Source Project Syndicate

PRAGUE, Czechia: Last week, after US President Donald Trump threatened to impose additional 100% tariffs on China starting next month, the US stock market tumbled, and bond yields fell. 

But markets have since rallied, apparently driven by the assumption that Trump will “chicken out” once again and that the US Federal Reserve will soon cut interest rates.

This pattern has become a feature of Trump’s second presidency, points out Brown University’s Şebnem Kalemli-Özcan. 

Investors understand “perfectly well” the risks raised by the Trump administration’s “bad economic policies.” 

Although the United States’ “long-term capacity to create wealth” is being systematically eroded, investors are “content to keep funding the US government at historically low yields,” because the “payoff structure rewards short-term momentum over long-term prudence.” 

This complacency will continue to pay – “until it doesn’t.”

The problem extends beyond risk-taking by institutional and professional investors, observes economist Dambisa Moyo. 

Digital platforms and mobile apps have drawn in a “surge of new retail participants” pursuing “speculative, short-term, and risk-heavy trading strategies.” 

If left unchecked, this frenzy could raise risks that extend beyond financial markets to include the “stability of household finances and, ultimately, the broader economy.”

Hilary J. Allen of the American University Washington College of Law points to another source of financial risk: an AI bubble. 

If this bubble bursts, leveraged financial institutions may be forced to engage in fire sales of many types of assets, not just tech stocks. 

A “crash in Ponzi-like crypto assets,” as well as stablecoin runs, is also likely. 

“Experts might not expect a stock-market crash to cause a financial crisis,” Allen notes, “but what if they are wrong?”

This risk underscores the Fed’s “policy challenge,” rooted in the “decoupling of US economic growth from the labor market,” explains Mohamed A. El-Erian of the University of Pennsylvania. 

If the Fed fulfills market expectations and cuts interest rates despite robust GDP growth, in order to “head off a labor-market slowdown,” it risks “further inflating asset prices and inadvertently fueling financial bubbles.”

To support financial stability, argue Nobel laureate economist Simon Johnson and former Securities and Exchange Commission policy director Corey Klemmer, the Fed should start by withdrawing the proposal to “reduce significantly the biggest US financial institutions’ capital requirements.” 

Given the proposal’s failure to “consider many of the possible consequences in any meaningful way, much less attempt to quantify the attendant costs and benefits,” it does not “does not provide a sufficient basis for final regulatory action.” 

Instead, it threatens to add “substantial additional risk to US financial stability.”