Finance and Democratic Demands
Capital, Scams, and Crypto
A modern functional society plans for the future. Individuals go to universities to study, entrepreneurs found businesses based on new technology and innovation, builders purchase tools to make greater things. Part of what enables this in a market economy is the flow of financial capital. Banks and other financial institutions are entrusted with what funds can be spared for the future and decide what gets to grow based on the law of the market.
When this works properly, economic growth follows. Not only do all those directly involved benefit - the debtors end up making money from their funded ventures, the banks profit from their interest, and the bank’s customers see their savings grow - but the totality of society benefits on average. In our era growth may actually be definitional for a modern functional society, for countries that do not grow have rarely remained functional for long.
Investment based on the market, which is to say investment based on strategies which return net profits in the timeframe of interest of the lender, is quite good at producing the growing future-looking society most of us desire to live in. Stock markets, hedge funds, private equity firms, investment banks, all the incredible array of financial institutions are all improving the allocation of capital to the best and most promising uses which improve growth. The way to profit in these markets is to choose the opportunities for growth better than the existing system, and each profit is therefore an improvement in the system’s knowledge and the collective activities around growth. The profit motive and the general good overlap. The market better allows for the most effective allocation of our collective knowledge in order to grow the future.
This is not how most people think of finance, regardless of their level of involvement with these institutions. For most, finance is about making money. Whether they end up creating a business that succeeds, creates jobs, makes people’s lives better, etc is a secondary concern. Rarely do we reflect on doing our small part to create the massive super intelligence that is the invisible hand of the market. Our goal is profit. When we speak of smart decisions around investments, when one buys early in a soon-to-be-successful business it is considered a shrewd bit of self-profit, a well chosen bet on a horse race, not part of that companies rise to success and the general welfare they produce.
This is not a problem. Whether one invests their money in the future for the good of society or for personal selfish gain does not matter; with the proper markets society benefits either way. And personal gain is perhaps the most effective motivator we know of, financial markets have been such a boon precisely because there is a wonderful coincidence between greed and good. But we ought to remember that it is the selfish gain that people are after, and there are times when the two goals become untethered.
—
Growth is crucial for functioning societies not only for its future-looking aspects, but because people demand that their own wealth increase. Declining wealth is a consistent recipe for social discord and misery, growing wealth is a near guarantee of contentment. Wealth increases are best achieved with growth, but sometimes shortcuts are taken. Many governments have spent on the present generation with full knowledge that it is at cost of the future, and do not care because it will not be their problem. Voters in democratic countries rarely voice their discontent at policies that disproportionately favor the current population at the current time. They express these same preferences in investment decisions, and whenever a present payout is possible at cost of the future, there is danger.
Most ventures are based on the prospect of generating profits in the long term, growing and changing with the society they are embedded in. On the other hand, businesses which are planned from the beginning to make money in the short term but not in the long future can often be classified as scams. Investment scams are about as old as investment and occur whenever opportunistic individuals realize that promise of profit can motivate investors enough to overlook the practicals of a workable venture. The South Sea Bubble of the early 18th century was able to expand based on general knowledge of how well previous oriental trading companies had done and let general enthusiasm for the profits that were to be made carry it past any hope of delivering on expectations. There is always this danger when the excitement for investor profits outstrips the profit of the venture itself.
But shockingly common too are the scams that trade on people’s selfishness and function only by convincing their targets that they will be one of the exploiters rather than the exploited. Schemes pyramid and ponzi have appeared and reappeared whenever finance is allowed to flourish and while some of the marks are honest, many deep down suspected that there was no future plan but only that they would be able to profit before they lost out.
In the immature financial space of post-Communist Russia, with average citizens looking desperately for any escape from abject economic malaise, the ponzi scheme MMM was able to attract what little money they could find. Investing heavily in legitimizing TV advertisements, the scheme was able to defraud millions of people before finally being shut down by the government. Billions of roubles were lost, millions had their lives set back, and the opportunity to invest that capital in a better future for Russian was squandered. The only good that MMM produced was perhaps more financial regulation in an already broken Russia, but it is hard to say that there was no way this could have happened earlier to a transparent ponzi scheme which ran for years.
Even less excusable is that MMM lived on. Shortly after its founder Sergei Mavrodi was released from a penal colony, he launched MMM Global, the same ponzi scheme but directed at even poorer people in the developing world. South Africa, Nigeria, Kenya, China, and Brazil were all plagued with years of investment into a pointless venture followed by sudden stops and crashes, sometimes multiple times. Government regulation was not able to move swiftly enough to stop the loss and waste. And the people’s demand for increase, for profit, especially in financially immature environments with no other alternatives, was difficult to resist. Most people knew in some sense that MMM was not a stable business generating 30% annual returns for its investors, it actually skirted regulations by claiming only to be a mutual aid society which is a nicer way of describing the fundamental ponzi mechanism. But they wanted their returns. In South Africa, a group of dedicated “Mavrodians” held a march calling for greater financial freedom in opposition to the government’s investigation of the scheme.
Protest is often linked with investment schemes allowed to grow into societal phenomenons, but it usually comes after the crash. In early 2000s Haiti, financial cooperatives had been allowed to expand in defiance of the elite-controlled banking system. These seemed legitimate: they were advertised on the radio and even tacitly endorsed by the president. But then they all collapsed as the schemes they were. Rather than accept the loss as a risky investment made by an individual, people took to the streets claiming that the government was responsible for encouraging and allowing such institutions and that it was on them to reimburse the victims.
The People’s Republic of China had suffered for most of its history with extremely poor access to finance, with most people keeping their money in heavily regulated savings accounts that did not even beat inflation. When financial markets began to open thanks to tech innovators like Alibaba and Tencent, people became excited and began to invest, seeing their wealth grow passively for the first time. In the mid-2010s, a new financial instrument enabled by mobile technology - mass peer-to-peer lending - promised to make finance much better by cutting out the banks entirely and allowing people to make more profit by directly funding each other. But then peer-to-peer lending turned out to mostly be ponzi schemes and evaporated overnight. In a country where protest is extremely dangerous, people protested and said the government should not have allowed such criminal organizations to flourish as if they were legitimate, and the government duly answered the desires of the people with more regulation.
Perhaps the most extreme case of scams and protest came in Albania in the late 90’s. Emerging from the stagnant cloud of Communism, Albanians were eager to embrace the market economies and to grow. But the best path to grow one’s money was by buying into pyramid schemes. The central bank was not overseeing commercial finance based on advice it received from the IMF, and the pyramid schemes kept generating returns, pulling a huge portion of the population in including many in government positions. They were too big to fail, and anyone who doubted the wisdom of investing their money in a financial instrument promising 100% annual returns with no substantive economic utility saw their friends profit while they remained poor. Until they all collapsed in 1997, triggering mass protests of the defrauded which spiraled into a civil war that saw thousands dead.
There are many stories like this. Such scams plague the developing world wherever there is sufficient financial maturity. Rich countries largely do not suffer to the same extent due to vigilant financial regulation, although some scams do make it through the cracks. Based on the evidence, it seems that it is a law of human nature or perhaps economics that in an environment where financial scams are not regulated, they will arise.
And this law is tragic, for it shows that the collective super intelligence of the market’s allocation of capital into businesses that will grow has limits, it has a stupid blindspot, a weakness it cannot resist. These schemes are old but the market continues to forget them, profits overcoming wisdom. MMM did not even have to change its name to continue to steal. Greed cannot be relied on.
—
Government’s role in this is to regulate, because it is what the people demand. They want to see their wealth grow, but if the government entrusts decisions fully to the people and to the market they comprise citizens will see a tacit endorsement after the crash. In order to have a society that invests in the future rather than the short term, it in some way needs to be illegal to invest in the short term.
Government financial regulation is far from perfect though. They cannot centrally manage finance, they have tended to be bad at it: before reform in the 2000s and 2010s China’s state-owned banks had 40% of loans go bad compared to 5% for US-banks during the height of the 2008 financial crisis. But looking even at permissive systems like the United States, the regulations seem far from rational and fair.
Transferring money, pooling savings of others for investment, selling stocks and bonds are all very basic functions in a market economy yet the number of legal entities allowed to do these things is kept extremely small deliberately. Only banks and other regulated entries can do this, and an entrepreneur who has new ideas about finance simply cannot join the club. There has been a governmental decision that only these approved players can make the decisions which drive investment.
However banks have not taken their immense responsibility as the appointed guardians of finance seriously and have been allowed to get away with much. Multi-day wait times to transfer funds and lazy policies like overdraft fees dominate unnecessarily. Even with regulation, finance bears some responsibility for recklessly gambling for their benefit and not the general welfare, at least partially causing the global economic recession of 2008. While fintech has helped speed things up a little, comparing the US’s consumer financial instruments to countries which have more fully embraced digital possibilities (China, Brazil), it becomes clear there is lots of low-hanging fruit which the banks are failing to act on not because of regulatory issues, but because of the comfort granted by the government quasi-monopoly.
This lazy status-quo has been the rallying cry of cryptocurrency for the last decade. Crypto promises to radically democratize finance by building from the ground-up. Blockchain technology is decentralized, allows open participation, and cuts out any central license-giving process. Blockchain also has the promise to be a final arbiter of disputes through instruments like smart contracts, wholly sidestepping legal systems. If two parties have a dispute about how much USD is owed for a deal, they go to court and the government decides; on blockchain, the contract is automatic and self-enforcing.
Crypto enthusiasts hope that all the corruption and centralized power of the current financial ecosystem can be sidestepped with this technology. Much of the world have their financial futures thrown away by their governments, not allowing financial innovation which would allow them to save for the future, or forcing them to keep their lives in inflated or artificially pegged currencies. Crypto has a hope of solving these problems, and blockchain technology has a lot of use cases beyond finance. On this promise, investment in crypto has skyrocketed since it came into public awareness.
Except it is not actually this promise that has driven investment in crypto. This is a fig leaf, people like to feel good about what they’re investing in, but the vast majority of investment in crypto is a simple hope for profit whether short or longterm. Because crypto is unregulated, all the various scams and corruptions that flourish in an open financial system have flourished.
But even beyond allowing these sorts of scams back into the world, crypto itself has the possibility to be one giant investment bubble which managed to sneak past regulators due to its complex nature and possible use-cases. In the regulated world of the rich countries, we have forgotten just how common these scams really are and that government guarantees do not always apply. FTX appears to have been a scam of sorts, but this ad from before the fall is an effective demonstration of what is attractive to crypto investors, and continues to drive business to FTX’s possibly legitimate competitors.
No use-cases, no promise for the future, just profit and the fear of missing out. Like MMM and the Albanian pyramid schemes, crypto has worked hard to legitimate itself as a real financial instrument with media ads and endorsement by prominent figures, and like those scams has usually failed to explain how exactly it will generate that value.
The decade-old promises have usually not been followed up on, crypto still has no real use among the unbanked. The major good that crypto has done is allowing people in certain regimes cut off from the international financial system to receive funds, but this is arguably downstream of its better enablement of crime. And cryptocurrencies are still used only as speculative assets, not as currencies. But what people are investing in are not the use-cases, they are only the speculative assets, and the mass investment in these over the use-cases is delaying what’s useful and endangering the longterm viability of the assets.
There are several paths the future might take. Crypto may crash and disappear, wiping out immense value. This would be a tragedy not only for the people affected and the economy in general, but for all the opportunities that were passed over in favor of crypto. Silicon Valley has invested in good interesting things before, and it would be a shame if we all lost out on good interesting companies because VCs put their money in a scam instead.
Crypto may yet manage to shift into its actual use-cases. Vitalik Buterin writes extremely compellingly about semi-utopian practical use-cases of blockchain technology. It would be wonderful if investment shifted from speculative coins and trading firms like the late FTX into companies that are going to make useful things, whether financial or not.
There is also the possibility that blockchain technology is largely useless: much of what it does can be done quicker and more efficiently by a centralized database, and the vast majority of people have no trouble trusting a centralized database (as evidenced by the fact that most people interact with crypto through centralized platforms). But, the idea of preparing for some kind of democratizing financial revolution might motivate the incumbent players to commit to innovating more. If blockchain technology does not work, but the movement around it creates a standard that funds should transfer in minutes instead of days, that would be wonderful. The developing world use cases could probably be better handled by non-crypto companies, but if it takes crypto to make it happen then I am for crypto.
But the fundamental problem that crypto has is this law of scams. If people can make a short-term profit through the promise of high returns they will. Any financial innovation, whether centralized or decentralized, will have to thread this needle and most innovators have failed to do so (China’s current crackdown on tech and finance comes after scams got out of the government’s control). It is a tragedy, an impediment to progress, directly embedded in the problem of how to improve finance. There is no way to improve the system without allowing the scams to ruin it for everyone. If blockchain technology has a solution to this, that is what I would be excited for.
—
There is a democratic demand for growth in personal wealth, and a democratic demand to be kept safe from scams within ones lifetime. The ponzis and pyramids must be kept illegal, and if crypto crashes that will be another public cry for regulation. But if too much is outlawed, people will not be able to grow their wealth. The best way for the government to solve this problem and deliver to its people is to provide safe and sure investment instruments. Sometimes this might look like index funds which distribute risk and contribute to the overall growth of the economy. But other times, it looks like regulation which keeps asset prices growing even at cost to the future. In the USA, where most own capital through the land their houses are build on, there is a democratic demand to keep real estate prices rising. There is much work to be done.