American outperformance in the global economy

One underdiscussed economic development following the shocks of the pandemic has been the outperformance of the U.S. economy compared with its G7 peers.

Over the past eight quarters, the American economy has grown at a 2.9% annualized pace and is on track to grow at or above 3% in the third quarter. This growth comes in an economy operating at full employment and price stability, consistent with the Federal Reserve’s dual mandates.

Taking into account foreign capital inflows, growth in the third quarter may exceed our forecast of 2.1%.

After the trade war and the pandemic and, now, with the war in Ukraine, few would have expected the economy to be so strong.

In fact, U.S. real gross domestic product through the second quarter was 2.3% higher than projections made by the nonpartisan Congressional Budget Office before the pandemic in January 2020.

Consider how other developed economies are faring. Real GDP in the second quarter was 8.7% higher in the U.S. than at the end of 2019 compared to growth in:

• Canada (5.5%)
• France (3.7%)
• Italy (3.3%)
• UK (2.9%)
• European Union (1.9%)

Germany’s real GDP is 2% lower now than in 2019. Japan’s GDP is 2.2% lower and China’s economy is ensnared in a multiyear deleveraging process.

This success of the U.S. economy can be traced to bold monetary and fiscal policies that have hardened supply chains, bolstered energy independence and started the rebuild of the nation’s infrastructure.

And there is reason to think that U.S. growth will continue.

The integration of sophisticated technology into business operations, robust market development, and the decision to increase immigration to replenish an aging workforce are all playing a part.

In addition, the intellectual, institutional and financial advantages of the American economy should allow the U.S. to compete and prosper.

This is nothing new. Over the past 75 years, the U.S. economy has shown that it fosters growth among our trading partners, which in turn benefits Americans.

Time after time, the U.S. has brought the global economy back to life after recessionary shocks. In this latest episode, we again see the U.S. first out of the gate as the global economy adjusts to the conditions of the post-pandemic era.

In the sections that follow, we look at the data that underlies the success of the U.S. economy. 

To the question of how the U.S. can grow so fast even as hiring slows, the answer is productivity. With productivity increasing at 2.7% year over year, the American economy is experiencing its best gains since the personal computer boom from 1995 to 2004.

That is why wages are rising above inflation, corporate earnings and profits are increasing, and the U.S. continues to outperform its peers.

It’s all a result of smart decisions after the pandemic, which increased supplies across the economy and encouraged long-term investments that integrate sophisticated technology into the commercial sector and everyday life.

The result has been a virtuous cycle, where rising productivity brings improved living standards for American households and rising profits among U.S. businesses.

Consider American incomes in the post-pandemic recovery. Since 2020, gross national income per capita in the U.S. has surged compared to other major economies.

While gross national income per capita among member nations in the Organisation for Economic Co-operation and Development increased by 5.1% per year during the recovery from 2021 to 2023, U.S. income grew by 7.5% per year.

Contributors to that rise do not include the efficiencies artificial intelligence and quantum computing are expected to provide.

Innovation

Global competitiveness today is less about labor costs and more about knowledge and skills embodied in the labor force.

Around 70% of the gap in per capita GDP between the U.S. and the European Union can be explained by lower productivity in the EU, according to an analysis by the World Intellectual Property Organization.

On a per capita basis, real disposable income has grown almost twice as much in the U.S. as in the EU since 2000.

This is where industrial policy has kicked in. The Inflation Reduction Act in 2022 and the EU’s Net-Zero Industry Act in 2023 have sparked significant planned investment in green technologies.

The director of the World Intellectual Property Organization sees two promising innovation waves across economies and societies:

• Digital innovation, built on artificial intelligence, supercomputing and automation
• Deep science innovation, based on biotechnologies and nanotechnologies

Corporate spending on research and development is poised to exceed $1 trillion, with information and communication technology as the primary driver. 

Capital flows

The U.S. economy is clearly an attractive target for foreign investors. Foreign capital invested in U.S. securities from July 2023 to June 2024 nearly matched the combined total for the 12 economies that attracted the next highest investment.

Investments in debt and equities are referred to as portfolio flows, as opposed to foreign direct investment, which is defined as the purchase of at least 10% of the equity shares of a corporation.

Investment has become an international proposition, which is the primary reason to insist on consistent U.S. governance. Without the 100% surety that the government and private issuers of debt will guarantee repayment, the intrinsic value of the dollar and dollar-denominated securities would be subject to the same risk as junk bonds.

To that point, portfolio flows into and out of the United States have become subject to business cycle effects, particularly since the 2008−09 financial crisis.

After the financial crisis, portfolio flows recovered, only to drop again during the fiscal austerity of 2010 to 2012. Foreign investors preferred holding cash, with the risk of a collapse of the U.S. economy outweighing the return on near-zero interest rates.

Similar episodes were brought on by the 2014−15 oil price collapse and mini-recession, the 2018−19 trade war, and the 2022−24 monetary policy tightening.

U.S. portfolio investment outflows follow the same pattern, with domestic investors preferring to hold on to their cash during a crisis, particularly during the era of extremely low interest rates.

Both inflows and outflows of portfolio capital have surged in the aftermath of the 2022−23 inflation shock.

This latest spike attests to the attractiveness of U.S. Treasury bonds, which are yielding significantly more than foreign bonds—and, in particular, U.S. investment-grade corporate bonds, which are yielding 170 basis points over 10-year Treasury bonds.

Those yields will be augmented by currency returns, given the strength of the U.S. economy and the likely continued strength of the dollar.

Whether this continues is likely to depend on the potential for further government dysfunction and geopolitical shocks. The severity of those disruptions would influence whether investors hold on to cash or invest in securities, which carry the risk of default.

Benefits of capital flows

A paper by the International Monetary Fund finds that the free flow of capital among nations allows for a more efficient global allocation of resources, by letting capital move from where it is less productive to where it is more productive.

This benefit explains why loose talk around dollar devaluation and capital controls is an economic and financial nonstarter.

The paper continues that capital flows can lower financing costs, incentivize technology upgrades, improve the allocation of resources across firms, and improve efficiency in production, all of which boosts productivity.

Foreign direct investment tends to boost efficiency in production through technology transfer, greater innovation and increased competition, while contributing to greater resilience of enterprises during crises.

Finally, capital flows also permit greater risk-sharing among countries, allowing them to smooth consumption through international borrowing and lending.

There are potential drawbacks, however, when money moves out of countries where it is most needed to countries experiencing rapid growth.

Finally, the wide gap between U.S. and European portfolio inflows is most likely because of the role of banks in Europe’s financing.

While U.S. corporations issue debt in the very liquid U.S. corporate bond market, Europe’s corporate financing has traditionally been via bank loans. U.S. corporate debt recently issued at substantially higher interest rates than those available in Europe has become that much more attractive to investors.

Foreign direct investment

The U.S. has become the most popular destination for foreign direct investment, moving ahead of financial centers that have traditionally dominated the cross-border flow of investment.

For decades, the U.S. trailed financial havens like Bermuda and the Cayman Islands when it came to FDI. An IMF analysis said that much of the category is made up of “purely financial investments with little to no link to the real economy.”

But even as offshore financial centers remain a major player for that capital, established economies like the U.S. and China are attracting an increasing share.

We see the increase in FDI as emblematic of the fundamental strength of the United States.

Investments from the Netherlands, Japan, Canada and the UK each account for 12% to 13% of FDI flows into the U.S. Roughly 41% of total FDI is going to manufacturing, of which 34% goes to chemical manufacturing. 

As for U.S. outbound FDI, the European Union accounts for 39% of that total. The financial centers in the UK and the EU account for the bulk of total U.S. outbound FDI.

International investment

The increase in equity prices and the strength of the dollar have inflated the value of foreign investment in the U.S. economy, helping to push the country’s net international investment position from negative $19.9 trillion at the end of last year to negative $22.5 trillion as of the second quarter.

The net international investment position of the U.S. is defined as the difference between the accumulated value of U.S.-owned financial assets in other countries and U.S. liabilities to residents of other countries.

As of the second quarter, U.S. investors are holding $36 trillion in foreign assets. Foreign investors are holding $58 trillion in U.S. assets.

The latter needs to be viewed in the context of U.S. total wealth, which reached $181 trillion through June 30.

It makes sense that foreigners are increasing their holdings of U.S. assets. Quite simply, the U.S. economy is offering higher rates of return.

The U.S. economy is attracting foreign capital such that its net international investment position is 10 times the liabilities of the UK and Brazil, its nearest competitors for foreign funds.

External capital flows into the U.S. are an important substitute for a lack of domestic savings, and help meet critical investment needs.

It also makes sense that the UK increased its liabilities from $68.2 billion in 2018 to $1 trillion last year. As a major financial center, London facilitates the moving of money and continues to attract capital from around the world even after Brexit.  

Also notable among the developed economies, Japan, Germany, China, Norway and Canada are the largest exporters of capital, with Japan traditionally the largest holder of U.S. debt.

As of the second quarter, foreign investors own $12.9 trillion in long-term U.S. bonds, which include $7.1 trillion in Treasury notes and $5.8 trillion in other bonds like higher-yielding corporate notes.

The dollar’s decade

We consider the dollar’s strength to be generational, based on trends in capital flows, the U.S. public sector’s investment in infrastructure and the private sector’s investment in productivity.

These long-term trends will of course be subject to short-term disruptions and trading. Nevertheless, long-term investments in technology are what ultimately move the economy and investment flows, as well as the demand for currencies.

Trading in the pound and the euro has flattened out, with trading now centered on their five-year averages of $1.29 per pound and $1.11 per euro.

Because the strength of the dollar augments the returns on higher-yielding dollar-based securities, and as long as the U.S. expansion continues to exceed growth in the UK and Europe, we can expect the pound and the euro to trade sideways compared with the dollar.

The takeaway

Monetary and fiscal authorities have engineered a soft landing for the U.S. economy after a series of shocks.  

The U.S. economy is outperforming in growth and employment, and in controlling inflation. It’s a remarkable policy achievement.

Because of technology investments made when interest rates were low, we see the U.S. economy entering a period of productivity-driven growth, alongside our trading partners with developed economies.

Those who recognize the significance of this achievement—and have the skill to manage the risks around the outlook and make critical investments—will be the winners.