Convenience lost

Throughout the postwar era, the dollar has reigned as the dominant global reserve currency. This has allowed the US to borrow more cheaply than other nations. Economists call this exorbitant privilege, a slightly acerbic term coined by France’s then-finance minister Valéry Giscard d’Estaing some 55 plus years ago.

In an article published in 2007, this advantage was estimated at 1-2% of GDP. The piece was widely cited, and the estimate became something of a benchmark. For comparison, the US entered this millennium with a budget surplus of roughly the same magnitude.

Since then, however, the fiscal balance has plunged to a deficit of 6.3% of GDP (2024). Federal debt has surged from around 55% to 120% of GDP. The question now is whether this dramatic debt expansion is devouring the entire privilege.

A working paper from the US National Bureau of Economic Research (NBER) offers a strikingly clear answer. The researchers estimate that the rise in federal debt has significantly eroded the advantage – especially at the long end of the yield curve. Technically speaking, we’ve seen a sharp reduction in the convenience yield. This refers to the credit premium investors forgo when buying US Treasuries due to their safety, liquidity, and regulatory advantages. As for the title, the authors have punned it Convenience Lost.

The researchers measure the convenience yield against two alternative rate series. One method uses swap rates (LIBOR until 2021, then SOFR), which are collateralised with US Treasuries and thus similarly risk-free. Simply put: a 5 percentage point increase in long-term debt as a share of GDP slashes the convenience yield by a full 0.94 percentage points. The effect is smaller for short-term debt.

The second benchmark is the interest rate on other countries’ sovereign bonds, hedged against the US dollar. Measured this way, a 5-point rise in the debt ratio reduces the convenience yield by 0.74 percentage points—again, only for long-term debt, so we can’t just divide the debt increase by 5 to see the impact.

But it’s not all bad news. Higher federal debt also means more dollars to harvest the convenience yield. The net effect is thus a product of two opposing forces. That product, however, is clearly smaller: the value of the exorbitant privilege has shrunk by 5-10% of the annual interest expense in the federal budget.

At the long end of the curve, today’s convenience yield is actually estimated to be negative (!). Since there’s still a positive convenience yield on short-term debt, one might imagine it would be beneficial for the US to issue more short-term bonds. But that merely pushes a refinancing risk forward – which will rear its ugly head at an even higher debt level later. Treasury Secretary Scott Bessent would likely not object to calling that a risk.

What’s interesting is that the current administration seems more concerned with another consequence of the dollar’s special status: it’s said to be the cause of the large current account deficit. The idea is that foreign investment in US assets creates a massive capital account surplus – which, by definition, mirrors the current account deficit (currency flows must balance). Alternatively, one could argue that the capital account surplus has artificially strengthened the dollar.

This neglects an important definition: the current account deficit must equal the gap between saving and investment. With large federal budget deficits, US national saving is low. And when the US saves less than it invests, a current account deficit follows. But of course – with lower interest rates, financing that deficit has been easier.

In any case, it can be argued that the overall privilege balance is starting to tilt the other way: while the US has long enjoyed major benefits from the dollar’s role as a global reserve currency, those benefits may now be overshadowed by the downside. I’m hard pressed to endorse that view – but that hardly matters.

Because there’s good reason to believe the current administration sees it that way. And now it has more research to back it up.