Private Money in Virtual Worlds

Will wildcat currencies shrink the state?

Wildcat Currency: How the Virtual Money Revolution Is Transforming the Economy, by Edward Castronova, Yale University Press, 288 pages, $30

Edward Castronova initially started researching the economics of cybernetic worlds as a joke, whimsically gathering stats on buying and selling in the roleplaying video game EverQuest starting in 2001. "Then," he says, "I saw how much money there is."

For those who know where to look, virtual worlds contain many riches indeed, from in-game currencies to Amazon coins to frequent flyer rewards. Castronova, a professor of media at Indiana University, has distilled his years of observing human economic behavior in online environments into a new book, Wildcat Currency. Evoking the so-called "wildcat banking" period in the mid-19th century, when American banks were only regulated by state governments, the book's title refers to the burgeoning system of digital currencies proliferating in virtual worlds. Equal parts ethnography, prophecy, and pre-emptive funeral oration for ubiquitous state control of financial activity, Wildcat Currency outlines the unprecedented opportunities the author believes virtual currencies will afford to private individuals—and the problems this poses for the established world order.

Could the mighty Federal Reserve one day be vanquished by the humble Linden Dollar? Linden Lab's official gig is developing the platform for Second Life, an online world intentionally designed without manufactured conflicts or set objectives. But for about a decade, the designers of this virtual world have stealthily moonlighted as a sort of central bank for its own ad hoc digital currency.

It all started with a simple in-game currency pegged to the U.S. dollar. As the Second Life economy diversified and more Linden Dollars changed avatars' hands, a more complex monetary policy was needed. So the developers created the LindeX, a currency exchange where users could trade Linden Dollars for real-world currencies. Linden Lab monitors the economic statistics revealed by the LindeX to tweak the growth rate of the money supply as needed. Monetary missteps have been made along the way: In 2007, major theft on the Second Life World Stock Exchange and a sudden ban on in-game gambling caused a banking crisis and recession, problems that could have been alleviated by a more accommodating Linden Dollar supply. Live and learn.

The Second Life economy's capitalization of over $600 million is nothing to sneer at. Still, it's hard to imagine that the Linden Dollar haunts Fed Chair Janet Yellen's dreams. Online communities and their currencies—well-managed though they may be—aren't "real," most thinking goes. As long as malevolent money laundering and fraudulent counterfeiting are kept at bay, authorities care little of the goings on with such "imaginary" economies.

But the value that these currencies represent is quite real to their users. It's rare to find a multiplayer platform lacking a spontaneous exchange economy facilitated by at least one commonly valued medium of exchange. Castronova traces this history back to Gods (1985), the first online game that allowed players to buy and sell goods. Then 1987's Gemstone III developed an economy that allowed players to make real-world money by arbitraging the in-game currency. A healthy out-world economy developed, much to the developers' surprise. (Castronova tracked down one player who claimed to operate as a spontaneous in-game central banker. Gold miners would sell him their wares, which he would "mint" and sell to other players as money.)

By 1998, having observed the unplanned monetary systems in previous games, the developers of Lineage explicitly designed their game world to encourage players to trade real-world currency for game currency at will (thereby maximizing the game developers' profit opportunities). Today, a cornucopia of these wildcat currencies proliferate in online platforms, blurring the distinction between the virtual and the real.

Castronova explores a colorful range of digital transfer phenomena. Could a frequent flyer mile–backed currency take off? The Economist calculated that the global stock of 14 trillion frequent flyer miles was worth more than $700 billion in 2005, exceeding the value of all U.S. dollars in circulation at the time; services such as points.com allow users to trade miles and points with each other for other rewards or for real money. A 2010 ruling by the Canadian Revenue Agency set a precedent that such a currency would at least be legal in the True North.

What if network giants like Facebook and Amazon allowed their payment token systems to be exchanged for real money? Legacy financial institutions (and the bankers' college classmates who regulate them) are unlikely to be pleased to see tech-darlings-cum-financial-service-conglomerates appearing out of the blue. In fact, Castronova suspects that some sneaky traders already use Magic: The Gathering card sales markets to avoid domestic sales taxes.

Curiously, the author dedicates only a few pages to the most dramatic and powerful recent development in stateless virtual exchange: Bitcoin. Like many others, Castronova erroneously discounts Bitcoin's viability because it does not map comfortably onto any pre-existing monetary institution. At one point, he deems Bitcoin to be "bad" money on par with state fiat currency because it has "no commodity value at all." But elsewhere in the book, he writes that Bitcoin's inevitable deflation will "encourage people to store their Bitcoins instead of spending them." Castronova does not go so far as to declare Bitcoin a senseless speculative bubble, but that is one obvious way to square this seeming inconsistency.

Economist George Selgin's characterization of Bitcoin as a "synthetic commodity" currency that combines the absolute scarcity of commodity currencies with the pure monetary functions of fiat currencies is closer to the mark-but still not quite right. The revolutionary blockchain technology introduced by Bitcoin allows an exciting array of non-monetary applications, including trustless legal arbitration, verifiable digital identity systems, and even "smart property" titles that automatically transfer ownership and access upon receipt of payment.

The nascent "sidechains" development proposal led by cryptocurrency pioneer Adam Back holds even more potential for Bitcoin innovation. If implemented, sidechain technology will expand the ease with which computer programmers can experiment and add value to the core blockchain, thereby creating another channel to address the monetary weaknesses alleged by Bitcoin skeptics. The more we learn about Bitcoin as a technology, the harder it is to dismiss it as a currency.

Put together, Castronova's descriptions of these monetary experiments and spontaneous orders suggest something radical: Virtual transfer systems expand our alternatives to the regulation and control wrought by government monopolization of money.

Non-state currencies are not new in themselves. Human economies, after all, are much older than the nation-state. Beads that may have been used as a sort of money were being made on the tectonic hotbeds of the Kenya Rift Valley by 40,000 B.C., long before the concept of a sovereign emerged. Crude oxen- and cowrie-based monies gradually gave way to more sophisticated metallic currencies.

State currencies, emblazoned with the Caesars of the era, commonly floated alongside private minted currencies, goldsmith notes, trade bills of exchange backed by wares such as fine cloths or the next season's wheat harvest, and private bank notes. With the right blend of legal and cultural institutions, free currency and banking systems flourished in countries such as Scotland and Sweden. (Castronova appears unaware of those countries' experiences, repeating the stubborn myth that financial panics are inherently more prevalent with competitive notes than in centrally managed systems.)

Yet today, the concept of money created outside the state strikes many as too absurd for serious consideration. It has been so long since governments took over currency creation that few realize there was ever a viable, let alone thriving, alternative. Most modern economists blithely accept the need for monopoly fiat currencies controlled by central banks, collected as taxes, and monitored for illegal activities by regulators and commercial banks.

But digital transfer systems now allow individuals to bypass the Great Government Eye of regulation and control in subtle and unexpected ways. Wildcat currencies' virtual game properties provide a dual shelter of legal greyness and plausible deniability: Offshore accounts in the Cayman Islands wave red flags to watchful IRS agents in a way that concealing InterStellarKredits in an EVE Online account does not. Wildcat currencies are fast, federated, and fungible. Governments can no longer rely on slow-moving paper trails and centralized bottlenecks that can be used to thwart corporate conspiracies. Illegal purchases and activities that state monitoring once made all but impossible are now in the grasp of anyone with a computer and enough determination.

The ease and obscurity of alternative currencies create more opportunities for subversion than have ever existed before. Castronova is refreshingly blunt: "Wildcat currencies may set off a general dynamic of state decline."

Stateless digital currency transfers present a double-edged quandary for governments. First, government power is threatened when government revenues are threatened. Scouring the illegible financial records of patchwork digital worlds in search of evidence of tax evasion may prove prohibitively costly for the officials seeking to stem these leaks. Trimmer budgets mean scantier state services, which in turn produce greater dissatisfaction among the dwindling tax base.

Second, a large increase in black market activity will further undermine trust and respect for the government. A country that cannot enforce its own laws barely has claim to legitimacy. Loyalty will dwindle as a critical mass starts to shrug.

Castronova sees this revolution primarily as technological, not ideological. The greater the burden the government imposes on an individual, firm, or industry, the larger the incentive to find an alternative. The tools to escape government control already exist and are constantly being refined. As cryptographic shields improve and digital transfers become more common, National Security Agency researchers will find it harder to simply exploit built-in back doors or develop their own dark materials of subjugation. In the short run, at least, technologies of resistance are outpacing technologies of control.

"Whether or not this is a good thing depends on your politics," Castronova writes. The book's final chapter, "Wildcat Currency and the State," presents an optimistic—and incongruent—spin for his more bureaucratically inclined readers. Just pages after discussing the ways wildcat currencies will undermine the state's ability to control crime, warfare, financial systems, purchasing power, taxation, and black markets, Castronova proposes that the authorities harvest the power of such currencies for themselves by experimenting with policies in virtual worlds.

The prospect of gleaning behavioral insights by manipulating and observing controlled virtual environments is exciting from a social science perspective. Still, this academic experimentation will likely provide cold comfort for political power brokers who find themselves leaking the legitimacy and tax revenues they need to govern as people switch to digital currencies.

Castronova's parting words, delivered in an epilogue titled "Dear Politicians: Please Don't Screw This Up," provide a hint of his underlying sympathies. Here Castronova lays out a broad legal principle that he believes will allow the benefits of wildcat currencies to coexist with the political need to oversee them: "When regulating or writing law for a virtual world, the goal of the virtual environment matters. Some virtual worlds are built for playing. Others are built for serious purposes. The law should treat them with equal respect, but differently." But the threads that elegantly weave through the book's preceding chapters—that the distinction between the real and the virtual are insubstantial, that human beings naturally seek ways to evade state control, and that the illegibility of digital communities and norms obviates traditional methods of state measurement-wholly undermine this advice.

For bureaucrats and those who love them, there may be no reassuring answer to the question of how the state can credibly manage the threat of stateless digital exchanges. The virtual money revolution will not just transform the economy; it will undermine the government's control of it.