Decentralized Finance and the debt cycles

In his fascinating study The Changing World Order, Bridgewater co-founder Ray Dalio studies the big economic and political cycles that have existed throughout history. By studying the nature of money and debt, one understands that the COVID pandemic is not the cause but rather the trigger of the upcoming global recession, probably the biggest in the last century. This recession was actually overdue because, as Dalio explains, we are in the late stages of a long debt term cycle, where debt burdens of companies and nation states reach unsustainable levels (relative to the income and cash flow levels) and Central Banks have limited maneuver as interest rates hit 0%. When debt cycles burst, Central Banks devaluate the currencies by printing new money (which is happening now), which van lead to disruptive events such as massive debt restructuring and defaults, the collapse of reserve currencies (monies that are widely accepted worldwide, currently the US Dollar) and even the emergence of a new monetary and financial order.

Such crisis have happened many times in the history before we were born. The current current system emerged in Bretton Woods in 1945 after the previous debt cycle bursted in the Great Recession 1929–1932. But this time, we have a new, parallel financial system that is emerging on top of an open, permissionless blockchains: Decentralized Finance. What will be its role in the upcoming crisis? Without mentioning explicitly blockchain technologies or crypto, Dalio gives us many analysis elements. Hint: it is bullish for crypto.

The nature of debt

Dalio explains that the nature of credit is cyclical. When we acquire it, credit let us consume more than what we produce; when we have to pay it back, it forces us to consume less than what we produce.

The nature of debt is cyclical. Source: principles.com/the-changing-world-order

Debt swings occur in two cycles: a short debt cycles, which take about 5–8 years; these add up into a long term debt cycles, which take about 75–100 years. Long term debt cycles arise when debt rises faster than income until it becomes unsustainable. When debt repayments grow faster than incomes, people, companies and governments are forced to cut spending, which lead to a decrease in income and the cycle reverses itself.

Short and long germ cycles. Source: principles.com/the-changing-world-order

There are many reasons to believe that we are in the late stages of both a short and long term cycle. The last long term debt bubble bursted in 1929, which led to the Great Depression, populism and a World War.

Actually, the parallels between the situation in the 1930’s and in the 2010/20’s are striking. Now, like, then, interest rates are hitting 0% and Central Banks printing money aggressively.

Source: Ray Dalio, principles.com/the-changing-world-order

Now, like then, countries accumulate unsustainable debt burdens.

Source: Ray Dalio, principles.com/the-changing-world-order

The long term debt cycles

According to Dalio, long-term debt cycles typically occur in different phases.

They all begin with low debt and “hard money”. Hard money, also known as commodity money, is an asset with intrinsic and standardized value in an economy, such as gold and other metals, salt, barley, etc. What separates commodity money from a regular commodity is its monetary premium. Commodity money has value as a utility and as money. Its monetary premium is determined by its use as a Store of Value, Medium of Exchange or Unit of Account.

We argue that Cryptoassets such as Ether and Bitcoin, fall into this category. Ether and Bitcoin are used for paying transaction fees for their respective network. For example, anytime a transaction is executed on the Ethereum network, an asset is moved, a DAO is started, etc., ETH is consumed. Anytime a p2p Bitcoin transaction is executed, BTC is consumed. This is the utility and its value as a consumable commodity. Some regulatory bodies such as the CFTC (United States Commodity Futures Trading Commission) share this position and consider BTC and ETH as commodities.

Assets with intrinsic value that are used as money are important because its trustless settlement; they are useful by themselves and don’t require a contract or law to ensure that the counterparty complies its promise to deliver. In other words, they are bearer instruments, transactions settle on the spot. Commodity money can be used by parties that don’t trust each other, such as countries in war could still pay in gold.

The “Quadrants of Trust”, by Ryan Sean Adams and Lucas Campbell. Source: https://bankless.substack.com/p/eth-is-irreplaceable

This will be the first global financial crisis will count with a digital version of a commodity money.

Later in the cycle, claims on hard money emerge. These claims are known as paper money or representative money. Paper money has no intrinsic value, rather a claim in a commodity, examples are gold certificates or USD before 1971 when it was backed by gold reserves. These claims on hard money become treated as money itself because they can be redeemed for tangible money. Initially, there is the same amount of claims on hard money as hard money itself on the bank. However, holders of these claims discover they can lend them to a bank in exchange for interest. Banks can borrow them and lend them again for a higher interest rate. Lending and borrowing increases to the point that the claims on money rise relative to the amount of good they are intended to buy. These claims on paper money are essentially debt assets that continue growing.

When the bank doesn’t have enough (hard) money to pay all the claims it will inevitably default on its claims or restructure the debt. A Central Bank has as choices to default or print money and devaluate it, as it is happening now. However many countries doesn’t have control over its own monetary policy (like in the EU) or have a weak currency which depends on a global reserve asset such as the US Dollar.

When hard money and claims on hard money become too restrictive, governments abandon them and issue fiat money. Fiat money is established by government regulation, has no intrinsic value, and cannot be redeemed for a commodity. Its value is derived from being declared by the government as a legal tender. This is the type of money that we have since 1971 when the Nixon administration defaulted on its commitment on redeeming US dollars for gold. There is no “Hard Money” to back the currency. The risk here is that whoever has the power to print. money (Central Banks) creates ever more money and debt assets in relation to the amount of goods and services produced. If Central Banks print money too aggressively, people will stop using it as a Store of Value and shift to other assets, such as hard money or claims on other assets. Governments may try to limit the “wealth exit” , such as outlawing gold transactions or even openly confiscating gold, imposing foreign exchange controls, etc.

We argue that Cryptoassets provide an alternative Store of Value asset. When confidence erodes in the current system (because the risk of devaluation and default), capital usually flees to alternative assets to hedge inflation risks, such as gold.

Debt levels increase through time, there are economic booms, and the quantity of claims on money rises relative to the amount of goods and services available to buy. Trouble comes when there is not income to serve the debts. In short term debt cycles, Central Banks can manipulate the demand for money by adjusting interest rates, When interest rates can not be lowered anymore (like currently), the only stimulative (inflationary) offer that remains is money printing.

When overprinting of fiat money goes too far, this leads to a sell — off of debt assets which reduce the value of debt and money and prompts people to flee out from currency and debt. If this process becomes too extreme, monetary system can break down after massive devaluations and defaults. Governments may then link again the currency to a “hard money” to regain confidence. This restructuring phase may be accompanied by social and political turmoil, revolutions or even wars. These restructuring phases normally take between 3 months and 3 years and can have long-term consequences such as breaking the currency system, which means that the reserve currency (currently the US Dollar) is stopped being used as a reserve currency.

The transition between the different monetary systems occur typically during during the long term debt cycles https://www.principles.com/the-changing-world-order/#chapter2. Source: Ray Dalio

We argue that cryptoassets will be the new hard money, to which people will migrate into.

The role of Crypto

This is the first global financial crisis with an emerging crypto financial system in place. With an emerging digital commodity money. What will be their role?

Crypto will accelerate the transition

In a scenario of devaluation and subsequent inflation of US Dollar as reserve currency, cryptoassets will be increasingly be used as an alternative Store of Value. Capital will increasingly exit current system selling off fiat currencies and debt assets and buying cryptoassets with monetary premium such as BTC and ETH.

Ethereum in particular has the potential to become a neutral, transparent censorship resistant settlement layer for the world economy. A platform used to settle transactions by competing companies and even countries. This will be crucial in times of economic downturn and political instability.

The current burst of the long term debt cycle can debilitate the world’s reserve currency (US Dollar) and position Ether as the new “digital” reserve currency. Stablecoins may surge as Medium of Exchange currencies alternative to sovereign currencies such as the US Dollar. The recent spike of transaction volumes in stablecoins after the market crash in March shows this.

Governments will increasingly regulate, limit, or even try to ban cryptocurrencies to slow down the exit of the system. The threat is real . If we have a strong decentralized systems in place, that should be difficult or even impossible to execute.

As we will see in further articles, DeFi platforms are usually overcollaterized, meaning that by design, there is always enough assets to guarantee the repayment of debts. This may emerge to a system that is less vulnerable to the debt cycles.

A legacy financial system has real risk of collapsing and simultaneously a new blockchain financial system is emerging in front of our eyes. Will these two dynamics reinforce? It will be extremely interesting to observe how this plays out in the next months and years.

Blue Swan Academy announces the launch webinars and online workshops to train individuals and businesses to use decentralized finance tools. The educational offers will be entry-level, with no previous knowledge required. We believe in “learning by doing”, so you will learn to use the most important protocols and applications. Please check out here our current offering.

Blue Swan Academy is an educational platform for blockchain powered economies, focused on the legal and financial industries. Sign up now to our introductory DeFi webinar and receive a coupon for free attendance!

Author: Juan Escallon

Follow us on twitter @jcescallon @academy_swan

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Juan Escallon

Juan Escallon

Head Blockchain Academy at Blue Swan. Blockchain Law. Decentralized Finance. Online training

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