The irony is that the overstretch thesis is about to be vindicated just when conventional wisdom considers it discredited. But this overstretch has almost nothing to with the US's overseas military commitments. It is the result of its chronically unbalanced domestic finances.

In just five years' time, 77m "baby boomers" will start collecting Social Security benefits. In eight years they will start collecting Medicare benefits. By the time they are all retired in 2030, the US will have doubled the size of its elderly population but increased by only 18 per cent the number of workers able to pay for their benefits.

Economists regard the commitment to pay pension and medical benefits to the elderly now and in the future as part of the government's "implicit" liabilities. But these liabilities are no less real - indeed, are far larger - than the explicit obligation to pay back the principal plus the interest on government bonds. In fact their size is such as to render the US government in effect bankrupt.

The scale of this implicit insolvency was exposed this summer by Jagadeesh Gokhale, a senior economist at the Federal Reserve Bank of Cleveland, and Kent Smetters, former deputy assistant secretary of economic policy at the US Treasury. They compared the present value of all the revenue the government can expect to collect in future with the present value of all its future expenditure commitments, including debt service. The shortfall was a staggering $44,000bn. In comparison, the federal debt - $6,500bn - is small change.

The official reaction to this report was simply to bury it - a natural response given the awesome scale of the problem. But investors cannot afford simply to go into denial.

One possible inference might be that future federal deficits are likely to be larger than forecast and that this spells the end of the recent bond market "bubble". After all, a widening gap between revenues and expenditures is usually filled either by selling more bonds or by printing money. Either response implies a decline in bond prices and hence a rise in long-term interest rates.

Is that what is happening right now? In recent weeks, long-term bond yields have risen sharply while the yield curve - which had become more or less flat by the late 1990s - is now sloping more steeply upwards. The spread between yields on 10-year bonds and index-linked bonds with the same maturity has also widened slightly, suggesting a rise in inflationary expectations.

Yet the markets' reaction seems modest, given the size of the fiscal crisis facing the US. One possible reason why yields remain at levels not seen since the 1950s is that there are strong deflationary pressures at home and abroad. Overcapacity generated during the 1990s boom, investor pessimism in the wake of the bust, consumer anxiety about job losses - all mean there is a lot of slack in the US economy. Alan Greenspan, Federal Reserve chairman, has said deflation is a worry.

The truth is that we are in uncharted waters. Previous fiscal crises were not like this because most of a government's liabilities took the form of official bonds, not statutory pledges to pay benefits. Investors are used to a world in which governments in fiscal trouble can allow inflation to erode the real value of their debts. But even a significant jump in inflation would do little to solve America's fiscal crisis.

First, much of the government's tradable debt is of short maturity - indeed fully a third of it is due to mature within a year. That makes it harder to inflate away, because any increase in inflationary expectations will force the government to pay much higher interest rates when it seeks to renew these short-dated bonds. Second, Social Security benefits are protected against inflation via an annual inflation adjustment. Medicare benefits are also in effect inflation-proof because the government unquestioningly pays whatever bills it receives.

So what is going to happen? According to Profs Gokhale and Smetters, the only ways to eliminate the fiscal imbalance are to increase taxes or slash spending. But neither of these things will happen soon. On the one hand, the Bush administration is ideologically committed to tax cuts. On the other hand, Medicare and Social Security constitute the "third rail" of American politics: any candidate for office who touches them is guaranteed to receive a violent, possibly fatal, shock.

So the president faces a tough dilemma. Political expediency rules out fiscal reform; but if the bond markets foresee a spiral of deficit finance, sooner or later they will mark down the price of US treasuries with a vengeance. And rising yields will only increase the cost of rolling over the government's explicit debt.

No one can say for sure how the crisis of the US welfare system will be resolved. What is certain is that the harder it gets to pay for the most politically sensitive items of the federal budget, the more tempting it will be to cut the rest. What could be more "discretionary" than the cost of governing far away countries such as Kosovo, Afghanistan and Iraq?

For this reason, the latest Department of Defense green paper - which projects a levelling off of the total US defence budget at 3.5 per cent of gross domestic product - may prove optimistic. Over the past 20 years, the Medicare budget has risen five times faster than the defence budget and that trend seems likely to continue.

In short, the colossus that bestrides the world has feet of clay. The latent fiscal crisis of the US welfare state implies at best an empire run on a shoestring; at worst a retreat from nation-building as swift as the original advance towards it. Niall Ferguson is Herzog professor of financial history at the Stern School of Business, New York University. Laurence Kotlikoff is professor of economics at Boston University. A longer version of this article will appear in the autumn issue of The National Interest