Central-Banks—A Bad Influence On Decentralized Finance
April 27, 2020, 8:21 a.m.
Modern money is debt and debt is money—Philip Coggan.
Few would disagree with this claim. Yes, the vast majority of money circulating today—so-called broad money—represents a specific type of credit-debt relationship.
But the modern economic reality we have internalized, is a breeding-ground of confusion for innovators in the DeFi and wider crypto communities because it combines the roles of government and money implicitly.
This duality, left unexamined, can be misleading for anyone trying to understand the design of independent monetary systems. And it is a mistake to view the modern central-banking framework as a starting point for how to think about monetary blockchain protocols.
The case I make here is simply that it is far more sensible to expand the function of commodity-monies in the spirit of Bitcoin than to "decentralize" central-banks in the spirit of MakerDAO.
1. Factoring Out Government Mandates
Someone mentioned the philosopher's stone. To the surprise of all present, John Law said he had discovered it. "I can tell you my secret" said the financier. "It is to make gold out of paper."
The debt instruments we see circulating as functional money today, are the most effective monies ever created. But the true secret of Law's paper, is that it's produced by banking systems with sovereign authority, and therefore inherits sovereign responsibilities. For example, the US Federal Reserve has the following stated mandates:
- Maximize employment
- Maintain stable prices
- Uphold moderate long-term interest rates
This means people who are upset with: losing their jobs, rapid price increases, and expensive debt can assign some measure of blame to the agents behind modern-money.
Ultimately the central-banking system we know and love is a flexible, discretionary, instrument, through which policymakers can support a body of people, governed by a body of laws.
Think of the central-banking system as a "god-mode" interface built for smart, well-meaning, decision-makers. And think of the Fed mandates as "reminder notes" pinned on the terminal.
We should be grateful this system exists, moreover that it's flexible and powerful enough for administrators to triage the economy though serious shocks—like the one we're currently experiencing.
But my point is, none of the mechanisms made for this almighty administrator, nor its mandates, should be carried over to the design of independent monies without consideration.
An independent money, has no people for whom to maximize employment. Therefore it cannot fear getting carried away with low interest rates, nor can it fear price-inflation incurred in the process of keeping employment rates up.
Perhaps such an independent system should not require a "god-mode" interface at all.
But before we get ahead of ourselves, let's first consider what the mandate of independent money actually is.
2. The Mandate of Independent Money
In 1944 Friedrich Hayek received a letter from a guest of the Claridge Hotel in Atlantic City, New Jersey. It congratulated the Austrian-born economist on his "grand" book, "The Road to Serfdom", which argued that economic planning posed an insidious threat to freedom. "Morally and philosophically, I find myself", the letter said, "in a deeply moved agreement."
Hayek's correspondent was John Maynard Keynes, on his way to the Bretton Woods conference in New Hampshire, where he would help plan the post-war economic order.
After the end of Bretton Woods, in a paper titled The Denationalization of Money, Friedrich Hayek went on to suggest that governments should allow the private issuance of money—such that individuals can choose to use whichever money they want.
Choice would lead to competition, he argued, placing a healthy pressure on central planners. It would force them to be judicious about their issuance of money, thereby preventing things like hyperinflation and prolonged mal-investment from ever occurring.
Yesterday—A check against inflation
Having witnessed extreme inflation after World War I in Europe (and notably Germany) where its desolation ushered in the rise of Hitler—Hayek remained vigilant against inflation throughout his career and was keen to highlight it.
But that was a different era.
And for all the money the US Central Banking system has injected in the past two decades, we haven't seen much price-inflation. The excess money, instead, has turned into increased leveraged speculation.
In other words, upon receiving a great sum of money, rather than consuming more—we've tended to invest more.
Today—A check against larger boom & bust cycles
As the rate of growth in emerging market economies outpaces the growth of the US, foreign economy demand for safe dollar-denominated assets outstrips the growth in supply.
This asymmetry between supply and demand, allows the US to rely on easy credit in normal times—and extremely expansionary macroeconomic policies in times of crisis.
Which seems great—being a reserve currency is truly an exorbitant privilege—but it is also an exorbitant burden. The problem is, neither countries in surplus nor those in deficit are incentivized to adjust their behaviors.
We can't stop supplying the global economy with dollars even if it hurts us, and the global economy can't stop demanding them.
This conflict of interests is known as Robert Triffin's Dilemma. And it is believed that from this dilemma we've seen excessive US indebtedness and risks magnified to disastrous proportions.
The historically increasing demand for dollar-denominated safe assets has encouraged the US to issue more and more short-run assets, leading to leveraged risk-taking, and magnified boom-bust cycles.
Now alarmingly, the global economy is so interconnected that these business cycles govern all traditional assets, affecting returns on labor and capital alike.
In other words, we have no choice but to be repeatedly dislocated by a cycle that even the authorities "in control" cannot escape.
3. The MakerDAO Way
I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter …. But now I want to come back as the bond market. You can intimidate everybody—James Carville
Broadly the MakerDAO protocol seeks to decentralize a debt-based system of money, and promises a stable currency—in the spirit of central banking.
Except in this system, policy decisions around fee-rates and collateral composition are made—not at the discretion of a sovereign authority—but at the discretion of a community.
If this sounds great to you, rest assured you're not alone.
But it should be made clear that this approach preys recklessly upon misunderstandings about what makes central banking work and why.
Depends on an ancillary market of rational actors to regulate supply
Debt has inherent risk because it requires a speculator to accurately anticipate whether a person can pay it back (with justifiable interest)—or it requires a speculator to accurately forecast the future value of a collateral asset.
Rather than increasing or decreasing the supply of its monetary token (DAI) in response to demand, the MakerDAO system utilizes a separate marketplace—with its own dynamics—to incentivize users to borrow more or less DAI against the collateral they deposit.
Has no authority to deliver on the promise of stability
Systems of this nature are flawed when disconnected from sovereign authority in general because such free-market systems operate by choice and incentive.
Participants cannot be forced to take on credit or debt for the good of a network. Nor can they be forced to stop taking on credit or debt for the good of a network. They can only be given incentives (like lower or higher interest rates) to directionally guide actions.
A problem arises, eventually, when market incentives become insufficient. We've seen this happen repeatedly in repo and bond markets; and these are some of the safest instruments out there.
However sweet a deal the Venezuelan bond market is offering, you may simply not want to receive any future payments in Venezuelan currency; and you cannot be forced to buy the bonds for the good of the country.
Similarly, in the case of MakerDAO, however badly the system needs more DAI to function, you may simply not want to borrow against ETH to supply it; and you cannot be forced to do so for the good of the network.
All open debt-marketplaces eventually face liquidity crunches, requiring bailouts, even ones run by sovereign authorities.
So unless the administrators of a debt-based money system can print bailout money, and ensure the new money has predictable value through legal, political, and economic leverage, the system is at the mercy of external lenders.
Think of independent systems like this as "god-mode" interfaces, missing a god.
Fulfills no mandate
Recall that Hayek's recommendation was for authorities to allow the independent issuance of money. Failing this, an independent system would need to be uncensorable to achieve the desired affect.
Systems prone to requiring bailouts, like MakerDAO, are either unreliable or continue to exist only at the discretion of central planners.
They work, until it matters.
Keeping in mind that we already have an effective centralized system with the necessary authority to bail others out in times of need, it is unclear what purpose there is for things like MakerDAO.
They cannot provide customers with meaningfully new choices, let alone keep things like inflation or mal-investment cycles in check.
What about providing access to banking services for the unbanked, you ask?
Offering access is much like providing choice. An unbanked user simply goes from having zero banking services to the choice of one or more banking services. In turn, this would place pressure on local governments to offer regulated alternatives of greater value or prepare to cede the infrastructure to external parties.
Similarly, if providing access requires explicit approval, then it is dependent (not independent) and doesn't require decentralized infrastructure at all.
4. The Bitcoin Way
Neither a Borrower Nor a Lender Be—Polonius
Broadly the Bitcoin protocol expands the function of commodity-monies like gold and silver, by making its system of money digitally transactable. Unlike a bank, however, Bitcoin has no balance sheet and possesses no notion of credit or debt.
In other words, the protocol maintains only what users own—not what is owed to them, or what they owe to others.
It promises only scarcity and censorship resistance, not stability. And although severe shocks to Bitcoin's demand can decrease the value of its coins, the losses do not break the system. Similarly, rapid appreciation in value does not break the system. As a result, Bitcoin cannot be bailed out, cannot bail others out, and requires virtually no supervision.
Like other commodity-monies, Bitcoin does not have a "god-mode" interface. It simply exists, and is difficult to censor or modify.
Fulfills mandates of independent money
Bitcoin functions as a check against inflation and mal-investment. Moreover its lack of consumptive utility distances it from traditional business cycles.
By comparison, commodities like oil can be used to speculate or store value, but are easily distorted by forces like the demand for travel—which is directly affected by the business cycles independent money seeks to escape.
Not a safe haven, not a problem
At present, Bitcoin is a risky asset relative to the dollar. Thus it would be unwise to retreat into it during times of panic unless other available assets are on even riskier ground.
But this neither invalidates Bitcoin's function as a check against inflation nor invalidates Bitcoin's function as a check against mal-investment cycles.
To understand this, we can simply imagine an economic recovery that is languishing on. Let's say that interest rates are low and consumption is low.
ie: upon receiving a great sum of money, rather than consuming more, we are saving more.
Holding dollars would guarantee losses to inflation, but weak consumption is also limiting the rate of return on stocks and commodities.
In this scenario, among others, Bitcoin provides optionality because its growth rate is easy to disconnect from things like output and consumption. It adds diversity to the ecosystem as a risk asset.
5. The Path Forward
In the longer run and for wide-reaching issues, more creative solutions tend to come from imaginative interdisciplinary collaboration—Robert J. Shiller
Throughout this post I've tried to show that we are truly not starting from scratch. Existing systems, like central-banking, operate effectively in some manners and ineffectively in others for a variety of reasons.
When borrowing from existing solutions, we ought to first understand the problems they were meant to solve so that we can avoid the immense cost of inheriting assumptions that simply do not apply.
It is straightforward to say that it's neither plausible nor beneficial to recreate the debt-money of sovereign issuers in a decentralized context at this time. However it does make good sense to expand the function of commodity-monies like gold, in the spirit of Bitcoin.
Given that Bitcoin already exists, how might we continue expanding the function of such monies?
We would begin by limiting our toolkit to that of scarcity and censorship resistance. We would then investigate how to increase the diversity of monies (not merely the number of monies). And we would seek to overcome the known limitations of fixed supply.
If you're curious to learn more about solutions of this nature, please visit ampleforth.org
Thanks for tuning in,
follow me on twitter: @evankuo