Reviewing the Current Definition of Capitalism

Let us begin by first asking what is the definition of capitalism? To me, owing to the intimate role of money in every aspect of our lives, capitalism is as much a cultural construct as it is an economic paradigm. As per empirical studies and philosophical interpretations, a capitalist society is one in which markets consist of multiple players who are all performing efficient value exchange operations under the premise of allocating scarce resources for their most optimal function. In such markets, regulations and policies act as levers which are to be used appropriately, based on clear rules, to achieve outcomes of prosperity for a society at large.

However, the precipitate of the analyses depicted in the previous two chapters indicates that the increased financialization of society has tarnished this definition. Today, capitalism has gone from a society that uses markets to reach certain shared prosperity objectives, to a society where everything is for sale, including risk. It can almost be said that we have gone too far with capitalism and that we have overused the three governing levers of capitalism—markets, regulations, and policies—to create matrices of inequality grounded on an unsound or misinterpreted understanding of efficiency. It is thus not surprising to find that no historical definition of capitalism encompasses all three levers.

Hence, to construct an updated definition of capitalism, we need to have a clear and discursive understanding of the current limitations of the three levers and the roles that they play. When redefining the role of markets, we need to inculcate the concept of inequality and ask ourselves whether the distribution of income and wealth governed by markets is a problem. Inequality by itself is not a fallacy; it is a motivational tool which allows for the development of skills and knowledge, which in turn uplifts marginalized peoples to previously unbeknownst levels of prosperity and happiness (sometimes referred to as the famed “middle class”). Inequality can thus be looked at as a catalyst for initiating a transitionary process that allows for the development of robust economies; the evolution of China over the past three decades is a good example of how the opening up of markets coupled with a combat against inequality can lead to transformative outcomes. Indeed, over the past thirty years, the increasing momentum of globalization has allowed for the use of societal inequalities as a catalytic agent to elevate close to a billion people from poverty (Olinto &Uematsu, 2013). But inequality can also be too much of a good thing. When inequality reaches a certain threshold limit, it leads to less social mobility and affects the future growth of the economy, as it alienates poorer sections of society from developing knowledge and skills that are germane to innovation (Chetty et al., 2015). Thus, while the market lever of capitalism has solved many problems with regards to poverty, the sub-factor of inequality has created new ones. Today we bear witness to the disenfranchisment of people across various strata of society. When inequality undermines the lever of markets itself, we must acknowledge that we have a problem.

The lever of regulation is a much more multifaceted hydra, as it variates at sectorial and societal levels. There is a rhetoric that it is crippling regulation that is currently stagnating the progress of society and infringing upon the waves of productivity. While there is evidence to support this claim, it belies what regulation is all about. Regulation allows a society to use market mechanisms to achieve outcomes, but in a way that is conducive to society at large, while allowing for fair game between market players. The process of regulation is to determine what is the ideal cost-benefit trade-off for what we want as a society and what markets need to do in order to help us get there. This encapsulates a plethora of societal concerns ranging from the destruction of monopolies to protecting the environment. It is needless to say that regulation is important. But, as we have seen, the current regulatory structure has led to the creation of banking oligopolies and is limiting the progress of technologies such as the Blockchain. As regulation is constantly evolving with a significant time lag when compared to the quickening frequency of technological waves, efforts need to be made to address this chasm. This is a complex and complicated endeavor and, in a later part of this chapter, we will discuss an alternative way to view regulation.

As markets and regulation are interwoven into the fabric of policy, the final lever of capitalism is the fundamental tool that guides the development of society. From an all-encompassing view, it can be said that today’s policies are inefficient in execution, as they fail to englobe the looping behavior of technology. As it has been seen in Boxes 3 and 4, the fastest branch of technological progress is software. Software excels in looped behavior. By using code to perform repetitive tasks, software allows for large-scale automation of tasks that were previously the domain of skilled workers. In the past, technological evolution posed threats to manual jobs. But as machine learning, neural nets, and AI continue to make significant and rapid strides, the threat is now faced by skilled personnel who were employed to perform cognitive tasks (Refer to Sidebar 3-1). As Marc Andreessen said, “Software is eating the world.” Today, software is increasingly threatening anyone whose job function involves a repetitive framework. With automation and financialization posing the biggest risks to industrialized economies, policies are needed that address the changes in productivity gains. Hence, it must be understood by policy makers that we have an ailing self-organized society that needs more direction in order to combat and adapt to the future technological changes. To do so requires policy makers to think about initiatives related to the development of a cashless society, technological unemployment, increasing life spans, and their macroeconomic impacts.

All in all, it must be understood by the helmsmen of the three levers that the future definition of capitalism cannot be based on theoretical abstractions, but by understanding the complexity and dynamism of future societies. As the fragmentation and digitization of society accelerates, we are witnessing the growth of multi-player relationships between real and virtual economic actors whose behavior is not portrayed by theorized ideal agents. While macroeconomists frequently talk about the economics of innovation, they often fail to consider the innovation of economics. Just as our institutes are predicated on growth expectations, it is imperative that there be a steady stream of innovation, even at the academic and theoretical levels. The laws of economics are not like the laws of physics, where a set of commandments works universally. What we will see in the next portions of this chapter is that, owing to the different kinds of economic and financial transitions, there are several variations of capitalism. Hence, rather than constructing a universal definition of capitalism, what is required is a buffet of theories. Prior to attempting this multi-theory development exercise, we first need to understand how technology in redefining work, income, and productivity in capitalistic societies as markets, regulation, and policy are intertwined with these factors. Sidebar 3-1 offers some insight.

A Changing Market Structure

The information revolution is reversing the industrial revolution and changing the structure of markets in the process. While the industrial age allowed for people to team up in large, mechanistic, organizational hierarchies to create factories and companies, the information revolution is in the process of breaking down communication barriers and creating technologies that reduce intermediaries to create smaller and more interconnected teams (Ravikanth, 2015). As technologies such as the Blockchain begin to remove central points of control, the evolving digital and decentralized structure of markets today are challenging the predefined theories on productivity, risk allocation, and labor requirements. Increased automation, propelled by rapid advancements in machine/deep learning, mobile payments, robotics, and the exponential increase in the computerization of tasks, is leading to the development of networked, on- demand businesses which are transforming and reorganizing firms and establishing new skill requirements across the entire economy. As tasks are digitized and operations are networked, processes can be codified and then replicated. As a result, these changes are beginning to challenge our relationship with technology, as machines that were created as tools to increase the productivity of workers are now turning into the workers themselves.

Although the majority of these technologies were created in an effort to challenge the existing incumbents, it is interesting to note that those firms that were created to utilize these technological changes have begun to create winner-take-majority effects, changing the market share decomposition in the process. While the rise of companies such as Uber or Airbnb have been amply discussed and function as effective success stories, these changes can also be seen in other sectors as well. Consider the case of AngelList, the successful fundraising platform, in its rise over the past few years. Founded in 2010, AngelList is a Silicon Valley-based community-styled company where startups meet investors. The company is responsible for moving millions of dollars in investment and does so with a team of only 22 personnel. Almost every operation including fundraising, recruiting, engineering, systems operations, product development, customer service, marketing, inbound deal processing, and deal closing is done in code. Of the 22 personnel, 16 are coders or have coding experience. (Slayton, 2014).

As digitization leads to massive increases in efficiency and network effects, markets are getting more Schumpeterian in the sense that those market players who are capable of digitizing business models are capable of overtaking existing incumbents and gaining larger portions of market share.

In The Wealth of Nations, Adam Smith famously said that the division of labor is limited by the extent of the market. Thus, as digitization overcomes the physical barriers to access markets, we notice that it is creating room for specializations that address granular subdivisions in existing and niche markets. Moreover, as the barriers of technical know-how and location get porous, the impact on strategy has been the obsession on customer focus. Offering unique and customizable services inherently entails a certain amount of risk on the part of the entrepreneur, as success is dependent on the willingness of future clients to move away from existing offerings to new ones. As a result, experimentation and risk- taking are now increasingly touted to be the pillars of innovation by the stalwarts of entrepreneurship. But what this is also doing is creating new risks across the business diaspora.

As it has been seen in previous sections of this book, the world of finance and economics is not oblivious to this phenomenon. However, from a market risk perspective, the world of finance is still plagued with the inherent dichotomy that is seen between economics and finance. While governments have been focused on increasing regulatory measures for financial institutions following the crisis, less attention has been given to the development of sensible and effective regulation for private financial services providers. As finance increasingly migrates to the online world, it becomes increasingly necessary for governments to ensure that economic growth is curtailed from systemic stability while allowing for the long-term scaling of democratic value exchange networks for maximum social utility.

It must be remembered that this new financial market is a scalar in construct, owing to the diversity of technology. But, as new innovations are launched, the regulatory responsibility is often not consistently defined across geographies and business functions. As a result, it is often seen that the regulatory stipulations are at odds with the company’s legal description and the financial activities that it engages in. The current rigidity of regulatory remits therefore does not allow for a holistic supervisory view, which in turn reduces the expansion of these business models and asphyxiates innovation.

For example, although consumers today have better access to alternative sources of credit, a lack of understanding of these new products and insufficient validation from regulatory bodies can shift the risk involved to the end investor. While the use of data provides the delivery of customizable financial services, these data-imbued services also entail cyber-risk, cyber-crime and data privacy issues. Hence, the establishment of standards in terms of safeguarding information has to be a quintessential safety objective to counteract any predatory misconduct and allow for large-scale adoption.

However, as technology has changed the risk profile of the market, it has also enabled the creation of techniques that can be used to enhance market stability. Thus, from a regulatory standpoint, the risks posed by technology can be addressed with a market framework that allows for the leveraging of technology to address these issues. The scalar configuration of the financial market requires for this fight-fire-with-fire approach to be deployed at multiple levels, based on the sector of financial services. We have already seen how different market sectors are changing with Blockchain and FinTech in the previous chapter. Hence, we will review today’s market structure by focusing on the two primary functions of a market: getting access to funds/credit (lending and payments market) and the exchange of goods (trade finance market), to see how Blockchain can be used to redefine market operations and thus provide a primer to the necessary policies required for scaling this change.

Lending and Payments

The lending and payments sectors share some common traits. First, increasingly these functions are moving out of the purview of the banking domain and into the commercial sphere at both the business and operational levels. Second, as more private market players get involved, there is an increasing tendency for the use of “private regulation”¹ between businesses and customers (notably for SME’s). The increased use of private regulation is leading to the sharing of risk exclusively between the client and the financial institution. The reason behind this practice is relatively straightforward. As FinTech firms use technology to create proprietary algorithms and software to address customer needs, the rate at which their offers proliferate the market is outpacing the adaptive abilities of regulators. As a result, we are faced with a scenario in which the regulations do not cover the consumers’ interest as they do with traditional channels.

The lending practices of large banks are mostly executed in the offline world and, as a result, are subject to more regulatory scrutiny. For example, in the US, an established firm that offers loans is subject to at least two regulatory control bodies. While commercial banks in a certain state are subject to local regulators, national banks (which function as member banks of the Federal Reserve), are subject to examination by the US Treasury Department. If the bank is considered a SIFI, then they are supervised by the Financial Stability Oversight Committee (FSOC) and may even have government representatives involved in their business and compliance operations (Murphy, 2015). When these institutions provide loans to businesses, they are further required to participate in the 5-step CAMELS evaluation ,² and if they were to receive a rating of 3 or more, would be subject to regulatory corrections. In addition to these regulations, following the crisis, the Dodd-Frank Act reforms and new Basel III stipulations require banks to hold significantly larger capital requirements and issue debt also in the form of contingent convertible (CoCo) bonds³ (see notes).

The result of these regulations have definitely led to a safer lending sector . But at the same time they have created adverse side effects. As commercial banks continue to settle lawsuits following subprime mortgage transgressions, they have unsurprisingly adopted more conservative tactics when making loans to riskier borrowers. As stated by John Shrewsberry, Wells Fargo's chief financial officer, “[the bank is not interested in making loans to riskier borrowers, even those who meet Federal Housing Standards]. Those are the loans that are going to default, and those are the defaults we are going to be arguing about 10 years from now. We are not going to do that again” (Koren, 2015).

These above-cited reasons have, however, not restricted the entry of the new entrants. On the contrary, the current climate and the lack of oversight has allowed them to thrive to a certain extent. In the mortgage industry, for example, 42% of mortgages issued in 2014 were issued by new lending firms as compared to 10% in 2009, and these firms currently account for 4 in 10 home loans (Koren, 2015). But all that glitters isn’t gold. As most of the new FinTech lending platforms provide smaller amounts of credit (less than $100,000) they are better suited to serving the SME loan market.

But as these credit providers are not defined as banks, they are not subject to the same regulatory pressures . In most cases these lenders may be required to register with a regulator and subject to examination, but this is not set in stone. As a result of this oversight, the new lending platforms have begun to participate in riskier business practices. Some Fintech lenders do not even ask for a business plan or future cash projections. All that is required to get a loan of less than a $100,000 is that the company needs to be in business for over 24 months, have at least $75,000 in annual sales and have no recent history of bankruptcy. If a large bank were to execute a similar practice, it would be criticized for being lackadaisical. This is not to say that there is not oversight at all. Lending Club, the well-known peer-to-peer lending company, is overseen by the US Securities and Exchange Commission, but this is mainly because it has now grown so large and receives a majority of funding from institutional sources (e.g,, insurance firms, banks like JPM Chase, etc.). In that sense, it can be seen as more of an exception to the current rules.

It can be argued that, owing to the small size of these new firms, subjecting them to the same stringent regulations as large institutions would be overkill and would thwart innovation. To a large extent this would be correct. But it must be remembered that as things stand, FinTech firms do not have to adhere to capital requirements. Hence, if the economic conditions were to take a downturn, these firms are ill-suited to respond to a cessation of credit supply. As an increasing number of consumers and SMEs turn to FinTech firms for borrowing money, such an occurrence could have disastrous effects for a number of SMEs. And as the current regulation is largely “private” and involves contractual agreements between provider and consumer, the liability ultimately falls upon the consumer, leaving them unprotected.

The payments industry is facing a similar conundrum as lending services, with the sector witnessing dramatic technological changes over the past few years, notably with the Blockchain. These changes reflect the altering needs of households and companies, and new payment providers have stepped in to address these needs. In a way, regulators have been more responsible in this arena and the recent launch of institutional networks such as CHAPS, the ACH network, and the Real Time Gross Settlement (RTGS) system , which currently transfer immense amounts each day (in the UK, RTGS settles around £500 Billion between banks every day—that’s almost a third of the UK’s annual GDP), shows how institutions have been able to adapt.

The growth of payment API’s and the rise of mobile banking (e.g., Atom Bank), has enabled non-bank entities to deliver better services using the payments infrastructure, and allowed these providers to grow without building an extensive network. Although this has provided the end user with benefits and savings, it has led to the creation of new risks. First, real-time payments make it harder to implement effective defenses against money laundering, terrorist financing, and various kinds of electronic fraud. The more connected a payment system, the higher the threat from cyber-attackers and the greater the risk of contagion. Second, traditional payment providers have direct access to payment networks and hence have to adhere to their regulations (Shafik, 2016). However, this is not the case with FinTech firms who normally use correspondent banks or alternative payment channels. Hence, the question needs to be asked as to whether regulation needs to be passed to include the new entrants into the existing payment platforms.

All in all, the lending and payments industry of today suffers from three fundamental limitations . First, the new entrants in these markets are not subject to the same regulations and supervision as their larger counterparts. This puts a greater amount of risk on the consumer, affects the scalability of new business models, and makes these sectors more vulnerable to systemic risks. Second, companies can only enhance their performance when immersed in a stable regulatory environment. A lack of this environment creates higher levels of profit uncertainty. Third, as the pace of technology outstrips the pace of regulations, supervisors have very little time to adjust and adjust at different paces in different areas. As a result, this is leading to imbalances of control within the system, which in turn increases the system’s vulnerability as weak links are created within the networks. To address these limitations, regulators have to extend their practices across all market participants while ensuring that the rules can be modified according to the role and the type of financial institution.

Furthermore, as mentioned in the previous chapter, the lending sector is beset by rehypothecation , which uses the channels of shadow banking to convert secure collateral into risky debt instruments and structured investment vehicles. Coupled with excessive borrowing and poor information available to investors, these shadow banking investment products were the source of the global financial crisis in 2007. Hence, apart from the three fundamental limitations, regulators also need to ensure that borrowers and investors are protected from debt maturity mismatches that are characteristic of shadow banking products, if they intend to avoid history repeating itself.

It is in responding to these limitations that the Blockchain offers a solution pathway. A lender or sender is essentially doing a simple operation: they are exchanging capital for an investment in an asset or transferring value from themselves to another. Thus, at a fundamental level, lending and payments involves a record of a transfer of existing capital for assets among a set of identified owners. This is the very definition of what a Blockchain does. It sends value across a network and records every movement that occurs in this space. The codified execution of smart contracts is another benefit for regulators. In the context of loans, the pre-determined terms such as loan amount, loan maturity, interest rate, principal, and interest payment schedule and permitted flexibility can be encoded in a smart contract. This allows regulators to verify if a firm is behaving in a predatory manner and creates better circles of competition within the sector. As actions can now be verified and challenged, assets can be tracked and their true value can be verified by following their exchange between market players. This in turn can lead to better consumer protection and a safer environment.

What regulators need to decipher are the advantages that are gained from the use of cryptographic laws instead of regular laws. Regular laws can be seen as “code” that is extrinsic to the system: the rules can be broken, but consequences flow from that breach to ensure compliance (UK Government Chief Scientific Adviser, 2016). Cryptographic law , on the other hand, is intrinsic: if any action goes against the code/rules, then an error is returned and no activity occurs. Thus, compliance is guaranteed through the operation of the code itself.

In light of the aforementioned challenges and advantages, government institutions ought to seriously consider the employment of the Blockchain. As stated before, one of the Blockchain’s main advantages is that it is an infrastructural tool. The fact that it offers public and private operational features also makes it relatively malleable. We can imagine a scenario in which a newly created firm approaches a government institution and applies for a licence to trade on its sovereign Blockchain, much like in the same way that a firm has to register its company status. Once the KYB (Know Your Business ) process is done, the firm begins to transact and the validation of these transactions can be done by registered governmental bodies or private enterprises that offer this service and which have a license to perform this function. This idea is not a far stretch from the existing practices, and Blockchain-based initiatives like this are already being deployed.

Consider the case of Ripple. In the Ripple protocol , the validation is done by a process called consensus, rather than proof of work. Consensus is different from proof of work in the sense it that depends on a system of voting. Every transaction is verified by the authorized transaction validators and the registered Ripple validators include reputed institutions such as Microsoft and MIT. When a supermajority (>70%) is reached by these validators, the transaction is deemed sound, verified, and added to the Ripple Blockchain. The advantage of this process is lower verification time and higher verification of transactions per second (TPS). It is for this reason that the Ripple protocol has been adopted by the Earthport payments network, which processes 150 million transactions per day.

Hence, from a technical standpoint, the solutions are present and worthy of exploration. What is required is the engagement of governments in order to achieve scalability and mass adoption. Institutional engagement will also spur innovation and also allow for the creation of Blockchains that are suited for specific operations. Using concepts such as a Sidechains and the InterLedger Protocol (ILP ) , usage-specific Blockchains can then be linked to the sovereign Blockchain, providing regulators with the necessary oversight.

But the efficient working of such a control system requires the deployment of the Blockchain at an institutional level. As things stand, most governments are focused on the risks of introducing this new technology into the financial sector and considering what steps need to be taken to limit or control it. In light of the potential of the Blockchain to foster prosperity, inclusion, and stability, perhaps the greatest risk is that conflicting government inertia could prevent it from fully reaching its potential.

Thankfully, there are some exceptions and some governmental bodies are seriously beginning to consider these ideas. In a recent speech given at the Bank of England, the Deputy Governor of the Bank of England stated her interest in using the Blockchain (or distributed ledger) to create “a [new] blueprint for the Bank’s settlement infrastructure.” If such a plan were to materialize, then it would mean that the events on the Blockchain could be supervised by the legal and regulatory systems under which banks and financial firms operate. This would in turn require that relevant legal and regulatory structures recognize the Blockchain as an authentic record of value exchange. It would also mean that sovereign currency would need to be tokenized so that their exchange on a Blockchain has legal status. The tokenization of sovereign currency will be addressed in the section dedicated to policy at a later part of this chapter.

The good news for governments is that the blooming of the Internet has already provided them with a historical frame of reference to tether their introspection. The Internet was able to grow thanks to the collaborative efforts of government, academia, and the private sector. Just as open standards like TCP/IP and HTTP led to the advent of the connected age, standards like Ripple are supporting market competition and liquefying the Internet of value. What is thus needed by governments is the definition of global standards, so that inventions like Ripple can work hand in hand with societal stakeholders to strengthen the fundamental principles and guide policy-making efforts. At an international scale, what is required is an ICANN-esque equivalent for the Blockchain.

Trade Finance

Trade is the oldest form of value exchange that human societies have engaged in. Today, the movement of goods across borders is carried out through supply chain management and trade finance. Supply chain deals with the processes that document the flow of goods from producer to consumer. It encompasses a wide range of procedures and structures that govern manufacturing, inventory management, and quality control. This involves a number of intermediaries and the transactions between them have to be documented to ensure the integrity of the trade process. The key word to remember is documentation. Today’s trade transaction and associated processes involves the transfers of records such as purchase orders, invoices, bills of lading, customs documentation, certificates of authenticity, etc. Most of these transfers are recorded on paper and unstructured electronic databases.

The other side of trade involves the financial institutions . While trade represents billions of dollars in revenue, it also entails significant risks related to time delays, condition of goods, Forex, political instabilities, and, of course, liquidity and cash flow limitations. Banks aid trade by providing companies with capital for production and manufacturing, aiding with regulation compliance/ prevention of fraud, and guaranteeing the creditworthiness of businesses that do not have well-known working relationships (KYC/AML regulation compliance across borders). Banks also provide services such as factoring, wherein a bank pays the seller of goods before the buyer of those goods makes the payment. In doing so, the bank takes on the risk of buyer payment delays or default, but charges the supplier a rate of 4% to 8 % for this service, eating into the supplier’s margins in the process. Banks thus play a central role in enabling these cross-border trade flows through payment execution, risk mitigation, and financing. In light of these services, banks have functioned as intermediaries that offset risk by acting as catalysts of cross-border trading. This has given rise to trade finance, which is a major source of revenue to banks. Trade finance is safe bet, as it provides a source of revenue that is independent of interest rates, provides cross-border payment fees, and has a low rate of default (up to 10 times lower than for traditional corporate lending (Accenture, 2016)).

Together, supply chain management and trade finance provide market players with capital to produce and sell products and services within territories and across borders. However, in recent times, supply chain management and trade finance have come under increased scrutiny, which has resulted in processing delays and additional risks. Institutions are unsatisfied with the current trade finance instruments, as they involve relatively high fees, involve complex procedures, and entail large time delays owing to their dependence on paper documentation. Furthermore, there are interoperability issues between banks and clients : banks require a complete view of a company’s transaction flow to provide value services at key points of the value chain. However, as a large number of the processes are still manual in nature, there are a spate of platforms that provide individual solutions but with low interoperability. This lack of interoperability reduces transparency, creates a higher risk of fraud and higher fees, and does not allow for the development of network effects that can transform the industry.

In order to respond to these limitations , an increasing number of institutions have opted for the use of open account transactions, where the exporter supplies the goods and the importer pays for them on reception or based on pre-agreed payment conditions. In recent times, open trade accounting has become increasingly popular and currently makes up 90% of global trade (Euro Banking Association, 2016). In doing so, institutions are moving away from the banks’ intermediated products, even though this comes at the price of reduced financing options. Institutions are responding to this loss by digitizing and improving the efficiency of the supply chain process, in terms of transaction services, risk mitigation, data transfer and matching, reporting, forecasting, Forex, liquidity, and cash management. As the shift from letters of credit to open account transaction continues, this digitization has led to the creation of new trade instruments (such as the Bank Payment Obligation⁴), digital trade documents (such as essDOCS ⁵ /Bolero) and new ERP’s (SWIFT MT798⁶).

In spite of these changes, the complexity of regulation from border to border has meant that the interoperability problem still remains an issue and large-scale network effects remain elusive. Banks have adapted by providing online portals which allows their clients to replace paper documentation flows with digital data flows and provide added value services such as invoice matching, forecasting, and balance sheet and cash flow analysis. But even these changes have been insufficient in addressing the problem.

The existence of this prevailing setback has resulted in new entrants trying to find solutions, which in turn has increased competition. As the competition between banks continues to ascend, new logistics companies, alternative supply networks, and niche trade finance companies that focus on commodity trade finance or which exclusively focus on SME’s have begun to fragment the market in recent years. (For example, Alibaba has entered partnerships with two UK startups to provide financing to small British businesses looking to buy from Chinese suppliers (Accenture, 2016).) As Basel III regulations have limited the supply of credit from large banks, these new entrants are capitalizing on these regulatory changes to offer better services for a plethora of trade finance clients.

But these new players have their work cut out for them. While all the services they provide can be grouped under the umbrellas of financing and risk mitigation, the fact that regulations can vary from geography to geography (and the lack of interoperability) means that there is always a dependence on intermediaries and repetition of processes. As stated by Lamar Wilson, CEO of Fluent, a Blockchain network for financial institutions and global enterprises,

“Currently, bank-run trade finance programs require a tremendous amount of resource-intensive due diligence, document collection, and processing, including coordination of remittance information. Financing rates are high for the businesses despite the low and shrinking margins for the financing provider. This is especially true at smaller banks who lack this infrastructure and must outsource these services for their larger clients," (Harris, 2016).

The final limitation of the current state of affairs of the trade finance sector is its lack of inclusiveness. While new players are entering the market and providing services to SME’s, this trend cannot be generalized globally. It is important to take this into consideration as SME’s provide employment to large swaths of populations in less developed countries. Across the OECD area, SMEs account for approximately 99% of all enterprises, and 2/3 of employment (OECD, 2010). In Western Europe, Japan, and USA, SMEs account for 55%–80% of total employment, while in Pakistan and Kenya, SMEs contribute to 80% and 60% of total employed population, respectively (Katua, 2014). Yet owing to a shortage of working capital to finance exports, limited information on markets, lack of standardized interoperable systems, inability to contact potential oversees customers, and inability to obtain reliable foreign representation, SMEs in these parts of the world are unable to participate in the global trading arena. The net result is that there is a US $1.4 trillion unmet global demand for trade finance⁷ (Asia Development Bank, 2015) (WTO, 2016).

In light of these limitations, regulators and policy makers need to look for technical solutions to overcome these shortcomings. Evidently, the objective should be to create a more interoperable system with specific standards to ensure trust and augment inclusiveness. It is here that the use of the Blockchain would make most sense. With the majority of trading occurring on an open account basis, the Blockchain can be used to gain real-time transparency of trade transaction documentation, including invoices, payments, change of ownership, customs documents, and bank-related data. This would not only streamline the trade process but also allow for better data matching, better dispute reconciliation, and better credit risk management. The transparency of the Blockchain would also allow for better audit trails, which in turn would help in credit risk assessment and fraud prevention, thus creating a more level playing field for all exporters and importers.

The automation provided by smart contracts will also help in reducing the number of intermediaries in the trade process. As transactions and documents get exchanged on the Blockchain, the transfer of ownership can be used as a trigger to execute the next leg of the trade process. As one party initiates a payment, the smart contract can be used to change the ownership of the goods to the other counterparty. The ability to link smart contracts to black/sanction lists and embargos will ensure that trade occurs within the norms of regulation and policy. As the shipping industry turns a technological corner and adds tracking chips to containers, the Blockchain will allow another level of IoT integration in the trade finance process. As smart contracts allow for immediate triggering effects, funds can be released sooner, thus enabling more granular payments. For example, if a smart contract between an exporter and an importer stipulates that, say, 15% of the funds are to be released to the exporter once goods have been cleared by customs, it would reduce the risk spread of the transaction, provide the exporter with some access to funds (which means more working capital), increase liquidity within the supply chain, and counteract duplicate invoicing, leading to the creation of a better level of trust within the market. Finally, if Blockchain and Smart Contract were to be used at a market level, it would allow for an upgrade of the existing IT systems and address the interoperability issues that currently challenge this market.

Just as digitization is changing the trade finance space, the Blockchain offers regulators a means by which they can construct a new framework of trade finance to improve efficiency, reduce the use of paper documentation, increase interoperability, automate processes, stimulate competition, and include a greater part of the global economy. Some critics might say that the scalability and the current scope of the Blockchain is ill-suited to this task. This is true to a certain extent, but as we have seen, progress is being made in many diverse ways (see Notes: “Scalability”). A more important question that these critics need to ask is if they ought to be content with the current provisions offered by the SWIFT system following recent events. In February 2016, hackers exploited weaknesses in local security systems, compromised networks, and sent fraudulent messages requesting money transfers on the SWIFT network . The hackers tried to pull off 35 bank transfers and, while a majority of these transfers were blocked, the hackers were still successful in transferring $81 million USD. Network members were asked to upgrade their security systems, and the worst was considered to have passed as the investigation commenced. However, at the end of August 2016, a letter was issued by the SWIFT network informing clients that new cyber-theft attempts—some of them successful—have been surfacing since June.

“Customers’ environments have been compromised and subsequent attempts (were) made to send fraudulent payment instructions,” according to a copy of the letter reviewed by Reuters.... “The threat is persistent, adaptive, and sophisticated—and it is here to stay.” (Finkle, 2016)

As it has been repeatedly mentioned, the immutability and protection that is offered by the Blockchain is the most promising alternative in terms of addressing security concerns of this ilk. A Blockchain-based trade finance system would reduce the number of intermediaries and still perform the same functions, but in a safer and more transparent manner. Figure 3-1 provides a summarized graphical representation of what this would look like.

Figure 3-1. Blockchain -based trade finance product and revenue model

But as was mentioned in the lending and payments market section, for such a system to work would require the deployment of the Blockchain at an institutional level. More than a technical challenge, the real obstacle is once again regulation. As long as trade finance institutions are unsure of how regulators view the use of the Blockchain, they are unlikely to make it the interoperable backbone of their processes. What is required by regulators is the provision of concrete rules and standards that will help reduce the risk of regulatory violation and thus scale the use of this technology with all its benefits. This is not to say that the technology is ready for deployment. There are a number of hurdles that have been cited in this book. But regulators need to acknowledge that there is proof in the pudding and determine how to act.

Thankfully regulators do not lack of a reference of how this can be achieved. Just as the evolution of the Internet provides a historical frame of reference, the ongoing development of the R3 consortium’s prototype platform, Corda (see Sidebar 3-2), can provide regulators with a current operational model of how the new market structure can look.

Capitalistic markets are a source of value creation, the means of prosperity dispersion, and thus the lifeblood of human societies. But the current impact of technology and the form that it is taking requires that we update our understanding of markets. Till today, markets have been defined as a medium where the exchange of goods and services takes place as a result of buyers and sellers being in contact with one another, either directly or through mediating agents or institutions. But as decentralization becomes a salient feature of today’s markets, we will need to ascertain what this means to our conceptualization of markets and what regulations are required to make this new market framework more inclusive in nature.

Regulating Regulation

The period after the crisis has been rife with regulation as bank and market-focused rules have been/are in the process of being implemented, notably in the US and in the EU, e.g., Dodd-Frank Act (2010), Volker Rule (2013), Third Basel Accord (2013), EU Commission’s Liikanen proposals (2012), European Market Infrastructure Regulation (EMIR) (2012), etc.… These regulations target liquidity and collateral requirements, money market funds, taxation, derivatives, and consumer protection rights, among others. As the scope of regulation is large, we will focus on the concept and role of regulation in the context of market players rather than entering the intricacies of specific regulations on different sectors.

Markets are often cited to be the whipping boys of regulation. Time and time again, terms such as “stifling regulation” or “excessive regulation” are cited by the media as impediments to innovation and economic growth, and regulators are portrayed to be “asleep at the wheel” or detached or aloof from the markets that are in their supervisory charge. Unfortunately, there is some truth to these statements, and this is partly due to the time lag between technological evolution and regulatory reform. Owing to this time lag, businesses are burdened to deal with time-consuming red tape; costly, outdated stipulations; and cartel-like turf wars. But in a number of ways, this view is a simplified misinterpretation and harshly diminishes the true function and importance of regulation.

Regulation exists to protect the rights and safety of citizens in a market economy by ensuring the fair delivery and exchange of goods and services. Rather than overwhelming businesses, the true function of regulation is to underpin the proper functioning of economies by acting as a balance between capital creation and investor protection. In performing this balancing act, the key objective for regulators is to increase the effectiveness of the financial system to absorb shocks and maintain financial stability.

But in the shadow of the global financial crisis, the effectiveness of regulatory frameworks has come into question. Repeatedly, we find ourselves asking the question that, in spite of all these regulations, how did we not see the crisis coming? While previous parts of this book provide some clues to this why this occurred, a large part of the problem lies in asymmetric information. As markets, investors, and regulators were exposed to different amounts of information, the lack of knowledge, and hence oversight, led to blissful pre-crisis ignorance. Thus, if we are to regulate sensibly, we need to go to the crux of the subject and focus on the data, rather than the legalese. It is only by being fully informed that we can ascertain risk, identify opportunity, and enact appropriate rules that are upstanding to the purpose of regulation. It does not work the other way around.

Accounting Jiggery Pokery

Recent times have been peppered with a number of financial scandals caused by “cooking the books” and inefficient business control systems. A prime example of this was the 2001 Enron scandal, where company executives and managers, in a blatant display of rule-flouting, used accounting loopholes, special purpose entities, and false financial reporting to hide billions of dollars of debt incurred by botched deals and projects. The Enron scandal had two primary outcomes. First, it led to the passing of the Sarbanes Oxley Act (refer to Notes at the end of this chapter). Second, it showed us the difference between the reliability and the relevance of financial data.

Financial data is important to investors, as it allows them to make decisions. It is based on this data (relevance) that investors can decide as to the future growth of a company and whether it will be a good investment or not. But just because data is relevant, it does not mean it is reliable. As seen in the Enron scandal, investors were provided with relevant false information or bloated figures, which encouraged them to continue investing. But in the meantime the reliable data (i.e., precise information that is free of bias and manager manipulation) was kept in the hands of the executives and obscured from view.

The dichotomy between the reliable and relevant reported data stems from the conflicting interests of businesses and investors. The source of the contradiction is not double-entry bookkeeping, but rather it is due to bias. Information producers, in this case managers and executives, are constantly faced with a conundrum: do they provide the most objective and true version of the information regarding their business (income and cash flow generation capability, assets and liabilities, etc.), or should they only provide the most relevant information that investors would normally seek? If they were to provide all the information, could it lead to a hampering or destructive effect? Would it not be a better idea to distort the economic reality of the firm to a certain extent in order to accomplish short/medium-term benefits for a group of large shareholders and thus protect the firm in the long term?

Information bias and cooking the books is not a recent phenomenon and the Enron scandal is just one example of this practice. The 2014 investigative documentary, The Price We Pay, by Harold Crooks, shows how companies like Apple, Google, and Amazon (among many others) shift profits to offshore tax residencies and tax havens, such as the Cayman Islands, beyond the reach of regulators and tax authorities. By undertaking such practices, managers are able to provide an alternative picture of their company’s obligations and liabilities, leading to substantial medium-term cash flow competitive advantage (Cilloni and Marinoni, 2015).

In the past, and till today, one means of controlling this behavior has been the use of private auditing firms. Private auditing firms are employed to make judgements on the potential information asymmetries that exist between the company executives and the stakeholders. By using an external auditor, the goal is to expose such information gaps. But this method of supervision is questionable, as private auditing firms, just as private companies, can also be inclined to provide partial information for their best interests. Today, we are familiar with the auditing firm oligopoly which goes under the moniker of the “Big Four”⁸. But prior to the Enron scandal, the sector was made up of the Big Five, the fifth member was Arthur Andersen who, in 2002, surrendered their Certified Public Accountant licenses after being found guilty of criminal charges relating to their handling of the auditing of Enron.

Private or self-regulation will always be subject to biases for two reasons. First, auditors for a company are selected by the company itself. As a result, when selecting an audit firm, managers will prefer selecting one that is inclined with their business interests. Second, while in principle companies are supposed to rotate their selection of auditing firms, the fact that the sector is dominated by an oligopoly of four private firms means that the people carrying out the auditing activities do not change, to a large degree. This reinforces the practice of bias, as the participants in these circles have tight bonds and in-group obligations and preferences. In short, it compromises objectivity, as there are mutually beneficial alignments of interests.

In light of these limitations , following the crisis, legislators have attempted to address the manipulation of financial information and ineffective business controls, by increasing the number of laws and corresponding organizations. But as stated in the beginning of this section, these attempts are not always conducive to innovation or business growth.

What is required today is a change in the perception of regulation. Rather than being seen as a balancing act between investor protection and capital generation, regulation needs to use investor protection as the foundation upon which capital generation is built. Regulation needs to be perceived as a public obligation and not simply as a private responsibility. For this to occur, we would require the existence of a public body that is focused on the objective analysis of companies in order to reduce the effects of bias seen in mutually beneficial oligopolistic structures. Regulation, in essence, needs to move from being a private business function to a social entity. Such a system would be more respectful of the citizens’ interest and be focused on long-term economic health and stability, rather than short-term profit maximization.

In order for such a public function to exist, regulators have to be equipped with a control mechanism that is governed by a suitable public authority. This public authority should consist of a Securities Exchange Commission-type board with the power to implement a system of independent auditing via the appointment of auditors in order to reduce bias. Unbiased trust has to be the center of regulation, as it is only by providing investors with the confidence they need to invest that regulation can allow for capital formation to flourish. Such a framework will have transparency and public interest as the tenets and allow for a tiered system of compliance rather than overarching sectorial rules.

The Blockchain can be used as a tool to construct such a framework, as its transparency provides a way to address the information asymmetries that have been described above. We can imagine a sovereign/institutional-level Blockchain that is capable of interoperability with other Blockchains that are used by private firms. (Such a composite Blockchain framework would be an amalgamation of the salient features of Corda and the InterLedger Protocol .) If companies were obliged to transact over such a framework, then a permanent record of their transactional activities would be visible to regulators in real time. As privacy will always be paramount, the ideas proposed by the Corda platform of secluding visibility of transactions to those who need to see it would be a concept to be indoctrinated in creating such a framework. This in turn would provide a rebuttal to the reliance-relevant debate, as in such a framework, the reporting and manner of analyzing the activities of firms is no longer cloaked by the judgment of firm interests.

However, this is only part of the solution for reforming regulatory practices. The second issue with regulation is the asymmetry between legal code and technical code in digital markets and increasingly cashless societies. As noted by Lawrence Lessig, of Harvard University, in a digital environment both laws (legal code) and computer code (technical code) need to be used to regulate activities (UK Government Chief Scientific Adviser, 2016). Thus along with the information gaps that we are currently faced with, a new public regulatory framework has to be able to inculcate this feature as well. Not only will this make the framework more suited to our digitized markets, but it will also reduce the effort that is required by regulators to determine if firms are respecting the rules.

This aspect of regulation in a digital environment was admirably and succinctly analyzed in Chapter 3 of the UK Government report, “Distributed ledger technology: beyond block chain” (2016), where it states,

“One fundamental difference between legal code and technical code is the mechanism by which each influences activity. Legal code is “extrinsic”: the rules can be broken, but consequences flow from that breach to ensure compliance. Technical code, in contrast, is “intrinsic”: if its rules are broken then an error is returned and no activity occurs, so compliance is ensured through the operation of the code itself. Another characteristic of software is that a machine will rigidly follow the rules even where that compliance produces unforeseen or undesirable outcomes. This leads to some striking differences in the operation of distributed ledger systems compared with the current financial system.”

What the report helps us see is that the elements for the construction of a new Blockchain-based regulatory framework (BRF) are starting to get in place. Financial markets are already administered by a combination of technical and legal code. However, the regulations such as those cited at the very beginning of this section (Dodd Frank, Liikanen proposals, EMIR, etc.), are largely legal in nature and regulatory compliance is tracked via legal code. As market players must provide the information to the regulator, it is inherently subject to the biases mentioned before. But with a BRF, this problem is overcome, as enterprises would need be operating on a Blockchain that is under the purview of regulators. Smart contracts or compliance software can then be provided to participants to issue transactions. As the code will not execute if a condition has been breached, this would reduce the need for external auditors. The role of these actors in such a system will inevitably change. They could go from being verifiers of transactions to verifiers of code, ensuring that the BRF is in tune with the dynamic changes of the market. This is a role that is of primary importance, as today’s regulatory framework is not capable of respecting the heterogeneity of the market.

While current regulations have made markets safer, there are two pitfalls which need to be taken in view first. Regulations can be constructed to protect incumbents and erect barriers of entry to newcomers. This stifles innovation and does not allow for the evolution of an industry. Second, in an attempt to counterbalance the first pitfall, regulators might go too far and issue policies that do not capture the risks of new technologies and new firms adequately. This brings us back to the problem of not safeguarding consumer interests, as seen in the lending and payments industry.

The BRF, and the smart contracts that it creates, thus has to have a multilevel approach. Rather than passing overarching rules for an entire sector, the BRF should aim to construct multiple standards for companies on a risk-oriented basis, where equals are treated as equals, and where the issue of concern should take priority over the size of the firm. For example, data privacy is not a concern for large firms alone. Hence all-encompassing rules related to data privacy can be established as a norm, such as the current European approach of defining harmonized EU-wide standards to combat data privacy breaches.

On the other hand young tech-led firms , such as FinTech companies that are still in their infancy, have small side effects and pose less systemic risk. Hence, regulators need to create their smart contracts with this in mind and define appropriately structured responses. The key is to be technology-agnostic when looking at innovation and concentrate on risk. The transaction data from the company can be used to determine the risk profile of the company and, based on this and a selection of sector-specific rules (such as leverage employed), a company would need to respect specific regulations.

A consequence of this kind of a regulatory framework would be that the role of existing auditing firms would change and they would function more as a consultancy than an audit firm. But for a large part this that is already the case, as all Big Four audit firms have well-established consultancy services. From a strategy perspective, it’s more a question of adaptability than it is of transformation. This could be good news for the Big Four for, as we know, adaptability is closely allied with further earning power.

Regulators are not incognizant of these possibilities, and an increasing number of them are seriously beginning to look at the Blockchain as a solution to the current problems. Sidebar 3-3 provides a summarized list of a few comments made by J. Christopher Giancarlo, the present Commissioner of the U.S. Commodity Futures Trading Commission (CFTC) at the recent Consensus conference (May 2016) and offers regulators some Blockchain food for thought:

The comments in the box above thus help us see to what extent a regulatory structure like the BRF would reduce information asymmetries and help in centering the direction of regulation towards investor protection. Such a system would have a number of advantages including:

• lower compliance cost, which can help funnel more funds for R&D and innovative projects at firms;

• greater transparency, which is a boon for investors and regulators;

• reducing the bias of firm managers and executives, making them more accountable. This would create a safer business environment and could aid in reducing systemic risk;

• faster identification of systemic risk and deployment of countermeasures by regulators;

• tailored regulation that is based on the risk-profile of a firm rather than the overarching sectorial rule compliance obligations. This can be beneficial for newcomers and startups, allowing them to experiment and scale faster;

• standardization of data. The ability of regulators and auditors to analyze and compare data between firms and the assets they own is a challenge today, as the information is not standardized. Moving to the BRF and establishing stipulated data standards will be able to combat this discrepancy;

• less work for regulators. Using a combination of technical code and legal code, regulators would be able to govern with less manpower and in a more robust manner;

• better oversight of tax revenues;

• finally, (and, once again, because it’s worth mentioning it twice), better citizen protection.

The effective working of the BRF would require the need for a sovereign Blockchain that is capable of interoperability and which needs to be deployed across different geographies if this is going to become a worldwide mechanism. This is a point that has been repeated at different points in this chapter. Hence, as we move from markets and regulation to the topic of policy, we will concentrate on the subject of sovereign blockchains and inquire what the benefits of such a system could be for society in general.

Policies for a cashless future

A review of markets and regulations in today’s economic landscape has shown us how changes are occurring and what challenges authorities are currently faced with. We have also seen that the Blockchain offers solution pathways that would be beneficial to investigate, and are being considered by certain authorities. But if markets and regulations are the pillars of an economy, policy is the base on which it is built. Governments pursue monetary and fiscal policy objectives to adapt to the changing market conditions and use the lever of regulations in order to ensure the proper functioning of their economies and hence improve the everyday lives of businesses and citizens.

As we have seen in Chapter 1, monetary and fiscal policy has often excluded the role of financial markets. Markets were seen as a porous shroud whose function was to ensure the discovery of prices and the right allocation of resources. By “outsourcing” this function to markets, policy makers could focus on the bigger task of maintaining economic growth by controlling interest rates and inflation. This in turn would ensure steady nominal demand growth for current goods and services, which in turn would ensure apt employment levels and a balanced level of inequality, and maintain societal prosperity.

But this operating thesis has been challenged since the crisis as excessive leverage, and the trade of financial assets which hold no intrinsic value have proliferated the market and changed its very structure in the process. Being more concerned with inflation and interest rates has caused central banks to ignore the creation and allocation of private credit, leading to rapid credit growth and excessive leverage. Today’s economies are faced with excessive debt levels that are projected to grow and exceed the productivity (GDP) of nations forever. Coupled with technological advances, increased globalization, and dropping productivity levels, the spread of inequality is on the rise.

A primary reason for this phenomenon has been the way that debt has come to be regarded in modern economies. Debt and credit by themselves are important levers of prosperity generation. By allowing individuals to borrow against future projected revenue growth, debt instruments allow households and businesses to achieve immediate levels of prosperity, hedge against fluctuations of income, and leverage new opportunities to ensure a safer and more prosperous future. But what has been seen in the past three decades is that the instruments of debt have now become commodities in and of themselves. Rather than directing credit to investments with productive ends and which have the greatest potential to push forward economic growth, credit instruments have been transformed into derivative assets that are exchanged based on speculative inferences.

This transformation of credit has reduced its social value. While derivatives are said to enhance better price discovery, better risk transfer, and economic efficiency (refer to the quotes of Alan Greenspan in earlier chapters), it has also led to large-scale betting. Price discovery is, of course, a useful function. But what is the social gain of exchanging these derivative products on a nanosecond-to-nanosecond level? What is the social-economic benefit from indulging in trading activities that exploit interest rate differences and future value expectations of these derivatives? If anything, this practice has led to the false allocation of resources⁹ (especially talent) and created a system where commercial banks can indulge in short-term profit maximization and increase the financialization of markets. As stated by Keynes in Treatise in Money,

“[There are] two types of transactions: First, those that involve the purchase of current goods and services whose value will be a fairly stable function of the money—value of current output (GDP). Second, those that involve speculative transactions in capital good or commodities…these are pure financial transactions and they bear(s) no definite relation to the rate of current production… the price level of the capital goods thus exchanged may vary quite differently from that of consumption goods.”

Financialization has transformed credit from being a means of achieving future prosperity, to a commodity that can be exchanged for value. At the base of this transformation is a conflict of categorization. While debt has come to be regarded as an asset, it is characteristically different from an actual good or service. Money and credit are in a different product category altogether, as their creation results in purchasing power, which in turn has macroeconomic consequences. This is not the same with creating a new product or services based on technological advances. A new product or a service affects productivity curves and creates economies of scale which reduce prices. Thus, any gains in purchasing power are a consequence and not the cause of their creation. Money and credit, on the other hand, offer immediate purchasing power improvements just by being created. It is for this reason that applying the free market principles that govern the creation of goods and services to credit and money supply is an excruciatingly delicate exercise.

Hence, we need to question the very mechanism by which money and credit is created and ask ourselves who needs to be at the helm of its production? Today, in any economy, money can be created in two ways: either the government takes on the role of creating fiat cash or we depend on the fractional banking system in which money is created through private credit issuance. But, as seen in the previous chapters,, leaving the creation of money (based on debt) to commercial banks has led to significant social problems, such as increased financialization, banks getting TBTF, and excessive debt levels at the sovereign level. In light of technological unemployment and the fact that private debt ultimately becomes pubic debt and creates debt overhang effects, what needs to be considered is the role of the state in money creation and if it is a better idea to only let the state control the production of money. If this seems too centralized and dictatorial, then the second option is to think about the creation of multiple forms of money that are created by different actors and all of which are recognized and accepted by citizens within a sovereign nation.

Both these money creation methods are not new concepts and have been explored and utilized in the past. The difference this time, however, is the cashless form of today’s money and the repercussions an entirely digital money or monies may have. Both these options will have significant impacts on the functioning of central banks and monetary and fiscal policy. Nevertheless, there are advantages and by adopting the right option, policy makers might actually be able to address the issue of debt-based growth in their economies. Let us thus explore both these options in order to determine which is the best way forward. We begin by looking at the concept of government control over money issuance. In this regard, it would be advantageous to familiarize ourselves/refresh our knowledge about the Chicago Plan. Sidebar 3-4 offers a summarized note:

Centralized Government Money Issuance and the Cashless Economy

When was the last time you remember seeing an advertisement that was exclusively marketing money? It would seem strange, would it not, that while almost everything today is advertised and marketed using customer segmentation behavioral analysis, the underlying unit of transfer is never advertised to help you get more luxury, feel better, look great, secure your children’s future, etc....

While the idea of marketing money might seem absurd, it represents our innate sense of belief in it. Money is as much a part of our lives as is eating food to sustain living. We grow up learning how to earn it, use it, and save it. This makes money a social necessity whose value is of social importance and the reason why its production has to be entrusted in the most responsible hands. This function today is supposed to be that of the state. But with fractional banking, this exclusive privilege has been handed over to commercial banks, which is why they command such power in our societies.

Understanding the source of the value of money is key to understanding its role. In the past, the value of money was based on its link to a certain commodity (mostly gold or silver in human history). But money is essentially a state-backed utility, whether it is fiat-based or commodity-based. It could be argued that fiat money derives its value from the state, while commodity money gets its value based on its link to a certain commodity. Nevertheless, in either form, there is an active participation of the state. Purists may argue that the value of commodity money is not as easy to manipulate as fiat money. But in making this statement, they overlook the fact that the commodity is managed, monitored, and manipulated by the state (Desai, 2015). As money becomes increasingly cashless, new purists purport that the Blockchain (and virtual currencies such as bitcoin) will replace the existing monetary system. But irrespective of any view, we remount to the same conclusion: money is a store of value, a unit of account, and a means of transfer which needs the backing of the state to ensure trust and widescale adoption.

In light of the discussion of the Chicago Plan and the fact that economies are now increasingly cashless, central bank-issued digital currency or fiat money issued on a Blockchain is a subject worth discussing in the context of monetary and fiscal policy. In recent times, no one has been more vocal about this subject than Andy Haldane, the chief economist of the Bank of England. Haldane makes a number of arguments as to why we should move to scraping physical cash altogether, and a number of his arguments echo the conclusions of the Chicago Plan.

First, he argues that moving to a cashless system would give governments more flexibility in the event of a financial downturn. Second, Haldane states that a cashless system would allow us to manage inflation better, as it would allow us to bypass the zero lower bound—the working assumption being that if a central bank introduced negative interest rates, then people would convert their savings into cash. But in a cashless system, that would not be possible. In his words,

“Central banks may then need to think imaginatively about how to deal on a more durable basis with the technological constraint imposed by the zero lower bound on interest rates … That may require a rethink, a fairly fundamental one, of a number of current central bank practices… [and] It would allow negative interest rates to be levied on currency easily and speedily.” (Giles, 2015)

While these possibilities seem worthwhile pursuits to central bankers, it would be prudent to check how far away are we from becoming a cashless economy and analyze if embarking on such a change is a worthwhile endeavor.

In terms of becoming a cashless economy, the situation is complex. It is true that, since the introduction of credit and debit cards, our use of cash has been in decline. The Bank of International Settlements states that the while the amount of outstanding cash in circulation in the largest 19 economies was 8.4% of GDP in 2010, it fell to 7.9% of GDP in 2014 (Tett, 2016). However, this decline has not been even across all economies. Owing to mistrust in banks, financial crises, threats of negative interest rates, and illegal operations (especially terrorism), the circulation of cash has actually increased in Japan, Switzerland, the EU, and the UK (Tett, 2016). But the future seems poised to change some parts of this trend. Growing dangers of terrorism and crime are urging policy makers to remove large denomination bills. As of May 2016, the ECB has stopped the production and issuance of the €500 banknote in an attempt to address these illegal activities.

But apart from the reasons stated by Haldane and the motivations of the ECB, there are other reasons why moving to a cashless system could be beneficial to society. First, there is the issue of cost. As per a recent report by the Imperial College and CITI, $13 trillion—almost 18% of global GDP—is withdrawn from ATMs annually. These and other such cash operations entail significant costs. The authors of the report state that moving to a cashless system could provide “up to $400 billion in annual savings, as well as powerful social benefits, by moving even a quarter of paper-based transactions to digital” (Davé, 2016).

Second, there is the issue of tax evasion . Cash allows us to make transactions anonymously and conceal our activities from the government. Bribes or payments made to illegal workers in cash, allow perpetrators to create an underground economy, avoid laws, regulations, and taxes, while continuing other forms of criminal activities. Research done by Harvard economist Kennett Rogoff, provides evidence that a large percentage of currency in most countries, generally well over 50%, is used precisely to hide transactions (Rogoff, 1998, 2002). This is a big difference from most forms of digital cash that, in principle, can be traced.

If we are to talk about tax evasion, then we also need to relook at the role of physical cash in crime and felony. Cash is used in two environments today: the legal domestic economy and the underground economy. Recent studies from central banks show that the amount of cash consumers admit to holding accounts 5–10% of the total currency in existence (Stavins & Schuh, 2015). A 2014 study done across seven countries (Canada, Australia, Austria, France, Germany, the Netherlands, and the United States) by the Federal Reserve of Boston showed that cash is by the most common means of payment vehicle for small size/low-value transactions ($5, $10), but for larger payments it is increasingly insignificant.

However, the same cannot be said for the underground economy. The underground economy includes not only illegal activities such as terrorism, drug trade, bribery, human trafficking, and money laundering, but also tax evasion via cash payments and employment of illegal immigrants. Some crimes are more serious than others, but irrespective of the type of crime being committed, it is the size of the underground economy and especially the impact of tax evasion that are truly noteworthy.

Studies done by the US Internal Revenue Service (IRS ) , show that business owners and corporations report less than their income to evade taxes. As of 2015, one study found that this led to a tax gap (difference between taxes paid and taxes due) of $500 billion in federal taxes in 2015 alone (Rogoff, 2016). A part of this sum is related to the cash that is stored in tax havens (refer to Harold Crooks), but this amounts to around 20% of the total sum (Zucman, 2015). Over 50% of the outstanding amount is related to cash-intensive activities (Rogoff, 2016). In other countries, a similar occurrence is seen. Although the figures may not be the same, the fact that EU countries have stricter tax laws means that the percentage value in comparison to GDP is much more significant. Figure 3-2 helps us see the gravity of the situation.

Figure 3-2. Underground Economy (not including all criminal activities) in terms of % of GDP Source: IZA World of Labor, Data and Calculations—“The shadow economy” F. Schneider (2013)

More serious crimes, like terrorism, bribery/corruption, and drug and human trafficking are very serious crimes that are mostly cash-based and involve large amounts of money laundering. But in comparison to tax evasion, that sum is relatively small.

In light of these practices, the obvious question is, why are central banks still printing cash even though they are aware of the benefits it provides to malicious and ill-intentioned members of society? The answer in a word is Seigniorage.

Seigniorage is the difference between the value of money and the cost to produce it. When commodity money was used, Seigniorage was the difference between the face value of the minted coins and the actual market value of the metal they contained. If the Seigniorage was positive, then the government made a revenue that was essentially a profit. However, with fiat money, the same formula does not apply. With a fiat money system, Seigniorage revenue is three-fold. First, revenue is obtained from the physical production of money. While it costs 10.6 cents to print a $50 note,¹⁰ the actual value of the note is $50. Between 2006 and 2015, the US government earned 0.40% of GDP per year by printing new notes and spending them, while the ECB earned 0.55% per year (Rogoff, 2016). Second, when commercial banks require cash, they purchase it from the central bank via the reserves that they need to hold at the central bank. This is turn is a source of revenue to the central bank and the Seigniorage is earned from the reduction in the central bank’s interest costs, as interest is payable on reserves but not on cash. Third, commercial banks can also purchase cash by entering a repo agreement with the central bank. In exchange for cash, the central bank buys securities from the commercial bank. But the commercial bank has to buy back the securities at a later date (hence a repo agreement). Seigniorage is thus made by the central bank during the repurchase phase of the repo agreement (Dyson and Hodgson, 2016).

As governments have complete monopoly over the printing of money, they enjoy considerable profits from its production. Remember that a commercial bank can issue money via offering a consumer a loan. But the physical printing of cold hard cash is still the right of the government, and the revenues from paper currency are considerable enough to offer the biggest counterargument to moving to a cashless system. But in light of the costs of the illegal activities that cash facilitates, the profits earned by Seigniorage are a pittance in comparison. As stated by Kenneth Rogoff in The Curse of Cash (2016),

The “profits” governments reap by blindly accommodating demand for cash are dwarfed by the costs of the illegal activity that cash, especially big bills, facilitates. The effect of curtailing paper currency on tax evasion alone would likely cover the lost profits from printing paper currency, even if tax evasion fell by only 10–15%. The effect on illegal activities is probably even more important.

Taking a stand against crime and taxation evasion alone, would seem motivation enough to move to a cashless economy. Critics to a cashless system abound and immediately after Haldane’s remarks to move to a cashless system were announced, other members from the Bank of England (including former members of the Monetary Policy Committee) were quick to criticize him, and some journalists cited that such a move was an “echo of Maoist China” (FT, 2015). It is sure that even if we were to move to a completely cashless economy, it would not be the answer to all our problems. But, nevertheless, there are advantages and possibilites that can be achieved which are not possible today, or can only be possible with increased regulation, oversight, and government cost. To ascertain if moving to a cashless sytem is a move that needs to be contemplated and how cashless do we need to be, let us review what could be the consequances of moving to a monetary system based on government-issued fiat currency on a Blockchain.

Fiat currency on a Blockchain

If central banks were to have complete control of money creation instead of the private sector, they would be in the position of providing individuals and companies with official digital money (as they already offer cash and coins) instead of deposits with commercial banks. There are two ways in which this can occur Either a central banks offers deposit accounts directly to the public or, instead, commercial banks offer accounts fully backed by central bank reserves (which is similar to the 100% reserve banking model discussed before).

The question becomes why should we indulge in such a transition ? The response is multifold. Evidently, it would allow governments to address the problems of tax evasion and other such crimes that were discussed above to a certain extent. But for the formal economy, the consequences would be more far-reaching. Such a monetary model would destroy the private banks’ debt-based deposit-funded model and change their function in society. They would still function as direct intermediaries between lenders and borrowers and offer investment products to households and corporations, but the broad money supply would now be more directly controlled by the central bank, making it independent of private lending decisions. The greater the quantity of broad money supply, in the form of sovereign digital cash or fiat money on a Blockchain, the greater the ease with which a central bank can use tools such as negative interest rates or helicopter drops (discussed in detail in the section on Universal Basic Income). It is important to highlight these two economic tools. Negative interest rates and helicopter drops are old theories and have been studied and critiqued for a while. But in light of technological unemployment and ageing societies, they might become quite indispensable in the future.

Building such a framework has become a resolutely mainstream subject in the past few months. In July 2016, the Bank of England published a 90-page report titled, “The macroeconomics of central bank issued digital currencies.” The authors, John Barrdear and Michael Kumhof (co-author the Chicago Plan report described in Sidebar 3-4), looked at the creation and consequences of a permissioned monetary system which issues a central bank digital currency. The author’s DGSE-calibrated model is based on the New Keynesian monetary model¹¹ (with nominal and real interest rate and inflation effects), but differs in two ways.

The first point of differentiation is that it incorporates the fractional banking system and acknowledges the existence of debt-based money . The authors argue that this has been done “because of the key role of [commercial] banks as providers of the monetary transaction medium that would compete with central bank digital cash in the real world.” The authors thus state and acknowledge the demand for private sector monetary transactions as their model encompasses the spending and investment traits of households, financial investors, unions, and banks (in tandem with a government that determines monetary and fiscal policies). Private money exists in the model in a 1-1 exchange rate with government money (100% reserve).

The second point of differentiation is that their model disregards government money as being exogenous to the economy. The authors state that their model allows for central bank digital currency to be held by the non-bank private sector (which is not the case today) and unlike regular cash, this digital currency is interest-bearing. As a result, it can compete with endogenously created commercial bank-issued money.

Having created the digital monetary framework based on these assumptions, the next question was the quantity of digital currency to be issued. Their model showed that if we were to manufacture and inject a sovereign digital currency equal to 30% of the GDP, it would result in a 3% increase in GDP, owing to reductions in interest rates, tax rates, and transaction cost savings (they chose 30%, as it was similar in magnitude to the QE conducted by central banks over the last decade. Their DSGE model was calibrated to match the US economy in the pre-crisis period).

Furthermore, the authors found that such a regime would offer policy makers with a new tool to stabilize the business cycle. As the quantity and/or price of the digital currency could be tempered by the government, it would allow them to leverage this flexibility in a countercyclical manner to the changing business cycle. While the supply of money today is dependent on private lending decisions, having a policy instrument that controls the price and quantity of cash becomes especially effective in times of economic shock when private money demand fluctuates. In this way, a sovereign digital currency offers better financial stability. Through further experimentation (the report is very detailed) the authors were able to identify a number of consequences that would arise with the introduction of a sovereign digital currency :

1. Government bonds purchased with digital currency could reduce interest rates: When a central bank exchanges money for government debt/bonds, it receives interest payments. However, if these interest payments are greater than the interest expenses (which it is on average), then it makes a profit.¹² As profits made from the central bank are remitted back to the government, it makes the government’s stock of debt more sustainable, which in turn lowers the government’s interest rate burden.

   With the introduction of a “central bank digital currency” (CBDC) , the authors state that retail transaction balances will gradually switch from bank deposits to CBDC. As a result, a large portion of bank financing will be dependent on market prices. As the interest rate on government debt is the ground on which we structure the entire economy’s interest rate structure, as the interest rate on bonds goes down, it would reduce the spread between bond interest rates and bank deposit interest rates. The overall result is lowered borrowing costs and declining real interest rates.

2. Lower interest rates provide fiscal benefits: The authors find that as a consequence of reducing interest rate expenses, the establishment of a CBDC framework would also allow for increased fiscal income and state that the output gains would be almost as large as the lowered interest rates. This increase of fiscal income would allow governments to either spend more or lower tax rates.

3. New control levers: As mentioned before, a CBDC also allows for the government to develop a policy instrument that can be used to temper the policy interest rate. The central bank could either calculate the quantity of CBDC relative to GDP or by adapting the spread between policy interest rate and the CBDC rate. Either way, the government is in a better position to control interest rates and respond to shocks in the economy.

4. Transaction cost reductions: The authors question whether official CBDC should be implemented via a central bank Blockchain or, as it is currently, through centralized registers held by the money issuers. They contend that a permissioned distributed architecture would provide improved efficiency in terms of settlement and improve resiliency. The net result is a reduction in costs.

5. Increased competition in accounts services: Non-physical official money could also allow central banks to offer deposit accounts to the public like commercial banks do. In some ways this is similar to 100% reserve backing, where commercial banks fully back their deposits with central bank reserves. As the CBDC would be comparable to the establishment of an “online-only, reserve-backed, narrow bank alongside the existing commercial banking system,” the authors state that this would result in an expansion of competition in the deposit account market.

   Second, there is the issue of risk with regards to deposit insurance. Currently, consumers and companies can only make payments via commercial bank deposits. Owing to this critically important role, governments underwrite insurance policies that guarantee bank deposits (up to €100,000 for regular deposit accounts and small business accounts). In doing so, commercial banks enjoy the extraordinary privilege of having their liabilities backed by a central bank. This is the primary reason for TBTF. In essence, this form of deposit insurance creates the impression that deposits are risk-free; in reality, they are risk-bearing, with the risk falling upon the taxpayer (Dyson and Hodgson, 2016). By issuing a CBDC, a government can provide depositors with a real risk-free asset which is connected to the government and not commercial banks.

6. Increased competition and better resilience in payment services: A primary function of today’s banks is transaction verification. While the pricing in the existing system is governed by the member institutions, a lower entry barrier to becoming a transactions verifier in a CBDC environment would mean that more players would enter the payment services market and lower the price of transaction fees so that it is more representative of the cost of verification.

   Second, current payment systems are subject to operational risks. If a bank or payment institution were to shut down even temporarily, all payments need to be routed via other channels. This could in effect cut off the end user from the payment system till they find an alternative. However, with a Blockchain¹³-based model, this problem is avoided, owing to its distributed architecture.

   The real advantage in terms of payments is with reduced collateral and settlement sums. Currently, any payment involves risk: credit risk (in case the bank goes bust) and liquidity risk (in case one of the counterparties does not have assets that can be turned liquid in case of nonpayment). To hedge against these risks, payment systems require that collateral be provided with assets that have a high liquidity and low credit risk, prior to engaging in a transaction. But with a CBDC system, settlement can occur directly between the counterparties across the central bank’s balance sheet. Thus there would be lower collateral requirements and greater amounts of liquidity in the market.

7. Better payment infrastructure can reduce TBTF: Financial settlement systems currently used by central banks (such as CHAPS, BACS, FasterPayments, Fedwire, TARGET2, etc....) are expensive, have large downtimes, and are stagnant are in terms of innovation (Danezis and Meiklejohn, 2015). Moreover, while some central banks already use an electronic equivalent to cash in the form of reserves (e.g., the Bank of England), these reserve accounts are only available to licensed commercial banks and a small number of financial institutions (Dyson and Hodgson, 2014). As a result, commercial banks have become the gatekeepers to the payments system, and have the capacity to become systematically important nexuses within the economy. As a result, new entrants, smaller banks, and other payment service providers have to enter the payments space via a licensed bank even if they are able to provide better payment services. Moving to a Blockchain-based payment infrastructure could provide a single solution to these multiple latencies and thus increase competition in the payments space. If a CBDC payment system were to be constructed alongside the existing system, it would provide an alternative payment network in case of the failure of a systematically important bank.

8. Better response to shocks: The comments of J. Christopher Giancarlo, Commissioner of the CFTC (refer to Sidebar 3-3), showed us the importance of having real-time access to information. Hence, a key feature of using a CBDC is the access it provides to transaction verifiers and to the public parties regarding historic and current transactions. This would in turn provide more data to policy makers about the interconnectedness of the financial system, allow for the use of smart contracts, and be a step forward in macroeconomic stability creation and response.

   The issue of holding deposits directly at the central bank is of relative importance to financial institutions such as pension funds and insurers. Currently, these market operators have to hold their deposits at commercial banks, but the government deposit insurance (see point 5 above) does not apply to them. If they were to hold their deposits directly at the central bank, they would be less affected by shocks on the financial system.

9. 24X7 operation: Commercial banks and payment systems might operate all day and all night, but central banks do not operate all day long and mostly function between 6am to 6pm (for IT maintenance). This arrangement exposes banks to overnight risks and is the reason why overnight transactions are limited in value. A decentralized architecture helps us work around this limitation.

The authors also look at some of the cons that a CBDC could create and state that there is a danger of a bank run from commercial bank deposits to CBDC, as consumers could prefer holding CBDC deposits instead of bank deposits. They also look at transition risks of moving from the status quo to a CBDC regime. Although they state that they have not looked at these cons in great detail, owing to the scope of the report, they acknowledge their presence and state maximizing the benefits of the CBDC would require “an appropriate choice of CBDC issuance arrangements, CBDC policy rules, and fiscal policy choices [along with] the need for a thoroughly tested and reliable digital infrastructure, including cybersecurity and protection against hacking, appropriate prior training of the human operators of such a system, careful analysis of the legal implications (including, if necessary, introduction of additional legislation), appropriate changes to financial sector regulation, full coordination with foreign central banks and foreign financial institutions, and many others”.

The conclusion of the report, like most good research, raises new questions worthy of exploration. While the authors did find a number of pros and a few cons with the introduction of the CBDC, they state that further research is needed to ascertain what the policy implications will be. They ask whether new policy rules should be based on inflation targets or should new information of financial variables be included, since a cashless regime would allow us to have more data and a better view of markets and financial institutions. But their overall consensus is that the pros far outweigh the cons. Issuing a sovereign currency on a Blockchain can widen the range of monetary policies, help address TBTF, encourage innovation and competition in account and payment services, provide real time information to regulators, and aid in identifying systemic risk thus making the financial system safer.

While the Bank of England report offers policy modifications in consideration of the coexistence of two currencies (traditional debt-based money created via fractional banking and CBDC ), they do not address the topic of the infrastructure that would be required to implement such a system in relative detail. But some recent research done by Positive Money, a non-profit organization based in London, has looked at what kind of framework would be required to implement government-issued digital cash.

In the report, titled “Digital Cash : Why Central Banks Should Start Issuing Electronic Money” (2016), Ben Dyson and Graham Hodgson state that governments have two options when it comes to providing CBDC. The first option is to provide citizens with accounts at the Central Bank. Via this direct approach (which has already been put in place by the Central Bank of Ecuador via their Sistema de Dinero Electrónico), every citizen would have an account at the central bank and the bank would take on the burden of providing all the functions of a commercial bank. This idea, although possible, is not a worthwhile solution as it nationalizes the entire banking system and puts a huge burden on central banks, not to mention the detrimental effects it will have on innovation and customer service.

The second option is based on the 100% reserve backing model as described in the Chicago Plan (refer to Sidebar 3-4). Here, central banks would create and hold digital cash, but all the operations related to transactions, payments, and investment would be provided by commercial financial institutions. However, these commercial financial institutions would need to hold 100% of their reserves at the central bank. The institutions would provide the statements, payment cards, mobile banking services, and customer support much like today, with the difference being that all the funds in their care would be held in equivalent as central bank deposits. This would also make the account holder’s deposits fully liquid and permit banks to repay customers the totality of their funds at any given time—largely different from today’s system, which only allows partial reimbursements. Commercial banks would thus become administrators of accounts but never actually own the deposit and would not be able to partake in fractional banking as is done today.

As the central banks would possess all the funds, the liabilities of the central bank would rise. However, the authors state that this can be offset by equivalent assets in the form of perpetual zero-coupon, i.e.., non-interest bearing bonds which would be issued exclusively for this function. As there is no interest or repayment date on these bonds, there is no additional debt incurred by the government.

In such a framework, commercial banks would no longer be able to issue loans or overdrafts. The authors are cognizant of this fact and state that an alternative can be arranged. Commercial banks wanting to provide credit facilities would need to fund loans by using CBDC borrowed from customers exclusively for this purpose. Such a system of credit issuance would be akin to how lending is performed in mutual building societies and credit unions. They state that such a method of providing credit would not necessarily increase the demand for credit overall, but will affect the demand for bank credit.

The question then arises with respect to the supply of credit. As banks cannot lend by creating new deposits, as they do with fractional banking, their loan portfolio will be affected. But the authors argue that the net effect on the supply of credit will not be significant. First, they state, that since reserves are zero-weighted for the purposes of calculating capital requirements for banks, moving from bank deposit accounts to 100% reserve accounts would not affect the capital requirements of banks. The level of money creation is based on the bank’s loss-absorbing capital, rather than the amounts of its reserves. Hence, in terms of capital requirements, the net effect on banks providing loans will not be affected by moving to 100% reserve accounts. Second, they state that, as reserve accounts become available to all licensed commercial financial institutions, new entrants, smaller banks, and other providers able to deliver better lending services would be able to enter the lending space directly and cut their ties with commercial banks (see point 7 above). Thus, as bank deposits are converted to reserve deposits, loans could be funded by money markets as well. As cash becomes available from digital cash lenders alongside bank credit, the supply of credit could actually increase.

The ideas and methods described in these two recent works allow us to gain a picture of how monetary policy could be executed if we were to move to a Sovereign cashless Blockchain-based infrastructure and adopt a 100% reserve system. They would apparently be able to provide us with significant answers to the gridlock that is faced by policy makers today in terms of improving the productivity and efficiency of executing their duties. They will also allow for better financial inclusion and greater transparency, and reduce systemic risks. But there are reservations that need to be considered with moving to a 100% reserve-backed system. Some of these reservations have been described in the concluding section of Sidebar 3-4, where we read about the Chicago Plan. First, just having 100% reserves at central banks will not solve the problem of excessive private credit creation, for if consumers feel constrained, they could create and use new financial instruments to bypass the system. Second, even if existing debt was replaced by reserves, it also means that there will be winners and losers. Third, governments have an unflattering track record of being in charge of money creation, and there is the danger that they would use this power to ensure short-term political gain. We need to find a way to allow us to manage the quantity and type of debt. Rather than depending on a central full reserve banking model, would the answer lie in multiple currencies existing together?

Multiple currencies in a cashless environment

There is a large amount of literature concerning the issuance of private money . One of the most vehement supporters of private cash was the Austrian economist, Friedrich Hayek, who argued that private agents could use markets to create currencies which were a store of value and a unit of account. According to Hayek, private actors could create a stable monetary system without the need for government intervention. As per his view, the government ought to let citizens use a currency of their choosing and permit entrepreneurs to innovate in the monetary sector by creating digital currencies and minting commodity money (Hayek, 1976).

But currencies such as Ethereum and Bitcoin are not commodity monies. They can be considered as privately issued fiat currencies which are fiduciary in nature, i.e., they are not commodity-backed and cannot be redeemed for any other asset. Although these currencies are effective ways to transfer value on a decentralized network, from an economic perspective, their ability to fulfil all three functions of money¹⁴ has been questioned due to their differences in comparison to a regular fiat currency. These include:

Volatility : The price swings of currencies like Bitcoin has been a subject of constant debate and had led analysts to comment that the currency will never be a good store of value since it is subject to large price swings. This is true, but if one were to look at the volatility over the past five years, the volatility has become less erratic. At the time of writing this chapter (September 2016), the 30 Day BTC/USD volatility was at 1.16%, while the 30 Day USD/EUR volatility was 0.32%. Between Sept 2015 and Sept 2016, the BTC/USD volatility swung from a high of 4.93% to a low of 0.32%, while the USD/EUR volatility stayed in the range of 0.67% to 0.32% (Figure 3-3). Effectively, bitcoin is yet to become as stable as a state fiat currency, but it is in the process of becoming less volatile as the network effect and user base expands. What was interesting to note was the surge in the price of bitcoin when the Brexit was announced (Figure 3-4). The changing value of cryptocurrencies still is a subject of concern, as it undermines their purchasing power ability and ability to function as long-term savings instruments.

Figure 3-3. Comparison of BTC/USD and USD/EUR volatility over the past five years Source: The bitcoin volatility index ( https://btcvol.info/ ). Accessed September 2016

Figure 3-4. Bitcoin price surge soon after the Brexit announcement (June 23, 2016) Source : CoinDesk ( http://www.coindesk.com/bitcoin-brexit-ether-price-rollercoaster/ ). Accessed September 2016

Legal status : As per the ECB, from a legal perspective, a currency refers to a specific form of money that is generally used within a state/country. As cryptocurrencies are not widely used to exchange value, they are not considered money and not currency either. They conclude that no virtual currency is a real currency.

The legal definition of what is an acceptable currency seems to be based on how it is legally interpreted as a way to transfer value. Money to be used for payments include euro banknotes and coins. These are considered as “legal tender” in the EU countries and therefore, by law, must be accepted as payment for a debt within those territories. However, bank money in euros or electronic money (e-money) in euros are not considered legal tender. Nevertheless, these forms of money are widely accepted for all kinds of payments by choice. The euro as a currency may therefore take the form of banknotes, coins, and electronic money. (ECB, 2015).

In spite of this choice-based interpretation of what can be legally accepted as money, the same rule is not extended to cryptocurrencies, as they use their own denomination, i.e., they are not electronic, digital, or virtual forms of a particular currency. They are different from known currencies and, as none of them have been declared as the official currency of a state, they do not have a legal tender capacity. Thus, no creditor is obliged to accept payment with it to discharge a debtor of its debt (ECB, 2015). This means that virtual currencies can be used only as contractual money, when there is an agreement between buyer and seller in order to accept a given virtual currency as a means of payment (ECB, 2015).

The legalese revolving around cryptocurrencies is even more complicated in the US, where it differs according to how it is being used (does it fall under the purview of the SEC, the CFTC, or FinCEN?), where it is being used (depends on the state. NY, for example, has begun providing a business license (BitLicense), which obliges virtual currency companies to adhere to a specific licensing regime), and who is using it (miners, banks, users, exchanges…). In other countries, the situation is the same and at present there is no legal consensus as to the status of cryptocurrencies.¹⁵ The definition and legal acceptance of cryptocurrencies is a primary impairment to its widescale use.

Apart from these two impediments, there are also other differences between cryptocurrencies and state fiat. Staying with the legal angle, it is the acceptance of legal tender that determines the use of a currency. Central banks already compete with currencies issued by other central banks within their own states and, to a domestic central bank, a private money is essentially a foreign currency as its monetary policy is governed by an entity that is outside the domestic government’s jurisdiction (Andolfatto, 2016). But the devil is in the fine print. Currency issued by a central bank is legal tender and is coupled to laws that certify its acceptance within a state. If parties within a state decide to use another currency instead of that which is issued by the central bank, then the laws do not apply. Hence, the state is absolved from any legal recourse in the case of any default of debt (for example) if the parties have entered a contractual agreement using a currency other than that of the state.¹⁶ This is the underlying thesis of Gresham’s law: bad money drives out good money and is the reason why central banks have a monopoly privilege in supplying money and why the production and supply of cash occupies a central function in monetary policy.

The supply of private fiat cryptocurrencies, however, is calculated in another way. As the private currency creators are essentially issuing tokens, which are intrinsically valueless, the value of these currencies is based on their scarcity, utility and reputation. As the tokens are unique and non-falsifiable, every user within the network is capable of verifying the total quantity in circulation and witnessing the flows between users. Thus, money supply is determined by profit maximization. As users witness the transfer flows of other users, they form belief systems about the exchange value of the private fiat and alter their behavior (save/spend) in order to protect their own individual interests. Profit maximization thus serves the same purpose as monetary policy with private monies (Fernández-Villaverde and Sanches, 2016).

The difference in the way the supply of private and state fiat currencies occurs is a key issue to determining how they can compete within a common state, and some recent work from researchers at the Federal Reserve Bank of Philadelphia and the University of Pennsylvania have highlighted the consequences of this difference. In a paper titled, “Can Currency Competition Work?” (April 2016), Jesus Fernandez-Villaverdea and Daniel Sanches use a quantitative model ¹⁷ to investigate the monetary possibilities with hybrid private and government monies.

First, the authors found that when only multiple private monies exist within an economy (as proposed by Hayek in Denationalisation of Money: The Argument Refined), an equilibrium point could be reached at which the real value of private currencies remains constant. However, this equilibrium state is temporary and, over the course of time, the value of private monies begins to decline. Furthermore, owing to profit maximization efforts of private actors, purely private monetary systems were also susceptible to hyperinflationary episodes much like state-issued money. The conclusion was that a purely private monetary system would not provide the socially optimum quantity of money.

Second, when the authors modified their model to simulate the coexistence of both private and government fiat , the price stability of both private and government monies could only be attained if the government maintained a constant supply of its money. In the real world, a government would need to indulge in expansionary and contradictory policies in order to react to market and political changes. As a result, the government would be obliged to deviate from this practice of maintaining a constant supply, which makes the coexistence of private and government monies an unstable means of exchange.

The volatility, legal issues, and supply complications of functioning with multiple currencies are further compounded with taxation challenges. When governments issue currencies, they also pass legal tender laws. These laws provide licencing requirements for money transmission to indirectly regulate the threat from competing currencies, and hence make it easier for governments to combat tax evasion and money laundering (Raskin and Yermack, 2016). If multiple currencies were to be used, then there would need to be a surveillance system which would allow for proper taxation based on all the currencies in use.

The existing evidence on sovereign cash and multiple currency hybrid systems seems to indicate that if we were to move to a cashless monetary system where currency was issued via Blockchains, then a single currency would be easier to adapt to. This, of course, is a working hypothesis based on existing data. As network effects and the scale of use of cryptocurrencies continues to augment, there is a possibility that we will need to revisit this hypothesis and adapt it to changing market trends.

There are critics who believe that private currencies like bitcoin will soon cease to exist. But there is no evidence to certify this opinion and the website “Bitcoin Obituaries ¹⁸” provides some entertaining evidence of how such opinions have been proved wrong. There is some new research (see Notes—Multiple Currency Mechanisms), which are being explored in the field of network science with regards to multiple currency operations. Nevertheless, from the perspective of large-scale Blockchain adoption, at the current time it would be more sensible to continue investigating the use of a single government-issued fiat currency on a Blockchain.

On a personal note, the bias of continuing with an approach centered around a single sovereign currency issuer is due to my personal belief that the increased financialization of markets have led to greater problems than benefits. This might seem contrary to the very ethos of decentralization (which is what the Blockchain is all about), but in light of the financial scandals and outright criminal shenanigans that we have witnessed over the past three decades, it would seem that personal profit maximization will always create circles of misaligned social interests and opportunistic, unscrupulous players. The unfolding events with respect to the Wells Fargo fake account and credit/debit card issuance scandal¹⁹ is just one more example of how those who are responsible for our financial care have betrayed their charge for making a quick buck.

Money is not like other products, as it offers immediate purchasing power upon its issuance. Regulators may be working at a slower pace, but the importance of their work is not to be disregarded based on impatience and personally opinionated conspiracy theories. What is required is clarity, and the Blockchain provides this. On this basis, when thinking about money, I am inclined to side with a democratic system of currency issuance based on trust in the state rather than adopt multiple echelons of trust for private issuers of coinage. This is, however, a personal opinion and not one I advocate to the readers. My goal is to provide information that will instigate a change in the direction of the conversation currently being had about the way monetary systems work, and any conversation is bound to begin with differences in opinions. If the future were to provide evidence to prove me wrong, I would gladly adapt my belief system (and maybe even write a book about it).

In summary, the evidence reviewed seems to side with the conclusion that the role of currency issuance is a function best led by the state. As stated by the English essayist Walter Bagehot over a century ago (1873) in the context of free banking ,

“We are so accustomed to a system of banking, dependent for its cardinal function on a single bank, that we can hardly conceive of any other. But the natural system—that which would have sprung up if Government had let banking alone—is that of many banks of equal or not altogether unequal size. … I shall be at once asked, Do you propose a revolution? Do you propose to abandon the one-reserve system, and create anew a many-reserve system? My plain answer is, that I do not propose it: I know it would be childish. … [A]n immense system of credit, founded on the Bank of England as its pivot and its basis, now exists. The English people and foreigners, too, trust it implicitly. …The whole rests on an instinctive confidence generated by use and years. … [I]f some calamity swept it away, generations must elapse before at all the same trust would be placed in any other equivalent. A many-reserve system, if some miracle should put it down in Lombard Street, would seem monstrous there. Nobody would understand it, or confide in it. Credit is a power which may grow, but cannot be constructed.” (Friedman and Schwartz, 1987)

Ultimately, when thinking about changing currency issuance and using different monies, it is not a question of how value is transferred. It is a question of how trust is replaced.

One digital money to rule them all—Fiscal Policy instead of Monetary Policy?

The Blockchain highlights the fact that the existing structures of money creation and policy making parameters were built for a pre-Internet world. As the world moves into a cashless environment , it requires policies that are adapted to it. But the changes to be made are not just with regards to the technical underpinnings of monetary design. In light of prolonged low interest rates, soaring debt levels, high deficits, and weak economic growth, what is also required is a rethinking of how we understand money and macroeconomic policies, and if moving to a completely cashless economy can help us address these issues. Without this line of questioning, the Blockchain is just a shiny new tool in an old, dilapidated shed.

Let’s first look at why we need to go cashless and what would be the biggest consequences of doing so. The evidence provided earlier in this chapter (refer to “Fiat currency on a Blockchain”) enumerates a number of advantages of moving to a cashless system from a monetary policy perspective. But the main point to be considered is negative interest rates.

If central bank liabilities were digital, paying a negative interest on reserves (essentially charging a fee) would be a fairly simple affair. But as long as money can be converted from electronic deposits to zero-interest bearing cash, it becomes very difficult to reduce rates below -0.25 to -0.50% (for example), and even harder to sustain that for long periods of time. Paper currency thus makes it difficult for central banks to take policy interest rates much below zero and, combined with the zero lower bound, this means that central banks cannot control interest rates nearly as much as they would like to in times of need.

The concept of paying a negative interest rate might seem incongruent to the function of monetary policy to some readers. But it is arguably not much different from inflation, which similarly reduces the purchasing power of a currency (Rogoff, 2014). If inflation were to become unstable, then paying negative interest rates would be a better approach to adopt.

The reason why negative interest rates have been in the news over the past year is mainly because of the persistently ultra-low inflation and near-zero interest rates (in most developed countries) over the past few years. When inflation becomes too low, it becomes harder for governments to deal with it, especially as interest rates drift toward the zero lower bound (also known as the “liquidity trap”). Second, since the crisis, world markets have seen a greater amount of economic volatility. The greater the volatility, the more likely it is that economies will be face severe downturns requiring central bank interest rate cuts (Rogoff, 2016), and therefore the more likely that we will need to indulge in negative interest rates. Third, an increasing tendency to save in emerging economies coupled with ageing populations in developed economies have had a net effect of reduced investment, and hence further perpetuate low interest rates. This was what Ben Bernanke alluded to when he hypothesised about a “global savings glut.” It is for these reasons that central bankers have been indulging in negative interest rates and debating upon their use.

Owing to the rarity of the long-term use of this policy instrument , it remains to be seen whether negative interest rates will be an effective solution to the problems of low inflation and near-zero interest rates. Negative interest rates are still an experimental policy, and they may be effective in theory, but no one can be sure what issues could arise if rates become significantly negative. Governments technically could circumvent negative interest rates and make citizens pay small episodic taxes on the cash they hold. Even if we phase out cash and apply negative interest rates, other complications such as tax issues or legal obstacles could arise and threaten stability. But in light of the current situation of low inflation and interest rates, policy makers might need to make use of this lever, and a cashless system would be the most effective way to do so if we are to scale at the level of an entire economy.

The move towards a cashless system would also call into question our orthodox view of monetary theory. According to the orthodox view, government spending is to be constrained by the amount of revenue it earns via taxation and borrowing. If governments were allowed to issue more fiat money than the output of the economy, there would be too much money chasing too few goods, and this would ultimately lead to inflation. They should thus not be allowed to “print” money at their whim. Instead, to complement their spending, orthodox theory decrees that governments should borrow money, but only to a certain extent; for if they were to borrow too much, then they would compete with the private sector for funds which in turn would push up interest rates and curtail private loans and investment. The orthodox view thus looks at fiat money as an exogenous entity whose supply, relative to output, affects the price of goods. For this reason, the supply of money needs to be contained and is central to controlling inflation (Wray and Nesisyan, 2016).

But as we have seen in Chapter 1, with the fractional banking system , this is not how fiat money supply is determined and central bankers are not in the driver’s seat when it comes to creating money. Money is created whenever a commercial bank offers a loan to a consumer. It is therefore the demand for loans that determines the money supply. Fiat money is thus endogenous to the economy and not exogenous, as described in the orthodox theory (Wray and Nesisyan, 2016). This endogenous perspective of money supply is referred to as the modern money theory.

It is important to understand the difference between the exogenous and endogenous function of money, as it will help us comprehend that governments do not have to depend on commercial banks for creating money and are not handcuffed to the fractional banking system. To explain this statement, we need to revert the conversation back to taxation. While the orthodox theory suggests that a government can only spend based on the revenue it receives from taxes and debt, the modern money theory states that a government does not need tax revenue before it can spend. In fact, if taxpayers need to pay their taxes in government fiat, then the government first has to spend before taxes are paid. In other words, the ability of governments to impose taxes in sovereign fiat gives them an advantage in terms of determining the money supply. Tax payments and bond sales (government loans) only come after the government has spent.

This concept of the endogenous and exogenous role of money and the comparison of the orthodox and modern money theories has been explained in detail and in the context of government balances by Randall Wray and Yeva Nesisyan in “Understanding Money and Macroeconomic Policy²⁰” (2016). In their research, the authors come to three conclusions:

First, a sovereign state that issues its own currency in not financially constrained and its spending is not financed by tax and loan revenue, as government spending must precede tax collection and bond sales. Governments thus do not suffer from financial constraints. Instead they suffer from resource constraints. If a government were to spend more than the output, then inflation would occur. But inflation results from too much spending and not too much money per se. How the spending is financed thus does not determine inflation. Hence the question becomes how should governments spend? There could be suitable reasons for why a government should curb spending, but citing that they are running out of money should not be one of them.

Second, as the quantity of money to be produced is based on the aggregate demand for money, the orthodox view that central banks can control the economy with interest rates and reserve quantities is false. As per modern money theory, it is only interest rate control that is at the central banks disposal. Finally, the authors state that as the supply of money is essentially a government decision, monetary policy is in effect fiscal policy. As fiscal policy can directly stimulate aggregate demand, governments in effect have a strong ability to control spending . In their words,

“… fiscal expansion can raise demand without worsening private sector balance sheets; indeed, government deficit spending actually improves private sector finances by providing income and safe government liabilities to accumulate in portfolios.... governments with monetary sovereignty are not financially constrained: they spend as they issue their own IOU’s [currency]. They can use this capacity to buy real resources, and in doing so to promote full employment.”

We began this chapter by asking ourselves what is the definition of capitalism in the context of markets, regulation, and policy. As we have seen, these three pillars of capitalism are in a state of change and the current definitions and ideologies on which they function are being challenged. Moreover, it is increasingly evident that, as the pace and impact of technological change continues to accelerate, any new definition will have to be one that is adaptable to the future ramifications.

What we need is a rethinking of capitalism. Since the crisis, policy makers have been rethinking this concept. Had they not, we would not have had initiatives such as QE and QQE that helped us avoid a global depression. However, now that the dust has settled, we need to review these actions and gauge their effectiveness.

Let us take the case of quantitative easing (QE) . QE works because low, long-term bond yields push up prices asset prices. This stimulates asset holders to consume or invest more and is therefore bound to increase inequality (Turner, 2015). We can also look at sustained low interest rates. While the goal of ultralow rates is to stimulate spending, there is a greater possibility that they will encourage risky and leveraged speculation before they stimulate demand in the economy. And they can only encourage demand by encouraging private credit growth, which is the bane of our problems.

Increasing private credit leads to financialization and the transformation of credit from being a means of achieving future prosperity to a commodity that can be exchanged for value. At the heart of this transformation is a conflict of categorization. Money and credit are in a different product category, as they are different from commodities, goods, and services. The creation of money and credit results in purchasing power, which in turn has macroeconomic consequences. This is not the same with creating a new product or services based on technological advances. Thus, applying the free market principles that govern the creation of goods and services to credit and money supply is fundamentally flawed and highlights how dicey and limited in scope monetary policy is. It is for these reasons that we need to turn our gaze to fiscal policy.

What policy makers need to understand is that today they have the capability of using technology to gain a more decisive position in markets, and that by the proper use of fiscal policy and regulation, they can create a monetary system that is more democratic and transparent. Ideas such as the Chicago Plan have existed for a long time, but with technology such as the Blockchain, we are in a position to utilize it at a societal level. This is not to say that we should immediately move to a 100% reserve system. As per the plan outlined by Benes and Kumhof, moving to a 100% reserve system would also entail writing off substantial quantities of debt. There are bound to be winners and losers in this case. What should therefore be envisioned is a way in which existing debt can be reduced gradually over time, while new bank businesses were conducted on the principles of the Chicago Plan. One option could be a modified use of CoCo bonds (see notes: “CoCo bonds and the Blockchain”), which allows for the conversion of debt into equity.

Making reforms that reflect these principles is crucial today because of our excessive debt levels. We must recognize that free market forces do not issue the optimal amount of credit or for the appropriate purposes. We need to reject the concept that credit creation can be left to the market and that the fractional banking system can be continue to operate in its present from.

Intervention is needed not in the issuance of credit, but in the quantity that is created. Less credit, however, does not mean less growth. As we have seen in previous chapters, a large amount of credit today is not used for economic growth, but is instead invested in housing/real estate. As a result, it does not proportionally increase demand, and leads to debt-overhang and recession. The main objective of policy makers should thus be to create a less credit-concentrated economy. Without such measures, capitalism is a ticking time-bomb propped up by inefficient regulations and policies.

As stated by Stephanie Kelton in “The Failure of Austerity: Rethinking Fiscal Policy” (2016),

“Along with aggressively deregulating financial (and other) markets, nearly every OECD country has substantially cut taxes over the past thirty years. The average marginal income tax rate on top earners dropped from 66% in 1981 to 43% by 2013. Average corporate income tax rates were also cut sharply, plunging from 47% to 25%, and taxes on dividend income declined from 75% to 42% over the same period. Instead of unleashing the job creators and extending prosperity to all, these supply-side maneuvers were closely associated with widening inequality and greater financial instability. In other words, these experiments have failed. Capitalism has become more unstable, the distribution of wealth and income has become more unequal and it takes the system longer and longer to claw back the jobs that are lost each time we suffer a recession,” (Jacobs and Mazzucato, 2016).

Moving to a sovereign, cashless, Blockchain-based monetary infrastructure based on the principles of the Chicago Plan is one way for governments to not just reduce debt levels, but also to rewrite the rule book on macroeconomics and governance. The role of policy is not just to correct and penalize the transgressions of free market players. It is also to shape markets in order to obtain the right allocation of resources, long-term value creation, social well-being, and lower inequality, and to ensure environment sustainability. Short-term GDP²¹ growth can no longer be the primary objective of governments.

Thus, as the definition of capitalism begins to involve the democratic state to a greater degree, we should also use this opportunity to see how we can address the problems of technological unemployment, education, productivity changes, inequality, and ageism. One solution pathway could lie with helicopter money and universal basic income.

Helicopter Drops and Universal Basic Income

Refresh your memory and think about the last time you heard these “keywords ”: technological unemployment, income inequality, stagnant wages, poverty, regulatory gridlock. If you are a regular follower of the news, then the chances are that you may have heard these terms almost on a weekly basis.

But these terms are large-scaling in nature and talk about multiple socioeconomic or political issues. It’s easy to get lost when thinking about these issues, as the barrage of data and opinions (mostly tangential) do not provide a steady anchor to everyday events and make us lose sight of the fundamental issue. The issue.... is the issue. So let’s look at one particular entity that is connected to all of these keywords and see how recent developments of this singular entity is linked to all the jargon being flung about today. The entity we will choose is Chatbots.

A Chatbot is essentially a service, powered by rules and artificial intelligence (AI), that a user can interact with via a chat interface. The service could be anything ranging from functional to fun, and it could exist in any chat product (Facebook Messenger, Slack, telegram, text messages, etc.). Recent advancements in Natural Language Processing (NLP) and Automatic Speech Recognition (ASR) , coupled with crowdsourced data inputs and machine learning techniques, now allow AI’s to not just understand groups of words but also submit a corresponding natural response to a grouping of words. That’s essentially the base definition of a conversation, except this conversation is with a “bot.”

Does this mean that we’ll soon have technology that can pass the Turing test? Maybe not yet, but Chatbots seem to be making progress towards that objective. The most advanced Chatbot today is Xiaoice (pronounced Shao-ice) developed by Microsoft, and which can respond with human-like answers, questions, and “thoughts.” If a user sends a picture of a broken ankle, Xiaoice will reply with a question asking about how much pain the injury caused, for example (Slater-Robins, 2016).

Unsurprisingly Chatbots are increasingly attracting investors. According to Tracxn (a Sequoia and Accel alumni-founded market research firm that globally tracks venture capital investment, corporate investment, and startup activity), over $140 million has been invested in Chatbots since 2010, with the majority, approximately $85 million, being invested between the 2015 to 2016 period (Tracxn, 2016). This interest is not just seen in finance, but almost any industry today: hospitality, journalism, medical, insurance, travel, retail, automotive, entertainment, etc. (CB Insights, 2016), and is creating a new wave of companies, such as X.AI. (AI scheduling assistant), Clara Labs, Julie Desk, Kono, Overlap, Babylon Health, Ozlo, Maluuba, GoButler, Your.MD, Arya (a research assistant), and so on. As stated in a recent report by Business Insider,

“Chatbots also have the potential to help businesses significantly cut labor costs. While complete automation of the customer service workforce is not feasible, automating customer management and sales positions in the US where possible through Chatbots and other automation technologies would result in considerable savings.” (“The Chatbot Explainer,” BI Intelligence, July 2016).

A conversation used to be a uniquely human activity but with the rise of Chatbots, this precept is being put to the test. The developments with Chatbots is just one single example of how technology is replacing human labor in what were essentially human-centric jobs. So let’s revisit those keywords from the beginning of this section, but from the context of Chatbots . What happens to the employment of existing call center workers with Chatbots? By 2020, Gartner predicts that this type of conversation automation will manage 85% of businesses’ customer relationships (Busby, 2016). How many people will this potentially effect? Just in the US alone, 5 million people are employed in call centers, while in countries like India and the Philippines, call centers provide employment to millions of people. So what impact will this one technology have on income inequality, wages, and poverty levels when it replaces labor?

Finding an answer to that question is not the reason for citing it. It is more to help us see that if we were to pull apart the fabric of a single technology, it reveals a tapestry of spillover effects which our current definition of capitalism is unable to envision, let alone provide contingency plans. If we were to repeat this exercise with other technologies, similar revelations would ensue. It would also show us how addicted we are to the concept of gain and unconcerned with spill over effects. Think about it. When was the last time you heard a manager say out loud, “What can I do to increase the number of employees?”

This brings us back full circle to the topics that were discussed in the beginning of this chapter (refer to Sidebar 3-1). While initially we were looking at technology from the vantage point of markets, regulations, and policy—the pillars of capitalism—looking at the minutiae of a single strand of technology brings us to same conclusion. Technology’s impact on jobs is the big yellow elephant in the room. Moreover, as technology continues to grow and evolve, it provides benefits to a few (who extort rent controls from it) and eliminates labor in the process. The charts in Figure 3-5 are from the Federal Reserve Bank of St. Louis. They help us see this paradigmatic shift in process. Notice the way employment and profits have taken distinctly opposing trajectories since the crisis.

Figure 3-5. Comparative charts of employment and corporate profit over the last 10 years

This trend is to be expected. Labor is the biggest expenditure of a corporation and if you can get rid of labor and replace it with technology, profits will go up ceteris paribus. But the effect this has is not limited to profits margins. When people in one sector are replaced by technology on a massive scale, it evidently causes unemployment in that sector, but also leads to underemployment²² in similar or related sectors. This creates a ripple effect, for as higher-skilled workers are forced to apply for the jobs of lower-skilled workers, it creates a self-sustaining circle of poverty for marginalized groups, pushes down wages across sectors, puts more burdens on the state, and impacts monetary and fiscal policy. Thus the question becomes: how does capitalism respond to the juggernaut of technological evolution?

Technology is embryonically linked to innovation, and innovation is often cited as the cure-all to problems in any sector. But the link between markets and governments in the context of innovation is often sidelined. It is for this reason that when we talk about innovation, especially innovation which is going to replace cognitive and manual repetitive work, we also need to talk about the effect it has on capitalism (see Sidebar 3-1). What needs to be remembered is that as labor size gets reduced, it also lowers/stagnates wages. While this makes it almost impossible for the working class to insure itself, it is also a concern for central bankers, for as people are displaced from jobs, it will reduce aggregate demand, exasperate income inequality, and augment the disparity between savings and investment, which in turn will force down the price of borrowing money, i.e., the interest rate. In net sum, technological innovation, while being the force that is pushing society forward, is also pushing us towards the zero lower bound.

It is for this reason that we need to overturn the current dominant paradigm with respect to the narrative of life under capitalism. The dominant paradigm today is that the private production of wealth is appropriated by the state for social purposes. But this is a fallacy for, in reality, wealth production is social and collective, which is then appropriated privately. To explain this statement, let us conduct a simple experiment. Look around you and select a piece of technology . It could be the lights around you, the tablet on which you read this book, or your smartphone that is attached to you at all times. Now that you have selected a technology, dissect it completely and trace back the origin of every piece of technology that it embeds. You will find that in every case, the technology you are analyzing could not have existed had it not been for a government grant. This is true even of the Blockchain. While the Blockchain was first created by a single person/group (Satoshi Nakamoto), what it represents is decades’ worth of research and development in cryptography, encryption, economics, and game theory—all subjects that have been funded massively by governments. Had it not been for the ARPANet, Vint Cerf and Bob Khan would have never received the necessary funding to develop packet-switching data and you would not be reading this book had that happened.

The development of technology is hence a collective production of wealth and it is for this reason that we need to turn the narrative of capitalism and show that there is no separation between free markets and the state. There would be no markets without states and there would be no capitalism if there was no state. But there would be no state if there were no private entrepreneurs. Hence, the relationship between markets and states is symbiotic and it is wrong to believe that they are separate entities.

By following this train of thought, we can thus see that if technology is developed by the collective efforts of the state and leads to the production of wealth, then it would only be logical for the contributors (the citizens) to receive a dividend for the investment they have made. It is this dividend that I refer to as the Universal Basic Income (UBI ) .

A UBI is an income that is granted unconditionally to every member of a political community. As per the Basic Income Earth Network (BIEN) there are criteria to be adhered to when talking about UBI:

1. It is an income that is given to secure existence and allow social participation.

2. It is an individual right’s claim and is paid to individuals rather than households.

3. It is payable without means-tested verification.

4. There is no obligation to work. It is paid irrespective of any income from other sources.

5. It is paid without requiring the performance of any work or the willingness to accept a job if offered.

While the concept of Universal Basic Income was not devised with technological unemployment in mind, it is increasingly bearing relevance to the current economic diaspora. It is essentially a guaranteed salary that is given to every person, every month, irrespective of what they do and how they live. It is an unconditional pact between the citizens and the state that ensures that everyone receives an income just for being part of the community. There are various ways in how such a goal can be implemented and the following parts of this section detail the history of UBI, the experiments that were conducted, the results of these experiments, and how we can create a framework for the UBI with the Blockchain.

The first major proponent of UBI was Thomas Paine , who stated in Agrarian Justice (1795) the philosophy behind a basic income. According to Paine, every owner of land owed a rent to the community for the land he held, as it was with this land that he was able to improve his prosperity. Paine thus suggested that this rent ought to be given back to the community in the form of a UBI ,

“In advocating the case of the persons thus dispossessed, it is a right, and not a charity, that I am pleading for. But it is that kind of right which, being neglected at first, could not be brought forward afterwards till heaven had opened the way by a revolution in the system of government. Let us then do honour to revolutions by justice, and give currency to their principles by blessings....

Having thus in a few words, opened the merits of the case, I shall now proceed to the plan I have to propose, which is … To create a national fund, out of which there shall be paid to every person, when arrived at the age of twenty-one years, the sum of fifteen pounds sterling, as a compensation in part, for the loss of his or her natural inheritance, by the introduction of the system of landed property: And also, the sum of ten pounds per annum, during life, to every person now living, of the age of fifty years, and to all others as they shall arrive at that age.” (Paine, 1795)

Paine, whose other works influenced the drafting of the US Constitution, was not the only person in history to propose UBI. Over the years, philosophers, politicians, economists, and social scientists such as Bertrand Russell, Dennis Milner, C.H. Douglas, James Meade, Milton Freidman, F.A. Hayek, and Ben Bernanke have all been advocates of UBI in one from or another.

Freidman had an alternative approach when thinking about UBI. As per his theory, if an economy was undergoing a fall in demand (which can result with technological unemployment and underemployment), he suggested that the government print some money and throw it from a helicopter. As people would pick up the scattered bills and spend them, there would be an increase in demand for goods and services, and nominal GDP would rise and result in some increase in inflation. This increase in inflation would of course depend on whether people spent or saved the money, but the net result would be tied to the quantity that was scattered from a helicopter. As per Friedman, a government was never out of options when it came to increasing demand, as we could drop cash into the state. Too much and we get inflation. But if it was small enough, then it could produce desirable results.

While Friedman’s idea might seem a bit dramatic and farfetched, today it is in fact technically feasible with or without a Blockchain. A state could route, say, a €1000 to every citizen’s bank account via their commercial bank accounts. Alternatively, he suggested a negative income tax or a cut in tax rates or a tax credit (paid in cash). The end result according to Freidman would be the same: nominal demand would go up and the extent to which it would go up would be proportional to the amount of cash injected. As it is effectively putting more purchasing power in the hands of consumers, it would avoid higher asset prices, curb credit expansion, remove the need for ultralow interest rates and thus be more beneficial than traditional fiscal or monetary policy instruments.

Incredible as this idea is, when we look at it in reference to all the material we have reviewed with regards to fractional banking , there is a chink in its armor. If the government were to apply a UBI via the existing system, it would be creating additional commercial bank reserves at the central bank. This would thus help commercial banks create additional private credit and debt-based cash. Hence, the initial stimulative effects on demand would soon be overcome by the multiplying effect it would have on private credit issuance and bring us back to where we are today in terms of rising debt levels and runaway credit.

The only way that such a system could feasibly work is if the banking system was based on the Chicago Plan. In such a system, the base money would be the only money in circulation. As a result, an increase in supply would stimulate demand but not increase private credit growth. Governments would thus be able to control the economy through pure fiscal policy. An extract from Adair Turner’s Between Debt and the Devil neatly summarizes how the concept of helicopter drops and the Chicago Plan could work,

“Fractional reserve banks thus complicate the implementation of money finance ²³ but the model of 100% reserve banks suggests the obvious solution: any dangers of excessive long-term demand stimulus can be offset if central banks impose reserve asset requirements. These requirements would force banks to hold a stipulated percentage of their total liabilities at the central bank and thus would constrain the banks’ ability to create additional private credit and money. Those ratios could be imposed on a discretionary basis over time, with the central bank increasing them if inflation threatened to move above target. But they could also in theory be deployed in an immediate and rule-driven fashion, increasing the required reserves of commercial banks at the same time as the electronic money drop and by precisely the same amount.

This would essentially impose a 100% reserve requirement on the new fiat money creation. We can in effect treat the banking system as if it were in part a 100% reserve system and in part a fractional reserve: we do not have to take an absolute either/or choice” (Chapter 14, Pg. 221, Between Debt and the Devil, Turner, 2015).

If you have got to this part of the book after reading all that was written before, then connecting the dots will be evident to you. A cashless society in which the government is responsible for the issuance of fiat money on a sovereign Blockchain can not only address the problems of debt, tax evasion, and excessive financialization, but can also be a tool by which governments can apply radical society-changing initiatives such as UBI. This is a concept that policy makers need to seriously consider, especially when faced with challenges such as technological unemployment and increasing income inequality. If we are to find an antidote to the current socioeconomic malaise, then we cannot depend on existing theories and practices, for they have been tried, tested, measured, and still found lacking. UBI is a program worth exploring and, while it is beyond the objective of this book to focus on this subject in depth, it has been included it in the text to show that it is indeed technically feasible. But it is by far only one example of what can be done with such a framework. What else can be done will be explored in the next chapter.

There are policy makers who are seriously considering the application of UBI , and some recent statements by Yanis Varoufakis show the level of thinking regarding this subject,

“To put it simply, in the 20th century, we had the stabilization and civilization of capitalism through the rise of social democracy, the New Deal in the United States and the social market developments in Europe. Unfortunately, this deal is finished and it can’t be revived. .... Basic Income is (thus) a necessity…it is not a question of whether we like it or not…it will be a major part of any attempt to civilize capitalism as capitalism is going through a spasm caused by its own generation of technologies that undermine itself.” (Varoufakis, 2016)

Those readers interested in learning more about UBI can refer the list of resources that were referenced in the notes section of this chapter (see Notes: UBI Reading).

Examples of UBI

We will conclude this note on UBI by seeing examples of its deployment, the impact they had, and how we can envision the deployment of a similar program.

Making policies based on probabilities

When I was a young recruit in the French Foreign Legion, my platoon commander always had a saying that I have found increasingly relevant in everyday life. Irrespective of where we were deployed, be it Africa or Afghanistan, he would always say, “ç'est le terrain qui command,” which, loosely translated, means that it’s the land on which you are that commands your actions. No matter how well-trained a soldier can be, it is always his ability to gauge his environment that will give him clarity about his situation and enable him to adapt to the surroundings in which he is immersed. That’s why training is so important. Not just to become competent in performing an action, but being capable of executing an action that you were not trained for. It is this formula of resourcefulness that can mean life or death in the battlefield and which coincidentally also determines how to plan a successful business strategy.

Capitalism today is in the throes of an environment that is constantly changing. We are attempting to adapt to this change, but we are using a scaffolding that was devised at a different time. Is it a wonder then that in spite of all our technological progress, we still have increasing levels of income inequality? Is it a surprise that we still use telephones and fax machines to settle trades that are conducted on a nanosecond basis? Is it really a shock when we realize that our first reaction to an idea like the Chicago Plan is to shun it and find reasons why it would not work, rather than challenge our existing belief system? And is it really a surprise that the ones who understand how the system works extoll a rent that is scandalous and vulgar by any measure of humanity?

The Blockchain is not a solution to these problems. As stated at multiple intervals in this book, is not a panacea. It is a tool which, if deployed correctly, can allow policy makers to create a capitalistic system that is not dependent on the fractional banking system, which is more transparent, more ordered and less financialized, and has lower levels of debt. But it cannot reach the zeniths of its capabilities if it is used just to make transactions faster and help financial institutions save on some costs. It has to be deployed in tandem with wide-arching societal programs that address the current economic malaise.

Undertaking such an endeavor is bound to be fraught with doubt and will require that we rigorously test our theories before deploying a project that can have wide-ranging social benefits. It is in this context that I introduce the subject of complexity economics, which we will explore in relative detail in the next chapter.

If we are to redefine capitalism, then what we require for the future is not just a new theory that is holistic in nature and modern in its outlook, but a buffet of theories. The reason for this multipronged approach is simple. As we have seen, economies are complex structures with multiple actors playing multiple roles, who are constantly changing the form and shape of the market with multiple spillover effects. This essentially means that the market is not in a state of equilibrium, as stated in traditional economics, but in a state of entropy. Information is exchanged and creates pockets of organized data structures which show some guise of steadiness. But as technological evolutions occur in bursts of concentric circles, it disrupts the false sense of serenity that is presented as a façade and forces the actors to adapt to the new environment they are immersed in. This is why innovation has become the chant of corporations and the curriculum of universities.

If we are to accept this based on the evidence that has been provided, then we come to a stark realization. Are we to continue governing ourselves on the efficient market hypothesis or adapt to the entropy of information that makes up to market place? With the Blockchain becoming mainstream, this question gains more gravitas, as we now have access to even more information that can be shared across multiple parties. Would it not make sense in that case to accept the entropy for what it is and develop theories and frameworks that would help us adapt to this state of constant flux? This is the promise of complexity economics and, in the next chapter, we will get an educated understanding of what this is and the models that can be used via this branch of science.

It must be remembered that, as information changes hands, it creates ripples of decisions which can create multiple scenarios. A government might think that by putting money in the hands of its citizenry via a UBI, it would spark demand. But what if that does not happen? What if the citizens prefer to save their money instead, or use it for other purposes such as saving it or taking holidays en masse? Is there any model that the government has that can offer a contingency plan to any reaction at either extreme or at different levels of granularity?

This is what complexity economics will help us to. By using a defined set of variables (and there is the possibility of using a great number of multiple variables as input data in complexity science models), we can create different simulations that will help policy makers not necessarily predict the future, but determine how to react in case a certain scenario begins to take form in reality. This scenario creation possibility, along with the advantages of the Blockchain, is what will be required if we are to safeguard ourselves from future crises.

For these objectives to be reached requires not just a comprehension of where we are going, but also where we come from, and it is the reason that this chapter refers to projects and proposals that have been stored in the annals of economic history. By juxtaposing the past, the present, and potentialities for the future of economics with the scientific methods of complexity science, we can develop theories, simulate economies, and test them rigorously to decide what course of action needs to be taken. Doing so will make economic policy proactive rather than reactive.

When we look at a capitalistic nation, how do we use the very force that is changing us to help address the jobs that it is removing? How do we define innovation in the context of capitalism? How do we raise the innovativeness of an entire capitalistic state so as to put ourselves on a trajectory of growth and find solutions to the problems that befall us today? Would it be irrational to ponder that the answers to these questions require that we need to innovate the theories of capitalism as they are defined and executed? If technology is practically changing the paradigms of employment and growth, then ought we not to meet it halfway by changing the paradigm of economic theory?

The answer to these questions, as stated in the beginning of this chapter, lies in culture, for capitalism is both an economic as a well as a cultural construct. As technology reshapes our lives, we need to develop a culture which can be traditional in nature, but has to emphatically be modern in its outlook. A culture in which citizens are comfortable with change, in which entrepreneurs and businesses think in terms of probabilities to find opportunities, where experimentation is based on the scientific method, and where theories are put to the test on a constant basis. Without such a culture, we will not be able to have a change in our economics mindsets, no matter how hard we scream about innovation.

Coming up with the right theories will be almost as important as having the right leadership in order to instigate this change in mindset. Theory is important, as it gives us direction. But theories also need to be tested to be proved valid. While current macroeconomic theories have been rigid, the future theories that we need to develop need to be more flexible. But when we talk about capitalism, testing a theory ends up involving citizens who are engaged in economic activities. Evidently, this is a risky practice to be adopted and might not go down too well if it causes adverse impacts on swathes of a population. This is why simulating the theories and testing their viability is of the upmost importance if we are to develop a buffet of theories.

While technology destroys old frameworks, it is also creating new ones. The technological framework of the Blockchain allows us to gain information about the entire financial system and create theories that incubate the financial system. But to test our theories we will also need to use new tools and methods. It is for this reason that we need to turn our gaze to complexity science models, as they are attuned for these kinds of analyses.

Notes

The following sections provide additional information on some relatively technical concepts.