When I was a kid growing up in the early eighties, I remember my parents opened up a savings account for me and let me take the interest out as an allowance. That was a pretty good deal for an eight-year-old.
I remember riding my bike to the bank every couple of months and showing them my bank passbook. That’s all it took to access my account at age eight! For those of you too young to remember, a bank passbook sort of looked like a passport and helped keep track of your transactions.
So, I would show the bank teller my bank passbook and I would ask her (always a woman) to give me all of my interest in cash. Invariable, she would give me about $20 every time I went. I wasn’t allowed to touch the principal and I have no idea how much money was in there.
This was the eighties with double-digit interest rates so I guess if I was pulling out about twenty bucks every couple months, you can probably do the math. If I did the same thing with my kids today, they would probably be pulling out a nickel.
Anyway, somewhere along the line, bank tellers stopped dispensing cash and the passbook disappeared—but the bank tellers did not. I say this because that was a genuine fear that people had with the advent of the ATM. They thought the ATMs would steal human jobs.
As it turned out, the ATMs ended up doing the simple work of dispensing cash and the tellers just focussed on the more complex stuff and everyone was happy. The moral of the story is that every time there is a new technology, it doesn’t mean the robots are going to steal our jobs. It just means that our jobs might look different.
This is particularly important to understand right now as we see artificial intelligence advancing at a rapid pace. What does a world with advanced AI and blockchain look like? Driverless cars? Equity markets without investment bankers? Who knows. But I am confident that we will continue to find things for us people to still do. It will just be different. Maybe I’m overly optimistic but I look back on human civilization and realize that we are incredibly good at adapting to our own new realities.
In 1798 Thomas Malthus published An Essay on the Principle of Population. In short, his theory was that human populations were going to outgrow our food supply. From where he stood, that might have been the case but it didn’t take into account our technological advancements in agriculture that made it possible to feed an ever-expanding human population. Similarly, I’m hopeful that our ingenuity will bail us out of some of the other challenges we face today like sovereign debt and global climate change.
Technological advancements since the advent of the internet are accelerating at a lightning pace. In the meantime, we face an increasingly insular world of nationalism and economic inequality that is more reminiscent of the early 20th century that ultimately culminated into the great wars. How all this ends up is anyone’s guess but one thing’s for sure. We live in interesting times (an old Chinese Curse).
My guest on this week’s Wealth Formula Podcast is well versed in all of the issues that I have discussed here including macroeconomics and technology. He looks at the problems of today with knowledge of the past and a keen insight into our future. His name is Diego Zuluaga and this was one of my favorite conversations on Wealth Formula Podcast so make sure not to miss it!
Diego Zuluaga is a policy analyst at the Cato Institute’s Center for Monetary and Financial Alternatives, where he covers financial technology and consumer credit. Before joining Cato, Zuluaga was Head of Financial Services and Tech Policy at the Institute of Economic Affairs in London. While at the IEA, he authored papers on the social value of finance, the regulation of online platforms, and the taxation of capital income, among others. His work has been featured in print and broadcast media, such as the Times, Newsweek, and the Daily Telegraph. Zuluaga is a prolific public speaker as well as a former lecturer in economics at the University of Buckingham.
Originally from Bilbao in northern Spain, Zuluaga holds a BA in economics and history from McGill University, and an MSc in financial economics from the University of Oxford.
- Diego Zuluaga’s background
- The forces that traditionally drive disintegration and what’s going on today
- More economically driven than other factors
- Are automatic robots really taking over our jobs?
- The ATM Scare
- Diego’s outlook of the future
- Thoughts on blockchain
- Should cryptocurrency be regulated
- The Howie Test
- Learn more about Diego Zuluaga
Buck: Welcome back to the show everyone. Today my guest on Wealth Formula Podcast is Diego Zuluaga. Diego is a policy analyst at the Cato Institute Center for monetary and financial alternatives where he covers financial technology and consumer credit. Before joining Cato, Zuluaga was head of financial services and tech policy at the Institute of Economic Affairs in London and while at the IEA he authored papers on the social value of finance, the regulation of online platforms, and the taxation of capital income amongst other works. He’s also been featured in print and broadcast media such as the Times, Newsweek and the Daily Telegraph. Diego, thanks for joining us today.
Diego: Hi Buck, it’s great to join you, thank you.
Buck: So I want to kind of start out, you know, you have a really interesting background and being with the Cato Institute and sort of libertarian think-tank and your involvement in tech, give us a little bit of your background to understand the perspective through which you’re seeing the financial world.
Diego: Sure. So I was born in Spain, born and raised. And then when I was 18 I moved to Canada and I studied there and lived there for a while, then I moved to the UK and spent some years there and then continued my education there and then worked for quite a bit of time, and eventually ended up in DC. And a lot of my interest in economics I think comes from the timing around a lot of these events in my life, you know I grew up around the time that the housing bubble in Spain was coming to its peak, obviously after that the plunge was quite significant. We had a housing crisis that’s comparable to the housing crisis in the worst parts of the US, and places like Nevada, Florida because we had a very similar economy at the time, very tourist-oriented construction-oriented, so employment large very high unemployment, very dim prospects, and indeed the Spanish economy is still struggling. And that was quite a scarring experience for anyone who lived through that and I had always had an interest in economics because my dad studied the subject and there were all these books lying around and so you know I would take a peek into them and even though I wouldn’t understand much of the terminology, there was something about it that made it seem really relevant. And so that’s how I came to the subject of Economics and Finance seemed to be the area of specialization that one should do at this particular point in time because so much is going on everybody is talking about the world becoming financialized, well the economy being handled through financial institutions of some form or another. More and more people saving for the future to prevent risks for their families, to invest in a business, whatever it is. It seems that economic development is pointing in the direction where finance is going to be an understanding of finance are going to be particularly important in terms of being able to play a positive role in the world and also do well for oneself, right? So that’s how I came into the into the subject. And the places where I have been based through my career have been very finance-oriented and also quite affected by the regulatory drive that happened post 2008. So there’s been a lot to talk about. There’s been a tremendous amount of controversy. And I think you know the world has changed quite a bit since 2008 both in terms of people’s perceptions of finance and its implications for the rest of the economy, and also in terms of what we understand the role of the state is in regulating banking and financial markets, in making sure that taxpayers are not exposed to risks.
Buck: Yeah, interesting. So let’s jump into some of the things that I know that you you talked about one of the topics you talked about which I thought was interesting, which is very relevant right now is the phenomena of Disintegration of the global financial system. And just for clarification, Disintegration through the globalization is something that we’ve seen increasingly over the years. We’ve seen it in Europe vis a vis Brexit,and then obviously since President Trump took office here in the US. What are the forces that traditionally drive Disintegration and maybe kind of get into what’s going on today.
Diego: Sure. So to begin, as you as you mentioned, Disintegration we understand as the opposite of globalization which is a process that has been really happening across the world, starting in the West but increasingly around the world since about 1960. And then from 1980 you have, not just North America and Europe integrating both within their own economic areas and across each other’s areas, but also China liberalizing and entering the world economy in 1990. India came through that’s about three billion people that suddenly joined the global economy. And so what we see then is that they share in all global GDP the share of imports and exports of all the countries involved in global trade, has been steadily increasing and it’s higher than it’s been ever before. Now that doesn’t mean that globalization is a one-off event. We’ve had process of globalization before and they were interrupted in one form or another, and as you rightly pointed out there are certain factors we can look at to try and see what drives the Disintegration, maybe at the political level maybe at the economic level, and try to find the things that we might want to guard against or the things that we might want to mitigate if we think that disintegration is a bad thing. I happen to think that Disintegration is a bad thing because trade is beneficial particularly to the poorest. It enables specialization, it makes innovation easier, it makes people want to speak to one another because both sides benefit, it’s got all these benefits, right?
Buck: But there’s also data there, right? I mean and and just to be clear you know I think sometimes, in certain circles, globalization has become a four-letter word, and but as you talk about sort of the some of the benefits of people getting along too and not having wars and things like that, but I’ve seen you point out some real data on this. It’s not just a matter of, I think it makes sense I mean people historically during times of globalization, have all done better. It’s not been, we don’t do as well because we’re letting somebody else do better.
Diego: That’s right, no, I think that’s absolutely right. And I think you know in terms of data there are a lot of I think important points that can be raised that might become too intuitive to people. For example manufacturing output both in the United States and in the United Kingdom is higher than it’s ever been. It’s just that were having more and more of it made by machines and people are moving to jobs in the services sector. But it’s not like manufacturing is declining in any meaningful economic way, we’re producing more than ever before, we are richer than ever before, we’re about twice as rich as we were in the 1970s in real terms, and I’m talking about Western countries. Of course if you look at China or India, you’re talking about much higher multiples. In China the extreme poverty rate has plunged from about eighty percent in 1981 to around 10 or 12 percent in the last few years, I mean this is in the context of the population increasing ever further. We have nine billion people on earth today versus 1 billion people in 1800’s when the Industrial Revolution started and more people are employed today, gainfully employed and productively employed, than were there before even though we have all these machines around. And we’re competing with each other much more, right? So that is the context in which this has happened. Most of the dependency are positive in terms of health outcomes, in terms of Education, in terms of human development and the freedom to move and the freedom to interact with each other and decide what you do for a living, you know, things like the caste system, or the class system that was implemented in China under the Communists, or discrimination in the United States are becoming a lot less prevalent. And I think part of it has to do with the economic development that’s happened.
Buck: So the one of the things that I’ve seen you say is that some of the drivers of Disintegration include, historically speaking, our depressions we’ve seen around World War I, you have inflation and also inequality, income inequality. And so when I look at what you say there, the first two things which is depression, and clearly at least in the US where we have what appears to be, I mean you know there’s arguments we made about this, but a booming economy, we are at inflation although I think many economists will argue and for good reason that inflation is something that we can look forward to, on with great certainty in the future with the amount of debt we have. That leaves income inequality. And so with what’s happening today, either in Europe or specifically in the US and our attitudes about it is that is inequality the main driver at this point in your view of the forces of Disintegration?
Diego: I think that inequality has played a role but I don’t think it’s the sole driver, nor is it really the main driver in my view and I’ll tell you why. So to start, all the factors you pointed out whether it’s war inflation or inequality, we’re talking about polarization. Polarization between people who live with one another and therefore can see the prosperity of some and the misery of others, which is drastically changing, right? So the previous wave of globalization which was after World War I it was throughout the 19th century and up to the World War I. What happened in one was that suddenly, some people were forced to go to the front, some people saw a lot of their wealth eradicated because they were on the losing side, but obviously the distribution of those losses was unequal within countries and I think the combination of the antagonism during the war and then the economic outcomes from that really polarized internally societies that previously had lived in some sort of harmony because of the expectation that all boats would be lifted by the rising tide. And the drastic change from that really change things within inflation. It’s similar because the people who own real assets, if you own real estate if you own stocks you’re shielded from inflation to a very large extent, but most people at the bottom at least until recently, thanks to financial technology that’s changing, but most people at the bottom had only cash savings or they had bonds of some form or another typically, and those were completely wiped out by high inflation. So you were saying about looking forward to inflation, I can see what you mean. but I think unexpected inflation and escalating inflation from the short we cannot really plan for, those are really problematic. That’s what’s happening in Venezuela right now and it’s one of those very rare cases where you had a housing bubble at the same time as you had a plunging economy because people were fleeing cash as quickly as they could buying real assets at the same time as the capacity of the economy was exhausted. Anyway that’s just the side comment on your main question, which is is inequality driving this? Well first of all inequality is rising in some countries within some countries. So it looks like the top 10 percent in the United States are capturing an increasing share of income compared to say 1970 or 1980. That doesn’t apply to the UK by the way, so it’s not a universal fact of the West, it’s a fundamentally a US phenomenon but it’s also been the case in other countries France, Germany have have a bit of that. But globally, inequality is decreasing precisely because the poorer countries the traditionally poorer countries are growing much faster. And as a result of that what you see is that extreme poverty is declining very fast and the top are not rising nearly as fast and so you have convergence. So at the global level we actually don’t have as much inequality as we used to. But within countries, within some countries it has increased and I think because the inequality within countries is much more visible because there are the people you live with, there are the neighborhoods to use to live in that you’re priced out of, you see a lot less of an income conversions except in some cities you see a lot less variety in terms of economic backgrounds of the people that live together, right? More and more we are sort of organically segregating into groups that are similar to us. Similarly educated, earning similar incomes, with similar political views and I think all of that is a driver of polarization because we’re not really exposed to what the rest of the world looks like. And I think that can sort of as a side effect or ultimate consequence of inequality, that can drive the polarization. The problem is that the policy solutions aren’t easy because you need, not all inequality is equal so to say, meaning that is it because the economy is rigged in favor of the rich, or is it because we have zoning laws in places like California but also in Washington DC where I live and in New York City where, which means that you cannot build and therefore the people who earn not very high incomes have to move out. Is it because of regulation or is it because somehow free markets are driving the negative outcomes? I happen to believe it’s much more with the regulation, it’s much more due to the regulation that creates privileges for the rich. But unless we agree on what the policy solutions are, even if we die diagnose the cause of the problem we’re not gonna be able to address it properly.
Buck: Understood so just a thought though in terms of what you’re seeing right now specifically in the US, what do you think beyond inequality? Because I keep going back to this thinking you know listening to your talk on Disintegration, I keep thinking to myself well the US should not be in a situation right now where we are becoming isolationist based on at least the historical issues. Do you think that in this case that some of it may be a function of things that are non-economic? I mean could it simply be well we obviously have issues with you know I’ve been going on for years and terrorism and all these other things, or is it fundamentally always financial in these situations?
Diego: Maybe it’s my own professional bias but I do tend to believe that it’s mostly economic. I think one difference today with the past is that we have the combination of a massive financial crisis that was perceived to be very unfair because people were rescued who were making lots of money before the crisis by the people who suffered the most from it right? And then together with that and we had a massive acceleration of technological transformation. And I think people don’t like volatility. So if you gave people certainty as to how the world is going to change, I think they would be quite happy with a fast pace of change, but it’s the uncertainty about what’s going to, how it’s going to unravel and who is going to be affected first and who last and who is going to be put out of a job. I think that’s what makes people, the absence of the ability to plan is what really drives people crazy in many ways and I mean crazy you know in the sense of saying, will I be able to form a family? Should i buy a house now? Should I invest in my education? Should I take out $50,000 in student loans? We have a record amount of outstanding loans for students in the United States. So I think a lot of those questions revolve around the fact that we have less certainty, we perceive we have less certainty about the future than we used to. I think if you find yourself on the receiving end of economic transformation in some of the industrial areas in some of the rural areas that used to thrive and now due to agricultural imports from other places are feeling downward pressure on prices, I think that changes your view about change and the goodness of it. Those are all economic factors. I am NOT ruling out that there are values differences or that people maybe have been participated by arguments that we find that other people find morally repulsive whether it’s on the left or on the right and that that’s also driving the polarization.
Buck: Well those are a lot more easily accepted when people can find someone to blame, right? I mean ultimately what we’re talking about is fear. We’re talking about fear that drives people, fear of uncertainty and in situations like that traditionally, what you see is people sort of becoming more insular and if you can scapegoat you know others and to blame for your plight then that’s frequently…
Diego: I think, let me just pursue the point just made. I think one important difference today versus say 50 years ago or even more, a hundred years ago, is that we used to have solutions to social problems locally and privately much more than we do today. Today most people whether on the left or the right look to the government and usually the national government or the federal government for solutions to poverty, to inequality, to discrimination, to fake news. A lot of things seem like they cannot be addressed by people talking to each other on a local level in coming up with solutions and in that competition between different solutions driving the best outcomes, and not only that but because we look to government we see it as fundamentally not a program of constructive dialogue meaning that everybody benefits, but rather who gets the spoils, because their government only has limited resources and somebody has to be in charge and decides who gets what, and I think the antagonism often comes from that too. If you believe the government is working for the immigrants and you believe that the immigrants getting things works against you, then you can have a very different attitude to immigration, than if you believe immigrants can benefit from coming to a country and contribute and can benefit you in the process. And I think some of it has to do with exposure and the perceived idea of who pays for what and how a problem solved.
Buck: It is sort of right for demagoguery to direct that. So let’s talk a little bit about automation.
When you think about jobs, makes me wonder a lot of us will be more worried about robots than they are the Chinese taking their job, I mean, what do you think the real implications of increased automation are to global economies and individuals within those economies trying to make a living? I think the fundamental fact is the one I mentioned earlier, that we have nine times as many people today as we did when we started properly automating the economy in 1800, right? And we have more people employed than we did then. Most of those people if not the overwhelming majority. I’m talking about 99.5 percent of those people are better off than they were then. There are pockets in you know sub-saharan Africa there are aspirant within but for the most part people are better off in most cases much better off making better things in things that are not necessarily economic outcomes, people are much better off health-wise, education wise and so on. That’s I think the fundamental fact, meaning historical precedent doesn’t give us any reason to panic in the long term, but that’s where the crucial difference is. In the long term, you know Keynes said in the long term world, that in the long term sure we’re all dead and that changes our view of things, that’s right, but if we’re looking at the aggregate impact of something that’s the way we look at it. The problem is the transition. People are worried about the impact on their job and the impact you know, what’s gonna happen, I’m 30 now, if I lose my job and I have to retrain over ten years by that time I’m 40, oh you know my lifetime earnings will go down, my life will be much more miserable and so on and so forth right. That’s completely understandable. Another problem is that we have a fundamental asymmetry in how we analyze something like automation, because we can look at the economy today and the research that’s going on today in terms of self-driving cars, in terms of factory manufacturing, the use of artificial intelligence, the transformation from manufacturing to services as far as people are important, so on and so forth. And we can see which areas are going to be easily automated, right? We know that call centers are going to go, truck drivers will probably go soon too, and a bunch of other occupations that do keep a lot of people busy and employed, and gainfully employed right now, but we cannot easily say first of all what’s gonna create the new jobs, and secondly how many there are going to be. So there was this famous study at the University of Oxford a couple of years ago. But I think by the guys who did the book the second Machine Age, so these are people who deal with you know automation and its implications on our daily basis. And they gave an estimate of the jobs that would be lost in the United States, I think it’s by 2050. And it was a number that revolved around 47 percent or so. Now the problem was that they accounted for the losses in the existing economy, so they gave you the debit side of the balance sheet, right? But they didn’t give the credit side because you know, and this is perfectly understandable, they couldn’t possibly predict where the new jobs were going to come from. So the example I use sort of to try and amuse people when when I’m asked this question is, in the United Kingdom there in 1965, they were under a thousand personal trainers. In 2016, there were 25,000. If you had someone, if you had asked anyone, especially an economist, if you had asked him in 1965, are they going to be twenty five times as many personal trainers and are they going to be properly revealed in the rating, he will probably have said well I have no idea but probably not, that’s not like a very plausible idea. And yet look at it right, in so many you know data scientists marketing and in sales people, a lot of those jobs in the way that we see them today we couldn’t possibly have imagined in 1980 or 1985, you know the vast number of programming jobs that are coming through and how many people are learning to code even for today occupations, right? You know it’s not it’s not a techy thing anymore. And I think if we look at that, I think it’s important to look at patterns and trends, and if we look at those we’d become much more optimistic than if we look at, oh, self-driving cars are coming all trucking jobs are gonna be gone now.
Buck: Yeah. And you know I think an interesting example I saw you make was with the ATM machines, right in the eighties. You want to talk about the fears that surrounded the ATM and what ended up happening?
Diego: That’s right. So most particularly low level entry level jobs in banking up until the 1980s were as tellers, as people cashing in checks, taking money out for people, you know helping depositors and so on, and then the automatic teller machine the ATM came around and the fear was that a lot of those jobs would be automated away and that therefore the number of jobs, and the number of branches in banking, and the you know the the physical presence of banks would be diminished, and the number of jobs would also decline. What happened instead was that ATMs lowered costs of operating any individual branch massively, and it also released a labor force that was paid pushing paper all day doing relatively low value-added tasks to market products instead, to talk to clients about the next thing that they should look into, the 401k plan or the certificate of deposit or refinancing their mortgage. And sometimes of course that ability to market was used in predatory ways, I’m not saying that people sometimes didn’t take advantage of customers but for the most part it meant that you could move, as a teller, you could move to a much higher value-added job. And it is in fact the case that from the 1980s, both the number of bank branches in the number of jobs in retail banking, it’s not even investment banking in retail banking, increased, contrary to everybody’s expectations. So it’s one of those lessons of history that I think we should heed in terms of looking forward.
Buck: So when you look at this as an economist, the confluence of automation, Disintegration, and some of the other factors that are common and potentially problematic, where do you see this all going? Where do you see our future you know over the next few years unravel? Is this a self-correcting phenomenon? Is this something that’s going to be potentially significant short-term pain trying to get things and then, just curious kind of on your outlook.
Diego: Well for over the next two years it’s hard to tell because there are so many competing numbers coming through giving us different signals. So we’re in the process of an expansion focusing on the US. We’re in the process of an expansion that’s been going on for about nine years, the longest expansion ever in the US is ten years and that was the 1990s, a very special time because the wall had fallen down, computers were being deployed everywhere, a lot of good things were happening and maybe that prolonged the expansion. So a lot of people are saying well this expansion is nine years old. It’s probably time for a recession. Now there are a few things that militate against that, and the first one is that the expansion since 2009 has been much slower than previous ones, and therefore we’ve taken a lot longer to get to where we were before this time. So it’s only natural that we would also expand for longer. That’s the first objection. The second one is that expansions will really die of old age. something has to go wrong. And unless you can point to something going wrong, it’s difficult to say well a recession is due any moment. Now a number of things look like they could very well go wrong, and especially the value at risk if you want to use the finance term, which means that if you have a really bad outcome, how bad can it be, which is the question that a lot of traders ask themselves everyday, right? You know the worst possible left-tail if you’re looking at our distribution of outcomes, the worst outcome you could have, how bad could it be? Well you look at the potential trade war with China, you look at the populist movements that are taking power in a lot of countries in Europe, you look at tensions in the Middle East and the decline of commodity prices, and the interaction of those two, and then political tensions in the US and you could point to a lot of factors that could really, if they were really bad, could result in something much worse than what we’ve seen in a long time. A lot of things seem to be coming yeah but they’re very low probability events. And the fact that they would, the the likelihood that they would happen all together at the same time is still very small, so should plan against it, but it’s difficult to predict the impact they will have over the next couple of years or so. People point to sovereign debts, the countries are borrowing a lot in currencies that are not their own and therefore the struggle to repay, even go bankrupt that might trigger another crisis. But I don’t see the numbers there yet. We don’t see the amount of leverage in the system that we used to see before the bursting of the housing bubble in the United States or in any European country, we don’t see the same level. So I wouldn’t predict any recession on that front in the near future, of course I’m not in the business of making predictions, I’m in the business of nations. But I think longer-term these change are inevitable . No one believes that suddenly the Luddites are gonna take charge and automation is gonna come to all. Trade may decline, but it is my belief that it’s so difficult to disentangle supply chains today between countries, like you would have a much harder time unraveling globalization than you did in 1918, because in 1918 it was mostly about importing raw materials, say importing oil from Saudi Arabia or Iraq and selling manufactured goods back. Right now it’s about intermediate goods, you build something in the United States that’s an intermediate component, send it to Mexico for finishing and then it’s imported back into the US. When you actually do the accounting for that, and as a protectionist you know imagine with someone in the Trump administration pushing protectionism, it’s very difficult to quantify the losses and to explain to people how they’re gonna benefit or lose, you know? And this came to the fore I think in the midterm elections in the state of Indiana, because the state of Indiana has a lot of manufacturing but it also has called a bit of Agriculture. So if you as a voter are trying to gauge the impact on your state of the president’s policies, do you look at the short-term benefits of protectionism our manufacturing sales steelmaking? Although then even then you know the cost of steel goes up, so a lot of manufacturing could be affected, or do you look at the positives from protecting agriculture, right?
Buck: Yeah and I think in general that’s a pretty complex question, is trying to understand what exactly the reality behind what the Trump administration is thinking. I mean a lot of people look at this and say , as a libertarian, somebody with Libertarian leanings like myself I look at it and say, what are we doing? Tariffs and creating barriers to trade and all that, but then the other side of it is that you know he’s known as the guy who wants to make a deal, so maybe he can get a better deal and that’s it’s just game of chicken with China, because China frankly would get probably more hurt by a trade war escalation over time than we would, and China knows that. Do you think, is that kind of what the prevailing thought on from from the academics is?
Diego: I think that’s right. The issue with China as well is that they’re a single-party state and the legitimacy of the party is predicated on the economy doing well. And it’s not another Chinese Communist Party value stability above all. So if you have a significant economic disruption I think they would try to do their best to fend it off, which is why I think the Trump administration is quite bullish on it’s, very strong, to put it mildly, tactics working out is that they think the Chinese have too much at stake and are willing to compromise particularly because they do export so much for the rest of the world and the US is still a trendsetter, whether for good or bad, in terms of international trade policies. And they have a lot of aid in the World Trade Organization and so on so I think on that front, yeah it’s probably the case that China might end up getting in, that’s the balance of probabilities. But it’s still a very destructive effort I think on the whole because we’ve all benefited from freer trade, we as consumers of course have benefited, and even as producers, we are able to specialize when the US economy is no poorer than it was when China started to open up and China has become a lot richer. And Chinese are buying all sorts of us goods and services, not least US higher education, which is a massive cultural export of the United States, I mean one thing one interesting thing with China is that the next generation of leaders are, for the most part, going to have been educated in the United States and that completely transforms your interactions I think. Because you look at the current president of China Xi Jinping and he was born and raised there, he suffered for a while because his father fell out of favor with the communist leadership and so he was banished, you know he grew up in China and he’s a very sort of culturally Chinese leader. I don’t think the next generation is going to be like that if they’ve all gone to Cornell and Princeton and Harvard and you know Southwestern and so on and so forth, you know and it’s just hard for me to believe that the relationship’s gonna be the same, if anything is going to be to the US advantage, just because the culture from the United States is as yet unbeatable, right?
Buck: Right absolutely. I want to change focus a little bit on something that you and I both have an interest in, which is blockchain. So what are your thoughts, well first of all, when was the first time you heard of Bitcoin and blockchain and what we were your initial thoughts?
Diego: So the first time I heard about Bitcoin was in 2013 in the middle of the first rally. And my first thought was, this is a Ponzi scheme, that was my first thought. Because that kind of crisis collation and not understanding the technology which is the key thing here, not understanding the technology, immediately means you believe this is just the trick, basically a sophisticated chain letter system where people are paying a lot of money to somebody in the expectation that somebody else is going to pay them even more money tomorrow. That is ultimately not sustainable. That was my first reaction. And then I actually began to look at it from a more technical perspective or you know from a work perspective, from about 2015 or so. And I started looking at the technology and I actually read the Bitcoin whitepaper for the first time then, which you know is something I should have done when I first heard about Bitcoin, because it’s not that long either and it’s very well-written. Any way I read it then, and this pseudonym which is a guy or a woman or a group of guys or a group of women or you know some combination of those, proposing what they call a peer-to-peer electronic cash system, and this is a very interesting proposal and it’s not the first time that people have tried to do this, but every time we run against one problem which was that the technology didn’t allow for me not knowing you Buck, to prove to you that if I say to you send me some good, some widget and I will pay you in Bitcoin that I haven’t also promised my Bitcoin to somebody else in the Internet, and therefore you’re never gonna get paid. And in the network that operates in that way, ultimately unravels because there’s not enough trust, so we always ended up with an intermediary of some sort. Even digitally we had PayPal and so on. And Satoshi Nakamoto finally comes up with a solution. He says well let’s create the incentives so that every user on the network is encouraged to behave in the right way. And how do you do that? Well you reward the people who confirm the transactions, the people who are actually going through every transaction and verifying that the person that A who is sending the funds actually has the funds, and that B who was receiving the funds actually does receive them. and if they get rewarded on that basis and it’s very costly to try and defraud the system because you have to try and fool all these other people, and suddenly you have a peer-to-peer electronic cash system. And Bitcoin is 10 years old as of last week, and it’s still going. Yeah sure a lot of volatility, but the market value is much greater than it was in 2009 when the first transaction started going, of course, but even in 2012. And as my friend Nick Carter says, people call it a bubble, but show me a bubble that’s come back as many times as Bitcoin has. And I think he has a point there.
Buck: Yeah I think you’re you know I’m I’m starting to become increasingly a Bitcoin maximalist myself, and so I agree with that assessment, but I also think that people underestimate sort of the what I would call this social phenomenon. It’s interesting I was listening to an interview with a true Bitcoin maximalist the other day and I’m thinking to myself, what this guy really is talking about is Austrian School of Economics, right? I mean this is really sort of the digital realization of that entire theory, and it’s really taken a hold and so to really understand the potential for this, I think that people need to understand even more than just the tech. They need to understand that it’s sort of the way for this theory that’s sort of been in the shadows for years and you know there’s always your Austrian school guys and stuff this is actually coming to life and people, young people, are really taking to it. Your thoughts on this?
Diego: Well I think that’s absolutely right, it’s very interesting point. And it’s absolutely true that this cryptocurrency technology and blockchain technology is very appealing to libertarians, on many levels, because you’re removing the government from potentially the management of a payment system, the creation of a currency, if it indeed ends up becoming a currency, it isn’t quite yet a currency, right? But if it became generally accepted, it could be used as currency. But also the fact that you don’t have an intermediary that the government can use to control your interactions. So right now banks have to comply with a lot of information provision, for tax reasons and anti-terrorism reasons and various other reasons that are well-intentioned, but often end up being much more intrusive than they should be and libertarians are very wary of that. And so they I think are quite encouraged by the prospect of a technology that removes you from that. What I do think that this is going to lead to though is a culture clash not dissimilar from the one that happened with the internet in the mid 90s, where you had the Declaration of Independence of the web on one hand, and then you had the rise of massive internet-based corporations from the late 1990s onwards, and we were in a bubble, right? The tech bubble of the late 90s. And so you see this in discussions of blockchain technology now, because the corporate giants are jumping all over this right and doing trials of it. iBM is on it, Amazon is on it, Maersk the shipping giant is on it, and that is very different from the vision that I think a lot of the cryptocurrency pioneers had in terms of peers on an individual level interacting with each other, people mining Bitcoin sort of with their laptops whenever they’re not doing work on it, you know now we have industrial, most of them based in China doing a lot of the Bitcoin mining. It’s a very different beast from the one I think that Nakamoto envisaged. And it’s a bit like when Bill Gates said that the biggest RAM was going to be 128 kilobytes or something like that in the mid-1980s, of course you know he made this confident prediction which was completely wrong but he still rode the wave of success. And I think eventually is going to be some sort of a cultural disagreement between some of the people you were describing. The more libertarian minded Bitcoin maximalist types, and the people who just want to use this technology for efficiency reasons.
Buck: Well and beyond that too, if you look at what’s happening even on Wall Street, and I hope you’ve been following this, but you know Bakkt that is being released by the Intercontinental Exchange, the owners of the New York Stock Exchange, they will be releasing a, they’ll start selling Bitcoin, actual custodian, physically-held Bitcoin on December 12th. And then you’ve got this ETF that is still on the table that’s backed by the Chicago Board of Options Exchange, I mean this is, the irony here to me is that exactly what you’re talking about is that Bitcoin was brought to life and ultimately I think got its initial push by these people who were unhappy with the banking system, right? People who looked at 2008 and said look at what they did to us, we’re gonna take that power back. But the the irony of it all is, it’s those very banks that are gonna take this currently two hundred billion dollar market cap and turn it into a two trillion dollar market cap, and all those Libertarian bit point Bitcoin maximalist are gonna become millionaires, billionaires.
Diego: There’s a scene, there’s an old movie, The Leopard, based in Sicily with Burt Lancaster, it’s from the 1950s but it’s set in the eighteen hundreds and there’s a revolution happening in Sicily, right? And the nobleman who used to run the place and sees revolution coming at one point in the movie says, all must change so that all remains the same. And this is a big, what is going on here is we have this massive disruption so that the people who are well connected and well placed can best take advantage of it. And I think this to some extent is inevitable, not least because if you want to invest in a lot of these projects you have to be an accredited investor or you have to be in a private equity fund or or some sort of trading fund and to have that exposure as a regular guy you cannot easily do it in the United States.
Buck: So let’s talk about that a little bit. That’s the other ironic part of it to me is now we’ve got SEC regulations on new projects. Should cryptocurrencies be regulated? Are these securities or are they commodities? What are your thoughts on that?
Diego: Well my first reaction is that it seems a bit too early to think too hard about these questions, I mean we have to because the regulators are talking about it and if we believe this technology offers some promise, then we have to have a think about how that promise can best be grasped. But you look at the market value of cryptocurrencies and it’s 200 billion dollars. The US capital markets are 32 trillion, and there’s about 320 trillion dollars of wealth in the world.
Buck: Yeah and Amazon and Apple are both trillion dollars.
Diego: Exactly right. So we have corporations that are multiples the size of the hook of the currency market. So in terms of the exposures and the kinds of investments that people are making, it doesn’t seem to me like it warrants that much attention. If you’ve been around the cryptocurrency world and have seen the returns in the volatility and are learning to make a quick buck, then you cannot say that somehow you were predated upon. Because there are plenty of warnings everywhere. And this is not mom-and-pop investors getting burned, I mean maybe there was a little bit of that at the end of 2017 with the big ICO group. But even then, I mean a lot of these fundraising rounds that happened, that went to nothing, they were tiny. We’re talking about hundreds of thousands of dollars, not more than that. So we’re talking about you know the the kind of Ponzi schemes that happen in stock markets. Historically were much bigger. So that’s the first reaction the first reaction, is before you have this heavy-handed solution, have some sense of proportion this is tiny. Let it develop a bit more and let’s see how it goes. My own view is that the best way, if we’re going to have any sort of introduction of cryptos into the financial regulation framework, the best regulation is that of commodities, because commodities currently are regulated by the Commodity Futures Trading Commission which is in charge of futures and derivatives, but it leaves a relatively free hand for commodities themselves. And the nature of cryptos, because they tend to be in fixed supply, they’re used to buy goods and services on a platform. They’re basically an input. They’re like a raw material. It seems to chime in well together with the notion of a commodity. The alternative is to regulate them like a security like a stock, but the problem with that is that cryptos have no cash flows. They don’t promise you dividend payments in the future, they just have value intrinsically because you want to use them for something eventually or somebody else will. And then secondly securities regulation is very onerous and so if we really do want to regulate these things of securities we’re running the risk of not making possible a lot of projects that are too small right now.
Buck: Yeah in last I think last week Bill Hinman, one of the thinking officials at the SEC, promised some written regulation on this and I think they are doing this in part because there’s a lot of pressure, you’ve got a lot of projects in blockchain, you’ve got a lot of projects that are either staying away from the US altogether or moving out not even allowing investors to participate. It hurts us financially from both the you know the the business and in keeping that business in the US, and also hurts our investors in not being able to get involved. So I think they have to create a little bit more information on this and guidance.
Diego: I think that’s right. The problem with the US is that it has not only a lot developers, but a lot of potential buyers of cryptos. And that’s where the regulators are very uneasy. If you look around the world, the jurisdictions that are most advanced in terms of tolerating this stuff are the places that have a big financial sector, quite a few developers, but where the customer base is small, so that regulators feel comfortable giving a relatively open environment, because if people get burned it will be mostly people outside of their jurisdiction. So it’s places like Singapore, Hong Kong, Switzerland, even London. In the US, because of the scale of the US in just the level of interest in Kryptos in the US, I think the the challenge for a regulator who is by nature risk-averse, because if good innovation doesn’t happen nobody will ever find out, but if some bad innovation ruins people then people will definitely find out and they will know who to blame, so they’re very risk-averse. I think the regulator looks at that and says well given this size of customer base, it’s probably not prudent to be open-minded about this stuff. But I like what Hinman was saying, I think he I think the sec is trying to understand this space. I don’t think they’re coming at it with a big hammer trying to you know demolish everything. But sometimes when you’re the Securities and Exchange Commission you will look at everything and everything looks like a security, you know? We’re talking about earlier about the problems of the world and I was saying that everything to me was economic or almost. You’re a securities lawyer and you will everything will look to you like a security. And I think the SEC should have a bit more sense of that potential bias in this one particular Commissioner of the SEC has the purse, who you may have come across, who has given a lot of very positive, very I think constructive speeches on this particular subject, because she I think is very aware of the potential to over-regulate early, and for regulators to act in the interests of the already established and in their own interest rather than the interest of the public as a whole. And so I think having her there has been really beneficial.
Buck: One thing that would be useful I think for for people to understand is how the SEC defines securities. There is something called Howey Test. Can you talk about what the Howey Test is?
Diego: Sure. So the Howey Test is named after a case from the 1940s where people leasing a piece of land to grow oranges were brought to court on the grounds of the contract that they’d sold was “a security”. Now it was left to the courts to define what a security was, and that’s exactly what the courts did. They said that a security met four criteria: it had to be 1) an investment of money, 2) in a common enterprise, so something joint, a business that’s involved in some activity, 3) with the expectation of profits is the third criterion. And those profits have to come from the efforts of others, right? So you think about those four principles and you can imagine the typical company fulfills them, right? If you buy a share of a company, you make an investment of money in some sort of enterprise and whatever profits you get are from the efforts of management, and therefore your ownership of that is a security. Now the argument is that cryptocurrencies are a security in some cases, that’s what the arguing that some people have made. It is an investment of money, is it in a common enterprise? Well Bitcoin is a network and it’s not owned by anybody, anybody can join, anybody can buy Bitcoin, and indeed you buy on the basis of the going price. It doesn’t entitle you to any face value or any payments in the future. Now there may be an expectation of profits, some people buy in order to make a buck, that’s no absolutely no question about that. But, do those profits come from the efforts of others? Again, hard to say, because sure there are miners were involved in fulfilling transactions, but miners are in it for their own gain. They’re not in it for serving others, in the process which is the virtual Bitcoin, but they’re not doing it for the benefit of others primarily or being directly compensated by others, they get some fee revenue but that’s what most of the revenue they get, right? So it’s a weak case. And it sounds to me like it’s shoehorning a new technology into a seventy-year-old definition that was meant for citrus groves in Florida, and not for decentralized networks
Buck: Well I think that’s right. And the other complex aspect of this, at least the way I try to get my head around this, is that Hinman also, going back to this SEC official that we keep referencing Bill Hinman, he also said, which I thought was interesting Ethereum, you know it has been ruled not a security, and the reason that if Etherium is not a security is because it is “sufficiently decentralized”, and that still doesn’t quite work. I mean listen I don’t want anyone to consider Ethereum or any other protocol a security, but I don’t know if I by what he’s saying. I mean just because something is sufficiently distributed, I mean people certainly buy Ethereum for the profits, and certainly no maybe there’s no effort, maybe there is no centralized business, is that what he’s getting at there? Do you have an idea what he’s talking about? I guess that’s the question.
Diego: I mean my interpretation of that is it’s important to say that Hinman’s remarks are non-binding. So he is an SEC official, a top-ranking sec official, but it doesn’t mean that that’s what the SEC believes. This was a speech he gave in California in June. I think what he was getting at is that at some point the notion of a common Enterprise disappears. And so there’s nobody actually in management. So if you look at some of the more recent crypto offerings, the famous initial coin offerings, ICOs, there you clearly have a group of developers saying give us money today and we will develop a platform that will be a decentralized platform, and you will get tokens in the future. And some people argue that that contract that these developers are offering is a security. now in the his material Ethereum did something like that but it was back in 2014 and four years later, most Ether is owned by a very sort of dispersed pool of people. And the intellectual leaders of Ethereum people like Joe Lubin, they owned a very small share of the whole, so they don’t have much trolling power. And they certainly don’t have any more power than any other developer in terms of persuading people or maybe impersonating people because they are credible figures, but not in terms of adding changes to the network, right? And I think Inman’s argument was well you know decentralization at some point is such that we no longer have a common enterprise and therefore the profits that are made cannot be said that are made by some for the benefit of others. In fact in that in the way that the Howey test describes. My problem as you were saying, you know my problem with sufficiently decentralized is that it’s a sort of term that a lawyer loves and an economist hates, the lawyer the lawyer can spend a lot of time and earn a lot of money discussing what that means and the economy’s kind of put it into an equation. It’s so you know it’s the sort of thing where it’s very difficult to quantify. And given how many people are worried about the uncertainty about security designations, you can imagine how they would try to game the system. And the sec being aware of this it’s never going to give, they’re not gonna say oh it has to be 60 percent decentralized or 67.7% decentralized. Still looking to get a number because they know that people will then game it and everybody would issue tokens up to the point where they were sufficiently decentralized, right? We don’t want that and I can understand that. But I don’t think it’s a good measure it’s a good criterion to ascertain this. What I’ve proposed is that all existing cryptos be designated commodities as I mentioned, and for ICOs, it depends on the nature of the offering. If I’m saying to you, give me money today and you cannot trade the contract I’m giving you, but I promise you if I succeed within six months I’ll give you a token, and if I don’t succeed you’ll get your money back. Then maybe that shouldn’t be a security. Whereas if I did I say, Buck, here’s a contract do with it what you will, I promise you this is going to be a unicorn, it’s gonna give you tokens and so on but you’re exposed, if I lose the money I lose the money and you know you have no liability or I have no liability. And that looks more like a risk-taking venture of the sort that a security is and so I say we’ll give two tiers and then let people structure their fundraising on the basis of that guidance. And I think that would create a more open environment.
Buck: Yeah I think that the real chance is the you know the things that are already out there. I mean the interesting thing I find about Hinman’s comment about decentralization is when you look at Bitcoin, there as you know there’s only ever gonna be 21 million Bitcoin and I think you know right now for example out of the 17 million or so that have been mined, only three million are in circulation or actually trading but everybody else is just ogling. So you’ve got probably you know huge amounts of Bitcoin in the hands of you and we know that’s the case. So that’s an interesting counter-argument to to you know anyway that it’s justified I think.
Diego: I think that’s true but you have to look at the, first of all, are the people who own the speed coin and creating value for others? Are they mostly miners? What role are they playing? Or our other unit for themselves because they’re not really managing anything. It doesn’t seem to me not even that the Winklevoss brothers who are on the video screens who are doing a lot of work for derivative products on the basis of cryptos. I wouldn’t say they play a management role in any of the cryptocurrency networks right? And then the other thing is do they have the incentive to do anything wrong with it? If you’re a bitcoin holder or if you’re a bitcoin miner, people worry about attacks from the network, right? That people will try to attack the system and on the Bitcoin run away and dethrone everyone and it only works once, so you know I thought the possibility is there but the incentive isn’t.
Buck: Right, I mean that’s one of the probably the silliest argument that people have I mean is that somebody’s going to attack the network but with a 51% attack but in reality if they did that the network would be worthless and they would lose all their money and it would be mutually assured destruction so like it’s not gonna be helpful, but anyway I don’t want to belabor the point. But what’s your thoughts in terms of blockchain, how this affects banks and financial services in the coming years because obviously there’s some significant technological advantages here too, and particularly if you’re looking at smart contracts and things like that I mean a lot of that work suddenly becomes almost automated right? And so how does that affect these financial institutions?
Diego: Well I think a number of things. The first one is that I think blockchain, technology at least at the outset is going to be particularly directed within firms. I think right now inter firm coordination for a lot of these multinationals involves very costly processes in terms of database keeping and record-keeping and being able to make sure that a delivery at one location happened and you can record the revenue at another location. And I think blockchain technology by its nature, because it’s a ledger that’s available to a lot of parties at the same time and it’s updated simultaneously and you can decide who has a right to update and so on, very well-suited for that and I can see why people like IBM would be very interested in using it, thinking those use cases are going to be the first. The bigger promise as you were suggesting is in the public, more public networks. In here particularly I think in terms of the trading of titles to things. So securities markets are going to be I think quite strongly affected. Right now some securities markets are very centralized and transactions take some time to clear, it’s expensive, the cost of what is called financial intermediation, a lot of which is trading, hasn’t really gone down since the 1970s which is counterintuitive. So there’s a big cost saving and time-saving potential in the application of blockchain technologies. The key is though what sort of system will you use, because right now we’re experimenting a lot in terms of how you can enable that trust with an approach between network, and the way Bitcoin does it is by using a lot of electricity. Now if you compare it to big payment networks like Visa and MasterCard, Bitcoin turns out not to be very wasteful, however it’s not the most efficient. And so as that experimentation goes we will probably find out what the scalability of a lot of these solutions is. It doesn’t seem to me that you know people send it right now, intermediation seems to be a very worth. To some people, intermediaries are, the people who are intermediates are very efficient. Visa is a very efficient intermediary and I should say you know for purpose of fairness all of its competitors but you know it’s the large tech firms. They’ve achieved enormous cost savings, you know you look at over which I sort of re-enter mediated transport, I mean it’s for the better. So the notion that we can decentralize everything and go to the extreme seems to me a bit unrealistic because at some point it’s just going to become very expensive to do certain transactions. And that by the way is what Bitcoin has discovered, which is that if you want to have small payments in a lot of small transactions going through you have to get them outside the blockchain for a while and then you reintroduce it again because otherwise it’s too costly to put them all through and that’s where the Lightning Network comes from in other initiatives like that. I won’t delve deeply into that. My point being though that we’re still evolving both the infrastructure on the public ledger side and also trying to see what the applications are to disintermediate, but I think in the change of solves the exchange of property titles particularly in countries that have unreliable technologies in other ways. The promise is very great.
Buck: Well listen this has been great talking to you Diego. Where can listeners learn more about your work and you know maybe get a chance to kind of get some perspective on your other views?
Diego: Absolutely so I’m on Cato.org which is the website of the Cato Institute where I work and you’ll be able to find my center within Cato the Center for Monetary and Financial Alternatives which covers a lot of the issues that we discussed, from financial technology and cryptocurrencies to banking and central banking and a lot of things that probably will be of interest to your listeners. And then more widely the Cato Institute if you have any interest in public policy issues and particularly believe in markets and individual freedom we offer a lot of resources there so I encourage your listeners to do that.
Buck: That’s great thanks again for being on the show today.
Diego: Thank You Buck it’s been a pleasure. Really enjoyed the discussion.
Buck: We’ll be right back.