A bona fide financial crisis has not broken out since the US housing meltdown of 2007. Even the Covid pandemic and subsequent upsurge in inflation didn’t lead to financial upheaval. The jitters produced by the collapse of Silicon Valley Bank in 2023 were soon forgotten.
Given this stability, it might take some effort to convince financial markets that another big one is around the corner. But it is. Financial markets and their regulating governments may believe they have acquired immunity, but the world is careening toward a moment of financial upheaval that could well dwarf the damage caused by the last one.
What’s most scary about this approaching moment is not the specific nature of the crisis, but the incompetence with which it will be handled.
Current US politics practically guarantee that Washington’s policy response will be misguided, steered by Donald Trump’s incontinent appetites and animosities. In a world where mistrust has strangled space for collective action, damages are likely to be compounded by similarly blinkered responses around the globe. As Maurice Obstfeld, former chief economist at the International Monetary Fund noted: “The political fundamentals are really bad.”
We’ll never know exactly when and how a crisis will hit. But one can envisage plausible pathways. Perhaps a financial bubble pops: stocks buoyed up by the current euphoria over the prospects of artificial intelligence could be downgraded sharply in light of disappointing returns, sending the stock market tumbling, shrinking consumer spending and damaging balance sheets of companies that have piled into the AI dream, as well as their financiers.
The largest risk, at this moment, revolves around the federal government’s accumulation of debt, now in excess of 120% of the nation’s gross domestic product, a near unprecedented level. It is likely to keep on growing at a fast clip given massive built in budget deficits for the next decade.
Both of these scenarios live in a global context: the US’s insatiable appetite for capital – to finance datacenters or the federal deficit – is met by China’s export of capital to recycle its huge trade surplus. A coarse, schematic way to think of it is China sells stuff to the US and invests the proceeds in the US. Then, Americans take money from China and use it to buy Chinese stuff.
A win-win fix would be for China to spend more on their own stuff while Americans, especially the federal government, splurged somewhat less. Given politics in Washington and Beijing, this arrangement seems exceedingly unlikely.
It is unclear what would detonate a sell-off of US government debt. Treasury bonds still provide the largest, most liquid pool of safe investable assets. But markets were in a tizzy last week, sending rates on government bonds sharply higher over worries about the Iran war and inflation. One must only think back to 3 April last year, when Trump’s tariffs on everything sent the price of treasury bonds briefly into a tailspin, to realize that Washington’s increasingly idiosyncratic decisions could send investors running for the exit.
The world is not that of 15 years ago, when real interest rates neared zero and central banks in China and many developing countries held massive amounts of treasury bonds, providing a stable source of financing for US deficits. Today, investors buying treasuries want yield and diversification. They will mercilessly dump US assets if the tide turns sour.
The US’s dysfunctional politics can still do a lot of damage. Say Trump starts bombing Iran again, or invades Cuba, or Greenland. Say he manages to take control of the Federal Reserve, and strong-arm it to cut interest rates. Or say he further increases the deficit via some orgy of military spending. He shows no concern over growing federal debt. And Republicans in Congress show no interest in stopping him. Which of them will stand in the way of his appetites, given his ability – well on display last week – to take down anyone who dares oppose him?
The closest anybody in the government has come to articulate a plan to address the nation’s massive indebtedness was Scott Bessent, the US treasury secretary, who claimed that AI will save the day by generating massive productivity growth and thus enormous tax revenues to fill the government’s coffers. On this side of science fiction, nobody has said a word.
What happens if investors freak out and sell off treasuries, raising interest rates on government debt? Trump might strong-arm the Fed to buy the bonds and keep rates low. But pumping that money into the economy would stoke inflation, which would encourage more investors to flee for the exits, sending the dollar into a tailspin.
The ideal strategy would be to close the hole in the federal budget. The Fed might force that path by refusing to print money and buy government debt. But Trump is unlikely to appreciate austerity. Given his lock on Congress and his increasing sway over the Fed, the odds of this are slim.
“If you try to war game it, the Fed doesn’t have any good options,” Obstfeld argued. “The only good option is fiscal regime change in the Congress.” That is not likely to happen.
Unfortunately, the US is not the only victim of snarled politics. France faces the unhelpful combination of a budget crisis and a looming election which is likely to bring to power a populist right wing that has much to share with Trump’s Maga.
China, the global player on the other side of the US’s financial imbalances, may not face political instability. But it has demonstrated little interest in helping address the imbalances contributing to the world’s financial fragility – insisting on a strategy of subsidizing manufactures for export in order to generate jobs.
What will we get when the crisis hits? It is hard to tell. Given the animosities that Trump has worked so hard to kindle, international cooperation is unlikely to play much of a role. We stare into an unprecedented future, one in which a financial crisis like the world has never seen invites the most self-defeating government response ever. It will be interesting to see what emerges on the other side.
