Is Bitcoin The Next World Reserve Currency?

Welcome to the third and final installment of our crypto & macro series.

A quick recap of what we covered so far:

The first article explained the Dollar Milkshake Theory: a hypothesis why the dollar has been rising and will continue doing so in the future.
The second article analyzed the Bretton Woods III framework: a theory saying that dollar dominance will, on the margin, reduce and the dollar will fall.
The first theory would probably be bearish for Bitcoin and other crypto assets. The latter sees a future where non-fiat currencies like Bitcoin could play a part in reducing dollar dominance.

But this one contains no more macro mumbo jumbo — crypto and crypto only!

Massive global change is already underway because of the confluence of so many factors:

Financial and military wars are back.
Rich countries apply advanced financial alchemy to deal with their debt burdens.
Demographic factors that are about to plunge countries into more turmoil
Massive technological change, with AI spurring the latest bit of excitement.

This article will tie it all together — the macro theories, the maelstrom of developments, and where crypto fits in. Because change also equals opportunity. And crypto is often seen as a liability in this changing system — but what if it turns out to be an asset? More precisely, can Bitcoin become the world’s reserve asset?

Russia's President Putin certainly seems to think blockchain payments will have their place.

This article analyzes:

A theory advocating for the adoption of Bitcoin as a national security asset.
A theory that the US may eventually back the dollar with Bitcoin as collateral.
An assessment and critique of whether Bitcoin can become the next reserve currency and take a central role in the political and economic system.

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Bitcoin as a Strategic Asset for US National Security

If you want to learn about Bitcoin and its role in the US financial and political system, look no further than Matthew Pines. The man is a certified encyclopedia on these topics. This section borrows heavily from his work:

Pines' point in a nutshell?

Bitcoin needs to be considered as a failsafe in case the current order breaks down and the financial system goes with it. It can benefit the US national security and geopolitical interests and achieve three objectives:

Defend and nurture sources of national strength.
Promote favorable distribution of power (i.e., counter China).
Defend democratic values.

How's Bitcoin going to do that?

Good thing we read all of Pines' work, so you don't have to.

Doesn't apply here, keep reading.

Defending and Nurturing Sources of National Strength

Pines argues that Bitcoin can incentivize scaling up renewable energy sources and improve the resilience of the power grid. It is ideal as a controllable load control. This means Bitcoin miners can smooth spikes in the grid load, like buying electricity when there's too much and turning off their farms when the load drops. Because they can do that in seconds, miners are perfect as electricity buyers and sellers of last resort.

Moreover, the US has a net-zero emissions target for 2050. That means the economy can't produce more emissions than it is taking out. To achieve that, it needs a lot more 'clean' energy from renewables and potentially nuclear. And that means, we need a lot more 'flexible load' like Bitcoin miners (basically those who can switch operation on and off within seconds).

This chart shows why controllable load like Bitcoin mining matches best with 'volatile' energy resources like renewables:

All of that, says Pines, will be a massive boon to the US energy sector. It could even be a massive investment opportunity. Even better, Bitcoin is the "first truly accessible hard asset that can be acquired by anyone with a phone and internet."

TLDR:

Bitcoin mining is great for the grid because it's flexible.
We'll need a lot more sources like Bitcoin miners to meet net-zero emissions targets.
This strengthens the US energy industry and the power grid and presents an investment opportunity in Bitcoin and Bitcoin mining.

Promoting Favorable Distribution of Power

It's been going great for the US in the last 70 years. But now, the most credible challenger to its hegemonic rule thus far is rising: China.

To make a very long story sufficiently short, the US financial system isn't going that great. The very basic story of the last 40 years has been:

America buys stuff from China → China buys America's debt with the dollars it gets → America gets very cheap debt and can finance cool things with it.

But now, China and America aren't on as good terms anymore as they used to be. So China started weaponizing the dollars it still gets to buy equities and infrastructure abroad. For example, one-third of Vancouver's real estate market in 2015 was accounted for by Chinese buyers (Canada has temporarily banned foreigners from buying property). China's Belt and Road Initiative is basically China investing its dollars in infrastructure projects abroad. And then there's the whole de-dollarization issue, which Bretton Woods III goes into.

Pines’ argument:

If we need a new collateral asset, and if they all want commodities as collateral, a neutral digital commodity asset they shall receive: Bitcoin.

Bitcoin is objectively a digital commodity. And it just so happens that the US has a lot of advantages when it comes to this digital commodity:

US citizens own a lot of this asset.
US citizens own a lot of its production capabilities (miners).
Monetization of this asset would generate revenue for the IRS via capital gains taxes.

The argument goes that the US stands to gain the most from monetizing (=pumping) Bitcoin as an asset. As its adversaries slowly but surely try to move away from US debt as collateral, they are looking for alternatives. Gold is one, but remonetizing gold is a) more difficult because of its market cap and b) would help America's adversaries (they have a lot of it).

Combating analog gold with digital gold is Pines' proposal.

Moreover, digital assets would counter authoritarian CBDCs like the digital yuan. Stablecoins can help weaken these currencies and allow citizens to bypass capital controls. They could also generate demand for US treasuries as collateral.

TLDR:

The dollar as a global reserve currency was long a source of strength but is becoming a liability.
America's adversaries are trying to move towards other assets to become more independent, such as gold.
The US has a lot to gain by parrying their move to gold with a better offer: digital gold = Bitcoin.
Stablecoins can work with Bitcoin to weaken adversaries' currencies.

Defending Democratic Values

Pines argues that Bitcoin promotes American values. It is "freedom money."

This is arguably an overlooked and underutilized aspect of Bitcoin since it is used by political activists, refugees, and in countries with hyperinflation. Moreover, Bitcoin mining can drive local development projects for renewable energy. Many developing countries have the highest rates of Bitcoin adoption, and Pines makes the case that the US should lean into this from a 'PR perspective.'

Risks

Pines admits it's not all that easy. Neither is Bitcoin replacing the dollar anytime soon. It should be seen as a viable alternative that can be added to the current 'currency mix.' Risks include:

Fiscal policy would become more important the more Bitcoin gains as a reserve asset (similar to the gold standard era). That could mean more economic volatility but also fewer tail risks (i.e., less risk of a complete blowup but a more volatile business environment).
Bitcoin's governance as a permissionless network can be influenced by anyone. Nothing would stop America's adversaries from trying to frontrun the frontrunner.
Nations with mining input would also gain (Russia and China have significant mining potential).
There are unknown unknowns for domestic energy production and potential disruption from Bitcoin becoming a systemic factor.

One factor Pines does not mention, but we will cover, is that Bitcoin as a reserve asset would also open a new geostrategic attack vector.

Now it's time to look at the even more bullish case for Bitcoin: backing the US dollar.

The Bitcoin Milkshake Theory

Luke Mikic, a through-and-through bitcoiner, makes the case that Bitcoin will, in fact, drink the dollar's milkshake. His argument: Bitcoin follows the diffusion of innovations theory and will be adopted according to an S-curve:

Source

The theory borrows arguments from both Bretton Woods III and the Dollar Milkshake Theory.

The US needs new buyers for its debt because the old ones aren't interested anymore. Since faith in treasuries is being lost, America "needs a new reserve asset." You would rather this be Bitcoin than oil-backed yuan.

The logic goes something like this:

Emerging market currencies lose credibility and value during the currency wars, so their citizens move into stablecoins (DMT).
But at the same time, faith in the dollar is slowly eroding, and the debt burden becomes untenable (BW3).
The solution is to back the dollar with Bitcoin and stablecoins to be a bridge between these two systems. Faith in the dollar is restored (thank you, Bitcoin!) and emerging markets can enjoy stablecoins (yay!).

The key quote:

"Countries may trust a gold-backed (petro-)ruble/yuan more than a dollar backed by worthless paper. However, a bitcoin-backed dollar is far more trustworthy than a gold-backed (petro-)ruble/yuan."

However, the "Bitcoin Milkshake Theory" is a bit short on how this would play out in detail. Would the US government start buying Bitcoin as a reserve asset? Would it announce an official backing like in the Bretton Woods era? What about mining?

There are also some holes when it comes to the viability of Bitcoin as "outside money," i.e., being non-confiscatable. If the US has the majority of the hash rate and outsiders hold Bitcoin, how is that different from having gold stored in New York?

Moreover, if the US telegraphs its intentions to adopt Bitcoin in some shape or form, that would undermine Bitcoin's neutrality. It would make much more sense to covertly 'infiltrate' the network if the government were to follow that plan.

Still, you can see why bitcoiners would like that to play out.

Can Bitcoin Become the Next World Reserve Currency?

Both theories somewhat relate to the Bitcoin Nation-State Theory that many Bitcoin bulls subscribe to.

But how realistic are they? Can Bitcoin really become America’s and the World’s reserve currency?

There is some merit, particularly to some of Pines' points. But there are also holes in the arguments.

Backing Fiat With Crypto Won't Work

First, "backing" the dollar with Bitcoin in any sort of form would be an indirect admission of failure by the state. It could lead to an even bigger loss of trust.

Countries go off a commodity standard because trust in the monetary system is so high. But countries don't just casually go on a commodity standard. That means the currency is borrowing credibility from the underlying collateral (gold or bitcoin). Only a failing or a brand-new currency would have to do that.

So the idea that a state can espouse Bitcoin adoption is an antithesis to a state’s objectives: accumulating more power. Bitcoin is 'anti-state money.' When is the last time you remember politicians giving power back to the people?

Imagine the dollar is in a really bad place. President Millennial announces a Bitcoin backing. It may restore confidence in the dollar. Or it may lead people to ask why a dollar is needed in the first place if Bitcoin is the better asset and can fulfill the same functions. A Bitcoin-backing could lead to the cascade it tries to prevent.

Mining As an Attack Vector

As we discussed in the Bitcoin security model deep dive, the network's security may be somewhat wobbly in the long run. Adopting Bitcoin could open several attack vectors:

Putting it on a central bank balance sheet increases the incentive for adversaries to mess with the network.
So does mining as a strategically important industry.
Even without large-scale attacks, corporate espionage or small-scale attacks on mining farms have disruption potential.
As mentioned, having a majority of the hash rate in one country (US) reduces the asset's neutrality. On the other hand, not having a majority of it reduces its potential to be weaponized in the same way the current system can be.
States with cheap energy resources could try to do a "mining vampire attack" to gain hash rate share and subvert the entire system.

The state when mining reaches an equilibrium is hard to predict. Ideally, there may be a state similar to mutually assured destruction where no state has a decisive advantage. But for all the benefits mining may have on the grid, it also brings potential problems.

Why Use Bitcoin at all?

Both authors argue (correctly) that US treasuries are losing in appeal and outside money is in vogue now. Let’s even leave aside a potential CBDC, which at least the EU seems open to. Some of the financial system’s problems can be at least significantly delayed with a widely available reputable stablecoin:

It could generate demand for treasuries if so mandated.
It would spread the influence of the dollar.
Most importantly, stablecoins don't have a community of annoying, anti-state libertarians telling the government it sucks.

Even though Ethereum does not have the same potential energy production benefits as Bitcoin, spreading its influence and pumping its network value would make more sense from a state's point of view. At least Ethereum has a clear "support desk" (hi Vitalik!) you can turn to and influence.

The Devil Is in the Details

Clearly, this is not a topic you can confidently predict the details of. But there are some obvious questions that would need good answers before we can even think about moving in that direction:

What is the projected impact of mining with non-rivalrous energy? Are there feasibility studies to back it up with data?
How do we ensure the rent from mining doesn't only end up in the pockets of miners but benefits society?
How do we deal with possible negative externalities of large-scale mining? (unknown unknowns)
How do we deal with a growing debt burden and less monetary policy to counter it?

Even leaving aside the significant incentive problems, there are a lot of execution problems.

Societal Breakdown May Have To Precede This

Currencies fail because they lose all legitimacy.

This happens quite a bit in dysfunctional and de-facto failed states. But it's rare that developed nations see a complete collapse of their currency (Germany 1923 was still preceded by a war).

The state would have to have a positive tradeoff for backing (let alone replacing) the dollar with Bitcoin. A breakdown in trust in the US financial system means there is some serious stuff going on. Something like a civil war or a war with another country (and the US is losing it). The seigniorage from backing fiat with "trust me, bro" is not to be underestimated. It would take a lot for states to move away from this.

Some Redeeming Factors

After all this criticism, it's worth pointing out the good arguments.

First, Bitcoin as a soft power tool is highly underrated and underutilized. The government cheering for Bitcoin as anti-state money may be a bit like parents invading Facebook — it instantly becomes a lot less cool.

But there is something to be said for Bitcoin as "freedom money." The US' last few 'freedom exports' didn't go so well. But the technology and culture America exports are still in high demand. Bitcoin even does the branding for you!

Rather than opposing the influence of Bitcoin in countries like El Salvador or on the African continent, the US may want to think about how to use it for its own goals. Similar to how financial institutions like the World Bank and the IMF were used for economic colonialism, Bitcoin could have soft and hard power benefits. Why not counter Chinese influence in Africa by promoting Bitcoin and L2 solutions like Lightning? This would be a low-cost way with potentially massive business opportunities to bring countries closer into America's orbit.

Authoritarian countries like Iran are writing the headlines for the US when they freeze bank accounts of protesting women. Promoting the "freedom money" aspect seems like a no-brainer and a massive missed opportunity.

In the same spirit, the US is doing itself a disservice by dissuading countries like El Salvador from Bitcoin adoption. Instead, risky projects like volcano bonds should be seen as an opportunity to have a proof of concept that can later be exported elsewhere. Much of the negative externalities would fall on the local population as well. Rather than being afraid of Bitcoin's success, the state should get in on possible success stories and try to own them.

The missing link here seems to be between Bitcoin and stablecoins. Both theories underline the importance of stablecoins. But at the moment, the only link between Bitcoin and stables is CeFi. And we saw how well that was going in 2022…

If a crypto-native connection between the Bitcoin network and stablecoins can be developed, it seems that would have positive consequences for both BTC and USD.

Conclusion

Can Bitcoin become the next reserve asset?

There are some good arguments in favor and against Bitcoin playing a meaningful role.Either way, you should not expect quick results. Bitcoin finds itself for the first time in an environment of high inflation and great economic uncertainty. No one will make big moves before we don’t have some clarity on what’s behind that door.

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