressive and controlling. Xi Jinping has clearly chosen the latter path, leading to increased internal repression and external assertiveness. This choice has profound implications for both China’s domestic development and its relationship with the global community.

The Military Response

China’s response to these challenges has included a dramatic military expansion, particularly in naval capabilities. Over the past 15 years, China has built the world’s second-largest navy, a remarkable shift from just a decade ago when its fleet was smaller than Britain’s. This military build-up cannot be separated from the economic challenges the country faces. It represents both a response to internal pressures and a potential source of future conflict, particularly regarding Taiwan and maritime territorial disputes.

The Historical Parallel

The situation bears some concerning parallels to Nazi Germany’s economic model in the 1930s. While this comparison might seem extreme, there are troubling similarities in economic structure: both featured heavily subsidized exports, high investment rates, suppressed domestic consumption, and ultimately, the need for external expansion to maintain the economic model. The key difference is that China’s global economic integration and technological capabilities make its trajectory even more consequential for the world economy.

The Information Vacuum

Perhaps most concerning is what I call the “Emperor’s New Clothes” effect. As regimes become more authoritarian, they increasingly cut themselves off from accurate information. When leaders surround themselves only with yes-men, they lose touch with reality and may make catastrophic miscalculations. This dynamic was evident in Putin’s miscalculation regarding Ukraine, and similar risks exist in China’s case, particularly regarding Taiwan and other regional issues.

The Global Technology Stakes

Unlike regional conflicts in the Middle East, which have limited global economic impact today, any conflict involving Taiwan would have devastating consequences for the global economy, particularly given Taiwan’s crucial role in semiconductor production. This makes the geopolitical risks associated with China’s trajectory fundamentally different from other regional tensions, with potential impacts that could reshape the global economic order.

The American Strategic Shift

While Donald Trump’s rhetoric on China may be controversial, the underlying concern about China’s trajectory is shared across the U.S. political spectrum. The focus of U.S. security concerns has shifted decisively from Russia to China, reflecting a realistic assessment of relative threats. This strategic reorientation suggests that regardless of who holds power in Washington, the trajectory of U.S.-China relations is unlikely to return to the more cooperative model of previous decades.

The combination of economic challenges, information control, and military buildup creates significant risks that the international community must prepare for while still seeking ways to encourage positive change. The next decade will likely determine whether China can find a path toward sustainable development or whether increasing tensions lead to more serious confrontation.

The Current Crossroads

We find ourselves at a crucial moment in China’s development trajectory. The combination of structural economic challenges, demographic decline, and increasing authoritarianism under Xi Jinping’s leadership has created a situation where the old model of development is no longer sustainable, yet the path forward remains unclear. The decisions made in the coming years will have profound implications not just for China but for the global economic order.

The Internal Party Reality

Understanding the dynamics within the Chinese Communist Party has become increasingly difficult as Xi Jinping has consolidated power. While we know there’s a “Shanghai clique” that traditionally represented a more reform-oriented approach, their influence has been significantly diminished. However, this doesn’t necessarily mean that reform forces are entirely absent within the system. The challenge lies in understanding how these internal dynamics might influence China’s future trajectory, particularly as economic pressures mount.

The Singapore Alternative

One potential path forward would be following something akin to the Singapore model, maintaining political control while allowing greater economic liberalization. Singapore has demonstrated that it’s possible to maintain a relatively authoritarian political system while fostering a sophisticated market economy. However, this would require a significant shift in current Chinese policy, including loosening control over information flows and allowing more market-based decision making – steps that seem increasingly unlikely under current leadership.

The Military Question

As Professor Mikkel Vedby Rasmussen has noted, the possibility of military intervention in Chinese politics might be higher than many realize. This adds another layer of uncertainty to future scenarios. The military has traditionally been a pillar of Communist Party rule, but as economic challenges mount and different power centers within the system compete for influence, its role could evolve in unpredictable ways.

The Technology Battleground

China’s ability to maintain technological advancement while potentially facing increased restrictions from Western countries will be crucial to its future development. The semiconductor industry and artificial intelligence development represent critical battlegrounds in this regard. China’s push for technological self-sufficiency faces significant obstacles, particularly as Western countries become more restrictive about technology transfers and supply chain integration.

The Provincial Challenge

A crucial factor in any future scenario is the relationship between central and provincial governments. The financial stress at the provincial level, combined with local banking problems, could become a catalyst for broader changes in the system. The central government’s ability to manage these stresses while maintaining social stability will be a critical test of the system’s resilience.

The Global Context

Whatever path China takes will have profound implications for the global economy. The country’s size and integration into world markets mean that its development will affect everything from supply chains to financial markets and geopolitical stability. The international community’s response to China’s challenges, particularly regarding trade and technology access, will play a crucial role in shaping which scenarios become more likely.

The Demographic Reality

Underlying all potential futures is the stark reality of China’s demographic decline. With a rapidly aging population and a workforce that peaked in 2006, any scenario must contend with these fundamental constraints on growth. This demographic challenge adds urgency to the need for economic transformation while simultaneously making that transformation more difficult.

The outcomes of these various uncertainties will shape not just China’s future but the global economic and political landscape for decades to come. While definitive predictions are impossible, understanding these dynamics and their potential interactions is crucial for policymakers and business leaders worldwide as they prepare for an increasingly uncertain future.

Beyond Traditional Analysis

As we conclude this analysis, it’s crucial to understand that our traditional frameworks for understanding China’s development need fundamental revision. The long-held belief that economic development would inevitably lead to liberalization has proven naive. Instead, we’re witnessing a complex interplay between economic challenges and political responses that could reshape the global order in profound ways.

The Western Challenge

The West faces a complex dilemma in dealing with China’s evolving situation. While Trump’s confrontational approach may seem extreme in its rhetoric, the underlying concern about China’s trajectory is well-founded. The U.S. security establishment, regardless of political affiliation, has increasingly identified China as the primary strategic challenge, surpassing Russia in importance. This represents a fundamental shift in global strategic thinking that will likely persist regardless of political changes in Western capitals.

The Taiwan Dilemma

The Taiwan situation represents perhaps the most dangerous flashpoint in the evolving global order. Unlike regional conflicts in the Middle East, which have limited global economic impact, any conflict involving Taiwan would have devastating consequences for the global economy, particularly given its crucial role in semiconductor production. This isn’t merely a military or political issue – it represents a fundamental economic risk that needs to be carefully managed.

The Economic Reality

The trend toward economic decoupling between China and the West appears increasingly inevitable, regardless of near-term political developments. This isn’t simply a matter of policy choice but reflects deeper structural changes in both economies. The underdevelopment of China’s capital markets, combined with its current political trajectory, suggests that financial integration with global markets will remain limited. This has profound implications for global investment flows, currency markets, and international financial stability.

The Future Perspective

While I maintain broad optimism about global economic prospects, China represents a significant risk that cannot be ignored. The combination of structural economic weaknesses, demographic decline, increasing authoritarianism, and military buildup creates a potentially volatile mix that could define global politics and economics for decades to come. The situation demands careful attention from policymakers and business leaders worldwide.

The Historical Context

History suggests that transitions from high-growth, state-directed economies to more sustainable models are inherently challenging. While Japan managed this transition successfully within a democratic framework, China faces this challenge within an increasingly authoritarian system, making the outcome far more uncertain. The path China chooses will have profound implications not just for its own people but for the entire global economic order.

Final Reflections

The situation in China represents one of the most significant economic and geopolitical challenges of our time. While catastrophic outcomes are not inevitable, the risks are substantial and growing. The key question remains whether Chinese leadership can accept the necessary reforms and adjustments to their economic model without perceiving such changes as threats to their political control. Given recent trends, I remain skeptical about this possibility, though pragmatic forces within the system might eventually prevail.

The challenge for the West will be maintaining productive engagement while preparing for potential conflict. This requires a delicate balance between deterrence and cooperation, between protecting strategic interests and maintaining economic ties. How we manage this balance may well determine the course of the 21st century. As economists and policy makers, we must continue to analyze and understand these developments while preparing for a range of possible outcomes. The stakes for global economic stability and international security could not be higher.

Note: This article expands on topics discussed during my interview on the Danish podcast ‘Rig på Viden’. For those interested in hearing our full conversation, you can find the episode here.

Social Networks in Flux – The Shift from X to Bluesky

In recent days, we have witnessed a remarkable migration of users from X (formerly known as Twitter) to Bluesky. This trend is not merely a reaction to Elon Musk’s controversial stewardship of X, but also deeply intertwined with the outcome of the recent US presidential election. The re-election of Donald Trump and Musk’s prominent role in the new administration have sparked widespread debate, further accelerating this exodus.

Bluesky, originally developed as a project during Jack Dorsey’s tenure at Twitter, offers a decentralised social media platform granting users greater control over their data and communities. Within days of the election, millions of new users had joined Bluesky, sparking discussions on whether the platform could genuinely challenge X’s dominance. All indications suggest that this migration is far from over.

As an economist, I find the dynamics of social networks particularly fascinating. Unlike traditional markets, the value of a network depends not only on the quality of its product but also on the number of other users – the phenomenon we term network effects. At the same time, switching costs – the loss of followers, connections, and data – act as a powerful barrier that often locks users into existing networks, even when dissatisfaction sets in.

To explore these dynamics, I have developed a simulation that uses machine learning to model how users choose between two competing social networks. This model sheds light on why a platform like X can maintain stability for an extended period yet remain vulnerable to sudden shifts. In the following sections, I will explain how the model works and what it reveals about the future of social networks.

How Does the Model Work?

To uncover the dynamics of social networks, I’ve created an agent-based simulation where each user is represented by an AI agent.

These agents face a choice between two social networks – Twatter and BlueOcean – and their behaviour is guided by reinforcement learning, specifically Q-learning. This framework allows us to understand how individual decisions and collective patterns can lead to both stability and abrupt transitions.

Reinforcement Learning: Learning Through Experience

In this model, agents learn which platform offers the highest value through feedback from their experiences. This process, known as Q-learning, is a form of reinforcement learning where agents adjust their expectations of each platform’s value over time. Each agent tracks two Q-values – one for Twatter and one for BlueOcean – representing the expected reward of being on each platform.

When an agent selects a platform and receives a reward, the Q-value is updated using the following formula:

Here, α (the learning rate) determines how quickly the agent adjusts its expectations based on new experiences. This process mimics how individuals often choose social networks – by experimenting, evaluating, and adapting over time.

How Rewards Are Calculated

The rewards agents receive depend on three key factors:

1. Network Effects: The value of a platform increases with its user base. The more users on a platform, the greater its value to each agent. To capture this, the model employs an exponential function, amplifying network effects as the platform reaches critical mass.
2. Costs: Platforms impose a fixed cost on users, which could represent subscription fees, time spent, or mental resources.
3. Switching Costs: When an agent switches platforms, they incur a penalty representing the loss of connections, history, and social capital. This penalty grows with the duration of their previous platform use.

The Decision-Making Process

Agents choose a platform based on their Q-values, typically selecting the one with the highest value. However, there’s also a small probability (ε) that they will randomly choose another platform. This ϵ-greedy strategy ensures agents continue to explore new options even after identifying a seemingly optimal platform.

Noise is also introduced to simulate unpredictable factors such as individual preferences or sudden changes in platform features, making the model more realistic and dynamic.

How the Simulation Unfolds

The simulation begins with an equal number of users on Twatter and BlueOcean, with agents randomly choosing a platform. Over time, agents learn which platform provides them with the most value, influenced by network effects, costs, and their own experiences.

At each time step, the model updates:

• Agents’ Q-values based on their experiences.
• The distribution of users between the two platforms.
• How network effects and switching costs impact the platforms’ attractiveness.

In the next section, I will share the results of the simulation and discuss how it reveals the mechanisms behind the stability and sudden collapse of social networks.

What Can We Learn from the Simulation?

The simulation offers profound insights into the mechanisms that govern social network dynamics, highlighting why platforms can enjoy prolonged stability yet experience dramatic shifts. These findings have not only theoretical implications but also practical lessons for established networks seeking to maintain their position or for challengers aiming to break through.

Network Effects: Strength and Vulnerability

One of the simulation’s key insights is how network effects – the increasing value of a platform as more users join – are critical to a social network’s dominance. In the simulation, Twatter maintains its position for over 200 time steps due to its critical mass of users, which makes the platform highly attractive to both existing and new users.

However, the same network effects that create strength also breed vulnerability. Once users begin leaving a platform, the same mechanism works in reverse: each departing user reduces the platform’s value for those who remain. This feedback loop explains why collapses often occur quickly and decisively, as seen in the simulation’s shift from Twatter to BlueOcean around period 300.

Switching Costs: A Double-Edged Sword

Switching costs play a crucial role in retaining users on a dominant platform. Early in the simulation, these costs slow the migration from Twatter, even as some users begin experimenting with BlueOcean. They act as a stabilising force, locking users into the incumbent platform despite frustrations.

However, when the value gap between the two platforms becomes too large, switching costs lose their deterrent effect. Users judge that the benefits of switching outweigh the costs, and once a critical mass begins migrating, the process accelerates.

This explains why dissatisfaction – as we see today with X/Twitter – poses a serious risk, even to a dominant player.

The Role of Randomness in Major Shifts

One of the most intriguing dynamics in the simulation is the role of randomness. Agents do not always act rationally but occasionally experiment with the other platform. These small, seemingly inconsequential experiments can, over time, trigger significant shifts. When some users discover that BlueOcean offers higher value, they set off a cascade that ultimately leads to Twatter’s collapse.

This dynamic mirrors reality: social networks often hinge on influencers, niche communities, or unexpected trends that catalyse larger migrations. Aspiring platforms can capitalise on this by targeting key individuals to ignite these cascades.

Stability and Fragility Go Hand in Hand

A critical takeaway from the simulation is that social networks can remain remarkably stable for long periods yet remain extremely fragile. Twatter dominates for over 200 time steps but loses its position in just a few once the tipping point is reached.

This demonstrates that even the most entrenched platforms cannot afford complacency. Small disruptions – whether user dissatisfaction or a competitor striking at the right moment – can escalate rapidly into seismic shifts.

Applying These Lessons

For established social networks, the solution lies in consistently delivering value to users. Frustrations, poor moderation, or a lack of innovation can erode trust, creating conditions ripe for migration.

Conversely, challengers like BlueOcean can break through by offering a superior experience and minimising switching costs – for instance, by helping users rebuild connections or transfer data from their previous platform.

Experimenting with the Model

An exciting aspect of this model is its interactivity, enabling you to explore the dynamics of social networks yourself.

The model, developed as an artifact in the Large Language Model Claude, uses reinforcement learning to simulate how users choose between Twatter and BlueOcean. You can tweak parameters and observe how changes influence the competition between platforms.

Have a look at the model here.

Explore Real-World Scenarios

The model is a powerful tool for examining real-world shifts in social networks. You can simulate scenarios where dissatisfaction with X leads to migration to Bluesky, or test how a new platform’s innovative features attract influencers and trigger a cascade of migrations.

By experimenting with the model, you can uncover how small changes in user behaviour or platform strategy can drive drastic shifts in social network dynamics.

In conclusion, this model provides a window into the future of social networks, offering a framework to decode the forces shaping their evolution. While social media often appears unpredictable, analyses like this help us understand how seemingly small decisions can lead to significant transformations.

Perhaps Elon Musk should take note.

PS you can find me on both Twitter/X (here) and Bluesky (here).

Picture created with fal.ai/FLUX.

———————

If you want to know more about my work on AI and data, then have a look at the website of PAICE — the AI and data consultancy I have co-founded.

China’s strategy of increasing debt issuance to stimulate the economy mirrors Japan’s reliance on public spending and debt during its “Lost Decade.” In response to a faltering economy, the Japanese government repeatedly increased public investment, hoping to jumpstart growth through infrastructure projects and other short-term measures. While these efforts provided a temporary boost, they ultimately failed to address Japan’s deeper structural issues.

Similarly, China’s response to its current economic slowdown has been to offer more debt to local governments and provide subsidies to low-income households. These measures, however, merely shift financial pressures rather than solve the systemic problems at hand. Much like Japan’s experience, China is seeing diminishing returns on its debt-fuelled investments, particularly in sectors like infrastructure and real estate, where growth has stalled. Rather than boosting productivity or fostering innovation, much of this investment has gone into projects that are no longer generating substantial economic value.

Japan’s public debt soared as the government continued to spend on projects that offered little long-term economic benefit. China is now facing the same dilemma. The over-investment in real estate and large-scale infrastructure projects has created vast areas of underused or unfinished development, a sign of inefficient capital allocation.

These projects might or might not inflate short-term growth figures but do little to contribute to the broader economy’s health. The danger for China is clear: continuing to rely on debt to stimulate growth will only lead to a deeper financial burden, much like what Japan faced when its economic model stopped working.

The Absence of Structural Reforms: Learning from Japan’s Mistakes

Japan’s economic stagnation in the 2000s stemmed from the government’s failure to introduce the structural reforms needed to revitalise its economy. Rather than transitioning to a more sustainable growth model, Japan clung to the same debt-driven, state-supported approach that had once fuelled its rapid growth. As a result, the economy languished, unable to generate meaningful productivity gains or escape deflation.

China now finds itself in a similar position. The Chinese government has repeatedly avoided addressing the core issues in its economic structure, particularly around capital allocation. While China’s production sectors may be privatised, capital allocation remains tightly controlled by the state through local governments, state-owned banks, and heavily regulated financial institutions. This has led to inefficient investments, especially in real estate, and left the country vulnerable to growing financial risks.

Much like Japan’s refusal to reform its financial and industrial sectors, China is resisting the kinds of reforms that could unlock long-term growth. The property market, which is deeply intertwined with local government finances, is now under strain as growth slows and real estate prices decline. But instead of reforming the sector or addressing the role of state-controlled capital in misdirecting investment, the government is simply shifting debt from local governments to the central government. This is a short-term fix that avoids tackling the structural issues head-on—just as Japan avoided deep reforms and paid the price with decades of stagnation.

The Renminbi: China’s Missed Opportunity to Rebalance

In the early 2000s, Japan struggled with deflation and economic stagnation, partly because it was slow to adjust its currency policies. China now faces a similar challenge.

If China is truly moving towards structural stagnation, as many indicators suggest, a logical response would be to allow the renminbi to weaken. However, the Chinese government has resisted such a move, fearing the political and social consequences of admitting that the economy is under pressure. By maintaining an artificially strong currency, China is effectively tightening its monetary policy at a time when it should be loosening it to combat deflationary pressures.

This refusal to let the renminbi adjust naturally mirrors Japan’s earlier hesitance to allow market forces to influence its currency and monetary policy. In Japan’s case, the failure to address deflation aggressively contributed to years of economic stagnation. In China, keeping the renminbi strong only worsens the challenges faced by the domestic economy, particularly in the property sector, where prices are falling, and debt is rising. Without a more flexible approach to its currency, China risks deepening its economic malaise, just as Japan’s failure to act led to a prolonged period of stagnation.

Xi Jinping’s Ideology: The Barrier to Reform, Just as in Japan

Japan’s stagnation was prolonged by the country’s political and bureaucratic resistance to reform. Japan’s leadership, reluctant to give up the old economic model that had once driven its success, clung to outdated policies long after they stopped working. In China, a similar dynamic is playing out under Xi Jinping’s leadership.

Xi’s commitment to state control over the economy, driven by his Marxist and Maoist ideology, is preventing the reforms that are necessary to revitalise China’s growth. While earlier Chinese leaders, such as Deng Xiaoping, embraced economic liberalisation and reform to unleash China’s growth potential, Xi has taken a different path. His administration has been rolling back many of the market-oriented reforms that were introduced in the 1990s and 2000s, instead favouring greater state control over key sectors of the economy.

Much like Japan’s unwillingness to break away from its debt-driven model, Xi’s insistence on maintaining tight control over the economy is limiting China’s ability to adapt to new challenges. The reluctance to reform capital allocation, liberalise financial markets, or allow the renminbi to weaken are all signs of a government more concerned with maintaining control than with fostering economic growth. This ideological resistance to reform is exactly what kept Japan from escaping its own economic stagnation, and China risks a similar fate unless it changes course.

Conclusion: China is Repeating Japan’s Lost Decades

The parallels between China’s current economic situation and Japan’s long period of stagnation are difficult to ignore. Both economies experienced rapid growth followed by a slowdown driven by deep structural issues, and both governments have relied on debt and short-term stimulus to try to restore growth. In Japan, these policies failed to address the root causes of the economic slowdown, leading to decades of weak growth and rising debt. China is now heading down the same path.

Without addressing the structural issues in its economy—particularly around capital allocation, real estate, and currency policy—China risks becoming trapped in a prolonged period of stagnation, much like Japan experienced. President Xi Jinping’s ideological commitment to state control is preventing the kinds of reforms that could set China on a more sustainable growth trajectory.

Unless China breaks free from this pattern and implements meaningful reforms, it will continue to face economic decline and rising financial instability. The lessons from Japan’s Lost Decade are clear, but China’s leadership appears to be repeating the same mistakes.

On Twitter/X, Bob Elliott has been sharing his observations about American consumer behavior. Elliott, a seasoned investor and businessman, points out a paradoxical economic scenario: despite low mortgage rates and increased household wealth, both consumers and businesses are exhibiting remarkable restraint in borrowing and spending.

Elliott noted:

“So far the expansion hasn’t required increased household borrowing to continue, but with rates falling we are now likely to start to see some pent up demand (particularly for houses) start to emerge. Mortgage rates have fallen to their lowest levels in years.”

He further explained:

“Part of the reason why households can be confident about taking on new borrowing is that those with assets have much greater wealth than they did relative to nominal incomes back in the 2000 period. And up considerably from pre-COVID levels.”

Elliott’s analysis leads to an important question: Why aren’t American consumers and businesses taking advantage of these favorable conditions to borrow more?

His insights got me thinking about the Expansionary Fiscal Contraction (EFC) theory, a powerful economic concept that shaped policy thinking during my time as an economist at the Danish Ministry of Economic Affairs in the late 1990s. The theory suggests that fiscal austerity—cutting government spending and reducing deficits—can stimulate economic growth under certain conditions, and this idea was central to Danish policy-making for decades. It contributed significantly to Denmark’s fiscal discipline and economic resilience.

The Danish Model: Fiscal Discipline Drives Growth

Denmark’s experience in the early 1980s serves as a textbook example of EFC in action. Faced with economic challenges like high inflation, unemployment, and public debt, the Danish government implemented a stringent fiscal consolidation program. Under the Schlüter government, Denmark cut government spending, raised taxes, and pegged the krone to the Deutsche Mark to stabilize inflation.

The results were remarkable. Inflation fell, interest rates dropped significantly, and private sector investment surged. Denmark’s current account balance shifted from a deficit into a surplus. While unemployment took some time to respond, it began to steadily decline, leading to sustained economic growth. This period is a prime example of how fiscal responsibility can lead to economic expansion.

The US Scenario: Fiscal Uncertainty Hampering Growth

In contrast, Elliott’s observations about the US economy reveal a different picture. Despite mortgage rates falling significantly, housing demand remains relatively weak. Household wealth has increased substantially in recent years, but this hasn’t translated into higher consumer spending or borrowing, as might typically be expected.

The root cause of this cautious behavior appears to be public debt. With US public debt growing rapidly and continuous deficit spending, uncertainty has been cast over the economy. Rational economic actors, anticipating future tax increases or inflation to address this debt, are understandably holding back. This is a textbook case of Ricardian equivalence, where expansionary fiscal policy is offset by private sector restraint due to fears of future fiscal tightening.

The Case for Immediate Fiscal Consolidation

The solution to this dilemma is straightforward: the US must embark on a path of fiscal consolidation immediately. This isn’t just about balancing the books; it’s about restoring confidence in the economy’s long-term stability. The government must implement substantial spending cuts and reform entitlement programs to ensure their sustainability.

Additionally, the tax code should be simplified to encourage work, saving, and investment. A clear, legislated path for deficit reduction with enforceable targets should be established, ensuring that future fiscal policies maintain discipline.

These measures will undoubtedly face political resistance. However, as Denmark’s experience shows, short-term pain leads to long-term gain. By demonstrating a genuine commitment to fiscal responsibility, the government can restore confidence in the economy’s future.

The Benefits of Fiscal Consolidation

Critics may argue that fiscal tightening will lead to a recession, but the EFC theory, supported by evidence from countries like Denmark, suggests otherwise. When implemented decisively, fiscal consolidation can lead to lower interest rates, which in turn stimulates private investment and boosts confidence in the economic outlook.

In Denmark, fiscal consolidation not only stabilized the economy but also increased international competitiveness, as resources shifted from the public sector to the more efficient private sector. This created a stronger foundation for export growth and economic resilience.

Restoring Confidence in the US Economy

Bob Elliott’s analysis suggests that there is untapped potential for growth in the US economy. Households have significant wealth, and businesses are financially strong. What’s missing is the confidence that the fiscal environment will remain stable in the long term. A credible commitment to fiscal consolidation would address this uncertainty and likely spur the private sector to borrow, invest, and spend more—unlocking the pent-up demand that Elliott identifies, especially in the housing market.

As I speculated in my own tweet, the US may be experiencing a “Ricardian” episode, where consumers and businesses are holding back due to fears of future tax hikes. This suggests that fiscal consolidation could be the key to restoring private sector confidence, just as it was in Denmark in the early 1980s.

Conclusion: Embrace Fiscal Responsibility

The path forward for the US is clear. To unlock the potential for growth that Bob Elliott’s analysis suggests is waiting in the wings, the government must embrace fiscal responsibility. This means making tough choices now to secure a prosperous future.

By learning from Denmark’s successful implementation of EFC principles, the US can create an environment of fiscal stability that encourages private sector activity. Only through a genuine commitment to sustainable public finances can we unleash the full productive potential of the American economy.

The time for half-measures and political compromises is over. The US needs a bold, unapologetic commitment to fiscal discipline. This is not just sound economics; it’s the only responsible course of action for a nation that aspires to long-term prosperity and economic leadership.

AI-Powered Synthesis of Austrian and Chicago ideas

Like many free-market economists, I began my early studies deeply influenced by the Austrian School, but over time I shifted toward the Chicago School, particularly when it comes to microeconomic theory.

These days, I consider myself primarily aligned with Chicago Price Theory on microeconomic matters, while my views on macroeconomics remain firmly in the Monetarist camp as regular followers of this blog should well-know.

That said, I haven’t completely abandoned the Austrian School. I still believe that Austrian economics offers essential insights into how real-world markets function.

Traditional neoclassical theory—especially Chicago Price Theory—excels at explaining equilibrium outcomes but does little to describe how markets actually work in the real world, where information is incomplete and dispersed. This is where the Austrian School, particularly through the works of F. A. Hayek and Israel Kirzner, provides valuable perspective by framing the market as a discovery process.

In this article, I introduce a new approach that I call Agent-Based Experimental Economics (ABEE).

ABEE blends the insights of both neoclassical economics and the Austrian School with modern artificial intelligence.

Using AI agents that learn and adapt over time, we can simulate market dynamics and observe how these agents interact in ways that are far more realistic than traditional economic models. ABEE captures not just the end state of markets, but the process of getting there—how agents discover information, adapt their strategies, and refine their behaviours.

The Experiment: AI Monopolist Learning in Action

In this particular experiment, we simulated a monopolist using reinforcement learning.

Reinforcement Learning (RL) is a type of machine learning where an agent learns by interacting with an environment. The agent takes actions, receives rewards or penalties, and aims to maximize its long-term reward by improving its decisions over time

The monopolist starts with no knowledge of the market and learns over time how to set prices through trial and error.

This simulation was coded in Python, with a little help from ChatGPT, which allowed us to create an adaptive AI that evolves its strategy based on profit feedback. See the code here.

Here’s how the experiment is structured:

Theoretical Expectations vs. Learning Process

Traditional economic theory provides clear predictions for a profit-maximising monopolist: set marginal revenue equal to marginal cost.

Given the demand curve and marginal cost MC=20 the monopolist should charge P*=60 and sell Q*=20 units.

In this experiment, however, the AI monopolist does not have access to this information.

Instead, it learns through exploration—setting different prices and observing the profit outcomes. Over time, the AI agent gradually “discovers” the optimal pricing strategy.

Results: Learning Toward Optimal Pricing

The results, visualised in the graph below, show how the AI monopolist learns to behave optimally (or very close to optimally) over time.

Initially, the agent’s pricing decisions are random and far from optimal, but as it gains experience, it converges toward the theoretical profit-maximising price and quantity.

• Price Evolution: The blue line in the graph represents the AI agent’s price decisions over time. Early on, the prices fluctuate as the monopolist explores different pricing strategies. However, as the episodes progress, the prices stabilise and converge toward the theoretical price of P=60 (shown by the red-dashed line).
• Quantity Evolution: The corresponding quantities sold also fluctuate early on as prices vary, but the AI agent gradually learns to settle around the optimal quantity of Q=20Q = 20Q=20.

It is also notable that once the AI agent reaches the optimal price and quantity, it doesn’t change the price significantly.

These results confirm that an AI agent, even starting with no knowledge of the market, can learn to mimic the behaviour predicted by traditional neoclassical economics.

Through trial and error, the AI monopolist discovers the price that maximises profit, demonstrating that markets can converge to the theoretically correct equilibrium even when participants begin with limited information.

Agent-Based Experimental Economics: A New Lens for Economic Research

The concept of Agent-Based Experimental Economics (ABEE) represents a new tool for exploring economic behaviour.

Traditional economic models often rely on simplifying assumptions, like the “representative agent,” to describe equilibrium outcomes. But ABEE allows us to simulate dynamic markets populated by AI agents that learn and adapt in real time, reflecting the diversity of decision-making we see in the real world.

In this experiment, we only simulated a single monopolist and fixed consumer behaviour. However, the potential of ABEE goes far beyond this simple model.

ABEE allows us to simulate large-scale economies with diverse agents, each learning and interacting in complex ways. This opens the door to a whole new range of experiments, from modelling market competition to testing different monetary policy rules.

The Market as a Process: Connecting Neoclassical and Austrian Insights

One of the things that to me makes ABEE particularly exciting is how it bridges the gap between neoclassical economics and Austrian insights.

While neoclassical theory is excellent at predicting equilibrium outcomes, it often overlooks how markets reach these outcomes. The Austrian School, particularly the works of Hayek and Kirzner, focuses on the market process—the idea that markets are constantly evolving as individuals learn and adapt.

In our simulation, the AI monopolist reflects this discovery process. The monopolist doesn’t start with perfect information or rational expectations but learns the optimal strategy through repeated interactions with the market.

This mirrors Hayek’s view of the market as a discovery mechanism, where decentralised information is gradually revealed through the actions of market participants.

Furthermore, the simulation demonstrates Israel Kirzner’s concept of entrepreneurial alertness—the idea that markets correct themselves through the discovery of previously unexploited opportunities. The AI monopolist gradually “discovers” the optimal price, much like how entrepreneurs discover profitable niches in real-world markets.

This dynamic approach also echoes Ludwig von Mises’ idea of the “Evenly Rotating Economy,” where equilibrium is a theoretical construct and real markets are always in flux. ABEE captures this dynamism by simulating markets as evolving systems rather than static, equilibrium-based models.

Applications of ABEE: From Policy to Strategy

The potential applications of ABEE extend well beyond academic research. Governments, businesses, and policymakers can use ABEE to simulate real-world scenarios, providing valuable insights into how markets react to policy changes, business strategies, and economic shocks.

1. Monetary Policy: Central banks could use ABEE to simulate the impact of different monetary policy rules on diverse agents.
2. Labour Market Studies: Policymakers can use ABEE to model the effects of minimum wage increases or changes in labour laws, capturing the varied responses of workers with different skills and backgrounds.
3. Business Strategy: Companies can use ABEE to test pricing strategies, product launches, or supply chain decisions in a simulated environment, observing how AI agents with diverse preferences react to these changes.
4. Income Distribution: Governments can use ABEE to simulate the effects of tax reforms or welfare programs, providing deeper insights into how different groups are affected by these policies.

Conclusion: ABEE as a Transformative Tool for Economics

Agent-Based Experimental Economics (ABEE) offers a powerful new framework for understanding market behaviour. By simulating dynamic markets where agents learn and adapt, ABEE allows us to explore the market process in ways that traditional static models cannot.

In this simulation, the AI monopolist learned to set prices that mirrored the predictions of neoclassical theory. But beyond simply confirming existing models, ABEE also provides new insights into how markets evolve over time, much in line with Austrian economics.

The results—visualised in our graphs—demonstrate that, even in the absence of perfect information, markets have the potential to spontaneously organize towards stable outcomes.

This aligns with Hayek’s and Kirzner’s views of markets as discovery processes, where entrepreneurs and firms learn by interacting with the market.

Looking forward, the potential of Agent-Based Economic Experiments (ABEE) to revolutionize economic research, policy-making, and business strategy is truly exciting.

The future of economic experimentation lies in these dynamic simulations, and with the help of AI, we are only scratching the surface of what’s possible.

These advanced tools promise to provide unprecedented insights into complex economic systems, allowing for more accurate predictions and better-informed decision-making across various sectors.

* Needless to say, my thinking these topics is greatly inspired by the great Vernon Smith – the father of traditional Experimental Economics.

———————

If you want to know more about my work on AI and data, then have a look at the website of PAICE — the AI and data consultancy I have co-founded.

I have asked NotebookLM to create a podcast on my blog post “AI Agents in Minecraft: Vernon Smith-Style Experimental Economics on Steroids“.

I think it’s pretty good – have a listen here:

If you want to know more about my work on AI and data, then have a look at the website of PAICE — the AI and data consultancy I have co-founded.