When I was at MIT, I hung with a group of experimental plasma physicists.  A livelier crowd than you might think, we all believed that it would take no more than a decade before fusion would usher in an era of clean, limitless energy.  That was in 1975.  It turned out that paradigm-busting is hard, a lesson I suspect is true not just for those grappling with the inexorable laws of nature, but also those trying to bend the more malleable, but still critical laws of man.  Which brings me back to Libra and what way-cool kids need to know about why rules govern the payment system.

In science, Occam’s Razor is known as the First Philosophic Principle of Newton’s Principia Mathematica, but each means that simple solutions are likely to be lasting solutions.  Using this razor to cut through the complexities of the payment system, we see that payment systems are constructs that only function when what goes in comes out and what’s in the middle ensures that this is true.  Absent some rules, individual incentives at each step of the payment stream may not align with the social-welfare objective of seamless, reliable, liquid, and principal-secure payments.  It’s just that simple.

This inherent incentive misalignment is why financial systems shifted from non-comparable mediums of exchange – goats for chickens, goldsmith notes – as markets expanded from tight-knit communities to larger trading networks.  As economies grew and financial systems continued to expand to anonymous, distant counterparties, central banking created fiat currency transferred through payment systems with regulated paying agents at each end and government-backed central banks in the middle.  It took the U.S. until 1913 to cotton to central banking when the cost in terms of financial crises of let-loose payment systems was inescapable.

Is a regulated payment system under central-bank fiat currency efficient?  Of course not.  Is it essential?  For sure.  Does this mean that legacy-regulated banks should retain control of each end of the payment system?  Not necessarily, but it tells us that substitutes for the traditional interbank payment system such as Libra need to be governed so that all the gain doesn’t go to the payment-system provider and all the pain is inflicted on hapless payees or, even worse, a national economy.  Rules may well need to be modernized – we don’t necessarily require specie currency any more in at least some cases – but Occam’s Razor cuts through all the gee-whiz in Libra’s releases to remind us that payment systems move money, money moves people to do bad things, and bad things must be prevented to the extent possible by effective rules backed by vigorous enforcement. 

Importantly, Libra isn’t the only venture pushing the limits of the regulated payment system.  As we noted yesterday in our analysis of a new BIS report, many other decentralized, tech platform-based providers are entering the payment system at each stage of the one, two, three processes underpinning it.  So far, only Libra has had the scale not only to contemplate payment-system entry, but also a payment-system medium based on a crypto-asset.  However, each of these payment-system constructs, while undeniably innovative and sometimes even inclusive, still fail to understand that payment-system friction ensures payment-system function.

What really bothers me about Libra is that it is so insouciant as to believe that it doesn’t even need a central bank or its backstops.  Its new currency in a new payment system serving the 1.7 billion vulnerable customers it counts as its beneficiaries is portrayed as a system in which what goes in goes somewhere into a stablecoin that goes through something owned by some sort of consortium that comes out somewhere else pretty much the same as what went in.  As with limitless clean energy, this is nice, but not as easy as a set of really nifty models might suggest. 

Many analyses of Libra in the last few days have highlighted the anachronistic nature of the payment system with all its barriers to entry and user costs.  It may well be time for regulated banks and their central-bank guardians to modernize or step aside, but the justice of these allegations will only be known when it is clear that a payment system without rules is a payment system that ensures that funds put in at one end of the payment system come out the other end without being the worse for wear.  Saying this won’t make it so for Facebook or other big-tech platform firms.  But, insisting that the system as is should be immutable won’t help banks preserve their role as payment intermediaries. 

Just the other day, I read that a new fusion-energy turbine shows great promise. Sooner than that, a new payment system will emerge with or without banks, with or without rules, with or without central banks.  The current paradigm is creaky and a new one is inevitable.  It’s just what it will be that remains to be determined.