U.S. economic policy has been highly erratic since the election of Donald Trump. For months, both friends and foes had little idea what to expect. Global economic uncertainty surged to the highest level seen in recent history, even exceeding its COVID peak.
Without a doubt, this has been a big negative for investment and hiring in recent months. High uncertainty over future profitability due to the imposition of tariffs and a potential trade war are a killer for companies’ investment decisions.
Following “liberation day,” the uncertainty has now been removed, more or less. But what has replaced it is not exactly better. The minimum tariff that foreign exporters now need to pay on their goods to come into the U.S. is 10%, and for many countries it’s substantially higher. The EU is facing a 20% tariff, Japan 24%, Vietnam 46%, China initially 34%, now 84%, the list goes on.
Global stock markets are plunging as a result. As U.S. consumers remain by far the biggest economic entity on the planet in terms of purchasing power, exporting regions like China, Japan, and the E.U. are now suffering tremendously from the imposition of these trade barriers.
Every single good for the U.S. consumer becomes way more expensive, so demand for those goods will fall accordingly. That’s why stock markets in Europe and Asia are currently tanking. Meanwhile, American stocks are plunging as well as financial markets are increasingly pricing in the risk of a U.S. recession.
How are financial crashes related to the labor market?
Well, as the famous saying goes: The stock market has predicted nine out of the last five recessions. There is definitely some truth to that. Financial markets can be volatile at times and do not always need to have an impact on real economic activity. The famous 1987 stock market crash, for example, did not really affect the labor market or economic growth.
On the other hand, most other financial crashes are highly correlated with economic downturns: think about the Great Depression in the 1930s or the 2008 Great Financial Crisis.
This does not necessarily mean that these crashes have always caused the downturn. In many instances a third factor, such as misguided monetary policy, was the main culprit.
Nevertheless, economist Roger Farmer has found that a lot of financial crashes do seem to have a causal impact on the labor market. The reason is simple. When several trillions of market capitalization are wiped out, households and companies become way more pessimistic about the future.
Americans, in particular, hold a lot of wealth in stocks, both directly and indirectly via their 401k (retirement plans). A stock market crash causes a negative wealth effect. When household net worth plunges, consumers tighten their belts and reduce their outlays. Discretionary spending, luxury items, eating out, or taking an expensive trip, is usually sacrificed first. More than 70% of the U.S. economy is consumption after all. When the consumer suffers, there goes the economy!
Significant declines in consumer spending therefore directly leads to labor market weakness. Since the U.S. labor market is quite flexible (shorter notice periods and lower barriers to lay off workers compared to Europe), one should expect a negative labor market response rather sooner than later.
And companies are affected as well. As financial markets suffer, borrowing costs usually surge. This, together with the rise in uncertainty and a grimmer economic outlook, deters the private sector from investing, which puts additional downward pressure on the labor market and economic growth.
That’s why Farmer found a correlation between a significant stock market crash and an increase in the unemployment rate. Not only that, but his studies also proved that the relationship is most likely causal, meaning that changes in wealth are directly causing labor market fluctuations via the mechanisms outlined above. What Keynes in the 1930s dubbed “animal spirits” (changes in consumer and business sentiment) can therefore create an economic downturn following large plunges in financial markets.
As the chart below shows, large declines in the S&P 500 are followed by significant increases in the unemployment rate (inverted axis).
Based on his research, Roger Farmer went as far as suggesting that central banks should directly target the stock market and prevent asset price crashes. This would then help to prevent a negative economic spiral from occurring in the first place.
While the current economic consensus among policy makers is that central banks should not actively prop up the market, there is no doubt that financial crashes can do a significant amount of economic damage—and not just in the short run.
Economic historians have found that financial crashes and banking crises lead to prolonged economic downturns that last longer than recessions without financial crashes.
Moreover, financial crises also lead to a rise in populism as voters become more extreme and alienated from mainstream parties, which is exactly what happened across advanced economies in the aftermath of the 2008 Financial Crisis.
What is the outlook?
All this explains why Trump’s unexpectedly high tariffs and the market’s reaction has caused financial institutions to reassess their outlook for both GDP growth and unemployment rather quickly.
While it is way too early to call a U.S. recession, it is very plausible that U.S. economic growth will crater in the first half of 2025. A decline from the previous 2% growth achieved last year to a growth rate that is much closer to zero is likely. And this would be enormously damaging for the American economy.
Pessimistic estimates suggest that U.S. unemployment could exceed 5% in the coming year. The tariffs, while extremely harmful, wouldn’t quite be able to cause a labor market downturn on their own.
But a financial market correction on top of tariffs, with several trillions of market capitalization wiped out, reined in consumer spending, uncertain business outlooks, and declining investments, that would do it!
Unfortunately, the signs are not encouraging. Early indicators tell us that the American consumer has become increasingly pessimistic in recent months, both about the economy and future labor market prospects. And that was even before the full extent of the tariff shock was known.
One big unknown is the reaction of the Fed (Federal Reserve). If they support the economy with rate cuts and allow the tariffs to be inflationary, then the U.S. could avoid a recession even as trade barriers weigh on growth. Unfortunately, the Fed is stuck in a hard place. Large supply shocks are both bad for growth and inflation, the trick is to not create additional weakness via falling demand in the economy.
Most likely, central bankers will have to find some middle ground, allowing inflation to overshoot its 2% target yet again in 2025 while also allowing some additional economic weakness. One thing is all but insured: Trump’s trade war will lead to higher inflation, lower economic growth, and higher unemployment. The exact split between the three of them, though, is yet to be determined because a lot will depend on how the Fed will react. Uncertainty about future economic conditions therefore remains extremely high for now, and the wealth wipeout will cause additional economic weakness.
