Sober liberal

A review of Sir Joseph Carruthers: Founder of the New South Wales Liberal Party by Zachary Gorman, Connor Court, Qld, pp.425, $59.95

Australia has a rich heritage of nineteenth century classical liberalism. But that history has been almost completely lost in the flood of historical work focusing on either federation or the labour movement. Zachary Gorman’s new biography of Sir Joseph , the nineteenth century free trade liberal and founder of the Liberal party of New South Wales, helps balance the ledger – recovering the tradition of free market liberalism that has been so significant in Australian history.

In many ways, Joseph Carruthers embodies that tradition, with its strengths and flaws. In the colonial era liberal political thought was one of the dominant strands of public life, and Carruthers’ career reflected its dominance. Born in 1857, he entered NSW politics in 1887. Carruthers was a father of federation, a minister under Henry Parkes and George Reid, and after the establishment of the Commonwealth became premier of New South Wales. He only left politics when he died in 1932.

Like his university friend George Reid, Carruthers was a great admirer of William Gladstone. He believed in balanced budgets, individual liberty, and that ‘we should encourage commerce in its freest sense’ (as he once informed a branch meeting of the Labour Electoral League).

Carruthers was a liberal, but not a radical one by the standards of the time. Gorman positions him as a moderate, or pragmatic liberal within the free trade movement. On one side was Bernard Wise, whose support for free trade was matched with a pro-government intervention and regulation program. On the other side was the radical free market liberalism of Bruce Smith, whose 1887 book Liberty and Liberalism was a full-frontal attack on the left-liberalism advocated by people like Wise. A working politician has to satisfy multiple constituencies. Carruthers was no exception, balancing both liberal and conservative supporters, as well as managing coalitions with the progressives.

Histories of political life can sometimes be a little deadening. Much drama in politics consists of a stream of legislation and amendment, which can be both complex and (in the hands of poor biographers) dull. Gorman does not fall into this trap: he is able to very clearly explain the significance of each well-chosen controversy in a way that makes the relevance to liberalism and Carruthers’ life obvious.

Gorman is also sensitive to instances of where Carruthers’ thought deviated from classical liberal ideas. These are worth detailing, because classical liberals have not always lived up to their underlying belief in the inherent equality and political dignity of all people. One philosophically minor but historical significant example was temperance. His father had struggled with alcohol and was ultimately involved in the temperance movement. Likewise many of the Liberal party voters were motivated by temperance. Gorman writes that Carruthers believed ‘liberalism could bend on this issue’. Carruthers ended up supporting the so-called ‘local option’ which handed the regulation of liquor licences to electorates and municipalities – not always a win for liberty.

More serious to modern readers was Carruthers’ opposition to female suffrage, for which he believed the case had not yet been made. His was perhaps a half-hearted opposition, and he later supported the suffragette movement in Britain when he visited there in 1908. But his stance compares poorly with some contemporaries like Bruce Smith, who actively called for universal suffrage in Australia.

Carruthers’ attitude to immigration presents a similar story. While being supportive of high immigration levels, he also backed the white Australia policy on the grounds that a multiracial society could harbour ethnic tensions. This view changed when he began to visit Hawaii, as he did regularly late in life. He saw there a society in which Americans, native Hawaiians, Japanese and Filipinos coexisted prosperously, helped in no small part by American free trade relationships.

Carruthers’ views were more admirable when it came to the relationship between colonists and the Indigenous population. As a child growing up in Macleay he had spent much time playing with Aboriginal children, and he maintained a sympathy with Indigenous people his whole life. He wrote later of the ‘ruthless indifference [of] the whites, who have invaded their homelands, bringing with them new diseases and vile habits, and sometimes unspeakable cruelties that have unnecessarily wiped out millions of so-called inferior and backward peoples’. Carruthers’ language often betrayed a paternalistic or patronising mindset but he was more wide-eyed than most about who bore the costs of colonialism.

For the most part, Carruthers was a needed defender of liberal values. During the First World War he refused to get too caught up with the anti-liberal sentiment of wartime Australia, and opposed the NSW government’s sedition bill (which had been mainly targeted at the labour movement).

This is not the first full length biography of Carruthers. Beverly Earnshaw published One Flag, One Hope, One Destiny: Sir Joseph Carruthers and Australian Federation in 2000, which as its title suggests finds interest in Carruthers because of his federation role. (Carruthers’ own memoirs also received commercial publication in 2005.) But for Gorman, Carruthers’ greatest legacy is the New South Wales Liberal party, which he views as one of the crowning organisational achievements of nineteenth century liberalism. While it has repeatedly changed its name, the NSW Liberal Party is still, organisationally, the same entity today as the one Carruthers established as the Liberal and Reform Association in 1902.

For modern classical liberals the post-Federation decade has a somewhat melancholy tone. The rise of the Labor party led to an alliance, and then fusion, between the free traders and protectionists under the banner of anti-socialism. Gorman’s book both adeptly navigates this history, and, with his picture of nineteenth century liberalism, underlines just what we lost.

Are Australians ready to embrace libertarianism?

How much influence does libertarianism have on Australian politics? The first thing to know is that the Australian political system has very few libertarians in it.

The only federal member of parliament to self-describe as a libertarian is Senator David Leyonhjelm of the Liberal Democratic Party. Other candidates – like my former colleagues at the Institute of Public Affairs (IPA), Senator James Paterson and Tim Wilson – describe themselves as classical liberals.

Ideological classifications can get very tedious very quickly, but generally libertarianism is a variety of classical liberalism. Both philosophies believe that public policy should be designed to maximise free markets and civil liberties. That is, governments should get out of both the wallet and the bedroom. Libertarianism is generally seen as inhabiting the more radical end of the classical liberal spectrum.

A 2007 study published by the Centre for Independent Studies (CIS) estimated that 3–6% of the Australian electorate were classical liberals. So it is unsurprising they have little electoral influence on Australian politics.

The reason libertarians and classical liberals exercise some degree of influence is that they make up a disproportionate share of Australia’s policy wonks, think tank staff (especially at the IPA and CIS), and political commentators.

An extremely big tent

Australia’s right-of-centre political community is not so large as to have exclusively libertarian or conservative think tanks, as exist in the United States. Everyone works together. This co-mingling hasn’t generally been an issue because Australian political debate has tended to pivot around economic issues (taxation, regulation, privatisation) or basic shared liberty issues (like freedom of speech) rather than the thorny moral debates that might divide the two camps.

Occasionally there have been polarising issues. Same-sex marriage is one. Conservatives were generally opposed, while libertarians tended to be in favour. But there was also broad agreement that any change to marriage laws should also protect religious freedom.

Immigration – particularly asylum seeker policy – is another. Libertarians are inclined towards freer immigration, whereas conservatives want more control over the borders. Here the tiny number of libertarians have been completely ineffective against the policy stalemate.

For the most part, there is much agreement between conservatives and libertarians about the current state of Australian politics. Both think the Turnbull government is a disappointment, for much the same reasons. It failed on the campaign to repeal section 18C of the Racial Discrimination Act, which has become an iconic restriction on free speech. It has also repeatedly raised taxes, and been unable to drive any serious economic reform.

This may sound excessively Pollyanna-ish, as if everything is just swell between Australian conservatives and libertarians. Much has been said (almost all by commentators on the left) about a political split between libertarians and classical liberals on the one side and conservatives on the other. But I don’t really see it.

In the US, the fusion movement of the 1950s and 1960s was a deliberate project to build an alliance between these two distinct systems of political thought. The presidency of George W. Bush pushed that alliance to breaking point, and it seems the Trump administration has broken it.

By contrast, Australian politics has never been large enough to maintain such divergent streams. Every Liberal prime minister has for the most part maintained a sort of centre-right middle ground that kept everyone equally disappointed and dissatisfied. People are leaving the Liberal Party under the Turnbull government, not because it is too conservative or libertarian, but because it is too, well, nothing.

Liberal achievements and libertarian growth

The last quarter of the 20th century saw Australian public policy take major strides in a classical liberal direction. The economic reform movement that substantially liberalised the economy was matched with social reforms such as the decriminalisation of homosexuality and the repeal of obscenity laws.

I’ve argued in the past that Australian economic thought has had a distinct – even occasionally dominant – classical liberal tradition. There is no question that this tradition has driven policy debate and reform at a few key historical moments.

Though classical liberal efforts were often focused on economics rather than social policy, it’s worth pointing out that the IPA was one of the key voices against state overreaches such as the Hawke government’s ill-fated Australia Card, and more recently, mandatory internet data retention.

In recent years, there has been some notable growth of libertarianism as a self-aware and distinct group. A large part of that has been the Friedman Conference – named after Milton Friedman, David Friedman and Patri Friedman, who represent nearly the entire spectrum of classical liberal/libertarian thought in one family – which attracts hundreds of libertarians and fellow travellers to Sydney every year.

The Friedman Conference is in its sixth year, thanks to the organisational efforts of Tim Andrews (of the Australian Taxpayers’ Alliance) and John Humphreys (of the Australian Libertarian Society). The political success of the Liberal Democrats with David Leyonhjelm in the Senate is another factor in libertarianism’s modest gains.

My hope is that this sort of organisational effort fosters the idea in Australia of libertarianism as a distinct political philosophy, not just a quirky sub-category of the Australian right.

There is a need for this. The challenges we face now are not the same as they were in the over-mythologised 1980s. The combination of growth of the regulatory state, radical technological change, and the crisis of democratic trust require new ideas and new policy solutions. Libertarianism offers a framework to understand how these economic and social questions interact.

Outsourcing vertical integration: introducing the V-form network

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

The Nobel laureate Oliver Williamson distinguishes between U-form companies and M-form companies.

Traditional U-form companies are unitary— their units are divided by business process (for instance, accounting, human resources, component manufacturing, assembly) and are not treated as separate cost centres.

M-form companies are multidivisional — their units are self-contained divisions that report profits and losses to an umbrella central body. They’re fully owned by a parent company, but they tend to have their own business services (accounting and human resources departments, for instance) and even market relationships.

But now we see a new corporate form — the V-form network — made possible because thanks to the application of distributed ledger technology to supply chain problems.

These V-form networks consist of a number of fully independent companies that effectively operate as one vertically integrated company through blockchain technology, coordinated and supplied by a third party.

This is a big change to the nature of the firm. We can already see V-form networks in the real world. They date as far back as January. It is surprising the economic community haven’t noticed them yet.

The IBM and Maersk TradeTech

Two weeks into 2018, IBM and the shipping giant Maersk announced a joint venture to develop a digital supply chain management system on their Hyperledger blockchain platform. Hyperledger is a private blockchain which requires permission to access.

In a previous Cryptoeconomics piece, we described how international trade is an information problem. As goods are shipped around the world, they are accompanied by information — really stacks of paperwork — that describe their provenance, destinations, regulatory and tax liabilities and so on.

In the IBM-Maersk system, each firm and bureaucracy in the supply chain — producers, shippers, port authorities, regulators, importers, retailers — will access and update a shared blockchain ledger containing all the information needed by each organisation.

And each organisation would have access to that information everywhere, ensuring complete visibility on where goods are in the world and which economic and regulatory hurdles they next need to overcome.

Before blockchains, there were only two basic ways to coordinate a supply chain: vertical integration, or regulation.

Vertical integration has problems. Large conglomerate firms struggle with the challenges of specialisation, and size tends to make firms less efficient.

Regulation has even worse problems. At the very minimum, regulation only works plausibly well within a single nation. The cost of multilateral harmonization — which includes things like treaties and global courts — is very high.

Blockchains can work to coordinate supply chains without the need for either (traditional) vertical integration or regulation. The vertical integration is outsourced to a distributed ledger. The blockchain provides the managerial service that coordinates each ‘unit’ (that is, firm) in the supply chain.

Regulators in any country can deal any firm in the supply chain as if it was a small unit of a larger, global company.

Each firm in the supply chain get the benefits of vertical integration through a network rather than a hierarchy.

The crucial role of IBM and Maersk

In this, the IBM and Maersk joint venture plays a novel economic role.

We’ve written in the past about the paradox of trust in the blockchain world: it takes a lot of trust to establish a trustless ledger.

Imagine a supply chain with seven firms in it: primary producer, manufacturer, exporter, shipper, importer, wholesaler, retailer. Each firm has an established and trusted business relationship with the firms above and below them on the supply chain. But do they have a similar relationship with those one- or two-steps removed? Would the wholesaler in one country necessarily trust the primary producer in another?

A supply chain of two or three firms would be able to easily come to an agreement over shared digital systems. They wouldn’t even need a blockchain — market discipline would be enough to ensure stable coordination.

But firms which do not have direct market relationships with each other face a trust problem when they try to coordinate.

IBM-Maersk provide the trust. They are a large trusted firm that can broker a solution — get all parties around a table — and build the network.

This is a different sales and service model to the IBM of the 1960s. But not that different. With Hyperledger for supply chains, IBM is selling a single solution to multiple clients — just as they did with mainframes or do today with their Watson artificial intelligence machine.

It is only possible because IBM (and Maersk) has already built up deep client relations over past century or so. It is both trusted and has internal information and knowledge about client needs.

(A regulator has none of this information. Neither would a potential corporate raider attempting to vertically integrate through a merger and acquisition strategy.)

We expect to see competition between firms (IBM and and other full-stack technology/strategy/management consultants) to seek ongoing (that is, locked in) contracts for these sorts of services.

The innovative thing here is that they aren’t offering their services to individual firms. They are consulting to a group, or chain, or network of firms — a network that they may have themselves helped create. Economic coordination in the simplest sense of the term.

That’s why IBM is involved. But why is Maersk? The shipping company in this case is the firm with the most to gain from the adoption of the new technology and architecture — that is, which would benefit most from reducing the costs of the existing market architecture.

Vertical integration can be outsourced elsewhere

In the V-form network, the blockchain’s token establishes the consortium, and incentivizes cooperative behaviour.

The token also serves to move rents around the network. In this way, the blockchain provides a market mechanism to solve the sort of bargaining problems described by another Nobel laureate, Ronald Coase, that may occur as the network operates.

Outsourced vertical integration could be applied to many industries that are now integrated. Energy firms that currently integrate the exploration, production, generation, and retail of electricity might be better decomposed, with blockchains and tokens taking the place of head offices. The token economy, rather than energy regulators, could make decisions about the distribution of rents around the network.

We expect that a blockchain economy will have more, smaller firms linked together by protocols. One question — which we expect will preoccupy regulators for decades to come — is how just many protocols? It’s worth pointing out that these networks are inherently global, and any regulatory questions global as well.

Governments might be able to exploit the V-form network themselves. Instead of selling a vertically integrated state-owned asset to shareholders (and then controlling rents with price regulation) they could then privatise components directly on a blockchain network. Ports and airports might be privatised successfully in this way.

In that sense governments would provide the initial coordination now being provided by IBM and Maersk — a trusted third party to broker and establish a decentralised economic network.

Tradetech and the problem of international coordination

With Darcy Allen, Sinclair Davidson, Mikayla Novak, and Jason Potts. Originally a Medium post.

International trade is an information problem.

As goods move between firms and across borders, information about the provenance, characteristics, and compliance liabilities (whether they are subject to taxes or tariffs) of those goods move alongside them.

Handling companies need to know which goods are going where.

Regulators and trade authorities need to know whether the goods crossing a national border are compliant with domestic regulations.

(Does a good need an import permit? Does it require any special documentation? In Australia the Minimum documentary and import declaration requirements policy is a 27 page document.)

And end-users increasingly demand information about where their goods came from and how they were produced.

(Consumers want to know where their food is grown, whether it was grown to organic standards, or was manufactured gluten-free or nut-free. Advanced manufacturing firms want assurances that components — such as aircraft or wind turbine parts — are of high quality. And everyone wants assurances that their goods have been looked after while in transit.)

The result is piles of documentation shipped alongside internationally traded goods.

And the demand for documentation is growing. Supply chains are getting more complex. Regulatory requirements are increasing. End-users want more information about what they’re buying.

Introducing TradeTech

FinTech is the application of new technology — particularly developments in computer science — to the financial services industry. RegTech does the same for regulatory compliance.

Now we have TradeTech — the application of information technology to reduce the information costs of international trade.

TradeTech can reduce transaction costs, increase transparency for firms, regulators, and consumers, facilitate trade finance, and significantly lower regulatory and tariff compliance burdens.

Tackling border costs

One TradeTech application, blockchains used to manage supply chains, have the potential to provide a new digital services infrastructure for international trade in goods.

Blockchains use a combination of cryptography and economic incentives to allow people to come to a consensus on a shared digital ledger without the need for a trusted third party. Blockchains are a technology for secure non-hierarchical information governance.

Blockchains can store information about the provenance and distribution of tradable goods through the entire supply chain in circumstances where firms (and regulators) through the supply chain do not necessarily trust each other.

The invention of the shipping container in the 1950s radically transformed international trade by tackling the high cost — and unreliability — of getting goods on and off ships intact.

But in the 2010s, it isn’t the cost of transport that is the biggest burden on international trade. According to IBM and Maerskthe costs of bringing goods across borders are higher than the costs of transport costs.

In 2018 and 2019 we expect blockchains used in supply chains and to facilitate global trade will be one of the breakthrough blockchain use cases.

The impact of this sort of TradeTech will provide an enormous boost to the potential for global trade.

Facilitating trade flows

The information flows that facilitiate international trade are still to a remarkable degree governed and organised on a one-to-one basis and using paper. Each firm in a global supply chain passes off information relating to a tradeable good to each other one step at a time, vouchsafing that information until it can be passed to the next firm on the chain.

Furthermore, despite two decades of the digitisation of global commerce, it is still the case that international trade is a significantly paper-based process — which is slow, error-prone and raises fraud risks.

The growth of the regulatory state over the last thirty years has significantly increased the compliance costs of trade. While regulatory harmonisation and tariff reductions have encouraged larger volumes of trade, these have been matched by greater demands for information those goods travelling across borders.

New regulatory concerns about labour, environmental, chemical, and biosecurity standards are being reflected in international trade agreements and are translating into more regulatory requirements at the border.

Longer and more complex supply chains as a result of globalisation has multiplied these compliance burdens.

Blockchains can provide a ‘rail’ on which all this information travels.

Blockchains are uniquely suited for an era of advanced globalisation, the regulatory state, and demand for information about product origins and quality.

But TradeTech needs multilateral coordination

Private industry is developing the technology for blockchain-enhanced supply chains.

But there is the need for an international coordination to ensure that industry is able to exploit the opportunities this technology presents.

For example: information rmanaged on blockchains needs to be accepted as valid and compliant by domestic regulators.

One risk is that industry-developed blockchains might not be not treated as compliant with existing regulations. Goods could then remain subject to existing paper-based processes, necessitating double-handling of compliance and reducing the benefits of blockchain-enhanced trade.

Another risk is that individual trading countries adopt their own standards, which would also necessitate double-handling.

A further risk is that standards are developed by early market leaders in the blockchain-facilitated trade space, are adopted by regulators and trade authorities on an ad-hoc basis, and through regulatory lock-in limit the contestability of this trade infrastructure.

The benefits of TradeTech will be realised in a world of open-standards, rather than closed ones.

Multilateral bodies like APEC (Asia-Pacific Economic Cooperation) should be considering these questions now.

We don’t think governments should try to regulate the development of blockchain technology, or compel its introduction. The blockchain is an experimental technology that needs space to evolve. But there is a clear role for multilateral bodies to set standards for information managed through blockchains.

TradeTech doesn’t need government regulation or direction. But it does need government cooperation.

KodakOne could be the start of a new kind of intellectual property

With Sinclair Davidson and Jason Potts.

It’s easy to be a bit amused about Kodak’s new blockchain and cryptocurrency, the KodakOne. The old photography company is the classic case of a firm that failed to keep up with technological change.

But now Kodak is exploiting one of the most interesting characteristics of the blockchain (the technology behind Bitcoin) to reshape how we understand and manage intellectual property.

Just like Bitcoin demonstrated it was possible to have a digital currency that didn’t require third parties (banks or governments) to validate transactions, KodakOne hints at a future where intellectual property works without the need for third parties to enforce property rights.

Blockchains are a system of decentralised, distributed ledgers (think of a spreadsheet or database that is held on a number of computers at once). Transactions are verified and then encrypted by the system itself.

Kodak’s plan is to use the Ethereum blockchain to build a digital rights management platform for photographs. Photographers will register their photos on the KodakOne platform and buyers will purchase rights using the KodakCoin cryptocurrency.

The platform will provide cryptographic proof of ownership and monitor the web for infringement, offering an easy payment system for infringers to legitimise their use of photographs.

In one sense, KodakOne resembles one of the many supply chain (or “provenance”) applications for blockchain, which track goods and their inputs (think agricultural products or airplane parts).

But photographs are purely digital assets. In a sense, what we’re seeing is a new form of intellectual property.

In KodakCoin, the underlying asset – the thing that is being bought and sold, the thing that has the economic value – is no longer the photograph, per se. Rather, it’s the entry on the global blockchain ledger. Control of that entry constitutes ownership of the asset.

KodakOne only really gets halfway to this idea. Like so many blockchain applications, the question is how this elegant system will interact with the messy real world. It’s one thing to detect infringing uses of a photograph, it’s quite another to enforce terrestrial copyright law on unco-operative infringers. And KodakOne is hardly the only firm working on digital asset management on a blockchain.

A new kind of intellectual property

But there’s another, more pure example of what blockchains can do for intellectual property that is worth discussing – CryptoKitties.

CryptoKitties is a silly little blockchain game, but the economics are worth taking seriously. Players buy digital cats – cryptographically secure, decentralised, censor-proof digital cats – and breed them with each other. Each cat has a mix of rare and common attributes and the goal is to breed cats with the rarest, most-in-demand attributes.

That’s the game. But in fact what CryptoKitties has invented is a new form of intellectual property. Each cat is a completely unique, entirely digital good. And it is completely, cryptographically secure. It can’t be copied.

Usually the protection of intellectual property requires lawyers and courts. But with CryptoKitties, the intellectual property protection is part of the asset itself – it’s baked in.

This is what blockchains were invented to do. Before blockchains, digital goods could be easily duplicated. That’s a great feature – unless you want to create digital money. Digital money won’t work if everybody can just copy their money and spend it over and over again.

The creator of Bitcoin, known as Satoshi Nakamoto, solved this problemwith Bitcoin’s blockchain. Previous attempts to solve the double-spending problem had relied on trusted third parties like banks to validate transactions. Nakamoto managed to get the network to validate itself.

KodakOne (and CryptoKitties) show us that intellectual property has much the same problem as digital currency – and may have the same solution. There’s no need for trusted third parties (governments) to enforce property rights. The blockchain does that for us.

Of course, there’s a lot of work to be done before we see real benefits from this sort of blockchain-enhanced intellectual property. CryptoKitties is its own new form of intellectual property – but can we retrofit “traditional” cultural goods like photographs, music and movies onto the blockchain?

Digitisation has challenged the protection of intellectual property like never before. Cultural producers need to find some way to be paid for their work. This is the direction we should be looking.

The blockchain economy: what should the government do?

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

Satoshi Nakamoto said Bitcoin would be “very attractive to the libertarian viewpoint”. The pioneers of cryptocurrencies were cypherpunks or crypto-anarchists who wanted to use this new invention to escape the state’s monopoly on money.

We’re sympathetic to this — as we argued in our last Medium essay ‘Byzantine Political Economy’.

But the state is not so easy to escape.

Not only are there many blockchain use-cases for government, but it is possible that positive government action could help the blockchain revolution along.

Just as the blockchain radically decentralises economic activity, the born-global nature of the blockchain can radically decentralise economic power.

Crypto-friendly governments — that is, governments that can rapidly adjust their regulatory frameworks to suit the blockchain economy — have a unique window to attract global investment.

Crypto-friendly governments: the state of play

A number of smaller countries and autonomous regions are trying to position themselves as crypto-friendly.

Both Great Britain and Australia have issued high-level government science reports on the prospects of the technology.

Other smaller countries (such as Estonia) and city-states (such as Singapore) have folded blockchain into a digital and e-government investment strategy.

City-states such as Dubai and states or cantons such as Zug in Switzerland and Illinois in the United States are trying to move many aspects of government services to the blockchain, or to create special crypto-economic zones.

Singapore and Australia have directed their financial regulators to issue detailed guidance about the regulatory, legislative and tax treatment of crypto-assets.

Political leaders in Japan and Russia have made multiple announcements broadly supportive of crypto-investment.

Those are the good news stories. However, most countries maintain a sort of benign neglect — either because of the relative small presence of the cryptoeconomy or lack of government interest or capability in the space.

And a small number of jurisdictions are outwardly hostile. New York adopted a hard line in terms of regulatory compliance when it introduced the BitLicense. China has banned initial coin offerings and cryptocurrency exchanges.

Global differences are going to matter

So far, the development of cryptocurrencies has been geographically concentrated in regions like Silicon Valley. But that won’t last. The blockchain is a distributed technology. The relationship between the regions that develop the technology and the regions that adopt the technology is unlikely to be strong.

In other words, the geography of invention is not the same as the geography of innovation.

The United States is highly successful in inventing blockchain technology. Yet it has been finding it hard to adopt blockchains because of American regulatory complexity.

Regulatory agility will be a significant factor determining which nations are able to successfully adopt blockchain technology.

This favors city-states (Singapore), smaller countries (Estonia, Australia) and subnational jurisdictions (Zug, Illinois).

The blockchain tax problem

How should cryptoassets be taxed? Are tokens money (taxed as spending)? Or are they debt or equity (in which case it would be treated as income or gains from a capital asset or investment vehicle)? We’ve argued that they cryptoassets are in fact the hypothetical asset class that Nobel laureate Oliver Williamson once called ‘dequity’. This means they should be taxed as capital assets, not as money.

But blockchain technology is not just another productivity enhancing technology that can be taxed at the point of adoption. Blockchains are actively associated with tax avoidance or tax shifting owing to the pseudonymous nature of transactions and the difficulty of establishing the correct jurisdiction for taxation.

This is going to be hard to unravel. As Chris and Sinclair told an Australian parliamentary inquiry in October 2017, blockchain-enabled organisations

are going to be harder to tax than the monolithic firms of the 20th century. We’ve published sceptically about the parliament’s efforts to prevent profit shifting by multinational firms. However, the born-global nature of blockchains will supercharge these trends. We do not believe there will be any easy regulatory solution to this, and parliament will need to rethink not just how it taxes, but what it taxes.

What should government do?

Nakamoto did not develop Bitcoin in a vacuum.

To the extent that government funding of academic mathematicians and cryptographers produced the initial research papers that were subsequently developed into the blockchain, then the early development of this technology was publicly sponsored — but not publicly planned.

Should government do more on the research side?

Let’s first assume that governments are benevolent — call this the public interest model of government.

Many economists, following Kenneth Arrow’s 1962 paper ‘Economic Welfare and the Allocation of Resources for Invention’, argue that the uncertainties and positive social benefits from invention can lead to a market failure in research and development.

It’s not clear that the blockchain has this problem. This is in part because token sales incentivise early adoption. What some people are calling a ‘bubble’ we think is massive experimental investment.

Alternatively, governments could substitute blockchains for their own existing services like the provision of money or property registries.

Governments should pick specific use-cases — such as identity and asset registries, licenses and certification, open government data, reporting and management of government contracts and public assets — then estimate the marginal cost and benefits of investment and adoption of this technology.

These benefits could be huge. For instance, a Bank of England report estimates a 3 percent gain in GDP from issuing a government cryptocurrency.

Other potential government involvement could focus on public goods problems — such as the need for the network communications infrastructure upon which a cryptoeconomy operates (particularly in the developing world).

Governments could also create open access data regimes and registries that can be harnessed and used by cryptoeconomy businesses.

But most fundamentally, governments should invest in high quality legal institutions (regulators, courts, bureaucracies, democratic systems, etc) to provide the cryptoeconomy with the needed predictability, efficiency, transparency, accountability, and efficacy.

But then again…

Why might some countries fail to make the necessary reforms for the blockchain economy? Governments might not know about the benefits or might misunderstand them (bounded rationality or information constraints). Governments might not be able to afford the necessary public investment (financial constraints).

Or we might not trust government enough. There are huge efficiency gains to be made from moving government registries like identity, property titling, tax, voting, central bank coin to the ‘trustless’ blockchain. But to do so itself requires high levels of trust in the government making that change.

This is the paradox: it takes a lot of trust to get to trustlessness. Sweden and Australia will be able to move easily to distributed land title registries. Haiti (where the need for a distributed land title register is much greater) will find it harder.

Governments against blockchains

Radical decentralisation will not always be in the interest of centralised governments.

In the public choice model of government, both governments and citizens have distinct objectives that they seek to maximize.

Citizens trade votes for services. Governments seek to create benefits for themselves (subject to the constraint of getting elected). What citizens want and what governments conflict, resulting in political exchange.

Take blockchain-enabled identity. From the perspective of the government, each citizen ought to have one and only one identity. A single, centralised identity is useful for entitlements and taxation — or conscription.

These centralised identity registrations are co-opted for commercial uses of identity (e.g. to open a bank account, or to rent a car).

But from the citizen perspective this is inefficient, because as identity is owned and managed by the state, they have no control over it, and cannot choose how to permission and share this data. It also creates problems of trust and privacy (for example in health and criminal records).

A decentralized identity would be more efficient, facilitating variety of types of identity for specialized uses and enabling user control. Citizens might want this. Governments do not.

What will other governments do?

Ideally, the approach of governments to the blockchain economy would be both rationally optimal from the perspective of its own citizens, but also a best response to the expected moves of foreign governments — many of which will differ in size, level of economic development, and institutional quality.

For instance, there is no doubt that many tax bureaucracies would like to constrain or control the growth of the cryptoeconomy as it will make taxation harder.

But their success will depend on what other countries as well.Blockchains — and the wealth and relationships on the blockchain — are both everywhere and nowhere.

In this world, it is not obvious what most effective public policy settings will be. There will be heavy learning costs involved. Some governments might rationally decide to delay decision making in order to learn from first-movers who can then be expected to incur costly mistakes in the experimental process of policy settings.

It is possible that larger countries will be much more cautious in adopting cryptoeconomic policies that are significantly divergent from other competing countries.

Alternatively, we could see bilateral or club-like coalitions of strategic investment and public policy harmonization — just as we do with tax and trade treaties.

Private governance and crypto-secession

When governments are particularly oppressive, blockchains can be used to move many aspects of an economy away from central control (identity, contract, money and payments, organization, data, etc). This allows what Trent MacDonald calls nonterritorial secession, or crypto-secession.

In the classic federal model of local public goods, governments competitively provide public goods with different offerings and price points. If an individual prefers a different bundle of public goods, they move to another jurisdiction. If a group of individuals collectively prefers a different bundle of pubic goods, they secede. But to secede, they have to physically move somewhere else, which is costly.

Non-territorial secession allows individuals to choose a different bundle of public goods without having to move. They just opt out of all or part of the government bundle. Crypto-secession is when the new bundle of local public goods is organized, coordinated and delivered through blockchain technology.

What does this mean in practice? An example of such emergent private governance of local public goods might occur at a local or regional level where a group of citizens create a pooling mechanism of social insurance, energy grid, or asset titling management through smart contracts, decentralised applications and distributed autonomous organisations.

This is more likely at the local, regional or city level than that of a nation state because of set-up costs and self-selection. We expect that the adoption of blockchain technology for governance will be a bottom-up phenomenon beginning with small groups.

Blockchains and property rights

Blockchain technology may also disrupt the relationship between government and property rights.

A fundamental question in the economics of law is this: Do property rights originate from the state and are then used by market participants? Or do property rights arise from markets and economic activity, and are thenefficiently enforced by the state?

While the former view (legal-centrism) is the most widely held among law and government scholars, public choice and market institutional economists tend to defend the latter (evolutionary) view.

Cryptocurrencies and crypto-assets provide a test of these competing views. It is not obvious what role the state plays in either creating or enforcing the property right claims over these assets.

One argument is that cryptocurrencies and crypto-assets have emerged entirely outside state jurisdiction and instead occupy a new software-enforced constitutional governance realm. In this strong form view, these are native crypto-property rights from which there is a risk of government predation.

An alternative argument is superficially similar, but allows that this parallel crypto-property rights regime has emerged in-the-shadow-of state law and enforcement. Crypto-property rights will remain in the domain of private law only until there are irreconcilable disputes, at which point there will be a role for government enforcement and sanctions.

This distinction about the origins of property rights matters because while governments provide public goods and support property rights(emphasised by the legal-centric school), they also impose costs by accumulating power (emphasised by the evolutionary school). A crypto-property rights regime will test which of these is more significant.

Creative destruction

Governments may also find themselves addressing the effects of creative destruction in a blockchain economy.

Past experience has shown that governments often end up supporting or compensating those negatively affected by new technology. They also end up making complementary investments such as education and workforce retraining.

The risk is that without such government action those who expect to be harmed by the adoption of a new technology may form political coalitions to block or raise the costs of developing the new technology.

Blockchain technologies face substantial hurdles from incumbents and vested interests that might lobby to slow or outright ban uses of the technology.

Governments may find themselves on both sides of creative destruction, seeking to promote the adoption of blockchains for social welfare maximizing reasons, while at the same time being captured by vested interests seeking protection.

Blockchain public policy

The blockchain is an extremely new technology. There is substantial uncertainty associated with its future uses, adoption levels — even its basic economic properties.

But it will be disruptive. And despite the libertarian, secessionist ethic of the blockchain community, government will be involved, for better or worse.The goal for the blockchain community and for crypto-friendly governments ought to be ensuring that this technology can be adopted in a way that benefits citizens, not rent-seekers.

Byzantine political economy

With Sinclair Davidson and Jason Potts. Originally a Medium post

For more than three decades economists and cryptographers have been working on the same problem.

Neither species has recognised their own work in the other.

But it turns out that the question of how to coordinate a society and how to ensure communication can be trusted is the same question differently phrased.

Our argument in this essay is simple: What cryptographers call byzantine fault tolerance and economists call robust political economy is the same thing.

This observation turns out to have some significant consequences for understanding the history of economic thought and the directions of institutional cryptoeconomics.

But to explain why, let’s quickly revisit one of the most important debates in the history of economics.

The socialist calculation debate

Economists from Adam Smith on have sought to explain the wealth of nations — why some nations are prosperous and others are not. By the twentieth century this debate had coalesced into a debate about which of two economic systems (communist central planning or capitalist decentralised markets) were more likely to bring prosperity.

Smith argued that market societies were characterised by spontaneous orders. Social order came from market incentives.

Karl Marx objected that the state (or some central coordinating authority) could produce superior outcomes to the market through conscious, deliberate planning.

Before the socialist calculation debate the liberal critique of socialism focused on the problem of incentives — how could a socialist community convince people to work hard if the product from their labour was redistributed? (See, for example, the discussion of socialism in Bruce Smith’s 1887 book Liberty and Liberalism.)

In 1920 the Austrian economist Ludwig von Mises published Economic Calculation in the Socialist Commonwealth. In this essay, Mises made a new, fundamental critique of socialist planning — the problem of information.

In a market economy, Mises argued, prices constitute signals about the highest value use of a good or service, providing a guide for what goods were in demand, and which were in a glut.

But a socialist system has no prices. As one of us has described Mises’ argument,

How would [a socialist planner] decide whether to send rubber to Tyre Factory 12 or Hose Factory 7? In a market economy, the factory that needed the rubber most would be willing to pay the highest price. But there is no natural price system in socialism — consumer prices are decided by the planner, and rubber allocated according to their diktat.

Mises’ critique of socialism was extended and elaborated by Lionel Robbins and Friedrich Hayek. Hayek turned this argument into one of the greatest essays in economics: ‘The Use of Knowledge in Society’, where he described prices as a decentralised knowledge network.

Centralised computer socialism

The Mises and Hayek argument today is well known, particularly after they seemed to be proven right by the fall of the Berlin Wall. By contrast, their opponents in the debate are less read today.

Mises and Hayek’s criticism was answered by the Polish economist Oskar Lange and extended by Hayek’s Russian-born student Abba Lerner.
Lange and Lerner accepted the importance of the price system in organising economic activity. But they argued that this system could be simulated mathematically.

Working firmly in the equilibrium economics school Vilfredo Pareto and Léon Walras, they imagined the price system as computational machine. In On the Economic Theory of Socialism, published first in 1936 and 1937, Lange concluded that a socialist economy could simulate the effect of the price system by trial and error.

Lange revisited his argument 30 years later. “Were I to rewrite my essay today my task would be much simpler”, wrote Lange:

My answer to Hayek and Robbins would be: so what’s the trouble? Let us put the simultaneous equations on an electronic computer and we shall obtain the solution in less than a second. The market process with its cumbersome tâtonnements appears old-fashioned. Indeed, it may be considered as a computing device of the pre-electronic age.

Not only could computers simulate the market but the computer could conduct long range planning and implement that plan — “a function which the market never was able to perform”.

How decentralised is Hayek’s market, really?

It is typical to cast these two visions of the economy as Lange’s centralised planned economy and Hayek’s decentralised market.

But Hayekian decentralisation still has a lot of centralisation in it.

Here the Marxists are right. Free markets have an awful lot of state involvement in them. Property is private but its enforcement relies heavily on public authorities — the legal system courts, sheriffs, police.

But what both the Hayekians and the Marxists missed is that property rights are not only about enforcement. They’re about the identification and verification of property rights. And (right now) the state does most of that.

As we argued in our previous essay, so much of what the modern state does is endorse, manage, and verify ledgers of social relations. The state manages the property titles register. It manages ledgers of social security entitlements. It manages the ledgers of who is a citizen and who can therefore participate in political bargaining.

This is a very big, important, and largely unappreciated function that the state fulfills. The state does is in charge of these crucial ledgers because it is a large ‘trusted’ entity. But of course how much we can trust the state is questionable.

The invention of the blockchain presents us with new institutional choices.

A new typology of political economy

In our new typology of political economy, political ideas are arranged in a grid of centralised and decentralised economies, and decentralised and decentralised ledgers.

In Lange’s computer socialism, the economy is centralised and the ledger is centralised — the state is a planning machine, both managing the ledger and executing a global plan.

In pre-Marxist communalism, such as the scheme devised by the Welsh utopian socialist Robert Owen, economic planning is centralised but the relevant jurisdiction — that is, the ledger-providing authority — consists of subnational groups of voluntary, socialistic communities.

Hayekian distributed capitalism has a decentralised economy — planning is done by individuals rather than the state — yet the state still organises, records, verifies and updates the ledgers of identities, rights, obligations, and entitlements.

By contrast, in a cryptoeconomy both the economy and the ledgers are decentralised. Blockchains take the state out of both planning and verification.

Information and incentives

Markets work because they align incentives into productive work and they harness distributed information productively.

In the second half of the twentieth century the public choice school extended the incentives critique to encompass the incentives of the planners themselves. How could a socialist commonwealth ensure that planners worked in society’s interest, rather than their own personal interest?

Today, what scholars now call a ‘robust political economy’ (see Mark Pennington’s book and this paper by Peter T. Leeson and J. Robert Subrick) is an economic system structured to deal with the twin problems of information and incentives. How can we coordinate action — make exchanges, build relationships and communities — in a world of incomplete information and potential rentseeking?

Turns out, cryptographers and computer scientists have been working on these two problems as well.

The Byzantine Generals’ Problem

Distributed computing systems have to deal with what is known as the Byzantine Generals’ Problem.

This problem was first expressed in 1982. Imagine a Byzantine army surrounding an enemy city.

Illustration from the 12th century Madrid Skylitzes, a history of Byzantium between 811 and 1057

The army consists of divisions, each headed up by a general, and they need to establish a consensus about when exactly to launch their attack on the city.

Centralised command is out of the question. No individual general has line of sight to all the generals — or the authority to impose consensus on the whole army at once. They can only communicate by messenger.

So there’s an information problem. The generals need a system — an algorithm — that allows all generals to agree on a consensus.

The problem is made even harder because it’s not certain that all generals are loyal. Some have been paid off by the enemy, and are actively trying to disrupt the plan. The traitorous generals don’t want the loyal generals to come to a consensus.

Thus Byzantine Generals’ Problem describes the challenge of a) achieving consensus in distributed, decentralised systems b) when information flows imperfectly, and c) in the presence of adversaries.

Blockchains achieve Byzantine fault tolerance in part by treating it as an incentive problem. The Bitcoin proof-of-work mechanism incentivises good behaviour, makes it extremely expensive to attack the network, and reduces the payoffs for a successful attack.

The so-called ’51 per cent’ attack on Bitcoin — the possibility that a majority of hashing power could coordinate and then undermine the network — is what would happen if more than half the generals were traitors. (Of course, that itself would be hard to coordinate.)

Two fields together

A decision to attack a city simultaneously is just a narrow slice of the general economic problem: how to coordinate activity in when information is incomplete, communication is imperfect, and people can be lazy, opportunistic, and self-interested.

What computer scientists have been trying to solve algorithmically, economists have been trying to solve constitutionally.

Where cryptographers have found their solutions in public key cryptography and proof of work mechanisms, economists have found solutions in markets, regulation, and institutions.

Blockchains bring these two fields together. They turn constitutional questions into algorithmic questions, and algorithmic questions into constitutional ones.

Byzantine political economy

One way to see this is as a curious historical instance of two largely unrelated fields (computer science and economics) somewhat simultaneously working on a structurally similar problem (decentralised coordination) and arriving at the same type of solutions (consensus protocols and market institutions).

But a more interesting perspective is that blockchain technology actually joins these worlds together in reality. Blockchains can provide the secure fault tolerant decentralised layer for property rights information and its verification and updating whenever that information changes, which can support a decentralised economic layer of markets.

The socialists were wrong in their hopeful quest that (centralised) computers would replace markets. Actually, it is decentralised computers (blockchains) than can replace governments.

Markets always need governance, and the limits of a market society were always the ability of the state to provide those services of record keeping, validation and verification of transactions in property rights. In return, the state levied taxation to fund these services.

Blockchains are a new technology of fault tolerant governance that can furnish the governance to underpin a market economy and society.

We call this Byzantine Political Economy.

The problem with Nobel laureate Richard Thaler’s nudgonomics

With Sinclair Davidson

Economists have spent the last 240 years – ever since Adam Smith published The Wealth of Nations – trying to understand how decentralised economies work. In that time they have established that the price mechanism does a pretty good job of coordinating economic activity, and that profits provide excellent incentives to stimulate human action.

In the course of understanding how economies operate, economists have had to develop a working model of human behaviour, and various simplifying assumptions have been made. An example of such an assumption is that people are pretty smart, and best know their own self-interest. That is the so-called rationality assumption.

But, of course, there are many rationality assumptions. Standard economic theory maintains what can be described as ‘strong-form’ rationality. In this view of rationality, the human brain is an unlimited resource and can easily and quickly compute all outcomes and make choices that maximise satisfaction and well-being.

Then there is a ‘semi-strong form’ of rationality – bounded rationality – associated with 1978 economics laureate Herbert Simon. He suggested that people intend to be rational but that there are limits to rationality. Finally ‘weak-form’ rationality, associated with the Austrian school, suggests that people economise on their brain power as they would any other resource and make use of rules of thumb and heuristics to make choices and decisions.

So the notion that economists have a single dogmatic view of human behaviour and rationality is something of a straw man, if not actually a whipping boy when non-economists debate economists.

Enter into this milieu Richard Thaler of the University of Chicago, and the latest economics laureate awarded for his work in behavioural economics. Thaler is a worthy Nobel winner. He has successfully challenged the mainstream and standard assumption of strong-form rationality. He has brought respectability to what would have been heresy as recently as the 1970s. Many of the insights of his research agenda and his followers have been profound, others have been trivial. That is to be expected from any productive scholar and intellectual movement.

What is unexpected is how successful behavioural economics has been in a policy sense. Popularly and politically, Thaler is best known for his book Nudge, written with Cass Sunstein. This remarkable book both established a new theoretical framework for government intervention and successfully marketed it to the governing class.

Nudge was published in 2008. By 2010, the Conservative government in Britain had established a ‘nudge unit’ within the Cabinet Office. Many other governments have followed suit. The rapid leap that nudge theory made from seminar room to law-of-the-land has been unprecedented.

These days, lots of policies are routinely described as ‘nudges’, and the word is as much a political branding exercise as anything. But Thaler and Sunstein were very specific about what they meant by a nudge. As they describe it, we all have two ‘semiautonomous’ selves: the ‘doer’ and the ‘planner’. The doer is irrational – thinking only about the short term and gratuitous pleasures. The planner is rational – thinking about the future, focusing on getting healthy and saving money.

The planner makes the best choices; the planner makes the choices we don’t regret and would make again. In nudge theory, government should design systems that allow us to favour what our planner selves would rather do, rather than our reckless doer selves.

In this way, Thaler and Sunstein avoid one of the central critiques of the nanny state – the nanny state wants to impose its own preferences on others. Both the planner and doer’s preferences are our own. We still get to choose. Thaler and Sunstein describe nudge theory as ‘libertarian’ paternalism.

But it has some serious practical and conceptual problems.

Rather than just leaving choice to the market, nudge theory says the government should try to discern a set of best preferences from our worst ones – but not impose its own. Then it should regulate the economy so it favours the choices of our planner selves, but doesn’t force us into any specific choice. This sounds like hard work for a government.

More fundamentally, is it true that we have two separate, distinct selves? Nudge theory needs there to be two distinct systems so the government can choose between them. ‘Dual systems’ theory, as it was known in the psychological literature, has now been replaced by theories that describe our cognitive processes as a continuum or graphical space. The upshot is that it is not meaningful to say we have two sets of preferences – good ones and bad ones – but an infinite number of sets of preferences.

With this shift, psychologists seem to have coalesced around the weak-form Austrian view of rationality: that rationality itself is a matter of trade-offs and choices. One could even say this was Adam Smith’s view. People are a rich mix of passion, interest and sympathy – not all-knowing, rational calculators.

Thaler’s contribution has been to help return us to that understanding. But it’s a big leap from the observation that ‘people are not always perfectly rational’ to ‘bureaucrats can make us rational’.

The Blockchain Economy: A beginner’s guide to institutional cryptoeconomics

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

The blockchain is a digital, decentralised, distributed ledger.

Most explanations for the importance of the blockchain start with Bitcoin and the history of money. But money is just the first use case of the blockchain. And it is unlikely to be the most important.

It might seem strange that a ledger — a dull and practical document associated mainly with accounting — would be described as a revolutionary technology. But the blockchain matters because ledgers matter.

Ledgers all the way down

Ledgers are everywhere. Ledgers do more than just record accounting transactions. A ledger consists simply of data structured by rules. Any time we need a consensus about facts, we use a ledger. Ledgers record the facts underpinning the modern economy.

Ledgers confirm ownership. Property title registers map who owns what and whether their land is subject to any caveats or encumbrances. Hernando de Soto has documented how the poor suffer when they own property that has not been confirmed in a ledger. The firm is a ledger, as a network of ownership, employment and production relationships with a single purpose. A club is a ledger, structuring who benefits and who does not.

Ledgers confirm identity. Businesses have identities recorded on government ledgers to track their existence and their status under tax law. The register of Births Deaths and Marriages records the existence of individuals at key moments, and uses that information to confirm identities when those individuals are interacting with the world.

Ledgers confirm status. Citizenship is a ledger, recording who has the rights and is subject to obligations due to national membership. The electoral roll is a ledger, allowing (and, in Australia, obliging) those who are on that roll a vote. Employment is a ledger, giving those employed a contractual claim on payment in return for work.

Ledgers confirm authority. Ledgers identify who can validly sit in parliament, who can access what bank account, who can work with children, who can enter restricted areas.

At their most fundamental level, ledgers map economic and social relationships.

Agreement about the facts and when they change — that is, a consensus about what is in the ledger, and a trust that the ledger is accurate — is one of the fundamental bases of market capitalism.

Ownership, possession, and ledgers

Let’s make a distinction here that is crucial but easy to miss: between ownership and possession.

Take passports. Each country asserts the right to control who crosses its borders, and each country maintains a ledger of which of its citizens have the right to travel. A passport is a physical item — call it a token — that refers back to this ledger.

In the pre-digital world, possession indicated ownership of that right. The Australian passport ledger consisted of index cards held in by the government of each state. Border agents presented with a passport could surmise that the traveller who held it was listed on a distant ledger as allowed to travel. Of course this left border control highly exposed to fraud.

Possession implies ownership, but possession is not ownership. Now modern passports allow the authorities to confirm ownership directly. Their digital features allow airlines and immigration authorities to query the national passport database and determine that a passenger is free to travel.

Passports are a relatively straightforward example of this distinction. But as Bitcoin has shown: money is a ledger, too.

Possession of a banknote token indicates ownership. In the nineteenth century the possessor — ‘bearer’ — of a banknote had a right to draw on the issuing bank the value of the note. These banknotes were direct liabilities for the issuing bank, and were recorded on the banks’ ledger. A regime of possession indicating ownership meant that banknotes were susceptible to be both stolen and forged.

In our era fiat currencies a five dollar bill cannot be returned to the central bank for gold. But the relationship remains — the value of the bill is dependent on a social consensus about the stability of the currency and government that issued it. Banknotes are not wealth, as Zimbabweans and Yugoslavians and Weimar Republic Germans have unfortunately learned. A bill is a call on a relationship in a (now synthetic) ledger and if that relationship collapses, so does the value of the bill.

The evolution of the ledger

For all its importance, ledger technology has been mostly unchanged … until now.

Ledgers appear at the dawn of written communication. Ledgers and writing developed simultaneously in the Ancient Near East to record production, trade, and debt. Clay tablets baked with cuneiform script detailed units of rations, taxes, workers and so forth. The first international ‘community’ was arranged through a structured network of alliances that functioned a lot like a distributed ledger.

The first major change to ledgers appeared in the fourteenth century with the invention of double entry bookkeeping. By recording both debits and credits, double entry bookkeeping conserved data across multiple (distributed) ledgers, and allowed for the reconciliation of information between ledgers.

The nineteenth century saw the next advance in ledger technology with the rise of large corporate firms and large bureaucracies. These centralised ledgers enabled dramatic increases in organisational size and scope, but relied entirely on trust in the centralised institutions.

In the late twentieth century ledgers moved from analog to digital ledgers. For example, in the 1970s the Australian passport ledger was digitised and centralised. A database allows for more complex distribution, calculation, analysis and tracking. A database is computable and searchable.

But a database still relies on trust; a digitised ledger is only as reliable as the organisation that maintains it (and the individuals they employ). It is this problem that the blockchain solves. The blockchain is a distributed ledgers that does not rely on a trusted central authority to maintain and validate the ledger.

Blockchain and the economic institutions of capitalism

The economic structure of modern capitalism has evolved in order service these ledgers.

Oliver Williamson, the 2009 Nobel laureate in economics, argued that people produce and exchange in markets, firms, or governments depending on the relative transactions costs of each institution. Williamson’s transactions cost approach provides a key to understanding what institutions manage ledgers and why.

Governments maintain ledgers of authority, privilege, responsibility and access. Governments are the trusted entity that keeps databases of citizenship and the right to travel, taxation obligations, social security entitlements, and property ownership. Where a ledger requires coercion in order to be enforced, the government is required.

Firms also maintain ledgers: proprietary ledgers of employment and responsibility, of the ownership and deployment of physical and human capital, of suppliers and customers, of intellectual property and corporate privilege. A firm is often described as a ‘nexus of contracts’. But the value of the firm comes from the way that nexus is ordered and structured — the firm is in fact a ledger of contracts and capital.

Firms and governments can use blockchains to make their work more efficient and reliable. Multinational firms and networks of firms need to reconcile transactions on a global basis and blockchains can allow them to do so near-instantaneously. Governments can use the immutability of the blockchain to guarantee that property titles and identity records are accurate and untampered. Well-designed permissioning rules on blockchain applications can give citizens and consumers more control over their data.

But blockchains also compete against firms and governments. The blockchain is an institutional technology. It is a new way to maintain a ledger — that is, coordinate economic activity — distinct from firms and governments.

Blockchains can be used by firms, but they can also replace firms. A ledger of contracts and capital can now be decentralised and distributed in a way they could not before. Ledgers of identity, permission, privilege and entitlement can be maintained and enforced without the need for government backing.

Institutional cryptoeconomics

This is what institutional cryptoeconomics studies: the institutional consequences of cryptographically secure and trustless ledgers.

Classical and neoclassical economists understand the purpose of economics as studying the production and distribution of scarce resources, and the factors which underpinned that production and distribution.

Institutional economics understands the economy as made of rules. Rules (like laws, languages, property rights, regulations, social norms, and ideologies) allow dispersed and opportunistic people to coordinate their activity together. Rules facilitate exchange — economic exchange but also social and political exchange as well.

What has come to be called cryptoeconomics focuses on the economic principles and theory underpinning the blockchain and alternative blockchain implementations. It looks at game theory and incentive design as they relate to blockchain mechanism design.

By contrast, institutional cryptoeconomics looks at the institutional economics of the blockchain and cryptoeconomy. Like its close cousin institutional economics, the economy is a system to coordinate exchange. But rather than looking at rules, institutional cryptoeconomics focuses on ledgers: data structured by rules.

Institutional cryptoeconomics is interested in the rules that govern ledgers, the social, political, and economic institutions that have developed to service those ledgers, and how the invention of the blockchain changes the patterns of ledgers throughout society.

The economic consequences of the blockchain

Institutional cryptoeconomics gives us the tools to understand what is happening in the blockchain revolution — and what we can’t predict.

Blockchains are an experimental technology. Where the blockchain can be used is an entrepreneurial question. Some ledgers will move onto the blockchain. Some entrepreneurs will try to move ledgers onto the blockchain and fail. Not everything is a blockchain use case. We probably haven’t yet seen the blockchain killer app yet. Nor can we predict what the combination of ledgers, cryptography, peer to peer networking will throw up in the future.

This process is going to be extremely disruptive. The global economy faces (what we expect will be) a lengthy period of uncertainty about how the facts that underpin it will be restructured, dismantled, and reorganised.

The best uses of the blockchain have to be ‘discovered’. Then they have to be implemented in a real world political and economic system that has deep, established institutions that already service ledgers. That second part will not be cost free.

Ledgers are so pervasive — and the possible applications of the blockchain so all-encompassing — that some of the most fundamental principles governing our society are up for grabs.
Institutional creative destruction

We’ve been through revolutions like this before.

It is common to compare the invention of Bitcoin and the blockchain with the internet. The blockchain is Internet 2.0 — or Internet 4.0. The internet is a powerful tool that has revolutionised the way we interact and do business. But if anything the comparison undersells the blockchain. The internet has allowed us to communicate and exchange better — more quickly, more efficiently.

But the blockchain allows us to exchange differently. A better metaphor for the blockchain is the invention of mechanical time.

Before mechanical time, human activity was temporally regulated by nature: the crow of the rooster in the morning, the slow descent into darkness at night. As the economic historian Douglas W. Allen argues, the problem was variability: “there was simply too much variance in the measurement of time … to have a useful meaning in many daily activities”.

“The effect of the reduction in the variance of time measurement was felt everywhere”, Allen writes. Mechanical time opened up entirely new categories of economic organisation that had until then been not just impossible, but unimaginable. Mechanical time allowed trade and exchange to be synchronised across great distances. It allowed for production and transport to be coordinated. It allowed for the day to be structured, for work to be compensated according to the amount of time worked — and for workers to know that they were being compensated fairly. Both employers and employees could look at a standard, independent instrument to verify that a contract had been performed.

Complete and incomplete smart contracts

Oliver Williamson and Ronald Coase (who was also an economics Nobel prize winner, in 1991) put contracts at the heart of economic and business organisation. Contracts are at the centre of institutional cryptoeconomics. It is here that blockchains have the most revolutionary implications.

Smart contracts on the blockchain allows for contractual agreements to be automatically, autonomously, and securely executed. Smart contracts can eliminate an entire class of work that currently maintains, enforces and confirms that contracts are executed — accountants, auditors, lawyers, and indeed much of the legal system.

But the smart contracts are limited by what can be specified in the algorithm. Economists have focused on the distinction between complete and incomplete contracts.

A complete contract specifies what is to occur under every possible contingency. An incomplete contract allows the terms of the contract to be renegotiated in the case of unexpected events. Incomplete contracts provide one explanation for why some exchanges take place in firms, and why others take place in markets, and provides a further guide to questions surrounding vertical integration and the size of the firm.

Complete contracts are impossible to execute, while incomplete contracts are expensive. The blockchain, though smart contracts, lowers the information costs and transactions costs associated with many incomplete contracts and so expands the scale and scope of economic activity that can be undertaken. It allows markets to operate where before only large firms could operate, and it allows business and markets to operate where before only government could operate.

The precise details of how and when this will occur is a challenge and a problem for entrepreneurs to resolve. Currently, oracles provide a link between the algorithmic world of the blockchain and the real world, trusted entities that convert information into data that can be processed by a smart contract.

The real gains to be made in the blockchain revolution, we suggest, are in developing better and more powerful oracles — converting incomplete contracts to contracts that are sufficiently complete to be written algorithmically and executed on the blockchain.

The merchant revolution of the middle ages was made possible by the development of merchant courts — effectively trusted oracles — that allowed traders to enforce agreements privately. For blockchain, that revolution seems yet to come.

Whither government?

The blockchain economy puts pressure on government processes in a whole host of ways, from taxation, to regulation, to service delivery.

Investigating these changes is an ongoing project of ours. But consider, for instance, how we regulate banks.

Prudential controls have evolved to ensure the safety and soundness of financial institutions that interact with the public. Typically these controls (for example, liquidity and capital requirements) have been justified by the fact that depositors and shareholders are unable to observe the bank’s ledger. The depositors and shareholders are unable to discipline the firm and its management.

Bank runs occur when depositors discover (or simply imagine) that their bank might not be able to cover their deposits, and they rush to withdraw their money.

One possible application of the blockchain would allow depositors and shareholders to continuously monitor the bank’s reserves and lendings, substantially eliminating the information asymmetries between them and the bank management.

In this world, market discipline would be possible. Public trust in the immutability of the blockchain would ensure no false bank runs occurred. The role of the regulator might be limited to certifying the blockchain was correctly and securely structured.

A more far reaching application would be a cryptobank — an autonomous blockchain application that borrows short and lends long, perhaps matching borrowers with lenders directly. A cryptobank structured algorithmically by smart contracts would have the same transparency properties as the bank with a public blockchain ledger but with other features that might completely neglect the need for regulators. For example, a cryptobank could be self-liquidating. At the moment the cryptobank began trading while insolvent, the underlying assets would be automatically disbursed to shareholders and depositors.

It is unclear what regulatory role government should have in this world.

Tyler Cowen and Alex Tabarrok have argued that much government regulation appears to be designed to resolve asymmetric information problems — problems that, in a world of information ubiquity, often do not exist any more. Blockchain applications significantly increase this information ubiquity, and make that information more transparent, permanent, and accessible.

Blockchains have their uses in what is being called ‘regtech’ — the application of technology to the traditional regulatory functions of auditing, compliance, and market surveillance. And we ought not to dismiss the possibility that there will be new economic problems that demand new consumer protections or market controls in the blockchain world.

Nevertheless, the restructuring and recreation of basic economic forms like banks will put pressure not just on how regulation is enforced, but what the regulation should do.

Whither Big Business?

The implications for big business are likely to be just as profound. Business size is often driven by the need to cover the costs of business hierarchy — in turn due to incomplete contracts and technological necessity of large scale financial investment. That business model has meant that shareholder capitalism is the dominant form of business organisation. The ability to write more complete contracts on the blockchain means that entrepreneurs and innovators will be able to maintain ownership and control of their human capital and profit at the same time. The nexus between operating a successful business and access to financial capital has been weakening over time, but now might even be broken. The age of human capitalism is dawning.

Entrepreneurs will be able to write a valuable app and release it into the “wild” ready to be employed by anyone and everyone who needs that functionality. The entrepreneur in turn simply observe micro-payments accumulating in their wallet. A designer could release their design into the “wild” and final consumers could download that design to their 3D printer and have the product almost immediately. This business model could see more (localised) manufacturing occur in Australia than at present.

The ability of consumers to interact directly with producers or designers will limit the role that middlemen play in the economy. Logistics firms, however, will continue to prosper, but the advent of driverless transportation will see disruption to industry too.

Bear in mind, any disruption of business will also disrupt the company tax base. It may become difficult for government to tax business at all — so we might see greater pressure on sales (consumption) taxes and even poll taxes.

Conclusion

The blockchain and associated technological changes will massively disrupt current economic conditions. The industrial revolution ushered in a world where business models were predicated on hierarchy and financial capitalism. The blockchain revolution will see an economy dominated by human capitalism and greater individual autonomy.

How that unfolds is unclear at present. Entrepreneurs and innovators will resolve uncertainty, as always, through a process of trial and error. No doubt great fortunes will be made and lost before we know exactly how this disruption will unfold.

Our contribution is that we have a clear understanding of a model that can be deployed to provide clarity to the disruption as and when it occurs.

Bitcoin investors should be taxed like any other investor

By Chris Berg, Sinclair Davidson and Jason Potts

Despite its name, cryptocurrency isn’t just money. It could also be debt or equity and so it should be regulated and taxed in the same way as other finance.

The tokens investors get when they buy a cryptocurrency, like Bitcoin, can be used to buy into blockchain startups (businesses that use the same online ledger as cryptocurrencies). When blockchain startups issue shares in their businesses using cryptocurrency, it’s called an initial coin offering. For investors, this is like any other equity investment.

Cryptocurrency can also be used to finance specific assets, like debt. So what we have is a single financial instrument that has the advantages of both debt and equity.

So startups issuing their own tokens for investment purposes should have to comply with the same rules and regulations that startups issuing more traditional instruments must comply with. Cryptocurrency investors should be taxed on the same basis as traditional investors.

Why cryptocurrency is a mix of money, debt and equity

Money is very often defined by its functions: a medium of exchange, a unit of account (used to represent the real value or cost of any economic item), and a store of value (that can be saved, retrieved and exchanged at a later time). The early consensus about Bitcoin among economists is that it’s not money.

At best cryptocurrencies are a medium of exchange. But many economists doubted that Bitcoin, given its volatility, could ever serve as a unit of account, let alone as a store of value.

So if cryptocurrency isn’t money, is has to be something else. It could be an asset of some sort.

Usually if investors acquire or sell an asset, it would be liable to tax, such as the GST. This means people using Bitcoin would be taxed twice when using it.

It would be taxed when the person buys the Bitcoin and taxed again when they used it to buy something. Luckily the federal government realised this was a bad idea and moved to repeal the double taxation of Bitcoin.

Clearly the federal government’s view is that cryptocurrency is not legal tender – so don’t try pay your income tax in Bitcoin anytime soon. And there are important differences between money, specifically legal tender, and cryptocurrency.

Cryptocurrencies tend to strictly rules bound. How they’re created, when they can be earned, how they’re distributed and how many there ever can be, is all determined by rules. In fact, users like strict rules.

By contrast government controlled money is not rules bound. Government employs substantial discretion in exercising control over money. So while the US dollar has the words “In God we trust” printed on it, this system actually requires substantial trust in government.

This trust has been repaid by a substantial reduction of value over the past century. It seems that government-backed money may also be a poor unit of account and store of value.

Debt and equity are financial instruments used to raise money to finance economic activity. It is something of a puzzle to financial economists why firms use debt in some instances to raise finance while using equity in other situations.

An important 1988 paper by the 2009 economics Laureate Oliver Williamson provides a possible answer to that question. Williamson argues that debt, being a strict rules bound financial instrument, is best used to finance general assets, while equity is best used for so-called specific assets. Specific assets are those assets that cannot be cheaply or easily redeployed from their current use to alternate uses without a substantial loss of value.

As it turns out Williamson had speculated about the existence of such an instrument (that he labelled “dequity”) and then rejected that instrument as being unworkable. The reason dequity was unworkable was due to opportunism – investors simply could not trust dequity issuers.

The ledger that cryptocurrencies use – the blockchain – is a actually “trustless” technology because it’s decentralised. It allow users to see each other’s ledgers and transactions, negating the need for a trusted third party to manage risk. Instead it relies on cryptographic verification.

With the absence of the ability for investors to game the system, cryptocurrencies are the dequity Williamson first imagined and it could become an efficient financing mechanism.

How dequity should be regulated

The idea of regulating or taxing cryptocurrency finance may not be to the liking of many crypto-enthusiasts who are likely to argue that traditional rules and regulations are very onerous. They are correct, of course. Yet the solution to over-regulation is not a carve-out for special interests but rather regulatory reform that reduces the burden for all business.

The good news for crypto-enthusiasts is that some governments appear willing to engage in genuine regulatory reform and tax competition to attract investment in this space. For example, the Singaporean government is relaxing existing regulation to accommodate cryptocurrency. Its proposed framework would require applicable companies to obtain a license from the Monetary Authority of Singapore, and divides payment activities into several categories.

But regulators should really regulate cryptocurrencies in much the same way as they do existing financial instruments. It shouldn’t be given special treatment.

Despite all the complexity of cryptocurrency it really is simple: it’s a financial instrument that combines all the advantages of money with debt and equity. It’s none of those well known concepts in isolation, but a viable and workable hybrid of all three.