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Think Inflation Is Done? Think Again!
Alasdair Macleod

A lethal combination of budget deficits and trade sanctions are going to be reflected in increasing price inflation for the US. And where the US goes, the rest of us follow.

In this article I focus on two reasons why inflation will rise leading to higher, not lower, interest rates and bond yields. The first is the destruction of credit’s value through its non-productive expansion, mainly by governments running budget deficits. The second has had almost no attention but is at least as serious: the consequences of the repatriation of supply chains being accelerated by trade tariffs and sanctions. I shall briefly comment on the first before turning my attention to the second.

Budget deficits always debase the currency

Margret Thatcher said something on the lines that socialism fails when it runs out of other peoples’ money. We appear to have reached that point. Rapacious tax policies are now reducing their yield. We are now sliding down the after-end of the Laffer curve. The economic force which drives any economy is being strangled by the burden of government.

Consequently, with mandated welfare and other expenses increasing, hopes that economic growth will reduce budget deficits are misplaced. Estimates for budget deficits in nearly all high-tax jurisdictions will turn out to be overly optimistic. This has important implications for inflation which are currently being ignored by everyone from governments, central banks, and down to investors.

Take the situation in the USA. As recently as February, the Congressional Budget Office forecast a budget deficit of $1,507 billion for the current fiscal year. Yet in the first six months, the deficit was already $1,100 billion, according to the US Treasury’s own figures. But this fails to explain the pace of borrowing. According to the US Debt Clock, US national debt is $34.77 trillion today, an increase of $1,600 billion this fiscal year so far. At this rate it will be $2.4 trillion by end-September, nearly a trillion over the CBO deficit estimate. It represents 9% of GDP, raw unproductive credit driving GDP higher and creating an illusion of a strong economy.

I suspect the budget deficit could turn out to be even worse, partly because it is a presidential election year, partly because the debt ceiling is not in place until January 2025, and partly because the productive economy is already in recession. This last assumption is based on simple arithmetic. If, according to the Bureau of Labor Statistics GDP grew by 4.5% in the year to last March, allowing for a budget deficit injection of 9% means the private sector actually contracted by 4.5%.

A rough and ready calculation perhaps, but it is important to understand that not only is the expansion of non-productive government debt concealing the true economic situation, but it is also debasing the currency. And currency debasement becomes reflected in higher prices. In other words, the inflation of CPI prices is not over.

The rest of this article examines how and why government attempts to protect domestic production and employment through trade tariffs and sanctions end up accelerating price inflation even more. The world saw the economically destructive consequences of anti-trade policies in the wake of the Smoot-Hawley Act of 1930, which are still relevant today.

The consequences of trade tariffs

First, we must visit a little theory. In a free market with sound money, expansion in the level of commercial bank credit deployed for productive purposes does not lead to permanent trade imbalances. It is the expansion of the currency that leads to a trade deficit. And it is the inflation of the currency, particularly when it is fiat which is the consequence of a government’s budget deficit.

If bank credit is expanded for non-productive purposes, then that leads to trade deficits because it finances excess consumption. But under sound money conditions, consumers tend not to borrow for excess consumption, restricting debt to what they can afford to repay. This was the origin of Dickens’s Micawberism about how spending in excess of one’s income led to misery, written in 1849 when Britain’s gold standard had firmly crystalised consumer attitudes at the time.

To summarise the conditions of sound money and free trade unhampered by government intervention, we can express it in the following accounting identity:

Trade Deficit = Budget Deficit — (Savings—Capital Investment).

This is the basis of the twin deficit hypothesis. If there is no change in savings and capital investment, then through credit creation by a central bank to finance a government’s budget deficit a similar trade deficit is bound to arise. It is a conclusion reinforced by Say’s Law, which defines the relationship between production and consumption through the division of labour. Government demand not met by revenue funded by private sector production can only lead to an increase in imports over exports, unless it is funded by additional savings.

America’s politicians take a different view. They think that by intervening with tariffs, they can reduce the trade deficit, but time and again they have been proved wrong. And the consequences of following this wrong-headed approach are best illustrated by the Smoot-Hawley Tariff Act of 1930. It was not coincidental that it was signed into law by President Hoover at the beginning of the Great Depression.

The effects of Smoot-Hawley were the subject of a 2005 dissertation by Dr Thomas Rustici of George Mason University, who pointed out that its destructive consequences have been badly underestimated following the Keynesian revolution. His conclusions which I draw upon are particularly relevant to today, with a new round of tariffs being imposed against China by the Biden administration.

We can summarise the consequences of Smoot-Hawley by quoting from a critical letter signed by 1,028 members of the American Economic Association dated May 5, 1930. In that letter, they made five points, which I paraphrase:

·The tariff would raise the cost of living by compelling the consumer to subsidise waste and inefficiency in industry.

·The farm sector would not be helped because cotton, meats and cereals are export crops sold worldwide.

·Exports would suffer, because countries cannot buy US goods unless they were permitted to sell to the US.

·The tariff would inevitably provoke other countries to introduce tariffs against US goods. And

·Americans with investments abroad would suffer since the tariff would make it more difficult for their foreign debtors to pay them interest due.

They could have made other points. Nevertheless, Smoot-Hawley’s contribution to both the slump in America and those of other nations was undoubtedly considerable, but today is ignored. According to Rustici, in the US real national income fell by 36%, unemployment rose to 25%, and 40% of banks were closed which collapsed bank credit. International trade and investment contracted severely as well.

The wealth destruction in America and elsewhere went far beyond previous cyclical downturns. The major difference between then and now is that when Smoot Hawley was signed into law, the dollar was on a gold standard at $20.67 to the ounce. The collapse in economic activity and bank credit raised the purchasing power of the dollar, because it was tied to gold’s value. Similar legislation today will collapse the dollar instead, being unanchored in any way to gold. This is because the political response to an economic slump will undoubtedly be to stop a collapse in credit by underwriting the banking system and its debtors, increasing the budget deficit thereby, and therefore undermining the currency at a time when foreign owners turn sellers of credit en masse. And they will then be followed by domestic users of credit, leading to Mises’s crack-up boom.

Today’s Smoot-Hawley problem

Let us look at the five points raised by the members of the American Economic association in 1930 in the context of President Biden’s economics. We should note that at that time, economists agreed on the reasoning behind Say’s law: that we work to earn our consumption and that we maximise our consumption by specialising in our output. Obviously, there is no room for state intervention in Say’s law, which Keynes had to dismiss in order to justify his General Theory. Tinkering with theory might change perceptions, but the reality behind economics cannot be dismissed. I shall take the points in the economists’ letter in their order.

·The tariff would raise the cost of living by compelling the consumer to subsidise waste and inefficiency in industry. Instead of consumers benefiting from competitive prices and technology they are forced to pay the higher prices of protectionist domestic cartels. Today, American technology lags China’s in key areas, such as battery technology, solar, and electric vehicles. By imposing 100% tariffs on Chinese EVs and tariffs of up to 50% on other technologies, US technology will sink further behind China’s and prices for these goods will rise, funded ultimately by an expansion of dollar currency.

·The farm sector would not be helped because cotton, meats and cereals are export crops sold worldwide. Farming is less important as a proportion of the total economy today, but this logic applies to all US exports, for which there is no benefit from protectionist domestic policies.

·Exports would suffer, because countries cannot buy US goods unless they were permitted to sell to the US. The point here is slightly different today. Foreign trade cut out of American markets leads to less demand for dollars. We see this with China selling her dollar reserves. In 1930, it would not have affected its purchasing power due to its firm link to real money, which is gold. But a contraction of global trade today would almost certainly lead to a reduction of the $32 trillion stockpile of dollars and dollar-denominated financial assets in foreign ownership. Dollars are likely to be sold for gold and other material commodities (as opposed to for other fiat currencies), collapsing its purchasing power relative to these economic inputs.

·The tariff would inevitably provoke other countries to introduce tariffs against US goods. Recent experience of tariffs against Chinese imports under President Trump confirms this is so. Under Smoot-Hawley, there was a substantial contraction of global trade as other countries responded with their tariffs against the US, intensifying the depression in the US as her export markets collapsed. China is likely to deny America her superior technology in the same way America is denying hers.

·Americans with investments abroad would suffer since the tariff would make it more difficult for their foreign debtors to pay them interest due. Today, US investments abroad are in the form of factories and other inputs into their supply chains. Biden’s tariff policies and their likely extension will end up hitting American businesses hard, if not as a first order effect, then by the consequences of second and further orders of effect.

Encouraged by the Americans, US tariffs against China are provoking the EU to introduce their own protectionist tariffs for fear of Chinese corporations dumping product which otherwise would have been exported to the US. And despite having a traditionally freer market approach, it is likely that the UK will follow suit

It is easy to see that Biden, presumably followed by Trump in 2025 is speeding up the change from fully diversified global supply chains to the repatriation of production. As well as the geopolitical dimension, the motive for these misguided policies is an erroneous belief that the trade deficit will be eliminated. But as we have seen from the accounting identity above, the trade deficit is linked to the budget deficit. It is the budget deficit which is the problem.

The link between the two deficits can be broken by US consumers increasing their savings and cutting their immediate consumption. That can be ruled out. The only alternative is a devaluation of the dollar, which is what FD Roosevelt did in January 1934 when he cut the dollar from $20.67 to $35 to the gold ounce. In a fiat currency environment, the devaluation of the dollar against commodities and consumer products will be achieved by markets. And it will be a continuing, accelerating process trying to find an elusive balance, which will continue until either fiscal and monetary authorities recognise the problem and change policies, or the dollar sinks towards worthlessness.

The implications are that led by the dollar, other fiat currencies’ purchasing power will continue to decline, with the rate of decline accelerating. And all financial assets valued in depreciating credit will crash when investors realise that the interest rate outlook is for potentially far higher, not lower rates.



Alasdair became a stockbroker in 1970 and a Member of the London Stock Exchange in 1974. His experience encompasses equity and bond markets, fund management, corporate finance and investment strategy. After 27 years in the City, Alasdair moved to Guernsey. He worked as a consultant at many offshore institutions and was an Executive Director at an offshore bank in Guernsey and Jersey.

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