Viewpoints

When the Balances Stop Balancing

In the global economy, nothing ever balances itself — it must be balanced. And the tool we use to understand that process is the financial balances identity:

(Private Sector Balance) + (Government Balance) + (Current Account Balance) = 0

This deceptively simple equation reminds us that the financial positions of households, businesses, governments, and the rest of the world are always interlinked — one sector’s deficit must be matched by a surplus elsewhere. But when policies distort trade and capital flows, they don’t eliminate this identity. They just shift the burden of adjustment — often suddenly and painfully — to another part of the system.

We’re now entering such a phase. As we explored in a previous piece (see the bond market and productivity), the global economy is confronting overlapping questions about how — and where — capital will be absorbed. That blog argued that it’s not simply a question of whether savings adjust (they must), but rather what mix of prices, policies, and expectations will force that adjustment — particularly as governments and firms simultaneously reach for the same pool of private capital to fund deficits and an AI-driven capex surge.

These concerns sit at the heart of what this next piece explores. Around the world, governments are pulling financial levers in conflicting directions. The United States is simultaneously contemplating financial transaction taxes, introducing punitive investment measures, and expanding fiscal deficits. Europe is loosening its purse strings in the name of strategic autonomy, while fast-tracking plans for a Savings and Investment Union that would re-anchor more capital within its borders. And China, still deeply mercantilist, is doubling down on export-led growth, capital controls, and state-directed investment — while keeping domestic consumption artificially suppressed.

Overlaying all this is a sharp resurgence in protectionist trade policy, with the United States now imposing tariffs across a wide swathe of imports. These frictions are not just policy noise — they are tearing at the global capital recycling mechanisms that once allowed persistent imbalances to be absorbed without systemic rupture.

As we wrote last time, markets may be pricing in an AI-led productivity renaissance — but if that narrative falters or is undercut by misaligned financial flows, the repricing could be swift and severe. And here’s the real concern: the fragile scaffolding that once allowed the world to function with these imbalances is now being dismantled — leaving a system where capital is needed in one place, unwanted in another, and increasingly blocked from flowing freely.

The United States Closes the Financial Tap

Suppose the US implements a tax on financial transactions or introduces new restrictions on foreign portfolio investment. This would mark a sharp reversal from decades of financial openness, fundamentally challenging the US model of attracting global capital to fund persistent fiscal and current account deficits.

Recent policy proposals, including those under the so-called "Big Beautiful Budget" clause and Section 899 of the Internal Revenue Code, point to a new willingness to weaponize financial channels. Section 899 allows for punitive taxation—so-called "revenge taxes"—on investors from countries deemed to have imposed discriminatory measures against the US. These steps create uncertainty for foreign capital and increase the risk premium on US assets.

If capital inflows shrink, the identity demands that either: • The current account deficit shrinks (via export gains or import compression), • The government deficit shrinks (unlikely given current policy), or • The private sector saves more than it invests.

This would strain the US economy. The dollar would likely weaken. Treasuries might lose some of their safe haven appeal, especially if yields rise to compensate for reduced foreign demand. Liquidity premia would widen. The US could no longer rely on the rest of the world to finance its deficits cheaply and reliably.

US Fiscal Expansion Without Financing

Now consider a parallel development: a renewed US fiscal expansion driven by tax cuts and defence spending. The federal deficit widens further. But with capital inflows potentially constrained, the private sector—households and corporations—must absorb the gap.

This creates a contradiction. Expansionary fiscal policy often tends to reduce household saving (more income, more consumption) and encourages firms to invest. But the financial balances identity demands the opposite: that the private sector save more to offset government dissaving and a flat or shrinking current account.

If private savings don’t rise, interest rates must. The result: pressure on equity and bond markets, and a risk that the US enters a cycle of high borrowing costs just as its productive potential hinges on long-term investment.

Vietnam’s economy has made impressive strides and is now nearly a third larger than it was on the eve of the pandemic. In 2024, it grew just above its potential rate—7% versus a 10-year pre-pandemic average of 6.5% per annum. That said, the best may be behind it. In Q1 2025, growth moderated to 6.9% year-on-year, down from 7.6%, with consumption, investment, exports, and imports—an important lead indicator of domestic demand—all softening.

Milton Friedman taught us that when it comes to evaluating the stance of monetary policy, look at monetary quantities, not the level of interest rates. A given level of federal funds rate can represent a tight monetary policy if the demand for credit is weak. In this case we would expect to see a relatively low rate of growth in bank credit. Similarly, that same level of the federal funds rate can represent an easy monetary policy if the demand for credit is strong. In this case we would expect to see a relatively high rate of growth in bank credit.

The federal funds rate has been at a level of 4.33% since December 25, 2024. Yet, as can be seen in the chart below, growth in bank credit has increased significantly. In the 13 weeks ended May 21, 2025, the annualized growth in bank credit was 7.9%, the highest since mid-August 2022. Adjusted for consumer inflation, today’s 7.9% growth in bank credit is higher than it was in August 2022.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in April were rather soft. In the one-month changes, Nevada’s fairly modest .55 percent increase was the largest, with Indiana the only other state with a gain higher than .5 percent. 12 states showed declines; all except Arkansas were in the Northeast and Middle West. Massachusetts had the largest decline (.47 percent). Over the three months ending in April seven states were down (again, all except Arkansas in the Northeast and Middle West), with Massachusetts on the bottom (down .67 percent) here as well. West Virginia’s 1.54 percent was the largest gain, while 9 other states had increases above 1 percent. Over the last twelve months, Iowa and Michigan were down, and eight others saw increases of less than one percent. No state had an increase higher than four percent (Utah was up 3.55 percent), and only three were at or higher than three percent.

The independently estimated national estimates of growth over the last three and twelve months were, respectively, .46 and 2.34 percent. Both measures appear to be a bit weaker than the state numbers would have suggested.

In Kevin Gaynor’s last post (see Crowding Out) he argued that fears of public borrowing crowding out private investment—particularly the surge in AI-driven capex—were likely misplaced. The real challenge is not whether savings will adjust—they must, by definition—but rather what shifts in prices, policy, or expectations will be required to expand household savings sufficiently to finance both government and corporate borrowing. In a world where global capital no longer flows as freely, that adjustment process becomes central.

There is also a deeper and more consequential issue lurking beneath these concerns: will the recent wave of AI-related investment actually deliver the productivity renaissance that markets now seem to be pricing in? The recent rally in equity markets—led by tech and infrastructure names—has been powered as much by narrative as by numbers, with investors embracing a vision of AI that promises to transform corporate efficiency and unlock a new era of structurally higher trend growth.

• Rising real yields reflect structural shifts: Long-end yields are climbing not just due to inflation fears but rising real rates, suggesting expectations of stronger trend growth, higher risk premia, or tighter global capital supply.

• Surge in capex demand: A coming wave of AI-driven investment, especially in the U.S., could significantly boost corporate capex, mirroring the dot-com boom and pushing the corporate sector into a net borrowing position again.

• Large fiscal deficits projected in most major economies: It’s not just a US story: China running an 8% government deficit through to 2030, and worsening budget positions in Germany and Japan.

• Global savings-investment imbalance tightening: Post-GFC changes, like reduced capital mobility, mean countries are increasingly reliant on domestic savings to fund investment and deficits—requiring higher interest rates.

• Sustained higher equilibrium rates likely: With large fiscal deficits across major economies and higher private investment needs, the bond market may be signaling a long-term rise in equilibrium interest rates (r*), ending the era of cheap money.

For better or worse markets had (more Trump trade headlines as I write) substantially reduced estimates for a recession this year. Betting markets have reflected the same sentiment. Our own measure of cross market implied growth has recovered smartly pushing implied vols back down in many markets.

But across all major markets back end yields have continued to trend higher - a process that began post Covid, paused for a bit and then started again last year before accelerating over recent weeks.

April saw little change in state labor markets. Five states saw statistically significant gains in jobs in March, with none larger than .4 percent. Texas’s .3 percentage point gain amounted to 37,700 jobs. A number of states had insignificant declines.

Four states (DC, Iowa, Massachusetts, and Virginia) had statistically significant increases in their unemployment rates, with DC and Massachusetts up .2 percentage points and Iowa and Virginia up .1 percentage point. Nevada’s rate fell .1 percentage point and Indiana was down .2. The highest unemployment rates were in DC (5.8%), Nevada (5.6%), Michigan (5.5%) California (5.3%), and Kentucky (5.2%). Hawaii, Montana, North Dakota, South Dakota, and Vermont had unemployment rates under 3.0%, while South Dakota’s 1.8% was yet again the lowest in the nation.

Puerto Rico’s unemployment rate was again unchanged at 5.3% and the island’s job count moved up by 1,100.

Geopolitics, AI, and the New Digital Divide In the final part of this series, we turn from the physical and technological constraints on growth to the geopolitical ones. Part I highlighted structural headwinds in the world’s labor, capital, and energy markets. Part II explored the potential of AI to act as a macro workaround—while warning that it is not immune to physical limits, particularly energy. Part III brings these threads together: AI is not just a labor-saving innovation or a capital redeployment tool. It is increasingly becoming a geostrategic asset—one whose deployment depends heavily on energy availability, infrastructure, and political control.

1. AI as a Tool of Statecraft What oil was to 20th-century power, processing power is becoming in the 21st. Nations are now racing to dominate the AI value chain—from chip design and fabrication, to data access, to the energy systems needed to power high-performance computing. Export controls, industrial policy, and national security reviews are no longer confined to oil tankers and pipelines—they now apply to GPUs and data centers.

The result is a world increasingly defined not by technological openness, but by fragmentation. From Trump's protectionist agenda—including tightened semiconductor export controls—to the strategic ambitions of the US CHIPS Act under the previous administration, and China’s intensified homegrown AI efforts, digital sovereignty has become an explicit geopolitical objective. The once-celebrated ideal of borderless innovation is yielding rapidly to a harsher reality: national power now hinges increasingly on digital dominance and technological self-reliance.

2. The Energy Arms Race Beneath the Silicon If the second in this series taught us anything, it’s that AI is not ethereal—it’s physical. It runs on electricity, minerals, and metals. It demands stable grids, high-capacity cooling, and energy infrastructure on a scale few countries currently possess. AI isn’t just compute-intensive. It’s energy-intensive. And that shifts the locus of global competition. The new AI geopolitics is not just a chip race. It is quite literally a power race. Countries that control abundant, cheap, and low-carbon energy will gain a disproportionate advantage in AI scalability. Those that don’t, risk falling behind, regardless of their tech ambitions.

As such, energy security is fast becoming the ultimate gating factor in the AI revolution. Just as the post-WTO growth boom in the 2000s was fueled by a surge in real energy consumption and prices, the AI boom may repeat that pattern—only faster, and more unevenly distributed.