Exorbitant Privileges, Burdens, etc. and the Implications for Fiscal Policy

The U.S. dollar is widely used outside the United States. That has implications for Americans that need to be managed, creating a tradeoff between domestic macro stability and fiscal "sustainability".

Foreigners play an outsized role in the U.S. dollar system. About 60% of the world’s foreign exchange reserves are held in U.S. dollars, about 80% of all cross-border trade (outside of Europe) is invoiced in U.S. dollars, about 60% of international and foreign currency banking assets and liabilities are denominated in U.S. dollars, and about 70% of foreign currency debts issued by companies is denominated in U.S. dollars. For perspective, the U.S. economy is worth only about 25% of the world economy. And at least 40% of the physical U.S. dollars in circulation by value, worth more than $1 trillion, are held outside the United States!

Put it together, and the choices of people in the rest of the world therefore have large effects on domestic U.S. financial conditions. That can benefit Americans under certain circumstances, but it also creates meaningful constraints that have to be respected and managed.

The supposed “exorbitant privilege” is that Americans are able to borrow much more—at relatively lower interest rates and relatively higher exchange rates—than would be expected given fundamentals. But the corresponding “exorbitant burden” is that Americans have to borrow unusually large sums in order to keep the U.S. economy operating close to full capacity, and even then, the composition of activity can end up distorted absent concerted policy action.

I believe that there are ways to manage this situation in ways that would work well for most Americans and for most people in the rest of the world. But the most straightforward solution looks radically different from what is recommended in standard public finance textbooks. Without substantial and persistent changes in foreign behavior, any attempt by the U.S. federal government to keep its budget balanced (on average across economic cycles, before interest) risks inflicting severe harm on the U.S. private sector. Alternative frameworks are necessary.

Accounting Identities Care About You Even if You Don’t Care about Them

Globally, income always equals current spending on goods, services, interest, dividends, transfers, etc. (Where else would the money go, or come from?) Split the world up into different countries—or economic sectors, or individual entities—however, and income does not equal current spending. Some entities spend less than they earn, using the difference to purchase financial assets. And other entities spend more than they earn, financing the gap by selling assets or by creating new liabilities that are sold to others. While those financial transactions have to balance out somehow, there is no inherent reason why they have to balance in any particular way.

This perspective is useful for considering what has been “exorbitant” about the past few decades, whether or not this constitutes a privilege or a burden, and what to do about it.

The chart below is one way of showing how sectoral balances in the U.S. have added up since 1960. The domestic private sector is in blue and the government is in red and pink. Those add up to the relationship between the U.S. as a whole and the rest of world (the black line, which is also the current account balance).

There are several interesting things to notice: