We're Too Stuck In An Old Paradigm to Start Blockchain

We're Too Stuck In An Old Paradigm to Start Blockchain
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One hundred and sixty-nine years ago yesterday, President James Polk delivered his State of the Union address to Congress.  He had quite a lot to talk about, starting off, as many Presidents did in those days, by decrying the state of affairs in Europe (some things may never change). The “troubled and unsettled condition of some of the principal European powers has had a necessary tendency to check and embarrass trade and to depress prices throughout all commercial nations”, including, he warned, the United States its then current prosperity notwithstanding.

The President’s primary attention was served not upon the constant foibles of Europe’s constantly warring powers but cast more in the direction of America’s just concluded conflict with Mexico.  The Treaty of Guadalupe Hidalgo, officially titled the Treaty of Peace, Friendship, Limits, and Settlement between the United States and the Mexican Republic, had ceded to the US a great deal of Western territory including Alta California.  Given that fact, Polk was pleased to announce, “The amicable relations between the two countries, which had been suspended, have been happily restored, and are destined, I trust, to be long preserved.” 

For President Polk, that positive outcome had almost immediately become even more positive given what his speech is truly remembered for:

“It was known that mines of the precious metals existed to a considerable extent in California at the time of its acquisition. Recent discoveries render it probable that these mines are more extensive and valuable than was anticipated. The accounts of the abundance of gold in that territory are of such an extraordinary character as would scarcely command belief were they not corroborated by the authentic reports of officers in the public service who have visited the mineral district and derived the facts which they detail from personal observation.”

The gold discoveries at Sutter’s mill along the American River had tickled the American fancy throughout ‘48, but many concluded it was just that, fanciful discussions among the poor yearning to strike it rich.  Polk’s address was, in essence, the official confirmation which would start the 49er California gold rush, in the process altering in many ways the demographic and monetary history of the United States.

Getting gold out of remote California was no easy task. Overland routes were cumbersome and expensive, including the costs to guard against sheer highway robbery.  The other option, the preferred option, was steamship transport down the Eastern Pacific either around South America to the US East Coast, or at least as far as the Isthmus of Panama for the short road-trip to the Atlantic. The water route, too, was fraught with difficulty and danger.

In September 1857, the steamer SS Central America foundered in a hurricane off the Carolina coast. Innumerable ships and boats had been lost on the route to New York City from Havana, but the Central Americaremains noteworthy for what it was carrying on that fateful trip. Departing originally from the port of Colon in Panama before stopping in Cuba, onboard were 477 passengers, 101 crew members, all their provisions and personal effects, and anywhere from three to 21 tons (estimates vary wildly) of gold mined out of California.

The loss of the ship contributed heavily to the Panic of 1857; a great deal of base money that was supposed to arrive at the New York money center instead was sunk to history. That particular panic, and the depression that inevitably followed, was one of the major factors in moving America into the Civil War.  It was also the first truly global economic catastrophe of the modern economic era (globalization didn’t start with NAFTA; it has been creeping for centuries).

Moving money around the world as had to be done in a true money gold standard involved often great risks.  Sometimes, as in 1857, it just doesn’t get there. The story of the Central America is admittedly an extreme example, but a poignant one nonetheless suggesting one reason why for many people gold was increasingly viewed so harshly. The world’s banks and central banks (not to mention maritime insurers and re-insurers) had great interest in coming up with ways to mitigate these grave monetary hazards as industrialization reshaped global economic cooperation.

One early method was something called a bankers’ acceptance.  This was a piece of paper but no ordinary one.  A trade firm, either importing or exporting goods, would deposit money at one bank in one place in exchange for what amounted to a cashier’s check.  The firm’s trade representative would then take the acceptance to wherever the merchandise trade was to take place and deposit it for payment with an “accepting” bank often in another part of the world. That meant it was for the interbank system to settle whatever money might need to be transferred, at risk only for losing that piece of paper should something go wrong in between.

The first truly global currency of this nature was the sterling acceptance market.  A robust monetary trade had developed as a means to mediate (the primary function of money is first as a means of exchange) burgeoning British trade across an empire so vast the sun never set upon it. 

In the early twentieth century, one of the primary founding principles for what became the Federal Reserve was to foster and nurture a competing acceptance market in dollar denomination and settlement. Just as the Bank of England traded in acceptances, so, too, did the early Fed making sure that the paper was liquid enough to be acceptable far and wide.

The idea of the bankers’ acceptance is to reduce as much as possible the transferal of gold or other forms of accepted money. Not only was physical transportation costly and dangerous, it was more than that highly inefficient for any bank, indeed the global banking system as a whole struggling to connect far flung often isolated monetary outposts.  You had to maintain a large excess of gold and money for what might have to be withdrawn or in real float transit to or from some other point in the world (obviously this was more of a factor to the money center banks in the big cities than any local country bank in whatever country).

It was also true for central banks whose primary task in those early days was to defend any currency, maintaining whatever official convertibility parity as if it was a first national interest (which, in many ways, it was). Rather than ship gold or cash reserves for every little claim, they would often engage in gold swaps (official paper claims) among each other to minimize what would ever be in transit.

We can think of the use of acceptances in global trade, then, sort of like a game of poker. At the outset, each player deposits real money with the dealer in exchange for poker chips that are used during play.  Once all the games are finished, a whole lot of hands where chips are moved several times between all parties including the dealer, the players settle up. Whoever has obtained more chips exchanges them back to cash and takes home additional money, while whoever loses is forced to pay up more in funds.

The advantage is that money only changes hands at the very end, after all business of the game has been conducted.

That’s what the acceptance market essentially became – a way for banks to conduct their thousands of individual transactions across time and geography with only having to ship, or wait to receive, money once the net sum of all those trades would come due.  It was a ledger system (poker chips) that was backed by deposits of gold and cash (with the dealer), as well as central banks (the house).

The eurodollar which supplanted the acceptance market even while the Bretton Woods gold exchange system remained nominally the official reserve standard was merely the next step for international monetary evolution along these lines.  How much more elegant might the whole operation become if we just eliminate the need for cash deposits altogether?  To a true money adherent, such an idea was and is today abhorrent. To a bank merely trying to operate as efficiently as possible, this was a dream scenario.

It worked simply because the poker game of increasingly globalized trade never stopped; it became, figuratively, games without any end. Thus, what mattered was not the cash deposited with the dealer or brought in by the house, rather what each participant needed was only sufficient chips to stay in the game (the game itself also just a means to an end, trade). Eurodollars were never designed to be a store of value, purely a means of international exchange. 

In general terms, the eurodollar system is a way to keep track of who owes what in this match that doesn’t stop. It is a ledger but decentralized down to individual participants. In other words, it is like millions of individual poker games, thus ledgers, all using poker chips as the primary means of exchange but often connected by players who play in more than one game. If you ever ran short of chips for whatever reason (whether losing in speculation, or, more likely, lending too much too fast to the real economy) you could obtain more poker chips from the dealer to stay in it.

The dealer’s (eurodollar bank) sole interest was to keep the game going no matter what (skim the ante).  The supply of chips was theoretically endless, given that theoretically the dealer worked for the house (central banks) and could therefore obtain any cash backing for whatever chips it might put into play. More often, however, the dealer could simply borrow more chips (LIBOR) from the dealer at the next table since they both implicitly trusted each other (and their shared connection to the house).

The events of August 9, 2007, then, were several points of failure combined into what seemed like a singular event. The players across all the individual tables had been playing for so long that none of them realized they were all on the losing side (it’s not a perfect analog), and thus everyone was down (only a few losing in speculative terms, most just synthetically short the “dollar” from doing nothing other than playing for so long and therefore accumulating assets outside the poker game) having been kept in the game by dealers constantly supplying chips.

Accrued losses at some major players forced other players and then dealers to re-evaluate whether or not they wanted to keep supplying chips to the chronic now massive duds. Once the dealers cut back on some individual games, they also started to cut back in agreements to supply chips between tables, too (contagion).

That inevitably meant dealers increasingly looked to the house for recourse (emergency chips).  The house dutifully responded, though in a comedy of errors.  These millions of individual poker tables had evolved using exclusively the bigger chips since it was high stakes, after all. While black chips were perhaps in some limited use, more common had become the purples, yellows, and even lots of flags.

The house (Fed, ECB, etc.) at first remained unconvinced there was any problem at all. It took barely any notice of not just what the poker players were doing but more so how many of them there actually were. Further, it had very little to no idea of how its dealers were in essence backing each other with often exotic arrangements not to secure cash or money but various kinds of chips they alone decided were appropriate. 

So the house once finally mobilized (December 2007) began offering small, limited quantities of some white and a few red chips. These could be used, of course, in the poker games having trouble with chip supply, but they were really unsuited for those games and therefore of very little help overall (my gas station analogy fits here, too). 

The panic of 2008 was really just too many poker tables being forced to more and more stop playing as players and dealers ran out of the kinds of chips used in each of those games, the related casino (global commerce) therefore crashing to a halt for want of poker chips (“dollars”).

Central bankers like Ben Bernanke took all the credit for 2009, only the credit, though their efforts amounted to very little that helped with the chip shortage – a lot of whites and reds (QE), maybe at most a few greens (dollar swaps) here and there.  What really happened is that enough tables were eventually shut down (economic shrinking) and dealers found enough reductions to settle out what chips might be owed to whom so that some level of poker gaming could begin to resume; all with the idea that every game put on hold would eventually be restarted in time.

Unfortunately, the supply of poker chips to all tables never really kept up, with the house (global central banks) still only contributing the least helpful chips that offered little to nothing positive (it’s theoretically possible to play in a game where flag chips, $5,000 each, are regularly tossed in the pot using instead whites, $1 each, but in practical terms it’s really impossible). Another drastic supply shortage hit in 2011, convincing dealers that it just wasn’t worth it to so freely create poker chips (“dollars”) and add new poker games (lack of recovery). 

The monetary issue isn’t really the poker chips, however, so much as it is how to solve the ancient task of settling who owes what for all the millions and billions of daily individual transactions that take place across the entire global expanse.  What is the best, most purely functioning tool as solely a means of exchange? The eurodollar system is just a dispersed, decentralized network ledger system (thousands of individual poker games) using tokens (bank liabilities) to settle between individual participants as well as between dealers (far more complicated bank liabilities). 

This is where blockchain may hold an answer. The technology behind Bitcoin (don’t get hung up on specifically Bitcoin) is nothing more than a network ledger. It is instead centralized, but it could in theory (with a bitmore work, pun intended) take the place of the decentralized eurodollar ledger. In the latter, the credit-based money system, the banks are what matter for creation of money supply (the dealers create all the chips, and even control what kind of chips may be played).  In the former, that weakness is removed as is the foolish dependency on incompetent, ideologically stunted central bank statisticians.

In other words, and this is going far out on a limb of very generalized theory, rather than millions of individual poker games there would be only a single, giant table (maybe at most a few) situated differently within the casino (as purely a global payment system). It would be far more difficult in this arrangement for it to evolve where all the players end up “short” chips again. The terms of playing in it are set at the beginning (blockchain parameters), and it can accommodate as many players, or as few, as is required not by more purely financial considerations so much as real economy concerns.

To many, this should sound a lot like a gold standard, and in many important ways (external constraint on money creation) it would be. But it is vitally more flexible and adaptable to the way the modern system works (as a virtual currency ledger more like a computer network than an actual currency), casting off the flaw of credit-based money but remaining still computer-based. It would be closer to gold (and could theoretically be linked directly to physical gold or whatever else) without going all the way back to the original inefficiencies of having to first find, then dig up, and then constantly ship metal all over the world.

The modern world has evolved to prefer, even depend upon, the speed and power of computer-based networks.  The eurodollar made its ultimate 2007 apex on those same preferences and principles, only it was faulty in the way all the chips were arranged; the decentralized ledger amounted to too much that was hidden and misunderstood, too many poker tables situated way off in the dark corners of the gaming floor beyond all levels of scrutiny (private as well as public).  More than that, it depended upon dealer largesse and willingness given only the under-the-table arrangements between them. 

In thinking (a lot) about what should come next, we need to first think about how to get from where we are now (chronic eurodollar decay) to where we want the world to be (stable global money). There is a lot that can happen between A and B, but at B is a very, very happy day. The economy that should (and I don’t use that word lightly) result at B would be nothing like we have seen in a very long time (dwarfing, perhaps, the economic resurrgence of the mid to late eighties). 

Getting there, however, is Step 2 in the process, and it’s the most dangerous one.  I would be in favor of as little disruption as possible even in fixing the flaws of what we have now while keeping some of the better attributes. A blockchain ledger, the right blockchain ledger, might just do it. 

The real problem right now isn’t that, it’s that most of the world especially in official capacities remains stuck on Step 1. We can’t even get started with blockchain because central bankers still don’t realize they really weren’t ever in the game.  

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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