Living on Borrowed Credibility

A Warning From Three Centuries of Hegemonic Debt

New research by Zefeng Chen, Zhengyang Jiang, Hanno Lustig, Stijn Van Nieuwerburgh, and Mindy Xiaolan on three centuries of fiscal history offers a sobering lesson for today’s United States.

The Dutch Republic, eighteenth- and nineteenth-century Britain, and the modern United States all became dominant safe-asset suppliers in their eras. In each case, investors – both domestic and global – were willing to hold more of the hegemon’s debt than its future primary surpluses could justify. The bonds of a hegemon carry a convenience yield (a premium investors pay for safety and liquidity), making them overvalued relative to their fiscal backing. The hegemon can thus run persistent fiscal gaps without immediate consequences. In fact, the overvaluation itself temporarily functions as an extra source of revenue, meaning that unfunded spending might not generate inflation in the short run. For a time, markets behave as if the government has a larger stream of future surpluses than it actually does. Until it doesn’t.

The point is made vividly by the British case. The authors estimate how much of Britain’s enormous nineteenth-century debt–up to 175 percent of GDP– was actually supported by future primary surpluses. They find that only about three-quarters of British debt before World War I was truly “backed.” Even after adding the extra revenue implied by Britain’s convenience yield – the roughly 1 percent premium investors were willing to forgo to hold British debt – the gap remains. In other words, British bonds were consistently overvalued relative to fiscal fundamentals.

Once the United States replaced Britain as the global safe-asset supplier, the pattern reversed. The authors write:

“Reflecting the reversal of fortunes, we find that the US government debt consistently exceeded its fiscal backing after World War II when the United States became the global safe-asset supplier. In fact, the gap between the market value of debt and fiscal backing is much larger for postwar United States than for prewar United Kingdom. According to our estimates, less than one-third of post–World War II US government debt was backed by future surpluses, with much of this gap attributable to the sharp rise in US government debt over the past two decades.”

The main point is that debt appears “backed” only because investors treat it as special.

As a result, a hegemon can drift for a long time, but it cannot drift forever. The market charges a steep penalty the moment it concludes that fiscal responsibility is not forthcoming. That is precisely what happened to earlier hegemons. When the fiscal fundamentals of the Dutch and British governments deteriorated, their safe-asset status eroded. Convenience yields shrank, bond prices fell, and the market value of their debt had to realign with actual future surpluses. Crucially, this adjustment did not come through legislative reform but through bondholder losses, currency depreciation, restructurings, and episodes of financial repression. Once investors stopped believing that future fiscal surpluses would materialize, the real value of nominal debt simply had to fall. Prices and yields moved until the remaining fiscal backing matched the remaining real debt. In fact, in the post-WWII period, Britain adjusted accordingly: it ran primary surpluses large enough that, even without a convenience yield, its debt was fully backed by future fiscal resources.

This reality raises troubling questions about the coming depletion of the Social Security and Medicare trust funds, which I wrote about recently. Investors currently behave as if Congress will eventually deliver the surpluses needed to stabilize the debt, and that belief allows the government to issue debt at prices detached from its underlying fiscal backing. When the trust funds dry up, if Congress chooses to avoid benefit cuts and instead funds 100 percent of the Social Security and Medicare shortfalls with borrowing supported by no credible plan for repayment, investors’ expectations could shift abruptly.

But the Chen-Jiang-Lustig–Van Nieuwerburgh–Xiaolan paper highlights something else: as long as the United States still enjoys its safe-asset premium, investors will treat Treasuries as special and continue to overpay for them relative to the government’s actual fiscal capacity. That overvaluation itself operates as temporary revenue, which is why large unfunded deficits have not yet produced sharply rising yields or a collapse in demand for U.S. government debt. This dynamic could even delay the full reckoning when the trust funds dry up, and legislators decide to put everything on Uncle Sam’s credit card.

But history shows that this reprieve won’t last forever.

One final point. In some circles, it has become fashionable to pin a wide range of U.S. economic troubles—deindustrialization, inequality, even rising federal debt—on the dollar’s reserve-currency status. I’ll take up those claims another time. For now, it’s essential to be clear about the basic reality: the source of America’s fiscal and macroeconomic fragility is not the dollar’s global role but Congress’s own policy choices. Nothing about being the issuer of the world’s safe asset required Washington to run trillion-dollar deficits at full employment. Those decisions were entirely voluntary. The dollar’s status has always conferred advantages—lower borrowing costs, deeper financial markets, and greater stability—not the liabilities critics insist upon.

But that privilege does not excuse fiscal irresponsibility; it makes discipline more important. The convenience yield has undoubtedly encouraged overspending, but policymakers were never blind to our long-telegraphed debt trajectory. They simply chose not to act. Reserve-currency status should have reinforced the duty to safeguard U.S. creditworthiness, not invited complacency. Debt appears “backed” only because investors treat U.S. obligations as uniquely safe. When that perception shifts, the adjustment will be sharper precisely because the privilege was misused.