This is Part 2 of a 7-part series examining the structural flaws in U.S. monetary policy and what Japan's $550 billion investment pledge reveals about the global dollar system.

Previous: Part 1 — Japan's $550 Billion Bet

One number captures the state of American public finance.

In fiscal year 2024, the U.S. federal government paid $881 billion in net interest on its debt. Defense spending that same year was $850 billion. Interest costs exceeded defense spending for the first time since 1940, according to the Congressional Budget Office.

The United States now spends more servicing its debt than protecting itself. That is the fiscal reality.

The more important question is where that interest money goes. Approximately 30% of U.S. Treasury securities — $8.5 trillion as of December 2024 — is held by foreign governments and investors (Treasury TIC data). Japan holds $1.19 trillion, China holds $0.8 trillion. Apply that 30% share to the $881 billion interest bill and the result is roughly $260 billion flowing overseas every year.

This is the reserve currency bug.

So long as the dollar remains the world's reserve currency, governments, corporations, and investors everywhere need dollar-denominated assets. That structural demand is what allows the U.S. to borrow at lower rates than any other country — the so-called "exorbitant privilege."

But when inflation rises and the Federal Reserve tightens, the structure runs in reverse. Higher rates inflate the interest bill. A growing portion of that bill flows to foreign creditors in Tokyo and Beijing. American taxpayers fund the interest payments; Japanese and Chinese treasuries collect them. The harder the Fed fights inflation, the more wealth crosses the Pacific.

This is not a failure of monetary policy in the conventional sense. It is a structural defect in how rate hikes function for a reserve currency issuer. Standard economic textbooks prescribe rate hikes for inflation. That prescription was written for ordinary economies, not for the issuer of the world's primary reserve asset.

How does this play out for ordinary Americans? That is what Part 3 examines.

Previous: Part 1 — Japan's $550 Billion Bet Next: Part 3 — How Rate Hikes Squeeze the Middle Class Twice

Sources: CBO: Monthly Budget Review FY2024 | CRFB: Interest Costs Surpassed Defense | U.S. Treasury TIC Data | 日本語版

Disclaimer | This article is for informational purposes only and does not constitute investment advice.