With the US debt-to-GDP ratio at historic highs, there is widespread concern for its long-term sustainability. Typical debt sustainability perspectives, often developed in the context of emerging markets or smaller developed economies, do not necessarily apply here, Maria Vassalou writes in her article on finews.first.
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The US has a unique position in the global financial architecture and geopolitical order that sets it apart from any other country. It is the ultimate case of «too big to fail» with the downside asymmetrically tilted against the Rest of the World (ROW).
Ever since Bretton Woods in 1944, the dollar has been the world’s reference currency, first through its convertibility to gold, and, from 1971 onwards, as a fiat currency. The economic stability and geopolitical dominance of the US rendered the dollar a natural global reference currency. This allowed the US to run persistent current account and budget deficits and support a higher level of consumption, lower inflation and higher growth than otherwise, financed through capital inflows from the ROW.
«Looking into the future, the availability of surplus capital flows may be severely diminished»
Over time, the ROW became an increasingly important investor in the US, not only in US debt instruments but also in equities. The superior ability of the US to develop new technologies, innovation, and unicorn companies has continued to attract non-US capital, intertwining the US and the ROW economies through a variety of complex mechanisms.
The financial arrangement that has emerged is central to the ability of the US to expand and support its increased indebtedness. Equally central is the continued ability of the ROW to generate capital surpluses that it is willing to invest in the US rather than in its domestic economy. Both conditions are inextricably linked to the strength and stability of the geopolitical alliances that the US fosters around the world and which support the US's central role in the world economic order.
Looking into the future, the availability of surplus capital flows may be severely diminished by impending investment needs in the capital-exporting regions themselves. As the world becomes less globalized and more geopolitically fragmented, the current equilibrium appears to be less long-term stable. In the meantime, the difficulty of the ROW in weaning itself off the use of US safe and other assets is the «glue» that preserves the current financial arrangement. Presently, it is also being used by US administrations as a negotiating lever for a wide range of matters involving American economic and geopolitical interests.
«A tipping point for US debt sustainability could occur when additional borrowing is required»
By 2028, interest expenses will represent over 60 percent of the US federal deficit. Therefore, a tipping point for US debt sustainability could occur when additional borrowing is required mainly to cover interest servicing costs. Such a development may provoke a significant selloff in US Treasuries that could quickly spread to other asset classes, including equities, giving rise to global market turmoil. Both the US and the ROW will have much to lose but the impact may be asymmetrically greater for the ROW.
The reason is that the ROW has «doubled down» on US risk through its massive US safe assets and equity investments. Therefore, in the case of a US-led market turmoil, it may be in the best interests of the official sector in the ROW to intervene in the markets and assist in providing a «floor» to US asset prices. The reality is that the complex relationship of the ROW with the US renders US debt more sustainable than it should be according to a classic debt sustainability analysis, it also elevates US equities to a high-yielding new proxy for US safe assets. So long as the current financial arrangement is in place, US equities will in fact serve as attractive high return-generating quasi «safe assets».
«An increasingly polarised world aims to challenge the dominance of the US»
But can the current equilibrium be sustained forever? The global demand for safe assets is proportional to the global GDP. As the developing world grows at higher rates than the countries that produce safe assets, the demand for safe assets will keep outpacing their supply. The US, being the dominant supplier of global safe assets, cannot expand its debt issuance forever to satisfy global demand without subjecting itself to significant economic fragilities and national security issues.
In the meantime, however, the main risk to US debt sustainability is geopolitical in nature. An increasingly polarised world aims to challenge the dominance of the US and the desirability of its assets in the global financial system. Initiatives such as those of the BRICS Plus merit close monitoring.
Maria Vassalou, former Co-CIO at Goldman Sachs Asset Management, now heads the Pictet Research Institute, which was launched in early 2024. In this role, she leads research on strategic asset allocation, portfolio construction, as well as global economic and investment trends. She studied and earned her PhD at the London Business School.
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