The Geopolitics of Bitcoin: A Macro Perspective
Volatility has returned to the cryptocurrency markets. After months of rangebound price action, Bitcoin market capitalization is now trading at yearly lows. When major moves such as this occur, investors have the tendency to seek out market narratives and identify causal relationships: Was this dump driven by the Bitcoin Cash hard fork? Crypto hedge fund redemptions? or investors looking to book capital loss for 2018 to offset capital gains? This essay will analyze the current macro outlook and provide historical context for what industry participants may be able to expect moving forward. My goal is not to identify the cause of these events, but to provide an analytical framework for the role Bitcoin may serve in the future global economy.
A Brief History
Bitcoin was created following the 2008 economic crisis. Unemployment in the United States had risen to about 10%, while consumer confidence reached its lowest point in decades. Faith in our financial institutions had been irreparably shaken. As a result, the government pursued the following recourse to address the growing despair: First, it reduced federal interest rates. This effectively lowers the cost of credit, which consumers are able to use to start new businesses and increase consumption in discretionary spending areas. This forms a ripple effect across the economy as more spending increases net revenues, which causes companies to hire more workers, and the cycle continues. Second, it increased government spending through expansionary fiscal policy. This came in the form of infrastructure investment, tax incentives, education, housing, and energy efficiency, amongst other categories, resulting in a multi-year recovery effort. By the year 2010 the economy was intact, and the previous instability had all but subsided.
Fast forward a few years and Bitcoin has started to gain adoption as a digital currency free from sovereign control, which resonated strongly with libertarians, crypto anarchists, and a few savvy businessmen. It has experienced several “boom and bust” cycles over this period. The most recent, the Mt. Gox exchange hack in 2013, caused many to dismiss it as a failed experiment, akin to previous attempts at digital cash. In fact, many objective observers admit that this should have killed Bitcoin, and the fact that it didn’t speaks to its resiliency in its present state. Further, it was during the last bear market that Vitalik Buterin launched the Ethereum ICO, which was the first step in a major revolution of new capital formation.
The explosion of Bitcoin’s price and the emergence of ICOs were direct evidence of the economy entering into a late stage cycle, fueled by low interest rates, corporate tax cuts primarily allocated towards equity buybacks, and quantitative easing. Throughout this period, the Federal Reserve has effectively purchased Trillions of dollars’ worth of government bonds, mortgage backed securities and other assets to support the economy. As assets go up in value, networths and spending/income levels rise. Investors receive more credit from lenders looking to increase their yearly returns, and similarly, investor risk appetite increases as consumer confidence skyrockets. The lenders and speculators make a lot of fast, easy money, which reinforces the bubble by increasing speculator’s equity.
It was the perfect storm. By the end of 2017, people felt invincible — maxing out credit cards and refinancing homes for the sake of making quick money. This time was marked by broad bullish sentiment, new buyers coming into the market, high prices relative to traditional metrics, and high leverage purchases. This is not atypical of the later stages of a bubble: most people believed these assets to be a treasure, and anybody who didn’t own them was missing out. The truth; however, is that the speculative value of cryptoassets had vastly exceeded the utility value. Bitcoin could not scale and created a backlog of hundreds of thousands of transactions; and exchanges were forced to pause new accounts, overloaded with the tsunami of new market participants. More time was needed to build out the infrastructure.
We are now currently in the midst of a deleveraging, caused by an imbalance in the supply and demand of crypto assets. Much of the liquidity has eroded as retail investors capitulate, their beloved altcoins now discounted by more than 90%. Unfortunately, this comes at a time when the macroeconomic perspective appears ever more unfavorable to risk assets. There is a tightening of monetary policy, with the federal reserve expected to continue raising interest rates through 2019, thereby increasing the cost of capital to US companies.
Bitcoin in Emerging Economies
Ok, here’s the silver lining. While the outlook for the US technology sector appears rocky at best, there are reasons to be optimistic about the role of Bitcoin in the not-so-distant future. Primarily, over the next decade Bitcoin will fulfill its role as a hedge against inflation and global instability. This is already evident in Turkey, Venezuela, Argentina, and other emerging economies that have been caught in an inflationary spiral.
In the economic system, currency and debt serve two purposes: 1) mediums of exchange and 2) store of value to hold wealth. Debt serves as a promise to pay, denominated in a certain type of currency (e.g. dollars, euro, yen, pesos). Central banks function by attempting to balance the level of growth and inflation in an economy by changing nominal interest rates and/or quantitative easing (i.e. managing the overall liquidity of the money supply). As a nation experiences capital outflows, this reinforces the need to add more money into the system, which reduces the relative purchasing power of holders of that currency. Furthermore, holders of debt denominated in a weak fiat currency are incentivized to sell these assets and move the assets into another currency or a store of value like gold or Bitcoin.
Countries experiencing hyper-inflation such as Venezuela have limited recourse to restore economic stability. As their fiat currency declines, the government is incentivized to print more money, which devalues the base currency. Currency declines inspire additional capital flight, which cause an escalated feedback loop of inflation and further devaluation of fiat. Furthermore, as holders of debt assets expect to convert them into money, goods, and services down the road, they are very conscious of its rate of purchasing power relative to the value they receive from holding it. The issue of rising debt levels is most pronounced in instances where a nation does not control its own reserve currency because there is no global bias to hold their currency/debt as a store of value. Since the value of outstanding debt is often denominated in USD, total liabilities increase with a strong U.S. dollar, and there is no way for non-U.S. central banks to produce more of an asset they do not control.
Bitcoin’s disinflationary model is a hedge to this form of global instability. Its sound money principles of scarcity, fungibility, divisibility, and censorship resistance make it an ideal store of value, similar to gold. The predictable supply schedule of new Bitcoins guarantees that no sovereign power will give into the temptation to print more, at the expense of devaluing the wealth of its citizens. Ultimately this will result in more capital inflows to the Bitcoin network as opposed to emerging market economies, furthering its status as a store of value. As more emerging nations begin to adopt this strategy, it will force others to take note or risk a net loss in purchasing power relative to the value of the Bitcoin network.
There is a clear incentive for developing nations to adopt the technology — at this point, that should be obvious. What’s less obvious is the role second-world nations such as Russia and China will play. They both arguably have much to gain from a destabilization of the US dollar. They have demonstrated the propensity to disrupt U.S. institutions, including U.S. voting systems and faith in media. Furthermore, it is now clear that Russia has used Bitcoin to finance their intelligence operations, and China is home to some of the largest Bitcoin mining operations in the world. The fact that Bitcoin is a payment network outside of the reach of any jurisdictional control is a feature — not a bug — of the system. The currency functions as an unseizable store of wealth and countries are trying to reconcile the inherent tradeoffs. On one side of the spectrum, countries with strict capital controls may seek to undermine Bitcoin to prevent capital flight and exert control over the populous. On the other hand, many countries may benefit from an external network in order to avert U.S. sanctions.
One thing is clear: it is impossible to stop Bitcoin, and the countries that delay risk losing purchasing power relative to more proactive, forward thinking countries. Given the broad grassroots effects of the Bitcoin community, I predict in the next decade it will grow to have significant geopolitical influence and how we prepare for this will have implications for future generations. Furthermore, as growing evidence suggests a negative outlook for the U.S. and global economy, there are significant areas of growth for Bitcoin as the infrastructure develops and the need for a self-sovereign store of value increases.
