Politico-Economic Theory of Decentralized Democracy
This paper describes foundational principles and practical approaches to
creating a decentralized version of such systems as fiat currency,
banking, taxation, budget allocation and self-governance at the state
and local level. Main characteristics of decentralized governance are
that the people vote on the money supply and its sources, tax and
interest rates; the majority voters may be financially liable to the
minority voters if public spending defaults; non-monopolistic central
banking system; stock market can be extended to small and medium
business.
The traditional democratic system has been designed in the times when
our capabilities were extremely limited in comparison to the modern
times. By extending the representative mechanism of democracy we can
construct a parallel system that adds another layer between the
traditional government and the market. In this paper we are going to
explore the limits that we can take democracy and constitutionalism to
with our current technology.
Author:
Andrew Sokolowski. Kyiv, Ukraine.
Contact:
decentralizeddemocracy@gmail.com
Table of Contents:
Introduction
This paper puts forward a theory of decentralized government and decentralized economy. Decentralized government is a collection of private sector firms and agencies that are hired by a voluntarily associated group of people to provide public goods and services. Decentralized economy is a state of economic arrangements when a community of people in a certain geographic location is financially invested into small and medium sized private sector firms in that community. In this paper we are going to theorize a shared financial and computer network that allows voluntarily associated groups of people to establish decentralized government and economic systems on municipal, regional and multiregional, national and international level.
The idea behind decentralized government and economy is to take the basic parts of the traditional model of government and economy as a template, and make it possible to create instances of the template on any geographical scale. The template contains an entire political and financial system. Every instance of the template has its own currency, taxation, budgeting, stock market, banking and central banking. The template provides a shared protocol for instances to interact with each other and to establish a common currency. We can think of the traditional financial system as a monolith. Having one financial system for the entire country makes it inflexible and hard to manage. But if it is subdivided into many identically structured parts then each part is going to be easier to manage separately and the system as a whole is going to be more flexible.
Political system of an instance of decentralized government determines how group-level decisions on group budgeting and spending, and personal income taxation of the group members are made. A budget for hiring private sector firms and agencies is divided into categories. Firms and agencies propose to a group their services in a certain category, and if they get selected by the group then they receive revenue in the form of personal income taxes paid to them by the members of the group. For each category of group spending there can be a different type of group decision-making mechanism for selecting firms and agencies such as fixed and flexible majority vote, ranked choice vote and quadratic vote directly by the group members, or non-voting market-oriented mechanisms such as futarchy. Voting for firms and agencies as an act in the system of decentralized government can be seen as agreeing to pay personal income taxes to firms and agencies that one has voted for. Voting also means agreeing to pay taxes to firms one didn’t vote for but that got the majority approval.
Anybody can create an instance of decentralized government and they will have to choose the political system of the instance as a set of selection mechanisms for different categories of group spending. Potential group members can then evaluate their options of political systems and decide which instance to join. Different selection mechanisms being applied to different categories of group spending allows it to fine-tune the decision-making process for each sector of the economy. Firms and agencies that are hired by a group of people represent the bureaucratic side of the decentralized government. An owner of a firm or agency that’s been selected by a group is responsible for hiring workers for their firm or agency, in contrast to the traditional government appointment process. When dealing with complex projects, a group can select a management agency that is supposed to subcontract multiple private contractors.
There are some non-conventional components of the political system that allow it to balance and scale, and that make it distinct from direct and representative democracy. The delegation mechanism allows group members to delegate to an entity their ability to vote and chain delegation allows entities to delegate to other entities. The entity may be an individual or an agency, it is going to receive revenue in the form of commission on personal income taxes paid by the group members. These factors are going to incentivise a layered system of delegation: most group members are going to delegate to a couple of bigger general interest agencies whose purpose is to chain-delegate to smaller specialized agencies. Bigger agencies can be seen as an equivalent to traditional political parties while smaller agencies can be seen as an equivalent to traditional government agencies. It means that the political process happens mostly in the general interest layer and that there is a certain political distance between democratic and bureaucratic sides of the decentralized government, similar to the traditional one. It also means that it is possible to scale voting as a selection mechanism for every individual group spending proposal without the need for individual voters to dedicate additional efforts to electoral decision-making.
Then there is a mechanism that allows it to balance the majoritarian system of group spending. It is expected that there are going to be situations when majority approved firms and agencies are going to fail to deliver the services that they promised to a group. A group member, who didn’t vote for a firm or agency and anticipates that it is going to fail, can buy a short position against it. If it does fail then other group members, who are in the majority that approved the failed firm or agency, are going to have to compensate the taxes paid by the group member who opened the short. Short mechanic can be seen as an alternative to the down-vote mechanic.
Another aspect of balancing the majoritarian system is that it doesn’t serve as a cut-off point for participation in the decentralized government. The cut-off point is funding, not voting. A firm or agency, that is voted for and therefore is financed by some minority of group members, can still be a part of the decentralized government if it has enough taxpayer funding to provide its services. While it is not financed by the whole group, some funding is better than no funding. It is going to allow for a majoritarian political system where minority interests are able to represent themselves.
One of the consequences of establishing a decentralized government is a possibility for emergence of a decentralized economy. What prevents small and medium firms from raising capital on the stock market? Costs of oversight and inability to attract investors are two major reasons. To overcome these obstacles a voluntarily associated group of people can choose to finance trustless institutional investors that put oversight costs onto themselves and that are only able to buy from the stock market specific to that particular group of people. Group members make a choice of lower returns on their investments in exchange for economic development of their own community. After the establishment of the stock market with the help of institutional investors that are a part of the decentralized government, institutional investors in the private sector are going to join that market under the same rules.
Together these and other components that are mapped out in this paper comprise a form of government that is called decentralized democracy. It doesn’t seek to replace the government or the market but instead seeks to supplement them and take some load off the traditional system. It seeks to open up new pathways for collective intelligence and community investment. There’s a potential for wealth creation in the small and medium business that is currently inaccessible to us because of the lack of appropriate governance structures. Societal changes needed to put such structures in place are fundamental but realistic.
Let’s explore an example of how decentralized governance could accomplish a simple task such as building and maintaining a road in a city. First of all city residents have to establish a platform for public tenders and procurements. City planning agencies must put up tender offers on the platform and residents must then select one or several of those offers personally or by delegation. Selected agencies must collectively come up with a city plan that designates specific areas for road construction. Construction and infrastructure maintenance firms must put up tender offers for the road and residents must then select one or several of those offers. Selected firms must collectively construct and maintain the road.
Firms and agencies that are selected by city residents are then financed through personal income taxation. Each firm and agency offers its own tax rate based on the amount of financing that it needs and residents then choose among proposed rates. Residents have to also select agencies that develop building codes and oversee construction quality. Selected firms and agencies are mandated to work together and figure out the specifics by themselves without involving the residents into minutiae decision making.
Let’s now explore an example of how a decentralized economy can allow a small enterprise such as a street food vendor in a city to raise capital. First of all city residents have to select one or several special investment funds whose investment capital is going to come from personal income taxation. The main feature of these funds is that they can only invest in that particular city and that they can be tied to a trusted stock market infrastructure. The funds can then go out and persuade local enterprises that have the desire to expand to raise investments by issuing stock. The funds appoint and pay for oversight boards that represent shareholder interests. This way enterprises do not incur additional expenditures that otherwise would make stock issuance financially unappealing.
One of the biggest reasons for closing a business is retirement (Zhou, 2023). This disadvantage makes small business inherently unattractive for long-term investments. However in our example when a street food vendor retires, instead of selling off their equipment and relinquishing their vendor permits an oversight board can appoint someone else to run it. This approach allows it to turn small businesses into community landmarks that persist throughout generations. Ultimately, this is a final end goal of the decentralized democracy project. To make one’s community the basis of one’s prosperity.
Introduction to Finance
Monetary System
A monetary system determines how currency is created. Sum of all currency units in the system forms the currency supply.
Gold Standard
Historically, gold and gold-backed currencies represented the standard unit of money. Ultimately, the total supply of gold is known and is fixed. It consists of the gold that is already on the market; and it also can be estimated how many more natural deposits of gold there are in the world. Gold standard is a monetary system with a fixed supply of currency.
A notable characteristic of the fixed supply currency is that credit generally tends to be expensive and limited. On the other hand, it is immune to inflation. However, long-term nobody can really predict with absolute certainty that the underlying asset is going to retain its value. For example, it may still happen that gold falls out of fashion or a synthetic alternative may be discovered.
Fiat Currency
The move away from the gold standard to fiat money was a move away from a monetary system with fixed supply of currency to a monetary system with variable supply of currency. The supply of fiat currency is determined by the supply of credit and consists of: consumer and commercial loans provided by commercial banks; government spending; operations by the central bank; and international trade transactions (Faure, 2013, p. 102).
To understand how banks supply currency let’s read from (Bank of England, 2019):
Most of the money in the economy is created by banks when they provide loans.
Most of the money in the economy is created, not by printing presses at the central bank, but by banks when they provide loans. …
Therefore, if you borrow £100 from the bank, and it credits your account with the amount, ‘new money’ has been created. It didn’t exist until it was credited to your account.
This also means as you pay off the loan, the electronic money your bank created is ‘deleted’ — it no longer exists.
Currency is created when banks make loans and currency is destroyed when loans are paid back. When loans are made by banks, they exist as bank deposits which are therefore used as a measure of currency supply.
Notable characteristic of a variable supply currency is that credit generally tends to be more available compared to a fixed supply currency. On the other hand, variable supply currency is susceptible to inflation. Another interesting effect is that money in the fiat system itself becomes subject to forces of supply and demand, when supply is not fixed but rather is shaped by demand. Credit availability is what drives most investment and it can be argued that it is directly responsible for the drastic increase in economic growth in the last several decades compared to the last several centuries (Faure, 2013, p. 127).
In economics saving and investing are the two sides of the same coin. And in finance all assets are viewed as a form of currency with a varying amount of liquidity. From the monetary theory perspective we can then say that all financial and commodity assets combined, including gold, constitute a monetary system with a fixed supply of currency. Looping back to economics, we can conclude that variable supply currency is more suitable for investing because credit is cheaper, and fixed supply currency is more suitable for saving because of the superior retainment of value.
Banking System
The banking system consists of the central bank and commercial banks. The primary role of the central bank is to limit in meaningful ways the total amount of loans that commercial banks are able to provide. All banks have a special account with the central bank that is called a reserve account. Reserve accounts hold a special type of money that is called central bank money (CBM). The amount of CBM that a bank holds is referred to as bank reserves or bank liquidity. CBM can be only created by the central bank and can only be transacted by banks and the central bank (Faure, 2013, p. 146). CBM can be viewed as an utility currency that facilitates the banking system.
Money that is created as a result of commercial bank credit is called bank money (BM). CBM cannot be converted into BM and vice versa. However, both CBM and BM are denominated in the same units with one to one equivalence in value.
Netting, Refinancing and Reserve Requirements
To understand how exactly the central bank regulates commercial banks, let’s expand on the example from (Bank of England, 2019). There are two commercial banks: bank A and bank B; and two customers: customer X and customer Y. Customer X has an account at bank A and customer Y — at bank B. The same as in the original example customer X takes a loan of £100 (BM) from bank A. Then customer X transfers the £100 to the account of customer Y at bank B in exchange for a good or a service.
At the end of the day the total amount of transfers between banks is summed up in a procedure that is called netting (Hook, 2022, p. 12), and in our example bank A owes £100 (CBM) in reserve obligations to bank B. It means that bank A has to transfer £100 (CBM) from its reserve account at the central bank to the reserve account of bank B. If bank A doesn’t have £100 (CBM) in reserves then it can ask the central bank for a special type of a loan that is called refinancing (European Central Bank, 2016) or a loan at key interest rate (Faure, 2013). At this point the central bank has to decide if it thinks that lending policy of bank A was valid and if it should grant the refinancing. Banks can also borrow excess reserves (CBM) from other banks. After the transfer Bank B has £100 (CBM) in excess reserves which means that it can be sure that it can make a loan of £100 (BM) and be able to cover its reserve obligations (CBM) to some other bank at the end of the day. Netting is performed by an independent agency that is called a clearing agency.
The reserve mechanism is there to prevent certain obviously malicious kinds of behavior, that’s why banks generally can’t make frivolous loans or make unreasonably large loans. However, only by itself it can’t limit the currency supply. If on the same day customer Y takes a loan of £100 (BM) from bank B that is then transferred to bank A, then reserve obligations of both bank A and B to each other are going to net out to zero allowing both banks to make more loans by lowering the interest rates. This behavior is generally undesirable because it can lead to excessive borrowing and inflation.
To establish a limit on the expansion of the currency supply there exists a regulation that obligates the banks to keep a certain amount of reserves at their reserve account. The amount is called required reserves and is calculated as a fraction of the sum of bank deposits. The fraction is called the reserve requirement ratio (r). Let’s say that in our example r is 10%. If a bank holds a deposit of £100 (BM) and £100 (CBM) in reserves then it must keep £10 (CBM) in their reserve account as required reserves and it can only be sure that it can make a loan of £90 (BM) and be able to cover its reserve obligations. This way more loans lead to more deposits which lead to more required reserves, hence making banks more reluctant to increase credit operations.
Credit Securitization
A bank can always try to sell a loan that it made as a security, effectively crossing it out from its books. A bank can make a loan of £100 at 5% interest to a customer and then sell that loan to a third party for £102.5, then close £100 on their books and keep the £2.5. Securitization leads to reduction in the currency supply (Gross & Siebenbrunner, 2019, p. 15).
Open Market Operations
A central bank can sell and buy treasury and corporate bonds (Hayes, 2022b)(Faure, 2013, pp. 94, 172). Operations on the open market by the central bank change the currency supply: sale operations destroy currency and purchase operations create currency. Banks can use excess reserves (CBM) to purchase treasury bonds.
Foreign Exchange Operations
When an entity sells a foreign deposit to a bank, the bank pays by crediting the account of the entity which increases the total amount of deposits and therefore the currency supply (Faure, 2013, p. 104).
Computer Networking
Each bank has a separate database where it keeps balances, transactions and client data. For example, if the bank database was to suddenly disappear out of existence then all the data is also gone. There is no backup database in the central bank that keeps everyone’s bank balances. Each bank has a separate infrastructure but one that is also bridged with other banks such as to enable transactions. However, one bank can’t access client data in another bank.
From the computer networking point of view it can be said that the banking system is a shared network of licensed nodes that is supposed to keep an account of fiat currency. It can also be said that fiat currency with the exception of notes and coins is a digital currency. 98% of the currency supply in most countries exists in digital form as bank deposits while physical currency is only 2% (Faure, 2013, p. 100).
Banks can and do sell customer data (Withers & White, 2019). Customers do not have control over this process. Banks also use customer data to construct predictive statistical models for a variety of purposes such as credit scoring and customer service.
Fiscal System
Fiscal system determines how taxation and government budgeting works. A government budget is a document that presents anticipated tax revenues and proposed expenditures. In most parliamentary systems, the budget requires approval of the legislature.
To understand how the government spending and taxation is arranged let’s read from (Wray, 2009):
Sovereign government spends by issuing checks or, increasingly, by directly crediting bank accounts. There is a simultaneous credit to bank reserves (the bank’s assets increase due to the reserve credit, and its liabilities to the recipient of the government payment increase by the same amount). Including leakage from bank deposits to cash withdrawals, government spending creates currency dollar-for-dollar. Tax payments reduce currency outstanding dollar-for-dollar, since tax payments take the form of a deduction from the taxpayer’s deposit at her bank and an equivalent deduction from the bank’s reserve account at the Fed. Essentially, the bank acts as an intermediary between government and the nongovernment sector (that receives payments from government and that pays taxes to government). Government currency is ‘redeemed’ when taxes are paid, which simultaneously destroys currency as well as the taxpayer’s liability to government.
To summarize, government spending effectively amounts to currency creation and taxation — to currency destruction. However, this is true only for the central or federal government. Regional and municipal governments cannot create money and can only raise it by issuing municipal bonds or taking loans, which are then financed by local taxes.
Stock Market
The stock market is crucial for long-term economic development. Stocks represent long-term investments that require institution building. Natural consumers of the stocks are pension funds. They are the ones who are interested in the long-term value of their investments, while most other market actors are more focused on their immediate gains. Pension funds usually form the demand side for long-term obligations. Stock exchanges, rating agencies, insurance agencies, financial regulators constitute the stock market infrastructure.
Board of Directors
A board of directors is the governing body of a company that is supposed to represent the interests of shareholders that hold the stock of the company. The company has to provide compensation for board members, and board members also frequently receive the stock of the company as a form of compensation.
Financial Instruments
Credit Insurance. A lender can give a loan that requires a purchase of credit insurance by a borrower. In the case when the borrower defaults on their loan or is otherwise unable to repay their loan, the loan is repaid by insurance (Business Development Bank of Canada, 2021). Insurance policies can be securitized in the same way as loans.
Revenue Share. A company can issue a debt obligation that is paid back from the company’s revenue (Fundopolis Securities, 2017).
Credit Default Swap. When a third party buys a loan from a lender, the third party can make an agreement with the lender that in the case of the loan default the lender has to pay to the third party some amount of money (Hayes, 2022a). To initiate the agreement the third party has to pay to the lender the amount that is lesser than that specified in the agreement, the difference between the two amounts is called premium.
Asset-Backed Security. When a third party buys multiple loans from a lender, it can bundle them up into a single security (Corporate Finance Institute, 2022).
Introduction to Decentralized Finance
Cryptocurrency
From the computer networking point of view it can be said that a cryptocurrency is a shared network of volunteer nodes that keep an account of the underlying digital asset. Each node is supposed to run under the same protocol and each node keeps the history of all asset transactions. It can be shown mathematically that under certain conditions it is practically impossible to compromise the network (Härdle et al., 2020). Given this property it can be said that such a network is trustless meaning that you don’t rely on faith but rather have relative certainty that the network is going to act in accordance with some predefined rules. It can also be said from the computer networking point of view that such a network is decentralized meaning that there is no single authority that is able to override the rules of the network.
Basic forms of cryptocurrency set the hard limit on the number of currency (asset) units that can exist. From the monetary perspective cryptocurrency is a monetary system with a fixed supply of currency.
Protocol that runs the network specifies the algorithm that can be used to randomly generate a pair of keys (or addresses). Generating keys can be viewed as an equivalent to creating an account that can hold currency units. First key in the key pair is public: you can give it to somebody who wants to send you a transaction. Second one is private: you never give it to anybody and you must use it in order to send a transaction to somebody.
Another form of cryptocurrency that is called stablecoin provides a digital asset whose market value is supposed to be tied to some other asset such as a sovereign currency or a commodity (Board of Governors of the Federal Reserve System, 2022). Potentially a useful financial instrument but one that is not particularly relevant to the present discussion.
Privacy vs. Anonymity
Let’s compare the banking system and basic cryptocurrency from the perspectives of a network customer and a network provider. When the customer opens up an account in a bank and makes a transaction, the bank knows exactly who the customer is and what the transaction was, and is supposed to keep that information secret from the general public. It can be said that the network customer has no anonymity in relation to the network provider, but the customer has privacy in relation to the rest of the world because nobody except the provider can know that the transaction has been made and what exactly the transaction was.
When the network provider is a basic cryptocurrency and the network customer makes a cryptocurrency transaction, the network provider doesn’t know the identity of the customer and just appends the transaction to the transaction history. It can be said that the network customer has anonymity because nobody knows who exactly made the transaction, but the customer doesn’t have privacy because anybody in the world can know that the transaction has been made and what exactly the transaction was.
There exists another form of cryptocurrency that provides full encryption of the transaction history. When a network customer makes a transaction of cryptocurrency that is fully encrypted, nobody can know who made the transaction, what the transaction was or if the transaction even happened. In this case it can be said that the network customer has both privacy and anonymity.
Smart Contract
There is a form of cryptocurrency that is the same as the basic cryptocurrency but that also uses a protocol that adds general computational capabilities to the shared network. A network client can generate an address and deploy an arbitrary computer program to the network at that address. They can then publish the address of the program on their website on the internet. Other network clients can use the address to interact with the program by taking actions that the program allows to perform. The program can be designed to allow additional privileges to its creator but it cannot be unilaterally altered or overridden by the creator nor anyone else. A program that runs autonomously on a shared network is called a smart contract (Minn, 2019).
Token
The most basic type of a smart contract is a token contract. Token is a type of digital asset that is similar to the stock issued by a company or corporation. However, unlike stocks, tokens do not represent equity. In fact there is no legal framework yet that defines the rights of token holders. Tokens can be bought in exchange for the base currency of the shared network (Nielsen, 2020).
Decentralized Autonomous Organization
Another type of a smart contract is a DAO contract. DAO is similar to a company or corporation but one that is governed by the network participants. However, unlike corporations, DAO doesn’t yet have a well defined legal status (Nielsen, 2020). The most basic type of DAO is an investment fund that is tied to a special type of token contract. Participants can buy fund tokens in order to vote for investment proposals that were submitted to the fund. The voting power of the participant is determined by the number of tokens that they hold. Proposals that cross some threshold receive funding from the revenue raised by the fund from selling tokens (Sims, 2019).
Central Bank Digital Currency
There is some exploration of the idea of a currency that is issued by the central bank (Board of Governors of the Federal Reserve System, 2022). However, given that most currency is created through bank credit and that the central bank is not supposed to provide commercial or consumer loans, and it’s not even possible for the central bank to take on all the demand for credit, it remains highly unclear what exactly CBDC is trying to achieve (Gross & Siebenbrunner, 2019). So far CBDC looks more like a sovereign digital asset, than a currency. Potentially a useful financial instrument but one that is not particularly relevant to the present discussion.
Another way to go is for the government to try to replicate the entire financial system with bank and central bank money, and license commercial banks to issue credit with CBDC. Presumably, it can allow the government to implement additional rules for transactions. However, this is something that the government can already do and does with the traditional banking system. The government has the power to order banks to implement any rules that it wants. There are no benefits to creating a duplicate system.
