In this special essay for Rum Rebellion readers, we’re going to take you on a quick tour of the history of the global monetary system.
Later this week, Ryan Dinse and I (Greg Canavan) will be releasing a new guide we’ve been working on.
Cryptocurrencies, within the space of a volatile few months, have come under extreme pressure. Even some crypto proponents are calling it a bear market.
But where others see this as a sign of weakness in the new decentralised system…others (and not just us) see a great opportunity opening up.
What’s coming later this week is a specific, detailed primer (outlining specific strategies and specific coins) to help you take advantage of this window while it’s still open. It may not be for long.
This is a chance to gain a foothold in a new financial system that may define the rules of investing for the second half of this decade and all of the next.
First, though, you need some big-picture background.
Forget all the daily lurches of the Bitcoin [BTC] price for a second. You need an understanding of the new money system that’s developing.
To understand what comes next and how it might evolve, you have to understand what came before. It will also give you the ability to see the recent crypto volatility in a new light. That is, we are in the era of price discovery.
Price discovery is a process of collective learning, mixed with bouts of fear and greed.
For every person buying crypto because it’s ‘going up’ (or selling because it’s ‘going down’), there are others who are genuinely trying to understand the asset and the system it’s a part of.
Once you get this big picture, sell-offs and ‘FUD’ (fear, uncertainty, doubt) in the crypto space are much easier to comprehend. They’re just a part of an evolving new system. And they actually present you with opportunities…if you see them through the prism of what we call ‘The New Game’.
To understand where things are going,
we need to go back…
This may seem like a bit of a jump from cryptocurrencies…but bear with me. To get the big picture of where we’re heading next, we need to go back to the early 20th century.
In most parts of the industrialised world, money was as ‘good as gold’.
The gold standard existed and most countries adhered to it to varying degrees. But because money was ‘hard’, economies were prone to devastating downturns and stock markets were extremely volatile.
In a hard money system, there was no central bank or government to come to the rescue. Societies took their medicine, recovered, and moved on. The other point to note is that gold was money in the hands of the people. Gold coins were legal tender. Money was highly decentralised. As a result, governments and central banks had limited power.
The First World War and the rise of democracy changed that. Hard money was incompatible with both. So gold started a long process of demonetisation.
It was still a very good store of wealth, but gold became concentrated in the hands of first the commercial banks, then the central banks. Gold (money) became centralised.
The final step in this process occurred with Nixon’s closing of the ‘gold window’.
This was a system that allowed foreign central banks to swap their excess dollars for gold. That happened in 1971. That’s why the 1970s was such a volatile period economically. To help provide stability to the unhinged dollar, Henry Kissinger negotiated an arrangement with the Saudis. The US would provide military support provided the Saudis bought US treasuries with the US dollars they received.
Source: Foreign Policy
In this way, US dollars flowed back into the system and helped stabilise a precarious exchange rate.
This was the era of the petrodollar. US trade deficits with the rest of the world ensured plenty of US dollars flowed around the global financial system. US dollars that existed outside of the US become known as Eurodollars. That’s because they were predominantly circulating through the European financial system.
By the early 80s, the inflationary conditions of the preceding decade were over. That was thanks to high interest rates that brought about a nasty recession. That set the US economy up for growth. Along with financial deregulation, capital flowed into the country. The US dollar was king. Gold was dead.
The rise of Japan
Meanwhile, US deficit spending continued. US dollars continued flowing into the rest of the world. In the 80s, Japan was in the ascendancy. Much like China is now, Japan was the world’s manufacturer.
The US ran massive trade deficits with Japan. But like the Saudis in the 70s, the US offered military protection in return for Japan buying treasuries with its excess dollars.
It wasn’t just about national security; it was very rewarding for the bankers.
You see, the US treasuries that Japan purchased sat on the balance sheet of the Japanese central bank as an asset. The US dollar was, after all, the world’s reserve currency (having usurped gold).
What was on the other side of the balance sheet? Yen-denominated liabilities: Reserves of the domestic Japanese banking system. The inflow of US dollars formed the basis for the inflation of Japan’s domestic banking system. It caused a financial bubble of massive proportions. It popped in 1989 and Japan has never recovered.
But it was very lucrative for those closest to the money source.
And just about every other nation running a surplus with the US (that is, receiving an influx of US dollars) followed a similar path.
World’s reserve asset: A noose around nations’ necks
US treasuries became an in-demand global asset. The more you accumulated, the more you could inflate your domestic banking system and juice your economy on the credit growth.
It was a short-term game irresistible to the central powers of governments and central bankers.
The biggest player in all this is China. The key to China’s massive economic growth over the past few decades has been its equally massive accumulation of US treasury assets from a very low base.
China is second only to Japan in their treasury holdings.
And it’s why China’s banking system has expanded to dangerous levels over the past few decades.
The important point to understand is this: The US dollar-based financial system ropes everyone into it. China’s holding of US treasuries is not a potential gun to the US’s head. It’s a noose around their neck.
If they dumped their treasuries tomorrow their banking system would collapse. That’s because selling treasuries would reduce the assets on the People’s Bank of China’s balance sheet. On the liabilities side, domestic banking reserves would have to shrink to match the decline in assets.
This would not be good for China. Or for any other country for that matter.
Nearly every country in the world is locked into the dollar-based monetary system. According to the International Monetary Fund, nearly 40% of the world’s debt is issued in US dollars. As a result, global banks need a lot of dollars to conduct business.
But that’s just what you do see. The ‘surface level’ borrowing and need for US dollars. Under the surface there is much more. I mentioned the Eurodollar market earlier. Thanks to decades of financial deregulation, this market has become massive.
All kinds of off-balance sheet activities like derivatives and interest rate swaps (conducted by global banks) are transacted in US dollars. This creates a huge market (and demand for) US dollars.
Collapsing on itself
But this US dollar-based system has now become so large and all-encompassing that it no longer functions without some kind of central bank or government (fiscal policy) support.
In my view, there are a few reasons for that. One is that the dollar system is debt based. And secondly, there is no disciplinary mechanism to rein in the level of debt. In fact, the system promotes US dollar debt growth because the rest of the world sees US dollar treasuries as an asset!
Demand for this ‘asset’ keeps US interest rates low and encourages the US government to issue more and more debt!
Since the 1970s, and especially following the deregulation of the 1980s, US total debt-to-GDP has exploded, as you can see in the chart below. According to Hoisington Asset Management, at the end of 2020 it was over 400% of GDP.
Source: Hoisington Asset Management
Here’s the problem with that.
As debt-to-GDP ratios get ever larger, each dollar of new debt has less of an impact on economic growth.
You can see this clearly in the chart below. It shows diminishing returns from the growing US debt pile. That is, every new dollar of non-financial debt produces a lower and lower amount of GDP.
Source: Hoisington Asset Management
In other words, more debt growth produces a smaller amount of economic growth.
Monetary policy is increasingly impotent as well.
While everyone marvels at the size of the Fed’s balance sheet and the ‘money printing’ that led to its expansion, there is less focus on the velocity of money.
But as the chart below shows, the velocity of that money has collapsed over the past decade. Yes, there’s a lot of money in the system, but it is stagnant, trapped in a broken monetary system.
Source: Hoisington Asset Management
Our conclusion is that the US dollar-based monetary system no longer works effectively.
Governments can spend and central banks can ‘print’, but it will only have a short-term effect.
Once it wears off, we’ll be left with a seriously impaired economy that cannot stand on its own two feet.
There will be howls to ‘do more’ and more, and more.
This will only undermine the current system — the ‘old game’. Because to ‘do more’ is just to do more of the same.
It will just give more impetus for a new system to replace it — ‘The New Game’.
This new game system, DESPITE what speculative activity in the cryptocurrency markets is doing, is actually growing in power by the day.
Forget the recent fall in prices. Volatility is the name of the game in the price discovery process.
In our view, the time to get seriously interested is after a 50% price decline.
We have a five-part strategy on this front.
If, like us, you believe the writing is on the wall, then you’ll want to seriously consider this strategy now.
You’ll receive it in full later this week.
Editor, The Rum Rebellion
PS: The Rum Rebellion is a fantastic place to start your investment journey. We talk about the big trends driving the Australian Economy. Learn all about it here.