US - From trade war to capital war

The early months of the Trump administration have concentrated on policies aimed at reducing the trade deficit, primarily through the implementation of tariffs. However, there exists an alternative approach to addressing the trade and current account balance, which, by accounting identity, must equal the financial surplus. By restricting foreign financial capital inflows, the financial surplus may be reduced. If foreigners are less willing to finance the US current account deficit, then the deficit must shrink. While we’ve yet to see explicit capital control policy, elements in the "One Big Beautiful Bill" could be interpreted and implemented to achieve such outcomes.

The concept of capital controls has circulated within Trump's inner circle. The Miran plan proposed a 'user fee' for holders of U.S. treasuries. American Compass, a think tank closely associated with J.D. Vance, advocated for capital controls in the form of a 'market access charge'. While developments are unfolding differently, Treasury Secretary Bessent has previously noted the improbability of implementing tariffs without strengthening the dollar, despite the apparent policy goal of a weaker dollar to enhance competitiveness. A policy path through the financial account would reduce demand for the dollar, depreciating it, while simultaneously narrowing the trade balance.

Section 899 of the Big Beautiful Bill enables the U.S. government to levy taxes on individuals and businesses from countries with 'discriminatory' tax regimes. According to the Tax Foundation, nations with 'unfair taxes' contribute approximately 80% of inbound foreign investment into the U.S. To some extent, the U.S. already possessed this capability under Section 891 of the current tax code, which could double the taxes for citizens and firms from such countries. A crucial distinction lies in the exemption for portfolio interest earned, potentially shifting foreign demand from other inbound investments to Treasuries, further supporting the notion that the government is actively seeking to bolster Treasury demand, an idea we outlined before.

A decline in demand for other U.S. assets would lead to higher borrowing costs and inhibit investment, reducing productivity and trend growth. Elevated borrowing costs would also suppress import demand, narrowing the trade balance. However, it would also adversely impact demand for domestically produced goods. The Federal Reserve could potentially intervene by lowering rates. This would further suppress the dollar, making imports more expensive, further narrowing the trade balance. Even then, this scenario confronts the same limitations already faced by the Trump administration: the U.S. economy cannot immediately produce all the goods it currently imports. The only solution is for the US to consume less.

The overall impact on the economy would not be favorable, and the repercussions for financial markets could be significantly worse. We’ve previously written about the US risking its control of the global financial system. This reputational damage has arguably been a major factor driving the dollar's devaluation in recent months. If foreign investors lose further confidence in the U.S. as a viable investment destination – which implementation of capital controls would certainly do - there would be severe adverse effects on the dollar and yields. A depreciated dollar would raise inflation, and higher rates would further impede investment. In summary, although the channels differ from tariffs, the outcome remains a stagflationary shock.