The Debasement Trade

 The Trump administration's latest attack on Jerome Powell, chair of the Federal Reserve, this week—in the form of a transparently baseless criminal probe—suggests that they really are set on compromising central bank independence by any means necessary. 

I doubt there is any complex economic motive behind this—at least not in Trump's brain. He has made clear overtly that he wants the Fed to bow to his wishes to cut interest rates, and really—the reasons why he would want this are if anything overdetermined. Lowering interest rates tends to make the stock market go up—which Trump regards as a barometer of his political success. It would also benefit him even more directly by keeping aloft the obscenely elevated valuations of various speculative assets—crypto, e.g.—in which Trump is personally invested, and from which he stands to gain. 

He therefore has a crass personal motive to keep blowing up speculative bubbles as large as he can make them; whereas central bank discipline would tend to mitigate the extremes of speculative frenzy. As John Kenneth Galbraith showed in his Short History of Financial Euphoria—this tug-and-pull between the short-term self-interest of speculative investors and the austerity of central bankers trying to reign in excess "euphoria" has tended to underlie most of the vicious fights in American political history over the question of a "national bank"—long before the Federal Reserve itself was established in the early 20th century. 

Another theory that would account for Trump's behavior, however, attributes a more complex and far-reaching object to him (or to his team of advisers): namely, that they are trying to inflate away the national debt. 

I first heard this theory floated last spring, after Trump's so-called "Liberation Day" tariffs sent terror through the bond market. This was when one first started to hear about the so-called "debasement trade"—namely, the theory that the Trump administration was deliberately trying to weaken the dollar's position so as to escape from the burden of our staggering public financial obligations. 

The hallmarks of the "debasement trade" were a sudden interest in buying gold (on the theory that the dollar was losing its place as the world's reserve currency), the weakening of the dollar relative to other major currencies, and the rising price of U.S. Treasury debt (hence the famous "yippiness" on the bond market that forced Trump to back off on some of his more extreme tariff proposals). 

One didn't hear much more about this "debasement" business over the summer or fall, as the dollar appeared to regain its strength. 

But then came Trump's latest apparent attempt to weaponize the Justice Department against chair Powell. 

The immediate reaction to this news on the stock market was notably muted. By the end of the first trading day after Powell's statement, the major stock indices had actually risen slightly for the day. 

But observers started to point to warning signs flashing in other parts of the market. The price of U.S. Treasury bonds crept up. Investors started to pile into gold again. Major currencies rose, at least for the day, against the dollar. Financial analysts suddenly started to talk about the "debasement trade" again. 

"It would be too cynical to suppose that, in order to secure the advantages [of escaping national debt] Governments (except, possibly, the Russian Government) depreciate their currencies on purpose,"John Maynard Keynes wrote in his Tract on Monetary Reform. "As a rule, they are, or consider themselves to be, driven to it by their necessities." 

But nothing is too cynical to attribute to the motives of this administration. They've proved that time and again. Besides, they too could invoke "necessity," or something close to it. The size of the national debt has indeed grown to historic proportions under this administration's watch. 

The only thing I find implausible about the theory that the administration is deliberately trying to inflate away the debt is—not that it is too cynical a hypothesis—but that it is not cynical enough. It requires Trump to be motivated by some perceived concern about the country's public finances—when, as we have already seen, there is a much more direct motive of self-interest (his and his family's numerous holdings in crypto tokens and other purely speculative assets) that entirely accounts already for his desire to "run the economy hot," as they say, by lowering interest rates prematurely. 

But suppose Scott Bessent or Stephen Miran or some of the other creeps and propagandists who grow up like toadstools around their decrepit moron of a boss have some hand in this—could they really have their eye on a deliberate debasement of the U.S. currency in order to reduce the burden of the debt? 

The policy is worth considering on the merits. As Keynes puts it—in the same work referenced above—it's not enough to reject such an idea merely by saying that it amounts in practice to a breach of contract. "When [...] we enter the realm of State action," he writes, "everything is to be considered and weighted on the merits"—since the public authorities must take account of the interests of society as a whole, not merely the contractual rights and expectations of one category of creditors. 

In the scenario where the U.S. inflates away its debts, the government would not be overtly repudiating its financial obligations. The Treasury would still, after all, be paying out the nominal value of the interest on its debts. It would merely have reduced the real value of those payments. 

And in a world where the real value of prior financial obligations has become unsustainable—as the public debt arguably already has—Keynes points out that you are faced in practice with committing a breach of implied contract—or at the very least, a "disappointment of reasonable expectation"—either way. You either have to shrink the economy through fiscal austerity to meet your debt obligations—which constitutes, as Keynes puts it, a massive transfer of wealth from the "active" part of the economic community to passive bond-holders—or else you have to frustrate the bond-holders (the rentiers, as Keynes calls them) by partially mitigating the real value of their anticipated earnings. 

In a choice between these two evils, which is the worse? Keynes was clear that it is better to err slightly on the side of inflation, if you have to err at all. "[I]t is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier," he writes. 

To punish the most active elements of society by holding them to the "dead hand" of accumulated indebtedness, Keynes argued, would be to paralyze industry and ultimately defeat its own stated objective—because people will simply not stand for it. They are more likely to throw off capitalism entirely than to endure it in its most austere form. 

Lest the public start to demand outright repudiation of debts or the collectivization of property—Keynes argues—it is necessary to be willing to meet them half-way. One does this by mitigating the burdens of debt, without overtly renouncing them, through modest inflation. 

That degree of modest inflation—though—is already reflected in standard Federal Reserve policy. There's a reason the bank never tries to actually lower the price level through deflation, or even to bring inflation down to zero. The reasons are exactly the ones Keynes gave—such policies would discourage investment, reduce employment, and ultimately incentivize the public to do nothing but hoard and sit on their accumulated cash savings (an outcome that would be fatal to economic growth). 

Rather, the central bank aims for an annual inflation of about 2%—a figure that policymakers long ago estimated to allow for sufficient growth to reach full employment, which ensuring a moderate degree of justice to bond-holders and other people living on a fixed income, who reasonably expect their investments in interest-bearing debt to retain some value over time. 

What the Trump administration appears to be aiming at is something quite different. Annual inflation held steady last month at 2.7%—which is still above the Fed's target. And the administration's efforts to bully and coerce the Fed into lowering interest rates at such a time appears to be an effort to allow for a permanently elevated level of inflation. 

We have already seen the hypothetical advantages of that scenario. "Running the economy hot" would allow for higher wages, increased employment, a diminished debt burden, and higher stock valuations—at least in theory. 

But that policy would also have a massive downside: namely, inflation itself! And if the last few years have taught us anything—I would have thought it was that people hate inflation!

The administration's answer to this—as always—appears to be to want to have it both ways. With their usual pugilistic demagogy, they are proposing in practice to coerce the Fed into inflating the price level, while at the same time promising that Trump is going to somehow personally bully the CEOs of various corporations one-by-one into lowering their retail prices.

This is an obviously absurd policy paradox. If Trump gets his way at the Federal Reserve, the price level will rise. If, by contrast, he gets his way when it comes to "bringing prices down," the economy and employment will shrink. 

As Keynes notes of Mussolini's similar claims to restore Italian prices to pre-war levels, currencies "d[o] not listen even to a dictator and cannot be given castor oil." Furthermore, if Mussolini had explained the real consequences of his deflationary goals to the public—Keynes adds—he would have had to admit that: "My policy is to halve wages, double the burden of the National Debt, and to reduce by 50 per cent the prices which Sicily can get for her exports[.]"

The same could be said of any American politician's vague promises to "lower prices"—rather than simply slowing their rise.  

Of course, Trump embraces this policy paradox because the public does as well. In our roles as investors, employees, and debtors, we want lower interest rates. But that means, in practice, we want inflation. We want the economy to "run hot." Yet at the same time, in our role as consumers or as holders of fixed-income assets, we hate inflation. We complain about "affordability" and the "cost of living." It's quite the oxymoron. 

Keynes in his book divides the public, for analytical purposes, into three categories: investors or rentiers (i.e., bond-holders and other creditors, for present-day purposes), business people or entrepreneurs, and wage-earners. 

He admits, however—that even at the time he wrote the book—there was frequent overlap between the three categories—and that each person might inhabit multiple roles in different parts of his life. 

Today, the distinction between these three classes is even harder to draw. Any given member of modern society might simultaneously earn a wage or salary at work, put some of our retirement savings into fixed-income assets like bonds that pay out set amounts of cash interest at pre-arranged periods, and invest the rest of our retirement savings into riskier assets like stocks. 

In two of our three roles, then, we benefit from a moderate amount of inflation. The equity we hold in various corporations—through owning stocks directly or investing in index funds—gains in value when the economy grows and corporations can harvest more profit by raising prices. As wage-earners, meanwhile, we also benefit from inflation when it results in higher salaries or increased employment opportunities. 

Where we do not benefit from inflation is when we are trying to buy things for ourselves or live on the proceeds of fixed-income investments. 

Many people, therefore, would like to have inflation for me but not for thee. They would like the prices they can charge (for their own labor or for their willingness to invest) to inflate; but not the prices they have to pay. 

But the economy doesn't work that way. You have to take the good with the bad, if you want inflation at all. 

Is there an argument to be made, then, that the Fed's 2% rate has indeed historically erred too far on the side of austerity, and that a permanently elevated rate of inflation would not necessarily be a bad thing? 

Maybe. The Fed itself thought so, until recently; they experimented during the pandemic with a policy that prioritized full employment slightly ahead of price stability. Chair Powell himself led this effort. It arguably resulted in years of a tight labor market and rising real wages. 

Politically, however, the public decisively rejected this approach. The Biden years, when this policy was in effect, saw massive public backlash against inflation. 

Now, in one of those absurd ironies in which the history of the Trump era bounds, Powell is being relentlessly castigated and raked over the coals for supposedly not allowing inflation enough—that is to say, for allegedly keeping monetary policy too restrictive for too long. 

Trump now mocks Powell as "Mr. Too Late," even though Powell was the one who brought us through the pandemic with full employment at the end of it and achieved the famous "soft landing"—perhaps, it is true, at the expense of allowing too much inflation to persist for too long, i.e. running the economy too hot—but now, that's exactly what Trump is calling on him to do!

Whatever. Suppose the result of all this really is that we have permanently elevated levels of inflation. How would that play out? 

It might not be as ruinous as the worst historical periods of inflation—such as after World War I. Keynes—writing in the aftermath of the wartime inflation—notes that part of the reason this episode was such a social disaster was that large parts of the public—and those seemingly the most financially cautious and "responsible"—had invested their life savings exclusively in fixed-income assets. They therefore had the savings of a lifetime of toil effectively wiped out by the war. 

The effects of a more modest sustained inflation in the United States today would not be so dramatic. People who follow today's "responsible" financial advice do not have all their savings tied up in government bonds. Instead, they have diversified portfolios with stock holdings, many of which would gain in value from "running the economy hot." 

Indeed, under the typical 60-40 split, most investors are poised to benefit more from an inflationary policy today than a deflationary one (the exact opposite of the turn-of-the-century situation Keynes described, where the most "conservative" investors had all their money in fixed-income "Consols").

Plus, maybe a modest increase in inflation would reduce our national debt burden? 

The alternative to this, of course, would be a tax increase; what Keynes calls a "Capital Levy." It is far and away the better policy choice of the two, since—as Keynes points out—it could be graduated according to wealth, rather than disproportionately affecting bond-holders (many of whom are the smallest investors). 

But in a world where raising taxes is politically challenging, if not impossible—governments will be tempted to use inflation as a disguised form of tax. 

Before the pandemic, it was common to hear the so-called "Modern Monetary Theorists" call for this overtly. They said: the government does not actually have to issue new debts or raise taxes, because it can always print more money. Thus, deficit spending is never actually a problem. 

Keynes, writing a century earlier, was well aware of this option. "A Government can live for a long time," he notes, "[...] by printing paper money. [... It] can live by these means when it can live by no other." 

Where the proponents of "MMT" got it wrong was in thinking that there was no other downstream negative consequence to this. They were not counting on inflation—which, Keynes points out, is essentially taxation by another name. It reduces the real purchasing power of people's earnings and cash savings as surely as if they were being taxed directly—even if it happens to do so silently and invisibly. 

Worse still, it happens to do so in a less equitable way, and one less subject to the oversight of the democratic process, than a statutory tax. 

"It is common to speak as though, when a Government pays its way by inflation, the people of the country avoid taxation," writes Keynes. "We have seen that this is not so. What is raised by printing notes is just as much taken from the public as is a beer-duty or an income-tax. What a Government spends the public pays for. There is no such thing as an uncovered deficit." 

The MMT proponents managed to ignore this seeming obvious problem and airily brush it aside, when deficits were actually significantly lower before the pandemic. Inflation, they said, was a chimera. 

After the U.S. government ran a real-world experiment in MMT following the pandemic, though, inflation briefly reached as high as 9%. 

One suddenly stopped hearing so much about MMT. Its proponents have gone notably silent. Indeed, I can't remember seeing a single person seriously defend it as a policy position after the first year of the Biden presidency. 

There are indeed trade-offs in economic life, then. If you want the benefits of inflation, you have to take the downsides. 

The question is: which side outweighs the other? 

Inflating away the debt through depreciating the currency—i.e., "debasement"—has an obvious appeal, as an alternative to either taking on more debt—the service of which has already grown to an enormous chunk of our annual budget—or else raising taxes, which our political system is notoriously averse to doing. 

But there are two other massive downsides to this policy that the administration does not appear to consider: 1) People will in fact notice the effective "taxation" that this policy requires, when they realize that their earnings and cash savings have declined in real value. Indeed, we already ran this experiment a couple years ago. The public's protests against the Biden-era inflation and the cost of living crisis were really about the hidden tax transfer that was taking place through inflation. (And a highly inequitable tax it was.)

And 2) the policy may well defeat its own objectives. "Running the economy hot" requires low interest rates. But the Fed alone does not exercise complete control over these rates. Eventually, if the U.S. appears to be trying to depreciate its currency in order to reduce the real value of its payments on Treasury bonds, investors will demand higher interest payments in order to compensate for this loss. 

This is the power of the famous "bond vigilantes," and it exceeds the scope of any government or central bank to control. They, like currencies, cannot be given castor oil. 

And so, any too-obvious attempt to inflate away the debt might simply backfire by increasing interest rates and hence the size of the debt burden. 

There is no way out of this dilemma—not for this administration; unless it was willing to radically alter its policies and undergo a complete moral and intellectual revolution. They have chosen to increase the national deficit massively by cutting taxes for the rich. They appear to have no appetite whatsoever to raise them again. And yet—as Keynes said—there's "no such thing as an uncovered deficit." 

And so they may be reduced to trying to pay off these debts by taxing us all secretly and invisibly through inflation—the "form of taxation that the public find hardest to evade," as Keynes puts it. 

And if they persist too long or go too far in that policy, they may end up defeating their own objectives—increasing interest rates and the debt burden in the long term, even as they raise the cost of living for us all in the short term. 

Let them stew in that insoluble riddle as long as they choose. There is in fact a penalty in this world for ignorance, greed, stupidity, willful blindness, self-delusion, and short-term thinking. And this administration—unless it suddenly has a wholesale change of heart—is doomed to reap it.