Should Europe Continue to Fund U.S. Federal Debt?

Abstract This paper examines the possible triggers that could unsettle the asymmetric equilibrium of the international monetary system, by eroding the global role of the dollar and the associated “exorbitant privilege”. We develop a calibrated two-period, two-economies general equilibrium model for the United States and Europe in which the latter derives a convenience yield from holding US debt—denominated in the dominant reserve currency. Our simulations indicate that a US fiscal expansion (even if combined with stronger economic growth), rising trade barriers, and heightened default risk on foreign-held US sovereign debt all tend to curb the external demand for US safe assets. The upward pressure on US real yields and the significantly weaker outlook for the real exchange rate of the dollar would imply a partial reversal of the benefits the United States derives from dollar dominance. For Europe its exposure to US policy and institutional uncertainty increases, a situation that is likely to persist lest Europe develops a genuine safe asset of its own.