What we think we know about defi

This essay follows an RMIT Blockchain Innovation Hub workshop on defi. Contributions by Darcy WE Allen, Chris Berg, Sinclair Davidson, Oleksii Konashevych, Aaron M Lane, Vijay Mohan, Elizabeth Morton, Kelsie Nabben, Marta Poblet, Jason Potts, and Ellie Rennie. Originally a Medium post.

The financial sector exists solely to smooth economic activity and trade. It is the network of organisations, markets, rules, and services that move capital around the global economy so it can be deployed to the most profitable use.

It has evolved as modern capitalism has evolved, spreading with the development of property rights and open markets. It has grown as firms and trade networks became globalised, and supercharged as the global economy became digitised.

Decentralised finance (defi) is trying to do all that. But just since 2019, and entirely on the internet.

Any business faces the question of “how do I get customers to pay for my product?” Similarly consumers ask the question, “Where and how can I pay for the goods and services I want to buy?” For the decentralised digital economy, defi answers this question. Defi provides the “inside” money necessary to facilitate transactions.

But what in traditional, centralised finance looks like banks, stock exchanges, insurance companies, regulations, payments systems, money printers, identity services, contracts, compliance, and dispute resolution systems — in defi it’s all compressed into code.

From a business perspective trade needs to occur in a trusted and safe environment. For the decentralised digital economy, that environment is blockchains and the dapps built on top.

And as we can see, defi doesn’t just finance individual trades or firms — it finances the trading environment, in the same way that taxes finance regulators and inflation finances central banks. If blockchain is economic infrastructure, defi is the funding system that develops, maintains and secures it.

These are heavy, important words for something that looks like a game. The cryptocurrency and blockchain space has always looked a little game-y, not least with its memes and “in-jokes”. The rise of defi has also had its own cartoonified vibe and it has been somewhat surreal to see millions of dollars of value pass through tokens called ‘YAMs’ and ‘SUSHI’.

Games are serious things though. A culture of gaming provides a point around which all participants can coordinate activity and experimentation — what we’re seeing in defi is the creation of a massive multiplayer online innovation system. The “rules” of this game are minimal, there are no umpires, and very little recourse, where the goal is the creation and maintenance of decentralised financial products, and willing players can choose (if and) to what extent they participate.

Because there is real value at stake, the cost of a loss is high. Much defi is tested in production and the losses from scams, unethical behaviour, or poor and inadequately audited coding are frequent.

On the other side, participation in the game of defi is remarkably open. There are few barriers to entry except a small amount of capital that players are willing to place at risk. Once fiat has been converted into cryptocurrency, the limit on participation in decentralised finance isn’t regulatory or institutional — it is around knowledge. (Knowledge is a non-trivial barrier, excluding people who could be described as naive investors. This is important for regulatory purposes.)

This is starkly different from the centralised financial system, where non-professional participants have to typically go through layers of gatekeepers to experiment with financial products.

The basic economics of defi

The purpose of defi is to ensure the supply of an ‘inside money’ — that is, stablecoins — within decentralised digital platforms and to provide tools to manage finance risks.

In the first instance defi is about consumer finance. It answers basic usability questions in the blockchain space: How do users of the platform pay native fees? Which digital money is deployed as a medium of exchange or unit of account on the platform?

In the second instance defi concerns itself with the operation of consensus mechanisms — particularly proof of stake mechanisms and their variants. The problem here is how to capture financial trust in a staking coin and then how to use that trust to generate “trust” on a blockchain. Blockchains need mechanisms to value and reward these tokens. Given the (potential) volatile nature of these tokens, risk management instruments must exist in order to efficiently allocate the underlying risk of the trading platform.

As we see it, the million yam question is whether the use of these risk management tools undermine trust in the platform itself. It is here that governance is important.

Which governance functions should attach to staking tokens and when should those functions be deployed? Should they be automated or should voting mechanisms be used? If so, which voting mechanisms and what level of consensus is appropriate for decision making.

Finally defi addresses the existence of stablecoin and staking tokens from an investor perspective. Again there are some significant questions here that the defi space has barely touched. How do these instruments and assets fit into existing investment strategies? How will the tax function respond? How much of existing portfolio theory and asset pricing applies to these instruments and assets?

Of course, we already have a complex and highly evolved centralised financial system that can provide much of the services that are being built from the ground up in defi. So why bother with defi?

The most obvious reason is that the blockchain space has a philosophical interest in decentralisation as a value in and of itself. But decentralisation addresses real world problems.

First, centralised systems can have human-centric cybersecurity vulnerabilities. The Canadian exchange QuadrigaCX lost everything when the only person with access to the cryptographic keys to the exchange died (lawyers representing account holders have requested that the body be exhumed to prove his death). Decentralised algorithmic systems have their own vulnerabilities (need we mention yams again?) but they are of a different character and unlike human nature they can be improved.

Second, centralised systems are exposed to regulation — for better or worse. For example, one of the arguments for UniSwap is that it is more decentralised than EtherDelta. EtherDelta was vulnerable to both hackers (its order book website was hacked) and regulators (its designer was sued by SEC).

Third, digital business models need digital instruments that can both complement and substitute for existing products. Chain validation instruments and the associated risk management tools presently do NOT have real world equivalent products.

Fourth and finally, the ability to digitise, fractionalise, and monetise currently illiquid real-world assets will require a suite of instruments and digital institutions. Defi is the beginning of that process.

In this sense, the defi movement is building a set of financial products and services that look superficially familiar to the traditional financial system using a vastly different institutional framework — that is, with decentralisation as a priority and without the layers of regulation and legislation that shape centralised traditional finance.

Imagine trying to replicate the functional lifeforms of a carbon-based biochemical system in a silicon based biochemical system. No matter how hard you tried — they’d look very different.

Defi has to build in some institutions that mimic or replicate the economic function provided by central banks, government-provided identity tech, and contract enforcement through police, lawyers and judges. It is the financial sector + the institutions that the traditional finance sector relies on. So, initially, it’s going to look more expensive, relative to “finance”. But the social cost of the traditional finance sector is much larger — a full institutional accounting for finance would have to include those courts and regulations and policymakers and central banks that it relies on.

Thus defi and centralised finance look very different in practice. Consider exchanges. Traditional financial markets can either operate as organised exchanges (such as the New York Stock Exchange) or as over-the-counter (OTC peer-to-peer) markets. The characteristics of those types of market are set out below.

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Defi exchanges represent an attempt to combine the characteristics of both organised exchanges and over-the-counter markets. In the very instance, of course, they are decentralised markets governed by private rules and not (necessarily) public regulation. They aim to be peer-to-peer markets (including peer-to-algorithm markets in the case of AMM).

But at the same time they aim to be anonymous (in this context meaning that privacy is maintained), transparent, highly liquid, and with less counterparty risk than a traditional OTC market.

Where is defi going?

Traditional finance has been developing for thousands of years. Along with secure private property rights and the rule of law, it is one of the basic technologies of capitalism. But of those three, traditional finance has the worst reputation. It has come to be associated with city bros and the “Wolf of Wall Street”, and the Global Financial Crisis. Luigi Zingales has influentially argued that the traditional finance system has outgrown the value it adds to society, in part because of the opportunities of political rent seeking.

This makes defi particularly interesting.  Defi is for machines. Not people. It represents the automation of financial services.

A century ago agriculture dominated the labour force. The heavy labour needs of farming are one of the reasons we were poor back then. As we added machines to agriculture — as we let machines do the farming — we reduced the need to use valuable human resources. Defi offers the same thing for finance. Automation reduces labour inputs.

Automation of course has been increasingly common in financial systems since at least the 1990s. But it could only go so far. A lot of the reason that finance (and many sectors, including government and management) resisted technological change and capital investment, was at the bottom, there had to be a human layer of trust. Now that we can automate trust through blockchains, we can move automation more deeply into the financial system.

Of course, this is in the future. Right now defi is building airplanes in 1902 and tractors in 1920. They’re hilariously bad and horses are still better. But that’s how innovation works. We’re observing the creation of the base tools for entrepreneurs to create value. Value-adding automated financial products and services comes next.

What we’ve learned from working with Agoric

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

Since 2017 we (along with our colleague Joe Clark) have been working with Agoric, an innovative and exciting smart contract team, who are about to launch a token economy model we helped design.

At the RMIT Blockchain Innovation Hub we’ve long been thinking about how blockchain can drive markets deeper into firms, resolving the electronic markets hypothesis and giving us new opportunities for outsourcing corporate vertical integration.

What we’ve discovered from working with the Agoric team is the possibilities of driving markets down into machines. Mark Miller’s groundbreaking work with Eric Drexler explored how property rights and market exchange can be used within computational systems. Agoric starts economics where we start economics — with the institutional framework that secures property rights.

This has been one of the most intellectually stimulating collaborations of each of our careers, and has shaped much of how we think about the economics of frontier technologies.

We first met the Agoric team through Bill Tulloh at the Crypto Economics Security Conference at Blockchain @ Berkeley in 2017, just as we were forming the RMIT Blockchain Innovation Hub. CESC was the first serious attempt we were aware of to bring the blockchain industry and social science together — such as our disciplines of economics and political economy.

In the presentation to CESC, we applied some of Oliver Williamson’s thinking to understand the economic properties of tokens and cryptocurrencies.

Bill — who had thought along similar lines — came over to chat during a break. We met again at the 2018 Consensus Conference in New York. Bill introduced us to Mark Miller. What started out as a quick chat to say hello over breakfast turned into a long discussion about Friedrich Hayek, Don Lavoie, and market processes in computer science. Through Bill and Mark we then met Kate Sills and Dean Tribble.

It is true that economic thinking is everywhere in the blockchain and cryptocurrency community. There’s a lot of lay reasoning about Austrian economics, monetary policy, central banks, and inflation. These ideas have brought a lot of people into the cryptocurrency space. Some of the thinking that brought them here is good economics (we’re very passionate about how Austrian economics can inform the blockchain industry ourselves — see here and our colleague Darcy Allen here) but unfortunately a lot of it is not-so-good economics. Many developers have self-taught economics, many have intuited economics from first principles, and we have observed a combination of brilliant insight, economic fallacy, and knowledge gaps.

Developers, however, tend to be very good at game theory; if only because unlike our colleagues in academia, the blockchain community is testing the assumptions of game theory and applying it in the real world for business models with real value at stake. Reality can be bracing. Only invest what you can afford to completely lose. This is still a highly experimental industry.

But economics has much, much more to contribute to our understanding of the blockchain economy than just Hayekian monetary theory and textbook game theory. Our friends at Agoric know this — they already had an economist in their team. They know and understand that it isn’t enough to have good code — to succeed, you need to have economically coherent code.

To that end, we have developed a new field of economics: institutional cryptoeconomics. In this field, we apply the transaction cost economics of Ronald Coase and Oliver Williamson to explore blockchain as an economic institution competing with and complementing the schema of firms, markets, states, clubs and the commons.

The economic foundation of our institutional cryptoeconomics is broad and solid. In addition to economics Nobel laureates like Hayek, Ronald Coase, and Oliver Williamson, we have also incorporated the work of other laureates such as Herbert Simon, Douglass North, Elinor Ostrom, and Jean Tirole into our blockchain research. Then we’’ve drawn on should-have-been-laureates such as Joseph Schumpeter, William Baumol, Armen Alchian, and Harold Demsetz are included. Economists such as Andrei Shleifer and Israel Kirzner could still win a Nobel.

Merton Miller — himself an economics laureate — once argued that there was nothing more practical than good theory. Our experience working with Agoric has convinced us of the value of very good theory. We have had plenty of help — actual practitioners trying to solve immediate real-world problems are hard task masters. Ideas cannot remain half-baked — they must be fully explained and articulated. Working with Agoric has been an intellectually intense, extended interactive academic seminar where ideas are taken from vague hunch to ‘how can this be implemented’ and back again. From whiteboard to business model.

As academics we have learned which ideas, models and tools are of immediate use and value in the blockchain world. There have been some surprises here. Whoever would have thought that edgeworth boxes would have a practical real world application? Or indifference curves? But here we are. When building an entire economic ecosystem — the Agoric economy — we have had to draw upon the full breadth of our economic training. We suspect that having an economics team on board will become an industry standard in the years to come.

We have benefited as educators too. Of course, explaining complex ideas to highly intelligent laypeople is a large part of our day job. The stakes, however, are much higher. The Agoric team aren’t seeking information to pass a class test. They are seeking information to pass a market test — that the market will grade. As another favorite economist of ours Ludwig von Mises explained, consumers are hard task masters.

Our own students particularly have benefited from our Agoric experience. We now have a deeper understanding of industry needs and thought in the blockchain space. We know which ideas interest them and which don’t. The Agoric team questioned us closely on some topics. Our students will know how to answer those questions.

It also turns out that financial engineering is far more important than we thought it would be when we first started working on blockchain economics. The work with Agoric has coincided with the defi boom — a richly anarchic and innovative movement within the blockchain space. As a consequence, the blockchain for business degree programs that we have launched at RMIT have huge dollops of finance in them.

We share with Agoric a vision of the future where technology leads to an improvement in human flourishing and an enhancement of our capacity to lead full lives.

In a new book published by the American Institute for Economic Research we’ve argued that blockchain and other frontier technologies offer us the tools to actively take back liberties we may have lost.

With Agoric, it is incredibly exciting to be able to actually build the economy of the future that we’ve been studying.

The New Technologies of Freedom

With Darcy WE Allen and Sinclair Davidson. American Institute for Economic Research, 2020

We are on the cusp of a dramatic wave of technological change – from blockchain to automated smart contracts, artificial intelligence and machine learning to advances in cryptography and digitisation, from Internet of Things to advanced communications technologies.

These are the new technologies of freedom. These tools present a historical unprecedented opportunity to recapture individual freedoms in the digital age – to expand individual rights, to protect property, to defend our privacy and personal data, to exercise our freedom of speech, and to develop new voluntary communities.

This book presents a call to arms. The liberty movement has spent too much time begging the state for its liberties back. We can now use new technologies to build the free institutions that are needed for human flourishing without state permission.

Available at Amazon.com

Blockchain innovation and public policy

Introduction to Journal of Entrepeneurship and Public Policy special issue ‘Blockchain innovation and public policy’, with Jason Potts and Sinclair Davidson. Available at Emerald.

Blockchain, or distributed ledger technology, invented by Satoshi Nakamoto (2008), has quickly and somewhat surprisingly emerged as one of the most disruptive new technologies of the early twenty-first century; it is facilitating an entirely new decentralised architecture of economic organization (Narayanan et al., 2016; Davidson et al., 2018; Rauchs et al., 2018; Werbach, 2018; Berg et al., 2019). While still an experimental technology, shrouded in technological, economic, regulatory and legal uncertainty, blockchain is nevertheless moving from being a proof-of-concept innovation to early-stage pilots that will likely significantly disrupt sector after sector in the coming years. This process of what Joseph Schumpeter called “creative destruction” first started with money (with Bitcoin, the world’s first cryptocurrency) and then payments, and is now moving through banking and finance (decentralised finance, or defi), logistics, health, and generally across the digital economy. Like other digital and internet-based technologies, such as virtual reality and machine learning, we are still in the early phases of an economy-wide disruption that is being driven and shaped by new entrepreneurial startups (since 2017 funded through initial coin offerings, although increasingly now through venture capital financing) and also by industry dominant firms who are working to reimagine and rebuild their business models and services on a more decentralised organisational architecture and business infrastructure (Rauchs et al., 2019).

A key challenge for all entrepreneurs, whether in start-ups or in large incumbent firms, is policy uncertainty in relation to this radical new technology. Blockchain technology facilitates an entirely new architecture for money and payments, for establishing ownership and storing value, for making contracts and recording data and facts. This means that legal and regulatory frameworks, tax models and economic policy settings are not designed for this technology and will need to be adapted (De Filippi and Wright, 2018).

This special issue aligns scholarship and analysis towards a better understanding of the nature of entrepreneurship in relation to the development and innovation of this new technology, and the way in which that entrepreneurship interacts with current public policy settings. The papers in this special issue broadly seek to explore particular problem domains where public policy is either failing or succeeding in this context, and also to explore new frameworks for public policy that are conducive to entrepreneurship and innovation.

These papers cover a broad set of questions, ranging from consideration about the shifting role of government and economic policy in a world with widespread blockchain adoption, to seeking to provide a global map of the policy dimensions upon which governments are acting with respect to blockchain technology, to exploring how public policy interacts with entrepreneurial discovery of blockchain use cases and commercial applications. Papers also explore the implications for constitutional experimentations and monetary policy reform.

In the first paper in this special issue, Berg, Davidson and Potts explore the long run policy equilibrium associated with the consequences of wide-spread blockchain adoption, drawing on theories of institutional cryptoeconomics (Berg et al., 2019). They argue that the long run policy implication of the industrial revolution and the era of modern economic growth through the twentieth century was for competition policy and industry policy to counterbalance the power of large hierarchical organizations (or the rise of very large firms as a basic dynamic of industrial capitalism). Berg, Davidson and Potts argue that blockchain technology predicts both market disintermediation and organizational “dehierarchicalisation”, which they then infer unwinds the economic justification for a large range of economic policies implemented through the twentieth century that sought to control the effects of market power and organizational hierarchy. “Capitalism after Satoshi” predicts widespread blockchain technology adoption could reduce the need for counter-veiling economic policy, and therefore shrinking the role of government, and therefore a new public policy equilibrium with reduced demand for economic policy. This shows the long-run relationship between digital technological innovation and the regulatory state.

In “Cryptofriendliness”, Mikayla Novak explores the chief aspects of policy interest in blockchain technology, and maps these to an index-based policy measure that she calls “cryptofriendliness” (see Novak et al. 2018). Novak is particularly interested in using national case studies of blockchain policies to identify “policy entrepreneurship” that seeks to foster and promote the discovery and development of entrepreneurial opportunities in the emerging, but still nascent, blockchain economy. Novak argues that so-called “crypto-friendly” jurisdictions are more likely to attract entrepreneurs and investors in the crypto-economic blockchain space.

Brendan Markey-Towler builds on the idea of blockchain as an “institutional technology”, a concept first developed by Davidson et al. (2018), in order to propose an evolutionary model of institutional competition. Markey-Towler shows how blockchain development is a form of institutional evolution that then interacts with national systems of innovation (which are themselves institutional systems), furnishing a macro-level concept of how blockchain technology interacts not only with economic administrative and organizational infrastructure (e.g. money and payments, supply chains, and specific sectors), but also with higher-order knowledge and innovation institutions. He argues that institutional competition from blockchain technology predicts superior performance from national systems of innovation, which in turn predicts greater opportunity space for entrepreneurs.

In “Governing entrepreneurial discovery” Darcy Allen explores how entrepreneurs discover opportunities in blockchain applications, which is a specific instance of the general problem of entrepreneurial discovery in early stage technologies. Allen focuses on the institutional mechanisms that facilitate the pooling of the broad information set that entrepreneurs require, and how policy choices that affect the institutional environment in turn affect entrepreneurial transaction costs. Elaborating on Novak’s argument that specific policy choices shape the viability of blockchain entrepreneurial development (what she calls crypto-friendly policy), Allen further argues that an important way that crypto-friendly policy is operationalized is through channels that lower the cost of opportunity discovery for entrepreneurs.

In “The market for rules” Nick Cowen builds on the constitutional tradition in economics (as pioneered by James Buchanan as a hybrid of New Institutional Economics and political theory) to observe that the entrepreneurial opportunity space of blockchain is fundamentally in the provision of rules for governance that are in effect hard-coded into blockchain platform infrastructure. Cowen therefore argues that blockchain technology facilitates competition between the entrepreneurial supply of governance rules – encoded in “private order” platform or protocol mechanisms – with the government or legislator supply of “public order” policy rules. Whereas Davidson, Berg and Potts argue in “Capitalism after Satoshi” that blockchain technology will reduce demand for public policy, via the mechanism of disintermediation and dehierarchicalisation, Cowen makes a different argument but with the same broad direction of prediction, namely, that competition from private-order rules (what Cowen calls “the market for rules”) will reduce demand for public-order rules.

In “Cryptoliquidity”, James Caton examines the connection between blockchain technology adoption and broad monetary stability. Caton observes that macroeconomic fluctuations tend to be in significant part a monetary phenomena, and therefore monetary policy stabilisation works through exogenous changes in money supply. He then shows that cryptocurrencies can create endogenous liquidity creation mechanisms through rules-based asset liquidation (assuming real-asset backed cryptocurrencies) as triggered by changes in macroeconomic variables. Entrepreneurial development of novel cryptocurrency instruments such as stablecoins can therefore also be potentially developed at the level of monetary aggregates in order to automate the supply of liquidity. This predicts that blockchain technologies can further facilitate the evolution of market economy institutions.

The six separate and distinct papers in this special issue each deal with different aspects that connect the economic study of entrepreneurship to both the immediate practical implications (e.g. Novak, 2019; Allen, 2019) and broadly philosophical implications (e.g. Berg et al., 2019; Cowen, 2019) of blockchain adoption for public policy. Yet taken together these papers all broadly point in the same direction, in terms of the predicted effect: blockchain technology, which is an institutional technology, offers institutional competition with public policy rules, and this entrepreneurial competition is expected to improve the overall quality of economic rules and governance. Taken together, these six papers predict that blockchain technology will, on the whole, induce a better institutional environment for entrepreneurial action.

References

Allen, D. (2020), “Governing the entrepreneurial discovery of blockchain applications’”, Journal of Entrepreneurship and Public Policy, Vol. 9 No. 2, pp. 194-212.

Berg, C., Davidson, S. and Potts, J. (2020), “Capitalism after Satoshi”, Journal of Entrepreneurship and Public Policy, Vol. 9 No. 2, pp. 152-164.

Berg, C., Davidson, S. and Potts, J. (2019), The Blockchain Economy: Introduction to Institutional Cryptoeconomics, Edward Elgar, Cheltenham.

Cowen, N. (2020), “The market for rules: the promise and peril of blockchain distributed governance”, Journal of Entrepreneurship and Public Policy, Vol. 9 No. 2, pp. 213-226.

Davidson, S., de Filippi, P. and Potts, J. (2018), “Blockchains and the economics institutions of capitalism”, Journal of Institutional Economics.

De Filippi, P. and Wright, A. (2018), Blockchain and the Law: The Rule of Code, Harvard University Press, Cambridge, MA.

Nakamoto, S. (2008), “Bitcoin: a peer-to-peer electronic cash system”, available at: https://bitcoin.org/bitcoin.pdf

Narayanan, A., Bonneau, J., Felten, E., Miller, A. and Goldfeder, S. (2016), Bitcoin and Cryptocurrency Technologies, Princeton University Press, Princeton, NJ.

Novak, M. (2020), “Cryptofriendliness: understanding blockchain public policy”, Journal of Entrepreneurship and Public Policy, Vol. 9 No. 2, pp. 227-252.

Novak, M., Davidson, S. and Potts, J. (2018), “The cost of trust: a pilot study”, Journal of British Blockchain Association, doi: 10.31585/jbba-1-2-(5)2018.

Rauchs, M., Glidden, A., Gordon, B., Pieters, G., Recanatini, M., Rostand, F., Vagneur, K. and Zhang, B. (2018), Distributed Ledger Technology Systems, Cambridge institute for Alternative Finance, University of Cambridge.

Rauchs, M., Blandin, A., Bear, K. and McKeon, S. (2019), “2nd Global Enterprise blockchain benchmarking study”, Cambridge institute for Alternative Finance, University of Cambridge.

Werbach, K. (2018), The Blockchain and the New Architecture of Trust, MIT Press, Cambridge, MA.

Further reading

Catalini, C. and Gans, J. (2017), “Some simple economics of the blockchain”, MIT Sloan Research Paper No. 5191-16, available at: https://ssrn.com/abstract=2874598

Caton, J. (2019), “Cryptoliquidity: how innovation and blockchain and public policy can promote monetary stability”, Journal of Entrepreneurship and Public Policy.

Markey-Towler, B. (2020), “Blockchains and institutional competition in innovation systems”, Journal of Entrepreneurship and Public Policy, Vol. 9 No. 2, pp. 185-193.

Trustless architecture and the V-form organisation

With Sinclair Davidson and Jason Potts

Abstract: Blockchain (distributed ledger technology) is an institutional technology that allows trust to be manufactured instead of being earned. Trust is an important component of business and trade and has previously been subsumed into information costs. It is only now that the importance of trust is being fully appreciated. Arun Sundarajaran has suggested that the creation of new forms of trust has driven the expansion economic activity throughout history. In this chapter we argue that the industrialisation of trust is going, again, to drive a massive expansion in economic activity through the emergence of new organisation forms that will deliver high-powered market incentives deep into what would appear to be hierarchical organisations. We are labelling these (as yet speculative) organisations forms the ‘V-form’ organisation. In this chapter we discuss the importance of trust, the evolution of trust, and the industrialisation of trust. We argue that current organisational forms have exhausted the levels of trust that have previously sustained them. Blockchain technology offers a new industrialised form of trust that can drive further economic activity.

Available in PDF or at SSRN.

The digital consequences of the pandemic

With Darcy WE Allen, Sinclair Davidson, Aaron M Lane, and Jason Potts. Originally a Medium post.

The global policy response to the COVID-19 pandemic has been extraordinary. We’ve seen a massive increase in government spending and social welfare programs, heavy handed policing, and some less remarked on crisis deregulation.

But the long run effect of the pandemic will be even more substantial. COVID-19 is driving far deeper, and profound, changes in the economy.

Some of these changes we can start to see already, but their full implications are still murky and distant. Nonetheless, as we argue in our book Unfreeze: How to Create a High Growth Economy After the Pandemic, the economy will not simply snap back into place. The post-COVID-19 economy will not look like the pre-COVID-19 economy.

Here we offer seven changes that have big consequences for policymakers, entrepreneurs, and employees.

1 — Digital acceleration

COVID-19 has massively accelerated the adoption of digital technology to facilitate work from home. But also shop from home, school from home, telehealth, and so on.

This digital shift is often remarked on but not well understood. Technology adoption normally follows a particular diffusion trajectory. Digital technologies that have significant scale effects must overcome behavioural and institutional resistance, and they can get stuck at take-off. This means that the productivity benefits from widespread technology adoption, especially infrastructural and production technology, can be very slow to realise.

COVID-19 arrived at a critical time in the history of technology — when a supercluster of digital technologies were forming, poised to disrupt the underlying infrastructure of the economy. This suite of digital platforms and technologies had been developing for the past several decades. But they had run into innovation constraints caused by coordination adoption problems and regulatory barriers.

In March 2020, many of these constraints suddenly vanished. The spread of online education and telemedicine, which had been until then a multi-decade process, occurred in a matter of weeks.

This was a massive, global, multisector, virtually-instantaneous coordinated adoption of digital technology. That’s utterly incredible — and perhaps unique in the history of technology adoption.

A major problem with platform technologies is to drive coordinated adoption. The pandemic did in a few weeks what decades of government effort had failed to do. Long-run that is very good. But short-run it is highly disruptive.

2 — A need for massive entrepreneurial adjustment

In Unfreeze we argue that there is an urgent need for entrepreneurs to adapt to the post-COVID-19 world. Economies are made of connections, information, contracts, webs of value, relationships. When we try to restart the economy, much of this connective tissue will be gone.

The rapid technological acceleration driven by the crisis creates its own unique needs for adaptation. We’re already seeing the formation of new consumer preferences, new types of jobs, new types of business models with new cost and demand structures, new patterns of supply, and new regulatory and legal uncertainties.

But this implies that a significant amount of human capital and physical capital (built for industrial era technologies and business models) has rapidly devalued.

The first priority for entrepreneurs in the post-COVID-19 economy will be understanding how particular markets and jobs and administrative functions have changed. For example, many restaurants have moved to take-away only. Will consumers expect those new services to continue? Much of the white-collar economy has moved to work from home. Will employees demand that continues?

Entrepreneurial skills are essential during periods of rapid change. Entrepreneurship is not something that can be supplied by governments. But it can be inhibited. Policymakers have to make sure they are facilitating — not impeding — entrepreneurial adaptation to the accelerated digital adoption triggered by COVID-19.

3 — Decentralised production and innovation

One consequence of this sudden digital uptake is increased decentralisation. With the rapid adoption of work from home — not just the technologies but the social practices — we’ve seen a shift in the locus of much economic activity from offices into homes.

This shift has several implications. One, it facilitates greater co-production of value. More household resources, including especially local information, are being mixed into production.

Two, this also shifts the sites of innovation, facilitating greater household innovation and user innovation. More innovation occurs in the commons rather than in markets and organisations. This in turn increases the need for trusted decentralised networks and, in turn, increases the demand for and use of distributed innovation technology and institutions.

Three, distributed production will require more distributed dispute resolution mechanisms. Traditional courts have been slow to adapt to the digital environment and parties will be looking to more agile forms of alternative dispute resolution.

Four, because more production and innovation is occurring in households and in the commons, this means that it is harder to measure value creation and improvements in these non-market contexts. The non-market part of the economy will increase in apparent scale. So our industrial era measurements of economic activity (like GDP) will need to catch up with these new digital era realities of value creation.

This new institutional economic order will require a new economics to make sense of these new patterns of consumption and production, and new digital forms of capital and value creation.

4 — Powered-up economic evolution

The pandemic is a selection filter. As the precursor and mechanism of many of these changes, the economic consequence of the economic policy response to the viral pandemic is a powerful evolutionary selection mechanism passing over the global economy and through each sector.

This brutal selection mechanism is causing job losses, contract terminations or renegotiations, demand reductions, business closures and bankruptcy, fire sales, credit shrinkage, asset repricing, factor substitution, and other distinct forms of economic destruction that will play out over the coming months and years.

This hard evolutionary selection mechanism is also a filter. It will kill off some things disproportionately and let other things pass through. Most obviously, digitally enabled businesses and sectors will do better, because they are more well-adapted to the new environment. Bigger firms with better capitalisation (or better political connections) will do better, and smaller firms will be selected against.

In labour markets some positions are more vulnerable than others, particularly part-time workers or contractors. While many workers and firms are on temporary support through public sector subsidy of wages or quasi-partial nationalisations, a proportion of those positions or organisations being kept alive will die as soon as support is removed. There are many zombies already.

Similarly, there will be a lot of bad debt on company books (and thereby in banks) that will be realised in market revaluations over coming periods. These collapses will release resources for subsequent entrepreneurial reconstitution and reinvention.

But we should also expect consolidation of existing markets and resources among surviving players. This may actually result in higher growth and profits among large adaptive companies — particularly technology driven companies. So a period of global economic destruction is not inconsistent with a booming share market.

5 — The twilight of conventional macroeconomic policy

At the same time, COVID-19 looks to fundamentally break the standard monetary and fiscal policy levers that have been used to manage business cycles over the twentieth century.

From a public finance perspective, the magnitude of the committed policy actions is already unprecedented. The levels of public debt that are planned in order to deal with this crisis — the policies to subsidise wages, provide rent and income relief, bail out companies, etc in order to avoid market catastrophe — are the largest that has ever been experienced. Moreover, these actions are being taken during a massive collapse in tax receipts. The implications for public finance are catastrophic, with a huge increase in public debt, a vastly worse central bank balance sheet, and looming inflation.

The result is a policy challenge that far exceeds capabilities of traditional monetary and fiscal levers. We will require institutional policy reforms to deal with the crisis. But institutional policy designed to free-up the supply side of the economy, to lower the costs and constraints on businesses, is politically much harder to achieve.

Indeed, the limits of these policy levers reveals the extent to which government administration (e.g. of money, of asset and property registries, of identity, of regulation and governance) is still the foundation of a modern economy. The pandemic has brought into sharp relief the limits and constraints of this centralised public infrastructure and the technocratic foundations of the macroeconomic policy mechanisms built upon them.

The real alternative to conventional policy levers isn’t different policies (like quantitative easing, negative interest rates, or universal basic income) but better institutional technologies. We’ve been looking in the past few years at distributed digital technology (that is, blockchain) that offers a new administrative and governance base layer of the economy (see herehereherehere and here to start).

A digital infrastructure base layer of industry utilities and digital platforms would provide a far more agile foundation for targeted economic policy and entrepreneurial adaptation.

6 — A new global trading order

One of the most powerful institutional forces over the past several centuries, and which has underpinned global economic prosperity in the industrial era, was the development of global trading infrastructure for commodities and capital. It was built around the Westphalian system of nation-state record-keeping and intra-nation state treaty-based institutional governance (i.e. trade zones). But it has come to a virtual halt in the crisis.

In the short and medium term the global trading order will rebuild around a different order, namely provable health identity and data to facilitate the safe movement and interaction of people. Where that can safely happen, so can economic activity. Health zones can become the basis for trade zones. Australia and New Zealand are already talking about a “health bubble”. It would be easy to include other highly successful health economies — Taiwan, Japan, Germany, potentially Hong Kong and Singapore, some Pacific Island nations.

Green zones (or cordon sanitaire) have long been used in pandemics and have once again been proposed as a way to exit lockdown. As the health zone grows, so can the trade zone. Economic zones can then free ride on the decentralised identity and data infrastructure created to build a health zone. The result will be the redrawing of physical and network boundaries, even eliminating artificial economic borders, to create integrated trade zones.

7 — A new political order

The costs of COVID-19 do not fall evenly across the population. The health risks fall heavily on some groups (the elderly and those with co-morbidities), and the costs of economic lockdown fall on different groups and will be felt differently. The differential impact by sector, jobs, education, human capital investments or physical or financial capital write-downs shape how the costs are distributed across society.

The virus imposes huge private costs that will be in part socialised through political bargaining. The outcome of these politically mediated bargains and transfers that will shape politics for years to come.

But the pandemic also shifts some of the anchor points of political economy. The sudden growth of the welfare state, of unemployment insurance and wage-support, of healthcare provision and childcare, even of social housing are unlikely to be easily rolled back. So there will be a higher demand for social welfare safety nets.

But to pay for this, along with the urgent need to address the huge deterioration of public balance sheets, economic policy will need an aggressive pro-market agenda to unleash economic growth. Politically, this is a pivot to the centre with very ‘dry’ economic policy and ‘wet’ social policy — what was called ‘third way’ in the 1990s.

The counterpoint to that centre-pivot is that many of the high-cost political projects of both the right and the left will be abandoned. Reduced economic growth means we can afford fewer of the luxuries of advanced capitalism.

This is a vision of a new kind of social-digital capitalism to be built after the reset — from the government-led physical infrastructure of the industrial era, to a digital era built on private, open and communally developed technology platforms.

Finally

The economic consequences of the COVID-19 pandemic are mostly currently being discussed as a macro policy response to dealing with the economic destruction that the public health strategy necessitates. This is talk of the V-shaped, U-shaped, L-shaped or W-shaped recoveries. In Unfreeze we wrote of the need for a square root shaped recovery — after the reopening, we’ll need a long period of high economic growth to return to the prosperity of 2019.

But here we’ve gone further. COVID-19 is driving structural evolutionary change in the economy. The accelerated adoption of digital economic infrastructure during the crisis will leave a lasting mark on the political and economic system of the future.

Unfreeze: How to create a high growth economy after the pandemic

With Darcy WE Allen, Sinclair Davidson, Aaron M Lane and Jason Potts. American Institute for Economic Research, 2020

During March and early April 2020, much of the world economy was deliberately shut-down and frozen to combat the COVID-19 pandemic. Modern economies are complex systems that are not easily frozen and unfrozen. Governments now face the challenge of unfreezing their economies. The social and economic cost of the pandemic will be enormous and long-lasting. This book develops an analytic and policy framework—cryoeconomics—for understanding what needs to happen next and how to restore our standard of living. We spell out the policy settings necessary for the rapid adaptation and market re-coordination that is required to resuscitate the economy. We explain why a return to business as usual is simply not enough to get everyone working again. A period of high growth prosperity will be imperative to deal with the costs of the freeze. This book tackles the tough questions and fills some of the current void of ideas and thinking about economic recovery. We develop a framework and principles for an institutional re-build, presenting a path to recovery based on the ideas of private governance, permissionless innovation, and entrepreneurial dynamism.

Available at Amazon in print and Kindle and Amazon Australia in Kindle edition.

On Coase and COVID-19

With Darcy WE Allen, Sinclair Davidson and Jason Potts

Abstract: From the epidemiological perspective, the COVID-19 pandemic is a public health crisis. From the economic perspective, it is an externality and a social cost. Strikingly, almost all economic policy to address the infection externality has been formulated within a Pigovian analysis of implicit taxes and subsidies directed by a social planner drawing on social cost-benefit analysis. In this paper, we draw on Coase (1960) to examine an alternative economic methodology of the externality, seeking to understand how an exchange-focused analysis might give us a better understanding of how to minimise social cost. Our Coasean framework allows us to then further develop a comparative institutional analysis as well as a public choice theory analysis of the pandemic response.

Available at SSRN or in PDF here.

Cryoeconomics: how to unfreeze the economy

With Darcy Allen, Sinclair Davidson, Aaron Lane and Jason Potts. Originally a Medium post.

The Australian government, like many governments around the world, wants to freeze the economy while it tackles the coronavirus pandemic. This is what the Commonwealth’s JobKeeper payments and bailout packages are supposed to do: hold workers in place and keep employment relationships together until mandatory social distancing ends.

Easier said than done. We are in completely uncharted territory. We’ve never tried to freeze an economy before, let alone tried to thaw it out a few weeks or months later. That’s why our new project, cryoeconomics, looks at the economics of unfreezing an economy.

To understand why this will be so hard, think of an economy as a remarkably complex pattern of relationships. Those relationships are not only between employees and employers, but also between borrowers and lenders, between shareholders and companies, between landlords and tenants, between producers tied together on supply chains, and between brands and tastemakers and their fans.

The patterns that make up our economy weren’t designed from above. They evolved from the distributed decisions of consumers and producers, and are shaped by the complex interaction between the supply of goods and services and their demand.

The problem is that the patterns the government plans to freeze are not the patterns we will need when they finally let us thaw.

When the government decides to pull the economy out of hibernation, the world will look very different. As a simple example, it’s quite possible that many Australians, forced to stay home rather than eat out, discover they love to cook. This will influence the demand for restaurants at the end of the crisis. On the other hand, our pent-up desire for active social lives might get us out into the hospitality sector with some enthusiasm. There will be drastic changes because of global supply chain disruptions and government policies. These changes will be exacerbated by the fact that not all countries will be unfrozen at the same time.

The upshot is that the economy which the government is trying to hibernate is an economy designed for the needs and preferences of a society that has not suffered through a destructive pandemic.

Unfreezing the economy is going to be extremely disruptive. New patterns will have to be discovered. As soon as the JobKeeper payments end, many of the jobs that they have frozen in place will disappear. And despite the government’s efforts, many economic relationships will have been destroyed.

Yet there will also be new economic opportunities — new demands from consumers, and new expectations. Digital services and home delivery will no doubt be more popular than they were before.

These disruptions will be unpredictable — particularly if, as we expect, the return to work is gradual and staggered (perhaps according to health and age considerations or access to testing).

As we unfreeze, the problem facing the economy won’t primarily be how to stimulate an amorphous ‘demand’ (as many economists argue government should respond to a normal economic recession) but how to rapidly discover new economic patterns.

It is here that over-regulation is a major problem. So much of the laws and regulations imposed by the government assume the existence of particular economic patterns — particular ways of doing things. Those regulations can inhibit our ability to adjust to new circumstances.

In the global response to the crisis there has already been a lot of covert deregulations. The most obvious are around medical devices and testing. A number of regulatory agencies have stood down some rules temporarily to allow companies to respond to the crisis more flexibly. The Australian Prudential Regulatory Authority is now willing to let banks hold less capital. The Australian Securities and Investment Commission has dropped some of its most intrusive corporate surveillance programs.

The deregulatory responses we’ve seen so far relate to how we can freeze the economy. A flexible regulatory environment is even more critical as we unfreeze. Anything that prevents businesses from adapting and rehiring staff according to the needs of the new economic pattern will keep us poorer, longer.

Today the government is focused on fighting the public health crisis. But having now turned a health crisis into an economic crisis, it must quickly put in place an adaptive regulatory environment to enable people and businesses to discover what a post-freeze economy looks like.

Age of currency disruption is here

With Sinclair Davidson and Jason Potts

It is unusual for the World Economic Forum’s Davos conference, held every year at the end of January, to be genuinely significant. But it seems this one was. Davos 2020 made clear that we are now living through a monetary reform era comparable to the great monetary events of the twentieth century.

The end of the gold standard, the creation of the Bretton Woods system in 1944, and that system’s collapse in the 1970s all brought about massive, structural economic changes. Our new age – the age of digital money competition – is likely to be just as disruptive.

At Davos the World Economic Forum announced a global consortium for the cross-border governance of digital currencies (including the class of cryptocurrencies stabilised against fiat money known as ‘stablecoins’) and a toolkit for the world’s central banks to establish their own digital central bank currencies.

The details of these Davos initiatives are less important than what they symbolise. Central banks have been experimenting with fully digital currencies for at least half a decade, ever since Bitcoin received its first big waves of press. But their experiments are suddenly urgent, for both commercial and geopolitical reasons.

On the one side, the Facebook-led Libra digital currency project offers a vision of corporate-sponsored non-state private money. On the other side, China is fast-tracking the development of a fully digital yuan, with a barely disguised goal to challenge the American dollar’s domination through technological innovation. Both projects create enormous problems for the rest of the world’s central banks – let alone finance regulators and foreign policy strategists.

Libra has been faced with a concerted hostile attack from central banks and regulators – an attack that begun literally the day it was announced in June last year. Many of the Libra consortium have been pressured into withdrawing from the project.

Mastercard, Stripe and Visa withdrew after they received a letter from US Senators in October declaring that if they stayed in Libra they could “expect a high level of scrutiny from regulators not only on Libra-related payment activities, but on all payment activities”. The Bank of France chief declared last week that “Currency cannot be private, money is a public good of sovereignty”, and the French finance minister has warned that Libra is not welcome in Europe.

This mafia-like behaviour from American and European regulators is short-sighted – astonishingly so. Whether Libra ends up being a successful global corporate currency or not, it represents a powerful and competitive counterbalance to the Chinese digital yuan.

Details have been dribbling out about the digital yuan since it was revealed in August last year. Its key feature is that it is fully centralised. The People’s Bank of China will have complete visibility over over financial flows, including the ability to control transactions tied to an individual consumer’s identity. This offers China the digital infrastructure for a type of financial repression that is without historical parallel.

And adoption is basically assured. The Chinese government can coerce financial institutions to adopt the digital yuan, if necessary, and can exploit the remarkably strong hold that digital payments like WeChat Pay and AliPay have on Chinese commerce.

Let us hope there are some serious strategists thinking about what happens if this digital currency becomes part of China’s foreign policy toolkit – what the consequences of yuan-isation will be for those countries torn between the Chinese and American spheres of influence.

This is the context in which the many of the world’s central bankers came to Davos to spruik their own digital currencies. More than 50 central banks surveyed by the Bank of International Settlements are working on some form of digital currency, and half a dozen have moved to the pilot project stage. Our Reserve Bank told a Senate committee in January that it too has been secretly working on an all-digital Australian dollar.

And of course in the background to this monetary competition between the corporate sector and the government sector is the slowly growing adoption of fully decentralised cryptocurrencies – the decade-old technology that first sparked these waves of monetary innovation.

The global monetary system of 2020s will be a regulatory and financial contest between these three forms of all-digital money: central bank digital currencies, corporate digital currencies, and cryptocurrencies. The contest has profound significance for the ability for governments to control capital flows across international borders, for financial privacy, for tax collection, and obviously monetary policy.

China has the authoritarian power to force adoption of its central bank digital currency. Countries like Australia do not. So it is not obvious which form of money will eventually dominate.

National governments have had nearly absolute control over national currencies for at least a hundred years, in some cases much longer.

The end of the Bretton Woods system in the 1970s incited a generation of economic reform, as domestic policymakers discovered that Bretton Woods had been propping up all sorts of regulatory controls, trade barriers and even labour restrictions.

We’re about to discover what centuries of state monopoly over money has propped up.