Moxie’s piece is a very articulate distillation of some thoughts I (and many others) have had recently about some of the fundamental tensions in Web3. I don't come to the same conclusions as the Signal founder, and my outlook on Web3 is much brighter, but I think it's worth taking seriously.

For example, it's a much more thoughtful and precise critique than Jack's a little while ago. And as Dan Finlay points out, it comes off as non-adversarial, genuine, and constructive.

First, the key points:

People don’t want to run their own servers, and never will...Even nerds do not want to run their own servers at this point. Even organizations building software full time do not want to run their own servers at this point.

Basically, the internet runs on AWS, and blockchains (through Infura and Alchemy) do too. This is true and the proof is right there in front of us. However, as Vitalik points out here, that might not really be the most useful way to conceptualize this problem, and it might not really be a problem at all as long as users have (by default) good tools to verify that the data they receive is being correctly validated.

A protocol moves much more slowly than a platform.

This is something that a lot of people in crypto struggle to come to terms with, and while many projects try to be decentralized from the start, most realize that starting in a more centralized, structured (potentially even hierarchical) way enhances productivity and increases the pace of development. Most teams hedge by making promises for decentralization down the line (and it's worth pointing out promising examples of this approach, such as ENS, which has done a remarkable job), but the problem is many of these teams will bump up against a compelling source of friction, which ironically comes as a natural consequence of their success: users like and prioritize fast, seamless UX and a company that can deliver on features quickly. Shipping high quality fast > decentralization.

Almost all dApps use either Infura or Alchemy in order to interact with the blockchain. In fact, even when you connect a wallet like MetaMask to a dApp, and the dApp interacts with the blockchain via your wallet, MetaMask is just making calls to Infura!

I think most people in crypto should already know this, but worth spelling out again for those who don't. More importantly:

These client APIs are not using anything to verify blockchain state or the authenticity of responses. The results aren’t even signed."

And regarding privacy:

All write traffic is obviously already public on the blockchain, but these companies also have visibility into almost all read requests from almost all users in almost all dApps.

Summarizing the last two points: when you use your MetaMask (or any similar) crypto wallet, you trust Infura to send you the right data, and to do so you also let Infura see all the requests you make via their API. The next point should make sense as a matter of consequence:

If your NFT is removed from OpenSea, it also disappears from your wallet. It doesn’t functionally matter that my NFT is indelibly on the blockchain somewhere, because the wallet (and increasingly everything else in the ecosystem) is just using the OpenSea API to display NFTs.

Basically, your MetaMask is just a view onto data that is being relayed from the blockchain through centralized third parties like Infura and, for NFTs, OpenSea. If OpenSea stops relaying that metadata, your NFT is—for the mainstream user—gone in a practical sense. Not really, of course, but this matters when you think about users’ motivations for interacting with NFTs (which we will return to below).

Ok this requires its own image because it's one of the more profound observations in the post. However, I think it’s not entirely correct. It’s true that “these technologies immediately tended towards centralization through platforms in order for them to be realized, ” but the reason for that is because a whole cohort of builders were attracted to the basic premise of technologies like Ethereum and wanted to build applications for Ethereum’s aspirational endstate. Shortcuts had to be taken to enable that building “now,” but it’s certainly not reflective of a complete lack of interest from the builders, quite the contrary. It’s also true that “decentralization itself is not actually of immediate practical or pressing importance to the majority of people downstream,” but there’s a distinction between what the users (their desired solution) and what the builders need to build (the solution they know actually fixes the problem at hand). I will come back to this sentence: “the only amount of decentralization people want is the minimum amount required for something to exist.”

You can't stop a gold rush: The people at the end of the line who are flipping NFTs do not fundamentally care about distributed trust models or payment mechanics, but they care about where the money is.

Yes, there are plenty of people who really care about artists and supporting creators, and yes NFTs are an important innovation to align interests and appropriately reward creators. But the vast majority of OpenSea’s volume has nothing to do with that. People are in it for the money, and it’s the big boys who are moving the money around, making a disproportionate amount of the profits, while the other 90% of retail traders scan Discord channels in hopes of making a flip before being left with the hot potato (read: flaming pile of doo doo).

And finally, two conclusions: a) We should accept the premise that people will not run their own servers by designing systems that can distribute trust without having to distribute infrastructure. And b) We should try to reduce the burden of building software.

In summarized format, that all looks a bit morose, although certainly pointed. So first, in response, why I’m optimistic:

• By now many (most?) people building at the protocol layer are aligned on the idea that people don’t want to run their own servers and that blockchains are better as data availability machines than as execution engines. Ethereum is building in this direction through its rollup-centric roadmap, Celestia is prioritizing this direction, etc.

• Moreover, light clients will allow for most people to only “lightly” verify state when they interact with the blockchain. Again, the latest iteration of the ethereum roadmap is very conscious of this. Lots of chatter on this recently with good highlights from Suzuha / Fiskantes / Zaki, and I’m excited about Rick Dudley’s Laconic Network.

• Also, and this is where Moxie's claim that little cryptography is involved in "crypto" befuddles a bit—there is a huge amount of effort going into building ZK systems that will allow regular users to rely on cryptography to verify blockchain state. This is undeniably an important pillar of crypto going forward and a real advance in the state of cryptography.

• Finally, even at the infrastructure layer, there are projects that aim to decentralize the stack from the bottom up - projects like The Graph and Pocket Network, the latter being a direct decentralized competitor to Infura and Alchemy. I want to put a pin in this one, however, as I'm not entirely convinced that this is a scalable answer (not really talking about technically scalable, but more so socially).

What the above points start to depict is a world where different levels of decentralization are possible at different levels of the stack, and at the very least we should all be able to fall back on a minimum level of decentralization through a combination of data availability chains, ZK rollups, and light clients.

However, there are higher-level points here to reflect on. For one, the idea that people don't want to run their own servers remains important at an abstract level, in that most people simply do not care about how decentralized the underlying tech is, unless they feel the direct consequence of centralization when things go sour. (I’m being literal here, I don’t mean most people in crypto - I mean the majority of humans.)

This brings me to something that Vitalik mentioned in his Bankless podcast interview just a week ago. Which crypto network do most people use as a payment system in Argentina? Binance. Not Binance Smart Chain, but Binance the exchange. Because guess what? The majority of people don't care about the idea of crypto - they just want a currency and payment system they can use that retains its value and can be used in everyday transactions as well as for savings. And Binance fills that need (for now) by offering what are essentially bank accounts where you can hold stablecoins like USDT and use them to pay other Binance account holders instantly and for free.

All that's happening here is that one centralized provider (Binance) is using another centralized provider's (USDT) “tech” (ie. balance sheet) based on another centralized provider's (the Fed) currency to provide people banking and payment services that are superior to the country's own centralized providers (Argentina's central bank and banking institutions). Very little of this activity (arguably none) is passing through decentralized rails, yet one of the core problems crypto is meant to solve is being addressed by Binance.

This example is similar to Moxie's example about OpenSea and NFTs. Most people do not really care that the .jpgs they are purchasing live on some servers they can't control and could be turned off any minute. As long as it all keeps functioning on the surface right now, and they can make money off of these NFTs, it's all gravy.

Both of these examples, however, reflect a state of affairs where things are generally going well. What crypto is really about is optimizing for adversarial conditions. History shows us that there will always be episodes where users do care about the aims of decentralization. And since users don’t care to put in the work of getting there, it's up to the builders to carry the torch of decentralization forward, and to build systems that are good and usable enough that they can become the default for anyone building or using applications built on top. In my opinion, that’s why building in Web3 is valuable. It’s about resetting the standard upon which everything else is built and doing it the right way, despite the inevitable disinterest of the majority. As such, I would have to modify Moxie’s statement to make it comprehensive and enduring: “the only amount of decentralization people want is the minimum amount required for something to exist” and to persist under adversarial conditions.

This leads to a series of questions:

Can we really decentralize every layer of the stack? And is it even worth doing so?

I think it’s worth trying, but we should be realistic about what motivates choices in the technology stack. My sense is that we will never reach full decentralization at every layer of the stack, because there will always be quicker, cheaper centralized alternatives. As a result, there will always be some percentage of the network running through Infura-like services. And even when we do decentralize, there’s always a layer deeper we could go, as the lower you go in the tech stack, the more commoditized it becomes, and the more important economies of scale become. A case in point is something like Pocket Network. I think it’s a fantastic project and a very worthy experiment. But it brings up questions: are we going to get the same QOS as Infura? Does it always solve the privacy issues brought up by Moxie? And when it comes to the servers themselves, are those actually being run by individuals? (From the Discord, it seems like many people are just running their nodes on AWS. I could be wrong about this and would love to see a breakdown of node types, but that’s what I gleaned from scanning the Discord.) In any case, it seems much more reasonable to place more emphasis on having verification by default in every person's wallet - that's what we should be aiming for.

What should we focus on?

First, as Dan Finlay puts it eloquently, it’s about the “right to exit.” Users, even if they are not generally interested or aware, must have the ability to fall back onto robustly decentralized infrastructure, as that is their way out of the pitfalls of centralization. It’s true, “the right to exit doesn’t matter when you can fully trust your provider, forever.” But that is unrealistic over a long enough period of time, at least for a non-trivial part of the global population. It means that a user should be able to choose speed and efficiency when the times are good, and always have a fallback that guarantees safety when times are not. For example, in the case of Argentina, the goal should be to provide a UX similar (if not better) than what Binance provides, while enabling users to always have self-custody of their assets and fall back on a secure public mainnet when their centralized provider of choice turns either faulty or malicious—all of this, by default.

Second, I think we tend to lose sight of the real objectives of Web3 - sometimes because the financial opportunities that present themselves are too strong a motivator (not so good), and other times because the technical complexity of the work is so alluring (at least this is sometimes productive). We need to remember that the user and the use case motivates the technical work. If you’ve had to make any global wires recently, if you have a global team on payroll, or if you live in Argentina, it should be fairly obvious why cryptocurrency—the original Web3 use case—just makes sense. And yet, the state of crypto today does not lend itself to fulfilling that basic, obvious use case satisfactorily. As developers, operators, researchers, and investors, we must not lose sight of what really matters.

On the other hand, however, we should be proud of what we’ve accomplished. The decentralized, disorganized nature of the crypto ecosystem has produced a wide range of compelling projects, from DeFi to NFTs to DAOs. Most of these are still in their “experiment” phase, but it’s precisely through these experiments that we’ve pulled (rather than pushed) the infrastructure forward. Protocols might be slower than platforms, but they incite more creativity and produce a broader design space for experimentation, which is only compounded by the composability these protocols exhibit by default (something Moxie barely touches on). Even their technical limitations force constraints that breed creativity.

The primitives of crypto have inspired and enabled builders to dream up a whole new series of applications that are designed for the endstate of Web3. I would argue these builders want to build on minimally-viable decentralized rails, they want to provide a “right to exit” - but the infrastructure has not kept up with the application layer - and as more builders come in to the space and congest the Ethereum network, builders have moved on to the next best thing, blockchains that provide a different tradeoff space: less decentralization, more performance. Yet the motivations are still there, and the reality of adversarial conditions still exists. It’s up to all of us building and investing in the space to stay cognizant of that reality and keep our north stars in sight.

I think we’re on the right track, and it never hurts to be reminded of our objectives by thoughtful critics.

Originally published July 16, 2020 on Medium. By Tanner Hoban and Tom Borgers. Both authors work in Corporate Development at ConsenSys. This report was an independent research effort to review the network economics of Ethereum 2.0 spec v0.12.

In March of this year, we were awarded a grant by MolochDAO for an economic review of Ethereum 2.0, which originated as a response to this RFP:

https://twitter.com/MolochDAO/status/1217202157084016640

Since then, we have been hard at work analyzing the Eth2 network and its Proof of Stake-based economic incentive system. Our conclusions are based on our own research, an economic model we built to reflect the inputs and outputs of the Eth2 network, and a series of stakeholder interviews representing the key participants in the Ethereum ecosystem.

All our findings are synthesized in the following report:

Ethereum 2.0 Economic Review: An Analysis of Ethereum’s Proof of Stake Incentive Model

We would like to thank MolochDAO, the stakeholders who we conversed with, and the Ethereum Foundation for their support throughout this project. Thank you especially to Danny Ryan, Barnabe Monnot, Trent Van Epps, and Vitalik Buterin for their comments and suggestions on drafts of this report.

While we highly recommend reading through the whole report, below we have included our executive summary. For any inquiries, please contact us through Twitter — @thomasborgers and @tehoban1 — DMs open!

—

The Ethereum 2.0 network upgrade is an ambitious and gradual shift towards a Proof-of-Stake consensus algorithm and incentive system, which has far-reaching implications on the economic properties of the network. The design of the system is complex — the incentive mechanism rewards honest network participants for validating transactions and finalizing historical states of the network, while penalizing offline and malicious validators. In this paper, we define, measure, and analyze Eth2’s cryptoeconomic security using a detailed economic model of the network and new economic evaluation tools.

First, to support an economic review, we constructed an economic model, built in Excel, for interpreting outputs of the system under current specifications and for select scenarios. Over the course of this project, we incrementally developed and leveraged this model to articulate expectations and form data-driven conclusions on validator revenues, costs, yields, and network issuance. The Eth2 system is reliant on nearly 100 variables that have a material impact on these outputs. With this model, we dynamically illustrate validator profitability at varying ETH prices and total ETH staked, underscoring the variability of impact on network security.

We define a required and sufficient level of economic security in Eth2.0 Phase 0 using a set of assumptions around the cost to attack the network. The objective is to make attacks costlier than the potential benefits of an attack and to achieve a similar level of security to the current Ethereum blockchain (Eth1). We identify two main categories of economic attack vectors, each with variants and differing levels of risk: Supermajority Attacks and Finality Attacks. In Phase 0, we are primarily concerned with attacks that aim to sabotage the network; we find the network is at risk of sustaining such attacks, but are more concerned about further phases. We estimate an ETH stake rate target of 13.8%, which provides adequate security from potential attacks under historical ETH price and hashrate conditions.

Security in Eth2 is highly dependent on ETH staked, which itself will be a function of yields. We form a model to understand the motivation of capital efficient investors, which we term the Required Serenity Active Validator Yield (RSAVY) model, addressing the risks and costs of staking and the corresponding required rate of return (RRR). Based on our results, we expect a required revenue yield (which we use as a proxy for a minimum yield) from validators under an optimized network (endogenous and exogenous) of 3.3% for validators to consider participation. Under a more bearish yet stable scenario, this revenue yield requirement increases to 11.6%.

The RSAVY model is leveraged not only to calculate required rate of returns, but also to form a picture of the network under select scenarios. We apply different parameters in these scenarios to support our conclusions and recommendations, which are summarized below.

Conclusions:

• Ethereum 2.0’s Proof of Stake is highly complex relative to Proof of Work. Eth2 is a highly complex and elaborate system. It is elegantly constructed and thoughtfully designed, but from a validator’s perspective can be difficult to grasp, contributing to a sense of uncertainty and unpredictability, presenting a practical and narrative barrier for potential capital efficient validators.

• Security of the network in Eth2 is dependent upon three key variables: ETH staked, the price of ETH, and volatility. Each of these variables has a direct or indirect impact on the cost of attacking the network. Total ETH staked is the most controllable variable, while the price of ETH has a direct and potentially large impact on network security but is outside the control of the system. Volatility can come from different sources and impacts both ETH stake and price of ETH indirectly.

• Attacks on Eth2 are easier to scale than on Eth1. In Eth2, the physical and hardware-driven burdens of network participation recede to essentially minimal hardware and power consumption. Moreover, the flourishing of DeFi and eventual connectivity to Eth2 can vastly accelerate and magnify this trend.

• Capital efficient validators are more predictable. While participation from Ethereum enthusiasts is important for a successful Beacon Chain launch, it is ultimately inadequate to reach sufficient levels of security. Attracting capital efficient validators will lead to higher fidelity in targeting a sufficient level of ETH staked.

• Targeting 13.8% ETH staked will match security levels of Eth1 at historical prices. We calculate that the target ETH stake rate for adequate security under historical price fluctuations is 13.8%.

• Economies of Scale for validating exist but are reduced at higher ETH prices. Unlike Proof of Work environments where profitability can only be accomplished by increasingly large-scale operations, Eth2 validating becomes progressively less expensive as the price of ETH increases. We generally find the network economics highly favorable for more decentralized network participation, meeting Eth2’s design objectives.

• 77.7% of the current ETH supply is in validator ‘qualified’ wallets (holding over 32 ETH). Approximately 86.6mm ETH (77.7% of total supply) is being held by non-exchange wallets with over 32 ETH. An additional 18.7mm ETH is managed by exchanges subject to staking services. This is a compelling serviceable addressable market, and a key objective of the incentive program to maximize network participation should be to convert these wallets into active validators.

• Eth2 is paying significantly less for security than Eth1. Using current beacon chain specs and 15.5mm ETH staked (13.8%), we estimate network inflation of 0.55% per year, far less than the current 4–4.5% from Ethereum’s Proof of Work network.

• Network security is heavily reliant on the price stability of ETH. Our primary concern with regards to the economic stability and security of Eth2 is the resilience of the network at low ETH prices. Combined with the ability for an adversary to rapidly scale attacks, we consider this a cause for concern.

• The lack of liquidity in Phase 0 and 1 might cause unpredictability and centralization. Given the lack of a two-way bridge between Eth1 and Eth2, and the lack of transaction capabilities in Phases 0 and 1, we expect a secondary market to form facilitated through derivatives and centralized exchanges. A high concentration of validators leveraging these platforms creates centralization risk and unpredictability.

• Beware of Derivative attacks. The Ethereum ecosystem is rapidly evolving and so is Ether as an asset class, with options volume increasing and unique financial instruments like “flash loans” being used in malicious exploits. With this momentum, derivatives could become the favored avenue of attack for adversaries.

Recommendations:

• Increase the Base Reward Factor to at least 128: We acknowledge the implications of increasing the network’s payment for security, but at a Base Reward Factor of 64, we believe the network is underpaying for security — and it would be prudent for the network to err on the side of caution during its phased migration to proof of stake.

• Explore a more dynamic method to changing Rewards in the event of a shock, such as an ETH price collapse (i.e. explore the implementation of a safety net). We recommend exploring a more dynamic method for scaling rewards or altering the Base Reward Factor in the case of network shocks. This could include using threshold triggers, step functions, or functions related directly to ETH price.

Please refer to the report for disclosures.

Originally published April 15, 2020 on Medium.

Should we let companies affected by COVID-19 fail and go through bankruptcy, as was recently proposed by Social Capital CEO Chamath Palihapitiya in this exchange on CNBC? If not, what is the best economic solution to this pandemic? This post was sparked by these questions, and while I don’t see it as a direct response to Chamath’s out-of-the-box approach, his exchange did, however, catalyze some of my scattered thinking from the past few weeks as the Federal Reserve has expanded its open market operations, much to the outcry of Twitter economists (Mises this and Money Printer that) — and, more curiously, motivated me to write.

I want to focus on what Chamath suggests in his exchange, my issues with that response given the catalyst of this economic crisis, and more broadly what the Fed and the government (this is at least as much a fiscal problem as a monetary one) should have done in response to the COVID-19 induced economic meltdown. In essence, I will argue that the optimal solution to our current economic crisis is not bankruptcies, nor is it the more traditional ballooning of the Fed’s balance sheet, but rather a mix of decisive fiscal policy stimulus paired with public health and monetary policy.

So what does Chamath suggest? Let’s take one representative example: the Social Capital CEO thinks we should let airline companies fail and go through bankruptcy rather than “bailing them out”. Chamath argues that bankruptcy is the best solution for the companies themselves and their employees, and we shouldn’t be too concerned if, as a byproduct, rich CEOs and institutional investors get wiped out:

“This is a lie that’s been purported by Wall Street. When a company fails, it does not fire their employees; it goes through packaged bankruptcy. If anything, what happens is, the people who have pensions inside those companies, the employees of these companies, end up owning more of the company. The people that get wiped out are the speculators that own the unsecured tranches of debt or the folks that own the equity”

Let’s dig into that. In a Chapter 11 bankruptcy, creditors are paid — and assets divided — in the following order:

1. Secured creditors — bondholders, typically banks

2. Unsecured creditors — generally including the company’s suppliers, employees, and banks.

3. Shareholders — any owner of the company’s stock, with further distinction between preferred (paid first) and common stockholders

The first takeaway here is that secured lenders (ie. banks) will get their money back first. This is, after all, core to bankruptcy in the first place and why stocks (particularly common) are a riskier investment than bonds.

Next in line are unsecured creditors, and it’s here things get tricky — employees are entitled to their salaries, wages, and contributions to employee benefits plans earned in the 180 days prior to filing, up to $10,000. And maybe certain unsecured bank lenders get wiped before employees obtain these claims, but it’s not necessarily clear to me that employees end up better in relative terms. More importantly, how do the employees end up faring in the long run? The record is murky, so it’s helpful to turn to an example or two.

Chamath mentions airlines, so perhaps an obvious example is Delta’s bankruptcy in 2005. Citing rising fuel costs, Delta filed for bankruptcy in September 2005, with debt amounting to $28B. After 19 months, the airline exited restructuring, having let go of 6,000 employees in the process — roughly 12% of its workforce. Delta has bounced back tremendously to become the leading US airline, and was by all measures thriving until the pandemic. However, is the cost to employees in terms of jobs lost worth it now given the context of the coronavirus?

Take another prominent example: GM filed for bankruptcy in June 2009, in the fourth largest bankruptcy in US history, with $95B of debt on its balance sheet at the time of filing. While it’s difficult to ascertain exactly the impact on personnel (some likely stayed on as part of the sale of certain assets; others likely lost their jobs as brands like Hummer and Saturn died), GM came out of the restructuring with 68,500 employees out of the original 91,000, or a 25% reduction. Again, is GM a stronger company today than it was in early 2009? Yes, undoubtedly. Yet are the airline companies today facing the same types of challenges that Delta was facing in 2005 or GM in 2009? Are the costs of those reorganizations reasonable to bear in today’s crisis?

Last on the list of priorities are stockholders, with preferred shareholders having preference over common stock owners (who of course include employees). Chamath mentions that employees end up owning more of the company at the end of a bankruptcy. I find that this is not necessarily substantiated (employees own a fraction of the company in the form of common shares). From the SEC:

“Although a company may emerge from bankruptcy as a viable entity, generally, the creditors and the bondholders become the new owners of the shares. In most instances, the company’s plan of reorganization will cancel the existing equity shares. This happens in bankruptcy cases because secured and unsecured creditors are paid from the company’s assets before common stockholders. And in situations where shareholders do participate in the plan, their shares are usually subject to substantial dilution.”

We should also keep in mind that while common stock is held in large part by institutional investors, a large portion of these assets end up in mutual funds and pension funds that ultimately make up the savings of “regular people.” Take a look at who owns Delta, for example:

You’ll no doubt notice the big names, like Berkshire Hathaway and BlackRock and State Street (SSgA Funds Management) — and don’t get me wrong, institutions certainly own a large chunk of these assets and would suffer from a stock price collapse. However, we should keep in mind that these are large mutual funds that ultimately serve as investment products for 401ks and other pensions plans. Vanguard, for example, is the second largest shareholder of Delta (or was on April 9, 2020), and as you’ll notice below, it (and other firms like it!) makes up a non-insignificant portion of very popular Vanguard ETFs and Funds.

A significant decrease in Delta’s share price will undoubtedly have negative effects on these Funds, and ultimately impacts the holders of these Funds. It’s difficult to estimate exactly what impact it has on the average pensioner relative to hedge funds or other institutionals — indeed, it’s likely that hedge funds suffer relatively more in financial terms, but does that matter if at the end of the day the average pension or savings account takes a big hit in absolute terms?

So where do we stand? Basically, there is not enough evidence to suggest bankruptcies benefit employees. And, as always, these are complex, nuanced questions — there very well might be some companies that should go through bankruptcy. But this raises the question of why companies go through bankruptcy in the first place. Bankruptcy is defined as the legal proceeding involving a person or business that is unable to repay outstanding debts. Thus, we are very much talking about a debt problem and a solution to avoiding debt-induced insolvency. Returning to the GM example, this was very much the case — they had nearly $100B of debt. Given this context, why are we considering bankruptcy in the case of airlines?

When asked why anybody deserves to get wiped out from a global pandemic, Chamath replies “My point is employees don’t [get wiped out]. Who are we talking about? We’re talking about a bunch of hedge funds that serve billionaire family offices; who cares?”

Effectively, Chamath is making the argument that these companies, and their institutional investors, should be wiped out because they can. And I suppose that’s not incorrect, but it’s quite different from suggesting the airlines, say, mismanaged their businesses into massive piles of debt. And further, is it really the right solution to the problem we are facing? In fact, are we even talking about the right problem? Maybe this is a better place to start.

Let’s remember, the current economic crisis is a direct result of the global pandemic. It did not originate in the financial sector and then contaminate the real economy; rather, it started in the real economy, which itself was impacted directly by the COVID-19 virus and by new laws and regulations imposed by governmental actors (from Federal to local levels). This isn’t a story about stock buybacks and securitized lending causing defaults and unemployment in the millions. [1] Airlines are failing because no one can travel, not because they took on too much debt. Restaurants are closing shop because no one can go out to eat. It is ludicrous to suggest that businesses should operate with the expectation that their customers will drop by 75–100% from one day to the next.

What we are facing today is an extreme but temporary shock to the economy caused by the COVID-19 virus, which is manifesting in entire sectors of the economy effectively shutting down — this itself is naturally having spillover effects to other parts of the economy, and inevitably this impacts the financial sector. Given the nature of the shock, what we needed at the outset was a correspondingly intensive and temporary response of a dual nature — that is, with monetary and fiscal policy. Such a response would have allowed us to bridge the economic gap created by the pandemic.

(Now, I can already hear the furious clatter of Twitter armies typing their posts decrying the temporary nature of this shock and in fact explaining that nothing will ever be the same — but please, bear with me — I’ll address that shortly. Remember, this is meant to address what we *should *have done at the very start of the pandemic, when the early warning signs from China were clear enough for many on Twitter, including of course Balaji, to draw serious conclusions and enact counter-measures.)

Let’s start with the basics: what are the goals of the response?

1. First and foremost, we should remember that we need to enable people to maintain their livelihoods with an eye to the long run. That is, people need to have enough money to pay rent, make mortgage payments, buy food, etc. And it’s not enough to simply give people a one-time check covering two months of sustenance; the goal should be to optimize for the longer term (ie. post COVID-19), including making sure we can restart the economy swiftly.

2. Secondly, we need to prevent a debt crisis, which could have much more long-term implications for the real economy, creating an economic climate similar to the Great Recession of 2008–09. If companies can no longer pay back their debt, and lenders are hit by loan defaults on the one hand, and deposit calls on the other, there is only one outcome: collapse. If banks fail, people’s savings are wiped, more companies collapse, growth is throttled, and the cycle repeats.

3. Third, we want to make sure not to create any egregiously bad precedents out of this crisis — let’s not forget that we were coming into this period at all time highs for the S&P and unfettered global government spending via debt monetization. We need to avoid coming out of this recession with a lingering policy hangover.

So let’s look at the dual response of monetary and fiscal policy, starting with the monetary response. We’ve all seen the memes of the money printer going BRRRR, and there’s certainly some truth to it in the larger context of inflationary policies targeted by the Fed and other central banks, but given the more immediate situation engendered by COVID-19, it would behoove us to look back to the Fed’s role in our financial system.

Aside from serving as banking infrastructure for all other banks in the US, the Fed has a primary dual mandate focused on promoting maximum employment and stable prices (ie. preventing deflation or excessive inflation), along with a responsibility to promote the stability of the financial system [2], which invariably influences the realization of the primary objectives. It is thus the Fed’s job to tend to our financial system when there are shocks to the economy.

How does it do that? Through the Federal Open Market Committee’s Open Market Operations — ie. the buying of securities, typically long term treasury bills (but also other assets like MBS), from its member banks. This increases the amount of money available for banks, who in turn can make sure to cover their liabilities and lend out money to debtors, which would increase the circulating money supply. In other words, the Fed is injecting liquidity into the financial system. Now, there are seemingly two primary concerns with the Fed’s actions:

1. The sheer size of its intervention. As you can see in the chart below, the Fed’s balance sheet now stands at ~$6T and the Fed on April 9th allocated up to another $2.3T in loans. This represents a significant increase from the past year, which was itself already a significant increase from the pre-2009 levels (albeit with a ~$1B reduction over the course of 2018–19).

2. The introduction of new forms of Quantitative Easing [3], including: the establishment of new corporate credit facilities for new bond and loan issuance and providing liquidity for outstanding corporate bonds; the creation of an SPV to support credit for asset-backed loans such as student and auto loans, credit cards, and Small Business Administration (SBA) loans; the creation of an SPV to buy up to $500M in municipal bonds; the creation of an SPV to buy ETFs (for now, only with exposure to corporate bonds)

Now we should evaluate these two points separately. While it’s true that the Fed has vastly increased its operations, the economic shock we’re enduring is also unprecedented in its severity and rapidity. Moreover, to date, the Fed has mostly relied on expanding Treasury purchases (rather than MBS or other assets). Theoretically, once the shock subsides, it could revert to decreasing its holdings over time, as it has done over 2018–19. Given the shape of the above chart, this is of course easier said than done — but the method is at least in line with precedent — even if the magnitude is not. The trap we should avoid is comparing the monetary expansion during this time of crisis with the inflationary monetary policy of recent times. There is no denying that at some point the massive debt bubble we have created will pop to devastating effects. However, it is during periods of relative prosperity that this should be addressed, not during a crisis — which is precisely when fiscal and monetary responses are required.

The second point is potentially far more troublesome in my view. Expanding the category of credit to lower grade assets and ETFs paves the way for a slippery slope into purchases of junk and equities, loosening the focusing restraints of the Fed — enabling it to expand the money supply at ever greater velocity and quantity, and creating a whole new set of negative behavioral externalities among the beneficiaries of these policies (what some are calling tantamount to the Fed “picking winners and losers”) [4]. One could argue this is already having spillover effects into the equity markets, with the S&P already back to early 2019 levels and with forward PE multiples at all time highs — effectively suggesting the stock market is massively overvalued.

Moreover, I can’t help but feel that these additional measures, designed to “support further credit flow to households and businesses,” [5] are a bit of a roundabout and overly complex way of achieving the basic primordial goal we outlined above — that is, to enable people to maintain their livelihoods. For these reasons, I would have prioritized a fiscal policy response with just enough monetary policy response (with the injection of liquidity) to keep banks afloat and avoid a debt crisis. The latter measure is to prevent knock-on effects of a longer term recession. A monetary response alone is moot without a decisive and aggressive fiscal policy intervention.

Remember, while the COVID-19 crisis is temporary, the fiscal response should ensure long-term economic health. The challenge with the delayed response we witnessed from Congress is that close to 16 million Americans have already lost their jobs, and some of the services businesses — in the restaurant industry for example — have shuttered with little clarity around their ability to reopen. We are in this situation today because neither the administration nor Congress acted quickly or decisively enough.

What we should have done was pair rigid public health measures (such as a nationwide 30-day shutdown of non-essential businesses) with strong guarantees around employment and debt repayment. Keeping people employed is a better long term solution than letting businesses collapse and sustaining individuals on unemployment. Thus, if we could have contained the duration of the crisis to a minimum and maintained full employment through government programs — ie. governments directly compensating businesses for their foregone revenues — we could have bridged the crisis and come out on the other side with most of the population still employed.

This does, however, make an assumption in so far as supply chains must keep running as normal, and business owners need to keep their personnel employed. An airline applying for government programs covering its revenues must keep its personnel even if they are not flying any planes, and they must keep paying their downstream vendors and suppliers, who in turn need to keep supporting their own suppliers — and the chain goes on. Mechanically, this would likely mean a few things:

• Designating a list of economic sectors impacted by COVID-19, from which companies could apply for the government programs

• Payment distribution would happen through the banking network, as it is currently happening with the CARES Act and PPP loans. More innovative approaches exist — like stablecoins and apps like Square’s Cash App, to be sure, but given the tight timing, this seems like the likeliest method (and this doesn’t preclude Square Capital to distribute these programs directly to its vendors).

• There will inevitably be individuals who fall out of this scheme, and this is where other measures come into cover the gaps, such as enhanced unemployment benefits and debt deferral.

As a hypothetical, what would it cost the government to sustain this type of scheme for 2.5 months? (It took China 10 weeks to reopen Wuhan). Assuming 25% of the economy is impacted, and 2019 US GDP of $21.4T, that equates to ~$4.5T of government spending to maintain the economy functioning. It’s no small fry, but given the CARES Act alone amounted to $2T, and Congress is actively preparing for a new stimulus package, I wouldn’t be surprised if we ended up spending far more, over a longer period of time, to fight this economic crisis. And what’s more, we will come out on the other side with millions of Americans unemployed, which will lead to a prolonged rebooting of the economy — with potential hangover effects for many months if not years. Indeed, although I have been speaking about this pandemic as temporary, our government’s sluggishness has undoubtedly extended its effects far beyond the original time estimate.

So where does that leave us? Of course, today we find ourselves in a situation where we are likely too far into the pandemic to simply “bridge the gap” to the other side. As a result, any fiscal option focusing on maintaining individuals employed will inevitably cost more and not be relevant in many cases; but we have no choice but to get to the other side. We must now optimize for the most economically viable option that saves the most lives. Moreover, a strong fiscal response can still be effective if we invest in research and the necessary equipment to tackle this pandemic head on. We need to emulate South Korea and reach testing levels such that individuals can be tested on a daily basis, enabling us to isolate and quarantine the negative cases surgically. This is likely our quickest path to safely reopening the economy. And it’s not enough to simply quarantine negative cases; we need to actively invest in retrovirals and other treatments, address the structural problems we have faced in coordinating and executing federal policy, and make sure our preventative national organizations are well resourced. In closing, we should note that while the more aggressive fiscal response proposed here is no longer feasible for this crisis, it does serve as a lesson for the future. There will be another pandemic in our lifetimes, if not another significant global event (natural disasters, etc.). We should do well to be adequately prepared for the next one.

TL;DR — bankruptcy is an interesting option that could work in some cases but isn’t the right solution nor the right problem to address. We are in this mess because of the novel coronavirus, which is a temporary and extreme shock to our economy, which deserves an equally decisive response from the Fed and the government, primarily in the form of aggressive fiscal stimulus, accompanied by reasonable monetary expansionary policy. Injecting liquidity in times of economic distress, particularly in reaction to shocks, is a good thing and is the Fed’s job. What needs to be avoided, however, is the overextension of the Fed’s actions, such as the buying of junk bonds or equities. This sets the wrong precedent and risks causing longer term economic impacts through an overvalued stock market.

Thank you to Rina Azumi, Eli Geschwind, Dimitri Borgers, Jack Clancy, and Tanner Hoban for reviewing a draft of this post.

Notes & References

[1] As was the case in the 2009 Recession.

[2] St. Louis Fed

[3] These measures primarily refer to the outcome of FOMC meetings on March 23 and April 9.

[4] On the other hand, the Bank of Japan, for example, has been buying sizable quantities of equity ETFs since December 2010. While the effect has been mixed in terms long term economic performance, the characterization of picking winners and losers is likely not warranted.

[5] See FOMC April 9 meeting notes.