Hackernoon logoBeyond Bitcoin: Truly Decentralized Banking by@ersun.warncke

Beyond Bitcoin: Truly Decentralized Banking

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@ersun.warnckeErsun Warncke

Bitcoin and other digital coins are at the peak of their hype cycle. The massive surge in their prices has led many to believe that they are on a trajectory towards mass acceptance and playing a vital role in the real economy.

As long as these coins are experiencing net capital inflows few people question their underlying economics and any critical voices are quickly drowned out.

While bitcoin is an important first step towards creating a better system for money and banking it largely copies earlier systems of money and banking and as a result it replicates their inherent flaws.

The Gold Myth

One of the most common misconceptions is that gold and other precious metals are inherently valuable, do not lose their value due to inflation, and will always be valuable under all circumstances.

Gold aficionados like to believe that gold is inherently superior to paper money because it has some intrinsic value that paper does not.

While it is true that pound-for-pound gold is more valuable than paper it is not true that gold has any other magical properties that make it any more useful as a currency.

Gold and silver money are just as subject to inflation as paper money.

When the Spanish Empire discovered America with its vast new supplies of gold and silver what followed was decades of rampant inflation as the money supply grew disproportionately to the rest of the economy.

Gold may not rust, so it does not lose its practical or ornamental utility, but that does not mean that it will always be valuable under all circumstances.

In an economic collapse prices for luxuries rapidly decline relative to prices for necessities.

Gold has almost no practical value for individuals so in an economic collapse the price of gold will plummet as jewelry, coins, and other small gold holdings are sold off to buy things with immediate utility.

Gold may be a better store of value than paper money in a hyperinflation but it will still be a worse store of value than almost everything else.

The Value Myth

The common misconception about gold being uniquely valuable goes hand-in-hand with an incorrect belief that money should be valuable.

Money is a technology that enables exchange. Nothing more.

If money is valuable then the value of money is a transaction cost for any exchange that takes place using money.

If money has value then anyone who wants to engage in economic exchange must first pay to acquire money. Whatever money costs is a tax on all exchange that takes place using that money.

The more valuable money is the greater the tax on exchange and consequently the greater the reduction in economic activity.

Paper money is a significant technological advance over gold money because it provides the same utility of enabling economic exchange at a far lower cost.

Digital money is a significant technological advance over paper money because it has an even lower (near zero) marginal cost.

If you don’t take into account the cost of the underlying infrastructure that enables digital money (computers, networks, etc) then digital money has virtually no cost at all.

Modern Banking

The world is divided between two groups of people: those who can create money out of thin air at no cost and those who must work to get money or borrow it at interest.

For those who cannot create money out of thin air, which is the vast majority of the population, the cost of money is very high.

While a bank creates money out of thin air you have to borrow that money at 20% interest if you need cash, or 10% interest to buy a car, or 5% interest to buy a house.

While the government creates money out of thin air you have to work to earn your money. Then you have to pay 30% of your income in taxes to the same government that is free to create as much money as it wants whenever it wants.

Between the ravages of taxation, interest, and transaction fees the average individual or small business pays a very high cost indeed for the money that they must acquire in order to engage in economic activity.

While modern money may be intrinsically worthless the monopolization of money creation makes money extremely expensive for those who cannot create it out of thin air.

The Problem with Coins

The embrace of Bitcoin is largely driven by dissatisfaction with the modern banking system but the designers and proponents of Bitcoin have made the fundamental and fatal mistake of believing that the problem with modern banking is that paper and digital money have no intrinsic value.

Since digital coins must be created out of thin air the creators of Bitcoin developed an ingenious method of making coin creation take computational power, thus imposing a cost on creating new coins, and allowing them to limit the total circulation of coins.

These measures give Bitcoin an intrinsic value (the cost of creating a new coin) and make inflation impossible by setting a hard limit on total currency issue.

Bitcoin is like gold but with the inflation problem solved. Unlike gold new sources of Bitcoin can never be developed after the issue limit is hit.

Bitcoin appeals to gold aficionados because they fail to understand the simple economic truth that worthless money is the best money.

Gold is a less efficient form of money than paper and Bitcoin is an even less efficient form of money than gold.

Paper supplanted gold as the dominant form of money and digital transactions have supplanted paper as the dominant form of money.

The path of technological progress is not to make money more expensive but to make money cheaper.

Bitcoin, which is designed to be even more expensive than gold, would be a giant leap backwards in the technological progress of money and it simply will not happen.

The creators and proponents of Bitcoin have got the economics of money backwards and as a result Bitcoin will never be viable as money for the real economy.

Decentralized Banking

Bitcoin moves the ball forward when it comes to decentralized currency issue but scores an own-goal with its underlying theory of money.

The path forward for money and banking is not to prevent people from creating money out of thin air but to allow everyone to create money out of thin air.

The proposal that everyone should be allowed to create their own money tends to make gold aficionados and other armchair economists shit themselves with their mouths wide open (thanks Jim) but it is hardly a radical concept.

The idea that eliminating monopolies and introducing competition will drive down costs is universally accepted economic orthodoxy.

Economic orthodoxy says that free markets act with more information and more immediacy than central planners and consequently they make better pricing and allocation decisions than central planners.

If this is true for everything else in our economy why would it not be true for money?

Money is Debt

People are conditioned to think of money as an object with inherent value but in actuality money is a debt contract.

When you give someone money in exchange for something of value you are giving them a promise to pay them something of value in the future.

Modern money is a standardized debt contract, guaranteed by a bank, which can be traded for valuable goods or services.

The standardization of debt contracts into money and the addition of a third party guarantor makes economic exchange dramatically more efficient and allows parties to engage in economic exchange without needing to trust or even know their counter-party.

The problem with modern money is that banks have been notoriously unreliable when it comes to paying out when the debts they guarantee go bad.

A Short History of Banking

Paper money began as notes issued by a bank that the bank guaranteed to pay on demand in gold or silver.

Since banks tended to issue paper notes greatly exceeding their reserves of gold and silver they also tended to go bankrupt on a regular basis.

Central banking was created under the theory that one central bank would be more reliable than a bunch of small independent banks.

Central banking did nothing to make bankers more honest or reliable but it did make them more politically powerful because if the one central bank failed then a nation’s entire economy would collapse.

Eventually bankers realized that as long as you can force people to accept your money you don’t have to worry about backing it with something of value.

To force people to accept money all you have to do is force them to spend money and conveniently there is an institution called government that has the power to force people to spend money in the form of taxes.

Government imposes taxes that can only be paid in central bank money and since people must obtain that money to pay their taxes a guaranteed level of demand for central bank money is created.

The demand for money created by taxes guarantees that the debt contracts that money represents will be paid in the future.

As more new money is created governments must borrow money from central banks which guarantees that taxes will continue to be imposed in the future and that the debts represented by that new money will continue to be paid.

Since the only way for old debts to be paid off is to borrow progressively larger amounts of money it is impossible for this debt to ever be paid off.

And then everyone lives happily ever after.

So What About Inflation?

Inflation is broadly defined as a general trend of rising prices throughout an economy.

It is pretty well accepted that the underlying cause of inflation is banks creating ever larger amounts of money out of thin air which then devalues existing money.

Banks claim that rising prices are a good thing, and since they allocate the money they create to the people who agree with them, there is a pleasant consensus among politicians, business leaders, and economists that “moderate” inflation really is in the best interest of everyone.

People who work for money as opposed to creating it out of thin air tend to view rising prices as a bad thing.

Inflation is synonymous with a decrease in the value of money which in effect means that inflation is a partial default on the debt contract that money represents.

When inflation is at the target rate of 3% that means that the central bank will default on 3% of the amount of debt it guarantees within a year.

If the central bank maintains its target inflation rate of 3% over a decade it will default on about a third of the debt it guarantees within ten years.

What if Everyone Could Create Money

If having a few central banks creating money out of thin air results in perennial inflation it would be natural to assume that if everyone could create money out of thin air this would result in truly stupendous levels of inflation.

What may comes as a surprise is that if an economy existed where people could only issue their own money inflation would be impossible.

Inflation can only occur when the supply of money grows faster than the supply of goods and services.

Since individuals would not have the power to force other people to accept their money the money supply could only grow when money was exchanged for goods or services.

If everyone issued their own money in a free market the free market would do what it always does which is regulate supply and demand.

Prices of goods and services would rise and fall and the amount of money created would rise and fall but there could never be a generalized tendency towards increasing prices.

The biggest problem with everyone creating their own money is not inflation but getting people to accept money from each other at all.

That however is a problem that technology can solve.

Truly Decentralized Money

Imagine a digital exchange system very much like the one that you use today.

When you walk into a coffee shop you swipe a card or press a button on your phone to pay $7 dollars for your cappuccino and muffin.

Instead of using Visa you use a digital exchange system that hasn’t been created yet.

This digital exchange system has a record of every transaction you have ever made. It has a record of every transaction that everyone who uses the system has ever made.

When you swipe your card you are giving your consent for the merchant to obtain your credit score. The merchant’s system then decides whether or not to extend you credit based on your credit score and the credit policy the merchant has specified.

Merchants offer standardized contract terms in existing currencies which makes transactions using this system just as simple and friction-free as using cash or credit cards.

The $7 dollar debt for the cappuccino and muffin you purchase is due in 30 days but all of the debts in this system are self-canceling.

If the coffee shop spends $7 dollars and you earn $7 dollars before your debt becomes due then your debt will be canceled out.

It does not matter where the $7 dollars is spent or earned since any equivalent debts in the system will cancel each other out.

By offering short term credit to each other market participants will be able to engage in economic exchange without having to pay the cost of money.

Because market participants will effectively be creating new money with every transaction they will be expanding the money supply and increasing economic growth with every transaction.

Just like paper money was bootstrapped on top of gold and silver this new digital exchange system will be bootstrapped on top of the existing money and banking system.

This digital exchange system is not a currency itself. It is only a record of debts denominated in existing currencies. Consequently it does not create any conversion costs or have any volatility risks.

Because this digital exchange system is not a currency and is not directly used to store or exchange any money none of the existing laws and regulations for banks, money transfer services, and other financial services apply to it.

Unlocking the Power of the Market

The decentralized digital exchange system of the future will make automated credit decisions based on public scoring algorithms and configurable credit policies.

At the same time merchants will be free to extend credit based on their own personal trust relationships and to adjust their credit policies in response to changing economic conditions.

The ability of market participants to set their own credit policies will expose an enormous amount of information about the real economy and the credit worthiness of individuals that is currently hidden and wasted.

This data will be used to shape a market-driven monetary policy that continuously evolves and adapts to changes in real world economic conditions.

The efficiency of this free market monetary policy compared to the planned economy created by monopoly central banks will be stupendous.

The economic growth that will result from adopting this system will transform the economy and transform the world.

As decentralized digital exchange replaces central banks the effective money supply will increase dramatically.

Because the increased money supply will be allocated by markets instead of central planners if will be allocated efficiently and will result in economic growth without creating inflation.

Creating Jobs and Economic Growth

According to the OECD the US Labor Force Participation Rate is around 70% with an average of 34 hours per worked per week (https://data.oecd.org/emp/labour-force-participation-rate.htm).

These numbers are not very good and there is strong evidence that the OECD is overly optimistic about the true state of the economy and job market.

According to the Gallup 2016 Global Great Jobs Report (http://www.gallup.com/services/190922/gallup-global-report-great-jobs-2016.aspx) which gets its numbers from participants in the labor force as opposed to economists the situation is far worse.

According to Gallup’s survey only 43% of adults in the US have a “good job” defined as working 30+ hours a week for an employer that issues a regular paycheck. For Europe the number is only 35%.

In Gallup’s State of the American Workplace Report (http://www.gallup.com/reports/199961/state-american-workplace-report-2017.aspx) it is reported that of the 43% of Americans with a 30+ hour a week job that pays a regular paycheck only 33% feel engaged in their work.

The conclusion from these two Gallup reports is that only 14% of American adults have a 30+ hour per week job paying a regular paycheck where they feel engaged in their work.

Gallup says that when comparing similar business units those with employees in the top quartile of engagement had 41% lower absenteeism, 28% less shrinkage, 70% fewer safety incidents, 40% fewer quality defects, 17% higher productivity, 20% higher sales, and 21% higher profitability compared to business units with employees in the bottom quartile of engagement.

The economic growth potential from getting people fully employed in jobs they actually want to do is staggering.

According to Gallup’s report company size is one of the strongest predictors of employee engagement. On average 41% of employees in companies with 25 employees or less are engaged vs. only 29% of employees in companies with 5,000 employees or more.

There is a consistent inverse relationship between increasing company size and decreasing employee engagement which in turn means decreasing productivity and growth.

The fact that the largest companies have the lowest levels of engagement means that the low level of engagement of workers generally and the economic retardation that results is directly attributable to monopolized central banking.

It is the monopolization of central banking that allows a wealthy few to create money out of thin air and use it to buy up and merge together ever larger mega-corporations with devastatingly negative economic results.

At the same time individuals and small businesses are strangled by interest and taxes and starved of the money they need to invest, build their businesses, and buy the goods and services they need.

Economists are practically universal in agreeing that individuals and small businesses are the real engine of economic growth and yet few can bring themselves to state the obvious truth that it is monopolized central banking and bad monetary policy that have ground the engine of economic growth to a halt.

The Inevitable March of Technology

Eliminating central banks and their monopoly on money creation is an economic necessity. It is the only path forward towards creating global prosperity.

The current money and banking system came into being because it was a radical technological advance over the economic technologies that existed before it.

Modern money and banking have created economic growth and prosperity that would have been unimaginable and impossible without them.

But the march of technology never stops.

The current system of money and banking is now obsolete and deeply inferior to what we can create with the power of modern computing and communications technologies.

With modern computing technology we can create a digital exchange system that is superior to money in its ability to facilitate economic exchange while having negligible transaction costs.

With modern computing technology we can create a digital exchange system that operates without money. In effect this means that money will become free and that the money supply can be dramatically increased while at the same time inflation will cease to exist.

The technology exists to create this system but Bitcoin and other digital currencies like it are not it.

Decentralized banking is the future but it is not here yet.

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