Week 28: Crypto and Wealth Creation

What I find appealing about the web3 / crypto space is it’s transformative vision of the future. The other week I was reading this piece about what 2040 could look like as web3 continues to grow. Before describing a possible future the author focuses on crypto’s wealth generation. They argue that crypto will continue generating wealth. This wealth will be spent on projects creating a better world. (From the piece is not clear why this future is better besides the assumption that decentralized is better than centralized).

While I support imagining better versions of the future, this piece left me confused about the current state of crypto. It seems true that crypto has generated a lot of wealth, but how exactly did it do that?

This piece is my exploration of : How is crypto generating wealth? To dig deeper on this I begin with some building blocks we might need to answer this question.

In my undergraduate studies we encountered macroeconomic models for how a countries wealth changes (GDP is the traditional measure used). Measuring the wealth of an entire country is complex so these models use simplifications to make the task manageable. Some of the simplest models use population growth as the driver of wealth. A countries’ wealth is dependent on how much labor is available. As the population grows so does the amount of possible labor. More labor = more wealth. This link between labor and wealth makes sense at personal level. I work for a company which pays me money increasing my personal wealth. I use my labor to increase my wealth.

If we dig a bit deeper on the relationship between labor and wealth a lot of complexity bubbles up. Some thoughts about this relationship based on my own experiences

• Not all labor is equal. One project might create more wealth than another. One person working on that project might create different amounts of wealth than another. We recognize this by paying people different amounts and different jobs paying different amounts

• Increasing the amount of labor does not simply map to how wealth will increase. If I worked on a project for 20hrs rather than 10hrs would the amount of wealth that I generate double? There is most likely not a linear relationship between amount of labor and amount of wealth.

• The amount of wealth I generate with an hour of labor changes over my lifetime. As I have more experience, develop more skills, one hour of my time becomes more productive. This is manifested in more senior workers getting paid a higher salary recognizing that their time is more valuable.

• The amount of wealth I generate is not only dependent on my ability but also the tools that I have at my disposable. Without a computer it would be really hard for me to work.

Macroeconomic models have different specifications to deal with these complexities. They take into account capital accumulation (how much I have spent on tools), technological progress / productivity (How helpful those tools are) and even knowledge accumulation (how much experience I have) . There is one aspect which shows up in most of these models that I have not touched on yet; the investment / savings rate.

Another way to grow my personal wealth is by investing the wealth I receive from labor into other sources. Investing money is hopefully a mutually beneficial relationship between the investor and the company. The investor fronts the company to help them create something that will generate wealth later give. Eventual the company will capture some of the wealth they are creating. The company should then return that wealth to the investor. In exchange for the investor giving the company money now, the money received in the future should be larger than what they invested. This agreement is easiest to understand with companies that pay out dividends. Eventually the investors earns back their principal and then some.

While investments in our present day society have become more complicated, this type of relationship is really important for wealth creation. Investment acts as a coordination mechanism allowing projects to be funded that otherwise would not exist. In exchange for allowing others to work on a project, investors have the opportunity to grow their own wealth. In the macroeconomic models countries with a higher investment rate grow their wealth quicker. This higher investment rate means more projects are attempted.

There are many economists who spend their full time studying these concepts. My quick explanations do not do their work justice, but having this foundation will be important for understanding crypto’s wealth generation.

In the framework we have been exploring there are two components: A group of people and a measure the wealth they hold. That group of people could be an individual, an organization, or a country. For each of these groups we have a way of measuring their wealth. For an individual it is the sum of their assets, for a company it is it’s valuation and for the country it is GDP. The amount of wealth of the group depends on labor, technological progress and investment.

In our society we use currency as the unit to measure wealth. My personal wealth measurement, a company’s valuation and GDP are all in units of dollars. Currency is a unit that allows us to compare very different assets. We are able to compare the value of an apple to that of a pear. The value of a flight across the country to the value of a laptop.

Now that we have a framework, let’s return to our original question, How is crypto generating wealth? For crypto to be generating wealth we need to identify our two components. The group of people is people who own crypto assets (bitcoin, ethereal etc…). The measure of wealth is the total value of those crypto assets. Crypto is generating wealth because the value of those assets are increasing. Using our framework two possibilities emerge about why the value of those assets are increasing:

1. Crypto assets are investments in a new technology which has the potential to generate wealth.
2. Crypto assets are a new currency representing a larger share of wealth that already existed.

Understanding crypto is difficult because it is a new financial instrument. It does not map neatly into our previous categories. It is simultaneously both a currency and an investment in a new technology

1. Crypto assets are investments in a new technology which has the potential to generate wealth. We can simplify buying crypto to be making an investment in a new technology. Buying crypto gives the people working on that technology money. For your investment to be worth it, the technology eventually must create wealth that will be returned to you. A tricky thing about investments though, is that they are based on people’s expectations about the future. If people’s expectations about the wealth crypto will generate are much larger than the truth, then we will have a crypto bubble.

2. Crypto is a new currency that represents wealth which already existed We could also simplify crypto to being a new currency. Each unit of currency represents a certain amount of wealth. Crypto becoming worth more means that other currencies are becoming worth slightly less. In this world crypto is not creating wealth but rather representing a larger share of existing wealth.

Crypto does not fit neatly into either one of these categories. It’s wealth generation could be derived from both of them. Crypto is a new financial instrument coupled with a transformative vision of the future. Some of the excitement about crypto is about the possibilities with the new technology, but a lot of it has also been about how this new financial instrument has generated a lot of wealth for people. Whether or not crypto actually generates wealth in the long term will be decided by the people in the crypto community. If the resources they have gained from this financial instrument are actually used to create value then it will not be a wealth transfer mechanism but a wealth generating one.

While writing this piece, there has been a question I have avoided which has been nagging me. What actually is wealth? So much of our society is organized around wealth. There is an inherent assumption that more wealth is desirable and we should aim to grow our measured wealth.

At some level, there needs to be a connection between wealth and our values. When I purchase an item, I am stating that I value that item. The amount of money that I pay for it is a measure of how much I value it. In theory, wealth should be strongly connected with improvements in the human condition. When we are creating wealth we are doing something that improves people’s lives.

But clearly, wealth does not perfectly represent improvement in human life. People who are wealthier are not always better off. There are many things which improve the human condition which currently are not taken into account in wealth measurements. In a healthy society our measurement of wealth is probably quite closely tied to actual improvements in the human condition.

This exploration has been helpful, but it has left me with even more questions than I started with. Some of those are:

• If our current measures of wealth do not accurately represent human health / values what do they represent?

• While wealth does not perfectly represent human values, there still is some connection. What happens to our understanding of wealth as human values change? If everyone started valuing public spaces a lot more how would that change our understanding of wealth?

• Our financial system has become quite complicated. Does all this complication create a better and more robust system? How do we measure if our system is working well? It feels like our system is quite susceptible to bubbles currently. The complication has made it difficult to actually value an asset.

• How does currency exchange work? What does it mean when one currency becomes more or less valuable?

Thanks to Basil Halperin, Holly Ormseth, and Jenny Wang for discussions that inspired this exploration.