What’s Coming Next May Hit Americans Hard — Steve Hanke

[00:00:00] Hank: because when this AI, right now, by the way, the AI stocks are down around 25% from their peak already. But there's a long way to go, because if it pops, it'll go down about 70%. And the collateral damage in the general markets will probably be a reduction of maybe 40% or something like that. Now, whether the extent of the overall economic damage will probably be pretty great. And worse than that, we won't have, as we have in some recessions of V-shaped recovery, I think we'll have a long slog getting out of the thing. So the damage will be quite pronounced and widespread. I mean, the AI investment, by the way, it's running over a little, about 5.2% of GDP. Now, there's just nothing like this in history. We're talking about a mega, mega thing going on with regard to investment. And we have this massive investment, and I would say overinvestment, massive overinvestment in AI. And when you have these things occurring, it usually results because you have two things going on at the same time. You have a huge credit expansion. And a huge increase in market cap in the sector where you have the credit expansion. So this is what, and what happens, by the way, the last time we had a bust, remember 2007, 2008, with housing. Huge credit expansion, huge increase in the valuation of houses. We had a bubble, a bubble pop. Well, bubbles occur when you have this dual huge increase. And if you look at the charts, it's just straight up, the credit expansion and the investment and valuation straight up. And that signals a bubble. So, and the research has been done on this, and it's been quite extensive, by the way, looking at over, there was an article in the 2022 Journal of Finance by Greenwood and three other authors. And they found that the increased probability of a financial crisis, that means the bubble popping, but also lots of collateral damage, that's a pure crisis, would increase to about 40%. If you had these dual things of overextension of credit and increases in valuation. So it isn't, it isn't in the bag, but the percentage goes up from the normal is about 7%, by the way, that you have some kind of a financial crisis. [00:03:11] Speaker 2: The conflict Hank describes is simple. The same investment boom supporting American growth may also be building financial risk. For Americans with retirement money and stocks, the question is how far a technology sell-off could spread. Keep two numbers separate. Hank cites research about the probability of a financial crisis, then gives his own estimate of potential market losses. Those are different claims, and neither supplies a crash date. What makes his warning worth following is the chain behind it. Expanding credit, rising valuations and revenues that may disappoint. Next, he explains why useful technology can still become a dangerous investment, and how that risk can reach [00:03:54] Hank: the banks. It's not, it's not that clear, actually, because what you can get, you can get to, if you have the overvaluation, it's eventually going to dissipate. Okay, so that's one thing. But you don't know whether it's going to be actually a pop or a slow deflation of the thing. So that's one aspect. The only thing that we really know much about is that the popping usually occurs if it's in conjunction, the bubble is in conjunction with a situation in which monetary policy starts tightening up. Let's say things go south, and we don't know if it's popping or deflating or exactly the nature of the going south in AI, which probably will occur, by the way, because it looks like the projections of investment in AI for the next five years. And the projections of revenue, these are just projections already. There's a 58% revenue shortfall that will not be funding and generating a rate of return of just 10% on the capital that's being invested. So it's clear something's going to happen because the revenue just isn't there to finance all of this. Well, that's true. But that's kind of the first order condition that would be, you know, private equity and the non-banking, shall we say. But it often comes back to haunt the banks because the banks have extended credit to these other non-banks have extended credit to these other non-banks. So it's a tangled web, the financial system. And as I say, the first order condition would obviously be the non-banks because they're the most active ones in it. But we have the hyperscalers. Let's talk about the hyperscalers. Now, originally, when they started pouring money into AI, they had free cash flows coming out of revenues from the hyperscalers. Well, they were, to give you some idea of the malinvestment, they had lots of free cash flow. They burnt through that. And then they jumped into the debt market big time. And now, what do you have? You have the credit default swap spreads going up. And basically, in simple terms, the cost of insuring the debt that someone's bought against default has gone up. Insurance costs have gone up. So the bond vigilantes smell some of this stuff out pretty quickly. So you can see some of this is actually being priced into the market right now. Now, to put this into perspective, though, I said that the AI investment is a large chunk of GDP. But if you look at the growth in GDP, the third quarter growth in the United States annualized with 3.4%. And if you drill down into that, which I've done, 96% of that was accounted for by AI, which means the rest of the economy right now is totally flat. There's nothing much going on, except AI. Again, it gets the thing into perspective. We're talking about something that's just massive here. Let's assume we go into a recession. Now, there are two kinds of recessions. One, the interesting part isn't necessarily when you go in. The interesting thing is when you go out. There are two kinds of recessions. One is a V-shaped recession where you come out fast, you bounce back fast, or you come back slowly, slowly, slowly. And I think with this kind of malinvestment, you're going to see a very slow recovery. So that, again, relates to the market. It's not going to be this one month wonder where a car crashes and boom, all of a sudden it goes back. It's going to be probably a long slog because it's massive and it touches a lot of different sectors of the economy. You mentioned electricity, some of the commodities and so forth. So those are also aspects that we want to be thinking about. We're in a corner, and this comes back to the Washington thing that you brought up, Maggie, and that is there isn't really much fiscal firepower that can be used. We're overextended. The debt is high. The critical thing is a deficit, which is running quite high by historical standards already. And it's been that way for a long time. It isn't something that we just all of a sudden it crept up on us and we have a deficit of 6% of GDP. No, it's been hanging around for a long time. So forget that idea of stimulating yourself out of the problem that's created by the bubble bursting. And also monetary policy. Right now, the inflation genie is out of the bottle. They're having trouble getting inflation down. Why do you think that Republicans got whacked? Well, they got whacked for a lot of reasons, but one factor is inflation and the cost of living. Everyone, one way or another, was complaining about the cost of living. And with monetary policy, I don't think they've got room to loosen and goose a thing unless they want a lot of inflation and basically stagflation. So the levers of the margin of safety in Washington, D.C. has been spent. There is no margin of safety. By the way, that goes back to Trump number one, Biden big time, Trump number two. They're not interested. No politician in Washington is interested in controlling government expenditures. Now, you have a few exceptions, but we're talking about a handful. [00:11:00] Speaker 2: Put those arguments together and Hank is describing a double squeeze. First, disappointed AI revenues could hurt investments financed with debt. Second, he believes the economy has become dependent on that spending while deficits and inflation constrain the response. His most consequential warning is about the recovery. A sharp fall is painful. A prolonged recovery creates a different problem. Households may need their savings while investments remain depressed. There is also an important distinction in his argument. Limited room for stimulus does not mean the Federal Reserve would refuse to intervene. Elsewhere, he says a financial crisis would force a liquidity response. His concern is the trade-off that intervention creates. That is why the next section matters. He connects the national balance sheet to interest rates, then brings the story down to the [00:11:55] Hank: community. It means that the bear market that we've been in bonds since 2022 will continue. We had 39 years, by the way, of a bull market in the bond market. People don't realize bond markets have very long bull and long bull market. So the one we had started in 1981, that was 39 years. If you were invested in the bond market, it was just a one-way ride. You were picking up your interest and you were getting a constant augmentation in capital gains. But that's not true now. Now we're in a bear market. So the bear market will continue. That's what it means. This gets a little bit technical. It depends on where you are in the yield curve. But let's say the 10-year, which is an interest rate, the 10-year U.S. government bond, which is a kind of anchor for all the most private sector interest rates, like mortgages and it's a benchmark type thing. I think it will stay up over 5% for quite some time. Now, the short end of the curve, I think, will probably end up going up because they'll be forced to tighten up and the Fed funds rates will go up. And the Fed funds rate, by the way, just looking at the numbers and calculations, the Fed funds rate could go up by 2.5% or 3% points from where it is now to be consistent with a 2% inflation target. Remember, I said 96% of that 3.4% annualized growth rate in the third quarter was AI. That's a lot of construction going on and work and so forth. Of course, the reason they don't like it in these local areas, if you have a little spurt in economic activity when you're building these sites, but then when they're built, they don't employ anyone. So you end up with a boomtown effect. They build it. There's a little boom going on. The locals do very well for a year or a year and a half, however long it takes to build a thing. And then that's it. [00:14:49] Speaker 2: Yeah. It seems some people are kind of wise to that time horizon for work. [00:14:54] Hank: Yeah. And then you're left with a humming sight or whatever. In effect, all the pollution associated with it afterwards and not very many jobs. These things are capital intensive. They're not labor intensive. Exactly. Just think of it as an individual household, as your family. If you're overextended all over the place and something bad happens, there's not much you can do about it. If you have a margin of safety and you've got savings and so forth, you know, you can mitigate the damage that befalls you. If somebody asked me right now, if you asked me to forecast, that's what you've been trying. You've been trying to squeeze out some kind of forecast with, "Hankey, what do you think is going to happen?" "Hankey doesn't know what the hell's going to happen." We love your honesty, Steven. Well, and no one else does either. Right now, this is literally a fog of domestic war, the political thing and the age of resentment, the age of big players, etc., etc., etc. So it's very difficult to have a clear picture. And remember AI. I have a pretty clear picture of AI. I think it's coming down. So what do you do? For any additional liquidities that you have, I wouldn't be putting them in the stock market. I'd be putting them in a money market fund. The main message is, I think everybody should be, you know, staying awake a little bit at night worrying about things because we do have a mega investment investment in AI. This is unprecedented. And most people don't realize that, how big it is. And there's a pretty good chance that it's actually a bubble. Or as you put it, I think the way you put it is actually better, a malinvestment. There's just everybody jumped on this bandwagon and there'll be a few on the bandwagon that win. But most of them will not. And that suggests that the market cap in that sector or silo will come down. It's too high and it will come down. [00:17:32] Speaker 2: Hank closes with a useful tension. He is strongly bearish on AI valuations, yet openly admits he cannot forecast everything that comes next. That uncertainty is central to the preparation message. His household example asks a practical question. How much room do you have if something goes wrong? His preference for putting additional liquidity into money market funds expresses that defensive outlook. It does not establish that every American should make the same portfolio decision. The takeaway is to examine dependence. Dependence on one investment theme, on continued borrowing, or on a quick recovery. Those are the vulnerabilities this interview brings into focus. Which part worries you most? Retirement savings, borrowing costs, or Washington's ability to respond? Share your view below and subscribe for more analysis connecting economic warnings to American life.