When Fed Chairman Jerome Powell announced that he was under criminal investigation by the Department of Justice, markets braced themselves for a shock. The investigation — centered on a $2.6 billion renovation of the Fed’s Washington headquarters — was immediately labeled by an unusually blunt Powell as a “pretext” to force rate cuts. Futures contracts fell.
However, when the market opened, while gold and silver soared, stocks remained calm and the dollar barely moved. For economist Tyler Cowen, the renowned libertarian at George Mason University and author of the influential blog Marginal Revolution, this lack of panic in the markets is the most revealing part of the drama. It’s not that investors trust the government’s motives; is that they have already accepted the “ugly and uncomfortable truth” that the Federal Reserve’s independence is a relic of a bygone era.
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“What Trump did was terrible,” Cowen said on technology podcast TBPN, referring to the administration’s erratic style of institutional pressure, which he likened to that of “Captain Queeg.” “But to me, the reason the markets haven’t reacted more is that we’ve already destroyed the Fed’s independence. That’s the ugly truth behind this story. It was already destroyed.”
In Cowen’s version, the damage was done years ago, through fiscal policy. Budget deals, tax cuts, and a chronic deficit have steadily narrowed the Fed’s real freedom of action, regardless of its formal mandate.
“The basic problem is that our debt and our deficits are so high that over time we are going to monetize them to some extent and have higher inflation because we prefer that to higher taxes, no matter what we may say,” Cowen said on the TBPN technology program.
This preference, Cowen argues, quietly erodes central bank independence. Even without explicit political pressure, a highly indebted democracy is one that limits its own monetary choices. At some point, inflation becomes the least politically painful way to manage obligations that voters are unwilling to finance through taxes or spending cuts.
A dark echo
This diagnosis grimly echoes the work of Ray Dalio, the billionaire founder of the massive hedge fund Bridgewater Associates, who has long warned of the “Great Cycle” debt trap.
Dalio’s framework suggests that countries with huge debts end up running out of good options. They are left with three politically toxic alternatives: austerity (massive spending cuts), default (unthinkable for a reserve currency) or inflation (“printing money” to devalue the debt).
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Dalio has often agreed with Cowen that for the United States, inflation is the only way forward, as it is an invisible tax that a democracy will always prefer to the political suicide of large tax increases or the dismantling of social programs.
In a recent conversation with another billionaire, David Rubenstein, co-founder of Carlyle, Dalio said: “My grandchildren, and great-grandchildren who haven’t even been born yet, will pay this debt in devalued dollars.”
Cowen offered a prediction of what Dalio calls “ugly deleveraging” will look like: The U.S. may need half a decade of 7% inflation to erode the value of debt relative to the size of the economy.
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“It is highly unpleasant, and many people will be thrown out of work and living standards will be lower,” Cowen said. “But we’ve already spent that money. We can’t default, and that’s what’s in front of us for the next 10 to 15 years,” suggesting that while default would normally be the way out of this kind of dilemma, the U.S.’s status as the richest economy in world history and home to the global reserve currency makes it unfeasible.
The irony, Cowen notes, is that the country’s unique status allows it to sustain higher debt than almost any other nation, including rich ones.
This privilege may raise living standards today, but it still weakens political discipline tomorrow, allowing leaders to not only “get away with more debt” but also explicitly destabilize the Fed without worrying too much about a negative market reaction.
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While neither Dalio nor Cowen brought this debt argument to the Powell-Trump conflict, at the heart of the dispute is a similar dynamic: How can the U.S. improve the living standards of its middle and lower classes?
Trump has been pressing Powell for interest cuts that would lower mortgage rates and make housing easier to afford, but this risks fueling an even bigger wave of inflation in the future — or even sooner.
Albert Edwards, Société Générale’s outspoken and eccentric global strategist, sounded eerily similar to Dalio and Cowen when he spoke to Fortune in November. “We’re going to end up with runaway inflation at some point, because that’s the outcome. There’s no appetite to reduce deficits,” Edwards declared.
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The miracle that could change everything
There is, however, a deus ex machina that could change the course of things: the productivity miracle that many economists hope will come, driven by artificial intelligence.
If AI could lift U.S. GDP growth by one percentage point per year, Cowen said, the country could grow out of the debt trap without resorting to a decade of high inflation. Still, he is skeptical.
About half of the American economy — government, higher education, much of healthcare and the nonprofit sector — is structurally slow, he argues. AI may save enough time for workers in these sectors to “spend more time chatting at the water cooler,” but not enough to drastically increase production.
Meanwhile, innovation can simply focus on already productive sectors of the economy. Without a radical efficiency gain in the half of the economy that does not produce “white belt or black belt” AI tools, the debt clock will continue to tick faster than the AI revolution.
The result is a new and more dangerous era for the US dollar.
“I’m not telling you not to worry” about the Fed’s independence, Cowen said. “I’m saying you should have been worried from the beginning.”
And yet, as Morgan Stanley noted in early January, something else enters the calculation along with the latest rumors about central bank independence: a 4.9% increase in annualized productivity, as new third-quarter GDP data suggests.
“We believe much of the rise is cyclical,” noted economists led by Michael Gapen, adding that “it is still an open question what is driving the acceleration in productivity.”
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