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Source: Grayscale; Compilation: AIMan@Bitchain Vision
Key points of this article:
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For fiat currency, reputation is crucial.Today, the U.S. government’s commitment to ensuring low inflation may no longer be completely credible due to high public debt, rising bond yields and uncontrollable deficit spending.We believe that strategies to manage the debt burden of the state will involve at least moderate high inflation, and this possibility is growing.If holders of dollar-denominated assets believe this, they may seek other means of store of value.
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Cryptocurrencies like Bitcoin and Ethereum may achieve this.They are alternative monetary assets based on new technologies.As a means of store of value, their most important features are programmatic, transparent provision, and autonomy that is not controlled by any individual or institution.Like physical gold, their practicality stems in part from their immutable and unaffected political system.
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As long as public debt continues to grow uncontrollably, the government cannot convincingly promise to maintain low inflation, and investors may also question the feasibility of fiat currency as a means of store of value..In this environment, macro demand for crypto assets may continue to rise.However, macro demand for crypto assets may decline if policymakers take steps to strengthen long-term confidence in fiat currencies.
Investing in crypto asset classes means investing in blockchain technology: a computer network running open source software that is used to maintain public transaction databases.This technology is changing the way valuable things (money and assets) flow on the Internet.Grayscale believes that blockchain will revolutionize digital commerce and have a profound impact on our payment systems and capital market infrastructure.
But the value of this technology – the utility it provides to users – is not just about the improvement of financial intermediary efficiency.Bitcoin and Ethereum are both payment systems and monetary assets.These cryptocurrencies have certain design features that can become a refuge for traditional fiat currencies when needed.To understand how blockchain works, you need to understand computer science and cryptography.But to understand the value of crypto assets, you need to understand fiat currency and macroeconomic imbalances.
Fiat currency, trust and credibility
Almost all modern economies use fiat currency systems: paper money (and its numerical representations) has no intrinsic value in itself.Surprisingly, most of the world’s wealth is rooted in worthless physical objects.Of course, the true meaning of fiat currency is not the paper currency itself, but the institution surrounding it.
In order for these systems to work, expectations of money supply need to be based on some basis—no one would use paper money without any commitment to limiting supply.Therefore, the government promises not to over-increase the money supply, while the public makes judgments about the credibility of these commitments.This is a trust-based system.
Yet history is filled with examples of government violations of this trust: policy makers sometimes increase the money supply (causing inflation) because it was a stopgap measure at the time.Therefore, currency holders will naturally be skeptical of the general commitment to limiting the supply of fiat currency.To make the commitment more credible, governments often adopt some kind of institutional framework.These frameworks vary by time and country, but the most common strategy today is to delegate the responsibility for managing the money supply to an independent central bank, where specific inflation targets are clearly set.This structure has been the norm since about the mid-1990s and is basically effective in achieving low inflation (Figure 1).
Chart 1: Inflation Targets and Central Bank Independence Helps Build Trust
When currency fails
When fiat currency has a high reputation, the public will not care about this issue.This is the goal.And for citizens of countries with historically low and stable inflation, the meaning of holding a currency that cannot be used to pay or repay debts on a daily basis may be difficult to understand.But there are many places in the world that obviously need better currencies (Figure 2).No one questioned why Venezuelan or Argentine citizens wanted to hold some of their assets in foreign currency or some crypto assets—they obviously need a better store of value.
Figure 2: The government occasionally mismanages money supply
The total population of the 10 countries in the chart above is about 1 billion, and many of them have used cryptocurrencies as currency life rafts.This includes Bitcoin and other cryptocurrencies, as well as the blockchain-based stablecoin Tether (USDT), which is pegged to the US dollar.Adopting Tether and other stablecoins is just another form of dollarization—replacement of domestic fiat currencies with US dollars—dollarization has been common in emerging markets for decades.
The world relies on the dollar
But what if the problem lies with the US dollar itself?If you are a multinational company, a high net worth person, or a nation-state, you can’t get rid of the influence of the dollar.The US dollar is both the local currency of the United States and the dominant international currency in the world today.According to the Federal Reserve, based on various specific indicators, the US dollar accounts for about 60%-70% of international currency usage, while the euro is only 20%-25% and the RMB is less than 5% (see Figure 3).
Chart 3: The US dollar is the dominant international currency today
It should be clear that the United States does not have the problem of mismanagement of currency compared with the emerging market economies in Figure 2.However, any threat to the robustness of the dollar is crucial because it affects nearly all asset holders—not just U.S. residents who use the dollar for daily trading.The risks facing the US dollar (rather than the Argentine peso or the Venezuelan Bolivar) are the real reasons that drive the largest capital pool to seek alternative assets such as gold and cryptocurrencies.Compared with other countries, the potential challenges facing U.S. currency stability may not be the most severe, but it is the most important.
The core is debt issues
Fiat currency is built on commitment, trust and credibility.We believe the U.S. dollar is facing an emerging credibility problem, which is increasingly difficult for the U.S. government to make compelling low inflation commitments.The fundamental reason for this lack of credibility is the unsustainable federal government deficit and debt.
This imbalance began in the 2008 financial crisis.In 2007, the U.S. deficit accounted for only 1% of GDP and total debt accounted for 35% of GDP.Since then, the federal government’s average annual deficit accounts for about 6% of GDP.Currently, U.S. Treasury bonds are about $30 trillion, equivalent to 100% of GDP—almost comparable to the level in the last year of World War II—and are expected to continue to grow significantly (Figure 4).
Figure 4: U.S. public debt is on an unsustainable upward track
Huge deficits have always been a common concern between the two parties, and remain even with relatively low unemployment rates.One reason why modern deficits are difficult to solve is that income now covers only rigid expenditures (such as projects such as Social Security and Medicare) and interest payments (see Figure 5).As a result, balancing budgets may require politically painful spending cuts and/or tax increases.
Figure 5: Government revenue covers only mandatory spending plus interest
Interest expenses: tight constraints
Economic theory cannot tell us how much government debt is considered too much.As any borrower knows, what matters is not the amount of debt, but the cost of financing.If the U.S. government can still borrow at extremely low interest rates, debt growth may continue without substantial impact on institutional credibility and financial markets.In fact, some well-known economists are optimistic about the rise in debt stocks in recent years, precisely because low interest rates have made financing easier.However, the decades of downward trend in bond yields now seem to be over, so the limits of debt growth are beginning to emerge (Figure 6).
Chart 6: Rising bond yields means restrictions on debt growth begin to take effect
Like other prices, bond yields ultimately depend on supply and demand.The U.S. government continues to issue more bonds, and at some point in the past few years, it seems that the demand for these bonds has been met (low yields/high price).
There are many reasons for this, but the key is that the U.S. government borrows both from domestic savers and from abroad.The U.S. domestic savings are far from enough to absorb the entire borrowing and investment needs of the U.S. economy.Therefore, there are both a large stock of public debt and a large number of net debt positions in the international accounts of the United States (Figure 7).A series of changes in the foreign economy have led to a decrease in demand for lower interest rates in international markets.These changes include a slowdown in the accumulation of official reserves in emerging markets and the end of Japan’s deflation.Adjustments to the geopolitical landscape may also weaken foreign investors’ structural demand for U.S. Treasury bonds.
Figure 7: The United States relies on foreign savings to finance borrowing
As the U.S. government refinances its debt at higher interest rates, a larger percentage of spending is spent on interest expenses (Figure 8).Low bond yields have allowed debt stocks to grow rapidly in the past 15 years, while government interest expenses have not been significantly affected.But this is now over, so the debt problem has become more urgent.
Figure 8: Higher interest expenses are constraints on debt growth
Why debt snowballs
To control debt burden, lawmakers need to: (1) balance the basic deficit (i.e., the budget balance after deducting interest expenses); (2) expect interest costs to remain at a low level relative to economic growth.The United States continues to have a basic deficit (about 3% of GDP), so even if interest rates are within a controllable range, the debt stock will continue to rise.Unfortunately, the latter question—what economists sometimes call the “snowball effect”—is also becoming increasingly challenging.
Assuming the basic deficit balance, the following conditions are met:
1. If the average debt interest rate is lower than the nominal economic growth rate, the debt burden (defined as the proportion of public debt to GDP) will decline.
2. If the average debt interest rate is higher than the nominal economic growth rate, the debt burden will increase.
To illustrate the importance of this, Figure 9 shows the hypothetical path of the proportion of US public debt to GDP, assuming that the basic deficit remains at 3% of GDP and the nominal GDP growth rate can be maintained at 4%.The conclusion is that when interest rates are higher relative to nominal growth, the debt burden will rise faster.
Chart 9: Rising interest rates could lead to snowballing debt burden
In addition to rising bond yields, many forecasters now expect structural GDP growth to slow down due to aging workforce and reduced immigration: the U.S. Congressional Budget Office (CBO) predicts that potential labor growth will slow to about 0.3% from the current 1% per year to about 0.3% by 2035.Assuming the Fed achieves its 2% inflation target—which remains an open question—a decline in real growth will mean a decline in nominal growth rate and accelerating debt stock growth.
How does the story end
By definition, unsustainable trends cannot last forever.The uncontrolled growth of U.S. federal government debt will eventually end, but no one can determine the exact time.As always, investors need to consider all possible outcomes and weigh the possibility of it happening based on data, policy makers’ actions, and historical lessons.There are essentially four possible outcomes that are not necessarily mutually exclusive (Figure 10).
Figure 10: Investors need to consider results and weigh their possibilities
The possibility of default is extremely small, because U.S. debt is denominated in US dollars, and inflation is usually less painful than not paying off debts.There may be fiscal austerity in the future—and it may eventually become part of the solution—but the U.S. Congress has just enacted the Big Beautiful Act, which keeps fiscal policy high in the next decade.At least for now, reducing the deficit by tax increases and/or reductions in spending seems unlikely.Bold economic growth will be the ideal result, but growth is currently weak and potential growth is expected to slow.Although the data has not yet been revealed, the significant increase in productivity driven by artificial intelligence technology will undoubtedly help manage the debt burden.
This leads to artificial low interest rates and inflation.For example, if the U.S. can maintain an interest rate of about 3%, a real GDP growth rate of about 2%, and an inflation rate of about 4%, it could theoretically stabilize the debt stock at current levels without reducing the base deficit.The Fed’s structure operates independently to protect monetary policy from short-term political pressure.However, recent debates and policymakers’ actions have raised concerns among some observers who believe this independence may be at risk.In any case, it may be unrealistic for the Fed to completely ignore the country’s fiscal policy issues.History shows that at critical moments, monetary policy is subject to fiscal policy, and the path with minimal resistance may be to get out of it through inflation.
Given the possible outcomes, the severity of the problem, and the actions policymakers have taken so far, we believe that long-term strategies to manage the country’s debt burden will increasingly likely bring average inflation above the Fed’s 2% target.
Back to cryptocurrency
All in all, the U.S. government’s commitment to controlling growth in money supply and inflation may no longer be completely credible due to the huge debt scale, rising interest rates and the lack of other viable means of response.The value of fiat currency ultimately depends on the government’s credible commitment to not increase the money supply.Therefore, if there is reason to doubt this commitment, investors in all dollar-denominated assets may need to consider what this means for their portfolio.If they start to think that the dollar is less reliable as a means of store of value, they may look for other options.
Cryptocurrencies are digital commodities based on blockchain technology.There are many types of cryptocurrencies, and their uses are usually not related to “store of value” currencies.For example, public chains have a wide range of applications, covering many fields such as payment, video games and artificial intelligence.Grayscale uses the “crypto sector” framework developed in collaboration with FTSE Russell Index, and classifies crypto assets based on their main uses.
We believe that a small portion of these digital assets can be regarded as a viable means of store of value due to their widespread use, highly decentralized and limited supply growth.This includes two crypto assets with the highest market capitalization – Bitcoin and Ethereum.Like fiat currencies, they are not “supported” by other assets that give them value.Instead, their utility/value stems from the fact that they allow users to make peer-to-peer digital payments without the risk of scrutiny and that they make a credible commitment that does not increase supply.
For example, the supply of Bitcoin is capped at 21 million, and the current supply is growing at a rate of 450 per day, with new supply dropping by half every four years (Figure 11).This is clearly articulated in the open source code that no changes can be achieved without consensus from the Bitcoin community.Furthermore, Bitcoin is not bound by any external institutions, such as financial institutions that need to repay debts, which may interfere with their low and predictable supply growth targets.Transparent, predictable and ultimately limited supply is a simple and powerful concept that helps Bitcoin’s market capitalization grow to over $2 trillion.
Chart 11: Bitcoin provides a predictable and transparent money supply
Like gold, Bitcoin itself does not generate interest and is not (at the moment) widely used in daily payments.The utility of these assets is what they do not do.Most importantly, their supply will not increase because the government needs to repay debts – no government or any other agency can control their supply.
Investors today must deal with a serious macroeconomic imbalance, the most important factor being the unsustainable growth of public debt and its impact on fiat currency credibility and stability.The purpose of holding alternative currency assets in the portfolio is to hedge against the risk of fiat currency depreciation.As long as these risks continue to increase, the value of assets that can hedge such results should be higher.
What can turn the situation around
Investing in crypto asset classes involves various risks and is beyond the scope of this report.However, from a macro perspective, a key risk to the long-term value proposition of certain crypto assets may be the government’s commitment to managing fiat currency supply to restore public confidence.These measures may include stabilizing and reducing the government debt-to-GDP ratio, reaffirming support for central bank inflation targets, and taking measures to consolidate central bank independence.The government-issued fiat currency has become a convenient medium for trading.If the government can ensure that it can also be an effective store of value, demand for cryptocurrencies and other alternative store of value may decline.For example, gold performed well when the credibility of US institutions was questioned in the 1970s, but in the 1980s and 1990s, gold performed poorly as the Fed controlled inflation (Figure 12).
Chart 12: Gold underperformed in the 1980s and 1990s as inflation fell
Public chains have brought innovation to digital currencies and digital finance.Currently, the most valuable blockchain applications are those that provide digital currency systems that are different from fiat currency functions—their needs are closely related to factors such as modern macroeconomic imbalances (such as high public sector debt).Over time, we believe that the growth of crypto asset classes will be driven by these macro factors and the adoption of other innovative technologies based on public chains.
