Understanding international capital flows, trade dynamics, and realistic macroeconomic strategies for fiscal sustainability
The U.S. federal debt cannot be understood in isolation from global economics. The US trade deficit stems from a persistent savings-investment gap, and without closing that gap, the deficit won't shrink. This creates a fundamental constraint on debt reduction that goes beyond simple domestic fiscal policy.
International capital markets determine the flow of funds first. If foreign investors channel more capital into US assets than Americans invest abroad, net capital inflows increase, driving up demand for dollars. This leads to currency appreciation, making imports cheaper and exports less competitive, widening the trade deficit.
If U.S. government borrowing pushes up the interest rate (an increase in the demand for loanable funds puts upward pressure on the interest rate), the higher real return will attract foreign funds. This creates a self-reinforcing cycle:
Trade deficits emerge when a country imports more than it exports, leading to a negative balance of trade. To offset the deficit, the importing country attracts capital inflows from abroad. These capital inflows can be in the form of foreign direct investments, loans, or the acquisition of domestic assets by foreign entities. The inflow of capital helps finance the trade deficit, allowing the importing country to sustain its consumption levels and economic activities.
A reduction in the fiscal deficit will lower the trade deficit only if it effectively narrows the savings-investment gap by reducing net inflows of capital. The standard textbook mechanism suggests that lower fiscal deficits lead to reduced interest rates, discouraging capital inflows and thereby improving the trade balance. However, if fiscal consolidation is perceived as pro-investment policy—especially when paired with deregulatory policies—capital inflows might actually increase, funding higher domestic investment. In this case, the savings-investment gap could widen, further expanding the trade deficit.
At the end of FY2025, total federal debt stood at $37.6 trillion, with total debt equal to 122.6% of GDP and public debt equal to 115.5% of GDP. More concerning, in the nine weeks since the start of fiscal year 2026, the government has spent $104 billion in interest on its $38 trillion borrowing burden. That's more than $11 billion a week, and already represents 15% of federal spending in the current fiscal year.
In fiscal year 2025, which ended on September 30, the federal budget deficit totaled $1.8 trillion—a decrease of $41 billion (or 2 percent) from the shortfall recorded in the previous year. Federal debt held by the public increased in 2025 relative to the size of the economy—rising to 99.8 percent from 97.4 percent of GDP at the end of fiscal year 2024.
Given the international constraints and macroeconomic realities, here are evidence-based strategies that can reduce U.S. federal debt without causing economic contraction:
International experiences of successful debt reductions suggest gradual, spending-focused policies. Reductions in social spending, as opposed to public investment, tend to produce more lasting fiscal improvements. Reducing primary deficits from their projected size (3.0 percent of GDP) to their historical average over the past 50 years (1.5 percent of GDP) would involve reducing the primary deficit by about $5 trillion over the next decade. Implementing such a change would nearly stabilize the growth of federal debt held by the public as a percentage of GDP over the next 10 years.
Any serious debt reduction effort must acknowledge the need to rein in the largest mandatory spending programs, Social Security and Medicare, which constitute a growing share of the budget and are the primary drivers of long-run deficits. Augmenting the tax-financed benefits for Social Security, Medicare, and Medicaid with investment-based accounts would permit the higher future spending on health care and pensions with a relatively small increase in saving for such accounts.
Reducing tax expenditures could make a major contribution to shrink future deficits without raising tax rates. This strategy could appeal to Republicans who want to see reductions in government spending and to Democrats who want to see increased revenue as part of any overall deficit reduction plan. Tax expenditures function as spending programs embedded in the tax code and reducing them is economically less distortionary than rate increases.
Less distortionary tax increases—including higher consumption, property, excise, and environmental taxes as well as reductions in tax expenditures—tend to produce more lasting fiscal improvements. A value-added tax (VAT) or carbon tax can raise substantial revenue while minimizing economic distortions compared to income tax increases.
Addressing the Department of Defense's annual budget could save $959 billion over the next 10 years. Reducing the number of active-component military personnel, reducing ground combat and air combat units, or relying on allies to provide their own defenses rather than using a U.S. combat force are possible methods of achieving the reform. This recognizes the post-Cold War security environment and NATO burden-sharing opportunities.
Medicare Advantage plans cover more than half of all Medicare beneficiaries. CBO offers three options to save money in Medicare Advantage by reducing payments to the program across-the-board or by making changes to its risk-adjustment policy. Savings from those policy measures range from $124 billion to $1 trillion over 10 years. Healthcare spending is the primary long-term fiscal challenge.
There are four ways to reduce the debt-to-GDP ratio: increase economic growth, raise additional revenue, cut spending, and reduce interest payments through default. While growth alone is insufficient, policies that boost productivity—infrastructure investment, R&D incentives, education reform—help grow the denominator of the debt-to-GDP ratio while maintaining living standards.
Narrowing the overall US trade deficit (reducing the investment-savings gap) may not be achieved through US policies alone; the international capital markets play a decisive role. Policies that increase national savings—automatic enrollment in retirement accounts, incentives for corporate retained earnings—can reduce dependence on foreign capital inflows, lowering interest rate pressures and improving trade balance.
Historically, the duration of significant debt reduction efforts has varied, but they are not short or easy. The dramatic decline in the debt-to-GDP ratio after World War II took nearly three decades (from 1946 to 1974) to reach its low point. Here's a realistic phased approach:
The public's perception that the government will actually fulfill its commitments and that the adjustment will be gradual, not "front-loaded" with large structural policy changes, is important for success. Rapid consolidation can trigger recession, but delay makes the eventual adjustment more painful. The key is credible commitment to a multi-decade plan with near-term actions.
U.S. fiscal policy operates within a global capital market. High U.S. interest rates attract foreign capital, which finances both government debt and the trade deficit. Debt reduction must account for how changes affect capital flows and the savings-investment balance.
Fiscal consolidations based on spending cuts have had fewer negative effects on GDP than tax increases. When revenue increases are necessary, focus on less distortionary sources: consumption taxes, carbon taxes, and eliminating tax expenditures rather than raising marginal rates on income.
There is basis for concern if borrowed foreign capital has been used to finance nonproductive endeavors, public or private. To ignore this aspect of the trade flow/capital flow relationship risks placing additional pressures on unenhanced future output when foreign creditors take their gains in real product. Distinguish between borrowing for consumption versus investment in infrastructure, education, and R&D.
Comprehensive plans generally phase in changes slowly in order to give people time to plan and to protect near-term economic growth. While some plans may rely more on spending reductions and others might depend more on tax increases, a key feature of most of these plans is that they include a combination of both.
A successful debt reduction strategy will achieve:
Reducing U.S. federal debt requires understanding that America operates within a global economic system where capital flows respond to interest rate differentials and investment opportunities. From the perspective of the US trade and current account balances, tariffs are a distraction. Given the depth of the US capital markets, investor sentiment and capital flows play a more decisive role in shaping external balances than trade policy.
The solution is not simple budget cuts or tax increases in isolation. Instead, it requires:
Now is the time for lawmakers to focus on long-term fiscal sustainability, as further delay will only make an eventual fiscal reckoning that much harder and more painful. Congressional leaders should follow through on convening a fiscal commission to deal with the long-term budgetary challenges facing the country.
The U.S. can reduce its federal debt, but it requires acknowledging macroeconomic realities beyond domestic politics. The investor-importer position creates both constraints and opportunities. By addressing the savings-investment gap, reforming entitlements, modernizing the tax code, and implementing gradual but credible fiscal consolidation, America can return to a sustainable fiscal path—but only with political will and public understanding of the trade-offs involved.