Introduction

Sentiment in the crypto market is low as bitcoin collapsed on March 12th, 2020, taking with it several crypto funds. Many market participants thought that bitcoin would function as a safe haven from general market conditions which was clearly not the case as correlations between bitcoin and traditional assets went from 0 to near unity.

For the bitcoin true believer, who always knows the current price of bitcoin as 1 BTC, there’s no reason to care why we have dollar panics, so this article is merely academic. Most of us however still live in a world where taxes have to be paid in USD and most goods are priced in USD. Yes, many of us know the dollar is eventually doomed, as so many fiat currencies that have come before it. We are still stuck with the problem of trying to navigate from a broken fiat monetary system to sound money whether it’s bitcoin or something else inspired by bitcoin.

Fractional Reserve Banking & The Federal Reserve

Fractional reserve banking was identified by Ludwig Von Mises in his 1912 book “The Theory of Money and Credit” as the cause of the business cycle. His ideas never gained widespread acceptance. Instead, the federal reserve act of 1913 created a central bank who immediately set to work destroying the value of the US dollar. Central bankers have experienced amazing success at their dual mandate of manufacturing crises and inflating away the value of our currency. Every gold bug and bitcoiner has seen a chart similar to the one below:

In less than 20 years the newly created federal reserve managed to oversee the extension of so much credit unbacked by real production that they were able to engineer the great depression. With an understanding of the causes of the business cycle, fellow Austrian economist Friedrich Hayek warned of an impending economic crisis in early 1929 as noted by the Nobel prize committee when awarding him a Nobel prize in economics in 1974.

In expanding on Mises’ business cycle theory with his 1929 book “Monetary Theory and the Trade Cycle” and 1931 book “Prices and Production”, he explained that with a stable supply of money, the supply of savings and the demand for such savings would find equilibrium at a price known as the natural interest rate. As a corollary, increasing the supply of money with fractional reserve banking increases the supply of money which drives down the price of money (interest rates). This incorrect price of money is what drives the misallocation of capital and labor. This misallocation of capital then increases the price of producer goods and raw materials with delayed transmission to consumer goods leading to reduced profitability.

We see this in terms such as “Dr. copper”, so named because copper prices forecast the business cycle quite well. As an input to many different kinds of production it is in accordance with Hayek’s theories that monetary distortions should first affect the general price levels here. So long as credit continues to be extended there is no theoretical limit on how long a boom may continue, but as a practical matter the misallocated capital investment makes the economy more vulnerable to the effects of any slowdown in credit growth for any reason. Once a cycle of liquidation begins, defaulting loans drive credit tightness that drives further liquidation.

This corrects the misallocation of capital, but the lack of credit driving the liquidation of all unprofitable businesses will also impact some otherwise profitable businesses as well. We call such conditions a “liquidity panic” or “dollar panic”. During such events, the need to raise cash to meet margin calls drives the marginal selling of everything that can be sold, both good assets and bad.

Homestake Mining in a Dollar Panic

We see below one example of a profitable business in the 1929 crash losing one-third of its value before going on to huge gains over the next few years. This is a prime example of how a wonderfully profitable business is sold due to the need to get dollars when everything else is crashing and margin calls must be met.

Conventional (Keynesian) economic theory agrees with Austrian economic theory during times of panic. Both recognize that credit conditions are too tight and would agree that liquidations impact even otherwise healthy, profitable companies. Austrians recognize that this is simply a mechanical result of monetary distortions of the capital stock caused by fractional-reserve banking. Keynesians believe that tight credit conditions are caused by “animal spirits”. “Animal spirits” of course control the economic decisions of people, unless those people are central bankers, then animal spirits have no effect and we are left with cool rational decision making. It makes sense if you don’t think about it too hard.

Among the measures taken to solve credit tightness in 1933 was the confiscation of gold by FDR and the devaluation of the dollar against gold from $20/oz to $35/oz. The “success” of inflation eventually provided the justification for fully removing the link between the dollar and any concept of sound money (i.e. gold).

Eurodollars & Rehypothecation

If this were the end of the story, it would already be bad enough, but it gets worse, much worse. Enter eurodollars. Even after removing the gold backing of the currency, fractional reserve banking can only take you so far on the road to crazy town. You still have the 10% reserve ratio providing at least some tether to reality, by which I mean the reality of the supply of savings meeting the demand for savings at a market clearing price known as interest rates. This is clearly no good for bankers and politicians. With eurodollars outside the jurisdiction of the federal reserve, no longer does the 10% reserve ratio hold us back, we now can go all the way down to 0%. Through rehypothecation, a single treasury bond can now be pledged as collateral for an infinite number of loans. Why would a banker hold a low yielding treasury bond when they could borrow against it and buy a higher yielding product like MBS, CDOs, and CMBS? At a macro level it’s easy to see that buying risky assets on infinite leverage is clearly a bad idea and will certainly lead to a spectacular series of booms and busts. Well, you would think this would be easy to conceptualize, but this very topic was investigated by the 2 economists at the federal reserve bank of St Louis in 1980 (Eurodollars and the U.S. Money Supply, Balbach and Resler). They concluded: “it is apparent that Eurodollar transactions have only a small effect on the U.S. money supply. Further, the Federal Reserve could easily offset this effect with appropriate open-market transactions.”.

The eurodollar system is incredibly complex as seen in the chart below. It would be fair to say that no one has a full understanding of how this system works.

Central banks have not given much further thought to how this system actually works and are content with treating it as a mathematical abstraction that will respond to fed inputs such as the fed funds rate. They have been treated to a continual set of surprises as they find out the system does not work the way they thought it did. Among these are negative interest rates for treasury bonds, negative swap spreads, and libor trading well above the fed funds rate. The federal reserve remains committed to its dual mandate which has evolved over the years to firstly, create inflation by any means necessary, whether that means buying junk debt or dropping money from helicopters, and secondly, crafting serious sounding statements to give the impression they know what they are doing. They have no more need to manufacture crises as we have, since the GFC, remained in a state of permanent crisis with the fed balance sheet growing and no clear way to ever reverse it. Now the focus needs to remain on controlling the “animal spirits” through painstakingly crafted statements, and I do believe there is some merit here. While “animal spirits” don’t have anything to do with the economic decisions, in any con game it’s important to keep the mark calm and distracted lest the scheme fall apart.

Gold in a Dollar Panic

In the 2008 great financial crisis, gold lost 30% of it’s value in the initial stock market crash with its correlation to equities becoming close to 1 during the bouts of heaviest selling. It was the same dynamic seen with homestake mining in 1929, following the initial drop gold went on to nearly triple in value over the next few years. Gold itself didn’t do this in 1929 because it was pegged to the USD at $20/oz.

Bitcoin in a Dollar Panic

With bitcoin having launched after the GFC, 2020 was the first year to see what would happen to bitcoin in a stock market crash. First we show the hourly correlation of BTC and S&P where it’s very easy to pick out March 12th where bitcoin crashed to near $4000 depending which exchange you were looking at. Many common measures of correlation would use daily returns, but that return frequency is too low to pick up on the quick sell off. In this case hourly returns better illustrate what happened as correlations became very high, but only for the periods where the selling was heaviest.

Like homestake mining in 1929 and gold in 2008, nothing has changed about the long term picture for bitcoin. If anything, the macro environment of endless quantitative heuristic easing and fiscal stimulus with matching huge government budget deficits coupled with a supply shock is nearly the perfect storm to see massive inflation going forward. While gold may have been seized in 1933, it should prove much more challenging to seize crypto in the next few years.

Predicting when and how high crypto may go in this type of environment is impossible. What can be confidently stated is that any form of sound money will continually appreciate in value against a monetary system that is continually inflating over a long time horizon.

The Collapse of Fiat Currency

Ludwig Von Mises said in “Human Action” (1949), “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”. Mises was prescient in predicting the economic collapse of communism in his 1920 essay “Economic Calculation in the Socialist Commonwealth”. He explained that “rational economic activity is impossible in a socialist commonwealth” and that such a system would be plagued by misallocation of capital with constant shortages and surpluses of goods. It is only through the free movement of prices to balance supply and demand that allows capital allocation to proceed efficiently.

The western world appears to be going “all in” on a currency crisis thus making Mises look more prescient than he already does. It’s as predictable as it is sad. The “final and total catastrophe of the currency system” even has a name now. It’s called Modern Monetary Theory (MMT) and it’s the final step needed in the push toward a currency crisis. Of course, if people were willing to believe that “animal spirits” were the cause of changes in aggregate demand, then there’s no reason to doubt the MMT concept that “sovereign deficits don’t matter as long as they are denominated in the national currency”. Paul Krugman argues effectively that MMT is a recipe for disaster. Unfortunately for him, mainstream economics ceased its role as an independent academic discipline in the early 20th century and only exists today insofar as it gives politicians cover for corruption and increasing the power of the state (see the bank bailouts of the GFC or the upcoming bailouts for whatever they end up calling this virus crisis). MMT is clearly more useful than mainstream Keynesian economics for politicians as no longer would budget deficits matter. I would argue this is the correct lens with which to view modern economics.

From the time the first coin was clipped by Nero to the third century crisis, the Roman empire may have taken 200 years to fully destroy their economy through taxes and inflation, bringing about plague, civil war, and economic depression. With modern speed and efficiency we may do it in half the time starting with our modern Nero, FDR, who first devalued gold from $20/oz to $35/oz in 1933. Looking at this pessimistically we already have 3 of 5 with high taxation, plague, and a brewing economic depression. There’s no way to time a currency crisis, but there’s every reason to hold crypto as part of your portfolio now. Gresham’s law may keep sound money out of circulation for now with legal tender laws, but the moment those laws become unable to be enforced Thiers’ law takes over and will drive USD out of circulation. There are clear examples of this happening in Weimar Germany and 2009 Zimbabwe.

Historical Fiat Currency Failures

At a high level all fiat currency failures look the same. They all start with a supply shock from some exogenous cause. War is the most common cause of a supply shock, but many other causes have sufficed in the past. The policy response to the supply shock then leads to a failure in price discovery which further impairs the economy which then leads to hyperinflation. This policy response is automatic, not a choice, fiat currencies can not sustain any significant amount of deflation. Ben Bernanke has been very explicit in this regard, see “Deflation: Making Sure *It* Doesn’t Happen Here”. Somehow, this doesn’t lead to any soul searching about whether there could be any inherent problem in a system that requires continual inflation to survive.

It’s not as simple as comparing the size of the money printing relative to the economy, the details about where the newly printed money is going matter. To the extent that new money drives increased production, the system will move back toward equilibrium. In the case where new money simply chases existing goods or even worse impairs otherwise good businesses, the hyperinflationary spiral takes hold.

In the case of Weimar Germany, war reparations that had to be paid in gold was the exogenous cause. With foreigners having an explicit claim on a fixed value of the German economy, domestic currency chased a diminished quantity of goods, which is a roundabout way of getting a supply shock. The policy response of printing more german marks exacerbated the problem leading to reduced output, while doing nothing to reduce the amount owed for war reparations.

In Zimbabwe, land reforms which took land from professional farmers and gave it to people with no agricultural experience beyond subsistence farming reduced agricultural output by about 60% in the 2000’s thus creating a supply shock. This led to the failure of many companies in the agricultural sector involved in the processing and transport of agricultural products. With the land confiscation and business failures, foreign direct investment went to near 0. The lack of foreign currency coming in to the country by way of exports or by investment resulted in having to print local currency to fund debts denominated in foreign currency.

In the US, fractional reserve banking commits us to a path of continual inflation. This kind of works as long as the new money finds its way into things like financial assets, fine art, and houses. As long as we continually increase production every year to mute the inflation finding its way into everyday goods like food and consumer items, the system will continue to function. The moment we get a supply shock of sufficient magnitude, the ensuing policy response will eventually cause hyperinflation here. We have no way of knowing if corona virus will give us a supply shock of sufficient magnitude, but certainly the probability is greater than 0 as there is definitely a supply shock here and now. If the policy response further impairs the economy, then we could quite possibly enter a hyperinflationary spiral. While it seems far fetched to even consider, the groundwork is clearly in place for something like this to happen.

Crypto as Sound Money

In the crypto era, we’ve seen clear adoption of crypto in nations experiencing economic crises or capital controls. Granted, this is small scale so far, but we can see the 2013 scramble for bitcoin in Cyprus when the EU began discussing a bail-in for failing banks. With the value of the Venezuelan Bolivar reaching the equivalent of a single satoshi, there has been widespread increase in the usage of crypto as money, both bitcoin and dash. It’s estimated that 10% of merchants accept crypto in Venezuela. Many in China have turned to crypto to evade capital controls.

If there’s one thing holding back adoption of crypto it is the continued reliance on and relative perceived stability of USD. How will the USD lose its reserve status? “Gradually and then suddenly”, as it is said. The gradual part is already happening. Although it’s impossible to say exactly when it will suddenly lose reserve currency status, by the time it is obvious it will also be too late to do anything about it.

There has been much discussion about whether crypto is money at all. Many gold bugs write off crypto as not money and say that only gold is real money. To them, being able to add more sound money by just creating new crypto means the supply is not at all constrained. I don’t believe this to be a good argument as money needs to have the quality of being widely adopted, which for almost all of the 1000’s of crypto projects other than a few is absolutely not true.

The well known “stock to flow” model says that the marketcap of money is related to it’s inflationary characteristics and absent government force would trade at a price that puts its stock/flow on the same regression line as all other money.

One of the arguments against this model is that as bitcoin continues to halve its flow every few years, the model would imply that the marketcap would eventually reach absurd values. I expect that if this model holds true, bitcoin of the future will not lie on the regression line computed today. What I would expect to see is bitcoin “stock to flow” of the future being on the same regression line as other assets “stock to flow” as computed in the future, with the line having a strictly lower slope than the one found today. In other words I would expect that bitcoin and gold would both find uses as sound money along with many other assets, but that the increased supply and quality of sound money with the increasing adoption of crypto would cause the slope of the line to fall.

While it doesn’t necessarily have to be bitcoin that becomes the sound money of the future, at this point it is the most likely outcome. The 2nd most likely outcome would be ETH or an ERC-20 token. Anything that’s going to function as money needs to be widely adopted and very few coins can meet that criteria. Just as people in the pre crypto era held gold, in this new era a portfolio should contain at least a small allocation to crypto. That would be true even without the backdrop of a brewing economic crisis, which makes it doubly important to have some sort of insurance in the form of money that is hard to censor or confiscate.