Why the $38 trillion national debt doomed Fed independence regardless of the Trump/Powell drama, top economist says

When Fed Chair Jerome Powell announced Sunday evening he was under criminal investigation from the DOJ this week, the markets braced for a shock.  The probe—centered on a $2.6 billion renovation of the Fed’s Washington headquarters—was immediately branded by an unusually direct Powell as a “pretext” to force interest rate cuts. Futures went down.

Yet, Monday came, and while gold and silver went vertical, equities stayed calm and the dollar barely drifted. To economist Tyler Cowen, the renowned libertarian from George Mason University and author of the influential Marginal Revolution blog, this lack of market panic is the most revealing part of the drama. It isn’t that investors trust the administration’s motives; it’s that they have already accepted the “ugly little truth” that the Federal Reserve’s independence is a relic of a bygone era. 

“What Trump did was terrible,” Cowen said on the technology podcast TBPN, referring to the administration’s erratic, “Captain Queeg” style of institutional pressure. “But to me, the reason markets didn’t react more is because we already wrecked the independence of the Fed. That’s the ugly little truth behind this story. It was already wrecked.”

In Cowen’s telling, the damage was done years ago, through fiscal policy. Budget deals, tax cuts and a chronic deficit have steadily narrowed the Fed’s real freedom to act, regardless of its formal mandate.

“The basic problem is our debt and deficits are so high that over time, we will monetize them to some extent and have higher inflation because we prefer that over higher taxes, no matter what we might say,” Cowen said on technology show TBPN.

That preference, Cowen argues, quietly undermines central bank independence. Even without overt political pressure, a heavily indebted democracy is one that limits its own monetary choices. At some point, inflation becomes the least politically painful way to manage obligations that voters are unwilling to finance through taxes or spending cuts.

A grim echo

This diagnosis is a grim echo of the work of Ray Dalio, the billionaire founder of top hedge fund Bridgewater Associates, who has long warned of the “Big Cycle” debt trap. Dalio’s framework suggests that nations with massive debts eventually run out of good options. They are left with a choice between three politically poisonous options: austerity (massive spending cuts), default (which would be unthinkable for a reserve currency), or inflation (“printing money” in order to devalue the debt). 

Dalio has frequently agreed with Cowen that for the United States, inflation is the only path forward, since it is an invisible tax that a democracy will always prefer over the political suicide of massive tax hikes or the gutting of social programs. Speaking with fellow billionaire, Carlyle co-founder David Rubenstein, Dalio recently said, “My grandchildren, and great grandchildren not yet born, are going to be paying off this debt in devalued dollars.”

Cowen offered a prediction about how what Dalio calls the “ugly deleveraging” will look: the U.S. may require half a decade of 7% inflation to erode the debt’s value relative to the size of the economy.

“It’s highly unpleasant, and a lot of people will be thrown out of work and living standards will be lower,” Cowen said. “But we’ve already spent that money. We can’t default, and that’s what’s facing us over the next 10 to 15 years,” implying that, while default would ordinarily be a country’s way out of this kind of dilemma, America’s status as the richest economy in world history and the home of the world’s reserve currency make that unfeasible.

The irony, Cowen notes, is that America’s unique status allows it to run higher debt than almost any other nation, even the wealthy ones. That privilege may boost living standards today, but it still weakens political discipline tomorrow, allowing leaders to not only “get away with more debt” but also explicitly destabilize the Fed without worrying too much about market backlash. 

Although neither Dalio nor Cowen have taken this argument about the debt into the feud between Powell and Trump, at its heart lies a similar dynamic: how can the U.S. improve living standards for its lower and middle class? Trump has been badgering Powell about interest rate cuts that would bring down mortgage rates and ease housing affordability, but that runs the risk of fueling an even higher inflation wave down the road, or sooner. 

Albert Edwards, an outspoken and eccentric global strategist for Societe Generale, sounded eerily similar to Dalio and Cowen when he spoke to Fortune in November. “We’re going to end up with runaway inflation at some point,” Edwards said, “because, I mean, that’s the end game, right? There’s no appetite to cut back the deficits.”

The god out of the machine

There is, however, a deus ex machina that could change the course of things: the productivity miracle that many economists expect to come, driven by artificial intelligence. If AI could boost U.S. GDP growth by a full percentage point per year, Cowen said, the country might grow its way out of the debt trap without resorting to a decade of high inflation. Yet he is skeptical. 

Roughly half the U.S. economy—government, higher education, much of healthcare, and the nonprofit sector—is structurally sluggish, he argues. AI may save workers enough time in these sectors to “hang out more at the water cooler,” but not enough to dramatically raise output. Meanwhile, innovation might just concentrate at already-productive sectors of the economy. Without a radical efficiency gain in the half of the economy that doesn’t produce “white or black-belt” AI tools, the debt clock will continue to outrun the AI revolution.

The result is a new, more dangerous era for the U.S. dollar.

“I’m not telling you not to worry” about Fed independence, Cowen said. “I’m telling you should have been worried to begin with.”

And yet, as Morgan Stanley noted in early January, something else appears on the calculus along with the latest rumbles about central bank independence: a 4.9% boost to annualized productivity, as suggested by fresh third-quarter GDP data. 

“We believe much of the rise is cyclical,” economists led by Michael Gapen noted, adding “it remains an open question as to what is driving the productivity acceleration.”

This story was originally featured on Fortune.com