With export options either limited or non-existent, and with storage facilities filling up, the U.S. Energy Information Administration (EIA) estimates that Saudi Arabia, Kuwait, Iraq, and the United Arab Emirates (UAE) have slashed their combined production of crude oil by about 7.5 million barrels/day in March and will shut-in 9 million barrels/day in April, on average. The EIA further assumes that production in the affected countries will not return to normal until the end of 2026.

Even this may be too optimistic. Rory Johnston estimates that shut-ins could approach 12 million barrels/day if the Strait remains closed through the end of April. Restoring production that has been shut-in will take time, even if there has been no long-term damage as a result of the conflict. While the world’s oil and products consumers went into the crisis with relatively abundant inventories, the shortfall in production is cumulating rapidly. The EIA estimates an inventory drawdown of about 460 million barrels in 2026Q2, much of which so far has been met by the depletion of strategic reserves, while Rory Johnston’s estimate is that there will be about 1 billion missing barrels by the end of July. If the Strait remains even partly closed after the end of this month, which seems plausible, the cumulative production shortfall would be correspondingly larger.

There will also be a time lag associated with shipping. Even if both (?) blockades ended immediately, it would still take at least 20—and quite possibly 30—days to load, ship, and unload crude oil currently held in storage from the Gulf to refineries in Singapore or elsewhere in East Asia.

The hit to supply will force (some) users of oil and refined products to cut their consumption. In a market-based system, this rationing occurs via price increases large enough relative to incomes to persuade—or force—people to buy less. After factoring in higher costs of shipping and insurance, the cost paid by (some) refiners for physical oil in the spot market is now over $200/barrel, even if benchmark futures prices for delivery in a month or so cost much less.

The only way that overall inflation could remain unaffected by soaring energy prices (relative to incomes) would be if non-energy prices and incomes fell.1 But a world where most prices are falling is also one where many businesses will struggle to service their debts and pay their workers and suppliers. As troubled businesses cut their spending, everyone else ends up with less income and is forced into an unwelcome combination of defaults and spending cuts, propagating the downward spiral. Policymakers rightly reject this approach, if they have the option, preferring to tolerate some inflation to manage the shifts in relative prices. This is why the pace of price increases in the rich countries is set to accelerate, at least for a bit.

The question for policymakers is what this “one-time thing”, as Federal Reserve boss Jerome Powell has called it, will do to the underlying trend rate of inflation.

The problem is that Fed officials have spent the past several years believing that inflation would fully revert to normal on its own, and kept lowering interest rates on the basis of this mistaken belief. Yet the Personal Consumption Expenditures (PCE) price index, which is what the Fed officially targets, has been rising remarkably steadily at ~3% annualized ever since the middle of 2022. A wide range of measures that attempt to strip out volatile and idiosyncratic components have shown little change since at least 2023. However you choose to define it, underlying inflation, like wage growth, remains about 1-1.5pp too fast to be consistent with the central bank’s alleged 2% yearly target.

Given all this, the most benign outcome would be for underlying inflation to remain about 1-1.5pp faster than before the pandemic, with officials either tacitly or openly admitting that the target has been revised from 2% to 3%. The pre-pandemic growth rate of nominal income was probably too slow, so there would be nothing inherently wrong with a modest change—at least, as long as officials hold the line against any further acceleration.

There are other, worse, possibilities.

For one thing, Fed officials are still dealing with an administration intent on suborning it to force interest costs lower. Powell is still under threat from a bogus criminal investigation. There is also the risk, as some astute policymakers have warned, that businesses and consumers may reasonably come to suspect that a sustained series of successive policy “shocks” is actually the new normal. Once is happenstance, twice is coincidence, three times is enemy action, etc.

After all, the direct price passthrough from tariffs to overall price indices should have been relatively modest, but there was already some evidence before the war that businesses were using tariffs as an excuse to raise prices even further, with the knowledge that their customers had plenty of purchasing power available to cover the higher costs. It is entirely possible that something similar could happen in response to this “shock”, especially given how many different commodities, from fertilizer to helium, are affected.

By all means, policymakers should “look through” what is happening with energy. But that requires recognizing the persistent pace of price increases in the rest of the economy—and the real possibility that this underlying trend could accelerate further.

The rest of this note is a more detailed breakdown of the latest inflation numbers for March, including a thorough analysis of why a gap has opened up between the Consumer Price Index (CPI) and the PCE.

Rising U.S. Goods Prices Are More About Strong Demand than Constrained Supply

Prices for physical goods were rising faster than at any point outside of the post-pandemic reopening before the Iran War. While some of that can reasonably be attributed to tariffs, tariffs are not the only, or even the main explanation.

There are at least three ways to see this.

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The deceleration is notable for several reasons:

• It would imply that wage growth is no longer running faster than the pre-pandemic norm, which could have benign implications for the inflation outlook

• It is an abrupt slowdown after years of stability, which could potentially reflect the lagged impact of job market weakening

• It is entirely a function of a sharp slowdown within the “private education and health services” sector—which is odd, because, until now, wage growth in this category has tended to behave just like the rest of the economy, on average, which cannot be said for other industries

The details of the apparent wage slowdown matter. If it is genuine, it would imply that the set of interest rates that made sense in the past might now be too high. If, however, the deceleration is a fluke attributable to idiosyncratic factors and/or measurement error, then policymakers should ignore it.

The Most Representative Sector Does Something Odd

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If Russian export prices rise further from here—which seems likely given the world’s growing desperation for oil, gas, and refined products that are not affected by the Iranian government’s growing realization that it controls all traffic through the Strait of Hormuz—then the Russian government could find itself with a windfall worth hundreds of billions of dollars. (Unless of course its own export volumes are constrained by Ukrainian attacks.) Russia is also poised to benefit from its position as a major exporter of fertilizers now that Middle Eastern exports are no longer available.

The bad news is that consumers of essential commodities are being forced to make do with less, with the constrained supply rationed according to the willingness (or the ability) to pay increasingly high prices. As is always the case, the global poor will be hit hardest.

The good news is that, as long as the allies hold the line on non-energy sanctions and export controls, the disruption in Hormuz will do little to improve Russia’s position in its war of aggression against Ukraine. For better or worse, Russian energy exports have never been that important to the war effort. Russian officials have been steadily reducing the importance of oil and gas taxes in financing day-to-day spending ever since the 2014 price crash, and their current plan is to assume that energy prices will not only revert to pre-Iran levels, but fall further. The windfall, such as it is, should allow the Russians to rebuild their National Wealth Fund (NWF), which has been partially drained in recent years, but it will not alter the Russian economy’s material constraints, particularly the ongoing shortages of men and manufactured goods.

Russia Is Not a “Gas Station Masquerading as a Country”

Looking at how the Russian economy and financial system responded to large changes in energy prices in the recent past is helpful for thinking through the current situation. The reaction to the 2014-2016 energy price crash has meaningfully changed the Russian government’s sensitivity to oil prices.

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What is not understandable is Fed officials’ faith that—leaving the war aside—inflation will return quickly to their 2% yearly goal as the economy accelerates and interest rates continue to fall.

This is a failure of analysis. According to Jerome Powell’s latest press conference, Fed officials believe that their policy has been “restrictive” (it has not), that inflation would already be at or close to 2% if not for tariffs (it would not), and that “the labor market is clearly not a source of inflationary pressures” (it is). The latest data, which run through February, make it clear that the inflation situation was continuing to get worse before the current conflict.

From that perspective, Fed officials should have been following the Reserve Bank of Australia, which has pivoted to raising rates, even without the war with Iran. Including a reasonable distribution of the possible consequences of the war into the calculations reinforces the case for rate increases.

Goods and Bads

Perhaps the most striking thing about Powell’s Wednesday press conference was the repeated—and wrong—insistence that excessive inflation was mostly about rising goods prices, which in turn were mostly about tariffs:

Inflation has eased significantly from its highs in mid-2022 but remains somewhat elevated relative to our 2 percent longer-run goal…These elevated readings largely reflect inflation in the goods sector, which has been boosted by the effects of tariffs.

To be fair, goods inflation was getting worse before the Iran conflict, and in some significant categories was worse than in the 2021H2-2022H1 price spike. In the years immediately preceding the pandemic, consumer goods prices regularly fell about 0.5%-1% each year. In 2024, those prices were flat. As of the eve of the war with Iran, consumer goods prices were rising by about 2% a year—and the pace was accelerating.

The picture looks worse when focusing on goods purchased by businesses, either as inputs or capital equipment.

Prices of “components for manufacturing” rose by 0.9% in January and by 1.1% in February on a seasonally-adjusted basis. The February increase was larger than in every month of the post-pandemic inflation except for January 2022. Capital equipment prices are rising about 5% annualized, up from about 3% in 2023-2024 and about 1% in the years before the pandemic. Prices of “supplies to manufacturing industries” have been accelerating rapidly, with the one-month increase in February the largest since April 2021.

Tariffs are not the only explanation for this. One of the biggest categories within “supplies to manufacturing industries” is “printed circuit assemblies, loaded boards, modules and consumer external modems”, which have mostly been excluded from tariffs because of their importance to the datacenter buildout. Those prices rose by 48% (!!) between January and February. Even if that were a typo, prices rose by 26% between January 2025 and January 2026, which is unprecedented in the history of the data going back to the early 1980s.

While all of this is both significant and unwelcome, it pales in importance to what has been happening with services prices.

The Underlying Inflation Elephant in the Room

Many of the forces affecting the prices of goods are relatively insensitve to changes in U.S. domestic monetary and financial conditions. The same cannot be said for services, which represent the bulk of economic activity, and which, by themselves, should be making Fed officials worry that their 2% inflation target is of reach.

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Crude oil exported from Iran, Iraq, Kuwait, Saudi Arabia, Qatar, and the United Arab Emirates (UAE) was equivalent to about 20% of global supply before the recent war with Iran, or more than 40% of all crude oil exports. Much of this supply is now unavailable,1 with traffic through the Strait of Hormuz still stuck around zero as ships avoid Iranian drones, missiles, and mines.

Yet as of this writing, front-month Brent crude futures are trading at just $103/barrel. That is still lower, in nominal terms, than in the first few months of Russia’s 2022 invasion of Ukraine ($110-$130). It is also lower than the stable average of about $110 that persisted from early-2011 through mid-2014.

Even more striking is how low the current price looks when adjusted for inflation and productivity growth. Dividing the monthly spot price of Brent crude oil by nominal U.S. disposable income per capita2 shows that today’s “real” price is right in line with the average since January 1988—and far below any previous period when the price of oil was considered too high.

Moreover, anyone willing to wait for physical delivery can lock in prices substantially lower than the current spot price. Equivalently, anyone who has physical crude oil available to distribute today can get paid a massive premium to clear out their storage space in exchange for the promise to refill later.

The August 2026 Brent futures contract was just under $90/barrel on the evening of March 12, the January 2027 contract was trading at just under $80/barrel, and the December 2027 contract was just $73/barrel. Those willing to wait until December 2028 could secure oil for the price of just $70/barrel. All of those futures contracts were barely higher than the $66/barrel price that prevailed across the curve on February 27 (the eve of the war with Iran). In fact, the prices of Brent contracts for March 2027 onwards were barely higher than where they were in the beginning of 2025.

The implication is that the current price spike is attributable to temporary disruptions that will soon fade, rather than permanent reductions in the world’s oil supply.

But even if a quick return to normalcy were the single likeliest outcome, which is far from obvious—I will defer to the military experts and oil gurus—there are many other possibilities, all of which would be worse for oil consumers. We simply do not know what is needed to restore pre-war shipping volumes through the Strait of Hormuz at pre-war insurance rates. As Defense Secretary Pete Hegseth unhelpfully explained, “The only thing prohibiting transit in the straits right now is Iran shooting at shipping. It is open for transit should Iran not do that.”

Given this uncertainty, comparing the current crisis with previous notable oil disruptions, both in terms of price and volume impact, is helpful for getting some perspective. There are three big takeaways:

• The current threat to supply is unprecedented

• Prior changes in prices required to reduce demand and/or increase supply were far larger than what we have seen so far, and the adjustment periods also took longer, even though the changes in volumes were also far smaller than what is currently happening

• The U.S. is still extremely sensitive to disruptions of crude oil imports despite being a net exporter of petroleum+products, at least when it comes to inflation

1973, 1979, and the 2000s

Over the past century there were three distinct episodes when oil prices more than doubled from “normal” levels and then stayed high.

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According to the latest Statistical Review of World Energy, about 20% of all liquefied natural gas (LNG) exports in 2024 came from Qatar, mostly going to East Asia. About a third of all crude oil exported in 2024 came from Iraq, Kuwait, Saudi Arabia,1 and the United Arab Emirates (UAE). Similarly, about 18% of global exports of refined petroleum products also came from those four countries.

As of this writing, those exports have more or less stopped. From Lloyd’s List:

Without the ability to export, storage facilities for crude are filling rapidly, and some producers have already responded by slashing output. The problem is not just that the Strait of Hormuz is unsafe for tanker traffic, but that much of the infrastructure for extracting, storing, refining, and exporting fossil fuels from the Gulf is currently under attack from Iranian drones and missiles. The longer the fighting lasts, the harder it will be to restore production and exports to pre-war levels.

So far, spot crude oil prices are up about 50% since the start of the year, and up around 25% as of this writing since the start of the conflict. That relative calm may reflect ample inventories in the major consuming societies plus, possibly, a temporary reduction of Chinese stockpiling. (Or it might just be a mistake.) Gas and refined products are harder to store, however, which explains why international prices for LNG, jet fuel, and diesel have roughly doubled over the past week. (China discouraging exports of refined products has not helped, although the net effect depends on what they are doing with their reserves of crude oil.)

The supply crunch is already flowing through to the price of fertilizer, which is made from natural gas, which could in turn affect the northern hemisphere’s spring planting cycle and, eventually, food prices. The impact may not stop there. In addition to being used directly for heat and energy, crude oil and natural gas are both inputs for manufacturing chemicals and plastics, which in turn are used as inputs for everything from pharmaceuticals to semiconductors.

Stocks and bonds suggest that traders outside of the energy markets are relatively sanguine about all of this, at least so far. And they could well be right. Betting against human creativity and adaptability—which is, essentially, what any sustained long position in commodities represents—is usually a bad way to make money.

Still, we can be reasonably be confident that, in the short term at least, there will be a price to pay via some combination of worse real growth and faster inflation. The only argument is about the magnitude of the impact, not the direction.

That would make this the third negative supply shock to hit the global economy in the recent past, following the pandemic, which began almost exactly six years ago, and then Russia’s war of aggression on Ukraine, which started almost exactly four years ago. The loss of Russian commodity exports and the near-total closure of the Black Sea constituted a massive shock to the prices of everything from wheat to semiconductors, which hit particularly hard in the first half of 2022. (The Chinese goverment inadvertantly lessened the impact thanks to its extreme “Covid Zero” policy.) For Americans, the war with Iran is arguably the fifth supply shock over the past six years, if we include the policy uncertainty that has been unleashed since last January, particularly around tariffs, as well as the massive changes in net immigration flows.

At some point it becomes reasonable to ask whether these even count as “shocks” anymore, given their frequency. Individually, they are all more or less random unpleasant surprises. Collectively, however, they are responsible for repeated spikes in prices. The risk is that people people respond by changing what they think is “normal”. That is how inflation accelerates on a sustained basis. As Goldfinger put it, “Once is happenstance. Twice is coincidence. Three times is enemy action.”

Lael Brainard, who was an influential Federal Reserve official from 2014-2023, was explicit about the implications back in 2022:

A protracted series of supply shocks associated with an extended period of high inflation—as with the pandemic and the war—risks pushing the inflation expectations of households and businesses above levels consistent with the central bank’s long-run inflation objective. It is vital for monetary policy to keep inflation expectations anchored, because inflation expectations shape the behavior of households, businesses, and workers and enter directly into the inflation process. In the presence of a protracted series of supply shocks and high inflation, it is important for monetary policy to take a risk-management posture to avoid the risk of inflation expectations drifting above target.

Austan Goolsbee, the President of the Federal Reserve Bank of Chicago, told me something similar when I interviewed him in 2024:

The direct impact of higher oil prices, there’s nothing you can do about that. You’re going to get inflation from it. But you try to prevent wage-price spiraling, you try to prevent it from getting folded into expectations where you can’t get rid of it…One thing we learned was the supply chain is so many stages now that when chips were not there, then the computers that use those chips had their prices go up, and then when the computers’ price went up, then the autos that use those little computers, their price went up. Then the FedEx driver who’s using the car—it had a “if you give a mouse a cookie” element to it. We should think about that when we’re thinking about monetary policy reaction to supply shocks.

The problem for policymakers in the U.S. is that inflation had been persistently faster than their alleged 2% yearly goal before 2025, with no sign of improvement over the past 12 months. If anything, the situation was only getting worse before the Iran war.

The rest of this note has two parts. First, some additional perspective on the disruption to gas and oil exports, in part informed by the recent experience with Russia’s war on Ukraine. Second, a detailed update on the latest U.S. numbers for inflation and the job market, which give us a sense of what the economy was looking like before the current conflict began.

The World Can Probably Live Without Qatari Gas, But Not Without the Gulf’s Oil

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Now the administration has come back with a different legal justification—Section 122 of the Trade Act of 1974—for a new set of tariffs. Quite a few lawyers and economists have argued that this is also illegal.

Unlike IEEPA, there is no ambiguity about whether the words in the law allow the administration to impose tariffs and/or quotas. But there is a debate, summarized nicely by , about whether the circumstances that could enable the use of worldwide tariffs under section 122 are even possible in 2026. The law is only supposed to be used when:

Fundamental international payments problems require special import measures to restrict imports— (1) to deal with large and serious United States balance-of-payments deficits, (2) to prevent an imminent and significant depreciation of the dollar in foreign exchange markets, or (3) to cooperate with other countries in correcting an international balance-of-payments disequilibrium

What are “fundamental international payments problems”? What are “large and serious United States balance-of-payments deficits”? What is an “international balance-of-payments disequilibrium”?

I am not a lawyer, but I know enough about both the history of this period and how the balance of payments work to take a stab at answering these questions. My conclusion is that Section 122 tariffs are allowed, even though they would also be unhelpful. (Part of the issue is that the drafters of Section 122 seem to have been confused about what it was supposed to do.)

The rest of this note will cover the following:

• The bipartisan track record of abusing wartime authorities to manage the financial system, and how this led to both Section 122 and IEEPA

• The important difference between what the Supreme Court ruled and what the Court of International Trade said back in May

• The traditional links between balance of payments management and trade controls, and whether those make sense

• The history of the U.S. “balance of payments deficit”, “exorbitant privilege”, and the end of the Bretton Woods pseudo-gold standard

• What people thought about Section 122 and balance of payments management at the time

• The current U.S. balance of payments situation and how tariffs might alter that situation

“Trading with the Enemy” as Macroprudential Regulation

Immediately after taking office in March 1933, Franklin Delano Roosevelt decreed that “all banking transactions shall be suspended”. FDR claimed that the legal authority for this extreme act “is provided in Section 5 (b) of the Act of October 6, 1917”, which was more commonly known as the Trading With the Enemy Act (TWEA). FDR knew that using a wartime law to manage a peacetime banking crisis was dubious, which is why he convinced Congress to pass a new banking law within days.

That was not the last time that this WWI measure was broadly interpreted. In 1968, Lyndon Johnson used the same section of the law, once again obliquely cited as “the act of October 6, 1917”, to justify restrictions on transfers of dollars abroad via foreign direct investment. LBJ also claimed that Truman’s declaration of an ongoing national emergency during the Korean War highlighted “the importance of strengthening the balance of payments position of the United States”. It was a strange way to do macroprudential regulation, but it was allowed under the law at the time.

Then in August 1971, Richard Nixon imposed a “surcharge” of 10% on all “dutiable imports”. At the time, he cited his authority under the Tariff Act of 1930, more commonly known as Smoot-Hawley, and the Trade Expansion Act of 1962. But when the government was sued by importers, administration lawyers also cited the TWEA, on the grounds that they had the authority to regulate cross-border transactions in an emergency. (They lost the case.)

LBJ and Nixon were both responding to the same problem, which was a real problem, even if their methods were questionable. Congress eventually changed the law to constrain presidential power while also giving them the tools to manage these challenges. Section 122 was meant to be an improvement over what Nixon did, which is why it includes a fixed time limit “unless such period is extended by Act of Congress”. It is also explicit that any tariff follow “the principle of nondiscriminatory treatment” and that “neither the authorization of import restricting actions nor the determination of exceptions with respect to product coverage shall be made for the purpose of protecting individual domestic industries from import competition”. Similarly, IEEPA was meant to be a constrained version of TWEA that could be used outside of wartime in exchange for tighter limits and more Congressional oversight.

IEEPA vs. Section 122: Why the CIT Ruling Matters

IEEPA clearly gives the executive branch sweeping power to engage in financial sanctions, export controls, asset seizures, and embargoes, among other things, in response to “any unusual and extraordinary threat, which has its source in whole or substantial part outside the United States, to the national security, foreign policy, or economy of the United States”.1 However, it does not explicitly grant unlimited presidential discretion to increase taxes on imports.

Being literalists, the majority of the Supreme Court ruled that IEEPA, which gives the president the power to “regulate, direct and compel, nullify, void, prevent or prohibit, any acquisition, holding, withholding, use, transfer, withdrawal, transportation, importation or exportation of, or dealing in, or exercising any right, power, or privilege with respect to, or transactions involving, any property in which any foreign country or a national thereof has any interest by any person, or with respect to any property, subject to the jurisdiction of the United States” was not the same as the authority to impose tariffs.

While one might think that the power to regulate or prevent any transaction involving any foreign national and anyone subject to U.S. jurisdiction would include the power to make imports somewhat more expensive, the majority argued that this was not so, because tariffs are taxes, and tax policy is the domain of Congress. Congress can, and has, explicitly delegated its authority to impose tariffs under clearly defined circumstances, but apparently it did not do so in IEEPA because the word “tariff” is missing from the text. Without that explicit permission, the Supreme Court majority declared that the IEEPA tariffs were illegal.

Perversely, this suggests the administration might have won if they had chosen to ban imports from certain countries outright, or used quotas to limit how much could be imported, rather than relying on price-based measures that happened to raise revenue.

By contrast, the Court of International Trade, which first heard the challenges to the tariffs, was explicit that the “reciprocal” IEEPA tariffs were illegal because the trade deficit was not an emergency.2 Moreover, they noted that the government always had the option to use Section 122 to impose tariffs to manage the trade deficit. The key difference was that this law limited the president’s ability to impose tariffs arbitrarily:

In 1974, Congress enacted the Trade Act, including Section 122 dealing with remedies for balance-of-payments deficits…Section 122 sets specific limits on the President’s authority to respond to balance-of-payments problems, such as a 15 percent cap on tariffs and a maximum duration of 150 days. Congress’s enactment of Section 122 indicates that even “large and serious United States balance-of-payments deficits” do not necessitate the use of emergency powers and justify only the President’s imposition of limited remedies subject to enumerated procedural constraints…Trade deficits are one of the key balance-of-payment deficits and can be directly impacted by mechanisms such as import quotas and tariffs, as authorized by Section 122. As a result, tariffs responding to a trade deficit fit under Section 122.

While the Court of International Trade is not necessarily the last word on this question, the fact that they explicitly endorsed the use of Section 122 to address the administration’s concerns seems like an important indicator of whether the new tariffs are legal. As Peter Harrell noted, the Court was explicit that Section 122 “refers, necessarily, to deficits within the various accounts comprising the balance-of-payments (including the trade of goods) rather than to an overall summary deficit, because there cannot be a balance-of-payments deficit per se.”

We do not need to take their word for it. There are plenty of reasons to think that Section 122 tariffs would be legal under today’s circumstances, although not necessarily helpful.

Tariffs as Balance of Payments Tool: GATT and the IMF

The founders of the post-WWII order were explicit that trade openness depended on international financial stability. Following Keynes, they knew that the threat of capital flight was a legitimate justification for mercantilist trade restrictions, which was they wanted to create institutions to prevent balance of payments crises. The International Monetary Fund (IMF) says it exists to “facilitate the expansion and balanced growth of international trade” precisely because its founders believed that balance of payments crises were a valid reason to restrict trade.

The General Agreement on Tariffs and Trade (GATT), which later evolved into the World Trade Organization (WTO), was explicit that any member was allowed to use broad-based import restrictions “in to order safeguard its external financial position and its balance of payments” as long as they notified other members and engaged in consultations. Originally, this procedure was only meant to allow import quotas that were otherwise supposed to illegal. Tariffs and other “price-based measures” for managing the balance of payments were apparently allowed with no restrictions.

The U.S. Senate Finance Committee’s report on Section 122 noted that many countries other than the U.S. had taken advantage of this over the years, including France (1955), Canada (1962), the U.K. (1968), and Denmark (1971), but those episodes occurred outside of any formal legal framework, just like Nixon’s 1971 tariffs. Congress therefore wanted the new law to help “the President seek modifications in international agreements aimed at allowing the use of surcharges in place of quantitative restrictions and providing rules to govern the use of such surcharges as a balance-of-payments adjustment measure”.

That is what ended up happening. The basic language of the original GATT has persisted into modern times, but there was a shift in 1979 away from using import quotas in favor of “import surcharges, import deposit requirements or other equivalent trade measures with an impact on the price of imported goods”, with “quantitative restrictions for balance-of-payments purposes [allowed only when] price-based measures cannot arrest a sharp deterioration in the external payments position”.

So tariffs are allowed in response to a balance of payments “problem”. Answering when that would be depends on understanding what the balance of payments actually represents.

Making the Balance of Payments Balance (Before 1971)

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Back in April, Steve Miran, who was then in charge of the Council of Economic Advisers, had argued that foreigners would bear the cost as their currencies depreciated. (Equivalently, the U.S. dollar would appreciate if investors decided that making things in America had become relatively more attractive.) Alternatively, foreign producers could cut their selling prices to preserve their market share. Either way, Americans would not have paid higher prices as a result of the tariffs.

That is not what happened. Economists at the Federal Reserve Bank of New York recently observed that foreign producers have barely cut their prices when selling to Americans, while the dollar has depreciated over the past year. Most of the extra customs duties have therefore been paid by U.S. importers, although the exact split between manufacturers, wholesalers, retailers, and consumers is still ambiguous. Everyone else who has bothered to look has found the same thing. Yet, Kevin Hassett, who is best known for writing Dow 36,000 and for predicting that the Covid pandemic would only last a few months because of a “cubic model”, said the NY Fed paper was “the worst paper I’ve ever seen in the history of the Federal Reserve system”.

I have previously argued that the entire debate misses the point. Tariffs are just taxes. If Americans “pay” the tariffs directly they will have lower incomes, which could lead to less spending on goods and services, including those produced in the rest of the world. If foreigners “pay” by lowering their prices, they will have lower incomes, which could also lead to less spending on goods and services, including those produced by Americans.

Regardless of who “pays”, what matters is that the U.S. government is taking away spending power from some combination of the U.S. private sector and the rest of the world. The ultimate impact depends on the extent to which Americans, the foreign private sector, and foreign governments are willing to dissave in response to this U.S. fiscal tightening.

Thankfully, it turns out that the question is largely moot because the answer is that nobody is paying the tariffs. The Supreme Court has finally stated the obvious: using the International Emergency Economic Powers Act (IEEPA) to arbitrarily impose import taxes is illegal.

The ruling does not affect the sectoral tariffs that have been and may be imposed under Section 201 of the 1974 Trade Act, the sectoral tariffs that have been and may be imposed under Section 232 of the Trade Expansion Act, nor does it affect the country-specific tariffs that have been and may be imposed under Section 301 of the 1974 Trade Act. But the Supreme Court ruling does wipe out the tariffs that were capriciously imposed over concerns about fentanyl as well as the “liberation day” tariffs that were devised by a chatbot. There will likely be refunds.

According to Customs and Border Patrol, as of mid-December 2025, the Treasury had collected about $133.5 billion in tariffs attributable to IEEPA, plus $49 billion in Section 232 sectoral tariffs, and about $41 billion in Section 301 China tariffs.

The administration has announced that it will use its authority under Section 122 of the 1974 Trade Act to impose worldwide tariffs of 10%1 to compensate for the loss of IEEPA. This measure is limited by law to “a period not exceeding 150 days”. According to the Yale Budget Lab, this should more or less restore the average effective tariff rate after losing IEEPA, although the net impact on revenues would still be negative given the time limit and the refunds.

Is it theoretically possible that many of the tariffs that were just removed could be recreated within the next five months using legal means? Maybe. But it would require heroic levels of effort by the technocrats who remain at the Commerce Department and the office of the U.S. Trade Representative (USTR), assuming they even want to do it.2 It would also be hard to raise whatever tariffs were imposed at the conclusion of any investigations without starting the process over again. The administration has therefore lost much of its ability to arbitrarily raise taxes and threaten perceived enemies, which should be particularly relevant for Brazilians and Europeans.3

That is just as well, because the tariffs of the past year clearly failed on their own terms, except insofar as they raised taxes by about 1% of Gross Domestic Product (GDP) without the consent of Congress.

According to the latest figures, price-adjusted spending on imports rose by more than real U.S. export earnings, with the net result subtracting 0.2 percentage points from the 2025 growth rate. Despite tariffs, Americans did not switch from buying foreign-made goods to domestic goods, nor did the tariffs suppress U.S. demand for imports relative to foreign demand for U.S. exports. Excluding gold, which is not counted in the GDP numbers, the trade deficit in 2025 was $921 billion, or 3.0% of GDP, essentially unchanged from 2024. These numbers include the surge in imports in the beginning of 2025 in anticipation of tariffs, but that does not change the overall picture.

More importantly, after accounting for the rebound in Boeing’s production of airplanes, which remains below where it was in 2018, U.S. industrial production has been more or less stagnant over the past year. Business investment was decent, but that was only thanks to the boom in data center construction—and that mostly means spending on foreign-made semiconductors and networking equipment, which were exempted from tariffs.

So at least some of the farce is over. What is the macro impact?

Tax Cuts are Stimulative, and Inflation is (Mostly) Not About Tariffs Anyway

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Based on the data we’ve seen and the conditions here and around the world, the Board now thinks it will take longer for inflation to return to target and this is not an acceptable outcome…Our updated view, driven by the latest data is that demand was stronger than expected over the second half of 2025 and we think some of that strength has carried into 2026. That strength has also meant that conditions in the labour market have held up well and unemployment has remained lower than thought…the global economy has turned out to be much more resilient than we thought despite the ongoing high level of uncertainty and unpredictably. And finally financial conditions have eased, and it is uncertain now whether they remain restrictive overall.

—Michelle Bullock, governor of the Reserve Bank of Australia (February 3, 2026)

Australia is a world away from the U.S., and the forces affecting its economy are often different from the ones on the opposite side of the planet. But Americans could learn something from the RBA’s recent about-face, because in this case, the circumstances are remarkably similar. The latest data imply that fears of U.S. economic weakness were overdone. If anything, cyclical sectors, including construction and manufacturing, have begun to re-accelerate. And all of this is happening as inflation remains persistently faster than the Federal Reserve’s ostensible 2% target, especially when focusing on measures that better reflect underlying demand. That should have implications for monetary policy, as it did in Australia.

Before digging more into the U.S. numbers, it is worth briefly examining what happened down under.

Behind the RBA Pivot

Australia had a relatively good pandemic, with far fewer deaths than in most other countries, as well as a vigorous rebound in economic activity. In fact, real Australian domestic spending grew substantially faster in 2019Q4-2022Q4 than in 2016Q4-2019Q4.1 Since the end of 2022, inflation-adjusted domestic final demand has continued to rise faster than it did in the pre-pandemic period, thanks in large part to faster growth in housing construction and business investment.

Nevertheless, Australia was still affected by the post-pandemic inflation shock that hit the rest of the world. Annualized inflation peaked in 2022, as in many other countries, at about 8% a year. As in the rest of the world, inflation decelerated sharply from that peak. But, as in the U.S., Australian prices since then have been rising modestly but persistently faster than in the years before the pandemic—and faster than the central bank’s target. With the odd exception of the second half of 2024, when prices barely rose at all, the growth rate in Australian prices has consistently averaged about 3.7% a year ever since the beginning of 2023.

That is not that much faster than the RBA’s target of 2.5% (technically the midpoint of the range between 2% and 3%) but RBA officials are evidently concerned by the lack of progress, especially after having been tricked by the misleading slowdown in inflation in 2024H2 into lowering the cash rate by 0.75 percentage points in 2025H1.

Part of the reason why the RBA was willing to start lowering rates was that the job market had been gradually weakening. Similar to the U.S., the Australian unemployment rate hit a multi-decade low of 3.5% at the end of 2022 / beginning of 2023. Since then, as in the U.S., the Australian jobless rate has been grinding higher. This occurred in two distinct moves. First, unemployment rose to 4% by the end of 2023, and stayed there through the end of 2024. Then unemployment began rising again, reaching 4.4% by September 2025.

Compared to the Fed, the European Central Bank (ECB), the Bank of England (BOE), the Bank of Canada (BOC), the Bank of Korea (BOK), or the Reserve Bank of New Zealand (RBNZ), the RBA was relatively late to begin lowering its policy rate, with the first cut occurring in February 2025. Until then, the modest weakening of the job market was not enough to justify a change in policy, especially as long as inflation was coming in relatively hot. Once inflation appeared to decelerate—at the same time that the job market looked to be rolling over, no less—RBA officials thought that conditions finally justified lowering rates.

But it turns out that this was an illusion. Not only did inflation quickly revive, so did employment. As of December 2025, the unemployment rate was back down to 4.1%. Meanwhile, Australia’s nominal wage growth has consistently been coming in around 4.5% a year, compared to about 2.5% a year before the pandemic. Just as in the U.S., the modestly faster trend in wages has corresponded with a modestly faster trend in prices.

To give credit where due, the RBA has been quick to change course, having last lowered the cash rate as recently as August 2025 and, at the time, having convinced RBA-watchers that the cash rate would continue to drop by another 0.5 percentage points by the middle of this year. Forecasts have changed accordingly.

The Fed may not end up following the RBA’s example, especially if the current administration succeeds in suborning the central bank, but there are good reasons for policymakers in America to consider following their colleagues down under.

The U.S. Job Market was Fine All Along

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That has implications for the negotiations currently underway in Abu Dhabi.

Russian officials have repeatedly insisted that they will only end their war on Ukraine if, among other things, they are given territories in Donetsk and Luhansk that they have been unable to conquer. The land in question is filled with defensive fortifications and difficult terrain, protecting the rest of Ukraine from Russian infantry and armor. Having failed (so far) to take it in battle, the Russian strategy over the past 12 months has focused on trying to convince U.S. officials to pressure the Ukrainians into surrendering the territory without a fight. The Russian argument is that their victory is inevitable, and that conceding now would be better than accepting the (far worse) terms of any future peace deal.

It takes heroic levels of squinting to notice meaningful changes in the Institute for the Study of War’s maps of assessed control of terrain between now and last year. The Russians have managed to advance a little bit compared to where they were three years ago, although not very far considering how much effort they have expended. They have proven far more capable of terrorizing Ukrainian civilians than gaining territory.

The latest official data from Russia’s Ministry of Finance and the Central Bank of Russia (CBR) suggest that the Russians may find it difficult to ramp their spending further. In fact, the publicly-available information suggests that they are already responding to constraints by raising taxes even more and planning for spending increases smaller than inflation. Those constraints are being exacerbated by the increasing pressure on oil exports due to tighter sanctions and the seizure of Russian ships, which should limit how hard they can continue to fight.

And if the Russians cannot increase their efforts from current levels, they will find it difficult to make much further progress—as long as Ukraine retains the support of its democratic allies. Rather than pushing the Ukrainians to accept a potentially unsatisfactory deal, the allies’ goal should be to force the Russians to realize that it is futile for them to keep fighting. The rest of this note covers the following points:

• Russian imports of critical goods remains constrained by sanctions, but it is less clear how much, if at all, the drop in oil and gas revenues is limiting imports

• Russia’s official numbers show that spending by both the federal government and the “constituent entities” rose sharply in both ruble and U.S. dollar terms, mostly thanks to a rise in the budget deficit, while the “Pension fund and social insurance fund of the Russian Federation” has also moved into a sharp deficit

• The “National Welfare Fund” has been selling gold for rubles to provide additional support to the military

• The Russian banking sector has sharply increased its lending to businesses associated with the war effort even as the government’s uncollected bills from the private sector have soared

Sanctions Are Still Constraining Russian Imports

The Russian military is extremely dependent on imported parts and components, and even the producers who manufacture weapons in Russia rely on imported capital equipment. The allies were able to inflict significant damage on Russia’s ability to fight via financial sanctions and export controls, which severely limited the Russians’ ability to import critical military goods.

The impact of those restrictions has weakened somewhat over time, both because European producers have been exporting to cut-outs in Central Asia and the Middle East, and because Chinese producers have decided to push the limits of the enforcement regime, but even so, the Russians are still unable to import as much as they would like from the rest of the world. After accounting for inflation and Russia-specific markups, the real value of imports, particularly of strategic goods, is substantially lower than implied by looking at the dollars spent.

Economists at the Bank of Finland estimate that “the median price change in exports to Russia was 75% for sanctioned goods and 0.2% for non-sanctioned goods” between 2021 and 2024. And the amount of dollars spent on goods imports is still (slightly) lower than in the pre-war period, which is why (different) economists at the Bank of Finland estimate that real imports of sanctioned goods fell by 27% by the end of 2023, which imposed large and persistent costs on Russian businesses involved in the military and high-tech sectors.2

Limits on Russia’s exports, particularly its exports of crude oil, refined petroleum products, and natural gas, have had less of an effect. The biggest reason, as I have warned for years, is that Russians earn so much more from their exports, including their non-energy exports, relative to what they spend on imports that it would be difficult to constrain their international purchasing power solely by suppressing their revenues from fossil fuels. The combination of lower oil prices and the oil price cap has done relatively little to dent Russia’s overall export earnings from selling goods to the rest of the world, which were $420 billion in 2019, $425 billion in 2023, $434 billion in 2024, and about $413 billion in 2025.

And to the extent that goods export revenues are slightly lower, Russian importers have offset the impact by simply spending slightly more on imports, relative to exports, than they did in the pre-war period (about 72% of goods exports in 2025 vs. 63% in 2014-2021).

There is plenty of room for the allies to tighten their export controls to limit transshipment through third countries. That should have been done years ago, but it would also be helpful to do it now, especially if the Russians continue to be intransigent about territory or other issues during the peace talks.

The Russian Government’s Spending Spree

According to the Russian ministry of finance, federal government spending—excluding transfers to “constituent entities” of the federation—in the 12 months ending in November 2025 was 15.3% higher (₽5.3 trillion) than in the 12 months ending in November 2024 in ruble terms. By contrast, revenues were up only 3.1% (₽1.1 trillion). Oil and gas revenues fell 19.4% (₽2.1 trillion), while tax revenues from import duties were down 11%. Taxes on the domestic non-oil and gas economy jumped by 30% (₽3.7 trillion).

For Russia’s “constituent entities”, which are responsible for substantial amounts of total spending, including for “national security and law enforcement”, spending was up 13.8% (₽3.4 trillion), while revenues excluding federal transfers were up only 6.3% (₽1.3 trillion) and transfers were up 8.1% (₽320 billion). The “off-budget funds” saw spending rise by 9.7% (₽1.9 trillion), mostly because the “pension and social insurance fund of the Russian Federation” saw expenses rise by about ₽1.4 trillion over the previous year. Revenues rose by 4.7% overall (₽950 billion), with revenues for the pension and social insurance fund up only 2.4%.

The pace of spending growth (in rubles) for the federal government, constituent entities, and “off-budget funds” was not much different from the year before, but revenue growth was much slower for all three (~5% vs ~20%). The result is that the combined budget deficit of the federation and constituent entities soared from about ₽2.8 trillion (4.7% of net spending) in December 2023-November 2024 to ₽‎9.1 trillion (13.3% of spending) in the 12 months ending in November 2025, while the balance between revenues and spending of the off-budget funds swung from +₽264 billion to negative ₽700 billion, for a total increase in the consolidated deficit of about ₽7.3 trillion.

Even with massive increases in value-added taxes, excise taxes, income taxes, and social insurance taxes, more than 80% of the increase in Russian federal spending over the past 12 months was financed by an increase in the deficit and more than 70% of the increase in spending by the “pension and social insurance fund of the Russian fund” was financed by an increase in the deficit. Across the consolidated budget, incremental deficit increases financed about two-thirds of the overall spending increase (in rubles).

Relative to the Russian economy, which is more than ₽‎200 trillion, these numbers are still relatively small, and Russian government debt is extraordinarily low relative to national income, especially when viewed in comparison to other countries. Nevertheless, Russian officials seem to believe that the additional rubles pumped into the economy via these budget deficits are unwelcome, which is why they are planning for slower nominal spending growth going forward, including no additional spending on the military and national security in 2026 compared to 2025 (in rubles).

It is perhaps more informative to consider the evolution of the budget in U.S. dollars, which helps adjust for changes in Russian inflation and for changes in the international prices of goods imported for the war effort. According to Russia’s official statistics, consumer prices rose by 7.4% in 2023, by 9.5% in 2024, and by 5.6% in 2025, which implies that real government spending rose much more in 2025 than in 2024. Somewhat counterintuitively, the ruble also appreciated against the dollar even as the price of Brent crude oil fell and as the discount of Urals crude to Brent rose.

The result is that Russian federal government spending, in USD, was 23% higher in January-November 2025 than in January-November 2024, which itself was essentially unchanged vs. January-November 2022. Energy revenues were lower in 2025 than in 2024, but perhaps not as low as one might have expected given the tightening in sanctions, the drop in oil prices, and Ukrainian strikes on Russian refineries. (Monthly spending numbers are often lumpy, with big spikes each December, but the picture looks the same when comparing 12 month sums from December-November.)

Similarly, spending by Russia’s constituent entities was up 21% in 2025 vs. 2024 and 2023 (in USD), while spending by the pension and social insurance fund was up 17%, after having been roughly flat in USD terms throughout 2022-2024. The official numbers imply that combined spending across all the layers of government was about 20% higher (in USD) in 2025 than in prior years, which is a meaningful increase relative to both the start of the war and the prior peak before the 2015-2016 oil price crash.

How to Finance It: The National Welfare Fund

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These modal probabilities may prove to be accurate forecasts, especially if the current administration succeeds in suborning the central bank to its whims. (As of January 20, the implied odds of a rate increase by the end of 2027 have increased to almost 6%, possibly as a consequence of financial asset sales by European investors in response to the Trump administration’s wanton aggression over Greenland.) But there are nevertheless good reasons to think that the implied probability of rate increases over the next two years is too low. The latest data on retail spending, on the job market, on inflation, and on household balance sheets are all consistent with an economy that is not obviously in need of lower borrowing costs.

In fact, the big risk is (still) that a reduction in rates could unlock the $16 trillion in un-monetized housing wealth that has built up since the end of 2019, leading to a flood of additional consumer spending. If businesses cannot accommodate all of this extra demand for goods and services by increasing volumes, as seems likely, they would be forced to raise prices, or combine price increases with other methods for rationing supply. Despite repeated statements that policy is “restrictive”, the reality remains that rates have been just high enough to keep spending and production sufficiently in balance to prevent inflation from getting worse. Lower rates threaten to disrupt this precarious situation and reignite inflation just as other policies are making things worse.

The Job Market is Still Strong

The most important feature of the current labor market is that 80.7% of Americans aged 25-54 had a job as of mid-December, which is essentially unchanged from the multi-decade high reached in mid-2023.1

Despite the reported increase in unemployment over the past few years from about 3.5% in early 2023 to 4.4% as of December, and despite the slowdown in aggregate job growth from about 2% annualized in 2023H1 to about 0% in 2025H2, the so-called “prime age” employment rate has been stable at the highs for more than two-and-a-half years. The only time the employment rate has ever been (slightly) higher was in July 1997-April 2001.

The current situation is the benign inverse of the jobless recovery of the 2010s.

Back then, declines in the headline unemployment rate (U-3) grossly overstated the recovery in the job market, because employment was not rising. Instead, prospective workers were no longer “actively” looking for jobs and were therefore not being counted as unemployed. U-3 peaked at 10% at the end of 2009, when the 25-54 employment rate hit its trough of 75%. By the beginning of 2013—more than three years later—U-3 unemployment had dropped to 7.5%, but the “prime age” employment rate was still under 76%.

Even when U-3 made it to 4.4% by early 2017—the same place it is now, which is down slightly from where it was in September and November—the employment rate for Americans aged 25-54 was still only 78.5%. That was well below the previous peak of 80% reached in 2006Q4-2007Q1, which was also the last time that U-3 hit 4.4%. The employment rate today is more than 2 percentage points higher than it was in early 2017 and almost 1 percentage point higher than in 2006Q4-2007Q1, despite U-3 being the same in all three periods. The difference is that the share of Americans aged 25-54 who were counted as being in the “labor force” is much higher now than in previous episodes, and has increased by about 0.7 percentage points since early 2023.

In other words, the reason why reported unemployment is up modestly from the trough is because a higher share of the people who do not have jobs are “actively” looking for work. As I explained in more detail last month, the official distinction between people who are “unemployed” and people who are “not in the labor force” can be surprisingly stringent. That is also consistent with the fact that most of the increase in reported unemployment is attributable to “labor force entrants” who cannot find jobs. From this perspective, nobody, or at least relatively few people, are actually worse off compared to before.

The Net Immigration Swing and Payroll Growth

Meanwhile, the slowdown in job growth, as I explained in more detail back in August, is largely attributable to massive changes in immigration inflows and outflows. These changes began in June 2024, and policy has shifted much more aggressively since then.

The latest estimates from economists at the Federal Reserve Bank of Dallas and the Federal Reserve Bank of San Francisco imply that net unauthorized immigration, including deportations and “self-deportations”, reduced the U.S. population by 600,000-1.1 million people in 2025, with most of the decline concentrated among people of working age. Net emigration in January-July reduced the U.S. population by 336,000, with deportations and self-deportations having surged from 30,000/month in 2024 to 113,000/month as of July. (Gross inflows were still positive, although down about 92% from the peak in 2023.)

In their baseline scenario, they assume that average monthly net unauthorized immigration in August-December 2025, for which they have no hard data, would be the same as in January-July (about -48,000). Their “downside risk” scenario “assumes the pace of monthly decline continues for the remainder of 2025”, with average net emigration rising to 153,000/month in the last five months of the year.

For perspective, net unauthorized immigration increased the U.S. population by about 2.5 million people each year in 2022 and 2023, and by about 1.5 million in 2024. The Dallas Fed’s previous projection, from last summer, was that net unauthorized immigration in 2025 would boost the U.S. population slightly (by about 88,000 people) and even their “mass interior deportation” scenario projected a net decrease of only 22,000 people in 2025, with monthly net removals slowly rising to 89,000/month by 2028. Current policy is already more severe than what they had anticipated as extreme just a few months ago.

This has implications for employment. According to the estimates from the Dallas and San Francisco Feds, most of the unauthorized immigrants who arrived in 2021-2024 were of working age, while most of the net deportations in 2025 were also of people who were of working age. Many, if not most of those people likely got jobs and contributed to the increase in payroll employment observed during that period. They were also spending what they earned, creating demand for goods and services and encouraging businesses to hire and invest.

The small weakening of the job market that occurred in 2023-2024H1, when the unemployment rate rose modestly and wage growth decelerated slightly, coincided with the period when net payroll growth, while impressive in absolute terms, was relatively low compared to net immigration. By contrast, the more recent period of slow job growth has coincided with zero net immigration of working-aged adults.

The hurdle rate for what constitutes a “good jobs number” has therefore plunged over the past 18 months and may already be negative. That in turn has implications for the trajectory of wage growth and spending, which should have implications for monetary policy.

Wage Growth, Retail Sales, and Inflation

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At first glance, this seems extremely odd.

Some have argued that the apparent interest rate / exchange rate disconnect can be explained by concerns about the Japanese government’s ability to continue servicing its debts. The central government currently owes about 1.3 quadrillion yen, or about 2x Japan’s national income. As that debt is gradually refinanced at new, higher, interest rates, the budget deficit may get pushed up, leading to even more debt issuance at even higher rates, etc.

Those who believe that the debt is unsustainable believe that the government will eventually be forced to choose between outright default and “debasement” that would cheapen nominal yen claims relative to assets in other currencies as well as relative to real assets. For those who have spent decades warning—or scaremongering—about Japanese public indebtedness, the persistent (nominal) weakness of the yen in the face of rising (nominal) interest rates over the past few years therefore seems like vindication that this process is finally starting.

As of now, however, there is a more benign explanation: Japan may have finally exited its post-bubble stagnation.

The return of modest inflation alongside persistently faster wage and income growth should align with higher interest rates than those that prevailed when the economy experienced essentially no growth in yen terms between 1997 and 2019. Moreover, if the recent growth in nominal incomes is sustained, Japanese government borrowing costs would still be lower, relative to expected revenue increases, than in much of the past few decades. (That helps explains why the yen has not appreciated recently despite the apparent convergence of nominal yields with the U.S. and other G10 economies.) Far from indicating trouble, Japanese bond prices are implying that Japan has converged, in at least one important way, with the rest of the rich world.

The Long Stagnation

Japan’s post-1980s bust was a harbinger of what would afflict much of the rest of the rich world in the 21st century.1

Companies that had borrowed too much in the second half of the 1980s slashed spending in the face of losses, so wage and price growth slowed sharply. Once they finished repaying their debts, they compulsively hoarded cash and equivalents. The Japanese corporate sector swung from a net financial deficit of nearly 9% of national income in 1990 to a net surplus of 10% of GDP by 2003. While the excess of profits over capital spending2 has shrunk somewhat since then, it has remained a large.

As of the end of 2025Q3, the latest available data, Japanese nonfinancial corporations held nearly 1 quadrillion yen in liquid assets, of which ~¥270 trillion were cash and deposits, ~¥233 trillion were bills and accounts receivable, and ~¥460 trillion were investment securities. Net of debt liabilities, nonfinancial corporations’ overall financial asset position relative to their total sales has shifted by more than 30 percentage points since the mid-1990s (or about ¥460 trillion). Put another way, the cumulative net saving of the entire Japanese nonfinancial corporate sector over the past thirty years is currently worth about 80% of Japanese GDP.

Government deficits exploded and public indebtedness soared in response, but it was not nearly enough to restore nominal income to its prior trajectory, so interest rates fell close to, if not below, zero, as Japanese lived below their means.

Japanese policymakers have tried to break this cycle for decades, with the goal of higher corporate investment powering faster wage growth and profit increases that would encourage further investment, raising living standards and boosting tax receipts. Koizumi Junichiro3 hoped that an agenda of deregulation and competition would get companies to spend, but that proved insufficient. More recently, Abe Shinzo and Kuroda Haruhiko had tried to use fiscal and monetary stimulus to change executives’ mindsets. Inflation was not the main goal in and of itself, but was supposed to be a mechanism to encourage capital spending and hiring (or at least shareholder payouts) because it functioned as a tax on corporate cash holdings.

From this perspective, “Abenomics” failed on its own terms, even if it did have a meaningfully positive impact on Japanese stock returns.

Corporate profits surged, but this was largely attributable to windfalls from the depreciating yen and interest rate differentials with the rest of the world. By contrast, Japanese wages, prices, and capital spending all remained stuck in the doldrums on the eve of the pandemic. Even then, profit growth had mostly stalled out by 2017. Japanese corporations outside of finance and insurance earned ¥56 trillion in operating profits in 2007 vs. ¥67 trillion in 2017 (+19%), ¥68 trillion in 2018, and ¥65 trillion in 2019. “Ordinary profits”, on the other hand, which includes net interest income and other forms of non-operating income, rose from ¥60 trillion in 2007 to ¥81 trillion in 2017 (+35%), ¥84 trillion in 2018, and ¥81 trillion in 2019.

Similarly, while employment had boomed, particularly among women and the elderly, the gains were overwhelmingly in precarious part-time, contract, and other “non-regular staff” positions.

Yet the pandemic and the response to it seem to have broken Japan out of the trap. As in the rest of the world, most notably the U.S., the experience seems to have reset expectations and altered behaviors in ways that should correspond to persistently faster nominal income growth and faster inflation. That should coincide with higher interest rates, especially at the long end. Encouragingly, hiring and investment have also been perking up, which means that the hoped-for passthrough from improved nominal outcomes to improved real outcomes is finally happening.

Japanese Wages, Inflation, and Hiring

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That is not necessarily a problem that justifies tightening monetary policy from here. As many people argued persuasively at the time, nominal income growth was too slow in the years before the pandemic. But the data imply that the burden for loosening policy should be high, especially given the latent risk that inflationary policy shocks start changing the behavior of consumers and businesses.

Lowering interest rates could make sense if the job market were clearly in danger of rolling over. It is also possible that lower rates could be appropriate if the “neutral” level had suddenly dropped, perhaps due to changes in population growth associated with net immigration. As of this writing, however, the job market still looks relatively healthy, or at least no less healthy than it did a few months ago. And while it is definitely possible that the reversal of the immigration influx of 2022-2024H1 will lower longer-term growth prospects, and therefore reduce the set of interest rates that would lead to the “optimal” mix of saving vs. spending out of income, it is also possible that the impact will be overwhelmed by enthusiasm about the potential productivity gains to be generated from investments in data centers and AI research.

The Impact of the Shutdown on Data Collection

The Bureau of Labor Statistics (BLS) was not able to do any work between October 1 and November 12 because of the federal government shutdown. That distorted much of the most recent data, and it may continue to distort some data in future releases.

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For the most part, this shift cannot be explained by changes in the underlying economic data, to the extent that we have it. (While the statistical agencies will eventually catch up, the federal government shutdown has ensured that most of the numbers available as of this writing only run through September.) The more plausible explanation is that a small but growing cadre of Fed officials have been reinforcing the pressure from administration officials for larger and faster reductions in interest rates. Against them is a sizable contingent of Fed officials—consisting mainly of the reserve bank presidents, who are somewhat more insulated from Washington politics—that is resisting the attempt to suborn the central bank.

So far, the latter camp has been fighting a rearguard action. The target band for short-term interest rates has already dropped by 0.75 percentage points just since September (to 3.5-3.75%), even though, as recently as July, traders had been betting against most, if not all, of those cuts, in line with what Fed officials had been saying.

From this perspective, the apparent preferences of the median official may not be particularly helpful for anyone trying to understanding how Fed officials as a group will actually respond to changes in the outlook. Instead, what matters most are changes in the relative size and strength of the emerging voting blocs within the Fed. Abstract institutional preferences matter far less than the choices of the specific individuals empowered to make decisions, and those decisions may be affected by external pressure as much as anything else.

What follows is a closer look at the shift within the Fed over the past 12 months and how it corresponds—or fails to correspond—to changes in the data.

The Dashed Dreams of 2024 (in 2025H1)

At the end of 2024, Fed officials were optimistic. “Under appropriate monetary policy,” excessive inflation would be essentially over by the end of 2026, and this would occur without unemployment rising and without any hit to real growth. Back then, the assumption of most officials was that short rates would need to be between 3.75% and 4% at the end of 2025 (0.25 percentage points higher than now), would not need to change much throughout 2026 “under appropriate monetary policy”, and then maybe fall slightly by the end of 2027.

A few things have happened since then.

By March—before the announcement of the “liberation day” tariffs, but after the new administration had already demonstrated its intent on everything from antagonizing Canada and Mexico to slashing support for scientific research to attacking law firms—Fed officials had concluded that Americans would be poorer even under the most benign scenario, with consumers paying higher prices while enjoying fewer goods and services. “Appropriate monetary policy” did not change (much) from December 2024 to March 2025, because Fed officials’ unemployment outlook did not change, but that was essentially a coincidence.

By June, the picture had become clearer (and worse). The risks to growth were slow-moving and secular, but unlikely to have much of an immediate cyclical impact.1 The risks to inflation, however, were both short-term and long-term. Tariffs and other supply disruptions attributable to policy choices were pushing up goods prices. More worryingly, these “one-off” disruptions were occurring at a time when underlying inflation was still running faster than the Fed’s 2% yearly target and at a time when consumers, workers, and businesses had already become primed to react, if not overreact, to changes in prices by adjusting their behavior in ways that would only reinforce the inflationary impulse.2

The implication, back in June, was that nominal interest rates would have to be somewhat higher “under appropriate monetary policy” to prevent inflation from getting competely out of control.

Even then, Fed officials expected that Americans would have to endure an additional 1% increase in the price level by the end of 2027 relative to what had been expected back in December 2024, while the real volume of goods and services produced in the U.S. would be 1.3% lower. Fed officials also thought that unemployment would have to be slightly higher “under appropriate monetary policy”, although they hoped that they could hold the line at 4.5%.

The Revival of Confidence and the Asymmetric Policy Response (in 2025H2)

Since then, Fed officials have become far more optimistic about the real growth outlook, although they have not gotten more optimistic about inflation “under appropriate monetary policy”. The net result is that the real volume of goods and services produced in the U.S. is now expected to follow essentially the same trajectory that had been hoped for back in December 2024, despite everything, while the price level will be higher.

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Yet this potential remains latent because “Europe” as a geopolitical entity does not exist. Instead of a strong and independent continent capable of securing the lives and freedoms of its citizens, Europe is divided into dozens of countries, all of which are too small individually to stand up to external threats. The problem is compounded by the mismatch between where the military resources can be found and where they are most needed. There is relatively little overlap between the places with the balance sheet capacity (mostly in the north), the places with the productive capacity (mostly in the center), the places with the largest populations of otherwise unoccupied fighting-age men (more in the south), and Europe’s front lines (largely, although not exclusively, in the east).

The result is that Europeans are unable to protect their interests from a rapacious neighbor and an increasingly undependable ally. But this is a solvable problem. Europeans can mobilize their abundant financial and real resources, and deploy those resources to where they are most needed, if they choose to do so. And while it may be a challenge to get European publics to agree that their common aspirations and fears are more important than their relatively trivial differences, it is not the most pressing one. Rather, the biggest immediate hurdle is that Europe’s elites are blocking the kinds of policy innovations necessary for the continent to meet this moment.

The rest of this note, based in part on my experience attending a stimulating conference hosted by the Centre for European Reform, will focus on three specific points:

• Europe’s national militaries are insufficiently coordinated in their deployment and procurement decisions

• The European Commission is poised to strangle Germany’s rearmament and investment push before it has a chance to bear fruit, which has implications for everyone

• The European Central Bank (ECB) is constantly undermining governments’ efforts to mobilize the Russian government’s frozen assets to support the Ukrainians

In the Wrong Places, with the Wrong Stuff

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While markets briefly seemed to be pricing in some of these changes in early April, by many accounts, the moment of the “sell America trade” seems to have passed. The prices of stocks, bonds, and currencies—although not precious metals—have all reflected strong demand for U.S. assets since April.

But it would be wrong to conclude from this that foreigners have ignored the regime shift in the U.S. Since July, foreign banks have been shedding assets held in their U.S. branches and agencies at one of the fastest rates on record.1 This has coincided with a sharp pullback in funding of these branches and agencies from “related foreign offices”.

The shift has gone largely unnoticed for two reasons.

First, it is still relatively small compared to the growth in foreign banks’ U.S. exposure since early 2020, even if the rate of change is substantial. As of November 5—the latest available data—net debt owed by the U.S. offices of foreign banks to their HQs or other foreign subsidiaries had only dropped back to the levels of late 2024/early 2025.

Second, the cutbacks have coincided with the ~$500 billion decline in deposits held by all banks at the Federal Reserve since the Treasury began rebuilding its own cash holdings after the debt ceiling was raised in July. The recent federal government shutdown also restricted spending relative to tax receipts, causing the Treasury General Account (TGA) to rise even further at the expense of base money available for the private sector.

But while this explains why the total volume of bank reserves has dropped, it does not explain why the U.S. branches and agencies of foreign banks have been responsible for almost all of the decline in reserves over this period, nor why they have reduced their borrowing from abroad. It is notable that, in the aggregate, the U.S. offices of foreign banks did not shed reserves in 2022, even though many U.S.-chartered banks were doing so.

This matters because foreign banks’ interoffice lending has been a meaningful source of financing for the U.S. current account deficit, especially in 2021-2022 and in 2025H1. As I have been pointing out since 2021, foreigners had helped offset the impact of dollar creation by (in the aggregate) lending export earnings back to their U.S. branches to buy reserves at the Fed, pushing up the exchange rate relative to what it would otherwise have been. That was particularly helpful when reserves yielded no interest.

If the bank flows continue to reverse, it could put downward pressure on the dollar in the absence of countervailing flows by portfolio and/or direct investors.

This Round of Reserve Shrinkage Has Been Different

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This note will focus on five sets of data: relative stock market returns, the distributional financial accounts; the distribution of disposable personal income, personal consumption, and personal saving; the detailed monthly components of consumer spending; and surveys of consumers that disaggregate results by income level. If the email gets cut off, please click the title at the top to read it on the website.

The Growth Re-Acceleration and the Stock Market

While inflation-adjusted spending on goods and services stagnated from December 2024 through May 2025—likely in response to concerns about tariffs and other policy disruptions—the data have turned around sharply since then. From May through August2, real consumer spending rose at a rate of 4% a year. Excluding components that are unusually volatile or are “other-than-market-based”, real personal consuption expenditures (PCE) rose even faster (4.3% a year). With inflation still coming in relatively strong, overall consumer spending in dollar terms is currently rising at an annualized rate of 7%. Even if that likely includes some make-up purchases to compensate for spending that had been deferred in 2025H1, growth meaningfully re-accelerated over the summer.

One common view is that this growth pop is being powered (supposedly) by a small number of Americans with high incomes and bouyant portfolios, even as most others are (ostensibly) doing badly. To be fair, nominal wage growth for lower-income Americans has been decelerating recently even as the pace of pay gains for higher earners has been picking up, according to both official government data and independent private-sector estimates. Financial asset ownership is also extremely concentrated, with the highest-earning quintile of American households holding about 87% of the stocks, bonds, mutual funds, and ETFs held by households.3

And real consumer spending has more or less tracked asset markets since the beginning of 2024. A typical 60/40 portfolio of global stocks and bonds steadily appreciated by 13% over the course of 2024, was more or less flat from the end of that year until the announcement of “reciprocal” tariffs in early April, fell sharply, and then had rebounded to the prior highs by May. Since then, the typical portfolio has appreciated by another 13% in almost a straight line.

Asset prices have been about 4x as volatile as real PCE over this period, but the direction of travel and the timing of the moves have been broadly aligned with real activity. It is tempting to conclude that there is some causal connection, with rising (or falling) asset prices translating directly into higher (or lower) consumer spending. If the relationship held through the past two months, the implication is that real PCE grew faster than 5% a year (!) in May-October.

All market data in this note come from Koyfin. Subscribers to The Overshoot can get either a free trial or a discounted subscription by using this link.

From this perspective, the aggregate U.S. economy should continue to grow briskly as long as asset prices keep rising—regardless of whether most Americans have actually been participating in either the wealth gains or the consumption boom. Conversely, any slowdown or reversal in asset appreciation, particularly among the big tech companies that have played such an outsized role in the past few years, could potentially shove the whole economy into a downturn as unrealized gains turned into un-monetizable losses.

There are other interpretations. While large swings in the stock market obviously can affect behavior, they also reflect changes in behavior. (A camera, as well as an engine.)

AI-adjacent stocks have obviously been among the strongest performers so far this year—and currently constitute almost 40% of the S&P 500 index by market cap—but they are from carrying the market alone. Industrials and financials have also kept pace with the overall market, while biotech stocks have outperformed so far this year. Even despite some recent losses, homebuilders’ stocks have vastly outperformed the broader market since January 2020 and kept pace with the S&P 500 index since January 2023. By contrast, consumer staples companies and other “defensive” stocks have been among the worst performers so far this year, just as they underperformed the broader market during both the 2021 bull run and during the long expansion following the October 2022 trough.4

Similarly, a simple equal-weighted portfolio of companies that should do best when consumers are struggling (fast food chains and dollar stores) has been crushed by a portfolio that should be more sensitive to consumers’ willingness to shell out on discretionary purchases (travel/dining companies and furniture retailers). This latter portfolio has also outperformed the broader stock market over the past few years, while matching it over the past few months despite no obvious exposure to the AI growth story. Reasonable people can disagree with the specific securities selected, but the picture is consistent with the sectoral returns.5

These relative performance patterns are also evident in the recovery from the trough following “liberation day”, which may have some signal value for interpreting the drivers of the recovery in real consumer spending over the same period. Rightly or wrongly, investors have been betting that broad swathes of the U.S. economy are doing well—as well as betting on the thesis that American consumers have spending power they are willing to use.

The stock market returns are suggestive, but they are not conclusive. Fortunately, they are consistent with the information available from official government sources on household balance sheets, income, and spending.

Debt Free, Cash Rich, Can’t Lose

From the end of WWII until the 2008 financial crisis, policymakers in the U.S. responded to downturns (mostly) by lowering interest rates to encourage consumers and businesses to save less, borrow more, and spend. That became increasingly untenable as private indebtedness kept rising and as rates continued to drift towards zero. The strategy reached its limit in the 2000s, when, in the memorable words of Paul Krugman paraphrasing Paul McCulley, “Alan Greenspan [created] a housing bubble to replace the Nasdaq bubble”.

The problem was that borrowing against assets that do not generate income—to finance consumption that does not increase debt-servicing capacity—is inherently unsustainable. Ultimately, the excess debt has to be dealt with one way or another, either by forcing borrowers to spend less so that they can repay what they owe, restructured/inflated away at the expense of creditors, or some combination.6 The U.S. and other rich countries avoided massive debt writedowns, inflation, and currency debasement, but still paid the price for past excesses with a permanently lower growth trajectory. It was better than the Great Depression, but not by much. By the eve of the pandemic, Americans (and Europeans) were trillions of dollars poorer than they should have been. And it also seemed as if the “new normal” since 2008 would put a ceiling on interest rates around 1.5-2%.

The pandemic—and in particular the economic policy response—changed everything, at least in the U.S.

In the 1940s, mobilization and wartime rationing created a surge in spending that wiped out private indebtedness and laid the groundwork for the long debt boom that followed. In the 2020s, unprecedented government income support, forced saving, and huge swings in demand for specific goods and services had a similar effect, albeit on a smaller scale: the trend growth rates of both nominal wages and inflation seem to have persistently accelerated and, particularly relevant for us, household balance sheets were cleaned up. The Federal Reserve’s distributional financial accounts (DFAs) show how the benefits were (likely) shared across a broad swathe of income and wealth cohorts.

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BCRA officials probably felt constrained by the ongoing pressure on the peso’s international exchange rate. BAIBAR has come down substantially since then as U.S. government officials have decided to increase their support for the Argentine peso by buying the currency outright, but the situation remains tenuous.

What happens next?

Treasury Secretary Scott Bessent claimed on October 17 that “we have the capacity to act with flexibility and with force to stabilize Argentina”. The BCRA has also announced the agreement of an official swapline “with the United States Department of the Treasury for an amount of up to USD 20 billion”, although the terms are not public and there is no corresponding announcement on the U.S. Treasury’s website. While there is no hard limit on how many U.S. dollars the government can create, it is not clear what amount of USD, if any, would be sufficient to get Argentina out of its current predicament—to say nothing of whether that would be a good use of the money.

As a first approximation, there are about $90 billion of private sector Argentine bank deposits denominated in pesos that have yet to be converted into hard currency or pulled out of the banking system entirely, plus around $43 billion of unpaid dividends owed to foreign direct investors.1 Argentine officials are well aware of this latent pressure on the currency, which explains why they still refuse to let companies pay dividends out of retained earnings generated before this year.

Then there are the ~$137 billion in Argentina’s net external debts, most of which are denominated in USD, with their associated interest and principal obligations.2 So even if the U.S. donated $250 billion outright—equivalent to more than 1/3 of Argentina’s national income—it still might not be enough to satisfy Argentines’ desire to replace pesos with USD at current exchange rates. From this perspective, temporarily lending $20 billion does not seem likely to accomplish much beyond bailing out some of Argentina’s short-term foreign creditors. (The Argentine government has to pay about $18 billion in interest and principal to foreigners over the next 12 months.)

How did this happen? While I would encourage anyone interested to read my previous note on the subject, it is worth digging into how Javier Milei’s government undermined its stabilization efforts almost from the beginning. This note also tries to estimate the size of the U.S. Treasury’s intervention thus far.

Milei’s Mistake: Expansionary Austerity

Argentina’s budget cuts have been substantial. But they have not been nearly big enough to fix the country’s inflation problem, nor were they sufficient to stabilize the peso. Ironically, Milei’s problem was that he succeeded where many others have failed, boosting growth while slashing government spending. While this rare case of “expansionary austerity” bolstered his political support, at least at first, it also exacerbated the country’s balance of payments stresses.

The problem is that the Milei government more than offset the impact of fiscal tightening with a credit boom to the private sector. The U.S. dollar value of Argentine banks’ claims on individuals and businesses tripled between the end of 2023 and March 2025. The extra credit was worth about $56 billion, or almost 10% of Argentina’s national income.

Put another way, the consolidated government budget balance shifted from a deficit of 8.4 trillion pesos in January-December 2023 to a surplus of 1.8 trillion pesos in January-December 2024, which deprived the private sector of about 10.2 trillion pesos of purchasing power. But Argentina’s domestic financial system printed 45 trillion pesos (worth $39 billion at the time) of new ARS-denominated private sector credit in 2024, plus $8 billion of net new FX credit.

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There is some confusion about how fiscal policy should be thought of in the design and implementation of International Monetary Fund (IMF) programs.

This confusion may originate in the belief that fiscal slippage was the key to the crisis in Argentina at the turn of the millennium. As expressed by Michael Mussa as Economic counsellor amongst others, such concerns evolved into the formalisation of the debt sustainability analysis (DSA) framework at Fund over twenty years ago.

Since then, Fund programs now focus excessively, perhaps exclusively, on the public sector DSA—and fiscal policy is now seen through that lens, to the detriment of balance of payments (BOP) analysis. This was notably the case during the Eurozone Crisis.

It is important to distinguish the role of fiscal policy in BOP analysis, therefore, and the possibility that meeting public debt sustainability thresholds does not automatically deliver the BOP adjustment that is the purpose of Fund programs.

We here recall the essence of the IMF’s traditional approach to balance of payments analysis and the role of fiscal policy in this adjustment.

Fiscal Sustainability

Consider the standard expression for the evolution of public debt:

Primary budget surpluses relative to Gross Domestic Product (p) cause the debt-to-GDP ratio (b) to fall. But if nominal interest rates on outstanding debt (i) are higher than the growth rate of nominal income (g), then the debt-to-GDP ratio rises based on how much debt there was before. The minimum condition for sustainability therefore relates the primary balance to the growth adjusted nominal interest on the existing debt stock:

Formally, this condition, when i is higher than g, ensures that the net present value of future primary surpluses in the steady state is equal to the existing debt stock—Ponzi schemes are ruled out as the debt is “serviced” rather than capitalized. This justifies investors holding the debt today; debt is “sustainable” in a forward-looking sense.

Suppose this condition is met. What about the balance of payments?

Balance of Payments Analysis

Write the fiscal dynamics equation instead as:

where ΔbD is the change in debt by locals vs. GDP and ΔdbE is the change in debt held by foreigners vs. GDP. The difference is determined by the residency of the owners rather than the currency in which the debt is denominated.1

Suppose that the central bank balance sheet evolves so that the change in international reserves-to-GDP (r) is equal to the change in base money-to-GDP (m) minus the change in domestic credit of the central bank-to-GDP (c):

Subtracting the fiscal expression from this, we get an expression for the consolidated government’s change in net external assets—liquid foreign assets in the form of international reserves net of long-term external debt of the government:

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Fortunately for me, I never got around to publishing what I was working on. In the months since, Argentina’s longstanding vulnerabilities to capital flight and inflation have reasserted themselves with a vengeance. Now the U.S. Treasury is preparing to commit tens of billions of dollars to Argentina through some combination of lending dollars to the BCRA, buying dollar-denominated Argentine government bonds, and (maybe) even buying Argentine peso assets. The IMF is apparently “coordinating support”, which could involve loans from the ~$175 billion of Special Drawing Rights (SDRs) held by the Treasury. According to Treasury Secretary Scott Bessent, the goal is to give Argentina “the tools to defeat speculators, including those who seek to destabilize Argentina’s markets for political objectives.”

At one level, this is incredibly stupid, because the Argentine government will almost certainly fail to repay the Treasury without doing something rash.1 At another level, however, I think that there is a germ of a good idea in Bessent’s proposal. The U.S. government should be more willing to take credit risk for the sake of mitigating balance of payments crises. The question is whether Argentina is the best case for doing this.

Lose Money Now, or Later

Ever since the 1920s, the biggest problem afflicting the international monetary and financial system is that the costs of excessive debt have been borne disproportionately by those who borrowed too much, while those who lent too carelessly were relatively shielded from any burden of adjustment. Aside from being unfair, this one-sided approach is guaranteed to retard global growth.

The immediate problem is that the people who were “living beyond their means” are forced to cut their spending—without any commensurate increase in spending by those who have the financial wherewithal to do so. The result is a drop in global demand that makes it harder for otherwise viable businesses to survive, no matter where they are based. That was what happened in the early 1980s, for example, when real import volumes plunged by as much as 60% in what were then called the “less developed countries” as they lost access to foreign financing. That corresponded to lost sales and company failures in the rest of the world. Creditors may have benefited from policy choices that prioritized their interests, but most people in the creditors’ home countries did not.

Even worse than the short-term effect is what happens when people learn that the only way to avoid painful sudden stops is to live perpetually below their means, spending less than they could on things that they want so that they can instead hoard reserves. That was what happened after the emerging market crises of 1997-8, and again after the euro crisis. The longer-term costs are persistent underconsumption and underinvestment, particularly in places that have experienced crises. The flip side is that many of the places that would benefit the most from additional capital investment are either paying punitive costs for financing, or are effectively transferring their own spending power to places that do not need it.

This has costs beyond the immediate economic ones, just as Keynes and the other founders of the IMF would have anticipated. Orbán’s authoritarian takeover of Hungary—and his tilt to China and Russia—was facilitated by the reluctance of the European Central Bank (ECB) and others to provide enough support during the financial crisis. He learned that lesson well enough to prevent being squeezed in the years since.

Perhaps even more consequential is what (may have) happened in Türkiye. I am far from an expert on Turkish politics, but one argument I have heard from people who are experts is that Erdoğan’s political transition can be at least partly explained by his supposed belief that Americans and Europeans have repeatedly let him down at crucial moments.2 The two most important episodes in this narrative are the French efforts to block Türkiye’s accession to the European Union in 2004 and the U.S. removal of its Patriot missile defense system from Türkiye during the Syrian civil war.

I do not know how much Erdoğan’s perceptions of these events actually explain his behavior, if at all, but if they are as significant as some suggest, then the decisions to exclude Türkiye from the Federal Reserve’s emergency lending in 20083 and again in 2020 should also be viewed as having contributed to the country’s authoritarian turn and its tilt towards Russia. From this perspective, it is notable that, unlike Hungary, Türkiye remains in a relatively fragile balance of payments position, although things have improved since 2023.

Preventing these sorts of outcomes is literally what the IMF is for, although it has sadly fallen short throughout its history. The good news is that the U.S. has both the ability and the self-interest to do much of the job by itself, should officials choose to pursue the path of enlightened self-interest. As I put it when asked for my thoughts on this question by members of the previous U.S. administration:

The U.S. government could build on its role as an intermediary of these destructive cross-border flows by massively expanding its provision of development finance and balance of payments support to the rest of the world. The catch is that the U.S. government would have to be willing to endure substantial losses on this international investment portfolio…There might be plenty of [market-based and official] financing going to poor places, but not nearly enough to sustainably raise living standards and protect against crises. Complaints about low yields in the rich countries make it clear that the constraint has been a lack of credible places to invest, rather than a lack of financing.

If even more money is going to go out the door, it will necessarily be going to borrowers who are even less capable of paying it back at market rates of return. So if the U.S. government were committed to meeting financing volume targets that were determined by macroeconomic objectives and development goals—to say nothing of strategic concerns—policymakers would have to be willing to incur some sort of fiscal cost.

From this perspective, there is nothing inherently wrong with risking U.S. taxpayer money to help a foreign country suffering from a balance of payments crunch. But there are good reasons to think that Argentina today may not be the best place to start, even if the Milei team has accomplished much in a short time.

Why is Argentina in this Position?

While corruption scandals and a strong result by the opposition in the Buenos Aires provincial election ahead of the upcoming midterms may be the proximate causes of Argentina’s most recent troubles, the country’s basic problem is that the people who live there do not want to hold their wealth in Argentine assets—and everyone else is only willing to hold Argentine assets when their risk tolerances (and global commodity prices) are unusually high. A society with the industrial mix of Australia and New Zealand cannot afford the politics and institutions of Türkiye.

In the nearly two decades since Argentina repaid its last IMF loans in 2006, Argentines have spent more than $200 billion accumulating foreign currency. Over the same period, total inflows of cash to the Argentine government and the BCRA were worth only $160 billion.

Despite persistent trade surpluses, the Argentine economy is often short of hard currency because Argentines prefer to hold hundreds of billions of dollars of cash, stocks, and real estate outside their domestic financial system. Argentines are (rightly) afraid of inflation, devaluation, and expropriation, but the irony is that they hedge these risks so aggressively that they generate precisely the outcomes they wish to avoid.

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