Proposal from a macroeconomist for an optimal crypto-currency

[jtimon]

The question will become: how do you control the nominal interest rate without any econometric data whatsoever?

There's a reason Freicoin's demurrage rate is flat: it's not out of laziness or ignorance. It's the best you can do! The only other real option is to track by means of a synthetic asset or prediction market, but that leaves the entire economy vulnerable to collusion and manipulation. But having a fixed demurrage rate doesn't make Freicoin broken - instead of the real nominal interest rate varying between 4-6%, it'll vary between -1% and 1%. This is an improvement. And, sadly, the best that can be done without sacrificing user privacy and/or decentralized control.

Perhaps I was a bit hasty in my discussion of Freicoin previously. If you could get an interest rate of -1% to 1% then without demurrage that would be an unambiguous improvement, since it represents a lessening of the inflation tax on holding money. However, doing it via demurrage is just replacing the inflation tax on holding money with an explicit demurrage tax. The fact it's explicit makes it marginally preferable, but the economic distortion is still there. People have to hold money to perform transactions, but they're penalised in doing so by the presence of inflation/demurrage.

Freicoin doesn't target 0% price inflation and that's probably impossible for a scarce currency. It targets 0% real interests, since 0% capital yields would mean the lowest profits and thus the lowest possible prices for consumers.
The constant 5% demurrage was recommended by Silvio Gesell based on historical data about real interest rates.
People need to hold money to perform transactions but:

1) They don't need hold big quantities. Thus they don't need to pay high costs.

2) They use 0% interest/0% demurrage mutual credit money like LETS systems or the Swiss WIR.

3) Holding cash-like scarce money (thus without default risks) represents an insurance against uncertainty, a "liquidity premium". Not paying for it is an externality that causes the basic interest and thus higher consumer prices, monetary cycles and encourages less investment.

If you want a 100% stable unit of account, it is completely possible and not hard to implement. Just define it (for example, as a basket of globally traded commodities) and use it as denomination for credit-based currencies. Like Lietaer's Terra but without the backing itself (Thomas Greco agrees that the unit without a scarce currency is better).

As an aside, the primary function of proof of work is not distributing the monetary seigniorage but securing the network!
Something proof of stake doesn't seem to provide so far.

[Cryddit]

I'll see if this can be remedied.

Modify 3 as follows, changes in red. These changes also ensure that the interest rates are 100% risk free, with the risk now being spread equally over all of the users of the currency, not just those participating in bond markets. I have an idea for further simplifying things by combining 3 and 4, but I'm not sure I have the will power to spend further time arguing here...

Okay...  After reading, this is all technically feasible and plausible.  Except for the last point.

And the last point is, what benefit does the community at large derive from this activity that makes it reasonable for them to freely choose to act as guarantors?  Why would they not prefer  another cryptocurrency that exposes them to no guarantor risk?

BTW, I am delighted to have someone who actually knows something about financial markets here, and I sincerely want to understand how that knowledge can be used to improve the state of the art in cryptocurrency.   I appreciate your work and knowledge, and sincerely thank you.

I don't intend my responses to be belligerent or argumentative, but instead keep asking questions because much still isn't clear to me.  I don't understand for example the motivations of people who would choose to use an over-collateralized market in debt instruments over the option of using the collateral itself.

[ZeroNominal]

And the last point is, what benefit does the community at large derive from this activity that makes it reasonable for them to freely choose to act as guarantors?  Why would they not prefer  another cryptocurrency that exposes them to no guarantor risk?

The guarantor risk appears to users of the currency as inflation risk, which all cryptocurrencies already expose them to. No movements in their balances would be observed, only (possibly) movements of prices denominated in the good. And, what is more, since this would be the first cryptocurrency which does not impose an "inflation tax" on cash holdings, the costs imposed by this inflation risk would be miniscule to them. Furthermore, as I said in the original post, by pinning the interest target (on both cash and bonds) at the long run real interest rate, prices would be roughly stable in the long run, so any inflation would be short lived rather than persistent.

BTW, I am delighted to have someone who actually knows something about financial markets here, and I sincerely want to understand how that knowledge can be used to improve the state of the art in cryptocurrency.   I appreciate your work and knowledge, and sincerely thank you.

I don't intend my responses to be belligerent or argumentative, but instead keep asking questions because much still isn't clear to me.  I don't understand for example the motivations of people who would choose to use an over-collateralized market in debt instruments over the option of using the collateral itself.

No need for the thanks or apologies, your discussion has consistently helped me clarify things to myself. I shouldn't have got exasperated...

Bitcoin has many similarities to gold. But societies have persistently chosen to use fiat currencies over gold. Gold however maintains a use as collateral in some real world repos, just as I'm proposing bitcoins would retain a use as collateral here.

[markm]

A point that puzzles me is how are the miners, following the implied instructions recorded in the blockchain, to manipulate the bitcoins?

Parts of the protocol seem to have the miners sending bitcoins somewhere, or holding bitcoins somewhere, but since the blockchain is the only data upon which to decide which bitcoins to send to where, how are the private keys controlling the bitcoins that are to be moved etc stored?

For example when someone uses bitcoins as collateral and gets a loan, where is the private key of the address used to hold the collateral (those bitcoins) stored?

-MarkM-

[ZeroNominal]

A point that puzzles me is how are the miners, following the implied instructions recorded in the blockchain, to manipulate the bitcoins?

Parts of the protocol seem to have the miners sending bitcoins somewhere, or holding bitcoins somewhere, but since the blockchain is the only data upon which to decide which bitcoins to send to where, how are the private keys controlling the bitcoins that are to be moved etc stored?

For example when someone uses bitcoins as collateral and gets a loan, where is the private key of the address used to hold the collateral (those bitcoins) stored?

Each individual wallet knows it's own bitcoin private key of course, and it is these individual wallets that are responsible for executing the bitcoin transactions they are required to execute for the protocol. A failure to execute these transactions would be detected and would count as default.

[weisoq]

Are you sure that any long term equilibrium state of mining power for a given cryptocurrency isn’t >50% control by one entity? If you’re not sure then the specific technicalities are secondary for a decentralised crypto. Perhaps in referring to collateralisation you need to take it a step further. To flip the role of cryptos to simply that of a peer-to-peer clearing mechanism of other currencies/assets, maybe using non-blockchain based coins, and getting the right underlying credit infrastructure in place first. Something like ripple is a possibility, or open transactions. I can’t see how any real repo financing market could emerge until participants can measure credit risk. Incorporating repo collateral that consists of the same or very similar liquidity, market and counterparty profile to the loan seems to create a loop in achieving the measurable funding security and risk stability required to make it work.

[digitalindustry]

Dear all,

I'm an academic macroeconomist (with a doctorate, university post etc. for what it's worth). As such, BitCoin and the various other crypto-currencies hold a great deal of interest for me. However, there's something I'd like to discuss with the community, possibly with the ultimate goal of collaborating on a new crypto-currency.

While I have very few doubts that a crypto-currency will come to dominate in the long run, I am somewhat sceptical that it will be any of the current crop, despite Bitcoin's substantial first mover advantage.

Given the constant proliferation of alternate crypto-currencies, it seems likely that in the long-run there will be a range of crypto-currencies all of which use an algorithm without obvious flaws, but which differ in the degree of inflation/deflation and/or price volatility they generate. In such a circumstance, which currency would people pick? Well, the answer to this depends on what the main costs of inflation/deflation are for them.

In standard macro-models today, there are two main costs. Firstly, people face costs due to the necessity of holding cash. If you have to hold cash to make purchases, and that cash is subject to inflation, then the contents of your wallet are constantly losing value -- you are effectively paying a tax to the people creating ("mining") new currency. Secondly, people face costs due to constantly adjusting prices and/or contract terms. For buyers, these costs include search costs, information costs, etc. etc. (If a loaf of bread always costs $1.00 in your normal supermarket, then when you see a loaf of bread on sale for $0.90, you know it's a good deal. If the cost of that loaf of bread is wildly fluctuating in your normal supermarket, then you face a much harder job assessing whether another store's price is a good deal or not.) For sellers, these costs include the cost of going round and physically changing prices in a store, and again various information costs.

Depending on which of these two sets of costs dominate, the exact optimal policy prescription varies, but never by so much. If the former cost dominates, then nominal interest rates should be set to 0 (so steady-state deflation is equal to the real interest rate), meaning there is no opportunity cost of holding cash rather than having your money in a bank. (This is the "Friedman-rule", not to be confused with the "Friedman K% rule", which is not optimal in any standard model.) If the latter cost dominates, then inflation rates should be set to 0.

Directly targeting an inflation rate of 0 to fix the second cost would be very hard with a crypto-currency. Yes, the supply could be controlled to ensure a constant exchange rate to some (basket of) currency(ies), but this would mean putting your trust in the maintenance of the value of the crypto-currency back with national central banks, rather defeating the purpose of using such a crypto-currency in the first place. Even monitoring the relevant inflation rate for a crypto-currency would be difficult, because at present much of their use (if I understand correctly) is in the purchasing of goods where one or both parties don't want it made public that the transaction took place (e.g. because the good is illegal), making it very hard to build a price index.

What about the first cost? Well, first note that with any electronic currency there's no need to set the nominal interest rate to 0 in order to remove the opportunity cost of holding cash. Instead, one can directly pay interest on the currency. With a crypto-currency, this can be done via Peercoin style "proof-of-stake" payments, where the payment rate is tied to the observed risk free nominal interest rate on the crypto-currency (appropriately smoothed). To get this risk free nominal interest rate, the creator of the crypto-currency would create a (ideally, decentralised) platform for the exchange of repurchase agreements denominated in the new currency, using "old" currencies as collateral (though in the long-run, other assets could come to fulfil this role). Although using repurchase agreements rather than unsecured loans removes much of the risk, it may still be desirable to construct a simple reputation system, so that the repo rate for high reputation parties is truly a risk-free rate.

If this is all one did, the interest rate and the inflation rate could be unstable. However, with a crypto-currency one has a second instrument, namely the release of new coins via the "proof-of-work" mechanism. With this one could ensure that the nominal interest rate remained at least (say) 4%, which is approximately the long run real interest rate, meaning that prices would be roughly stable (thus minimising the second cost), and is high enough that any problems stemming from the zero lower bound on nominal interest rates are avoided. In the unlikely scenario in which interest rates actually exceeded 4%, then Peercoin style transaction costs could be applied, though this is to be avoided if at all possible since transaction costs reduce allocative efficiency, having a big welfare cost (and meaning consumers won't be persuaded to use your currency).

Happy to discuss this further if anyone's interested. And if anyone's seriously interested in creating this crypto-currency and wants help, PM me. Another possibility would be open development which seems the best way of avoiding the stink of scammery...

Best regards,

ZeroNominal

In the above paragraphs you basically discribe    what Quark achieved.

Also take into account distribution time relationship with price stability , what fixed currency supply is issued over say 100 years?

All of these flawed models will been shown to be less than efficient in the market, and they are.

[digitalindustry]

"not to be confused with the "Friedman K% rule", which is not optimal in any standard model.) If the latter cost dominates, then inflation rates should be set to 0."

The k-percent rule I contest is optimal and none of the standard models apply*, as crypto does not function under a debt based monetary principals.

Crypto can better be described as decentralized economic , its a merger of Austrian principals + decentralized network effects.

So on one hand the monetary side is very much simplified,  and in the other their are added socioeconomic complexities.

Anyone that has been "traditionally" economics educated ( and im not saying this ys yourself) may struggle with the simplicity of the monetary side.

And find the decentralized aspect alien.


* the only time that rule is not optimal is in a time when there are needs for sharp shifts in expansion Wars are an example, but are easily taken into account. 

[xjabc]

Regarding the modified proposal, I believe it is not a repo deal any more, it's more like a fx swap deal. As a result, Rr is not real repo rate of repocoin, but a function of the rates of both coins. If so, how could we apply these numbers to adjust repocoin's PoS interests rates?

[ZeroNominal]

Regarding the modified proposal, I believe it is not a repo deal any more, it's more like a fx swap deal. As a result, Rr is not real repo rate of repocoin, but a function of the rates of both coins. If so, how could we apply these numbers to adjust repocoin's PoS interests rates?

Yes, it's an interest rate swap, but implemented as a repo in order to reduce the contractual requirements. You're correct that it's non-trivial that the market clearing mechanism will return the right interest rates, as we have two interest rates to pin down from the intersection of two surfaces. But the given market clearing mechanism ought to work. To see this, suppose there were opportunities for investing bitcoin and repocoin with net (e.g. 0.02) risk free interest rates r_r and r_b. Furthermore, for simplicity, let's forget about the lost interest on the locked coins (it can be shown that everything we say ignoring the locked interest on the locked coins also holds in the limit as the time interval goes to zero). Then the seller (no matter how risk averse) will wish to participate in the swap/repo at least if R_b>=1+r_b and r_r>=R_r-1, likewise the buyer (no matter how risk averse) will wish to participate at least if R_r>=1+r_r and r_b>=R_b-1. Solving these four inequalities gives R_b=1+r_b, and R_r=1+r_r. Thus, in the presence of heterogeneity in risk aversion in the market, we should expect to see highest trade volume when R_b=1+r_b, and R_r=1+r_r i.e. when the "repo" interest rates reveal the true interest rates.

[r0ach]

Bitcoin has many similarities to gold. But societies have persistently chosen to use fiat currencies over gold.

I LOVE how you portray this as a positive thing when it's really the start of where all the fraud began.  People started to deposit gold into facilities with people having last names like "Goldman", "Goldberg", "Goldstein", and they would give them paper certificates representing that value.  They realized not everyone tried to withdraw all of their gold at once, so they started lending fractional reserve, and so began the fraud of the millennium.

Massive amounts of lobbying, coercion, military force, etc, was then used to maintain this fraud.  People did not just "choose" to be scammed for perpetual eternity.

If it fails the Occam's Razor test for a currency, IT'S A SCAM.  You don't need a magician behind the curtain setting variable interest rates at a whim and all this other jibberish you're talking about.

[Ix]

I LOVE how you portray this as a positive thing when it's really the start of where all the fraud began.

The Roman empire ran on a fiat-like system where coins were valued higher than their metal contents, they did pretty well for a long time. The British empire used tally sticks for some 6 or 700 years, and did pretty well. The US...

Of course, there's a pretty imperialistic theme to go with those monetary systems, but you can't question their ability to produce. With a "math-based" cryptocurrency that ascribed to emulate fiat a bit more than bitcoin, there should be no reason to presume that the imperialism or fraud themes would continue anymore than they would in bitcoin, because governments and banks don't control it all the same. If you're worried about manipulation, clearly bitcoin and other closed systems are not immune.

[Cryddit]

Bitcoin has many similarities to gold. But societies have persistently chosen to use fiat currencies over gold.

I LOVE how you portray this as a positive thing when it's really the start of where all the fraud began.

Y'all may not have noticed this, but local rhetoric aside where 'fiat' is always short for 'government fiat', from an economist's perspective, or a literalist's, Bitcoin is absolutely a fiat currency. 

A fiat currency is defined by the fact that there is no one promising to exchange it for a fixed quantity of some valued object or service as a way of guaranteeing its value.  Nobody's offering to give you a beer (or whatever) per bitcoin even if the bitcoin price drops below the price of a beer (or whatever), and that makes Bitcoin a fiat currency. 

[xjabc]

Then the seller (no matter how risk averse) will wish to participate in the swap/repo at least if R_b>=1+r_b and r_r>=R_r-1

the seller would participate in the swap/repo if R_b>=1+r_b and r_r<=R_r-1, only if his gain on one leg is greater than the loss on the other leg. No need to gain on both legs.

In fact, suppose the real interests rates of Repocoin and Bitcoin were r_r and r_b. Currently, Alice holds B bitcoins and Bob holds B*P repocoins (P is the current price of repocoin in one unit bitcoin). Alice and Bob make a one week swap deal, and will get B * r_b bitcoins and B * P * r_r repocoins after the deal respectively. In a equilibrium market, the new price of repocoin one week later will be P * (r_r / r_b).

However, in my opinion, the real interests rates of both coins can't be independently revealed by the market. Even a well functional market can only reveal the relation between r_r and r_b, more specifically, r_r / r_b. When I am putting or accepting an order with 3 quantities: B, r_r and r_b, another order with 0.5B, 2r_r and 2r_b is almost same to me. The only difference is the latter has a leverage of 2 times.

[ZeroNominal]

When I am putting or accepting an order with 3 quantities: B, r_r and r_b, another order with 0.5B, 2r_r and 2r_b is almost same to me. The only difference is the latter has a leverage of 2 times.

They have very different exposures to exchange rate risk though. The market rates will be the safest, so demand should cluster at that point. I accept it's not perfect though. This may be an argument for the preferability of a Ripple-esque system without collateral.