I think that all existing cyrpotocurrencies share a common flaw, which is that they have no way to dynamically control the money supply in response to economic demand. Every currency, whether crypto or fiat, comes with a monetary policy. This is a set of principals governing when money should be added or subtracted from the economy. For the sake of this discussion, we can divide policies into two camps, discretionary and constitutional. Discretionary policy can best be summed up with the following quote from Dr Who explaining why the TARDIS always looks like a British police box from the 60's, when the series debuted:
Amy: Why is it a police box?
Doctor: It's camouflage. It's disguised as a police telephone box from 1963. Every time the TARDIS materializes in a new location, within the first nanosecond of landing, it analyzes its surroundings, calculates a twelve-dimensional data map of everything within a thousand mile radius, and determines which outer shell would blend in best with the environment. And then it disguises itself as a police telephone box from 1963.
Or, put another way:
Public: Why did you raise or lower interest rates?
Central Bank:It's camouflage. The interest rate is political cover that prevents people from voting their government out of office. Every time the bankers meet, they analyze all available economic statistics, calculate a twelve-dimensional data map of all imports/exports, employment rates, income growth, and spending habits, and determine the precise target interest rate that would best keep the economy stable and well regulated. We then pull a number out of our asses because no one wants to admit it's all a house of cards anyway.
The creator or creators of Bitcoin were responding to the financial crisis of 2007, which they believed was in part due to overuse of central banker discretion, which all too often is subject more to political influence than to expertise. Bitcoin is more aligned with the constitutional policy advocates. These folks do not deny the expertise of top economists - often they are top economists - but propose the radical idea that central banks should formulate a plan and then write that plan down and then... here's the radical part... follow the plan. The hard part of constitutional policy is that you've got to write the plan first, before there are economic and political events that might tempt us to do something different, and then follow through when reality strikes.
So - why not make a computer do it? A computer doesn't care which fourth grader as been elected to the US Presidency this year. Note that automating monetary policy doesn't eliminate the role of human expertise any more than any other complex software writes itself. Someone's got to figure out the right policy and there are now dozens of cryptos experimenting with different approaches. However, they are all missing something.
The father of discretionary monetary policy is Milton Friedman. He proposed the k-percent rule. This simply says that the money supply should be increased at some fixed rate for all time. That rate is "k". Easy, right? Yes, economies go through boom and bust cycles. However, argued Friedman, fixing the rate would smooth these cycles and in the long run the economy of a stable country expands as population and productivity increases. Bitcoin follows the k percent rule better than any preceding currency. The number of coins in existence increases at the rate which they can be mined, which is roughly constant. Friedman would be proud. However, most modern discretionary policy economists agree that the k percent rule is insufficient. Yes, in the long run economies expand. Also, in the long run we're all dead. And if you're rounding up, the Earth's surface is all water. We can also talk about median incomes as though the differences didn't matter. With all due respect to Friedman's intelligence and insights, life is lived in the seems and cracks. It is true that we don't want to mico-manage our currencies, but there has to be some middle ground between the caprice of human bankers and the immutable drum beat of hash rates.
Modern discretionary economists argue that we still need to be able to both increase and decrease the money supply, and the rates of increase and decrease should be variable. There is something called the demand for money. One way to look at this is basically the amount of money an economy needs at any given time to keep the inflation rate within a fixed range. The goal of discretionary policy is to equalize the supply of money with the demand for money. If we can calculate the demand, then you have your policy rule right there and you don't need to pull numbers out of your derriere.
How do you know what the demand for money is? This is a matter for debate. One could use the inflation rate. In the US, we have the Consumer Price Index, or CPI. This however is a poor measure. For starters, it does not capture economic reality very well. The CPI in America has remained stable for nearly 20 years now. How is that even possible? The financial genius of Ben Bernanke? The problem is that CPI is focused on consumer goods that have benefited from huge advances in globalization, automation, consolidation of markets by big players like Amazon and Walmart, and the logistical improvements afforded by the fusion of the Internet, big metal computing, and the optimizing math of good old operations research. That is a Dr Who way of saying that technology and cheap labor have removed wild fluctuations in the price of everyday products. If it seems like a lot of things cost roughly the same as they did 10 years ago or even more, it's because they do. Our ancestors did not experience this stability.
BUT - you may have noticed that a lot of things don't cost roughly the same. Like houses. Or oil. The CPI ignores these things because they are more volatile, but maybe the old way of thinking about them is no longer valid. Low inflation is an illusion. If you're asking how it is possible to experience a 10 year bull market with record low unemployment without a spike in inflation, then the answer is it's not possible. The money is flowing elsewhere, into areas we aren't looking at.
We could attempt to fix this by somehow calculating a normalized figure for real estate and energy prices and rolling that into CPI, but that's no good for cryptocurrencies. It illuminates the second problem with using inflation as a yardstick for monetary policy. Right now, the computation of CPI or any other inflation target is not automated. It's still government agencies that are solving the twelve-dimensional data map with laboriously gathered statistics. How is a cryptocurrency suppose to compute a target rate based on data outside its blockchain? Not only does the calculation of inflation require humans to gather and analyze data, but it also opens a new avenue for political influence.
Politician: It's an election year, you've got to open up the money spigot
Banker: Sir, we follow a constitutional monetary policy. We can only change the money supply when the inflation rate changes.
Politican: So change the inflation rate, dummy!
There's a song about this. It's called "There's a hole in my bucket, Dear Eliza". Only the bucket is the US Dollar or the Euro and Eliza is the latest ship of fools that has landed on the shores of the Potomac or the Senne. The dilemma faced by Dear Willy (You Silly) is that he can't solve the problem if he keeps moving it around or changing the subject. I'm sure you've had plenty of arguments with your spouse that go like this. If you don't want to really solve the problem, you'll find a way to not solve it. We can pretend that we have a constitutional monetary policy that depends on established rules, but if the variables in those rules depend on something else that falls under human discretion, then what we have done is dressed up discretionary policy as constitutional policy and solved nothing. In fact, we've made the problem worse by lending the system the sheen of rationality it doesn't deserve. Don't let his charm fool you. Look for the whites of his eyes - he's still crazy.
There's a term for this in the engineering world. You blind them with science. That is, you throw around a bunch a figures that look very scientific, but they all depend on assumptions. So what is an economist to do? There are schools of thought that propose a calculation of supply and demand that depends only on the data within the monetary system itself. There is no need to figure out the price of milk or any product. This is great, because this is the only thing we can do with a cryptocurrency. However, there is another problem: assuming we can calculate the right interest rate, how does a crypto enforce it? Central banks do things like open market operations and enforcing reserve requirements. Decentralized currencies can't do this. They could potentially change the expansion rate, but how do they take money out of the system? This is a problem that MUST be solved before cryptocurrencies can be a useful everyday unit of transaction, and not a speculator's dream (or nightmare).
As far as I can tell, no one is publicly working on this. Perhaps there are labs somewhere working on it in silence. There has to be something. But I don't know. I have my own ideas. I probably have no business trying to sell them, but no one can stop me. What I want to do in future posts is dwell on these two concepts.
How does a cryptocurrency calculate the demand for money within the confines of a blockchain?
How does a cryptocurrency dynamically increase and decrease its supply of money?
Tune in next time?