Unraveling the Bedrock: The Deterioration of the US Global Currency Reserve System - Part 3

What the Next System Looks Like

The configuration of the next system remains uncertain, and various proposals have been put forth.

Regardless of its specific form, the next system will likely be decentralized, meaning it won't be exclusively tied to any single country's currency, as no single country possesses the necessary scale for that role anymore. It could revolve around neutral reserve assets or adopt a regional-reserve model based on a few key currencies from different countries, accompanied by an expanded range of payment channels.

Decentralized Energy Pricing

Central to these new systems is the shift away from the US dollar's exclusive status as the currency for energy pricing. Instead, trade agreements could involve the use of currencies like the euro, yuan, and potentially others, or even a neutral reserve currency, for purchasing oil, gas, and various commodities. This would facilitate increased global trade and the accumulation of reserves in these currencies. This transition is already gradually occurring in Eurasia and is supported by the growing use of alternative currencies among trading partners, including for energy transactions. The United States, if it believes the current system is no longer advantageous, could potentially accelerate this shift by building foreign exchange reserves and supporting non-dollar payment systems for energy and commodities.

In this scenario, the world would transition from relying on a single "global reserve currency" to a system with several "regional reserve currencies." This shift does not necessarily require new technology or the creation of new neutral currency units, but it does depend on the ongoing development and utilization of non-dollar payment systems. Additionally, central banks could increase their holdings of gold as a neutral reserve asset, a trend that has already been observed over the past five years.

Furthermore, countries are increasingly exploring or launching their own digital versions of fiat currencies, known as central bank digital currencies (CBDCs).

In addition to the core outlook described above, there are additional possibilities that can be considered, as outlined in the following sections.

Digital Global Bancor

One such concept is the digital Global Bancor, which has been proposed by several policymakers. The Bancor idea, which already exists in a diminished form as the IMF Special Drawing Rights (SDR), would serve as a neutral reserve currency for international trade. Mark Carney, the former Governor of the Bank of England, attracted attention in 2019 when he suggested the use of a new digital currency for international trade to address some of the existing system's challenges. This proposal from the head of the central bank of one of the United States' close allies generated considerable interest, particularly as it was made at the annual Jackson Hole Symposium, attended by US Federal Reserve officials.

The dollar’s influence on global financial conditions could similarly decline if a financial architecture developed around the new [digital currency] and it displaced the dollar’s dominance in credit markets. By reducing the influence of the US on the global financial cycle, this would help reduce the volatility of capital flows to emerging market economies.

-Mark Carney, Former Governor of BOE, 2019

Carney also expressed a more positive view of the Libra compared to many other policymakers. In the previous year, Facebook garnered attention by introducing the concept of the Libra, a digital currency comprising a basket of multiple currencies. Essentially, the Libra can be seen as a stablecoin version of the Bancor, issued by a large private corporation instead of a supranational entity.

Ironically, the Libra represents a form of centralized decentralization. In other words, it entails a centralized agreement to create and employ a trade unit that is neutral and detached from any specific national currency.

However, the challenge with the proposal for a global digital Bancor, akin to a supranational version of the Libra rather than one issued privately, is that it necessitates extensive international cooperation and consensus for its adoption, akin to a new Bretton Woods agreement. While not impossible, such an arrangement appears unlikely given the current fragmented geopolitical landscape.

Digital Regional Bancors

A more modest iteration of the global digital Bancor concept involves the implementation of regional Bancors. For instance, let's consider the scenario where the 15 nations participating in the Asia Pacific's new RCEP trade agreement agree to establish and utilize a neutral digital currency among themselves. Since they already form a trading bloc, organizing such an arrangement within this regional context could be more feasible compared to a global scale initiative.

Furthermore, it is conceivable that a few additional nations, such as Russia, might be open to accepting the Bancor of this trading bloc as payment for commodities like oil and gas, similar to their acceptance of the euro. Notably, Russia's prominent commercial bank, Sberbank, has already dabbled in blockchain technology and demonstrated a keen interest in investing in tech companies.

Blockchain technology offers new possibilities for decentralized international payments, which can be linked to a specific fiat currency or a basket of fiat currencies based on a particular metric. This application of software to the conventional global banking system has the potential to create a more liquid medium for trade.

In recent developments, major commodity companies like BHP, Vale, and Rio Tinto have successfully conducted blockchain-based sales of iron ore to Chinese firms. Singapore banks were also involved in these transactions. Additionally, Singapore served as the hub for counterparties testing blockchain transactions with Russia's Sberbank. Technological advancements open up a range of new payment channels.

Discussing the growing usage of existing private stablecoins on cryptocurrency exchanges, Nic Carter, the first crypto analyst at Fidelity and co-founder of blockchain analytics firm Coin Metrics, who is actively involved in a blockchain venture fund, emphasized the efficiency of stablecoins with the following statement:

Lastly, capital existing in tokenized fiat format tends to enter the crypto industry but not leave. This is because crypto rails are fundamentally more convenient, more globalized, and less encumbered than traditional payment and settlement rails.

-Nic Carter

By involving governments in the process, it becomes possible to leverage similar technology on a broader scale to create regional multi-currency stablecoins, such as regional Bancors, specifically designed for international trade.

Gold Standard

Certain gold investors hold the belief that countries may revert to a system similar to the pre-1944 era, where central banks held substantial gold reserves to support their currencies.

However, it is unlikely that any country would willingly adopt a gold standard at this stage. Doing so would limit their ability to run significant deficits, expand the money supply, and contradict the current incentive of maintaining weak currencies to enhance competitiveness in global trade and generate trade surpluses.

Nevertheless, in times of crisis or periods of inflationary pressure, some countries might consider turning to a gold standard as a means to stabilize their currency if other systems break down.

Notably, the Dutch central bank made a statement last year suggesting that gold could serve as collateral in the event of a collapsed financial system, potentially allowing for a fresh start.

Shares, bonds and other securities: there is a risk to everything. If things go wrong, prices can fall. But, crisis or not, a bar of gold always holds value. Central banks such as DNB have therefore traditionally had a lot of gold in stock. After all, gold is the ultimate nest egg: the trust anchor for the financial system. If the entire system collapses, the gold supply will provide collateral to start over. Gold gives confidence in the strength of the central bank’s balance sheet. That gives a safe feeling.

-DNB, 2019, translated to English

Several years ago, the Reserve Bank of India initiated the issuance of sovereign gold bonds on behalf of the Indian government, representing a more favorable approach. These bonds, denominated in grams of gold, function as government securities. They offer lower interest rates compared to conventional Indian sovereign bonds due to the elimination of currency risk. The government benefits from the ability to borrow at a reduced yield, while investors benefit from a more conservative investment linked to the price of gold instead of India's currency. This allows them to earn a positive yield based on their exposure to gold.

Even if currencies are not widely backed by gold in the future, central banks can still hold gold as a reserve asset within various global monetary systems. For instance, it could be incorporated into the aforementioned decentralized energy pricing system or alongside baskets of digital currencies.

Bitcoin as a Reserve Asset

While facing dismissal from some, there exists a passionate group of advocates who firmly believe in the unstoppable nature of Bitcoin's network effect. They argue that it will continue to expand exponentially until it permeates the global financial system, a phenomenon referred to as hyper-bitcoinization.

Bitcoin, being a decentralized and open-source project, has gained widespread adoption among programmers and supporters worldwide. Numerous intelligent individuals have dedicated their careers to Bitcoin, and the community surrounding it is known for its fervor. Over time, there has been an influx of Wall Street investment into Bitcoin as well.

Thus far, Bitcoin has exceeded most expectations, transforming from a non-existent entity into a digital asset with a market capitalization surpassing $350 billion in just over a decade. Its algorithmic price patterns have demonstrated a growth rate comparable to that of the most successful tech companies:

Furthermore, within the Bitcoin ecosystem, numerous businesses have emerged, including exchanges, lenders, custodians, security solutions, and more. These entities contribute to the overall infrastructure surrounding Bitcoin. Moreover, additional technologies have been developed to layer Bitcoin with other blockchain solutions, enabling its use as collateral in digital asset protocols and decentralized finance applications. These innovations also aim to enhance Bitcoin's scalability.

To draw an analogy from Game of Thrones, while the leaders of the Seven Kingdoms engage in power struggles to control the Iron Throne and dominate Westeros, a growing threat looms beyond the Wall. The inhuman White Walkers quietly amass strength, far removed from the opulent castles, with the objective of supplanting the established system and rendering the trivial human conflicts over the throne irrelevant.

Returning to the present, Bitcoin has indeed gained worldwide adoption as a store of value in a specific context. Individuals in many developing countries with weakened currencies have utilized it for storing value, while people in developed nations have seen it as a speculative asset for potential growth. Recently, publicly-traded companies listed on major exchanges have purchased Bitcoin, and platforms like Square's Cash App and PayPal enable users to buy it. Influential investors such as Cathie Woods, Bill Miller, Paul Tudor Jones, and Stanley Druckenmiller express optimism about its prospects. Fidelity began researching Bitcoin in 2014, engaged in mining operations in 2015, and continues to develop institutional-grade custody and trade execution solutions.

In addition, there are emerging use cases for Bitcoin by certain states. Iran, for example, has increasingly turned to Bitcoin as a potential tool for international trade, despite facing sanctions and isolation. Bitcoin's verifiability, provability, and suitability for large irreversible international transactions without requiring trust or cooperation make it an attractive option. Iran can subsidize Iranian Bitcoin miners using electricity resources, acquire the generated bitcoins, and employ them for international trade.

Even if Bitcoin never achieves the scale envisioned by some proponents, it could still be integrated into a global monetary system. It could serve as an additional neutral reserve asset or be utilized by smaller isolated countries that leverage its features, with limited means for other nations to hinder their adoption, similar to Iran's approach.

To ascertain its trajectory, we must observe whether Bitcoin continues to increase its market capitalization or if it eventually fails to gain market value during one of its halving cycles, reaching a saturation point.

Meanwhile, the Bitcoin community holds diverse perspectives on the asset's significance. There is no unified vision within the community; instead, there are various viewpoints regarding the protocol's long-term potential. Some see it as the future global currency, while others perceive it as digital gold, a store of value, or a virtual bank existing alongside sovereign-issued currencies.

For instance, Michael Saylor, the billionaire founder and former CEO of a publicly traded company on a major exchange, who allocated hundreds of millions of dollars of corporate funds to Bitcoin as a treasury reserve asset, considers Bitcoin not as a currency but as a digital savings bank.

Bitcoin is not a currency, nor is it a payment network. It is a bank in cyberspace, run by incorruptible software, offering a global, affordable, simple, & secure savings account to billions of people that don’t have the option or desire to run their own hedge fund.

-Michael Saylor, 11/12/2020

This is why Bitcoin should be neither a currency, nor a payment network. The principles of humility & harmony dictate that we should allow technology partners to provide for payments, & defer to governments on matters of currency. BTC is a purely engineered Store of Value.

-Michael Saylor, 11/19/2020

Returning to the present, Bitcoin has indeed gained global adoption as a store of value, albeit in a niche manner. Individuals in many developing countries with weakened currencies have utilized it as a means to preserve value, while people in developed nations have seen it as a speculative asset with growth potential. Notably, publicly-traded companies listed on major exchanges have purchased Bitcoin, platforms like Square's Cash App and PayPal enable users to buy it, and influential investors such as Cathie Woods, Bill Miller, Paul Tudor Jones, and Stanley Druckenmiller express optimism about its prospects. Fidelity, a prominent financial services firm, began researching Bitcoin in 2014, engaged in mining operations in 2015, and continues to develop institutional-grade custody and trade execution solutions.

Additionally, certain state actors have started exploring Bitcoin for their own purposes. Iran, for instance, has increasingly turned to Bitcoin as a potential tool for conducting international trade despite facing sanctions and isolation. Bitcoin's verifiability, provability, and ability to facilitate large irreversible transactions without requiring trust or cooperation have made it an attractive option. Iran subsidizes Iranian Bitcoin miners with electricity resources, acquires the generated bitcoins, and employs them for international trade.

Even if Bitcoin never reaches the scale envisioned by some of its proponents, it could still find utility within a global monetary system. It might serve as an additional neutral reserve asset or be utilized by smaller isolated countries that leverage its features, with limited avenues for other nations to impede their adoption, similar to Iran's approach.

To gauge Bitcoin's trajectory, we must observe whether its market capitalization continues to grow exponentially or if it reaches a saturation point during one of its halving cycles, failing to gain further market value.

Meanwhile, the Bitcoin community holds diverse perspectives on the asset's significance. There is no unified vision within the community, but rather a range of viewpoints regarding the protocol's long-term potential. Some see it as the future global currency, while others perceive it as digital gold, a store of value, or a virtual bank coexisting with sovereign-issued currencies.

For instance, Michael Saylor, the billionaire founder and CEO of a publicly traded company on a major exchange, who allocated hundreds of millions of dollars of corporate funds to Bitcoin as a treasury reserve asset, views Bitcoin not as a currency but as a digital savings bank.

Summary

The world experiences periods of geopolitical order and disorder, leading to the creation and eventual weakening of the global monetary system.

A significant issue with having a global reserve currency, as highlighted by economist Robert Triffin many years ago, is that the country must continually supply the world with its currency through structural deficits or other means.

Initially, the benefits of being the reserve currency nation outweigh the costs. However, over time, the costs accumulate while the benefits remain relatively stable, eventually making the system unsustainable.

Moreover, a system established when the US accounted for 35% of global GDP does not function as effectively when its share has diminished to, for example, 20% of global GDP. Maintaining hegemonic status is not solely dependent on the size of the US military; it hinges on whether the current global monetary system is still mathematically viable and supports US interests.

In essence, there is an inherent economic entropy associated with the status of a global reserve currency. Flaws within the system continue to compound until they reach a breaking point. The challenge lies in identifying when that breaking point will occur. A shift in the global monetary system does not necessarily mean negative consequences for the United States (as evidenced by the post-war economic boom experienced by the United Kingdom after losing reserve currency status). However, it does require finding a balance between international and domestic interests and reconfiguring trade accordingly.

Based on that assessment, it is probable that the global economy will enter the third bear cycle for the US dollar in the current petrodollar system over the next few years. In such a scenario, assets like global equities, quality residential real estate, precious metals, industrial commodities, and alternatives such as Bitcoin are likely to perform well.

Furthermore, the global monetary system is gradually becoming more decentralized as alternative payment systems and currency settlements gain traction among trading partners. This represents a structural shift towards a new system, which may unfold gradually or accelerate if the US itself moves away from the deteriorating system.