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.

Bibliography

Christensen, L. (2011). “Market Monetarism: The Second Monetarist Counter-Revolution.” Working Paper.

Granger, C.W.J. (1969). “Investigating Causal Relations by Econometric Models and Cross-spectral Methods.” Econometrica 37(3): 424-438.

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.

Sumner, S. (2012). “The Case for Nominal GDP Targeting.” Mercatus Center Research Paper.

The calendar reads June 13, 2025, but I’m getting flashbacks to December 1977.

As Israeli fighter jets strike Iranian nuclear facilities and President Trump calls Federal Reserve Chair Jerome Powell a “$600 billion numbskull,” we’re witnessing a dangerous historical parallel to the Carter-Burns-Miller transition that helped create the Great Inflation.

Yet today’s constraints—with federal debt at 119% of GDP versus 35% in Carter’s time—make the situation far more perilous.

The anatomy of a central banking disaster

The playbook is eerily familiar.

In 1977, President Carter praised Arthur Burns as “Mr. Fiscal Integrity personified” before replacing him with G. William Miller, a corporate executive with no monetary policy experience.

Carter’s advisers, led by Stuart Eizenstat and Charles Schultze, complained that Burns refused to be a “team player” and wouldn’t coordinate fiscal and monetary policy.

When Burns publicly criticized the Carter administration as ineffective in October 1977, his fate was sealed.

Today, Trump’s assault on Powell follows an nearly identical script.

After initially praising Powell’s appointment, Trump has escalated his attacks, branding him “Too Late Powell” and declaring his “termination cannot come fast enough.”

The President’s June 12 outburst—claiming Powell costs America “$600 billion a year” by refusing to cut rates—represents the most direct presidential attack on Fed independence since Nixon’s infamous pressure on Burns.

The candidate speculation mirrors 1977 with uncanny precision. Carter’s shortlist included corporate executives like Miller, Reginald Jones of GE, and Irving Shapiro of DuPont.

Today, Trump eyes Treasury Secretary Scott Bessent and former Fed Governor Kevin Warsh, with Bessent emerging as the favorite. Both eras feature the disturbing pattern of prioritizing political loyalty over monetary expertise.

The velocity nightmare I warned about is materializing

In my February post, “Trump’s Tariffs and the Fed: A 1970s Velocity Nightmare,” I highlighted the most ominous parallel.

When Carter announced Miller’s appointment in December 1977, velocity of money accelerated by 4% within months—before any policy changes or external shocks. By the time of the Iranian Revolution in February 1979, velocity had surged 7% from pre-Miller levels.

The mechanism is devastatingly simple: when markets lose faith in Fed independence, households and businesses reduce money holdings, accelerating velocity and driving inflation without any increase in money supply.

Today’s data confirms my worst fears: Michigan’s latest survey (June 2025) shows one-year inflation expectations at a staggering 5.1%, down from May’s catastrophic 6.6% but still far above anything sustainable.

Even more concerning, the survey notes that “consumers remain guarded and concerned about the trajectory of the economy” despite the modest improvement.

Miller’s tenure proved disastrous. Inflation rose from 6.6% when he arrived in March 1978 to 11.8% when he departed in August 1979. The dollar plummeted 34% against the Deutsche Mark and 42% against the yen.

Economic historian Steven Beckner’s assessment was brutal: “If Nixon appointee Burns lit the fire, Miller poured gasoline on it… Without question the most partisan and least respected chairman in the Fed’s history.”

Geopolitical déjà vu with nuclear overtones

Yester, June 13, 2025 Israeli strikes on Iran’s nuclear facilities create an eerie parallel to the 1979 Iranian Revolution.

Then, the fall of the Shah triggered oil prices to surge from $13 to $34 per barrel, while Iranian production fell by 4.8 million barrels daily.

Today, Brent crude initially spiked 13% to $78 on news of “Operation Rising Lion,” though modern energy markets show more resilience with U.S. shale production and strategic reserves providing buffers absent in the 1970s.

Yet the fundamental dynamic remains: Middle East instability tests central bank credibility precisely when political pressure peaks.

In 1979, the oil shock forced Volcker to choose between accommodating inflation or crushing the economy. Today, Powell faces the same dilemma with the added complexity of Trump’s tariffs creating simultaneous supply shocks.

The geopolitical timing appears almost orchestrated. Carter faced the Iranian Revolution just as Miller’s policies unraveled. Trump confronts an Israel-Iran conflict as his attacks on Powell intensify.

Both presidents used external crises to justify political interference with monetary policy, creating the very instability they claimed to prevent.

The unpleasant monetarist arithmetic of fiscal dominance

Here’s where the monetarist arithmetic becomes truly unpleasant—and where today’s situation diverges catastrophically from the 1970s. Let me walk you through the numbers that keep me awake at night.

In 1977, with federal debt at just 35% of GDP and interest rates around 7%, debt service consumed roughly 1.5% of GDP—manageable even with Volcker’s eventual 20% rates.

Fast forward to 2025: federal debt stands at around 120% of GDP, with interest rates at 4.5%. Current debt service already consumes about 3.8% of GDP – and we are heading towards 5% of GDP rather fast.

Now here’s the killer: the fiscal dominance equation. When debt-to-GDP ratios exceed 100%, the central bank loses its ability to control inflation through interest rates alone.

Why? Because raising rates sufficiently to combat inflation would explode debt service costs, forcing either:

1. Fiscal austerity so severe it would crash the economy, or
2. Monetization of the deficit, creating the very inflation you’re trying to fight

With $35 trillion in federal debt, each 1% rate increase adds roughly $350 billion to annual interest costs—but that’s just the direct effect.

The unpleasant arithmetic comes from the feedback loop: higher rates → larger deficits → more debt issuance → higher term premiums → even higher rates. At current debt levels, this spiral becomes self-reinforcing above certain threshold rates.

My calculations suggest that threshold is around 7-8%.

Here’s why:

The critical equation is r > g + (p/d), where r is the real interest rate, g is real GDP growth, p is the primary surplus, and d is the debt-to-GDP ratio. With debt at 120% of GDP and realistic primary deficits of 2-3% of GDP, the math becomes unforgiving.

At 7-8% nominal rates:

• Interest costs hit $2.8 trillion annually (about 10% of GDP)
• The required primary surplus to stabilize debt/GDP exceeds 6% of GDP
• But higher rates crush growth, making g negative
• This pushes the required fiscal adjustment above 8-9% of GDP

No democracy has ever achieved fiscal tightening of this magnitude without revolution or default.

Above 8%, the arithmetic becomes truly explosive: every 1% rate increase requires an additional 1.2% of GDP in fiscal adjustment, creating an accelerating spiral. The market knows this, which is why term premiums would explode, pushing rates even higher.

Volcker could take rates to 20% because with 35% debt/GDP, the fiscal adjustment needed was painful but achievable – about 2-3% of GDP.

Powell faces a required adjustment 3-4 times larger. The fiscal constraint binds long before inflation is conquered.

The expectations-velocity death spiral

This is where my February warning might become prophecy.

The monetarist identity MV = PY is iron law—if velocity (V) rises and money supply (M) doesn’t fall proportionally, either prices (P) or output (Y) must adjust.

With the Fed constrained by fiscal dominance, they cannot reduce M enough to offset rising V.

Result: P must rise.

But here’s the truly unpleasant part: velocity isn’t mechanical—it’s driven by expectations.

When people expect inflation, they reduce real money balances, velocity rises, and inflation becomes self-fulfilling.

The Michigan survey’s 5.1% inflation expectation (down from May’s terrifying 6.6%) remains dangerously elevated. As the survey notes, consumers’ fears about tariffs have only “softened somewhat”—they haven’t disappeared. And rising oil prices certainly won’t help to reduce inflation fears.

The data from 1977-78 is instructive but understates today’s risks. Then, velocity rose 12% over five years. Today, with instant information, algorithmic trading, and crypto alternatives, velocity shifts could happen in months, not years.

A 10% velocity increase with current M2 of $21 trillion would add $2.1 trillion of nominal demand—roughly 8% inflation even with zero real growth.

Why Powell cannot be Volcker (even if he wanted to)

The arithmetic is brutal and inexorable. To achieve positive real rates with 5.1% inflation expectations, the Fed would need nominal rates above 7%. At those levels:

• Federal interest expense: $2.5 trillion (versus $952 billion projected for 2025)
• Interest expense as % of federal revenue: 50-55% (versus ~20% today)
• Required primary surplus to stabilize debt/GDP: 5-6% of GDP

That last number is the killer. The U.S. hasn’t run a primary surplus above 2% of GDP since the 1990s. Achieving 5-6% would require either:

• Cutting Social Security, Medicare, and defense by 35%, or
• Raising all tax rates by 50%

Neither is politically feasible. The Fed knows this. Markets know this. Which is why Trump’s pressure, combined with fiscal dominance, creates a doom loop: the Fed cannot credibly commit to fighting inflation because everyone knows fiscal constraints will force capitulation.

The terrifying endgame

Here’s what keeps me up at night: we’re not heading for a 1970s-style inflation.

We’re might instead be heading for something much worse—a fiscal dominance trap where monetary policy becomes subservient to debt dynamics.

The sequence will likely be:

1. Velocity acceleration (this might already have started): As Fed credibility erodes, velocity rises 5-10%
2. Inflation surge: With fiscal constraints preventing adequate response, inflation hits 6-8%
3. Bond market revolt: Real rates turn deeply negative, term premiums explode
4. Fiscal crisis: Interest costs spiral, forcing either overt monetization or default
5. Currency crisis: Dollar loses reserve status as foreign holders flee

The irony is exquisite in its horror. Trump attacks Powell for “$600 billion” in interest costs, but his assault on Fed independence risks triggering a sequence where interest costs exceed $3 trillion, inflation destroys middle-class savings, and the dollar’s global dominance ends.

Conclusion: When history rhymes in a minor key

The Carter-Miller-Volcker sequence taught us that political interference with central banking creates disasters requiring painful cures.

But that lesson assumed the cure remained available. Today, fiscal dominance means the Volcker solution—crushing inflation with extreme rates—is mathematically impossible.

We’re not just repeating the 1970s; we risk replaying them without an exit strategy.

The unpleasant monetarist arithmetic shows why: when debt exceeds 100% of GDP, fiscal dominance trumps monetary independence. The central bank becomes a prisoner of debt dynamics, unable to fight inflation without triggering sovereign crisis.

Trump’s “$600 billion numbskull” comment will prove tragically ironic. By undermining Fed independence precisely when fiscal constraints bind most tightly, he’s creating conditions for interest costs that will make $600 billion look like pocket change. The real numbskulls are those who think you can suspend the laws of monetary economics through political will.

History doesn’t repeat, but it does rhyme. This time, however, it’s rhyming in a minor key, and the song ends not with Volcker’s triumph but with fiscal and monetary ruin. The unpleasant arithmetic admits no other conclusion.

Introduction: Why Monetary Policy Needs a Firm Theoretical Foundation

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

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

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

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

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

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

The Origins and Development of the McCallum Rule

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

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

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

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

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

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

The ECB’s Historical Relationship with Monetary Aggregates

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

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

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

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

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

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

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

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

The Quantity Theory of Money and Nominal Income Targeting

The McCallum rule builds on the classical equation of exchange:

M × V = P × Y

Where:

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

In growth terms, this becomes:

Δm + Δv = Δp + Δy = Δx

Where:

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

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

The McCallum Rule Formalised

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

Δmₜ = -vₜ + xₜ + λ(x*ₜ – xₜ)

Where:

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

This rule has several compelling features:

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

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

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

Why Use M3 Instead of the Monetary Base?

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

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

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

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

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

Empirical Implementation: Estimating Trends

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

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

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

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

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

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

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

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

Historical Review Through the McCallum Lens: A Detailed Narrative

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The crucial insight comes from examining the full period.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

This convergence vindicated both the ECB and the McCallum framework.

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

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

The velocity graph below illustrates the mechanism of these spillovers.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The lesson is clear: systematic monetary policy works.

Conclusion: The Visual Verdict and the Path Forward

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Introduction: A Nation of Spend First, Ask Questions Later

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

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

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

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

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

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

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

Why an Interactive Model? Transparency Over Oracles

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

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

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

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

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

The Engine: How the Model Works

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

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

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

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

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

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

Endogenous Real Rates: When Markets Update Their Expectations

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

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

Policy Levers: Stabilising Debt via Tax or Inflation

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

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

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

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

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

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

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

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

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

Baseline: Inertia as Policy

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

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

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

Fiscal Consolidation: The Road Not (Usually) Taken

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

The required adjustment, to be clear, is substantial.

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

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

“Beautiful Bill”: The Populist’s Shortcut

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

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

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

What the Model Leaves Out: The Limits of Arithmetic

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

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

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

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

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

Conclusion: The Arithmetic Does Not Negotiate

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

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

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

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

Stanley Fischer has passed away at the age of 81.

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

A Life Shaped by Economics and Public Service

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

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

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

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

The Master of Nominal Stability – My Own Assessment

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

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

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

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

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

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

Not Without Critique – But Always With Respect

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

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

A Lasting Legacy

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

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

Selected blog posts on Stanley Fischer:

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

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

This is genuinely remarkable.

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

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

The Magnitude of What Just Happened

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

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

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

Why This Matters Beyond Trade Policy

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

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

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

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

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

A Personal Note on Constitutional Victory

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

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

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

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

The Constitutional Economics at Stake

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

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

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

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

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

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

Why Markets Should Celebrate This Constitutional Victory

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

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

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

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

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

What Happens Next

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

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

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

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

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

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

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

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

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

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

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

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

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

The Return of the Unpleasant Monetarist Arithmetic

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

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

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

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

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

The Political Class Is Asleep at the Wheel

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

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

The Dollar’s Exorbitant Privilege Has Limits

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Basic Economics 101: Tariffs Are Taxes on Consumers

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

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

Walmart’s net profit margin hovers around 3%.

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

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

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

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

Déjà Vu: Populists Blaming Business for Inflation

Does this all sound familiar?

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

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

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

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

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

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

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

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

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

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

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

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

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

Nixon Redux: The Ghost of 1970s Stagflation

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

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

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

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

Conclusion: The Markets Are Not Wrong — Policy Is

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

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

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

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

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

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

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

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

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

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

Further Reading and Sources

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