The AI bubble could pop the US and global economies

Is artificial intelligence a bubble that is about to burst? If so, what would be the consequences for the U.S. and global economy? 

These issues have come to the fore as the U.S. stock market has surged to record highs on the back of massive gains by AI-related companies. Current valuations rival those during the peak of the tech boom in the second half of the 1990s.

At the International Monetary Fund’s annual meeting last week, the chief economist warned that the AI investment boom has “echoes” of the 1990s dot-com bubble. Previously, former IMF head Kristalina Georgieva said that indicators of financial instability were growing and investors should brace themselves for the challenges ahead.  

Countering this perspective, analysts from Goldman Sachs contend that “anticipated investment returns are sustainable.” Their assessment calls for U.S. productivity to rise from 1.5 to 1.9 percent per year in the early 2030s. If so, they believe investments firms are undertaking to build data centers and expand software production should generate returns to justify current stock valuations. 

Nonetheless, while there is general agreement among experts that the adoption of AI has potential to transform the U.S. economy over time, some question whether the optimism about productivity gains will be borne out.   

Beyond this, there is uncertainty about the impact that a plunge in AI stocks might have on the U.S. and global economy. A key consideration is whether a tech selloff would mainly be felt by equity investors or would have broader ramifications.

During the bursting of the dot.com bubble, for example, the stock selloff did not trigger a contraction of bank credit, as the Federal Reserve eased monetary policy considerably. As a result, the recession that ensued was relatively mild, with real GDP declining by about 0.3 percent.

In comparison, the decline in home values in the mid-2000s rippled throughout the financial system and spawned a contraction in overall credit availability. It resulted in a more severe and protracted recession, in which real GDP fell by 4.2 percent from mid-2007 to 2009.

The prevailing view until recently has been that the AI boom is mainly being financed by companies that have sizable cash holdings and strong balance sheets. If so, the risk of a selloff of AI stocks spreading throughout the economy could be mitigated. 

Those who are worried about a bubble, however, have expressed a variety of concerns. 

One is that a group of AI tech giants are funding each other through circular deals called “related party transactions.” These deals, in which companies invest in or provide financing to customers, can inflate valuations by creating a distorted impression of growth prospects. 

Another is that some firms are increasingly turning to debt issuance to finance costly infrastructure such as data centers. The buildout of infrastructure has bolstered the economy this year, but it could add to risks if interest rates rise at some point. 

One of the International Monetary Fund’s concerns relates to patchy oversight of nonbanks that include insurers, pension funds and hedge funds. This sector has grown rapidly and now holds roughly one half of the world’s financial assets.   

So, what might this portend for the U.S. and global economy? 

Gita Gopinath, former chief economist of the IMF now with Harvard, calculates that a market correction of the same magnitude of the dot.com crash could wipe out about $20 trillion in wealth for American households. This would be equivalent to nearly 70 percent of U.S. GDP.  She estimates that foreign investors could also face wealth losses exceeding $15 trillion, or about 20 percent of the rest of the world’s GDP.   

Gopinath’s conclusion is that the structural vulnerabilities and macroeconomic context are more perilous today than in the early 2000s, when one takes into account the fallout from higher tariffs, potential loss of Fed independence and loss of confidence in the U.S. dollar. 

My take is that an equity market selloff today may not be comparable to that of the early 2000s, when the S&P 500 and the NASDAQ Composite sold off by 50 percent and 75 percent, respectively.

The reason is that, in addition to the overvaluation of tech stocks, two other forces kicked in then. One was the Sept. 11, 2001 attack, and the other was the Enron scandal in 2002, which caused investors to question how widespread accounting fraud was.

That said, I share Gopinath’s concerns about the current macroeconomic context. I also take note of the rapid expansion of margin debt, which reached a record high of $1.1 trillion in September and is up by 34 percent over a year ago according to the Financial Industry Regulatory Authority. The leverage on underlying positions can exacerbate losses if the stock market declines.  

Accordingly, a stock market selloff of 20 to 30 percent is possible, which could tip the U.S. economy into a moderate recession at some point.   

Nicholas Sargen, Ph.D., is an economic consultant for Fort Washington Investment Advisors and has authored “Global Shocks: An Investment Guide for Turbulent Markets.”