This article is the second in a series on great macroeconomic trends and what they mean for crypto.
In case you missed it, the article on the Dollar Milkshake Theory and crypto explained the case for a strong dollar and not-so-strong crypto.
But not everyone agrees that the dollar is on course to drinking every other currency’s milkshake. In fact, a very popular theory argues the opposite: the dollar is destroying the trust it has built and will decline in the next few years.
This theory was popularized by Zoltan Pozsar, an economist at Credit Suisse that has dubbed his theory "Bretton Woods III."
This article looks at:
What Bretton Woods III is and where the theory comes from.
How Bretton Woods III could play out and if we are already in it.
Criticism of Bretton Woods III.
What Bretton Woods III means for Bitcoin and crypto.
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What Is Bretton Woods III?
Bretton Woods III is Zoltan Pozsar's theory of a new world monetary order that will be "centered around commodity-based currencies in the East that will likely weaken the Eurodollar system and also contribute to inflationary forces in the West." It follows Bretton Woods I, the exchange rate system established after WW2 pegging the price of the dollar to gold, and Bretton Woods II, the abandonment of that peg in favor of a free-floating dollar.
Pozsar expects the U.S. dollar to emerge weaker on the other side of "this crisis" (referring to the war in Ukraine but presumably also to a possible Taiwan crisis or war). He predicts "the renminbi [will be] much stronger, backed by a basket of commodities."
"From the Bretton Woods era backed by gold bullion, to Bretton Woods II backed by inside money (Treasuries with un-hedgeable confiscation risks), to Bretton Woods III backed by outside money (gold bullion and other commodities). After this war is over, “money” will never be the same again… …and Bitcoin (if it still exists then) will probably benefit from all this."
In a debate with fellow economist Perry Mehrling, he somewhat retracted this statement — Bretton Woods III would bea "reconsideration of what is a reserve."
Pozsar said he does not expect currencies to establish a link to gold or to a basket of commodities or even to unseat the dollar. Instead, states would reconsider what they see as a reserve and move away from U.S. treasuries and towards hard assets and commodities as reserves.
Where Does Bretton Woods III Come From?
The Bretton Woods III theory is an antithesis to the current monetary world order.
The current monetary order is based on the strength and liquidity of the U.S. dollar:
Its strength comes from the financial markets in the United States being the most mature and open in the world.
Its liquidity is backed by the depth of the dollar market, as well as the depth of the eurodollar market. Eurodollars are dollars created outside the United States (think of them like a fiat version of USD stablecoins.)
Thus, even though the dollar is not 'backed' by anything, it is the most trusted fiat currency in the world.
Bretton Woods II, a monetary order that backed fiat currencies partially with gold, fizzled out in the 1970s. Following Bretton Woods II, capital flows around the world increased: most of these capital flows were in U.S. dollars. The oil trade being almost exclusively in USD played a significant role and established the "petrodollar."
Over time, the U.S. became a net importer of commodities and consumer goods, while other countries and regions became exporters of commodities (Middle East: oil) and consumer goods (China: stuff). These exporting countries got paid in dollars and recycled them by investing in U.S. equities (stock market) and U.S. treasuries (debt). All was going well until...
The U.S. pulled the rug under Russian central bank assets after the start of the war in Ukraine.
Pozsar and many other U.S. dollar bears see this as the catalyst — they expect the appeal of "outside money" (like gold and commodities) to rise at the expense of "inside money" (confiscatable assets like US treasuries).
How Could Bretton Woods III Play Out?
Here are Pozsar's predictions of what will happen as Bretton Woods III emerges:
Although Pozsar doesn't predict the collapse of the U.S. dollar, he foresees a decline at the expense of other currencies. As a result, multiple global currencies may compete: some partially backed by "outside money" like commodities, and others backed by "inside money" like credit.
Has Bretton Woods III Already Begun?
Hard to say.
But we can compare Pozsar’s predictions to the facts on the ground to check if they are playing out.
Prediction: Inflation and interest rates in the U.S. will rise.
Reality: True. U.S. consumer price inflation has slowed a bit towards the end of 2022, but is still at multi-decade highs. Interest rates are forecasted to go to 4-5% in 2023.
Prediction: the demand for foreign currency reserves, particularly for those of geopolitical rivals, will fall.
Reality: (partially) true. The U.S. dollar share of global FX reserves was 59.5% in Q2 2022, down from 65% in 2016. Meanwhile, the yuan share of global reserves has risen from 1% to about 3%. So the dollar dominance is still massive, albeit falling slightly.
Prediction: supply chains will become less efficient and more aligned with national security interests.
Reality: true. All points to more fragmented supply chains in the near future, from the U.S. sanctions on the Chinese tech sector to the EU getting liquid natural gas from the U.S. to Chinese exports to Russia surging:
Prediction: commodity exporters will increasingly demand payment in non-dollar terms.
Reality: true (on the margin). The yuan’s share of Russia’s forex market is up to 45% in November 2022 (from only 1% in January). Meanwhile, Saudi Arabia is considering the yuan as means of payment for oil exports. And Vladimir Putin said he’d fancy a blockchain-based settlement network.
Prediction: the demand for commodity reserves will rise as countries hoard them to become more autarkic.
Reality: true, but it’s complicated. On the one hand, blocs like the EU are scrambling for energy commodities. Ironically, the EU — afraid of being locked out of Russian energy — is importing more liquified natural gas from Russia than ever before. Also, central bank gold reserves are bouncing back to record levels. On the other hand, non-dollar trade is still a tiny fraction of dollar-denominated trade.
Still, overall Pozsar’s predictions seem off to a good start. But not everyone agrees with his takes…
What Do Critics Say About Bretton Woods III?
Bretton Woods III has attracted a fair share of criticism. China expert Michael Pettis outlined several reasons why he thinks the framework doesn’t work:
It’s difficult to execute for America’s adversaries.
It would require massive changes to the economic modus operandi of several countries.
Accumulating commodity reserves would be pro-cyclical and wouldn’t make economic sense.
He also contends that America’s adversaries are, in fact, happy with America also carrying the economic costs of a reserve currency. Countries like China, the only rival that is big enough, don’t even want the transparent corporate governance and free capital controls needed to rival the dollar.
Michael Every from Rabobank echoed these points in an extensive rebuttal of Bretton Woods III. His takeaway:
“In short, BW3 is not looking like a global alternative to USD – just a cluster of Chinese hub-and-spokes offset/barter trades trying to avoid USD as middleman.”
Every’s argument is that the theory makes for a good narrative, but dollar dominance will remain, even if slightly weakened. His main points in a nutshell:
Governments won’t want to give up the conveniences of unbacked fiat (read: money printing) for a commodity standard.
Other currencies lack the trust or scale of the USD and the yuan is soft-pegged to the dollar anyway.
Many minerals, food and energy exporters are not aligned with either side.
The commodities trade is only one-fourth of global trade and not as important globally as it's made out to be.
The U.S. may be actually happy with sharing some of the costs of a global reserve currency.
The only way this could happen is if the dollar lost all credibility and collapsed or if the U.S. shuts out foreigners from its markets.
However, there may be a third way between dollar collapse and dollar dominance…
What Bretton Woods III Means for Bitcoin and Cryptocurrencies
Have you ever heard of the Bancor? (the system, not the cryptocurrency)
The Bancor is a synthetic supranational currency that consists of a basket of currencies and was proposed as a global unit of account. It never really caught on, but now, there is something similar but better: crypto.
Many a Bitcoiner’s dream is for BTC to become the global unit of account (and currency). Conveniently, Bitcoin offers the alternative payment system that some countries are looking for if they want to move away from the dollar.
Can Crypto Benefit From a Bretton Wood III System?
Well, it’s complicated. On the one hand, crypto could become an alternative payment system or even a global reserve. Bitcoin, as a digital commodity, could become a marginal addition as a central bank reserve. Even a Harvard University research paper recommends Bitcoin. On the other hand, there are significant downsides for nation-states to adding Bitcoins to their reserves, as we explored in the Bitcoin Nation-State Theory. The more BTC is seen as a digital commodity and not a speculative asset, the less volatile it will be, and vice versa.
Since states are the most risk-averse actors, logic would dictate that they’ll be the last to adopt Bitcoin as reserves. As long as individuals and the private sector don’t see it as a reliable store of value, neither will states. Even in countries like Argentina, which has a massive inflation problem, Bitcoin is not sought-after as a medium of exchange or store of value. Instead, stablecoins are the name of the game.
Cryptocurrencies, as a whole, add to the dominance of the dollar. Stablecoins are an organic way of getting your hands on synthetic American dollars — how else would an Argentinian be able to save their wealth from rampant hyperinflation?
Thus, crypto, and specifically stablecoins, put the breaks on a Bretton Woods III-type of order. For individuals, the choice is easy: no matter how much someone from a developing country may dislike the “American Empire,” they still acknowledge the utility of its currency. For corporations, it’s not much different. Why deal in yuan when you can deal in stablecoin? Profit trumps ideology for corporations, so they would probably choose doing business in stables over yuan.
Of course, stablecoins have their own scaling and sanctions challenges. They are just as liable to be blacklisted or targeted by sanctions as “real” dollars. The current market capitalization of USDT/C does not support major trade invoicing, neither is it offered as a currency option.
However, states will struggle to prevent citizens from getting access to this liquidity. Lyn Alden aptly illustrated this point in a little thought experiment:
The U.S. will be only too happy to undermine the financial stability of authoritarian countries through stablecoins. A regulatory push that approves and supports certain USD stablecoins seems therefore likely in the medium term.
Can America Leverage Cryptocurrencies To Support the Dollar?
The Dollar Milkshake Theory made the bull case for the dollar. Bretton Woods III outlined the bear case. But is there a crypto bull case somewhere between those two theories?
We’ve seen parts of both theories play out already: the dollar surging higher and states buying up gold and dealing in other currencies. The latter in particular suggests that crypto could play a bigger role in the changing world monetary order.
In the final installation of the crypto & macro series, we look at how the U.S. could leverage cryptocurrencies for its national interests. Read about it here.
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