As stock markets hit record highs, rising financial fragility is setting off alarm bells across the US and Europe. The warning signs are everywhere – and they are disturbingly familiar. Asset prices are climbing well beyond what can be justified by underlying fundamentals, while non-bank financial intermediaries now play a similar role to that of “shadow banks” in the years leading up to the 2008 financial crisis. At the same time, the rise of stablecoins has pulled regulated banks into the opaque world of cryptocurrencies, and vast sums of speculative capital are flooding into AI stocks, driven more by hype than by proven returns.
These trends bear the unmistakable marks of a financial bubble entering its most precarious stage, when even minor shifts in investor sentiment can trigger a sharp correction. The recent collapse of US auto parts supplier First Brands and subprime auto lender Tricolour, both heavily leveraged and closely linked to non-bank financial institutions, may be early indications of structural vulnerabilities that are only just coming into view.
Behind this growing fragility lies the rapid expansion of private financial institutions over the past decade. And the dismantling of already-weak financial regulations under US President Donald Trump has only compounded the threat.
Taken together, these forces could set in motion the manic cycle famously described by economic historian Charles Kindleberger. The first stage, “euphoria,” is dominated by optimism and excess. It is inevitably followed by a period of “stringency” as defaults rise and credit tightens, before giving way to “revulsion,” when fear grips financial markets and even solvent borrowers struggle to find financing.
If history is any guide, the question is when – not if – another major financial meltdown will occur. For most of the world’s population, however, the more pressing concern is how a crisis that originates in the US and Europe will affect their own countries.
The precedents are hardly reassuring: both the 2008 cri sis and COVID-19 showed that turmoil in the US and other wealthy economies can devastate poorer countries with limited fiscal space and little protection against external shocks.
Entrenched currency hierarchies exacerbate the problem. The dominance of the dollar, for example, ensures that in times of heightened uncertain ty, private capital flows back to the US, causing sharp depreciations and banking crises in lower-income countries. The fallout could be especially severe for debt-distressed countries, many of which built their growth strategies around exports to advanced economies. Developing countries must recognise these risks and take urgent steps to strengthen their economic resilience. The top priority should be to diversify trade relationships. Confronted with the Trump administration’s erratic and often unreasonable demands, some have already begun reducing dependence on the US. This process, though necessary, will not be painless.
To bolster their financial resilience, developing countries need to limit their exposure to volatile capital flows by adopting effective capital management tools and strengthening financial oversight, not merely through prudential regulations but by curbing speculative and opaque activities. Such safeguards must be in place before the next crisis erupts.
The writer is Professor of Economics at the University of Massachusetts Amherst.