Markets are facing an unprecedented storm as a series of interconnected risks threaten to trigger the biggest economic shock of modern times.
The recent
Annual Economic Report of the Bank for International Settlements (BIS) shows that there was indeed resilience, but also luck, during the first half of 2026. Moreover, it shows that risks are emerging, especially in the interaction between fiscal and financial vulnerabilities. To these should be added the social, financial and other vulnerabilities that are likely to exist or be exacerbated by the triumphant march of artificial intelligence in the economy.
It is not difficult to imagine shocks to which the capacity of the public sector to react effectively is more limited than is currently taken for granted. More specifically,
1. Trump’s trade war was less damaging than expected on the so-called “liberation day” (April 2, 2025)
This was partly because the tariff levels ended up being significantly lower than initially suggested, partly because American companies absorbed some of the costs (possibly temporarily) through lower profit margins, and, importantly, because the tariffs were highly unequal.
The inevitable result was a trade diversion from direct Chinese exports to the US to exports via other emerging economies (mainly in East Asia) that could produce using Chinese inputs. Moreover, and crucially, the rest of the world did not copy Trump’s protectionism. Wisely, it judged him too irrational to imitate.
2. The global economy also had a very large dose of macroeconomic luck — the boom in artificial intelligence
This has triggered not only a boost in confidence in an already overvalued stock market, but also a huge surge in domestic investment in the US.
This, in turn, has had significant knock-on effects on the supply of inputs from East Asia. As a result of this boom, along with the aforementioned trade rebalancing, world trade has remained remarkably strong.
3. In 2026, however, the global economy suffered another major shock — the reckless attack on Iran
This led to the effective closure of the Strait of Hormuz, the world’s most important transit point for oil, gas, and many other critical commodities. This has now been going on for four months. From a supply perspective, this has been the largest oil shock of all time, although inventories have cushioned the blow.
Putting all these points together, the BIS says, four economic vulnerabilities emerge:
A. Inflation has risen
The question for central banks is whether this will be short-lived and transitory, or large and long-lasting enough to trigger a new rise in the price level, as happened with the inflation boom after the pandemic. Could a second shock significantly destabilize inflation expectations? Yes. Failing to hit the inflation target once may be bad luck; failing a second time, even mildly, would look like negligence.
Β. Τhe AI spending boom could slow, perhaps abruptly
One reason may be the strong public backlash against the technology. In the long run, the combination of intense competition and disappointing returns could lead to a collapse in investment. This, the BIS notes, has happened in past investment booms driven by innovation.
C. The current loose financial conditions could tighten sharply, resulting in a traditional panic market reaction
We are seeing compressed risk premia, rising leverage and, not least, the rapid growth of a relatively opaque and unregulated non-bank financial intermediation. Note also that private debt is not far from 2007 levels.
D. Governments in high-income countries are losing control of their public finances
With few exceptions, they are running large structural budget deficits, while average public debt-to-GDP ratios are at levels not seen since World War II.
These countries, particularly in Europe, are also facing the challenges of high energy prices and aging populations. Interest rates, both nominal and real, are at levels not seen before the global financial crisis.
The days of low inflation and near-zero interest rates are a thing of the past.
In addition, the Bank for International Settlements (BIS) highlights the interaction of sovereign defaults with sovereign debt markets. In particular, it highlights the growing role of hedge funds in financing governments. Their strategy is based on high leverage. This increases the risks of panics, in which positions are liquidated very quickly. We saw such disruptions at the beginning of the pandemic and again in the United Kingdom in September 2022.
What are central banks looking at?
For central banks, all of this together threatens to cause significant problems.
One risk is fiscal shocks, which, as the BIS emphasizes, are also likely to reduce the room for monetary policy flexibility.
Furthermore, any disruptions in financial markets are likely to be dealt with with strong support from the authorities.
But this is certain to further increase moral hazard. The current shift towards pro-cyclical deregulation of the financial sector further enhances the likelihood of this risk.
There is the BIS’s new “bet noir”: stablecoins, which are intended by some as equivalents of money, but in every crisis they will not be.
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