Nov 8, 2020
Today we’re going to have a foundational episode, laying the framework for further episodes on digital piracy, venture capital, accelerators, Bitcoin, PayPal, Square, and others. I’ll try to keep from dense macro and micro economics but instead just lay out some important times from antiquity to the modern financial system so we can not repeat all this in those episodes. I apologize to professionals in these fields whose life work I am about to butcher in oversimplification.
Like a lot of nerds who found myself sitting behind a keyboard writing code, I read a lot of science fiction growing up. There are dystopian and utopian outlooks on what the future holds for humanity give us a peak into what progress is. Dystopian interpretations tell of what amount to warlords and a fragmentation of humanity back to what things were like thousands of years ago. The utopian interpretations often revolve around questions about how society will react to social justice, or a market in equilibrium.
The dystopian science fiction represents the past of economics and currency. And the move to online finances and digital currency tracks against what science fiction told us was coming in a future more utopian world. My own mental model of economics began with classes on micro and macro economics in college but evolved when I was living in Verona, Italy.
We visited several places built by a family called the Medici’s. I’d had bank accounts up until then but that’s the first time I realized how powerful banking and finance as an institution was. Tombs, villas, palaces. The Medici built lasting edifices to the power of their clan. They didn’t invent money, but they made enough to be on par with the richest modern families.
It’s easy to imagine humans from the times of hunter-gatherers trading an arrowhead for a chunk of meat. As humanity moved to agriculture and farming, we began to use grain and cattle as currency. By 8000 BC people began using tokens for trade in the Middle East. And metal objects came to be traded as money around 5,000 BC.
And around 3,000 PC we started to document trade. Where there’s money and trade, there will be abuse. By 1,700 BC early Mesopotamian even issued early regulations for the banking industry in the Code of Hammurabi. By then private institutions were springing up to handle credit, deposits, interest, and loans. Some of which was handled on clay tablets.
And that term private is important. These banking institutions were private endeavors. As the Egyptian empire rose, farmers could store grain in warehouses and then during the Ptolemeic era began to trade the receipts of those deposits. We can still think of these as tokens and barter items though. Banking had begun around 2000 BC in Assyria and Sumeria but these were private institutions effectively setting their own splintered and sometimes international markets. Gold was being used but it had to be measured and weighed each time a transaction was made.
Until the Lydian Stater. Lydia was an empire that began in 1200 BC and was conquered by the Persians around 546 BC. It covered the modern Western Anatolia, Salihli, Manisa, and Turkey before the Persians took it. One of their most important contributions to the modern world was the first state sponsored coinage, in 700BC. The coins were electrum, which is a mix of gold and silver.
And here’s the most important part. The standard weight was guaranteed by an official stamp. The Lydian king Croesus then added the concept of bimetallic coinage. Or having one coin made of gold and the other of silver. Each had a different denomination where the lower denomination was one dozen of the higher. They then figured out a way to keep counterfeit coins off the market with a Lydian stone, the color of which could be compared to other marks made by gold coins. And thus modern coinage was born. And the Lydian merchants became the merchants that helped move goods between Greece and Asia, spreading the concept of the coin. Cyrus the second defeated the Lydians and Darius the Great would issue the gold daric, with a warrior king wielding a bow. And so heads of state adorned coins.
As with most things in antiquity, there are claims that China or India introduced coins first. Bronzed shells have been discovered in the ruins of Yin, the old capital of the Shang dynasty dating back hundreds of years before the Lydians. But if we go there this episode will be 8 hours long.
Exodus 22:25-27 “If you lend money to my people—to any poor person among you—never act like a moneylender. Charge no interest.”
Let’s put that bible verse in context. So we have coins and banks. And international trade. It’s mostly based on the weight of the coins. Commerce rises and over the centuries banks got so big they couldn’t be allowed to fail without crashing the economy of an empire. Julius Caeser expands the empire of Rome and gold flows in from conquered lands. One thing that seems constant through history is that interest rates from legitimate lenders tend to range from 3 to 14 percent. Anything less and you are losing money. Anything more and you’ve penalized the borrower to the point they can’t repay the loan. The more scarce capital the more you have to charge. Like the US in the 80s. So old Julius meets an untimely fate, there are wars, and Augustus manages to solidify the empire and Augustus reformed taxes and introduced a lot of new services to the state, building roads, establishing a standing army, the Praetorian Guard, official fire fighting and police and established a lot of the old Roman road systems through the empire that Rome is now known so well for. It was an over 40 year reign and one of the greatest in history. But greatness is expensive.
Tiberius had to bail out banks and companies in the year 33. Moneylending sucks when too many people can’t pay you back. Augustus had solidified the Roman Empire and by the time Tiberius came around Rome was a rich import destination. Money was being leant abroad and interest rates and so there was less and less gold in the city. Interest rates had plummeted to 4 percent. Again, we’re in a time when money is based on the weight of a coin and there simply weren’t enough coins in circulation due to the reach of the empire. And so for all my Libertarian friends - empires learned the hard way that business and commerce are essential services and must be regulated. If money cannot be borrowed then crime explodes. People cannot be left to starve. Especially when we don’t all live on land that can produce food any more.
Any time the common people are left behind, there is a revolt. The more the disparity the greater the revolt. The early Christians were heavily impacted by the money lending practices in that era between Julius Caeser and Tiberius and the Bible as an economic textbook is littered with references to usury, showing the blame placed on emerging financial markets for the plight of the commoner. Progress often involves two steps forward and one back to let all of the people in a culture reap the rewards of innovations.
The Roman Empire continued on gloriously for a long, long time. Over time, Rome fell. Other empires came and went. As they did, they minted coins to prove how important the ruling faction was. It’s easy to imagine a farmer in the dark ages following the collapse of the Roman Empire dying and leaving half of the farm to each of two children. Effectively each owns one share. That stock can then be used as debt and during the rise of the French empire, 12th century courretiers de change found they could regulate debts as brokers. The practice grew.
Bankers work with money all day. They get crafty and think of new ways to generate income. The Venetians were trading government securities and in 1351 outlawed spreading rumors to lower the prices of those - and thus market manipulation was born. By 1409 Flemish traders began to broker the trading of debts in Bruges at an actual market. Italian companies began issuing shares and joint stock companies were born allowing for colonization of the American extensions to European powers. That colonization increased the gold supply in Europe five fold, resulting in the first great gold rush.
European markets, flush with cash and speculation and investments, grew and by 1611 in Amsterdam the stock market was born. The Dutch East India Company sold shares to the public and brought us options, bonds and derivatives. Dutch perpetual bonds were introduced and one issued in 1629 is still paying dividends. So we got the bond market for raising capital.
Over the centuries leading to the industrial revolution, banking, finance, and markets became the means with which capitalism and private property replaced totalitarian regimes, the power of monarchs, and the centralized control of production. As the markets rose, modern economics were born, with Adam Smith codifying much of the known works at that point, including those from French physiocrats. The gold standard began around 1696 and gained in popularity. The concept was to allow paper money to be freely convertible into a pre-defined amount of gold. Therefore, paper money could replace gold and still be backed by gold just as it was in antiquity. By 1789 we were running a bit low on gold so introduced the bimetallic standard where silver was worth one fifteenth of gold and a predefined market ratio was set.
Great thinking in economics goes back to antiquity but since the time of Tiberius, rulers had imposed regulation. This had been in taxes to pay for public goods and bailing out businesses that had to get bailed out - and tariffs to control the movement of goods in and out of a country. To put it simply, if too much gold left the country, interest rates would shoot up, inflation would devalue the ability to buy goods and as people specialized in industries, those who didn’t produce food, like the blacksmiths or cobblers, wouldn’t be able to buy food. And when people can’t buy food, bad things happen.
Adam Smith believed in self-regulation though, which he codified in his seminal work Wealth of Nations, in 1776. He believed that what he called the “invisible hand” of the market would create economic stability, which would lead to prosperity for everyone. And that became the framework for modern capitalistic endeavors for centuries to come. But not everyone agreed. Economics was growing and there were other great thinkers as well.
Again, things fall apart when people can’t get access to food and so Thomas Malthus responded with a theory that the rapidly growing populations of the world would outgrow the ability to feed all those humans. Where Smith had focused on the demand for goods, Malthus focused on scarcity of supply. Which led to another economist, Karl Marx, to see the means of production as key to providing the Maslovian hierarchy. He saw capitalism as unstable and believed the creation of an owner (or stock trader) class and a working class was contrary to finding balance in society. He accurately predicted the growing power of business and how that power would control and so hurt the worker at the benefit of the business. We got marginalize, general equilibrium theory, and over time we could actually test theories and the concepts that began with Smith became a science, economics, with that branch known as neoclassical.
Lots of other fun things happen in the world. Bankers begin instigating innovation and progress. Booms or bull markets come, markets over index and/or supplies become scarce and recessions or bear markets ensue. Such is the cycle. To ease the burdens of an increasingly complicated financial world, England officially adopted the gold standard in 1821 which led to the emergence of the international gold standard, adopted by Germany in 1871 and by 1900, most of the world. Gaining in power and influence, the nations of the world stockpiled gold up until World War I in 1914. The international political upheaval led to a loss of faith in the gold standard and the global gold supply began to fall behind the growth in the global economy.
JP Morgan dominated Wall Street in what we now called the Gilded age. He made money by reorganizing and consolidating railroad businesses throughout America. He wasn’t just the banker, he was the one helping become more efficient, digging into how the businesses worked and reorganizing and merging corporate structures. He then financed Edison’s research and instigated the creation of General Electric. He lost money investing on a Tesla project when Tesla wanted to go wireless. He bought Carnegie Steel in 1901, the first modern buyout that gave us US Steel. The industrialists from the turn of the century increased productivity at a rate humanity had never seen. We had the biggest boom market humanity had ever seen and then when the productivity gains slowed and the profits and earnings masked the slowdown in output a bubble of sorts formed and the market crashed in 1929.
These markets are about returns on investments. Those require productivity gains as they are usually based margin, or the ability to sell more goods without increasing the cost - thus the need for productivity gains. That crash in 1929 sent panic through Wall Street and wiped out investors around the world. Consumer confidence, and so spending and investment was destroyed. With a sharp reduction needed in supply, industrial output faltered and workers were laid off, creating a vicious cycle.
The crash also signaled the end of the gold standard. The pound and franc were mismanaged, commodity prices, new power Germany was having trouble repaying war debts, commodity prices collapsed, and thinking a reserve of gold would keep them legitimate, countries raised interest rates, further damaging the global economy. High interest rates reduce investment. England finally suspended the gold standard in 1931 which sparked other countries to do the same, with the US raising the number of dollars per ounce of gold from $20 to $35 and so obtaining enough gold to back the US dollar as the de facto standard.
Meanwhile, science was laying the framework for the next huge boom - which would be greater in magnitude, margins, and profits. Enter John Maynard Keynes and Keynesian economics, the rise of macroeconomics. In a departure from neoclassical economics he believed that the world economy had grown to the point that aggregate supply and demand would not find equilibrium without government intervention. In short, the invisible hand would need to be a visible hand by the government. By then, the Bolsheviks had established the Soviet Union and Mao had founded the communist party in China. The idea that there had been a purely capitalist society since the time the Egyptian government built grain silos or since Tiberius had rescued the Roman economy with bailouts was a fallacy. The US and other governments began spending, and incurring debt to do so, and we began to dig the world out of a depression.
But it took another world war to get there. And that war did more than just end the Great Depression. World War II was one of the greatest rebalancing of powers the world has known - arguably even greater than the fall of the Roman and Persian empires and the shift between Chinese dynasties. In short, we implemented a global world order of sorts in order to keep another war like that from happening. Globalism works for some and doesn’t work well for others. It’s easy to look on the global institutions built in that time as problematic. And organizations like the UN and the World Bank should evolve so they do more to lift all people up, so not as many around the world feel left behind.
The systems of governance changed world economics.The Bretton Woods Agreement would set the framework for global currency markets until 1971. Here, all currencies were valued in relation to the US dollar which based on that crazy rebalancing move now sat on 75% of the worlds gold. The gold was still backed at a rate of $35 per ounce. And the Keynesian International Monetary Fund would begin managing the balance of payments between nations. Today there are 190 countries in the IMF
Just as implementing the gold standard set the framework that allowed the investments that sparked capitalists like JP Morgan, an indirect financial system backed by gold through the dollar allowed for the next wave of investment, innovation, and so productivity gains.
This influx of money and investment meant there was capital to put to work and so bankers and financiers working with money all day derived new and witty instruments with which to do so. After World War II, we got the rise of venture capital. These are a number of financial instruments that have evolved so qualified investors can effectively make bets on a product or idea. Derivatives of venture include incubators and accelerators.
The best example of the early venture capital deals would be when Ken Olson and Harlan Anderson raised $70,000 in 1957 to usher in the age of transistorized computing. DEC rose to become the second largest computing company - helping revolutionize knowledge work and introduce a new wave of productivity gains and innovation. They went public in 1968 and the investor made over 500 times the investment, receiving $38 million in stock. More importantly, he stayed friends and a confidant of Olson and invested in over 150 other companies.
The ensuing neoclassical synthesis of economics basically informs us that free markets are mostly good and efficient but if left to just Smith’s invisible hand, from time to time they will threaten society as a whole. Rather than the dark ages, we can continue to evolve by keeping markets moving and so large scale revolts at bay. As Aasimov effectively pointed out in Foundation - this preserves human knowledge. And strengthens economies as we can apply math, statistics, and the rising computers to help apply monetary rather than fiscal policy as Friedman would say, to keep the economy in equilibrium.
Periods of innovation like we saw in the computer industry in the post-war era always seem to leave the people the innovation displaces behind. When enough people are displaced we return to tribalism, nationalism, thoughts of fragmentation, and moves back into the direction of dystopian futures. Acknowledging people are left behind and finding remedies is better than revolt and retreating from progress - and showing love to your fellow human is just the right thing to do. Not doing so creates recessions like the ups and downs of the market in the years as gaps between innovative periods formed.
The stock market went digital in 1966, allowing more and more trades to be processed every day. Instinet was founded in 1969 allowing brokers to make after hour trades. NASDAQ went online in 1970, removing the floor or trading market that had been around since the 1600s. And as money poured in, ironically gold reserves started to go down a little. Just as the Romans under Tiberius saw money leave the country as investment, US gold was moving to other central banks to help rebuild countries, mostly those allied with NATO, to rebuild their countries. But countries continued to release bank notes to pay to rebuild, creating a period of hyperinflation.
As with other times when gold became scarce, interest rates became unpredictable, moving from 3 to 17 percent and back again until they began to steadily decline in 1980.
Gold would be removed from the London market in 1968 and other countries began to cash out their US dollars for gold. Belgium, the Netherlands, then Britain cashed in their dollars for gold, and much as had happened under the reign of Tiberius, there wasn’t enough to sustain the financial empires created. This was the turning point for the end of the informal links back to the gold standard. By 1971 Nixon was forced to sever the relationship between the dollar and gold and the US dollar, by then the global standard going back to the Bretton Woods Agreement, became what’s known as fiat money. The Bretton Woods agreement was officially over and the new world order was morphing into something else. Something that was less easily explainable to common people. A system where the value of currency was based not on the link to gold but based on the perception of a country, as stocks were about to move from an era of performance and productivity to something more speculative.
Throughout the 80s more and more orders were processed electronically and by 1996 we were processing online orders. The 2000s saw algorithmic and high frequency trading. By 2001 we could trade in pennies and the rise of machine learning created billionaire hedge fund managers. Although earlier versions were probably more just about speed. Like if EPS is greater than Expected EPS and guidance EPS is greater than EPS then buy real fast, analyze the curve and sell when it tops out. Good for them for making all the moneys but while each company is required to be transparent about their financials, the high frequency trading has gone from rewarding companies with high earnings to seeming like more a social science where the rising and falling was based on confidence about an industry and the management team.
It became harder and harder to explain how financial markets work. Again, bankers work with money all day and come up with all sorts of financial instruments to invest in with their time. The quantity and types of these became harder to explain. Junk bonds, penny stocks, and to an outsider strange derivatives. And so moving to digital trading is only one of the ways the global economy no longer makes sense to many.
Gold and other precious metals can’t be produced at a rate faster than humans are produced. And so they had to give way to other forms of money and currency, which diluted the relationship between people and a finite, easy to understand, market of goods.
As we moved to a digital world there were thinkers that saw the future of currency as flowing electronically. Russian cyberneticist Kitov theorized electronic payments and then came ATMs back in the 50s, which the rise of digital devices paved the way to finally manifest themselves over the ensuing decades. Credit cards moved the credit market into more micro-transactional, creating industries where shop-keepers had once kept debits in a more distributed ledger. As the links between financial systems increased and innovators saw the rise of the Internet on the way, more and more devices got linked up.
This combined with the libertarianism shown by many in the next wave of Internet pioneers led people to think of ways for a new digital currency. David Chaum thought up ecash in 1983, to use encrypted keys, much as PGP did for messages, to establish a digital currency. In 1998, Nick Szabo came up with the idea for what he called bitgold, a digital currency based on cryptographic puzzles and the solved puzzles would be sent to a public registry using a public key where the party who solved the puzzle would receive a private key. This was kinda’ like using a mark on a Lydian rock to make sure coins were gold. He didn’t implement the system but had the initial concept that it would work similar to the gold standard - just without a central authority, like the World Bank.
This was all happening concurrently with the rise of ubiquitous computing, the move away from checking to debit and credit cards, and the continued mirage that clouded what was really happening in the global financial system. There was a rise in online e-commerce with various sites emerging to buy products in a given industry online. Speculation increased creating a bubble around Internet companies. That dot com bubble burst in 2001 and markets briefly retreated from the tech sector.
Another bull market was born around the rise of Google, Netflix, and others. Productivity gains were up and a lot of money was being put to work in the market, creating another bubble. Markets are cyclical and need to be reigned back in from time to time. That’s not to minimize the potentially devastating impacts to real humans. The Global Financial Crisis of 2008 came along for a number of reasons, mostly tied to the bursting of a housing bubble to oversimplify the matter. The lack of liquidity with banks caused a crash and the lack of regulation caused many to think through the nature of currency and money in an increasingly globalized and digital world. After all, if the governments of the world couldn’t protect the citizenry of the world from seemingly unscrupulous markets then why not have completely deregulated markets where the invisible hand does so?
Which brings us to the rise of cryptocurrencies.
Who is John Galt? Bitcoin was invented by Satoshi Nakamoto, who created the first blockchain database and brought the world into peer-to-peer currency in 2009 when bitcoin .1 was released. Satoshi mined block 0 of bitcoin for 50 bitcoins. Over the next year Satoshi mined a potential of about a million bitcoins. Back then a bitcoin was worth less than a penny. As bitcoin grew and the number of bitcoins mined into the blockchain increased, the scarcity increased and the value skyrocketed reaching over $15 billion as of this writing. Who is Satoshi Nakamoto? No one knows - the name is a pseudonym. Other cryptocurrencies have risen such as Etherium. And the market has largely been allowed to evolve on its own, with regulators and traditional financiers seeing it as a fad. Is it? Only time will tell.
There is about an estimated 200,000 tonnes of gold in the world worth about 93 trillion dollars if so much of it weren’t stuck in necklaces and teeth buried in the ground. The US sits on the largest stockpile of it today, at 8,000 tonnes worth about a third of a trillion dollars, then Germany, Italy, and France. By contrast there are 18,000,000 bitcoins with a value of about $270 billion, a little less than the US supply of gold. By contrast the global stock market is valued at over $85 trillion.
The global financial markets are vast. They include the currencies of the world and the money markets that trade those. Commodity markets, real estate, the international bond and equity markets, and derivative markets which include contracts, options, and credit swaps. This becomes difficult to conceptualize because as one small example in the world financial markets, over $190 billion is traded on stock markets a day.
Seemingly, rather than running on gold reserves, markets are increasingly driven by how well they put debt to work. National debts are an example of that. The US National Debt currently stands at over $27 trillion dollars. Much is held by our people as bonds, although some countries hold some as security as well, including governments like Japan and China, who hold about the same amount of debt if you include Hong Kong with China. But what does any of that mean? The US GDP sits at about $22.3 trillion dollars. So we owe a little more than we make in a year. Much as many families with mortgages, credit cards, etc might owe about as much as they make. And roughly 10% of our taxes go to pay interest. Just as we pay interest on mortgages.
Most of this is transparent. As an example, government debt is often held in the form of a treasury bond. The treasury.gov website lists who holds what bonds: https://ticdata.treasury.gov/Publish/mfh.txt. Nearly every market discussed here can be traced to a per-transaction basis, with many transactions being a matter of public record. And yet, there is a common misconception that people think the market is controlled by a small number of people. Like a cabal. But as with most perceived conspiracies, the global financial markets are much more complex. There are thousands of actors who think they are acting rationally who are simply speculating. And there are a few who are committing a crime by violating or inorganically manipulating markets, as has been illegal since the Venetians passed their first laws on the matter. Most day traders will eventually lose all of their money. Most market manipulators will eventually go to jail. But there’s a lot of grey in between. And that can’t entirely be planned for.
At the beginning of this episode I mentioned it was a prelude to a deeper dive into digital piracy, venture capital, Bitcoin, PayPal, Square, and others. Piracy, because it potentially represents the greatest redistribution of wealth since the beginning of time. Baidu and Alibaba have made their way onto public exchanges. ANT group has the potential to be the largest IPO in history. Huawei is supposedly owned by employees. You can also buy stocks in Russian banking, oil, natural gas, and telecom.
Does this mean that the split created when the ideas of Marx became a political movement that resulted in communist regimes is over? No. These have the potential of creating a bubble. One that will then need correcting, maybe even based on intellectual property damage claims. The seemingly capitalistic forays made by socialist or communist countries just go to show that there really isn’t and has never been a purely capitalist, socialist, or communist market. Instead, they’re spectrums separated by a couple of percentages of tax here and there to pay for various services or goods to the people that each nation holds as important enough to be universal to whatever degree that tax can provide the service or good.
So next time you hear “you don’t want to be a socialist country, do you?” Keep in mind that every empire in history has simply been somewhere in a range from a free market to a state-run market. The Egyptians provided silos, the Lydians coined gold, the Romans built roads and bailed out banks, nations adopted gold as currency, then build elaborate frameworks to gain market equilibrium. Along the way markets have been abused and then regulated and then deregulated. The rhetoric used to day though is really a misdirection play handed down by people with ulterior motives. You know, like back in the Venetian times. I immediately think of dystopian futures when I feel I’m being manipulated. That’s what charlatans do. That’s not quite so necessary in a utopian outlook.