Capital flows and U.S. foreign debt and pension reforms, oh my!

By Professor Olena Staveley-O'Carroll

Trillions of dollars’ worth of financial instruments (national currencies, corporate and government bonds, stocks, and many others) are traded in global capital markets each year. The combined value of all of the existing securities in these markets is very difficult to measure, but by some estimates it was expected to reach 900 trillion U.S. dollars in 2020, more than ten times the value of the entire global output of goods and services in that year. The cross-border flows of financial capital bring with them many benefits: they facilitate international trade in goods and services, help to channel money from wealthy countries to developing economies full of promising investment opportunities but lacking funds to finance them, and allow individuals and financial institutions to diversify their portfolios of stocks and bonds (to avoid putting all of their eggs into just one country’s basket). On the other hand, unchecked and unregulated financial flows can wreak havoc in global capital markets, propagating one country’s financial crisis to its neighbors and exacerbating national economic downturns by withdrawing international lending just when it is most sorely needed.

Given the projected increase in international capital flows over the next several decades in response to global economic growth (especially in China and India) and to financial innovation, it is Important for researchers and policymakers to understand the mechanisms driving these flows. A large part of my own academic research focuses exactly on this question. Several years ago my co-author and I were examining patterns in the movements of financial instruments across different parts of the world. We noticed an interesting regularity: countries with more generous pension systems tend to be net borrowers in global capital markets. Upon closer examination, we also found that such countries borrow from abroad using bonds and invest a portion of the proceeds into foreign equity (stock markets), akin to a venture capitalist. Our own economy is a prime example of this pattern. The U.S., as an aggregate entity comprised of all of its households, firms, and the government, raises funds from abroad by issuing government bonds and concurrently invests a portion of its national income in foreign equities. In absolute terms, the U.S. is the world’s largest debtor nation, owing over 14 trillion dollars to foreigners as of 2020. (We also have the world’s largest economy, though, and relative to our 2020 GDP, the burden of foreign debt – about 67% of our annual output – falls much closer to the middle of the global distribution).

Intrigued by this finding, we developed a two-country theoretical framework with internationally traded bonds and stocks to trace the effects of a country’s government-run pension system on the investment portfolio composition of its households. In essence, we made the assumption that saving and investment choices of individuals, when added up across millions of households in an economy, make up that economy’s aggregate cross-border financial capital in- and outflows. Using our model, we uncovered a very interested and compelling mechanism linking a person’s investment decisions and the generosity of the public pension system.

First, given a credible guarantee of retirement benefits provided by the government, like the U.S. Social Security system, people in developed economies make riskier investment choices during their working years. More specifically, workers shift their savings towards more profitable but also more volatile stock markets, both domestic and foreign, and away from low-risk, low-return government bonds. The promised future retirement benefits act as a sort of financial safety net in case stock market returns end up being lower than expected, or even negative. Second, the pay-as-you-go structure of the pension systems in most advanced economies—taxing current workers to support current retirees—encourages younger workers to borrow money (in particular, from abroad) in order to offset the burden of social security taxes. This borrowing, done by issuing bonds (which, for all intents and purposes, is equivalent to a loan from a foreign bank), is done in anticipation of, and with the implicit collateral of, the state-guaranteed future retirement benefits. When aggregated across all workers, this behavior translates into high levels of borrowing from foreign nations via bonds, and a (relatively smaller) level of investment into foreign equity. Contrastingly, workers in emerging economies without state pension safety nets tend to be net savers and conservatively invest their retirement savings in low-risk financial instruments, such as government bonds of advanced economies.

Our proposed diagnosis of the past capital movements can next be used to anticipate changes in future financial flows that will arise in response to the inevitable, and in some countries already ongoing, pension system reforms triggered by demographic changes. Birth rates have been falling in many parts of the world; in most developed nations, they are now below the replacement rate needed to keep population constant. Projected several decades forward, these falling rates, combined with medical advances resulting in longer longevity, also imply that developed economies will experience a continually decreasing ratio of workers to retirees. This demographic shift creates an existential crisis for pay-as-you-go pension systems that transfer income tax collections (from relatively young workers) to immediately finance state-guaranteed retirement benefits of existing pensioners. As a specific example, the U.S. Social Security Administration expects that, in the absence of legislative reforms, scheduled tax revenues will cover only about three quarters of the promised retirement benefits by mid-2030s.

There has been a lively debate in the academic literature for the last several decades about the best ways to reform pay-as-you-go pension systems, none of which are costless and all of which will lead to cross-generational wealth redistribution. We can hypothesize about the resulting capital flow patterns following a change in the U.S. pension system towards a defined contribution structure. Generally, in a defined contribution plan, a worker puts a portion of her monthly income into a retirement account, which is managed (channeled into various domestic and foreign stocks and bonds) by a financial investment firm up until the worker’s retirement. Returns on this investment may vary from year to year with the overall health of the economy and its financial markets. Thus, defined contribution plans are inherently riskier for the worker than the current pay-as-you-go framework. Faced with a more uncertain financial future, such a worker will likely wish to hedge her retirement nest egg by shifting her other investment away from risky equity and towards safer bond markets. In international capital markets, developing countries may consequently experience lower availability of equity financing and may have to rely on less flexible loans, jeopardizing the speed of their economic development.

While the direction of U.S. pensions reforms is as yet uncertain, this thought exercise offers a starting point for thinking about their possible global implications, so that they do not one day come as an unwelcome surprise to investors, financial institutions, and national government themselves.

(REVISED Octeober 13th 2021)

Professor Olena Staveley-O'Carroll
Associate Professor of Economics, Department of Economics and Accounting
College of the H
oly Cross


  • Economics of the European Union (ECON 210)

  • Macroeconomics (ECON 256)

  • International Finance (ECON 330)