This year, Bitcoin has mesmerized many investors. Never mind the fact that it has doubled in price, after tripling in 2020; nor that figures such as Elon Musk have backed it – in April he tweeted that Tesla cars will also be sold in bitcoin.
What is even more remarkable in my opinion is that some establishment players such as Citigroup now think bitcoin “may be optimally positioned to become the preferred global currency for trade” in the future, a role currently occupied by the dollar.
Such picture perspective in my opinion applies not only to temporal and geographic breadth, but also to viewing the cryptocurrency, digital currency and financial markets including economies through the lens of long-term cycles and trends, including the disruption brought by the 4th Industrial Revolution:
Let’s start by looking at ‘Productivity Growth’.
Real per capita GDP in the United States has increased at an average rate of near 2% over the past 100 years as a result of productivity gains, but has fluctuated widely around this trend based on the prevailing long-term and business cycles.
The long-term credit expansion and its process is in my opinion self-reinforcing because rising spending in principal generates rising incomes and rising net worths, which raise borrowers’ capacity to borrow more, which in principal allows more buying and spending. The up-wave in such a cycle typically goes on for decades, with variations in it primarily due to control of central banks tightening and easing credit which creates business cycles.
Although self-reinforcing, the credit expansion phase – seen aggressively since the financial crisis of 2008 – ultimately reaches a point where it can no longer be extended. Quantitative Easing (QE) and stimulus financing can’t go on forever. In the United States we had a 1.9 trillion dollar stimulus on ‘American Rescue Act’ passed in March 2021 with the expectation of roughly 7% economic growth this year, an additional 2.3 trillion dollar for the ‘American Jobs Plan’ to upgrade US infrastructure (not passed yet), an additional 1.8 trillion dollar on the ‘American Families Plan’ proposed last month. Yet America’s fiscal splurge began more than 400 days ago with Donald Trump’s 2.3 trillion dollar ‘Cares Act’, which was supplemented by a 900 billion dollar passed in December 2020 to help America through the pandemic. This totals to 9 trillion dollar in less than 2 years bringing America’s debt to more than 130% of GDP.
Eventually the debt service payments become equal to or larger than the amount we can borrow and the spending must decline. It is in my opinion an illusion to make us believe that government debt through QE and stimulus financing does not matter as long as economy growth exceeds current interest levels. When promises to deliver money (more debt) can’t rise any more relative to the money and credit coming in, the process works in reverse and we see deleveragings. Since borrowing is simply a way of pulling spending forward, the person spending 110,000 dollar per year and earning 100,000 dollar per year has to cut his spending 90,000 dollar for as many years as he spend 110,000 dollar, all else being equal. The same counts for governments.
In a phase of deleveragings, rather than debts rising relative to money as they do in up-waves, the reverse is true. As the money coming in to debtors via incomes and borrowings is not enough to meet debtors’ obligations, assets need to be sold and spending needs to be cut in order to raise cash. The Biden administration recently started the topic of increasing corporate taxes to justify their spending spree.
This leads in my opinion to asset values to fall most probably by early next year, which reduces the value of collateral, and in turn reduces incomes. Because of both lower collateral values and lower incomes, borrowers’ credit worthiness is reduced, so they justifiably get less credit, and so it continues in a in my opinion self-enforcing manner.
Unlike in recessions, when cutting interest rates and creating more money can rectify this imbalance, in deleveragings monetary policy is ineffective in creating credit. In other words, in recessions or times of post-pandemics (when monetary policy is effective) the imbalance between the amount of money and the need for it to service debt can be rectified because interest rates can be cut enough to
(1) ease debt service burdens,
(2) stimulate economic activity because monthly debt service payments are high relative to incomes, and
(3) produce a positive wealth effect;
However, in a phase of deleveragings, this can’t happen. In deflationary depressions (deleveragings), monetary policy is in my opinion typically ineffective in creating credit because interest rates hit 0% and can’t be lowered further, so other, less-effective ways of increasing money are followed. Credit growth is difficult to stimulate because borrowers remain over-indebted, making sensible lending impossible. In inflationary deleveragings, monetary policy in my opinion is ineffective in creating credit because increased money goes into other currencies (including cryptocurrencies like bitcoin and ether) and inflation hedge assets because investors fear that their lending will be paid back with money of depreciated value.
The business cycle therefore refers to fluctuations in economic activity. In the business cycle, the availability and cost of credit are driven by central bankers, while in the ‘long wave cycle’, the availability and cost of credit are driven by factors that are largely in my opinion beyond central banks’ control. In the standard business cycle, the central bank can boost a lagging economy by lowering interest rates. In the deleveraging phase of the ‘long wave cycle’, central banks can’t exert any influence by lowering rates because rates are already at or near zero. Encompassing nearly 80 years, this current period in the United States does not contain any deleveragings other than the one that began in 2008. And economies and markets behave in my opinion differently in deleveragings than in standard recessions or in times of a pandemic – most probably to be seen by the beginning of next year.
By focusing more broadly through both time and geography, we are able to draw upon past instances that are comparable to the current situation (e.g. Great Depression, post-bubble Japan, Latin America defaults).
In regard to the cycles that affect individual countries, we can even take a broader perspective, measured in centuries rather than decades. I certainly believe that all countries move through a five-phase cycle:
Phase 1 – Countries are poor and think that they are poor.
Phase 2 – Countries are getting rich quickly, but still think they are poor.
Phase 3 – Countries are rich and think of themselves as rich.
Phase 4 – Countries become poorer and still think of themselves as rich.
Phase 5 – Countries go through deleveraging and relative decline, which they are slow to accept.
Currently, we are in my opinion in the United States and other industrial countries like for example Italy and Spain (among others) in the leveraging up phase – i.e., debts are rising relative to incomes until they can’t anymore. Based on Covid-19 pandemic government spending continues to be strong, they continue to appear rich, even though their balance sheets deteriorate. The reduced level of the past of efficient investments in infrastructure, capital goods and research and development (R&D) slow their productivity gains. The countries’ cities and infrastructures become older and less efficient than those in the two earlier stages like for example the United Arab Emirates (UAE). Their balance of payments positions deteriorate, reflecting their reduced competitiveness. They increasingly rely on their reputation rather than on their competitiveness to fund their deficits. They typically spend a lot of money on the military at this stage (US/China), sometimes very large amounts because of wars, in order to protect their global interests. Often, though not always, at the advanced stages of this phase, countries run “twin deficits” – i.e., both balance of payments and government deficits.
In the last few years of this stage, frequently bubbles occur as we currently experience.
These bubbles emerge because investors, businessman, financial intermediaries, individuals, and policy makers tend to assume that the future will be like the past so they bet heavily on the trends continuing. They in my opinion mistakenly believe that investments that have gone up a lot are good rather than expensive so they borrow money to buy them, which drivers up their prices more and reinforces this bubble process.
These bubbles burst when the income growth and investment returns inevitably fall short of the levels required to service these debts once inflation rise kicks in and interest rates start rising. The financial losses that result from the bubble bursting contribute to the country’s economic decline. Whether due to wars, pandemics or bubbles or all of them, what typifies this stage is an accumulation of debt that can’t be paid back in non-depreciated money, which leads to the next stage.
After bubbles burst and when deleveragings occur, private debt growth, private sector spending, asset values, and net worths decline in a self-reinforcing negative cycle. To compensate, government debt growth, government deficits, and central bank “printing” of money typically increase – in the near future through “digital codes”. In this way, their central banks and central governments cut real interest rates in order to ease debt burdens.
As a result of these low interest rates, weak currencies, and poor economic conditions, their debt and equity assets are poor performing and increasingly these countries have to compete with less expensive countries that are in the earlier stages of development. Their currencies depreciate and they like it. As an extension of these economic and financial trends, countries in this stage see their power in the world decline.
But while all of this is headline-grabbing, there is a second crypto tale unfolding that most people have noticed less: central bank experiments!
In March the Bank for International Settlements (BIS) held an “innovation” conference, at which Jay Powell, Federal Reserve chair explained that Fed officials are working with the Massachusetts Institute of Technology (MIT) to explore the feasibility of a dollar – based central bank digital currency (CBDC).
Details so far are sparse. But a CBDC essentially enables consumers to use computerized code as “money”, thus echoing some of the features of bitcoin, or the type of crypto coin being developed by Facebook. But this computer code would be created and controlled by the Fed – not Facebook’s Mark Zuckerberg or faceless bitcoin “miners”. Powell stressed this digital dollar would not emerge quickly, if at all, saying “there is no need to rush”. But the symbolism in my opinion is striking, since it reflects a subtle but notable shift in attitude among regulators. Or is it a preparation for ‘Phase 5’?!
When bitcoin and other fintech innovations first emerged this century, many central bankers either dismissed or derided them. They remain so: Powell suggested that bitcoin was primarily a speculative investment substitute for gold, not for the dollar; Agustin Carstens, BIS head, warned it was mostly used for regulatory arbitrage.
But what central bankers in my opinion are belatedly realizing is that the reason such innovations have emerged is that entrepreneurs are responding to two big flaws in modern finance. One revolves around something that central bankers seem unwilling or unable to address: the risk that fiat currency is debased in the future by excessive supply, i.e. quantitative easing (QE). The other is something central bankers do want to address: the clunky nature of the modern payments system. As Powell recently observed: “The Covid crisis has brought into even sharper focus the need to address the limitations of our current arrangements for cross-border payments.”
Thus, what the Fed and others are in my opinion now trying to do is a mild version of the “if you can’t beat’em, join’em” strategy: instead of ignoring bitcoin or Facebook’s experiments, they hope instead to harness some of the ideas behind such innovations as blockchain ledgers on their own terms. Or, if you like, out-crypto the crypto kids.
Will that work?
There are in my opinion reasons to be skeptical. One major problem is style: asking stodgy central bankers to embrace the type of freewheeling creativity found in fintech is like asking grandpa to listen to rap or techno.
Another, even more daunting, issue is that CBDCs create huge policy headaches, such as the future role of private sector banks. Commercial banks currently earn fees by “creating” money for consumers, (loans), by using money supplied (or created) by a central bank. A CBDC, however, would give consumers money (digital tokens) inscribed on the computing ledgers of central banks. This could potentially disintermediate banks in a way that would shatter revenues. Therefore, if the Eurozone intend to create CBDCs, they might need to retain a two-tier distribution system to keep commercial banks involved and to avoid another financial crisis.
Then there are plenty of data, privacy and liability issues. Central banks might not want to hold consumer data on their ledgers. On top of that investors might hate losing the anonymity associated with cash.
A possible solution is that CBDCs could coexist with cash, which is what Powell in my opinion expects to see. But the logistics and legal framework for this could be daunting, not least because a recent BIS survey suggest that only a quarter of the world’s central banks have clear legal authority to create such a currency and the percentage is even less if we look at International Monetary Fund (IMF) country members.
Yet it would in my opinion be wrong to assume that nothing will happen, just because the logistics look daunting. The same BIS survey suggests that 60% of central banks are considering CBDCs and 14% are carrying out pilot tests. The Covid-19 pandemic and the creation of massive debts by governments and central banks has added new motivations to this journey. The survey stated: “While most (central banks) have no plans to issue CBDCs in the foreseeable future, central banks collectively representing a fifth of the world’s population are likely to launch retail CBDCs in the next three years.”
The Bahamas is already one example: it already has a CBDC, called the sand dollar. More significantly, China is now racing to create a digital renminbi, sparking US angst about competitive threats to the dollar. Which in my opinion might explain why the Fed has suddenly teamed up with MIT.
This all may not be as thrilling as a Musk tweet. But my key point is that if such initiatives eventually fly, they could displace some of the rationale for private sector crypto projects. The would-be disintermediators of fiat currency might thus be disintermediated themselves. If so, that would be distinctly ironic. Bitcoin investors should watch Beijing – and Boston and should take a deeper look at upcoming private sector crypto projects (utility tokens, payment tokens, equity tokens) which fall under a certain governmental regulatory framework.
This is the background against which to assess the Fed’s next challenge: the danger of an inflation resurgence. After a quarter of a century in which core inflation, excluding volatile food and energy, has tended to undershoot the Fed’s 2% target, prices now threaten to rise faster than desired. If the Fed allows this to get out of hand – and the rate accelerates into the 3 to 4% range – the fallout could be globally disruptive.
The central bank, playing catch-up, would have to jack up the cost of borrowing. Financial markets would tumble. Leveraged companies would go bankrupt. A strong dollar would hammer emerging economies that have debts denominated in greenback and earnings in something else. The chatter about inflation in my opinion began already six months ago and has grown louder. Donald Trump’s 900 billion dollar December stimulus has been amplified by Joe Biden’s 1.9 trillion dollar March package, with talk of at least two audacious spending bills to come as previously described.
Meanwhile, in the private sector the high personal saving rate – in my opinion a red flag, because it could portend a whoosh of future spending – has continued to climb. Before the pandemic, it hovered just over 7%. Last December it was 13.5%. In the first quarter of this year it averaged 20.5%. Millions of newly vaccinated Americans are sitting on a mountain of dry powder (more than 1 trillion dollar alone with the three biggest US Banks – J P Morgan Chase, Goldman Sachs, Citi Bank) that could set the US economy alight.
What’s more, changes elsewhere have damaged the firebreaks. The pandemic has driven some businesses under, compromising the economy’s ability to satisfy surging demand. Trade tensions have blunted globalization’s ability to damp prices. Biden’s “Buy America” injunctions, his encouragement of trade unions and his drive to improve conditions for gig workers could all push costs up. Meanwhile, the pandemic has transformed consumer habits. Until businesses adjust, inflationary bottlenecks may result.
At this point, doves will object that unemployment remains elevated, so employers can easily scale up production to meet additional demand. But available workers are not necessarily in the right places or sectors. The Philadelphia Fed reports that 45% of manufacturing companies have vacancies that have gone unfilled for three months or more. According to iCIMS, a recruitment agency, job openings were up 22% in the first quarter, but applications were down 23%.
In sum, an inflation breakout is not inevitable – the slight rise in unemployment in the US reported last month supports in my opinion the doves’ view on labour – market slack. But the risks are significant. A lot hangs on whether the Fed is ready to react firmly if prices do surge. And this brings us to the second part of the discussion. The Fed’s critics advance three reasons why it may lack the fortitude to respond.
First, the Fed has muddied its commitment to its inflation target. To balance past inflation undershoots, it now wants to overshoot the 2% mark for an unspecified period. Since monetary policy works with a lag, this wait-and-see attitude could mean rate rises come too late to damp price increases before they develop momentum.
If inflation accelerates past 3%, you might expect the Fed to respond fast. After all, the past two decades of low inflation have seldom involved missing the 2% target by more than a percentage point. But the critics’ second concern is that the Fed may judge an inflation surge to be temporary – a blip that will correct once workers shift into new sectors and companies adjust. If this is wrong, inflation will have space to entrench itself further.
This leads to the third, most basic worry. Despite the misleading precision of their forecasts, central bankers make decisions under uncertainty, and they are inevitably political. Their independence in my opinion exists not in ivory – tower isolation, but in congressional appearances, meeting with administration officials and a willingness, notwithstanding, to decide that higher interest rates are sometimes warranted despite the short-term cost. An army of professional Fed-watchers loves to speculate that central bankers lock the spine to make this judgment. Some even whisper that Fed chair Jay Powell, a Republican, may err on the side of easy money to secure his reappointment by a Democratic president.
It’s in my opinion an enduring parlour game because neither side can know the answer in advance. The enthusiasm for cryptocurrencies testifies to the suspicion that the Fed will let inflation rip. But the last time the skeptics were proved right was in the 1970s, and the cautionary tale of that decade is seared into the memory of every central banker. Perhaps, half a century later, we should embrace the possibility that certain American institutions really are dependable. The past, at least sometimes, can serve as guide to the future. An inflation surge seems in my opinion all too likely. A supine Fed does not.