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(Disclaimer: The author works at Ryze Financial)
The 2008 financial crisis exposed weaknesses in the US banking system. Seemingly indestructible monoliths such as Lehman Brothers and Bear Stearns were taken as casualties. Americans lost $9.8 trillion in wealth.
However, an entirely new kind of money was born as a product of this crisis — Bitcoin: decentralized, deflationary, digitally-native money. The ’08 recession set the stage for Bitcoin’s creation, and the economic impacts of COVID-19 could set the stage for Bitcoin to shine as a hedge against inflation and store of value.
In an attempt to mitigate the economic repercussions of the coronavirus pandemic, central banks are bailing out industry-leading corporations, small businesses, and individual consumers alike. Governments have announced over $7 trillion in total relief spending, with $2.3 trillion from the US, equivalent to roughly 11.2% of US GDP. A significant portion comes from central banks printing money to buy bonds and other financial instruments.
Printing new money to buy bonds, or “quantitative easing (QE),” increases the money supply. In addition, governments are effectively handing out money to their citizens, which may cause inflation even with the US Dollar. Increasing the supply of any asset decreases its value unless demand increases at the same rate. This opens up an opportunity for Bitcoin since its inflation rate will be cut in half as a result of the May 2020 Bitcoin Halving. Bitcoin’s value may rise as a result of this quantitative tightening, while government-backed currencies across the world could lose value due to inflation.
The economic impacts of COVID-19 will test two key narratives for Bitcoin: its use as a hedge against inflation and store of value, and its potential to replace government-controlled fiat currencies.
How did we get here in the first place? The story starts in 1913 with the passage of the Federal Reserve Act. This created the Federal Reserve, an independent central bank in charge of monetary policy. The Fed was given control of money supply and interest rates and tasked with the goals of lowering unemployment and inflation. In the decades to follow, The Fed didn’t always meet these 3 objectives.
From 1913–1919, the US Dollar underwent a period of nearly 20% annual inflation. This was a product of vast government spending during WWI and a shortage of resources, which led to high production costs and prices. During WWII, we saw upwards of 13% annual inflation, even with measures in place to freeze wages and prevent inflation.
Between the wars, however, the USD underwent periods of massive deflation during the recession of the early ’20s and the Great Depression of the ’30s. These deflationary periods balanced out the inflationary ones, resulting in average annual inflation of ~1% from 1913–1960.
A causal element that enabled such rampant government spending was the abandonment of the gold standard. Prior to the Great Depression, the US allowed the redemption of any amount of paper money for its value in gold. This enabled large transactions to be completed without the physical transfer of gold bullion. The value of paper money was guaranteed by gold reserves held by governments.
At the start of the Great Depression, depositors didn’t trust financial institutions with their money, so they started hoarding gold to preserve their wealth. In 1933, FDR passed an executive order forcing banks and consumers to give up their gold to the US government in exchange for paper money, effectively eliminating the gold standard.
The gold standard discouraged government debt, budget deficits, and inflation. Since then, the Fed has been able to issue money at will, without having to back new money with any real assets.
Nixon furthered FDR’s actions beyond the domestic sphere in 1971 when he ended international fixed-rate conversions between the dollar and gold. Subsequently, the 1970s were the most recent period of high inflation in the US. Unlike previous periods of high inflation, which were caused by wars, inflation in the ’70s was largely a result of an economic shock.
In 1973, an oil embargo enacted by OPEC against the US caused oil prices to quadruple. This increased consumer gas prices, the cost of transporting goods, as well as the cost to manufacture oil-dependent goods such as plastics. As a result, prices across industries went up, causing double-digit inflation.
In response to rising prices, demand for goods and services decreased, causing lower utilization and lower revenues for businesses. Faced with lower demand and higher costs, companies were forced to lay off workers. Rising unemployment resulted in lower demand, forcing more layoffs and creating a vicious cycle. The combination of high inflation and high unemployment is called stagflation.
To combat stagflation, the Fed initially increased the money supply and lowered interest rates, with the hope of increasing aggregate demand. Higher demand decreased unemployment, but increased prices and cost of living. As a result, unions demanded higher wages, causing higher costs for businesses. Higher labor costs led to layoffs and more unemployment, causing demand to fall again.
In response, the Fed continued to increase the money supply and lower interest rates to increase demand, restarting the cycle, and ultimately resulting in runaway inflation and higher and higher unemployment. By ’73, inflation was at 8.8%, and by the end of the decade, it had increased to 14%. Politicians were focused on decreasing unemployment and putting people back to work in order to garner votes.
Paul Volcker was appointed chairman of the Fed in 1979, and unlike his Keynesian predecessors, Volcker’s focus was on curbing inflation. He reversed monetary policy and raised interest rates to as high as 20% and decreased the money supply. This initially led to a massive reduction in demand, and substantial unemployment, causing the recession of ‘81-’82. However, inflation eventually slowed and prices fell, increasing demand and bringing the economy out of stagflation.
Similar to the ’70s, we find ourselves in an economic shock, this time as a result of a global pandemic as opposed to an oil shortage. Social distancing and other public health measures taken by policy-makers have disrupted the flow of people, goods, and services globally. Disrupted manufacturing and distribution has resulted in a supply shock. This is occurring in tandem with a demand shock caused by consumers being stuck in their homes.
As a result, businesses large and small have decreased revenue, and are forced to lay off employees. So far, 33 million Americans are filing for unemployment, nearly 20.5% of the workforce, the highest since 1934. For context, we didn’t see double-digit unemployment during the Great Depression for nearly three years. Investors are in a scramble for cash, causing equities, corporate and other non-government bonds, commodities, and even cryptocurrencies to fall. The Dow Jones Index is down >30% from peak to trough.
To mitigate economic damage, central banks have responded in true Keynesian fashion (just as they did in the ’70s) by lowering interest rates and engaging in quantitative easing (QE). QE entails purchasing debt in the form of mortgage-backed securities and Treasury bonds, and printing money for corporate and individual taxpayer bailouts.
Interest rates have a lower bound of 0%. Negative interest rates, which have been tested in the last decade by European and Asian countries, can incentivize consumers to pull their money out of commercial banks. Money sitting in savings accounts would have a storage charge as opposed to earning positive interest, incentivizing consumers to hoard physical cash outside of banks.
Officials at the Federal Reserve, European Central Bank (ECB), and Bank of Japan (BoJ), among others, agree that we are at a pivotal moment in the history of monetary policy and fiat currency. Interest rates have steadily declined over the last 50 years since Volcker raised the rates. Volcker raised rates when inflation was high. Now, inflation is low and interest rates have reached lower bounds. The Fed must either follow the footsteps of the ECB and BoJ by entering negative interest rate territory or follow the footsteps of Volcker and hike rates to reset the economy. Neither are particularly attractive options, and the government is instead resorting to fiscal stimulus.
Over $2.3 Trillion (11% of US GDP) is being printed by the US government and pumped into the economy through the CARES Act. This money is helping expand unemployment benefits, provide one-time checks for consumers, and support SMBs, hospitals, and state/local governments.
The funding from the CARES Act comes from the sale of Treasury bonds. Who’s buying $2.3 Trillion in government debt? The Federal Reserve, which has announced unlimited QE to fund the Treasury’s operations. QE generally entails the purchase of Treasury bonds and mortgage-backed securities, but this time, the Fed is following in the footsteps of the ECB and BoJ by also buying up corporate debt.
Japan, however, is no stranger to QE. The BoJ first started injecting money into its economy in the early 2000s to fight deflation. Initially, banks were flooded with extra liquidity by the government to encourage lending, and thus, consumer spending. QE in Japan hasn’t resulted in significant inflation, potentially because it was limited to public and private debt markets. This time around, we’re seeing governments issue new money and distribute it directly through individual stimulus payments to consumers. This is more likely to cause inflation than buying treasury or corporate bonds.
Money printing and low interest rates across the world could cause fiat currencies to lose purchasing power as inflation increases. Increasing supply decreases value if demand doesn’t increase at the same rate. In comparison to traditional stores of value such as gold, fiat currencies have lost >80% of their purchasing power in the last decade alone.
Traditionally, gold has been a hedge against inflation, and during times of economic crisis, investors flock to assets such as gold to preserve value. Unlike fiat currency, it has limited supply and scarcity. Bitcoin shares both of these properties, as its maximum supply is finite, and it has “unforgeable scarcity” due to the costliness of its creation. Just like gold, new Bitcoin can’t be arbitrarily created as fiat currencies can.
Moreover, Bitcoin is becoming more scarce as a result of the May 2020 Bitcoin Halving, a preprogrammed functionality of the Bitcoin protocol that reduces the rate of supply by 50% roughly every 4 years. Scarcity is not just a function of the current supply, the rate of supply is also a factor. Bitcoin’s annual inflation rate will also decrease to 1.8%, lower than the global average inflation, and lower than the inflation rate of Gold.
This increase in scarcity can be modeled through stock-to-flow or SF, the ratio between the amount of Bitcoin in existence (stock) and the amount that is created each year (flow). SF is used as a fundamental measure of value in precious metals, and was first applied to Bitcoin by pseudonymous analyst Plan B. Gold has the highest SF at 65, and after the 2020 Halving, Bitcoin’s SF will be 58, significantly higher than all precious metals other than gold.
Bitcoin’s potential as a store of value could be actualized first in developing nations with weak central banks. A COVID outbreak will devastate 3rd world countries, especially as the Southern Hemisphere heads into winter. Single-product economies such as Venezuela’s may collapse (again), leading to central bank failure and currency devaluation.
Central banks in developing countries have a poor track record of curbing inflation. During colonialism, local currencies were pegged to the colonizer’s currency at fixed rates. Post-colonialism, from 1946–1971, money in developing countries was pegged to the US Dollar at fixed rates. This arrangement, known as the Bretton Woods system, fell apart in 1971 after the US abandoned the gold standard. During the ’70s, developing countries faced 3x higher inflation on average than their first-world counterparts. While the US was able to curb its inflation starting in the early ’80s, developing countries have seen average annual inflation of 75.7%.
The Bretton Woods system and other post-colonial monetary exchange policies acted as barriers against inflation. The abandonment of the gold standard and collapse of the Bretton Woods system meant that central banks in these developing countries had to curtail inflation on their own. Objectively, most countries have failed miserably. Only a handful of developing nations with central banks haven’t experienced significant currency devaluation. Extreme cases of inflation include the Russian ruble, which is worth 1/4000th of its USD value in 1970, along with Venezuela, Argentina, and Zimbabwe, all of whom have experienced central bank failures.
Monetary theorists maintain that “the best thing [developing countries] can do to reverse their poor monetary and economic performance of recent years is to abolish their discretionary central banks and fix their currencies to foreign currencies with relatively good records of low inflation.” Instead of foreign currencies with low inflation, central banks in these countries may benefit by fixing their currencies to Bitcoin, the only deflationary money in the world. Countries such as Venezuela, Brazil, and Argentina where central banks have failed are already seeing increased Bitcoin adoption.
Another possible avenue for Bitcoin adoption in developing countries rests on a modification of the Dollar Milkshake Theory, first posited by Brent Johnson, CEO of Santiago Capital. In a nutshell, Johnson purports that liquidity injected into the global financial system will all eventually be sucked into the US Dollar. However, the dollar isn’t globally accessible, as governments impose controls on exchange amounts. Since Bitcoin is more versatile than gold, and more accessible than the dollar, as anyone with a cell phone and internet access can own Bitcoin. Some portion of the liquidity injected into the global economy will find its way into Bitcoin.
COVID-19 has far-reaching economic impacts, and we’re just seeing the tip of the iceberg. The economic shock of the 1970s was, at first, unsuccessfully combated with lower interest rates and increased money supply. It took a whole decade of rampant inflation and unemployment until policymakers enacted contractionary measures and raised interest rates, which ultimately brought stagflation to an end.
The coronavirus pandemic has brought on the worst economic shock since the ’70s, and we’re reacting in the same way we initially did 50 years ago. Interest rates are reaching their lower bounds, and trillions of dollars in fiat currency are being created out of thin air. We’ve never pushed the fiat system to this extent, and it’s impossible to predict the long-term repercussions of the actions governments and central banks are taking. As BitMEX CEO Arthur Hayes stated, “Inflation like this has been eradicated from our collective memories. Inflation has been low and stable for over 30 years and politicians and the public are unaware of the risks.”
Bitcoin, as a construct outside existing financial systems, poses a potential solution to the fundamental problems with fiat money that have been created over the last 50 years. Its value as a hedge against inflation will shine as it undergoes quantitative tightening as a result of the 3rd Halving in May. We could see adoption in developing countries where central banks are likely to fail or have already failed.
Smart-money sees this coming, and institutions are paying more attention to Bitcoin. Grayscale, which provides avenues for institutions to invest in crypto, reports $500M+ in new investment in Q1 2020, more than double the previous record.Bloomberg, in a recent report, commented on Bitcoin’s convergence with gold, furthering its narrative as a store of value.
Bitcoin was created in the midst of the 2008 financial crisis, and the economic impacts of the coronavirus pandemic are setting the stage for Bitcoin’s greatest test yet.
(Disclaimer: The author works at Ryze)