The almighty dollar in 2025

US economy and thus the dollar, is in our own policy-making hands. Without question, we face one of the most daunting economic challenges in our country’s modern history. The federal deficit this year is hovering at postwar highs as a percentage of GDP, is twice the level collected in individual income taxes, and is more than we will spend on domestic discretionary programs and our nation’s defense. In other words, we could eliminate all the federal government’s discretionary spending programs and the deficit would still exist. Further, the deficit could top $1 trillion a year for decades to come and some objective analysts, employing modestly conservative assumptions, foresee our debt-to-GDP ratio quadrupling to 200 percent by 2030 and 300 percent by 2050. Net interest on the debt will surpass military spending by mid-next decade. Mandatory spending which was just 25 percent of the budget in the early 1970s, is now over 55 percent and climbing. Entitlement spending is now around 9 percent of GDP and is heading to over 20 percent by 2025. All of these trends are sobering and unsustainable, and will require tough choices over the coming years. We are capable of making such choices, but it will demand strong, unselfish leadership and a bipartisan effort pursuing an “everything is on the table” approach.

But a bold and responsible fiscal policy is not the only requirement. An independent, inflation-focused, and respected central bank is also critical, and any effort to weaken the Federal Reserve’s autonomy would undermine the attractiveness of dollar-denominated assets and therefore the dollar itself. We also need to maintain a near rabid support for an open economy and the free flow of goods, services, and capital. A misguided lurch to protectionism in an effort to soothe the middle class angst over globalization may offer a temporary anesthetic to voters, but will prove damaging longer term. Finally, we should encourage the productive capacity of the economy, emphasizing higher national savings, capital formation, a rational regulatory regime, and a world-class system of education. On the latter, the United States can no longer afford for one-third of its ninth graders to drop out before finishing high school, or for a large portion of those who do graduate to possess skills no better than those of the average middle-school student. Human capital is a critical ingredient for our future success.

Even if elected officials do enact the optimal policy mix over the coming years, we may ultimately conclude that reserve-currency status is an economic disadvantage, in which case we would jettison the so-called strong-dollar policy. A recent excellent study from the McKinsey Global Institute posits that the long-perceived “exorbitant privilege” due to the dollar’s reserve status may be overstated and that the net benefits are modest at best. This is especially true, according to the study, for corporations in the tradable-goods sector. However, a retreat from the strong-dollar policy, in place now for close to 15 years, could prove risky. The strong-dollar mantra is in essence a pledge that the United States will not use the currency as tool to gain competitive advantage in a beggar-thy-neighbor manner. The value of the dollar is simply a derivative of other factors—a reflection of relative cyclical and structural fundamentals and policy—and not a direct target of policy. The policy is also a pledge to protect the value of Treasury-issued US debt, which is the modern gold standard for all other debt instruments. If the rest of the world perceives that the United States will seek to gain competitive advantage via a deliberately weakened dollar, others may try to race us to the bottom, launching a potentially devastating sequence of events. But that begs an important question: which currencies might rival the dollar in the future?

After the dollar, the contenders for the title of the world’s dominant reserve currency are rather limited and obvious. The euro, representing an economic entity roughly the size, complexity, and productivity of the US economy, has gained acceptance since its inception a decade ago and now makes up about 28 percent of the $4.4 trillion in global official reserves. Moreover, the European Central Bank has built a strong track record and reputation in pursuit of its sole mandate of price stability. But the euro suffers from several deficiencies: It’s defined by highly fragmented capital markets that can’t offer the size and liquidity of the $600-billion-a-day US bond market. There is no central fiscal authority, the banking system is balkanized, labor and resource mobility is limited, and reallocation is frightfully slow. Further, Europe suffers from the same dire fiscal outlook as the United States but with lower growth prospects, deeply embedded and well-protected national interests, crippling demographics, and without the advantage of substantial immigration to support population growth.
by Linda Burkhead