Did capital outflows from the U.S. already start?

The likely effects of a self-imposed "sudden stop" of capital inflows.

Today’s column was unplanned, but spurred by listening to this morning’s 7:00 a.m., Bloomberg Surveillance (March 17, 2025) radio broadcast. In that broadcast, Tom Keene, interviews Mike Green with Simplified Asset Management about Mike’s statement: “money is moving back to Europe”.

I froze when I heard that and listened to the next minutes with baited breath. “Really, could it happen that fast?”, I wondered. “If so, I should write a short column explaining it and what other likely macroeconomic effects to watch for.”

Hence today’s column.

Short Reminder on Trade Deficits and Net Investment

I recently wrote an article explaining the link between trade deficits and net investment into an economy and trade surpluses and net investment flows out of an economy. The full article is here, but the main point is that you cannot both attract (net) investment into the USA and run trade surpluses. Net investment inflows finance things that are not yet produced and for which we do not yet have full capacity, and, therefore, those things - or the materials to make those things - must be imported, driving trade deficits, not surpluses.

As the Trump administration pushes the US to move from trade deficits to surpluses much harder and more seriously than ever before, I worry that this time they might actually succeed. So, I’ll comment on three likely effects of actual success in driving down trade deficits and potentially create surpluses: (1) net global investment flowing out of the United States (i.e., net financial capital outflows in economics lingo), (2) higher domestic interest rates, and (3) a decline/slowdown in GDP (i.e., a recession).

Please note that these are likely macroeconomic effects from actually shifting trade balances from deficit to surplus. The tool the Trump administration is using to achieve this happen to be tariffs, but this is not about the microeconomic effect of tariffs on costs, etc. Those tariffs, plus negotiations, and other pressures, should they all succeed, can drive deficits to surpluses. It’s the macro effects of that switch that I’m writing about today.

Normally, when we see this switch from trade deficits to surpluses happen in a relatively short period of time, it’s being caused by global investors suddenly becoming concerned with an economy or a region of the world and pulling investment out. That forces trade deficits¹ to switch dramatically to surpluses and leads to the effects I’ll discuss. This type of crisis is known in global macroeconomic circles as a “sudden stop” crisis, first termed by Prof. Guillermo Calvo in 1998 (links to some readings at the end of this column) based on what he says is an old banker’s adage: “it’s not the fall that kills, it’s the sudden stop”.

I must also confess here that I believed Trump’s desire for a growing economy would temper his administration’s tariff-raising plans. It means, my hopeful guess in my column “Thinking Through Trump Tariffs” (November 2024) was sadly wrong.

Notes from The Bloomberg Interview

Here is what Mike Green said on Bloomberg. I’ve tried to quote 100% accurately.

“One of the things we have clearly seen is that European and rest of world investment into the United States primarily to access the MAG 7, but honestly, increasingly through things like passive total market allocations, has been invested in the United States. Now that Europe has to bring that money home, we actually are starting to see the first signs of, you know, what we have always talked about as financial repression which is directed return of assets.

You’ve seen pension plans in the UK encouraged to bring more assets home. You’re seeing headlines of, you know, French banks buying into strategic waste water and, uh, treatment in their own country. This is causing the dollar to sell off as that money comes back and is converted to Euros and it’s also causing US assets to sell off.”

The Bloomberg conversation continued with a focus on the effects on the US stock market since the show is primarily for investors. Mr. Green’s comments were essentially that the effect will depend on which US investments get unwound and which sectors or companies are affected.

If everything he said is accurate, then we are seeing this re-alignment happen way sooner than I would have expected and we are watching it in real time. Very interesting to me as an academic and researcher, but very troubling for me as a member of the US and global economy.

Let me unpack Green’s comments and pre-emptively answer a few questions you might have:

1. For me, the key is investment funds flowing out of the USA. The rest are details that don’t concern me as a macroeconomist. If these investment outflows are real and significant - currently I consider Mr. Green’s comments troubling but anecdotal - then this is going to be bigger and likely more negative than I originally anticipated.

2. “Now that Europe has to bring that money home”. I don’t know why he said this. “has to” is strong. Is that for economic reasons, political reasons, …? I don’t know. He later argues that Europe and the rest of the world need those funds back from the US in order to finance their own reinvestment, for example in Europe, in domestic military and other things which they have to build up in this new world of withdrawing-US-support. Those seem like one-off cases. It’s not clear to me that they are large enough in scale to drive the macro trends I’m worrying about. But maybe. And maybe they are just the first warning signs. We need to watch.

3. I have no idea what “MAG 7” and “total passive market allocations” are. It’s irrelevant from my point of view as a macroeconomist. Again, the point for me is that funds are flowing out. The more finance/investment oriented reader might be interested in those details. I did Google them: passive investing and Mag 7.

4. Economists don’t call a directed return of assets “financial repression”², but okay. Let’s just call it “directed return of assets”. That’s the key anyway: reverse financial investment flows.

5. I’ll discuss the dollar part below.

The Three Likely Effects of a “Sudden Stop”

Let’s cover the three likely effects of actually suddenly reducing trade deficits or, worse, turning them into surpluses:

(1) Net global investment flowing out of the United States. This is the “sudden stop” we’re worried about and refers to the stop of net investment flows into the USA. I explained why this must occur in brief at the beginning of this column and at length in my last column (here). But it is the sudden stop that is the key driver of the subsequent points. If Mike Green is right, we are seeing this start now. I hope he’s wrong.

(2) Higher domestic interest rates. This happens for very simple supply and demand reasons in the US economy. #1 above comes about because Savings - Investments = Net Exports, or simply, S - I = NX. With a trade deficit, NX < 0, we have S < I. That is, domestically, our total savings is insufficient to finance our desired level of investment. Recall that the source of investment funds for companies comes from other people trying to save money. When NX goes from negative (S < I) to zero (S = I) or positive (S > I), one of three things can come about: Either I decreases or S increases or a little of both³.

• Case 1 “Decrease I and no or little domestic interest rate increase”: In this case, total investment in the United States would fall down to equal the amount of savings that domestic residents are willing to supply. That would mean that domestic interest rates would not need to change. But, let me say it again, this would mean a decline in the total amount of investment in the United States. The immediate impact of a drop in investment would be a decline in domestic demand for goods and services (part of the reason it reduces the trade deficit) and this would cause a recession. The long-term impact would be less capital formation which would mean fewer new businesses would be launched, there would be less expansion of domestic production capacity and less new research production. All those things would severely limit long-term US GDP growth.

• Case 2 “Increase S and a major increase in domestic interest rates”: In this case we would keep investment at the same high level in the United States as it is currently. To finance that, however, we would need to dramatically increase the total amount of savings which is the source of funds for investing.
  To see what would need to happen, think of your own, personal case. If you suddenly need to, say, double the amount you and your family save, you would either need to increase your income dramatically or dramatically decrease your spending. As both a person and as an economy, it’s nearly impossible to raise your income (i.e., GDP for an economy) dramatically. The only option, then, is really to decrease spending (i.e., aggregate consumption for an economy).

  In a free economy, the only way to convince private and free people to increase their savings dramatically is to increase the interest rates they earn on their savings. This means that raising savings up to the level of desired investment would require a severe increase in US domestic interest rates to encourage domestic residents to save much more. The immediate effect of this would be a dramatic drop in consumption which would drive a recession.

• Case 3 “A little of both and some increase in domestic interest rates”: It’s rare that these extreme cases (I moves alone or S moves alone) but I would expect some of each to happen. This means we would see some decline in investment and some increase in domestic savings and, hence, some increase in domestic interest rates. Both the drop in investment and the drop in consumption (to allow more savings) would still drive a recession in the short run and the drop in investment will lead to a decline in capital formation limiting GDP over time. Because the long-term effect comes from the drop in investment, it would be less of a negative effect in this case, but still negative.

(3) A likely decline/slowdown in GDP (i.e., a recession). I think this should be clear from point 2 above. Less investment and/or less consumption would cause a drop in aggregate demand today and drive a recession.

What About Effects on the US Dollar?

The effects on the US dollar come up regularly. Let me say that they are not clear.

Higher exports (EX) means more demand for US dollars and hence a stronger dollar. Foreigners importing US goods need to first buy US dollars in order to pay US exporters for their goods.

Higher imports (IM) means more demand for foreign currency and hence a weaker dollar. Just like foreigners buying our goods need our currency, when we buy their goods (imports) we demand their currency, driving up it’s value relative to dollars.

Trade balance (NX) effects… If our current trade war decreases exports because foreign countries also impose tariffs or the popularity of American products declines, then this will weaken the dollar. If we lower imports, then this will mean less demand for foreign currency relative to dollars and strengthen the dollar.

Notice, however, that we are reasoning by assuming EX or IM move exogenously, by force or magic or something, and then looking at the effect on the exchange rate. Doing just this suggests that, in Trump’s ideal world where exports rise and imports fall, we’d have a stronger US dollar.

But…and this is a bit BUT… these things do not happen in isolation and drive the dollar. This is all part of an organic whole, called a market, where everything is connected.

A stronger dollar also means that US exports are more expensive for foreigners to buy and therefore they buy less, lowering EX and worsening the trade deficit, EX - IM. And the stronger dollar means Americans suddenly find goods in foreign currencies cheaper and they therefore buy more of them, raising IM and worsening the trade deficit, EX - IM.

Finally, as net investments leave the USA and flow into other countries, investors must sell US dollars and buy foreign currency which will weaken the US dollar relative to other currencies. But the realignment of the domestic savings and investment market would raise interest rates and this makes investment in the US more valuable, not less, limiting the outflow and also raising the value of the dollar.

Therefore it is not clear at all to me what all this means for the US dollar. It will likely therefore mean more volatility as various aspects of this process play out in different ways and at different times.

Conclusion

Fundamentally, I do not believe the US government can move the US from trade deficits to trade surpluses via policy and free markets. That is not a prediction that we will move to more draconian measures. It is a claim that the ultimate goal of running US trade surpluses across the board will fail.

What is happening is that the administration’s ability to shrink deficits and move toward balance or surplus via policy, threats, foreign retaliation, lowering the popularity of American products abroad, and so on is larger and happening more quickly than I could have imagined. If Mr. Green is right, then we are seeing the first signs of this realignment, and it’s shocking that it’s happening so soon and clearly.

My hope is that it is anecdotal. My hope is that the end result is a reciprocal lowering of tariffs to avoid economic and political damage. And I hope that happens sooner rather than later. I am not in favor of higher tariffs. I think the focus on trade balances is absurd. But some higher tariffs and some lower domestic taxes would not be the end of the world.

Large and substantial swings in our trade balance can, and might already be, causing capital outflows and that, unfortunately, would have severe negative effects including a recession, higher US interest rates and slower long-run economic growth. That worries me. I will continue to watch for signs in the news.

Thank you for reading!

Some references for interested readers

• My International Economics course. We cover sudden stops in the first weeks of that class. All the effects I discussed above are here: https://www.chrisball.us/international-economics

• Professor Guillermo Calvo’s 1998 article on sudden stops. chrome-extension://efaidnbmnnnibpcajpcglclefindmkaj/https://www.tandfonline.com/doi/pdf/10.1080/15140326.1998.12040516. He’s written more on it, just Google his name and “sudden stops” and you’ll find stuff.

• You can also Google “sudden stops” or “sudden stops of capital inflows” or either of those and “IMF” and you’ll likely find tons of articles in the last 20 years. Sudden stops usually happen to economies for very bad reasons. The US case is different and I hope the negative effects would be less. Still not good, but hopefully less bad.

1. Technically it drives current account deficits to current account surpluses, but for most countries the current account is primarily driven by trade balances (CA = NX + interest owed or due on net international asset holdings). I’ll just use trade balances since people know what they are generally and it’s the focus of all the policy action and it’s 90% of the time moving with current accounts so I think the slight of hand here is fine. If I see a place it matters - which I can’t think of at the moment - I’ll point it out.

2. Economists use the term “financial repression” to refer to periods when government’s explicitly try to keep interest rates low to minimize their own debt burden costs. We saw this in the USA post WWII for example with laws that restricted interest rates and some (likely) intentional inflating away the real debt of the government.

3. For anyone with basic economic training, just draw a supply and demand diagram. Supply here is the supply of savings and demand is essentially an “investment” curve (i.e., firms demand people’s savings from them in order to invest them in their businesses). The “price” is actually “the” interest rate. Now, draw your diagram and put the interest rate below the equilibrium (market clearing) rate. You should have quantity supplied (S) < quantity demanded (I) and this difference is the trade deficit. To eliminate that gap you must either shift D leftward (Case 1) keeping the interest rate constant, or move up along the supply curve, increasing the quantity supplied (S) until interest rates rise to their market clearing level (Case 2). Or some of both (Case 3).