LONDON, April 11 (Reuters Breakingviews) - Donald Trump has suspended U.S. tariffs above 10% on imports from countries other than China. Investors let out a collective sigh of relief. Still, the events of recent weeks show that the president is serious about pushing the interests of his political base at the expense of Wall Street. His administration is also promising to reduce the U.S. trade and fiscal deficits. Trump’s policies pose an existential threat to the American bubble economy. As Japan discovered three decades ago, there’s no easy escape.
A bubble economy is one in which the financial sector crowds out the real economy. Asset prices become severely inflated and detached from their underlying fundamentals. Companies are managed to maximise financial returns rather than market share. As asset prices rise, capital gains replace genuine savings. A bubble economy is sustained by continuously rising debt, which is mostly used for financial purposes rather than investment. Credit growth also boosts corporate profits.
The United States meets that description. The contribution of its finance, insurance and real estate sector to GDP has doubled since 1945, while that of manufacturing has shrunk by more than half. In recent years, U.S. stocks have traded at near record valuation levels. By the end of last year, aggregate household wealth stood at 5.7 times GDP, far above its long-term average. Savings are around half their long-term average level. Last year, total debt (private, public and financial) exceeded $100 trillion, more than three times U.S. national income. Companies and private equity firms spend trillions of dollars on share repurchases and leveraged buyouts, but corporate investment has been relatively weak.
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Capital inflows into the United States have helped to sustain the bubble economy. Foreigners currently own $57 trillion dollars of U.S. financial assets, according to Federal Reserve data. Their purchases of American financial securities have kept down bond yields and raised stock prices. Capital inflows have helped to finance the U.S. government’s massive fiscal deficits. These deficits in turn have boosted aggregate demand, contributing directly and indirectly to record U.S. corporate profits, according to John Hussman, opens new tab of Hussman Funds.
America’s bubble economy is politically troubled. Its financial gains have been unequally distributed. Household wealth may be close to an all-time high but, as Treasury Secretary Scott Bessent has pointed out, opens new tab, the top 10% of Americans own 88% of U.S. equities while the bottom 50% are mired in debt. Furthermore, what the former hedge fund manager calls the “highly financialized economy” has not been conducive to strong wage growth. Sending manufacturing jobs offshore was good for corporate profit margins but hurt blue-collar workers.
The bubble economy is inherently fragile. Debt cannot indefinitely continue to rise faster than income. Sooner or later, fiscal deficits must be reined in, or the country will go bust. In Bessent’s view, the U.S. has become addicted to government spending. A “detox period” is necessary he says. Stephen Miran, chairman of the Council of Economic Advisers, believes that large capital inflows into the United States have resulted in a continuously overvalued dollar, opens new tab, which has hurt competitiveness and is responsible for its large trade deficits. Tariffs are intended to reverse these pressures.
Neither Trump nor his economic advisers explicitly acknowledge that they are trying to pop the bubble economy. But that’s what their actions amount to. As Julien Garran of MacroStrategy Partnership points out in his latest note, if Trump is serious about unwinding the long-running squeeze on blue-collar workers this means unwinding decades of policies that have been super-friendly to financial capital.
The labour share of national income will have to rise at the expense of corporate profits. Reining in fiscal deficits would also hurt corporate profits. Slapping tariffs on imports and forcing more companies to manufacture in the United States puts further pressure on bottom lines. If corporate profits shrink then the stock market, which is still trading at a historically elevated valuation, could have much further to fall. Once capital gains are replaced by losses, households will have to save more, further depressing aggregate demand. A vicious cycle could replace the virtuous one that kept the bubble economy afloat.
Richard Duncan of MacroWatch fears that reduced foreign demand for American securities could push up long-term U.S. interest rates. He is also concerned about a potential run on the dollar as foreigners reduce their holdings of U.S. financial securities.
A singular advantage of issuing the world’s reserve currency is that the United States has long been able to run vast trade and fiscal deficits without losing the market’s confidence. Yet earlier this week, yields on U.S. Treasury bonds spiked. The bond market rout raised concerns that the Trump administration could be facing its own “Truss moment”, a reference to the short-lived administration of British Prime Minister Liz Truss, whose large projected fiscal deficits triggered a collapse in the UK gilts market in September 2022.
Bessent expects a “smooth transition” as policies shift to favour Main Street at the expense of Wall Street. Recent market turmoil suggests otherwise. Besides, the experience of Japan suggests that restructuring a bubble economy is a fraught process.
During the second half of the 1980s Japanese real estate and stocks rose to extreme valuations. Debt surged and financial engineering enhanced corporate profits. Towards the end of the decade, policymakers in Tokyo decided to change course. The Bank of Japan hiked interest rates with the intention of bursting the bubble. A senior official told the Washington Post that “the real productive economy won’t be hurt. Land and wealth won’t disappear, but phony wealth will.” This was wishful thinking. The collapse of Japan’s bubble economy was followed by several banking crises and two “lost decades” of economic growth.
At the beginning of this year, the U.S. stock market accounted for 64.4% of total world value according to the UBS Global Returns Yearbook. By coincidence, Japan’s stock market in 1988 accounted for the same share of the MSCI EAFE Index, which tracks stocks in developed countries in Europe, the Middle East and the Asia-Pacific region. Over the following decade, Japan’s weight in the benchmark dropped by more than two-thirds. Investors in U.S. stocks should take note.
