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This paper is part of a new initiative from the Peterson Foundation to help illuminate and understand key fiscal and economic questions facing America. See more papers in the America's Fiscal and Economic Outlook series.
The foundation of the US economic and monetary system is trust. Over 60 percent of central bank foreign exchange reserves are held in dollars and nearly 90 percent of foreign exchange transactions involve the dollar. The high and enduring global demand for dollars allows the US Treasury to borrow at much lower costs, which masks the underlying fiscal imbalance.
There have been six global reserve currencies in the last six hundred years, with Great Britain’s pound achieving the longest reign at 129 years. The dollar, having served as the reserve currency for 77 years, is getting long in the tooth. The challenge to the dollar is coming not from another country but from a new class of digital and crypto currencies. Digital currencies are a superior technology, allowing instant decentralized clearing and embedded digital contracts. According to the digital asset analysis firm Messari, the global transaction volume of stablecoins reached $1.7 trillion in the second quarter of 2021 compared with just $25 billion in the first quarter of 2019. Superior technologies always win out so the chance that the dollar is displaced as the reserve currency is high. The winner of the new game could be a regulated stablecoin or a central bank digital currency. The winner might be dollar based, preserving its reserve currency status. Or, if US policymakers fail to keep pace with the technological shift, the winner will be based on a foreign currency.
Crypto currencies have been around for a decade. Why are they surging now? The reason is that the aggressive fiscal and monetary action during the pandemic sparked a fear of inflation and currency devaluation. People who bought crypto currency based on the fear of inflation have been aptly awarded. Now that inflation is here, the case for alternatives to fiat currencies is getting stronger. Crypto exchanges are offering savings accounts with three to seven percent interest rates while dollar accounts offer zero percent. With five percent inflation, savings in a traditional US dollar checking account would lose half its value in 13 years. The threat to the old dollar is real.
Inflation has spiked in the US because fiscal and monetary policy were connected in a powerful way. During the great financial crisis, the Federal Reserve bought bonds with newly created reserves. These special reserves could only be held by banks and never circulated in the general population. This time around the central bank bought Treasury bonds and the Treasury sent checks to the general population. In other words, the new money is circulating in the economy. As a result, demand has spiked, and with the supply side of the economy constrained, prices have to rise to balance supply and demand.
Inflation may wane as demand cools and supply rebounds; or it may persist if continued fiscal expansion keeps demand inflated. The longer inflation lasts, the more likely it becomes embedded into contracts and expectations, allowing it to achieve self-reinforcing momentum. Sustained inflation would pull interest rates higher and expose the underlying rot in the US fiscal situation. If net interest payments as a share of GDP were to rise at the same time the Federal Reserve was fighting inflation, the US would have no choice but to sharply contract fiscal spending.
The main point is that equilibriums change. Low interest rates today do not tell us where interest rates will be in ten years. Charles Goodhart of the London School of Economics argues in a recent book that we are on the cusp of a great demographic reversal that will revive inflation and raise interest rates. To Goodhart, ageing societies, waning inequality, and increasing inflation mean that the world will look very different in a decade’s time. It is completely irresponsible to run US economic policy today on the assumption that the global interest rate balance will never change.
The pandemic has shown that America has many needs, adding more stress to our fiscal situation as policymakers worked to protect the most vulnerable populations who lost work and income. The explosion in fiscal spending was necessary during the pandemic but cannot become permanently rooted into the budget. We have to return to a thoughtful budget process rather than continuing with a blank-check mentality.
A robust binding budget process ensures that programs compete so that only those with the highest chance of success are funded. A fiscal environment where any program is funded at any level is sure to extract resources from the private sector via higher taxes and result in less private sector job opportunities. US economic policy should strive for a robust private economy and a vigorous public sector. In both spheres, ideas must compete for scarce resources. Discipline is automatic in the private sector, as poor performing companies fail, but is a choice in the public sector.
One of the best uses of resources is crisis prevention and preparedness. I estimate that over $10 trillion of our $29 trillion in national debt is attributable to two events: the global financial crisis and the COVID pandemic. Rigorous monitoring of the subprime housing market or a ready-made plan to confront a disease that spreads by aerosols rather than droplets would have saved the country trillions in economic damage. Preparedness programs are miniscule in size compared to spending on the massive entitlement programs or the military.
The world is also facing a huge challenge in moving to a decarbonized global economy with the hope of changing the temperature of the planet. Europe has showed that you can move too fast as well as too slow. By eliminating coal and nuclear power, Europe has greatly increased their dependence on Vladimir Putin. In fact, global energy reserves are concentrated in just two countries today: Saudi Arabia and Russia. Neither wind nor solar is a reliable source of energy. The wind stopped blowing in the North Sea this year causing the UK to bid for natural gas. At the one point, the UK was paying the equivalent of $230 per barrel of oil for its gas. A cold winter this year will cause great suffering and remind us that reliable energy is also a policy choice.
The world cannot move off carbon without embracing nuclear power. Nuclear power needs to supply at least 20 percent of each electricity grid for it to have the ability to run carbon free without power outages. The good news is that the next generation of nuclear power is here. Sodium fast reactors that use natural or depleted uranium (instead of enriched uranium) dramatically reduce safety and proliferation concerns. This technology was developed with a combination of public and private resources. The world can move off carbon but only with a thoughtful strategy that avoids concentrating power in the hands of autocratic countries. The solution to climate change need not be expensive if high-value solutions are used rather than a scatter shot “all of the above” approach that guarantees wasteful spending.
Despite our long list of challenges, the world is getting better. The last thirty years has brought the greatest reduction in global poverty in history. Technology is offering up the solution to our biggest problems. Governments need to invest more in basic science, technology, and preparedness. A rigorous budget process is essential to making government programs compete so that the best solutions are funded while the private sector is allowed to flourish as well.
We also have an obligation to leave future generations the fiscal space to deal with problems that we cannot envision today. It is the height of arrogance to assert that we know with certainty the greatest problem fifty years in the future. No one would think that the leaders of 1970 should have set all of our fiscal priorities today. Adaptability is the key to survival and the greatest gift today’s leaders can give to future generations is the fiscal room to solve their own problems.
Marc Sumerlin is Managing Partner at Evenflow Macro, a global macroeconomic consulting firm he founded in 2013. He is a member of US Treasury’s Financial Research Advisory Committee, which is tasked with identifying significant financial risks. From 2003 to 2012, he served as Managing Director and co-founder of the Lindsey Group, during which time he testified before the Congressional Oversight Panel on the origins of the financial crisis; he also traveled extensively to Japan, China, and Europe. From 2001 to 2002, he served as Deputy Assistant to the President for Economic Policy and Deputy Director of the National Economic Council. In that capacity, he helped President George W. Bush develop and implement his economic agenda. He also worked as an economic policy advisor for the George W. Bush for President campaign, after starting his career at the U.S. Senate Budget Committee. Sumerlin holds a master's degree in applied economics from Johns Hopkins University and a master's degree in public policy from Duke University, where he was a Senator Jacob Javits Fellow. He graduated magna cum laude from Georgetown University. He serves on the Board of Governors at the Johns Hopkins Wilmer Eye Institute.