How markets could topple the global economy

IF AMERICA’S stock market were to crash, it would be one of the most predicted financial implosions in history.

Everyone from bank bosses to the International Monetary Fund has warned about the stratospheric valuations of US tech companies. Central bankers are bracing for financial trouble; investors who made their names betting against subprime mortgage bonds in the 2007-to-2009 period have resurfaced for another “big short”.

At any sign of a wobble, such as a recent slight weekly fall in the Nasdaq index of tech stocks, speculation mounts that the market is on the precipice.

And no wonder. The cyclically adjusted price-earnings ratio of the S&P 500 index of stocks, propelled by the “Magnificent Seven” tech giants, has reached levels last seen during the dotcom boom. Investors are betting that the vast spending on artificial intelligence (AI) will pay off.

But the numbers are daunting. For companies to achieve a 10 per cent return on the AI capex projected by 2030, they will collectively need US$650 billion of annual AI revenues – equivalent to over US$400 per year from every iPhone user, reckons JPMorgan Chase, a bank.

History shows such lofty expectations are often disappointed, at first, by new technologies, even if they go on to change the world.

Yet, although a market crash would surprise almost nobody, few have thought about its consequences. That is partly because the chances of a big fall in stock markets bringing about a broad financial crisis are, for now, slim.

Unlike in the late 2000s, when widespread leverage and complex financial engineering helped cause a debt-fuelled bubble in subprime housing, today’s AI euphoria has been mostly equity-financed. What is more, the real economy has shown in recent years that it can weather shocks, from Europe’s energy crisis to American tariffs, remarkably well. Recessions are increasingly rare events.

Still, it would be a mistake to think that the effect of big stock market losses would stop at the wallets of investors. The longer the boom goes on, the more opaque its financing becomes. And even without financial Armageddon, a dramatic stock market fall might at last topple a hitherto resilient world economy into a downturn.

The root of the vulnerability is the American consumer. Stocks account for 21 per cent of the country’s household wealth – about a quarter of that at the height of the dotcom boom. Assets related to AI are responsible for nearly half the increase in Americans’ wealth over the past year.

As households have become wealthier, they have grown comfortable saving less than they did before the Covid-19 pandemic (albeit not as little as during the subprime boom).

A crash would put these trends into reverse. We calculate that a fall in stocks comparable to the dotcom bust would reduce US households’ net worth by 8 per cent. That could cause a big retrenchment in consumer spending.

By one rule of thumb, the pullback would amount to 1.6 per cent of gross domestic product – enough to push the US, where the labour market is already suffering, into a recession. The effect on the consumer would dwarf what is likely from any drying up of AI investment, much of which goes on chips imported from Taiwan.

The shock, and weaker American demand, would spill over to low-growth Europe and deflationary China, compounding the blow to exporters from US President Donald Trump’s tariffs. And because foreigners have US$18 trillion worth of exposure to American stocks, there would be a mini-wealth effect globally.

The good news is that a global recession with its roots in the equity markets need not be deep – just as the downturn that followed the dotcom crash was shallow, and avoided by many big economies.

Importantly, the Federal Reserve has enough room to lower interest rates to boost demand, and some countries would respond with fiscal stimulus. Yet, a downturn would expose vulnerabilities in today’s economic and geopolitical landscape by further weakening America’s hegemony, undermining government budgets and worsening protectionist instincts.

Without the AI boom, the US economy would be left looking as it did this spring: threatened by tariffs, beleaguered institutions and increasingly fractious politics (as we published this, America’s longest-ever government shutdown was only just coming to an end).

In a recession, the US would usually be a haven. But in these circumstances – and with the US taking the worst growth downgrade – a rush to the dollar, which is down by 8 per cent this year, would not be assured.

Although a weaker US dollar would be a blessing for the rest of the world, for which a pricier greenback tightens financial conditions, it would strengthen the idea that American exceptionalism is not what it was. The risk to the dollar would be especially great given that 2026 could bring far greater political influence over the Federal Reserve.

A recession would also put indebted governments everywhere to a stern fiscal test. Central banks would cut interest rates, easing the costs of servicing the rich world’s enormous debt pile, which is worth 110 per cent of its GDP. But deficits would widen, too, as welfare spending rose and tax receipts fell.

In the most vulnerable economies, fiscal fears might cause long-term bond yields to stay put or even rise as central banks cut short-term rates – a dynamic that has occasionally been on display over the past two years. It is hard to imagine markets affording France or Britain, say, much space for stimulus.

The final consequence would be for trade. Americans spending less would almost certainly reduce the trade deficit, which would please Trump. With markets in a bad way, the White House would also be less belligerent on trade.

But the other global-trade flashpoint – China’s surplus in manufactured goods – would worsen. Already, European and Asian producers must compete with a glut of Chinese goods, which is growing as China exports less to the US. A slowdown in America would cause that glut to swell further, sharpening the protectionist backlash.

The world may be predicting a US stock market crash. That does not mean it is prepared for the consequences.

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