Eduardo Porter writes:

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. [Continue reading…]