It is widely recognised that the United States has been living beyond its means. Over the past quarter-century, national debt as a share of gross domestic product has nearly tripled, reaching about 98%, according to official estimates. Projections suggest that figure could climb to roughly 166% by the middle of the century. Such levels would generally be difficult to sustain, yet the U.S. government has continued to borrow at scale, helped by the enduring global appetite for its debt. In 2023 alone, the Treasury sold an estimated $28 trillion in securities.

That willingness to lend rests heavily on the dominance of the U.S. dollar. Dollar-denominated assets account for more than half of global foreign-exchange reserves, and the dollar is used in the vast majority of international currency transactions. New research by finance scholar Mindy Xiaolan argues that this privileged position underpins America’s exceptional fiscal capacity — its ability to raise funds far beyond what its budget fundamentals might otherwise support.

Her work examines what could happen if that privilege were ever weakened. If another currency displaced the dollar as the world’s primary reserve asset, U.S. government borrowing could become more constrained. Bondholders might suffer significant losses as the market value of Treasury securities fell, while the federal government could be forced into painful fiscal adjustments. As Xiaolan notes, when a country’s finances deteriorate at the same time as its currency loses global status, its ability to borrow cheaply tends to shrink, often at the expense of investors.

Whether the United States will face such consequences remains uncertain, but history provides sobering precedents. Xiaolan and her co-authors compare America’s current trajectory with that of earlier monetary powers whose currencies once dominated world trade. In the seventeenth and eighteenth centuries, the Dutch florin held that role, followed by the British pound through the nineteenth century and into the Second World War. In each case, the leading currency belonged to the world’s dominant economy of the era.

While their influence lasted, investors treated Dutch and British government bonds as exceptionally safe, paying a noticeable premium relative to other sovereign debt. That demand allowed both governments to borrow heavily, often to finance wars, pushing debt levels far beyond what could be justified by ordinary budget surpluses. Dutch debt exceeded 200% of GDP during the Napoleonic period, while Britain’s surpassed 130% at the end of the Second World War.

When those currencies lost their pre-eminent status, the adjustment was severe. Bond prices collapsed, inflicting considerable losses on investors, and governments were forced to abandon deficit spending in favour of sustained surpluses. The transition was economically painful and politically challenging, underscoring the risks tied to overreliance on monetary dominance.

Xiaolan argues that the United States shows signs of following a similar path. Analysing the federal balance sheet as if it were a private firm, the researchers estimate that expected future revenues cover only a fraction of outstanding debt. That gap has widened sharply since the global financial crisis and the pandemic, even as borrowing costs remained unusually low thanks to what she describes as America’s “exorbitant privilege”.

For now, global investors continue to tolerate this imbalance, though there are hints of fading confidence. The market value of U.S. government debt has fallen notably since 2020, suggesting investors are demanding greater compensation for risk. If that trend accelerates, the U.S. may face higher financing costs and renewed pressure to run fiscal surpluses — something it has not done for decades.

The dollar’s saving grace, at least for the moment, is the absence of a clear rival. Potential challengers face economic and political constraints of their own. Yet history cautions against complacency. Monetary privilege has never proved permanent, and the past suggests that adjustment, when it comes, can be abrupt.

More information: Mindy Xiaolan et al, Exorbitant Privilege Gained and Lost: Fiscal Implications, Journal of Political Economy. DOI: 10.1086/738149

Journal information: Journal of Political Economy Provided by University of Texas at Austin