At the end of our previous article about inflation, we briefly discussed Ray Dalio’s theory of the Long Term Debt Cycle (LTDC). In short, the LTDC is the monetary epoch and system underpinning the more regularly recurring short-term debt cycles also known as business cycles. The short-term debt cycles are the normal ups and downs experienced during a beginning phase of credit and business expansion followed by a contraction which in total typically lasts 8-12 years. The LTDC has many of these short-term cycles subsumed within it and typically lasts 60-80 years under a certain monetary regime and by the end of the cycle, there’s typically a transition into a new LTDC with a new monetary regime underpinning the economic system. According to Dalio, we’re entering the end phase of our own LTDC.
The Twilight of the Petrodollar
The US dollar has been the world’s reserve currency since the conclusion of the Bretton Woods conference in late 1944. At the time, the United States was the focal point for secure global trade and finance after the decimated powers in Europe could no longer be the relied upon to be the underlying infrastructure for the global economic system. For the first 27 years of the Bretton Woods system, the US dollar was backed by gold reserves and other fiat currencies were pegged to the US dollar. But by 1971, the United States de-pegged the US dollar from gold reserves after their gold liabilities exceeded their available gold reserves, thus moving the world economy to a pure fiat regime with a floating rate currency at the center of it. Post-1971 the USD was “backed” by the full faith and credit in the US government, and later in 1974, an agreement between the United States and Saudi Arabia secured the dollar’s position as the sole currency used to purchase oil from Saudi Arabia and other OPEC nations. Even if a country like Australia or Spain wanted to buy oil from Kuwait, for example, they must transact in US dollars under this setup. Any country that wanted to buy oil, needed to be able to get dollars to procure it, either by earning them or exchanging their native currency for them. This creates demand for US dollars internationally in much the same way that taxes in the United States create demand for US dollars domestically. This system has since been known unofficially as the “petrodollar” system and in exchange for this privilege, the US offered military protection and general stewardship of the global order.
Under the monetary regime of post-1974, the US has been the de-facto security infrastructure supporting the global political and economic system, In addition, many of the earned dollars post-1974 were reinvested into US Treasuries and stored as foreign exchange reserves by the world’s central banks. In effect, a large fraction of US federal deficits during the last four decades, with military spending being the largest portion of those deficits, were financed and sustained by foreign governments who earned “risk-free” interest on their Treasury holdings. Thanks to cheap foreign financing, the United States government, under the petrodollar system, has had the privilege of perpetually over-consuming relative to what it taxed. However because of the dollar’s relative strength internationally, US manufacturers increasingly couldn’t compete in global manufacturing because their goods were more expensive, as the dollar always traded at a premium. The cost of this loss of competitiveness was almost exclusively levied on regions and populations in the US that relied on manufacturing labor for economic sustenance. The US had effectively ceded much of its manufacturing base to the rest of the world in exchange for cheap over-consumption and global reserve hegemony. Foreign nations like Germany, Japan, China, and many others were able to build up large trade surpluses against the United States and build up their manufacturing capabilities to sell back to the American government and consumers who enjoyed the international strength of the dollar
At the beginning of the petrodollar system, this configuration made sense for the political and economic context of the time. The US was an absolutely dominant economic force in the world, representing 35-40% of global GDP, and was engulfed in a fierce Cold War with the former Soviet Union. Keeping the US dollar as the preferred payment method for global commerce helped the US keep its role as a geopolitical policeman that could protect foreign nations and global trade from the threat of international communism.
However, with the share of US global GDP falling precipitously over the years to the current levels of 20-25% and the Soviet Union collapsing over 30 years ago, the petrodollar system makes much less sense and many nations want out. Foreign countries have seriously reduced their once voracious appetite for US treasuries, some are selling their Treasuries, and some are starting to use other currencies increasingly in international trade. In addition, the hollowing out of domestic manufacturing has had increasingly perverse effects on the United States itself. The loss of manufacturing jobs and economic dynamism in once-healthy regions of the United States has contributed to an increasingly angry public citizenry and an increased reliance on foreign supply chains for important goods. This puts US national security at risk if sudden shocks hit the international supply chain and weakens the government’s international negotiating position. Although the US might have all the information or blueprints it needs to manufacture any good it needs, it would still take time to build up the know-how necessary to actually execute on those blueprints. Less and less of the US population knows how to make the goods it relies on. What started as a privilege has morphed into an unhealthy burden.
The only way to get out of the position of running perpetual trade deficits and relying on foreign manufacturers would be to end the US dollar’s dominance as the de facto reserve currency and encourage more global trade be transacted in other forms of payment. This will reduce demand for dollars internationally, thereby weakening its purchasing power for international goods, but this will allow US manufacturing to become more competitive domestically and internationally.
In short, not only are many in the international community moving away from the traditional petrodollar system, it’s looking more strategically attractive to almost everyone in the United States itself to break away from King Dollar. If you’d like to learn more about these dynamics, macro-investor Luke Goreman has been a succinct and lucid voice on the benefits and costs of the petrodollar system, on not only the world but the United States. He goes into great depth on all of these topics to help the curious investor make sense of our global system and where it’s heading.
United States vs RCI
The current locus of geopolitical, and thus petrodollar tensions, revolves around the relationship between the United States and the RCI powers: Russia, China, and Iran.
Russia has been aggressively de-dollarizing its economy for the last 5 years, increasing its gold reserves precipitously and increasing its use of the Euro and its own currency in foreign trade. In January of this year the Russian Federation’s gold reserves, worth approximately 134 billion, made up a greater share of its international reserves than US dollars for the first time on record. Seven years ago, Russian exports to China were close to exclusively dollar-based. As of early 2020, 50% of exports are euro-based, 33% of exports are dollar-based, and the rest is done with the Ruble and the Yuan. And for the first time on record, the fraction of the Russian Federation’s global exports sold in dollars dipped below 50%. Keep in mind Russia’s exports are significantly energy-based, which gets to the heart of the petrodollar system.
A high-stakes concrete example of these tensions is the natural gas pipeline project known as “Nordstream 2”. The US has been furious about this project for some time, because this project threatens the US’s stranglehold on the flows of energy, money, and thus influence within Europe.
China, at one time, was a voracious buyer of US treasuries, but since 2013 has actually decreased its US Treasury holdings and has instead doubled its gold reserves in the last 5 years. Uncoincidentally, in 2013 China also launched its famous Belt & Road infrastructure initiative intending to become more dominant in world trade and global development. So instead of China financing US deficits which enable the US to cheaply be the world’s consumer and geopolitical hegemone, China has instead increased its geo-political influence all over the world. In effect, US trade deficits are helping finance Chinese geopolitical ambitions.
Iran has been under some form of US economic sanctions since 1979, severely impacting its ability to conduct international commerce. Europe created INSTEX in 2019, special purpose financial infrastructure, to avoid US sanctions on Iran. China is the largest importer of Iranian oil but US sanctions on Iran make their economic relationship stressful and China’s relationship with the US even tenser. Russia has similarly been caught in the crosshairs of US foreign policy concerning Iran, being accused of routing around US sanctions, shipping Iranian oil to Syria to help bolster a struggling Assad regime.
RCI countries have obvious motives and have shown a common desire to move away from the US-led petrodollar system and each is housing major bitcoin mining operations. If we combine these facts we can see Bitcoin as a common way to subvert the US-led system over the long term and as a tool to use immediately if the US ratcheted up draconian economic measures against any and all of them. However, it would be untrue to say these regimes are unilaterally positive towards bitcoin and cryptocurrencies outside of a geopolitical context. Each of them has unfavorable regulations for businesses and individuals who want to engage in crypto-powered enterprise. No government is a monolithic entity that has everyone on the same page or even a blanket positive or negative outlook on complex situations.
And although these regimes might keep bitcoin and other cryptocurrencies in their back pocket as a geopolitical shield, or even a weapon to use against the petrodollar system, we should remember the US government is also not a monolith and has good reasons for not being antagonistic towards the development of Bitcoin and other cryptocurrencies. As we’ve mentioned before in this post the economic and political context of the petro-dollar system has largely evaporated and has become a burden for the United States in the form of perpetual massive trade deficits and a decimated manufacturing sector, while at the same time indirectly financing China’s rise through its Belt & Road Initiative. Although the dethroning of King Dollar will hurt the US consumer’s ability to buy foreign goods cheaply, it could lead to a renaissance of the US manufacturing sector which reduces dependence on foreign supply chains and could reinvigorate economically depressed populations and regions within the United States.
In addition, despite commentators’ insistence that the US would just ban bitcoin for the last decade, a few top regulators, Senators, Congressmen, and Mayors have made very favorable statements towards the development of Bitcoin and crypto within the US. Crypto firms have hired former US regulators, US professors teach popular crypto courses at top US universities, one of the top crypto exchanges in the world just recently had a successful public listing on NASDAQ, major US corporations like Tesla, Square, and Microstrategy hold Bitcoin on their balance sheets, the US is second only to China in total hash power, and many states like Wyoming, Texas, and Kentucky have pursued favorable regulatory frameworks for crypto-related enterprises. By letting the petrodollar slide into history and keeping a handoffs, non-confrontational approach to the development of Bitcoin and cryptocurrency more broadly, the United States doesn’t have to cede reserve status to any other nation and can continue being a critical focal point for technological advancements and global financial flows just by letting its entrepreneurs compete in the global marketplace.
The Geography of Bitcoin
Bitcoin is everywhere and nowhere in particular at the same time. Units of bitcoin sit on a shared ledger that’s maintained by people and entities all over the world. Hurting the network is possible, but killing the network is an extraordinarily expensive and difficult goal given its distributed and flexible nature.
The key infrastructure for Bitcoin includes miners, nodes, businesses, and holders that are dispersed all over the globe. When we look at each segment of infrastructure we see how truly global Bitcoin is. While there is certainly more concentration in one locality compared to another for any given segment, no locality has a stranglehold on all segments. And given the flexibility of the network and its operators, if any influential locality moves to hurt the network, infrastructure and holders can quickly migrate to areas less antagonistic to the network. To be clear, a nation-state level attack would hurt perception and would disrupt markets, but killing the network altogether is probably fool’s gold. Even under immense pressure, the network would still process transactions and carry on as if nothing happened, and its social layer of individuals and businesses all around the world would adapt as quickly as possible to the threat.
- China: ~55%
- North America(US & Canada): ~11%
- Russia: ~10%
- Kazakhstan: ~9%
- Iran: ~8%
- Other: 10%
- EU: ~35%
- United States: ~20%
- Canada: ~3.3%
- UK: ~2.7%
- Russia: ~2.5%
- China: ~2.5%
- Rest of the World: ~20%
- Unknown: ~17%
Biggest Crypto Exchanges (Volume):
- Binance (Cayman Islands)
- Coinbase (United States)
- Huobi (Seychelles)
- Okex (Belize)
- Bithumb (South Korea)
- Bitfinex (Virgin Islands)
- Kraken (United States)
- Bitflyer (Japan)
- Coinone (South Korea)
- Poloneix (Seychelles)
- Liquid (Japan)
- Bitstamp (United Kingdom)
Bitcoin: The Energy Pricing Schelling Point?
In the immediate aftermath of the LTDC and the deprecation of the petrodollar system, we’re left with a multipolar monetary order. This opens the door for Bitcoin to be an option in this order and might be the focal point that a temporary multipolarity collapses into.
Given the context laid out above we could be heading toward a decentralized petro-bitcoin standard in the not too distant future. As petro-dollar energy pricing continues to fray due to the activities of China, Russia, Iran, and Europe we’re likely to see a fracturing of global energy pricing, with many different global currencies used to price and conduct more and more global commerce. This would be inefficient and could create complicated negotiations between powers who don’t want to leave one fiat regime for another fiat regime in which they are again subject to the whims and monetary policy of another power.
This fracturing opens the door for Bitcoin to play a role as a politically neutral monetary instrument whose payment network can’t be censored nor can its issuance be inflated by any of the major global powers. A common apolitical reference point could end potential anxieties over “who” the next reserve could or should be and relieve any potential standard-bearer of the costs and responsibilities associated with maintaining the de facto reserve currency. In addition, not only is Bitcoin a neutral medium for measurement and payment, through its proof of work consensus algorithm, it also gives every power a neutral trading partner and way to monetize its energy resources, giving many countries a source of revenue for securing the Bitcoin network. Each nation can help secure the network by exporting some of their energy resources to the Bitcoin network and in return the Bitcoin network pays them with new units and transaction fees of un-censorable, sound money.
Bitcoin is an elegant money game every sovereign can benefit from without ceding too much authority to any other sovereign. Bitcoin might be the perfect money for geopolitical rivals.