The Fraying World Order

And Game Theory around the Dollar and Euro

Mar 29, 2022

Hello readers,

This week we’re examining geopolitical game theory as it relates to sanctions, energy, and currencies. This is a very complex topic that has been on my mind for some time. Russia’s invasion of Ukraine and the subsequent economic sanctions imposed on Russia have re-ignited interest in this area. So it’s time to write about it again.

Topics Covered:

Economic Sanctions, Energy, and Geopolitical Game Theory
Gold and Bitcoin

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Let’s go.

Economic Sanctions, Energy, and Game Theory

Imagine you live in a foreign country and you have an online business that sells products and services to consumers in the United States. You are paid in dollars. However, your local currency is not dollars. Therefore you convert most of your dollar revenue back to your local currency to pay for goods and services. And you keep a stockpile of dollars because dollars are the reserve currency and tend to hold their value better than your local currency.

And then one day the United States decides that your country is bad for the world order, imposes economic sanctions, and shuts it off from the world economy.

Your dollars are no longer money.

This is essentially what the United States, along with our allies, just did to Russia. Putting aside whether Russia’s actions are right or wrong (they are clearly wrong), let’s examine what this could mean for energy, energy pricing, the dollar, and the euro.

Impact on Global Energy Pricing

Russia is the third-largest producer of oil and the second-largest producer of natural gas worldwide. About 40% of Europe’s natural gas imports come from Russia, with Germany and Italy the largest importers. About 27% of Europe’s oil comes from Russia. 100% of these contracts are priced in euros and dollars. But Russia no longer wants euros and dollars for its energy. After all, we literally just told them their dollar reserves were no longer money.

So, what do they want? They want their local currency, Rubles. Or Gold. They have even indicated they would accept Bitcoin. Nations that Russia deems to be friendly will have the option to transact in their currencies - China in Yuan, and Turkey in Lira.

The US has largely been able to maintain its hegemony and grip on the reserve currency due to the pricing of commodities in dollars. Of course, our military then defends the network built around the dollar which starts with energy pricing.

Therefore, these moves by Russia away from the dollar and the euro could represent the beginning of the end of the dollar as the preeminent reserve currency. This would also significantly weaken the euro and likely all fiat currencies.

For the record, Europe is saying they are going to refuse to pay for energy contracts in Rubles, Gold, or Bitcoin. The contracts were made in dollars and euros and they want those contracts to be honored. However, does anyone think Russia is willing to play by the rules here? They scoffed at this, replied that they would not be doing any charity, and added that supply would need to be shut off if their demands are not met.

I hate to say it, but Russia is holding the cards here. If Germany and the rest of Europe had an option, they wouldn’t still be buying energy from Russia. They don’t have an option. At least not right now. Energy appears to be the trump card here and Russia is holding it.

The countries that get to price energy in their currency obtain massive leverage in the regime of free-floating fiat currencies. The United States took the mantle in the early 70s when we removed the gold peg and convinced Saudi Arabia to price oil in dollars in return for weapons and military protection. This creates demand for the currency pegged to energy and props it up against other currencies. It also causes major shifts in world trade.

Russia is essentially taking a play out of the US playbook that spawned the Petrodollar system in the early 70s.

Of course, it is very possible we end up with a neutral reserve asset for settling energy. The only two options here are gold or Bitcoin. In this case, the dollar could remain the reserve currency (as it was on the gold standard post-Bretton Woods). The difference would be that the Fed would be constrained in terms of money printing. They could do it, but they would cause the price of gold and or Bitcoin to appreciate rapidly against the currency due to scarcity of the reserve asset.

Saudi Arabia and China

What happens if Saudi Arabia decides they don’t want to accept dollars for their oil exports? Per the Wall Street Journal, they are already considering such a move.

It appears that the Saudis are becoming more and more incentivized to price oil in the Chinese Yuan. Why? China buys about 25% of the oil that Saudi Arabia exports.

Relations between the US and Saudi Arabia have been deteriorating under President Biden. This is due to the Saudi’s perceived lack of support for their intervention in the Yemen civil war, the Biden administration’s recent attempt to strike a deal with Iran over its nuclear program, as well as the precipitous US withdrawal from Afghanistan last year.

China stands to benefit from increased tension between Saudi Arabia and the US. As such, they have stepped up their courtship of the Saudi Kingdom in recent years by helping Saudi Arabia build its own ballistic missiles, consulting on nuclear programs, and investing in Crown Prince Mohammed bin Salman’s pet projects.

The US once imported more than 2 million barrels of Saudi crude oil per day in the 90’s. That figure is down to 500,000 barrels of oil today. By contrast, China’s imports of Saudi oil have expanded over the last few decades. Saudi Arabia is now China’s top oil supplier, with Russia #2.

Takeaways

It is not clear exactly how this will all play out over time. But what is very clear is that we are likely seeing the beginning of an evolution in the world order. China and Russia would love to move toward a system where energy is priced in anything but dollars and euros. Historically, world orders shift when there is a change in the owner of the preeminent reserve currency. Ray Dalio has done some fantastic work in this area. His recent book, The Changing World Order, is an absolute must-read in the context of what we are seeing around the globe right now. In the past, these monumental moves have corresponded with the end of a long-term debt cycle (we are at the end of one with the dollar) as well as geopolitical conflict and wars, and a rising world power (China). When we layer in a global pandemic and a major demographic shift, it becomes clear that we are mixing up quite the cocktail for some big changes in the coming years.

What we are learning in real-time is that energy is the real currency. In a fiat-based world order, power is captured by the countries that get to price energy in their currency.

Bitcoin and Gold

There are only two monetary instruments that are nobody else’s liability: Bitcoin and Gold. To some extent, we could put Silver in this category as well.

What exactly does that mean?

It means Bitcoin and Gold are the only two monetary assets that an individual, business, or Central Bank can hold that leave them clear from the mercy of another state actor.

For example, dollars are the liability of the Federal Reserve. Any country or individual holding dollars is at the mercy of US politics, sanctions, as well as decisions by the Federal Reserve. This is true for any sovereign currency.

As trust in the current world order begins to fray, the output can be that individuals and nations have to rethink what exactly their money represents. Is it really your money if a bank, broker, or nation-state can cut you off from it?

Bitcoin and Gold are non-soverign. They are bearer assets. They are not the liability of anyone else. If you own some Bitcoin (in self custody) or physical Gold, you have a bearer asset. Nobody can control it but you. You do not need permission from anyone else to access your asset or use it in commerce.

When you hold these assets you don’t have to trust anyone else to do something or refrain from doing something. For example:

You don’t have to trust that the Federal Reserve won’t debase your savings
You don’t have to worry about your country imposing capital controls
You don’t have to trust that the stock market won’t shut down during a period of extreme market turmoil (as is happening in Russia and happened in the US in the past)
You don’t have to trust your bank or worry about a bank run
You don’t have to trust that a politician will decide that they do not like your business or a cause you stand for, and hence cut you off from accessing your assets (as has happened in the US and Canada recently)

In the United States, we have been extremely lucky and haven’t really had to worry about the above scenarios. Therefore, assets like Bitcoin and Gold, for the most part, have not been needed for the past 40 years or so. A consistent world order, stable financial markets, low debt/GDP, property rights and laws, trust of institutions, etc has all created such an environment that most investors wouldn’t even understand why someone would want to own something like Gold or Bitcoin.

With that said, assets like these could do extremely well during periods of great uncertainty.

This would have sounded crazy just a few months ago, but it’s possible that Gold, Bitcoin, and a basket of additional currencies all take the place of the hegemon that was the US dollar when this war is all said and done. This doesn’t mean the dollar is going anywhere or that the world will end. It just means we will have a disruptive period for a while as the world reorganizes itself. If the dollar did lose the reserve currency status, I would expect very high inflation and a devaluing of the dollar against gold, bitcoin, commodities, real estate, stocks, etc. It’s possible this could be kicked off due to potential instability in Europe over energy and energy pricing.

The US still produces more energy than any country in the world and will be fine in the long run.

Looking Ahead

If we fast forward a year or two, it is very possible that Bitcoin could be trading at $100k or $200k and it will seem obvious in hindsight why. I could see a similar outcome for Gold.

It’s never obvious why anyone would hold a bearer asset like Gold or Bitcoin, until, well, it’s really obvious.

Which could do better?

This is hard to say. In my view, Bitcoin is clearly a 10x improvement to Gold. It has very similar characteristics to Gold, but enhances Gold in 3 critical areas:

Portability. Gold cannot be easily moved or transacted. Bitcoin is a bearer asset that has zero custody costs and can be transported and transacted instantly around the world in a peer-to-peer fashion. Bitcoin is basically gold with a peer-to-peer, global payment system attached to it. It’s built for a modern economy and the digital age.
Scarcity. Gold is one of the scarcest financial assets on the planet. The difficulty in producing gold is one of the core reasons it has maintained its value relative to fiat currencies over long periods of time. That said, Gold has average inflation of about 1.5-2%/year. If the price of gold doubled to $4k/ounce, producers would rush into the market. More gold would be produced. This is not possible with Bitcoin. Bitcoins supply is completely inelastic to price action. Today, Bitcoin’s inflation rate is 1.7% per year. It has a fixed monetary policy. Come May of 2024, the inflation will drop to .85%/year. And 4 years later it will drop to .42%. This will continue every 4 years until all 21 million Bitcoin is mined (in 2140).
Divisibility. Each Bitcoin is divisible into 100 million units, or Satoshis. This enables commerce in a way that gold cannot achieve since it simply does not have this divisibility built into the physical instrument.

Bitcoin has a much smaller market cap and therefore could have more upside as well. With that said, Bitcoin is just 13 years old and Gold today is the preferred asset of Central Banks around the world. Will they start to move into Bitcoin in the coming years as competition amongst fiat currencies ramps up? Only time will tell. There could be a massive first-mover advantage to doing so. The United States has the largest concentration of Bitcoin around the world today. It’s possible that the Central Bank could become incentivized to adopt Bitcoin as a means to preserve the lead and also protect the wealth already in the country.

Another interesting angle here is how energy companies are moving into Bitcoin mining. For example, Exxon Mobil has commenced a pilot program using excess natural gas flares to mine bitcoin as a means to reduce carbon emissions. The collaboration between energy producers and bitcoin miners is an under-reported and extremely interesting subplot when it comes to bitcoin adoption and how bitcoin interacts with fundamental aspects of the real world such as energy.

We can also expect nation-states to move in the direction of Central Bank Digital Currencies (CBDCs). This would just be another form of fiat currency, but it is something to think about as it will have a massive impact on the global monetary system.

It is anyone’s guess as to how this will play out in the coming years. But what is abundantly clear is that money and world powers have changed throughout history. It appears we could be on the cusp of one of those changes.

I haven’t even touched on some of the impacts the war could have on food scarcity and food prices. If you dare (you may need a cocktail), check out the latest episode of the All-In Podcast.

Of course, I could be overthinking everything. The war could somehow end tomorrow and we can forget about all of these scenarios.

My gut just tells me that is not likely to happen.

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