A higher U.S. government debt‐to‐output (D‐O) ratio does not forecast higher surpluses or lower returns on Treasurys in the future. Neither future cash flows nor discount rates account for the variation in the current D‐O ratio. The market valuation of Treasurys is surprisingly insensitive to macro fundamentals. Instead, the future D‐O ratio accounts for most of the variation because the D‐O ratio is highly persistent. Systematic surplus forecast errors may help account for these findings. Since the start of the Global Financial Crisis, surplus projections have anticipated a large fiscal correction that failed to materialize.

We study three centuries of fiscal history. Dominant safe asset suppliers issue more debt than future primary surpluses can justify, even after accounting for seigniorage revenue from convenience yields. This pattern holds for the Dutch Republic (seventeenth to eighteenth centuries), the United Kingdom (eighteenth to nineteenth centuries), and the United States (twentieth to twenty-first centuries). When Dutch and UK fiscal fundamentals deteriorated, they lost their dominant position as the safe asset supplier, and their debt became fully backed by primary surpluses. Exorbitant privilege stems from issuing overpriced debt in the early stage, followed by bondholder losses and financial repression in the later stage.

We propose a simple model of the sovereign-bank diabolic loop, and establish four results. First, the diabolic loop can be avoided by restricting banks' domestic sovereign exposures relative to their equity. Second, equity requirements can be lowered if banks only hold senior domestic sovereign debt. Third, such requirements shrink even further if banks only hold the senior tranche of an internationally diversified sovereign portfolio--known as ESBies in the euro-area context. Finally, ESBies generate more safe assets than domestic debt tranching alone; and, insofar as the diabolic loop is defused, the junior tranche generated by the securitization is itself risk-free.