Fire Marshal Trump

Today I am moderating a panel at Risk Live Europe entitled “’Our golden age has just begun’ MAGA’s mercurial markets.” Please introduce yourself if you are attending and please subscribe if you haven’t already.

In preparation for the panel I have been ruminating on an opinion that I’ve long held that Donald Trump is an antidote to Minsky Moments, both the financial ones that Hyman Minsky theorized and those in other realms. I still think that characterization holds, i.e. contrary to conventional wisdom, his behavior is risk reducing. But I perhaps underappreciated that his policies may simultaneously risk triggering latent catastrophic events.

What are Minsky Moments?

The late American economist Hyman Minsky hypothesized that prolonged periods of stability would naturally generate financial crises. Low financial volatility encourages risk taking and increasing use of leverage. Eventually, albeit with unpredictable timing, some likely innocuous event will trigger a deleveraging that snowballs into a financial crisis as a vicious circle of falling asset prices and deleveraging reinforce each other.

The concept of Minsky Moments gained popularity during the Global Financial Crisis (GFC), but it need not only apply to finance. One can think of the same mechanism operating in other arenas. The stability of an oligopolistic auto market created a disruptive opportunity for Tesla. The stable monopoly center-right and center-left political parties in the West held on power helped fuel the Politics of Rage now rocking those democracies. The peace and globalized prosperity of Pax Britannica facilitated a buildup of rivalries that manifest as World War I.

What hides behind the calm?

Two important features of Minsky’s theory are often underappreciated. First, policies designed to create financial stability – bailouts, liquidity injections, et cetera – perversely increase systemic risk by facilitating greater risk taking and leverage. Second, volatility is not the same as risk, the subtle implication of which is that calm façades may mask the buildup of catastrophic risks in the background.

This is why Donald Trump’s methods mitigate Minsky Moments: he doesn’t suppress volatility, he creates it. In doing so, he makes the system safer by increasing perceived risk and dampening risk taking. For instance, “Liberation Day” volatility unwound large overweight positions in US assets held by global fund managers. In doing so, it reduced the potential for a more painful and consequential deleveraging later.

But recall that Covid only recently provoked a similar large-scale deleveraging, hence positions were overweight but not dangerously so. What if the buildup in overweight US asset holdings was not four but ten years old? Or even older? What if such risks had been building for decades?

The monsters lurking in the shadows

Readers of Thematic Markets know from Global entropy: Enter the dragons (free) and my Leitmotifs for 2024 and 2025 that I see many monsters stalking the periphery, each with unknowable probabilities of near-term occurrence: debt crises, hyperinflations, socio-political upheaval and civil wars, regional and world wars. Common to them all were the policies of a long line of feckless Western leaders. While they hailed from both the center left and center right and from both sides of the Atlantic and Pacific, they all brimmed with the undue confidence of Apex neoliberalism and the lack of vision to see the dangers they were creating.

The underappreciated features of Minsky Moments were critical to those leaders’ failures. Allowing market volatility, or social or geopolitical tensions to “blow off” or resolve naturally is politically unpopular while the long-run costs of short-run suppression are rarely visible at the time. As a result, most politicians, especially in an age of Overquantification, choose the expedient path of volatility suppression that contributes to financial, political and geopolitical risks that build in the background until they become too big to repress.

Wildfire management

One of my clients, David Dredge of Convex Strategies, grew up, like me, in the Western United States where wildfires have been endemic since the dawn of time. Dave is arguably the leading “practitioner expert” on systemic risk and often likens risk management to fire control measures. The key to preventing major fires, like financial crises, is periodic controlled burns to remove a buildup of undergrowth and to create regularly spaced fire breaks.

But, about a century ago US fire management philosophy shifted from controlled burning and acceptance of small-scale natural fires to full fire suppression. Any fire is viewed as an unacceptable risk and immediately put out. The shift in policy has led to a century-long buildup of dead wood and dense undergrowth with few natural firebreaks, creating the potential for far larger, far more dangerous fires like the one that swept away my old home and thousands of others in the Pacific Palisades in January.

Controlled burns in a tinderbox

Now suppose that a politician came along who reversed fire suppression policies, i.e. one who would accept small natural fires and institute a program of controlled burns. How would he or she (safely) enact such a policy with a century’s worth of kindling piled up across Western US forests?

This is the central contradiction in my characterization of Donald Trump as a Minsky mitigator. His volatility-creating methods may be risk reducing. But with decades of dead brush and gnarled old growths accumulated in financial, economic, energy, social, and foreign policy, his policy of “controlled burns” risk conflagrations in each domain.

(Un)controlled burns?

Consider the following catastrophic risks created by various Trumpian controlled burns:

• State-level conflict: The ongoing Israel-Iran war is a perfect illustration. The war isn’t new but instead represents a “gloves-off” intensification of a decades-old conflict that Pax Americana had suppressed into intermittent proxy skirmishes. With the global policeman stretched thin, tired and more willing to let them “fight it out,”¹1 the intensified, open conflict between the two states has directly threatened Middle East oil production in ways previous conflicts did not. More consequentially, while developments in the last 24 hours suggest the “burn” may be successfully controlled,²2 the war risks destabilizing the global order and increasing the likelihood of great power conflict. US missile stocks already were running low and have been depleted even more rapidly in Israel’s defense. That creates a US vulnerability that invites strategic rivals like China to provoke new conflicts – e.g. India and Pakistan – or more worryingly, to move on Taiwan earlier than planned.
• Statecraft-driven supply disruptions: After a bipartisan consensus on unfettered globalization presided over the evisceration of the industrial base the US needs to defend itself, US industrial policy is a necessity, not a choice, in an age strategic competition. But no safe path for reversal exists. The Biden Administration’s approach of subsidizing desired industries pushed the US budget from questionably sustainable to obviously unsustainable. Yet, Trump’s tariff solution has exposed the US to immediate weaponization of China’s monopolization of critical inputs (specialty magnets, microprocessors, pharmaceuticals) or, worse, pushes China towards kinetic warfare.
• EMU dissolution: While Mario Draghi’s “whatever it takes” policy at the European Central Bank (ECB) deservedly saved the European Monetary Union (EMU) when it last came under stress in 2011-’14, it was the German balance sheet backing the ECB that allowed Mr. Draghi to save the day. Europe as a whole is only fiscally solvent due to low German debt and deficit levels. Another Trumpian controlled burn of (rightly) pushing Europe to pick up its fair share of NATO’s defense spending risks undermining the guarantor of EMU. Debt sustainability is a function not only of debt level but of potential growth and real interest rates. The upshot of Germany’s spending plans is that its debt and real interest rates are going higher, but the concessions Chancellor Merz made to the Greens to secure that spending likely diminish, not raise, German potential growth. The combination threatens not just German debt holders but the entire euro project.
• Advanced economies’ electrical supply: One systemic financial risk that was not reduced by Covid but was instead further subsidized is the Green investment bubble. But the greater risk from it is the potential for large-scale disruptions in electricity like the one that crippled Spain in April. The combination of increasing reliance on renewable electricity generation and decommissioning traditional thermal power generation that structurally embeds stabilizing inertia has dramatically increased the risks of failure in electrical grids that are, by their nature, complex nonlinear systems(The Brawl Street Journal). The EU’s maximalist push for Green energy leaves it the most vulnerable to catastrophe. But Doomberg points to another controlled burn by the Trump Administration that exposes my old home state of California, the world’s fourth largest economy, to ruinous grid failure: the Big Beautiful Bill, if passed, removes all the subsidies needed to “fix” California’s lack of grid inertia with battery storage.

These are but a handful of examples within what amounts to a revolution in American foreign and domestic policy under the Trump Administration. But they illustrate the breadth of non-traditional systemic risks lurking in the shadows of Global entropy that the break in American policy risks triggering.

Evolution of risk management

One of the panelists for today’s Risk Live Europe event, Francis Lacan of Wolters Kluwer, aptly described to me the evolution of risk management over the last few decades in three phases: Phase I was the quantification and management of unitary risks in terms of “Value-At-Risk” (VAR). Phase II was the realization – with the GFC – that risks across asset classes, geographies, and types (e.g. market, counterparty) are interconnected. That led to an emphasis on quantitative “stress testing” of known scenarios. Phase III, which we have now entered, is the realization that we face non-quantifiable, often unknown risks like those described above, which cannot be stress tested. As a result, we instead need to invest in real-time monitoring capabilities and highly capable risk managers.

Correlation and clustering of risks

Francis’s description brilliantly illustrates the problems of Overquantification and the need for new leadership that I wrote about two weeks ago. My only adjustment – with which I think he’d agree – is that just as risk managers found out during the GFC that their financial risks were correlated in unexpected ways, we are finding out now (or soon will) that non-quantifiable risks of the type noted above also are interconnected. Vulnerable electrical grids that rely on magnets manufactured only in China make for compelling targets of state sabotage, and unreliable electricity is likely to further undermine European (and US) debt sustainability. Et cetera, et cetera…

The GFC not only brought attention to correlated risks and Minsky Moments, but also to Carmen Reinhart and Ken Rogoff’s analysis of eight centuries of financial crises, This Time Is Different. One of the less heralded lessons of that book is that financial crises tend to cluster in time: low volatility encourages risk taking everywhere and the popping of one bubble generates financial shrapnel that explodes others nearby. Still less well known is that geopolitical and social disruptions cluster in time. The former tend to bunch around declines in hegemonic power, and periods of rapid technological and economic change;³3 the latter cluster in periods of “overproduction of elites,” which also coincide with economic change.⁴4 Humanity has just enjoyed one of its longest periods of stability and prosperity in history and simultaneously we face profound technological and economic change against a backdrop of Global entropy in the post-War US order. Prepare accordingly for Complexity cascades and the resultant Uncertainty.