One of the more underdiscussed economic developments following the shocks of the pandemic has been the outperformance of the United States economy compared with its G-7 peers.
This success of the U.S. economy can be traced to bold monetary and fiscal policies that have positioned the U.S. for continued growth.
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.
Once one also takes into account foreign capital inflows, there is a chance that growth in the third quarter will exceed our forecast of 2.1%.
After the trade war, the pandemic and, now, the war in Ukraine, few would have expected the economy to so strong.
In fact, U.S. real gross domestic product through the second quarter is 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 is 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 2.0% 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 the business operations, robust market development and the decision to increase immigration to replenish an otherwise aging workforce all are 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 underlie the success of the U.S. economy.
The productivity boom
If one asks 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 that 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 improving living standards for American households and rising profits among U.S. businesses.
Consider Americans’ incomes in the post-pandemic recovery. Gross national income per capita in the U.S. since 2020 is surging compared to other major economies.
While gross national income per capita among nations in the Organization for Economic Cooperation and Development increased by 5.1% per year during the recovery from 2021 to 2023, U.S. income grew by 7.5% per year.
That rise does not include the efficiencies that will occur because of artificial intelligence and quantum computing that lie ahead.
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 European Union since 2000.
This is where industrial policy has kicked in. The Inflation Reduction Act in 2022 and the European Union’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.
Spending on corporate research and development is poised to exceed $1 trillion, with information and communication technology as the primary drivers.
Capital flows
The attractiveness of investing in the U.S. economy is evidenced by the sum of foreign capital invested in U.S. securities being greater than the sum of foreign capital invested in the next 12 economies.
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 the consistency of 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 will 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 financial crisis.
After the financial crisis, portfolio flows recovered only to drop again during the fiscal austerity from 2010 to 2012. Foreign investors preferred holding cash, with the risk of a collapse of the U.S. economy greater than the return of near-zero interest rates.
Read more of RSM’s insights on the American economy and the middle market.
There were similar episodes brought on by the oil-price collapse and 2014-15 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 onto 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 that are yielding significantly more than foreign bonds, and, in particular, U.S. investment-grade corporate bonds that 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 likelihood of continued dollar strength.
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 held onto cash or invest in securities, which carry the risk of default.
Benefits of capital flows
An IMF paper 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.
Such benefits are all the more reason why loose talk around dollar devaluation and capital controls are economic and financial non-starters.
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, and greater innovation and competition, while contributing to greater resilience of enterprises during crises.
Finally, capital flows also permit greater risk-sharing among countries, allowing countries to smooth consumption through international borrowing and lending.
There are potential drawbacks, however, with money leaving countries where it is most needed to countries that are experiencing rapid growth.
Finally, we should mention that 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. In this latest episode, U.S. corporate debt issued at substantially higher interest rates than Europe has become that much more attractive to investors.
Foreign direct investment
The U.S. has become the largest 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 foreign direct investment. An International Monetary Fund 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 United States 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 U.K. 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 U.K and the E.U. 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 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 is defined as the difference between 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 of foreign assets. Foreign investors are holding $58 trillion of U.S. assets.
The latter needs to be put in the context of U.S. total wealth, which reached $181 trillion though 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 the U.S. net international investment position is 10 times the liabilities of the U.K. 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 in the process they help meet critical investment needs.
It also makes sense for the U.K. to have increased its liabilities from $68.2 billion in 2018 to $1 trillion last year. London is a major financial center, which 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 of 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 and the U.S. public sector’s investment in its 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 $1.31 per pound and $1.09 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 U.K. 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, without causing the economy to fall into an extended period of slow growth or outright recession. It’s a remarkable policy achievement.
Because of investments in technology that were taken when interest rates were low, we see the U.S. economy entering a period of productivity-driven growth that should continue along with our trading partners among the developed economies.
Those who recognize the significance of this achievement and who have the skill to manage the risks around the outlook and make critical investments will be the winners.
