Global currency, recession and Bitcoin, part 1: What, why and how?
How to make sense of Bitcoin next to the rise of a global digital currency to replace the US dollar.
This article was originally published on 27 August 2019. It's the first half of a two part series.
This part one looks at how the current economic system was built, contextualises the current recession and explores how circumstances are leading to the rise of a single global digital currency.
Part two looks at the current role of the US dollar in the global economy, how this can inform the design of a new global reserve currency and how well Bitcoin stacks up to this design.
Wage growth is stalling, mortgage defaults are rising, retail sales are falling, market omens such as the dreaded inverted bond yield curve are appearing, the US federal reserve cut interest rates for the first time since just before the GFC and almost every ounce of existing precedent says the world is about to experience another recession.
But while these can rattle investor confidence and hasten collapse, they're still just the symptoms of recession, rather than the cause.
Take a step further back, to where most observers are currently standing and you'll see people blaming the impending recession on factors like the US-China trade war and Brexit.
But let's take another step back and look for the broadest possible cause. Here we find an extremely brittle web of international commerce, built piece by piece over the last few decades, which has turned the global economy into a rickety debt-driven house of cards, dependent on constant growth and healthy relations between separate countries to avoid collapsing.
This brittle structure means unfortunate incidents like real estate derivative bubbles (driving the 2007 GFC), trade wars (driving the expected 2020 recession) or the violent robot uprising of 2057 (resulting in the collapse of the Glorious Terran Republic) can have outsized impacts.
These days, the international webs of debt are global affairs. It's perfectly ordinary for countries to have total debt that far exceeds their GDP, and it's increasingly clear that there's no way in heck many of those debts will ever be paid off.
Consider the charts below, showing debt profiles for China, Australia, Germany and the USA. Each dot represents 1% of each country's GDP worth of debt. The green dots are corporate debt, the blue dots are government debt and the pink dots are household debt.
There are a few things to unpack here.
Firstly, as an incidental matter of interest, note Australia's large household debt (pink dots). Australia has some of the world's highest levels of household debt, so that number of pink dots relative to the total is pretty much the highest anywhere in the world. These charts provide a neat visual benchmark of that.
Secondly, note how debt to GDP ratios popped off between 2006 and 2009, giving the global economy a shot in the arm to help it get up after the GDP. Paying down that debt explosion is a slow process and the world has never really recovered from it. Even today, the overall picture still has a clear "post-GFC" look to it, marked by elevated debt levels.
Thirdly, note that China's debt to GDP ratio is absolutely on fire, rocketing past all the other countries and the USA from 2006 to now. That debt-driven growth in China has been a key force of economic recovery over the last decade, but now it's running out of gas with no filling station in sight.
This is where things are standing now.
Local economic issues in some of the world's larger economies can spill over and affect the whole world. After all, the subprime mortgage crisis was at its heart an American fascination with unaffordable housing, but geographical distance didn't help anyone on the other side of the planet who lost their own perfectly affordable home in the ensuing crisis.
We can't separate China's debt bubble from the global economy either.
"China, more than the US, has been the extra gear for the global economy since the 2008 financial crash, but the country is in the throes of a full-blown debt crisis," The Guardian notes. "State industries have borrowed heavily and so have consumers. Banks are weighed down by loans that will never be repaid."
The ability of individual countries to solve these local problems is also hampered by the interconnected nature of the global economy.
In the case of China, it's been unable to safely rein in its own corporate debt bubbles because doing so risks harming the global economy, while necessary efforts to diversify from a manufacturing-centric to a more service-based economy are in turn hampered by the world's reliance on China as a manufacturing centre. And if the global economy falters, that would backfire on China's own economy.
"Each time Beijing has attempted to rein in excessive consumer and corporate lending, the global economy has wobbled, forcing China's policymakers to loosen credit again," The Guardian says. "Meanwhile, industrial production growth is at a 30-year low at 4.8%. Beijing wants the economy to become more self-contained with a shift from manufacturing to services, but it's a long haul."
The world's largest economies are packed together like sardines in a can. Whenever one of them tries to scratch a local itch like underemployment or low consumer spending, it can't help but elbow its neighbour in the face. This limits the kinds of economic policies that you can implement.
An economic house of cards
The same issues impact currency. As all the drama around China's recent yuan devaluation illustrates, countries can't manage their own currencies anymore without creating issues. And in Europe, for example, Germany's relatively low levels of national debt are thanks in part to the European Central Bank's massive multi-trillion dollar quantitative easing program, which also saw the euro start sinking, igniting small talk of currency wars and competitive devaluation in the process.
The USA, in particular, has an outsized impact on the global economy. And there it doesn't help either that economic policy tends to shift every four or eight years, swinging between fiscal conservatism from one party, to candied tax cuts from the other.
There are a lot of causes and symptoms behind the current economic downturn, such as the trade war and mounting global debt, but the inescapable cause underlying all of that is the fact that the global economy is a fragile house of cards, where different countries lean on each other and it all risks falling down at any time.
This is where the idea of a global reserve currency comes in. In part it's intended to be a solution for this underlying "house of cards" problem, opening the door to a new set of international economic policies, and solving many of the problems that are currently hampering central banks.
One of the most recent calls for a new global reserve currency came at the Jackson Hole gathering of central bankers, where Mark Carney, the governor of the Bank of England, called for the creation of a new global digital currency, or "synthetic hegemonic currency" (SHC) as he called it.
It was the latest in a long line of talk about the possibility of a real global currency.
This is far from the first time the world has looked at solving the house of cards problem with a supranational global reserve currency. But it is around the first time it's done so with the benefit of high-speed Internet, a more global-than-ever economy, a focus on the benefits of digital currency and with more than a century of critical economic lessons under its belt.
The most important economic lesson in history
The most acute lesson has come in the form of two world wars, which destroyed a lot of economic value, and people.
When the first world war came around, each country needed to find a way of financing it all. Some raised taxes and many chose to temporarily abandon the gold standard to more freely print money. Germany, in particular, decided to borrow money to finance its war, gambling that it would pay off when it won the war.
That didn't happen.
Instead, Germany lost while Great Britain and the Allies racked up their own massive debts through the war, with the intention of extracting it from Germany later. When the dust settled, all the world's largest economies were economically tied together by a shared debt load in a way they weren't previously, with Germany bearing much of it either directly or indirectly.
It obviously couldn't pay it off and Germany quickly entered a period of hyperinflation in an effort to keep up. This chaos would eventually let a nationalistic leader with funny ideas about Lebensraum and tiny moustaches seize power.
But before then, the debt chain worked its way through the global economy. Germany couldn't pay France who couldn't pay Britain who couldn't pay the United States. This chain of debt hit the United States in the late 1920s, right as it was in the middle of an overly-optimistic stock market bubble of its own.
The reason the debt chain arrived when it did was because the US federal reserve had decided to raise interest rates in an effort to tamp down on that excessive stock market exuberance. These higher rates pushed Europe's debt load over the edge, resulting in a slowdown of demand for American goods in Europe and the cold realisation that a whole lot of the money supposedly circulating in the world was actually European debt that could probably never be paid off.
So began the Great Depression.
The fed's decision to raise interest rates in 1928 is a quintessential example of how isolated decisions to crack down on local market issues can spark unexpected chain reactions in the global economy.
After the depression hit, citizens starting hoarding gold to protect their personal wealth, which inhibited governments' abilities to titillate their economies back out of recession. This led to the widespread abandonment of the gold standard.
Largely as a result of the depression, the second world war broke out several years later. A few tens of millions of deaths later, the world woke up extremely hungover and with the realisation that the whole thing could probably have been avoided by better and more unified global economic handling in the interwar period.
The Bretton Woods agreement, made in 1944, was the agreement the world made when it sat down to devise a new global economic system, with new rules for nations to work together to prevent this kind of thing from ever happening again. That was where the International Monetary Fund (IMF) came into being.
The Bretton Woods are lovely this time of year
Among other things, the Bretton Woods system required countries to maintain a peg within 1% of some kind of global reserve currency, in order to facilitate international trade.
There were disagreements over what exactly this global reserve currency should be. Britain proposed a supranational global currency called the Bancor, but the United States pressured it back in favour of inserting the US dollar as the global reserve currency instead, convertible to gold at a fixed rate of $35 per ounce.
By some accounts, British representatives at the time seemed to have had a real sense that they were seeing the sun set on the British empire and the rise of the American empire.
If so, they were spot on.
The US dollar as the global reserve currency, in conjunction with the outsized manufacturing power the US now wielded on account of not having recently been bombed to rubble, set the US on its path to global dominance.
With this history, it's kind of funny that the Bank of England is once again the institution that's calling for a supranational global reserve currency, to the displeasure of American interests.
The US dollar was arguably the world's first truly global reserve currency. Unfortunately, it was doomed to fail. A national currency cannot also be a sustainable global reserve. The two are just fundamentally incompatible, as per the "Triffin paradox".
The Triffin paradox
The Triffin paradox is named for economist Robert Triffin who outlined it in 1960, although people were aware of it even before Bretton Woods.
As the Triffin paradox goes, if the US dollar is a functional global reserve currency, other countries would need to expand their US dollar reserves in order to grow their own economies. There are only two ways, then, for other countries to grow their US dollar reserves:
- The US runs at a trade deficit against them.
- The US keeps printing an infinite amount of money.
In both cases, the world would not be able to maintain confidence in the value of the reserve currency.
This is what happened through the postwar era of the 1950s. The US dollar inflated rapidly and flowed around the world, building up in foreign banks and diminishing US gold reserves, threatening the stability of the global financial system.
Beyond its inherent unsustainability, it was also just plain unfair, and would inevitably inflame international tensions when the entire point of the system was to help maintain world peace.
As economist Barry Eichengreen said: "It costs only a few cents for the Bureau of Engraving and Printing to produce a $100 bill, but other countries had to pony up $100 of actual goods in order to obtain one."
Bretton Woods was fatally flawed. We essentially screwed up our first attempt at a functional global reserve currency through just plain bad design choices.
The system slowly collapsed in a series of unpleasant economic shocks, as countries left Bretton Woods by cashing out into the system's gold backing and by refusing to maintain their US dollar pegs.
Efforts were made to save the system, such as the IMF's creation of "special drawing rights" (SDRs) in 1969, as a new global reserve currency of sorts. Each SDR was worth a bit less than a gram of gold and was accepted among all member countries. The idea was that SDRs could slide into the role that US dollars used to occupy to bring the benefits of a global reserve currency without the downsides of having that currency also be a national currency.
But these steps and other measures didn't address the underlying problems with Bretton Woods. Bretton Woods properly died with the "Nixon Shock" of 1971, when the United States unilaterally stopped letting countries cash out US dollars for gold reserves.
Without Bretton Woods and the US dollar peg holding them back, gold prices and the value of other currencies started taking off.
The collapse of Bretton Woods left us with the system we know today, where different countries have their own currencies with floating exchange rates, and the gold standard is no more.
The world as we know it
In respect to the fact that Bretton Woods collapsed under its own poor design and saw the world return to a system of floating exchange rates and largely unbacked currency, Bretton Woods was an abject failure.
But it was a rousing success in other ways. It left us with institutions like the IMF, a more civilised rulebook for international commerce, and fun legacies like SDRs. And despite the fact that it could never last as designed, Bretton Woods was an undeniable driver of growth and stabilising influence while active.
The table below shows the number of banking crises in 70 countries around the world from 1800 to 2009. As you can see, the Bretton Woods era from 1945 to 1971 was marked by a profound lack of crises.
The current international economic system we so often take for granted – a house of cards of floating exchange rates, international tensions, chain reactions, lingering US dollar dominance and a seemingly endless cycle of debt and inflation – isn't the way it is because that's somehow the natural order of things or because it's an especially good system.
Rather, it just happens to be how the pieces fell after the collapse of Bretton Woods. It's just one more era in the global economic cycle.
As Carney said in his calls for a synthetic hegemonic currency, "blithe acceptance of the status quo is misguided."
Back to the future
So, coming back to today, is it time for the world to deliberately enter another economic era? Is it time to go big and attempt a radical overhaul of the economy as we know it?
On the one hand, if it ain't broke, don't fix it. On the other hand, it's very literally broke.
The world is now drowning in something like $62 trillion of debt and counting.
Far from airing out the dusty balance sheets, the 2007 financial crisis just saw the heaping of more debt onto the pile, and the conventional economic wisdom of this era isn't helping. The world is still in recovery mode following the GFC of 2007, and now along comes the next crisis.
Part of the problem is that governments have a limited toolbox for handling it. As previously mentioned, one country's recovery plan often ends up being another country's problem, and a natural consequence is that we just kick the can down the road.
Another part of the problem is that those tools are increasingly ineffectual. Trying to revive the economy with interest rate cuts, for example, is starting to look a bit like efforts to revive a corpse with a defibrillator. The shock elicits a brief jump, but at a certain point, you're out of energy and just have to concede that you've lost the patient.
Wages are low, debt is high and these days, people use rate cuts to pay off loans faster, rather than to go shopping.
Many of the more creative solutions are cut from the same cloth. Deep negative rates, which the IMF is increasingly suggesting to push more of a "use it or lose it" approach to money on citizens, still don't directly address underlying problems like stagnant wages and unemployment. It also cuts both ways, by reducing the spending power of retirees and other savers.
Even wilder ideas, like modern monetary theory, are also largely focused on stabilising individual cards in the house, rather than reinforcing the entire house of cards. It would also be an extremely drastic change with some extremely unpredictable results.
A new global digital currency, however, goes straight to reinforcing that house of cards with relatively limited downsides, barring technical problems.
All we need to do is build it and then hopefully not rue the consequences of humanity's hubris.
This is part one of a two-part series.
You can find part two here.
Disclosure: The author holds BNB and BTC at the time of writing.
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