Policy game framework of the Trump 2.0 era

In early-November, following Trump's election as the new president, the market was momentarily engulfed in optimism over a new round of expansionary policies, experiencing a surge in U.S. stocks and a strengthening dollar. However, with Trump's formal inauguration and the gradual unfolding of his actions, the policy trajectory of the 2.0 era seems to be taking shpe, potentially differing from initial expectations.

After Trump took office, several developments sparked intense market discussions, including a comprehensive foreign tariff policy, active efforts to promote a ceasefire between Russia and Ukraine, and the upheaval caused by DOGE's significant layoffs. Throughout this process, the market observed a decline in the dollar index, a gradual cooling of economic data, and the Nasdaq has already retraced all its gains since November. The logic surrounding the actions of the new U.S. government may be shifting in the market.

1. Fiscal constraints facing the Trump administration

From the current situation, fiscal constraints appear to be a significant challenge that the Trump administration will need to address, as the elevated deficit rate is already placing considerable pressure on the economy.

How high is the deficit rate in the U.S.? As of March 2025, the federal government's deficit rate has surged to 7.3% (for the fiscal year 2025), significantly higher than the 6.4% recorded in 2024. This increase is primarily due to tax cuts, rising defense and border spending and a heavier interest burden. The European Union's Stability and Growth Pact sets a 3% deficit ceiling, and while many countries exceeded this limit during the financial crisis and the pandemic, consistently surpassing it could lead to a loss of credibility.

What are the potential issues if the high deficit is not addressed? A direct consequence is the substantial interest on debt: in the first four months of 2025, net interest payments accounted for 38% of the deficit, and for the entire year, it may exceed $1.3 trillion, surpassing defense spending. Theoretically, the U.S. can issue new debt to pay the interest on existing bonds, but if the credit rating of those bonds declines, it may face a lack of buyers. Currently, the three main buyers of U.S. Treasury bonds are foreign central banks, domestic banks and the Federal Reserve.

2. How to solve this problem? It's nothing more than opening up revenue, cutting expenditure and debt deferral

Firstly, the government plans to reduce spending, which includes cutting military expenses, decreasing foreign aid, and laying off public sector employees.

1. Military spending cuts: The Trump administration has recently proposed an annual reduction of 8% in the defense budget over the next five years, aiming for a total reduction of $300 billion by 2030, while exempting "strategic assets" such as those in the Indo-Pacific region and nuclear submarines.

2. Foreign aid freezes: The Trump administration announced significant cuts to foreign aid contracts from the U.S. Agency for International Development (USAID) and the State Department, planning to reduce about 90% of aid projects, covering approximately $60 billion in international assistance.

3. Public sector layoffs: Through a "buyout program," the government aims to lay off over 100,000 federal employees, targeting a budget reduction of 30%-40% for various agencies.

Efforts to resolve the Russia-Ukraine conflict quickly are unfolding against this backdrop.

Secondly, the government can also alleviate fiscal pressure through debt restructuring. Simply put, this involves extending the maturity of debt, converting short-term bonds into 10-year or 20-year bonds to gradually ease short-term debt pressures. Before this, it is also necessary to lower interest rates to reduce interest costs.

3. The trade-off between inflationary pressures, economic growth and tariff policies

To lower interest rates, it brings up another important goal: reducing inflation.

Trump once pressured the Federal Reserve to cut rates; however, due to the rising risk of inflation, the Fed paused its easing cycle.

In fact, lowering inflation is not only essential for controlling interest expenses by reducing rates, but it was also a commitment made to the public during Trump's tenure. Moreover, it is a prerequisite for the subsequent recovery of economic growth; otherwise, the economy could fall into the trap of stagflation.

However, with high input and high growth, it is challenging to bring inflation down. Therefore, Trump may need to balance inflation pressure, economic growth, and tariff policy: on one hand, tariffs are needed to support the growth of the private sector, while on the other hand, inflation pressure can be mitigated through public sector layoffs. Therefore, the intensity and pace of U.S. tariff policies may be connected to factors such as inflation trends and economic growth.

From this perspective, the essence of the Trump 2.0 policy mix may be "exchanging recession for space," meaning restructuring the economy through short-term pain. Thus, in terms of short-term impacts, Trump's policies might lead to more recessionary pressure, such as economic downturns caused by public sector cuts and demand growth pressures stemming from tariff disruptions. This poses challenges not only for the U.S. but also for the global economy. Of course, in the long run, if the economic structure transition is successful, it could benefit demand growth, but it also carries significant risks, such as whether tariffs can truly stimulate the private economy, whether the degree of economic recession is controllable, and related social issues.