Crypto Cannot Avoid The Iron Laws of Economics

New Study by Economist Eric Budish

We make fun of a litany of political proclamations and government programs because they violate the iron law of economics. You can violate them, but only for so long.

When innovation happens, it often changes the cost structures around those iron laws of economics. For example, one of the key laws of economics is you can produce a product until the marginal cost to produce one more is equal to the marginal profit. It’s expressed in a simple equation, MR=MC. If you produce one more where cost exceeds profit, you lose money.

In many companies, they call this the customer acquisition cost versus the long-term value of the customer, or CAC=LTV. There are businesses out there where the cost to add a customer is greater than the value of that customer and so it will never make money despite how great an idea it is. One of those was in wealth management for small accounts. Using an algorithm to attract and service tiny wealth accounts turns out to be a money-losing operation.

There are other iron laws of economics. One of the most fascinating parts of economics is that it weaves its way through all of the other disciplines. Law, psychology, human behavior, medicine and anything else you can think of would not be as innovative or efficient without the iron laws of economics.

University of Chicago Economist Eric Budish just released an academic paper on cryptocurrency. Here is his webpage. I predict it will make some waves in the academic community but it will take some time to have an effect on the venture capital and business community. However, it is extremely provocative. This is an important paper.

In the opening paragraph, Budish asserts this and I agree 100% with him.

Economists have long widely agreed that the market system requires some form of government and rule of law for support. This is uncontroversial among even the most free-market oriented thinkers. Adam Smith (1776) mostly argues for reducing government interference in markets, but he does not go all the way to zero, writing that “commerce and manufactures can seldom flourish long in any state” without a legal system, property rights and contract enforcement, as well as certain public goods. Hayek (1960) grapples at length with the paradox that to maximize freedom—which he defines as the absence of coercion—it is necessary to have a government that has the power to coerce. Friedman (1962) famously described the government’s role establishing the “rules of the game” for the market system and acting as its “umpire.” There is significant debate within modern economics about what else government should do beyond these basic supports for the market system (e.g., social insurance, correcting externalities), but that there is some role for government and rule of law is essentially taken for granted.

I am going to ask you to dispel any opinion you have about cryptocurrency. Many people dismiss it because they don’t understand it. Many seize upon the idea because it is the current thing and seems like an elegant way to disintermediate huge swaths of established incumbents that they dislike. Still, others think that using Bitcoin would stop inflation because there is a limited supply of Bitcoin, which in itself is a flawed idea. Bitcoin has decimals.

If you dismissed Bitcoin because you don’t understand it, this paper is awesome because it outlines exactly how it works in plain English so most people can understand it. Bitcoin fanboys often use a lot of shop talk to describe Bitcoin and they do it because they themselves don’t understand it or because they can’t distill a difficult concept into plain English to make it easy to understand. For what it is worth, a great hallmark of Chicago School economists is to take very difficult concepts and put them into language so anyone can grasp the concept.

Bitcoin was invented in 2008 and immediately seized upon as the next great innovation in software. Programmable money was enticing because moving money through a system can have very high costs. There are also very high costs when it comes to settling contracts. One example would be the cost of settling an over-the-counter derivatives contract between two parties.

Marc Andreessen talked about how Bitcoin solved the Byzantine General’s Problem that has confounded computer scientists for a generation.

Reliable computer systems must handle malfunctioning components that give conflicting information to different parts of the system. This situation can be expressed abstractly in terms of a group of generals of the Byzantine army camped with their troops around an enemy city. Communicating only by messenger, the generals must agree upon a common battle plan. However, one or more of them may be traitors who will try to confuse the others. The problem is to find an algorithm to ensure that the loyal generals will reach agreement. It is shown that, using only oral messages, this problem is solvable if and only if more than two-thirds of the generals are loyal; so a single traitor can confound two loyal generals. With unforgeable written messages, the problem is solvable for any number of generals and possible traitors.

The blockchain solved the Byzantine General’s problem. All of a sudden, there was a trustless way with a proof of work time stamp.

A long time ago, my friend Professor Craig Pirrong wrote a blogpost on how blockchain could be anti-competitive. Because participants were locked into a blockchain, that blockchain could exert monopoly price competition on the community since the switching costs to another blockchain would be too high.

Budish takes a different approach to analyzing the crypto ecosystem. He uncovered a fatal flaw in the 2008 paper by Satoshi.

Some personal background. I have had a long intellectual journey with crypto. One reason I think Budish’s paper is so interesting is it opened my eyes to a hole that I couldn’t describe but my gut felt I saw. I have invested in cryptocurrency companies that are building businesses to this day. Billions of dollars have been invested in crypto companies by venture capitalists and angels.

Crypto is appealing to me because of the free market nature it is based on. In economics, there are theories about free markets and perfect competition. There are assumptions about rational investors. Detractors of free markets will often say those theoretical notions work on the blackboard, but do not in real life hence we need to regulate and control them.

As a trader in a pit, I saw the free market work. Was competition perfect? No, but it was pretty perfect. Was there ease of entry and exit? Exit, yes. Entry, no but it was close to perfect. The ideas of Adam Smith were on display in a trading pit every day.

Cryptocurrency is appealing in many ways. However, crypto has been rife with fraud and since 2008 despite the billions of dollars invested, nothing of note has been built that is very useful for everyday life. Another very appealing aspect of crypto was that participants wouldn’t need to hire lawyers or worry about a court system to enforce a rule of law. At first, I thought crypto would be used to help give better price signals to supply chains.

The reason I came to that conclusion is because there is competition in supply chains. They have many businesses that compete and cooperate with them. If you wanted to enter or exit the competition there were costs depending on which part of the supply chain you wanted to compete in, but in some spots the costs to enter and exit were minimal. Many supply chains are cross border and participants have to navigate different systems of law and currency. It seemed like crypto could be a very elegant way to make supply chains more efficient.

It hasn’t happened yet.

Budish in his paper shows why. It’s because of the costs of scaling a blockchain. This paper is a fascinating read, and it is backed up with math. Any dissenter is free to dissent, but you better bring the mathematical analysis to show your argument. If you always thought crypto was tulip bulbs, then you probably weren’t critically thinking about blockchain in the first place.

Budish identifies a concrete example of why cryptocurrency doesn’t scale. It has to do with the cost of security.

The essential difference between the Nakamoto trust model and the traditional model grounded in rule of law is depicted in Figure 1. A criminal is thinking of robbing a bank. In the traditional model, the criminal must first consider how many security guards he will need to overcome. Then he will have to take into account that the bank will call in reinforcements from police, and that, if caught, he will go to jail. Similarly, consider a country thinking of whether to invade another country. They will have to consider the soldiers at the border (analog of security guards), but also that the invaded country will call in military reinforcements (analog of police), and that the invaded country may launch a counter-attack in retaliation (analog of Beckerian deterrence from courts). In contrast, the Nakamoto model is just to have a very large number of security guards at the bank, or soldiers at the border. This works, but it is very expensive and scales terribly with the stakes (bold mine)

Here is the start of Budish’s conclusion.

Nakamoto (2008)’s novel form of trust—a completely anonymous and decentralized “permissionless consensus,” without any support from government or trusted intermediaries—is ingenious but expensive. Equation (3) says that for the trust to be meaningful requires that the flow cost of maintaining the trust must be large relative to the one-shot value of attacking it. This is like a very large implicit tax. Moreover, the cost of Nakamoto trust scales linearly with the value of the attack—e.g., securing against a $1 billion attack is 1000 times more expensive than securing against a $1 million attack. This equilibrium constraint suggests that if cryptocurrencies were to become a more significant part of the global financial system than they have been to date, then their costs would have to grow to absurd levels (absent implicit support from rule of law). In the base case analysis considered in Section 4, it would take all of global GDP to secure the system against a $40 billion attack. Traditional trust, whether from rule of law, reputations, relationships, collateral, etc., is by no means perfect, but is a bargain relative to Nakamoto

Could this flaw be fixed? Maybe. I am not a computer programmer so I couldn’t begin to figure out how. However, what’s the opportunity cost of fixing it? Is it cheaper for society to fix existing systems of trust and make them more efficient rather than fix the cryptocurrency system and then try to implement it across society which has its own costs?

Another concept Budish touches on is a central bank digital currency. I have been against a CBDC because I think the threat to individual liberty through the use and monitoring of a CBDC is far greater than the efficiency gained by having one. In economic parlance, the opportunity cost is far greater than the cost.

This paper has the potential to blow up the entire cryptocurrency ecosystem. That means all investments in it go close to zero.

I have put a link to the paper at the top of this post and I would encourage anyone participating in the cryptocurrency ecosystem to read and understand it.