A universal framework for understanding incentive design in crypto and fiat systems — Part 2

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Mar 25, 2019 · 23 min read

Prelude

“Asleep and naked as an Indian lay An honest factor stole a gem away; He pledged it to the Knight, the Knight had wit, So kept the diamond, and the rogue was bit.” — Alexander Pope[1]

18th Century, France

The following contains quoted sources that have been rearranged in sequence for narrative clarity. [2][3][4][5]

“And it wasn’t just wealthy investors who were caught up in the scheme. People from every class of French society rushed to get involved. Coachmen and cooks made millions in days. Trading was centered on the tiny street in Paris where John Law lived, the Rue Quincampoix, and crowds gathered every day to shout and scrap for Mississippi shares [of the Compagnie des Indes or the Company of the Indies].

John Law was the architect of a novel fiscal and monetary system. He convinced the French government to let him open a bank, that could issue paper money or banknotes and collect taxes. [His venture was backed by the Governor of Fort St George in South India, Thomas “Diamond” Pitt. Pitt had made his fortune by smuggling the Regent Diamond out of India and selling it to Phillipe II, Duke of New Orleans.] It seemed that John Law’s paper wealth created from transporting 6,000 settlers and 3,000 slaves [to the Louisiana Colony] had obliterated the normal rules of economic life.

But Law’s theory of money was incomplete. He neglected the impact that the issuing of millions of shares would have on the money supply, and on inflation. Law kept issuing more and more banknotes to fund purchases of shares in the company. Notes and coins in circulation went up by 186% after the company floated. Prices were rising by 23% per month.

John Law was losing control of his scheme. He proposed that shares in the Company be gradually deflated by 50% over a period of months. The speculators started to sell. The smarter ones have already left France, buying up precious metals and gems. Others also sought liquidity, buying especially land titles. To support the rapidly falling price, Law opened a company office to buy shares at 9000 livres. The bank also bought them, and the notes in circulation have risen by 600 million. But the notes have also lost trust, and many were exchanged for gold and silver coins.

To protect the bank’s metal reserves was the hoarding of cash forbidden. The price of a mark of gold and silver were raised [and] their export was forbidden. The Compagnie was also allowed to make house searches for precious metals and to confiscate them. The carrying of pearls, diamonds and gems was forbidden, punished by a steep fine and confiscation. Silverware was forbidden or limited in weight. And this is where the story ends. There were ugly scenes on the streets of Paris where dozens were crushed in the crowds, desperate to withdraw coins from the remaining banks. France would take generations to recover from this collapse.”

Present day

The “post-gold standard era” which emerged during the 1960s — 1970s is regarded as the scientific innovation that allowed the global modern economy to scale after World War Two and avoid another Great Depression.

As discussed previously in part 1, the system design of the prevailing nation network model relies on the use of a bank credit custody framework to represent a single combined monetary and currency plane. This bank credit custody framework is then presented to the network users as money in the form of bank deposits and physical banknotes. Trade network contracts, including financial instruments, rely on the supply and demand equation for these bank credits to (a) measure approximations of units of value and (b) establish relative price signaling for goods and services.

The governance layers of the single unified monetary and currency plane then manipulate approximations of units of value and relative price signals for goods and services in order to influence and control user cognition and behavior to achieve a target output.

One curious feature of the Fiat monetary system plane is that it views the adjustment of the supply of currency into the system as a mechanism to generate output. Specifically, the model views the manipulation of the currency supply by vested interests as a feature and not a bug for the network users. The benefits presented by this model are as follows:

We will investigate:

1. Whether the Fiat model of control has achieved its goals by its own stated criteria;
2. The embedded operating logic of the model;
3. The effects on network users from this embedded operating logic; and
4. Whether the Crypto model of open-source consensus adequately addresses the concerns that were brought up by the Fiat model.

We will then use those findings along with the Nakamoto Framework to further our understanding of the Fiat Network Topology (FNT) and Crypto Network Topology (CNT) at the levels of incentive design.

Let’s begin by playing with Legos!

Chapter 5: Playing with Legos

Imagine that Amazon enforces a new rule requiring all its users to use Amazon credits instead of USD to access their platform and make purchases. Imagine further, that these credits can only be obtained from Amazon USING Amazon credits. The users are left with two choices. Either to switch to a different platform that does not require Amazon credits or to figure out a way to obtain Amazon credits to use the service.

Now suppose that on top of being able to enforce the use of Amazon credits on all its users, Amazon also had the power to disallow anyone else from offering a similar service. Once they exercise the latter, the users have no choice but to use Amazon.

Since the users no longer have the choice to use any other service, they must find a way to obtain Amazon credits. This is a chicken and egg problem which Amazon solves by introducing a lending service. This is to allow the users to borrow credits from Amazon and use those credits to access the service. But since these credits are a form of debt, they must eventually be repaid back.

But what if the users do not have enough credits to pay off the debt since they spent some of those credits to use the service? That’s certainly a problem. The users can borrow credits from their friends, perform work for another network user to obtain some credits or even transfer assets corresponding to the value of the credits they owe to Amazon as a last resort. But can they ever be debt free once the wheel starts spinning?

The users are essentially stuck in an infinite loop where they are forced to pay for a service with that service, but since the users are unable to do that and have no other choice, they are compelled to borrow and create debt for themselves. And then to pay off their debt, they are accruing more debt. They have been trapped by the Moloch of TPE + FNU + DBID that we introduced in part 1.

The current Fiat monetary system is no different. The key hidden premises behind Fiat incentive design are that money must (1) exist as debt in the form of banknote currency and (2) be forced on users as a common standard through the state’s monopoly on violence. This is a critical observation, which is often overlooked by most observers. Even those that may agree with the above statement may not have a clear understanding of what that means for network users over time.

“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.” — Satoshi Nakamoto[9]

Indeed, as we have seen from the previous chapter on FNUs in part 1, the “money” held by banks was never our money in the first place. It existed as debt in the form of bank credit that users are forced to borrow by the governance layer of Fiat.

Fiat has redefined money as a network service that supplies currency units into the system. It is a service that is run by a single monopoly that forces users to borrow currency units into existence and then pay the rent for its use in the same units. The network and its users have no choice but to use the service. As the network users and their activity continue to grow, more and more units have to be borrowed and as a result, the network debt will continue to increase.

Chapter 6: Revisiting the Canonical Narrative

6.1 The Moloch triangle

The canonical narrative of the current Fiat system consists of three parts.

The first part

Prior to the establishment of the Federal Reserve, the private notes issued by the state-chartered commercial banks, community credit unions, and even merchants were the dominant form of currency. The technological constraints of paper notes and lack of digitization meant that the supply of these notes and the accurate representation of their use in a ledger was a concern. This justified the TPE to push an FNU to limit user choice to one currency and appoint a single unipolar currency supplier. Thus the modern Fiat central banking paradigm was established along with the Federal Reserve to push further FNUs.

The second part

The expansion of the centrally controlled money paradigm was seen as a solution to the Great Depression wherein the instability of prices, the loss in purchasing power, decreases in economic activity, increases in asset forfeitures, and the lack of adequate currency supply led to catastrophic losses for the network users. Fear and the need to prevent this from happening again created the context for the TPE to centrally control the money supply.

The third part

The Fiat central banking paradigm could now create money through a centrally controlled bank credit supply. Money took the form of debt for the network users and this money was deployed in the form of a centrally controlled credit supply. But there was a need to adjust the total supply of currency to meet the market supply and demand for goods and services. It was further argued that being able to add more bank credits into the network for the users to borrow on an ongoing basis would encourage more network activity. The Gold Standard was seen as a barrier to achieving this goal and was abandoned so that DBID could be fully implemented.

Various bank credit mechanisms were used to make unilateral adjustments to the money supply and encourage network activity to achieve certain policy goals. This process of centrally controlling the supply and demand equation of network bank credits and regulating the flow of currency units in the system was presented as a feature that would benefit network users by stabilizing purchasing power and prices. Let’s explore this further by revisiting first principles and understanding the difference between real value, perceived value, and the relative price signal.

6.2 Price vs Value

The real value is a measure of importance assigned to various goods and services. The relative price signal is a unit of measurement to express that value. The approximation of that value is different for different users. A winter jacket may be extremely valuable to someone living in sub-zero temperatures and yet be of no value at all to someone living in a desert. As a result, it can be said that the concept of value is very subjective and depends on the user’s cognition and viewpoint. It cannot be necessarily normalized for a large superset of users unless there is a shared common standard to express each user’s subjective approximation of value in terms of common units.

At the same time, the relative price signal itself is a function of the number of units of account in the monetary system plane. It can be manipulated by adding or subtracting currency units into or out of the Fiat monetary system plane. Any variation in price signal impacts the perceived value of that good or service, causing the users to think that the value has changed. When in reality, this perceived value may have little to do with the relative real value of that good or service for that user.

The Fiat governance layer’s argument is that the merger and control of the monetary and currency system planes can allow the governance layer to control asset prices and perceived value. And that this is necessary to ensure price stability and preserve purchasing power for network users.

What is left unsaid is that these monetary policies are enacted to control and manipulate user viewpoints in order to achieve targeted output goals. While this could be considered coldly efficient from an administrative standpoint, doing so has resulted in the exact opposite of the stated goals of ensuring price stability and preserving purchasing power.

If the users are forced to use a single monetary system plane and a central authority has the power to perform FNUs within that plane, this central authority has the power to affect the perceived approximation of value by playing with various supply and demand parameters. But since user preferences tend to return to equilibrium once they realize the true value and that everything was a temporary bubble, the net effect is that users have lost wealth and purchasing power. This is reminiscent of what happened when John Law pegged the price of shares above their market level. It led to a massive issue of notes in exchange for shares. People’s preferences went back to equilibrium and the Compagnie des Indes declared bankruptcy.

The 2008 housing crisis provides another example with which to study the impact of the Fiat governance layer’s control of the monetary system plane. The governance layer increased the supply of currency units available to borrow by reducing the interest rates for housing loans. This resulted in an initial surge in the housing prices, causing more and more people to invest in houses based on their perceived value, thus creating the bubble. But when the user preferences started to shift towards equilibrium for various reasons, the collapse happened, leaving the users with debt, asset forfeitures, and less purchasing power.

It is critical to realize that adding more currency units into the monetary system plane has very little to do with the real value. Doing so will only increase the prices momentarily but the true value remains unchanged. Once the users begin to realize the “bubble” and start taking advantage of the situation for personal gains, we end up with a defect-defect condition and the economy collapses.

6.3 Inflation vs Deflation

When all the users within a network are forced to use a single monetary system plane as they are in Fiat, the governance layer has the capability to affect real and perceived economic growth through the control of (a) the mechanism of money creation as bank credit and (b) the expression of that mechanism in the units of account for that monetary system plane.

This awareness along with the understanding that this kind of power can lead to decisions that can seriously damage the economy led to the inflationary vs deflationary currency debate.

The Monetarist View addresses this problem through the notion of a balanced budget, encouraging the governance layer to cut down on spending in order to narrow the gap between GDP and the currency supply as it did during the gold standard era. On the contrary, the Keynesian View addresses this problem by adding more to the supply of currency units while encouraging the government to spend more. The argument is that having more of a supply of currency units is better than not having enough of a supply of currency units. And that deploying more currency units in the system encourages network activity and growth, even if it were to cause a price increase in goods and services and a loss of purchasing power for some network users.

Consider that the Keynesian vs Monetarist debate is only relevant if users are all forced to use a single monetary system plane. In Crypto, the users are not confined to using a single monetary system plane as they are in the Fiat paradigm. As a result, there is no longer a need to manipulate the supply of currency units. In Crypto, the value of a commodity can be discovered through user choice as reflected in supply and demand interactions. Even if a TPE were to manipulate the token supply, the users are not forced to use that network, which reduces the risk significantly. Crypto design can prevent a TPE from controlling the entire monetary system plane and pushing FNUs that influence or compel the user to choose defect-defect.

Moreover, the Bitcoin solution also took advantage of digitization and divisibility to set the smallest unit of account, one satoshi, equal to 1/100000000th of one Bitcoin.

By making the smallest unit of account as small as a Satoshi, Bitcoin’s solution ensures that there are always enough units of account to represent the true value of the market and power economic activity. This eliminates the need to regulate the total currency supply for a single monetary plane via FNUs and TPEs in order to generate relative price signals and manipulate perceived approximations of value. Suppose if we are to reach a point in the future where economic growth surpasses the total units of account, the users are not restricted to the BTC network. They have a choice to use multiple different networks based on their incentive design preference.

“I’ve always been in favor of abolishing the Federal Reserve and substituting a machine program that would keep the quantity of money going up at a steady rate” — Milton Friedman [21]

Chapter 7: Fiat Network Topology (FNT)

7.1 FNT Mental Setup

The mental setup of a user in FNT expresses a dominant memeplex that prefers a resolution mechanism in place that is enforced by a third party.

This cognitive language causes users to select and elect various forms of institutionally centralized governance layers. It empowers these TPEs at the command line to design and to deploy nation network protocols or to perform FNUs to run the system. The government and civil institutions, for example, compile and deploy laws that inform and enforce public and private contracts using the logic of violence. These contracts are the executables that Fiat users interact with on a daily basis without a second choice. These contracts may include tax laws, interest rates, or policy schemes that dictate how and where the bank credit or currency can be created or used.

7.2 FNT Incentive Design

Because FNT governance models are centralized through their insistence on the geometry of the TPE rule, the governance layers of FNT are able to perform FNUs at the command line on all users compiled through the logic of violence (such as the design change from the gold standard to Fiat currency). Indeed, the very definition of the word “Fiat” itself reveals its structural geometry since “Fiat” by definition is not backed by anything but the legal declaration from the governance layer of the network that the network users must use it.

Fiat currency or FNT bank credit gets minted as debt and has to be borrowed into existence with interest. The original issuance of Fiat currency as network debt is a crucial design element that is often overlooked. This means that interest payments must accompany the debt.

Consider that at the original issuance, the Fiat debt units required to pay interest on the initial set of Fiat debt units borrowed into existence do not yet exist. The Fiat debt units needed to pay the interest must, therefore, be borrowed into existence as well.

The creation of more debt Fiat units by definition and legal declaration requires yet further payments of interest as the new debt Fiat units are borrowed into existence. So as the system cycles, interest accumulates and the users must borrow more or be taxed to pay the interest, which in turn sets up more debt and interest to be accumulated within the system.

“Commercial banks create checkbook money whenever they grant a loan, simply by adding new deposit dollars in accounts on their books in exchange for a borrower’s IOU.”- Federal Reserve Bank of New York, “I Bet You Thought”, p. 19 [23]

The Fiat Incentive Design Equation is given by:

Where D represents the total Fiat currency that was borrowed as debt from the governance layer and is in circulation, and i represents the total interest that needs to be collected on D.

For the users of the network to be debt free they must return D + i to the governance layer which controls the network. But this i can only enter the system if more debt, D, is created. As a result, the governance layer continues to create more debt Fiat units by creating more bank credit token claims and forces its users to borrow these bank credit token claims and pay interest in the form of ever-increasing taxes and fees. This creates an infinite regression where there is no point in time when the network and its users would ever be completely debt free.

7.3 FNT Network User Effects

The FNT design scheme forces its users to borrow and use Fiat debt units in the form of bank credit token claims. The users then have to pay back their use either through taxes, interest, or through the transfer of real assets, even though they never wanted to borrow and use these Fiat debt units or bank credit token claims in the first place but were forced to via FNUs deployed by the FNT governance layer.

Moreover, as the supply of Fiat debt units or bank credit token claims continues to grow geometrically or exponentially by its built-in incentive design, the purchasing power of network users commensurately declines while the purchasing power of the third parties in control of the FNT governance layer will commensurately increase.

The decline in purchasing power requires ongoing injections of yet more Fiat debt units into the system, whose associated purchasing power will accrue to the owners of the governance layer disproportionately according to a J-curve distribution. This is what is referred to in the Fiat banking policy circles as “seigniorage.” In reality, Fiat is a highly-optimized, rent-seeking financial scheme in the form of a global co-evolving memeplex.

A Crypto manifest Thucydides may wryly remark that the inevitable consequence of the architecture of the DBID + TPE based Forced Network Update shall ever be the same: “the weak suffer what they must.”

Chapter 8: Crypto Network Topology (CNT)

8.1 CNT Mental Setup

In CNT, the mental setup of a user expresses a dominant memeplex that prefers to have a resolution mechanism in place that stems from the geometry of open source consensus rules as opposed to third-party enforcement rules.

This cognitive language causes the users to create decentralized governance mechanisms at the command line in which no single third party or collection of third parties is capable of performing an FNU on all users or make mistakes that could affect the economy of the entire network. The cognition of open source consensus rules as a resolution mechanism led to the development of blockchain governance at the command line.

Various smart contracts and services can be built on top of these blockchains through contributions from anyone that is part of the network. Crypto users interact with these smart contracts, which then determine how the Crypto tokens are created and spent. All the laws in CNT regarding token distribution, ownership, and records of spending exist in the form of code that theoretically cannot be altered by the unilateral violence of a third party through a global FNU except under a set of known and measurable conditions.

8.2 CNT Incentive Design

In contrast with FNT, Crypto tokens do not have to be created as a debt agreement, debt for network users, or as bank credit. No user can be forced to borrow and use a particular CNT token. Rather, users are offered the choice to acquire or invest in any token of their preference based on which network they find valuable. The value of the tokens is a measure of the users’ perception of the network utility value and depends on factors including the type of service the network offers, the network hash rate, whether the token provides an underlying cash flow, whether the token is unforgeable and uncensorable, whether the token dynamics are designed for political manipulation, the token supply amount (limited or unlimited), the attention of developers, intensity of community support, number of users in the network, and so on.

One cannot enforce the use of a particular Crypto token across all users in CNT. Users are allowed to freely use the network and the token of their choice. If they disagree with the rules of a particular network, they are free not to participate, cannot be compelled to participate, and have the power to leave the network and create their own. In CNT, users are not compelled to pay rent to anyone in the form of debt and interest for the use of the tokens.

That said, the Bitcoin solution and decentralized governance technology cannot be taken for granted. Attack vectors, including adjustments to governance and adjustments to incentive design by known and unknown parties, represent a changing argument surface that must be actively monitored and counteracted.

8.3 CNT Network User Effects

Unlike in FNT, the CNT design scheme does not force its users to borrow and use CNT currency units. Nor are the currency units globally constrained to be minted as network debt. This means that the users of CNT do not have to pay back their use of network tokens with additional interest or through the transfer of real assets to pay network debt as they do in FNT.

The value proposition of the CNT token issuance model is that the users are NOT restricted to a single monetary system plane and the original issuance of tokens is NOT compelled to take the form of debt or bank credit for network users.

Moreover, unlike in FNT, a global FNU by a single or multi-centric authority or third party can be made practically impossible to enforce in CNT.

The value proposition of the CNT blockchain governance model is, therefore, decentralization, which allows the model to make statements about the following without relying on a central authority or third party enforcer:

1. Trust
2. Security
3. Privacy

By decentralization, we specifically mean decentralization of power, of checks and balances, and reducing the risk of unilateral decision making that can wreck the system. Given that TPE and FNU might be a good optimization in some cases, identifying what aspects of the system could be centralized vs which ones must be decentralized will make the path to decentralization more practically oriented.

Recall that in part 1, we defined money as an agreement about energy. It is a shared standard between two strangers to agree upon (a) approximations of units of value and (b) relative price signals for goods and services.

It is important to realize that money is not a thing or a resource. Fiat money is not so much money as it is currency. Fiat currency is not so much currency as it is a policy abstraction that can take multiple forms.

The governance layers of Fiat unilaterally adjust the creation and supply of an inventory of infinitely available bank credit in order to manipulate approximations of units of value and relative price signals for goods and services. This mechanism is in turn used to influence and control user cognition and behavior to achieve a target output policy.

The objective of the current Moloch is to present this policy abstraction to network users as “money” in the form of bank credit or debt. Users are then forced to accept the bank credit system as a common standard. This is achieved by restricting user boundaries to a single combined monetary and currency plane through the state’s monopoly on violence.

The objective of decentralization of power is to remove this boundary and unplug Neo from the Matrix. We will continue this discussion further and dive into the scaling debate and stable coins in part 3 of this series.

References

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