The Dollar Milkshake Theory is the Samuel Jackson of foreign exchange theories: the dollar drinks the other currency's milkshake, then shoots it in cold blood.
Jokes aside, this theory has been one of the major macro narratives in 2022. That is why this article looks at:
  • What the Dollar Milkshake Theory is and where it comes from.
  • How it could play out and if we are already in it.
  • What the theory means for Bitcoin and Ethereum.

 

What Is the Dollar Milkshake Theory?

The Dollar Milkshake Theory is a framework for a sovereign debt crisis. It explains why the U.S. dollar will strengthen against other fiat currencies and predicts that the U.S. dollar will “suck liquidity” out of other fiat currencies, like from a proverbial milkshake.

How does the Dollar Milkshake Theory work?

Let's explain it with two imaginary countries: Bankruptia and Thriftistan.
Bankruptia is a profligate country that likes to live above its means and raise a lot of debt. It also has a history of defaulting on its debt. Therefore, Bankruptia has a weak currency that investors do not trust.
Thriftistan is the opposite in many ways. It has a high savings rate and although it also raises a lot of debt, it always pays back on time. Thriftistan has a good reputation among investors and a strong currency.
Both have one thing in common: they have built up high debt burdens over the last decades. But while Thriftistan can borrow in its own strong currency, Bankruptia often has to rely on borrowing in dollars due to its poor “credit score.”
One day, the U.S. starts raising interest rates. This increases Bankruptia's cost of borrowing money — it has to pay more interest on debt denominated in USD. But Thriftistan feels the impact too: investors that would normally buy its debt now have a more attractive alternative — they can buy US sovereign debt (the “safest” debt).
Eventually, Bankruptia follows its historical track record and collapses under the weight of debt payments and defaults. Thriftistan doesn't, but investors rush out of its currency to invest in U.S. debt, weakening its currency in the process.
This is a rough example of how the Dollar Milkshake Theory explains and predicts the weakening of fiat currencies against the dollar. Both Bankruptia (similar to Argentina) and Thriftistan (similar to Japan) feel the impact, even though their circumstances are different. As a rule of thumb: the worse a currency's credit record and the higher a country's reliance on USD, the more likely its currency is to depreciate.

Where Does the Dollar Milkshake Theory Come From?

Brent Johnson, founder of the investment fund Santiago Capital, is the brain behind the theory.

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The foundation for Johnson's theory is:

a) the long-term debt cycle.

b) the high reliance on the U.S. dollar for debt and asset pricing.

States have good and bad incentives to build up debt:
  • Good incentives are using debt to make investments that raise productivity, such as education.
  • Bad incentives are using debt to pay for less productive causes like social security.
Eventually, states need to pay back this debt. They can do so through austerity, where saving exceeds spending, or raising new debt to pay old debt. Austerity is unpopular because it is painful: states sooner or later always choose to pay debt with debt. When the debt becomes too big to be paid back, states inflate their currencies or default: this is the end of the long-term debt cycle.

Since the U.S. dollar is the fiat currency with the most liquidity and highest degree of trust, it is widely used outside of the U.S.. Examples are trade invoices, investments or funding (raising debt).

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Source: https://www.cambridge.org/core/elements/can-brics-dedollarize-the-global-financial-system

This record of liquidity and trust goes so far that even neighboring countries may use the U.S. dollar instead of a local currency when trading with each other. For example, African countries mostly invoice their exports in USD even when they trade with other African countries.

How Could the Dollar Milkshake Theory Play Out and Are We Already In It?

A brief look at the U.S. dollar strength in 2022 may lead you to conclude that the theory is already playing out:

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However, Brent Johnson himself said that the theory would take two to five years to play out and would lead to sovereign debt crises. A strong USD would "destroy the system" because even rich countries like Japan or the EU bloc would face hitherto unseen currency crises. Imagine a situation like in Bankruptia, with Bankruptia being Japan. The consequences for the global economy could be catastrophic.
Moreover, Johnson maintains there is nothing the rest of the world can do about a stronger USD. Only the U.S. has the power to depreciate its currency. According to him, Federal Reserve President Jerome Powell "wants his legacy to be that inflation is under control," so the US would put up with a stronger dollar.
Are the consequences of a surge in the USD really that bad?
Yes. Johnson predicts a "meltdown" in the rest of the world if the theory fully plays out. In part, we can already see this happening in the two countries that served as role models for our explanation. Both the Argentine peso and the Japanese yen have significantly decreased in value against the dollar:
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However, Johnson expects much more chaos to come as the theory plays out. Examples would be:
  • Sovereign debt defaults.
  • Big equity markets tanking (e.g. in Europe).
  • Swap lines being extended (swap lines are agreements between central banks to swap their currencies with each other).
He also expects countries to monetize their debt (= money printer go brr). Japan is already doing this by holding its debt payments artificially low and putting up with a weakening currency.
Since there is so much USD liquidity and so many assets outside the U.S. denominated in USD, Johnson does not see a way around debt monetization without a "massive crash" happening. His long-term prediction is that the dollar will "fail last." Any moves by the rest of the world to "prevent" this from playing out would fail due to the global dependence on the dollar.

Although some countries are trying to reduce dollar dependency in areas like trade invoicing and commodity pricing, the dollar’s hegemony in investability (= storing savings) and funding (= getting credit) won’t be challenged any time soon. Quite the opposite, restricting companies and individuals from accessing USD liquidity only increases the appeal of the dollar and leads to more short-term volatility. Crypto adoption rates in developing countries like Nigeria and Vietnam are a testimonial to that.

But most importantly, and most interestingly for crypto investors, Johnson predicts the price of hard assets to increase as the theory plays out. Liquidity fleeing from weak currencies has to go somewhere — preferably to a solid store of value.

What the Dollar Milkshake Theory Could Mean for Bitcoin and Ethereum

While cryptocurrencies, specifically Ethereum and ERC-20 tokens like stablecoins, aim to improve the existing financial rails, Bitcoin and its community have declared a metaphorical war on the legacy financial system. This could mean that the Dollar Milkshake Theory impacts Bitcoin and other cryptocurrencies differently.

Ethereum

For Ethereum, a sovereign debt crisis would be bad since it would most likely cause liquidity to rush out of risk assets. You could argue that liquidity would rush into the U.S. dollar, and thus stablecoins would benefit from it too — and you may be right. However, without further use for these stablecoins, they would just serve as a store of value.
Therefore, Ethereum itself would not benefit much from it as long as there is little further real-world use for stablecoins. Since you need ETH to transact ERC-20 tokens, more demand for stablecoins as a medium of exchange increases the demand for ETH to pay for gas — and increases its price. But as long as stablecoins are only a store of value that is preferred over an emerging market currency, ETH benefits only marginally. Ironically, this is the same store of value vs. medium of exchange conundrum that Bitcoin faces.
The best case for Ethereum would be increasing the adoption of cryptocurrencies, specifically USD-denominated stablecoins, as a medium of exchange in the real world. This will likely require cooperation with governments and large corporations — something the crypto community is allergic to. However, with a sort of “government approval” of the technology, cryptocurrencies will probably suffer from any type of economic crisis.

Bitcoin

Bitcoin is still a risk asset, no matter how much the community wants the opposite to be true. Thus, a sovereign debt crisis would probably be equally bad for its valuation. Even a short-term rush into BTC would probably only be a bridge for liquidity to flow into dollars. Although Bitcoin's digital scarcity is real, the market feedback has been clear: when the economy enters crisis mode, the BTC price falls.
This hypothesis has a simple invalidation: if BTC appreciates against non-USD currencies during a sovereign debt crisis, this would be a sign that Bitcoin is becoming the "hard money" it aspires to be. Since Bitcoin plans to replace or at least rival the USD in the long term as currency and store of value, the emergence and adoption of a Vitcoin-based parallel economy is a prerequisite for its success.

Could the Dollar Milkshake Theory Be Wrong?

But what if Brent Johnson is wrong? What if the Dollar Milkshake Theory has already peaked, and we are heading for dollar weakness? After all, dollar strength has been on the retreat since the start of November 2022:

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There is a rival theory that calls for the dollar to weaken over the next few years in favor of commodities and hard assets like Bitcoin. It's called Bretton Woods III, and you can read about it here.