The Coming Crash?

Thoughts on Trump's ongoing destruction of the economic world as we knew it, complacent markets, is Britain heading for an IMF bailout, and will France get there first

Photo by Tiana Attride on Unsplash

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In this newsletter:

• America’s New Role: Global gangster

• The Coming Crash: Complacent Markets

• Apocalypse Britain: 1976 redux?

• France’s Turmoil: The next euro crisis

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1. Global Gangster

It was another wild week in the ongoing destruction of the economic world as we knew it. Last Sunday I wrote about Donald Trump’s assault on the core principles of American capitalism (Trump’s Crony Capitalism). Since then, there has been no let up in events that once would have been considered truly shocking but now seem to cause barely a ripple in the markets. Here is a sample:

• Trump announced he was firing Lisa Cook, a Federal Reserve governor, on the basis of unproven allegations of historic mortgage fraud, as part of his ongoing campaign to gain control of the central bank and force it to cut interest rates. Whether he has the authority to do so is likely be ultimately decided by the Supreme Court. If he succeeds, it would mark the end of Fed independence, which for decades has been regarded by global markets as the ultimate guarantee of US commitment to monetary and financial stability.

• US tariffs of 50 percent on Indian imports took effect. Trump ostensibly imposed an extra 25 percent tariff to punish Delhi for importing Russian oil. But since no other country was similarly published, this is an unconvincing explanation. The New York Times reports that the actual source of the rift was Prime Minister Modi’s refusal to credit Trump with brokering the ceasefire that ended the recent conflict between India and Pakistan and thus bolster his campaign to be awarded the Nobel Peace Prize.

• Shares in renewable energy provider Orsted, which is 50 percent owned by the Danish state, tumbled after Trump halted work on a $1.5 billion windfarm that was 80 percent completed, casting doubt on a much-needed rights issue. No serious explanation was given for the decision, but it was widely noted that the decision came days after Orsted signed an agreement with Gavin Newsom, the Governor of California and leading Trump critic.

• Weeks after the one-sided EU-US trade deal, Trump threatened substantial tariffs against countries that impose digital services taxes. At the same time, it was reported that the Trump administration is considering imposing sanctions on European officials involved in implementing the EU’s Digital Services Act. As many feared at the time, Europe’s surrender to Trump has only emboldened the US president to demand ever greater concessions.

• A federal appeals court ruled that many of Trump’s tariffs imposed under emergency powers were illegal, but it allowed them to remain in place until October 14, giving the administration time to appeal to the Supreme Court, where Trump-friendly conservative judges are in the majority. Even if the Supreme Court upholds the verdict, Trump still has multiple avenues to reimpose most of the tariffs or could ask Congress to change the law.

What links all these stories together is the lack of anything that links them together other than the whims and grievances of Donald Trump. There is no grand strategy here, no attempt to replace one rules-based system with a new set of rules, or a new system. Instead, what is unfolding amounts to the concentration of quite extraordinary power in the hands of one man, who is free to exercise it in pursuit of his own narrow interests or personal vendettas apparently unconstrained by institutions, individuals or the rule of law.

In an essay for Foreign Affairs, Adam Posen, the president of the Petersen Institute for International Economics, presents a compelling argument as to where all this may be leading. He says that Trump is transforming America’s role in the global economy from providing insurance to operating a protection racket.

The previous insurance provider model was the ultimate win-win. The rest of the world benefitted from a reduction in global risks, which allowed them to focus their attention on developing and growing their economies, while America benefitted from “dirt cheap funding” and the chance to shape the global rules in its interests. The Trump administration may think that they are simply delivering a one-off increase in insurance premiums to better reflect the costs to the American taxpayer. But that is not how it is viewed by the rest of the world:

The United States’ withdrawal of its former insurance will fundamentally change the behavior of the country’s clients and its clients’ clients—and not in the ways that Trump hopes. China, the country whose behavior most U.S. officials want to change, will likely be the least affected, while the United States’ closest allies will be the most damaged. As other U.S. partners watch these reliant allies suffer, they will seek to self-insure instead, at great cost to them. Assets will become harder to save and investment abroad less appealing. As their exposure to global economic and security risks rises, governments will find that both foreign diversification and macroeconomic policy have become less effective tools for stabilizing their economies.

Evidence of how the world is adapting to America’s new role as global gangster can be seen in Modi’s decision to travel to Beijing this week to meet President Xi and attend the Shanghai Cooperation Organisation alongside Vladimir Putin and 20 other world leaders. As previously noted (EU-China), China has been taking advantage of the disruption caused by Trump to deepen economic links with the Global South. As Posen says, the biggest losers from this emerging new world order are those countries most dependent on the US for their security and thus least able to resist Trump’s pressure tactics, chief among them Europeans.

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2. The Coming Crash?

Why has Trump’s assault on the economic world we know it not provoked more of a market reaction? Paul Krugman wrote a great post on this last week. His answer, which certainly tallies with my observation based on more than 30 years in and around financial markets, is that markets have always been very poor at anticipating shocks, right up until the moment that they happen:

My read of economic and financial history is that market pricing almost never takes into account the possibility of huge, disruptive events, even when the strong possibility of such events should be obvious. The usual pattern, instead, is one of market complacency until the last possible moment. That is, markets act as if everything is normal until it’s blindingly obvious that it isn’t.

That said, a crash is coming to America sooner or later. At least, that is the conclusion of Kenneth Rogoff, professor of economics at Harvard and a former chief economist at the International Monetary Fund, in a must-read piece in Foreign Affairs on the likely consequences of America’s soaring public debt levels which is set to rise as a result of Trump’s Big Beautiful Budget Bill:

With long-term interest rates up sharply, public debt nearing its post–World War II peak, foreign investors becoming more skittish, and politicians showing little appetite for reining in fresh borrowing, the possibility of a once-in-a-century U.S. debt crisis no longer seems far-fetched. Debt and financial crisis tend to occur precisely when a country’s fiscal situation is already precarious, its interest rates are high, its political situation is paralyzed, and a shock catches policymakers on the back foot. The United States already checks the first three boxes; all that is missing is the shock.

Even if the country avoids an outright debt crisis, a sharp erosion of confidence in its creditworthiness would have profound consequences… In the long term, a severe debt or, more likely, an inflationary spiral could send the economy into a lost decade, drastically weakening the dollar’s position as the dominant global currency and undermining American power.

What might trigger such a shock is impossible to tell in advance. It could be the bursting of the AI bubble, which has been showing signs of cracking in the last few weeks. Or it could be events outside America. What is clear is that the only sure hedge against such a scenario is gold. No wonder that last week it hit another record high. Not all investors are waiting until the last moment.

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3. Apocalypse Britain

While Trump is busy tearing up the global order, in Britain much of the right-wing political and media class appears to have convinced itself that the country stands on the brink of economic and societal collapse. Indeed, it is hard to avoid the suspicion that some are actively seeking to bring such a crisis about. Breathless reporting by once-respectable newspapers on the location of planned demonstrations against asylum seekers has bordered on incitement. It is a credit to the public, or perhaps testimony to the legacy media’s lack of influence, that the numbers attending these demonstrations have been tiny.

On the economic front, the latest doom-mongering was prompted by a front page story in The Sunday Telegraph last week citing a prominent economist warning that Britain was on the brink of a 1976-style crisis, when the country had to be bailed out by the IMF. At almost any level, the comparison is absurd. Britain is not in the midst of a sterling crisis as it was back then - the pound has been rising not falling this year. Nor is at risk of losing market access: the most recent 10-year gilt auction was more than three times covered. Nor are today’s high energy prices in any way comparable to the inflationary oil shock of the 1970s.

To the extent that there is any justification for such panic-spreading, it lies in the recent rise in the 30-year gilt yield to 5.6 percent, close to its highest level since 1998 and the highest among developed countries. In isolation, that can be seen as the market casting a negative verdict on the UK’s prospects. But of course, it makes no sense to look at UK gilt yields in isolation, let alone 30-year gilts which have their own market dynamic. All major countries have seen a sharp rise in long-dated bond yields this year - the UK is hardly an outlier. Indeed, when one looks at rises in 10-year bond yields, the UK is well within the pack.

The fact that levels of UK yields are higher than peers should hardly come as a surprise. It can be largely explained by the fact that Britain has not only the highest inflation but the highest growth. Inevitably, that has led the market to conclude that UK interest rates will have to stay higher for longer than other major economies and so gilt yields have risen to reflect this.

Indeed, concerns about the long-term outlook for UK inflation and thus interest rates can only have been compounded by the bizarre decision of the Bank of England to cut interest rates in August. I wrote ahead of that decision how odd that would be (Frightened Old Lady), given that inflation is running at almost double the BOE’s two percent target and businesses and consumers expect inflation to remain well above target for five years - which is hardly surprising when one considers that the BOE has not hit its target for more than four years. UK inflation of 4 percent compares with just 2 percent in the eurozone.

Since then, the data has only reinforced the perception that the BOE made an error. The UK inflation rate in July came in stronger than expected at 3.8 percent. August flash PMI survey indicated that growth had accelerated over the summer to its fastest rate in over a year. Business confidence is rising, according to the latest Lloyds Business Barometer. Indeed, 63 percent of businesses said they felt confident about their own trading prospects - the highest level since 2014. That hardly tallies with the apocalyptic warnings in much of the media.

That is not to dispute that the UK faces a particular challenge with its public finances - in common with almost every other major economy. NIESR, an economics think-tank, forecast over the summer that Rachel Reeves could be faced with a £51 billion budget shortfall after the summer to comply with her fiscal rules, although most economists reckon it will be closer to £20 billion. Boxed in by her manifesto promises not to raise taxes on workers, Rachel Reeves has spent the summer engaged in endless kite-flying, as she tests political and market reaction to raising taxes on property and banks. That has inevitably given the media a field day and hardly instils confidence in Treasury policymaking.

The best articulation of the catastrophist case that I have read is this by Helen Lewis of Blonde Money. The argument runs that, despite a working majority of 155, Labour is unable to deliver a budget that fills the fiscal hole because of an extreme backlash in either the party or the country against the budget measures. In that scenario, Labour splits, Starmer is forced out, and Britain is plunged into a financial crisis until it can find a government able to deliver steep spending cuts.

I find this far-fetched. A fiscal hole of £20 billion is not huge in the context of a £2.6 trillion economy. Of course, it would be better if it could be filled with spending cuts - or, if taxes must rise, by a rise in income tax or VAT which carries fewer risks of unintended consequences. But as Pantheon Macroeconomics notes, to the extent that today’s higher gilt yields reflect concerns about increased borrowing and higher issuance, a budget that fills the fiscal hole will see those concerns fade. That would make today’s high yields a buying opportunity.

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3. France’s Turmoil

If Britain is unlikely to need an IMF bailout any time soon, what about France? In a startling intervention last week, finance minister Eric Lombard warned that France could be heading for an IMF bailout if the French parliament failed to back the government in a vote of confidence on September 8 that Prime Minister Francois Bayrou has called in an attempt to win backing for his budget plans. The government is trying to rein in a budget deficit that hit 5.8 percent of GDP last year to stem the growth in public debt, currently 113 percent of GDP.

Adding to the sense of impending crisis in France is the fact that French government bond yields have now rise to within a whisker of those of Italy, which has long been regarded as the greatest risk to eurozone financial stability. Indeed, France must now pay more to borrow than Greece, which a decade ago couldn’t even issue its own bonds. Now French 10-year government bonds yield 3.49 percent, nearly half a percent more than the equivalent Greek debt and around 0.8 percentage points more than German bunds.

That said, as with the UK, talk of imminent IMF bailouts is hyperbole. As Deutsche Bank notes:

First, the market is already pricing a lot of risk premium, as argued by our fixed income colleagues. [French government bonds] are now trading cheap on all their valuation metrics and already pricing in rating downgrades

Second, despite a very weak government, budget execution this year has been remarkably positive and in line with what would be expected to meet the government’s budget deficit target

Third, in the event of the government collapsing, it is not clear to us that the alternative that emerges would be worse than the current status quo. We will get either a new Prime Minister supported by the existing parties, or – in the event of an election – another fragmented parliament

True, the turmoil makes it unlikely that France will achieve Bayrou’s goal of cutting the deficit to 4.6 percent of GDP in 2026. But the market didn’t expect it would be able to deliver this anyway, with most analysts forecasting a budget target of closer to 5.1 percent. It is also true that a much bigger fiscal effort than anything proposed by Bayrou will eventually be needed to bring France’s debt under control. Goldman Sachs reckons that France will need to reduce its primary deficit before interest costs from 4 percent to zero simply to stop its debt burden growing as a percentage of GDP. The market knows that this is not going to happen this side of the presidential election, not due to take place until 2027.

In the meantime, the real risk to Europe is not that France’s political turmoil triggers an imminent new euro crisis, but that it makes it even harder for Europe to deliver the kind of reforms that are urgently needed to enable the continent to confront growing global threats. The depth of Europe’s predicament - and scale of what is needed - was set out in a hard-hitting speech last week by Mario Draghi, the former Italian prime minister, that echoes many of the core themes of Wealth of Nations over the last two years and which really merits reading in full.

Draghi’s core message was that recent events have exposed the idea that Europe’s economic power could translate into geopolitical power as “an illusion”.

Europe is ill-equipped in a world where geo-economics, security, and the stability of supply sources, rather than efficiency, shape international trade relations. Our political organization must adapt to the existential demands of its time: we Europeans must reach a consensus on what this requires.

To face today’s challenges, the European Union must transform itself from a spectator—or at best a supporting actor—into a protagonist.

Draghi’s argument is that to become a pole in the new multipolar world, Europe will need to deepen its integration. That means deepening the single market and investing in critical technologies. That in turn requires common debt:

Only forms of common debt can support large European projects that fragmented national efforts could never achieve. This applies to defense—especially research and development—to energy, with the investments required in European networks and infrastructure, and to disruptive technologies, an area where risks are very high but potential successes are crucial for transforming our economies.

But what are the chances of Europe agreeing on the new common borrowing that is urgently needed to fund its rearmament, technological capabilities and energy infrastructure if France cannot get its own borrowing under control? The same is true of plans to complete Europe’s banking union and integrate capital markets, which are much-needed to boost growth and European autonomy. A weak France means a weak Europe. In that respect, France’s inability to tackle its public debt may be sowing the seeds of the next euro crisis.