Discussions of a possible US default have dominated the news cycle for the past few weeks. This is now the second time in as many years that debates over the debt ceiling have pushed the boundaries of the US government’s borrowing infrastructure. Having seen a similar scenario unfold in 2011, reactions from financial markets this time around may be foreseeable. Incidentally, this scenario may also provide a valuable opportunity to understand bitcoin’s developing role in the macroeconomic landscape.
In Familiar Territory
The current political disputes in Washington have led to a series of escalating outcomes. As the result of a failure to pass a continuing resolution to appropriate the existing budget the federal government has furloughed hundreds of thousands of employees, leading to an estimated $160M per day hit to the country’s economy.
On top of that is the looming debt ceiling, the amount of debt the US is legally allowed to have outstanding, which is expected to be reached on October 17. After the ceiling is reached the government cannot take on more debt, which it needs to pay existing liabilities. Partisan disagreements over the contingencies to pass a debt ceiling increase have resulted in a stalemate with no end in sight, driving concerns around whether or not the US will be able to service payments on their existing debt.
While the US government has historically been known for a pristine credit rating- other than a few missteps – extreme delays in raising the debt ceiling in 2011 led to financial turbulence and an eventual downgrade of the US credit rating by Standard & Poor’s.
The financial fallout from the 2011 debacle was significant and is showing initial signs of repeating. On the Friday before the Monday debt ceiling deadline two years ago, the Bureau of Economic Analysis announced a downward revision of historic GDP figures, adding additional market headwinds. Even as lawmakers narrowly avoided default just hours before the deadline on August 1, risk markets began a dramatic tumble which was ultimately exacerbated by S&P’s downgrade of the US to AA+ on August 5.
Between July 25 and August 8, 2011, the S&P 500 fell more than 16% and remained highly volatile for weeks. Amid the flight to safety, 10-year US Treasury yields dropped 90bp to 2.1% by mid-August and gold climbed $200, reaching $1880/oz.
During the same period, bitcoin was also in one of its most historic and volatile periods, but for a host of other reasons. Two U.S. Senators asked for an investigation into bitcoin and Silk Road in June of that year, leading to a dramatic sell-off. Shortly thereafter Mt. Gox suffered an attack that resulted in the theft of thousands of bitcoin from its account holders and mybitcoin.com, a popular hosted wallet service, was shuttered and left users with only fractions of the bitoin they had deposited. As one would imagine, the abundance of micro events in a market with a total capitalization equivalent to $3-20M at the time makes drawing any sort of correlation to macroeconomic events relatively futile.
A Test of Confidence
Bitcoin has matured dramatically since then and is increasingly finding relevancy on the global economic landscape. While many are familiar with bitcoin’s role in subverting capital controls and offering an alternative to debased government fiat due to the innovative technical protocol, it has also recently found a role more similar to one of the oldest financial assets in the world: gold.
Since mid-May, after the speculative bubble settled somewhat, bitcoin’s correlation to gold has been remarkable. The relationship may come as a surprise to some, given gold’s role as a safe haven asset and bitcoin’s relatively high volatility, but they also both serve as a pure monetary alternative to government fiat. With concerns around government stability as a primary driver of the global economy for years now, seeing the two assets similarly bid shouldn’t come as a surprise.
Every day we loom closer to the October 17 debt ceiling deadline and the related fallout if an accord is not reached. Though gold has been notably under-performing recently due to initial signs of economic recovery, skepticism of a default occurring, and prospects of Fed tapering weighing on demand for safe havens and inflation protection, if 2011 is an indicator the yellow metal may be set for gains as investors become increasingly skeptical that the US can prevent a default. More interesting may be the test of bitcoin if tensions continue to grow and a potentially catastrophic US default remains on the horizon. Bitcoin’s ability to maintain its relationship with gold during these events may offer important insight into whether investors truly trust the digital currency or simply trade it speculatively alongside a more trusted asset with similar supply dynamics.
If a flight to safety drives up the price of gold like was seen in 2011 and the gold-bitcoin correlation breaks, it may signal that faith in bitcoin’s ability to store value has not yet reached the level required for broad adoption. If the correlation holds, it would be a strong signal that digital currencies are developing a more significant role as an asset class within the global financial system. A scenario where true fear drives investor reactions may be about to unfold and would offer insight into where bitcoin stands at this point it its relatively short life.
An Inevitable Consideration
Regardless of bitcoin’s financial performance at this still-early stage, current events are forcing conversations likely to benefit digital currencies in the long run. As the US government enters gridlock, yet again threatening the stability of the global financial system, people will be forced to reassess their understanding of fiat value. With Congress reaching the lowest yearly average approval rating since 1974 this week, anyone holding US Dollars has to wonder just what exactly the full faith and credit of the US government is worth anymore.
With this scenario developing further every day, the prospect of a currency not at the whim of political interests becomes increasingly appealing. In the reasoning for their 2011 downgrade of the US sovereign rating, S&P stated,
“The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy.”
By proving them true, the US government has only further shaken the foundation on which the assumption of value behind fiat currency is built. While the world has a ways to go before digital currencies reaches mainstream acceptance, we’ll have the existing powers to thank most of all if it does.