Dog Coins to Trillions or Global Depression: Boomers take the Wheel. The rise of Fiscal Dominance
Given the increased debt burdens of developed nations, interest rates this high are likely unsustainable.
Governments will need to return to easier monetary policy to ensure that government demand for funding does not crowd out the private sector.
Expect an eventual return to QE, or a move to Yield Curve Control (YCC)
Such a move should again increase the supply of money, be inflationary, and provide a strong backdrop for crypto assets.
Tracing the Path: From the Global Financial Crisis to Post-Covid Economics
Aside from regulatory considerations and consumer adoption trends, perhaps no other variable is as important in predicting crypto cycles as the macroeconomic backdrop. In this piece we take a 30k foot view and draw some inferences as to how macro and by extension the monetary system could impact the path of crypto in the intermediate term which we will define here as the next 18 months to 3 years.
Before laying out the thesis, we need to provide a bit of historical context to explain how we got to this point today.
The Global Financial Crisis that began in 2007 ushered in a period where developed economies introduced extraordinary tools to prop up the financial system and restore confidence. The two principal policies on the monetary side were: 1) interest rate cuts; and 2) Quantitative easing (QE).
Lower interest rates reduce the cost of capital for financing debt and by extension boost lending. Quantitative easing is the process by which central banks buy back government bonds – removing less risky assets from the market in exchange for cash. As they cut interest rates and buy bonds back the return available from these risk-free assets falls (risk premia attached to these investments shrinks), forcing investors to take far more risk to reach their required rates of return. This not only adds liquidity to the system, but it spurs risk taking.
On the fiscal side, the government cut taxes and pursued infrastructure spending to spur job creation and increase aggregate demand.
These tools have been used frequently in the post-GFC world. They have succeeded in repeatedly stabilizing economic growth but perhaps more pointedly in elevating asset prices. They have had an immense impact on driving wealth inequality.
Low interest rates and QE greatly benefit capital (asset owners) over labor (income). Lower interest rates not only make leverage more affordable, but they drive up the multiples on long duration assets (for example tech stocks, crypto, and housing).
Post-GFC the next biggest economic test was the Covid crisis.
Juggling Debt, Interest Rates, and Inflation: The Tightrope of Modern Economies
Developed markets, led by the US, responded with a double-barreled approach of both monetary and fiscal policy. On the monetary side, they cut interest rates, did QE, opened several credit facilities and made direct asset purchases. On the fiscal side, they did business loan forgiveness and direct checks to households.
Combined with supply chain bottlenecks, the impact of fiscal and monetary measures this time flipped developed markets from a disinflationary bias to the first real bout of inflation since pre-GFC.
Below you can see a visualization of US Core Inflation (ex-energy and food) measured year over year since 2002.
The US historically targets price stability with an inflation target of around 2%. Well why is any of this relevant?
Because as developed markets have shifted post Covid from a disinflationary bias to an inflationary bias all the extraordinary policy tools used in the post-GFC period suddenly bear a much higher cost.
In the last 18 months the US Federal Reserve has embarked on an aggressive campaign to reign in inflation. The primary means of managing this has been to raise the federal funds rate (risk free rate) from essentially zero to 5.33%. This has a major impact on the pricing of long duration assets, or anything that’s growth is discounted well into the future.
The easy decision post-GFC was for governments to issue lots of debt with interest rates so low. If interest rates are low high debt burdens are not problematic; however, the combination of a high interest rate and high debt burden puts many sovereign nations in a precarious spot.
And that is the problem we face today. US Debt to Gross Domestic Product (GDP) is pushing 120% and this does not include off balance sheet liabilities (like entitlements) which will start to come on balance sheet in the future.
Aggregate federal debt is now pushing 32tn. The US is now issuing and refinancing between 700-1Tn of treasury debt per quarter. The US federal budget is forecast to be $6.4tn in 2023. 1.5tn of this is the forecast deficit as of May. This means the 12m forward run rate for interest expense is forecast to be around 1tn. This is in excess of 15% of the US Federal budget. Or measured another way nearly 25% of forecast tax revenue!
Fiscal Dominance: Navigating the Balance between Inflation and Deflation
Fiscal dominance is not a term most of us in developed markets recognize. But no doubt we are now entering a period where it will become something we will all need to understand. The US is running greater than a 5% deficit in a non-recessionary environment. It will be very difficult for deficits to shrink from this level given the growth in entitlement spending that is on the horizon. This says nothing about a left tail event like a hard recession or another pandemic causing a real blow out in deficit spending.
Fiscal dominance is best defined as the need for governments to fund deficits by printing money. It is essentially an “inflation tax.” It is where monetary policy takes a back seat to fiscal policy to ensure the government can properly fund itself. Price stability becomes secondary to the spending obligations of the nation.
How does crypto fit into all of this? Fiscal dominance is likely to lead to more persistent inflation, particularly if the printing of money outstrips the production of goods and services. It will also entail growth in the supply of money.
While the US is presently attempting to shrink the size of its balance sheet and keep rates higher for longer to tame inflation, intermediate term it is more a balancing act. If the economy slows too much and by extension tax revenue drops and the deficit widens, then the debt burden also worsens as you have less revenue to cover the cost of interest expense.
What is the way out? There are a few. The best way would be a productivity miracle shows up like the internet in the 90s. Perhaps AI eventually does help in this regard. But it is best to be realistic about the medium term and not pray for miracles.
Aside from productivity miracle, there are really only two paths out of this – a debt jubilee where we start to allow defaults and work down the excesses of a 70yr debt super cycle (this would probably entail a very messy 10 to 20 years), or print more money and allow a persist period of higher inflation where real yields are modestly suppressed to allow the debt to be monetized to a level where more ordinary monetary policy is possible in the future.
Given older generations own most of the wealth it is unlikely they will opt for a deflationary bust. They will likely vote to protect their own standard of living. Hence with time it is likely governments will choose inflation over deflation as no government is going to willingly allow itself to not meet its spending needs. We are presently in a moment where interest rates are high and monetary policy is not all that accommodative. But it’s easy to see given the funding backdrop for governments that that policy should change in the intermediate term. If push comes to shove its likely boomers will choose dog coins over deflation.
Anticipating the Future: Role of Cryptocurrencies and Yield Curve Control
The most likely outcome is developed nations will need to help the private sector fund the deficit. This likely means a return to QE or perhaps this time YCC – a process in which the government agrees to purchase all debt above a certain yield threshold. Japan has been in YCC for 20 years. Short of this, as the debt burden continues to grow private sector investors may require higher and higher interest rates to purchase treasuries and this would crowd out other private sector investments.
Real yields pictured below are the compensation investors receive after inflation is factored in. Overly simplified, if real rates are higher than the real growth of the economy it’s likely the debt burden is growing relative to GDP. If real rates are lower than the real growth of the economy conversely the debt burden could be shrinking.
A persist period of negative real rates (otherwise known as financial repression) can be used to reduce or monetize the debt burden by “inflating it away.” This would likely be accompanied by a sustained period of above target inflation.
Suffice to say a period of yield curve control where governments are forced to become the biggest buyers of government debt is likely an environment where your focus goes from thinking about real returns to being more focused on nominal returns, or not losing purchasing power.
This would be an ideal backdrop for crypto assets as many crypto assets work as an escape valve for excess liquidity.