Last Monday, global stock markets plunged, with America’s benchmark S&P 500 enduring its biggest single-day drop since 2022, and Japan’s benchmark TOPIX index posting its worst performance in 37 years. Among the worst hit were large tech companies, reflected in a 3.4% drop in the NASDAQ index.

Mohamed A. El-Erian, President of Queen’s College at The University of Cambridge, warned that this could happen, as two pillars of US investors’ bullishness over the last year – “faith in the ‘sky-is-the-limit’ prospects of certain technology firms” and “widespread confidence in American economic exceptionalism” – came under growing pressure. This left the “durability of any positive outlook” more dependent on the third pillar: “enduring faith in the US Federal Reserve to support financial assets.” But that faith was shaken when the Fed defied expectations by deciding not to cut interest rates last week.

For James K. Galbraith of the University of Texas at Austin, this is no surprise: he argues that the Fed essentially “engineers” a recession “whenever unemployment is low and the president is a Democrat.” And a recession, in his view, is exactly what the market meltdown portends. If the “Fed’s economic shock” causes a slump, it could cause Democrats to lose the White House in this November’s presidential election.

According to J. Bradford DeLong of the University of California, Berkeley, this prospect – which implies a second presidential term for Donald Trump – is precisely why “inflation hawks” are wrong to “worry most about a premature lowering of rates.” After all, Trump has made his “inflationary, financially destabilizing intentions all too clear.”

But the Fed is not solely to blame for the recent stock-market turmoil. As Harvard’s Kenneth Rogoff pointed out last year, investors have long been shorting Japanese bonds on the assumption that interest rates would rise and bond prices would fall – the so-called widow-maker trade – but their hopes were repeatedly dashed. Now, the Bank of Japan has moved toward raising rates precisely when other central banks are pursuing cuts – a step that Rogoff fears could spark a “systemic financial crisis.” Add to that the unwinding of the yen carry trade, whereby investors borrow in yen to invest in higher-yielding assets, and market volatility was all but inevitable.

What is still not clear, says economist Dambisa Moyo, is whether a “financial-market bubble” is set to burst fully, and what might follow. But two factors can indicate the likelihood of “a market correction or a broader economic crisis”: the intrinsic productive value of underlying assets, and how investments are financed. That is why “greater scrutiny of unproductive, leveraged assets is crucial.”

CAMBRIDGE – Investors in US markets over the past year have shown a remarkable ability to brush off domestic and external risks to the economy’s well-being, as well as to the functioning of the global economic, financial, and trading system. This decoupling of risk from market sentiment has been driven by three factors: faith in the “sky-is-the-limit” prospects of certain technology firms, widespread confidence in American economic exceptionalism, and enduring faith in the US Federal Reserve to support financial assets. But two of these factors have lately come under pressure, leaving the durability of any positive outlook more dependent on the third.

A number of developments over the past year would normally have led to volatility, and a downward overall trend, in stock markets. The Hamas-Israel war – and the agonizing images of the large-scale loss of innocent civilian lives and massive destruction of livelihoods and physical infrastructure – has increased the probability of a region-wide conflict that could further disrupt shipping and trade, and drive up oil prices.

Moreover, the Sino-American relationship has grown only tenser. With the United States imposing yet more restrictions on technology-related exports to China, other countries are forced to navigate an increasingly complex field of secondary sanctions. The US presidential campaign has reminded everyone that new waves of tariffs against allies and adversaries could come as soon as next year. Meanwhile, domestic and regional elections have weakened moderate center-left and center-right parties in key European countries.

Investors’ ability to look past these developments cannot simply be attributed to the old mantra that “markets are not the economy, and the economy is not the markets.” Instead, markets have been insulated by the three factors mentioned above.

The first – ever-greater confidence in certain tech companies – reflects the impact of, and high hopes for, the artificial-intelligence revolution, a historic technological shock that is still gaining momentum. The direct effect is reflected in the US stock market’s impressive gains. But these have been driven mostly by just a handful of tech firms that are immediately connected to new generative and predictive AI models and their supporting infrastructure and hardware.

These firms have experienced eye-popping surges in their market valuations. The leading example, of course, is Nvidia, the market capitalization of which has exploded from under $300 billion in late 2022 to over $3 trillion this past June. Other winners include already dominant tech firms like Alphabet (Google) and Microsoft.

The market’s infatuation with these companies is not only understandable, but also warranted. They are at the forefront of a technological breakthrough that will fundamentally reshape much of what we do and how we do it. The products and services they are rolling out promise to drive widespread productivity gains that could improve the outlook not just for some companies, but for entire economies.

But while the reasons for optimism in these companies remain strong, the sharp increase in their stock prices has triggered a debate about whether a pause may be needed. After all, such unbridled enthusiasm could culminate in a costly bubble, the fallout from which would not necessarily be confined to one sector or economy.

Confidence about America’s continued economic exceptionalism is also coming under pressure. While overall consumer spending remains robust for now, lower-income households are already under considerable strain, as are small businesses. Much therefore depends on the US labor market, given its centrality to incomes, spending, and financial security. And here, the data are mixed, with some metrics – such as the overall unemployment rate – starting to flash yellow.

These developments make the Fed’s monetary policy even more important. The general assumption among investors is that “the Fed has our back.” This “Fed put” usually translates into expectations that any economic slowdown or bout of excessive market volatility will trigger a swift loosening of monetary policy. The Fed’s reactions to crises over the past two decades – from the 2008 crash to the COVID-19 pandemic – have reinforced this behavioral dynamic in US markets, as has its response to smaller episodes of market tumult, such as in the fourth quarter of 2018.

Does continued confidence in the Fed put remain warranted? Yes, but only if the Fed can look beyond its stated desire to get inflation down to its 2% target as soon as possible. That will mean cutting interest rates in the next two months to avoid an overly restrictive monetary policy, which in turn could cause undue damage to employment and the economy. Indeed, too tight of a policy could further weaken the first two factors, making it a lot harder for markets to continue to brush off the ever-expanding sources of domestic and international uncertainty.

AUSTIN – The stock market crash is – perhaps – the long-awaited signal of a US economic slump. For President Joe Biden’s administration and Kamala Harris’s presidential campaign, the timing could not be worse. For years, they have tried to sell their economic record as a success story. With markets in decline and unemployment rising, that sale just went from hard to impossible.

The market meltdown and impending recession come over two full years after the Federal Reserve started hiking interest rates to “fight inflation.” They are the direct, but delayed, consequence of that policy. So, the Fed’s policy is finally having its intended effect – over two years after inflation peaked and began to fall, for reasons unrelated to the Fed’s policy.

Will a recession now come? For at least 40 years, an inverted yield curve on US Treasuries has been a reliable indicator of recession in America. In 1980, 1982, 1989, 2000, 2006, and 2019, the interest rate on 90-day Treasury-bills rose above that on ten-year bonds, and a slump followed within a year. In all cases after 1982, the inversion was over when the recession arrived – but it arrived nonetheless.

This happens because when the Fed raises short-term interest rates, credit for business investment, construction, and mortgages begins to dry up. Why lend at 4% or 5%, or even more, with risk, when you can park your cash, risk-free, for 5%? Other factors, including a rising dollar (bad for exports), and interest resets on old loans (bad for credit card and mortgage defaults, notoriously in 2007-08), also play a role. Eventually, long-term rates start to rise, and the inversion ends, but then high long-term rates do further damage.

In this cycle, while the yield curve inverted in October 2022, no recession ensued – until now. Offsetting forces supported the economy, including very large fiscal deficits, the payment of interest on a historically large national debt, and the direct payment of interest (since 2009) on very large bank reserves. The economy rolled along, despite the Fed’s best efforts to slow it down.

No more. Unemployment is up almost a full percentage point over the past year, and job creation is way down. The number of newly unemployed, newly employed part-time for economic reasons, and those not in the labor force but wanting a job increased by over a million from June to July. Claudia Sahm’s indicator of recession – a half-point increase in unemployment on a three-month moving average basis – is blinking red. The Sahm rule has held since at least 1960.

In 2007, two co-authors and I studied the history of Fed behavior in response to economic conditions. We found that, contrary to rhetoric, after 1984 the Fed ceased reacting to inflation (to be fair, there was not much to react to). Instead, the Fed would raise short-term interest rates in response to a low or falling unemployment rate – the classic concern of bosses who fear their workers may demand higher wages or desert them for better jobs.

Most important, we tested whether the US presidential election cycle had a statistical effect on the yield curve after controlling for inflation and unemployment. We found – in every model we tried – that there was a distinct and strong effect: in presidential election years, the Fed pursues an easier policy if the Republicans hold the White House, and a tighter one if the president is a Democrat. Specifically, our model predicted a tightening effect of about 1.5 points when the unemployment rate is low, with an additional 0.6 in a presidential election year when the Democrats hold the White House, compared to an easing effect of 0.9 if the president is Republican. Thus, in an election year with low unemployment, the predicted swing is about three percentage points in the yield curve.

In all key respects, our 17-year-old model predicts the current situation. From bosses’ point of view, unemployment has been disturbingly low. And a Democrat is in the White House. The yield curve is inverted by about 1.5 percentage points. We therefore would have expected a flat yield curve if the president were a Republican, and a positively sloping curve – the normal situation – if unemployment had also been higher. Statistically speaking, the model explains why the Fed has stubbornly refused to lower interest rates, despite the steady decline in the inflation rate.

Democratic presidents have no one to blame for this but themselves. For decades, they have deferred to the Fed as the “fight inflation” institution. For decades, they have reappointed Republican chairs: Alan Greenspan, Ben Bernanke, and Jerome Powell. Beyond the chairs, bankers and economists are strongly represented on the Fed’s Board of Governors and in the regional Federal Reserve Banks. 

These people may see themselves as non-partisan high priests, but they are broadly aligned with Wall Street and against the interests of workers. The result, predictably, is recurrent paralysis of progressive economic policy.

Back when Democrats took workers seriously – roughly the late nineteenth century through the 1960s – they understood that Big Finance had to be confronted and controlled. From the 1930s until the late 1970s, America had regulations and regulators committed to that task. But this dispensation was largely swept away in the 1980s, and since the Bill Clinton era the Democratic Party has left the Fed alone – and received a lot of Wall Street cash in return.

This presidential campaign has seen a lot of twists and turns. The Fed’s economic shock – if it continues to develop – will be another big one. Given the possible effect come November, Democrats may now face another long period out of office. May they use it, if they must, to reflect on the unwisdom of their 30-year bargain with Big Finance.

BERKELEY – Inflation in the United States is lower than it was a year ago, and substantial economic weakness elsewhere is driving other central banks toward interest-rate cuts. With little empirical basis to believe that US monetary policy is not restrictive, I continue to believe that in 18 months, the US Federal Reserve will have wished that it had started cutting rates in January 2024.

If I am right, the US is not headed for a soft-landing path; it is already on the runway, albeit with a monetary-policy rudder steering sharply toward contraction, rather than being held in a straight-ahead neutral position. Yet many commentators and Fed officials continue to believe that interest rates should remain at their relatively high levels, because they are fixated on the 1977-79 period, when a near-stabilized inflation rate spiraled out of control.

Back then, the Carter administration’s nominal GDP forecast had been dead-on, real growth came in two percentage points low, and inflation came in two percentage points high. Then came the Iranian Revolution and the second major oil-price spike of the decade, leading ultimately to the “neoliberal turn,” the Volcker disinflation (when the Fed hiked rates to 20%), and Latin America’s “lost decade.” To those who worry that history will rhyme, keeping interest rates too high for too long is a risk worth taking.

But even if you are an inflation hawk, why would you worry most about a premature lowering of rates? Is a recurrence of 1977-82 really the scenario that should keep you up at night? With Donald Trump seeking to return to the White House, surely there is a much bigger risk on the horizon. Among other things, Trump has promised to impose significantly higher tariffs than Biden has. And while Biden at least has national-security and industrial-policy rationales for his trade policies, Trump would pursue random, chaotic, corruption-ridden interventions that are almost certain to be substantially inflationary.

Moreover, Trump is keen to remove Fed Chair Jerome Powell through untested legal means, so that he can either install a loyal crony or at least set off a fight with Congress in which he can appear to be challenging the “establishment.” He is also itching to mobilize social-media mobs, if not real-world insurrectionist terrorists, against Fed governors and bank presidents who refuse to lower interest rates at his command.

Far from hyperbole, this threat of political violence is a familiar issue in Washington today. As journalist McKay Coppins writes in his recent book on Mitt Romney: “One Republican congressman confided to Romney that he wanted to vote for impeachment, but declined out of fear for his family’s safety. The congressman reasoned that Trump would be impeached by House Democrats with or without him – why put his wife and children at risk if it wouldn’t change the outcome?”

This would be a MAGA rerun of Andrew Jackson’s Bank War in the 1830s, when the president ultimately succeeded in killing off the Second Bank of the United States, arguing that it benefited a wealthy elite at the expense of the American people. In fact, the Bank War ultimately brought financial disruption, commercial bankruptcies, and deflation, thus destroying some share of national wealth and shifting the rest from entrepreneurial debtors to already-rich creditors.

True, later historians argued that Jackson’s battle against the oligarchy of Philadelphia bankers led by the Second Bank’s president, Nicholas Biddle, prefigured Franklin D. Roosevelt’s battle against “economic royalists” a century later during the New Deal. And yet, nothing is better for already-rich heirs and heiresses than general deflation. Should Trump return to the White House and launch a Fed War, the effect would be as economically damaging as Jackson’s Bank War. But, like the Bank War, the effort would probably be popular with his base.

Is this all overblown? Bill Dudley, the former president of the Federal Reserve Bank of New York, recently downplayed the risk that Trump would pose to Fed operations, arguing that the next president will appoint only two of the Federal Open Market Committee’s 12 voting members. I am less sanguine. Fed governors and bank presidents who do not feel like spending $5,000 a day on security might be induced to resign. And while the Fed chair can be dismissed only “for cause” (inefficiency, neglect of duty, or malfeasance), the conservative majority on the Supreme Court has demonstrated that its commitment to precedent, original intent, or the black-letter meaning of statutes cannot be taken seriously.

Moreover, Dudley himself recognizes that another Trump presidency would be damaging enough, regardless of what he manages to get away with:

“The dollar has become the world’s reserve currency and a stable store of value thanks to prudent economic management, a strong rule of law, deep and liquid capital markets, and free movement of capital. If efforts to control the Fed threatened these key attributes, the dollar would likely weaken, stock markets would decline and risk premia on US fixed income assets would increase, impairing the country’s economic health.”

For now, Powell and the FOMC are doing their best to make marginal adjustments to interest rates and financial conditions to keep the economy in its soft-landing, slowing-on-the-runway groove. The biggest threats to monetary and economic stability right now have nothing to do with what they decide at their next meeting. If inflation hawks are serious about price stability and the long-term economic outlook, they should be much more worried about the return of Trumpism.

CAMBRIDGE – Could Japan become the world’s next great growth story? Billionaire and legendary investor Warren Buffett seems to think so. And the International Monetary Fund expects the Japanese economy to grow by 1.4% in 2023 – an impressive figure for a country whose population has steadily declined for the past 14 years.

But the Japanese economy could also be a ticking time bomb. Its labor market is tight, inflation remains stubbornly high despite the introduction of gasoline subsidies, and the yen’s real exchange rate has reached a three-decade low. After decades of maintaining near-zero interest rates, it is unclear whether the Bank of Japan can raise them without sparking a systemic financial crisis.

While the BOJ’s new governor, Kazuo Ueda, has said that the Bank will maintain its ultra-loose monetary policy, he also acknowledged the global economy’s “very high uncertainty.” Given the forces driving up inflation and interest rates worldwide, it is increasingly clear that Japanese monetary policy can no longer be conducted in isolation.

Over the years, many investors have bet against the BOJ, shorting Japanese bonds on the assumption that the zero-interest-rate policy could not last. Time and again, the speculators were crushed. Now, however, the “widow-maker trade” might actually pay off.

The BOJ’s reluctance to increase its short-term policy rates is understandable, given that Japan’s gross government debt currently stands at 260% of GDP, or 235% of GDP after netting out $1.25 trillion in foreign-exchange reserves. Should the Bank be compelled to raise its short-term policy interest rates by 3% – about half as much as the US Federal Reserve has – the government’s debt-servicing costs would explode.

Moreover, a sharp interest-rate increase would put enormous pressure on the Japanese banking sector, particularly if long-term rates were to rise as well. This is precisely what happened in the United States in March when the Fed’s monetary tightening triggered a chain reaction that led to the collapse of Silicon Valley Bank and several other financial institutions.

Hiking interest rates in an environment of near-zero interest rates, when investors expect rates to remain ultra-low forever, will be challenging, no matter how the BOJ frames its actions. But if inflation remains persistently high, policymakers will be forced to act. After all, markets will inevitably push up rates across the yield curve.

Over the past two years, as real interest rates have soared worldwide, they have declined in Japan, despite the rise in inflation. This is not sustainable in the long run, given the country’s deep integration into global financial markets.

As one of the first industrialized countries to grapple with population decline and a systemic financial crisis, Japan has served as the world’s macroeconomic laboratory for more than two decades. While some pundits cite Japan as evidence that enormous government debts do not matter, the fact is that they do. Like other highly indebted countries such as Greece and Italy, Japan has experienced extremely low average growth over the past three decades. In the early 1990s, Japanese GDP per capita reached 75% of US levels; it has since declined to less than 60%, even though the US experienced only modest growth during this period.

In addition to its debt problems, Japan’s economy is caught in the middle of the escalating rivalry between the US and China. Over the past few decades, as Ulrike Schaede notes in her insightful book The Business Reinvention of Japan, Japanese firms have found a high-value niche within the Asian supply chain. While the country’s most profitable companies may not be household names, primarily because many of them provide intermediate products to businesses rather than final products to consumers, they operate in high-tech sectors with huge markups.

But much of this economic reinvention has been based on taking advantage of China’s rapid growth. Now that the Chinese growth engine is sputtering, and with heightened geopolitical tensions threatening to make things worse, it is unclear whether this unique strategy can last.

At the same time, much like Europe, Japan faces the urgent need to boost defense spending. Alarmed by China’s growing assertiveness, especially in light of Russia’s invasion of Ukraine, the Japanese government has unveiled plans to double military spending to 2% of GDP in the next five years. With such spending likely to increase further in the long term, Japan will no longer be able to maintain low taxes by free-riding on the US defense budget.

To be sure, as the world’s third-largest economy (after the US and China), Japan has many tools to tackle its demographic and economic challenges. For example, it could confront outdated corporate social norms that discourage women from having children. It could also use public-policy tools, such as welcoming more immigrants.

But policies to stem decline will only bring forward the need for interest-rate normalization. The most severe financial crises often happen where they are least expected. A resurgent Japan is good for the global economy, but resurgent Japanese interest rates could be a major risk.

LONDON – The signs of bubbles emerging in financial markets are clear to see. The Dow Jones index recently surpassed 40,000 for the first time, and the UK FTSE 100 and French CAC 40 also have reached new highs. Forward price-to-earnings ratios in the United States are trading at a multiple of around 25 – well above the historical average of 16 – and these high valuations have persisted despite interest rates above 5%.

Such trends certainly justify worries about new stock-market bubbles. But not all bubbles are equal, and only some are problematic for the wider economy. What matters – as we saw after 2007 – is whether a burst bubble will trigger a chain reaction that undercuts growth for years thereafter.

From an investment perspective, two factors can provide an early warning of where and when a bubble might burst, and whether it will be followed by a market correction or broader economic crisis. The first is the underlying or intrinsic value of an asset (whether it is productive or unproductive); and the second concerns how that asset is financed (be it through equity, cash, or a substantial degree of leverage).

With this two-factor framework, we can evaluate four types of bubbles. The first – and least dangerous for the wider economy – involves a productive asset primarily financed by equity or investor cash. Think of an equity investment in a telecommunications or broadband cable company. If the bubble bursts, the lost capital will be largely contained or ring-fenced among the direct investors (those holding the stock), without many spillovers to the wider economy. Moreover, telecoms/cable companies hold tangible assets with intrinsic value, which both limits the downside risk and represents upside potential for when the economy recovers.

The second category is a bubble of productive assets funded by debt, as when corporations take on debt to finance their operations or remain a going concern. In this case, a bubble bursting can have systemic implications, because large losses will reverberate through the banking system or capital markets, ultimately slowing the economic recovery as financial institutions work through their losses and reduce lending. However, the losses to the economy will be limited, because this scenario still involves productive assets.

In the third scenario, unproductive assets are funded by equity or cash, as in the case of much cryptocurrency investing. Here, the underlying asset is unproductive in the sense that it will not yield a future cashflow stream. If it falls in value, there is no fundamental basis – business or financial, such as hard assets – from which it can recover. But like the first category, the equity/cash financing implies that the spillovers will be contained.

That brings us to unproductive assets financed by debt. The prime example is the subprime mortgage crisis that erupted in 2008-09. An excess of housing meant that the underlying asset was unproductive – uninhabited homes will not yield future cashflow streams – and the manner of financing through mortgage and debt markets meant that the collapse in house prices would trigger a chain reaction.

In today’s financial markets, one can find pockets of highly levered, arguably unproductive assets. Even more worrying, many of these lie outside the purview of regulatory oversight. For example, roughly 70% of leveraged loans and mortgages in the US are now held in the shadow banking sector, where institutions take on debt and provide financing without being subject to traditional banking regulations, and without recourse to emergency federal bailout facilities should they become illiquid or insolvent.

These investments obviously carry risk by dint of their debt exposure, and it remains unclear whether they are supported by productive or unproductive assets. Because they are in the shadow banking sector, there is far less visibility regarding the capital structure (the nature and sources of capital used to finance the investments). Specifically, we don’t know whether investments are being financed with leverage or through savings that have been accumulated over time. Moreover, if a company has taken on debt, it is hard for outsiders, including regulators, to discern how much the asset is leveraged.

While a loss taken by someone who used accumulated savings will have only a limited effect on the wider economy, losses taken on “borrowed” money, especially with high leverage, could prove contagious.

A system with low visibility regarding the sources and forms of capital underlying many investments is a risky one. Greater scrutiny of unproductive, leveraged assets is crucial to avoiding a financial crisis.