On August 5th, US District Judge Amit Meta released a Department of Justice (DOJ) ruling against Google, which sets a dangerous precedent that could potentially hinder a common business practice in many industries, signaling a shift in antitrust policy that could negatively impact economic growth. 

The facts state that Google pays Apple roughly $20 billion per year to be the search engine default in Apple’s marquee browser, Safari.  The high price tag and Google’s large market share caught the ire of federal antitrust regulators, who argued that the payments were effectively preventing competition, resulting in Google’s persistently high market share. By singling out Google’s behavior as harmful, the court sets a precedent that could hinder legitimate business practices common in both online and offline markets.

Paying for privileged status is a routine, lawful, and often beneficial strategy employed by businesses to gain visibility and drive sales. Regardless, as the court will admit, these tactics are only valuable when the product is of sufficient quality to actually attract customers. To argue that Google’s payments are anticompetitive ignores the broader context in which such transactions occur and fails to appreciate the options that remain available to consumers.

Consider the example of product placement in retail stores, a practice deeply entrenched in the business world. Consumer goods companies routinely pay retailers for prime shelf space — often at eye level — to increase the visibility of their products. Consumers retain the freedom to choose alternative products, even if those products are less prominently displayed. The ability to pay “slotting fees” for prime shelf space does not guarantee a sale; it simply enhances the likelihood of consumer engagement. The court’s decision against Google fails to account for this dynamic. Just as consumers can walk past a product at eye level and choose something else, they can just as easily change their default search engine.

Beverage companies negotiate exclusive contracts with restaurants, schools, stadiums, and other establishments. If consumers don’t like the soda beverage options, they drink alternative beverages like water or go to different venues that offer the experience they seek. This, in turn, would drive more competition for the contract itself as other more reputable brands try to fill that void. The existence of exclusive contracts does not mean that consumers are harmed or that such contracts forgo competition. 

The main difference is that no soda beverage company maintains as high a market share as Google, but that shouldn’t matter as long as there is competition for the contract and no demonstrable consumer harm. Antitrust enforcement has never taken high market share as inherently indicative of anticompetitive behavior but rather has focused on consumer welfare. The market for search engines remains competitive, with Bing, DuckDuckGo, Yahoo! (once the top search engine to beat) and other options available to consumers, and many of those companies are bidding on the same contract as Google. The notion that Google’s payments have somehow stifled all competition ignores the presence of these alternatives and the fact that consumers are increasingly aware of and able to exercise their choices. 

The court’s decision fails to acknowledge that consumer behavior is not dictated solely by defaults. Users have shown a willingness to change search defaults when they perceive the alternative to be superior, whether due to privacy concerns, performance, or other factors. The existence of these alternatives and the ability of consumers to choose them should be sufficient evidence that the market remains competitive. 

As Geoffrey Manne, President and Founder of the International Center for Law and Economics, notes in his review of the case, “Google’s default agreements can’t be deemed to have caused anticompetitive harm because defaults are readily overcome by high-quality, reputable alternatives.” The ruling itself even acknowledges that there was no “price that Microsoft could ever offer Apple to make the switch because of Bing’s inferior quality.” In other words, the price of the contract and Google’s market share are irrelevant because there is no other product that matches the quality of its search. Consumers clearly have options when it comes to search, but because they consistently choose one product over the other does not mean that the exclusive contracts indicate anticompetitive behavior. Companies invest in marketing, partnerships, and product placements to increase their visibility and, ultimately, their revenue. This is not anti-competitive; it is the essence of competition.  

The DOJ’s aggressive approach could have broad economic implications. If businesses are discouraged from investing in securing market positions due to fear of antitrust repercussions, we could see a reduction in advertising spending, marketing partnerships, and other forms of competitive economic behavior. This would hurt not only the companies themselves but also the industries that rely on such spending, from advertising agencies to retail chains. It could also harm consumers by raising prices, since distributors would no longer have the subsidy of the contract to help lower the price for consumers. The ripple effects could be far-reaching, dampening economic activity in sectors that depend on the flow of investment from businesses seeking to enhance their market presence.

In conclusion, the court’s decision to penalize Google for its payments to Apple as part of securing the default search engine position on Safari is a narrow interpretation of competitive behavior that fails to account for the broader business practices prevalent across various sectors. Paying for privileged positions is a common strategy employed by businesses to enhance visibility and drive sales, whether in retail, advertising, or digital markets. These payments do not inherently stifle competition; instead, they represent a legitimate and often beneficial investment. If anything, Google’s payments to Apple for default placement on Safari are akin to a company paying for a prime billboard spot. It’s about visibility, not coercion. The court should recognize these facts during the ensuing appeals process. 

One popular version of the case for industrial policy goes like this: free markets and free trade are great. These policies are the best means of promoting economic growth and widespread prosperity at home except when foreign governments don’t follow these policies. To the extent that our trading partners use tariffs, subsidies, and other tools of industrial policy, we can no longer stick with free markets. We must instead match the economic interventions of foreign governments with economic interventions of our own. If we don’t do so, we leave ourselves unarmed against the economic aggression of other countries — aggression that will impoverish us if we don’t repel it with our own tariffs, subsidies, and other tools of industrial policy.

The most obvious flaw in this case for industrial policy is its illogic. If tariffs and other government interventions into the economy harm the people of the home country when other governments follow policies of free trade and free markets, when a foreign government raises tariffs or otherwise intervenes more heavily into its country’s economy the result will be to weaken, not strengthen, that foreign-country’s economy. Far from requiring retaliatory economic interventions by our government, the economic interventions by the foreign government will themselves drain that foreign economy of efficiency and vigor, thereby making it less, not more, effective at ‘competing’ with our economy.

Relatedly, foreign-government deviations from free-market policies do not miraculously give officials in the home government the knowledge these officials must have to out-perform the market at allocating resources. If home-government officials had reliable access to such knowledge (and could be trusted to use it in the public interest), they should practice industrial policy regardless of the economic policies pursued abroad. The principal economic argument against industrial policy is that government officials cannot possibly know enough to out-perform markets and cannot be trusted even to try.

Over the years I’ve asked many protectionists “Why, if free trade is the best policy for our economy when other countries practice free trade, does free trade become a bad policy for us when other countries practice protectionism?” On rare occasions the answer will be that by raising our tariffs we will pressure foreign governments into lowering their tariffs, which will benefit the people of both countries. This answer is at least logically sound, if its practical merit is meager. But most of the time the answers are nothing more than verbal fusillades of inapt war and sports metaphors. “If we don’t retaliate with our own tariffs, we go into battle unarmed!” “If we don’t match their export subsidies with our own export subsidies, the playing field will be uneven!” “If we don’t pursue industrial policy as other governments pursue industrial policy, we’ll send our producers into the boxing ring with one arm tied behind their backs!”

Analogies such as these favorably impress only the economically uninformed, for only the economically uninformed believe that trade is a zero-sum (or even negative-sum) game in which the people of one country can gain only by inflicting losses on – by economically defeating – the people of other countries.

But protectionist arguments are plagued not only by logical flaws; the actual empirical record is also unfriendly to these arguments – as two recent reports make clear.

One report, in The Economist, is about China. The government in Beijing is keen on picking industrial ‘winners’ for that country, and one such chosen winner in recent years is the electric-vehicle industry. Using a variety of means, Chinese Communist Party officials and mandarins in Beijing have directed substantial resources into EV production — a policy that allegedly justifies matching support from the US government for American-based EV producers. But as matters are developing, this ‘winner’ in China is turning into a loser. According to The Economist,

At least eight large makers of the cars have shut down or halted production since the start of 2023. The ripples are visible throughout the supply chain. Qingdao Hi-Tech Moulds, a large auto-parts supplier, warned in a statement earlier this year that the halting of production at HiPhi, an automaker, could send its net profit tumbling by up to 60 percent. saic Anji Logistics, an auto-industry logistics provider, said in recent bankruptcy proceedings that it collapsed mainly because Aiways, another troubled automaker, had failed to pay its bills. The failure of Levdeo, yet another carmaker, has left 4bn yuan ($550m) in unpaid bills to suppliers, agents and banks. Some 52,000 ev-related companies shut down in China last year, an increase of almost 90 percent on the year before, according to one estimate.

This development is unsurprising. No matter how smart and clever are President Xi and his lieutenants, they cannot work miracles. If the Chinese have no comparative advantage at producing EVs on a scale as large as the one desired by these government officials, diverting resources on this scale into EV production is likely to backfire — as it’s now doing. It’s possible that if Beijing diverts yet more resources into this industry that eventually the Chinese will come to have the necessary comparative advantage at producing EVs. But as things now look, this possibility is a bad bet — although it’s a good bet that Beijing will in fact strive to buoy China’s troubled EV producers with yet more subsidies and special protections. After all, the money that Chinese-government officials are spending isn’t their own; it’s money forcibly taken from Chinese taxpayers and consumers.

But even if the unlikely occurs and the Chinese do eventually become efficient at producing EVs on the scale fancied by Pres. Xi, at what price for the Chinese people? Not only will they have been forced to subsidize losses during the period when Chinese EV producers have no comparative advantage at producing EVs on such a scale, this government-engineered creation of a Chinese comparative advantage at producing EVs necessarily — by the inescapable logic of comparative advantage — will have taken away from the Chinese a comparative advantage at producing some other outputs.

It’s impossible for officials in Beijing to know which Chinese industries their EV subsidies are destroying. It’s also impossible for them to know if the advantage that China will gain if and when it gets a comparative advantage at producing EVs will have been worth the cost. Indeed, because the money spent by government officials isn’t their own, and because these officials are not directed in their economic decisions by market prices, it’s almost certain that government-engineered economic outcomes are worse than would be the outcomes generated by freer markets.

Why we Americans should quake in fear at these self-destructive Chinese economic shenanigans is a mystery.

The second report, in the Financial Times, is about the US. The opening lines of this report speak volumes:

Some 40 per cent of the biggest US manufacturing investments announced in the first year of Joe Biden’s flagship industrial and climate policies have been delayed or paused, according to a Financial Times investigation.

The US president’s Inflation Reduction Act and Chips and Science Act offered more than $400bn in tax credits, loans and grants to spark development of a US cleantech and semiconductor supply chain.

However, of the projects worth more than $100mn, a total of $84bn have been delayed for between two months and several years, or paused indefinitely, the FT found.

The same economic and political obstacles that prevent US government officials from outperforming the private sector at allocating resources when Beijing and other governments are liberalizing their economies prevent the US government from outperforming the private sector at allocating resources when Beijing and other governments start intervening more heavily into their economies. And the time, effort, and resources spent by American producers lobbying for special privileges is made no less wasteful just because foreign governments engage in orgies of special-privilege giveaways.

If we Americans want our economy to be as productive as possible and to ensure as well as possible a high and growing standard of living for as many Americans as possible, we must keep our economy as competitive as possible. This condition means no protective tariffs and no subsidies. If other governments insist on harming their countries’ economies with such interventions, that’s their business. We can pity the citizens of those countries. But both economic logic and the empirical record are clear that the best course for us is economic freedom without special favors or penalties.

In June 2024, all three of the AIER Business Conditions indicators maintained their levels from the previous month. The Leading Indicator stood at a mildly expansionary level of 54, while the Roughly Coincident Indicator remained at 83 and the Lagging Indicator at a moderately contractionary 42.

Leading Indicator (54)

Among the twelve Leading Indicator components, from May to June 2024 seven rose, two fell, and three were neutral. Among the rising constituents were the 1-to-10 year US Treasury spread (5.8 percent), US Initial Jobless Claims (4.4 percent), Conference Board US Leading Index of Stock Prices (3.4 percent), University of Michigan Consumer Expectations Index (1.2 percent), US New Privately Owned Housing Units Started by Structure (1.1 percent), Conference Board US Leading Index Manufacturing, New Orders, Consumer Goods and Materials (0.6 percent), and the Conference Board US Manufacturers New Orders Nondefense Capital Good Ex Aircraft (0.1 percent). 

United States Heavy Truck Sales fell 8.7 percent, and the Adjusted Retail and Food Service Sales declined 0.2 percent. The US Average Weekly Hours All Employees Manufacturing, Inventory/Sales Ratio: Total Business, and FINRA Customer Debit Balances in Margin Accounts remained unchanged.

Roughly Coincident (83) and Lagging Indicators (42)

In the Roughly Coincident Indicator, five components rose and one declined. From May to June 2024, Industrial Production and Coincident Personal Income Less Transfer Payments each gained 0.3 percent, while Coincident Manufacturing and Trade Sales and the US Labor Force Participation Rate rose 0.2 percent. US Employees on Nonfarm Payrolls rose by 0.1 percent, and the Conference Board Consumer Confidence Present Situation Index declined by 3.9 percent. 

Among the six Lagging Indicators, one rose, four declined, and one was neutral.

Core CPI year-over-year fell by 2.9 percent, the Conference Board US Lagging Average Duration of Unemployment by 2.4 percent, and both the Census Bureau’s Private Construction Spending (Nonresidential) and US Commercial Paper Placed Top 30 Day Yields by 0.1 percent. US Manufacturing and Trade Inventories increased 0.3 percent while US Lagging Commercial and Industrial Loans rose were flat. 

The substantial divergence among the three indices perpetuates a trend of ambiguity rather than clarity. However, as will be elaborated in the discussion section, with the benefit of observing developments through July and mid-August there is increasing evidence that the Lagging Indicator has provided the most accurate reflection of underlying economic conditions.

Discussion

At the end of July 2024, applications for US unemployment benefits surged to their highest point in nearly a year, clearly indicating a labor market slowdown: initial claims for the week ending on July 27th increased by 14,000 to 249,000, exceeding the 236,000 expected. Continuing claims, representing the number of individuals receiving unemployment benefits, rose to 1.88 million in the week ending July 20 – the highest level since November 2021. 

Further, recent Worker Adjustment and Retraining Notification (WARN) data indicate that the layoffs which began in California’s tech sector are now spreading across Sun Belt states and industries. Texas has been particularly impacted, as have Nevada and Tennessee. Over half of US states, including Washington, DC, have experienced rising unemployment since March 2024. Approximately 35 percent of the US population now resides in areas where the three-month average unemployment rate has risen by more than 50 basis points from its twelve-month low.

The July 2024 Institute for Supply Management (ISM) manufacturing survey underscored the significant deterioration in labor market conditions. Although the survey’s overall index underperformed expectations, registering 46.8 compared to the anticipated 48.8, the most concerning development was the employment component’s steep drop to 43.4, well below the projected 49.2. That figure represents the lowest level since June 2020, and, excluding the pandemic period, the weakest reading since 2009. The underperformance in new orders further accentuates the prevailing economic weakness, as does the decline of average weekly hours worked to approximately 34.2. This is only the third occurrence of that level in the past two decades. The previous instances coincided with the 2008 and 2020 recessions.

The sharper-than-expected decline in July’s industrial production statistics likely exposes the impact of restrictive monetary policy on the real economy. Durable consumer goods and business equipment production are both on a downward trajectory, signaling weak factory output. Among the key results:

Industrial production fell by 0.6 percent in July.

Manufacturing output decreased by 0.3 percent.

Consumer goods production dropped by 1.0 percent, following an 0.6 percent rise in June, with consumer durables such as automotive products and appliances—categories sensitive to interest rates—falling by 4.0 percent in July and 5.2 percent on a year-over-year basis.

Nondurable consumer goods output saw an 0.2 percent decline after a 0.7 percent increase in June. Including intermediate nondurables, production increased by 0.4 percent, similar to June’s performance.

Despite unusually warm weather in early July, electricity output decreased by 4.3 percent, significantly contributing to the overall drop in industrial production.

Capacity utilization fell sharply to 77.8 percent from 78.4 percent in June, reflecting both reduced factory activity and worker hours.

The Empire State and Philadelphia Fed manufacturing surveys for August 2024 served to reinforce indications of a softening in activity with a notable decline in employment metrics. The Empire State index slightly improved to -4.7, while the Philly Fed index dropped sharply to -7.0, reflecting mixed underlying details including declining new orders in New York and slower growth in Philly. Despite surface variations in the data, both surveys showed declines in employee numbers and average hours worked. Numerous signs of contraction in interest-sensitive sectors indicate that producers are scaling back in anticipation of weakening demand.

On the consumer side, in July, US spending was predominantly channeled towards essential grocery items, with discretionary spending remaining subdued. The 1 percent rise in headline retail sales exceeded expectations, driven largely by a recovery in auto sales, while the control group’s modest 0.3 percent gain reflects a cautious consumer environment. Excluding autos and gasoline, sales grew by 0.4 percent, marking a deceleration from the previous month and highlighting ongoing consumer restraint.

The tepid growth in consumption underscores an increasing reliance on discount-driven purchases as strained consumers navigate weak financial fundamentals. The food services sector, a critical indicator of service demand, showed a slight rebound with a 0.3 percent increase, yet continues to lag behind typical growth patterns, further illustrating cautious spending behavior. 

A somewhat brighter spot can be found in recent inflation data, which suggest progress in the Federal Reserve’s disinflation efforts. The June Personal Consumption Expenditure (PCE) index and several months of core inflation prints roughly aligned with the Fed’s 2 percent target indicate that the central bank may soon have the latitude to cut rates. Headline PCE inflation rounded up to 0.1 percent month-over-month in June, while the core PCE deflator rose modestly to 0.18 percent, slightly exceeding estimates. July’s Consumer Price Index (CPI) report showed a softening in the core measure, though inflation in core services such as housing rents and car insurance remains elevated, suggesting a mixed outcome for the core PCE deflator. If forecasts hold, the combination of July’s CPI and Producer Price Index (PPI) data imply an acceleration in the core PCE deflator on both monthly and annual bases. Nevertheless, the one-, three-, and six-month annualized changes in core CPI were 2.0 percent, 1.6 percent, and 2.8 percent respectively, with the first two measures meeting the Fed’s target pace and the third approaching it. Although PPI components feeding into the core PCE deflator were slightly softer in July, rising financial-service costs continue to exert upward pressure on this key inflation gauge. 

All of these factors have intensified calls for rate cuts and increased demand for long-duration assets. The frequent occurrence of headfakes and reversals in various economic indicators and aggregates in recent years necessitate a cautious interpretation of even seemingly clear economic trends, such as those now describing a contractionary path. While the Federal Reserve’s progress in controlling inflation may provide the latitude needed to begin rate cuts aimed at supporting employment and growth, the activation of the Sahm Rule suggests that the United States has either entered, or is on the verge, of entering a recession.

LEADING INDICATORS

ROUGHLY COINCIDENT INDICATORS

LAGGING INDICATORS

CAPITAL MARKET PERFORMANCE

Public debt, sometimes called government debt, is money borrowed by governments. Like all debt, public debt finances spending today by borrowing on the promise to repay what is borrowed in the future with interest.  Richard E. Wagner, an economist who has studied the borrowing of money by governments, explains the process of government borrowing by noting that democratic governments act as financial intermediaries, bringing together lenders and borrowers, “some willingly and others forcibly.” He observes that those willing to borrow are those who want greater spending today for their preferred programs despite a lack of current resources, while those who are forced would prefer lower taxes in the future over government programs today.

Public debt is not a new phenomenon. Governments and rulers in nearly every civilization have taken on public debt to finance large government projects, especially war and infrastructure. The rise of commercial society and the wealth it spawned made it easier for those in government to borrow money to finance spending of all sorts. As the merchant class became wealthier, the government found a growing pool of lenders who were happy to lend to the government with the promise of being paid back with interest. Writing in 1776, Adam Smith noted,

The government of [a commercial state of society] is very apt to repose itself upon this ability and willingness of its subjects to lend it their money on extraordinary occasions. It foresees the facility of borrowing, and therefore dispenses itself from the duty of saving.

Smith’s observation describes the current circumstances faced by the United States government. At all levels of government, willing lenders are happy to lend money and buy US Treasury securities and municipal bonds, allowing federal, state, and local governments to fund spending today by promising to pay in the future. This Explainer looks at that public debt, its impact on taxpayers, and what, if anything, can be doneto mitigate the scope and impact of that debt.

Read the full Explainer:

Explainer_UPDebt

Woosh, woosh, woosh.

The helicopter blades cut through the crisp summer air, and the thundering roar of the engines echoes through the mountain valley. A handful of workers 1,200ft up the mountain stand ready to put in place the massive steel barriers lifted there by the chopper. All day, for a couple of days in a row, these teams of engineers, construction workers, and skilled pilots moved a few dozen huge barriers from the airfield on the other side of the valley to the steep slopes above the main portion of the village.

Watching the helicopter make its hypnotic journey has me thinking about the public finance implications of constructing and maintaining avalanche protections.

Certainly, the literal value at risk is quite extreme: the thousand-odd inhabitants of my little village have plenty of houses and cars and belongings — not to mention their own, invaluable lives — as well as the major businesses in town (hotel, harbor, church, offices) in the way of potential avalanches. Most of us stand to lose a lot if a snowy flood descends from the ominously steep mountain above us.

It makes plenty of financial and economic sense to expend labor, raw materials, and a decent amount of fossil fuels to erect this protection against the elements. Tail-risk insurance against nature.

But avalanche protection, like defense or streetlights, is what economists classify as “public good,” being both non-rivalrous and non-excludable. Once in place, an inhabitant like myself cannot be prevented from benefiting from the service, whether or not I financially contributed to its construction or upkeep.

Thus, says elementary public finance, an otherwise well-functioning market of prices and individual private property fails to provide (enough) of these goods. With an insufficient amount of protection, our village will have too many avalanches damaging too much property. The reason is that a profit-oriented entrepreneur cannot recoup his or her investment since once provided the good is non-excludable and the business can’t charge for the service.

On the other side of that transaction, consumers, who backward-induct that they’d be protected regardless of how much or little they contribute, have a strong incentive to shirk (free ride) — and receive the benefit anyway.

Because the market supposedly fails, the government is justified in saving the day by taxing everyone fairly, and supplying just enough of these goods to maximize a benevolent social planner’s utility function.

The age-old question is, of course, how this social planner knows the relevant quantities. Market exchanges are expressions of marginal value: this much extra protection for that much extra money. The government doesn’t know these quantities. Interventions, writes Guido Hülsmann so eloquently in his book Abundance, Generosity, and the State, “reduce the ability and willingness of private households to make gifts.” He continues: “In a private setting, these problems are moderated by the limits of private property. A private donor will wish to make sure that his donation really achieves its purpose, and he can stop funding any projects that are contrary to purpose.” 

Government involvement removes all that, puts unaccountable bureaucrats in charge, and blankets the financing across a wider taxpaying area. Where I lived, tacked onto every citizen’s insurance policy is a percentage tax, destined for a fund to deal with these matters. 

To no surprise among those well-versed in political economy and public administration, it turned out earlier this year that from the tax levied specifically for protective works, some 40 percent goes straight to the Treasury — and not to the fund tasked with flood and avalanche protection. Even under this supposed solution to a market failure, we’re getting less public goods than we get shafted for. Like many other well-intentioned public finance policies, in time they turn into pure money grabs. 

I approve of this spending of money. I’m happy that these workers and the committees and decision-makers opted for spending money on my protection (they could have spent it elsewhere, and my tax contribution would have been a pure redistribution). I like it so much, indeed, that I’d be willing to contribute myself — many multiples of the $10 my insurance company levied on me for my pittance of a policy, and much closer to the $1,000 or so that the per-person expenditure of the fund would have amounted to among the municipalities and villages for which they were erecting avalanche protections in the last decade. (Accounting for the disproportionately at-risk physical assets run by big companies in the village, the average household would likely be on the hook for much less.)

Centralized government financing takes away the ability for people to express their values monetarily. I can’t “overpay” the surcharge, can’t tip the workers or pilots for a job well done. The outsourcing of decisions, financing, and responsibility alienates citizens from the issue. I am annoyed at the $10 taken without my explicit consent but would have been proud and excited to contribute to a locally organized avalanche protection — even if the exact amount would have been much higher. 

Why, just put out a call for citizens to contribute? We have Facebook pages and regular local newspapers and booklets, and the old-fashioned word-of-mouth. In How Economics Can Save the World Erik Anger, of Stockholm University, tells of a local swimming society that funds itself mainly through competitive overbidding on homemade jams and pies, made and organized by the locals. Strong communities and a shared sense of purpose can compensate fully and sufficiently for the supposed underproduction of public goods.

Suppose, then, that there isn’t enough funding for some proposed version of a community project. Then we can either individually tell people to donate more or realize that insufficient funds raised is the populous saying they don’t actually value the additional avalanche protection received over what else they could be spending their funds on. The (e)valuation — willingness to pay — is the very limiting factor in deciding how much of a public good ought to be provided. 

Such accountability drowns in the major political questions of a larger, centralized country, where local governments end up bidding against each other for projects from the central honey pot. 

Another example of the same public finance themes of risk-reward is a prospective tunnel through the mountain. One of the two roads out of the valley squiggles around a steep mountain cliffside, unstable and vulnerable to landslides. The central government recently said a tunnel to cut out the dangerous cliff is a priority. 

Over coffee with a neighbor when I first moved here, I was told that he much approved of a tunnel but didn’t want to pay a toll for passing it. It’s an extra difficulty, he said, and it’d be unfair since the people in the capital are richer than those residing in our little village. But why does that matter? He, and other villagers like him, are the ones benefitting the most from the potential tunnel. 

No matter what the optimal or suboptimal quantities of public goods are, what the existence of a third party far, far away does to local affairs like this is to outsource the cost and the responsibility. 

It’s time we radically shrunk the size of the state, such that responsibility and financing of collective affairs rest squarely with the local people that most benefit from public goods — whether or not they be underproduced compared to some idealized blackboard model.

In We Need to Talk About Inflation, his thoughtful, accessible tour of the history, theories, politics and future of inflation, Stephen King warns us that: 

          “Inflation is never dead.”  

He is right about that, and that blunt reminder alone justifies the book. 

The book begins, “In 2021, inflation emerged from a multi-decade hibernation.” Well, inflation had not really been in hibernation, but rather was continuing at a rate which had become considered acceptable. It was worry about inflation that had been hibernating. People found themselves caught up in the runaway inflation of 2021-2023, a wake-up call. As the book explores at length, that explosive inflation had been unexpected by the central banks, including the Federal Reserve, making their forecasts and assurances look particularly bad and proving once again that their knowledge of the future is as poor as everybody else’s. 

Now, in the third quarter of 2024, after historically fast hikes in interest rates, the current rate of inflation is less. But average prices continue going up, so the dollar’s purchasing power, lost to that runaway inflation, is gone forever. Inflation continues and has continued to exceed the Fed’s 2-percent “target” rate. And the Fed’s target itself is odd: it promises to create inflation forever. The math of 2-percent compound shrinkage demonstrates that the Fed wants to depreciate the dollar’s purchasing power by 80 percent in each average lifetime. Somehow the Fed never mentions this. 

King shows us that such long-term disappearance of purchasing power has happened historically. Chapter 2, “A History of Inflation, Money and Ideas,” has a good discussion, starting with the debate between John Locke and Isaac Newton, of the history, variations and continuing relevance of the quantity theory of money. It also contains an instructive table of the value of the British pound by century from 1300 to 2000. The champion century for depreciation of the pound was the twentieth. The pound began as the dominant global currency and ended it as an also-ran, while one pound of 1900 had shriveled in value to two pence by 2000. The century included the Great Inflation of the 1970s, during which British Prime Minister Harold Wilson announced, the book relates, that “he hoped to bring inflation down to 10 percent by the end of 1975 and under 10 percent by the end of 1976.” His hopes were disappointed, as King sardonically reports: “The actual numbers turned out to be, respectively, 24.9 percent and 15.1 percent.”

These inflationary times need to be remembered, as should numerous hyperinflations. Best known is the German hyperinflation of 1921-23, the memory of which gave rise to the famous anti-inflationist regime of the old Bundesbank. (It was once wittily said that “Not all Germans believe in God, but they all believe in the Bundesbank” — however, this does not apply to its successor, the European Central Bank.) King also recounts that the effects of the First World War gave rise to three other big 1920s hyperinflations — in Austria, Hungary and Poland, and that “inflation in the fledging Soviet Union appears to have been stratospheric.” He discusses the 1940s hyperinflation in China, and how in the 1980s “Brazil and other Latin American economies…succumbed to hyperinflation, currency collapse and, eventually, default.” We must add the inflationary disasters of Argentina and Zimbabwe.  

All these destructive events resulted from the actions of governments and their central banks. The book considers the theory of how to put a stop to this problem that Nobel Prize-winning economist Thomas Sargent made in 1982. First and foremost, as described by King, it is “the creation of an independent central bank ‘legally committed to refuse the government’s demand for additional unsecured credit’ — in other words, there was to be no deficit financing via the printing of money.” Good idea, but how likely is this suggested scene in real life? The central bank says to the government, “Sorry about your request, but we’re not buying a penny of your debt with money we create. Of course, we could do it, but we won’t, so cut your expenses. Good luck!” Probably not a winning career move for a politically appointed central banker, and not a very likely response, we’ll all agree. 

Moreover, in time of war or other national emergency, the likelihood of this response is zero. War is the greatest source of money printing and inflation. War and central banking go way back together: the Bank of England was created in 1694 to finance King William’s wars, was a key prop of Great Britain’s subsequent imperial career, and in 1914, fraudulently supported the first bond issue of the war by His Majesty’s Treasury.i The Federal Reserve was the willing servant of the U.S. Treasury in both world wars and would be again, whenever needed. In the massive war-like government deficit financing of the 2020-2021 Covid crisis, the Fed cooperatively bought trillions in Treasury debt to finance the costs of governments’ closing down large segments of the economy. 

Reflecting on the enduring temptation of governments to inflate and depreciate their currencies, King rightly observes: 

“Inflation is very much a political process.”  

“Left to their own devices, governments cannot help but be tempted by inflation.” 

“Governments can and will resort to inflation.” 

“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” (Here he is quoting J.M. Keynes.) 

Just as economics is always political economics and finance is always political finance, central banking cannot avoid being political central banking. The book considers at length the inevitable interaction between government spending and debt, on one hand, and money creation and inflation, on the other—in economics lingo, between fiscal policy and monetary policy. In theory, there can be a firm barrier between them, the spending and taxing done in the legislative and executive branches; and the money printing, or not, in the control of the central bank. In practice, the two keep meeting and being intertwined. King calls this the “Burton-Taylor” problem. Here is his metaphor: 

“History offers countless examples in which fiscal expediency trumps monetary stability. The two big macroeconomic levers are the economic equivalent of Elizabeth Taylor and Richard Burton, the Hollywood stars who were married twice [and divorced twice] and who were, perhaps still in love when Burton died: occasionally separated but always destined to reconnect.”  

Indeed, governments’ desire for deficit spending and the ready tool of money printing and inflation are always destined to reconnect.  

This reflects the fundamental dilemma of all politicians: they naturally want to spend more money than they’ve got to carry out their schemes, including wars. As the book observes, “Wartime provides the ultimate proof of inflation’s useful role as a hidden tax.” Politicians want to keep their perhaps lavish promises to their constituencies, to reward their friends, to enhance their power, to get re-elected; they like much less making people unhappy by taxing them. The simple answer in every short term, is to borrow to finance the deficit and run up the government’s debt. When borrowing grows expensive or becomes unavailable, the idea of just printing up the money inevitably arises, the central bank is called upon, and yet another Burton-Taylor marriage occurs.  

Just printing up the desired money is a very old idea. As the book discusses, this frequently practiced, often disastrous old idea has been promoted anew—now under the silly name of “Modern” Monetary Theory. 

King writes: 

“The printing press is a temptation [I would say an inevitable temptation] precisely because it is an alternative to tax increases or spending cuts, a stealthy way in the short run of robbing people of their savings…. Ultimately, there is no escaping ‘Burton-Taylor.’” 

When governments and central banks yield to this temptation, can the central banks correctly anticipate the inflationary outcomes? Do they have the required superior knowledge? Clearly the answer is no. 

Chapter 6 of the book, “Four Inflationary Tests,” provides an instructive example of failed Bank of England inflation forecasts, to which I have added the actual outcomes, with the following resultsii: 

Forecast MadeCurrent InflationOne Year AheadTwo Years Ahead(quarter)(estimated)ForecastActualForecastActual3Q 20200.30%1.8%2.8%2.0%10%4Q 20200.62.14.9210.71Q 20210.82.16.22.110.22Q 20211.72.39.228.4

To apply an American metaphor to these British results, that is four strikeouts in a row. The inflation forecasting record of the Federal Reserve presents similar failures. 

Central banks try hard, including their large political and public relations efforts, to build up their credibility. They want to preside over a monetary system in which everybody believes in them. 

But suppose that everybody, including the members of Congress, instead of believing, developed a realistic understanding of central banks’ essential and unavoidable limitations. Suppose everybody simply assumed it is impossible for central banks to know the future or the future results of their own actions. Suppose, as King puts it, the whole society had “a new rule of thumb… ‘these central bankers don’t know what they’re doing.’” Rational expectations would then reflect this assumption. 

In that case, central banks would certainly be less prestigious. Would our overall monetary system be improved? I believe it would be. We Need to Talk About Inflation, among many other interesting ideas, encourages us to imagine such a scenario. 

One of my more memorable exchanges with a student came in a principles of economics class. Part of the assignment for that week was chapters from Matt Ridley’s The Rational Optimist. Ridley compared the living standards of an average worker today with those of The Sun King, Louis XIV, in 1700. Some of my more ahistorical students were incredulous at Ridley’s description of the grinding poverty of the average person just a few centuries ago. 

The King had an opulent lifestyle compared to others. Louis had an astonishing 498 workers preparing each of his meals. Yet his standard of living was still a fraction of what we experience today. 

Ridley outlined the miracles of specialization and exchange in our time — an everyday cornucopia at the supermarket, modern communications and transportation, clothing to suit every taste. If we remove our blinders and see how many individuals provide services to us, Ridley concludes we have “far more than 498 servants at [our] immediate beck and call.”

Then, the memorable exchange occurred. One student shared that he would prefer to live in 1700, if he had more money than others and power over them. My first reaction was amusement; I thought the student was practicing his deadpan humor skills. He wasn’t. For him, having power was an attribute of a meaningful life. 

If only my student’s mindset were an aberration.

During the reign of Louis XIV, French mathematician and philosopher Blaise Pascal diagnosed why some lust for power. In his Pensées, Pascal wrote, “I have often said that the sole cause of man’s unhappiness is that he does not know how to stay quietly in his room.” Pascal explained that, out of the inability to sit alone, arises the human tendency to seek power as a diversion.

Pascal asks us to imagine a king with “all the blessings with which you could be endowed.” A king, Pascal told us, if he has no “diversions” from his thinking, will “ponder and reflect on what he is.” Pascal’s hypothetical king will be miserable because he “is bound to start thinking of all the threats facing him, of possible revolts, finally of inescapable death and disease.”  

“What people want is not the easy peaceful life that allows us to think of our unhappy condition.” That is why “war and high office are so popular,” Pascal argued.

Pascal argues individuals seek to be “diverted from thinking of what they are.”  I would argue a better choice of words is what they have made of themselves. 

I’ll let the reader decide how many modern politicians Pascal’s ideas apply to. With Pascal’s insight, we understand why conflict is a feature of politics and not a bug.   

Pascal spares no one’s feelings. Some “seek external diversion and occupation, and this is the result of their constant sense of wretchedness.” For them, “rest proves intolerable because of the boredom it produces. [They] must get away from it and crave excitement.”

Let that sink in. A person able to exercise coercive power can use their morally undeveloped “wretched” mind to create endless misery for others merely because exercising power distracts them from their failures as human beings. 

Many of America’s Founders had a classical education and they understood the dangers of power. John Adams wrote, “There is danger from all men. The only maxim of a free government ought to be to trust no man living with power to endanger the public liberty.”

We can overcome our “sense of wretchedness” and need for “excitement” not through the perverted means of seeking power but by creating meaning in our lives.

Viktor Frankl, the author of the seminal Man’s Search for Meaning, understood the importance of having a meaningful life and how damaging it is when the drive for meaning is thwarted. He observed how easy it is to “despair over the apparent meaninglessness of one’s life.”

No wonder those who are unfulfilled without meaning wish to be diverted from what they have made of their lives. What Frankl observed is consistent with Pascal: “Sometimes the frustrated will to meaning is vicariously compensated for by a will to power.” 

Frankl added, “In other cases, the place of frustrated will to meaning is taken by the will to pleasure.” Similarly, “The main joy of being a king,” Pascal observed, is to be surrounded by people “continually trying to divert him and procure him every kind of pleasure…  and stop him thinking about himself.” Pascal and Frankl would understand why someone would reach for their phone every few minutes. The maladaptive behavior is an attempt to scratch an existential itch.

Frankl also understood why people would become followers of authoritarian leaders. Mass movements attract followers who fail to make meaning in their lives and seek a borrowed meaning from a destructive leader.

Among the ways Frankl believed we could make meaning were thorough purposeful actions, creative endeavors, and loving others. Entrepreneurial activity — the pursuit of new ways of serving consumers’ most urgent needs — is fertile ground for making meaning. While capitalism is a mechanism for meaning making, even the term itself is loathsome to some; and thus, they fail to avail themselves of opportunities. 

Insightfully, Frankl saw, “Ever more people today have the means to live, but no meaning to live for.” Frankl wrote, 

For too long we have been dreaming a dream from which we are now waking up: the dream that if we just improve the socioeconomic situation of people, everything will be okay, people will become happy. The truth is that as the struggle for survival has subsided, the question has emerged: survival for what? 

Frankl called meaninglessness an “existential vacuum” and warned it is “increasing and spreading to the extent that, in truth, it may be called a mass neurosis.”

What Frankl observed, we see as a crisis of our time. Many people without meaning believe they are victims, and experts encourage them to think that way. Frankl called this “neurotic fatalism.” 

Neurotic fatalism hides a basic fact of human life: People who make meaning in their lives don’t seek “freedom from conditions” they realize they have the “freedom to take a stand toward the conditions.”

Pacal’s authoritarian king or many of today’s modern politicians have no meaning in their lives but find a corrupted false sense of meaning by exercising power over others, starting wars, issuing edicts, punishing enemies, etc. Likewise, those engaged in carrying out their orders have no meaning in their lives other than what they are borrowing from those leading them. This unvirtuous cycle threatens freedom. In a virtuous cycle, with meaningful lives, there is no demand for leaders who impose their will on the public. 

So where does that leave us? Are we willing to find meaning in our lives by taking a stand toward the conditions and challenges we face? 

Frankl’s imperative is to answer the call of what life demands of us. His experiences taught him “it did not really matter what we expected from life, but rather what life expected from us.”

People will seek power, but they depend on followers. People making meaning in their own lives are immune to that sirens’ call.

There’s strong and growing evidence that the “next” US recession has begun – or will begin soon. Of course, many economists will remain unsure about it, having not forecasted it, or because they refuse to forecast, or because they don’t believe something’s real until it passes them by (perhaps not even then). Similarly tardy will be the National Bureau of Economic Research, but that’s by design, because it assigns “official” dates to the start and finish of each recession and wants to be sure about the final status of oft-revised economic data before it makes its public pronouncements. Such “back-casting” and even “nowcasting” (offered by the New York Fed) are little help to those who prefer foresight and time to adjust before trouble begins.

Roughly a year ago, I reminded AIER readers that the US Treasury yield curve was inverted (i.e., the 10-year bond yield was lying below the 3-month bill rate), that all eight US recessions since 1968 were preceded (12-18 months) by such an inversion (with no false signals of recession arising without a prior inversion), and that another recession would likely begin in 2024. I wrote:

No better, more reliable forecaster of the US business cycle has existed in recent decades than the initial shape of the US Treasury yield curve, and since last October it’s been signaling another US recession that’s likely to begin in 2024. This is important, because recessions have been associated with bear markets in stocks and bull markets in bonds. Moreover, if a recession arrives early in 2024 it may affect the US elections in November.

The fact that the yield curve signal works so well for recessions is one thing, but why does it work so well? In September 2019, while forecasting the recession of 2020 (which was deepened but not caused by COVID-19 “lockdowns), I explained the logic in some detail to AIER readers:

First, a sharp decline in bond yields means a sharp rise in bond prices, which suggests a big demand for a safe security, reflecting a desire by investors to immunize against trouble ahead. Second, the longer the maturity at which one lends, the greater (normally) is the yield one receives (due to credit risk and/or inflation risk), so if bond yields are below bill yields it signals materially lower short-term yields in the future (i.e., Fed rate-cutting), which occurs during recessions. Third, the essence of financial intermediation is institutions “borrowing short (term) and lending long (term).”  If longer-term yields are above shorter-term yields, as is the normal case, there’s a positive interest-rate margin, which means lending-investing is fundamentally profitable.  If instead longer-term yields are below shorter-term yields, there’s a negative interest-rate margin and lending-investing becomes fundamentally unprofitable or is conducted (if at all) at a loss.  When market analysts observe credit markets “seizing up” before (and during) recessions, it reflects this crucial aspect of financial intermediation.

The recent, sharp deceleration in the growth rate of US manufacturing output is illustrated in Figure One, where I also indicate the point at which the latest yield curve inversion began: October 2022. That was twenty-one months ago, whereas since 1968 recessions have begun about ten months (average) after an initial inversion. If the next recession begins soon, it’ll come after a longer-than-usual lag, to be sure, but the lag prior to the “Great Recession” of 2007-09 was also long: 17 months. That it’s been inverted for so long, seemingly without negative results, could reasonably be construed as a bad thing. But negative results have been registered already: output growth has decelerated to zero (Figure One).     

The graphical history of US Treasury bond and bill yields, the yield-curve spread, and the eight recessions recorded since 1968, is given in Figure Two. In the lower panel, negative yield spreads (in red) entail yield curve inversions (bond yields below bill yields), which precede recessions (periods shaded in grey).  The upper panel shows that yield curve inversions usually result from Fed rate hiking, allegedly to “fight inflation,” but in fact to fight, curb and if necessary, reverse the economy’s growth (which it falsely presumes causes inflation). The curve can also invert when the Fed keeps its short-term rate steady as the bond yield drops.

Figure Two shows that the most recent inversion has lasted longer and has gone deeper (a more negative spread) compared to all prior recessions except those of the early 1980s. Historically, the longer and deeper has been the initial inversion, the longer and deeper has been the subsequent recession. Sadly, this latest inversion is nearly “off the chart.” Moreover, it’ll likely persist for the balance of this year, as the Fed further delays (or minimizes) rate-cutting. As such, the recession could be relatively long, lasting well into 2025, perhaps even into 2026. The Great Recession lasted nineteen months; that same interval from here brings us to March 2026. The inordinately wide yield spread (deep into negative territory) also suggests that the magnitude of the coming output contraction could be larger than normal.

Although yield curve inversion provides an early and reliable signal of recession — with a lag time sufficient for people to immunize themselves and alter their spending habits, business plans, and investment portfolios — a shorter-term indicator is also available (and reliable). It is the Sahm Rule, which is based on the discovery (by Claudia Sahm) that recessions tend to begin soon after a specific uptick in the unemployment rate. It doesn’t take much — a jobless rate that’s at least 0.5 percent points above the previously low rate.

Figure Three plots the status of Sahm’s indicator since 1968. The recently reported US jobless rate was 4.3 percent (for June), which is more than 0.8 percent points above the previous low rate (from early 2023) of 3.5 percent. The Sahm threshold has been breached. This signal is effective because once the jobless rate rises by such a degree over a brief period, it rarely reverses. If indeed recession takes hold, the jobless rate keeps rising until after a recovery occurs.

Oddly, the yield curve signal alone didn’t convince many market professionals of pending economic trouble. So they’re surprised by dire economic data or equity-price plunges; they don’t know the model — or know it but refuse to believe it. If the Sahm rule had been triggered without a prior curve inversion, perhaps they would have met that news with similar indifference. But the two measures together are significant and telling. First, we get the signal that another recession will arrive within 12-18 months, then we get the signal that says recession is imminent. The door knocks are getting harder and louder. Something’s out there.  

Still, there is disbelief. It’s well known that employment levels lag other measures over the business cycle and don’t decline until after recessions begin. The fact that jobs are still being added this year may give some folks comfort, but perhaps it shouldn’t. Shifts in the composition of employment, however, do provide a key signal. Figure Three disaggregates US employment between the public sector and private sector. Recessions tend to occur after private sector job growth has decelerated and then dropped below the growth rate in government jobs. That’s been happening for the past half-year or so — yet another signal of a pending recession.

Why might this employment differential exhibit predictive power for the economy? Whereas private employers produce wealth and are profit maximizers, public employers largely consume wealth and are budget maximizers. The former are the essence of “the economy.” If the more productive sector is losing ground (and jobs) to the more parasitic sector, the real economy itself is also losing ground. Government is a burden on output, not its “stabilizer.”

More than two years after Russia invaded Ukraine in February 2022, the war drags on with no apparent end in sight. Ukraine has recaptured 54 percent of the territory initially seized by Russia, but further offensives to push Russia out of Ukraine have stalled. Russia continues to control 18 percent of Ukraine, and recently opened a new northeastern front in the war around the Ukrainian city of Kharkiv. The Russian blockade of Ukraine continues, as does the periodic bombardment of Ukrainian cities, power infrastructure, and civilian targets. Entrenched Ukrainian forces continue to hold the line in the east while also attacking Russian forces and infrastructure with drones and missiles. Though the West has pledged $278 billion to aid Ukraine ($175 billion from the United States, with $107 billion in direct aid sent to Ukraine), there is now considerable “donor fatigue,” especially in the face of a distinct lack of success and no clear strategy for how Ukraine can secure a victory.

In short, the Ukraine war has become a frozen conflict, a war that drags on for years (or decades, in some cases), with no political resolution to the crisis. There are few prospects for substantive success for either side any time soon, with Ukrainian civilians paying the steepest price. There is no plausible scenario for a total Russian defeat, in which Ukraine expels all Russian forces out of its territory, certainly not without Russia escalating to nuclear use. The kind of total victory that Ukrainian (and some American chickenhawk) rhetoric seems to require is simply implausible. Just as implausible is a total Ukrainian defeat; the poor performance and the steady losses of the Russian military, along with the unexpectedly effective resistance by Ukrainians, enabled by Western weapons and munitions transfers, means that Ukraine will almost certainly not be swallowed up by Russia. So if the war will not end with Ukrainian total victory and Russian total defeat (or vice versa), what is likely to happen?

A frozen conflict with no ceasefire would be one of the worst outcomes for Ukraine. Permanent semi-war would mean an entire society remains uprooted, with continuous loss of life, constant threat of physical destruction and attacks on infrastructure, an inability to resume the normal economic and social functions of daily life, and an unresolved territorial conflict with a larger, aggressive neighbor. Unless Ukraine and Russia decide to seek peace, or at least a ceasefire, this is also the likeliest scenario.

But all wars end, and this one will too — eventually, one way or another. It is long past time to consider what the end of this war might look like.

Some kind of ceasefire will likely emerge. This will require both sides — and the United States, which seems to currently prefer a war of attrition continue to a ceasefire — to want to seek peace, or at least a respite from the war. A more-or-less permanent ceasefire seems likeliest to emerge after public support for continuing the war collapses, or once it becomes apparent that one or both sides can no longer conscript enough new recruits to continue the war effort at the current level of intensity. Such a ceasefire would need a mediator to initiate; Turkey has been proposed as one possibility.

Former German Chancellor Gerhard Schroeder has claimed that Ukraine initially used him as an intermediary to seek a ceasefire with Russia, but he was forbidden from continuing to negotiate by the United States. Schroeder has stated that the Ukrainian peace plan included a renunciation of NATO membership, the installation of two national languages (Ukrainian and Russian), autonomy for the Donbas region, security guarantees for the sovereignty of Ukraine, and ongoing negotiations on the status of Crimea (seized by Russia in 2014).

Regardless of Schroeder’s claim, this is a reasonable starting point for a peace plan. This would require tremendous political sacrifices on the part of Ukraine, which at least publicly continues to make maximalist demands against Russia. To be clear, Russia has also adopted a maximalist position that would require Ukraine to cede the eastern oblasts (territories) of Donetsk, Luhansk, Kherson and Zaporizhzhia and agree to not join NATO. It is difficult to conceive of an end to fighting and a resolution of the war without Russia achieving some of its aims, primarily a promise that Ukraine will not join NATO and that the Donbas region become either an autonomous zone or part of Russia. Such a ceasefire arrangement sets the stage for peace but would be insufficient for long-term peace and stability.

A stable peace could emerge in several ways, with multiple historical case studies as potential models for what peace could look like.

South Korea after the Korean War is one such model. The Korean War began in 1951 and technically remains in progress — the very definition of a frozen conflict — since the parties involved in the war signed an armistice and not a peace treaty in 1953. The armistice established the Demilitarized Zone (DMZ), which also remains in place. While this arrangement has prevented the outbreak of major war between North and South Korea since 1953, it has not led to a cessation of tensions. Both sides maintain large militaries — and the United States retains almost 30,000 personnel in South Korea — and there have been numerous violent clashes and provocations over the decades. South Korea alleges that the North has committed more than 220 violations of the armistice agreement, though there have been no new deaths on the DMZ since 2010 and casualties have fallen precipitously since the 1970s. This model could be applied to Ukraine, with an armistice rather than a peace treaty and a formal or de facto division of territory. What we are describing is a frozen conflict that has gotten hot on several occasions, with many subversion attempts by North Korea, repeated military incursions by special forces infiltrators and naval forces, and a heavily-mined DMZ to physically separate the two Koreas’ militaries, which remain on constant watch. This would not be an ideal scenario for Ukraine, though it is an improvement on the status quo.

Post-WWII Austria and Finland offer two additional models for a postwar Ukraine. The United States and the Soviet Union debated and strategized the fate of these two countries after the war. Would Austria become a divided nation, as with Germany, with NATO occupying part of Austria and the Soviets the other, with Vienna divided along the same lines as with Berlin? Ultimately, once NATO membership for Austria was taken off the table and a Swiss model of neutrality for Austria was adopted at Soviet insistence, the question became moot. Soviet security concerns were allayed, and Austria remained neutral during the Cold War (it is still not a member of NATO). The country was not divided, nor occupied permanently by either side.

Likewise, there are many parallels between modern Ukraine and Finland after the Second World War: it, too, had an extensive border with the USSR and a distributed population, and it likewise fought a savage war with the USSR in 1939-40 resulting in significant casualties for the Soviets. Finland was forced to cede about 10 percent of its territory along the border with the Soviet Union, but was otherwise allowed to retain its sovereignty and was not occupied by Soviet troops, unlike the rest of Eastern Europe. Throughout the Cold War, Finland maintained a policy of what the West German media pejoratively called “Finlandization,” in which Finland’s foreign policy was subordinated to that of the Soviet Union. Finland did not publicly oppose Soviet foreign policy, it did not seek alliances with the United States or NATO, and it mostly stayed out of questions of foreign policy altogether during the Cold War, a not-inappropriate policy for a small country on the periphery of a larger one that had few to no inherent foreign policy interests of its own.

The Austrian and Finnish examples are more positive and comfortable models for a future Ukraine than that of South Korea.

The United States and NATO cannot force Ukraine to seek peace — only Ukraine can do that — but they can induce significant pressure on Ukraine because without external aid, Ukraine’s ability to continue the grinding war of attrition it is currently undergoing relies on that aid. The United States should insist that NATO membership for Ukraine is off the table; joining NATO is certainly in Ukraine’s best interest, but it is not in the United States’ or NATO’s interest. 

This will be an easy concession to make in peace negotiations with Russia. It goes without saying that the United States should cease sending additional military aid to Ukraine. If the European allies want to — they can certainly afford to — then they are welcome to do so. But the United States should begin working with Ukraine to help it determine what its political future will be. Having Ukraine become a new Cold War-era Austria or Finland is probably the best outcome for a tragic situation.

The Federal Reserve system in the United States is the largest financial institution in the world with more than $7 trillion in assets. It “manages” the most important currency in the world. Its decisions can dramatically affect the course of the largest economy in the world. 

Wouldn’t it be nice if its officials knew what they were doing?

Yet ever since the 2008 financial crisis, the Federal Reserve has more or less been whistling in the dark. After that crisis, it dramatically changed its approach to monetary policy and targeting interest rates. For a decade it struggled with inflation being “too low.” Then, in 2021 and 2022, it had to deal with the forest fire of inflation — a fire still burning in some sectors of the economy.

Three months ago I wrote about the “Ratchet Effect” on the Fed’s balance sheet. In its May 1st announcement, The Fed said it would slow its bond roll-off plan from ~$1 trillion annually to about $600 billion annually. That means, ceteris paribus, that its balance sheet will drop below $7 trillion by the end of this year, $6.4 trillion by the end of 2025, $5.8 trillion at the end of 2026, $5.2 trillion at the end of 2027, and $4.6 trillion at the end of 2028 — finally reaching its pre-COVID level.

Consider how, if the trend of asset growth at the Fed from 2002 – 2007 (~4.4 percent annual growth) had continued, the Fed’s balance sheet at the end of 2023 would have been a modest $1.76 trillion instead of $7.7 trillion. And forecasting out to 2028, would have been roughly $2.2 trillion — less than half where the Fed will be if its current quantitative tightening continues for four more years.

How did we get here?

The entire framework for traditional monetary policy was thrown out the window in 2008 with the Fed’s response to the 2008 financial crisis. Open market operations were no longer used to maintain a target interest rate. In the name of preventing a second Great Depression, then-Fed Chairman Ben Bernanke opened a Pandora’s Box of monetary ills in 2008. And like the Greek myth, there may be no way of putting these ills back in the box.

In March of 2008, markets were uneasy. Housing prices had stalled and began falling in 2007. Mortgage-backed securities (MBS) began falling too. Leveraged financial firms began reporting huge paper losses. Bear Stearns saw its stock price crater from $172/share in January of 2007 to less than $10/share by March 2008, as it faced potential bankruptcy. The Treasury and the Fed decided that Bear should be acquired rather than be allowed to fail.

To persuade JP Morgan Chase to purchase Bear, the Fed agreed to buy ~$30 billion dollars of Bear’s riskiest assets. The Fed was not technically allowed to do this. So it set up a shell company, Maiden Lane, and lent Maiden Lane the money to purchase these assets from Bear. JP Morgan initially agreed to purchase Bear for $2/share but was strong-armed by Bear shareholders to revise the offer to $10/share. Bailing out equity holders departed from the Fed’s ‘lender of last resort’ role.

In the fall of 2008, the giant insurer, AIG, ran into financial trouble. It had written a huge amount of insurance on the prices of MBS in the form of credit default swaps. Under the terms of this insurance, if the price of the underlying MBS fell enough, AIG would have to post collateral. As the entire MBS market plunged throughout 2008, AIG found itself on the hook to post tens of billions of dollars of collateral.

Enter the Federal Reserve Bank of New York. Calling a similar play to the Bear bailout, the NY Fed set up Maiden Lane II, and used it to provide a secured credit line to AIG for up to $85 billion. The terms of the credit line involved taking a majority ownership stake in AIG. This vehicle also purchased MBS from AIG’s subsidiaries. Maiden Lane III was set up for the similar purpose of buying collateralized debt obligations (CDOs). Besides facilitating direct lending to AIG, Maiden Lane II and Maiden Lane III were used to stabilize the prices of MBS and CDOs.

In addition to these lending facilities, the Federal Reserve began buying large quantities of securities directly — not only Treasury securities, but also securities issued by government-sponsored enterprises like Fannie Mae and Freddie Mac. It bought Fannie and Freddie debt instruments. IT also bought large quantities of MBS issued or insured by Fannie and Freddie. Beyond that, the Fed even bought some private-label MBS — again, to support the price of these assets, to reduce paper losses in the financial system.

Besides bailing out specific financial institutions, the Fed wanted to provide even more liquidity directly to the broader market. Rather than banks and money market funds having to mark down or offload their assets at “fire sale” prices, they could sell them to the Federal Reserve or borrow money against them from the Fed at valuations well-above the fire sale market prices.

So, Fed officials created an alphabet soup of liquidity “facilities” to carry out these massive asset purchases: the AMLF (Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility), the CPFF (Commercial Paper Funding Facility), and the MMIFF (Money Market Investor Funding Facility).

This, by the way, was the Fed’s playbook in dealing with the failures of Silicon Valley Bank and Signature Bank in March of 2023. The Fed immediately created a facility, Bank Term Funding Program (BTFP), to lend money to banks against bond portfolios whose market value had plummeted as the Fed rapidly raised interest rates starting in 2022. The BTFP ultimately injected about $400 billion dollars to shore up the banking system.

These liquidity facilities flooded the market with bank reserves, which raised the question: how would the Fed successfully raise and meet higher interest rate targets when the market was flooded with a huge number of reserves?

Under the traditional open market operation framework, the Fed would have to effectively reverse its liquidity creation by selling hundreds of billions of dollars of MBS and agency debt. That action could destabilize financial markets again. Instead, the Fed opted to change its operating framework to a floor system. Congress had given approval to pay interest to banks for reserves held at the Fed — reserves that ballooned in response to the Fed’s asset buying spree.

Interest on reserves raised the opportunity cost (or floor) of banks lending money to one another. Raising the interest it paid on reserves effectively raised the Fed funds rate floor. Changing its interest rate target became a matter of changing the rate of interest the Fed paid banks on their deposits. Only there was one more wrinkle. For these interest rate changes to affect any of the market beyond banks, the Fed would have to engage in similar behavior with all financial institutions, not just banks.

For example, banks would not make loans at 2 percent if they received 3 percent interest on their reserves at the Fed. But non-banks might make loans for 2 percent – unless they, too, had a 3 percent lending alternative. To address this, the Fed increased its use of repo and reverse-repo market. Repo and reverse repo basically mimic the function of the federal funds market, only the transactions are collateralized — involving the temporary exchange of securities — and are open to all kinds of non-bank institutions. Over the past two years, the Federal Reserve has paid over $300 billion dollars in interest on bank reserves alone — not including interest paid on repo transactions.

When quantitative easing flooded the market with bank reserves, interest rate targeting was severed from the size of the Fed’s balance sheet. The Fed could now increase the size of its balance sheet, seemingly without limit, and raise its target interest rate. The Fed began raising interest rates in 2022 with an enormous balance sheet of almost $9 trillion. And it will likely begin cutting interest rates next month without having to change how many assets it currently holds.

This is the brave new world of monetary policy we live in today.