It has been an astonishing decade for the U.S. federal-debt load. From the budget deficits of the Great Recession, to President Trump’s tax cuts, to the spate of large pandemic-relief packages, the federal debt has grown from about $5 trillion to $21 trillion. That means public debt is now roughly the same size as the economy — a ratio that is expected to double by 2050. What makes this story even more amazing is that this remarkable surge in current and expected public debt has not caused any meaningful change in inflation. Both current and expected inflation still reside near 2 percent.
This absence of spiraling inflation has left many observers perplexed. Surely, they say, there should be some signs of rising inflation given the soaring trajectory of national debt. Some of these folks, in fact, have been warning about higher inflation for most of the past decade, only to be proven repeatedly wrong. It has been a long ten years for them.
Despite their failed predictions, these prophets of bond vigilantism do raise some good questions. Specifically, why have investors maintained their relationship with U.S. Treasury securities given the surge in public debt? Why are they not abandoning Treasurys or the dollar in general? Are investors not worried that the U.S. government may cheat on them by monetizing some of the growing national debt?
These questions are fundamentally about the relationship between investors and U.S. public debt. Its stability and strength, therefore, can be understood by looking to insights from a long-lasting romantic relationship. Specifically: Breaking up takes time, there is no one else as special, and the relationship is an eternal flame.
Breaking Up Takes Time
The first insight is that ending a long-established romantic relationship takes time. Breakups in such settings usually do not happen overnight, but occur through a gradual fading of interest and commitment to the partner. The stronger the relationship, the longer this breakup process can take.
This dynamic is also true of the long-established relationship between investors and U.S. Treasury securities. A breakup, which would entail investors selling off bonds in anticipation of a monetization of the debt, would likely take a long time to end as evidenced by the closest thing to a breakup this relationship has experienced, the so-called “Great Inflation” from the mid-1960s to early 1980s. This famous episode started with the large fiscal impulses of the Great Society and the Vietnam War followed by the breakdown of the Bretton Woods System, the oil shocks of the 1970s, and the stop-go policies of the Federal Reserve. Together, these developments led to a steady decline of trust in U.S. public finances over the course of 16 years.
This deterioration of trust is seen in the figure below in terms of inflation expectations. Its gradual unmooring began in 1965 and continued through 1981. This 16-year journey, despite its length, did not actually lead to a breakup of the relationship between investors and Treasury securities, but it did put it to the test. This journey indicates a breakup of the relationship would probably take a very long time. It also suggests that the first step to starting such a journey is sustained increases in expected inflation. This has yet to materialize and implies investors are still very committed to this relationship.
This first insight, that breaking up long-established relationships takes time, is one reason the prophets of bond vigilantism have been so wrong over the past decade. But it is not the only reason: The fact that the Great Inflation could not end this relationship suggests there is something very special about it.
There Is No One Else as Special
The second insight from a long-lasting romantic relationship is that there really is no substitute for your soulmate. This is also true for the investor relationship with Treasury securities and dollar-denominated assets more generally. There really is no one else as special as the global dollar system.
To see why, first note that the United States plays an important role in the global financial system. It is, by orders of magnitude, the largest supplier of safe and liquid assets to the world. This happens since foreigners treat the U.S. financial system like a bank: They deposit their funds in the United States and, in return, receive claims on money-like assets. The most sought-after of these assets are government-protected ones such as currency, bank deposits, and treasury securities. Foreigners, however, also seek other relatively liquid assets, including repo, commercial paper, and money-market funds. As of 2020, these safe and liquid assets issued to the rest of the world totaled about $20 trillion.
Second, there is another $12 trillion in dollar-denominated assets issued by entities outside the United States, according to the Bank for International Settlements. Combine this with the dollar assets exported from the United States, and there exists roughly $32 trillion in relatively liquid and safe dollar assets abroad, as seen in the figure below.
There is no other currency system that comes close to providing so many safe and liquid assets to the world. On one hand, this outcome is not surprising, given the dollar’s dominant role in the global economy. On the other hand, the implication of this fact is astonishing: There is no alternative source of safe and liquid assets available on such a large scale. This means that if investors wanted to break up with the global dollar system, there would be nowhere else to go to meet all their relationship needs.
Moreover, this large chasm between the supply of dollar-denominated and other assets reinforces itself through network effects. That is, as investors turn to dollar investments because they are in ample supply, the network of dollar users expands and, in turn, makes dollar assets more liquid. As a result, this enhanced liquidity increases the demand for dollar assets and reinforces the dollar’s dominance. This dollar cycle intensifies during crises, when investors rush for safety and further expand the dollar’s network effects.
Network effects are a key reason the global dollar system maintains its status as the only large-scale supplier of safe and liquid assets. U.S. Treasury securities and other government-supported assets are at the heart of this system and therefore make it hard for investors to break up with U.S. public finance.
This relationship, though, is more than a forced marriage. It is also a relationship based, in part, on the belief it will be a forever affair.
The Eternal Flame
A third insight from a long-lasting romantic relationship is that its strength is derived, in part, from a belief that one’s partner will be there for the long haul. The investor relationship with the U.S. national debt is that and then some: It is based on the expectation that the United States, its government, and its financial prowess will continue forever. This expectation, to paraphrase the Bangles, means the investors burning for U.S. government securities is an eternal flame.
The forever nature of this relationship means that the U.S. government can roll over and refinance its debt indefinitely. Now it can only do so as long as the growth rate of the U.S. economy exceeds the financing costs of the national debt, but as economist Olivier Blanchard has shown, this typically has been the case. This pattern is also likely to persist given the ongoing elevated demand for safe assets and the unique role, outlined above, that the U.S. government plays in supplying safe and liquid assets to the world.
The eternal flame, in other words, means that the investor relationship with the national debt can weather severe storms and survive. This has been evidenced by the ongoing low interest rates on Treasury securities and the stable inflation outlook despite the current and expected run-up in public debt.
For all these reasons, then, investors breaking up with U.S. Treasury securities and other dollar-denominated assets is much harder to do than the prophets of bond vigilantism have been predicting. This is not to say a breakup is impossible, but it does suggest that ending investors’ affinity for the global dollar system would probably require something drastic like the United States coming apart. Since such an outcome is highly unlikely, it is equally improbable that there will be a sustained surge in inflation.
To be clear, this is not an argument for more federal expenditures but merely an assessment as to whether the past and proposed federal outflows will be highly inflationary. The answer is no and, if anything, safe asset yields suggest investors are delighted to have treasury securities and other dollar-denominated assets at their disposal. To invoke another 1980s song, investors are still singing they are “happy to be stuck with you” to the global dollar system. This song will be their anthem for the foreseeable future.