CHAPTER 3

Macroeconomics, Monetary Policy, and Bitcoin’s Perfect Storm

In November 1989, Mexico City began implementing its “Hoy no circula” driving program, translating to “today, [your car] does not circulate.” This was a government policy designed to reduce city pollution by reducing the number of cars on the road by day. The last number on your license plate dictated whether or not you could drive that day. Two numbers per day, from 5 a.m. to 10 p.m., were banned from driving. The Mexican government wanted an increased reliance on public transportation and ridesharing to cut down on city pollution. What they got was families buying second or third cars to avoid the new restrictions. Oftentimes they purchased old, inefficient cars seeing as they would only use the vehicle once or twice per week. The number of motor vehicles in Mexico more than tripled from 1990 to 2019 and carbon emission levels rose 13 percent.1

This is the law of unintended consequences. Politicians with the goal of reducing carbon emissions in their city instituted a policy that ran counter to the incentive structure of the average citizen. Waking up an hour earlier one day a week to enter a crowded bus, or adding taxi expenditures to your budget, or having a coworker wake up earlier to pick you up on the other side of town is simply a nuisance. For a middle or upper-middle class family with two vehicles and two incomes, the simple work around involves purchasing an old, nonfuel-efficient vehicle to use once or twice per week with a different license plate number. Politicians failed to understand the complexity of the system and the incentive structure of the average working citizen.

A nation’s economy is a complex system, much like the commuter economy of Mexico City. For a central planner, however well intentioned, to claim to know what is best for all stakeholders takes incredible hubris. Oftentimes, they make decisions with incomplete knowledge that lead to unintended consequences. I do not believe that all politicians or central bankers are nefarious or unintelligent people. Most central bankers have Ivy League educations and most politicians have an incredible record of public service. Yet combine a dangerous economic theory with the law of unintended consequences and you get a low growth, low inflation, negative real interest rate zombie economy. You get a bloated financial system, a wealth gap not seen since the 1920s, and mass populism. Economies are normally the interaction of land, labor, capital, and technology on the open market. Western economies are centrally planned on a debt-based perpetual growth model that requires inflation to keep the system afloat.

Most of the lower- and middle-class sense that something is unfair but cannot articulate their discontent. For this reason, populism takes form on the left and right. The root of 21st-century populism is the economic system created post-1971, where the cost of living continuously rises through inflationary policies while wages remain stagnant. Wage earners own less of the pie over time, whereas asset owners own more over time. Most of international relations theory rests on the rational actor model—the simple assumption that individuals and nations make rational social and economic decisions based on the information they have. Placing blame on social media, the millennial generation, the baby-boomer generation, the left, the right, or anything of that matter is simply a scapegoat for a centrally planned economic system that benefits the few at the expense of the many.

In this chapter, we will examine how the Federal Reserve, in an attempt to counter the business cycle, simply doubles down on the debt and easy credit that led to a business cycle downturn in the first place. Overtime, this leads to a lack of economic dynamism and perpetually low growth, similar to Japan and Europe. Next, when the Fed no longer has the tool of manipulating interest rates to create growth, they must rely on increased money printing. This is where the U.S. economy is today. With interest rates at the zero-lower bound, I examine why monetary policy 2.0 is required if the government wants to avoid a deflationary spiral. Bitcoin is the clear winner from this policy because the currency serves as the release valve when interest rates no longer work to stimulate. Lastly, I ruminate on the potential for monetary policy 3.0—Central Bank Digital Currencies (CBDCs). Using blockchain technology allows for direct to consumer, targeted stimulus. It also allows for easy on-ramps to Bitcoin, Ethereum, and other Decentralized Finance (DeFi) protocols. While some would consider austerity the responsible thing to do, increasing taxes and decreasing spending with the current debt overhang would lead to depression-level human suffering as central bankers have kicked this can down the road for 40 years. For the political class, this is not a feasible solution. Economic central planning has created an unstable financial system and Bitcoin is the insurance policy.

A Dangerous Idea

By manipulating interest rates and increasing the supply of money, the Federal Reserve can prevent recessions and achieve its dual mandate of maintaining high employment and stabilizing prices. Much like Mexico City’s “Hoy no circula” program, I will explain how this idea has done more harm than good for any country that adopted it. In the face of economic weakness, global Central Banks act as a counter-cyclical force. They loosen credit and expand the money supply to increase aggregate demand and pull economies out of recessions. Loosening credit is a euphemism for creating more debt, and monetary expansion is a euphemism for currency debasement. This has been the U.S. monetary playbook since the end of the inflationary era of the 1970s.

Following is a chart of the Fed Funds Rate, the interest rate set by the Federal Reserve, over the last 40 years (Figure 3.1). It makes a series of lower highs and lower lows in a perfectly linear downward channel. Why is it that when the economy normalizes, interest rates cannot pass the level of the previous recession? In a recession, corporations and households struggle to make their debt service payments due to reduced economic activity. Normally, this would lead to default or restructuring on behalf of the economic actor. However, with artificially lower rates, these actors can reduce their debt burden by refinancing to survive another day and take advantage of lower rates to take on more debt to create growth. Accompanying a downward channel in rates is an upward channel in corporate, sovereign, and household debt. When interest rates rise again, the economy begins to weaken at a lower rate than the previous recession. This makes intuitive sense. How can companies that struggled to make debt service payments at 800 bps possibly make them at 600 bps and twice the debt load?

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Figure 3.1 Effective federal funds rate since 1980

As an investor, long bonds has been the best trade for nearly half a century as a play on this countercyclical, kicking the can down the road Fed reaction function. When the economy is weak, stock prices decrease and bond prices increase. The 60/40 stock and bond portfolio has underpinned institutional finance and retail portfolios for over 40 years because Fed policy created anticorrelation. It also succeeded because rates had room to fall in each recession. In a recession, rates drop an average of 500 bps (or 5 percent). Before the 2020 recession triggered by the corona-virus, the Effective Federal Funds Rate topped at 2.4 percent. When rates are below 5 percent and the Fed needs to stimulate, it relies on the money printer. With the size of the debt burden, interest rates must remain low as even small increases in the interest rate lead to substantial increases in interest payments and defaults. The money printer will play a central role in future stimulus.

Before 2008, interest rates was the primary tool to stabilize the economy and create growth. Once interest rates hit the zero bound for the first time in the Great Financial Crisis of 2008, Central Banks began to rely heavily on a policy of quantitative easing (QE). Today, money creation through QE constitutes the second half of the Central Bank equation. In this policy, Central Banks create money to purchase assets from large banks that free up their balance sheets to support lending and investments. In the United States, these assets include, but are not limited to, government bonds, corporate bonds, and mortgage-backed securities. The Bank of Japan will buy its countries’ equities as well and currently owns nearly 80 percent of the Japanese Exchange Traded Fund market and 43 percent of the entire Japanese Government Bond Market. When Central Banks purchase these assets, their balance sheet expands. If previous purchases come to maturity faster than new purchases, the balance sheet contracts. From 2008 to the end of 2020, the Federal Reserve Balance Sheet has exploded from $880 million to $7.4 trillion. The money printing will continue at this extraordinary pace in order to stave off a deflationary spiral. Scarcity wins when the global unit of account is abundant. This means taking abundant Central Bank-created dollars and placing in them in scarce, nonmanipulatable assets. As previously demonstrated, nothing is more scarce than Bitcoin and this concept explains why dollar cost averaging into Bitcoin has outperformed every complex investment strategy that exists today.

In terms of asset prices, QE increases bond prices (thereby decreasing bond yields) and increases stock prices. Bond yields decrease because they see trillions of dollars of artificial demand from the Central Banks. The European Central Bank’s QE programs have forced yields negative for the 10-year bond and most government bonds. This means that a purchaser of European government bonds is guaranteed to lose money. Equities rise in a more circuitous manner. While the U.S. Fed does not buy equities, it replaces bonds with cash on the balance sheets of major banks. Well-known primary dealer banks include J.P. Morgan Chase, CitiGroup, Wells Fargo, Goldman Sachs, Morgan Stanley, and so on. While the Fed cannot directly purchase riskier assets such as equities and high yield credit, primary dealer banks can through hedge funds, trading desks, and other market participants. Central Banks target lending but banks tighten lending standards in the face of recessions. Therefore, newly created cash at the Federal Reserve does not become lent out for productive means but sits on bank balance sheets or finds its way to risk assets. The Forex market, buying and selling currency exchange rates for profit, sees $6.6 trillion of daily volume. For comparison, Japanese GDP is $4.9 trillion, German GDP is $3.9 trillion, and South Korea’s GDP is $1.6 trillion. In an attempt to increase lending, Central Banks have created an unproductive, hyper-financialized economy and lifted the prices of all financial assets. This is the unintended consequence of misguided policy. Unfortunately, with rates already at zero, money printing programs are the only tool available at the Fed to replace lost capital. QE will only take up a larger share of the Fed equation to spur growth.

If income growth does not exceed debts owed, economic actors cannot make their debt service payments and will default. Therefore, the idea behind monetary policy is to increase growth by slashing the cost of borrowing. In a free market economy, the cost of borrowing is not manipulated by a central authority. There is a free market for the cost of borrowing through a self-regulating mechanism that involves savers and borrowers. More individuals are inclined to save with high interest rates, offering their savings as loanable funds for entrepreneurs to take out loans. Too many savers drive the interest rates lower, incentivizing borrowing. Too many borrowers drive the interest rates higher, incentivizing saving. Central banks attempt to dissuade anyone from saving because that money does not enter the market for consumption or investments. They do this through a high inflation rate and low interest rate, ensuring that your savings will lose value over time if it sat in a bank account. Adopting Bitcoin or any store of value as savings ensures that your money can be spent on your terms.

By manipulating interest rates, U.S. growth becomes debt based, not organic. Debt is deflationary because future income is promised to something that has already been consumed. The more debt one takes on, the larger percentage of current expenditures go to debt and interest payments. Therefore, the greatest consequence of a debt-based growth system is its drag on future growth as we’ve seen in Europe and Japan—the latter of which has a debt-to-GDP ratio of 250 percent. It’s the law of diminishing returns applied to debt-based growth. U.S. government debt-to-GDP increased from 32 percent in 1980 to 106 percent by the end of 2019. All the while the rate of change of growth has declined steadily.

According to a study by Dr. Lacey Hunt of Hoisington Investment Management Company, each dollar of debt produced in 1980 created a rise in GDP of 60 cents. In 1940, with a 42 percent debt-to-GDP ratio compared to 1980’s 30 percent, that number was 54 cents. As debt increased substantially following 1980, each dollar of debt went on to create 42 cents of growth in 1989 and 27 cents in 2019. Increased debt creates decreased returns on growth as more of that debt goes to pay interest.2 Since 1980, each additional dollar of debt went on produce less than half of the original growth.

Another study by the Institute of International Finance in 2018 concluded that it took $185 trillion of debt globally to create $46 trillion of growth. At one-quarter growth to debt, this study aligns with Dr. Hunt’s. We have reached debt saturation. We have record levels of debt, interest rates at zero, and more debt creates less growth. Income growth will not exceed debts owed on a significant basis because this debt-fueled growth model has reached its zenith with the cost of borrowing at zero. The next section looks at ways out of this debt trap and why all roads lead to decreasing the debt owed through inflation as opposed to artificially creating growth. Structural flaws in the financial system have created a need for increased money printing. That money printing will be a boon for Bitcoin.

Monetary Policy 2.0

In addition to his role as a fund manager for Bridgewater Associates, Ray Dalio also provides thoughtful books and articles that combine economic history and theory to inform his investment decisions. In his article titled “Paradigm Shifts,” Dalio makes the claim that investors will see differences in what typified this decade from the previous decade based on Central Banks reaching the limits of monetary policy. Major themes of the last decade include massive stock market gains, global disinflation, stock buybacks, the rise of passive investing, low GDP growth, low volatility, QE/the expansion of the Fed balance sheet, artificially low interest rates, big tech, and reduced cost of labor.

These themes all relate to one another. QE and low interest rates led to stock market inflation and the rise of passive investing, which is inherently a low volatility strategy. Cheap money also allows for stock buybacks and mergers and acquisitions, further inflating asset prices. Technology monopolies such as Google, Amazon, and Apple reduce economic dynamism through reduced competition and reduce labor costs by displacing labor. Writing in 2019, Dalio then comments on when this paradigm shift will occur:

I think that it is highly likely that sometime in the next few years, 1) central banks will run out of stimulant to boost the markets and the economy when the economy is weak, and 2) there will be an enormous amount of debt and non-debt liabilities (e.g., pension and health care) that will increasingly be coming due and won’t be able to be funded with assets.3

With rates at zero, Central Banks can no longer rely on manipulating borrowing costs to increase growth. QE, meanwhile, has proven to favor financial markets over the real economy. How can a country outgrow its debts when there is no growth to be had? The answer is they do not. They eliminate their debt.

In his book, Principles for Navigating Big Debt Crises, Dalio offers a four-pronged solution to reducing a debt burden that has become too large. Countries can enact austerity, which entails taxing more and spending less. They can default on their debt and restructure their economies, they can transfer money from the haves to the have-nots through increased taxes on the wealthy and increased social programs, or they can inflate their way out of the debt. They can also use some combination of the four.4

To begin with, austerity is politically and economically infeasible. There are no political parties touting fiscal responsibility as evidenced by $6 trillion balance sheet expansion in roughly a decade and the emergence of “deficits don’t matter” ideology of Modern Monetary Theory. The government issues bonds to spend money that it does not have at incredibly low rates. The Central Banks, in order to avoid deflation that would force governments to curb spending and create a recession, must print money to purchase these bonds. Under this system, no consequences exist for deficit spending from a political standpoint. Monetary debasement is the economic consequence. Meanwhile, the consequences of voting for austerity as a politician involves being elected out of office. As far as political incentives go, deficit spending will continue.

Economically, the amount of debt in the system with levered financial markets, levered housing markets, levered corporate balance sheets, and Central Banks acting as the buyer only resort for government debt issuances, austerity is not an option. Recessions often act as brushfires, eliminating the nonproductive companies and making way for entrepreneurs to fill the gaps. By combating each recession with lower rates, the Fed did not allow this cleansing to occur. Now, we have a massive, inefficient field that even a small spark could set ablaze. Cutting spending, increasing taxes, or increasing interest rates will have major consequences. For corporations and individuals, it will make debt service payments unmanageable and pop a 40-year debt bubble. Companies will default en masse and we will see a deflation in the price of housing and stocks. It will force the government to cut already underfunded pension system promises and erase the retirement hopes of a generation overallocated to stocks. For governments, it will force them to cut fiscal spending, decreasing the social safety net during an objectively difficult time. Contemporary policy is more about keeping the system afloat after the inefficiencies created by decades of central planning. Rates will remain low and Central Banks will not hesitate if they see the need to inject liquidity. Learning from the Greek example, austerity would collapse prices and any hope for growth while only increasing social tensions.

Secondly, the United States will not default. Countries that own their own printing presses never default because an easier alternative exists to erasing debts—printing the money. I believe the third option, large-scale wealth transfers, will happen to an extent but will not nearly be enough.

I believe the Fed has already signaled that they will inflate the debt away by promising to keep rates at zero through 2022 and target over 2 percent inflation. They will accomplish this by printing more money than is necessary. Under a policy of inflation, dollars in the future are worth less than current dollars. With fixed payments, debtors are paying their debt back with less money than when they received that debt. For example, at 1 percent interest and 3 percent inflation, a debt burden is halved in only 36 years. This is essentially a slow-motion default and less painful way to erase debt.

In the words of Ray Dalio:

So there will have to be some combination of large deficits that are monetized, currency depreciations, and large tax increases, and these circumstances will likely increase the conflicts between the capitalist haves and the socialist have-nots.5

Monetary policy 2.0 will not rely on interest rate manipulation to outpace debt growth. It will rely on inflation to decrease the debt burden because all the growth was had with rates currently at zero. The future will involve currency depreciation, debt monetization, high inflation, de-globalization, increased tension, helicopter money, and increased taxes. The alternative is a painful restructuring and an unwind of the debt spiral. As previously mentioned, the release valve is the currency. Bitcoin will play a larger role in monetary policy 2.0 as the only form of sound money in existence.

Here is an analogy to think about the paradigm shift between current monetary policy to 2.0, then to 3.0. Maslow’s hammer is a cognitive bias that states, “When all you have is a hammer, everything looks like a nail.” The Federal Reserve had a hammer to counteract the business cycle in interest rates. It smashed them lower and lower as it was their only solution. When rates hit zero, they replaced the interest rate hammer with the money printing hammer. Now in the face of economic weakness, the Federal Reserve prints money and frees up bank balance sheets to create lending. When this hammer proves ineffective, it will be replaced with a scalpel. Processes are in motion for blockchain based CBDCs that can provide targeted stimulus to a desired demographic group. If the money printing hammer benefits Bitcoin by debasing the currency, the CBDC scalpel benefits Bitcoin by digitizing money on a global scale.

Monetary Policy 3.0

The current tool of global Central Banks is the printing press to inflate the debt away. This is the perfect storm for Bitcoin. However, there is one major flaw with QE known as the Cantillon Effect. Due to this flaw, governments are beginning to implement helicopter money in the form of stimulus checks. If the banks will not lend the money the Fed gives them, the government will put the money directly into the pockets of consumers. Monetary policy 3.0 is a blend between monetary and fiscal. Once the technology exists to target a specific demographic group and provide them with stimulus, I believe QE programs will be significantly reduced. The role of the Fed will be to monetize the deficits created by fiscal spending, not to act as it sees fit through changing the interest rate.

The Cantillon Effect was named after Richard Cantillon, an Irish– French economist who first observed this concept in the 18th century. It states that the first recipients of new money benefit the most from monetary expansion because they can spend it before prices rise. Therefore, the infusion mechanism matters greatly. As previously mentioned, the government and primary dealer banks of Wall Street receive the money first through the Fed’s bond purchasing program. However, as part of the CARES Act of 2020, the Fed expanded its program and to begin buying an array of corporate bonds in addition to government bonds and mortgage-backed securities.6 The first recipients include the government, large banks, and large corporations.

That money typically stays in the financial system and influences the prices of financial assets such as stocks, bonds, private equity, and real estate before making its way to the real economy. In fact, governments and large banks receive this money at negative real interest rates and lend it out at higher rates to small banks or small-to-medium-sized businesses. Aside from a mortgage that uses the home as collateral, the average person does not have such easy access to capital. Those without access to capital, those who do not own financial assets, and those with fixed wages such as pensioners, minimum wage earners, and even salaried professionals of the middle class are hurt the most by this top-down approach. The first recipients of printed money have the exorbitant privilege of receiving that money for free and charging interest or routing that money to financial assets if they feel the need to tighten lending standards due to economic uncertainty.

The Cantillon Effect plays itself out through inflation differentials. Freshly printed money nests itself into financial assets and services with easy access to capital. Since 1997, college tuition and hospital services have inflated by roughly 200 percent each. Why? Universities and health care providers can charge exorbitant prices for services as long as the government subsidies and easy lending standards ensure that the bills will be paid. In terms of financial assets, the S&P 500 is up over 300 percent and housing prices, as measured by the Case-Shiller Housing Index, are up 274 percent. Overall inflation, as measured by the Consumer Price Index, increased 62 percent during the same time frame. While abundant goods become cheaper as technological advances reduce production costs, the prices of essential services and financial assets explode. This increases the wealth gap and contributes to the general sense of unfairness felt internationally that led to the rise of populism.

I do not believe this system can continue indefinitely. Central Banks, to their credit, have asked governments for fiscal support as they only have two tools currently to stimulate the economy. Governments responded in 2020 with mass stimulus checks, which I believe serve as a precursor to Universal Basic Income. If governments wish to create inflation in goods other than financial assets and subsidized services, they will need to change the cash infusion mechanism from bond purchases to helicopter money or direct-to-consumer checks. Similar to interest rates or QE, helicopter money is a hammer used to combat deflation. Though the service and travel industries are most affected by a pandemic, stimulus checks will also reach software engineers, lawyers, and those whose professional life saw little or no change from the pandemic. However, this will change in monetary policy 3.0.

The Bank for International Settlements along with seven global Central Banks published a report in October 2020 titled “Central Bank Digital Currencies: foundational principles and core features.” The Central Banks of Canada, Japan, Switzerland, the United Kingdom, and the United States all collaborated on this piece and even state, “this report summarizes where they collectively stand.”7 First of all, let’s begin with defining a CBDC. The report defines it as “a digital payment instrument, denominated in the national unit of account, that is a direct liability of the central bank.” In essence, it is a blockchain-based digital dollar held at the Central Bank as opposed to an individual’s personal bank.

Though the report includes many motivations such as financial inclusion and cross-border payments, I believe the section on “facilitating fiscal transfers” constitutes the true calling card of CBDCs. Quickly and without a third party, Central Banks could credit your account with desired stimulus. A digital dollar also allows for “programmable monetary policy.” For example, and the report specifically mentions these examples, Central Banks could program an expiry date to the stimulus or conditions such that it must be spent on certain goods or services. It could also target specific demographics such as those who work in the travel or restaurant industries during a pandemic. Using CBDCs, Central Banks can specifically target who or what they want provide stimulus to. It trades their hammer for a scalpel.

Interestingly enough, the report highlights the largest risk of creating CBDCs—disintermediating banks. If everyone holds an account at the Central Bank for the convenience of fiscal transfers, and one can use that account for regular, daily purchases, there is no need for a commercial bank account aside from certain services such as private loans. Additionally, the second of three “foundational principles” listed of CBDCs is coexistence, stating that “central banks have a mandate for stability.”

At this point, I remind you of the most dangerous course of action analogy presented in the previous chapter. How could a private money succeed when it undermines the legitimacy of governments that issue currency and banks that charge fees for transactions? Many critics claim that Bitcoin could never succeed because it challenges entrenched powers. However, it appears the opposite is happening. Central Banks are utilizing blockchain technology to create their own digital currencies, touting coexistence and their mandate for stability while admitting that it undermines traditional banking. Getting the entire population accustomed to online banking on a blockchain-based platform will provide simple on ramps to Bitcoin and other DeFi protocols. I believe that through CBDCs, we are witnessing the transformation from a physical dollars and gold-based system to a digital dollars and Bitcoin-based system.

Conclusion

Bitcoin benefits from this Central Bank trap. For 40 years, Central Banks refused to allow the business cycle to cleanse the economy from a misallocation of resources by dropping interest rates to pull aggregate demand forward. They essentially kicked the can down the road. When the issues of too much debt and too little growth threatened the economy, they doubled down instead of undergoing restructuring. Restructuring at this point will lead to massive deflation and depression-level human suffering.

Global Central Banks are stuck. They need to keep the system afloat and cannot do it with interest rates alone. Therefore, they began using the printing press. However, the printing press is both inefficient and grants exorbitant privilege to governments, large banks, and large corporations through the Cantillon Effect. An overreliance on the printing press with rates at zero provides the perfect storm for Bitcoin’s price. Targeted fiscal deposits through CBDCs will complete the transfer from a physical dollar and gold to a digital dollar and Bitcoin.

Understanding the Central Bank trap is why the 60/40 portfolio model of the past will not provide the same results in the future. Bonds perform exceptionally well in an environment where interest rates trend lower. Bonds perform poorly when interest rates have nowhere to go but higher and the threat of inflation constantly looms given the amount of monetary and fiscal expansion. In this environment, real and monetary assets will outperform bonds. Most investors are oblivious to the fact that the western world is reaching the limits of monetary policy and their portfolios are completely unprepared. Future portfolios need to diversify away from credit and into hard assets such as commodities and Bitcoin. Hard assets constitute the antifragile parts of the portfolio that strengthen with additional currency devaluation and financial experimentation.

While many see gold as the quintessential hard asset, Bitcoin is theoretically superior to gold and its price action compared to gold demonstrates this. If investors buy Bitcoin and gold for the same reasons, and Bitcoin outperforms gold by 10× to 20×, one must wonder why invest in both unless as a hedge against the probability of governments fighting Bitcoin. However, all evidence points to the contrary through blockchain based CBDCs and increased institutional adoption. Thus far, readers should have a mental model to understand Bitcoin, its potential role in portfolio management, and the macroeconomic factors that make it such an attractive asset to own. In the subsequent chapters before discussing Ethereum and Altcoins, I will delve into the specifics of Bitcoin investing to include how to value it and how to invest in it.

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