This blog post first appeared in the Economic Forces newsletter. Its author is a Senior Fellow at BPI and Chair of the Department of Economics at Ole Miss.
Last week, there was a large Bitcoin conference in Nashville. What made this particular conference notable is that three separate politicians, Robert F. Kennedy Jr., former President Donald Trump, and Senator Cynthia Lummis, each proposed some variation of a plan for the U.S. government to hold a strategic bitcoin reserve. Not surprisingly, these proposals were cheered by conference attendees. However, in the aftermath of the announcements, a number of pundits and economists have come out and said that the idea is silly. Today, I would like to think through these proposals. Is there any merit here? Under what circumstances? Bitcoiners seem to like these proposals because they assume it will make the price go up, but what should they be concerned about? Let’s let price theory be our guide.
While there are significant differences in implementation across the proposals, each is motivated by the same goal: the United States government should own a substantial amount of bitcoin. The natural question to ask is whether this makes any sense.
There are essentially two ways to implement this sort of policy. The first would be to have the U.S. Treasury Department issue debt in order to purchase bitcoin. The second would be for the U.S. Treasury to convert some of its other assets into bitcoin. For example, the U.S. Treasury owns a significant amount of gold. It could sell some of this gold on the open market and use the proceeds to buy bitcoin. Thus, contrary to the claims of some critics, proposals would not require that the government borrow to buy bitcoin.
So, why would the government possibly do this? The most compelling economic argument for doing this would be in terms of option value.
The U.S. national debt is rising quickly. Many have pointed out that the current trajectory of the debt is unsustainable. In order for government debt to be on a sustainable trajectory, the government would need to increase taxes, cut spending, or both. Each of these options are politically unpopular. However, if the debt continues on an unsustainable path, there is a third possible outcome: inflation via debt monetization. In other words, when the market believes the debt is unsustainable, people will buy fewer government bonds (or no bonds at all). In that scenario, the Federal Reserve will become the buyer of last resort and will be forced to own a larger and larger fraction of the debt. The expansion of the Fed’s balance sheet will be inflationary.
Of course, these arguments are largely about flow variables rather than stock variables. The debt is a stock variable. Taxes and spending are flow variables.
Another way to think about government debt is to think about the government’s balance sheet. The U.S. government owns a lot of assets. The Treasury Department owns a significant amount of gold, for example. The U.S. government owns a lot of land that is currently used for things like national parks. It is therefore conceivable that there is another alternative to raising taxes or cutting spending and that would be for the U.S. government to sell some of its assets. Selling the national parks wouldn’t be popular, but it would be an option.
Herein lies a critical point. When the U.S. government debt rises, all else being equal, this increases the option value of the assets that the government owns. This option value is derived from the government having the option to sell these real assets for dollars that they could then use to buy back and retire government bonds.
Given this interpretation, one might argue the government should seek to maximize the value of its portfolio of real assets. One way to do that would be to purchase assets that have a real value that is likely to appreciate as government debt rises. In fact, if the government could construct a portfolio that generates a real rate of return that exceeds the real rate of interest on the government debt, the net worth of the U.S. government would rise and a given amount of debt would be more sustainable. The difficulty here is in finding a portfolio whose real returns exceed the real rate of interest on government debt when government debt is on an unsustainable path (since the real rate of interest on government debt rises as the debt becomes more unsustainable).
Okay, so where does bitcoin fit in? One way to think about this is to note that any government that can print money doesn’t have to repay its debt with taxation. It could resort to money printing. Thus, defaulting on sovereign debt when the debt is denominated in a currency that the government or central bank controls, doesn’t come in the form of a failure to repay, but rather in the form of inflation. Everyone gets repaid in nominal terms, but there are substantial losses in real terms. (You receive the promised dollar amount, but the purchasing power of those dollars is dramatically lower.)
When this sort of thing happens, people tend to race to buy real assets to protect them from inflation (in fact, this is part of the inflationary process itself). One such asset might be bitcoin. Given its fixed supply, a scramble to buy more bitcoin would dramatically increase its price in terms of the domestic currency. Those already holding bitcoin would therefore be insulated from the dramatic decline in the real purchasing power of their domestic currency. Bitcoin is therefore a hedge, or a form of insurance.
Now, apply this to the government’s balance sheet. Suppose the government already owns real assets, like gold and bitcoin. In the event that investors believe that the debt is unsustainable, they are likely to buy these real assets. But as the prices go up, this increases their option value since the government always has the option to use its capital gain to pay off some of the debt.
It is important now to consider the implications of doing so. Most models of fiat money that use rational expectations have two steady state equilibria. There is one equilibrium in which money has positive value (i.e., positive purchasing power). There is a second equilibrium in which money has no value. Given the nature of fiat money, the equilibrium in which money has positive value is unstable. A dramatic shock could push the value of money sufficiently far from the positive value equilibrium and start the process of moving toward the zero value equilibrium. This process is otherwise known as hyperinflation.
It is important to consider the strategic reserve proposals in light of this well-known result. One possibility is that by buying bitcoin, this reinforces the positive value equilibrium. For example, if people are concerned that the U.S. won’t pay back its debt and they buy real assets like bitcoin, this bids up the price of bitcoin. The government, owning a significant supply could then sell the bitcoin to buy back some of the debt and retire it. However, with rational expectations, everyone knows that this is what the government will do. Therefore, in anticipation that the government will sell the bitcoin when the price gets sufficiently high to repay the debt, people don’t have to worry that the U.S. is unable to pay the debt, and therefore investors don’t have to buy more bitcoin. We simply stay in the same equilibrium in which the fiat currency has positive value.
In reality, this implies some type of commitment mechanism on the part of the government. For this to work, the government would actually have to buy a significant amount of bitcoin and promise to hold the bitcoin while maintaining the option to use any capital gains to pay off the debt.
But herein lies the challenging aspect of these proposals. The positive value equilibrium is unstable. As a result, a sufficient shock can create expectations of higher inflation. Due to the nature of these models, those expectations can be self-fulfilling. Thus, aggressive and/or large, recurring purchases of bitcoin (or any other real asset, for that matter) could cause people to think that the situation is much worse than they imagined and that these purchases are motivated by the urgency of the situation. These people might begin to expect that the urgency reflects a coming hyperinflation and, if so, these expectations can become self-fulfilling.
Thus, any proposal to create a strategic bitcoin reserve must recognize that while there is possibility that such a reserve could restore confidence in the ability of the government to finance its debt, it could also undermine that intended purpose with the most costly of results. The way to avoid that outcome is to avoid doing anything drastic. RFK Jr.’s proposal (the most aggressive proposal of the three) for the government to purchase 550 bitcoin per day until the government owns 4 million bitcoin seems like an example of something quite drastic.
Another concern, and one likely to bring scorn from Bitcoiners, is the role of self-fulfilling expectations as it pertains to the current state of bitcoin adoption. While bitcoin has become dramatically more popular over the years, large-scale adoption just isn’t there yet. Part of this is just ignorance (perhaps rational ignorance) about bitcoin. But some part of it is skepticism. Many skeptics think that bitcoin is worthless.
Thus, by buying bitcoin, the U.S. government might generate one of two possible outcomes. The first is that the government’s purchase of bitcoin could provide some legitimacy to the asset. The second possibility is that those who are ignorant and those who are skeptics might believe that this proposal is no different than buying a worthless, platinum trillion dollar coin. If so, self-fulfilling expectations can set in as people come to believe that the government has lost its mind or is desperate and the situation is dire. (It is also important to note here that it is irrelevant whether the decision-makers in the government have objectively lost their mind or not. What is important is if people believe it.)
Bitcoiners have naturally applauded the proposals. Their reason for doing so is obvious, a large-scale buyer in the market for an asset in fixed supply is likely to raise the price and make them wealthier. However, even setting aside the issues with self-fulfilling expectations, one should approach such proposals with caution. As I have previously written about bitcoin, one should be skeptical of government involvement. States have a long history of manipulating the value of money and engaging convoluted debt consolidation schemes. Although Bitcoin itself is censorship resistant, Bitcoin is not immune from the sorts of interventions I describe. One should therefore approach state intervention with caution.
Regardless, I have tried to approach the issue using basic insights from price theory (after all, the price of money is a price) rather than resorting to cheerleading or blind criticism. The U.S. finds itself in a precarious position given the trajectory of its debt and we shouldn’t dismiss outside-the-box thinking. Instead, we should apply some price theory and let people make up their minds.
