Preserving the global safe asset status of US Treasuries and the US dollar is in everyone's interest

Some observers blame the strength of the dollar, due to its role as global reserve currency, for the decline of manufacturing jobs in the US. In this blog post, we outline the arguments for and against preserving the safe asset status of US Treasuries and the dollar and argue that the advantages outweigh the disadvantages.

What is a safe asset?

A safe asset is like a good friend for its holder: a reserve for bad times. More specifically, it is valuable and can be sold at a good price when one faces an idiosyncratic shock or a global crisis. People, including foreigners, are willing to hold safe assets like the US Treasury for these reasons. Hence, the issuer, the US government, does not have to pay high interest on it. In other words, since the safe asset provides holders some “service flow,” they are happy to hold it with low (or even negative) cash flow in the form of low interest payments. Hence, the real interest rate on the US Treasury is typically below the growth rate of the global economy, 
i.e. r < g.

What are the long-run structural advantages and disadvantages of being able to issue the global reserve asset?

There are three long-term structural advantages. First, the interest rate the US has to pay for its debt is lower. It enjoys a convenience yield. Second, the US can continuously print money and issue government debt without ever paying it back, as long as the interest rate does not exceed the global GDP growth rate. In a sense, the US can issue a bubbly asset to foreigners. By issuing more bonds continuously, the US can run a trade deficit forever. Third, this advantage is particularly high during times of crisis, when the extra benefit of holding a safe asset is particularly valuable. The appreciation of the safe asset in crisis times makes it even more attractive for its holders and hence drives interest rates even lower. Overall, the US enjoys a large, exorbitant privilege.

While the convenience yield in the form of an interest rate advantage can be measured and included in the US current account, the other components of the exorbitant privilege are not easily measured. In other words, the US current account deficit (including trade deficits) is particularly susceptible to mismeasurement. It is well known that the US, with its tech and financial industries, has a surplus in services. However, the measured services do not include the “service flow” that bubbly US Treasuries provide to foreigners. If this “service export” was accounted for in the balance of payments, the US current account would be smaller than reported by the Bureau of Economic Analysis. The reported imbalances suggest unsustainability even when it is not the case. In short, the public debate to some extent overstates the problem.

Supplying global reserve assets has structural costs and disadvantages for the US. The demand for US dollar assets leads to the real appreciation of the dollar, which can be disadvantageous under certain conditions. For example, a stronger dollar can make US tradable sectors less competitive and shift manufacturing abroad. If the production of tradable manufacturing goods benefits from increasing returns to scale or "learning-by-doing" externalities, this shift allows countries like China to improve their production technology more rapidly, potentially leaving the US behind. Thus, the privilege of supplying safe assets can become a long-term disadvantage.

Tariffs also interact with the safe asset demand and reduce the exorbitant privilege. A permanent tariff (without retaliation) improves US terms of trade if US consumers exhibit some preference for home-produced goods. This makes the foreign country poorer and reduces their safe asset demand, which, in turn, reduces the (permanent) trade deficit and attenuates both the advantages and disadvantages mentioned previously.

What are the (dis)advantages of the reserve/safe asset status over the cycle?

The advantage of issuing US Treasuries is particularly high during global crisis times. Because of the “flight-to-safety” phenomenon, foreign (and domestic) citizens are particularly keen to buy US Treasuries when global risk is high. Hence, US Treasuries gain in value during these times, allowing the US to issue debt at favorable terms and run fiscal stimulus programs at home. In contrast, other countries have to implement austerity measures during times of global crisis. This cyclical “service flow” is particularly valuable and speaks in favor of maintaining the safe asset status for the US dollar. Importantly, this cyclical service flow is also not reflected in trade or current account deficit statistics. Hence, the trade deficit is overstated.

Supplying the global reserve asset also has a cyclical disadvantage in an economic downturn. Notice that the “flight-to-safety” in the US dollar leads to its appreciation, hurting US exporters during crisis times. To the extent that this is not offset by US stimulus programs, the dollar appreciation depresses demand for US goods. If consumer price adjustments are sluggish, then an output gap opens up—production is below potential. This adverse effect is particularly pronounced for the safe asset providing country. However, these effects are smaller for large countries, like the US, than for small safe asset suppliers, like Switzerland.

The loss of safe asset status and the Triffin Dilemma 2.0

The Triffin Dilemma 1.0 refers to the Bretton Woods period before 1971, during which international exchange rates were fixed to the US dollar, which in turn was pegged to gold. As the world economy grew faster than the US, the rest of the world demanded more US dollar reserve assets. This required the US to issue more dollar liabilities. As US gold holdings were not increasing, the dollar’s fractional backing declined over time. Hence, the probability of a run on gold reserves or other confidence crisis in the US dollar became more likely.

Since 1971, exchange rates have predominantly been flexible. However, a "Triffin Dilemma 2.0" has emerged with three key differences. First, the focus has shifted from the US dollar to US safe assets, specifically US Treasury securities. Second, instead of the increased risk of a run on gold, the potential loss of the (bubbly) safe asset status now poses an increasing threat to the global financial architecture. Third, the diminishing backing of the US dollar by gold has been replaced by the declining backing of US Treasuries by US fiscal capacity. Specifically, whenever the safe asset status is questioned, the US has to be able to raise taxes and cut government expenditures to support high US Treasury prices with fiscal (primary) surpluses. The necessary fiscal measures might trigger social hardship and political unrest, especially if implemented suddenly.

US dollar versus US Treasury: Rising term spread

As long as the US is a beacon of stability, US Treasuries help those holding them improve their resilience. However, if there is uncertainty about the possible loss of the safe asset status in the future, the dollar exchange rate will weaken and an additional risk premium for long-term US Treasuries will arise, in line with recent market developments. The reason is that the US Federal Reserve would likely react with interest rate hikes to a loss of safe asset status in order to contain the inflation and dollar depreciation pressures associated with a confidence crisis in the dollar. As a result, long-term US Treasuries would be hit harder in such an event. Ex ante, a higher probability of a future loss of safe asset status raises the term spread to compensate investors for this additional risk. Note this loss of safe asset status risk premium is different from a default risk premium. It can emerge even if investors are confident that the US Treasury will never default. Also, the value of the US dollar might not depreciate right away if the danger of a loss of safe asset status is only in the future.

A world without a global safe asset makes it more difficult for agents to hold valuable resources against idiosyncratic or aggregate shocks. Hence, people have to bear more risk and might scale back on risky investments. Since it is not easy to establish an alternative global safe asset in a short time frame, it is in the interest not only of the US but of the whole world to maintain the important global role of the US dollar and the US Treasury.  

This blog post builds on a two-country version of our earlier paper Safe Assets (Journal of Political Economy 2024). Watch the Keynes Lecture at Cambridge University that presents the two-country version.