Paper & Blocks

Labour vs Capital has always had an interesting dynamic in economic theory. They are the two of the three main productive outputs of the economy, at least according to the Cobb-Douglas production function (the third being technology, or ‘total factor productivity’—TFP).

In recent times, the dynamic has shifted. Labor’s share of income has fallen while capital’s share of income has risen. While the examination as to why this is occurring is worthy of further study, that is better left to others like McKinsey who has covered the topic thoroughly here.

To me, the labour vs capital dynamic is interesting in that the characteristics of the two inputs has also started to change. In comparing them side by side, there are some similarities.

Labour trades time for dollars. Capital trades time for dollars. Equal.

Where the differences begin is in how the ‘dollars’, or more specifically the growth in those dollars, compound.

The returns to labor are a linear function. Labour does not create more labour.

The returns to capital are an exponential function. Capital can create more capital.

This incredibly oversimplifies things, but it points to the idea that over time, returns on capital should eventually exceed returns on labor. It is then unsurprising to see widening inequality in the world or findings like this Pew Centre research that shows that upper-income households have seen more rapid growth in income in recent decades—they have the capital to prove it.

Economic inequality is at least partially attributable to the idea that Return on Capital (ROC) exceeds the Return on Labor (ROL).

Yet, these realities vary across industry sectors. One where the labor vs capital dynamic is becoming incredibly confusing is in crypto.

Crypto is the industry that brought us the ability to create digital scarcity. The cryptoassets at the center of the industry are a form of money, and hence, are also a form of capital. But crypto has a unique property that did not exist before: it is programmable capital. It is technology (or TFP) fused together with capital and technology is the ultimate disintermediator of labor. We use technology to complete tasks with more efficiency, from using ovens to cook food instead of fire, to using computers to store and distribute information instead of books. In crypto, DeFi in particular, I’d argue that this is particularly true: programmable capital means we are able to disintermediate financial labor.

For example, if we distill down the core function of a bank to its roots, what you’re left with is ‘maturity transformation’. Financial institutions borrow money cheaply on short-term timeframes and lend money out at a higher rate of return on longer-term time frames. The difference between the two is the bank’s interest income or revenue. On the cost side, there is a conglomeration of customer service representatives, risk officers, compliance departments, and physical bank branches that help to complete this task. These are the bank’s expenses (also known as the labor needed to perform maturity transformation). If the revenue earned is greater than the cost side of the ledger, the bank makes a profit—their net interest income.

Where crypto becomes interesting is in its role as the ultimate disintermediator of financial labor. Programmable capital means we can perform maturity transformation without the stack of people and bank branches sitting in between. The cost side of the ledger disappears as the functions they perform are automated and built into DeFi protocols.

One of the largest DeFi protocols, Aave, performs maturity transformation. It allows users to ‘borrow short’ by depositing their tokens in a liquidity pool and earn an interest rate that fluctuates based on supply and demand. It also functions to ‘lend long’ by enabling users to borrow assets from those same liquidity pools at a rate above the deposit rate.

In another example, labour is also used to secure and operate the financial system. Best described as the 90% of the financial system iceberg that sits below the surface; transaction, clearing and settlement networks are the backbone that hold the financial world together. Facilitating and verifying transactions along with their settlement requires a huge financial labor force working everywhere from clearinghouses like the DTCC to payment networks like VISA.

In crypto and DeFi, this ‘financial labor’ around transaction verification, clearing and settlement is performed at the protocol layer and is executed through a decentralized system of nodes operating on the same consensus mechanism. While the proof of work consensus mechanism demonstrated that financial labour could be replaced by expending computational effort, proof of stake has advanced the ball further down the field, replacing financial labor not with computational effort, but rather, with capital itself. By staking your 32 ETH and activating the validator software, you’re effectively using your capital to complete the financial labor of running and securing the financial system.

The implication: now that we have programmable capital, or ‘money with code’, code can now function as labour in two ways:

• automating financial labor functions like maturity transformation, and;
• automating network operating labor functions to secure the financial system.

While this could mean more returns accrue to the capital that performs these functions, what is more likely is that the financial system operates more efficiently, replacing a less efficient cost layer with a more efficient way of accomplishing the same tasks. That means the cost of financial transactions for the users of the financial system (essentially all people, corporations and governments) could be reduced. If we ever get there, I’m sure merchants would be happy with a reduction in interchange fees. Individuals would be happy earning a higher interest rate on their chequing and savings deposits. Corporations would be happy with lower cost methods to access capital markets. The list is long when it comes to the number of people you could make happy by taking some of the slack out of the financial system.

That is potentially the promise of crypto and DeFi: becoming the technology that is the ultimate disintermediator of financial labor. And while this may enflame the issue of returns on capital exceeding returns on labor, it might not be an enhancer of inequality as is the case in the current financial system. In fact, it might be a leveler of inequality.

In the existing system, one of the exacerbators of inequality is selective and/or discriminatory access to financial opportunities and a notable reason for which is the cost structure of the existing financial system.

Those with lots of capital are able to access exponential returns through a huge variety of opportunities. Those with little capital are not. Account minimums, accredited investor rules, dollar-based commission structures… the list of structural items contributing to the problem is long. While some of these systems are in place to protect investors, most are barriers that have risen due to the cost to serve smaller clientele. That’s why most of the financial system today is set-up to provide the best service to the largest clients.

Fintech firms have been chipping away at this reality, lowering the cost structure of their business models, thereby allowing them to serve smaller clients than traditional financial institutions.

Crypto, on the other hand, drops the cost down to almost nothing. Global, permissionless, and accessible, there is more equality in the crypto ecosystem (the decentralized parts, at least). Small accounts can access the same opportunities as large accounts. Small amounts of capital can earn the same returns as large amounts of capital.

So while return on capital might continue to widen its lead on return on labor, at least the opportunity to access those returns can be made available to a wider range of people.

(This only works if more people become owners – more on that here).