Grey Rhino, Inflation And The DEFI MATRIX

DEFI MATRIX

Newfound appreciation for orderbooks is a positive externality resulting from the emergence of all the different crypto currencies. In financial markets, the orderbook shows the intersection of supply and demand and is the ultimate tool for price discovery. Today, the majority of transactions are fiat based, but with a deeper understanding of orderbooks there is a higher likelihood for the DEFI MATRIX to become reality. The DEFI MATRIX is essentially an orderbook that through tokenization and blockchain technology shows everything priced in everything, which facilitates liquidity. In the near future, personal and institutional digital wallets can store stocks, bonds, NFTs and more, which in real time connects to the DEFI MATRIX. When each asset is continuously repriced against all other assets, the demand for cash/fiat currency decreases, adding pressure to traditional currencies already battered from inflation. In addition, cross collateralization of assets is made possible. I believe the DEFI MATRIX is a potential next step in the evolution of our economy.

Bored Apes is one of the most popular NFT projects.

Inflation

The DEFI MATRIX transition will accelerate under the current Keynesian monetary and fiscal system in western society. In Doom, a book about the politics of catastrophe, Niall Ferguson demonstrates why governments and central banks manipulate the economy – albeit with good intention – to avoid expected negative shocks. Expectations fall within a probability distribution meaning that all economic outcomes considered prevented by fiscal and monetary policy action are not Black Swans. The expression Black Swan was coined by polymath Nassim Taleb to describe events that are perceived impossible based on human heuristics. Black Swans are often confused with their cousins – Grey Rhinos – which American author Michele Wucker defines as “dangerous, obvious and highly probable” events. Grey Rhinos like the 2008 financial crisis and COVID-19 are therefore confused for Black Swans – bolts from the blue – even if predicted by contemporaries; just watch the Big Short or consider why Coronavirus research exists. If Grey Rhinos are rare, then Dragon Kings are extremely rare. The French geophysicist, Didier Sornette, defined Dragon Kings as events so vast in magnitude that they fall outside of probability distributions including those with a fat tail like the Poisson and Power law distribution.

Michelle Wucker

Dragon King

But what is the tipping point turning Grey Rhinos or Black Swans into Dragon Kings? In Doom, Niall argues that revolutions are responsible for tipping points by using the industrial and technological revolution as examples. From an economic standpoint, we should ask if current inflation is a symptom of deep misalignments expanding in our economy. If so, will policy makers thread the needle or will the constant short-term price fixing turn into an inflationary Dragon king event? Is it possible for FED to shrink their balance sheet of 8.87 trillion dollars to a sustainable level? Or will continuous Grey Rhinos perhaps limit the impact of USD as the world’s reserve currency and lead to more decentralized solutions with the DEFI MATRIX, which like the internet is a potential Dragon King.

Geophysicist Didier Sornette

Volcker

At 7.0%, the US experienced its highest inflation since 1982 and the FED must take action to combat excessive price expansion. The common definition of inflation – as a general price expansion – is outdated and I prefer Milton Friedman’s definition, which refers to inflation as an increase in money supply. Per Friedman’s definition, US inflation has been around since 1971 when President Nixon dropped the gold standard. Inflation is actually a part of the Fed’s dual mandate. To enforce the dual mandate, the FED must keep inflation stable at around 2% and maintain a so called natural unemployment rate of around 4%. Taking action against inflation means using the FED’s primary tool – the federal funds rate – to increase or decrease interest rates. In economics, there is a relationship between interest rates and inflation called the Fisher rule, which states that real interest rates equal nominal interests minus inflation. Per the Fisher rule, the FED controls the nominal interest rate to impact inflation and real interest rates. A higher FED funds rate slows inflation all else equal and no one knows the Fisher relationship better than perhaps the most powerful FED Chairman of all time, Paul Volcker. In 1980, the US inflation was so high that then Chairman Volcker was forced to drastically raise the nominal interest rate. In 2022, the inflation is once again reaching the persistent peaks of the 1980s and may force the current Chairman, Jerome Powell, to follow Volcker’s lead. A move to raise rates slows down inflation because borrowing costs increase and consumers are more incentivized to save. Higher discount rates also tend to lower equity valuations and expand market volatility. According to many economics experts, 2022 will be a year of rate hikes. I think that the FED should raise rates, but I do not think we are at an economic inflection point. The world is emerging from a pandemic with low labor participation, which means people are on edge. Slowing down the economy right now may slow consumption and put the economy into another recession. In addition, there are no investors that will buy the assets on the FED balance sheet, which may cause the bond bubble to burst. I would not be surprised if the FED tries to raise rates in March only to turncoat. I also think Biden will provide economic stimulus through his infrastructure bill. FED turning dovish in combination with economic stimulus will lead to further increases in inflation in the real economy.

Chairman Volcker

What Prices Are Increasing and Where

Similar to the US and according to data from OECD, the consumer price index (CPI) for the 38 countries included in OECD rose by 5.8% in 2021. The high inflation number across OECD demonstrates that global and not just US specific factors are behind expanding prices. The CPI measures the cost of food, transportation, energy and housing, which are all key goods for the typical household. The rapid price expansion means governments and central banks are now on high alert, as low income families take the largest hit if goods and services become more expensive[1]. There are certain things in life equaling human rights and inflation might remove some of the human rights away. People should have a home and food and they should not freeze if it is cold outside. For example, in Sweden the government has proposed 600 dollar subsidies on electricity costs to families impacted by higher energy prices, which is an inflation trade-off. However, inflation is also a double edged sword, as the wealthy tend to hold risky assets at a much larger percentage of their portfolio than those with less wealth. Higher prices therefore tend to lessen wealth inequality on a relative basis, as rising interest rates have historically correlated with equity and bond sell-offs. In my opinion, the consumer price index fails to capture the entire cost of living narrative. Per OECD, FED and other central banks, the definition of inflation is a general increase in the price level of the CPI. OECD economists argue that CPI is the optimal measure of inflation, as the basket of goods is directly tied to living expenses. However, the value of currency is not included in the CPI narrative. If country A prints money going into financial assets and not on goods included in the CPI, then inflation seems dampened based on a CPI measure despite a depreciating value of country A’s currency relative to foreign currencies. Also, central banks have tendencies as a group to exclude certain goods in the CPI to make the CPI seem lower than it actually is to justify money printing during periods of economic hardships. As a result of more money printing and fiscal stimulus in combination with CPI fixing and supply bottlenecks, we now see explosive acceleration in inflation as measured by the CPI. If continued, these price increases will have people ask for alternatives and that is where the crypto industry steps in.

Declining interest rates, which have spurred on inflation.

The DEFI MATRIX

Instead of government and central bank controlled financial markets, the new decentralized market is emerging as a complement/alternative for storing value, lending and trading. As of 2022, the crypto market was valued at over 1 trillion dollars, which is still way behind its multi-trillion cousin. The decentralized market was spearheaded by Austrian minded blockchain developers like Vitalik Buterenin, Satoshi Nakamoto, and Sam Bank Fried and exist on the internet using code instead of middlemen - like banks - to legitimize ownership and facilitate transactions. By utilizing smart contract technology, the decentralized market removes clearing houses and instead settles transactions on the blockchain. Smart contracts also prove ownership of goods and services, which has a lot of application. All users in the decentralized economy will have their own digital wallets connected to their own personal address where they store stocks, bonds, NFTs and cryptos. With the click of a button blockchain networks will be able to clear dollars against bitcoin, rare paintings against stocks and real estate against music rights. The DEFI MATRIX will make these transactions liquid. Each pricing pair should be considered as a submatrix and it is the sum of all these submatrices that forms the powerful DEFI MATRIX. Soon exchanges such as the stock, currency and crypto exchange will merge into our digital wallets freeing up an enormous amount of liquidity. With the DEFI MATRIX there is no longer a need to convert illiquid stuff into cash, but rather barter directly through digital wallets. Creating liquidity is super important for efficient allocation of resources. For example, an IPOs is considered a liquidity event, as it opens up the company to public ownership in return for providing capital to the firm, which decentralize ownership and hopefully creates a more efficient firm and the same will happen in our economy.

DEFI Orderbook for Euro against Bitcoin

Conclusion

I believe that a weakening US dollar is a major Grey Rhino. A continuous devaluation of the dollar has certainly been the case since President Richard Nixon dropped the greenback’s peg to gold back in the 1970s. A follow up question is then asking what happens to our society if the dollar value inflates away to a point in which the greenback is no longer the world’s reserve currency? What happens to global markets if the dollar decreases in value by 100% over 5 years? Would the dollar replacement be a basket of global currencies agreed upon by the G20 or a decentralized currency that thrives on a transparent yet immutable blockchain technology? I am asking these questions now because time and again throughout history large empires have crashed and burned due to monetary mismanagement, including Spain in the 1600 century and the Great British Empire at the end of the 1900 century. What is to say that the money printing by the US Federal Reserve (FED) is different from that of the Spanish manipulating the silver price due to supply shocks or the 1900 century British treasury lowering amounts of silver in coins they minted. All of these actions lead to inflation. In the beginning of 2022, the market priced in five 0.25% interest rate hikes by the FED. If other central banks around the world also pursue contractionary interest policy together with an inability to decrease balance sheets, then there will be a push to alternative systems. If they continue to money print then that will generate higher inflation, which also increases the likelihood of a future with the DEFI MATRIX. If central banks and governments thread the needle with economic policy that will only slow down the transition to a more decentralized economy. There are currently so many products being developed by talented people in the crypto space and only time will tell when blockchain technology catches fire among us luddites.

[1] https://data.oecd.org/price/producer-price-indices-ppi.htm#indicator-chart