Abstract. In this essay the Ethereum network and its native cryptoasset Ether is used as an example to illustrate that an adjustable system of taxation, together with an automated way of setting a risk free interest rate can be used by nation state treasurers and central bankers to control inflation and manage the economy.
This essay covers a wide area of disciplines. What I have attempted to do is flesh out an educated idea of how blockchains may be integrated to existing models for the financial management of nations. Ambitious ? Yes and way beyond my pay grade. I welcome corrections and improvements.
I assume the reader has some understanding of how central banks (I use the Reserve Bank of Australia (RBA) as an example) set the risk free rate of interest and how this rate is used to manage the inflation rate within target ranges. Nevertheless, I set out some basic explanations of the system so it can be compared and contrasted with the economics of the Ethereum system. For those not familiar with the cryptoeconomics of Ethereum and blockchains generally I set out some primer material in the appendix.
The proposition I put forward in this essay is that the cryptoeconomics of Ethereum and ether, when taken together with a variable transaction tax rate, can better achieve the same economic management objectives of the existing central bank model. The existing manual system of measurement and adjustment can be replicated with a self-adjusting system based on real time immutable and transparent economic data.
In explaining this proposition I use the existing central bank model and overlay features of the Ethereum model that could substitute elements of the existing model.
2. Manually Adjusted Risk-Free Cash Interest Rates and Target Inflation Levels
Set by the RBA, the cash rate is the interest rate on unsecured overnight loans between banks. It’s the (near) risk-free benchmark rate for the Australian dollar and it is used by banks and financial market participants as the base rate upon which their services (lending products etc.) are built.
The process for setting the cash rate is manual but methodical. The full process is set out in this document. The process involves the collection of various economic data points and independent assessment of whether the rate should be adjusted up or down depending on the level of economic activity, which is measured in part by reference to the inflation rate. Typically, when the RBA feels they need to support the economy they will reduce the Cash Rate. For example during the early part of the COVD pandemic the RBA advised that :
‘…The Reserve Bank Board reduced the cash rate twice in March 2020, to 0.25 per cent, and to 0.1 per cent on 3 November 2020. This boosted the cash flow of businesses and the household sector as a whole. It also helped Australia’s trade-exposed industries through the exchange rate…’
As inflation increases the RBA tends to increase the cash rate to dampen economic activity and bring inflation to within their target range (2%-3%). In August 2022 the RBA advised that :
‘…Today’s increase in interest rates is a further step in the normalisation of monetary conditions in Australia. The increase in interest rates over recent months has been required to bring inflation back to target and to create a more sustainable balance of demand and supply in the Australian economy…’.
Money supply of course can have a significant impact on inflation and is an added complication when supply is increased on a un-limited basis (see Jerome Powell interview here).
During COVID so called money printing by central banks was at record highs and this has the effect of reducing the purchasing power of money, which of course is another way of causing inflation. The below chart showing the growth in AUD assets on the RBA Balance Sheet is one indication of ‘printing money’ as the assets have essentially been bought with newly created money.
The above is a simplification of the system, but it’s not really not that complicated, the system could be described as follows :
‘…a manually adjusted base interest rate is used to stimulate or curtail economic activity depending on weather the inflation rate is trending upwards or downwards…’ (this is my simple description)
3. Self-Adjusting Risk-Free Interest Rates under the Ethereum Model
A study of the economics of Ethereum network reveals that a similar adjustment method works to set a staking return rate, this staking return rate is similar to the risk free rate set by central banks.
The Ethereum network utilises a Proof-of-Stake consensus mechanism. This method requires validators to lock-up 32 ether as Stake. This staked ether then acts as collateral that can be destroyed (in full or in part) if the validator behaves dishonestly or lazily. The validator is responsible for checking that new blocks propagated over the network are valid and occasionally creating and propagating new blocks themselves. In return for this service validators are paid a fee. The total amount of fees represents the total income of the network.
The Annual Percentage Rate (APR) for staking is calculated in two parts as follows :
Part 1 — Base Reward = Net Issuance Rewards X ((Epoch per year/10 (to the power of 9))/ 32)
Note 1. Both elements on the right side of the formula are fairly fixed
Note 2. NIR increases slightly as the amount of Ether staked increases (see below).
The below graph set out the Base Reward issuance curve.
(source : Collin Myers @stakeETH File here)
Part 2 — Fees Reward = Total Fees/Total Staked Ether x (Your Staked Ether/Total Staked Ether)
Note 1. Total fees increase as economic activity increases, this leads to higher returns, which leads to more people staking, which leads to lower returns
So each validator (staking 32 ether) will receive a Base Fee and a Validator Fee. The Base Fee is relatively stable.
The Validator Fee varies depending on the amount of economic activity on the Ethereum network and the amount of ether staked. This is where the idea of staking rate being the equivalent of the cash rate plays out. So for example, if the economic activity on the Ethereum network increases so too will the staking rate as more fees are earnt, this increases the numerator in the formula. But then, as staking rates increase there is an incentive for people to stake more of their ether, this will drive down the staking yield because staked ether is the denominator in the formula. The numerator (economic activity (which is akin to the GDP of the network)) and the denominator (amount of staked ether (which provides the security to the system)) work against each other to arrive at a risk free rate equivalent for the Web 3.0 economy.
Now let’s consider the risk profiles of the central bank cash rate and the ether staking rate.
4. Risk Analysis
In the case of the central bank risk free rate, the risk is that of the sovereign. That is to say if there is default at the sovereign level the entire financial and economic system is at risk of failure. Similarly, it is the case that if there is a failure of the Ethereum blockchain, the applications built on top will suffer catastrophically as well. That is to say, the financial soundness of the sovereign and the security of the blockchain are systemic type risks.
The risk to the sovereign model is poor financial management of national income and expenditures leading to excessive foreign debt and a default on that debt (see here). The risk to the Ethereum blockchain (or indeed any blockchain) is a Sybil or so called 51% attack. These risks, failed state finances and a 51% attack are quite different.
Throughout human history we have seen the centralised state financial model in practice. It has always ended in corruption of the system and failure of the state. Arguably the best systems we have are the ones we see today. The most decentralised form of government we have ever had, the democratic states, seem to be the most robust and provide the greatest good for the greatest number of people. But they are under stress and certainly need improvement.
By comparison the 51% attack risk (in the context of computer software) is relatively new. Sataoshi Nakamoto’s invention of Sybil resistant distributed consensus essentially mitigates this risk and this is why Nakamoto-style consensus is such an important computer science breakthrough. The subsequent adaptation of the invention by others for general purpose public blockchains like Ethereum offers the opportunity to widen adoption of the technology. Bitcoin is only 13 years old so is still a very early stage experiment, yet the experiment is working as planned. There has never been a successful 51% attack on the network. Although not as old as Bitcoin the Ethereum network is also working as it should. The change to Proof of Stake in September 2022 is an incredibly important test on the Ethereum system.
Rating the risk of sovereigns is a well established activity. The same cannot be said for the security risks of the Bitcoin or Ethereum blockchain (in terms of the probability of a successful 51% attack). However, instead of subjective human based sovereign risk assessments, blockchains are tested everyday in the field as attackers constantly seek a way to penetrate the systems. Public blockchain systems have trust built into their code, they are battle hardened by relentless attacks in a live hostile environment. Public blockchain security is not rated by subjective human trust models.
5. Money Supply Policy
Another significant difference between the traditional central bank model and Ethereum is money supply policy.
The central bank model is committee based, with an independent committee of experts assessing the need for liquidity in the markets/economy and making adjustments accordingly. For example in times of a liquidity squeeze, such as the Global Financial Crisis or Covid 19 pandemic the central bank can ease the liquidity by ‘printing’ newly minted currency and flushing through the system. This is an inflationary supply model.
The Ethereum monetary policy is automated. The overall amount of ether on issue maxes out in September 2022 at around 120 mio ETH. This supply then decreases over time as the base fees are burnt. An equilibrium between the burn rate and issuance rate is estimated to form in around 200 years time. This is a deflationary supply model.
(Source : Justin Drake https://ultrasound.money/)
Broadly speaking Keynesian economists favour a variable monetary supply as it allows the central banks to ‘step in’ in times of illiquidity to save the market. This is where the ‘don’t bet against the Fed’ narrative comes from and what it means is that regardless of the fundamentals of a particular company, if the whole market looks like it’s going to collapse the Fed will ease money supply to float all companies. Many short sellers have been caught short because of Fed intervention.
So called Austrian School economists such as Ludwig von Mises and Friedrich Hayek prefer a hard or fixed money supply model. In the event of a liquidity crisis or market downturn they take the view that poorly managed enterprises should be allowed to fail and that out of such pain comes a stronger long term economic environment.
It’s fair to say that the current monetary experiment, since 1971 when the gold standard was unilaterally abandoned by President Nixon, is a Keynesian model. Out of the 192 countries using this model perhaps only 8 or 10 have half-decent money. Most countries have completely given up on even trying to manage their own monetary policy. More than 65 countries peg their currencies to the USD dollar while five U.S. territories and eleven foreign nations use the USD as their official currency (see here). These countries are incredibly poor and often kept afloat only because of USD loans from the IMF or World Bank.
It’s time to move on from binary choices of this or that system. We have technology which enables evolutionary thoughts and the automatic tax system set out below may help with some of that thinking.
6. Automatic Taxation
Collection of revenue in the native currency of the sovereign by the sovereign is one of the most important pillars of the nation state. This does not have to be undermined with the introduction of Bitcoin or Ethereum, it can in fact be enhanced.
In Australia, the taxation system is a complete mess. Hundreds of thousands of people are engaged in complex but completely unproductive work preparing and checking tax returns, arguing about nuanced interpretations of tax law and spending millions of dollars on compliance. The whole compliance and payment process is a significant drain on resources and a negative force on the economy which holds productivity back.
It’s my view that the entire system can be replaced with an automatic micro level transaction tax (as low as one or ½ a basis point) built into every base layer blockchain protocol. Imagine a world where the economic activity on Ethereum is 1000x of what it is today and a world where each transaction results in a micro and automatic collection of tax to the sovereign. A system of instant and automatic taxation is possible and I believe an inevitable outcome in the long term.
If we consider this within the Ethereum economy. The level of Ethereum fees, based on the level of economic activity, adjusts automatically. By adding a layer of taxation to the mix Governments can adjust the tax rate up or down to stimulate or curtail economic activity in the same way that it uses the risk free rate today to achieve the same result. It is also possible (but not necessarily desirable) with this model to tax different areas of the economy differently and to direct certain tax revenue directly to specific projects. Toll road transactions to road maintenance for example. Tax reductions can be given to specific sectors or demographics that need stimulation with immediate effect and absolute accuracy.
I have put forward the proposition that the Ethereum staking rate is to the internet (Web 3.0) economy what the risk free rate is to the central bank model. It is the risk free rate for the internet economy. The rate adjusts automatically based on the level of economic activity on the Ethereum blockchain and the amount of security in the system.
For both systems the risk is systemic. A successful ‘51% attack’ is as devastating to the applications built on the blockchain as foreign debt default is to a nation state. However, the type of risk is different. The risk to the central banker model is corrupt or incompetent financial management of a nations finances. The Ethereum blockchain risk is a double spend or reorganisation of blocks/transactions, a successful ‘51% attack’ on the network.
The debate around the monetary policy aspects is not new. The Keynesian model (liquidity injection at times of crisis) followed by central banks vs the Austrian model (hard money) embedded in the Ethereum model is an ongoing debate that will not end anytime soon.
The addition of automated taxation of transactions on the Ethereum blockchain is a novel concept. If adopted it could give central bankers a method to intervene with liquidity at the times of crisis (reducing the tax rate is the same as a stimulus check) without the monetary debasement and inflationary risk of money printing. Other novel uses of an automated tax system can be developed. The effect of increasing or decreasing the tax rate has a more direct and immediate effect on economic activity than the current system of increasing or decreasing the interest rate.
There is quite a bit to understand with Ethereum and it is not all in one place. I have found that podcast explanations are a good place to start. I set out below some of the most essential topics to understand.
Ethereum researcher Justin Drake is one of the best people to learn from so I have used mainly his explainers and podcast interviews as a guide.
Blockchain Crypto Economics
‘Cryptoeconomics refers to the study of economic interaction in adversarial environments. The underlying challenge is that in decentralised P2P systems, that do not give control to any centralised party, one must assume that there will be bad actors looking to disrupt the system. Cryptoeconomic approaches combine cryptography and economics to create robust decentralised P2P networks that thrive over time despite adversaries attempting to disrupt them. The cryptography underlying these systems is what makes the P2P communication within the networks secure, and the economics is what incentivizes all actors to contribute to the network so that it continues to develop over time.’
All public blockchains must have robust and transparent cryptoeconomics. The very first of course is the Bitcoin blockchain and one of the best analysis’ of this I have seen is from the Central Bank of Finland’s paper titled ‘Monopoly without a monopolist: An Economic analysis of the bitcoin payment system’, it can be found at this link.
For an excellent explanation of Proof of Work and Proof of Stake this summary by crypto exchange Kraken is a good place to start.