The Financial Gulf Stream Is Nearing a Tipping Point
For decades, the global economy rested on a financial arrangement that allowed the United States to borrow cheaply and absorb much of the world’s surplus output. But that system is beginning to come undone amid escalating geopolitical tensions and growing doubts about US policy stability.
Giancarlo Corsetti
FLORENCE – For decades, the global economy has been carried along by a financial equivalent of the Gulf Stream.
Originating in the United States, it has pushed financial flows outward, like warm water at the ocean’s surface, sustaining America’s voracious demand for goods and services.
Those goods are produced elsewhere and move back through global supply chains, mirroring the colder currents running in the opposite direction.
This financial Gulf Stream took shape in the 1990s and gathered strength for two decades, then flattened after the 2008-09 global financial crisis.
Today, much like its namesake, there are signs that it may be approaching a tipping point.
Chart 1, which overlays America’s external balances on a map of global ocean currents, helps illustrate this shift.
The image, widely circulated among economists, is deceptively simple: a smooth orange line traces the rise of US current-account deficits, capturing the ongoing export of financial wealth in exchange for goods and services produced abroad.
As with ocean circulation, the outward flow of financial assets is matched by a countercurrent of goods moving through global production networks and trade routes, carrying intermediate and final products across borders and ultimately delivering a large net inflow back into the US.
From the 1990s through the late 2000s, the financial Gulf Stream steadily created room for foreign economies to pursue export-led growth, invest in new technologies, and build industrial capacity.
The stream has slowed since then, but it continues to finance America’s absorption of the world’s surplus output.
The chart’s light green line shows how US net foreign assets have evolved over time.
Unlike the orange line, which shows borrowing alone, this measure also captures gains and losses driven by swings in asset prices and exchange rates.
In effect, it combines cumulative current-account deficits with changes in the market value of US foreign assets and liabilities, represented by the dark green line.
Comparing the dark green and orange lines reveals a striking pattern.
Before the 2008 crisis, the US was borrowing more, yet its overall position still improved because gains on overseas investments outweighed losses on its debts.
After the crisis, those valuation effects faded but continued to offset the buildup of net external liabilities.
That dynamic changed after 2016, as valuation effects began to work against the US, steadily eroding net foreign wealth and, by 2020, leaving it worse off.
With that reversal, the financial Gulf Stream entered a new phase.
From the 1990s through 2008, the US was able to buy goods and services from the rest of the world on credit without a commensurate rise in its debt-service costs.
Large current-account deficits fueled demand by American households, firms, and government agencies, while favorable valuation effects eased the burden of servicing that debt.
Once those valuation gains disappeared, however, borrowing costs began to rise.
Consequently, the financial Gulf Stream weakened, and the growth of cumulative current-account deficits slowed markedly.
Losing Faith in America
What explains this remarkable turnaround?
One answer lies in the changing role of dollar-denominated assets.
For decades, investors were willing to accept lower returns in exchange for these assets’ safety, liquidity, and ease of use – the “convenience yield” – which allowed the US to borrow more cheaply than other countries.
While that advantage endured well into the 2010s, it has since largely vanished for all but short-term instruments.
Yet the convenience yield’s erosion also reflects a broader shift in sentiment.
Increasingly, investors see the US as a riskier long-term bet than they once did, especially compared with other advanced economies.
Why that perception has changed, and whether it is warranted, remains the subject of fierce debate.
To be sure, US equities have vastly outperformed their foreign counterparts over the past two decades, owing to the innovation, scale, and market power of American firms.
But the US equity premium cannot be explained by performance alone, since a significant portion of it was priced in well in advance, reflecting compensation for risk rather than unexpected gains.
This shift has had two major consequences.
As US stocks grew more attractive, foreign investors poured into American markets, raising their share of US equities to roughly 20% (Chart 2).
At the same time, greater foreign ownership has changed how market gains affect the external balance.
Until the mid-2010s, American investors owned more equity abroad than foreign investors did in US stocks.
That balance has since flipped, with foreign investors owning roughly 50% more equity in the US than Americans own overseas.
As a result, when US stocks perform strongly, the country’s net foreign position deteriorates, because rising share prices increasingly send capital gains abroad.
Bond markets tell a similar story.
Even as foreign private investors increased their exposure to American equities, holdings of US government-backed and corporate bonds fell sharply after the 2008 financial crisis and then leveled off.
Demand for Treasuries proved more resilient, but also began to decline by the mid-2010s.
Similarly, currency investors no longer seem confident that the dollar will appreciate during global crises.
International portfolios remain heavily exposed to the greenback – there are few viable substitutes for its liquidity – but that exposure is increasingly hedged through derivatives.
A Risky America Is Still Attractive – for Now
Although the global financial landscape is increasingly shaped by opposing forces pulling in different directions, the US remains a powerful magnet for international capital, as the prospect of earning a sizable equity premium continues to attract foreign investors.
For Europe, this has meant sustained outward investment, driven not only by the appeal of US assets but also by structural challenges such as aging populations, stagnant growth, and uncertainty about the continent’s productive base in the face of American and Chinese competition.
Without real progress toward a fully functioning single market and a genuine savings and investment union, these pressures are unlikely to ease.
China faces its own structural headwinds, including a rapidly aging population, persistently high savings, weak consumption, and deflationary pressures fueled by the collapse of its housing bubble.
These challenges promise to impede further the country’s long-delayed transition away from export-led growth toward domestic demand.
On the US side, despite repeated promises to revive domestic manufacturing, President Donald Trump’s economic policies have not significantly reduced reliance on foreign capital or imports.
The US remains deeply embedded in global markets, and international investors continue to buy stakes in American companies.
But how long will that remain true?
If anything, recent policy shifts in the US have fed investors’ perception of a “riskier America.”
The Trump administration’s efforts to shrink the external deficit through sweeping tariffs and abandon multilateralism in favor of a patchwork of bilateral trade deals are constantly testing investor confidence.
The demand to boost foreign direct investment in the US that typically accompanies these deals evokes the risk that political weaponization of economic relations will extend to capital markets.
What if new “Liberation Days” limit repatriation of profits by imposing extra taxes on income and capital gains of assets owned by foreign residents?
Similar concerns have arguably motivated governments around the world to diversify their international reserves, reducing holdings of dollar-denominated assets (a topic that merits a commentary of its own).
The elephant in the room is of course the US public debt.
Unlike past administrations that carefully avoided undermining confidence in US Treasuries, the Trump administration may be inclined to intervene if and when borrowing costs rise and remain elevated.
Even the prospect of higher taxes or administrative limits on capital movements may be enough to unsettle foreign investors and trigger a sudden reversal of capital flows.
At this point, fiscal sustainability is at stake in a gamble on the promise of an unprecedented AI-driven productivity boom, although the gains are unlikely to be evenly shared, deepening income and wealth inequality.
Will the rich agree to raise their contribution to the budget, sharing a small fraction of their gains?
Change of Course
As geopolitical tensions escalate and technological innovation accelerates, the period of relative stability that has defined the past few decades is coming to an end.
The future course of the financial Gulf Stream depends on forces that are impossible to predict.
The system may be edging closer to a tipping point.
We can only speculate about possible outcomes.
Given the high level of uncertainty and the trend in income and wealth distribution, safe-asset returns are poised to remain low or fall further.
This is not necessarily good news for governments around the world, as rising fiscal risk and inflation premia may drive up their borrowing costs at a time when the need to scale up defense commitments and tackle disaster risks is deteriorating their fiscal outlook.
Although the problem exists independently of the financial Gulf Stream, a sudden change in direction may further exacerbate it.
The ongoing fragmentation of the global economy into rival blocs not only threatens to weaken the foundations of international cooperation but also calls into question macroeconomic and fiscal stability.
In the absence of a new global geopolitical equilibrium, fragmentation of trade and production chains will increase the frequency and intensity of stagflationary supply shocks.
Such shocks will challenge the prevailing model of fiscal, monetary, and regulatory interactions.
Combined with high public debt, they may force advanced economies to tolerate spells of variable above-target inflation.
This would also raise the temptation to flirt, if only implicitly, with financial repression.
In this respect, it is crucial not to repeat the mistakes of the 1970s, when, like today, high fiscal costs of conflicts in the US and a crisis in international relations (underlying the decade’s oil shocks) resulted in a prolonged period of macroeconomic instability.
A key mistake would be to envision benefits from elevating walls around national borders and pursuing a course of aggressive non-cooperation.
Going down this path would ignore the simple fact that our economies are highly integrated, and policy cooperation is a pillar of domestic macroeconomic stability.
Concretely, some level of coordination is crucial in preventing and/or containing global inflationary and recessionary shocks.
Domestic and international stability are strictly interwoven, and global stability is a public good.
Like all metaphors, the financial Gulf Stream has its limits.
But it provides a useful way to understand the forces shaping today’s global economy.
A precipitous change in this current’s intensity or direction would simultaneously be a byproduct and a cause of far-reaching economic and geopolitical fractures.
It would clearly do more than rattle capital markets.
It would further push governments along paths that are ultimately damaging even from a strictly national perspective.
The global shock it would create might redraw the map of global economic power in ways that few are ready to confront, with the US, in particular, perceiving the large portfolio reshuffling as an unbearable challenge to its hegemonic status.
Giancarlo Corsetti is Pierre Werner Chair at the Robert Schuman Centre and Professor of Economics at the European University Institute.
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