Last week, new employment data for the United States revealed that the country might be closer to a recession than previously understood. That resulted in a cascade of financial market turmoil. The trouble was noticeable on Wall Street, with the Dow Jones Industrial Average, Nasdaq, and S&P 500 markets all seeing steep falls. But the problems spread around the world and were especially concentrated in Japan.

Did the U.S. Federal Reserve make a mistake by not lowering interest rates last month? Are tech stocks currently overvalued? And does the United States maintain its strength regardless of what happens in the economy?

Those are a few of the questions that came up in my recent conversation with FP economics columnist Adam Tooze on the podcast that we co-host, Ones and Tooze. What follows is an excerpt, edited for length and clarity. For the full conversation, look for Ones and Tooze wherever you get your podcasts. And check out Adam’s Substack newsletter.

Cameron Abadi: The Federal Reserve did not lower interest rates in the weeks before this turmoil. Should we conclude that the Fed messed up here? Do you think that Jerome Powell, the head of the Fed, foresaw this risk?

Adam Tooze: I think we need to be fair to the Fed here. I think everyone was taken by surprise by the scale of this shock. To use a sort of weather forecasting analogy, I think this is a little bit like blaming ourselves for getting drenched at the barbecue because we got hit by a sudden summer thunderstorm and everyone got drenched. I feel it’s that kind of an event. The Fed took the decision to hold rates and to postpone the interest rate cut because it was, broadly speaking, confident about the state of the U.S. economy. And I think that was really the read last week, which was that we bought into the soft landing scenario. That’s what the Fed was taking to heart, that the economy was landing soft and it was landing fast. The U.S. economy is in reasonably strong health, so you don’t cut rates now because you don’t need to, because the economy doesn’t need the support. But you’ll make the cut in the fall.

But that entire thesis of the soft landing hinges—in the view of the markets, which is the crucial variable here, because what we’re trying to explain is this huge market tantrum—on a strong labor market. So, you have to believe that there’s a strong labor market sustaining household income and therefore sustaining consumption. And it’s then those weak labor market numbers that break the envelope of complacency that’s sitting around the market.

And then a bunch of technical factors kick in. So-called quant funds that chase trends in the market all basically found themselves on the wrong side of what were then evolving developments. So they’d been moving into stocks, even if they appeared quite highly valued. They’d been betting against rich-country bonds because those are a safe haven asset. So, if you’re going onto the equity side, you short them. And they’d been betting on a weak Japanese currency as a source of funding. And all of those developments suddenly pitted the other way. And that’s what then produced this really dramatic unwind. And we’re talking about tens if not hundreds of billions of dollars of assets that need to be reallocated.

Now, should the Fed have anticipated all of this? Did the Fed anticipate all of this? No, it clearly didn’t, and neither did the markets. Because if the markets had anticipated this, they would have moved in a different way. And arguably, it’s not healthy for the markets to believe that the Fed does anticipate this kind of thing. The Fed has a dual mandate, which is price stability and maximum employment. And if the market turmoil impacts those two variables, should the Fed react in any kind of way? There was quite a lot of talk in the middle of the panic that the Fed might do an early rate cut to somehow stabilize. I think that is—from the point of view of the broader political economy—the least healthy thing the Fed could do because that would feed the instinct of high-risk investors that they basically have what’s called the “Fed put”—in other words, protection against downside from the Fed.

I think the much sounder policy is really for the Fed to take a distance view of this, keep its cool, see if anything substantial develops—but on the whole, really keep all of this technically driven market development at arm’s length.

CA: Tech stocks seem to have dropped amid this turmoil after rising for so long. Are tech companies overvalued in the stock market—and how would we even know whether this sector is overvalued in the first place?

AT: Well, valuation is always going to be about relativity. That’s the only way we can really do it. And so the answer is a series of ratios. And you can see this operating in the mind of America’s most famous and in some ways most successful investor, Warren Buffett. So, Buffett apparently has one rule that he is quite famous for: the Warren Buffett stock price rule. That is a ratio that compares the overall valuation of the U.S. equity market to American GDP. So it’s a ratio of what Americans’ income flow is and the valuation of the American stock market. That currently is a ratio that is close to 2, and that’s very high.

In other words, U.S. GDP is about $28 trillion, and the American stock market is about $56 trillion in terms of valuation. And that tells you that stocks in general are overvalued relative to GDP, according to historical trends.

So, what Buffett did and Berkshire Hathaway did was they moved out of long equities into cash. They have about $277 billion worth of cash sitting around. But how do you do this? You’ve got to sell assets. Famously, what Berkshire Hathaway announced over the weekend, between the first drama of last week and this week, is that they had sold half their Apple portfolio. Why would you sell Apple? Well, because they’ve run up and so you’ve got profits to take. But nowadays, if you’re going to sell your portfolio, it’s going to be these big stocks. Thirty-seven percent of the value of the S&P 500 is right now made out of 10 stocks. And the Magnificent Seven—Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla—make up 31 percent of the index. So, deciding that you are going to pull back from stocks altogether, you end up by default pulling back from tech.

Is tech in particular especially overvalued? Well, then that comes down to another ratio. We’ve had the Buffett ratio of equities to GDP. We’ve had the share of the big stocks in the equities. Now the question is, are the stock prices overvalued relative to what? Well, the basic ratio that you’d use is the so-called PE ratio, the price-to-earnings ratio. And that is the amount of dollars you would spend to buy a dollar of a company’s revenue. If you are optimistic about a company, you obviously will tend to pay more for the chance to get a dollar of its revenue. A value investor—somebody who is looking over the long run, not just following trends and following memes or whatever—would, generally speaking, look for a ratio of about 20-to-1. So, you pay $20 to get $1 of earnings. You could think of it almost as a 5 percent return in terms of income on your $20 investment, right? Of course, you also hope to get a return from the appreciation of the underlying assets. But that’s why 20 comes out as a ratio; anything less than that is probably undervalued, and numbers above that are scary-high valuations. The dot-com bubble, which was the kind of epic period of massive tech overvaluation, produced ratios of 60-to-1.

So, where are we now? Well, if you look at the Alphabets, the Microsofts, the Metas of the world, they’re all actually around the 30-to-1 mark. Google is at about 30-to-1. Microsoft is at about 33-to-1. These are expensive, but they’re not massively expensive shares by comparison. If you want dot-com bubble levels of valuation, you have to go to Nvidia, which is peaking at a 60-to-1, or Tesla, which is peaking at a 58-to-1—something like that—price-to-earnings ratio.

There are two different ways of looking at that. One is that the prices are too low, and so you ought to bid them up even more. Or you could say the earnings of these companies are just super resilient. They have good business models. These are not fancy, glorified online pet food dealers—the most notorious instances of the dot-com bubble. These are world-bestriding tech titans whose business models will literally define how we live for the rest of our lives. And so paying 30-to-1, 34-to-1, even 40-to-1 is not something that’s a crazy kind of bid.

And then you ask, why is this? And you come to another ratio, which is their earnings. How are they generating those earnings? Are they having to work like crazy, or do they have decent margins? And again, if we look at the dot-com bubble, the margins on the tech businesses were small. They were down in the low teens. And the margins on tech businesses today, how much profit they take out of any given volume of business, are well over 20 percent, which means that they have pricing power. They have market power. So you put all of that together, and you conclude, as I think as most people do, that as elevated as these valuations are—with the exceptions of the Nvidias and the Teslas, which are really steep in price by these ratio measures—companies like Microsoft, the leader in artificial intelligence, or Google, the dominant search engine on the Western side of the Great Firewall, would not appear on the face of it to be massively overvalued by this kind of ratio and analysis.

There may be other stories out there that blow all this kind of confidence up, but this is why, generally speaking, people were not expecting some giant unwind.

CA: Is there something paradoxical about the value of the dollar and how it maintains its strength? When the U.S. economy is strong, the dollar becomes stronger, too—but when the economy weakens, everyone wants dollars then, too? So, what are the circumstances under which the dollar does weaken?

AT: It is true, as you say, that there is a fear-and-optimism-driven logic that says that when the American economy is doing well, the dollar strengthens because people want to buy into American financial markets to get a slice of the earnings. The American stock exchange booms; people move into the dollar to buy. And this is the kicker: When things are bad and the world economy is stressed, people also want to buy dollars, not to buy American equity but to buy the safe haven reserve asset of the world—which is U.S. Treasurys, American government debt. So the dollar strengthens in bad situations, too. This is a kind of strength in the sense of resilience—a little bit like a trampoline is strong, right? You go down; you know you’re going to come back up again.

It’s also true that reserve assets are, generally speaking, held either in dollars or in other currencies really closely related to the dollar. (They’re closely related because their central banks have very close relations with the Fed, and so, in extremis, they could get dollars by way of what’s called a currency swap.) So, the fact that people are shuffling out of U.S. dollar reserves into euros or Australian dollars or Canadian dollars or Swiss franc always seems to me a little bit of an illusion because you’re basically just moving your money around within the Federal Reserve-superintended, dollar-backed global financial system. So that’s another definition of dollar strength.

But if you ask about dollar strength in the most conventional sense—in other words, where does it stand relative to peer currencies in value over time?—the answer is much more ambiguous. If you take the longest dollar index that we’ve got—which is relative to the other members of the G-7, so the rich economies of the world—and if you look at a very long series all the way back to the early 1970s, when the gold-backed dollar system ended and we moved into floating exchange rates, there’s really no trend in the value of the dollar. To put it more precisely, there is a downward trend in the value of the dollar from the early ’70s until 2008, and then that reverses. The downward trend—and I’m just eyeballing this, not doing econometrics—is to the tune of about 20 percent, and the reversal has been to the tune of about 20 percent.

So we live in a period of dollar strengthening in the order of 20 percent, which means that, according to this index, the dollar’s position right now is exactly what it was in the early 1970s. At that level, you can’t speak about strength, as it were. The dollar soaring against the euro or the yen is not the long-run historical norm.

And the reason why the U.S. dollar has not appreciated in price terms while having this preeminent position is that America’s political economy—its fiscal policy, its monetary policy, and the actions of its private balance sheets—takes ample advantage of America’s dominant position. They exploit exorbitant privilege to basically produce lots of dollars. So, as much in demand as the dollar is, you could count on the American credit system and its policymakers to liberally provide it. And that, in a sense, is what keeps it in this equilibrium.

So it’s strong, not in the naive sense of being more expensive or always at a certain value. It’s strong in the sense that it’s where you come back to always. You can’t really go anywhere else. It’s that image of strength, like, “I’ve got you. There’s going to be dollar credit.” This is what the Fed has said again and again and again to global markets: “I don’t care what pickle you’re in. We’re not going to ask too much about moral hazard. We understand the system has to keep on going.” And so at crucial moments the dollar will be there.