Could a capital war be the next big risk for the global economy?

Paul Diggle:

Hello and welcome to Macro Bytes, the economics and politics podcast from Aberdeen with me, Paul Diggle.

Luke Bartholomew:

Me, Luke Bartholomew.

Lizzy Galbraith:

And me, Lizzy Galbraith.

Paul Diggle: So today on the podcast, we are asking: could the trade war become a capital war? It's an increasing concern of financial markets and participants in markets that although over the past few months, trade and tariff concerns have moved somewhat onto the back burner as a driver of markets and the global macro, that as part of the broader structural trend towards higher trade barriers, a degree of breakdown in globalisation and the global trading system, that not just goods trade, but in time, potentially services trade, and capital and financial flows themselves, could become affected. And of course, services trade, capital flows are all important aspects of globalisation and global economic integration, just as goods flows are as well. So I think it's an important question. It's one that's become a bit more topical in markets recently, especially after Davos week, where one of many topics of conversation were this potential broadening of tariff and trade tensions into capital markets as well. And I'll maybe start us off, Luke and Lizzy, with a little bit of, sort of, Economic Theory 101, like open economy macro, or balance of payments accounting, because I think that's a good theoretical framework for thinking about why the goods trade deficit and capital markets are inextricably linked. So it's a natural question to think about: does it spill over into capital markets? Because in balance of payments accounting, the financial and capital accounts of a country are, by identity, the mirror image of the current account. A current account, right, being the balance of trade in goods and services. And that ‘and’ will be important because we're going to talk about how services trade could have potentially be affected in time. But the size of that current account surplus, or deficit in the US’s case, must be offset or mirrored in an equivalent deficit or surplus, the latter in the US's case, on the financial and capital accounts. That is to say, to buy goods and services from the rest of the world, a country must sell them financial assets, generating net capital inflows, which is what you then use to fund any good trade deficit. And those capital inflows mean things like selling financial assets to the rest of the world, cross-border purchase of financial assets, equities, bonds, foreign direct investment, loans, reserve transactions, and so on. So by balance of payments logic, by ‘Macro 101’, the trade deficit, or more broadly the current account, is inextricably linked to the financial and capital account. So it is natural, I think, to progress from thinking about trade wars to perhaps capital wars.

Luke Bartholomew:

And then in thinking about how a capital war might work, I think it is worth carrying on with some of this basic thinking, Paul. But just to make explicit the idea that in a trade war around goods, it can have, at least on the surface, two slightly conflicting goals, which is to say, on the one hand, it's about restricting imports into your own home economy. On the other hand, it can also sometimes be about restricting exports from your home economy internationally. So of course, tariffs are the canonical case of the former, putting taxes on imports to reduce the volume of imports coming in. But also trade wars can typically involve embargoes on certain export restrictions, critical raw materials, for example, high tech goods or other desirable things that your economy produces, that you don't want to give access to, to the rest of the world. And the reason for setting that up is that a capital war could involve similar dynamics. So on the one hand, it could be restricting export from capital at home to abroad. And on the other hand, it can be about restricting the access of capital from abroad into your home economy. And I think it is that latter case of restricting capital coming into your economy, which is perhaps where countries might have the most leverage over the US in this current conjuncture. And the reason for that is that perhaps it's on those lines where you get the most closest analogy to traditional political economy ways of thinking about trade wars and how you do retaliation in a trade war, because often what you're trying to do in a retaliation is not maximise the degree of economic harm per se, you're opposing on your trading partner, but it's to exert pain in those places which are of political significance, or of significance in such a way that's likely to bring about a change in policy. So a great example of this is this trade war that occurred between the EU and the US in the early 2000s under the Bush presidency, the second Bush presidency. And this was a trade war over steel, the US had put some tariffs on the import of European steel. And the way the EU retaliated was with tariffs on citrus fruits and Harley Davidsons. Now, neither of those are strategically important in the grand scheme of the US economy, not particularly macroeconomically significant, but where they are significant is in the economy and the politics of the states of Florida and Wisconsin, respectively. And those were two states that were crucial to the Bush electoral coalition. So what the EU was trying to do was go after politically sensitive parts of the economy in the hope of changing policy that way. And the thought is that the nature of US capitalism now is that those firms that are most politically connected, that have the best lobbying networks that are most likely to bring about a change in policy are not goods exporting companies. They are things like banks, tech firms, other service providers that rely on their ability to deploy capital around the world. So if a country or a group of countries were to restrict imports of US capital, stop those kind of firms from deploying capital in their country, then that might be a way of exerting leverage on the US, which is which is much closer to a standard way of doing a trade war in that it targets those areas where you're most likely to encourage firms to want to lobby for a change in policy.

Lizzy Galbraith:

And one of the things that we saw discussed an awful lot at Davos last week is the fact that the EU actually already has the legal ability to extract that leverage. So it already has a basis through which it would be able to target services, to target big tech finance of any country that it wanted. It has something that is called the Anti-Coercion Instrument, or ACI. The press often refers to it as the EU's trade bazooka, which makes it sound quite dramatic. But all it is really is a legal framework for responding to any instance of economic coercion by any country that it identifies it in. It was originally put together in response to a series of attempts at what the EU deemed to be economic coercion over the course of the 2010s, including an instance in which the Lithuanian government accused China of introducing trade restrictions in response to foreign policy of the Lithuanian government. So the ACI has actually been around now for quite a few years, but it's never actually been triggered by the Commission. Part of the reason for that is that it's actually quite a clunky mechanism, although its potential impact is very significant. As we'll get on to, in typical EU fashion, it's quite a clunky mechanism to work with. So not only do you have to go round the houses a bit in terms of getting permission from member states for it to be authorised, so if the Commission actually does identify evidence of coercion by a third country, it then has to present its findings to European member states. Member states then get a vote, and then qualified majority rules apply. So the threshold is 55% of member states must approve use of the ACI, but that 55% must represent 65% of the EU's population. So it's not requiring, unlike some other measures, absolute unanimity, but there's still a threshold there that needs to be met. And crucially, the entire response window for the ACI takes something like four months for the investigation to take place, then possibly another two months for the voting process. So while we were talking last week about whether or not President Trump would levy tariffs on the EU, whether or not the EU would respond to that, and what type of response it could levy, we're talking about measures that aren't necessarily imposed over the same time frame here. President Trump has the advantage of being able to levy tariffs, at the moment at least, through executive order, with very rapid implementation. The EU doesn't necessarily have the same luxury when it's considering some of these more consequential measures. So there is an element to which the time frame here is slightly inconsistent across the third countries that the EU is most likely, at present at least, to want to debate use of the ACI against. But in terms of the specific measures that we could see, as I said, the ACI is not a single measure. It's not a single policy, it's actually a framework. There are many, many measures that can be triggered under the ACI, and really all that vote does is it authorises the Commission to consider which of those measures is most appropriate in response to whatever coercion has taken place. So there's no single action that comes out of triggering the ACI. But to give you a flavour of some of the things that are possible here, we can see tariffs, as has become relatively conventional when talking about some of these disputes. We can see, more consequentially and more uniquely, restrictions on services trade where the third country runs a structural surplus with the EU. That would include the US, if we were talking in specifics as of last week. You can see public procurement bans that lock firms headquartered in that third country out of the EU's procurement process. That's worth billions of euros a year. You can also see limits on FDI investment, either wholesale or in strategic sectors, and even restrictions or freezes on intellectual property. So some, all, or variations within those, are all possible once the ACI is triggered. It's relatively flexible once those barriers of timeframe and implementation are actually met. But as we said, the EU has so far never actually got to the point where it's been triggered.

Paul Diggle:

And even last week during the peak of the Greenland standoff and threats between the US and the EU, triggering the Anti-Coercion Instrument was still only likely in some of the more extreme scenarios, which did not in the end materialise. And we're not, sort of, making here a call that Europe fighting back in the trade war via the Anti-Coercion Instrument is imminent. The point is that we are in a structural environment of building barriers to trade across the global economy. And the ACI is a very specific, concrete example of the way in which that could have happened in certain extreme scenarios and could yet happen in the future, depending on what happens. And of course, one of the, sort of, more extreme things that Europe could maybe do with the ACI, Lizzy, as you were describing, is put up significant barriers to the operation of US digital and tech firms within the EU. So we’re talking, in extremis, sort of, blocking certain digital services in Europe, US provided. And that’s interesting because, or it might even be something that’s thinkable for the EU, that might be one of the ways in which Europe has leverage, or a sort of ability to hurt those vested interests that you were describing.

Lizzy Galbraith:

Yeah, so one of the ways that you would likely see the ACI used is to turn public opinion in that third country, whether that's the US or someone else against whatever action that the EU has deemed to be coercive. So in this type of instance, where you would see the EU targeting digital services companies, potentially even financial services companies, what you're basically doing is you're going after some of the largest corporations in the US, corporations that have significant interests in the EU, but also leverage over the party of the president, they are often donors, they often hold quite significant sway in election cycles, they have a lot of money to give, and their opinion does count. So you're not necessarily going to see the ACI used on a permanent basis. But it can, as you said, be potentially a very effective leverage in changing policy, because the consequences of some of these measures are so significant. So you could see things like limitations on providing digital services, as you mentioned, Paul, you could also see, you know, data controls that impede the ability of those companies to operate in the EU as they would normally do, regulatory action to introduce new operational barriers under the Digital Markets Act, or the Digital Services Act, or simply just blocking FDI, making it harder to expand or operate in the ways in which you would normally want to within the EU. So that's not cost neutral for the EU by any means. But it certainly maybe changes the calculus for some of those companies, and will potentially push them to pressure the governments of that third country for a resolution.

Paul Diggle:

I mean, it's worth emphasising, it really is not cost neutral for the EU because of the dominance of US tech firms in the European tech stack. So things like cloud provision, online marketplaces, social media, mobile operating systems, these are all overwhelmingly provided by US-based companies in Europe. There is no European-based foundational LLM, for example, there's no European ChatGPT. So Europe would be, in many ways, cutting off its nose to spite its face. And that's a different barrier, actually, to some of these, these more extreme scenarios being realised. And meanwhile, as just as Europe is a big net importer of tech from the US, tech services, is a big net exporter of finance still. And the US, of course, has, if we're getting into a world of services barriers to trade, an ability to retaliate that really hurts Europe around the financial piece as well. So we should be legitimately thinking through the scenarios in which these things come to pass, but also recognising some of the important institutional constraints on the sort of trade war broadening to services in this way.

Lizzy Galbraith:

And one of the debates that has been present around the ACI really from the beginning is whether or not it was actually a credible tool, because of some of the consequences that you would see if the EU were to take some of the more significant measures that the ACI theoretically entails. And particularly for some countries within the EU, the consequences of activating those measures could be really quite significant and potentially very negative. So to take an example, on that US tech front, Ireland would likely be significantly negatively affected if the ACI were triggered and were to target US digital services companies, its headquarters, it's got the European headquarters of many of those companies, it derives significant amounts of its GDP from the operations of those countries. So disrupting that would be extremely negative. And as we've discussed, no single country has a blocking vote over the triggering of the ACI. So there are serious consequences here, if the vote were to overrule, in the unlikely event that a vote were to overrule, a minority that were to be highly negatively affected by the implementation of the ACI. But that again, brings us back to that credibility point. Is the ACI actually a credible tool that the EU holds? Or is it actually too consequential for it to ever credibly use?

Luke Bartholomew:

Well, the other threat that's sometimes made in the context of a capital war, and this is an example of restricting export of capital from your market overseas, which also has serious questions of credibility, is this idea of Europe dumping its holdings of US Treasuries. So selling off the US capital that it has, restricting European capital being deployed in US capital markets. And the thought is, you know, Europe is a very large holder of Treasuries, something like 10% of Treasuries are held by European investors of one form or another. But I think that phrase ‘of one form or another’ is the key one here in the sense that there isn't just one institution, one entity that one can point to, and call it the holder of Treasuries in Europe, some public sector institution that is easily coordinated that can make some decision and then act on it accordingly. Those holdings are across the entire private sector of pension funds, insurance companies, banks, and they are hold for a variety of different investors, variety of different reasons, and they will have fiduciary duties around their holdings of these US Treasuries, and in the way that they are cared for, for clients. And so the idea that they can just be sold on the basis of geopolitical need is very hard to see how that could occur, who is coordinating this, what is the legal basis on which they are bringing about those sales. And besides, it is worth stressing, of course, you know, we were talking about how aspects of the ACI and restricting tech could be very painful to Europe. I think forcing sales of Treasuries would potentially be even more painful to Europe than it would be to the US. Ultimately, the reason Europe is invested in these Treasuries is because it's providing a vital service to European capital, it is a provider of a deep and liquid market, it is dollar access and dollar financing. It is far from obvious where European capital would go, if it was selling out of Treasuries, and more the point, it would presumably hurt the value of holdings as they're all sold out, causing great losses for the European financial system as a whole. So this threat that sometimes may that the capital war could turn into a wholesale sale of US Treasuries by European investors, I think is, is probably wildly exaggerated.

Lizzy Galbraith:

But we are potentially seeing a little bit of a shift at the margin. So we are starting to see reports of some pension funds in Europe, making strategic reallocation away from Treasuries and US assets more broadly. Now, that is probably a valuation story, whether or not the US actually still represents a good value investment, given where future returns are likely to be. However, it's also potentially around increasing questions of the political stability and possibly even the financial stability of the US in the long term, where the risk premium actually needs to be higher when we consider those types of investments in the US going forward. So what we're not seeing is some sort of wholesale divestment or dumping of US assets, either as a knee jerk reaction to events over the past month, or to the Trump presidency itself. But it is likely to be indicative of investors starting to ask more questions of the US outlook. So it's something to bear in mind as we move forward.

Luke Batholomew:

And I suppose one of the things the European institutions could do to support that reallocation of capital at the margin, if it's something that they wanted to do as a way of increasing leverage, or at least reducing their dependence on the US financial system, is to use this moment as a galvanising event to push towards greater European financial integration. You know, there's a lot of talk about how the last couple of years has been galvanising when it comes to European defence spending and the need for European countries to increase defence spending to boost their strategic autonomy in the context of perhaps the instability or the unpredictability of US foreign policy. Or similarly, perhaps this could be a galvanising moment to encourage countries that, you know, for a variety of reasons, have had deep reservations about moving towards a more integrated European financial system, development of a euro bond market, to perhaps put some of those concerns aside, and to move towards the creation of a much deeper, more liquid euro bond market. Now, this would require, you know, significant pooling of fiscal financial authority. It's not a small thing. There are various interests that would need to be squared up here. But again, perhaps this moment is one which encourages those political forces to sort of come together to create that sort of moment of greater European integration.

Paul Diggle:

China is also an important player here, right, when we're thinking about capital flows, because China has one long-term interest in raising use of its currency, the RMB, in international transactions, albeit it will have to significantly open its capital account and supply more financial assets to the rest of the world if it wants that to happen. So its vested interests are not in waging a form of capital war necessarily, it's actually in opening up more to the rest of the world in terms of its capital markets. And at the same time, I think just as you point out, Luke, that speculation about the possibility of Europe dumping US Treasury holdings, there's this perennial worry in pockets of the market that China could at some point do the same. And I expect that is similarly wide of the mark, because of the sort of self-inflicted harm that would go on. And then the US is, of course, a player in all this. As we've delved into on previous podcasts, its control of the dollar financial system gives it enormous sway and influence, geopolitical hard power influence, via financial markets. And you're already seeing a few measures touted, largely not implemented, but at points floated in ways in which it might leverage capital flows for its advantage, just as it has leveraged the large amount of goods it buys from the rest of the world. So one area the administration has at times talked about is changing the tax treatment of sovereign wealth funds purchasing dollar assets. And of course, they purchase huge amounts of dollar assets because, as we've said, the dollar market is huge, the Treasury market is the benchmark safe asset of the global financial system. And there's been talk of the Inland Revenue Service, the IRS, expanding the definition of commercial activity to include sovereign wealth funds and foreign pension funds, which if enacted would then make their activities, their investments, taxable. So removing the longstanding exemption where the IRS has called those activities ‘investment related’ and therefore has not taxed them. So things like debt restructuring, private credit exposures, direct equity stakes, particularly in private firms, suddenly become taxable for sovereign wealth funds and significantly broaden their US tax liabilities. And the administration would presumably see that as a potential source of revenue, an important source of revenue. But it also would maybe have this chilling effect on the flow of capital into US markets.

Luke Bartholomew:

And then another example that we've talked about on the podcast before is so-called ‘Treasury user charges’ that were part of the Miran plan, as was, and I suppose, ironically, in some sense, the point of these user charges is actually to at the margin slightly discourage capital flow from the rest of the world into the US, which I suppose goes to show how valuable being able to park capital in the US is for much of the rest of the world. And again, to speak to that point of the Europeans or the Chinese selling Treasuries would in fact probably be more painful for them than it would be for the US. But again, it is just another example of how US policymakers are thinking very hard about how they might extract leverage and monetise their position in the global financial system. And in this case, yeah, making it more expensive for foreigners to hold Treasuries in the US.

Lizzy Galbraith:

And finally, we have Section 899, which for about a week and a half had all of us on the edge of our seats. Last year, it was a measure that was contained in a draft of the One Big Beautiful Bill Act, we now know as OBBBA, President Trump's reconciliation bill that was passed last year. And it was a measure that would have given provision for the Treasury Secretary to take measures against countries that the US considered to have an unfavourable tax code for US entities. So we've talked about the EU's trade bazooka, this was or would have been the US's revenge tax. And in particular, what it was going to do would be to target retaliatory measures at countries that were utilising the undertaxed profits rule under the OECD's Pillar 2 tax projects, as well as measures like digital services taxes, we know President Trump has pretty strong views about those, and diverted profits taxes as well. So this would have been an automatic tax increase for entities that were residents or headquartered in those countries that had used those types of tax measures. It would have increased taxes on their US income by 5 percentage points each year up to 20%. So it would have been a very significant change. And as I said, it did cause quite significant ripples through financial services world when we realised that it was buried in a page of that draft bill. Now, eventually, it never actually materialised. We ended up seeing the US reach a deal with the other G7 members to exempt the US companies from any new OECD minimum tax regimes. So the measure was dropped from the bill. And we now don't need to worry about it for now, at least. But as I said, President Trump does have very strong views about things like digital services taxes. He's absolutely not a fan. So if we did see another reconciliation bill go through Congress, which is tricky given Congressional maths, but not impossible. You'll absolutely see us checking the fine prints to see if a similar measure is buried somewhere in the thousands of pages worth of text that we tend to see with US reconciliation bills.

Luke Bartholomew:

All right, well, that is all we have time for this week, Lizzy, I do hope you don't find yourself having to rummage through a thousand pages of tax legislation later this year for a variety of reasons. But if we do, we will no doubt be discussing it on the podcast. So tune in for that. But in the meantime, please do like, subscribe, if you have not already done so. And what remains is for me to thank you all for listening. So thanks very much and speak again soon.