Over the past two decades, the US has actively utilised fiscal policy for macroeconomic stabilisation and transfer policies, leading to a significant rise in public debt levels. Currently, public debt exceeds 100% of GDP. Coupled with rising interest rates, this has raised concerns about the sustainability of US public debt and the government's ability to meet its obligations (e.g. Farhi and Maggiori 2017, Rogoff 2020).
Figure 1 Fed funds rate and US public debt to GDP
One argument mitigating these concerns is the US's role as a global safe asset and reserve currency supplier. The potential loss of this ‘exorbitant privilege’ in the event of a default imposes substantial costs, incentivising the US to continue servicing its debt. Farhi and Maggiori (2018) formalised this argument, suggesting that the threat of losing the monopoly rents associated with being the dominant supplier of safe assets makes US debt safe. But how significant are these incentives in allowing the US to sustain its debt levels?
How large are the government benefits from exorbitant privilege?
To gauge the extra debt capacity generated by the exorbitant privilege status, we must first measure its benefits. There are two primary dimensions to these benefits.
First, the US government can issue debt at very low interest rates. On average, the yield on US Treasuries is 60 basis points lower than on comparable safe corporate bonds. This spread, known as the convenience yield, reflects the additional liquidity and collateral properties of US debt valued by investors (Krishnamurthy and Vissing-Jorgensen 2012). This yield saves the US government 0.7% of GDP in interest payments annually on a debt stock of 120% of GDP.
Second, significant foreign holdings of US dollar currency provide seigniorage revenues to the US government (Krugman 2021). Current foreign holdings of US currency amount to $1 trillion, which, although lower than the stock of foreign US public debt ($8 trillion), still contribute 0.16% of GDP in seigniorage revenues annually, assuming a 4% interest rate.
Combined, these benefits save the US government approximately 0.9% of GDP annually due to its status as a safe asset issuer.
How much debt capacity does the eventual loss of these benefits generate?
Assessing how much debt capacity is lost with the forfeiture of these benefits requires a quantitative model. In our paper, Choi et al. (2024), we develop a sovereign default model enhanced with two features characterising the US's special status in safe asset markets: a non- pecuniary value of US public debt (convenience yield) and seigniorage revenues from foreign holdings of US currency.
The model involves a large number of lenders and the US government. Lenders provide funding by purchasing US debt, while the government manages fiscal policies, including tax revenues, seigniorage revenues from issuing currency, and decisions on debt issuance and repayment.
The model incorporates two primary benefits that the US enjoys due to its role as a global safe asset provider:
- Convenience yield: US debt offers additional value to investors due to its liquidity and use as collateral. This makes US debt attractive at lower interest rates compared to other forms of debt, saving the government substantial interest payments.
- Seigniorage revenues: Foreign entities hold significant amounts of US dollars, which generate seigniorage revenues for the US government. This occurs because the US can issue currency that is widely accepted and held globally.
The model studies the US government's decision-making process regarding how much debt to issue and whether to repay or default on existing debt. The government's decisions are influenced by the benefits of maintaining its special status, which include lower borrowing costs and additional revenues from seigniorage. If the US defaults, it loses its special status, leading to higher borrowing costs and loss of seigniorage revenues. The model explores how this loss affects the US's ability to sustain its debt levels.
The model is calibrated to match key economic moments related to public debt and the external balance sheet of the US. This includes matching historical data on US public debt, interest rates, and the convenience yield of US Treasuries. Using the calibrated model, the paper quantifies the additional debt capacity due to the US's special status. The special status increases the maximal sustainable debt by approximately 22% of GDP. Most of this increased capacity arises from the convenience yield channel: an economy without the non-pecuniary benefits of US debt can sustain 18% less debt. The absence of a convenience yield increases debt costs directly and reduces incentives for the US to repay debt, highlighting the importance of this channel for debt sustainability.
To illustrate debt capacity, economists often use the concept of a Laffer curve which plots the total revenue from issuing a certain level of debt where the revenue is defined as the product of the debt level and price at which the debt is issued. The price is usually less than one since lenders require additional compensation owing to default risk. Figure 2 plots the Laffer curve for the US under various scenarios. For debt levels that are low enough, US debt is practically safe and so the debt capacity is unaffected by the special status. However, the figure illustrates that special status allows the US to sustain much higher debt levels and lower interest rates. This difference can be as large as 30% of GDP.
Figure 2 Debt Laffer curve
The analysis suggests that maintaining the US's special status in global financial markets is crucial for debt sustainability. Efforts by other countries to establish competing safe assets could pose challenges to the US's dominant position, impacting its debt management strategies.
References
Choi, J, D Dang, R Kirpalani and D J Perez (2024), “Exorbitant Privilege and the Sustainability of US Public Debt”, NBER Working Paper 32129.
Farhi, E and M Maggiori (2017), “The new Triffin Dilemma: The concerning fiscal and external trajectories of the US”, VoxEU.org, 20 December.
Farhi, E and M Maggiori (2018), “A Model of the International Monetary System”, The Quarterly Journal of Economics 133(1): 295–355.
Krishnamurthy, A and A Vissing-Jorgensen (2012), "The Aggregate Demand for Treasury Debt", Journal of Political Economy 120(2): 233-267.
Krugman, P (2021), “Wonking Out: The Weakening U.S. Dollar”, The New York Times, 28 May.
Rogoff, K (2020), “Falling Real Interest Rates, Rising Debt: A Free Lunch?”, The Journal of Policy Modelling 24(4): 778-790.
