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With markets in the grip of AI euphoria and myriad uncertainties surrounding the global economy, investors are understandably anxious to know where we are in the business cycle.
Yet there is no satisfactory answer because the cycle has been hugely distorted by a series of shocks ranging from the Covid pandemic to the Trump tariffs. These have in turn prompted government and central bank interventions that make a nonsense of traditional business cycle analysis.
More fruitful is to look at the state of the much longer financial cycle, which reflects the ebb and flow of risk appetite in credit and property markets, as opposed to the peaks and troughs of output and employment. Turning points at the top of this cycle are often followed by banking crises and deep market drawdowns — peak to trough falls — from which prices can take years to recover.
In a remarkably prescient essay for the Bank for International Settlements in 2014 Claudio Borio drew attention to what he called excess financial elasticity — an inability on the part of policymakers to prevent the build-up of financial imbalances arising from unsustainable credit and asset price booms. Serious banking crises and deep recessions or depressions result.
Perceptions of value and risk, he argued, were highly procyclical and were amplified by market participants’ natural tendency to take on more risk as perceived wealth increases. Borio concluded that a failure to tailor domestic policy to cope with outsized financial cycles was entrenching instability while returning us to the divisive competitive devaluations of the interwar years. This would ultimately trigger “an epoch defining seismic rupture in policy regimes, back to an era of trade and financial protectionism and possibly stagnation combined with inflation”.
That is a pretty good description of today’s Trumpian world of zero-sum geopolitical competition, tariff tantrums and financial instability — a ruptured world that bears the lasting taint of the 2007-08 financial crisis.
As luck would have it, the current state of both the business and financial cycles is relatively benign. On the business side, fiscal policy is supportive with the US running a fiscal deficit in 2005 of 6.2 per cent of GDP. No restraint is in prospect, so public debt of about 100 per cent of GDP is set to rise inexorably.
In China and the rest of the world, fiscal policy is largely expansionary. Interest rates in the US and other advanced countries are reckoned still to be on a downward trajectory. A further expansionary impetus can be expected in 2026 from the release of pent-up demand and the lessening of firms’ hesitancy to hire and invest as the shock and awe of tariff tantrums erodes.
On the financial side there is not yet a credit bubble since the Big Tech companies’ huge investment in AI data centres has been substantially financed from rich cash flows. Nor is housing overheating. Yet there are tell-tale signs that leverage is accelerating.
As my colleague Gillian Tett has pointed out, many AI start-ups — such as OpenAI, Anthropic and Elon Musk’s xAI — are lossmaking and their heady valuations are being boosted by variants of cross-cutting vendor financing. The net result is a pattern of incestuous circular flows that echo the behaviour of banks and insurance companies in credit derivatives before the bursting of the bubble in 2008.
Helped by financial liberalisation, the duration of the financial cycle, Borio suggests, has stretched out since the early 1980s to 16-20 years in the US, which leads the global cycle. Taking his estimate of the last trough as 2013, the bursting of the boom/bubble may thus be still some way off — especially since the Trump non-administration is bent on a procyclical relaxation of the bank capital regime along with other financial deregulatory measures. The punchbowl is emphatically not being removed from the party.
The uncomfortable truth is that we have been locked in successive cycles where policymakers have been too timid in leaning against financial booms and then too aggressive and persistent in alleviating financial busts. The existence of this safety net is a morally hazardous spur to the amplification of an already outsized cycle.
With public debt across the big advanced economies at levels hitherto only seen in wartime, financing the next bailout will be an almighty challenge, as will debt reduction, given poor productivity and anaemic growth. What limited appetite there is among policymakers for debt consolidation via increased taxes and reduced public spending is largely a tribute to bond vigilante discipline. Much easier to hope that AI will deliver a productivity deus ex machina.
It follows, in an ever more populist climate where central bank independence is under increasing attack, that there will be resort to inflationary monetary financing of fiscal deficits by central banks. Also to financial repression, which entails financial institutions accepting below-market rates on enforced holdings of public debt. The unsettling message for investors is that all bar the shortest-dated nominal fixed interest paper is now potentially treacherous.
john.plender@ft.com
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