The long love affair between investors and US Treasuries is not ending anytime soon.

It has been an amazing decade for the US federal debt burden. From budget deficits from the Great Recession, to President Trump’s tax cuts, to the wave of sweeping pandemic relief plans, federal debt has grown from around $ 5 trillion to $ 21 trillion. This means that the public debt is now roughly the same size as the economy – a ratio that is should double by 2050. What makes this story even more astonishing is that this remarkable surge in current and projected public debt has not caused a significant change in inflation. Both current and expected inflation still reside almost 2 percent.

This lack of spiraling inflation has left many observers perplexed. According to them, there should certainly be signs of rising inflation given the upward trajectory of the national debt. Some of these people, in fact, have warned of higher inflation for most of the past decade, but have proven themselves wrong time and time again. It’s been ten years for them.

Despite their failed predictions, these prophets of link vigilantism raise good questions. Specifically, why have investors maintained their relationship with US Treasuries in the face of soaring public debt? Why don’t they ditch treasury bills or the dollar in general? Aren’t investors worried that the US government could trick them into monetizing a portion of the growing national debt?

These questions focus on the relationship between investors and US public debt. Its stability and strength, therefore, can be understood by looking at the ideas of a long-lasting romantic relationship. Specifically: Breaking up takes time, there is no one else so special, and the relationship is an eternal flame.

Breaking up takes time

The first idea is that ending a long-established romantic relationship takes time. Breakups in such contexts usually do not happen overnight, but occur through a gradual decrease in interest and commitment to the partner. The stronger the relationship, the longer this breakup process can last.

This dynamic is also true for the long-established relationship between investors and US Treasury securities. A break-up, which would result in investors selling bonds in anticipation to remove debt, would likely take a long time to complete, as evidenced by the closest thing to a break-up this relationship has experienced, the so-called “great inflation” of the mid-1960s to the early 1980s. This famous episode began with the great fiscal impulses of Great Society and the Vietnam War, followed by the collapse of the Bretton Woods system , the oil shocks of the 1970s and the shutdown policies of the Federal Reserve. Together, these developments have led to a steady decline in confidence in US public finances over the past 16 years.

This deterioration in confidence can be seen in the figure below in terms of inflation expectations. Its gradual undocking began in 1965 and continued until 1981. This 16-year journey, despite its length, did not lead to a breakdown in the relationship between investors and Treasury securities, but it did. ‘put to the test. This trip indicates that a relationship breakup would likely take a long time. He also suggests that the first step in starting such a journey is a sustained increase in expected inflation. This has yet to materialize and implies that investors are still very committed to this relationship.

This early idea, that severing long-established relationships takes time, is one of the reasons the prophets of bond vigilance got it wrong over the past decade. But that’s not the only reason: the fact that Great Inflation couldn’t have ended this relationship suggests that there is something very special about it.

There is no one else so special

The second glimpse of a long lasting romantic relationship is that there really is no substitute for your soul mate. This also applies to the investor relationship with Treasury securities and dollar-denominated assets more generally. There is really no one else as special as the global dollar system.

To understand why, first note that the United States plays an important role in the global financial system. It is, by order of magnitude, the largest provider of safe and liquid assets in the world. This happens because foreigners treat the American financial system like a bank: they deposit their funds in the United States and, in return, receive claims on money-like assets. The most sought-after assets are those protected by the government, such as currencies, bank deposits and treasury securities. Foreigners, however, also seek out other relatively liquid assets, including pensions, commercial paper, and money market funds. In 2020, these safe and liquid assets issued to the rest of the world totaled approximately $ 20 trillion.

Second, according to the Bank for International Settlements, there is still $ 12 trillion in dollar-denominated assets issued by entities outside of the United States. Combine that with the dollar assets exported from the United States, and there is approximately $ 32 trillion in relatively liquid and safe dollar assets abroad, as shown in the figure below.

There is no other monetary system that comes close to providing so many safe and liquid assets to the world. On the one hand, this result is not surprising, given the the dominant role of the dollar in the global economy. On the other hand, the implication of this fact is amazing: there is no other source of safe and liquid assets available on such a large scale. This means that if investors wanted to break away from the global dollar system, there would be nowhere else to go to meet all of their relationship needs.

In addition, this great gulf between the supply of assets denominated in dollars and other assets is reinforced by network effects. That is, as investors turn to dollar investments because there are enough of them, the dollar user network grows and, in turn, makes dollar assets more liquid. As a result, this increased liquidity increases the demand for dollar assets and strengthens the dollar’s dominance. This dollar cycle intensifies during seizures, when investors rush for safety and further extend the dollar’s network effects.

Network effects are one of the main reasons the global dollar system maintains its status as the only large-scale provider of safe and liquid assets. At the heart of this system are US Treasuries and other government-backed assets, and therefore make it difficult for investors to break with US public finances.

This relationship, however, is more than a forced marriage. It is also a relationship based, in part, on the belief that it will be an eternal affair.

The eternal flame

A third glimpse of a long-lasting romantic relationship is that its strength comes, in part, from the belief that your partner will be there for the long haul. The investor’s relationship with the US national debt is this and more: It is based on the hope that the United States, its government, and its financial prowess will continue forever. This expectation, to paraphrase the Bangles, means the investors burning for US government securities are an eternal flame.

The eternal nature of this relationship means that the US government can roll over and refinance its debt indefinitely. Now it can only do so as long as the growth rate of the US economy exceeds the costs of financing the national debt, but as economist Olivier Blanchard showed, this has generally been the case. This trend is also expected to continue given the continued high demand for safe assets and the unique role, described above, that the US government plays in providing safe and liquid assets to the world.

The Eternal Flame, in other words, means that the investor’s relationship with the national debt can weather severe storms and survive. This has been demonstrated by the still low interest rates on Treasury securities and the stable inflation outlook despite the current and expected rise in public debt.

For all of these reasons, then, investors’ break with US Treasury securities and other dollar-denominated assets is much more difficult to do than the prophets of bond vigilance predicted. That’s not to say that a breakup is impossible, but it does suggest that ending investor affinity for the global dollar system would likely require something drastic like the separation of the United States. Since such an outcome is highly unlikely, it is equally unlikely that there will be a sustained surge in inflation.

To be clear, this is not an argument for increased federal spending, but simply an assessment of whether past and proposed federal exits will be highly inflationary. The answer is no, and if so, safe asset returns suggest that investors are happy to have Treasury securities and other dollar-denominated assets. To invoke another song from the 1980s, investors always sing that they are “happy to be stuck with you” To the global dollar system. This song will be their anthem for the foreseeable future.