Why the failure of US economic policy will reignite inflation
In this article I look at the inflationary consequences for the dollar of Trump’s proposed tariffs. Hint: it’s not good!
ALASDAIR MACLEOD
Last week, I explained why I thought that the economic policies of Trump/Bessent 2025 would fail.
The assumption is that they would pursue MAGA (make America great again) by tax policies favourable to businesses while protecting their markets through tariffs.
Both Trump and his nominee for Treasury Secretary have promised to cut corporation and income taxes and to raise revenue instead through tariffs —“the most beautiful word”.
And DOGE (a new Department of Government Efficiency headed by Elon Musk and Vivek Ramaswamy) would cut out wasteful spending to the tune of $2 trillion.
As Dr Johnson said of second marriages, DOGE represents the triumph of hope over experience.
And it won’t be the first time that brilliant businessmen such as Musk have been bested by government bureaucracy.
Either they knuckle under into a thoroughly bureaucratic environment, in which case their attempts to reduce wasteful spending fail, or they face ignominious defeat and resignation.
Whichever way, the cuts in spending are not going to materialise to any degree, and the revenue shift from corporate and income taxes to tariffs will be attempted against a background of a rapidly tightening Federal debt trap, making funding the budget deficit increasingly difficult.
Bubbles accumulate and eventually pop
Since 1981, I have counted six debt bubbles or crunches: two in the ‘eighties, one in the ‘nineties, the dotcom in 2000, the securitisation crisis of 2008, and the repo crisis in 2019.
From the first of these forty years ago, all these events have been addressed by the Fed collapsing interest rates to progressively lower levels, a policy which has prevented each bubble from having been resolved — kicking the can down the road.
Instead, they have been rolled up into the following one, ensuring that it becomes more potentially catastrophic.
And each successive cut in interest rates took them lower, ending with zero in 2020.
All the surges in interest rates which precipitate these crises have been reversed by the Fed forcing interest rates lower.
The process whereby capital is withdrawn from failures and redirected towards the promise of economic progress is prevented.
Unless there is a washing of the spears, malinvestments continue to accumulate and zombies are perpetuated.
Muscling rates lower when they should rise has always been the Fed’s response.
So, how are they going to deal with this bubble when bond yields rise again, and equities crash?
Realistically, the Fed cannot force rates into negative territory.
Furthermore, the US Government is now ensnared in its own debt bubble, with foreigners reluctant to buy.
We faced this problem in the UK in the 1970s, when sterling began to slide in a deepening recession, and gilts had to have coupons of 15% and more to fund the government’s deficit.
It was called a buyers’ strike.
Today, it is commonly suggested that quantitative easing must return.
But that’s printing dollars when consumer price inflation has already resumed, and with Trump’s tariffs is set to persist.
In last week’s article I also pointed to the dangers of tariffs fuelling an economic slump, which was the consequence of the Smoot-Hawley Tariff Act of 1930.
This time round, we can expect a new round of trade tariffs, which will be on top of Trump’s earlier ones and those of the Biden administration (not to mention the protectionist tariffs of earlier presidents) almost certainly tipping the whole international trading system over the edge, as supply chains are rapidly forced into closing down.
But there is another effect which will fuel inflation.
Unless American citizens become savers rather than spendthrifts, then consumer prices must rise.
How credit is sourced is what matters.
Assume that there is a budget deficit.
And assume that it is financed by consumers deferring their purchases, or in other words saving to buy the necessary debt.
Immediate consumption declines, and demand for goods and services with it.
Given there is a continuing supply of goods and services from both domestic production and imports, this fall in immediate demand results in lower consumer price inflation to the extent that savings have increased.
Furthermore, this fall in demand is reflected in lower imports.
This is precisely the reason why Japan and China have persistently low inflation accompanied by a high savings rate, and trade surpluses.
Alternatively, if the government’s budget deficit is financed not by savings, but by the expansion of bank credit, then consumption is enhanced by the extra credit as government spends it into the economy.
There is now a surplus of demand for goods, which broadly leads to an increase in net imports, leading to a trade deficit.
Now let us assume that tariffs and import restrictions are imposed, and there is no change in the savings rate.
Fuelled by excess government spending over revenues and the funding of the deficit being by bank credit unmatched by increased consumer savings, prices will rise due to this “printed” supply of credit and the restriction of imported supplies.
Trump’s desire to impose yet more protectionist tariffs is therefore bound to increase consumer price inflation, while potentially driving the world into the tit-for-tat tariff wars that made Smoot-Hawley so destructive.
If the Smoot-Hawley effect is repeated, the world including America will face a deepening recession, which used to be called a slump.
This will undermine government revenues while increasing welfare and other liabilities, increasing the budget deficit even more.
There is a worrying circularity in all this.
Unless Americans save, inflationary pressures from deficit spending will increase, undermining the dollar which is already in a debt trap of 130% relative to nominal GDP.
And a fall in nominal GDP will rapidly propel that ratio substantially higher.
If the Fed tries to cover this escalating debt by QE and by pushing the interest rate back to zero, it will be the only buyer of Federal debt.
But it will have to completely abandon its inflation mandate.
Without this intervention, bond yields would be far, far higher — likely climbing even above the 15%+ seen in sterling gilts in the mid-1970s.
To foreign holders of dollars, the collapse in their financial asset values which is the consequence of higher bond yields will lead to massive dollar liquidation at precisely the time when the Federal Government needs more buyers of their debt.
Until we know otherwise, the proposed Trump-Bessent tariffs of 2025 are almost certain to collapse the value of dollar credit.
The wise, including foreign central banks are already getting out of dollar credit into real money, which is gold.
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