The US stands unrivalled as both a military and financial superpower. This column uses a game-theoretic model to show how the global dominance of the US dollar – what economists call the ‘exorbitant privilege’ – is inextricably linked to America’s unmatched military strength. This dual hegemony allows the US to finance its defence spending at enviably low rates while cementing its geopolitical supremacy and supporting its allies abroad. Yet, this privilege is neither inevitable nor eternal; it hinges precariously on the stability of global power dynamics.
The US today enjoys an unparalleled position, wielding both overwhelming military strength and the financial advantage of borrowing at favourable interest rates. But this dominance wasn’t preordained – it’s the result of historical transitions where military power has repeatedly reshaped the global financial order.
Consider Figure 1, which captures the seismic shifts in interest rate differentials during periods of geopolitical upheaval. After WWI, the US supplanted the UK as the world’s leading financial power, with bond yields flipping in America’s favour (Eichengreen et al. 2012). A similar dynamic unfolded earlier, when the UK emerged as the dominant power after the Napoleonic Wars, replacing Dutch supremacy. These reversals underscore a clear pattern: financial dominance follows military might, especially during periods of global instability.
Figure 1 Changing military dominance and bond yields in history
a) US/UK bond yields around WWI
b) UK/Netherlands bond yields around Napoleonic Wars
Note: Panel A plots the government bond yields for the US and the UK from January 1870 until December 1970 (end of Bretton Woods). A vertical line the start of World War (July 1914). Panel B plots the 10-year government bond yields for the UK and Netherlands from 1700 (when UK yields become available) until 1900. The vertical line indicates 1795, when the Netherlands was invaded Napoleon. US and UK bond yields are from Global Financial Data. Netherlands bond yields are from Korevaar, Francke and Eichholtz (2020). The Netherlands yield for the 1700s uses data for the Province of Holland.
So, what sets dominant currencies apart? Conventional wisdom credits the depth of financial markets and robust trade networks (e.g. Eichengreen 2011, Rey et al. 2014). While these factors certainly play a role, they cannot explain the striking alignment between military strength and financial privilege. Figure 2 drives this point home, showing how geopolitical crises consistently enhance the US borrowing advantage. During the Gulf War, Iraq War, and Russia’s invasion of Ukraine, US bond yields dropped as investors flocked to the safety of assets issued by a militarily dominant nation. The conclusion is clear: military might is not just a supporting factor; it’s a cornerstone of financial supremacy.
Figure 2 Developed country-US borrowing costs vs geopolitical risk
Note: This figure plots the spread between an equal-weighted average three-year government yield from six developed countries (Australia, France, Germany, Italy, Japan, UK) minus the three-year US government bond yield against the historical geopolitical risk index for the US (in annualized %). (GPHRC USA) from Caldara and Iacoviello (2022). The yield spread is stochastically de-trended by subtracting a 10-year moving average, with all yield data from Global Financial Data. The German three-year government bond yield is extended with Bloomberg data after 2021. We take the log of the geopolitical risk index and a 12-month moving average to reduce the effect of outliers. The sample is monthly and runs from January 1980 to November 2023. Geopolitical risk is standardized to have a mean of zero and standard deviation of 1.
Indeed, victorious powers like the US after WWI and WWII maintained lower inflation and stronger financial stability, while vanquished countries faced soaring inflation and crippling debt devaluation. Military dominance thus reassures investors that a nation will not suffer the economic chaos of defeat, solidifying confidence in its relative creditworthiness.
In our working paper (Pflueger and Yared 2024), Carolin Pflueger and I propose a game-theoretic model that lays bare the self-reinforcing loop between military and financial dominance. Military strength enhances investor confidence in a nation’s ability to honour its debts, especially in times of crisis. Conversely, financial dominance allows a hegemon to fund its military at lower borrowing costs, reinforcing its global standing.
However, this system is not invulnerable. Our model highlights its fragility: a rival with deep financial markets could upend this cycle, triggering a rapid hegemonic transition. For instance, China’s push to internationalise the renminbi poses a direct challenge to the US dollar’s dominance. A globally accepted Chinese currency could attract international capital, undermining America’s financial privilege and its ability to sustain military superiority.
Some key takeaways from our research are as follows:
- Prudent debt management supports military dominance. The US’s ability to tap global financial markets at low interest rates currently provides it with an important geopolitical advantage. However, a loss of creditworthiness – whether from high inherited debts or repeated debt-ceiling standoffs – has the potential to threaten both the US’s financial and military status.
- Deficit spending is strategic. Conversely, borrowing to fund the military isn’t merely a fiscal burden – it strengthens America’s financial privilege. By securing its geopolitical dominance, such spending can secure relatively lower long-term borrowing costs.
- Severe military cuts are catastrophic. Reducing military funding would be a grave error, not just geopolitically but financially. A weaker military would erode the US’s borrowing privilege, make all public spending more expensive, and ignite a vicious cycle of rising interest rates and waning global influence.
- An internationalised Chinese currency presents security risks. Should China succeed in globalising the renminbi, it would pose a significant threat to US dominance. The resulting fragility in the global financial system could accelerate a dramatic power shift.
In sum, the interplay between military and financial dominance is not merely academic; it’s a matter of survival for the current global financial system with the US at its centre. America’s ‘exorbitant privilege’ isn’t just an economic perk – it’s the bedrock of its global leadership. Yet, mounting debt and unchecked entitlement spending threaten this delicate balance. As the US faces an increasingly multipolar world, prioritising fiscal discipline and military strength isn’t just prudent – it’s imperative. Without decisive action, the self-reinforcing cycle of American hegemony could unravel, with dire consequences for both national security and global stability.
Source: cepr.org