The great danger of narrative rationalisation

There's an important concept which I would like to warn against: The inherent human tendency to assign logical meaning to everything even in cases where there's in fact none. This is often made worse due to accompanying false narratives that we spread, which on the surface appear to explain the issue at hand, but typically completely break down if you dig just one level deeper. The world of traditional finance is plagued by false narratives.

Thankfully there's an extremely simple antidote: Ask "Why?". Often times you'll notice that even the first "why" completely destroys the proposed narrative, allowing you to truly dissect and possibly improve the underlying system.

Inflation targets are completely arbitrary

Let's point out a great example of such false TradFi narrative: The concept of central banks' Inflation Target. This number, in most developed economies set to 2%, indirectly influences the amount of financial capital available to the government, businesses as well as individual consumers. In other words, inflation target influences literally everyone. You can either accept that "2% good, anything else bad", or you can do a little digging.

I'm from the Czech Republic and our central bank doesn't bother to explain why 2% is even the target, plainly stating that we follow it because it's a value used by most developed economies in the world. [1]

The resources provided by the US FED are a bit more elaborate, providing a narrative stating that 2% offers a reasonable buffer from deflation without putting too much pressure on the subjects in the economy. [2]

It's worth noting that the belief that going below 2% would break things is mostly based on an idea that "there would be less room to cut rates to [boost the economy during a downturn]"[2]. This idea originated from the generally accepted (yet again unfounded and recently proven completely false) narrative that the world would implode if the interest rates ever go negative.

So now we at least know the publicly proposed narrative "why this is good", but we still don't have insight into the actual logic behind choosing 2% specifically. In search for answers we discover that the US didn't invent this value. They simply copy-pasted it from New Zealand.

Unfortunately the climax of our little adventure to the history of finance is as underwhelming as it gets: New Zealanders essentially made the number up from thin air. Turns out that the NZ legislators wanted to anchor the efforts of their CB into the law and hence the CB had to come up with a specific target. In the end they came up with the 2% target based on an offhand comment by the former NZ finance minister during a TV interview. [3] One of the most important pillars of any modern economy, the central bank's inflation target, is quite literally an arbitrary number.

“It wasn’t ruthlessly scientific,” Michael Reddell, one of Brash’s colleagues at the Reserve Bank, admitted. But once the target was set, its gospel had to be spread(...) [3]

The inflation target is just one of many instances of flawed fundamentals of the Trad-Fi world. There are many more that I’ll be exploring in future articles, but I hope this example illustrates that nothing should be taken for granted.

It's not the end of all times though.

During the QnA section of my presentation in Prague someone pointed out that this is normal for most early systems - that you initially choose some parameters arbitrarily and then refine them later as you gain more knowledge. I wholeheartedly agree with that statement.

The problem is that a large portion of Web3 builders, despite knowing that Trad-Fi is fundamentally flawed, are squandering the once-in-a-lifetime opportunity to reinvent the systems. Instead they resort to blind copy-pasting the concepts using a new tech stack.

We've built various stablecoins, borrowing & lending, trading, leverage and hedging primitives among other things, but so far the main innovation is mostly that "It's on-chain".

I challenge you to explore the fundamental pillars of the financial system you're building / using and to scrutinise the elements you might've considered as immutable. You'll most likely discover that they can be radically redesigned and improved.

Don't be afraid to break things - now is the perfect moment to do exactly that.

Follow me on Twitter (@steve_fau) or Linkedin (in/stevefau) where I post more content about opportunities to innovate the financial system. My DMs are always open. Let’s reinvent some wheels together.

Sources

• [1]: https://www.cnb.cz/cs/menova-politika/inflacni-cil/

• [2]: https://www.federalreserve.gov/faqs/economy_14400.htm

• [3]: https://qz.com/2022696/where-did-the-feds-2-percent-inflation-target-come-from