Fiscal and Monetary Policy: On Thin Ice

Will Kevin Warsh Move the Crowd From the Ice?

Pieter Bruegel the Elder, Winter Landscape with Skaters and Bird Trap (1565)

It is a desperately unpopular undertaking to dare to sound a discordant note of warning in an atmosphere of cheer, even though one might be able to forecast with certainty that the ice, on which the mad dance was going, was bound to break.

This quote is from Paul Warburg, one of the architects of the Federal Reserve System, who was referring to the years just prior to the market crash of 1929. While we live in a different era, the warning is timeless. The façade of prosperity can be premised on policies whose consequences sometimes are too long ignored—and deadly. The U.S. economy today is the world’s greatest, but its fiscal and monetary policies are excessive and unsustainable, and because of that, they have placed the nation’s economy on thin ice.

The Dance Continues

For the moment, the economy continues to grow moderately. The year just finished saw better than 2% GDP growth, and for 2026 Congress has provided additional tax incentives and spending intended to assure growth through the year. As a result, the U.S. has experienced a record-breaking stock market, rising asset values and high housing prices, and consumers are taking advantage of these benefits to borrow against rising values and expand consumption.

Also, while investment in capital goods is mixed, there is strong capital demand for AI investment, projected this year to reach $2 trillion globally and over $500 billion for the United States. The volatility of tariffs has added uncertainty to the economy, but their effects appear to be less significant than originally feared. Finally, the government is deregulating American businesses, thereby promoting innovation. This all suggests continued growth through this year at least.

Underpinning this economic story, however, have been highly stimulative fiscal and monetary policies that carry large risks to the nation as debt levels rise and the Federal Reserve (Fed) prints money to monetize that debt. At the start of this year, a series of tax incentives took effect: tax exemptions on employee tips and overtime pay, reduced taxes for senior citizens, tax deductions for car purchases and tax breaks on capital expenditures, all designed to boost growth. As a result, during 2026, the federal government again will spend over $6 trillion but fund only $4 trillion of that spending out of current revenues.

Complementing this fiscal expansion, and despite rhetoric to the contrary, the Fed restarted its accommodative monetary policy. The real fed funds rate is 1% (the Fed has lowered the nominal rate to near 3.5% while Consumer Price Index inflation is 2.5%.) The neutral, or equilibrium, policy rate is likely above 1% as U.S. productivity gains, returns on capital and corporate demand for capital have likely pushed the equilibrium real rate higher. Accompanying lower interest rates, the Fed has resumed quantitative easing operations, purchasing more than $40 billion per month of new government securities, thereby rapidly expanding its monetary base.

Fiscal Dominance Effect

These policies are designed to run the economy hot. However, while bullish and exciting in the moment, these policies come with risks.

The federal debt has exploded; liquidity demands to fund this debt have increased proportionately. The Fed once again has stepped forward, determined to assure a smoothly functioning, liquid and stable Treasury market. It will succeed in doing so, but at the cost of reallocating resources and undermining its primary mission, price stability.

Much is made of attempts to make the Fed bend to political pressure, but long before its independence became an issue, it had already surrendered much of that independence. For decades the Fed repeatedly intervened in nearly every U.S. money and financial market crisis, providing needed liquidity and making markets temporarily stable. It intervened in markets during the Great Financial Crisis, the pandemic and the 2019 bailout of the highly leveraged government securities market. Unfortunately, in each of these instances, the Fed left emergency measures in place long after the crisis had passed. Its actions reduced market accountability, changed market incentives and promoted speculation.

These actions also have changed incentive for the federal government, which has come to expect the Fed to ensure that the exploding Treasury debt market remains liquid and runs smoothly with low, stable rates. Beyond its mandates regarding price stability and employment, the Fed implicitly is determined to do “whatever it takes” to meet that expectation. The result has been dramatic. Consider, for example, all that happened between 2005 and 2025:

• Nominal GDP increased two and a half times, from less than $13 trillion to over $30 trillion, while real GDP increased one and a half times.

• The CPI index almost doubled.

• The gross federal debt increased nearly 5 times, from $7.9 trillion to $38 trillion.

• The Standard & Poor’s 500 index increased five and a half times, more than the national debt

• In contrast, real weekly earnings, wage and salary, increased only 1.2 times.

These numbers show the effects of voluntary fiscal dominance. If this trend continues, the U.S. will add $2 trillion or more of debt to its balance sheet each year well into future, and the Fed will print the base money to assure funding. For example, it has just committed to buying $40 billion of Treasury debt each month. The party continues, but another crisis is inevitable if the U.S. stays on this path.

Avoiding the Break

Without change, the ice on which the economy rests must break. Kevin Warsh, President Trump’s nominee to chair the Fed, recently proposed establishing a Fed–Treasury policy accord, like that established following World War II, the last time the debt-to-GDP ratio exceeded 100%. At the time, as now, the Treasury wanted the Fed to keep interest rates and the cost of the federal debt low. Inflation was rising, however, and the Fed couldn’t both peg low rates and control inflation. The conflict between the Treasury and the Fed was tense, but ultimately, they reached a compromise in the form of the Fed–Treasury Accord of 1951, which freed the Fed to pursue its price stability objective.

Over the following decade, the U.S. debt-to-GDP ratio fell from 90% to 55%. Fiscal deficits averaged close to 2% of GDP. Fed policy rates averaged to 2.5% and were never higher than 3.5%. The unemployment rate averaged 4.6%. And impressively, inflation remained near 2% while real GDP growth averaged 4%.

Thus, the new Fed chair, working with the Treasury, could establish a new Fed–Treasury Accord of 2026. Under it, the Treasury and the administration, working with Congress, could carefully reduce the deficit from nearly 7% of GDP to 2% or 3%. With less debt to fund, upward pressure on interest rates would ease, allowing the Fed to pursue real price stability, and the Treasury could steadily grow out of the debt dilemma. As history suggests, the nation would enjoy renewed, sustainable economic growth. While the postwar economy was different from today’s, there is no reason that a renewed discipline around fiscal and monetary policy couldn’t provide similar outcomes, before the ice breaks. The U.S. cannot continue its current path, consuming more than it produces and creating and monetizing enormous fiscal and international deficits, without devastating consequences. A new Fed chair and Treasury secretary are well positioned to deliver results. The U.S. is the greatest economic success story in all of history, and if it chooses, it will remain so.