Fiddle Didi. Source: AFP/Getty Images.
“Investors have to rethink the entire China structure,” David Kotok of Cumberland Advisers said last week. For Hong Kong, the One Country, Two Systems principle was “dead.” As for the crackdown on some of the nation’s tech giants, the Beijing government’s treatment of Alibaba “is not a one-off. Neither is DiDi. Everything China touches must be viewed with suspicion.”
Wait, you’re saying that investing in the other side in the early phase of Cold War II might have been a bad idea? You’re telling me that “long totalitarianism” was not a smart trade?
For the past three years, I have been trying to persuade anyone who would listen that “Chimerica” — the symbiotic economic relationship between the People’s Republic of China and the United States of America, which I first wrote about in 2007 — is dead. The experience has taught me how hard it can be for an author to kill one of his own ideas and replace it with a new one. The facts change, but people’s minds — not so much.
Chimerica was the dominant feature of the global economic landscape from China’s accession to the World Trade Organization in 2001 to the global financial crisis that began in 2008. (I never expected the relationship to last, which was why I and my co-author Moritz Schularick came up with the word: Chimerica was a pun on “chimera.”) At some point after that, as I have argued in Bloomberg Opinion previously, Cold War II began.
Unlike with a “hot” war, it is hard to say exactly when a cold war breaks out. But I think Cold War II was already underway — at least as far as the Chinese leader Xi Jinping was concerned — even before former President Donald Trump started imposing tariffs on Chinese imports in 2018. By the end of that year, the U.S. and China were butting heads over so many issues that cold war began to look like a relatively good outcome, if the most likely alternative was hot war.
Ideological division? Check, as Xi Jinping explicitly prohibited Western ideas in Chinese education and reasserted the relevance of Marxism-Leninism. Economic competition? Check, as China’s high growth rate continued to narrow the gap between Chinese and U.S. gross domestic product. A technological race? Check, as China systematically purloined intellectual property to challenge the U.S. in strategic areas such as artificial intelligence. Geopolitical rivalry? Check, as China brazenly built airbases and other military infrastructure in the South China Sea. Rewriting history? Check, as the new Chinese Academy of History ensures that the party’s official narrative appears everywhere from textbooks to museums to social media. Espionage? Check. Propaganda? Check. Arms race? Check.
A classic expression of the cold war atmosphere was provided on July 1 by Xi’s speech to mark the centenary of the Chinese Communist Party: The Chinese people “will never allow any foreign force to bully, oppress, or enslave us,” he told a large crowd in Beijing’s Tiananmen Square. “Anyone who tries to do so shall be battered and bloodied from colliding with a great wall of steel forged by more than 1.4 billion Chinese people using flesh and blood.” This is language the like of which we haven’t heard from a Chinese leader since Mao Zedong.
Most Americans could see this — public sentiment turned sharply negative, with three quarters of people expressing an unfavorable view of China in recent surveys. Many politicians saw it — containing China became just about the only bipartisan issue in Washington, with candidate Joe Biden seeking to present himself to voters as tougher on China than Trump. Yet somehow the very obvious trend toward cold war was ignored in the place that had most to lose from myopia. I am talking about Wall Street. Even as China was ground zero for a global pandemic, crushed political freedom in Hong Kong and incarcerated hundreds of thousands of its own citizens in Xinjiang, the money kept flowing from New York to Beijing, Hangzhou, Shanghai and Shenzhen.
According to the Rhodium Group, China’s gross flows of foreign domestic investment to the U.S. in 2019 totaled $4.8 billion. But gross U.S. FDI flows to China were $13.3 billion. The pandemic did not stop the influx of American money into China. Last November, JPMorgan Chase & Co. spent $1 billion buying full ownership of its Chinese joint venture. Goldman Sachs Group Inc. and Morgan Stanley became controlling owners of their Chinese securities ventures. Just about every major name in American finance did some kind of China deal last year.
And it wasn’t only Wall Street. PepsiCo Inc. spent $705 million on a Chinese snack brand. Tesla Inc. ramped up its Chinese production. There were also massive flows of U.S. capital into Chinese onshore bonds. Chinese equities, too, found American buyers. “From an AI chip designer whose founders worked at the Chinese Academy of Sciences, to Jack Ma’s fast-growing and highly lucrative fintech unicorn Ant Group and cash cow mineral-water bottler Nongfu Spring Co., President Xi Jinping’s China has plenty to offer global investors,” my Bloomberg opinion colleague Shuli Ren wrote last September.
Recent months have brought a painful reality check. On July 2, Chinese regulators announced an investigation into data security concerns at DiDi Global Inc., a ride-hailing group, just two days after its initial public offering. DiDi had raised $4.4 billion in the biggest Chinese IPO in the U.S. since Alibaba Group Holding Ltd.’s in 2014. No sooner had investors snapped up the stock than the Chinese internet regulator, the Cyberspace Administration of China, said the company was suspected of “serious violations of laws and regulations in collecting and using personal information.”
The cyberspace agency then revealed that it was also investigating two other U.S.-listed Chinese companies: hiring app BossZhipin, which listed in New York as Kanzhun Ltd. on June 11, and Yunmanman and Huochebang, two logistics and truck-booking apps run by Full Truck Alliance Co., which listed on June 22. Inevitably, this nasty news triggered a selloff in Chinese tech stocks. It also led several other Chinese tech companies abruptly to abandon their plans for U.S. IPOs, including fitness app Keep, China’s biggest podcasting platform, Ximalaya, and the medical data company LinkDoc Technology Ltd.
To add to the maelstrom, on Thursday Senators Bill Hagerty, a Tennessee Republican, and Chris Van Hollen, Democrat of Maryland, called on the Securities and Exchange Commission to investigate whether DiDi had misled U.S. investors ahead of its IPO. Also last week, U.S. tech companies such as Facebook, Twitter and Google came under increased pressure from Hong Kong and mainland officials over doxxing, the practice of publishing private or identifying information about an individual online.
For several years, I have been told by numerous supposed experts on U.S.-China relations a) that a cold war is impossible when two economies are as intertwined as China’s and America’s and b) that decoupling is not going to happen because it is in nobody’s interest. But strategic decoupling has been China’s official policy for some time now. Last year’s crackdown on financial technology firms, which led to the sudden shelving of the Ant Group Co. IPO, was just one of many harbingers of last week’s carnage.
The proximate consequences are clear. U.S.-listed Chinese firms will face growing regulatory pressure from Beijing’s new rules on variable interest entities as well as from U.S. delisting rules.
The VIE structure has long been used by almost all China’s major tech companies to bypass China’s foreign investment restrictions. However, on Feb. 7, the State Council’s Anti-Monopoly Committee issued new guidelines covering variable interest entities for the first time. Recognizing them as legal entities subject to domestic anti-monopoly laws has allowed regulators to impose anticompetition penalties on major VIEs, including Alibaba, Tencent Holdings Ltd. and Meituan. This new framework substantially increases risks to foreign investors holding American deposit receipts in the tech companies’ wholly foreign-owned enterprises. For example, Beijing could conceivably force VIEs to breach their contracts with their foreign-owned entities. In one scenario, subsidiaries of a Chinese variable interest entity that are deemed by Beijing to be involved in processing and storing critical data could be spun out from the VIE — just as Alibaba was reportedly forced to spin out payments subsidiary Alipay in 2010.
The stakes are high. There are currently 244 U.S.-listed Chinese firms with a total market capitalization of around $1.8 trillion, equivalent to almost 4% of the capitalization of the U.S. stock market.
Major Chinese companies have seen their U.S.-listed stocks crater this year (Baseline=100)
And the pressure on them is coming from the American regulators, too. The Holding Foreign Companies Accountable Act passed last December empowers the SEC to require foreign companies to disclose shareholder information and auditing records to the Public Company Accounting Oversight Board. Three consecutive years of noncompliance will force a delisting. The SEC’s new regulations went into effect in April, so the earliest delisting could be in 2024. But the requirements extend to revealing information about companies’ boards of directors and their affiliations with the Chinese Communist Party, as well as about the extent to which Chinese companies are owned or controlled by “a government entity.”
This is in direct conflict with Article 177 of the revised China Securities Law, which “prohibits foreign regulators from directly conducting investigations and collecting evidence” in China, and restricts Chinese firms from releasing documents related to their securities outside of China without approval from the China Securities Regulatory Commission. The combination of new regulatory pressure from both Beijing and Washington seems likely to force a significant number of Chinese companies to delist from U.S. exchanges over the next decade. Indeed, Washington has already delisted China’s three big telecommunications companies, China Telecom Corp., China Unicom and China Mobile Ltd., on the ground that they have Chinese military ties.
The fight over U.S.-listed Chinese firms has coincided with another sign of impending decoupling. Tesla’s love affair with China appears to heading for a rocky end. There has been a marked increase in criticism of the U.S. electric vehicle company, both in mainland newspapers and on social media, focusing on concerns about Tesla’s safety standards. In February, Chinese agencies, including the State Administration for Market Regulation, China’s most important market watchdog, summoned Tesla executives to discuss what they said were quality and safety issues in their vehicles. In March, the government was reported to have banned employees of state-owned enterprises and military personnel from using Tesla vehicles.
There has also been speculation in Chinese media that Teslas may be prohibited from entering certain “sensitive” areas. And last month, the Chinese government ordered a recall of almost all the cars Tesla has sold in China — more than 285,000 in all — to address an alleged software flaw. According to the China Automotive Technology and Research Center, Tesla’s share of the Chinese market for battery electric vehicles fell from 23% in the first quarter of 2020 to 11% in the second quarter of 2021.
To Wall Street’s way of thinking, China’s behavior makes no sense, especially in the context of a potential check to China’s economic recovery. Expansion in manufacturing slowed in June, as export demand weakened and supply bottlenecks held back production, according to official statistics released last week. China’s services sector, which has lagged behind manufacturing since the pandemic began, also showed signs of renewed weakness, partly because of recent outbreaks of Covid-19 in Guangdong and elsewhere.
Moreover, these short-run wobbles are trivial compared with the much bigger economic problems that American China-watchers detect. In a new piece for Foreign Affairs, the Rhodium Group’s Daniel H. Rosen paints a dark picture:
Since Xi took control, total debt has risen from 225 percent of GDP to at least 276 percent. In 2012, it took six yuan of new credit to generate one yuan of growth; in 2020, it took almost ten. GDP growth slowed from around 9.6 percent in the pre-Xi years to below six percent in the months before the pandemic began. Wage growth and household income growth have also slowed. And whereas productivity growth … accounted for as much as half of China’s economic expansion in the 1990s and one-third in the following decade, today it is estimated to contribute just one percent of China’s six percent growth, or, by some calculations, nothing at all.
The standard view, to which I also subscribe, is that the combination of accumulating private-sector debt and demographic decline — a trend made significantly worse by the pandemic — condemns China to significantly lower growth in the coming years. So why, burnt investors ask, jeopardize China’s access to Western capital, not to mention the access to Western technology that comes with large-scale U.S. foreign investment in China?
The answer has to do with the political calculations of the Chinese Communist Party, a way of thinking that could hardly be more foreign to the wolves of Wall Street.
As one hugely successful Chinese tech investor put it to me on a visit to Beijing in September 2018, there are three Chinas: the “New New China” of the dynamic technology sector; the “New Old China” of the most profitable state-owned enterprises, such as banks and telecoms; and the “Old Old China” of the heavy industrial, rust belt state-owned enterprises.
“We are New New China,” he told me. “We have U.S. passports, we cross the Pacific often, we are in California a third or half of the year.” In short, the Chimericans. But “New Old China” is the Communist Party elite — the “princelings” descended from the senior party figures who survived the madness of Mao, and their children, whose wealth comes from the state-owned cash cows. “Old Old China” is everyone else, whether in the miserable rust belts or the impoverished countryside.
Three years ago, my friend correctly predicted growing pressure on New New China from the Communist Party, which had begun to regard the big tech companies as so large and powerful as to pose a political threat. Jack Ma’s decline and fall — from an Elon Musk level of stardom in China to near invisibility — has proved that prediction right. It was Ma’s blunt and public criticism of the Chinese financial regulators last year that led to the cancellation of the Ant Group IPO and his eclipse as a public figure.
If you thought the CCP’s top priority was global economic dominance, cancelling Ant’s IPO made no sense. Ant had the potential to become the most powerful financial services platform in the world, its artificial intelligence technology honed on the vast trove of Chinese data harvested by the Alipay app, its game plan simple but brilliant, as its chief executive Eric Jing once explained to me over dinner in Hangzhou: to make Ant the default online market for all financial products throughout the world’s emerging markets.
So why did Beijing decide to abort this potentially world-beating mission? The answer is that the Communist Party’s top priority is domestic: specifically, the preservation of its own power.
The CCP did not plan for China to become home to the only tech companies in the world big enough to compete with Silicon Valley’s. It just happened because there was enough freedom from regulation for Ma to create, with breathtaking speed, “Amazon with Chinese characteristics.” Such are the consequences of allowing a free-market system to flourish even as you retain control of state-owned enterprises that you assumed would always be the economy’s commanding heights. Already in 2018, however, it was becoming clear to Xi and his fellow princelings that Jack Ma and his arriviste counterparts at the other big tech companies were getting too big for their boots. And the crux of the matter was their ownership of all that data generated by their Chinese users.
Significantly, China’s new data-security law, which was completed in June, gives the government greater power to get private-sector firms to share data collected from social media, e-commerce, lending and other businesses by classifying such data as a national asset. That ended the ambiguity that had led some big tech representatives to suggest that users’ data might not be available on demand to the government.
A similar logic explains Beijing’s sudden iciness toward Tesla. According to Article 36 of the Data Security Law, data stored in China cannot be transferred to foreign law-enforcement authorities or judicial bodies without prior Chinese government approval. “Provisions on the Management of Automobile Data Security,” released in May, specifically targeted automobile data storage and processing. The new rules state that geographic and mapping data collected by smart cars could constitute critical infrastructure information — again a matter of national security.
A cynic would say that Tesla is merely receiving the treatment previously meted out to many other Western companies. It has been welcomed into China just long enough for homegrown companies to copy its technology; now the future will belong to the likes of BYD Auto Co. Yet this is to understate how seriously the government takes the data issue. If you are intent on building a new kind of surveillance state, applying the power of artificial intelligence to all the data you can harvest from your citizen-helots, it makes perfect sense to ensure that the Communist Party has complete control over the data. And if you believe you are in the early phase of Cold War II, it makes perfect sense to ensure that companies based in the other superpower are cut off from the data.
Like the Soviet Union in Cold War I, China believes that the U.S. will behave the same way it does. Maybe it’s true —maybe Tesla would make data gathered by its Chinese vehicles available to the U.S. National Security Agency. But you can be absolutely certain BYD would make U.S. data available to the NSA’s equivalent in Beijing if they had sold a lot of Chinese electric vehicles to Americans.
Xu Zhangrun, who was a professor of jurisprudence and constitutional law at Tsinghua University until he was fired last year, believes that Xi has restored tyranny in China, by removing the constraints on his power — such as informal term-limits — that his predecessors had imposed after Mao’s death. “Tyranny ultimately corrupts the structure of governance as a whole,” Xu has written, “and it is undermining a technocratic system that has taken decades to build.” That may well prove to be true.
In the short run, however, the big losers from Xi’s tyranny and the Cold War that he is waging will be those Western investors who foolishly believed that Chimerica could survive not only a global financial crisis made in America, but also a global health crisis made in China.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
The Fort Knox of the future. Photographer: Andrey Rudakov/Bloomberg via Getty Images
What is the money of the future? My nine-year-old son thinks it will be Robux. For those of you trapped in the human museum known as adulthood, Robux is the currency used by players of Roblox computer games. If I offer Thomas grimy dollar bills for household chores, he shows an almost complete lack of interest and motivation. But if I offer him Robux, it’s a different story.
The current exchange rate is around 80 to the dollar. So, in order to incentivize my son to do the dishes, I need to go online and buy 2,000 Robux for $24.99. This I do by entering my credit card details on a website, an act of self-exposure that never fails to make me feel sick. However, the dishes get cleaned and, later, my son blows some of his Robux on a cool new outfit and a pair of wings for his avatar, earning the admiration of his friends.
Robux is just one of the new forms of money that exist in the parallel world of online gaming. If your kids play Fortnite, then you’ve probably had to buy them V-Bucks (short for VinderBucks). And gamer money is, in turn, just a subset of the myriad means of payment that now exist on the internet.
Writers of science fiction got many things right about the future, from pandemics to flying cars to artificial intelligence. None, so far as I know, got the future of money exactly right. In William Gibson’s seminal Neuromancer (1984), paper money (the “new yen” or N¥) has survived but is used only for illicit transactions. In Neal Stephenson’s Snow Crash (1992), hyperinflation has ravaged the value of the dollar so much that, in Compton, California, “Street people push … wheelbarrows piled high with dripping clots of million- and billion-dollar bills that they have raked up out of storm sewers.” A trillion-dollar bill is known colloquially as an “Ed Meese.” A quadrillion is a “Gipper.” (Only we Boomers now get the allusions to the former attorney general and the president he served in the 1980s.) In other dystopian futures, readily available commodities such as bullets or bottle caps serve as makeshift money, rather like cigarettes in occupied Germany in the immediate aftermath of World War II. My favorite imagined currency are the “merits” in the British TV show Black Mirror, which have to be earned by pedaling on exercise bikes.
If some other author predicted the future of money accurately, I missed it. Unfortunately, this lack of foresight now seems also to afflict U.S. policymakers, leaving the world’s financial hegemon vulnerable to a potentially fatal challenge. Not only are the American monetary authorities underestimating the threat posed to dollar dominance by China’s pioneering combination of digital currency and electronic payments. They are also treating the blockchain-based financial innovations that offer the best alternative to China’s e-yuan like gatecrashers at their own exclusive party.
Let’s begin with the future of money that no one foresaw.
In 2008, in a wonkish paper that bore no relation to any sci-fi, the enigmatic Satoshi Nakamoto launched Bitcoin, “a purely peer-to-peer version of electronic cash” that allows “online payments to be sent directly from one party to another without going through a financial institution.” In essence, Bitcoin is a public ledger shared by an acephalous (leaderless) network of computers. To pay with bitcoins, you send a signed message transferring ownership to a receiver’s public key. Transactions are grouped together and added to the ledger in blocks, and every node in the network has an entire copy of this blockchain at all times. A node can add a block to the chain (and receive a bitcoin reward) only by solving a cryptographic puzzle chosen by the Bitcoin protocol, which consumes processing power.
Nodes that have solved the cryptographic puzzle — “miners” — are rewarded not only with transaction fees, but also with more bitcoins. This reward will get cut in half every four years until the total number of bitcoins reaches 21 million, after which no new Bitcoins will be created. As I argued here last November, there were good reasons why Bitcoin left gold for dead as the pandemic was wreaking havoc last year. Scarcely over a year ago, when just about every financial asset sold off as the full magnitude of the pandemic sank in, the dollar price of a Bitcoin fell to $3,858. As I write, the price is $58,746.
The reasons for Bitcoin’s success are that it is sovereign (no one controls it, not the “whales” who own a lot, and not the miners who mine a lot), scarce (that 21 million number is final), and — above all — smart. With every day that the system works — not being hacked, not crashing — the predictions that it would prove to be a “shitcoin” look dumber, and the pressure on people to affirm their smartness by owning bitcoins grows stronger. Last year, a bunch of tech companies, including Square, PayPal and Tesla, bought a pile. Several legendary investors — Paul Tudor Jones, Stan Druckenmiller, Bill Miller — came out as long Bitcoin. Perhaps most importantly, Bitcoin began to be treated like a legitimate part of the financial system. BNY Mellon now handles Bitcoin. So does Mastercard. There are now well functioning Bitcoin futures and options markets. This kind of adoption and integration is what has driven the price upward — a process that has much further to run. My $75,000 target price back in 2018 (assuming that every millionaire would one day want 1% of his or her portfolio in XBT) now looks a bit conservative.
Meanwhile, as Bitcoin has grown more respectable, the cool kids have moved on to decentralized finance (“DeFi”), “an open, permissionless, and highly interoperable protocol stack built on public smart contract platforms” such as the Ethereum blockchain, to quote a recent and excellent St. Louis Fed paper by Fabian Schaer. Like Bitcoin, DeFi has no centralized third-party system of verification and regulation. But it is a much looser, more variegated system, with multiple coins, tokens, exchanges, debt markets, derivatives and asset management protocols. As Schaer puts it:
This architecture can create an immutable and highly interoperable financial system with unprecedented transparency, equal access rights, and little need for custodians, central clearing houses, or escrow services, as most of these roles can be assumed by ‘smart contracts.’ … Atomic swaps, autonomous liquidity pools, decentralized stablecoins, and flash loans are just a few of many examples that show the great potential of this ecosystem. … DeFi may lead to a paradigm shift in the financial industry and potentially contribute toward a more robust, open, and transparent financial infrastructure.
(I told you it was cool.)
For the true believers, Bitcoin and DeFi are the first steps toward a libertarian Nirvana. In a widely quoted tweet, crypto guru Naval Ravikant added steps three to seven:
Bitcoin is an exit from the Fed.
DeFi is an exit from Wall Street.
Social media is an exit from mass media.
Homeschooling is an exit from industrial education.
Remote work is an exit from 9-5.
Creator economy is an exit from employment.
Individuals are leaving institutions.
We are on our way, according to Pier Kicks, to the “Metaverse” — a “self-sovereign financial system, an open creator economy, and a universal digital representation and ownership layer via NFTs (non-fungible tokens).” Yes, even art is now on the blockchain: Witness the sale by Christie’s last month of “Everydays: the First 5000 Days,” by Mike Winkelmann, aka Beeple, for $69.3 million.
What is the right historical analogy for all this? Allen Farrington argues that Bitcoin is to the system of fiat currencies centered around the dollar what medieval Venice once was to the remnants of the western Roman Empire, as superior an economic operating system as commercial capitalism was to feudalism. Another possibility is that the advent of blockchain-based finance is as revolutionary as that of fractional reserve banking, bond and stock markets in the great Anglo-Dutch financial revolution of the 18th century.
Like all such revolutions, however, this one, too, has produced its haters. Well-known economists such as Nouriel Roubini continue to predict Bitcoin’s demise. Bridgewater founder Ray Dalio has warned that, just as the U.S. government prohibited the private ownership of gold by executive order in April 1933, so the same fate could befall Bitcoin. Perhaps most ominously, the central bankers of the western world remain sniffy. A new line of attack (highly appealing to monetary officials eager to affirm their greenness) is that the electricity consumed by Bitcoin miners makes crypto dirty money.
Are we therefore heading for a collision between the old money and the new? Perhaps. As we approach the end of the first 100 days of Joe Biden’s presidency, I am tempted to paraphrase his former boss’s jab at Mitt Romney back in 2012: “The twentieth century is calling to ask for its economic policy back.” There is something very old-school about the Biden administration.
It believes in Keynesian demand management and stimulus. It is proposing a massive infrastructure investment plan. The result is that fiscal and monetary expansion triggered by a public health emergency seems set to continue beyond the duration of the emergency. The administration’s economists tell us there is nothing to fear from inflation. Meanwhile, in foreign policy, Team Biden seems committed to Cold War II against China. All of this hinges on the enduring credibility of the U.S. dollar as the preeminent international reserve currency and U.S. Treasury bonds as the safest of all financial assets — not to mention the enduring effectiveness of financial sanctions as the ultimate economic weapon. Yet precisely these things are threatened by the rise of an alternative financial system that essentially bypasses the Federal Reserve and potentially also the U.S. Treasury.
So you can see why Ray Dalio might expect the U.S. government at some point to outlaw Bitcoin and other cryptocurrency. The last administration occasionally muttered threats. “Cryptocurrency … provides bad actors and rogue nation states with the means to earn profits,” stated the report of Attorney General William Barr’s Cyber-Digital Task Force last year. Treasury Secretary Steven Mnuchin considered forcing U.S. exchanges to gather more information about individuals withdrawing their Bitcoin. Pro-Bitcoin politicians, such as Miami mayor Francis Suarez, are still in a minority.
Abroad, too, there are plenty of examples of governments moving to limit cryptocurrencies or ban them altogether. “We must do everything possible to make sure the currency monopoly remains in the hands of states,” declared German Finance Minister Olaf Scholz at a G-7 finance ministers meeting in December. The European Commission shows every sign of regulating the fledgling sector with its customary zeal. In particular, the European Central Bank has stablecoins (crypto tokens pegged to fiat currencies) in its sights. China is even more stringent. In 2017, the Chinese Communist Party restricted the ability of its citizens to buy Bitcoin, though Bitcoin mining continues to thrive close to sources of cheap hydroelectricity like the Three Gorges Dam.
But is it actually true that the state should have a monopoly on money? That is a distinctly German notion, stated most explicitly in Georg Friedrich Knapp’s State Theory of Money (1905). History begs to differ. Although states have sometimes sought to monopolize money creation, and although a state monopoly on the enforcement of debt contracts is preferable, a monopoly on money is far from natural or even necessary. For most of history, states have been satisfied with determining what is legal tender — that is, what can be used to discharge contractual obligations, including tax payments. This power to specify legal tender drove the great monetization of economy and society in Ming China and in Europe after the Black Death.
Money, it is conventional to argue, is a medium of exchange, which has the advantage of eliminating inefficiencies of barter; a unit of account, which facilitates valuation and calculation; and a store of value, which allows economic transactions to be conducted over long time periods as well as geographical distances. To perform all these functions optimally, the ideal form of money has to be available, affordable, durable, fungible, portable and reliable. Because they fulfill most of these criteria, metals such as gold, silver and bronze were for millennia regarded as the ideal monetary raw material. Rulers liked to stamp coins with images (often crowned heads) that advertised their authority. But in ancient Mesopotamia, beginning around five thousand years ago, people used clay tokens to record transactions involving agricultural produce like barley or wool, or metals such as silver. Such tablets performed much the same function as a banknote. Often, through the centuries, traders have devised such tokens or bills without government involvement, especially at times when coins have been in short supply or debased and devalued.
In the modern fiat monetary system, the central bank, itself supposedly independent of the state, can influence the money supply, but it does not monopolize money creation. In addition to state-created cash — the so-called high-powered money or monetary base — most money is digital credits from commercial banks to individuals and firms. As I argued in The Ascent of Money (2008), money is trust inscribed, and it does not seem to matter much whether it is inscribed on silver, on clay, on paper — or on a liquid crystal display. All kinds of things have served as money, from the cowrie shells of the Maldives to the stone discs used on the Pacific island of Yap.
Although Bitcoin currently looks to outsiders like a speculative asset, in practice it performs at least two of the three classic functions of money quite well, or soon will, as adoption continues. It can be (like gold) both a store of value and a unit of account. And, as my Hoover Institution colleague Manny Rincon-Cruz has suggested, it may be that the three classic functions of money are in fact something of a trilemma. Most forms of money can perform at least two of the three; it’s impossible or very hard to do all three. Bitcoin is not an ideal medium of exchange precisely because its ultimate supply is fixed and not adaptive, but that’s not a fatal limitation. In many ways, it is Bitcoin’s unique advantage.
In other words, Bitcoin and Ethereum, as well as a great many other digital coins and tokens, are stateless money. And the more they can perform at least two out of three monetary functions tolerably well, the less that banning them is going to work — unless every government agrees to do so simultaneously, which seems like a stretch. The U.S. isn’t going to ban Bitcoin, just tax it whenever you convert bitcoins into dollars.
The right question to ask is therefore whether or not the state can offer comparably appealing forms of digital money. And this is where the Chinese government has been thinking a lot more creatively than its American or European counterparts. As is well known, China has led the world in electronic payments, thanks to the vision of Alibaba and Tencent in building their Alipay and WeChat Pay platforms. In 2020, some 58% of Chinese used mobile payments, up from 33% in 2016, and mobile payments accounted for nearly two-thirds of all personal consumption PBOC payments. Banknotes and credit cards have largely yielded to QR codes on smartphones. The financial subsidiary of Alibaba, Ant Group, was poised last year to become one of the world’s biggest financial companies.
Yet the Communist Party became nervous about the scale of electronic payment platforms and sought to clip their wings by cancelling Ant’s planned IPO in November and tightening regulation. At the same time, the People’s Bank of China has accelerated the implementation of its plan for a central bank digital currency (CBDC). In a fascinating article in February, former PBOC governor Zhou Xiaochuan explained the fundamentally defensive character of this initiative. “Blockchain technology features decentralization, but decentralization is not a necessity for modernizing the payments system. It even has some drawbacks,” he wrote. “The possible application of blockchain … is still being researched, but is not ready at this time.”
Last year, the PBOC seized the opportunity presented by the pandemic to rush its CBDC into the hands of Chinese consumers, conducting trials in three cities — Shenzhen, Suzhou and Chengdu — as well as the Xiong’an New Area near Beijing. Crucially, its design is two-tier, with the PBOC dealing with the existing state-owned commercial banks and other entities (including telecom and tech companies), not directly with households and firms. The abbreviation “DC/EP” (with the slash) captures this dual structure. The central bank controls the digital currency, but the electronic payment platforms can participate in the system, alongside the banks, as intermediaries to consumers and businesses. However, the easiest option for consumers will clearly be to withdraw “e-CNY” from bank ATM machines onto their smartphones’ e-wallets. The system even allows transactions to happen in the absence of an internet connection via “dual offline technology.” In 2018 I predicted there would soon be “bityuan.” I only got the name wrong.
This new Chinese system not only defends the CCP against the twin threats of crypto and big tech, while ensuring that all Chinese citizens’ transactions are under surveillance; it also includes an offensive capability to challenge the U.S. dollar’s dominance in cross-border payments. And this is where the story gets seriously interesting. Today, as is well known, the dollar dominates the renminbi in foreign exchange markets, central bank reserves, trade finance and bank-to-bank payments through the Belgium-based Society for Worldwide Interbank Financial Telecommunication (SWIFT). This financial superpower, fully appreciated and utilized only after 9/11, is what makes U.S. financial sanctions so effective and far-reaching.
The Chinese are creatively exploring ways to change that. Exhibit A is the Finance Gateway Information Service, a joint venture between SWIFT and the China National Clearing Center within the PBOC, which aims to direct all cross-border yuan payments through China’s own settlement system, Cross-Border Interbank Payment and Clearing. Exhibit B is the Multiple CBDC (mCBDC) Bridge project by the Hong Kong Monetary Authority and the Bank of Thailand to implement a cross-border payments system based on distributed ledgers, again using a two-tier system. Exhibit C are the cross-border transfers between Hong Kong and Shenzhen currently being piloted. According to Sahil Mahtani of the South African investment manager Ninety One, the ultimate goal of Chinese policy is “to create a parallel payments network — one beyond American oversight — thereby crippling U.S. sanctions policy.” In Mahtani’s words:
The expansion of a Chinese digital currency will ultimately pry open the U.S. grip over global payments, and therefore compromise U.S. sanctions policy and a significant measure of U.S. power in the world. … It is not that China’s digital currency is going to become the dominant standard of payments … But it could become one standard, creating a parallel system with which to avoid the long arm of U.S. regulation.
What does the United States have to offer in response? When Mark Carney, the former Governor of the Bank of England, argued for a “synthetic hegemonic currency” at Jackson Hole in 2019, he was politely ignored. When Mark Zuckerberg proposed a Facebook stablecoin, Libra, he was impolitely rebuffed. (Libra has been renamed “Diem,” but getting regulatory approval still looks like an uphill struggle. According to Tyler Goodspeed, who recently left the Council of Economic Advisers to join us at Hoover, “If you’re issuing very short-term liquid liabilities that are redeemable on demand for, say, dollars or euros, and you’re backing that commitment by holding highly liquid dollar- or euro-denominated bills, then I’m sorry to say it but you are a bank.”
Other countries are exploring creating their own CBDCs — 60% of more than 60 central banks surveyed by the Bank for International Settlements last year. Cambodia and the Bahamas are already there. Even the European Central Bank has not said “non” or “nein,” though Bundesbank head Jens Weidmann is not alone in worrying that an e-euro might disintermediate Europe’s already ailing banks unless the Chinese two-tier model is adopted.
And the Fed? According to Chair Jay Powell, some of his officials are working with economists at the Massachusetts Institute of Technology to explore the feasibility of a U.S. CBDC. But, says Powell, “there is no need to rush.” Like his “What me, worry?” approach to inflation, this smacks of insouciance. China is seeking in plain sight to build an alternative international payments system to that of the U.S. dollar, and there’s no need to rush to meet this challenge? Nor any thought of actively integrating Bitcoin — a tried and tested decentralized form of “digital gold” — into the U.S. financial system, rather than treating it as a rather suspect parvenu?
If the future of money arrives as rapidly as I think it will, in the form of a widely adopted e-CNY, do not be surprised if all we can offer our kids are Robux.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
William Hogarth knew a bad investment when he saw one. Photographer: Edward Gooch Collection/Hulton Archive via Getty Images
The mistake of betting that a stock will fall, then getting crushed when it doesn’t, goes back a long way.
In August 1719, as the first stock market bubble in history was gathering steam, the mercurial Scottish financier John Law made a bet with Thomas Pitt, the earl of Londonderry and uncle of the prime minister, William Pitt, that the price of British stocks would fall in the year ahead. Law was at that time the master of the French financial universe, the man in control not only of the Mississippi Company, which held a monopoly on trade with the French territory of Louisiana, but also of the Banque Royale, and hence the French money supply. He was long France, short England.
Law sold 100,000 pounds of British East India Company stock short for 180,000 pounds (that is at a price of 180 pounds per share, or 80% above face value) for delivery on Aug. 25, 1720. The price of the shares at the end of August 1719 was 194 pounds, indicating Law’s expectation of a 14-pound price decline.
At first, Law’s “long France” trade was all that seemed to matter. Shares in his Mississippi Company soared by a factor of 20, from 98% of their face value to 1965% in November 1719. But at that point the Mississippi bubble burst. Within a year, the stocks were down to 200%.
Big Bubbles Abroad
Share price as a percentage of par = 100
Sources: Antoin E. Murphy, "John Law: Economic Theorist and Policy-Maker" (Oxford, 1997); Larry Neal, "The Rise of Financial Capitalism: International Capital Markets in the Age of Reason" (Cambridge, 1990)
To compound Law’s woes, he was also on the wrong side of a short squeeze. Far from declining, by April 1720 the price of East India stock had risen to 235 pounds, and it continued to rise as investors exited the Paris market for what seemed the safer haven of London (then in the grip of its own less spectacular South Sea Bubble). By June the price was at 420 pounds, declining only slightly to 345 pounds in August, when Law’s bet fell due. As much as the bursting of the French bubble, it was his big, bad short that ruined Law.
Contemporaries agreed that Law’s grand financial experiment had been a disaster. From London, Daniel Defoe was scornful: the French had merely “run up a piece of refined air.” So incensed was one Dutch investor that he had a series of satirical plates specially manufactured in China. The inscription on one reads: “By God, all my stock’s worthless!” Another is even more direct: “Shit shares and wind trade.”
As far as investors in Amsterdam were concerned, the Mississippi Company had been trading in nothing more substantial than wind. As the verses on one satirical Dutch cartoon flysheet put it, Law’s scheme had been “wind and smoke and nothing more.”
Fast forward just over three centuries, and wind and smoke are back in financial markets in ways John Law’s critics would immediately recognize. It was already obvious last summer that the Covid-19 pandemic was creating conditions of irrational exuberance in U.S. financial markets. Near-zero interest rates, checks from the government and shelter-in-place orders: these, along with the no-commission trading made possible by online platforms such as Robinhood, had opened the gates of the stock market to a new generation of financial barbarians.
The rise to fame last year of Dave Portnoy was just one symptom. Portnoy boasted of his two rules for making money in stock markets. Rule one is that “stocks only go up.” Rule two: “When in doubt whether to buy or sell see Rule One.”
Coarse, sunburned and perpetually dressed for a sophomoric spring break, Portnoy brought to investing what Donald Trump brought to politics: the sweaty smell of populist excess. On the other side of the big, bad short were “the suits” — professional hedge fund traders such as Andrew Left of Citron Research and Gabe Plotkin of Melvin Capital Management LP. Like a lot of smart guys last year, Left and Plotkin were betting that the stocks of traditional bricks-and-mortar retailers like GameStop Corp. or Bed Bath & Beyond Inc. would fall. After all, weren’t they on the wrong side of both technological change and coronavirus lockdowns? Quarterly disclosures made those short positions public.
It wasn’t Portnoy but “u/Jeffamazon” who four months ago proposed “The REAL Greatest Short Burn of the Century” in a Reddit post to the r/wallstreetbets group. The argument was simple: The scale of the short positions against GameStop was much too large in relation to the amount of stock available to be traded. “GME’S ACTUAL SHORT INTEREST IS OVER 110%,” wrote u/Jeffamazon. “Shorts are beyond trapped in their position. … GME’s balance sheet is healthy with $100M in net cash … so they aren’t going bankrupt anytime soon.”
“Thanks to MMs [money managers] literally not using their brain and relying on ze maths to configure their entire business, we can take advantage of them sleeping at the wheel for a few seconds.” But the stated rationale for this classic short squeeze was not purely financial. As befits a populist insurgency, it was to deliver “a kick in the shorts’ teeth” because “the only way to beat a rigged game is to rig it even harder.”
For journalists and politicians also spending way too much time indoors (just spending it less lucratively), this was an irresistible story. While they had been appalled by a mob of several thousand MAGA and QAnon types storming the Capitol, the political class was enchanted by the spectacle of two million subscribers to wallstreetbets storming Wall Street itself.
The story found its shaman in the person of Keith Gill, a dude in a red headband who goes by the name “Roaring Kitty” on Twitter and something unprintable on Reddit. The foot soldiers of this insurrection were exemplified by the Reddit subscriber who commented on Jeffamazon’s post: “I don’t understand any of it, f*** it im in.”
This was a movement, gushed the Wall Street Journal, of “ordinary investors, stuck at home in the pandemic, swapping tips and hatching trading strategies on online forums … often buying things Wall Street has bet against. Many tout their long-shot wagers with the expression ‘YOLO,’ or, ‘You only live once.’”
Politico couldn’t resist: “The Internet-driven populist sentiment that helped propel politicians to national office is now coursing through global markets … Some segments of the younger generation, flush with extra cash in part due to stimulus payments and weighed down by boredom during the Covid-19 pandemic, are looking to exact a measure of vengeance on big Wall Street hedge funds.”
Any journalist who ventured to question this narrative — for example, my Bloomberg Opinion colleague John Authers — was soon sifting gingerly through an inbox full of invective: “How much did Melvin pay you to write this garbage? shill. Literally trying to protect an industry trying to fleece jobs from low income workers. Sleep well chump.” And: “Plus 1 for the little guys.” And: “The American dream and being able to make your own way. This isn't a casino. This is a riot.” And: “Bloomberg defending the suits. Not surprised. They’re just mad the rubes are in on the joke now.”
As the mania grew in magnitude and spread to other uncool stocks — notably AMC Entertainment Holdings Inc. (the cinema chain) and BlackBerry Ltd. — and from there to silver and even to the joke cryptocurrency Dogecoin, the plot thickened. First, the short burn caught fire, as planned: From below $20 on Jan. 12, GameStop stock soared to above $347. AMC leapt from $2.29 to $19.90. But then Robinhood began to restrict trading in GameStop. “I’ve never been more convinced about market manipulation and hedge funds controlling the game than today,” complained Portnoy to Fox News’s Tucker Carlson. Ted Cruz chimed in.
The Reddit Effect?
GameStop and AMC share prices index, Jan. 12 =100
Yet this was the kind of populism that appeals to the left as well as the right. On CNN last Sunday, Elizabeth Warren called for a Securities and Exchange Commission investigation into the role of “big money.” The Progressive Pasionaria Alexandria Ocasio-Cortez exulted at this “populist rally.” “People were really feeling like everyday people were finally able to collectively organize and get back at the folks who have historically had all the marbles on Wall Street,” she told the streaming platform Twitch. She demanded a congressional hearing and an investigation into Robinhood’s “unacceptable” restrictions on GameStop trading.
To anyone who bought this tale of populists v. suits, I recommend Charles Kindleberger’s classic “Manias, Panics and Crashes,” first published in 1978. Among the book’s many insights, you will find Kindleberger’s five-stage life-cycle of a bubble:
1. Displacement: Some change in economic circumstances creates new and profitable opportunities for certain companies.
2. Euphoria or overtrading: A feedback process sets in whereby rising expected profits lead to rapid growth in stock prices.
3. Mania or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money.
4. Distress: The insiders discern that expected profits cannot possibly justify the now exorbitant price of the shares and begin to take profits by selling.
5. Revulsion or discredit: As share prices fall, the outsiders all stampede for the exits, causing the bubble to burst altogether.
The key to this framework is the different roles played by insiders and outsiders.
Ever since the creation of the first joint-stock companies in the early 17th century — the Dutch and English East India Companies — and the first exchanges, such as the Amsterdam Beurs, where shares could be traded, stock market bubbles have had three recurrent features.
The first is the role of what is sometimes referred to as asymmetric information. Insiders — those familiar with the management of bubble companies — know much more than the outsiders. Such asymmetries always exist in business, of course, but in a bubble the insiders can fully exploit them.
The seasoned speculator, based in a major financial center, may lack the inside knowledge of the true insider. But he is much more likely to get his timing right — buying early and selling before the bubble bursts — than the novice investor. He is also likely to have much more money than the newbie and therefore to be able to speculate in size without risking an excessive proportion of his capital. In a bubble, in other words, not everyone is irrational; or, at least, some of the exuberant are less irrational than others.
Secondly, each group of insiders and outsiders will tend to move together. The difference is that the insiders will operate like a wolf pack, the outsiders like a flock of sheep — if not lemmings.
My favorite illustration of this is the way George Soros successfully speculated against the British pound in September 1992, one of the biggest shorts of my lifetime. Older readers will remember Soros’s thesis that the rising costs of German reunification would drive up interest rates and hence the deutschmark, and that this would make the UK government’s peg to the German currency — formalized when Britain had joined the European Exchange Rate Mechanism in 1990 — untenable.
As interest rates rose, the British economy would tank. Sooner or later, the government would be forced to withdraw from the ERM and devalue the pound. So sure was Soros that the pound would drop that he ultimately bet $10 billion, more than the entire capital of his Quantum fund, on a series of transactions whereby he effectively borrowed sterling in the UK and invested in German currency at the price of around 2.95 deutschmarks.
His Quantum fund made around one billion dollars as sterling slumped — ultimately by as much as 20% — allowing Soros to repay the sterling he had borrowed, but at the new lower exchange rate, and to pocket the difference.
The popular version of events was that Soros single-handedly “broke the Bank of England.” This was naïve. Quantum’s assets under management were around $5 billion in 1992. The international reserves of the Bank of England were $44 billion — nearly nine times greater. If Soros had taken on the Bank of England on his own, he would have lost.
On the other hand, the Federal Reserve estimated that daily turnover on the world’s foreign exchange markets had increased from $58 billion in 1986 to $167 billion in 1992. In the words of the Economist, “The British Treasury’s seemingly comfortable reserves were as nothing compared with the speculators’ firepower.” The key to the Soros trade was thus to get a critical mass of investors to put on the same trade that he had in mind. That was not hard because Soros was already part of a network of like-minded investors.
As Robert Johnson of Bankers Trust recalled: “I walked out of [a meeting with Soros] with absolutely no question that we were going to go after this thing [and] I knew other people in the banks and counterparties would imitate us.” Soros’s partner Stan Druckenmiller recalled: “We really went after this thing and kept going and going and going like the Energizer bunny … So anybody with a brain is going to ask his dealer, ‘What the hell is going on?’ And I know people talk. It’s Quantum.”
In some cases — notably with Louis Bacon — Soros and Druckenmiller shared information over the phone. Other hedge fund managers who were in the trade included Bruce Kovner of Caxton Associates LP and Paul Tudor Jones. Magnifying the scale of the short selling were the efforts of the banks who were lending the hedge funds money.
Finally, as the role of the banks in Soros’s big short illustrates, a crucial difference between insiders and outsiders is that the insiders usually have better access to credit than the outsiders.
Knowing these things would have helped many people better understand the events of recent months.
Let’s begin by disposing of the populist insurgency hypothesis. According to Federal Reserve data, the top 10% of Americans in terms of wealth own 88% of corporate equities and mutual fund shares (up from 80% 30 years ago) while the bottom 50% own just 0.6% (down from 1.4%). More than half is now owned by the top 1%. Not surprisingly, therefore, some of the leading YOLO investors are current or former financial services professionals. Not surprisingly, the largest holders of GameStop stock during its dizzying rally were institutions, notably BlackRock Inc., as well as hedge funds such as Senvest Capital Inc.
The Rich Get Richer
Distribution of U.S. household wealth
Source: Federal Reserve
Now, let’s look at how the smart and the dumb money worked. Robinhood itself is one of a new generation of online brokers, catering to smaller “retail” investors — the outsiders. Robinhood’s service is free to the outsiders. It gets paid by the insiders: among others, the market maker Citadel Securities LLC, part of Ken Griffin’s Chicago-based hedge fund and financial services group, for funneling transactions its way. When Robinhood had to post additional billions to the National Securities Clearing Corporation in response to the volatility of stocks such as GameStop, the money — a cool $3.4 billion — was provided by some of the biggest names in venture capital, including Sequoia Fund Inc. and Andreessen Horowitz, as Gillian Tett pointed out last week, as well as the hedge fund Tiger Global. The key point about Robinhood is that if they really were outsiders, they would have blown up because they would have lacked that kind of support.
The conspiracy theory that Robinhood froze new purchases of GameStop shares in response to pressure from the hedge funds makes no sense, however. Citadel and Point72 Asset Management LP injected $2.75 billion into Melvin Capital on Jan. 25. Two days later, Melvin announced that it had closed out its short position in GameStop. It was only after that, on the 28th, that Robinhood froze new purchases of GameStop shares — not to help Melvin, which had already exited the trade and realized its losses, but to help itself.
Notice, too, who has been cheering on the “Gamestonk” — none other than the richest man in the world, Elon Musk, who has an ax of his own to grind when it comes to short selling. “Here come the shorty apologists,” Musk tweeted on Jan. 28. “Give them no respect Get Shorty.” One of the worst trades of 2020 was shorting Musk’s electronic car company, Tesla Inc., a trade that has burned some famous fingers, notably those of Jim Chanos and — surprise! — Gabe Plotkin of Melvin Capital. The Tesla shorties lost more than $39 billion last year.
But if the biggest beneficiary of the Tesla short squeeze was the richest man in the world, this sure ain’t the sequel to Occupy Wall Street. As for who the biggest losers of this episode were, that’s easy: the outsider retail investors who bought GameStop or AMC at or near the top of the bubble.
Finally, remember the crucial role of access to credit. The Fed has created the conditions for multiple bubbles by promising zero rates and quantitative easing as far as the eye can see, and never mind if inflation goes above 2%. “Frankly we welcome slightly higher … inflation,” Fed Chair Jay Powell said last month. “The kind of troubling inflation people like me grew up with seems unlikely in the domestic and global context we’ve been in for some time.”
Maybe. But general asset price inflation and a rash of bubbles are pretty much guaranteed. Margin debt is currently growing at its fastest rate in 30 years — faster than in the dot.com bubble, faster than on the eve of the global financial crisis. When the first margin calls go out, needless to say, they will be to the little guys.
Of course, if Powell is wrong — if the combination of mass vaccination, post-pandemic euphoria, yet more fiscal stimulus and an overflowing monetary punchbowl does reignite inflation expectations, as Larry Summers warned last week — then all stock market investors, insiders and outsiders alike, may be in for a rude awakening. According to a recent and exhaustive analysis of long-term equity returns in 39 developed countries over the period from 1841 to 2019, there is “a 12% chance that a diversified investor with a 30-year investment horizon will lose relative to inflation.”
That might not have surprised John Law. But in times like these, financial history offers the kind of perspective that all market participants — yes, even Dave Portnoy and Keith Gill — badly need and are mostly short of.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
No, money isn’t free. Photographer: Matthew Lloyd/Getty Images
After the disease, the debt. After the plague, the pile of IOUs. It is a veritable mountain — a reminder that the original public debt in medieval Venice went by the name monte. According to the International Monetary Fund’s October Fiscal Monitor, the Covid-19 pandemic and associated lockdowns have prompted a plethora of fiscal measures amounting to $11.7 trillion, around 12% of global GDP — and that number has probably risen since it was calculated on Sept. 11. “In 2020,” according to the Fund, “government deficits are set to surge by an average of 9 percent of GDP, and global public debt is projected to approach 100 percent of GDP, a record high.”
In advanced economies, public debt relative to output has increased as much since the late 1970s as it did between 1914 and 1945. Together, the global financial crisis and the pandemic have had roughly the same doubling effect as World War II. While Covid-19 will not kill as many people globally as history’s biggest war, the ultimate U.S. death toll is very likely to be higher. The pandemic’s financial cost also looks similar to that of a world war.
The IMF’s global averages conceal huge variations between countries. The deficits of seven developed countries — Canada, the U.K., the U.S., Brazil, Italy, Spain and Japan — have each risen by more than 10% of GDP. In all these countries, gross public debt will exceed 100% of GDP this year, with Japan’s reaching 266%. The IMF’s projection for U.S. gross debt is 131%.
In many advanced countries, public debt will exceed 100% of GDP this year
Source: International Monetary Fund
Because the Federal Reserve has purchased most of the new Treasury bonds created this year, the increase in the federal debt held by the public is not so daunting. 1 The Congressional Budget Office projects that it will be just under 100% this year (98.2%), but that is still nearly three times what it was at the beginning of this century. Next year it is forecast to surpass the level in 1945.
But the story doesn’t end there, because the federal government is expected to keep borrowing as far as the eye can see, with the deficit rising inexorably from 4% in the late 2020s to over 12% by mid-century. The CBO’s baseline projection is for the federal debt in public hands to reach 195% of GDP by 2050, nearly twice as high as at the end of World War II.
U.S. debt in public hands could near 200% by 2050, nearly twice as high as at the end of World War II
Source: U.S. Congressional Budget Office
Historically, large public debts have had a terrible reputation. In his “Rural Rides,” which he began in 1822 and published in 1830, the English radical William Cobbett inveighed against the vast national debt incurred during the Napoleonic Wars. The political purpose of the debt, Cobbett argued, had been “to crush liberty in France and to keep down the reformers in England” but its principal effect after the war was redistributive. “A national debt, and all the taxation and gambling belonging to it, have a natural tendency to draw wealth into great masses … for the gain of a few.”
“The Debt, the blessed Debt,” he continued, was “hanging round the neck of this nation like a millstone.” It was a “vortex,” sucking money from the poor to a new plutocracy.
Cobbett was not wrong. According to the best estimates from the Bank of England, Britain’s wars between 1776 and 1815 drove up the debt/GDP ratio from 86% to more than 172% by 1822. In those days, government bonds were almost entirely owned by a tiny wealthy elite, while taxation was largely indirect, on imports and consumption, and therefore highly regressive. Moreover, real (inflation-adjusted) long-term interest rates were strongly positive, averaging 5.27% in the 1820s.
The “Blessed Debt”
In the 19th century, Britain’s war debts and high real rates enriched a new plutocracy
Source: Bank of England
The good bad news is that today’s public debts have a very different character. Ownership is more evenly distributed, as most bonds are held institutionally by insurance and pension funds and other financial institutions. Taxation everywhere is far more progressive than it was in the early 19th century, a time when income taxes were regarded as wartime expedients. And, as we have seen, a significant portion of today’s public debts are held by central banks, meaning that one part of the government owes money to another.
In an important new paper, economists Jason Furman and Lawrence Summers argue that public borrowing today offers something very like that rarity in economics: a free lunch. The key is the historically low level of nominal and real interest rates. On the one hand, low rates mean that “monetary policy cannot be relied on to stabilize the economy.” On the other hand, low rates also mean that “fiscal expansions themselves can improve fiscal sustainability by raising GDP more than they raise debt and interest payments.”
Today’s interest rates mean that debt/GDP ratios are a bad way to measure debt burdens. After all, the accumulated public debt is a stock, whereas GDP is a flow. If debt is measured relative to estimates of the present value of GDP or prospective tax receipts, then “current debt levels are at low rather than high levels.”
Furman and Summers are not saying — as the proponents of modern monetary theory do — that debt doesn’t matter and the sky is the limit. They are simply arguing that “traditional ideas of a cyclically balanced budget on the grounds that [high debt] would likely lead to inadequate growth and excessive financial instability” are anachronistic. Fiscal policy can support growth with ongoing deficits so long as real debt service (i.e., interest payments adjusted for inflation) does not rise above 2% of GDP over the coming decade.
If governments borrow to finance investment, then, so much the better because “many public investments pay for themselves, or come close to paying for themselves, and the risk of not undertaking these investments is larger than the risk of doing too little deficit reduction.”
“Currently,” Furman and Summers conclude, “the primary worry for policy in the United States and several other countries is doing too little to expand the debt, not doing too much.” Democrats hoping for dual victories in next month’s Senate run-off elections in Georgia will read these words with tears of joy in their eyes. If they can only replace Sen. Mitch McConnell with Vice President-elect Kamala Harris as master/mistress of the Senate, they can fulfill their campaign pledges of spending up to $4 trillion, with nothing to fear from the bond vigilantes that terrorized former President Bill Clinton’s administration in its early days.
Furman and Summers are by no means the first to argue that debt-to-GDP is the wrong way to measure fiscal sustainability. In 2001’s “The Cash Nexus,” for example, I made a similar point: What really matters is keeping the real growth rate above the real debt service rate. Like Furman and Summers, I cited the pioneering work of Laurence Kotlikoff, who focuses on the present value of projected spending and revenues, as well as on the distributional effects of fiscal policy between generations.
And credit where credit is due. In the debates on interest rates and inflation that followed the global financial crisis, Summers was the winner. His 2014 lecture on “secular stagnation” — which argued that for a variety of structural reasons (e.g. aging populations and inequality) interest rates would remain stuck close to zero for the foreseeable future — proved prescient. Those of us who worried (as I did briefly) that Fed purchases of bonds (quantitative easing) might be inflationary were wrong. So were the Fed economists who wanted to normalize monetary policy by raising rates preemptively. (Remember how well that went two years ago?)
The problem is that for there to be a free lunch, financed by borrowing that pays for itself, secular stagnation has to continue: In other words, interest rates have to stay at their present low levels, which isn’t what the CBO expects. In its most recent long-run forecasts, nominal and real rates rise over the course of the 2020s. That means that net interest payments would rise above 2% of GDP from 2030 onward and hit 8.1% in 2050.
No More Free Lunch
Rising rates would drive up the government’s net interest payments
Source: U.S. Congressional Budget Office
True, as Furman and Summers point out, the CBO has been consistently wrong about the future path of interest rates, overshooting repeatedly since 1990. True, any forecasts beyond a ten-year time horizon are subject to great uncertainty.
Even so, my Hoover Institution colleague John Cochrane has history on his side when he expresses concern. As he argued in National Review last week, the situation is very different today from the situation in 1945, the last time the U.S. had a debt mountain this big. “By 1945, the war and its spending were over. For the next 20 years, the U.S. government posted steady small primary surpluses, not additional huge deficits. Until the 1970s, the country experienced unprecedented supply-side growth in a far less regulated economy with small and solvent social programs. … [Today] we are starting a spending binge with the same debt relative to GDP with which we ended WWII.”
In any case, as noted above, around three-quarters of this year’s deficits have been financed by Fed money creation in the form of excess bank reserves. “When the economy recovers,” Cochrane argues, “people may want to invest in better opportunities than trillions of dollars of bank deposits. The Fed will have to sell its holdings of Treasury securities to mop up the money. We will see if the once-insatiable desire for super low-rate Treasury securities is really still there. If not, the Fed will have to raise rates much faster than their current promises.”
This goes to the heart of the matter. A debt mountain doesn't matter only so long as interest rates remain low. That implies that there could very well be a key role for monetary policy if market participants anticipate higher inflation and start selling their holdings of Treasury bonds. The Fed has a new framework now, which states that inflation above its 2% target is just fine, after 12 years mostly below that level, as long as it averages out around 2%. But that clearly means a prolonged period of negative returns on government bonds, made worse for foreign investors if the dollar continues to slide against other major currencies.
If market rates start to rise, the Fed will be put to the test. Will it behave as it did in World War II, intervening to keep rates low in order to avoid a rapid rise in government debt-servicing costs? There is a widespread belief that it will and that Japanese-style “yield curve control” lies ahead. But in 1945 that was a wartime expedient and it was ended with the Fed-Treasury Accord of 1951, which restored the separation of monetary policy from debt management.
Another way of thinking about this is to contrast the likely trajectory of the post-pandemic economy with the sluggish path of recovery after 2008-9. A financial crisis originates in overstretched balance sheets — in the case of the 2008-9, those of banks, shadow banks and subprime mortgage borrowers. It took the better part of a decade for balance sheets to be repaired, which was one reason for the slow pace of recovery in the Obama years — the background against which secular stagnation seemed the right diagnosis.
The post-pandemic economy will be very different — and this is the bad good news. This year, thanks to Covid-19, the U.S. household savings rate has had its most volatile year since modern data began in 1948. In the second quarter, it jumped to an unprecedented 26%, compared to 7.3% a year before. As lockdowns and other restrictions were relaxed, the rate declined to 16% in the third quarter.
To expect such high rates to persist into 2021, as the OECD does in its latest Economic Outlook, is surely wrong. This was forced saving of income boosted by government handouts, prompted by a supply-led shock (lockdowns), not balance-sheet repair as after 2008-9. According to our estimates at Greenmantle, U.S. households are now sitting on roughly $1 trillion of excess savings as a result. Many are itching to spend a large chunk of that money as soon as they can.
The best analogy for the Covid-induced economic slump is not a normal recession but a war. With vaccine distribution in sight, society is now preparing to demobilize. As World War II wound down, many esteemed economists — notably Alvin Hansen, who coined the term “secular stagnation” — wrongly predicted an enduring economic crisis. Instead, the gradual removal of wartime restrictions led to a boom in consumption. Something similar seems in prospect next year.
The key question is how inflationary that post-pandemic boom will be. Most economists seem to agree with Furman and Summers that secular stagnation is here to stay. Charles Goodhart of the London School of Economics is one of the few to predict a “surge of inflation” as soon as next year. If he is right, the promised debt-funded free lunch could turn out to be a very expensive dinner.
While I doubt Goodhart’s prediction that inflation might rise to 5% next year, inflation can come at you fast, as my Bloomberg colleague John Authers pointed out last week. The U.S. housing market has roared back. Home equity withdrawals have soared. Bank deposits are way up and household debt-service ratios are at all-time lows. We are heading for a roaring 2021, if not the full Roaring Twenties. With a weak dollar and rising commodity prices, inflation might just give the Fed a fright.
I am not a macroeconomist; I am a mere economic historian. To me, past experience is more compelling than any model. The lesson of history is indeed that there is no correlation between debt-to-GDP ratios and long-term interest rates, just as there is no simple relationship between the size of central bank balance sheets and inflation.
But history also teaches us that debt and power are connected: A great power or empire that accumulates too high a mountain of debt and fails to keep growth ahead of debt service is destined to decline. The Bourbons, the Ottomans and the British all learned this hard lesson. So the post-pandemic debt dynamics matter not just for markets but for geopolitics.
In a new book published in online installments, “The Changing World Order,” Bridgewater Associates LP founder Ray Dalio argues that the U.S. is in the wrong stage of classic debt cycle. “When the government runs out of money (by running a big deficit, having large debts, and not having access to adequate credit) it has limited options,” he writes in chapter 9:
It can either 1) raise taxes and cut spending a lot or 2) print a lot of money, which depreciates its value. Those governments that have the option to print money always do so because that is the much less painful path, but it leads investors to run out of the money and debt that is being printed. Those governments that can’t print money have to raise taxes and cut spending, which drives those with money to run out of the country, state, or other jurisdiction because paying more taxes and losing services is intolerable. If these entities that can’t print money have large wealth gaps among their constituents, these moves typically lead to some form of civil war/revolution. This late-cycle debt dynamic is now playing out in the United States.
Scary stuff. And, to judge by an essay written by Guo Shuqing, chair of the China Banking & Insurance Regulator Commission and party secretary of the Chinese central bank, Dalio has influential readers in China, the inexorable rise of which is the other big theme of his book.
Still, I am old enough to remember Paul Kennedy’s argument in “The Rise and Fall of Great Powers” that the total U.S. federal debt in 1985 (then a mere 35% of GDP) was a sign of impending American overstretch reminiscent of “France in the 1780s, where the fiscal crisis contributed to the domestic political crisis.” What followed instead was the collapse of the Soviet empire and American triumph in the Cold War, not to mention Japan’s lost decades.
Most commentators are ending the year bullish on China — the only major economy that grew this year, and forecast by the OECD to grow by 8% next year. China’s gross public debt will be just 62% of GDP this year, less than half the U.S. figure.
But it is private debt that worries Chinese officials such as Guo and Vice Premier Liu He, not public debt. Since President Xi Jinping came to power in November 2012, according to the Bank for International Settlements, credit to households has doubled as a share of GDP to 59%, while credit to non-financial corporations has jumped by 38 percentage points to 162%.
China’s “Gray Rhino” Risk
The government is more worried about private debt as a share of GDP than public debt
Source: Bank for International Settlements
Guo’s fear is that excess leverage in the property sector — which accounts for about 39% of total outstanding bank lending — is the “biggest gray rhino risk” facing China’s financial system. The enduring impact of the pandemic has created a growing problem of non-performing loans, driving smaller lenders to insolvency. Last month saw a series of defaults by state-owned companies in China. And last week S&P Global Ratings warned that local government financing vehicles could be the next casualties as the authorities clean house.
After the disease, the debt. But it’s important to look not just at public debt but also at private debt when trying to see which great power has the steeper mountain to climb.
(Adds footnote in fourth paragraph to clarify what is included in federal debt held by the public. )
The federal debt held by the public excludes bonds held by federal trust funds such as Medicare and Social Security, but includes bonds bought by the Federal Reserve.