Is U.S. Economic Dominance at Risk?
Introduction and Outlook
The U.S. economy has performed exceptionally well through the first half of the year. By several measures, economic activity remains robust. Private nonresidential investment, boosted by favorable changes in tax laws and what seems like an insatiable demand for AI and related technologies, is growing at a rate near 8%. U.S. productivity has been better than expected, and corporate earnings announcements have been strong.
Employment remains surprisingly strong, with initial unemployment claims at historic lows. Households, benefiting from high home and financial asset values, continue to spend at a healthy pace, with retail sales increasing by nearly 7% year over year.
Finally, our federal government is spending another $8 trillion dollars this year, supporting aggregate demand.
Together, these factors are putting projected GDP growth for this year near 2%.
So, what could possibly go wrong? The United States is the world’s largest and most dynamic economy. It benefits from having the deepest capital markets, exceptional innovative capacity, a strong institutional foundation and the world’s leading reserve currency.
Perhaps, however, despite these impressive results and advantages, matters may be more fragile than acknowledged as markets enjoy the moment and ignore the imbalances and risks that may undermine the nation’s long-term economic future.
This boom-like economy is supported in no small part by expansionary fiscal and too accommodative monetary policies. Tariffs, energy price shocks and geopolitical conflicts have added to inflationary pressures, but it is the former policies that keep inflation elevated and sow the seeds of economic instability. As a result, people are uneasy about the future and increasingly question whether U.S. long-term economic dominance might be at risk.
The following discussion examines U.S. fiscal and monetary policies and the risks they pose to U.S. long-run economic leadership.
Fiscal Excess
Following the Great Financial Crisis, in 2010 the U.S. federal deficit reached nearly 10% of GDP. It rose again during the COVID-19 pandemic, peaking at approximately 14.5% of GDP in 2020 as emergency fiscal programs were enacted to stabilize the economy.
Given the extraordinary circumstances, these deficits were widely viewed as necessary. Most people expected, however, that as the economy recovered, they would return to pre-crisis levels so that the U.S. would not become trapped in a cycle of permanently accelerating debt.
Instead, Congress has shown little willingness to restrain itself. Federal spending, currently at 23% of GDP, continues to significantly outpace revenues of only 17%, leaving large deficits despite an economy operating near full employment. As a result, the nation’s accumulated total federal debt, which stood at $10 trillion in 2010, is now approaching $40 trillion, nearly 120% of GDP.
Put simply, current U.S. fiscal policy poses a growing long-term risk to the nation’s economy.
Initially, such deficit spending stimulates economic activity and temporarily boosts growth. That makes it very appealing to politicians, who are operating on short-term election cycles. Over time, however, as experience teaches, the accumulating debt leads to inflationary pressures, rising interest costs, reduced private investment and slower productivity growth.
Ultimately, as such imbalances between revenue and spending persist, economic crisis follows and policymakers are forced to confront painful tradeoffs involving taxes, sudden spending reductions and slower economic growth.
Central Banks: Enablers of Fiscal Profligacy
While Congress is responsible for the nation’s accumulation of deficits, it is the Treasury that must sell the debt and, increasingly, the Federal Reserve that helps underwrite it.
Following both the Great Financial Crisis and COVID-19, as Congress created record levels of Treasury debt, the Federal Reserve engaged in large-scale purchases, a process known as quantitative easing (QE). These purchases added abundant liquidity to the Treasury debt market, suppressing interest rates that would have otherwise moved higher as funds were pulled from the private sector toward government.
In the end, the Federal Reserve’s balance sheet expanded from roughly $2 trillion in 2010 to nearly $9 trillion at its peak in 2022. Although it has since modestly declined, it remains near $7 trillion—approximately seven times its size before the financial crisis of 2008.
While the Fed’s actions stabilized financial markets during periods of acute stress, the extended use of QE following such events led to inflated asset values and consumer price inflation, the longer-term consequences that continue to unfold even today.
Inflation: The Price of Policy Discretion
The interaction between Treasury borrowing and Fed QE purchases has resulted in inevitable unintended consequences. Most obvious, perhaps, has been the substantial increase in asset prices. Homeowners who purchased property before the recent inflation are unintended winners enjoying significant gains in housing wealth. The losers are new buyers grappling with much higher home prices and mortgages. Since March 2021, the S&P CoreLogic Case-Shiller U.S. National Home Price Index has risen by more than 35%. Similarly, rising equity prices have rewarded existing investors but made entry into financial markets more difficult for younger households and first-time investors.
The story is similar regarding the effects of consumer price inflation. Over the past five years, the Consumer Price Index has increased by more than 27%, while real average hourly earnings have remained largely stagnant.
Supply-chain disruptions, energy-price shocks, tariffs and geopolitical events all contributed to inflation surges. It is sustained fiscal deficits and prolonged monetary accommodation, however, that have extended those surges well past the supply shocks.
Persistent inflation and widening disparities in wealth resulting from inflation’s distributional effect also have had broad social consequences, including a loss of trust in public and private institutions and intensified social and political tensions.
The Fed’s Dilemma
The Federal Reserve’s commitment to price stability is the last guardrail protecting the nation from these kinds of outcomes.
Chairman Kevin Warsh has stated that restoring inflation to the Federal Reserve’s 2% target and reassessing the use of QE will be among his priorities. Those objectives are commendable. But achieving them depends on the Federal Reserve’s renewed commitment to avoid monetizing Congress’s excess deficit spending.
If the federal government continues to spend and significantly exceed its revenue limits, and if the Federal Reserve continues to underwrite such deficits with its money-creating power, then asset and price inflation will persist, distorting and undermining the economy. This outcome is inconsistent with the Fed’s mandate and Chairman Warsh’s promise to the American public.
If, instead, the Federal Reserve refrains from creating money to underwrite excessive debt, then the private market itself must absorb this rising debt. As government borrowing competes with private investment for available savings, higher interest rates follow, creating funding stress on housing, credit markets and private investment. This stress will increase the risk of slower economic growth and recession.
If the Fed is to fulfill its promise to restore price stability without risking economic growth, it must soon make clear that the only way forward is for Congress to address the real problem: the national debt.
Economist Judy Shelton has shown that the post-World War II period through the early 1970s—characterized by relatively modest federal deficits, low inflation and strong monetary discipline—coincided with annual labor productivity growth averaging nearly 3%, and real GDP growth averaging closer to 4%.
This outcome is achievable today, but it requires both the Congress and the Federal Reserve to do their jobs as intended and not as they have done in recent decades.
Dollar Dominance
Finally, as fiscal deficits accelerate and too-high inflation persists, the dollar’s role as the world’s reserve currency is being questioned. For now, its role is safe, but dollar dominance is not a birthright. It rests on the strength of the American economy and the credibility of its institutions and markets. Persistent fiscal deficits, prolonged monetary accommodation and excessive inflation undermine that confidence, slowly but inevitably.
Conclusion
Economic leadership rarely disappears suddenly. It erodes gradually as policy credibility weakens and institutional advantages diminish.
The challenge facing the United States is not one of economic capacity but of political will. The choices made today will determine whether future generations inherit an economy that sets the global standard for prosperity, innovation and opportunity.