15 June 2018

Keynes, Capitalists, Communists, Cryptocurrency and Central Bankers

Cryptocurrency emerges from the notion that it is better to trust an algorithm than the judgement of a central banker. 

So before we evaluate cryptocurrency, let's evaluate central banks.

I stand with conservatives who argue for the importance of family, church, state, bank and corporation. Two-parent families raise children less likely to go to jail and more likely to go to university (speaking of institutions). People who go to church weekly live longer. If you live in a failed nation-state your income prospects are cut by tens of thousands of dollars and your life expectancy by a decade or more.  And a great financial system (what I mean when I say bank) helps to create trillions in wealth and enable R-n-D, infrastructure, consumption, and entrepreneurship. 

When healthy and strong, these institutions make lives better. Showing a disregard for these institutions is to show a naivete about who we are as individuals. (Spoiler alert: alone we're less able to survive than dodo birds.)

Where I depart from conservatives is in my conception of these institutions. I do think they are hugely important. I don't think they are sacred. Instead, I think they are just tools.

The church is just a tool, no different from a juicer. What a church makes is more important than what a juicer makes, though, and that is why it is more important. Through a church people make things like meaning, faith in an uncertain future, compassion, identity and community. Those things matter more than juice so churches are more important tools than juicers. It is both that simple and complex.

Once we conceive of institutions as tools, we realize a couple of really important things. One, they didn't always exist. Like a car or toaster, church, state and banks are inventions. Two, just like other products or tools, they can be continually improved. If the purpose of a church is to create compassion, we can design rituals and beliefs to better enhance that just like we can design a saw to more accurately cut wood or a car to more comfortably get us across town. We can judge the Mormon Church or Catholic Church or Church of Scientology by how happy its members are, how much grief they cause non-members, and whether they make the world around them better. (And we can leave it to various churches to discover later who - if anyone - gets sent to heaven and who to hell.) If a church forces its members to disregard the Copernican Revolution or evolution and as a result its members end up in more primitive, less prosperous, anti-science communities we can judge that as a design flaw that needs updating, requiring change no different than debugging needed when  software keeps crashing or works on a laptop but not a smart phone. Catholicism, the United States, IBM, a chest freezer and a bulldozer all share this simple characteristic: they are merely inventions and can - indeed should - be changed and improved. It's true that children do better in two-parent households than they do in one: those two parents may be two dads, two moms, a grandma and a dad, etc. There is no sacred formula for effective institutions but some designs are more effective than others. The best societies design their institutions for who they actually are, not who their ancestors thought they were.

Banks - like churches and nation-states - are not sacred. They are just tools. When effective, they are tools for the masses and not just the elite.


So many questions arise from this orientation but a key one is, Who gets to use these tools? The answer is that it depends on how evolved a community is. The nation-state that is a tool of the monarch is more primitive than the nation-state that is a tool of the people. Dictatorships are more primitive than democracies. No one was richer than King Louis XIV in France or Saddam Hussein in Iraq or is richer than Putin in Russia. A nation-state that is the tool of the elite is only partly evolved. The bigger the market for a tool, the more benefit. This was true of computers once bought only by nation-states and now by most people and is true of nation-states once conceived for the glory of the king.

The progress of the West has come in two phase for each of its big institutions. 

In the first phase, creative geniuses conceive of and create institutions like church, state, banks and corporations that make us part of a bigger us. These social inventions hack into our tribal instincts and - rather than leave us in a small tribe of 150 or so - make us the part of a larger group, more people than we can ever hope to meet. "I'm a Christian," we say or "I'm an American" and we feel affinity for a group of billions or hundreds of millions of strangers. Social inventions make us part of a bigger us and that makes us more prosperous. A tribe is poor. Always. A tribal economy doesn't have enough people to allow specialization, economies of scale or the growth in knowledge that comes out of millions or billions of people interacting with one another. The state economies in the US before the Civil War were not as prosperous as the national economy of the US after. The bigger the group, the greater the prosperity. This act of social invention is incredibly important to progress.

In the second phase, the institution is made the tool of the masses and not just the elites. Martin Luther's cry of "We are all priests" or Jefferson's cry of "All men are created equal," were revolutionary. Why? They called for a shift in power from popes and monarchs to the common person. They made church and state tools for anyone to use. In the wake of this reconception of church and state we have religious freedom and democracy and now church and state policy are the product of every- and any-one.

The simplest way to think about the central bank is that it is a means to do for banks what Luther and Jefferson did for church and state: the central bank is a means to make banks a tool for the masses and not just the elites.

Four times the West has created the great institutions that have come to define market economies. Three times it has turned those institutions into tools for the masses. (The corporation is only now changing from tool for the CEO to tool for the newly entrepreneurial employee; that is not something that I'll get into here.) 

It took centuries for the Protestant Revolution that transformed the church in the West to culminate in religious freedom. Martin Luther nailed his 95 theses onto the door of the Wittenberg Castle Church in 1517 and it was not until 1648 that the Treaty of Westphalia was signed to grant religious freedom. (And of course what they thought of as religious freedom we would think of today as hugely restrictive.)  It took about a century for democratic revolutions to transform monarchies across the West. So I guess one ought not to be surprised that the revolution that transformed the bank -  a revolution that largely played out between 1933 and 2000 - is still not really understood or appreciated. You have to understand that revolution before you can really understand cryptocurrency.

"You have made yourself the trustee for those in every country who seek to mend the evils of our condition by reasoned experiment within the framework of the existing social system. If you fail, rational change will be gravely prejudiced throughout the world, leaving orthodoxy and revolution to fight it out."
- John Maynard Keynes in an open letter to FDR in 1933

The revolution of the third economy - like the two before it - turned that period's dominant institution into a tool for the masses. The bank became a tool for everyone - and not just bankers - through a couple of mechanisms. The first was simply the work of social evolution - market forces at work. As capital became more abundant, the competition in capital markets shifted from households and businesses competing for capital to lenders and investors competing for customers of capital. The ads for credit cards, home mortgages, and 401(k) accounts late in the 20th century were evidence that capital markets had become as eager for thousands of dollars in business from tens of millions of people as they had earlier been for the tens of millions of dollars in business from thousands of elites. That alone helped with the popularization of capitalism from the wealthy elite to the average consumer. Keynesian policies were the second tool for turning banks into tools for the masses.

Before Franklin Roosevelt became president in 1933, the American economy had been in recession 48% of the 20th century. Half the time GDP was contracting. The good news is that capitalism was creating entirely new industries and technologies as transformative as electricity, radio, automobiles, and airplanes. Life was markedly better with the fruits of capitalism but it was also a world that generated about as many busts as booms. The bank obviously made capitalists rich but it wasn't as clear that it was benefiting workers. (Spoiler alert: it was but not not as rapidly or obviously.) Bankruptcy emerges after banks. From this turmoil of sudden wealth and poverty, income inequality and booms and busts communism was born. Communists knew the pain of that institution the bank and they wanted to be rid of it. It seemed to them wildly unfair and inefficient to have capitalists get rich while workers were losing careers each time a new industry emerged and an old one contracted. The innovation and automation that capital fueled could obsolete entire careers. Instead of banks, communists thought they'd use the nation-state as a mechanism for creating, investing and distributing capital.

The battle before Keynes was between capitalists (who Keynes refers to as orthodoxy in the quote above) and communists (the folks Keynes saw calling for revolution). Capitalists wanted the bank to be unchallenged and unchanged, left a tool for the elites to profit from with little or no regard for the worker or the broader economy. The capitalists were to the bank what royalists were to the nation-state or Catholics were to the church. They thought capitalism sacred. (They even referred to the market as the invisible hand, a nod, of course, to the hand of God that had earlier been thought to drive change and, of course, as with God's will, the market's decisions were not to be questioned or overturned.) Communists, by contrast, wanted the bank eradicated. Treat the institution as sacred or disposable? Side with the capitalists or communists? 

Well, the Keynesian response was to create policies that allowed capitalists to profit (profit motive remains a pretty clear signal about where to best allocate capital) while regulating banks through laws and central bank policy. The Federal Reserve's mission is to keep unemployment and inflation low.  Keynesian policy is fairly simple in concept: banks can do their thing as long as that doesn't mess up the larger economy that includes workers who have to stay employed and are also paid wages that can be made weaker by inflation. Capitalists were left free to profit as long as capital markets helped everyone prosper. Like freedom of religion and democracy before it, this "American Dream" treated a major institution both irreverently and as vital. 

After 1933, the world had three competing models running. One model was communism, another orthodox capitalism and the third Keynesian. (The orthodox capitalism models included a mutated form known as fascism that shared the orthodox belief in the natural inevitability of elites and the need to subordinate workers to business owners (and, of course, the state).) There was no competition. The Keynesian model was a triumph. As mentioned, from 1900 to 1933, the American economy was in recession 48% of the time. Since then it has been in recession only 14% of the time. In the 20th century, throughout the West, incomes and life expectancy rose dramatically. Keynesian economies trounced communists and unregulated market economies. People steadily got more access to credit and investment markets and as they did, wealth increased more than in any previous century.

The inventions of church, state and bank were so very, very cool. Turning them into tools for the masses rather than just elites was even more cool.

The punchline of the third economy's transformation of the bank? A banking system needs a central bank and regulations that save it from sub-optimization. Keynesian policies subordinate the banking system to the broader economy. Without that the economy booms and busts in ways that costs everyone - even banks.

So now let's turn to cryptocurrencies, the currency that relies on an algorithm rather than a central bank.


Cryptocurrencies are designed to avoid central bank policy. As long as they remain a minor part of the economy, this isn't such a big deal. Their value will vary wildly against other currencies but that won't adversely affect the economy, just the investors lucky enough to catch it on a swing up or unlucky enough to catch it before a big fall. 

But the more widely cryptocurrency is adopted, the more it will drive variation in GDP growth. Cryptocurrency promoters are not communists or Keynesians but instead are orthodox capitalists who have come back with algorithms. They are true believers in financial markets as forces that act best unsubordinated to anything else. They are designed to avoid central bank influence. If they are right than Keynes was wrong.

The good and the bad thing about algorithms is that they are rules that don't change in different environments. A new species can change an environment, though. The mortgage instruments that seemed like just a new product for bundling mortgage debt into securities that could be sold ended up changing the financial market in 2008. They were a key trigger to the Great Recession. It is not just that cryptocurrency would change the financial environment as it becomes more popular. The simple algorithms it follows will behave very differently in an environment in which they are dominant than one in which they are marginal.

Simple rules can still lead to weird chaos. This is one reason that the Federal Reserve has goals rather than rules. Things change and a constant growth in money supply can be a problem in an economy subject to shocks and surprises. Central banks change the variables they can to effect stability in employment and inflation. They are not perfect - that's impossible - but they are willing to subordinate capital markets to broader goals and they are willing to change things in novel or unexpected ways to effect such change. A cryptocurrency disconnected from any central bank or government regulation won't subordinate to broader economic goals and any attempt to suddenly change a predictable algorithm to do that could lead to chaos within the cryptocurrency market.

We see already that the simple algorithms that drive cryptocurrencies don't translate into stable prices of cryptocurrencies. As (and if) they become more popular they will not translate into stable economies. 


Speaking of social inventions, currencies are just made up. As it turns out, though, the point of currencies is not currencies. Currency just facilitates economic activity. To do this currencies have to be a store of value as well but that is incidental to its property, not its purpose. Currency induces people to work, to part with resources, to sacrifice or work now for future gain, and so on. A body is not made more healthy by the production of more RNA (that can, in turn, synthesize protein) any more than an economy is made more healthy by the production of more money. Hyperinflation is a reminder that the goal is not to maximize currency (or even to minimize it or keep it constant). 


One of my beliefs with the fourth economy is that what limits in one economy becomes abundant in the next. In an industrial economy, capital is so scarce that more of it will almost always provoke more economic growth, the creation of more jobs and wealth. In an information economy, though, capital has become more abundant and introducing more of it has a diminishing effect.

What limits economic progress now is not the capital to finance education for knowledge workers or factories for capitalists or the startup capital for entrepreneurs. We have trillions wandering the globe in search of returns (and arguably driving prices of stocks higher than is justified by expected profits).

A key question to ask about cryptocurrency is whether it has emerged because we have so much capital in search of novel returns or if it exists because we do not have sufficient currency to facilitate the economic activity that creates new jobs and wealth. For me, the answer seems obvious. Cryptocurrencies emerged during a time of such capital abundance that the interest on Dutch bonds - and they have records that go back to the time of Martin Luther - was negative for the first time. It is hard to argue that the problem with the modern world is a lack of capital or currency. 

Cryptocurrencies seem a symptom of a glut of capital rather than shortage.


Nor do we have a shortage of currencies. It seems plausible that the euro that emerged out of the EU will be  a prelude to the consolidation of currencies within regions. There are about 180 currencies around the world (most nation-states have one). It's not clear that we need more.  

Cryptocurrency advocates argue that bitcoin is poised to become the replacement currency for many of these national currencies. If currency needed no Keynesian policies to direct its behavior, this would actually be plausible. It is unclear, though, what would act as a central bank mechanism for any cyrptocurrency. I actually think it more plausible that the World Bank could issue a currency at some point.


Keynes published The General Theory of Employment, Interest, and Money in 1936. (But as was evident in his 1933 letter to FDR, he'd been thinking about this theory for years.) Kurt Godel published his incompleteness theorem in 1931. Godel essentially argue that a system cannot contain its own proof. Ultimately, a system needs an outside reference. Keynes notion of capitalism was similar to Godel's notion of math: it needed an outside reference point to keep it from collapsing in on itself. 

A currency or financial system ultimately needs an outside regulatory engine or mechanism to keep it running smoothly. (Or relatively smoothly. Booms and busts are inevitable even if it is not inevitable that the busts are underway half the time.)

Currencies are only part of the system. The economy is the whole system and in order to optimize the economy you have sub-optimize the parts of it, including its capital or currency.  The lesson of Keynes is that banks, capital and currencies have to be regulated by something outside. (Lightly. But regulated nonetheless.)


Cryptocurrency seems like modern technology based on an old, pre-Keynesian worldview that trusts in self-regulating financial markets that don't disrupt employment and GDP. I'm not sure that using a computer rather than a printing press makes that worldview any more effective. In fact, it could even make it more dangerous.

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