Wednesday, January 19, 2011

The almighty dollar in 2025
13 January 2010

The dollar’s prolonged swoon throughout much of 2009, coming at the end of a near ten-year slide, has sent currency analysts, financial officials, and politicians of all stripes into a hand-wringing melancholy regarding the greenback’s long-term prognosis. Of course, many ignore the fact that the world fled to the dollar during the financial crisis as a safe harbor from the stormy seas of financial and economic chaos. The global consensus is now that the dollar is on a structural decline, and is a symbolic proxy for the long-term decline of the US economy.

It certainly wouldn’t be surprising if the dollar gave up some of its status as the preeminent global reserve currency. After all, it attained that role in the post–World War II era when the United States stood virtually alone in economic and financial prowess. Such a unique position was unsustainable over the long term and inconsistent with historical trends. Indeed, we have witnessed the rise of rivals and the emergence of a multipolar world, a phenomenon accelerated by the financial and economic crisis and its US origins. But the fact that the dollar faces competition and will likely lose some market share does not necessarily portend its demise. The doomsday scenarios are premature. To truly tumble to second-tier status and lose the distinction of the world’s principal reserve currency, the United States would need to make a series of ghastly policy mistakes, which is possible but not very likely.

The fate of the 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.

In Asia, which is the current roaring growth engine of the global economy, both the Japanese yen and the Chinese yuan are seen as posing a competitive challenge to the dollar. Japan is still the world’s second-largest economy. It possesses enormous wealth, a well-educated population, and has best-in-class corporations, notably in the export sector. But like the United States and Europe, Japan’s fiscal condition is precarious, with the country’s debt-to-GDP ratio now hovering at 200 percent and with massive deficits as far as one can see. The country also suffers from deflationary pressures that hamper consumption and capital expansion, an underperforming, low-productivity service sector, and a demographic trajectory that will increasingly weigh on growth.

China, the consensus choice as the new economic superpower, continues to make history with its multidecade record of rapid economic growth, highly open economy, breakneck pace of surging prosperity, and increasingly global firms. But China faces many challenges, too. It still has a closed capital account, a questionable banking system, an embryonic legal system, rudimentary capital markets, and a less-than-independent (though highly trained and professional) central bank. Without question, China suffers from an incredibly inefficient allocation of capital, which is unlikely to improve anytime soon. Moreover, a large portion of the population still lives in the most challenging of developing-world conditions. China is addressing these obstacles and will undoubtedly make enormous progress between now and 2025. But even under the best of circumstances, and assuming that the rest of the world remains static, the yuan will likely compose no more than 10 percent to 15 percent of global reserves. It’s not clear that such a gain comes solely at the expense of the dollar.

Of course, pondering the euro, yen, or yuan’s possible role as a principal reserve currency presupposes that the relevant political capitals are seeking that status for their currencies. In fact, it’s far from clear that the Europeans, the Japanese, or the Chinese are prepared to run perpetual—and at times large—current account deficits and expose their tradable sectors to even greater price competition. The most likely answer is that they do not, and will not for the foreseeable future. Such reluctance helps explain some of the discussion in policy-making circles on the possible reserve role of the IMF’s Special Drawing Right (SDR), which is simply a composite of the world’s top five currencies. While policy makers will continue to explore an enhanced role of the SDRor some other supranational artifice, it’s unlikely that national governments will soon give up sovereign authority over monetary and currency policy to the IMF or any other multilateral entity.

In sum, while the dollar’s long-standing status as the preeminent reserve currency is something of an historical aberration, and the currency faces competitive challenges from Europe and Asia and is vulnerable to unprecedented domestic policy challenges, it’s hard to bet against the dollar retaining a dominate reserve role in 2025. US officials will need to show uncharacteristically bipartisan cooperation, looking past the short-term considerations of the next election cycle and making the tough choices to put the country’s fiscal trajectory on a more sustainable path. They will also need to fight against the antitrade and antimarkets populist sentiment now bubbling in the wake of the financial and economic crisis and support and protect productivity-fueling private and public investment, while ensuring that the US workforce is second to none. Finally, US officials will need to decide whether they want the dollar to continue its role as the predominant reserve currency, given that the cost-benefit analysis may not prove as beneficial as once thought. But before they throw the greenback overboard, they should ponder what a postdollar world might look like and whether it’s an attractive alternative. In 2025, the mostly likely scenario is that the dollar is still the star of the show, but will have to share the stage and limelight with several other performers. The United States could still stumble, but it’s unclear whether the dollar rivals will have the capacity and the willingness to take over the lead role.

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