The United States has Encountered a Force it Cannot Stop
Today, the United States has the privilege of issuing the global reserve currency. All around the world, countries save and transact with US dollars due to the Bretton Woods Agreement and the petrodollar system. The petrodollar system, which spawned from an oil deal between the Nixon administration and Saudi Arabia, enabled the US to maintain its role as the global superpower as it abandoned its peg to gold. This role, though, did not come without a cost. Wars started over oil in the Middle East have resulted in decades of death, destruction, and deficits. Further east lies the biggest threat to the US, China. China recognizes that without the petrodollar system, the US dollar could lose its status as the global reserve currency. Oddly enough, though, the fall of the dollar won’t be caused by currencies issued by nation-states. Decentralized across the globe, Bitcoin and other cryptocurrencies will end dollar dominance as we know it. Moreover, the US won’t have any choice but to let it happen.
The Gold Standard
The 19th century Civil War was one of the lowest points in American history. Our country tore itself apart over whether or not to continue the sickening institution of slavery. Additionally, the country broke from its gold and silver based monetary system in favor of paper currency. To this day, governments have issued bonds or printed more currency outright to finance their wars. During the Civil War, the Confederacy issued the Confederate States dollar, which crashed in value as the Union army appeared to be winning the war.
While federal greenbacks were issued and circulated among the United States following the war, the nation was divided on whether to back the currency using silver or gold. Silver was more plentiful, so “silverites” argued more money would lead to higher wages and greater profits for farmers. Those backing a gold standard suggested a limited money supply backed by the scarcer resource would lead to more price stability and, in turn, would be good for business. The national gold vs. silver debate ended when William McKinley was elected President in 1900 and signed the Gold Standard Act.
The gold standard didn’t last long. During the Great Depression, President Franklin Roosevelt intentionally inflated the per ounce value of gold to help farmers receive more money in exchange for grain. By manufacturing inflation, Roosevelt thought he could decrease the unemployment rate. Similar flawed thinking would plague the US in the years to come. In 1934, all gold coins were withdrawn from circulation and US currency could no longer be redeemed for gold. The US treasury purchased gold from sellers for $35, but only sold it to international monetary authorities. Gold had become monopolized by the government.
While war sped the implementation of the gold standard, it also formally brought the gold standard to an end. After World War II, the Allied nations signed the Bretton Woods Agreement, which shifted the world from the gold standard to the dollar standard. Central banks were to fix their currencies’ exchange rates to the US dollar, which itself remained tied to gold 35/1. Additionally, the allied nations formed the International Monetary Fund and World Bank to help stabilize world currencies and develop emerging markets, respectively. Global world order appeared to be established and centered around the US dollar.
The Rise of the Petrodollar System
Following the Bretton Woods Agreement, international trade grew. As the world’s reserve currency, demand for US dollar reserves outstripped the US stock of gold. Inflation sped upward throughout the late 1960s and foreign central banks exchanged their US dollar reserves for gold. Richard Nixon brought this to an end in 1971, as he ended the dollar for gold exchange between nations. The gold standard was ended and currencies were allowed to float.
As Richard Nixon brought the US off of the gold standard, he needed a way to prevent the fall of the dollar. The devaluation of the US dollar coincided with the OPEC oil embargo. In response to US support of Israel during the Arab-Israeli war, Arab OPEC discontinued its sales of oil to the US. Because the US had become incredibly dependent on oil imports, oil prices skyrocketed. The US appeared to be spiraling down an inevitable path towards a recession.
In what proved to be a brilliant short term move, the Nixon administration made what is now a declassified deal with Saudi Arabia and other Middle Eastern oil producing states. The oil rich countries would sell their fossil fuel exclusively for US dollars in return for US weapons and military protection of their oil fields. Additionally, the Middle Eastern countries agreed to reinvest their dollar profits back into the US by clandestinely purchasing US treasuries. International oil trade maintained dollar adoption across the world and enabled the US to continue its deficit spending. Soon enough, US dollars became used for the majority of international trade. This privilege, though, would create an addiction to deficit spending that will cripple the US dollar.
Defense of the Petrodollar System
The deal the US struck with Saudi Arabia in 1974 had unanticipated long term consequences. Though the deal helped the US retreat from the brink of financial collapse, Saudi Arabia assumed enormous influence over the US by becoming one of its largest creditors. Saudi Arabia managed to avoid blame for the September 11, 2001 terrorist attacks by threatening to sell as much as $750 billion in US treasuries. The threat was effective, as the US hasn’t publicly acknowledged Saudi Arabia’s role in 9/11.
The recent decline of oil prices and its war with Yemen has created pressure for the Saudi Arabian Finance Ministry to find alternative revenue sources to plug its growing budget deficit. The US has continued to play nice, though, having recently sold billions of dollars of arms to Saudia Arabia. As a debtor nation interested in maintaining its privilege of issuing the global reserve currency, I expect the US to continue its subservience to Saudi Arabia.
Reserve currency status, while undoubtedly a privilege, needs to be defended. US politicians claimed the invasion of Iraq was a means of seizing Saddam Hussein’s weapons of mass destruction, but no such weapons were found. Coincidentally, the Iraq war shortly followed talks between OPEC representatives and the European Union about the possibility of a petroeuro. Oil sales denominated in euros, rather than dollars, would compromise the US dollar’s status as global reserve currency. This possibility never manifested. Not long after the invasion of Iraq, the US ensured that Iraqi oil transactions were priced in dollars.
Iraq’s neighbor to the east, Iran, made an unsuccessful effort to exchange oil for alternative currencies. In 2007, Iran asked its oil trade partners to pay using currencies other than the US dollar. This commodity exchange, which became known as the Iranian Oil Bourse, was met with a strong US reaction. While attributing economic sanctions instituted in 2010 to the development of nuclear weapons, the US crippled Iran’s economy. In 2012, the US further ratcheted up sanctions by cutting Iran off from SWIFT. SWIFT is a messaging platform that enables international financial transactions. Foreign banks and firms were prohibited from investing or transacting with Iran’s energy sector, or else the US threatened to likewise exclude them from the global banking system. I’m not suggesting evidence of Iran’s nuclear program is to be discounted. I am, however, saying that the Iranian Oil Bourse further motivated the US to come down hard on Iran.
Libya, an African country sandwiched between Algeria and Egypt, sits atop billions of barrels of oil. Though the resource rich country and its leader were positioned to grow wealthy through oil exports, Muammar Gaddafi’s early death offers a lesson to leaders challenging the US. Gaddafi railed against “US imperialism.” He wanted to trade oil between Arab and African nations using the gold dinar as currency, rather than the US dollar or Euro. His threat was never to be realized. In 2011, an American funded rebel force rose against Gaddafi, took over the country, and brutally killed him. Soon after the rebels assumed control, Libya returned to the petrodollar system.
A Formidable Opponent Challenges Dollar Supremacy
While it’s clear the extent to which the US will go to ensure its currency remains in global reserves, China nevertheless is making continued efforts to adopt an alternative. Viewing gold as an alternative store of value to the dollar, China went on a gold buying binge, expanding its reserves to over 40 tons. Further complicating matters, the US is in a bit of a debt trap with China. China owns over a trillion dollars in US treasuries, making it the second biggest holder of US debt. Should China choose to rapidly sell on the open market, inflation could spike before alternative buyers are found. The threat of treasury market disruption is enough to make the relationship between the US and China shaky. That said, the debt trap is just one point of contention among a growing list.
As a rising power with an alternative model to democracy, China wants the US dollar replaced. If the US didn’t have the privilege of issuing the reserve currency, China would have a far easier claim to the role of global superpower. Though China has been purchasing gold, gold prices have remained low and are subject to manipulation. China’s own currency, the yuan, also won’t emerge as an alternative. China artificially depresses the value of the yuan to give it a price advantage over the US for global exports. Additionally, China has been opaque and unpredictable in their market operations. Investors want transparency and predictability in their global reserve currency. So, with neither gold nor the yuan as potential dollar competitors, China is forced to look elsewhere. Just recently, the cryptocurrency bull market has presented China with a (digital) golden opportunity.
Bitcoin and Other Cryptocurrencies as Alternatives to the Dollar
Throughout history, groundbreaking technological innovations have completely transformed society. The printing press in the 16th century destroyed the “idea monopoly” the Church had over citizens. Gunpowder changed the way in which humans organized themselves. Silicon chips rapidly accelerated processing power, which enabled the augmentation of human intelligence. Cryptocurrencies and the blockchains that underpin them are likewise ushering in transformational changes. In fact, they will reshape the intermediated financial system and reduce nation-state control of currencies.
The rise of bitcoin and the broader cryptocurrency market over the past decade has been remarkable. Created after the financial crisis, an anonymous cryptographer or group of cryptographers created bitcoin using the pseudonym Satoshi Nakamoto. Since the first bitcoin was mined in 2009, thousands of other cryptocurrencies have been created. Just recently, the cryptocurrency asset class reached a value of two trillion dollars. To underscore the point, in just over ten years, a new technology led to the creation a global financial ecosystem independent of government control. The cryptocurrency market was thrust into spotlight due to retail investors, but it has now caught the attention of institutional investors. Wall Street firms have issued bullish bitcoin price targets and the SEC has received several applications for cryptocurrency exchange traded funds. While governments have largely been skeptical, if not outright hostile towards cryptocurrency, it’s inevitable that their position changes.
Mathematics Create Trust
Cryptocurrencies like Bitcoin differ markedly from fiat currencies like the US dollar. They don’t require an intermediary to establish trust between transacting parties. Instead, computer code facilitates the transaction. Without going into much detail, bitcoin is a decentralized currency that uses mathematics in place of a financial intermediary to verify transactions. Rather than having J.P. Morgan Chase settle my dollar-denominated transaction with my local deli via Visa, bitcoin miners can add my transaction to the bitcoin blockchain using bitcoin’s proof of work algorithm. The amount of bitcoin that gets “mined” over time is dictated by computer code, rather than by the whims of a centralized power. Moreover, the amount that is mined decreases over time. Bitcoin is therefore deflationary.
Returning to my deli transaction, the deli owner doesn’t need to trust that I have money for the sandwich. Nor does he need to pay Visa a 2% fee for assuming the risk that I can’t fund the transaction. Mathematically enabled peer to peer transactions of this nature will create efficiencies and drastically reduce costs over time. Most importantly, these transactions aren’t limited to payments. Elections, property ownership, and other convoluted systems can be streamlined and secured using blockchain technology.
The printing press invited the masses to participate in intellectual and theological dialogues, which enabled laymen to compete with the Church over how truth is defined. Similarly, alternative currencies and transactional frameworks will breakdown centralized control of currencies, institutions, and social networks. Increased competition creates efficiencies, price reductions, and better products and services. While historical precedents may suggest centralized powers would meet threats with destructive force, there’s enough competition among our power centers to warrant more nuanced responses. The US government, specifically, will be forced to allow the cryptocurrency paradigm shift to unfold, or else it will concede leadership in the space to China.
Game Theory Suggests Crytpocurrency Adoption
To help make clear why the US will allow a cryptocurrency like bitcoin to replace the US dollar, let’s picture a two-player game between the US and China. Each player uses its military might, relationships, and economy as a means of assuming the title of global superpower. The US chooses to play the game as a democracy, forming relationships with other countries based on the shared value of national participation in its government processes. China, by contrast, plays with a more centralized model it refers to as socialism with Chinese characteristics. China’s president has a lifetime tenure and its most powerful institutions are under his administration’s control. With such divergent methods of gameplay, the US and China are constantly vying to prove to the world their method’s superiority.
Lately, China seems to be winning the game. It has rapidly recovered from the coronavirus pandemic, swiftly eliminated a democratic uprising in Hong Kong, and has built one of the most effective state surveillance systems in existence. As I previously mentioned, the biggest problem China has in dethroning the US as the global superpower is the US dollar’s reserve currency status. Bitcoin is emerging as an increasingly viable currency, which creates complications for the US. Just recently, China referred to bitcoin as an investment alternative, effectively encouraging adoption among its billion citizens. The US has so far failed to offer any clear stance on bitcoin. If the US discourages bitcoin investment through overregulation, it will present China with a perfect opportunity to invest in and evangelize a US dollar alternative. If, however, the US offers a full-throated bitcoin endorsement, bitcoin could overtake the US dollar as the global reserve currency. So, what can the US do when caught in such a tough position?
Enter game theory. John Nash, the schizophrenic professor popularized in A Beautiful Mind, won the Nobel prize for his development of the Nash Equilibrium. The Nash Equilibrium, which is under the umbrella of game theory, states that no player can obtain a higher payoff, holding all other players’ strategies constant, by choosing a different strategy. Our two players have the below strategies they can employ in response to the advent of cryptocurrencies like bitcoin:
1. The US Discourages Bitcoin Investment/China Invests in Bitcoin
Let’s say the US discourages bitcoin investment by overregulating the new asset class. Again, this would give China the opportunity to drive up bitcoin’s value by investing in it. As a new, innovative technology endorsed by the Chinese government, the Chinese people would be on the forefront of cryptocurrency and blockchain technology. China has already positioned itself as a leader in artificial intelligence and it can do the same with cryptocurrencies and blockchain. This would attract top talent in the cryptocurrency and blockchain space to China. Moreover, China can encourage its trading partners to adopt a deflationary US dollar alternative. Of course, if the US were to take a hostile stance towards bitcoin, it would all but ensure bitcoin replaces the US dollar as the reserve currency. China could conceivably spur the adoption of a “petrocrypto” alternative to the petrodollar. The US cannot kill bitcoin, as it’s geographically redundant. No one country issues bitcoin. If the US takes an anti-bitcoin stance while China assumes a pro-bitcoin stance, the US would lose its superpower status to China.
2. The US Invests in Bitcoin/China Invests in Bitcoin
It’s easy to argue that US dollar mismanagement led to the incredible bitcoin price appreciation. The US hasn’t had a budget surplus since 2001, as US presidents since Clinton have been poor capital allocators. Bush’s horrific decision to engage in wars in the Middle East cost the US trillions of dollars, a decline in the way the world perceives the US, and thousands of lives lost. Obama’s Affordable Care Act did little to address the increasing healthcare prices while costing the US government hundreds of billions in annual subsidies. Trump’s corporate tax cuts and incompetent pandemic management reduced government revenue and accelerated deficit spending to new highs.
Inflation worries largely led to the run up in the price of bitcoin during the early stages of the coronavirus pandemic. As a deflationary currency, investors believed bitcoin was a better store of value than the rapidly devaluing US dollar. US investment in bitcoin would inevitably lead other governments and global institutions to follow suit, thereby causing bitcoin price appreciation. The US could set up bitcoin mining operations and subsidize development in the blockchain space. These investments would likely generate strong US dollar returns and deflate costs through increased innovation. US dollar returns on bitcoin investment could be used to pay down the deficit. A balanced budget would ensure the US isn’t beholden to countries like Saudi Arabia.
That said, greater bitcoin adoption would inevitably hurt the US. If global commerce were no longer settled in dollars, the US would lose much of its influence and have less visibility into international capital flows. It would be more difficult for the US to collect taxes, which would hurt its primary income stream. With such negative consequences of worldwide bitcoin adoption, why would the US invest in it? Simply because it has no choice but to do so. Poor dollar management led to bitcoin’s rise, which gave China an opportunity to usurp the dollar. It will capitalize on the opportunity.
Not all is bad for the US. Investments from the US and China could ensure they’re both stewards of the next wave of technological innovation. This could lead the two nations to increased cooperation. A SWIFT-like cryptocurrency system could revolutionize international finance. The two major superpowers’ participation would speed the transition.
While it may appear that I’m being naive in thinking the US and China would be willing to cooperate on the development of a new financial system, we’re seeing that cooperation is possible. The US and China are both united in their views on climate change. Despite the fact that each country is jockeying to lead the effort to slow the pace of climate change, they’re both headed in the same direction. A similar approach may be taken with cryptocurrency.
3. The US Invests in Bitcoin/China Discourages Bitcoin Investment
China had initially taken a stance against Bitcoin, but it has since reversed its course. The majority of bitcoin miners are located in China, as is Binance, one of the largest cryptocurrency exchanges. If China were to discourage bitcoin investment, it would harm a rapidly growing asset class and peripheral ecosystem. It would also pass up on its opportunity to displace the dollar as the global reserve currency.
It also seems unlikely that the US would invest in bitcoin if China took a hostile stance toward cryptocurrencies. The US knows how privileged it is to have its currency function as a global reserve. But, the US abused its privilege, which helped accelerate bitcoin adoption and precipitate the fall of the dollar. Seeing China publicly acknowledge bitcoin as an alternative investment forces the US to invest as well, lest it concede cryptocurrency leadership to China.
4. The US Discourages Bitcoin Investment/China Discourages Bitcoin Investment
If both the US and China were to discourage investment in bitcoin and cryptocurrencies more broadly, they would be passing up on one of the most rapidly growing asset classes in history. And because bitcoin is geographically redundant, other nations can assume leadership roles in this new industry. Countries like Venezuela in the midst of hyperinflation can find salvation in bitcoin. Nigeria’s central bank declared a “ban” on bitcoin and other cryptocurrencies, yet peer-to-peer trading since the ban has surged 27%. Bitcoin is not a fiat currency and therefore cannot be banned. The two superpowers conceding cryptocurrency leadership to other countries could lead to a new world order. A game played with these strategies would have two losers.
What Happens Next: the Fall of the Dollar
Bitcoin and other cryptocurrencies have now gone mainstream. Institutional investment managers like J.P. Morgan and Blackrock, which initially opposed bitcoin, are now helping their clients invest in cryptocurrencies. As more powerful institutions invest in cryptocurrencies, governments will increasingly be pressured to impose sensible regulatory guidance on the new asset class. If cryptocurrencies are here to stay, what will the future look like? I think further adoption of cryptocurrencies will lead to the fall of the dollar. That said, the fall of the dollar won’t necessarily be as terrible as it sounds.
Bitcoin, as a decentralized currency, isn’t controlled by a single entity. In fact, this fundamental principle has spawned the advent of decentralized finance, or DeFi. DeFi is a nascent innovation sitting atop the blockchain that enables individuals to lend to one another via smart contracts. A smart contract, which is computer code that facilitates a transaction between two parties without the need for an intermediary, is as democratic as it gets. Rather than relying on a credit bureau or bank to determine creditworthiness, decentralized finance simply requires borrowers lock up collateral in excess of their loan amount. With no intermediary using its discretion to determine who does and does not get a loan, the financial system becomes fairer. In effect, DeFi further democratizes finance.
By investing in DeFi, the US would double down on democratic principles and reap the benefits of increased efficiencies in the process. DeFi is the antithesis of China’s centralized model of government. By becoming a leader in the DeFi revolution, the US would implicitly promote democracy and showcase the viability of decentralized system. The coming years will be incredibly disruptive, but the disruption could ultimately benefit the disenfranchised and disillusioned. It’s time to embrace the change and welcome the next revolution.
Do you have thoughts about the fall of the dollar and rise of cryptocurrencies? Leave a comment below or contact me directly.