The Code of Capital: Markets, Big Tech, & Blockchain | Katharina Pistor

The Code of Capital: Markets, Big Tech, & Blockchain | Katharina Pistor

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The Hidden Forces podcast features long-form conversations broken into two parts, the second hour of which is made available to our premium subscribers, along with transcripts and notes to each conversation. For more information about how to access the episode overtimes, transcripts, and rundowns, head over to You can also sign up to our mailing list at, follow us on Twitter @HiddenForcesPod and leave us a review on Apple Podcasts. And with that, please enjoy this week's episode. What's up everybody.

My guest on this episode of Hidden Forces is Katharina Pistor, a professor of comparative law at Columbia Law School and a leading scholar and writer on corporate governance, money and finance, property rights, and comparative law and legal institutions. She's also a prominent commentator on cryptocurrencies, has testified before Congress about them, and has written papers dealing with the issues of digital statehood and monetary sovereignty. Her latest book, The Code of Capital is a tour de force that explains in captivating detail how the law is used to code and construct capital, protecting some assets over others, how this creates wealth for society and how it's use and abuse can make the difference between societal cohesion and political revolution. In our conversation today we focus on three different but interrelated topics that have long interested me and which I think will captivate you as well. The first deals with the nature of property and how the legal system and its network of lawyers turn assets into capital by encoding them with certain key attributes, specifically priority, which ranks competing claims to the same asset; durability, which extends priority claims in time; universality, which extends them in space; and convertibility, which operates as an insurance device that allows holders to convert their private credit claims into state money on demand.

This last attribute has been notably expanded in its application over the last 13 years. As central banks, the guardians of state money, in an effort to forestall liquidations and reduce volatility in credit markets have accepted an ever broader basket of assets as collateral and use their balance sheets to monetize, not only government debt, but mortgages, corporate bonds, and stock ETFs. The political implications of these actions cannot be overstated, but neither can the distortions that they create in markets and this leads us to the second topic of conversation, which is cryptocurrency, and the astronomical growth and the market value of bitcoin as an exogenous response to the erosion of trust and credibility and the conduct of monetary policy by central banks, and in response to questions about the integrity of public money. Can a private currency like bitcoin eventually come to displace state issued fiat currency? Can monetary sovereignty exist without territorial sovereignty or must the two go together? Can and will the code of law be used to enclose the digital space? Are we already seeing evidence of this, and what does it mean for society and the individual? Lastly, Katharina and I discuss how creatures of the legal code, incumbents, so to speak, like Facebook, Google, Amazon and others are using that same code to not only control markets, but to effectively break them and transform the economic space into something that more closely resembles a system of bonded labor, but one whose shackles are invisible to all but those sitting at the very top of the social pyramid.

Make no mistake about it, we are living through an extraordinary period in human history and everyone is trying to grapple with the implications of changes that are, in some cases, truly unprecedented, whether we're talking about the transformation of central banks from being market participants, to taking the place of markets, or cryptocurrencies and distributed ledger technology and its potential to decouple territorial for monetary sovereignty or data monopolies and the political threats they pose to self sovereignty and the integrity of our democratic form of government. My objective in this conversation is to help you understand how the law is used as a powerful tool for social ordering and wealth creation and how it has become increasingly co opted for use in the service of private consolidation and political control. I see Blockchain and cryptocurrencies like bitcoin as a sort of immune response to the erosion of trust in public institutions and the law that has come about as a result of these abuses, and yet our current system has embedded in it the tools to right itself and rest the power of the state firmly in the hands of the people. We should all be wary therefore, of arguments in favor of trading in that power for some utopian vision of a digital techno state, whether or not that state runs on a Blockchain or on a proprietary set of servers in Silicon Valley or Shenzhen. Today's episode is meant to help you begin to better understand how the world we live in today came to be, how its code has been altered and why promises of a frictionless deterministic future are chimeras designed to divest us of not only our power, but of the very agency that makes this experiment in democratic self-governance possible in the first place.

And with that, please enjoy this deeply insightful and important conversation with my guest, Katharina Pistor. Katharina Pistor, welcome to Hidden Forces. Thank you so much for having me.

I'm very excited to have you on. I really loved reading your book, The Code of Capital and a number of other papers that you've written as well. Before we start maybe you could tell me and our listeners a bit about your background.

I know you were Freiburg, Germany. How did you go from being a kid living in Freiburg to becoming a leading legal scholar and writer on corporate governance and property rights and money and finance and all of this stuff? Yeah, well, it's a long journey obviously. I did go to school in Germany and to high school and I went to law school back in Freiburg. In between my family moved further north, but I went to back to Freiburg, which is a beautiful town, for my law school training. I have to say when I was studying law in Germany I found this increasingly, maybe not boring, but unsatisfactory, I wanted to do more and I wanted to do more internationally as well. So I did an LLM degree in London and studied at the time Soviet law and Chinese law and that was in 1988-'89 and in June '89 of course Tiananmen Square happened in China and when I returned home to Germany in the fall of '89, the Wall fell.

So, I then started studying Russian. I had studied Soviet law and Chinese law and I decided that I probably would master Russian more easily than Chinese without being able to live there for many years, so I studied Russian and followed the transition period in Easter Europe from the Soviet Union. I spent some time in East Germany in Dresden to help rebuild legal institutions and I went to Russian and did a lot of research on how they tried to privatize state owned enterprises and turn them into private corporations and I think this period was really formative for me because it helped me denaturalize institutions.

I really tried to understand how these institutions came about and in what context. By institutions, I mean something like a corporation or property rights or a contract. So the question for me was all the time under what conditions do they work? What do they need? What kind of support structures and belief structures do you have to have in place to make them work? It was pretty clear to me that when I talked to economists on the other end, they thought it's just easy, you just privatize these things, you do mass privatization, you just give shares to individuals and then they start trading them, and I kept saying, "Well, if share is a piece of paper or just an entry in a computer, you have to do more to make sure that people believe that they get something for this share." So this period helped me deconstruct, I think, the economic system that we call capitalism that I had grown up with and we take so much for granted, but trying to build it in a very different context helps you understand that there are lots of elements that we do take for granted that you have to explain. So, I spent the 1990s mostly researching on that. I should add that I came to the U.S. in '92 to do a two year degree at the Kennedy School

of Government at Harvard, and came across all the economists who were doing privatization, Andrei Shleifer or Jeff Sachs was doing microeconomic stabilization in Russia. I took their courses, I fought with them, I argued with them, but I learned a lot as well, and I tried to convey my arguments about the importance of institutions, including legal institutions or legal infrastructure for what we call the capitalist economy. Then after the Kennedy school, I spent a couple of years researching at the Harvard Institute for International Development under the leadership of Jeff Sachs. So, he took me under his wing after I first had fought him in Russia. At the time we then shifted gears a little bit and worked on a project on the rule of law in legal institutions in Asian economic development with a similar take, just deconstructing the economies and trying to understand how the tigers and dragons had grown into the 1990s and of course then in '97 the East Asian Financial Crisis hit and so forth. At some point I went back to Germany, but then I came back to the U.S. I taught at the

Kennedy School for a while and then I was hired by Columbia Law School. So, this was the typical random path, you take an opportunity that presents yourself, you can't really design a career like that, it kind of happened. I think I was just lucky in terms of time and circumstances, the fact that I had studied Russian, that I had spent so much time there gave me access to information and data that I shared with others and that helped me think about the world and think about capitalism in particular. So I've been teaching at Columbia since 2001.

I moved to New York in June 2001, just three months before the 9/11 event happened and I've been really happy there ever since because I have a great faculty and I've been able to pursue my own interest as I moved forward. As you can see from the latest book I've sort of, after I had deconstructed socialism and tried to understand how capitalism might take hold there, I shifted gears mostly after the crisis of 2008, to think about the capitalist system itself and how it was constructed. So I wrote a paper, which I call A Legal Theory of Finance explaining that the global financial system as we know it today is mostly a construction of law and then from that it was just a small step to come to my book, The Code of Capital, which really tries to understand where the institutions that we use today to construct our global financial system have come from, how they have evolved over time and what other objects or interests, resources or assets they have coded earlier in history. Wow. Your experiences is beyond enviable.

It's almost tailor made for what you do. Maybe we could start with the obvious question of what is capital? What do we mean when we talk about capital, and how should we think about the evolution of capital and the evolution of property as a legal concept, how did that all come about? There's lots of definitions of capital around and many economists think that it's one of the two factors of production, it's there's labor and capital, you put the two together and then you create products. They very often think of capital as a thing, as an object and Marxists have told us for two centuries already that actually capital is not a thing, but a social relation and I'm basically saying capital is a wealth generating asset. It's an interest that can produce wealth, but it has to have a particular type of social relations, it links directly to the state in the center of everything because what you want to do is when you have a simple piece of land, which is just a piece of dirt, it doesn't have any financial economic value, but you can turn it into a capital asset by zoning it, by titling it, by allocating the title to a particular person and by guaranteeing that person that its rights to this asset will be enforced against anybody who comes along, whether or not that person had known that the first one owned this piece of land. So we have created basically a very complex social structure that has helped us allocate specifically interest to, not only land as a tangible object, but to future payments, a promise to future payment or an idea, which is an invention.

We can code them as property rights and allocate specific rights to them to different people, but this works only because that's backed by state power. It's backed by a collective resource that we call law and it's ultimately enforceable. So, if you don't respect the lines that we have drawn with the help of law, the people who might claim that their rights have been infringed might go to court and enforce their claims. As long as they can prove that they have title, they can reclaim their assets, including intangible assets.

So I think it's really important to realize that capital is just not physical thing, it's an abstract idea and it's created by grafting certain types of legal interests onto these assets. Is it possible in your opinion to have ownership, to claim ownership over something or to have something as property without having formal title to it, and what makes something property? Is it, in your view, the backing of the state, the ability to enforce a claim? Yes, that's what it is ultimately. In simple societies, you can have, of course, just the physical possession of a thing, gives you control over it and you might be able to hire the best thugs to protect it against any intruders. That's how most systems evolve over time, but in complex economic systems like the ones that we have, nobody can afford to protect all their interest, including in their intangible assets, such as their financial claims, by hiring thugs to protect them.

We're instead relying on a complex system that we call law, which says that if we have a claim to future payment that is organized and construed in such a way that it is enforceable, then it's actually tradable and somebody else will buy it and just because it is enforceable, maybe not only here in this locality, in this country, but even in other countries elsewhere, helps us construct global financial market. So, it is this third party backing and the third party is basically a state, it's a collective resource that we mobilize to protect these interests. The game, of course, is then about trying to construe interests that look like a title that we have created in the past and say, "Well, if we can create a title in this fashion, maybe we can create a title also in another fashion," and thereby expand the types of interest that could be owned or could be claimed, at least, at a level that is akin to form of property rights. So to clarify, what you're saying is capital, another way to think about it or define it is as the right to future cash flows protected by law, correct? Correct. So how did this evolution come about? In your book you begin with the enclosure acts that Parliament enacted between 1720 and 1840. You actually begin with the story of the Maya people of Belize and their legal battle against the government to recognize their collective use rights to the land, which actually is a really interesting paradigmatic case.

Why did you begin with these two examples and how should we think about the evolution of property and of capital in Western society? Yeah, I begin with land because that's where it really started. I have a wonderful quote in the book by Bernard Rudden, the late legal historian, also an expert in Soviet law from Oxford, and he wrote in a 1994 article that the institutions of property rights were forged during the age of feudalism, but what not many people realize is that the same institutions are now coding... he didn't use of word coding, but I'm paraphrasing, they're now being used to protect funds that can be moved by a stroke of a key across the oceans in no time.

That was 1994. So I think this captures the basic idea. We go back to land because that's what we created something like priority to certain interests, this is property right that you can enforce against the world. Actually, most of the enclosure happened even before the big enclosure acts that you mentioned. It started in the 16th Century, through individual disputes over who had access to this piece of land, the commoners or the landlord? Could the landlord exclude the commoners when he wanted to? In the end the courts, case by case, but fought over a century, agreed that the landlords had ultimately the better rights, they had seniority. So you rang rights to land, you create priority rights, that's one core feature of property rights essentially.

You allow the owners to use the land to give a mortgage, so they can raise funds and then they can back their obligation to repay those funds with a mortgage. Then the question is what kind of rights do the creditors have? So when you then look over 300-400 years or so, you can see that also the relationship between owner and creditor can change over time, and it's mostly a battle over who has the stronger right. Most of these battles are then fought over when the funds have dried out, when you're insolvent or when you're in bankruptcy. I call it, therefore, the asset test for who has the better right. That's interesting. Yeah.

What really happened over the course of the 19th Century is that, especially with land reforms taking hold and inefficiencies, also, the property rights regime that England had created coming to the fore, that people realized that you could use the same mechanisms that we had used in the past to protect the interest of landowners in their land, you could use exactly the same mechanism to protect to their interest in future cash flows. So we start with tangibles and then we transpose the very same mechanisms to other things and more and more to financial assets, future cash flows dressed up as bonds and shares and derivatives and what have you. You mentioned the asset test.

We're going to actually get into that a bit later when we discuss smart contracts because I think one of the very interesting, maybe thought experiments is to wonder out loud whether or not it's even possible to construct, to get rid of our legal system in other words, and operate an economy to market entirely through deterministic self-executing software. So, just a teaser there. Before we do that, let's talk a little bit about how this coding happens. You talk about it in terms of legal modules. One is priority, another one is durability, another is universality, and the fourth is convertibility.

Why are these attributes important and how does their legal encoding in the form of an asset turn property into capital and effectively create wealth out of whole cloth. So very simplistically put, I'm basically saying give me any resource, any object, any promise to future payment or any idea, and I can dress it up so that it becomes a capital asset by grafting certain types of rights onto these assets and these rights, as you mentioned, I call them also attributes or priorities or have better rights than others, I can make them durable, so I can protect a pool of assets against too many claimants so that they can incubate over time. I create universality, which is basically that the state will enforce these claims against the rest of the world, and convertibility is basically the way in which financial assets attain durability. So, financial assets are all about exit, right? You want to get out and you want to convert them into state issued legal tender as fast as possible when the financial crisis hits because only tendered state issued money can retain its nominal value, which is critical in times of financial crisis. So, convertibility is one of the other attributes. Now with this framework in mind, when you take apart the different types of things that have been or interest that have been coded as capital over time, you realize that we can use the same mechanisms, we can use property rights, we can use collateral law, we can use trust or corporate law to create different asset pools.

Whether you would land into them or whether you put financial assets into them is relatively a matter of secondary importance. What is really important is the legal coding as such and you can see how the same tools that lawyers have honed back in 16th, 17th Century when they were fighting for the landlords to protect their property rights, they used their skills later on to help the same landlords to protect their property rights against their creditors, and then they helped the creditors to protect their interest against the landlords, and so forth. So, there's a continuous learning process going on and the testing happens when somebody challenges something that is happening and takes it to court. What is really important in this entire story is that process of coding and the challenges of coding strategies happens in a highly decentralized fashion.

There's no police or regulator that oversees this. Regulators come in when things get really, really wrong and they're trying to reset the goalposts a little bit. Most of the action really happens in the interaction between private parties and their lawyers who are trying to fight for better rights and if challenged they go to court and then they have to fight it out over legal principles, not violently in the streets. I've heard you say that if you have the right legal tools or the right lawyers you can basically reduce or mitigate the cost effects of almost any regulation if you're smart enough to do so. How creative can and do lawyers and those who are experts in the law get in both encoding assets and also protecting wealth and giving it special attribute, tax exemptions, et cetera. They can get really creative.

When you think about why lawyers make as much money as they do, it's not just because they are packaging something. The lawyers themselves like to say with the packaging industry, we're just taking the ideas of our clients and make sure that they are consistent with existing laws, but in this process they're also making sure that they design their interest in such a way that they do not conflict with too many laws. The best way to put this and a lawyer has basically created this methaphore for me and my students, she has said, "When you think about the existing regulatory regime, just think of it is scaffolding, like a scaffolding around a building and as a lawyer what you want to do is you want to create a new asset type or a new intermediary that fits through the gaps in the scaffolding." So you don't want to violate existing rules because if you're violating the rules they could enforce it, and the entire purchasing power of the asset is down the drains. What you want to make sure is that you design them such that they fit through the gaps that the scaffolding necessarily leaves. There's no regulation that is watertight.

To break the spirit of the law in other words? Correct, so you're formalistically complying with, but you're not complying with the idea and you're trying to find ways in which basically there's space for regulatory arbitrage, and that's what lawyers exploit and that's how they build new types of institutions and new types of coding strategies for their clients. I think it would surprise most people to hear that, not that lawyers are so creative that they can skirt any or almost any regulation and break the spirit of a law without actually breaking it, but that the code itself is inherently porous and that laws and regulations will never and can never be full proof. Can you explain that? What is it about the law that gives it that type of malleability or hackability, if you will? Two things.

One is that law is inherently incomplete, as everything that we do, every contract is incomplete. Economists understand that, but law too, especially law that is designed to be general and applicable to many different cases in the future, cannot describe every possible case that might come within its purview that could then be enforced. You could of course say and we have different variations in which legal systems are designed, you could say we have just very general principles and if you violate that principle we will go after you, and there are parts of our legal system that you could point to. When you think about securities regulation in the U.S. you have this wonderful principle

of materiality, so if you misrepresent information that is material, the SEC might go after you and market participants have also wanted the SEC to be very clear about what materiality means and they have declined to do so. So to the extent that the SEC has the resources to go after people when they violate something and then enforce these broad principles, you get close to what you describe as an ideal, we actually have law that everybody has to abide to. But it's this combination of most rules and regulations can be arbitraged around, either because they're so broad you don't really know where the borderline is and you have to wait until somebody enforces it, or they're so narrowly construed that you can easily arbitrage around them just by creating a parallel universe of similar types of activities that just don't carry the specific name, and then you have to have another regulation coming back and closing that gap as well. What we are having a hard time doing, and this is also related to our basic idea of rule of law, is to update our regulations constantly. We don't want to give regulators too much power because we want to make sure that also private parties have scope to play and you don't want to give them so much discretionary power that they can reinvent the rules all the time. Congress authorizes them to do specific things and then they are bound by these boundaries that Congress has created for regulators, but once people have figured out how to get around that, Congress has to come back and update and it updates only after a crisis, and it takes some times to get to that crisis so we get the updating moment.

This is why we're always are in a catch up situation, when we try to regulate private activities where the private parties have these modules of the code of capital, the property rights, the collateral law, the contact law, all private law institutions that are fairly malleable, which they can use to construe strategies to get around legal constraints, and the political process is bound by legislation, regulation, limitations on discretion of regulators and that process is slow and cumbersome by definition. I wonder if we would even want a regulatory system that was so rigid that you couldn't get around it, given the fact that there is always a gap between the intentions of the regulator and the outcomes of the law. That's one thought I have. Also, just another observation, which is that, yes, crisis do offer opportunities to alter the regulatory landscape, but what I also find to be true and I think you've mentioned this as well, is that once the crisis is over, once the regulators have acted, the impetus to actually change the regulations in order to create a healthier environment goes away, the political will goes away.

So, I guess, you can respond to both of those, one, what do you think of the idea that we want to have some level of fuzziness in how we regulate and interpretations, et cetera, and then the other, how do we deal with the fact that once the crisis is gone, there's no actual incentive for politicians to act, so how do we actually get the system to right itself? I think the tools are related. I think it's really impossible to have a system that is tight and still gives you room to maneuver. You can have complete financial suppression, you can go to the very extreme, you can say you just don't allow private banks, something like that, or we don't allow certain types of activities, but you also have to have a very strong state to suppress these types of activities. You'd also get black markets in that case, to your point.

I was just going to say that. I studied the Soviet Union and the kind of arbitrage stuff that they had going on, even during the time of the Soviet Union, you just get a sense that people are innovative. They also have to deal with constraints, there's no system, at least to this day, that has been able to plan in a comprehensive fashion, so under those circumstances there's just no way out.

What you would want ideally is a system that has a better updating mechanism, like a set of meta rules that allows us to update, which brings us to the political issue, we need this pressure to do something, and of course, how much pressure you need depends very much on the interests involved. The financial sector is pretty powerful, especially in this country and also in the UK. That's basically the jurisdictions where they have built empires and given the way we fund elections and the political system, there are just many politicians that are dependent on financial resources, so that it's hard to do that.

Even apart from that, I think just getting politicians to focus on one particular thing and do this again and again, even if just smaller things change, is difficult. So, we would need to have different ways to update. The U.S. does this sometimes by having sunset provisions, so that regulation will expire unless we do something new and we review everything, but that can also end in a crash because you just might end up with no regulation if there's no political will to put a regulatory in place. When the sailing is smooth, politicians very often think that, "Well, maybe we don't need a regulator here.

We can defund them or we can let them lapse." So I have one more foundational question before we get into the meat of our conversation and that has to do with the relationship between capital and credit because while the same law is being used to code, for example, CDS contracts, that's being used to code, let's say, mortgage securities, the former is a credit derivative, the latter is a type of capital instrument. So, how do these two relate to one another? I would describe credit in all its manifestation as capital asset to the extent it has these kind of attributes that I define and credit being a financial interest, it's mostly about making sure that the creditor has priority rights over others and that the creditor can, if necessary, convert his claim against a debtor into something that is safer and that these interests can be enforced against multiple parties, against the world. So, with these three attributes, I can say that credit actually, if properly legally designed, does fit my definitions of capital.

It's different from land in the sense it's not about durability, about holding onto this thing, but exactly opposite, to be able to convert it to something else. So when you're looking to asset back securities or their credit derivatives the CDSs, the CDOs that you can build on top of that, you find exactly these elements. You're creating cash flow interests to a pool of assets, all these mortgages that we pool behind a legal veil, which is a trust or corporate form.

So, again, you use the same elements that we've used since the 17th Century or so and then you create priority rights against this cash pool by what the financial sector called tranche them, like the French verb tranche, you cut them into different types of cash flow, so you create a contractual mechanism that gives some creditors better rights over other rights, and when it comes to the asset test that we mentioned early, when it comes to enforcement, those with stronger rights at the top are the last ones to bit the bullet and they're always the first ones to get the cash flows when they come in. So you're recreating in these, behind the veil of these instruments, they sound so fancy, CDSs and CDOs and all these acronyms that we use, but behind that are legal structures that look very much the same as the entails back in the 18th Century with which the landlords in England protected their own land. So this question follows on what you said or derives from it, which is, did CDS contracts become more like capital during the previous financial crisis because central banks, in many cases, put their balance sheets behind them, like in the case of AIG and AIGFG with the feds credit facility? Yeah. I think it's not clear to me necessarily that the people before 2008 who were designing CDSs and CDOs anticipated that they would all end up on the balance sheet of the central bank eventually. In fact, I've talked to people who were right in the midst of this, working for AIG Financial Products, which was the subsidiary of AIG that was issuing all the CDSs, who felt that they were working with the smartest people in the world and they were doing really, really well, and that sort of a really ingenious design, which in many ways they had.

What they of course forget are just fundamental truths, like uncertainty, we just don't know what this future will hold and it's actually also not clear that you can create both fresh mortgages, securitize them, throw them into CDOs and then create CDSs for those people who hold these assets or maybe not even hold them but are naked on these assets, to protect them against losses, that this will always continue and you can always charge the fees and keep this time machine up and running. I think what is certainly clear is that at every stage of the design, when you take a look at these instruments, is that whether you can convert them into something and whether you have access to cash is critical. For example, for CDSs, they were very often margin calls. So, if something happened and the asset that you had insured, in fact definitely with the CDS, with the credit default swap, if the value of the asset declined, the person that had bought the insurance, that had bought the CDS could require the issuer of CDSs to make a cash payment.

This way you get your convertibility, you're getting at least an assurance in sort of a partial cash payments to protect you against further loss. The claim for these cash payments was what brought AIG and its subsidiary, Financial Products, to its knees because when Goldman Sachs started in 2007 to make these cash calls and then every other big bank that had bought CDS also made cash calls, it turned out that the subsidiary didn't have enough cash, so it used the credit line it had been given by the parent to create the appearance that everything was fine, you could always have cash. So, they started bleeding AIG, the parent company, to death because it also doesn't have infinite amounts cash. It had much more than the subsidiary, but it took only a year to bring it to its knees as well, which is when the government had to step in.

So I think there was an illusion in financial market that somehow they had overcome the problems of constraints and scarcity, that they could create just as many financial assets as possible, that somebody would always want them. If you just gave them the right insurance, then for sure somebody would buy them, and at some point it turned out that this was no longer true and the entire system went in reverse. Just to clarify, what you're saying is that a U.S. Treasury Security, for example, has

a higher degree of convertibility than a CDS contract or at least then a CDS contract as it was originally constructed- Correct. .... though in a crisis more assets become convertible. In other words the minus factor or the capital factor of a credit instrument increases the closer it gets to the central bank. Correct.

So let's actually get into the meat of the discussion and I want to pull a series of quotes from your book because you are really brilliant. Your book and your work is some of the best I've ever read in the area of finance and of course it's legal as well, but also you're understanding of Blockchain technology and the way that you think about it is also really insightful. So I'm going to quote a number of times. In the book you describe this creeping erosion of the legitimacy of states and their law in the face of growing inequality, and that this quote, "Increasing threat to laws legitimacy may turn out to be capital's greatest threat yet." I wonder if you can elaborate on this because I think it's actually relevant to this other discussion about convertibility and the move along the continuum from credit towards capital.

Where do we see evidence of this erosion of legitimacy of states and their laws today? Well, I think we see it all around us, and what is interesting to me after having studied the collapse of socialism, is that at the countries that I would call to be at the core of the capital system, England or the UK and the United States, is where you had the strongest backlash over the last 10 years. There are a couple of others, but when you think about Brexit and when you think about Donald Trump and his voters, you get a sense that there's a deep seeded dissatisfaction with the system that we have. The way I would interpret this is that people have the feeling that they have lost control over their destiny.

These are both countries with a longstanding democracy with the idea that we can somehow collectively design our own fate and can be the masses of the world and it's in those countries where all of a sudden people are calling for a more nationalist backlash, getting out of the EU, getting out of international trade agreements and really caring for themselves. So I think to me these are signs are certain symptoms of a system that has seriously problems. You see it also in the pace with which our legal institutions have being shaken and eroded. I just don't have to say too much about the recent attempt to overturn elections using the court system and so far the court system has held together, but you can see how the law has been turned very often in private practice already as a weapon against your fellow citizens, against the other parties with whom you had a contract, and it's increasingly also turned into a weapon to fight out elections. So law is losing sort of its reputation, its authority as a general universal, maybe fair way of organizing our lives and instead it's being used by those who have best access to the law as a weapon to win and declare victory over others. So I'm going to take another quote from your book because it actually follows, I think, nicely from what I quoted before and what you just said.

You write in the book, "The more market participants rely on credible legal commitments and equate them with predictability of actual returns, the larger but also the more volatile the system becomes. Once defaults mount and they typically begin to mount on the periphery, every market participant will necessarily seek to protect itself, calling in claims against others and rebalancing assets that have lost value. If all do so at the same time, the system will self-destruct. Retreat from there is possible, but only by compromising the very pillars on which the system rests.

It requires the relaxation of the full force of the law by suspending existing commitments or by offering state money, liquidity where none is owed. Relaxing, if not suspending the full force of the law undermines the credibility of legal commitments needed to scale the financial system to size." This is my question to you and I'm going to ask many about this paragraph, also, brilliantly written, which is, first of all, isn't what you're describing what happened in 2008 and how important was 2008 in undermining the credibility of governments and the legal system in Western societies? I think it was critical.

So, first of all, yes, what I say in this book is directly basically what I think I saw in the 2008 crisis, and what I described also in an earlier paper, a Legal Theory of Finance, where I describe what you just mentioned, just read, as the law finance paradox, which basically says we need law to scale financial system to national or global size. For the reasons I explained early, you need enforceability, you need the credibility of enforceability to have an anonymous market to trade these types of assets, but by sort of dressing up these assets in enforceable claim we sometimes forget that there's still this phenomenon of fundamental uncertainty in that you can have a very strong enforceable right, but if the assets are of no value anymore, you have nothing to enforce against and your rights don't matter anymore. Of course, once you have built a system which sort of... Hyman Minsky would have called

in a Ponzi system because it basically relies so much on refinancing, finding others who are willing to come in and put their money into the system that maybe next time it will really deliver what we all hope it will deliver, but it really can't and once people realize that it can't, then it collapses like most Ponzi schemes do, people head for the exit and that's the end of it, and this is where it comes in. Of course, everybody will want to enforce their rights when things become stressful because every private party by definition, has its own binding survivor constraints, as Minsky also called it. So, if this is the essence of a private market economy, that private parties can participate only as long as they can manage their assets and their liabilities, so they have to do what they did, is they have to try to enforce their contracts no matter what it meant for the system and if everybody starts enforcing their contract at the same time, the system will collapse.

It was safe from the collapse only by the massive intervention of the central banks and here I have to admit I'm really divided. On the one hand I thought it was good that they intervened. Certainly at the time I felt it was critical that they intervened because you don't know what would be at the end of the tunnel after a major collapse. In the 1930s we saw what it means to have 25% unemployment and in the U.S. you came

out with the New Deal and then of course, on the World War that helped us rebuild this country, but in Germany where I'm from, we came out with Hitler and fascism. So you don't really want to have a system collapse, but when you help it stabilize, then what happens is what we discussed earlier, you lose the political world to go beyond and reform the system. You stabilize it, by bailing out some.

This is how people observed it, you bail out some entities, typically those at the core because you're trying to protect the system, while you enforce the claims on the periphery, you evict the homeowners, right? They were the last ones to get some benefit from the central bank, and people perceive that. I think it's just perceived to be fundamentally unfair. So the idea that we're all equal before the law and that there's fair play here is undermined and I think that has implications that I just discussed earlier, is how people respond in their political lives, whom they are going to elect, what kind of rights they claim from their representative in Congress or in Parliaments in Europe. So 2008 by your definition would be something along the lines of a finite time singularity and federal intervention is a way of bridging that singularity. This is something for listeners that we discussed with Jeffrey West, the founder of the High Energy Physics Group at Los Alamos, on episode 19, dealing with scaling socioeconomic versus physical systems.

There's another great quote in the book related to this exactly, to this point, and you write that, "The problem is that if any of the players default or retreat, the system will invariably destabilize. At that stage there may not be a big enough backstop to stabilize it and if true, the downward spiral suggested by the law of finance paradox would run its full course, bringing down the global monetary sovereign with it." So, I think this is a major concern for those who have been following this issue for a long time, who have experienced in financial markets, which is that you can only bail out the system so many times, and with each bailout you actually exacerbate the problems that exist in the first place, one of which is the gross inequities of allocation in wealth, but more importantly, the concentration of power in the hands of fewer and fewer private sector actors, who then have the money and the ability to corrupt and control the government for their own personal ends. I wonder where you feel we are today in this cycle? Well, I think we're repeating it and we're going further. When you look at what happened during the whole COVID crisis, I think the central bank, in particular in the U.S., but in other countries as well, what's even faster and spent even more money faster than before, they spent it more widely.

So, I think they also were aware and Congress came in and acted the first CARES Act and of course we know that we're getting a little bit more money out to the periphery of the system this time around as well, but when you look at discrepancy between stock market prices and the relative health of the financial system, relative to the underlying economy, I think there's, in my mind, no doubt that the financial systems are on a kind of artificial life support that takes advantage of the resources that the central banks can provide and the central banks are also most effective in providing these resources to financial intermediaries rather than to ordinary households. And so I think that -- I should just say, it seems that financial health has become synonymous with proximity to the core. Correct.

Proximity to the central bank and to the government. Correct, yeah. Yeah, it totally depends. So, we have basically socialized the financial system.

Which is one of the hallmarks of a corrupt society and a corrupt economy. Correct. I agree with that, yes. Yes, and so I think we have done even more and I think where we are now I think we have to think post COVID and I'm not sure whether the political will is there for it, but it's trying to come out of this crisis and trying to reset the system should be our goal because ultimately, what we also learned in COVID is that you can do differently as well, right? You can also at least spend some of the resources and perhaps more on people on the periphery for their own income, for their education, for infrastructure, for other things.

So what my hope would be is that we will have the courage to say what we're dealing with is a collective resource, it's the money that the central bank manages, it's the future productivity of the society and how do we organize that and who shall benefit from that more than others? I think these are fundamental questions where we need to revamp our system if we want to stabilize it at a fundamental level, both financially and then of course also politically. Well, one of my concerns and I know you share this having read your work is that what's happening in our society with our economy, our financial markets and our political system is a fundamental threat to our system of democratic self-governance, it puts it significantly at risk. I think we're going to come back to this conversation a bit later as well when we discuss data privacy and data monopolies, but I want to shift a little bit actually, and deal with what you describe as the enclosure of digital code because this will get us into a conversation about Blockchain and also again some of these large data monopolies.

You have said in the past, I don't know where it was, but I read it somewhere, that the digital code is not immune from the powers that have come to control the legal code and that, "The first steps for legally encoding the digital code are already underway." I think that there still remains this utopian vision of the digital code and maybe when we talk about the digital code we should define what that is, I think we're describing software, maybe opensource software that's maintained in the private sector or with a collection of government funded entities. How has the evolution of the digital code related to the body of law and what is the relationship between the two? I think this is still evolving. I said what you just quoted, I think in the book, in the Chapter 8, where I ask whether the digital code could be the new code and then ask myself what might change. It seems sometimes that you can reinvent the wheel by just moving from a social coding strategy that we've called law and state to a new one where we have a technical device and could do everything differently.

It looks to me when I read the materials that people in the technological world have produced that they're facing very similar issues that we face also with the legal system. So, in some ways they're just mimicking what we do with the legal code, which is to create... somebody has to define who has access to a particular platform that you have set up. Somebody has to- You cite Nick Szabo a number of times.

Yeah, so all these things are basically fundamental questions of how to allocate property rights and other entitlements that we have in the social system as well, and I think it's a delusion to think that they're not doing it, because that's exactly what they're doing. On top of that we of course, these digital operations are happening in a world that is deeply structured in the law and most people who understand that have realized that and also have sought protection. So, when you go back to mid 1980s in the U.S. there was this computer anti fraud act that was enacted, which basically said that once somebody has amassed enough data and put them on a physical device, on a computer basically, then hacking into this data is theft.

So, they didn't really say this is not property rights, but they treated it as if it was a property right. So some of the tech companies realized early on that while they wanted to be able to have access to data and digitize them and then use them for whatever purposes for free, claiming that the data that we produce are not our property, but are basically wild animals, which they can capture and then declare to be their own, they did want to have protections against theft and they can do this to some extent and I think they've become better at it, they can do this with technology, but they can also use it with law. It's an interesting analogy, the idea that effectively the data that leaks off of our daily activities is in effect the equivalent of nature's bounty, unregulated, that they can capture, but the moment they capture it, they have made it their property. Correct. So property rights work to protect them but not us, essentially. Of course and that's the same that we've seen with the commoners and with the enclosure of knowledge as well.

So, this is always a one sided game when somebody can claim the social protection of law in the state that others can't. So I'm curious to explore a couple things. One, I'm curious to understand how the digital code is being legally enclosed to the benefit of incumbents, so to speak, and to what degree would a system reconstructed along techno utopian lines actually accomplish any of the goals stated by the utopians? I think what has happened in terms of the enclosure is what I mentioned before, like property rights and then folks who were able to raise finance through conventional mechanisms, such as corporations would use these property rights and monetize them by selling access to them to use them for advertisement, et cetera, et cetera. So when you look at the story of, first of all, the internet and then later on, of search engines and other devices, you can see they're increasing capitalization in the sense that I think the founders who might have had great utopian ideas, Shoshana Zuboff describes this for the Google founders in the 1990s, once they realized that their funders might go away unless they adopted advertising models they switched.

So, you can see the conversion point where they basically placed their more utopian visions under below the needs for funding and then off we go, we see the same mechanisms helped them happening elsewhere. So I think what you can see when you look at the legal organization of everything that is digital, they're all using the same mechanism, the corporations, the trusts, they have contracts, they have property rights. They can do more and more, I think, technologically and I think that raises interesting questions also about democratic self-governance when all of a sudden the laws, as problematic as they are, but they're still the tools by which we self-govern ourselves as societies, when some of these things can substituted by relatively singular autocratically governed interventions that are done entirely on the digital space. So in the book, which I completed the book two years ago, in the fall of 2018, my sense was still that the legal code would probably enclose the digital code, that the strongest alliances would be between tech companies who have that know-how, who can raise the funds from legacy institutions, like financial intermediaries and ultimately get the backing of the state because the states can still control access to their territory. To some extent I think this is still true, when you think about how the Libra has been fought back and- That was going to be my next question actually.

If Libra is a perfect example of this, of this attempt in other words? Yeah, when Libra was announced in the summer of 2019, my book had just come out and I had of course this entire framework in my mind and I looked at this and I just thought, "Oh my God, I might have been wrong in the book," that the law will encode, because here's an example where somebody of course uses legal devices, they go and create a foundation in Switzerland and they know why they're there and they also know what tools they use, such as a foundation to create it, but then they create a new currency, a new digital currency that is basically piggybacking on safe currencies that states like the United States or England or the euros with Swiss frank have issued to create something new, which potentially might even be independent of these state currencies. So that really caused me to rethink whether the legal code will forever enclose and thereby also rein back of the digital code. I'm no longer so sure about this, but so far I think that's what we've seen. Well, I want to ask you about this idea.

Again, we're sort of flirting with two different questions here. One is, will incumbents manage to use the legal code to envelope the digital code or will an entirely new form of decentralized governance arise out of the digital code? My question right now actually deals with the latter, and I actually mentioned this to listeners in last week's episode, which was a replay of my appearance on the bankless podcast, where the hosts asked me about me about my views on whether or not Blockchain or distributed ledger technology would be able to replace the legal system or make the nation state obsolete on the presumption that these technologies would supplant the need for much of what the nation state already provides, especially in a world where so many people work remotely, are contracted out internationally, et cetera, et cetera. I wonder what your views are on this? How realistic is such an idea? Would it be possible, in other words to have not only monetary sovereignty without territorial sovereignty, but also to have a complete system of rules and regulations governed by smart contracts rather than our current legal system? I'll start from the premise that the territorial based nation state is relatively young.

We trace it back to 1648 to the treaties after the 30 years war in Europe, so territorial based governance has had its important time. We also have created empires that were knit together mostly through territory, but also very much through people whom you would send there to basically be on this outpost in govern them for you. Then we have something like, let's say, the Catholic church or religions more generally that are not territorially bound and still bind people to their norms and have enormous power over their behavior and some even deeply institutionalized like the Catholic church with the Vatican they used to be territorial based and then they retreated to this little place in Rome and I think Islam or Judah, they don't even have those territorial based thing. So, I could imagine that we could create societies that are not necessarily territorial bound, but they're bound by ideas, they're bound by certain common platforms- Without the ability to employ force you would able to generate this? Well, I think there are limitations, of course, to that. The question is what kind of coalitions do you create. You can hire your thugs in theory, so when we say you use force and we use enforceability, what are the other institutional variance with which we could create them.

So we know that there have always been mercenary armies and they're employed more and more. Even the U.S. has used them extensively in the Iraq and Afghanistan Wars, a force probably not for the better but it's not this is unheard of that you couldn't outsource this and then hire them back for particularly purposes that you want to achieve.

Well, then you know you've replicated what we were talking about initially, which is you may be running all of this on servers, but you're creating a kind of territorial sovereignty in this event. Yes. By the way, this raises a further question about residual rights and how ownership would even be validated before you even begin transacting on a public ledger and relying entirely on self-executing deterministic software to manage ownership, including when there are disputes about ownership that arise from theft or some other event in the material world that separates me from what we would normally consider to be my lawful property. For instance, if you stole my passphrase and took control of my account and transferred funds, how would I be able to prove that I'm the rightful owner of those funds, since the only thing that ties me to them is an account whose passphrase I no longer control? I certainly think we need processes for verification.

My understanding is that the Blockchain technology is actually pretty good at figuring out who had the right to transact over certain things and I think you could also find out who the hackers were and then you have to find enforcement mechanisms. Now to be clear, I do realize that we humans are on this planet earth and we're bound to physical operations and I think also that the digital world, of course, has a very strong, big physical footprint, they need energy, they need to have data plans somewhere, but they could also hire them and they do, right? It's not that Google has everything only United States. How would you prosecute someone, for example? Help me understand how that would work.

Let's say if I steal someone's property in the physical world how would that person be prosecuted without the use of the law? How would you hold that individual accountable in order to reclaim your property? Yeah, we're still working with physical incarceration, but you could also exclude them. When you think about the Chinese social credit system and you say you don't get any access to healthcare, transport, whatever. We have your face we can digitize you, wherever you appear, you're just being excluded like they did in the Middle Ages, right? You're out there, an outlaw, and everybody can go after you. So how would someone determine that? In other words, if I steal someone's property in the physical world, how would the digital code understand that it's been taken? I could take it and destroy it. How would someone know that I've done that, you know what I mean? Does that make sense? Yeah, I see. I think we would have to update it.

I think the people who are thinking about this, you said you can access the house only if you use a digital code, if you break that digital code, is this verifiable at the time that you enter. So, I think there are complex questions to be resolved, and I'm not saying that you can resolve all of them, but I would also say that our system today we don't prosecute everything. We let people get away with embezzlement because we can't prove. We can't prove and we don't have the resource to go after them.

So I think it's a question of relative likelihood of certain things to be able to contain through the digital abilities that we might be developing, but we're certainly not there yet. I'm not sure I would want that world either, but I think when I look at what is happening in China I can see that there could be a total control of what we're doing in a way that we have not experienced yet. It doesn't exclude, I think, the direct physical harm that we can to each other, the question is whether this would also then be recorded somewhere because you have a reporting system and then it becomes part of the social crisis and who knows? I imagine China represents the ultimate envelopment of the digital code by the legal code, by the incumbent, so to speak? Correct, yes. I want to spend more time explore this in the overtime, professor. I also want to conduct a thought experiment and compare the Lehman bankruptcy and how the law was used to unwind that firm and manage the liquidity that we saw in markets in 2008 with the Dow hack and subsequent fork on a theory, which is something we also discussed in a previous episode with Camila Russo, I think that was 145.

Also, again, when we discuss the capacity or the capability of the digital code to supplant the legal code, I'm reminded of an episode that I did with Ray Monk on philosophical mathematics and the incompleteness of formal systems because I'm not sure it would even be possible to construct a system free of internal contradictions that could be dependent on to work without relying on human intervention. I'm also curious to get your thoughts on what you think the future will look like. I've heard you describe it as becoming more volatile and I think that's right and I think your views on this align pretty strongly with my own actually.

For anyone who is new to program Hidden Forces is listener supported. We don't accept advertisers or commercial sponsors. The entire show is funded from top to bottom by listeners like you. If you want access to the second part of my conversation with Professor Pistor, as well as the transcripts and rundowns to this episode and every other episode we've ever done, head over to There's also a link in the summary page to this episode with instructions on how connect the overtime feed to your phone, so that you can listen to these extra discussions just like you listen to the regular podcast. Katharina, stick around, we're going to move the second part of our conversation into the subscriber overtime.

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2021-01-08 00:02

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