Separation of powers and credible commitment

Douglass North and Niall Ferguson, among other historians, have observed the dramatic lowering of English government bond rates after the Glorious Revolution in 1688 (alternatively seen as a Dutch invasion aided and abetted by Parliamentary and City of London traitors to the House of Stuart, and a subsequent "political merger" of the former enemy nations, as Ferguson puts it). North and Ferguson have imputed these lower rates to the superiority of modern democracy which they see as having been given birth by that Revolution.

Aside from the very uncommon but verbose Jacobite, and aside from that sad majority of historians who are shallow parrots of yesterday's tabloid headlines and fail to see the importance of anything so abstract as government bond rates, there is general agreement by the remaining historians about the effect of the Revolution on the great lowering of England's bond rates. But, while the identification of the Glorious Revolution as a great improvement in the financial condition of the English government (and subsequent world dominance of the British Empire, spread of free trade, abolition of slavery, etc. -- as well as to modern evils such as historically unprecedented rates of deficit spending, taxation, and inflation) is accurate, the attribution by North and Ferguson of these lower rates to the supposed "democratic" nature of the Revolution is quite wrong.

A more accurate if rather vague view of the situation is given by Nicholas Gruen:

Be that as it may, one of the huge things that powered us into the modern world was the idea of subjecting monarchs to the rule of law - particularly in Holland and the UK (after the Glorious Revolution of 1688). Because debtors for the first time had an expectation of being repaid when the monarch borrowed money off them, bond rates went right down and the government could borrow money. ‘A free nation deep in debt’ I think was the contemporary expression as Britain and Holland’s stars rose.

We can be far more specific about how the Dutch Invasion of 1688 caused England's bond rates to decrease. There are rather three specific events, quite related to the rule of law but not at all related to voting of the masses (which was not a feature of England for more than a century following that Revolution), but far more pertinent to the English government's immediately subsequent ability to finance itself at low rates. The first was the Bank of England. Whatever the advantages or faults of central banking to the general economy, the Bank of England was the financial engine behind the Royal Navy's subsequent boast, factual until the 20th century, that "Britania Rules the Waves", and specifically its ability to enforce free trade and destroy slavery. The two other events are quite related. The second event was a now-obscure lawsuit against King William and Queen Mary resulting in a crucial legal opinion written by one of England's greatest Chief Justices, Lord Holt, in 1701. The third was a now-obscure provision of the 1701 Act of Settlement which reasserted the independence of Holt and the other English justices from both Crown and Parliament. The Bank of England is well known, but these latter two events are at least as important and deserve to be yanked from their obscurity and put into every History 101 lesson.

Justice Iredell gives a good description of The Banker's Case in the later U.S. case Chisholm v. Georgia. Briefly, in the case brought by banker creditors of the Crown in 1701 to collect in what was owed them under debts contracted by the Stuart kings, the House of Lords (the ultimate court of appeal), led by Lord Chief Justice Holt, held that that the Court of the Exchequer had the power to decide and remedy a case of debt brought against the Crown, and that their decision holding the debts valid and remedying them with payment from the Exchequer was proper. In this particular case, William had no power to renege, not only on debts incurred under his reign, but on the debts incurred by his Stuart predecessors Charles II and James II.

This would not have meant too much of the Crown had retained a unilateral ability to fire the justices of the Court of the Exchequer for deciding against the Crown. In the Act of Settlement Parliament determined that the Crown's justices held their posts for life "on good behavior": it would take a vote of the House of Commons, the House of Lords, and the concurrence of the Crown itself to impeach a justice.

The combination of The Banker's Case and judicial tenure for life created what economists call a credible commitment for the government to abide by its contracts. This is a comitment that neither a single person as sovereign operating under Ulpian's principle of Roman law that "the prince's will is law", nor a democratic legisulature acting under Rosseau's principle that "the general will" supposedly reflected in the enactments of this legislature are unreviewable law, can make. Such a sovereign can simply declare it to be the law that they need not abide by their contracts or by the property rights of their subjects. It is the separation of powers -- and especially an judiciary with power of final decision over contracts involving the government treasury that is as independent as possible of those tax collectors, borrowers, and repayers -- not democratic voting that makes the credible commitment of a government to repay its debts and otherwise honor its contracts possible.

Polynesians vs. Adam Smith

Adam Smith observed how even the most basic of products in 1776, at the dawn of the industrial revolution in Britain, depended, directly and indirectly, on the work of thousands of people:

Observe the accommodation of the most common artificer or day-laborer in a civilized and thriving country, and you will perceive that the number of people of whose industry a part, though but a small part, has been employed in procuring him this accommodation, exceeds all computation. The woollen coat, for example, which covers the day laborer, as coarse and rough as it may appear, is the produce of the joint labor of a great multitude of workmen. The shepherd, the sorter of the wool, the wool-comber or carder, the dyer, the scribbler, the spinner, the weaver, the fuller, the dresser, with many others, must all join their different arts in order to complete even this homely production. How many merchants and carriers, besides, must have been employed in transporting the materials from some of those workmen to others who often live in a very distant part of the country! How much commerce and navigation in particular, how many shipbuilders, sailors, sailmakers, ropemakers, must have been employed in order to bring together the different drugs made use of by the dyer, which often come from the remotest corners of the world! What a variety of labor, too, is necessary in order to produce the tools of the meanest of those workmen! To say nothing of such complicated machines as the ship of the sailor, the mill of the fuller, or even the loom of the weaver, let us consider only what a variety of labor is requisite in order to form that very simple machine, the shears with which the shepherd clips the wool. The miner, the builder of the furnace for smelting the ore, the feller of the timber, the burner of the charcoal to be made use of in the smelting-house, the brickmaker, the bricklayer, the workmen who attend the furnace, the millwright, the forger, the smith, must all of them join their different arts in order to produce them. Were we to examine, in the same manner, all the different parts of his dress and household furniture, the coarse linen shirt which he wears nest his skin, the shoes which cover his feet, the bed which he lies on, and all the different parts which compose it, the kitchen grate at which be prepares his victuals, the coals which he makes use of for that purpose, dug from the bowels of the earth, and brought to him perhaps by a long sea and a long land carriage, all the other utensils of his kitchen, all the furniture of his table, the knives and forks, the earthen or pewter plates upon which he serves up and divides his victuals, the different hands employed in preparing his bread and his beer, the glass window which lets in the heat and the light, and keeps out the wind and the rain, with all the knowledge and art requisite for preparing that beautiful and happy invention, without which these northern parts of the world could scarce have afforded a very comfortable habitation, together with the tools of all the different workmen employed in producing those different conveniences; if we examine, I say, all these things, and consider what a variety of labor is employed about each of them, we shall be sensible that without the assistance and co-operation of many thousands, the very meanest person in a civilized country could not be provided [emphasis added], even according to what we may falsely imagine the easy and simple manner in which he is commonly accommodated.

Leonard Read used the pencil as an even more startling example of how a simple 20th century product depended on a vast global network of economic relations. The number of people required, directly and indirectly, to manufacture a high-technology device, such as a cellphone or laptop computer, is probably in the millions. Friedrich Hayek explained the fine-grained division of labor that makes modern technology and wealth possible as a division of knowledge in "The Use of Knowledge in Society":

The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate "given" resources—if "given" is taken to mean given to a single mind which deliberately solves the problem set by these "data." It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know.

Yet there existed a culture, the pre-European Polynesians, which established self-sufficient economies sometimes not totalling more than a few hundred people on dozens of small islands int the Pacific. Due to the small number of people that made up a self-sufficient economy, they did it using technology and institutions radically different from the agricultural civilizations of the Eurasian continent where they had come from. The Polynesians did not work metal: metalworking (for example the mining, smelting, smithing, etc. required to extract and work iron) requires too much of a division of labor. They used only the materials readily available on a South Seas island: their houses, ovens, boats, weapons, etc. were all made out of plants, stones, and animal parts. Since they lived at a Malthusian equilibrium (which almost every culture lived under until northwest Europe in the 17th century started a long climb out of it), their standard of living was on average the same as the world average -- dirt poor by our standards. This was enough, however, to produce catamarans that could navigate the South Pacific long before Magellan and Cook.

Small island economies greatly increased the premium and resulting emphasis on trade between islands in Polynesia and Melanesia (the Melanesians were an earlier group of island settlers). When inter-island trade was feasible, large proportions of resources and attention went into it. The kula ring was a splendid example of a sophisticated trade institution that developed among some of the Melanesians.

What's more, the Polynesians could do something that we moderns cannot -- replicate their entire economy from one island to another by packing up their families, along with a variety of plants and a handful of animals, onto a handful of catamarans. Could we similarly replicate our entire modern global economy, or a set of tools that could produce an equivalent result, to, say, another planet on a handful of rockets? That was the ambition of K. Eric Drexler's nanotechnology: pack a rocket full of "assemblers": self-replicating robots that can make almost anything. In the mid-20th century, mathematician and computer scientist John Von Neumann sketched a theoretical model of a self-replicating machine -- a self-replicating pattern in the 2-dimensional world of "cellular automata" (where, among other simplifications, copy operations come for free). I have long been skeptical of the idea that physical self-replication can be done with a simple design:

While going from macroscopic industrial parts proposed by von Neumann, or the nucleic acids, amino acids and myriad of tertiary biochemicals in bacteria, to atomic-scale diamondoid parts reduces the search space, and thus complexity, but this also reduces the degrees of design freedom. It could be that the search space of diamondoid replicators is so small that there is no possible configuration of, say, 10 million carbon atoms can copy itself in practice, when we get down to the details of atomic placement in each operation. A particularly difficult task in atomic placement for one small segement of a Stewart platform (eg assembling the ratchet complex) may necessitate a blowup in the complexity of the platform itself or in the machinery that brings molecules to and places them for the platform. To be truly self-replicating we need to close all the loops in the graph of operations. Attempts to close the last 1% ("vitamins") might introduce even more open loops than we close. The minimum complexity might easily exceed the degrees of freedom in the search space, in which case a solution does not exist.

The seeming simplicity of the the small-island Polynesian economy, lacking a sophisticated division of production and distribution operations and thus lacking a highly complex division of knowledge, is in one sense an illusion. This simplicity was made possible by making intensive use of very high evolved plant life. The complexity of life is extremely high. The self-sufficiency of the pre-European Polynesian economy is only possible if agriculture can be productively accomplished with tools made by the farmer or his friends. There is no simple design of a pan-assembler or self-replicating device -- the simplest ones we know of, life, are of extremely high complexity, and it will be a long time before we create new versions of life, much less artificial self-replicating machinery, in a lab.

Partially self-replicating machines are, of course, quite possible. The actual direct and indirect labor required for these machines, like those required for laptops and cell phones, is in the millions of people, and for many of the same reasons -- these machines are based on sophisticated microchips and plastics, among other parts of complex origin. Even if we radically redesigned every tool and machine we have for our hypothetical self-sufficient extraterrestrial economy -- and such radical redesign would be utterly necessary -- it would still likely require hundreds of thousands of people and gigatonnes of machinery, at least, to have a wealthy yet self-sufficient economy beyond earth.

Take Smith's coat and Read's pencil, elaborate the required network still further for today's complex products, and multiply by many thousands of products -- that is what is required to fill the shelves of your hardware super-store (in the U.S., Home Depot and Lowe's). Do this again for your drugstore, your clothing store, etc. You'd have no such super-stores in our space colony. It would in many ways be quite poor by earth standards.

The Polynesians relied on the ready availability of high-evolved life that could readily be grown in the native environment (no complex artificial creations like Plexiglass domes or grow-lights needed), and yet were dirt-poor by our standards. Modern products generally require elaborate divisions of labor necessarily involving millions of people. Such an economy cannot be planned, as numerous attempts to do so demonstrated in the 20th century. A modern economy requires a decentralized information-transmitting mechanism such as a market to work. In sharp contrast to the Polynesian small-island economy, our global economy cannot be easily replicated. We have to make it work here, or nowhere.

Money and the efficiency of plunder

(Note to readers -- after several months of posting reruns, I am back to doing original posts until further notice).

Arnold Kling describes his militaristic theory of the origins of money, and kindly also quotes and refers readers to my theory (or set of theories, as I posit that shell proto-money played a crucial role in several different kinds of hunter-gatherer transactions). Here is the gist of Kling's theory:

Imagine that you're a warlord leading a band of soldiers. Your business model is that your soliders prey on farmers, taking plunder and tribute. To help motivate your soldiers, you promise them a share of the booty. When the band of warriors is small, the promises can be verbal and informal. However, in order to organize a large army, you need formal, written contracts. Lacking lawyers and xerox machines, you make little carvings on metal, hand them out to soldiers, and say, "After the battle, turn this in to the clerk and we'll give you a share of captured slaves and grain and stuff."

There may not be as much contrast between our theories as Kling suggests. We both seem to agree that the traditional economists' explanation of money emerging from a barter market that otherwise obeyed the principles of efficient modern markets is not historically sound (although I do believe it is theoretically and empirically sound as a theory of the way things can happen -- money-like intermediate commodities can and have been observed to emerge from barter markets). Where we may differ, and perhaps not by much, is on the role of coercion. I believe that both coercive and voluntary transactions (and transactions that partook of both components) were important, and that the voluntary transactions were not efficient market exchanges:

Voluntary spot trades are not the only kinds of transactions that benefit from lower transaction costs. This is the key to understanding the origin and evolution of money. Family heirlooms could be used as collateral to remove the credit risk from delayed exchanges. [As explained elswhere in the article, these were typically exchanges that involved very high transaction costs. I'd add in clarification now that the closest modern economic model of them would be bilateral monopoly, not spot exchange on an efficient market]. The ability of a victorious tribe to extract tribute from the vanquished was of great benefit to the victor . The victor's ability to collect tribute benefited from some of the same kinds of transaction cost techniques as did trade. So did the plaintiff in assessment of damages for offenses against custom or law [emphasis added], and kin groups arranging a marriage. Kin also benefited from timely and peaceful gifts of wealth by inheritance. The major human life events that modern cultures segregate from the world of trade benefited no less than trade, and sometimes more so, from techniques that lowered transaction costs. None of these techniques was more effective, important, or early than primitive money -- collectibles.
...
Warfare involved, among other things, killing, maiming, torture, kidnapping, rape, and the extortion of tribute in exchange for avoiding such fates. When two neighbor tribes were not at war, one was usually paying tribute to the other. Tribute could also serve to bind alliances, achieving economies of scale in warfare. Mostly, it was a form of exploitation more lucrative to the victor than further violence against the defeated.

Victory in war was sometimes followed by an immediate payment from the losers to the victims. Often this just took the form of looting by the enthusiastic victors, while the losers desperately hid their collectibles. More often, tribute was demanded on a regular basis. In this case, the triple coincidence could and sometimes was avoided by a sophisticated schedule of payments in kind that matched the losing tribe's ability to supply a good or service with the victor's demand for it. However, even with this solution primitive money could provide a better way -- a common medium of value that greatly simplified the terms of payment – very important in an era when terms of the treaty could not be recorded but had to be memorized. In some cases, as with the wampum as used in the Iriquois Confederacy, the collectibles doubled as a primitive mnemonic device that, while not verbatim, could be used as an aid to recall the terms of the treaty. For the winners, collectibles provided a way to collect tribute at closer to the Laffer optimum. For the losers, collectibles buried in caches provided a way to “under-report”, leading the victors to believe the losers were less wealthy and thus demand less than they might. Caches of collectibles also provided insurance against over-zealous tribute collectors. Much of the wealth in primitive societies escaped the notice of the missionaries and anthropologists due to its highly secretive nature. Only archeology can reveal the existence of this hidden wealth.

Hiding and other strategies presented a problem that tribute collectors share with modern tax collectors – how to estimate the amount of wealth they can extract. Value measurement is a thorny problem in many kinds of transactions, but never more so than in the antagonistic collection of tax or tribute. In making these very difficult and nonintuitive trade-offs, and then executing them in a series of queries, audits, and collection actions, tribute collectors efficiently optimized their revenue, even if the results seemed quite wasteful to the tribute payer.

Imagine a tribe collecting tribute from several neighbor tribes it previously defeated in war. It must estimate how much it can extract from each tribe. Bad estimates leave the wealth of some tribes understated, while forcing others to pay tribute based on estimates of wealth they don't actually have. The result: the tribes that are hurt tend to shrink. The tribes that benefit pay less tribute than could be extracted. In both cases, less revenue is generated for the victors than they might be able to get with better rules. This is an application of the Laffer curve to the fortunes of specific tribes. On this curve, applied to income taxes by the brilliant economist Arthur Laffer, as the tax rate increases, the amount of revenue increases, but at an increasingly slower rate than the tax rate, due to increased avoidance, evasion, and most of all disincentive to engage in the taxed activity. At a certain rate due to these reasons tax revenues are optimized. Hiking the tax rate beyond the Laffer optimum results in lower rather than higher revenues for the government.

We do seem to differ in that Kling's account is basically an account of the origins of coinage in the agricultural era, and mine is an account of the origins of shell proto-money in the hunter-gatherer era. As indicated above, I believe both coercion and voluntary transactions (and admixtures of same) played an important role in the hunter-gatherer era, and as a general matter that's also true of the agricultural era.

I have very little disagreement with Kling's account of the importance of coercion in the origin of coinage. Indeed, here's what I had to say about the origins of coinage:

Given what we have seen about the benefits of proto-money to tribute and tax collectors, as well as the critical nature of the value measurement problem in optimally coercing such payments, it is not surprising that tax collectors, specifically the kings of Lydia, were the first major issuers of coinage. The king, deriving his revenue from tax collection, had a strong incentive to measure to value of wealth held and exchanged by his subjects more accurately. That the exchange also benefited from cheaper measurement by traders of the medium of exchange, creating something closer to efficient markets, and allowing individuals to enter into the marketplace on a larger scale for the first time, was for the king a fortuitous side effect.

My account of coinage differs from Kling only in that I'm looking at the measurement problem that occurs when collecting the plunder; he is looking at the measurement problem that occurs when distributing the plunder out to the soldiers. Both are important. Indeed I have also discussed the latter before on this blog (I don't recall the origins of the idea -- I may have read it somewhere -- a bleg to my kind readers, if you know of a reference, please post it in the comments):

Markets will tend to standardize on whatever the dominant transactor, the party that controls the largest plurality of cash flow, standardizes on, and in most historical societies the dominant transactions were tax collection and the payment of those taxes to soldiers.

By "dominant" here I just mean constituting the plurality (the largest player), not the majority of the value of all transactions, whether coercive or voluntary or some admixture of same. Coinage made measuring the value of both plunder and the distribution of plunder more accurate: both were important in increasing the efficiency of plunder and giving rise to coinage. More efficient exchanges, resembling more spot exchanges than bilateral monopoliies, and thus a larger tax base, were a fortuitous consequence for the Lydian kings (and later for the Greeks who eventually conquered the relatively coinless Persians).

The issue of coercion is also deeply implicated in the origins of agriculture itself. After all, hunter-gatherers were expert botanists compared to the modern layman. They were perfectly well aware that one could plant seeds (and shoots, for asexual reproduction) and have them grow, and could have easily learned the basic techniques associated with early agriculture once they had experimented with this knowledge. Yet these expert botanists with brains the same size as ours existed for 100,000 years before the agricultural breakthrough occured. The problem was not one of farming technique, it was one of securing this capital investment from fellow tribe members and foreign tribes. Only once this problem in coercion and transaction costs was solved could agricultural society appear. More here and here.

Law embedded in the world

Trying to beat the protocol can get you in trouble:

Confidential auditing

I once described how confidential auditing was possible and beneficial:

The auditing function is a vast and indispensable part of the modern economy. Auditing controls allow, among other things, employers to delegate resources and authority to employees, franchisors to delegate to franchisees, stockholders to delegate to management, advertisers to count eybeballs, marketers to gather more reliable data on customers, and make possible a wide variety of other such relationships. Auditing controls might fairly be called the security protocols of capitalism...[However,] auditing is in deep conflict with efforts towards greater privacy. Auditors have an ethic of recording, investigating, and reporting as much as possible, and often see privacy efforts as attempts to prevent auditing and potentially cover up fraud...[But confidential auditing is possible because] we can achieve auditing logs unforgeable after commitment via secure timestamps. We can then achieve to a great extent unforgeability prior to commitment, with segregation of duties via multiparty integrity constraints. We then audit these commitments via multiparty private computations.

In an article about multiparty secure (i.e. private) computations I described this process as follows:

Performance phase analysis with multiparty secure computer theory would seem to apply only to those contracts which can be performed inside the virtual computer. But the use of post-unforgeable auditing logs, combined with running auditing protocols inside the shared virtual computer, allows a wide variety of performances outside the virtual computer to at least be observed and verified by selected arbitrators, albeit not proactively self-enforced.

The participants in this mutually confidential auditing protocol can verify that the books match the details of transactions stored in a previously committed transaction log, and that the numbers add up correctly. The participants can compute summary statistics on their confidentially shared transaction logs, including cross-checking of the logs against counterparties to a transaction, without revealing those logs. They only learn what can be inferred from the statistics; [they] can't see the details of the transactions

In this I had been inspired by Eric Hughes' idea of encrypted open books. My sketch is more general insofar as it addresses pre-transaction forging (with separation of duties), post-transaction forging (with secure timestamping), and the auditing protocol itself (with multiparty private computation running off the logs themselves rather than Hughes' specialized protocol running off already prepared books).

But my description was only a proof-of-concept sketch that one could go all the way from preparing to transact to transaction log to finished audits while maintaining both integrity and privacy, with neither depending on large amounts of trust in the auditors. Recently Shen et. al. came up with a detailed design of such a confidential auditing scheme in the context of gathering statistics from the logs of distributed computations:

...no single TTP [trusted third party] node can have the full knowledge of the logs, and thus no single node can misuse the log information without being detected. On the basis of a relaxed form of secure distributed computing paragidms, one can implement confidential auditing service so that the auditor can retrieve certain aggregated system information e.g., the number of transactions, the total volume, the event traces, etc., without having to access the full log data...To prevent an unsupervised TTP from manipulating the system, we design query processing schemes that require TTP nodes work together, using the multiparty private computation, to perform any useful auditing functions.

Secure timestamping and confidential auditing

Another interesting protocol is cryptographic timestamping. The purpose is to prove that a particular piece of content (i.e. some array of bits) existed at a particular period of time. The basic idea goes back to the anagram publication technique that Robert Hooke, Galileo, and some other early scientists used to prove that they discovered certain things long before they published them. When Hooke, for example, discovered his law of elasticity, he published the gobbledygook letters "ceiiinosssttuv." Later, when he published his law of elasticity, he published "ut tensio sic vis" (as the extension, so with the force). The earlier published anagram proved that he had discovered this law long before he published it.

The modern protocol uses cryptographic hash functions instead of anagrams. Any set of bits (digital content, a network event, whatever) is passed through the hash function, turning into into a unique random-looking string of bits. Those bits are then published to multiple timestamp servers on the Internet. The timestamp servers create a chain of hashes. Using the chain of published hashes, it is easy to later prove that (1) the hash was published before one event and after another event, thus proving the time of publication, and (2) that the hash uniquely corresponds to a particular content.

Note that the content of the file does not need to be published until proof is needed. Thus, for example, one could digitally timestamp a secret digital inventor's notebook in order to prove later that the invention existed at that time. (Might be quite useful under the American first-to-invent system).

Indeed, using multiparty secure computation or the related protocols called zero-knowledge proofs, one can even make a later proof without publishing the content. For example, if Bob received a secret encrypted e-mail message from Alice, Alice and Bob could prove to the world that Alice sent a message at 18:42:39 and Bob received it at 18:43:05 without revealing the actual contents of the message. In a confidential audit of Alice's books based on securely timestamped transactions between Alice and Bob and Alice and Charles, performed using secure multiparty computation, Alice can prove to the auditor that her books balance based on real transactions with Bob and Charles, without revealing in unencrypted form to the auditor either the transactions or the books. Such is the magical reality of cryptography!

Here are some links to papers and other references on secure timestamping.

Bit gold markets

The basic idea of bit gold is for "bit gold miners" to set their computers to solving computationally intensive mathematical puzzles, then to publish the solutions to these puzzles in secure public registries, giving them unique title to these provably scarce and securely timestamped bits. These titles to timestamped bits will be more secure and provably scarce than precious metals, collectibles, and any other objects that have ever been used as money. In a description of bit gold, which was mostly an overview of the technology, I wrote about how, because the algorithms and architectures for solving computationally intensive mathematical puzzles to create bit gold will often be dramatically improved, the bits (the puzzle solutions) from one period (anywhere from seconds to weeks, let's say a week) to the next are not fungible. But fungible units can be created from non-fungible ones:

bit gold will not be fungible based on a simple function of, for example, the length of the string. Instead, to create fungible units dealers will have to combine different-valued pieces of bit gold into larger units of approximately equal value. This is analogous to what many commodity dealers do today [pooling commodities with a wide variety of qualities into a handful of standard grades] to make commodity markets possible.

Bit strings (puzzle problem/solution pairs) are securely timestamped by their time of publication. More recent solutions that have been produced in greater quantities will be discounted by markets. To create fungible units dealers will bundle strings of different value into pools of a standard value (i.e. collect strings into a pool so that the sum of the market values of the strings in the pool add up to the standard value).

It's a bit indirect, but computers can easily handle these logistics. Leaving aside the gold metaphor for a minute, one can think of these bit strings as digital rare postage stamps. Each stamp might trade for a different price, but one can sort stamps into pools so that the prices of stamps in each pool add up to the same total price. Then divide each pool into tranches to create your standard currency denominations.

The rare stamp metaphor is, however, in other ways very misleading. Unlike stamps, but like gold, there are no ongoing changes in subjective valuations between bit strings to worry about, but instead the demand for bit gold is purely for its monetary functions, and thus purely based on how scarce the supply of puzzles solved during a given time period was and is. As a result, pooling and tranching will work far better for bit gold than it does for actual rare postage stamps.

This deserves more elaboration. It seems to be a common objection to bit gold that the mere difference in the price of a bit from one time period to the next produced by technology improvements introduce intractible subjective valuations, making the matter of comparing one week to the next subject to too much uncertainty and transaction costs, as occurs with many collectibles. Just as pooling and tranching rare postage stamps would be a somewhat risky affair as subjective valuations of the underlying stamps change, so too this is supposed for bit gold.

The problem that would occur if we tried to turn most collectibles into a standard currency by pooling and tranching is that, besides a subjective aesthetic component in the demand curve that doesn't come into play with computer bits, their scarcity is uncertain. Art can turn out to be forged, rare stamps thought to be lost or to have never existed might be found, and so on. The supply curve, in other words, can be highly uncertain and in danger of elasticity. Since the supply and demand curves of different pools can change differently over time, the relative values of pools would diverge from their initial values, so that trying to use tranches as standard denominations of a currency would create arbitrage opportunities.

By sharp contrast bit gold will be entirely public: no one gains secure title to any puzzle solutions until they are published. Thus, the exact amount and kind of puzzle solutions during a given period are well known, and perfectly define the supply curve relative to future weeks for all time thereafter.

There will be, in other words, a perfectly objective, measurable, and inelastic supply curve, completely derivable from the relative scarcity of bits (puzzle solutions) on the week (or the day, or the hour, or the minute, if necessary) of their publication. Arbitrage to set the different prices of different weeks (or minutes) can be computerized on this basis. The demand curve, the demand for puzzle solutions for the monetary functions they can perform as a store of value and medium of exchange, will be based on recognition of the superiority of bit gold as a form of money that is more secure and has a far less elastic supply curve than traditional commodities such as precious metals. Since there are no aesthetic differences, the demand curve will be the same function of scarcity for all weeks (or minutes), so it won't affect the simple scheme of automated arbitrage between epochs with different supply curves. The supply and demand curves of different pools will change in the same way over time, and the relative values of pools will not diverge from their initial relative values. Using tranches as standard denominations for a currency does not create arbitrage opportunities.

For most of history collectibles were used for as stores of value and media of exchange; aesthetics played an important role. But before we can separate out the roles of scarcity and aesthetics, we must ask why humans evolved such aesthetic values. The aesthetic instincts, for example the instinct to collect shiny things, evolved just because in the evolutionary environment they approximated an instinct to collect scarce things, and to distinguish hard-to-find from easy-to-find things, i.e. an instinct to recognize and collect objects that can best perform monetary functions, as I describe here, in the "Evolution..." section early in the paper, and the "Attributes of Collectibles" section late in the paper.

As a proximate matter, the contribution to the demand curve from demand for monetary functions (store of value or medium of exchange or both) and the contribution from aesthetic considerations are completely separable. One can demand a commodity for its aesthetic value, or for its value as money, or for both, or for neither. Thus a check for a million dollars might have a design that is utterly philistine, yet the check is still worth a million dollars.

The value of gold today is almost entirely based on its monetary value rather than mere aesthetic value. There are plenty of metals that are as shiny and smooth as gold, but people don't demand them as a store of value or medium of exchange because they are common. There are plenty of rocks that look as good as diamonds, but "diamonds are a girl's best friend" because they are hard to obtain and thus hold their value. Value comes to attach to the unique aesthetic features of gold or diamonds because these features signal scarcity. The value of precious metals or gems as stores of value, media of exchange, or even as cultural icons does not come from these aesthetic features, it is only signalled by them. It is their secure scarcity, not their aesthetic features, that allows them to be more securely used as a store of value and thus gives them a monetary value, and often a corresponding emotional and cultural value, far above the often trivial value they would have if they had the same aesthetics but were common.

There will be a problem defining futures contracts for yet-to-be produced bit gold: how much it might cost to solve a given puzzle a year later, or even a month, will be a very uncertain matter. But the pools that define currencies will be based on spot prices for already produced bit gold, not on futures.

[These comments edit and add to comments of mine under previous blog post(s)]

Bit gold

A long time ago I hit upon the idea of bit gold. The problem, in a nutshell, is that our money currently depends on trust in a third party for its value. As many inflationary and hyperinflationary episodes during the 20th century demonstrated, this is not an ideal state of affairs. Similarly, private bank note issue, while it had various advantages as well as disadvantages, similarly depended on a trusted third party.

Precious metals and collectibles have an unforgeable scarcity due to the costliness of their creation. This once provided money the value of which was largely independent of any trusted third party. Precious metals have problems, however. It's too costly to assay metals repeatedly for common transactions. Thus a trusted third party (usually associated with a tax collector who accepted the coins as payment) was invoked to stamp a standard amount of the metal into a coin. Transporting large values of metal can be a rather insecure affair, as the British found when transporting gold across a U-boat infested Atlantic to Canada during World War I to support their gold standard. What's worse, you can't pay online with metal.

Thus, it would be very nice if there were a protocol whereby unforgeably costly bits could be created online with minimal dependence on trusted third parties, and then securely stored, transferred, and assayed with similar minimal trust. Bit gold.

My proposal for bit gold is based on computing a string of bits from a string of challenge bits, using functions called variously "client puzzle function," "proof of work function," or "secure benchmark function.". The resulting string of bits is the proof of work. Where a one-way function is prohibitively difficult to compute backwards, a secure benchmark function ideally comes with a specific cost, measured in compute cycles, to compute backwards.

Here are the main steps of the bit gold system that I envision:

(1) A public string of bits, the "challenge string," is created (see step 5).

(2) Alice on her computer generates the proof of work string from the challenge bits using a benchmark function.

(3) The proof of work is securely timestamped. This should work in a distributed fashion, with several different timestamp services so that no particular timestamp service need be substantially relied on.

(4) Alice adds the challenge string and the timestamped proof of work string to a distributed property title registryfor bit gold. Here, too, no single server is substantially relied on to properly operate the registry.

(5) The last-created string of bit gold provides the challenge bits for the next-created string.

(6) To verify that Alice is the owner of a particular string of bit gold, Bob checks the unforgeable chain of title in the bit gold title registry.

(7) To assay the value of a string of bit gold, Bob checks and verifies the challenge bits, the proof of work string, and the timestamp.

Note that Alice's control over her bit gold does not depend on her sole possession of the bits, but rather on her lead position in the unforgeable chain of title (chain of digital signatures) in the title registry.

All of this can be automated by software. The main limits to the security of the scheme are how well trust can be distributed in steps (3) and (4), and the problem of machine architecture which will be discussed below.

Hal Finney has implemented a variant of bit gold called RPOW (Reusable Proofs of Work). This relies on publishing the computer code for the "mint," which runs on a remote tamper-evident computer. The purchaser of of bit gold can then use remote attestation, which Finney calls the transparent server technique, to verify that a particular number of cycles were actually performed.

The main problem with all these schemes is that proof of work schemes depend on computer architecture, not just an abstract mathematics based on an abstract "compute cycle." (I wrote about this obscurely several years ago.) Thus, it might be possible to be a very low cost producer (by several orders of magnitude) and swamp the market with bit gold. However, since bit gold is timestamped, the time created as well as the mathematical difficulty of the work can be automatically proven. From this, it can usually be inferred what the cost of producing during that time period was.

Unlike fungible atoms of gold, but as with collector's items, a large supply during a given time period will drive down the value of those particular items. In this respect "bit gold" acts more like collector's items than like gold. However, the match between this ex post market and the auction determining the initial value might create a very substantial profit for the "bit gold miner" who invents and deploys an optimized computer architecture.

Thus, bit gold will not be fungible based on a simple function of, for example, the length of the string. Instead, to create fungible units dealers will have to combine different-valued pieces of bit gold into larger units of approximately equal value. This is analogous to what many commodity dealers do today to make commodity markets possible. Trust is still distributed because the estimated values of such bundles can be independently verified by many other parties in a largely or entirely automated fashion.

In summary, all money mankind has ever used has been insecure in one way or another. This insecurity has been manifested in a wide variety of ways, from counterfeiting to theft, but the most pernicious of which has probably been inflation. Bit gold may provide us with a money of unprecedented security from these dangers. The potential for initially hidden supply gluts due to hidden innovations in machine architecture is a potential flaw in bit gold, or at least an imperfection which the initial auctions and ex post exchanges of bit gold will have to address.

Origins of the joint-stock corporation

The modern joint-stock corporation has many sources in medieval Europe. First among these was corporate law itself. Although the era is commonly referred to as "feudalism," for the hierarchy of individually owned "fiefs" of land and control of serfs as fixtures of that land, large amounts of wealth in Europe were actually controlled by corporate entities. Chief among these were church lands, the corporate entities being dioceses, religious orders and the Roman Church itself. These entities controlled a substantial fraction of the land in Western Europe. Furthermore cities (with varying degrees of political independence), merchant guilds, craft guilds, and many charitable entities (such as hospitals) were legal "corporations," i.e. artificial and perpetual legal persons under law. Some basic issues in corporate law (for example, when are officers individually liable for acts of the corporation, and when the corporation is liable for acts of its agents) had already been solved in canon law and urban law long before the joint-stock corporation.

Another source of the joint-stock corporation was the tradition of dividing ownership over tangible things into "shares." For example, it was common in Italian maritime states fund the construction and operation of ships by dividing them into a certain number of shares (24 and 64 were common divisions). Share owners were responsible for funding voyages (not including cargo, which was typically paid for by trading partnerships called commenda) as well as the initial construction capital, and divided up the profits (fees paid by the merchants less costs). This tradition faded away in Venice when that republic's government took over ship ownership, but thrived across the Italian penninsula in Genoa. Ship shares became embedded into maritime law all over Europe and even survived the British Empire (today in Canada when you register a boat the government still registers 64 shares in it for its owner). The only organization controlled by the shareholders, however, was the captain and crew of the ship.

The medieval organizations that most resembled later joint-stock corporations were the Genovese maone. These bore some strong resemblances to the publicani tax farming corporations of the Roman Republican era, although it is not clear how they could have survived the intervening Late Empire and Dark Ages other than as very obscure (and perhaps now lost) written descriptions. In form and function maone also bore strong resemblances to some early joint-stock companies such as the Bank of Amsterdam, Bank of England, and the Dutch and English East India Companies.

The Italian cities often sold off their tax receivables to wealthy merchants at a discount as a way to borrow funds. (Discounting was one of the many ways late medieval financiers avoided the rather lax and narrow usury restrictions). The debts were divided into equal shares called loca or partes. Legally, these shares were personal property (chattels) and could be freely traded.

Technically, no organization was created when the city sold its tax receivables to merchants. However, to effectively collect the taxes, the holders of loca formed an organization called a maona or societas comperarum. This organization would then subcontract to tax farmers to collect the taxes. By the fourteenth century, Genovese maone also engaged in military conquest and colonization. These were, quite literally, corporate raiders.

Normally, maone were temporary, but some of them ended up lasting for a long time. In 1346 the Maona di Chio e di Focea (a company for managing the taxes of Chios and Focea) was formed. This organization's members obtained from Genoa the exclusive right to collect taxes from Chios (an Aegean island) and Phocaea (a port on the Anatolian coast). But first the company would have to conquer them! Although technically a temporary organization, it lasted until 1566.

Rather than going to buy receivables from Genoa, subscriptions to the di Chio e di Focea's loca shares (still legally debt, but to be paid out in dividends as taxes and trading revenues were collected) went to fund 29 galleys to conquer Chios and Phocaea. The Genovese Republic, for a fee, granted the organization exclusive rights to collect taxes from the conquered territories as well as special trading privileges. The conquests, taxes, and trading were at least partially successful, and by the 16th century more than 600 persons owned loca of the maona. This function and some of this structure would later be emulated by the Dutch and English India Companies, but with a basic legal difference -- "shares" in these later joint-stock companies would constitute ownership (like ship shares) not debt as with the maona.

The most famous Genovese maona was the Officium procuratorum San Giorgio, later the Banco di San Giorgio. Founded in 1407, this bank (and a later Genovese bank along the same lines, the Bank of Genoa) would be the inspiration for later central banks such as the Bank of Amsterdam and the Bank of England. Banco di San Giorgio came to administer most of the Genovese Republic's debts. Dividends were paid out of tax collections (less directly than with earlier maona, but still more directly than the later Bank of England). The maona business was becoming more monopolistic, as it had become in Venice and would become with later central banks.

At the same time, however, the ship share system spread to northern Europe and branched out beyond ships. In Italy and Germany by the 16th century a wide variety of mines were divied up into ownership shares. During the Reformation, a pious follower of Martin Luther gave him some kuxen, shares in a mine in Saxony. Luther complained that he did not know what to do with them. (Indeed, since as with ship shares the mine managers could call on investors to pay up more capital, ownership was not for the financially naive).

Martin Luther

Ship shares and mine shares like these were issued in small numbers (usually between 24 and 640) and thus were not typically traded on exchanges. The number of employees was also small, usually no more than a few dozen. Kuxen were reportedly sometimes traded at the Leipzig fairs. Indeed, illiquidity was the rule in the first century of English joint-stock companies. It was not until the Vereenigde Oostindische Compagnie (the Dutch East India Company, founded out of a merger of smaller colonial companies in 1602) that volume existed to trade company shares on exhanges (which up to that time traded state and municipal bonds and commodities).

Interestingly, the first joint-stock companies chartered by the English Crown (starting in 1553) were companies involved in trading (the Muscovy and Levant companies), mining (the Royal Mines and the Mineral and Battery), and trading combined with conquest (the India Companies, the Virginia and Plymouth companies, etc.) The two mining companies borrowed not only shares but managers and engineers (presumably along with their techniques) from Germany. The Genovese for their part would have felt at home with the trading and conquest companies.

References include:

Harold Berman, Law and Revolution.

Guido Ferrarini, "Origins of Limited Liability Companies and Company Law Modernisation in Italy: A Historical Outline", Centro di Diritto e Finanza WP 5-2002.

Meir Kohn, "The Capital Market Before 1600", working paper 99-06, February 1999.

Emergency economics

For those of you who didn't catch me on econ-law a few months ago [2005] during the hurricanes, here is an expanded version of what I posted there:

Here are some alternative ways of rationing in an emergency. At least some of these have been written about by Yoram Barzel. We have witnessed all of them during hurricane Katrina [and also this summer (2008) during Ivan]:

(1) market prices ("price gouging")
(2) waiting in line
(3) centrally planned rationing
(4) don't ration: just let the resource run out

It's not clear that, even with perfect knowledge, with or without an emrgency, centrally planned rationing could operate without using one of the other methods of rationing. In any case, our very poor knowledge about each others' needs is sufficient to ensure that, short of a perfect price system, we can't get what we want without waiting in line, and sometimes we just can't get what we want (or even, the Rolling Stones notwithstanding, what we need). The worse the price system -- in other words, the higher the transaction costs -- the more we wait in line or do without, as East Germany once demonstrated (cf. West Germany) and as North Korea continues to demonstrate. Luckily for those of us in largely market price based economies, we need only wait in line when trying to do business with the government, call a toll-free service line, go to a hot movie on opening night, or during an emergency -- i.e. in the remaining situations where prices don't operate very well or at all, due to transaction costs imposed by law or otherwise.

Mises and Hayek long ago demonstrated the weakness of centrally planned economies such as the old Soviet Union (or today's North Korea) -- the lack of knowledge the government has about peoples' needs and desires. Similarly, lack of the requisite detailed rknowledge of the needs of others, especially at specific times of crisis when they need our help most, is a huge problem even if we were perfectly charitable. Not even the local governments exhibited much knowledge of the needs of their neighbors, especially in New Orleans. Much less did the state or Feds (FEMA being only the most glaring example) exhibit even a tiny fraction of the knowledge that would be required for an optimal outcome. This is not the fault of the people in the government agencies to not act as knowlegeably as they are capable of acting, but rather the fault is in their implied promises and our expectations. For example, TV commentators, watching pictures of some Coast Guard helicopters, seem to have come to expect that government agencies will swoop down from the sky and rescue everybody and take on other attributes of God. Such as, for example, being able to knowledgeably evacuate people and distribute other scarce goods and services in a disaster.

Per Mises and Hayek, even if the Soviet Union had been run by an perfectly beneficient dictator, people would have, short of a matching omniscience of said dictator (and of enough of his underlings to receive and act on the knowledge) still have waited in bread lines. When price controls hit gasoline in the United States in the 1970s, people similarly waited in gas lines.

In emergencies rationing becomes extreme: people wait in long lines, pay "extortionate" prices, or, even worse, do without. We are thrown into economically unfamiliar territory and transaction costs balloon. Goods will always be rationed in one or more of the above four ways, and in an emergency the rationing can be quite severe. Our charitable spirit can temporarily overcome self-interest, but it can't overcome the knowledge problem or the scarcity of goods.

Given that waiting in line, or doing without, are very painful (even sometimes deadly) alternatives, and that allowing the charge of very high prices can largely prevent use of these extreme and wasteful forms of rationing, why do we have price gouging laws?

Can price gouging laws be explained as follows? In a zero transaction cost world, consumers would successfully negotiate with retailers for an insurance policy that caps prices in case of emergency. This may be, for example, because retailers are better able to bear the risk of emergency supply shortages than consumers are, or because consumers don't want to bear the risk of having to have an unusually large amount of money at hand during an emergency. (Katrina may be a good example of this -- it reportedly struck just before many paychecks were due, leaving many people who live from paycheck to paycheck without funds). However, the transaction costs for negotiating with consumers for such contracts are too high. Therefore, the default retail sales contract should include such insurance. Price gouging laws are a convenient way to do this. More generally, if it weren't such a bother almost all of us would like to purchase insurance against volatile prices in order to make our budgets more predictable.

Whether and when wholesale contracts include such price caps provisions would provide interesting evidence in favor of or against this hypothesis, and under what conditions it would have been rational to for consumers and retailers to have made such a contract.

As we have seen, there is a strong economic argument against price gouging laws. Consistent application of market pricing during an emergency would minimize the other inefficient, and occasionally deadly, rationing methods above, especially (4)actually running out of emergency supplies. Consumers could be confident that supplies will not run out, so stocking up on excess supplies based on fear of imminently running out of the supply (such as we've seen consumers do in some areas recently with gasoline) would be minimized. Given modern technology, perhaps we should work on improving the availability of credit and liquidity in emergencies via always-up wireless devices and immediately payable liquidity insurance policies instead of price gouging laws.

Furthermore, the promise of very high prices might motivate retailers to fly in special deliveries of emergency supplies at otherwise prohibitive transportation rates. On can even imagine for-profit organizations doing many of the tasks that the National Guard, Red Cross, and similar organizations are doing now. Of course, the moral indignation would be enormous. People, at least in political discussion, tend to be extremely averse to "windfall profits" and seem to have a strong psychological preference for an implicit insurance policy that puts a price cap during emergencies on retail contracts.

Patent goo: self-replicating Paxil

In his novel Cat’s Cradle, science fiction writer Kurt Vonnegut postulated “Ice-9.” Ice-9 was a form of water that was frozen at room temperature and catalyzed any normal water it came in contact with into more crystals of Ice-9. Once released into the environment, it froze all water, including us. Eric Drexler in the 1980s raised the specter of nano-robots that made copies of themselves and ate everything in their path: "gray goo." A wide variety of similar hypothetical disasters have since been given referred to as some sort of "goo."

Self-replicating chemicals are not merely hypothetical: since Cat's Cradle, scientists have discovered some real-world example of crystals that seed the environment, converting other forms (polymorphs) of the crystal into their own. The population of the original polymorph diminishes as it is converted into the new form: it is a “disappearing polymorph.” In 1996 Abbott Labs began manufacturing the new anti-AIDS drug ritonavir. In 1998 a more stable polymorph appeared in the American manufacturing plant. It converted the old form of the drug into a new polymorph, Form 2, that did not fight AIDS nearly as well. Abbott’s plant was contaminated, and it could no longer manufacture effective rintonavir. Abbott continued to successfully manufacture the drug in its Italian plant. Then American scientists visited, and that plant too was contaminated was contaminated and could henceforth only produce the ineffective Form 2. Apparently the scientists had carried some Form 2 crystals into the plant on their clothing.

Another instance of the “disappearing polymorph” may be the anti-depressant, Paxil (U.S. brand name for the chemical paroxetine hydrochloride). No, self-replicating Paxil doesn’t naturally spread into our brains and make people happy for free. It's not "happy goo." On the contrary, self-replicating Paxil converted, according to one of the parties in the ensuing lawsuit, an old, and now off-patent, form of Paxil into a new, patented form of Paxil. Once the new form, the hemihydrate form of Paxil, was created, its crystals started floating about, converting small fractions of the old form, anhydrous Paxil, into hemihydrate. Both forms of the drug work equally well as an anti-depressant, but it became impossible to manufacture the off-patent anhydrate without some of it being converted into the patented form. Call it "patent goo."

Apotex, a generic drug manufacturer, was all set up to manufacture the off-patent anhydrous generic Paxil when it discovered small fractions of it were being converted into the hemihydrate. They couldn’t remove the contamination. Smithkline, owner of the patent on the hemihydrate, sued them for patent infringement. Apotex argued that the hemihydrate form occurred naturally, so that Smithkline’s patent was invalid. Smithkline argued that it was a disappearing polymorph, that the hemihydrate form had not existed before they had created it in their labs, and that it was up to Apotex to remove the hemihydrate from its product or pay it a royalty. Apotex was unable to remove the hemihydrate and unwilling to pay a royalty.

Judge Richard Posner heard this case in the trial court and wrote an opinion that contains a good explanation of the self-replicating Paxil controversy. The Federal Circuit heard the appeal and decided that Smithkline’s patent on the hemihydrate was invalid as “inherently anticipated” because anhydrate naturally converts into hemihydrate. Normally, anticipation would require an actual reference describing the claimed chemical structure (in patent lingo that the hemihydrate was "taught in the prior art"). But Judge Rader held that inherent anticipation occurs when, more likely than not, an operation that is taught in the prior art would result in the claimed chemical. The anhydrate which was taught in the prior art would more than likely result in natural creation of some hemihydrate. Judge Gajarsa in concurrence argued that the drug was discovered not invented, making it unpatentable subject matter. Gajarsa’s opinion may have inspired the United States Supreme Court to raise the subject matter issue on its own (i.e., it had not been argued by the parties to the case) in Metabolite. The Supreme Court is considering whether to take the appeal on the self-replicating Paxil case as well.