Paradoxically, one can have greater confidence in the long-run prospects for a currency than in its short-run prospects. This is because the relationship between long-run fundamentals and long-run value is stronger than in the corresponding short-run case. The explanation for this reality is that endogenous risk in forex markets is much greater in the short-run than in the long-run.¹ For this reason, we shall assume in this brief note that a bet on long-term currency values is largely a bet on fundamentals. But even here we must be careful, for it is not US fundamentals that will matter to the value of the dollar in the long-run, but US fundamentals compared with those of other countries. This is true because the value of any currency is a relative value. As Richard Cooper of Harvard University taught the author many years ago when the dollar was under attack, “Never ask whether the dollar is a rotten apple. Ask rather whether it is the most or least rotten apple in the barrel of all currencies.”

Which fundamentals matter to the long-run value of the dollar on a relativistic basis? We shall argue that there are four such variables: the relative wealth and power of the United States; the relative long-run inflation rate of the United States; the relative size of its current account deficit and its associated debtor/creditor status; and the success of the nation in managing its fiscal deficits. The only variable here that might seem surprising in a currency market context is this fourth and last one. It is included because the next quarter-century will be the period in which most all G-20 nations will have to cope with a completely new phenomenon: the aging of their populations in a political environment that makes cutting “entitlement benefits” extremely difficult. The resulting increases in fiscal deficits will probably emerge as a very important determinant of exchange rates. This is a development without historical precedent.

So important will the fiscal stance of nations be that we will condition our forecast of the dollar upon two fiscal scenarios: successful US fiscal reform and unsuccessful reform. Our choice of a binary conditioning event reflects the fact that fiscal reform is an either-or story in the case of nations confronting rapidly growing future deficits. (Recall that total US sovereign debt will double from $10.9 trillion today to over $20 trillion by 2019, after which the nation will confront some further unfunded Social Security and Medicare liabilities in the range of $50 trillion.) Either the United States will get its fiscal house in order, with its current debt-to-GDP ratio of 0.8 stabilizing between 1 to 1.5, or this ratio will increase quite rapidly to 3 or higher, giving rise to banana-republic scenarios. The equations governing the dynamics of the “debt trap” in public finance theory are inherently unstable in this regard, giving rise to either-or bifurcations of this kind. We discuss the possibility of sound US fiscal reform in a postscript below, and do so because this will likely be the central issue during the next few decades.

Case 1—Successful Fiscal Reform: In this scenario, the dollar’s relative value should rise by about 50 percent from its current level, on a trade-weighted basis. The principal driver here will be the rising spread between the power and wealth of the United States relative to that of other nations or blocs, with the exceptions of China and India. Via the fundamental theorem of growth theory, the growth rate of the wealth of a nation (its national net worth) is the growth rate of GDP. This should average about 3 percent over the next 50 years in the United States given normal US productivity growth (higher than most any other nation) and given the favorable demography the United States will enjoy relative to that of other blocs. Indeed, the US workforce growth will be the highest of any major nation except that of India. This will result from a higher-than-normal birth rate and higher-than-normal immigration, and the reality that baby boomers and their children will work into their 70s, largely because they will need to.

In contrast, the GDP growth rate (and hence, wealth growth rate) of Europe should average 1.6 percent, with productivity growth 0.4 percent lower than that of the United States, and workforce growth 1 percent lower. On this basis, the dollar should appreciate at least 60 percent against the euro. Japan’s long-run growth of GDP, and thus of wealth, is expected to be a dismal 0.8 percent, with some analysts claiming it could even be much lower because of its rapidly declining workforce. Russia is in a similar position, unless it becomes the resources mecca that it hopes to become. On a wealth and power basis, it thus seems clear that the yen will depreciate significantly against the dollar. The ruble should also decline, but as Russia is an emerging nation this is a more difficult call. Finally, India and China should see long-term growth rates of 5 percent and 7 percent respectively, so their currencies too should rise against the dollar in this regard. This is particularly true of the Chinese remnimbi since it has been held artificially low for so long. It should soar at least 400 percent and win the global currency sweepstakes over the long run.

As for prospects of trade balances, we expect the US trade deficit to shrink significantly in the longer run. This is partly because of the inevitable appreciation of the Asian currencies (except for the yen, which will depreciate sharply), and partly because we see manufacturing returning to the United States. New technologies and modes of automation will increasingly reduce the need for “cheap Asian labor,” and Asian labor will become increasingly expensive. Finally, as for inflation, the US inflation rate should continue to run slightly higher than that of Europe, which will slightly boost the euro, other things being equal.

To conclude, the principal driver of the dollar will be the relative rise in the wealth of the United States due to more rapid long-term growth than will occur in most other blocs. This will primarily be due to the US advantage in workforce growth, and in this regard, demography will probably prove to be destiny in the realm of currencies.

Case 2—Unsuccessful Fiscal Reform: In the event that the United States cannot restrain the growth of its future fiscal deficits by reining in “entitlements spending,” the situation will be grave and indeed unprecedented. If we assume that all nations except for the United States manage to staunch their demographically driven flow of red ink, then the dollar could collapse as the United States morphs into a banana republic of sorts. If on the other hand, other nations confronting much worse demographic prospects than the United States (and all do except for India) prove unable to stem their own tide of red ink, then the dollar could still appreciate. Once again, currency values are relative. We ascribe a 65 percent probability that the United States will confront its demographic problems better than most other nations, primarily because its prospects are better, and because there are solutions to US entitlements spending, as sketched in the postscript below.

All in all, the long-run value of the dollar will be driven by two principal developments: the long-run growth of the wealth and power of the United States as determined by its workforce and productivity growth, and the United States’ ability to get its fiscal house in order. Another way to state this is that a long-run bet on the dollar today is a long-run bet on the balance sheets of nations. Overall, we expect the dollar to rise against most currencies except for those of China and India, with a trade-weighted rise of about 55 percent.

Postscript on US red ink

The fiscal threat confronting the United States stems from the reality that US federal debt will rise from about $11 trillion to over $20 trillion between 2009 and 2019, and then by an additional $55 trillion of unfunded entitlement liabilities between 2019 and 2070. As the author has written elsewhere, the Social Security deficit of some $18 billion can be driven to zero, assuming that the effective retirement age rises to 70. This is likely to happen by choice as more and more workers realize that they will have to work longer to enjoy the retirement they want.

The Medicare and Medicaid deficits of some $40 trillion can be reduced by over 50 percent should policy makers come to understand and apply the following theorem in microeconomics: For any outward shift α in the demand curve for medical services (a shift corresponding to greater access to health care due to subsidized insurance and to a growing number of elderly people), there exists a real number β > α such that, if the supply curve shifts outward by the magnitude β, then the total cost of medical care as a share of GDP (currently 17 percent) will not rise at all, and can even fall. The tragedy of “Obama-care” is that it flies in the face of this logic by shifting the supply curve backwards (e.g., by paying doctors ever less and thus driving them out of the business). The result will be soaring total costs and quantity rationing.

What policy makers ought to do is apply the logic of the above theorem, and shift the supply curve way out: (1) by deregulating the industry that is at present like a medieval guild (e.g., remove outdated “ceilings” on the number of medical school students), and (2) by encouraging sharply increased productivity growth (e.g., install low-cost but highly intelligent expert systems operating 24/7/365 in every pharmacy so as to obviate costly and time-consuming visits to doctors in the case of routine ailments). Incidentally, it is precisely this logic at work that explains why the share of national income that goes to most products and services (e.g., food and clothing) has decreased over the past century—the true meaning of rising living standards. Why should health care be any different, accounting for an ever-larger share of income that imperils the fiscal integrity of the United States?

¹ Recall that “endogenous” risk refers to that portion of total observed volatility that cannot be explained by the volatility in the value of fundamentals. The latter is referred to as “classical” or “exogenous” risk, and is now known to account for at most 20 percent of short-term risk—and much less in times of market turmoil. The sources of endogenous risk are pricing model uncertainty (investors’ acknowledgement that they do not know how to “price” news about fundamentals), the existence of correlated mistakes in investors’ bets about the values of fundamentals (for example, the underestimation by virtually everyone of the soaring default rate in the US mortgage market during 2007–2010), the inability to hedge all risks, and finally, excessive leverage. In the past, I have advanced the view that a large portion of the “misbehavior” in the value of the dollar (overshooting too high and too low) has stemmed from pricing model uncertainty. The simple fact of the matter is that no one agrees on any model purporting to give the “correct” value of the dollar even when all news about fundamentals is in hand. Using advanced game theory, this can be shown to lead to pronounced cycles of overshoot/undershoot as a consequence of highly rational behavior—not irrational behavior as is commonly and incorrectly assumed.

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