The use of knowledge in computers: introducing nanoeconomics

With Sinclair Davidson, Jason Potts and Bill Tulloh. Originally a Medium post.

In his 1945 essay “The Use of Knowledge in Society”, Friedrich Hayek first drew attention the knowledge problem. Information is distributed throughout an economy. No central planner can effectively bring it together.

Hayek, obviously, was talking about a human economy, where people exchange with people. But machines suffer from knowledge problems too. This is the domain of nanoeconomics — which we suggest is the study and evaluation of the economics of machine systems.

Hayek in the machine

Nanoeconomics is about human-machine exchange, and machine-machine exchange. It is the economics of distributed ledgers and artificial intelligence, of object-capability programming and cybersecurity, of ‘central planning’ in the machine, and of ‘markets’ in the machine.

As we’ve come to understand blockchains and other distributed ledger technologies as an institutional technology, we’ve also learned that not only can blockchains coordinate and govern decentralised human economies (as governments, firms and markets do) but they can coordinate and govern decentralised machine economies (or human-machine economies).

This extends what Hayek called catallaxy — the spontaneous order of the market — from the market coordination of human action to the coordination of human-to-machine and machine-to-machine economies.

Nanoeconomics is not a new idea. In their Agoric papers published in 1988, Mark Miller and K. Eric Drexler developed the idea of a computational system as a space for economic exchange. The development of object-oriented programming has created software agents, which vie for scarce resources in the machine. But right now, these agents are governed through planning, not markets. Miller and Drexler suggested an alternative: a market-based computation system. In this system:

machine resources — storage space, processor time, and so forth — have owners, and the owners charge other objects for use of these resources. Objects, in turn, pass these costs on to the objects they serve, or to an object representing the external user; they may add royalty charges, and thus earn a profit.

With global computers like the smart-contract platform Ethereum we now have the bones of such a market-based computational architecture.

Nor is the idea of an analytical layer below microeconomics a new idea. Kenneth Arrow used the word nanoeconomics for the study of single buying and selling decisions. But that line of research has been subsumed into behavioural and now neuroeconomics. Alternatively it is used to describe the economics of nanotechnology.

But in an age where we deploy digital, quasi-autonomous agents to act on our behalf, and where the traditional economic problems of opportunism, asset specificity and bounded rationality are intimately tied into cybersecurity and digital services, we have to drive our economic analysis — and our institutional choices — into the machine.

Nanoeconomics is the study of an economy of software agents, using market institutions and property rights to order computation and bid for computational resources. It is the study of choices and market exchange that occur between computational objects in object-oriented software architectures, and which are economically coordinated through blockchain infrastructure.

As Miller and his colleagues have pointed out, a key problem with ‘centrally-planned’ computation are the implications for computer security. A decentralised software economy would instead seek to operationalise tradable property rights for access to objects through the principle of least authority.

Contract theory, not choice theory

Nanoeconomics is not simply a new field of economics — it is a significant extension. Where the choice-theoretic branch of economics has managed to drive its analysis down into the brain, the contract-theoretic branch has stopped at the level of human-to-human exchange.

What do we mean by choice-theoretic and contract-theoretic? Choice theory studies why people make the choices they do. This branch has traditionally been split into macroeconomics (the study of the aggregate economy) and microeconomics (the study of individual market choices).

In recent decades many economists have sought to drive their analysis deeper into the brain. Why do they have different preferences? Behavioural economics applies psychology to economics, and even more recently neuroeconomics applies biology. The choice-theoretic branch of economics goes: macro, micro, behavioural, neuro.

The contract-theoretic branch is the economics of Ronald Coase, James Buchanan, Oliver Williamson, Friedrich Hayek, and Elinor Ostrom. This branch looks at exchanges (that is, contracts) and the human institutions we have devised to constrain or facilitate those exchanges. Firms, markets, governments, clubs and commons (and now blockchains) are institutional environments to make exchanges, sign contracts, and otherwise pursue economic goals.

Contract-theoretic economics starts with constitutional economics — the macro level structuring of political and economic choices. It applies a transaction cost approach to microeconomic analysis. And with nanoeconomics we can start look at machine agents as economic actors, making exchanges — and acting opportunistically.

As more and more of the economy becomes machine-mediated, we need to worry about the security and efficiency implications of centrally-planned machine economies. But the underlying knowledge problems are general.

We’ve previously argued that blockchains are constitutional protocols for catallactic ordering. Nanoeconomics is about how they can not only facilitate improved decentralised economic coordination for humans, but also for machines.

Capitalism after Satoshi: Blockchains, dehierarchicalisation, innovation policy and the regulatory state

With Sinclair Davidson and Jason Potts.

Abstract: What are the long-run economic and policy consequences of wide-spread blockchain technology adoption? We examine the structural economic effects of this institutional innovation as disintermediation in markets, dehierarchicalisation of organisations, and growing private provision of economic infrastructure for exchange, contracting and coordination. We predict that these institutional economic dynamics undercut the historical rationale for much modern economic policy, originally formulated to enable capitalism to cope with market power, to control hierarchy, and to furnish public infrastructure for trust. We argue that capitalism built on distributed ledger technology requires different economic policy settings to industrial capitalism, based on centralised ledger technology. We formulate the institutional logic of this dynamic co-evolutionary model, and discuss policy settings for an economy coordinated with blockchain infrastructure and associated distributed digital technologies for economic coordination (Web3, Industry 4.0). We find that much modern economic policy will be differently instantiated (e.g. hard-coded in platforms) or variously no longer necessary (because of new institutional solutions to problems of trust and coordination). We argue that the institutional innovation of blockchain engenders a new post-industrial economic era that requires new policy rules. This paper seeks to explain why this change will occur, and to explore a new framework for economic policy adapted to economic infrastructure built on distributed ledgers.

Available at SSRN.

Blockchains and Constitutional Catallaxy

With Alastair Berg and Mikayla Novak

Abstract: The proposition that constitutional rules serve as permanent, fixed points of interaction are challenged by observations of contestable rule amendment and the emergence of de facto authority. This observation not only applies to conventional political constitutions, but to the fundamental rules which govern interactions by numerous people using new forms of technology. Blockchain technology aims to coordinate action in a world of incomplete information and opportunism, but the governance arrangements in blockchain protocols remain far from settled. Drawing upon recent theoretical developments regarding constitutional change, we interpret changes to the fundamental working rules of blockchain protocols as central to the adaptive, emergent nature of activity within this technological space. We apply this concept of “constitutional catallaxy” to selected blockchain platform case studies, illustrating the dynamism inherent in establishing protocols within the blockchain. Blockchain coordination changes and adapts not only to the technological limitations of the available protocols, but to mutual expectations and influence of interacting stakeholders.

Available at SSRN

From Industry Associations to Ecosystem Associations: Blockchain, Interest Groups and Public Choice

With Mikayla Novak, Jason Potts and Stuart J Thomas

Abstract: Conventional public choice literature suggests that interest groups have a largely malign effect upon the economy. Suggesting that interest groups are primarily established to lobby governments for rents, the public choice approach essentially rests upon normative presumptions concerning the appropriateness of relationships between interest groups and the state. This analysis tends to overlook constructive roles undertaken by interest groups to facilitate economic coordination, including the facilitation of technology adoption, and to collaborate with political and other actors to overcome obstacles to innovation and industry dynamics. The development of blockchain technology in recent years serves as a useful case study illustrating the role of interest groups in contributing toward the development of a blockchain-enabled economy. We provide support for our general hypothesis of a beneficial economic contribution by interest groups by profiling the activities of blockchain industry associations. This paper also considers to what extent interest group involvement in blockchain coordination and governance is designed to pre-emptively avoid more stringent governmental action, or respond to perceived inadequacies in public policy settings. This study contributes to a revision of public choice scholarship regarding the appropriateness of interest group activity.

Available at SSRN.

Outsourcing vertical integration: Distributed ledgers and the V-form organisation

With Sinclair Davidson and Jason Potts

Abstract: This paper introduces the V-form organisation, a new form of firm organisation where vertical integration is outsourced to a decentralised distributed ledger (a blockchain). V-form organisations rely on the coordination of a (trusted) third party. It looks specifically at two instances of V-form organisation being established on the IBM-Linux Foundation Hyperledger permissioned blockchain. The paper concludes with four recommendations for strategic management about how to adjust to a V-form world, and four recommendations for policymakers.

Available at SSRN

Should I use a blockchain?

With Sinclair Davidson and Jason Potts. Originally a Medium post.

Blockchain as a business model can be imagined in one of two ways. It can be thought of as being a new general purpose technology. This category of technologies includes electricity, transistors, computers, the internet, mobile phones, and so on. To this way of thinking a blockchain can be represented as the next generation of the internet.

But if this is how people come to think of a blockchain we believe that many are going to be disappointed. Here the blockchain would be — what economists call — a factor augmenting technology. This is the standard economic story about how technology drives economic growth. People adopt a new technology because it reduces the productions costs associated with producing a given output. Technology ‘economises’ on scarce resources. We do more with less. This is the better-stronger-faster-cheaper model that we have come to associate with new technology.

But there is a problem with this approach to blockchains.

It is not immediately obvious that a blockchain is better-stronger-faster-cheaper for many general purpose uses. If managers are looking for improvements to their back room operations they will likely be underwhelmed by what a blockchain has to offer. There are many existing database software solutions that will very likely outperform a blockchain.

Another way to think about blockchains is as an institutional technology. As The Economist magazine insightfully suggested some years ago the blockchain is a trust machine. We have argued that blockchains industrialise trust. This is where the gains to using blockchain technology originate — not that it economises on production costs, but that it economises on transactions costs — especially trust.

When Satoshi Nakamoto solved the Byzantine general’s problem he also provided a solution to what economists call the coordination problem. Historically economists have recommended the price system, bureaucracy and managerial hierarchy as solutions to coordination problems. Now we also have the blockchain.

That blockchains are fundamentally an institutional rather than a technological innovation is not mere semantics. This distinction matters because it focuses attention on what is actually driving the creative-destruction this innovation generates.

What has changed is the technology of economic coordination and governance.

In the real world there is a trade-off between the price system and bureaucracy and hierarchy. The price system provides clear incentives — prices and profits determine what should be produced, how it should be produced, and who will produce it. In bureaucracy and hierarchy, however, those high-powered incentives are missing. But large scale economic activity generates large transaction costs and a lack of trust means that prices and profits can’t weave their magic.

This is where blockchains have a competitive advantage — the decentralised ledger technology provides a platform for coordination where transactions costs are dramatically reduced and trust industrialised. In an environment of complex economic activity that previously relied on bureaucracy and management we can now have prices and profits doing their magic.

Those adopters who think blockchain is just another backroom business tool are missing the main game. The blockchain is going to be your business model.

Opportunities for crypto-havens to capture business

With Sinclair Davidson and Jason Potts.

Blockchain technology is set to drive a new era of global public policy competition. In May 2018, the premier of Bermuda, David Burt, announced to the 8,500 attendees of the Consensus blockchain and cryptocurrency conference his country’s new Digital Asset Business Act and Initial Coin Offering Act. This legislation is intended to establish Bermuda as a premier destination for blockchain business by providing regulatory certainty around new business models.

But Bermuda is hardly the only jurisdiction seeking to attract blockchain firms. Singapore, Switzerland, Dubai, Estonia, subnational jurisdictions and dependencies like Illinois, Zug, the Isle of Man and Gibraltar are all positioning themselves to capture blockchain services. In October 2017, the then prime minister of Slovenia, Miro Cera, declared the country was “setting itself up as a blockchain-friendly destination.”

What we are seeing right now is an aggressive policy-driven grab to become a world leader in blockchain technology, and to capture some of the enormous value that this can unlock. Where once we saw global tax competition – as small nations attracted investment with business-friendly tax and regulation policy – now we are able to watch the green shoots of global blockchain competition. Blockchains are a unique technology, and that uniqueness presents some unusual public policy challenges. They offer us a new platform to organize economic activity: to make trades, to arrange production processes, to store information about assets and property ownership. Blockchains provide an economic infrastructure on which parallel technological developments, such as artificial intelligence and machine learning, the Internet of Things, 5G, and automation, can be built.

We expect to see a great deal of economic activity that currently takes place in firms, in markets, even in government, to be displaced by distributed ledger technology. Blockchains will tie organizations together that have currently cooperated only through market exchange, or by the force of regulation. It will lead to demergers, as large firms realize that a decentralized ledger is an alternative to complex multidivisional corporate structures.

But we have spent hundreds of years building complex taxation and regulatory systems around these institutions. The dominance of large firms has led governments to impose anti-trust laws. Principal-agent problems between owners and firm managers has led to the introduction of complex schemes of directors duties and manager controls. Securities law is built around the dominance of the public offering, taxation law around a sharp distinction between currency and other assets, and labor law around the employer-employee divide.

As a new technology of governing economic activity, blockchain applications pull at the threads of all these traditional regulatory frameworks. Globally, there are still deep uncertainties over the most basic questions around cryptocurrencies, such as when they are taxed, and as what: currency or security? The initial coin offerings that have brought so much money into the industry exist in a legal gray area almost everywhere in the world.

Blockchains are an incredibly young technology – just ten years old. Distributed autonomous organizations, decentralized labor markets, blockchain-secured intellectual property assets and blockchain-enhanced international trade will raise complex issues about fundamental regulatory structures, like labor, competition, and companies law – structures which have been reasonably fixed for the better part of a century. As more applications around economic problems, such as identity management, charities, healthcare, finance and global trade, are developed and introduced into the real world, they will face a spiraling number of regulatory and policy barriers that will need to be overcome. We face decades of regulatory uncertainty and demand for reform.

This is where crypto-friendliness matters. Crypto-friendliness does not mean the government needs to subsidize, plan or control blockchain technology. The sector is awash with funds: a happy by-product of the enormous speculative investment in cryptocurrencies that has occurred over the last eighteen months. No government planner could predict how this technology is going to develop, and given its global nature, no regulator has a hope of controlling it.

But blockchains do require governments to facilitate adoption. Because of the many ways blockchain use cases interact with existing regulatory frameworks they will need the help – or at least the acquiescence – of public policymakers to reform those frameworks to suit. The biggest regulatory risk in the blockchain space is uncertainty. Right now, those uncertainties are about how crypto-assets will be taxed, how and when they will be treated as securities, and the levels of disclosure around anti-money laundering and know-your-customer rules.

Governments that want to attract blockchain firms to their jurisdictions need to be resolving those uncertainties as soon as possible.

A crypto-friendly government is one which is not only focused on resolving current uncertainties but is able to credibly commit to facilitating the sorts of regulatory reforms needed in the future. Technological change is unpredictable. We do not know what blockchain applications are going to be the most successful and disruptive. Consumer demand is unpredictable. Governments should ensure, as far as possible, that regulation is both predictable and adaptive, that shape-changes in regulatory regimes do not occur, and that yet there is adequate space for entrepreneurial experimentation.

Which governments are likely to be the most crypto-friendly? At the first instance, the governments which have already demonstrated themselves as business-friendly environments are obvious candidates for blockchain friendliness. The ingredients of long-run economic growth – liberal, responsive institutions, the rule of law, limited government, regulatory modesty, and low taxes – are as important for blockchain firms as they are for other industries. The Isle of Man, for instance, has long been an established global leader in gambling and e-gaming, thanks to a deliberate effort on its part to establish welcoming and certain public policy. The Isle of Man is now a thriving site of blockchain innovation. As this suggests, blockchain technology presents a historically significant opportunity for the Cayman Islands, and any other jurisdiction which has a reputation for business-friendly policy. The last few decades of global tax competition have shown that smart policy can shape the geography of global capitalism just as strongly as labor or natural resources. Blockchains are a decentralized network but their developers, entrepreneurs and users exist in a real world, subject to real laws. Crypto-havens can capture that business.

Blockchain: An Entangled Political Economy Approach

With Darcy Allen and Mikayla Novak. Published in the Journal of Public Finance and Public Choice.

Abstract: This paper incorporates blockchain activities into the broader remit of entangled political economy theory, emphasising economic and other social phenomena as the emergent by-product of human interactions. Blockchains are a digital technology combining peer-to-peer network computing and cryptography to create an immutable decentralised public ledger. The blockchain contrasts vintage ledger technologies, either paper-based or maintained by in-house databases, largely reliant upon hierarchical, third-party trust mechanisms for their maintenance and security. Recent contributions to the blockchain studies literature suggest that the blockchain itself poses as an institutional technology that could challenge existing forms of coordination and governance organised on the basis of vintage ledgers. This proposition has significant implications for the relevance of existing entangled relationships in the economic, social and political domains. Blockchain enables non-territorial “crypto-secession” not only reducing the costs associated with maintaining ledgers, but radically revising and deconcentrating data-conditioned networks to fundamentally challenge the economic positions of legacy firms and governments. These insights are further illuminated with reference to finance, property and identity cases. Entangled political economy provides a compelling lens through which we can discern the impact of blockchain technology on some of our most important relationships.

Fast track available at the Journal of Public Finance and Public Choice

Blockchains and constitutional catallaxy: an EOS case study

With Alastair Berg. Originally a Medium post.

The EOS mainnet launched earlier this year.

In EOS we are witnessing the emergence of what Ludwig von Mises and Friedrich Hayek would recognise as constitutional catallaxy — open source constitutional orders in which participants are continually developing the rules of the game even after the game has started.

EOS operates under a Delegated Proof of Stake (DPoS) consensus mechanism, with 21 Block Producers (BPs) overseeing the validation of transactions. As an open source constitutional order, the jurisdiction of these BPs has been guided by de jure constitutional arrangements. In the pre-launch phase of EOS, documentation was drafted and debated outlining an EOS Constitution, while users were to include a hash of that document in their transactions to acknowledge their understanding and acceptance of it.

However, open source constitutional orders like EOS also have stakeholders who may exercise de facto authority in the absence of formal procedural rules or technical constraints.

The launch of the EOS mainnet provides examples of how de jure and de facto constitutional arrangements can diverge. While no token holder vote has taken place on the EOS Constitution (via their proxies — BPs), de factosovereignty was quickly exercised through the banning of seven (and later many more) accounts following a conference call between BP representatives and a body known as the EOSIO Core Arbitration Forum (ECAF).

As a result of this call, BPs chose to exercise de facto sovereignty and freeze these accounts. Only retroactively did this dispute resolution body ECAF issue a statement which indicated their support of the actions of BPs.

Similarly, 6 weeks after launch, an announcement was made to fundamentally change the way in which economic value is distributed across the EOS protocol. On July 28 Brendan Blumer, CEO of (the organisation which developed the EOS mainnet), announced changes in the way EOS inflation is to be allocated. This will see new EOS tokens being distributed to users who stake tokens and vote for BPs, in addition to the rewards BPs receive for overseeing the validation of transactions.

These actions have drawn support as well as opposition. Some have called it a successful demonstration of off-chain governance, while some see it as jurisdictional overreach by emergent institutions.

In previous articles, we have argued that blockchains are a lot like countries. These (usually) open source protocols are constitutional orders which define how individuals interact and transact — complete with their own currencies, property, laws, corporations and security systems.

Blockchains, along with nation states, attempt to coordinate action in a world of incomplete information and opportunism — while computer scientists and economists have different vocabularies, Byzantine fault tolerance and robust political economy are the same thing.

Systems of governance for blockchain protocols are not new — the genius of Satoshi Nakamoto was to allow the Bitcoin network to reach consensus when two equally valid blocks are presented by miners, in effect solving the double-spend problem.

Yet now we can observe the emergence of — and have debate over — other governance arrangements in blockchain protocols. (Who writes and has permission to change the law (code), who enforces the rules, the role and method of voting, the role of developers and token holders, on-chain and off-chain governance etc).

What’s interesting is that these are analogous to the debates that individuals had during the emergence of nations. Consider the United States. With little to guide them but the musings of philosophers and radical thinkers, individuals grappled with a myriad of competing principles and interests as they set the ground rules for how their new constitutional order was to be governed.

Previously, constitutional orders emerged from revolution, civil war, conquest and other usually violent means — much like the constitutional order that emerged in the 13 American colonies.

In the real world, the emergence of institutions — as well as the jurisdiction which they exercise power over — can take many years after their formal establishment. The Supreme Court of the Unites States has the now familiar power of judicial review, evaluating the constitutionality of legislation and executive action. However it was only 16 years after it was established that the Supreme Court granted itself the power to declare acts of Congress unconstitutional as a result of Marbury v. Madison. Similarly, the role of the President has significantly expanded over time, with the term the Imperial Presidencyaccounting for the increased powers gradually vested in the US executive since the administration of George Washington.

The US Constitution has similarly been amended, challenged and otherwise interpreted in a myriad of different ways over its lifetime, demonstrating a real-world divergence and interaction of de jure and de facto constitutional arrangements.

Constitutional catallaxy

Likewise, blockchains are constitutional orders governed by social norms as well as technical constraints. The de jure constitutional order which governs how BPs represent EOS token holders, and the ways in which disputes are resolved, are ultimately subject to the exercise of authority by those who have the means.

What we are seeing is a process of constitutional entrepreneurism — constitutional catallaxy — in the establishment of new economies. The institutions that coordinate activity in these economies change and adapt to both the technological limitations built into the protocols, as well as the mutual expectations and power of interacting stakeholders.

Crypto Public Choice

With Alastair Berg and Mikayla Novak

Abstract: This paper presents ‘crypto public choice’ which examines the economics of collective decision making in the functioning of blockchain protocols and among related communities of users. We introduce the blockchain community to public choice theory and show how it can be applied to the study of this technology. Public choice offers an extensive literature that can be applied to blockchain design, can interpret the actions of different types of blockchain users, and can explain governance problems and challenges in each of the blockchain protocols. Blockchains are institutional technologies which provide new ways in which to produce public goods including consensus over shared facts and the security of property rights. Collective decision making by users of blockchain protocols relates to consensus over the contents of a shared ledger, as well as the initial design and subsequent upgrading of these protocols.

Working paper available at SSRN