Can crypto save the world?
Incentive problems, and the issue with externalities
Disclaimer: crypto alone will not save the world, especially not literally. But I want to outline two ways in which crypto protocols can help us change how we think about the current monetary and economic systems, combining some ideas I have been chewing on for the past couple of months.
Do you want to make the world a better place? I’m sure most, if not all of us, would answer this question with “yes, of course”. So why is it not? In many cases, it comes down to misaligned incentives and the effects of externalities.
We witness misaligned incentives each time someone is (in)directly incentivised to do something beneficial for themselves, but harmful to others. Externalities refer to unforeseen consequences which are not accounted for or ignored when taking a decision. The world around us is riddled with these, ranging from very small- to very large-scale. And they’re related. Together, they often prevent us from “making the world a better place”.
It’s hard for anyone individually to do something about them. Taking a different perspective on money, currencies, and value creation might help. Specifically, we need to do two things:
- optimise our value chains for throughput instead of inputs and outputs
- reconnect actual “physical” and monetary value creation
Crypto protocols and primitives can be a crucial enablers for this shift. Protocols enable transparent cooperation across value chains. Primitives open up new ways for participation in and accounting for value creation.
Money incentivises externalities
Money
Money and currencies emerged as a means to quantify value. When we first started to trade, one of the assets already in circulation additionally assumed the role of currency. This greatly simplified price discovery and trade, as all trading pairs could be denominated in that base currency. Assets still carried an intrinsic value though, against which the value of other things was assessed. In some way the currency was endogenous to the economic system.
We then introduced a layer of abstraction — “money” — as a representation of an underlying asset (e.g. with the gold standard), until we finally stripped that away as well. In today’s world currencies are backed by the faith in the issuing institutions. As such, currencies have become a standalone primitive that runs alongside economic activity. An exogenous variable of sorts.
Exogenous currencies allow us to measure value creation through a single metric, a number. This made accounting very efficient. It also led to a system where economic actors strive to minimise input (costs) and maximise output (value), to optimise monetary returns.
This is not problematic per se. The pursuit of monetary returns was a key factor for progress and innovation. It provided a clear north star: maximising output. It also incentivised productivity gains because that meant cost reductions. Companies, the driving force of value creation, emerged as engines transforming input like raw materials or labor into outputs (products, services).
Externalities
“If one supposes that the negative effect is that of killing the fish, the problem to be discussed is as follows: is the value of the lost fish higher or lower than the contamination of the stream? There is hardly any need to say that one has to consider this problem both within its totality and within its margin.” — Ronald Coase, The Problem of Social Cost
Companies have no intrinsic interest in estimating the true cost of their activity. Instead, optimising for the difference between inputs and outputs creates an incentive for them to ignore negative and overstate positive ones.
Over time, firms have become reasonably good at estimating the value of intangible assets like brand names or IP. Doing so increases value creation in monetary terms. There is no comparable effort from companies to identify and value intangible costs. Understandably so, as this would reduce value creation in monetary terms.
At scale, this has massive negative effects. The failure to accurately price in long-term consequences of economic activity is responsible for many of the most pressing issues we face today.
Environmental and air pollution, or exploding carbon emissions are perfect illustrations for this. Without proper frameworks to describe the value of clean air or rivers, there is no way to properly price in the adverse effects of economic activity on these public goods. Ultimately, externalities mean that we underestimate the true cost of economic activity, inflating the value captured by corporations or individuals at the expense of society as a whole. They are a transfer of value from everyone to individuals and/or institutions.
Pricing externalities
“Without a clear understanding of how the ecosystem produces and captures value, it becomes almost impossible to align the capital allocation strategy with what creates a long-term successful and resilient ecosystem. “ — Designing Token Economies, Packy McCormick & Tina He
So far, the debate has been focused on whether and how to effectively “price in” externalities. The rationale is simple: if we can create a mechanism to assign a price to some goods, economic actors will adjust their way of doing business to reduce or avoid the cost that comes from using this good in their economic activity.
Inside the current economic paradigm this might be the best approach we can come up with. The underlying idea is also surprisingly simple — probably part of its appeal. Carbon markets are an attempt to implement a top-down price on carbon emissions and force companies to incorporate this price into their balance sheet.
Linear thinking, circular thinking
Linear thinking
Addressing externalities one-by-one from the top down hinges on individual legislative initiatives, making it cumbersome. It also does not solve the underlying incentive problem. Value chains right now are optimised to minimise inputs and maximise outputs to produce financial returns. These financial returns are stored in the form of money, or cash. This takes returns out of the economic system and “puts them into” the financial system.
Value chains are therefore traditionally described in a linear way, with clear starting and end points. Externalities that were not accounted for during value creation are financially irrelevant once the process is concluded (e.g. CO2 emissions during a production process). Their real-world consequences are not. The linear, clearly delineated perspective, therefore, is not in line with reality.
Circular thinking
A model from sustainability theory might offer an alternative. The idea of “cradle to cradle” in supply chains describes a shift in perspective from buying raw materials or parts to use in production processes and producing an end product to sell to consumers. Instead, it takes a usage-based view: companies use inputs to offer a certain service to customers for a specific period of time.
For example, a company might manufacture a car and make it available to someone to use. However, the responsibility and ownership of all the materials remains in the hands of the company. Therefore, they are also responsible for the car at the end of its useful life. Taking this one step further, companies “lease” the raw materials from so-called metal banks instead of outright buying them. This means that if they simply discard the car at the end of its lifecycle they will need to pay for the used raw materials indefinitely.
This creates a natural incentive to consider possible ways to both extend useful life and to recycle raw materials from the outset. Maersk introduced the first fully recyclable cargo vessel a few years ago. It is constructed to be completely dismantled at the end of its use so that parts and raw materials like metals can be reused, partly to build a new ship.
This approach to economic activity shifts the focus from describing it in terms of inputs and outputs, with prices assigned to them, to describing the throughput of the system. It promises a more sustainable and accurate accounting of the impact and value created through different processes, and aligns incentives across the entire, circular value chain.
Protocol-based value chains
The developments in the crypto space could turn out to be a crucial element to implement this shift. The “business model” of crypto protocols is mostly geared towards taking a cut from economic activity that is enabled by and funnelled through the protocol. These protocols therefore are inherently throughput-focused.
Open-sourcing these protocols furthermore ensures that anyone can both understand the underlying process and how it creates value, but also directly plug into the protocol to offer add-on services, or participate in the value creation process. As everyone involved in the value creation process benefits from increasing overall throughput there is an incentive to collaborate across the value chain, while also enabling healthy competition for providing the most efficient mechanism to reap benefits of parts of it.
Transparency and aligned incentives can help shift the viewpoint from focusing on steps in an isolated way to focusing on the bigger picture, and how the individual steps contribute to it. Primitive development over the past years has created the building blocks to properly assess and manage throughput of a protocol.
Protocol tokens serve the function of making throughput explicit, visible and measurable, functioning as the unit of account. Token standards like ERC-20 have radically simplified the creation of these tokens describing various types of activities and throughputs. Decentralised exchanges enabled price discovery between different tokens describing different kinds of activity. Concepts like financial NFTs and nested assets will allow for arbitrary bundling of different types of tokens and assets.
This could ultimately culminate in the ability to properly describe complex production processes and material manipulation in an abstracted way while not decoupling it from the underlying assets — as describing everything in monetary terms does.
Internalising externalities
But transparency about what is going on can only go so far. To get rid of externalities requires thorough measurement of all variables of a process. If we don’t know about carbon emissions that result from a manufacturing process, for example, we cannot consider them. Rapidly improving sensor technology allows us to measure almost anything, anywhere, at any time. What is missing often is the incentive to measure in the first place.
Here, crypto protocols might present a potential way forward as well. The ability for various entities to plug into and build upon an open protocol to capture part of the value creation, or provide part of the utility, also means that these entities could potentially provide additional data streams and information about the process.
Decentralised autonomous organisations allow individuals to agree on and pursue a common set of goals, raise funding to do so, and distribute the returns of their activities back to participants, token holders, or both. If economic activity happens in a transparent manner, DAOs can plug into that process to participate. Right now, DAOs are mainly focused on purely digital use cases, but are increasingly broadening their scope to bringing physical assets and activity on-chain.
So far, incentives have been mainly financial. However, there could be other incentives as well. Local groups might rally around measuring polluting effects of some activity and attribute the effects to that activity by adding data to the public protocol steering the activity. For-profit entities might look for previously overlooked adverse effects of some protocol to develop and market a solution mitigating these effects. Public institutions might push government bodies to add information about effects at scale to break them down to lower levels. With the right incentives, these groups could plug into a throughput-focused protocol, creating an internalisation engine.
We are currently separating monetary and economic systems. We look at value creation in a linear way, creating incentives to overstate positive, and downplay negative consequences. Consequently, we are failing to accurately describe and assess our activities. First and foremost, we have to identify potential solutions to this disconnect. The open standards, transparency, and collaborative nature of crypto protocols make them an ideal candidate to form the backbone of that new system. Crypto will not save the world. But it might play a pivotal role in enabling us to do so.
Reluctant Euphoria is an attempt to look at things with a healthy combination of skepticism and optimism. Pieces are always intended to inspire discussion. If you have thoughts on the topic, please feel free to reach out, I’m always happy to debate! Also, leave a follow if you want to stay in the loop on the next posts.
