The “fiscal” and “monetary” policy tools of smart contract blockchain platforms may work even better than the economic policy tools of governments.
ECON 101 3.0
WHEN WE SPEAK of an economy, we usually refer to a country or a region where interrelated activities of production, consumption, and trade happen. When we speak of blockchains, we speak of decentralized computer networks. On the surface, these two seem unrelated. But with on-chain activities growing at warp speed, the ecosystems of layer 1 public blockchains (the foundational blockchain protocols where decentralized databases and computer programs are run) are starting to look more and more similar to national economies—except the nation in this case is not a physical territory but a decentralized digital network.
The trustless and programmable nature of public blockchains have made it possible to implement new “fiscal” and “monetary” policy tools in the blockchain economies, which in many cases have advantages over the traditional economic policy tools of national governments. In addition, the proof-of-stake mechanism adopted by second-generation public blockchains introduces a de facto “universal basic capital income” for their network “citizens.” This could be a major innovation in how economic systems distribute values among participants, with broader income-distribution implications for years to come as blockchain economies grow. (Disclosure: I hold cryptocurrency and have previously advised crypto funds.)
PUBLIC BLOCKCHAINS ALLOW anyone to deploy decentralized applications (DApps) on top, which users can interact with. Currently, decentralized finance (DeFi) applications and non-fungible token assets (NFTs) are the two main economic activities on layer 1 blockchains and associated layer 2 chains. (Layer 2 chains are secondary blockchain networks that rely on the underlying layer 1 for security, but typically offer faster and cheaper transactions.) Both activities have grown tremendously in the past couple of years. At the end of November 2021, gross total value locked from DeFi in the top 10 layer 1 blockchain platforms exceeded $250 billion, a year-over-year growth of 1,400 percent. And according to NFTGo.io, the market cap of NFT projects on Ethereum alone reached over $7 billion in November, increasing over 14,500 percent from a year before.
The oldest and largest smart contract blockchain is Ethereum, which started in 2014. But newer chains that boast cheaper transactions and faster settlements, such as Solana and Avalanche, are quickly gaining momentum. Unlike the first-generation blockchains such as Bitcoin that use proof of work (PoW) to protect network security, most newer layer 1 chains are proof-of-stake (PoS) systems. These require transaction validators to lock up—that is, “stake”—an amount of their holdings of the blockchain’s native tokens to prevent malicious attacks. Validators/stakers then get rewarded in the platform’s tokens for providing the transaction validation service.
For example, validators on the Avalanche blockchain are required to stake at least 2,000 AVAX tokens. That’s around $220,000 per validator (using end-2021 AVAX token price). The high staking cost makes it prohibitively expensive for an attacker to gain control of enough validators to compromise the chain’s security.
Almost every activity on a layer 1 chain needs to pay transaction fees to the platform in the chain’s native token. If you want to do anything in the Ethereum nation, you need the ETH token. If you want to enter the Solana nation, you need the SOL token.
This enables an L1 platform to bootstrap its national economy over time through a flywheel between financial speculation around its native token and actual building of applications and activities in its ecosystem. When the native token price goes up, it attracts more monetary liquidity into the nation, which funds more applications built in its territory. That, in turn, expands use cases and grows the on-chain “gross domestic product,” which attracts more users and creates a bigger network effect. The demand for the native token increases as a result and the native token price goes up.
Such a system is similar to how traditional currencies work for physical nation-state economies. You need USD in almost every economic transaction in the United States. When the US GDP grows (values and numbers of transactions go up), the demand for USD increases, other things being equal. This is one of the reasons why, when an economy grows fast, its currency tends to appreciate against others, barring foreign exchange interventions from the national government.
This is consistent with the price movements of layer 1 chain tokens in recent periods. As blockchain platforms’ economies exploded with the growth of DeFi and NFT, prices of layer 1 native tokens have outperformed the overall crypto market. As of the end of 2021, eight of the top 15 crypto assets by market cap were PoS layer 1 tokens (counting Ethereum, which is moving to PoS). Yet five of them were not in the top-15 list two years ago.
The PoS layer 1 chains can then leverage their monetary flywheel to further grow their network by issuing new tokens. As the on-chain economy grows, demand for the blockchain nation’s native tokens builds, which allows the platform to issue more tokens as rewards to validators without impacting the token’s market price. Those rewards in turn attract more participants into the ecosystem, powering future growth. For example, Solana had grown its validator network by over 20 times in the past year and a half to over 1,300 active validator nodes as of end 2021.
NO ECONOMY GOES up in a straight line forever. Levels of activities always ebb and flow. In the real world, we call this business cycles—economies going through booms and busts. The governments of nation-states have long used fiscal policy (taxes and public spending) and monetary policy (interest rate and money supply) tools to try to smooth out recessions and booms. Blockchain nations also have fiscal policy (transaction fees) and monetary policy (staking yield, token issuance and burn) tools. And in many cases they may work better than the economic policy tools of governments.
When an economy is overheating with excess demand, a national government typically tries to tighten its fiscal policy by raising tax rates and cutting public expenditures. And when the economy is in recession, it does the opposite.
In reality, though, such counter-cyclical fiscal policies are rarely executed well, due to limited time horizons and judgment errors of decisionmakers. In boom times, fiscal tightening is hard because the government has higher revenues available to spend. When the cookie jar is overflowing, few have the discipline or political fortitude to not eat more cookies. Plus, recency bias can trick the government into believing that if the jar is full today, it will be tomorrow, too, and under-preparing for the eventual downturn. By the time recession hits, the fiscal buffer is too small to meaningfully stimulate the economy without taking on additional debt.
In contrast, blockchain nations’ fiscal policies are preprogrammed in self-executing smart contracts and thus immune to human discretion. Take Ethereum. Think of the gas fee paid to the Ethereum platform on each transaction as a value-added tax or sales tax. The base fee is preprogrammed to adjust depending on the level of network congestion. When the network utilization rate goes over 50 percent (economic boom), the base fee increases by up to 12.5 percent. If the activity level goes under 50 percent (economic recession), the base fee decreases. The counter-cyclicality of the on-chain fiscal policy is enforced by code. No individuals or entities, no matter how powerful they are, can change it on a whim.
On the monetary front, traditional central banks try to adjust interest rates and money supply according to economic cycles to keep the prices of goods and services stable—lowering interest rate and expanding money supply in recessions and doing the opposite during booms. But again, these decisions depend on human discernment, which often has limited foresight. In addition, the impact of monetary policy tends to happen with significant friction and uncertain time lag as it needs to be transmitted through the banking system.
The monetary policy of blockchain economies, on the other hand, does not depend on human judgment and the impact is more direct. On Ethereum, the base fee collected for each transaction is “burned,” reducing money supply. This means that during an economic boom where there are more transactions, more ETH tokens are taken out of circulation, pushing up the value of ETH relative to on-chain products and services and helping to cool the economy. During a recession, the opposite happens, and the lower transaction costs help stimulate more activities. And since the transmission of this monetary policy does not depend on the actions of any financial intermediaries, its effect is likely more immediate.
THE PROOF-OF-STAKE MECHANISM itself also has profound economic implications. Aside from being a faster and more energy-efficient consensus mechanism compared to proof of work, proof of stake gives blockchain “citizens” sustaining motive to participate in the on-chain economy, efficiently distributes the economic output across the blockchain nation, and provides the base ingredient for an on-chain financial system.
The PoS validator rewards, or “staking yields,” gives users a tangible incentive to hold and stake the underlying layer 1 token beyond the speculative expectation of token price going up, as is the case with Bitcoin. In this respect, the staked layer 1 tokens resemble government bonds—a relatively stable, yield-generating financial instrument backed by the economic output of the nation itself.
The entry barrier to blockchain staking is low. Even if you only have 1 ETH, you can earn a consistent yield through delegated staking. Liquid staking services like Lido make it even easier. Normally, if you want to withdraw your staked tokens from layer 1 chains, there’s an unstaking period when you cannot move your tokens. Liquid staking services remove this lock-up period for a small fee. You can go in and out as you please and also use your staked tokens as collaterals in DeFi to get more liquidity.
In the long term, this increases the stickiness of a chain’s citizenship, boosts price stability of everything denominated in the layer 1 token, and lowers the transaction cost associated with excess price volatility for everyone.
The PoS staking mechanism is also a new way to distribute economic gains across the platform. Traditionally, the GDP of an economy is distributed to its participants in two forms: labor income (salaries, wages and benefits, about 60 percent of GDP in the US) and capital income (profits, dividends, interests, realized capital gains, about 40 percent of GDP). Labor income is the primary way for most people to get a slice of the national economic pie. But labor-replacing technology, globalization, and demographic shifts have shrunk the share of labor incomes across the globe in past decades. And with more progress in automation technologies coming, the trend is not expected to reverse itself anytime soon. As a result, income inequality is becoming a bigger and bigger issue in advanced and emerging market countries alike.
While it may still take the governments of traditional nation-states many years to reform existing social transfer regimes and implement new policies such as universal basic income, the blockchain nations are in a sense already implementing basic incomes for citizens through PoS staking.
As discussed, the blockchain platforms’ revenues come from two sources: 1) fiscal revenues from transaction fees, and 2) monetary revenues from token issuance seigniorage, i.e. the monetary profit a token issuer gets that stems from the difference between market value of the token and its issuance cost. Part of these revenues are paid as staking yields to citizens, allowing everyone that participates in the platform to share the output of its economy as non-labor earnings. It’s a capital income for the masses.
And these yields are nothing to sneeze at. Currently the staking APY (annual percentage yield) ranges from 5 to 14 percent on different layer 1 chains. These are a lot more attractive than the saving rates offered by traditional banks, but more stable than yields in riskier DeFi products. Just like how US Treasuries provide benchmark interest rates for the financial market and serve as base-layer primitives for other financial products to build on top, layer 1 staking could become a foundational building block of a new on-chain financial system. DeFi products such as Anchor from the Terra blockchain are already using staking on major PoS chains on the backend to offer retail saving products for USD stablecoins.
THE BLOCKCHAIN NATIONS are still small. The DeFi total value locked (TVL) on Ethereum, the biggest layer 1 smart contract chain, was $150 billion as of end 2021. If we assume the Ethereum GDP is a third of its TVL as a back-of-envelope calculation, that puts the size of the Ethereum economy at par with Slovenia.
But combined with the advancement in AR/VR, metaverse use cases of public blockchains—such as in online gaming, decentralized communities, and tokenization of traditional assets—are expected to grow exponentially in years to come. It’s likely that we’re only seeing the beginning of the growth of blockchain national economies.
Physical nation-states are beginning to wake up to the potential of digital money. According to the BIS, over 80 percent of central banks in the world are either researching or launching their own CBDC (central bank digital currency). But actual user adoption of retail CBDCs has been limited so far. Perhaps it’s time for nation-state governments to take a page from blockchain nations’ token playbooks in considering how to design a competitive national currency of the future.
https://www.wired.com/story/blockchain-cryptocurrency-economics/
