The world economic system that the US has dominated since WWII, first through Bretton Woods I (US run gold exchange window for nations from 1944–1971) and then Bretton Woods II (a petrodollar system with US Treasury Bonds (USTs) as the world reserve from 1973–2022) is ripping at the seams. The cornerstones of the petrodollar system, stable USTs’ oil purchasing power over time and dollar-denominated energy trade, are in doubt.
USTs, the supposedly risk-free reserve asset held as the main foreign reserves of central banks to underpin international trade, are having their worst monthly performance in 42 years. Countries are terrified for their own foreign reserves after Russia’s were seized on February 26th of this year. Russia, Iran, and Venezuela no longer sell their oil in dollars. Even the Saudis are openly talking about no longer exclusively selling their energy in dollars(1). Just like in 1971, the US has defaulted on the dollar’s reserve asset. What replaces USTs as the basis for international trade may take years to determine.
Will another fiat currency like the Chinese Renminbi replace the US dollar, as the dollar replaced the British pound? Will the world return to a system backed by hard money like gold, Bitcoin, or some basket of assets (potentially commodities)? Will multiple competing currencies exist simultaneously, like silver and gold did for thousands of years?
To get a sense of what asset, or potentially assets, will underpin global trade in the future, we must first understand what money is and what monetary systems have already existed. I will start with a quick overview of monetary assets: what their properties are and how they differ from other assets. I will then describe the Bretton Woods I and II systems before delving into the Bretton Woods III system that is emerging: a global Americanized cyber-economy.
A Brief History of Money
Monetary assets have fundamentally different properties from the other two main classes of assets: consumptive assets and productive assets. Consumptive assets are meant to be consumed. Think food, consumer electronics, cars, gasoline. Productive assets mainly exist to create those consumptive assets. Think farms, factories, oil refineries.
Consumptive and productive assets can be monetized—i.e. the asset can be bought not to be consumed or to produce but for monetary reasons. This usually happens when the existing money lacks some valuable monetary property. In America, housing is an obvious example. Dollars lack good saleability across time (i.e. their purchasing power decreases over time) so we see millions of Americans buying houses not just to live in but also to protect future purchasing power. Anything can be used as money. Humans have used glass beads, sea shells, copper, iron, silver, gold, giant rocks, tobacco, cigarettes, stock indexes, sovereign debt, and metal roofing (just to name a few) as money(2). The assets with the best monetary properties tend to outcompete other monies in the long run, however. So what exactly makes something a good money?
The core monetary properties are saleability across time and saleability across space(3). Saleability across time is how well the asset retains purchasing power into the future. If I put a dollar into the bank today, how much stuff will that dollar buy me in 10 years? A good way to tell an asset’s saleability across time is to check its stock-to-flow ratio—i.e., how much of it exists today relative to how much is, or could be, made of it each year? Bitcoin and gold both have stock-to-flows of about 60, meaning that the total amount in existence of both is 60 times greater than the amount typically mined each year(4). Many of the world’s top commodities like oil or iron only have a stock-to-flow of only about 1.5-2. If an asset with a low stock-to-flow is monetized, it’s easy to inflate the supply and steal some of that monetary value. It’s not too surprising then that gold outcompeted so many other assets to become the world’s dominant money by 1914. Gold itself was outcompeted in the 20th century, however, because it has terrible saleability across space.
The difficulties of transporting and verifying gold necessitated the development of paper money, which subsequently unseated gold when conversion of paper money for gold was suspended. To verify a gold coin or a thin bar requires a spectrometer, which costs about $10,000. To verify one tonne of gold requires melting it down. By trading gold redemption certificates instead of physical gold, paper money overcame these issues. Gold was stored at centralized bank vaults and people could conveniently exchange paper bills that are easy to move and of which it is easy to spot counterfeits.
As gold became centralized it became an easy target for governments in need of revenue.
Figure 1. Monetary Gold Stock of the United States Over Time
During World War I, the European powers suspended gold redemption, confiscated private gold from bank vaults, and issued unbacked paper in exchange(5). Their issuance of paper money far outstripped their gold reserves. Rather than massively devalue their currencies after the war to get them in line with gold reserves, countries forsook gold redemption altogether. WWII put even larger strains on governments and by the end of the Second World War they had no willingness to allow their citizens to ever redeem this huge quantity of paper money for gold. A new monetary system was needed.
Bretton Woods I
As the Allied victory in WWII became clear by July 1944, delegates met at the Bretton Woods resort in New Hampshire, at what was known officially as the United Nations Monetary and Financial Conference, to devise a new monetary system(6). The US advocated for a dollar-denominated gold exchange system. Global trade would run on the US dollar which would be pegged to gold at $35/oz. In exchange, countries but not individuals could take their dollar surpluses and exchange them at the US Federal Reserve for physical gold. The British, led by John Maynard Keynes, advocated instead for a supranational unit of account, called “Bancor,” based on a basket of commodities held by the world’s largest economies—rather than on just the US dollar. The US with its dominant military and nearly hegemonic control of industrial production, gold reserves, and commodities won out, and the first Bretton Woods system was born.
Bretton Woods I slowly destabilized over time as the US ran budget deficits to fund numerous wars and a large expansion of its welfare programs. The newly rebuilt European powers grew uneasy as the supply of dollars outstripped the US’s gold reserves. They began to steadily redeem more and more physical gold from US federal vaults. To balance the supply of dollars with the US’s gold reserves, the Europeans urged the US to devalue the dollar from $35/oz to a rate three to four times that. Instead, on Aug. 15, 1971, with US gold reserves at just a sixth of their 1944 levels (Figure 1), President Richard Nixon shocked the world by announcing the “temporary” suspension of the gold exchange window(7).
Without a trusted gold-backed money, inflation accelerated across the world. The future of money as well as global trade was in doubt. The US was still the unrivaled military power but it no longer had the gold or industrial supremacy that it had held in 1944. Its energy production was now dwarfed by the booming middle eastern oil fields. In this American power crisis, the Secretary of State and National Security Adviser, Henry Kissinger, tasked the undersecretary of the Treasury, Paul Volcker, with developing a new value proposition for the dollar that could curb global inflation while maintaining the US’s hegemonic position(8).
To maintain the dollar’s critical role in the global economy Volcker struck upon the novel idea of redesigning the dollar to have a stable peg to the price of oil rather than the price of gold(9). In exchange for military guarantees, the US quickly inked agreements with the major oil exporters, mainly Saudi Arabia and Iran, that they would accept only dollars for their oil. To supply the world with the dollars needed to buy this oil, the US had to run deficits. For example, Germany needed to earn dollars via trade surpluses with the US so that it had dollars to go buy oil from Saudi Arabia with.
The inflationary impact of these dollar deficits would be tamed by having creditor nations recycle their dollar trade surpluses into US Treasury Bonds. Creditor nations sometimes bought these US Treasury Bonds in return for explicit security guarantees (in the case of the Saudis) or because of the interest rates the bonds provided. (Using cryptocurrencies as an analogy, the petrodollar is thus an oil stablecoin that uses the rewards from staking the token (interest rates on USTs) to maintain the peg.) Suddenly the gold-rich but energy-poor Western European powers and the other industrial power, Japan, had to scramble to buy dollars. To ensure the oil markets were large enough to underpin global trade, Kissinger worked with the Arab allies to have oil prices quadruple in 1973. The petrodollar was born(10).
Bretton Woods II
As the first global fiat currency not backed by a hard money like gold or silver, this Bretton Woods II petrodollar system was a phenomenal success. From 1973 through 2005 the dollar maintained a peg to oil of $15-30/barrel (Figure 2). Whenever the peg was in danger, such as in 1979, the US responded by increasing interest rates on USTs (Figure 3). Higher returns for holding USTs incentivized capital to move into USTs, strengthening the
Figure 2. Spot Crude Oil Price: West Texas Intermediate
Figure 3. Federal Funds Effective Rate
dollar relative to energy prices. The US maintained its hegemonic position while the world had a stable unit of account for trade and a reliable store of value in their US treasury holdings. Bretton Woods II eroded the real US economy. Because the dollar was the reserve currency the dollar was relatively strong, weakening US exports and causing the US to import more and more of the goods it needed. Trade deficits steadily rose and then accelerated with the North American Free Trade Agreement (NAFTA) in 1994 and the admittance of China into the World Trade Organization (WTO) in 2001 (Figure 4). The bright spot for the US economy was digital growth and global finance that boomed during the 1990s.
The bursting of the US dotcom bubble in the early 2000s put enormous strain on the US economy. To minimize the impact on the domestic economy the US decided to recover from the dotcom crash by printing large amounts of money, intentionally inflating the US housing market(11). The increased supply of dollars inflated oil prices above its $15-30/barrel peg in 2005(12). Now the US was faced with the choice: damage the domestic economy by increasing interest rates or risk destabilizing the petrodollar by failing to maintain the oil peg. Unlike in 1979, the US decided to put the domestic economy ahead of supporting the world reserve currency by failing to sufficiently increase interest rates. Worse, as the housing market crashed in 2008, the US responded by further cutting interest rates, calling into question the value of the trillions of dollars of USTs held by foreigners.
The world responded to this weakening of the reserve currency by beginning to diversify away from USTs. In 2013, the Chinese announced their Belt and Road initiative(13). Instead of recycling trade surpluses into USTs the Chinese would now invest in hard assets such as infrastructure and commodities in the developing world. Facing sanctions for its 2014 annexation of Crimea, Russia began to swap USTs for physical gold and began to rapidly increase the share of its non-dollar denominated energy exports(14). Another two large oil exporters, Iran and Venezuela, saw themselves cut off from the dollar system and likewise moved to non-dollar energy trade.
The US responded to this decrease in foreign demand for USTs by regulating its domestic banking industry into buying more USTs(15). This kicked the can down the road for a few years, but by autumn, 2019 the banking sector had had enough. The critically important interbank lending markets seized up and interest rates spiked. The Fed moved in to save the banking sector by providing trillions of dollars of liquidity through the standing Repo Facility, a system where banks can lend their USTs to the Fed in exchange for dollars, essentially making USTs and dollars interchangeable. The Fed maintained this unprecedented level of support throughout the fall of 2019 and into the spring of 2020.
Suddenly, in March 2020 the COVID-19 pandemic that had spread quietly in China for months exploded into Europe. Italy, the world’s eighth biggest economy, locked down their entire country overnight. Soon the rest of the world followed suit. The global economy ground to a halt. Credit markets seized up. The stock market crashed. The Fed responded with limitless liquidity, buying not just USTs but mortgage backed securities and corporate debt. Not to be outdone, Congress passed unprecedented spending bills that dwarfed the rescue packages of the Great Recession of 2008(16). Trillions were handed out to businesses and hundreds of billions in direct stimulus to individuals.
Figure 4. Balance of Current Account and Trade Balance Over Time
COVID-19, and the global response to it, had profound impacts on the world economy. The US now has a debt to GDP ratio of over 120%, an annual trade deficit approaching a trillion dollars, and unfunded entitlement and pension obligations of well over a $100 trillion that are rapidly coming due as the Baby Boomer generation retires (Figure 5). US annual spending on debt servicing, entitlements, and defense now outstrip tax receipts, even with tax receipts at record highs. CPI, the most common measure of inflation, is now running the hottest it has been since 1981(17); and if you use the original CPI methodology, inflation is higher now than at any point in the US since the American Civil War(18). Despite this inflation, the Fed’s Federal Funds Rate, the key rate that banks charge each other to borrow overnight and which typically drives US treasury bond rates, is only at 0.25%, implying more than a negative ~8% real interest rate. This means that holders of USTs have actually been rapidly losing purchasing power over time. The 40 year bond bull market that kicked off in the early 1980s is over and we appear to be entering a period like the 1940s where bond holders suffered large purchasing power losses.
In response, the Fed said it would begin to aggressively raise interest rates. But can it? Each 1% rise in interest rates leads to $300 billion more the US federal government has to spend on its debt interest payments. The impact on the housing market and credit markets would also be profound. Already more than 20% of US businesses spend all of their net income on servicing their debt(19). Even a small 2% or 3% increase in rates would cause a large recession. That was the US situation at the beginning of 2022. Then on February 24th the Russians invaded Ukraine.
The western world and its allies (US, Europe, Japan) responded to Russia’s invasion of Ukraine by suspending $300 billion of Russia’s foreign reserves(20). This meant that Russia could not access its funds for any reason such as purchasing goods or settling debts. The freezing of Russia’s foreign reserves amounted to a US default on the foreign reserves that had backed the dollar for decades. No longer were foreign reserves risk free. The slow-acting sickness plaguing Bretton Woods II that started when the US failed to protect the oil peg in the 2000s is metastasizing and threatening to kill the entire world economic order.
Now, like in 1971, the US has again defaulted on the asset backing the dollar currency. USTs are selling off aggressively, but it will likely take years to transition to a new world monetary system. The question is, what replaces the petrodollar?
Figure 5. US Annual Spending on Entitlements, Defense, Interest Payments versus Tax Receipts
What Replaces the Petrodollar
The only country that anyone argues has a chance of replacing the US as the unilateral issuer of a world reserve currency is China. Hedge fund manager and investment philosopher Ray Dalio, in his 2021 book Principles for Dealing with the Changing World Order, claims that the Chinese renminbi will eventually replace the US dollar as the world reserve currency due to China’s booming manufacturing industry(21). What Dalio misses, however, is that China lacks the dominating control of world trade and military power that the British and then the US used to maintain control of the world’s reserve currency.
Britannia ruled the waves, and thus key trade routes, for the entire period of the pound’s dominance from the end of the Napoleonic Wars in 1815 until the start of WWI in 1914(22). They also secured key rail routes and the critical economic resource of the 20th century, oil. The high levels of British war indebtedness and the emergence of the US as the largest post WWI economic and military power spelled the end of the pound as the reserve currency, but it took another world war and almost 30 years for the dollar to supplant it(23).
The US hegemon used similar tactics to the British Empire: It controlled the oceans and monopolized the oil industry. Like the British Empire it was also able to project military strength across the globe, mixing carrots and sticks to keep countries in line(24). Increasingly, it has moved to dominate the emerging economy of the 21st century, the cyber economy and the microprocessors and raw human information technology talent that fuel it.
The Chinese are in a comparatively weak military and economic position. They lack control of trade routes. They barely have control of the waters around them. They’re boxed in by Taiwan, Japan, the Philippines, Australia, and India—all hostile countries with military alliances with the US. Not only do they have a weaker military than the US, they’ve never shown the ability to project power. This makes Chinese control of the oil regions in the manner the British and US exercised highly unlikely.
When it comes to the 21st century cyber-economy, the Chinese are further behind still. The US dominates software development, attracting the top talent from around the world. The Chinese run a firewalled version of the internet with heavy censoring. US protectorates, Taiwan and South Korea, control the advanced microprocessing production and the US has already announced plans to onshore key portions of that microprocessing production. Chinese microprocessing is still small-scale and primitive. Without control of the keys to 20th century power or the prospects to control the 21st levers, China will not be the world’s sole reserve currency issuer.
A Bancor System Threatened by The Cyber Economy
Given there is no single country with the power to replace the US as sole reserve currency issuer, I anticipate a multiyear period where the largest nation states adopt a Bancor-like currency system while an Americanized cyber economy steadily gains market share over industrial economies.
The Bancor currency is the model devised all those years ago by Lord Keynes, which lost out to the gold-backed exchange window the Americans chose at Bretton Woods. Bancor is a multinational currency backed by a basket of commodities(25). Each country’s share of that currency would be tied to the size of their economy and trade deficits would cause Bancor surpluses or shortages that countries would then adjust to balance trade. The exact commodities that would make up that basket are unclear. Likely some share would be gold and some oil. Bitcoin, rapidly gaining US and foreign government acceptance, could easily form some fraction as well. While I think it likely that the large economies try some version of Keynes’ Bancor system, getting it to stick will be extremely difficult in a climate of low trust, high indebtedness, and outright military conflicts. The Gold Standard system had been functioning well for decades before it fell apart in the first month of WWI.
This Bancor system would be attempted under even worse conditions. Global debt in the world is four times global GDP (Gromen, FFTT). That means that if interest rates on that debt average 4%, the world would have to grow 16% annually just to keep pace with debt servicing costs as a share of GDP. That’s not happening. Instead countries will continue to aggressively inflate their currencies to undermine the real value of the money that they owe; essentially another soft default similar to what happened after the last two World Wars. In addition, average tax rates globally will likely increase, especially as more and more capital flees the rapidly inflating currencies. Many currencies will likely not survive this period. We’ve already witnessed the collapse of the Argentine peso, the Venezuelan bolivar, the Lebanese lira, the Turkish lira, and the Sri Lankan rupee.
The rapid growth of the cyber-economy made up of both legacy internet companies (Web 2.0) as well as emerging cryptocurrencies and crypto companies (Web 3.0) presents a challenge to a Bancor system, and also challenges the ability of heavily indebted nations to increase tax revenues. The crypto economy grew from just $14 billion in 2017 to over $3 trillion in November 2021(26). Meanwhile, Web 2.0 has multiple trillion dollar companies. Both sectors are highly mobile. Jobs can be done remotely from anywhere. If a nation tries to attack them, the capital, intellectual property, and even workers could move out at a speed unprecedented for nations used to negotiating with lumbering industrial conglomerates.
The cyber economy will continue to grow and capture market share from the legacy economies of the 20th century. The cyber economy is not burdened by regulation. It can relocate to where taxes are low while attracting world class talent from anywhere in the world. All the while its participants can store their wealth in new cryptocurrencies that are censorship and seizure resistant. Apart from kidnapping someone and forcing them to reveal their encryption keys (not a very scalable process) cryptocurrencies like Bitcoin and Ethereum cannot be confiscated. For the first time in history there are assets that allow immigrants to bring all of their wealth with them. All they have to do is memorize twelve words. This checks the ability of the state to implement high taxes or confiscate wealth, as FDR did when he confiscated gold in 1932, or as banks routinely have done when their currencies have collapsed (see Cyprus, Argentina, Russia, Lebanon).
Much of the software underpinning this cyber economy has been built by Americans, recent immigrants to America, or those who align with American values. America has successfully brain-drained much of the top software developer talent in the world. In addition, America now accounts for 35% of Bitcoin mining activity(27). Wyoming was the first jurisdiction to legalize decentralized autonomous organizations (DAOs) and several US states are moving to recognize Bitcoin as money(28). America has a massive human capital and cultural advantage entering this shift from the industrial age towards the cyber economy and is likely to reap much of the rewards.
We’re still in the early days of this transition to the cyber economy, though. Transitions are often messy. Maintaining flexibility is wise. As entrepreneur and philosopher Balaji Srinivasan advises, “rent physical and own digital.” It’s impossible to know how things will shake out. While Europe fell apart during WWII, many of those who made it to America ahead of time did quite well. With crypto assets you have an even easier time of it, because you can bring your wealth, your talents, and your business to whichever jurisdictions end up championing this transition.
The macroeconomic paradigm that the world has known for the past 50 years is in the process of collapsing. Major shifts like this can be frightening. But as always in such scenarios, the shifting tides also reveal opportunities to be exploited.
by Philip Galebach