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What if the crypto crowd becomes the Ruling Class?
The Case for Crypto Part III: Those who can manipulate the money supply will eventually try... What then?
Click here for Part I of this series.
Click here for Part II of this series.
Click here for Part IV of this series
Click here for Part V of this series
This is a crucial point in my attempt to explain crypto to a notional unbanked potter who made the coffee mug I hold tightly in my hands on a cold winter morning. Here I can go on a useless riff about ‘Proof of Stake’ vs. ‘Proof of Work’ or descend into any number of other such useless academic rabbit holes. I’ll have to tackle ‘Proof of Stake’ at some point, but it will be better to see it emerge from a pattern seen in history.
Money and control of the social order
It is hard today to grasp how ‘church order’ and ‘social order’ were once the same thing. In the early to mid 1600’s, during the reign of King Charles I, the English Crown provoked the Scots. Where the war dramatized by Mel Gibson in Braveheart arose from the King Edward I’s earlier attempt to take advantage of a vacuum left by the lack of a clear heir to the Scottish throne, Charles I sought to dictate the social order in Scotland by appointing bishops over their Church. Naturally, the Scots weren’t having it.
After fighting one war to a stalemate, the calling of Parliament, and the subsequent rejection of the Crown’s demands, Charles abolished Parliament and sought to raise an army to fight again. To pay for it Charles confiscated gold from the Royal Mint belonging to English merchants. While this ‘forced loan’ was paid back, upon receiving their gold, English merchants abandoned the Royal Mint in favor of local, trusted goldsmiths. In return for their gold, the goldsmiths issued receipts.
The utility of these receipts as money quickly became apparent. As long as they were genuinely redeemable for the gold held by the goldsmith, they were more easily carried, and could be issued in various fractions of the underlying gold. A goldsmith could issue 10 receipts for an ounce of gold, each representing 1/10th an ounce, and then require presentation of 10 such receipts to redeem that same ounce. In other words, one could ‘make change’ in gold by having it mediated by paper receipts.
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And then the goldsmiths became the Ruling Class
The central lesson from this history is this: If a group of people (even if not formally organized into a single group) are able to manipulate the money supply to their advantage, they eventually will. It became apparent to these goldsmiths that they could issue ‘extra’ receipts and lend them out at interest. As such, the ‘notional’ (the professional class might use the word ‘nominal’) amount of gold circulating in the economy by way of these receipts began to exceed the ‘real’ amount actually held by the goldsmiths.
This was originally a huge scandal because it represented the same kind of theft we have already described by looking at the ‘real’ value of the U.S. Dollar as days of shelter. If you divided the real amount of gold held by the goldsmiths (the numerator) by the ‘nominal’ amount of all receipts circulating (the denominator), the issuance of these extra receipts devalued each person’s gold by that percentage. If everyone insisted on being able to redeem their receipts at their face value, it then became a race to line up at the doors of the goldsmiths. No one wanted to be the next guy in line holding worthless receipts after the last of the gold was redeemed.
This difficult situation provoked the development of a concept called ‘fractional reserves’. The actual, physical gold held by the goldsmiths represented the ‘reserves’. The total amount of gold circulating in the economy by way of the face value of the receipts represented the ‘fraction’. To simplify, if we agree to allow a goldsmith to issue twenty percent more in receipts than the ‘reserves’ actually held, we have a one-fifth (1/5 - one extra one-ounce receipt for each five ounces of gold) fractional reserve monetary arrangement. (This is what the specialty language of the finance profession calls ‘monetary policy’).
You cannot spend money that does not exist. The power of the Congress is the power of ‘fiscal policy’ (how money is spent). The real power is over ‘monetary policy’ (how much money is available to be lent out, spent, and collected as taxes).
The lesson we must learn from this is the ‘Ruling Class’ are the people who control the money supply. In our modern arrangement, the Congress has the ‘power of the purse’ and we think that means that the party which controls the Congress is the ‘Ruling Class’. This is wrong: You cannot spend money that does not exist. The power of the Congress is the power of ‘fiscal policy’ (how money is spent). The real power is over ‘monetary policy’ (how much money is available to be lent out, spent, and collected as taxes).1
Ethereum 2.0: What happens when the Ruling Class tries to game the system?
(For the finance pro, don’t worry - I'll get to Proof of Stake shortly. Just note: Proof of Stake, per se, is not what matters as much as the enforcement mechanism it makes possible. Read on, please.)
The Ethereum Blockchain started out as a Proof of Work Blockchain like Bitcoin, but added the ability to set conditions on transactions. The banked will understand this as ‘escrow’. The escrow agreement requires certain things of each of the two parties. Escrow is open by depositing a certain amount of money at opening with the third-party escrow provider, and then more as certain requirements are met. Once the escrow agent confirms all requirements have been met, payment from escrow is issued to the seller and any excess funds refunded to the buyer. These escrow arrangements are called a ‘Smart Contract’ on the Ethereum Blockchain.
To the unbanked we might explain this as a requirement for freshness when buying milk. If an unbanked person can buy milk from a grocer using crypto, like with any other form of money, the assumption is the milk will not be spoiled. A Smart Contract might require the buyer to reserve Ether for the seller, bring home the milk, and access a smart phone app to verify the milk is not spoiled. That verification then triggers the final transaction deducting Ether from the buyer’s digital wallet and adding it to the grocer’s. Instead of relying on the integrity of a third-party escrow provider, all of this is executed automatically on the Blockchain.
Punishment for attempted “double-spending”
If we go back to our lesson from Charles I and the local goldsmiths and imagine the ‘secret’ reserve fraction was 1/2 - for each ounce of gold held in reserve the goldsmith secretly issued an extra receipt for one ounce - we see what the crypto crowd calls the “double-spending” problem (the ounce of gold is spent twice). This is probably the single most important general innovation in crypto - the Blockchain makes “double-spending” almost impossible.2
While Ethereum 2.0 moves away from Proof of Work to Proof of Stake, the real innovation - when we look at the history of money described above - is called a ‘slashing’. Not only does Ethereum as a Blockchain address the problem of double-spending, it builds in a punishment for even trying. We’ll start explaining ‘Proof of Stake’ by looking at this punishment.
In ‘Proof of Stake’ a participant (an individual or group in a ‘staking pool’) converts fiat to Ether at the market rate and ‘stakes’ 32 Ether. This Ether remains owned by the participant, but is not spendable. In a sense it is ‘leased’ in return for priority assignment of the validation of transactions. This validation still requires the solving of a math problem, for which Ether is earned.
(In my final installment I will discuss how this arrangement creates a ‘yield’. The priority place in the line to validate transactions and earn Ether means the original ‘stake’ of 32 Ether ‘earns’ a certain growth of Ether over time… just like lending money at interest. Because I am writing for a notionally unbanked potter, I won’t go down this particular rabbit hole, but this is really no different than converting fiat to gold and then leasing the gold.)
What makes this arrangement so compelling, however, is not the potential to earn a yield in Ether. It is what happens when someone tries to use their stake to game the system.
Any attempt to corrupt the Ethereum 2.0 Blockchain will require the corrupt party to first buy a stake on the Blockchain. This locks up a certain amount of their resources. If they attempt double-spending or any other malicious efforts on the Blockchain they will lose up to their entire stake. But this will not be a confiscation to the benefit of another digital wallet; the staked Ether will disappear. This is probably the strongest case possible for using a digital asset over a physical one like gold.
The supply of a precious metal cannot be deflated
I’ll restate this because it is so critically important to understanding the case for crypto: The price for attempting to cheat on the Ethereum Blockchain is the destruction of the cheater’s staked Ether. This means that cheating results not only in loss to the cheater, but gain to the honest participants. The overall supply of Ether is decreased by this ‘slashing’ - meaning the remaining Ether held by honest others like my unbanked potter will buy her more of her basic needs. This is highly impractical with fiat currencies and physically impossible with precious metals.
The unbanked potter’s labor is stolen so Congress can make promises they cannot keep while the banks profit from their efforts to pretend they can.
We see why this is so critical when we return to our basic rationale for crypto - sentiment. No one likes a thief. Today we rely on the Ruling Class to enforce the rules and punish the thief. The Great Financial Crisis showed us what many suspected for years before it: The Ruling Class is neither willing nor capable of even setting viable rules, to say nothing of enforcing them on everyone equally. Congress seems perfectly happy with this arrangement because it allows them to pawn off their responsibility onto the Federal Reserve and their member banks. My unbanked potter’s labor is stolen so Congress can make promises they cannot keep while the banks profit from their efforts to pretend they can.
Just like English merchants refused to put up with theft and called bullshit on the Crown by fleeing the Royal Mint for local goldsmiths, Main Street is calling bullshit on the Ruling Class by fleeing the U.S. Dollar in favor of crypto - for exactly the same reason.
last next installment will provide a very simple three-part definition of an ‘asset’. We’ll see why no Proof of Work crypto currency can meet this definition. This will show why Bitcoin cannot be considered an asset, and therefore should not be seen as an investment. We will also see why the proliferation of crypto-tokens (I’ll explain why they are distinct from crypto-currencies) is irrelevant to the future of crypto. But we will also see - in light of how Proof of Stake works - why Ether on the Ethereum 2.0 Blockchain can become an asset, and as such offers us a real alternative to fiat currencies like the U.S. Dollar.
Click here for Part I of this series.
Click here for Part II of this series.
Disclaimer: I am a cyber security professional, not a financial advisor. I hold no licenses in the financial sector. I have relatively small positions in ETHE and GBTC which hold Ether and Bitcoin in trust on behalf of shareholders. I am weighted toward ETHE for reasons that will become clear in this series of essays. It will also become clear in these essays why I believe crypto currencies are not an investment. This does not mean there is no case for owning crypto. It just means the current case has nothing to do with traditional investment theses. In any event, do not - under any circumstances - make investment decisions on the basis of anything I write.
The Constitution says “Congress shall have the authority to coin money and regulate the value thereof.” Congress invested this authority in the Federal Reserve by passing a law creating the Fed, but without any fixed rule governing its policies. Because the Fed’s monetary policies are not bound by any rule, the real power lies with the Fed, not with Congress.
As noted in my last installment, if over 50% of participating computers are controlled by one entity, cheating becomes technically possible, but will still be apparent to the other participants.