USA in 1970’s was reeling under the effect of rapid monetary expansion fueled by the huge military spending to sustain the Vietnam war and the splurge in social security spendings under the Great Society Program. Inflation proved to be untamable despite repeated hikes in interest rates. To add to the woes, USA also faced persistent trade deficits with the rest of the world, resulting in a steady erosion in confidence in the US dollar. Countries with trade surpluses started converting their dollars into gold, creating a de facto run on the US Treasury, eventually forcing USA to disavow the gold standard which they had helped create in 1945. USA in effect defaulted on their debt without saying so. This and other associated measures provided some respite as the currency depreciated and exports picked up, but the worst was yet to come. In 1974, the OPEC nations jacked up oil prices in retaliation for the US support to Israel in the Yom Kippur war, jolting the already lumbering US economy into oil-shock. The result was the first case of full-blown stagflation in all its elements that stayed on to dog the USA through most of the seventies.
Fast forward to 2025. Do we get a sense of deja vu? US debt is at an all time high of $36 trillion with the annual interest payout estimated to reach nearly 19% of the Fed budget in 2025! The trade deficit woes of the US has continued unabated, smoothened only by the robust capital account flows. And that also is changing. For some time now, countries like China and India have been dumping US dollar and buying up gold, just like France and Germany did in the 1970s. In short, some of the actors may have changed, but the script that is playing out looks eerily similar. The only thing that has been missing is the supply shock, but not any more. Trump with his tariff blitzkrieg has provided just that. So all the old ingredients are in the pot and the heat is turned on, will the broth be any different?
Not much hope, at least in the short term. It looks like we will see a replay of the seventies show with a new cast. There is a high probability that USA will slip into a stagflation soon, due to the combined effect of the high supply side inflation caused by import tariffs and the structural infirmities already entrenched in the system. Exports may rise, but only marginally because US exporters still have to compete with Chinese manufacturing juggernaut and also deal with retaliatory tariffs. The US dollar is likely to depreciate gradually or even sharply due to the reversal of capital account flows triggered by trust deficit and recessionary forces. However, in the mid-term the broad based fall in asset and commodity prices may counterbalance the inflationary forces, so the stagflation may turn into a normal recession after the initial shock. That is, the stagflation may prove to be transient rather than sticky, this time.
One thing we should not lose sight of is that there is some method in Trump’s madness. No-one likes market mayhem especially when the blood on the streets is our own, so it is natural to feel animosity towards the person orchestrating the carnage. But truth be told, USA has been a disaster waiting to happen for some time now. I believe Trump chose to engineer an implosion of the type and size of his own making rather than fending off of a future crisis precipitated by market forces or adversaries of the USA. This sentence may annoy many, but Trump is nobody’s fool. Unlike a currency crisis or debt default, a tariff war is something Trump can tweak, tinker and bend at will. The self induced recession may also help to refinance the old debt at lower interest rates, providing some breathing time to set the house in order. There is more. Trump’s real game plan appears to be to divide the world into two trade-blocs and force countries to choose sides. The real stand-off is between China and USA, others are mere side shows. The weakness of Trump’s plan is, to borrow his own phrase, he doesn’t have the cards. USA is no longer the USA of the 1970s and Trump has not been exactly making friends. So a lot will depend on how the other players act; will they call his bluff or agree to play along? I think most Western Bloc countries would eventually play along, because Trump’s USA may be an irritating bully but China is something else altogether. So old allies may play safe and stick to a known bully rather than side with a lurking menace. Whatever happens, one thing is clear: the world has changed forever. As Lenin said, ‘there are decades when nothing happens and there are weeks when decades happen’. This has been one such week.
The author is a banker and a blogger.
