Economics / Technology

The new economics of blockchain

This week I too was at the Sydney Blockchain Workshop, with both Darcy and Trent. I had the opportunity to participate in the ‘Alternative economies and reputation-based systems’ session, where I spoke about the economics of emergent economies built on blockchains. Also on the panel was Michel Bauwens (P2P Foundation), Primavera de Filippi (Harvard Berkman Center), and Gregory Meredith (Synereo, which incidentally, is building the platform for social media constellaxy).

The topic of my bit was ‘The new economics of blockchain’ and I used my time to first identify the blockchain as the general purpose technology siting at the heart of the new cryptoeconomy, and then introduce three pre-eminent economists of the blockchain: F.A. Hayek, Elinor Ostrom, and James M. Buchanan.

The upshot is that the insights from these three economists—(1) that economic knowledge is dispersed and needs some signalling and aggregating mechanism (Hayek), (2) that polycentric institutions of governance beyond markets and states such as commons can help in this regard (Ostrom), and (3) that it is citizens themselves who ultimately control their own social order in their search for rules of the game that best serve them (Buchanan)—explain the dynamics of emergent economies built on blockchains.

Below is a loose transcript of my comments. First some context:

There are two broad ways of making classifications of types of economy: by dominant or ascendant institutions (socialist, collectivist, and centralised versus market-capitalist and distributed), or by dominant or ascendant technology or technological regimes (a.k.a. ‘means of production’).

It wasn’t long after the invention of the macro-economy in the 1930s, whilst under the influence of development theory and the hopeful prospect of industrial planning, that we started to classify macro-economies by their predominant production form, e.g. subsistence, agricultural, heavy industrial, etc. along with reference to their institutional vector, e.g. emerging, transitional, and catch-up.

As technology rolled on, by the 1980s and 1990s we started using labels that referred less to specific nation-state economies, or their political economy (e.g. socialist, mixed, capitalist), but to super-clusters of new technologies—collectively labeled the new economy—such as the information economy, the knowledge economy, the post-industrial economy, and the digital economy.

An information economy is broadly based on information and communications technologies (ICT) as the dominant GPT or ascendant techno-economic paradigm. This decade, the 2010s, following the Web 1.0 and 2.0 economy, has seen the rise of what is variously called the sharing economy, or platform economy, or peer-to-peer economy (some call this the Web 3.0 economy).

This is now ushering in what can be called the cryptoeconomy—built on the blockchain, as the latest new general purpose technology (GPT):

A cryptoeconomy is the techno-economic paradigm built on the general purpose technology of the blockchain, which is itself emergent from an information economy. Institutionally considered, a cryptoeconomy is an extreme form of decentralised or distributed economy.

As a general-purpose technology, the blockchain is new, just as steam power, iron and steel, electricity, plastics, computers, and the Internet once were.

As these technologies were adopted and scaled, they gave us the industrial economy, and then the information economy. These are technologies for making things, for moving atoms and bits. This is the economics of Adam Smith and Joseph Schumpeter.

But the blockchain is a different type of technology because while it is, at base, an information technology, it is also an institutional technology. It is like a market, a firm, or a government, which are also institutional technologies. These are technologies for coordinating economies, for moving people into an order that produces value.

And the cryptoeconomy is just like other economies, except probably with more commons-based peer production and peer governance:

There will always be economies. An economy is made of resources (matter-energy), physical technologies (knowledge) and social technologies (institutions). All economies involve specialisation (the division of labour) and coordination (putting it back together again). All economies are social, make use of specialised knowledge, and transform inputs into higher valued outputs.

What changes as an economy grows, develops and evolves are not the resources; what changes are the technologies. For the past few hundred years, economics has focused mostly on the physical technologies, because that is what has changed the most. The social technologies—markets, firms and governments—have changed less so.

But the blockchain is a new institutional variable. It is a new institutional technology that directly competes with other coordinating technologies—firms, markets and government. However, it is also not new, because the social technology it is modelled on is actually the oldest of all coordinating technologies for economies—namely, the commons.

But the commons has never been competitive as a generalisable coordinating technology because it scales poorly. Firms and markets have through the past few hundred years historically been far more effective governance institutions for ordering ‘economies’ because they can draw upon centralised monopoly government institutions (provided by nation-states) to provide rules, record-keeping, adjudication, money, property rights definition and enforcement, and all the governance necessary to underwrite the social technologies that enable firms and market forms of economic ordering to be efficient.

The commons, on the other hand, while much maligned, is not as flawed as an institution as the proponents of firm-market-government institutional efficiency would have us believe. Elinor Ostrom has taught us this. The commons works at small scale—where it is actually more efficient than firms, markets, and government—when it can effectively make use of local feedback to create private governance.

But the problem is that it doesn’t scale, essentially because of information, monitoring, and enforcement problems. Blockchain changes that equation. And the implications of that are far-reaching.

The blockchain is a shared, trusted, decentralised public ledger. It continually updates, and is secured through cryptography. Anyone can see everything on it, and no single person controls it: it operates by consensus, backed by proof of work (this is the cryptography part). It is a trustworthy record, protected by mathematics. It is also a transaction database; a technology layer protocol (like TCP/IP); and an information technology.

The thing here is that this makes it very cheap to make a community and supply it with infrastructure to manage interactions on a platform, because the third party trust problem (and associated problems of free-riding) is already solved. Blockchain enables people who don’t know each other to collaborate/cooperate without requiring a third party to intermediate.

This is about new structures of community and commons-based governance. Ostrom’s key insight: people are good at making up rules to deal with novel situations. They can in this way self-govern (or self-regulate). Ostrom’s design principles: boundaries, congruence, monitoring, participation, proportionality, conflicts, autonomy, nested systems.

Yet the Ostrom model hinged on small groups, because cheap talk and costly punishment. The problem was that they didn’t scale. Today, traditional issues related to shared common-pool resources—such as the free rider problem or the tragedy of the commons—could be addressed with the implementation of blockchain-based governance, through the adoption of transparent decision-making procedures and the introduction decentralised incentives systems for collaboration and cooperation.

The transparent and decentralised nature of the blockchain makes it easier for small and large communities to reach consensus and implement innovative forms of self-governance. The possibility to record every interaction on a incorruptible public ledger and the ability to encode a particular set rules linking these interactions to a specific transactions (e.g., the assignment of cryptographic tokens) makes it possible to design new sophisticated incentive systems, which might significantly differ from traditional market-based mechanisms.

But what of our economists of the blockchain?

When I first started thinking about the economics of the blockchain, I immediately saw this as an information technology revolution, and reached for Joseph Schumpeter and Ken Arrow. But then I realised this was really about Ronald Coase, because of transactions costs and the economics of efficient coordinating institutions.

These are not flawed insights. You can get a long way with those (still somewhat radical) economic approaches. But to get to the heart of what is going on here, we need to look past the technological change dynamics and the marginal substitution between existing institutional economic forms and realise that what is actually being reinvented here are economies themselves.

Paging Professor Hayek:

An economy is a designed order, as an intended outcome of a firm or a government-planned economy. A catallaxy is an emergent order that results from the divergent goals of many different individuals interacting within a market exchange.

Hayek’s point was that the economic order of a nation-state (he preferred the term ‘great society’) is not that of an economy, but of a catallaxy—it is an emergent order. In other words, the economy only exists in its parts, in the firms and organisations, but the broader order of the market is that of a catallaxy, and not of an economy. Hayek meant this as a critique of government central planning: you can plan an economy, but never a catallaxy.

And his most important work—‘The use of knowledge in society’, published in 1945—was based on a distinction between two types of knowledge, technical or scientific knowledge, and knowledge of time and place, or market knowledge. His point was that economies can only coordinate the first type of knowledge, but it requires a catallaxy to coordinate the second type of knowledge.

The first thing to understand about the revolutionary economics of the blockchain is that Hayek’s insight is new again. The real question is not Coasean: what are the boundaries of the firm and the market? (Or even more generally in neoclassical economics on the boundaries between the market and government.) The basic question is Hayekian: what are the boundaries between an economy and a catallaxy? This is the fundamental margin that blockchain technology reengineers.

To understand why, we need to turn the other two economists of the blockchain: Elinor Ostrom and James Buchanan.

Many blockchain types who dabble in economics might have come across Elinor Ostrom—a political scientist who won the Nobel Prize in economics—because of the sublime resonance between her work on effective self-governance in small-scale natural resource using communities and its similarities to effective peer-to-peer crypto-governance.

But perhaps fewer are familiar with James Buchanan, who won the 1990 Nobel economics prize for his work on constitutional economics and the problems of public choice. In fact, he laid the theoretic foundations to explain the political dynamic of cryptosecession even before formative cypherpunk writer Timothy May declared his Crypto Anarchist Manifesto.

What connects Hayek, Ostrom, and Buchanan is that they were all focused, in very different ways, on the problem of how communities coordinate to choose in groups, and thereby create economies. They were all obsessed with social rules, and with rules for making and choosing rules.

What Hayek gave us was an understanding of what decentralisation actually does: it processes distributed information. For Hayek, market prices were the beginning of the separation of catallaxy from economy. What Ostrom gave us was an understanding of how local governance forms, as a social architecture of community created rules, to create an economy. What Buchanan gave us was the constitutional principles, and specifically the principles of unanimity in collective decision mechanisms, that connected a catallaxy to a web of economies.

The blockchain is a new information and social technology, and it is currently being analysed as such. This is a good start, and it is useful to orient our thinking, but it also risks being profoundly misleading because it does not get at the essence of the revolutionary change that is happening:

What blockchain does is not to shift the boundaries between firms and markets, creating more nimble and well-formed organisations. Nor is it to shift the boundaries between markets and government, breaking the vast monopolies of governance that have accumulated over the past few centuries. Or rather it does all of these things, but these are consequences, not causes. We focus on these aspects because they make sense in terms of changes to our received economic models.

But what is actually changing is something deeper, but something that can be read in Hayek, Buchanan, and Ostrom. What blockchain does is to shift the boundaries of an economy into a space previously occupied only by catallaxies. It does so by changing the level at which the rules of governance operate. Blockchain technologies are social technologies for whole new institutional forms of economies.

This new conception of an economy that the blockchain gives us can actually be rebuilt from within modern economics—just not from the standard textbook models. Our new foundations are Hayek, Ostrom, and Buchanan.

An economy is a group of people coming together (connecting, into a community) to do something of value, using coordinated specialised knowledge, and applying that to a resource context. A few nouns and adverbs aside, that’s actually the same definition we started with. But now look at it anew, without the institutional priors of firms, markets or governments: what is needed to achieve an ‘economy’?

In essence, an economy is achieved through rules of governance, which in large part are rules of what you can and cannot do in a social context, and the pay-off consequences (i.e., as analysed in game theory). This is where analysis usually stops, as in institutional economics, which is the deeper form of the once deep neoclassical economics.

But now go one step further, and ask what needs to be true for that to be true, and you arrive at the genius of the blockchain. The blockchain is the secure, verifiable, trustless (i.e. cryptographically secure) mechanism to record the actions upon the rules.

And right there you have it. The blockchain is doing what prices do in markets, what commands do in firms, and what laws do in governments. It is providing a clear and unambiguous public signal, as a coherent rule-system, to coordinate private action. That means that the blockchain is a technology for building new economies.

The case for the blockchain as a source of economic welfare comes from releasing the vast captured resources we have hitherto devoted to artificially manufacturing trust. The blockchain is described in its economic aspect as a new currency, a new digital ledger, a new infrastructure, a challenge to extant firms and governments, and so on.

These are all true. And they give rise to the language of radical decentralisation, autonomous corporations, distributed records, and new governance systems beyond monopolies—all of which pivots off the transition from our old centralised ways of doing things, both technologically and socially.

This is indeed a remarkable promise. And it is attractive as a foundation for social order, built on mathematical truth as verified, rather than political force as threatened.

The new economics of the blockchain is that it is a new technology for making new economies. That’s less like the invention of steam or electricity, and more like the invention of private property or government.

Advertisements

11 thoughts on “The new economics of blockchain

  1. Pingback: Cold Soup: Innovation satire, Baltic Bitnations, and fatally conceited planners | Meso Soup

  2. Pingback: CryptoGoss podcast on emergent nations and emergent firms | Meso Soup

  3. Always thinking big… 🙂

    I think I’m missing something about how exactly a new “blockchain economy” is going to solve the problem of enforcement. I can see how it can resolve some trust issues, and that is a good thing, but I don’t think the trust problem is the defining feature of governance structures.

    When comparing different governance systems, one of the differentiating features is the method of enforcement for the rules in that system. For the state, they have guns & bombs… for markets you have the promise of profit and threat of losing money… for firms you have the promise of a raise and the threat of being fired… for community groups you have the promise of achieving your social goals and the threat of being excluded from the group.

    I’m trying to work out how the blockchain changes that dynamic. Maybe the issue is that blockchain provides the promise of enhancing your reputation and the threat of tarnishing your reputation… with the understanding that a person’s reputation will be critical in having them accepted or rejected from various other markets, firms, and social groups.

    What have I missed?

    Like

    • That’s right, John. There’s still the problem of people acting coercively in real life. When it comes to enforcement, in cryptoeconomies the threat of losing accumulated reputation (following ostracisation) could be potentially large. Also, it may be possible to design incentive-compatible mechanisms using self-executing smart contracts, escrows, and ‘internet of things’ capability. That is, automated, self-enforcement. It all depends just how much coordination and exchange can be shifted from legacy economic institutions to new crypto-blockchain-ish ones (and whether individuals wish to use them).

      Like

  4. Trent, this (above) is really interesting. But there’s a lot more to an economy than transferring digital currencies around. People need food and shelter and safety. Babies and the old and infirm need care. People and goods need to go places. How does all that get coordinated on a blockchain?
    (Note: I’m not saying it can’t be done. I actually think it can be done. But I haven’t seen any evidence yet that blockchain fans know how to do it. And when it does get done – that is, coordinated in a new way – I am not sure a blockchain will be the way to do it. Maybe part of the way, but what is the remainder of the way?)
    I hope that all communicated. If not, yell, I suscribed to new comments.)

    Like

  5. Ostrom’s work only looks at the management of common-pool resources, so even if those forms of governance could be scaled via blockchain, they would leave out the vast majority of economic activity. Even for common-pool resources, the blockchain by itself does nothing to make it possible for distant partners to observe who is doing what to, say, a roving school of fish in the ocean. It just makes it possible to record in a trustworthy way what someone has claimed about someone else’s (or their own) action. As a transaction/property technology it seems closer to barbed wire or written records than to private property or government.

    Like

  6. Ostrom did an awful lot of work on common-pool resource governance, but taking a step back from this, I think of her work as about ‘polycentric governance’. Not markets or states, or commons or clubs—but all forms of governance in a polycentric institutional order. That’s her big contribution: look beyond markets and states to hybrids. Blockchains might be one such hybrid; or it might be a platform for the discovery of such hybrids.

    First, I don’t think anybody can get away with the claim that ‘blockchain governance’ will transition every piece of economic activity (or property) to commons. That’s silly. And second, surely, as you say, the fisheries of the world will probably not be helped all that much by blockchains. But a lot of economic activity that could have been organised in hybrid forms (but for better mechanisms of governance) might be improved with blockchains. It’s a platform on which Ostrom’s design rules might be implemented and automated. Look at backfeed.cc for an example of this.

    Like

  7. Pingback: The cryptoeconomy is just like other economies, except probably with more peer production | P2P Foundation

  8. Land (in its wider sense of natural resources, including sea and airwaves) can’t be treated as private property without the sort of ructions that have brought world economies to their knees, Trent. Commodifying land leads to speculative rent-seeking, leads to economic recession/depression. We need to, but obviously do not, pay the economic rent of the natural resources we occupy exclusively into the public purse. My earned income and your earned business profits (i.e. not gained from rent-seeking in natural resources) are indeed private property and should not be confiscated in part by taxation. Land rent is owed to the local society for exclusively-occupied lands and there should be no taxation of private property. That part of the bible Jews and Christians alike choose to ignore was maybe onto something when it said land must not be sold in perpetuity. A number of great philosophers, including John Locke the apostle of freedom, have said much the same thing. The rape, pillage and plunder of the planet conducted under the aegis of ‘private ownership’ bears witness to the nonsense of the absolute ownership of land. Interestingly, the word ‘owner’ originally derived from the Middle English ‘owerner’, he who owed the rent. Private ownership of land seems to be libertarianism’s Achilles heel.

    Like

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s