An excerpt from Graeme Leach’s article, ‘The Future of Money’.
This is the second in a series of papers from Kingsgate, on future strategic issues of profound importance for business. We continue with a paper on the future of money and bitcoin, which might seem strange given the recent collapse of FTX, and fears of an enduring crypto winter. CEO of cryptocurrency exchange Binance, Changpeng Zhao (CZ), stated that “... it's devastating for the industry. A lot of consumer confidence is shaken, and I think basically it sets us back ... years”.
But read on. This paper will reveal why the fundamental 'hard money' attribute of bitcoin will yet transform the world economy. We think recent events, interpreted correctly, reveal bitcoin's fundamental strength not weakness. Simply put, if bitcoin has no underlying value, why hasn't it utterly collapsed? Why hasn't it been confined to the speculative bubbles of economic history, such as tulipomania and the South Sea bubble? To see why is to understand the significance of the future privatisation of money.
That's not easy right now though. The transition from the old world to the new can be messy. Before the introduction of Henry Ford's Model T automated production, there were around 250 automobile manufacturers in the US. Or think back to the Tesla 'death watch' after the financial crisis. You have to look at the economic fundamentals and they're screaming revolution. If we’re correct, inflationary debasement of national currencies in the 2020s will likely lead to their progressive replacement with bitcoin as a reserve currency in the 2030s. This won’t happen overnight. Just like the Internet, there won’t be a day when we say it came of age, but looking back from the 2030s, the transformation will be crystal clear. Right now, the best parallel is that bitcoin is at the same stage of development as the Internet was in the late 1990s.
There is no doubt that this optimistic assessment looks highly unlikely from the perspective of 2022, but as we unpack the argument, it will be shown that economic fundamentals scream out the death of national currencies - as a result of blockchain technology and bitcoin in particular. This is not any old cryptocurrency analysis. It is an explanation of why the current crypto winter will almost certainly give way to spring in the mid-2020s and a bright summer in the 2030s - of immense consequence for business
Recent years have seen a crypto explosion followed by a crash and subsequent ongoing recovery. Bitcoin market capitalisation has fallen from a peak of nearly $1.3 trillion to $0.4 trillion, now beginning a recovery reaching $0.5 trillion. Given that the USP for bitcoin in the notorious title of one book - Bitcoin: Hard Money You Can’t F*ck With, it would appear that the case for bitcoin has completely unravelled. Moreover, central banks, having lost control and been late to the party, are now embarked on a monetary tightening aimed at putting the inflation genie back in the bottle. The Federal Reserve has raised interest rates to the highest level since 2008, and so at first glance, the debasement argument might appear weak.
Future debasement of national currencies via the printing press also looks less likely when bodies such as the IMF project a stabilisation in fiscal policy with G20 net public debt – as a percentage of GDP – flat and gross debt falling, over the next 5 years. The vocal critics of bitcoin, of which there are many, would seem to have been vindicated.
Warren Buffet has described bitcoin as “rat poison squared”, economics Nobel Laureate Joseph Stiglitz has asserted that bitcoin is only used for “nefarious activity” and Wall Street guru Nouriel Roubini has dismissed it as nothing more than a “scam”. President Biden has also described bitcoin as a scam, but tellingly he has also acknowledged that it is trying to compete with the dollar as the currency of the world.
To dismiss bitcoin now would be a grave mistake. It would mean missing out on the future revolution that will yet transform bitcoin from niche to mass market. This paper sets out the fundamental reasons why bitcoin will come to rule the world and replace the dollar as its reserve currency. That is a very bold statement, but Kingsgate agrees with the view: “While the full ramifications of Bitcoin’s creation are not well understood, we believe that it will contribute more dramatically and profoundly to the evolution of monetary and financial systems than any other breakthrough in history”.
We will address each of these drivers, whilst placing the greatest emphasis on the importance of the first driver, debasement of the currency by inflation. The spectre of inflation again haunts the land. The beast that had been in chains for more than 30 years has been released to reap its havoc. So, what has caused the acceleration in inflation? Most people would answer the surge in energy prices, particularly gas, but that would be mistaken. The spike in gas prices associated with war in the Ukraine is merely a symptom, it is not the underlying cause. The underlying cause was the surge in the growth in the money supply in 2020-21 in response to the pandemic.
Central banks around the world turned on the printing presses. Broad money growth exploded in the US and UK in particular. US broad money growth peaked at 26% (yr-on-yr) growth – the fastest rate in peacetime history. In the UK broad money growth peaked at 16% (yr-on-yr) – the fastest rate since the 1970s. In the euro-zone broad money growth peaked above 12% (yr-on-yr). To put this in context, 2% to 3% real GDP growth and a 2% inflation target is roughly consistent with 5% to 6% growth in the broad money supply. When monetary growth was 3-4 times that consistent with low inflation, a train wreck was always around the corner. But back in 2020, amidst the media focus on the deepest recession in 300 years, all the talk was of deflation not inflation. Inflation arguments based on the money supply gained little traction in the economics profession. The majority of the profession, including central banks, largely ignored it to their and our great cost.
Before the financial crisis in 2007-08 the Federal Reserve’s balance sheet was less than $1 trillion. Five years later in the wake of quantitative easing it had more than quadrupled to $4.5 trillion. Prior to Covid-19 it had reduced to around $4 trillion but then the flood gates opened, and it has exploded to almost $9 trillion. If you want to debase a currency this is a textbook operation. Noah’s monetary floodgates have been opened and they’re unlikely to shut. Electorates across North America, the UK and Europe increasingly look to government to solve every significant problem, be it the pandemic or the fuel crisis. Each time more money is being created and with it, latent inflationary pressure. Moreover, this is only the beginning.
If we look at the United States, all the leading government economic bodies – OMB Treasury, CBO and GAO - agree that fiscal policy is totally unsustainable in the long-term. Between now and 2031 federal revenues are estimated to average 18% of GDP with outlays at 22% - a 4% shortfall. But thereafter in the 2030s, the deficit permanently explodes towards 12% of GDP and beyond. That means much higher taxes or much less spending, neither of which is likely politically.
Hence many on Capitol Hill now argue for what is called Modern Monetary Theory (MMT). MMT theorists argue that governments don’t face a fiscal budget constraint because they can tell the central bank to print all the money required to pay the public sector’s bills. This is the slippery slope to ruin which threatens to fundamentally undermine the value of the dollar in the long-term and lead to it losing its status as the world’s reserve currency. Not this year or next year, but very possibly in the 2030s. Where America leads, the world is likely to follow. But if printing money was the solution to our economic ills, Zimbabwe and Venezuela would be the world’s leading economies, and counterfeiting the most successful business.
One of America’s leading academic economists, Laurence Kotlikoff, has estimated5 that if you add up all the promises politicians on Capitol Hill and in the White House have made, and subtract the taxes that are expected to be collected, the future unfunded liabilities on social security, Medicare and Medicaid etc amount to $211 trillion.
To put the scale of that number in context, the total amount of US public debt – excluding intragovernmental holdings - at the end of 2022 was around $24 trillion. If you think current US debt levels are high, unfunded liabilities are almost 9 times greater.
Economic history teaches again and again that when the printing presses get turned on, the currency eventually goes through the floor. Unequivocal, no exceptions. Bitcoin will then come of age. The perfect currency for the digital era. And it’s di cult to see how the central bank printing presses won’t run hotter and hotter in the future. This is not a US phenomenon alone. A quick glance at Europe shows a dismal outlook also, with potential public debt levels across the EU-27 way beyond current levels. Moreover, EU projections are very often excessively optimistic about future productivity growth – which will be suppressed by the burden of higher taxation and regulation – and so the outlook is far worse than even the dismal headlines. And none of these projections – in the US or the EU – take on board the additional costs of future recessions. If the euro is unlikely to replace the dollar as a reserve currency, what about the renminbi? Not so fast. The Chinese economy has far deeper banking and debt problems which you could write a book on. It’s without doubt the world’s most indebted economy.
In dramatic contrast, with bitcoin, there is no central authority and that’s the fundamental point. Bitcoin can’t be controlled by the government or central banks. It is a wholly decentralised market-based currency which can’t be shut down because it exists on millions of independent computers. This characteristic makes it digital gold.
In October 2008 Satoshi Nakamoto – a pseudonym – released a white paper titled: Bitcoin: A Peer-to-Peer Electronic Cash System. Bitcoin was born. Nakamoto announced his revolutionary concept with the innocuous words: “I’ve been working on a new electronic cash system that’s fully peer to peer with no trusted third party”. At a time when the global financial system was in turmoil, fractional reserve banking was stressed to the limit, and central banks were beginning to print more and more money, Nakamoto’s disintermediated model removed the need for commercial banks and theoretically provided a hard backstop against the inflationary consequences of central banks printing money. When the underlying problem is printing more and more money, only 21 million bitcoin will ever be produced, and most of them already exist. It won’t bend with the wind like politicians and central bankers. The significance of the hard top can’t be stressed enough and distinguishes bitcoin as the cryptocurrency when seen alongside its market share – it’s the Google or Amazon of cryptocurrency.
In a world of declining trust in institutions, lack of faith in commercial banks (in the wake of the 2008 financial crisis) and central banks (in the wake of QE and the pandemic printing press) the bitcoin network replaces the existing third-party trust-based system with a trust-minimised system. This is revolutionary because it heralds the privatisation of money and monetary policy. The global financial system could shift from being controlled by nation states to individuals.
Kingsgate agrees with the view that: “Bitcoin fundamentally shifts how a financial system distributes trust, eliminating the roles of several institutions ... In contrast to a central bank that controls monetary policy, or a commercial bank that controls the custody of assets or a payments processor that controls consumer transactions, the Bitcoin network and all its participants oversee all such functions”.
An obvious criticism of the significance of debasement for bitcoin is that the acceleration in inflation over the past year has been associated with a collapse in the cryptocurrency market. Leaving aside the fact that other cryptocurrencies don’t have a hard supply cap, bitcoin would seem, at first glance, to still have a problem given that it has imploded also. But this is an incorrect interpretation. The reason bitcoin has boomed and busted over the past year is precisely because of the effects of central bank control of monetary policy.
The Federal Reserve, the Bank of England and the ECB printed trillions of dollars, pounds and euros and that wall of cheap money was desperately seeking a return. In grossly distorted financial markets, it was central banks which caused the cryptocurrency market boom. Subsequently, in the wake of the inflation take-off, interest rates rose well above the zero bound, causing the bust, in a flight to safety and the higher yields available on deposit – cash in the bank finally made sense after a decade of making no sense at all. This process was always going to end in tears when bitcoin market capitalisation was so small compared to that of traditional currencies. A wall of money washed in and out with massive price volatility the inevitable consequence. Also, the gold price tends to slide when dollar interest rates rise, because in itself gold has no yield and so there is then an opportunity cost in holding it. Bitcoin has displayed the same digital gold characteristic, over the course of the monetary tightening in 2022-23.
More fundamentally however, financial markets are still trying to work out the value of this new form of money, just as companies across the globe are trying to work out new business models in the wake of the broader digital revolution – it takes time. Bitcoin is a frontier technology. It is not based on an underlying asset and yet it has amazing potential because of its acceptance to date, and its attribute as a store of value, based on the 21 million bitcoin supply cap. But until this is manifest in mass market use, volatility is almost inevitable, with ebbs and flows in sentiment. And so paradoxically, in the intervening period, there will be times when it won’t display the store of value required of money. It’s an asset that needs to be held for the long-term. Latest figures suggest 70% of bitcoin holdings are above 155 days, but people will begin to think much longer, over a 5 year plus horizon, as the economic significance of the hard supply cap is more widely understood.
Throughout history, assets displaying scarcity have been key to retaining value. The revolutionary dimension to bitcoin is digital scarcity. Gold is attractive as an asset because of its limited supply which depends on mining, but generally rises less than 2% per annum. But bitcoin is even more scarce and we know the supply in advance with certainty, due to the cycle of halving, which will limit the total number of bitcoin to 21 million. This rock-hard supply cap provides the perfect base for a reserve currency. No supply surge is going to undermine the value of bitcoin. The only way to hack bitcoin is to control more than 50% of the widely distributed computer network - and that ain’t going to happen.
Practically money is said to need to satisfy three criteria. It needs to function as a store of value, unit of account and medium of exchange. Bitcoin certainly doesn’t meet fully any of these criteria yet, but that is the key word, yet. Bitcoin is highly portable, transferable and verifiable with cryptographic signatures. It uses public and private keys which are akin to a bank account number and secret pin code. Transactions are validated through nodes in bitcoin’s peer to peer network. So-called ‘miners’ secure the transactions, which are then irreversible and guaranteed. Thus far bitcoin has settled around $2.5 trillion in transactions. There will be an evolution. The transfer from coins to promissory notes didn’t happen overnight. The best money evolves naturally. It begins as a store of value, has a natural scarcity and evolves slowly into a medium of exchange and unit of account.
Bitcoin is highly divisible, with tiny fractions of a single bitcoin. You can purchase a satoshi or a sat which is one hundred millionth of a bitcoin. We don’t need bitcoin yet to buy a coffee, existing money works fine, but if the debasement argument plays out, it is likely to lead to hyperbitcoinisation whereby bitcoin slowly becomes a medium of exchange and unit of account. And the more it is used, the more stable it is likely to become, with much reduced volatility thereby confirming its capacity as a store of value. Moreover, even the volatility of the past year displays grounds for confidence. Historically, purely speculative booms and busts such as Tulipomania or the South Sea Bubble, tended to result in worthless assets, but the bitcoin price has not collapsed to zero, it has found a floor around $20,000, recovering towards $30,000. For a massive sell-o - in something which has no underlying asset - to find a floor in this manner tells you that bitcoin has fundamental value. The bitcoin price has merely rewound to where it was before the pandemic. It remains far and away the best performing asset in the post financial crisis era.
(Continued in PDF).
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See other articles from Kingsgate:
The Future of the UK Housing Market - Graeme Leach
The Future of the UK Commercial Property Market - Jonathan Gibson
The Future of Cyber Security - Rhys Gillespie
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