Is the US Running Out of Time as the Rest of the World Runs Out of the Dollar?
Global trust in the US and its almighty dollar seems to be in question, with some nations scrambling to create alternative payment systems to compete with it. Some believe it is because the budget deficit is out of control, with the debt ratio rising to a nearly unprecedented level. Bond market jitters forced the Treasury to engage in unusual actions to prop it up. Stubborn inflation that began during the COVID era has risen in recent months and shows no end in sight—forcing the Fed to raise interest rates. The President imposed punishing tariffs even on some of our closest allies, pushing Canada to pursue closer relations with the European Union (EU).
And tariffs are not the only divisive policy that has rattled international relations. Like presidents before him, Trump has seized foreign-owned assets and used financial sanctions as well as outright military interventions to punish nations. The US-Israeli war against Iran has disrupted global shipping—especially of petroleum products—and has destabilized much of the Middle East in a manner that will be difficult to rectify. Likewise, the war in Ukraine has had political and economic consequences across Europe, and despite President Trump’s claim that he could negotiate a peace, the hostilities seem more entrenched and have spread beyond the direct combatants. All this has shaken confidence in the US and its dollar.
In this policy note I examine the current US challenges and argue that the orthodox views of the causes and appropriate economic policy fixes are fundamentally flawed. To tackle these problems, we need to carefully separate fact from fiction and formulate fact-based policy.
Fed Hikes Rates
As Chairman Warsh warned on August 28th, “Price stability is not self-executing,” so “we have work to do.” (New York Times 2026a) With inflation remaining well above its target, the Fed finally addressed it on September 16th, raising its policy rate by 25 basis points—the smallest amount considered—and markets believe another rate hike is coming at the next meeting. Yeva Nersisyan and I argued in our last policy note (Nersisyan and Wray 2026b) that the Fed is thoroughly steeped in the erroneous belief that it can, and should, single-mindedly pursue a 2 percent inflation rate target. James Galbraith recently showed that the Fed has never been charged with that mission (Galbraith 2026). But the group-think (Bloomberg 2025) that dominates forced even Trump’s hand-picked Chairman—whose mandate was to reduce rates—to snub his benefactor and make the vote unanimous (afterward, Trump claimed he had provided permission for Warsh to do so).
The way this is supposed to work is by increasing borrowing costs, forcing households and firms to forgo spending. The already-depressed housing market, with a shortage of housing but stagnant prices because of an affordability crisis, will do part of the work of relieving inflation pressure—by curtailing building and making the housing crisis worse! Consumers already burdened with credit card, auto, and student loan debt will face higher interest costs and cut their consumption. In other words, the thinking is that by ramping up the affordability crisis, the Fed might be able to cool the inflation that is largely fueled by Trump’s raging fire in Iran.
Markets were already worried about rising rates at the long end of Treasury securities. Indeed, Treasury Secretary Bessent had tried to relieve pressure through buybacks of the Treasury’s own debt (Nersisyan and Wray 2026b). That was mostly unsuccessful—with most mainstream observers arguing that the volume purchased was simply too small to make much difference. Furthermore, markets are watching the federal government’s rising debt ratio as well as the chronically large deficits and pricing in the risk of government default. The large outstanding debt plus rising interest rates mean even bigger deficits in the future.
Reality Check
As Yeva Nersisyan and I argued, interest rates are set by the Fed, not by bond markets. If the Fed holds its interest rate target constant and is expected to continue to do so, the rates on Treasury bonds are going to remain steady—no matter how much the deficit rises. However, bond markets had been expecting a rate hike—which is why it had largely been priced into bond prices—so all the Fed has done is confirm that bond markets were correct. And now we can reasonably expect the Fed to continue to raise rates, probably over a very long period, so the rates on long-term bonds will remain elevated and even rise. This has nothing to do with vigilantes or actual inflation—it has to do with the way that central banks operate, targeting a 2 percent inflation rate and using rate hikes to achieve it.
As I have argued over the years, the evidence that raising interest rates reduces inflation in a predictable manner is weak—because, as even mainstream economists admit, spending is not very sensitive to interest rates. However, there is one correlation that does stand up very well: the Fed predictably raises interest rates going into recessions (Nersisyan and Wray 2022). As The New York Times rightly reported, “Going back to the 1950s, Fed hiking cycles have lasted 22 months on average … Recessions occurred after each cycle except one: the last time, when Jay Powell was chair.” Correlation doesn’t prove causation; however, it does at least raise the question: when the Fed starts raising rates, is the goal to keep raising them until it brings on a recession? Even if that truly is the goal, the problem is that recessions do not necessarily end inflation—they can instead result in stagflation, the worst of both worlds. And given the current risky financial environment, thanks to leveraged borrowing in the tech sector, a recession now could bring on a deep financial crisis (see Wray 2026; Nersisyan and Wray 2026a).
Impacts of Fiscal and Monetary Policy on Deficits and Inflation
Rate hikes by the monetary authorities affect the federal government’s budget by raising the interest cost of servicing the debt. With the federal government already spending $1 trillion a year on interest, rate hikes will likely increase the deficit. A bigger deficit means more debt will be pumped into bond markets that are already said to be worried about runaway borrowing by governments, including that of the United States. To satisfy the vigilantes who simultaneously face greater risk of government default and higher inflation, interest rates will have to rise—accelerating growth of the deficit in a manner that is said to be unsustainable.
Turning to fiscal policy, according to the Congressional Budget Office (CBO), Trump’s war of choice against Iran has cost about $43.6 billion[1] up to the beginning of September, with costs expected to continue to run another $2 billion or $3 billion per month (Congressional Budget Office 2026). However, those estimates do not include the cost of replacing the draw-down of equipment, including interceptors. Secretary Hegseth’s Department of “War” did not provide estimates of those costs but has asked for additional appropriations of just over $68 billion for the war. The full costs of the war are much greater, including damage to US bases in the region and the added inflationary pressures (largely due to impacts on energy costs), with the CBO estimating that the inflation rate was boosted by 2.3 percentage points in the second quarter of 2026.
A vicious cycle of more debt, higher inflation, slower growth, and higher interest rates is said to make government budgets unsustainable. Simple math shows that once the interest rate on government debt exceeds the growth rate of GDP, the debt ratio explodes toward infinity. An infinite debt ratio is hard to fathom but must be bad.
Jared Bernstein, the progressive economist who led President Biden’s Council of Economic Advisers, has flipped over this: while he used to pooh-pooh the deficit hawks warning that Biden’s spending was creating an unsustainable budget stance, he’s now warning that—to borrow a phrase from the perennial deficit doomster Kenneth Rogoff—this time is different (see Wray and Nersisyan 2010):
Our fiscal reality has changed significantly since those days, and so has my stance on public debt. Here’s why: The basic budget math has worsened as the interest rate on our national debt has climbed closer to the economy’s growth rate. If the compounding debt consistently grows faster than the economy, we risk entering a debt spiral. Our annual deficits, currently about 6 percent of G.D.P., are way above where history says they should be. We’re not in a recession, but we’re borrowing as though we were. Politically, neither party shows any interest in addressing the problem. President Trump and Treasury Secretary Scott Bessent, in fact, are aggressively creating the very risks I worry about. (Bernstein 2026)
True to form, Trump has promised to reward November’s voters with $5,000 per adult if they hand government over to the Republicans. That adds another trillion dollars to the current trillion-dollar deficit. However, the Treasury Secretary assured critics that won’t happen: “I believe there are ways to do it that would not affect the deficit” (Bloomberg 2026). Since Congress has the power of the purse—controlling both spending and taxing—he must have in mind shifting spending from other programs to pay the bribe.
Let’s examine options. Interest spending is currently a trillion, and so is spending on defense. So, if he stops paying interest on the debt, or eliminates funding of the military (or cuts each in half to split the difference), Bessent could find the money.[2] (The only other components of federal spending big enough are Social Security [$1.5 trillion] and Medicare/Medicaid [federal spending on Medicare is about $1.6 trillion, and on Medicaid is about $0.6 trillion]—but these are largely protected by trust funds,[3] making it hard for Bessent to raid them.) A cut to interest payments is, by definition, a voluntary default on debt—and it is not going to happen. With the US in the middle of a war that has no end in sight, cuts there are unlikely.
Perhaps Bessent intends to simply cut the checks? While circumventing Congress will be challenged, those checks can be cleared by the Fed as it credits bank reserves and banks credit household checking accounts. While that technically is a deficit, I suppose Bessent could argue that no debt in the form of Treasury bonds has been created. But if government does not cut spending to compensate, that potential trillion-dollar boost to household consumption would add fuel to the inflation fire. While I do not believe this is ever going to happen, the shock of such a politically and economically radical proposal has already convinced markets that there is little likelihood that this administration is going to tackle the deficit.
The perpetual deficits will push up interest rates, and once they exceed GDP growth rates, we are off and running toward infinity and whatever lies beyond.
Reality Check
While Trump’s attempt to bribe voters is as shocking as it is economically dangerous, there are two reasons to reject the mainstream fears about unsustainability. First, a sovereign government can always make any payment on debt denominated in its own currency—there is no risk of involuntary default.
Second, the “infinity and beyond” scenario is highly unlikely for the simple reason that as government “deficit spending” (fueled by interest payments) rises, those payments go back into the economy, fueling nominal GDP growth.[4] This can kick in the “automatic stabilizer” as income growth increases tax revenue, automatically limiting the size of the deficit. That’s what happened during the Clinton years, when robust growth raised revenue and produced a significant, multi-year budget surplus (for the first time since 1929! See Papadimitriou and Wray 1998). Given the current weak economy,[5] we would need an even bigger deficit for that stabilizer to boost growth sufficiently. But the problem with Trump’s prospective bribe is not unsustainability but rather inflation. Just as the second round of COVID “stimulus” checks boosted the supply-chain-induced inflation (see Wray and Nersisyan 2022), Trump’s checks to reward voters would likely boost the war-and-tariff-related inflation.
To conclude: there is no chance that budget deficits will force the US government to default on its debt—no matter how high interest rates and deficits might go. However, high interest rates as well as other spending can increase the inflation danger. But it does depend on where the spending is directed. If the government were spending in areas that would increase the nation’s productivity, that could be disinflationary. Spending on interest and war (especially war that shuts off the global supply of oil) is likely to be inflationary. The problem with too much of the wrong kind of spending is not the risk of default, but, rather, the risk of inflation.
International Considerations
There is one final issue to examine, in which I believe the mainstream has put its finger on a real and present danger: declining trust in the administration’s policies is creating problems in bond markets and increasing the risk of a revolt. As the issuer of the main international reserve currency, the US had been relatively immune from vigilantism by bond markets. However, successive presidents have increasingly used sanctions to punish what they perceived to be bad behavior by rogue states. In addition to erecting trade barriers and tariffs, the US has the reserve currency issuer’s power to restrict access to the dollar payment system itself. The downside risk of using sanctions excessively is that it creates mistrust in the US and fuels attempts by the rest of the world to create alternatives.
And that is where the US finds itself today—facing growing use of a variety of alternatives. Of course, international payments can be made in other national currencies such as the UK pound and the euro—but that is relatively small potatoes so far. There have been attempts to develop sophisticated multinational cross-border clearing systems used, for example, by African nations and by the BRICS (Brazil, Russia, India, and China, joined more recently by others). There are also experiments in use of cryptocurrencies, and in central bank digital currencies (that are denominated in national moneys of account). All of those options are on the table for expanding use.
More surprisingly, countries are returning to the pre–Bretton Woods system of clearing settlement in gold. Today, the physical gold is not necessarily changing hands—most remains safely locked up in central bank vaults—only the name of the owner is switched as the payment is made. The US Federal Reserve was the largest holder of gold—much of it owned by foreign governments—until recently. The current mistrust of the US is so high that gold is flowing out of the US Fed and into the vaults of foreign central banks in London, France, Beijing, and Zurich, for example.
This is one of those own-goal mistakes that have become all too common in the Trump administration. Secretary Bessent’s Operation Economic Outcast, which promised harsh sanctions on Iran, added to that flow out of the dollar. In response, he proclaimed that the US does not fear competition (New York Times 2026b). He also warned bond markets not to bet against the Treasury, asserting that he is the “house now” and they can bet against him at their own peril (Goldstein 2026).
Yet even the IMF has suggested that “Geopolitical factors and U.S. weaponization of the dollar through financial sanctions are causing central banks and other official investors to attempt to diversify away from dollar assets” (New York Times 2026b). Trump’s suggestion that the US might grab Greenland, his proclamations that he would like to make Canada the 51st state, and his recent imposition of devastating tariffs on America’s second most important trade partner (Canada, again), have fueled distrust of the US. This has led to closer relations between Canada and the EU, which proposes to make it an Associate Member of the union—perhaps with even closer ties in the future. Christine Lagarde, the president of the European Central Bank, weighed in, warning that “erratic policymaking in the United States was setting the stage for a ‘global euro moment.’” (New York Times 2026b) The New York Times reports: “Mr. Carney wants the bloc to work with Canada to build systems for payments and cloud computing that will offer an alternative to those of the United States in a bid to secure sovereignty” (New York Times 2026c).
Reality Check
Many mainstream economists worry that growing mistrust will reduce willingness of global savers to invest in the US—they will park their savings elsewhere, perhaps leaving our government unable to finance its deficit. This is false, as we’ve known since at least 1936 (when Keynes published The General Theory)—saving does not finance spending. Government spends by marking up balance sheets, and government deficits create nongovernment surpluses. Bond sales logically come afterward—as a place to park the savings created by government spending. In a worst-case scenario, where foreigners and even domestic households, firms, and financial institutions are reluctant to buy longer-maturity bonds, Treasury can sell bills at a small mark-up over the Fed’s target rate because that yield is better than the alternative, which is bank reserve holdings at the Fed that pay even less.
Does that mean we are completely out of the woods? No! As I explain in the next section, ruining trust in the dollar does have undesirable consequences.
Implications for the Exchange Rate and Interest Rate
I don’t want to overstate this threat, but loss of the dollar’s “exorbitant privilege” (Eichengreen 2011) could be costly. The big advantage the US has had is that it does not need to use monetary policy to protect the value of the dollar—trust in the US has provided sufficient protection. The global demand for the dollar has allowed the US to run chronic current account deficits, maintain low interest rates (when desired by the Fed), and endure periods of higher inflation without much impact on the dollar’s exchange rate. That is the dollar’s privilege.
Typically, the US can—when the Fed wants to—enjoy low interest rates and a strong dollar. As the US is a big importer, the strong dollar minimizes imported inflation (aside from impacts of large OPEC price increases in the past, or the war against Iran currently). When the Fed does raise rates, many central banks around the world follow suit to prevent currency depreciation that would fuel domestic inflation. The Fed largely sets the pace. That independence is worth something.
The Fed’s recent rate hike will increase US Treasury spending on interest, and yields on other nations’ bond yields will also rise for two reasons: they must compete with what have always been seen as the safest asset—US Treasury bonds—and their central banks will likely raise target rates to protect their currencies. There is some justification for Bessent’s swagger: the exorbitant privilege granted to the international reserve currency provides a competitive advantage. Gradual loss of that privilege will reduce the advantage the US has enjoyed.
Conclusion: Prospects for the Economy
Mainstream economists—right, left, and center—are sounding a warning about chronic deficits, Treasury’s trillion-dollar interest payments, stubborn inflation, and threats of the bond vigilantes. From their points of view, we are on an unsustainable path. While I’ve disagreed with their evaluation of the causes and with their proposed solution (mostly, fiscal and monetary policy austerity), I agree that the US is facing a reckoning that is largely of its own making.
I will finish by outlining the rather immediate challenges.
1. In announcing the rate hike, Warsh said that inflation has been too high for too long, so the indication is that the Fed will raise rates at least one more time this year—and will continue to raise rates multiple times, as inflation is not likely to fall to the Fed’s chosen target of 2 percent anytime soon. If the past is any guide (as Chairman Greenspan was fond of saying), we can look forward to a long series of rate hikes that will end only when the economy goes into a recession. Given the leverage in financed AI build-out, the shaky foundations of private lending and private equity markets, and the affordability crisis of American households, the coming recession will generate a financial crisis.[6]
2. Trust in American institutions is falling, posing a threat to the dollar’s status—perhaps even bigger than that faced during the Reagan years when it looked like the Japanese yen or German mark could challenge it. If use of alternative payment systems continues to grow quickly, the dollar could be devalued, setting off more inflation pressures and leading to stricter monetary policy that would push up interest rates to fight inflation and protect the dollar. Remember, we saw the Fed putting its target at an economy-killing 20 percent in the Reagan years.
3. Big and chronic budget deficits have become the new normal in the US and in many other rich, developed countries. While most of the fears about their unsustainability are completely unfounded, they are politically problematic and do pose some economic problems. I have discussed the portion of the US government’s budget devoted to interest service on the debt—a trillion dollars a year is now baked into the budget. That spending is not very efficient—it goes to high-wealth individuals, to financial institutions, and to foreigners. And it fuels the austerians—who demand cuts to social spending to “close the gap.” That is a real and present danger.
Further examination of the structural causes that have made large deficits “normal” is required but beyond the scope of this note. Clearly, it is not a simple matter of absence of fiscal rectitude and won’t be resolved by austerity. Fortunately, most of the worst of the supposed problems caused by deficits—such as involuntary default, or hostage-taking by bond vigilantes—are not going to happen.
While we can agree that the current fiscal stance is troubling, rather than worrying about the supposedly unsustainable government debt we ought to be preparing for the more immediate problems facing the US private sector as the Fed raises rates, and for the international repercussions of loss of trust in the dollar.
References
Bernstein, J. 2026. “Our Fiscal Reality Has Changed.” New York Times, September 14, 2026.
Bloomberg. 2025. “Federal Reserve Independence, Explained via Charts.” Bloomberg, September 14, 2025.
Bloomberg. 2026. “Bessent Says He’s Supportive of $5,000 Checks for Americans.” Bloomberg, September 15, 2026.
Congressional Budget Office. 2026. “Estimating the Cost of Combat Operations against Iran.” Congressional Budget Office, September 15, 2026.
Eichengreen, B. 2011. Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. Oxford: Oxford University Press.
Galbraith, J. K. 2026. “The Impotence of Being Kevin Warsh.” Institute for New Economic Thinking, September 8, 2026.
Goldstein, S. 2026. “Bessent Says, ‘I Am the House Now.’ What That Means for the Yen—and U.S. Stocks.” Yahoo Finance, September 9, 2026.
Nersisyan, Y., and L. Randall Wray. 2026a. “Plutonomy—the AI Edition—and the Coming Crisis.” Levy Economics Institute Working Paper No. 1122, July 8, 2026.
_____. 2026b. “Treasury Buybacks: Much Ado about Nothing?” Levy Economics Institute Policy Note 2026/7, September 4, 2026.
_____. 2022. “Is It Time for Rate Hikes? The Fed Cannot Engineer a Soft Landing but Risks Stagflation by Trying.” Levy Economics Institute Public Policy Brief No. 157.
New York Times. 2026a. “Fed’s Kevin Warsh, in Speech, Addresses Inflation.” New York Times, August 28, 2026.
_____. 2026b. “Trump, Debt, Sanctions and the Global Economy.” New York Times, September 16, 2026.
_____. 2026c. “E.U. Weighs Associate Membership for Canada amid Trade Tensions.” New York Times, September 16, 2026.
_____. 2026d. “Pentagon Seeks Billions More as Iran War Costs Mount.” New York Times, September 18, 2026.
Papadimitriou, D. B., and L. R. Wray. 1998. “What to Do with the Surplus.” Levy Economics Institute Policy Note 1998/6, June 1998.
Wray, L. R. 2026. “Artificial Intelligence: Friend, Foe, Fraud.” Levy Economics Institute Working Paper No. 1107, February 20, 2026.
Wray, L. R., and Y. Nersisyan. 2010. “Does Excessive Sovereign Debt Really Hurt Growth? A Critique of This Time Is Different, by Reinhart and Rogoff.” Levy Economics Institute Working Paper No. 603, June 18, 2010.
Wray, L. R., and Y. Nersisyan. 2022. “What’s Causing Accelerating Inflation–Pandemic or Policy Response?” Levy Economics Institute Working Paper No. 1003, March 4, 2022.
[1] The Pentagon is asking for another $70 billion in emergency funding for the war (see New York Times 2026d).
[2] See the documentary Finding the Money for an alternative, Modern Monetary Theory, view: https://findingmoneyfilm.com/.
[3] Social Security and parts of Medicare are covered by trust funds—part of Medicare as well as Medicaid are budgeted by law. It is hard to see how the Treasury could raid any of these for funds.
[4] Even if payments are to foreigners, these can help to raise demand for a nation’s exports, stimulating domestic growth.
[5] Growth is driven by AI “investments” and consumption by the rich—the vast majority of Americans are struggling, more than they were in the stagnation of the mid-1990s.
[6] As Yeva Nersisyan and I have argued, the AI bubble is orders of magnitude greater than the dot-com bubble and perhaps even bigger than the housing bubble that led to the global financial crisis (see Nersisyan and Wray 2026a).
