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We are in the latter stages of a long-term debt cycle, which typically plays out every 75-100 years. A long-term debt cycle consists of multiple short-term debt cycles that tend to play out every 7-10 years. These credit expansion and contraction cycles occur because debt and debt servicing costs rise faster than incomes to support them.
Central banks lower interest rates when debt burdens become too large to allow credit expansion. This pattern of booms and busts makes up the short-term cycles. We have been in a 40-year downtrend of these short-term cycles, where the cyclical peaks and troughs of interest rates are lower in each subsequent 7–10-year cycle, as you can see in the graph below.
But what happens when interest rates hit zero, and sovereign debt reaches astronomical heights in the final stages of a debt supercycle?
Essentially, the U.S. has four options to pay back its debt:
- Increase productivity
- Austerity (spend less)
- Debase the currency
With U.S. debt to GDP in a perpetual uptrend, reaching as high as 133% in 2021, option number one of increasing productivity is out of the cards. The second option, austerity, would require a hard pivot in fiscal policy, cause extreme pain for the everyday citizen, and be politically damaging for anyone in elected office. Next, a hard default on the debt would be significantly more painful and politically damaging than austerity and would have unimaginable consequences for the U.S. and the rest of the world. A soft default (i.e., breaking from the gold standard) is not an option because the currency isn’t pegged to anything – there’s no peg to “break” since America’s quiet default in 1971. This brings us to the fourth option: debase the currency.
Debase The Currency
As Ray Dalio points out, debasing and/or monetizing the debt is the least painful way to service sovereign debts initially and at least on the surface. Effectively, by devaluating the currency, the sovereign makes its debt repayments cheaper in real terms, which it has the luxury of doing because it controls the reserve currency and has the power to change the monetary policy of its reserve currency however it may please. This allows the sovereign to meet its debt obligations to creditors at the expense of the currency’s purchasing power that the debt is denominated in. This route of debasing the currency appears to be the option that central banks have already chosen to take.
Generally speaking, debasing the currency causes inflation, which hit a 40-year high of 7.5% in the U.S in February of 2022. The textbook reaction to high inflation is for central bankers to raise interest rates to make borrowing money more expensive, which causes the economy to cool down. But substantially raising interest rates when U.S. sovereign debt is this high make debt obligations exponentially more expensive to service with each marginal raise of rates, thus increasing the probability of a default – which is not an option for reasons previously discussed.
The Federal Reserve, the most important central bank, is stuck between a rock and a hard place, as Luke Gromen and Lyn Alden indicated. The Fed will likely keep interest rates low and let inflation run hot – which is politically damaging but not as untenable as a default – to effectively debase the currency and make servicing the debt more obtainable.
However, the end of this sovereign, long-term debt cycle comes at another inflection point in history: for the first time in the current dollarized world as we know it, other sovereigns are less interested in buying our debt. Global superpowers paused, stopped, or significantly decreased their purchasing of U.S. treasuries in the last decade, effectively de-dollarizing. To make up for the lack of outside interest in new U.S. debt issuances, the Federal Reserve has become the buyer of last resort. In 2009, the Fed owned 4% of U.S. debt. Today, it owns 19%. So how did we get to this point?
The Petro-Dollar System
Since the U.S. and Saudi Arabia’s agreement to price oil in dollars in the mid-1970s, every nation around the globe that wants oil needs U.S. dollars to buy it. And considering that energy is the base-layer asset for productive economies, every nation needs oil. So, the U.S. and every other nation buys oil from the Middle East in U.S. dollars, and the oil producers take their dollar surpluses and buy U.S. treasuries – that was the agreement.
This perpetual buying of U.S. treasuries kept the dollar strong relative to other fiat currencies, creating a dollar quasi-backed by oil, or what has become known as the petro-dollar system.
A constant bid for treasuries kept the dollar so strong that the “Great Financialization” occurred in the United States. The U.S. financial sector swelled, and the U.S. manufacturing base was largely sent to other regions of the world where currencies were cheap relative to the dollar, which meant labor was also cheap. As globalization increased, supply chains were optimized for efficiency and not resiliency because they could be, and this continued until March of 2020 with the dawn of the Coronavirus.
The Consequences of a Strong Dollar
While there are certainly trade-offs to this dollarized monetary order – of which the side effects are relative depending on your geographic location – the Great Financialization created a fiat currency dilemma of having to earn fiat “twice” to preserve one’s purchasing power, as pointed out by Saifedean Ammous. The U.S. stock market became (and is) disproportionately large relative to the country’s productivity, and investors were (and still are) forced to go further and further out on the risk curve to preserve their purchasing power and keep up with the perpetual state of nominal growth. The S&P 500 essentially turned into a savings account for U.S. citizens that were wealthy enough to own investable assets.
However, only half of U.S. citizens are wealthy enough to own investable assets. The other half of the U.S. has no investable assets, so they do not benefit from the Great Financialization of the U.S. economy that caused asset prices to soar. A recent study showed that 10% of American households now own 89% of all U.S. stocks – these households benefit handsomely from the current system. This bifurcation is one of the contributing factors to wealth inequality in the U.S., and some argue it’s the most prominent factor. Billionaire hedge fund legend Stanley Druckenmiller recently said that the Federal Reserve is the country’s greatest engine of inequality.
As the gap between the haves and have-nots widens due to asset inflation, certain second-order consequences of easy monetary policy begin to surface. As Ray Dalio indicated, societal discontent and political polarization become more prevalent as the class of people who do not benefit from asset inflation begin to feel poorer. This creates a higher probability of political movements – that once seemed unimaginable – to materialize. This is not only true in the U.S. as of late; this pattern is evident throughout hundreds, if not thousands of years of human history.
The privilege of earning a wage and saving in the world’s reserve currency is still better than how most of the world earns and saves but saving in a currency designed to debase makes the saver a victim of a shadow tax that is largely unknown to most savers.
However, this petro-dollar system that made the dollar the reserve currency is now fracturing before our eyes. While Russia began to slow its buying of U.S. debt within the last decade, the G7’s recent financial sanctions levied on Russia’s foreign currency reserves fundamentally changed the global order, particularly the dollar’s role as the world’s reserve currency, and likely put an end to the Bretton Woods II system that has existed since 1971.
Now, other nations must question the credibility of dollar debt as an international savings device, as pointed out by Nic Carter. If the West has the power – and is willing – to unilaterally freeze a nation’s foreign currency reserves, then the nation is strategically incentivized to a) adhere to U.S. and Western interests or b) divest its dollar-denominated foreign currency reserves, which are used to buy dollar-dominated oil, into a savings mechanism or currency that is less vulnerable to freezes and seizes, and one that the energy producers accept.
The New Monetary Order
As previously mentioned, energy is the base layer of a functioning economy. Recognizing energy as the “real” asset is the Schelling point I think we’ll witness on the global stage in the coming months and years. February 2022 marked the beginning of the transition of “money” from fiat currencies backed by government trust to currencies backed by energy. As Zoltan Pozsar suggests in his “Bretton Woods III” essay, we may be headed towards a new monetary order “centered around commodity-based currencies in the East that will likely weaken the Eurodollar system and contribute to inflationary forces in the West.”
Arthur Hayes has discussed the possibility that the global economy turns to a hard money standard to denominate international value exchanges, such as gold or a currency backed by a basket of commodities that require some form of proof-of-work. Arthur specifically believes governments will turn to gold first – and reasonably so.
Gold is a thousand-year-old technology that governments have previously used as a monetary standard. Governments also own a ton of gold, and it would be politically acceptable for them to turn to gold, given the historical precedent of its use. However, the gold standard has failed each time it’s been implemented, and I believe it would eventually fail again, in the long-term, if it were to be adopted this decade, for the same reasons it has failed time and time again throughout history.
Ironically, the physicality of gold is why it has not been and is not suitable as a monetary good for economies at scale. History shows us that the custody of gold tends to become centralized since it is so cumbersome to move across space. This results in sufficiently divisible paper claims on the gold that are easier to move, which requires trust in the institution or government custodying the gold not to issue more credit than the redeemable amount in the vault.
No government or institution has resisted the temptation of abusing the peg between gold and the layer two credit system built on top of it. Taking final settlement and physical custody of gold is the only way to prevent the gold standard from failing once again, i.e., requiring final settlement on a transaction-by-transaction case of the bearer monetary instrument. This reduces the trust requirement between sovereigns and eliminates a build-up of “redeemable” credit that may or may not be honored in this new de-globalized world order.
Nations will likely grow tired of the expenses and logistics required to transfer gold across land, air, and sea safely, and I believe, with time, they will turn to the digital alternative currency that is backed by energy and the one that perfects the monetary properties that gold approximates: Bitcoin.
Bitcoin is a permissionless monetary network that cannot be censored at the network level. Any nation can use its payment rails to conduct international trade with nearly instant settlement times on a decentralized, immutable ledger secured via cryptographic energy.
In this new geopolitical landscape, where credit representations of “money” can no longer be trusted and numbers kept in a centralized SQL database mean less than they once did, the ability to instantly self-custody a digital hard money backed by physical energy changes everything. Instead of having ships full of gold cross the seas to settle each transaction, sovereigns can press a few buttons on a computer and achieve the same outcome.
While nations may turn to gold first, it’s likely they will eventually realize that Bitcoin is superior to gold as a monetary good on the international scale because it is natively digital. This prevents the centralization of its custody and therefore removes the temptation for a government to create more paper claims on its gold than the amount of gold it owns in its vault. Additionally, it’s easier and less expensive for a nation to verify that the bitcoin it receives is actually bitcoin than verifying that the gold it receives is actually gold.
I will not delve into each one of Bitcoin’s monetary and technological characteristics to explain why I believe it’s the best form of money for nations to adopt but examining the shortcomings of gold relative to Bitcoin is key to understanding how this transition may play out. I believe nations will first turn to gold because they’re comfortable with gold, they already own a lot of it, and because bitcoin is simply not liquid enough to handle international trade settlements at this time. But directionally speaking, the jump from a gold standard to a bitcoin standard is consistent with the digitization trends we’ve witnessed in nearly every other instance of technological progression.
While the latter part of this essay contains much speculation, one thing is for sure: it is definitely an interesting time to be alive.