A tale of Facebook’s Libra, missing gold and a U.S. government default
If Facebook manages to pull off the Libra project, it will become a global functional currency. What does that mean for the world’s existing currencies? In this article I take a closer look at the U.S. dollar in particular, and one (likely) scenario under which the U.S. defaults on its debt.
One gold rate to rule them all
In 1971, the year the Beatles split up and David Bowie headlined the first Glastonbury festival, a seismic shock hit the financial world: President Nixon announced the U.S. would be withdrawing from the Gold Exchange Standard.
27 years earlier in 1944, the Bretton Woods agreement (otherwise known as the Gold Exchange Standard) was put in place. This global agreement pegged the U.S. dollar to gold at $35 per ounce, and in turn pegged all other currencies to the U.S. dollar. It was not the first time the world has seen a gold standard, however it was effective, with many economists believing it led to 27 years of global economic stability through the late 1940s, 50s and 60s.
The reason Nixon ended the agreement, and the ensuing global economic effect are topics for another day. What’s important is that, under Bretton Woods, the U.S. dollar was positioned as the world’s fixed link to gold, which in turn made the U.S. dollar the world’s reserve currency; many countries simply held U.S. dollars instead of gold, knowing they could exchange it at a fixed rate at any time. Therefore if that link were removed then we might have expected countries to rush to convert their dollars to gold. But that didn’t happen, instead most governments, just continued to hold dollars anyway.
Skip forward 48 years to 2019.
Sony owns the Beatles, David Bowie is dead, and most living adults are addicted to their smartphones.
And the U.S. dollar still remains the world’s main reserve currency. Without any gold backing it.
Will that ever change? And what would be the tipping point?
A tech giant with 2.1 billion users launches a global currency
Facebook’s project Libra is a simple idea, but a giant undertaking. Born out of the same public distrust that gave birth to Bitcoin, Libra is the obvious next step: create a payment medium to crush transaction time and cost, allow the un-bankable to access the financial system, and remove layers of intermediaries from the equation.
However unlike Bitcoin, Libra includes two key components: (i) 100 major global corporations equally form the backbone of the system, continually keeping each other in check while creating wider trust, and (ii) each Libra coin is backed by traditional assets denominated in various currencies, which should — in theory — create a stable value for Libra when converted across a range of currencies.
If this works it will change the face of money as we know it. Imagine travelling to a foreign location and paying for a meal using Libra stored on your phone — the same Libra that you also used to pay for a takeaway pizza at home the night before. Sending money to friends or relatives abroad becomes as simple as a few swipes, with no currency conversion to think about. Citizens of countries with hyperinflation could retain the value of their wealth and use Libra as a means of payment.
But perhaps the most interesting outcome of all: banks as we know them could cease to exist. Anyone in the world would be able to store their Libra on their phone or an online wallet, and access it instantly from anywhere. The 30% of the world’s population that do not have access to a bank account, overnight would gain access to the world’s financial system.
Libra also has significant implications for financial markets.
Here at Globacap we have already created equity and debt securities in blockchain, allowing for all the benefits outlined above. However to settle securities transactions instantly, we’re missing a solution for the payment side of the transaction. Cryptocurrencies are still too volatile and not trustworthy enough for institutional adoption, therefore we are still reliant to an extent on traditional payment intermediaries (which add cost and time to every transaction). Using Libra would allow us to settle financial markets transactions instantly while removing layers of intermediaries from the process, resulting in greater transparency and lower costs.
If Libra works, and people all around the world start using it, it’s a logical assumption that governments around the world may start to hold it as one of their reserve currencies. Governments hold reserve currencies that they trust will retain value. For centuries that was gold, in the last one century that has been the U.S. dollar.
But what does that mean for the U.S. dollar?
To answer that question, let’s start with a simpler one first: how do governments hold U.S. dollar reserves?
Contrary to what you may see on TV, they do not keep piles of paper notes locked in a vault (except perhaps for a short while in Mexico after a successful raid on a drug cartel). They do keep some dollars in an account at the Federal Reserve, however in reality the amounts are relatively small (it’s not a good idea to hold cash, as its value gets eroded by inflation).
Instead, a better — and the most common — way of holding U.S. dollar reserves is by investing in U.S. Treasuries. These are loans to the U.S. government that pay back an interest rate each year (hopefully beating inflation) with the borrowed amount payed back in full at ‘maturity’. If you decide you want your cash back before the maturity date, then you can sell the loan to another investor in an active secondary market.
The U.S. government funds some of their budget this way. In fact, they have funded so much of their budget this way that there is now $16 trillion of U.S. public government debt outstanding ($22 trillion when including intra-governmental debt within the U.S.). To put that in perspective, U.S. GDP was $21 trillion in 2017, and the total supply of all U.S. dollars in circulation is only $14 trillion (I’m also being generous here by using ‘M2’ which includes non-cash accounts, as opposed to just $4 trillion under the ‘M1’ classification).
Sounds big, but here are a few even more staggering key points:
- Interest payments on that debt cost $325 billion in 2018, or 7.9% of all U.S. government expenditure
- The U.S. budget deficit was $779 billion in 2018, meaning the U.S. had to borrow an additional $779 billion in order fund its budget
- In 2018, $1.3 trillion of Treasuries matured, meaning the U.S. had to borrow an additional $1.3 trillion just to repay existing lenders!
These mind-blowing numbers mean one thing: if investors don’t continue buying Treasuries, at some point the U.S. government will go bankrupt.
Who keeps buying all those Treasuries?
Remember that part about the U.S. dollar still being the main global reserve currency? Non-U.S. governments currently hold 39% of U.S. Treasuries. That’s a big number, and it’s up from 13% in 1988, which means foreign investors have become an increasingly important support for the U.S. government over time.
The remaining 61% comprises domestic institutions, such as pension funds and banks. Domestic buyers will always be loyal to buying Treasuries, it’s inherent in their respective structures.
Foreign buyers, on the other hand, have no reason to continue buying U.S. Treasuries forever. Incidentally, the largest holders of Treasuries are China ($1.13 trillion — while there’s headline talk of a trade war, in reality China is still the largest single financer of the U.S. government’s daily operations), Japan ($1.02 trillion), and Brazil ($313 billion).
So now we’re getting to the really interesting questions:
- Could Facebook’s Libra result in reduced demand for Treasuries from foreign buyers?
- Could that lead to a U.S. government default?
Could Facebook’s Libra result in reduced demand for Treasuries?
To answer this we need to delve into some numbers.
If Facebook’s Libra succeeds in becoming a globally standard medium of payment, then it would be logical for foreign governments to diversify some of their reserve holdings into Libra. Governments currently trust the dollar as the most globally accepted currency. However if Facebook’s Libra starts to facilitate a large share of global monetary transactions, then that would require governments to reallocate some of their dollars into Libra.
If foreign investors were to allocate just 10% of their current U.S. dollar allocation into Facebook’s Libra right now, then domestic buyers would have to invest an additional $660 billion to make up the shortfall. The below table illustrates different amounts (in USD trillions) compared to current holdings (%) by foreign investors:
That might be possible, if there are no significant recessions in the next 10 years … or maybe not.
If there are more sellers than buyers in any market, then the price goes down. In the case of Treasuries, this has an important additional implication: if treasuries fall in value then the interest rate on new issuances will increase (each new Treasury issuance is auctioned, if there’s less demand for Treasuries then the U.S. government will have to offer a higher interest rate in order to attract more investors).
To find the tipping point of amount sold that would impact the price, we have to look at average daily volume (ADV) traded. According to the Federal Reserve Bank of New York and SIFMA, over 2018 there was an ADV of $565 billion.
Most traders know that when they want to execute a really large order, they have to do it over multiple days so as not to impact the price. While there’s no widely accepted convention, some traders limit large orders to 1% of ADV.
If we follow that rule, then we can assume that any more than $6 billion executed in any one day will impact the price.
Adding this into our table, we can see how many days it would take to sell that portion of Treasury holdings without impacting the market:
If we assume that most investors would seek to make a portfolio shift over the course of 1 month at the most, then this suggests the Treasury market could absorb only a 2.5% re-allocation over 1 month.
Flipping that around, if foreign investors were to sell more than 2.5% of their Treasury holdings over 1 month, Treasury prices would go down, pushing the U.S. government’s cost of borrowing up.
Could that lead to a U.S. government default?
If the cost of borrowing goes up, then the government is spending more on interest payments which means it has less to spend in other areas.
In 2018, the government spent $325 billion on interest payments, or 7.9% of the total budget. That’s the second biggest expense in the U.S. budget, behind the Department of Defense at $574 billion, and ahead of the next biggest — the Departments of Veteran Affairs and Education at $79 billion and $68 billion respectively.
To compound things, U.S. government debt is also expected to rise over the next 10 years.
By 2027, the Congressional Budget Office (CBO) estimates an additional $7 trillion of debt would have to be added to cover expenses, with interest payments forming 13% of all government expenditure (which would make it the single largest expense item in the U.S. budget — more than spending on Defense).
The CBO’s numbers, however, assume constant demand for buying Treasuries, which may fall as seen above
The U.S. pays approximately 2.9% on its 10 year Treasury. If only 5% of foreign holdings are reallocated away from Treasuries, that borrowing cost could increase to 4% or higher.
The Tipping Point
At that level, the U.S. government would no longer be able to afford the interest payments on its debt, and be forced to accept the harsh reality of two choices:
1) Default (e.g. write-off some of its debt)
2) Print money to pay off the debt
If they defaulted, then their borrowing cost would go even higher. However they would still have the same annual budgetary outlay which they cannot afford without borrowing funds.
If they printed money to pay off the debt, or at least the interest on the debt, then we would see a devaluation of the U.S. dollar, which would lead to foreign governments re-allocating even more U.S. dollar reserves into an alternate reserve currency, and so on — a cycle with no real end in sight.
In either scenario, there is little the U.S. government could do to stay solvent.
A new global equilibrium
While I have focused on the U.S. dollar, the economies of several other smaller reserve currencies (GBP, EUR, JPY) would be heading for the same outcome. All of their respective economies also have exceptionally high levels of government debt.
I’ll leave you to decide whether that outcome is positive or negative.
Facebook removed borders, connecting billions of users around the world. The Libra project has the potential to take that a giant leap further, however if it works, for better or worse, we will see a radical transformation in the global political landscape.
Here at Globacap we are excited to see a truly digital currency emerge, whether that is Facebook’s Libra or a digital central bank currency. In either case it is complimentary to the digital securities we have already created, and together will be truly transformative to the financial markets industry.