Exorbitant privilege or why the UK cannot do what the US does

Living in the UK, there is strong support for low tax policies and US style tax cuts to boost growth. But as the disastrous mini-budget by ex-PM Liz Truss has shown, such an economic policy is unachievable in the UK at least when it is done by increasing budget deficits. A couple of recent studies show why the US is in a privileged position vs. the UK and can get away with reckless budget deficits like no other country can.

The key difference between the US and the UK is, of course, the currency. The US Dollar is the world’s reserve currency and everyone who is involved in international trade or international investments has to own US Dollar. But nobody has to own Sterling (sorry, Brits, but it’s the truth).

Of course, until the first half of the 20^th century, the UK was the leading economic nation and Sterling was the world’s reserve currency. But at the latest with the Bretton Woods agreement, this role has shifted to the US Dollar. And even decades after that shift one can document the decline of Sterling as a currency of international trade and investment in the data.

Jason Choi and his colleagues have measured the elasticity of demand for Sterling and US Dollar and its evolution between 1980 and 2017. The chart on the left below shows that the demand elasticity for UK debt rises from 0.77 in 1980 to 1.57 in 2017. In plain English, these numbers mean that in 1980 a one percentage point increase in the debt/GDP-ratio of the UK led on average to a 0.77% drop in the demand for public debt while in 2017, a one percentage point increase in the debt/GDP-ratio led to a 1.57% drop in the demand for UK government debt. Over the same period, the demand elasticity for US government debt declined from 2.53 in 1980 to 1.67 in 2017.

Demand elasticity for UK debt (left) and US debt (right)

Source: Choi et al. (2022)

The last forty years, then, demand for UK government debt has become more elastic and demand for US government debt has become more inelastic. Hence, the US can borrow more and run higher government deficits and debt/GDP-levels with less reduction in demand for its debt and currency.

In a follow-up paper, the same group of researchers recently estimated how much lower US debt/GDP-ratios would be if the US did not have the exorbitant privilege of the world’s reserve currency and benchmark safe haven asset.

They conclude that US debt/GDP-ratio would be 18 percentage points lower today if the US Treasuries were not the world’s benchmark safe asset and it would be 3 percentage points lower if the US Dollar was not the world’s dominant currency for trade and investments. Taken together, the US debt/GDP-ratio today is some 22 percentage points higher than without this privileged position.

Or to translate that into numbers, US central government debt is currently 110% of US GDP. But it would be 88% of GDP if the US could not rely on the inelastic demand for US Dollar and US Treasuries. In that case, the US government would have to pay much higher interest rates on its debt and would have a much harder time finding enough buyers to finance its deficits. And of course, the US government has made use of this privilege and continued for decades to run excessive government deficits without being punished for it. And as long as the US government continues to benefit from this exorbitant privilege it will continue to live beyond its means while countries like the UK cannot.