No, the global economy isn't falling apart despite Trump's shocks

Despite warnings of a meltdown, Trump's policies have barely dented global growth forecasts

Since April 2 — the day President Donald Trump declared as “Liberation Day” — we have been told that the world economy is headed for a massive setback and markets for a meltdown.

 

Mr Trump announced reciprocal tariffs on some 180 countries and territories. On April 9, he declared a 90-day pause on these tariffs for all countries except China. Since then, he has raised tariffs on Chinese imports to 145 per cent. The Chinese have retaliated with a 125 per cent tariff on imports from the US.

 

President Trump is confident that tariffs with all countries, including China, will be suitably negotiated. But nobody knows by what date and at what levels the tariffs will settle. In early April, experts warned that prolonged uncertainty caused by Mr Trump’s tariff war would result in economic chaos.

 

A month on, the picture is nowhere near as grim as experts made it out to be. The International Monetary Fund  (IMF) sees global economic growth slowing from 3.3 per cent last year to 2.8 per cent this year — a deceleration of 0.5 percentage points. The US economy is expected to slow from 2.8 per cent in 2024 to 1.8 per cent in 2025. That seems sharp, except that US growth in recent years has been powered by heavy government borrowings. The long-term trend growth rate for the US is 2 per cent; 1.8 per cent is not very far from the trend.

 

China is projected to slow down from 5 per cent to 4 per cent, which is better than the 3 per cent many commentators had predicted even without the Trump tariffs.  The Indian economy will grow at 6.2 per cent instead of 6.5 per cent. So, yes, the Trump tariffs will adversely impact growth worldwide. However, the IMF projections hardly point to an economic collapse.

 

To judge how big the tariff shock is, just look at the impact of two major shocks of the past, the global financial crisis (GFC) of 2008 and the Covid crisis of 2020. The GFC caused world economic growth to fall from 2.7 per cent in 2008 to minus 0.4 per cent in 2009, a decline of 3.1 percentage points. The Covid crisis saw global growth fall from 2.9 per cent in 2019 to minus 2.7 per cent in 2020, a drop of 5.6 percentage points. The drop in global growth of 0.5 percentage points projected on account of the tariff shock seems piffling in comparison.

 

Some commentators believe an economic crisis will emanate, not from the real economy, but from the financial sector. The yield on US 10-year government bonds rose from 4.19 per cent on April 2 to 4.39 per cent on April 9, when Mr Trump announced the 90-day pause in what was seen as an attempt to calm the bond market. The S&P 500 sank by 12 per cent between April 2 and April 8. The US dollar index, which measures the value of the dollar with respect to six currencies, has fallen by nearly 4 per cent up to May 6 with respect to the level on April 2.

 

Many commentators saw the events between April 2 and April 9 as a vote of no confidence on the part of investors in the Trump administration and the US economy. They said investors were reacting to the prospect of low growth, rising inflation, and the erosion of the rule of law in the US — and were exiting American bonds and equities.

 

US Treasury Secretary Scott Bessent was quick to scotch the interpretation. Mr Bessent observed that the selloff in US bonds in the first week of April was a story he had seen several times in his career. Mr Bessent said, “There’s one of these deleveraging convulsions that’s going on right now in the markets. It’s in the fixed-income market. There are some very large leverage players who are experiencing losses and are having to deleverage.” Mr Bessent, a legendary hedge fund manager, would know a thing or two about financial markets.

 

Hedge funds borrow in the repo market to take bets on US government bonds using various trades. They use government bonds as collateral for their borrowings. When the value of government bonds falls, they get “margin calls” from the lenders — that is, they are asked to provide more cash towards meeting margin requirements.

 

Hedge funds may sell government bonds they hold in order to generate cash to pay for higher margins. Or they may “unwind” their trading positions — that is, sell bonds and use the proceeds to repay lenders or “deleverage”. In either case, bond yields would move up. They may also sell equities to raise cash, which would explain why bond and stock prices fall simultaneously in such episodes.

 

These episodes can lead to a crisis if bank exposure to hedge funds is excessive. Or if banks themselves are taking large trading positions similar to those of hedge funds, which would require them to sell bonds and incur mark-to-market losses when bond yields move against them. Neither possibility is high today.

 

Following the collapse of the hedge fund Long Term Capital Management (LTCM) in 1998, bank exposure to Highly Leveraged Institutions came to be closely monitored. Bank ownership of hedge funds in the US is severely restricted by the Volcker Rule. Proprietary trading by banks has been dis-incentivised by higher capital requirements for such trading. Banks are much better capitalised today than during the GFC of 2008. The chances of hedge funds blowing up the banking system and causing a financial meltdown are much lower today.

 

Mr Bessent’s reading of the convulsions in the US bond market after Liberation Day has turned out to be correct. The yield on US government bonds dropped to 4.32 per cent on May 12 from 4.49 per cent on April 11, and several US government bond auctions since then have gone through smoothly. The US stock market too has recovered smartly.

 

The Economist, which is among the most strident critics of Mr Trump’s economic policies, admits that US stocks “are not pricing in a recession, let alone a trade catastrophe” (April 30, 2025). It believes the market is being myopic; it certainly didn’t think the market was being myopic when yields on US government bonds surged in early April! Analysts believe that US stocks are still overvalued. It makes sense for foreign investors to exit US equities, and that could be one of many reasons for the dollar index to fall. To construe a fall in the dollar index as a lack of faith in the US economy seems far-fetched.

 

Mr Trump has said repeatedly that his attempts to remake the US economy would entail transition costs. As he put it, American kids will have “two dolls instead of 30 dolls” and the two dolls would cost a “couple of bucks more”. The remarks enraged his critics. His critics miss the point. Mr Trump accepts there will be short-term pain, but he doesn’t think his policies will result in economic apocalypse. It appears for now that the IMF and the financial markets think he’s right.

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