Trump’s Achilles’ Heel
First, some background. For many years, the United States has run large deficits on both its current account and its public finances. These deficits must be financed by substantial inflows of foreign capital. If this inflow proves insufficient, two effects occur: the US dollar depreciates and US interest rates rise.
Under normal circumstances, financing these so-called “twin deficits” does not pose a major problem for the United States. This is because the dollar serves as the world’s reserve currency and the US economy generally grows faster than most others. As a result, relatively high returns can be achieved in the US. This explains why the United States has been able for many years to sustain large current-account and fiscal deficits without significant difficulty.
The next step is to examine the situation in Europe and many other countries. If President Trump has made one thing clear, it is that European countries must become far more self-reliant militarily and in many other areas. Support from the United States will be sharply reduced, if not withdrawn altogether.
This comes at a highly inconvenient moment for Europe, as a war is ongoing between Russia and Ukraine. Ukraine requires support across many dimensions, which is extremely costly. In addition, defence spending must be increased substantially now that the US intends to scale back its contribution to European security.
Even this alone represents a major strain on European public finances. However, this is far from the whole picture. Europe is also being hit hard by population ageing. The number of people in employment is declining relative to the number of non-working dependents. This drives higher expenditure on healthcare, rising medical costs, and pensions—items that weigh heavily on government budgets—while tax revenues come under increasing pressure.
Moreover, it is unavoidable that significantly more resources must be allocated to combating climate change. Taken together, these factors place a heavy burden on public finances, which in most European countries are already in poor shape.
The first response is typically austerity. However, given that interest rates are now clearly above previous levels and are more likely to rise than fall, spending cuts alone are insufficient. Interest expenses are increasing rapidly.
This implies that tax revenues must be increased. As a result, governments everywhere are exploring whether tax rates can be raised further. The problem is that this approach has been pursued for so long that the tax burden has reached a level where additional increases are likely to generate more disadvantages than benefits.
As a result, the only apparent option left for governments is to take on additional debt. Given the rapidly deteriorating state of public finances, however, this option is limited. At some point, investors lose confidence and interest rates surge, worsening the situation even further.
It therefore appears that Europe could reach a point of policy gridlock. This may lead to increased capital flows into the United States. At first glance, this might suggest that there is “no problem at all” for the US. Yet there are two ways in which this dynamic could turn out differently.
First, Trump has shown little regard for national or international rules and laws. He is willing to act aggressively against opponents, both domestically and abroad, and appears to be concentrating power increasingly in his own hands. This places large capital holders outside the US in a difficult position. While returns in the United States are relatively attractive, how certain can foreign investors be that their assets will not be frozen or even confiscated if tensions escalate?
There is also another risk. Trump is attempting to exert greater influence over the Federal Reserve and pressure it into cutting interest rates further. Under current conditions, this would effectively amount to pursuing an inflationary policy.
The question is whether these risks may ultimately outweigh the higher returns.
As far as the latter point is concerned, there is little reason to fear that Europe will adopt an inflationary policy in the near term. Klaas Knot is widely expected to succeed Ms Lagarde as President of the ECB, and he is not known as a proponent of such an approach. At the same time, the European economy and public finances are in weak condition, making it unlikely that the ECB will act as a “saviour” in the short term.
Paradoxically, this very precarious situation is forcing Europe to take constructive steps, such as deeper cooperation and reforms to economic rules and legislation that create more room for entrepreneurship. As a result, Europe’s medium-term prospects could improve significantly.
Conclusion
Policies pursued by the Trump administration are increasingly prompting large international capital holders to turn away from the United States, while Europe’s outlook appears to be improving. It therefore seems likely that international capital flows will gradually shift from the US toward Europe.
This could be highly beneficial for Europe, but detrimental for the United States. For the US, it would mean higher interest rates, potentially triggering sharp declines in real estate and equity markets. The question is whether Trump will recognise this risk in time to reverse the trend.
