Blockchain is a digital, decentralized, distributed ledger.
Most explanations of the importance of blockchain start with Bitcoin and the history of money. But money is only the first use case for blockchain. It is unlikely to be the most important.
It may seem odd that a ledger – a dreary and useful document primarily associated with accounting – would be described as a revolutionary technology. But blockchain matters because ledgers matter.
Ledgers went all the way
Ledgers are everywhere. A ledger is more than a record of accounting transactions. A ledger contains only data composed of rules. Any time we need a consensus of facts, we use the ledger. Ledger records the facts that underpin modern economy.
The ledger confirms ownership. Property rights registry maps who owns what and whether their land is subject to any warnings or reservations. Hernando de Soto has documented the suffering of the poor when they own property not recognized in the ledger. A company is a ledger, as a network of ownership, employment and production relations, its purpose is simple. A club is a ledger and its structure is who benefits and who doesn’t.
Ledger confirms identity. Businesses record their identities on government ledgers to track their presence and their status under tax law. Registers of births, deaths and marriages record the presence of individuals at critical moments and use that information to identify those individuals as they interact with the world.
Ledger confirmation status. Citizenship is a ledger that records who has rights and is bound by national membership. The electoral roll is a ledger that allows (and in Australia, obligates) those who vote on the list. Employment is a ledger that provides contractual claims to employees in exchange for work.
Ledger confirmation authority. The ledger determines who can effectively sit in parliament, who has access to which bank accounts, who can work with children and who has access to restricted areas.
At its most basic level, ledgers map economic and social relationships.
Agreement on facts and when they change – that is, agreement on what is in the ledger and trust in its accuracy – is one of the basic foundations of market capitalism.
Title, possession and ledger
Let’s make this distinction, which is important but easy to overlook: the difference between ownership and possession.
Take passports, for example. Every country has the right to control who crosses its borders, and every country has a ledger in which its citizens have the right to travel. Passports are physical items — called tokens — that refer to this ledger.
In the pre-digital world, possession indicated ownership of that right. The Australian Passport Ledger consists of index cards held by each state government. A border agent holding a passport can assume that a traveler holding a passport is included in a remote ledger allowing travel. Of course, this left border control is vulnerable to fraud.
Possession means ownership, but possession is not ownership. Modern passports now allow the authorities to confirm ownership directly. Their digital capabilities allow airlines and immigration authorities to consult national passport databases and determine that passengers are free to travel.
Passports are a relatively simple example of this distinction. But as Bitcoin shows: Money is also a ledger.
Holding a note token indicates ownership. In the 19th century, the owner of a banknote, the “bearer”, had the right to demand its value from the issuing bank. These notes are the direct responsibility of the issuing bank and are recorded in the bank ledger. Possession means ownership means bills are easy to steal and counterfeit.
Legal tender in our time a five-dollar bill could not be returned to the central bank for gold. But the relationship remains – the value of the act depends on a social consensus about the stability of the currency and the government that issues it. Paper money is not wealth, as the Zimbabweans, Yugoslavs and Germans in the Weimar Republic unfortunately learned. A bill is a call to a relationship in the (now synthesized) ledger, and if that relationship breaks down, the value of the bill also breaks down.
Evolution of the ledger
Despite this, ledger technology remains largely unchanged…… Until now.
The ledger appears in the dawn of written communication. Ledger and writing developed simultaneously in the ancient Near East to record production, trade, and debt. Clay sheets baked in cuneiform script detail units such as rations, taxes, and workers. The first international “community” was arranged through a structured network of alliances that functioned much like a distributed ledger.
The first major change in the ledger came in the fourteenth century with the invention of double entry bookkeeping. By recording debits and credits, double entry bookkeeping preserves data in multiple (distributed) ledgers and allows information to be reconciled between ledgers.
In the nineteenth century, with the rise of large enterprises and large bureaucracies, ledger technology made new progress. These centralized ledgers greatly increase the size and scope of the organization, but are entirely dependent on trust in the centralized institution.
At the end of the twentieth century, the ledger switched from analog to digital. In the 1970s, for example, the Australian Passport Ledger was digitized and centralised. Databases allow for more complex distribution, calculation, analysis, and tracking. Databases are computable and searchable.
But databases still rely on trust; A digital ledger is only as reliable as the organizations that maintain it (and the individuals they employ). Blockchain solves this problem. Blockchain is a distributed ledger that does not rely on a trusted central authority to maintain and validate the ledger.
Blockchain and capitalist economic system
The economic structure of modern capitalism has evolved to serve these ledgers.
Oliver Williamson, winner of the 2009 Nobel Prize in Economics, believes that people produce and exchange in markets, companies or governments depending on the relative transaction costs of each institution. Williamson’s transaction cost method provides the key to understanding what institutions manage ledgers and why.
The government maintains a ledger of powers, privileges, responsibilities and access. Governments are trusted entities that maintain databases of citizenship, travel rights, tax obligations, social security rights and property ownership. If ledgers need to be enforced, they need the government.
The company also maintains ledgers: ownership ledgers for employment and responsibilities, ownership and deployment of physical and human capital, ownership of suppliers and customers, intellectual property and corporate privileges. Companies are often described as “contractual relationships”. But the value of a company comes from the orderliness and structure of relationships – the company is really a ledger of contracts and capital.
Companies and governments can use blockchain to improve their productivity and reliability. Multinational corporations and networks of companies need to coordinate transactions across the globe, and blockchain allows them to do so almost instantaneously. Governments can use the immutability of blockchain to ensure that records of property ownership and identity are accurate and not tampered with. Well-designed licensing rules for blockchain applications could give citizens and consumers more control over their data.
But blockchain also competes with companies and governments. Blockchain is an institutional technology. This is a new way of maintaining a ledger, or coordinating economic activity, as opposed to companies and governments.
Blockchain can be used by companies, but it can also replace them. Contracts and capital ledgers can now be dispersed and allocated in ways that were previously impossible. The Identity, Permissions, privileges and rights ledger can be maintained and enforced without the need for government support.
Institutional cryptoeconomics
This is the study of institutional cryptoeconomics: the institutional consequences of encrypted and untrusted ledgers.
Classical and neoclassical economists understood the purpose of economics as the study of the production and distribution of scarce resources and the factors that underpin it.
Institutional economics understands the economy as rules. Rules (such as laws, language, property rights, regulations, social norms, and ideologies) allow decentralized and opportunistic people to coordinate their activities together. Rules facilitate exchange – economic exchanges as well as social and political exchanges.
What has come to be known as cryptoeconomics focuses on the economic principles and theories that underpin and replace blockchain implementation. It looks at game theory and incentive design related to the design of blockchain mechanisms.
In contrast, institutional cryptoeconomics focuses on the institutional economics of blockchain and cryptoeconomics. Like its close cousin, institutional economics, the economy is a system of coordinated communication. But institutional cryptoeconomics does not study rules. It focuses on ledgers: the data made up of rules.
Institutional cryptoeconomics is interested in the rules that govern ledgers, the social, political, and economic institutions that have developed to serve these ledgers, and how the invention of blockchain is changing the pattern of entire social ledgers.
The economic consequences of blockchain
Institutional cryptoeconomics gives us tools to understand what’s happening in the blockchain revolution — and what we can’t predict.
Blockchain is an experimental technology. Where blockchain can be used is an entrepreneurial question. Some of the ledgers will be transferred to the blockchain. Some entrepreneurs will try and fail to move the ledger onto the blockchain. Not everything is a blockchain use case. We may not have seen a blockchain killer app yet. Nor can we predict what the combination of ledgers, cryptography and peer-to-peer networks will produce in the future.
This process would be extremely disruptive. The global economy faces, as we expect, long-term uncertainty about how the facts that underpin it will be reassembled and dismantled.
The best use of blockchain must be “discovery”. They must then be implemented in a real-world political and economic system with deep, mature institutions that already serve the books. The second part will not be free.
The ledger is so pervasive — and the possible use of blockchain — that all — are included — that some of the most basic principles governing our society have been snatched away.
Institutional innovation destruction
We’ve been through revolutions like this before.
Comparisons between the invention of Bitcoin and blockchain and the Internet are common. Blockchain is Internet 2.0 – or Internet 4.0. The Internet is a powerful tool that has revolutionized the way we interact and conduct business. But if there’s anything cheaper than blockchain. The Internet enables us to communicate and communicate better, faster and more efficiently.
But blockchain allows us to exchange in different ways. A better analogy for blockchain is the invention of mechanical time.
Before mechanical time, human activity was modulated by nature in time: cock-a-crow in the morning, slow descent into darkness at night. As the economic historian DouglasW.Allen has put it, the problem is the variability of time: “The measurement of time has changed so much… Has no useful meaning in many everyday activities.”
“The effect of a reduction in time-measured variance was felt everywhere,” Allen writes. Mechanical time opened up entirely new categories of economic organization that had previously not only been impossible, but unimaginable. Mechanical time allows transactions and exchanges to synchronize over great distances. It allows the coordination of production and transportation. It allows the day to be structured so that work is compensated based on hours worked – and workers know they are fairly compensated. Both employers and employees can look at standard independent tools to verify that the contract has been implemented.
Complete and incomplete smart contracts
Oliver Williamson and Ronald Coase (also winners of the Nobel Prize in economics in 1991) put contracts at the heart of economic and business organisations. Contracts are at the heart of institutional cryptoeconomics. This is where blockchain has its most revolutionary meaning.
Smart contracts on blockchain allow contractual protocols to be executed automatically, automatically and securely. Smart contracts could eliminate the entire class of jobs that currently maintain, enforce, and validate contract enforcement — accountants, auditors, lawyers, and most legal systems.
But smart contracts are subject to limitations specified in the algorithm. Economists have long focused on the distinction between complete and incomplete contracts.
A full contract sets out what will happen in every possible contingency. Incomplete contracts allow for renegotiation of contract terms in the event of unexpected events. Incomplete contracts explain why some exchanges take place within companies and why others take place in markets, and provide further guidance on issues surrounding vertical integration and company size.
Complete contracts are impossible to enforce, and incomplete contracts are expensive. While blockchain is smart contract, it reduces the information cost and transaction cost associated with many incomplete contracts, thus expanding the scale and scope of economic activity that can be carried out. It allows markets to operate where only big corporations can operate, and businesses and markets to operate where only governments can operate.
The exact details of how and when this happens are challenges and problems for entrepreneurs to solve. Currently, Oracles provides a link between the algorithmic world of blockchain and the real world, where trusted entities transform information into data that can be processed by smart contracts.
We believe that the real fruits of the blockchain revolution are the development of better and more powerful Oracle — the conversion of incomplete contracts into contracts complete enough to be written algorithmically and executed on the blockchain.
The commercial revolution of the Middle Ages was made possible by the development of commercial courts, which allowed merchants to enforce agreements privately. For blockchain, that revolution doesn’t seem to be here yet.
Whither government?
The blockchain economy puts pressure on government processes in a variety of ways, from taxation to regulation to service delivery.
Investigating these changes is our ongoing project. But consider how we regulate banks.
Prudential controls have been developed to ensure the safety and soundness of financial institutions that interact with the public. Normally, depositors and shareholders do not have access to a bank’s ledger and these controls, such as liquidity and capital requirements, are justified. Depositors and shareholders cannot bind the company and its management.
When depositors discover (or simply imagine) that their banks may not be able to pay their deposits, they rush to withdraw.
One possible application of blockchain would allow depositors and shareholders to continuously monitor banks’ reserves and loans, greatly eliminating information asymmetry between them and bank management.
In this world, market discipline is possible. Public trust in the immutability of blockchain will ensure that there will be no fake bank runs. The role of regulators may be limited to proving that blockchain structures are correct and secure.
A broader application will be a cryptobank – an autonomous blockchain application that can borrow short-term loans and possibly match borrowers directly with lenders. A crypto bank structured through smart contract algorithms will have the same transparency attributes as a bank with a public blockchain ledger, but with other features that may completely ignore the need for a regulator. Crypto banks, for example, could clear themselves. Crypto banks currently start trading when they fail, and the assets are automatically paid out to shareholders and depositors.
It is not clear what regulatory role governments should have in this world.
Tyler Cowen and Alex Tabarrok argue that much government regulation seems designed to solve asymmetric information problems – problems that often no longer exist in a world where information is ubiquitous. Blockchain applications significantly increase the ubiquity of this information and make it more transparent, permanent, and accessible.
Blockchain has its uses in so-called “regtech” — the traditional regulatory functions of applying technology to auditing, compliance and market oversight. We should not ignore the possibility that there are new economic problems in the blockchain world that require new consumer protections or market controls.
However, the restructuring and re-creation of fundamental forms of the economy, such as banks, will put pressure not only on how regulation is implemented, but also on what regulation should do.
Whither Big Business?
The implications for big business could be just as profound. Due to the technical necessity of incomplete contracts and large-scale financial investments, business scale is often driven by the need for business-level cost. This business model implies that shareholder capitalism is the dominant form of business organization. The ability to write more complete contracts on blockchain means that entrepreneurs and innovators will be able to retain ownership and control of their human capital and profits at the same time. The link between running a successful business and having access to financial capital has been weakening over time, but may even be broken now. The age of human capitalism is coming.
Entrepreneurs will be able to write a valuable application and publish it in “Wild”, ready to be used by anyone who needs it. Entrepreneurs, in turn, simply observe the micropayments that accumulate in their wallets. Designers can publish their designs to “Wild,” and end consumers can download the designs to their 3D printers and own the product immediately. This business model could see more manufacturing in Australia than it currently does.
The ability of consumers to interact directly with producers or designers will limit the role of middlemen in the economy. However, logistics companies will continue to prosper, but the advent of driverless transport will also disrupt the industry.
Keep in mind that any disruption to business also disrupts the company’s tax base. The government may have a hard time taxing businesses – so we may see greater pressure for sales (consumption) taxes or even poll taxes.
Conclusion
Blockchain and related technological changes will severely disrupt current economic conditions. The industrial revolution ushered in a world in which business models were based on hierarchy and financial capitalism. The blockchain revolution will see an economy dominated by human capitalism and greater individual autonomy.
It is not clear how this will unfold. Entrepreneurs and innovators will, as always, resolve uncertainty through trial and error. There is no doubt that great wealth will be generated before we know exactly how the destruction will unfold.
Our contribution is that we have a clear understanding of a model that can be deployed to provide clear information when outages occur.
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