The Frontier

March 30, 2021

Unsustainable Finance

COVID-19 has reinforced a vicious spiral in public finance--one that will ultimately debase the world’s reserve fiat currencies, namely the US Dollar. Developed world governments have been able to borrow very cheaply for a very long time. This has invited a moral hazard into public finance: why cut spending or collect more tax when borrowing can support the economy just fine? And further: as long as inflation remains suppressed, a country’s federal reserve can continue to print money and buy that same country’s cheap debt. This self-referential public financing works as long as at least one of two conditions hold:

1. Real economic growth exceeds zero (nominal growth exceeds interest rates)

2. The Federal Reserve is able to enforce low interest rates because inflation is muted.

As of this writing, the United States Treasury has delivered three stimulus packages in response to COVID-19, one in March 2020 for $2.8 Trillion, one in December 2020 for $900 Billion, and one in March 2021 for $1.9 Trillion. Furthermore, over the same timeframe, the Federal Reserve has created roughly 40% of all US dollars in circulation. Aid was needed to shepherd the American economy through a genuine force majeure, but stacking the largest ever fiscal and monetary interventions is unsettling.

As of this writing, the United States Treasury has delivered three stimulus packages in response to COVID-19, one in March 2020 for $2.8 Trillion, one in December 2020 for $900 Billion, and one in March 2021 for $1.9 Trillion. Furthermore, over the same timeframe, the Federal Reserve has created roughly 40% of all US dollars in circulation. Aid was needed to shepherd the American economy through a genuine force majeure, but stacking the largest ever fiscal and monetary interventions is unsettling.

And intervention doesn’t stop there. Having passed these stimulus measures, the US government is now liable for $27 Trillion in debt obligations, a 170% increase since 2008. This mountain of debt currently funds medicare/medicaid, social security, unemployment benefits, and pension payouts, among other things. An aging population and increasing unemployment due to automation will only lengthen the lives and amplify the scale of such obligations. Politicians are elected for two-to-six-year terms and arrive in office beholden to someone, without the long-term horizon to address the fiscal problem. Their incentives to do so are non-existent. The US government will continue to fund these accelerating liabilities through debt issuance. And the Fed will continue to print dollars and monetize the debt to offset the fiscal dovishness. A precarious chain of dependencies.

The game of musical chairs comes to a halt when the combination of low rates and non-existent inflation inevitably vanishes. If and when inflation forces interest rates to rise, the US Treasury will neither be able to refinance its existing debt nor issue new debt at favorable rates. Just as a climbing “risk free rate” may enfeeble the fiscal machine, a surge of even mild inflation may neuter the Fed’s monetary lever. With this confluence of events, the Federal Reserve would be unable to soak up the Treasury paper that international debt holders are increasingly unwilling to hold. 

A vicious cycle is unleashed: an accelerating fiscal deficit leads investors to abandon the dollar through the dumping of US government debt. A weaker dollar ends the Fed’s decade-long Quantitative Easing program and it is unable to continue buying treasury debt (never mind the broader risk assets it dabbles in). If the Fed loses control of rates, risk assets will suffer as the present value of their future cash flows declines. Equities are prohibitively expensive at the moment--they have been co-opted as a modern store of value against the backdrop of low interest rates. When inflation creeps into the system, savings in dollars and fixed income investment begin to erode. Embroiled in this environment, investors must seek alternative inflation hedges.

Bitcoin

Bitcoin is a decentralized, peer-to-peer network that enables users to exchange bitcoin with one another. We believe owning bitcoin is a desirable hedge because its value appreciates as:

1. Fiscal and monetary policy deteriorate

2. The world grows more digital

3. Geopolitical and domestic turmoil persists

Bitcoin is commonly called “digital gold” as both are stores of value. While gold lends its adoption logic to bitcoin, bitcoin’s case is more cogent. First, bitcoin’s supply is limited to 21 million while gold’s scarcity is not really fixed--as the price of bullion rises, so do the incentives to mine previously unprofitable ore. In reality gold’s supply increases by ~2% per year. Bitcoin is also far more portable than gold. A large quantity of gold is prohibitive to move while bitcoin travels at the speed of light. Finally, gold’s indivisibility makes it inconvenient for transaction whereas bitcoin is infinitely divisible. Nonetheless both are considered hard money because their supply is limited. Because a steady stream of fiat money keeps the economy afloat, hard money is a necessity.

Adoption of a digitally native currency is inevitable as more of our lives move to the internet. COVID-19 has accelerated the rate at which society has transitioned from physical to digital. The guaranteed ownership, portability, and divisibility of a virtual value store highlight the extent to which contemporary financial institutions are gatekeepers. Incumbents do indeed offer digital services and exchange, but these functions are built on legacy infrastructure and walled off. The savings held in a bank are an IOU, as Greek citizens will so keenly recall. While it takes 3-5 days to move value internationally via SWIFT, it takes 10 minutes via the Bitcoin network. For these reasons, CEOs of Square, Paypal, MicroStrategy and Tesla have all adopted bitcoin as part of their strategic moats. This basket of superior traits has become too clear to miss. 

With the dollar inflating and the internet becoming more prominent, we expect an increase in the adoption of the Bitcoin Network. With negative real rates emerging across the globe and the strong precedent set by companies like MicroStrategy and Square, more individuals and corporations will turn to bitcoin as a store of value. This will solidify the collective belief in bitcoin leading to even more adoption. While it is difficult to predict how Bitcoin will appreciate if adoption continues, gold provides a useful benchmark. Bitcoin has a market capitalization of $1 trillion while gold’s is $10 trillion. If Bitcoin supplants gold as a store of value, then one bitcoin would be worth $500,000.

Blockchains

The supply of bitcoin is limited to 21 million because the Bitcoin Network uses a blockchain to record ownership. Blockchains allow computers to make commitments.¹ The decentralization of the underlying network makes this possible. The same code is distributed across each node in the network and a consensus algorithm ensures that the state of each node remains synchronized. Blockchain consensus algorithms require nodes to spend valuable resources, such as electricity, to participate in the network. Nodes that misrepresent the state of the blockchain forfeit said resources, securing the veracity of the blockchain. This diverges from the traditional model where software is controlled and executed by a central intermediary. While the central intermediary can modify the code as they see fit, code on the blockchain is immutable once it has been deployed to the underlying network.

Bitcoin exemplifies the value of independent computers that make commitments. While central banks engorge the money supply and commercial banks limit access to financial services, the supply of bitcoin remains fixed and the Bitcoin network services anybody with an internet connection. Code is simply less corruptible than humans with self-interest. 

As society grows more digital, the ability for computers to make commitments becomes paramount. This is clear when one observes the growing apprehension about the power of big tech companies. Their power resides in complete monopoly over the software, forums, and marketplaces that run our digital lives. Blockchains offer an opt-in bazaar against the grim backdrop of a FAANG cathedral.² Bitcoin is to the Federal Reserve as Web 3.0 is to FAANG.

We expect the internet to be redesigned around blockchains. Blockchains dis-intermediate software from big tech, enabling digital self-sovereignty. Digital self-sovereignty is the unalienable ownership of scarce digital assets by individuals. It is a paradigm shift that is stimulating a cornucopia of entrepreneurial growth. Technical talent is disproportionately sowing seeds in the soil of Web 3.0, generating a flywheel on innovation in the space. The undergird is laid and a rich ecosystem of blockchain applications is emerging.

The advantages of distributed blockchains will disrupt most major economic sectors, transforming the way we do business. Take financial services. Financial intermediaries buy, sell, and custody risk packaged as financial securities. These instruments are simply mathematical abstractions whose governance is better suited to code and whose trading is better suited to a direct P2P exchange. Obviating financial intermediaries via blockchains decreases fees and slippage and bolsters speed of exchange. Or consider cloud storage. Amazon, Google, and Alibaba benefit from immense economies of scale but act as wardens with carte blanche over the data housed inside their walls. Just as AirBnb monetized idle real estate, so do blockchain applications enable activation of slack storage on a distributed network of computers. Or finally, telecoms. It’s capital intensive to offer coverage to a new area. Planning, purchasing private land, construction, and ongoing overhead prohibit coverage in thinly populated areas. What if we could tap into the unused bandwidth of individual wifi nodes in the subject coverage area and reward those nodes for participation? As these use cases portend, an entire space of decentralized applications remains to be discovered. Blockchain is the next frontier and will disproportionately accrue capital and returns. This is Venice during the Renaissance.³ This is Philadelphia in 1775. This is the internet in 1994.

1. https://cdixon.org/2020/01/26/computers-that-can-make-commitments

2. https://en.wikipedia.org/wiki/The_Cathedral_and_the_Bazaar

3. https://allenfarrington.medium.com/bitcoin-is-venice-8414dda42070