The Crypto Monetary Solution
A comparison of inflation and velocity of money to today’s system
Some thoughts on system design of monetary policy and incentives. In complex systems, as an economy, I believe it is important to keep principles simple.
So again, this is an oversimplification of a complex system where I try to get the general point across. The Fed is tasked with balancing maximum employment and stable prices by controlling the cost of capital. The underlying assumption for that to work is that the economy is debt-driven, and through the cost of debt one should be able to balance supply and demand. In terms of system design, this leaves a lot to be desired and yet has led to a great era of prosperity (on the whole, of course many disparities created) over the last 40 years roughly. Go humans! Even with an, I think, mediocre system we have done great. But, as Chris Cole would say, you cannot destroy risk but only transform it. With the cost of capital at zero, it seems we have run our course using debt demand to balance the economy. Recent monetary experiments have mostly created financial asset demand, which has created other issues (bubbles and inequality) that make it seem like the reward for balancing employment and prices is greater instability elsewhere. What of inflation? Well that is much more recent, as fiscal spending experiments are now paired with monetary experiments. In all, the system that for many years held stability in the desired economic variables appears to now create instability.
I would like to challenge one of the key assumptions used in implementing the current system: low but positive inflation is good. Why? The economic textbook explanation for it is that falling prices leads to a “deflationary spiral” in which buyers are incentivized to NOT spend, as the purchasing power of their savings increases with time. What is wrong with not spending so much? The “spiral” part is a bit dramatic in my opinion, if this were the norm it wouldn’t cause spirals. It is a key debate though and realistically it will have to remain a philosophical one. So stay open minded, but here’s a theory: what the system designers were thinking here is that a stable/increasing velocity of money is important. In the Quantity Theory of Money (MV = PQ), central planners felt if they can get a wrangle on V by avoiding a deflationary spiral then by controlling M they would balance the other side of the equation. Just a theory, please don’t cancel me. The control of V was achieved by steadily increasing prices, which only works if you also have steadily decreasing cost of capital ie rates. Future thought exercise: perhaps the Fed balance sheet unwind can be achieved if paired with fiscal stimulus to offset falling asset prices. Tough balance though.
As as we design new monetary systems in the crypto economy (wooo!), let’s try to design a system without the inflation is good assumption. Would this decrease the rate of investment as holding cash is a positive return investment? Probably, but it would still be less positive than a cash generative investment. Simply, it raises the risk-free rate. Hmm, so what would control the risk-free rate? This is where central planners get nervous. In the short term, it would be the same as it is today at extremes: risk appetite. Hence the instability. Difference is we wouldn’t have big brother to step in and tell us “no no, the risk free rate is going lower not higher, it’s better to invest/lend/spend than hoard.”
This is why crypto is such an amazing solution. “The Internet Bond” really hasn’t caught on like I thought it would, perhaps when (if?) Ethereum finally moves to PoS. But the cool thing about The Internet Bond is that the risk-free rate is the return you get for securing the network. How this inevitably trickles down through a Dai-type savings rate or just the staking APY or other is to be determined. The mechanism, however, is insane! Revolutionary! This bear market, if that is what we have here, will be very interesting to see how it works. Are lending rates going to crater as risk appetite and leverage fall? Great! That is exactly how the system, without a central planner, should work. Instead of lending Luna to get bLuna to buy more Luna and leverage my position, I will just stake my Luna and happily sit with a lower LTV. I am making an assumption here about the protocol’s staking rewards being tied to supply/demand of the protocol token (higher V of the token means more transactions to validate so higher payout rate while higher supply of tokens to be validators means lower rate. The latter is not ubiquitous). This system design is really elegant in my opinion, balancing V with the cost of capital without having a central planner. How exciting! In an economy with constant M (say the max number of tokens have been mined so staking rewards are from settlement/transaction fees), Q is increasing because of improving productivity (an assumption) and V is managed by risk appetite balanced by the risk-free rate of staking rewards which move inversely to V and manifests in changes in P. Might need one of those cork-boards with red string to make that all clear but I think it works! It basically leaves productivity as the driving force of the system.
A prediction: one of the toughest transitions to a crypto economy will be use of leverage/debt. Without having control of M, it becomes much harder to damper a deleveraging, which is money destruction. The current system got itself in trouble because every deleveraging was met with massive monetary stimulus to keep the system from contracting. In the world we crypto-folk are asking for, Satoshi can’t increase the supply of BTC. The good of that means we don’t lose value of our holding. The bad means we need to be a lot more careful about debt. A classic case of “be careful what you wish for.” Are we ready to live within our means? Perhaps having a base currency that is deflationary will alter that relationship over time. We are in for a heck of a ride!
Thank you for reading, if you’ve made it this far. I would like to stress that what excites me so much about this space is the uncertainty and room for innovation. Point being: I am open to being totally wrong and really enjoy the working through other possibilities.
