What a Debt Crisis Means for Bitcoin

Ever since Nixon broke the dollar in 1971, the dominant economic story in the West has been rising debt and slowing growth. This is unsustainable, and likely leads to a crash. How will that crash affect Bitcoin?

First, why the crisis. The debt is rising because low interest rates subsidize new debt, and without the threat of gold export, central bankers do nothing to fix it.

Meanwhile, productivity is slowing because regulatory and tax burdens discourage or outright ban productivity-driving investment or starting new businesses.

The result is we borrow faster than we produce, meaning debt eventually gets so big that the shriveled-up economy can’t float it.

Now, the crisis won’t necessarily happen this year, or this decade. But it is inevitable unless we reverse course, which is very unlikely given policymakers’ incentives and voters’ apathy. So the smart money is on a crisis where the debt will, one way or another, have to be neutralized.

Famed hedge fund manager Ray Dalio has been interested in this for awhile, which he calls the long-run debt cycle. He published a now-classic video called How the Economic Machine Works in which he listed out 4 ways a deleveraging can happen: governments spend less (austerity), taxes are raised (redistribution), debts are defaulted (restructuring), or money printing (inflation).

Today I’ll go through these, with some comments on impact on Bitcoin.

Politicians Have Goals, Too

First, I assume policymakers, being human, are self-interested. So they’re not going to choose for the good of the nation, they’re going to choose for the good of themselves. Sometimes those coincide, but usually they don’t.

After all, politicians and bureaucrats have goals in life, such as staying employed, getting promoted to the next boss level, getting lucrative job offers outside government, or simply being popular enough to be re-elected so they can accumulate power and prestige. They make choices in life accordingly. Of course, they don’t mind if the country happens to benefit, but it’s not their actual goal.

So, turning to Dalio’s scenarios, I’ll order them by least attractive to the policymaker, thus the least likely to actually happen. Note this is nearly the exact reverse of the good of the country, but then that won’t surprise you.

Austerity

First in fantasyland: austerity. This means cutting government spending so the productive sectors of the economy have more resources to create wealth.

The problem, of course, is austerity runs counter to everything policymakers want in life: they want more power, not less. More money, not less. More problems to pretend to solve, not less.

Indeed, the last time there was widespread talk of austerity, after the spending orgy leading into the 2008 crisis, it amounted to precisely nothing. In fact, spending actually rose.

Take the UK, where austerity is even blamed for Brexit. Indeed, the UK is the very government whose bailouts headlined the original Bitcoin block.

In the wake of 2008, there were widespread protests in Britain against alleged austerity, with sky-is-falling predictions across the media. What actually happened? From 2008 to 2013, spending went from 686 billion pounds to 767 billion pounds — a rise of 16 billion per year. Now, to be sure, this was slower than the previous 5 years, when it had risen by 38 billion per year. But halving the poison dose ain’t gonna cure the patient.

So, taking the UK’s “austerity” as a natural experiment, we might expect that when the debt hits the fan, governments will, like Britain, make token reductions to cover their rears. We might expect those cuts to hit people the regime dislikes, to get a little spite bonus from the base, but it won’t be substantial because, just as companies seek profits, policymakers seek budget.

So austerity is a joke — window-dressing at best.

Tax Hikes

Next up, hiking taxes. This is much more attractive for the budding power-mad sociopath, but it’s also historically unlikely. Not because politicians dislike taxes — they love them, especially punitive taxes on those people they dislike. But taxes are unlikely simply because there are much easier ways to fleece the voters that they won’t notice.

We saw over this past year where, due to Covid lockdowns and spending, the Feds are now projecting $6.8 trillion in spending and $3.8 trillion in revenue, up from $4.4 trillion and $3.5 trillion two years earlier. So $2.4 trillion more spending, and $300 billion more in taxes. So much for tax hikes.

Where did that extra money come from? The Fed printed it. In fact, by buying copious amounts of Treasuries alone, they printed enough to cover the $2.4 trillion in new spending, plus another $800 billion for politicians to buy something nice for the mob back home.

That comes to $3.2 trillion in fresh new cash, siphoned from the people. Who generally aren’t even aware they were robbed.

Just imagine, for a moment, the naive politician trying to squeeze that much money out of actual taxpayers. You’d literally have to double or triple taxes. And that, fundamentally, is why central banks exist: rookies raise taxes, pros raise inflation.

So no more happy talk about fiscal prudence, austerity, and taxes, now we’re in cold, hard reality: the shell-games. Featuring the ever-popular default and inflation.

Default

There are many ways to default on a debt: you can just walk away, you can negotiate to reduce the amount, or you can negotiate to change the terms — the rate of interest, the time-structure of payments. But they all amount to the same thing: partial or total cancelation of a debt.

In the aggregate, default is deflationary, since it vaporizes debts that were serving as money substitutes (“store of value”). Cancelling a debt is, in terms of inflation, the same as lighting a pile of money on fire — it reduces the money chasing the goods, which is supply deflation.

Still, modern central banks take such deflation as a green-light to print more money. So default-driven deflation is probably neutralized — it simply transfers, via the central bank, yet more purchasing power from the people to government spending.

So how likely is default? Again going to the ticker, very likely: in the wake of the 2008 crisis, US states including Illinois and California stopped paying dollars, using IOU’s instead. The crisis turned out to the sufficiently short that they never properly defaulted, but apparently they’re eager to have a go.

Meanwhile, also in the wake of the crisis, Greece pulled a proper default, informing its international creditors it would stiff them unless they cut the debt in half. It was jarring since Greece was the first OECD country to default on the IMF.

Notably, while the media at the time framed it as Greece being unable to pay, actually they were paying a lower percentage of GDP in official debt service than the US was at the time. In other words, Greece defaulted not because it had to, but because it wanted to — the debt had gotten so large that politicians felt they’d gain popularity proposing default.

I mention this because a lot of commentators in the US seem to assume default is about ability to pay when, in reality, it has nothing to do with ability to repay, it’s about wanting to repay. And that’s a much bigger risk, since it means every additional trillion makes it materially more likely the Feds walks away from the whole debt. The situation is worse, of course, in many countries from Europe to Japan to poor countries swimming in debt.

So, yes, default is very likely. It mostly hits the Fed’s Treasury stash, which is imaginary money anyway, along with corporate and overseas lenders — not many individual Americans directly own Treasuries.

So the biggest impact on regular Americans would be that the financial system would largely implode. Which many of us were hoping would happen in 2008, so it could be replaced with something not permanently bankrupt. Even better, replaced with a new financial system based on a Bitcoin standard.

Inflation

And that brings us to the grand kahuna, the elephant in the room, that sweet, sweet antifreeze in the policymakers’ cocktail bar: inflation.

The idea is you print up so much money that endless spending in a stagnating economy can be sustained.

The problem, of course, is that public reaction to inflation tends to be very lumpy: first they ignore it, then they laugh at it, then they panic. Central bankers know this, which is why they’re so nervous about inflation “getting out of control.” And, yet, they keep playing with fire precisely because policymakers find inflation so much fun in the beginning.

So how likely is inflation as solution to deleveraging? Guaranteed. Remember, this entire crisis so far has been inflated and then some. They’ll continue inflating as much as they can get away with without the public getting angry. When does the public get angry? Nobody quite knows, but 10% is usually a Schelling point.

Now, I think 10% is unlikely, simply because the US dollar got where it is today by the Fed’s relative prudence. By being the cleanest dirty shirt among central bankers when it comes to inflation. Well, maybe not the cleanest — Japan and Switzerland exist — but the cleanest big economy. Still, the Fed has been pretty cavalier about jumps in money supply recently, so it’s an open question if they’ll let it rip.

In sum, we are in an unsustainable debt trajectory, and the most likely outcome will be more of the same — inflation. Unless it gets out of hand, at which point they’ll default. Both will hit the dollar, inflation much more than default.

Where are we today?

Even though this entire crisis has been papered over with printing new money, price inflation was initially muted for two reasons. First, spending went down because of the crisis itself — people stayed home, skipped vacations and fancy dinners. And, second, people were saving more, which is typical in a crisis when people get worried. But, gradually, people started relaxing both, leading to rising prices, now officially at a 5.3% year-on-year change.

Now, 5.3% is higher than recent years, but it’s not yet catastrophic: in July, 2008 the official CPI hit 5.5%, and in October, 1990 it hit 6.4%. And I think if you mention the great inflation of October 1990 at a cocktail party you’ll get blank stares.

True, the modern way of measuring CPI under-estimates inflation, but that was certainly true in 2008 as well. And there are more shoes to drop in inflation, such as owner-equivalent rent. Still, for perspective, the last real inflation crisis in the 1970’s had CPI in the 10–15% range. So we’re not there yet, and the Fed hasn’t yet thrown credibility entirely to the wind. So, if I had to guess, we continue with mild-to-high inflation for a spell, as the debt keeps getting worse, but the comeuppance is inevitable.

What next for Bitcoin?

So out of these paths, what’s the impact on Bitcoin?

Both austerity and tax have surprisingly little impact on Bitcoin, because realistic ranges on both only marginally increase or decrease economic growth. Thus, both only marginally impact inflation, meaning muted impact on Bitcoin on their own.

Default, also, has relatively little impact: it’s deflationary in aggregate, but since modern deflation is simply a green-light to central banks, they’ll gobble it up in inflation. Yes, there would be a bigger impact if people lost faith in the dollar altogether, but that won’t come just because the feds default — it would only come if they pair that with lots of new money printing.

And, so, all roads lead to inflation.

Perhaps the most surprising aspect of this crisis has been that the inflation so far has gone entirely into Bitcoin rather than gold. When CPI started rising in June of last year, Bitcoin was at $10,000 and Gold around $1,800. Now, two and a half trillion USD later, Bitcoin’s closing in on $50,000 while gold languishes at… $1,800.

This is a big deal since gold, historically, has been the alternative for a fallen dollar. The white knight in Armageddon, the loving friend who’s always there for inflation-ravaged investors. But not this time.

Perhaps because never before has Bitcoin existed during an inflationary crisis.

Given gold has a roughly $10 trillion market capitalization — about 10 times higher than Bitcoin — that would be a momentous shift. Indeed, it would directly imply a $500,000 price for Bitcoin simply on gold-replacement. If that sounds silly, remember that during the last big inflation in the 1970’s gold went from a low of $34.78 in 1970 to a high of $843 in 1980 — a 24-fold rise from a boring 10%-15% inflation.

And so if, indeed, the Fed keeps pushing the envelope and fails to sterilize their loot, the numbers could get downright goofy. After all, remember the standard inflation pattern: first the public ignores it, then they laugh, then they panic. If that panic sends a hunk of fiat’s $120 trillion in savings into Bitcoin instead of gold, it would be fairly epic.

In sum, while there are lots of idiosyncratic factors to Bitcoin’s price — uptake via Lightning Network, legal tender laws, regulation, Bitcoin applications — I think it’s safe to say that the modern governmental response to a debt crisis is the precise solution that is most glorious for Bitcoin: inflation, early and often, as much as you can.

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Originally published at https://cryptoeconomy.substack.com on August 21, 2021.