US Public Debt and Safe Asset Market Power

Q1. What is the theoretical framework for U.S. market power in safe assets?

The paper develops a deterministic, infinite-horizon, two-country model in which the U.S. is the sole provider of an asset with a non-pecuniary benefit to foreign (Rest of World) households, so the U.S. faces a downward-sloping demand curve for its public debt and acts as a monopolist in equilibrium. In the model, purchasing U.S. public debt yields a non-pecuniary flow benefit captured by an increasing, concave function f(b*). Because of this benefit, the equilibrium return on U.S. debt is lower than the return on capital — the gap being the convenience yield, defined as the spread between the U.S. capital return and the return on U.S. public debt. The U.S. Ramsey government internalizes the inverse demand function for its debt when solving its optimal fiscal problem, creating a standard monopoly markup: the equilibrium markup equals the inverse of the demand elasticity, µ = 1/ε_D, where ε_D is the price elasticity of foreign demand for U.S. Treasuries. Under price-taking, the markup is zero and the convenience yield reflects only the non-pecuniary value; under the monopoly model, the convenience yield is inflated by the markup, reducing debt supply below the competitive level.

Q2. How does the paper test monopoly versus price-taking behavior empirically?

The paper applies the conduct-testing approach of Bresnahan (1982) and the model selection test of Rivers and Vuong (2002): since rotations in the demand curve (changes in the elasticity, holding the level fixed) shift prices only if the firm exploits market power, a finding that convenience yields increase in high-elasticity regimes while quantities decrease is evidence of strategic behavior. The paper uses a regime indicator for periods of high global volatility (measured by the rolling standard deviation of MSCI UK Index returns over 1935–2020) as the demand rotator: during high-volatility periods, investors’ demand for safe assets is more inelastic (flight-to-safety), causing the demand curve to both shift outward and rotate (become steeper). The monopoly model predicts that the U.S. responds to the more inelastic demand by raising the convenience yield through higher markups and restricting supply, whereas the price-taking model attributes any convenience yield increase purely to shifts in marginal cost.

Empirically, the data show that convenience yields are higher and debt-to-GDP ratios lower during high-volatility periods — inconsistent with the price-taking model’s prediction that both prices and quantities should rise in a demand shift, and consistent with the monopoly model’s prediction of reduced supply. The estimated demand semi-elasticities are −0.20% per log-point in low volatility and −0.59% per log-point in high volatility (OLS), implying demand elasticities of 1.07 in low volatility and 3.18 in high volatility. The Rivers-Vuong test statistics reject price-taking in favor of the monopoly model at the 1% significance level under both OLS and IV specifications and across a wide range of assumed cost elasticities.

Q3. What is the quantitative magnitude of safe asset underprovision?

Using a demand elasticity of 2.2 (the average of the OLS and IV estimates from specifications without the demand rotator, consistent with the prior literature), the paper’s calibrated monopoly model implies that the U.S. safe asset supply is approximately half as large as it would be if the U.S. acted as a price taker: the steady-state total safe assets-to-GDP ratio is 0.39 in the monopoly equilibrium versus 0.59 in the competitive equilibrium. The markup accounts for approximately 45% of the average convenience yield of 68 basis points, implying a markup of about 30 basis points. The interest rate on U.S. public debt is 0.97% in the monopoly equilibrium versus 1.09% in the competitive equilibrium — a difference of 12 basis points — reflecting both the lower debt level and the higher convenience yield that the monopoly generates. These results hold across alternative parameterizations of the cost and demand elasticities.

Q4. What are the welfare implications of safe asset market power?

Market power generates significant welfare gains to the U.S. and welfare losses to the Rest of World: transitioning from the monopoly steady state to an economy with no special role for U.S. assets costs the U.S. 0.21% in permanent consumption equivalents and benefits the Rest of World by 0.34%; transitioning to a competitive equilibrium (price-taking but maintaining the special role) costs the U.S. 0.08% and benefits the Rest of World by 0.10%. This decomposition implies that roughly 60% of the U.S. welfare gain from its safe asset status is attributable to the non-pecuniary value (the benefit function f), and approximately 40% is attributable to market power per se. The interpretation is that the U.S. captures surplus from global safe asset demand through both the intrinsic value of its debt and through monopoly rents from restricting supply. The paper interprets these welfare gains as a quantification of “exorbitant privilege” arising from the supply side rather than from risk premium considerations.

Q5. What happens when safe asset competition increases?

The paper analyzes the effects of introducing Cournot competition among multiple sovereign safe asset suppliers, finding that while the aggregate supply of global safe assets increases substantially with more competitors, the U.S. public debt level itself is fairly stable, borrowing costs for the U.S. increase, and the Rest of World welfare improves. With N=2 symmetric Cournot competitors, the aggregate safe asset supply approximately doubles relative to the monopoly baseline, but each supplier’s equilibrium quantity is roughly unchanged. As N increases further, aggregate supply continues to grow, convenience yields fall, and interest rates on U.S. debt rise. A domestic financial fringe competing with U.S. government debt is modeled differently: because the U.S. government internalizes domestic fringe profits, domestic competition results in less competitive pressure, higher markups, and smaller welfare losses for the U.S. than the same amount of competition from foreign suppliers. These results quantify the macroeconomic stakes of initiatives to create alternative safe assets, such as euro area supranational safe bonds or Chinese reserve currency aspirations.

Q6. What identifies strategic versus competitive behavior using debt holder composition?

As a complementary identification strategy, the paper exploits time variation in the composition of U.S. Treasury holders: foreign investors (primarily official sector) have more inelastic demand than domestic investors (primarily financial institutions and mutual funds), and the increasing share of foreign investors since the 1970s implies a secular decline in the average demand elasticity. The paper estimates demand elasticities separately for the two groups, finds the foreign investor curve is more inelastic, and uses the implied time-varying average elasticity as a second demand rotator. The conduct test under this alternative approach also rejects price-taking in favor of the monopoly model. The monopoly model explains the observed increase in long-term convenience yields since the 1970s through rising markups driven by the shift toward less elastic foreign investors, rather than through rising marginal costs of debt issuance.

Key Concepts

safe asset market power

the U.S. government’s ability to internalize the downward-sloping foreign demand curve for U.S. Treasuries and restrict supply to maintain a high convenience yield; the paper provides the first formal empirical test and quantification of this strategic behavior in the global safe asset market.

convenience yield markup

the component of the observed convenience yield on U.S. Treasuries attributable to monopoly pricing rather than to the intrinsic non-pecuniary value of the assets; estimated at approximately 45% of the total convenience yield (about 30 out of 68 basis points) under the paper’s baseline demand elasticity of 2.2.

demand rotator (Bresnahan identification)

a variable that changes the elasticity of demand without shifting its level, enabling identification of strategic conduct: observing that prices rise and quantities fall when demand becomes more inelastic (as during high-volatility regimes) is evidence of monopoly pricing, since a price taker would not respond to an elasticity change alone.

safe asset underprovision

the quantity distortion from monopoly pricing in the global safe asset market; the paper estimates the steady-state safe-asset-to-GDP ratio is approximately 50% lower in the monopoly equilibrium than in the competitive benchmark, reflecting the standard monopoly restriction of output to exploit the downward-sloping demand curve.