Exorbitant Privilege Gained and Lost: Fiscal Implications

Q1. How does the paper measure fiscal capacity?

The paper follows the Jiang-Lustig-Van Nieuwerburgh-Xiaolan (2019) methodology, expressing the market value of outstanding government debt as the present risk-adjusted discounted value of expected future primary surpluses under the government’s intertemporal budget constraint — the no-arbitrage condition that rules out rational debt bubbles. The market value of the government debt portfolio equals the present value of tax revenues minus the present value of government spending. A Vector AutoRegression (VAR) imposing cointegration of GDP with tax revenues and government spending is used to forecast the joint dynamics of the surplus. The paper uses the market or output risk premium as the discount rate, imputing the risk properties of GDP to spending and tax revenue claims.

A key methodological challenge is handling structural breaks: before World War I, U.K. fiscal policy was pre-Keynesian — acyclical spending and taxes (except during wars) — so spending and tax revenue as shares of output inherit the risk properties of output, and the market risk premium is the appropriate discount rate. After World War II, spending becomes counter-cyclical and taxes pro-cyclical in the Keynesian framework; the paper argues that applying the market risk premium in this regime produces an upper bound on the PDV of surpluses. For the U.K., this methodology is validated: the correlation of fiscal capacity with the debt/output ratio is 0.90 in the pre-WW-I sample and remains high after WW-II, despite the fiscal regime change.

Q2. What are the quantitative findings for the U.K.?

The paper finds that before World War I, U.K. fiscal capacity fell systematically short of the observed market value of U.K. debt: the average debt/GDP ratio was 87.06% while the estimated fiscal capacity was only 69.32%, with the ratio of fiscal capacity to debt averaging 74.32% — implying roughly 26% of U.K. debt was not backed by future surpluses even after including convenience yield seigniorage. The U.K. earned average long-term convenience yields of approximately 100 basis points per annum from 1873 to 1931 (translating to approximately 0.47% of GDP in annual seigniorage), reflecting its dominant position as the world’s safe asset supplier and the quasi-monopoly position of gilts in global securities markets (U.K. national debt accounted for more than half of the world’s traded securities around 1815). Despite these convenience yields, the gap between fiscal capacity and debt persisted throughout the 19th and early 20th century.

After World War II, the picture reverses: the U.K.’s average post-war fiscal capacity of 82.03% of GDP exceeds its average debt/GDP ratio of 53.42%, leaving more than 50% of fiscal capacity unborrowed. The correlation with debt dynamics persists but the sign changes — U.K. borrowing is now constrained by own macro fundamentals rather than extended by global coordination.

Q3. What do the authors find for the United States?

The U.S. experience mirrors the pre-war U.K. after World War II but with much larger magnitudes: the paper’s estimates indicate that less than one-third (32.20%) of post-war U.S. Treasury debt is backed by future surpluses, with the gap between fiscal capacity and debt growing sharply toward the end of the sample to exceed U.S. GDP. Before World War I, the U.S. did not earn convenience yields — it was forced to borrow at higher rates than the U.K. despite having lower debt-to-output ratios — and its fiscal capacity exceeded its debt, with the ratio of capacity to debt averaging 169.36%. After World War II, when the U.S. became the global safe asset supplier under the Bretton-Woods architecture, the relationship inverted: average U.S. fiscal capacity of 13.20% of GDP represents only 32.20% of outstanding debt. The gap is increasingly large in recent decades as U.S. debt has grown while surplus projections have not expanded commensurately.

Q4. Why does safe asset supplier status allow a country to borrow beyond its fiscal capacity?

The paper argues that global investors coordinate on a single safe asset issuer based on relative macro fundamentals; this coordination is self-reinforcing because each additional investor holding the asset reduces rollover risk and renders the debt safer for all others, creating strategic complementarities that concentrate global fiscal capacity in one country beyond what its own surpluses would warrant. Unlike domestic convenience yields (arising from household demand for safe assets to insure idiosyncratic risks), the global safe asset effect creates a form of extra-fiscal capacity that depends on investors’ common belief about which country is the hegemon. The measured seigniorage from convenience yields — about 0.47% of U.K. GDP before WW-I and 0.36% per year for the U.S. post-war — does not fully capture this coordination benefit; the remaining gap between fiscal capacity and debt reflects the additional “license to borrow” that comes with global hegemon status.

The transition from U.K. to U.S. hegemony illustrates the mechanism: as U.K. macro fundamentals deteriorated relative to U.S. fundamentals after the world wars, investors shifted the concentration of fiscal capacity toward the U.S. The U.K. lost its license to borrow beyond its fundamentals; the U.S. gained it. The paper notes that the U.K. debt/output ratio exceeded 200% after WW-II — a level associated with the loss of hegemony.

Q5. What historical data and institutional context does the analysis use?

The paper uses annual data for the U.K. from 1729 to 2020 (from the Bank of England’s Millennium of Macroeconomics dataset and the Ellison-Scott dataset on individual bond market values from 1694 onward) and for the U.S. from 1791 to 2020 (from Hall-Sargent and CRSP), constructing primary surpluses, tax revenues, spending, GDP, and convenience yields consistently over nearly three centuries. U.K. convenience yields before WW-I are measured as the interest rate differential between U.K. government securities and otherwise comparable bonds from countries on the gold standard; the sample average is approximately 147 basis points at the short end and 110 basis points at the long end, with the spread declining at longer maturities (the opposite of what default risk would predict), providing evidence that convenience yield rather than residual default risk drives the differential. U.S. post-war convenience yields are constructed from the spread between the 3-month Treasury yield and the 3-month CD rate (or bankers’ acceptance rate before 1964), averaging 36 basis points per year from 1947 to 2020.

Q6. What are the implications for models of fiscal capacity and debt sustainability?

The results favor models in which the safe asset supplier’s fiscal capacity is determined partly by relative macro fundamentals (which country the global financial system coordinates on) rather than solely by absolute fundamentals (its own surpluses), and challenge models that treat the transversality condition as a binding constraint at all times for all countries. The finding that a large fraction of U.S. Treasury debt is not backed by future surpluses — even when the market risk premium is used to discount — has implications for debt sustainability analyses: standard present-value-of-surpluses calculations will understate the true fiscal capacity of the safe asset supplier, while overstating it for others. The paper’s framework suggests this extra capacity depends on maintaining relative macro fundamentals and global investor coordination, and can be lost — as the U.K. experience demonstrates — when relative fundamentals deteriorate.

Key Concepts

fiscal capacity

the present risk-adjusted discounted value of a government’s expected future primary surpluses, computed from the government’s intertemporal budget constraint under no-arbitrage; in this paper, inclusive of seigniorage revenue from convenience yields earned on government debt.

exorbitant privilege

the ability of the safe asset supplier country to borrow at below-market interest rates due to global demand for its government debt as a safe asset; quantified in this paper as the gap between the market value of debt and estimated fiscal capacity from surpluses alone, which exceeds fiscal capacity for the pre-WW-I U.K. and post-WW-II U.S.

convenience yield

the yield reduction (below comparable risky borrowing rates) that the safe asset supplier earns from global safe asset demand; measured as approximately 100 bps long-term for the pre-WW-I U.K. and approximately 36 bps on average for the post-WW-II U.S., contributing 0.47% and 0.36% of GDP annually in seigniorage revenue respectively.

transversality condition (TVC)

the condition ruling out rational government debt bubbles, requiring the expected discounted value of outstanding debt to approach zero at long horizons; the paper imposes the TVC and finds that for the pre-WW-I U.K. and post-WW-II U.S., the observed debt level exceeds fiscal capacity even under this constraint, interpreted as evidence of the extra borrowing license conferred by safe asset supplier status.