Monetary and Fiscal Interaction in the Terra Economy at SFBW

Hey. I am Nicolas and I am the newest member of the Terra research team.

I gave a talk on the Macro.WTF event during SFBW, analysing the theories of the price level and explaining how we utilize fiscal and monetary policy to achieve price stability in the Terra economy.

If you are a fellow economics nerd, feel free to have a look at the slides!
pres.pdf (1.5 MB)

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I think it’s great you acknowledge the limits of the quantity theory of money here. The original terra whitepaper based a lot on that theory and I never quite understood how it could calculate seigniorage for the Terra economy (eg calculation of GDP in the equation is based on final goods, how do you calculate what a “final good” is in the terra economy?).

I also appreciate the point that “seigniorage should determine
discounts, and not the other way around!” A seemingly obvious statement but crucial to remember.

Logically I still don’t understand how seigniorage can be calculated accurately for a coin that is pegged to an exogenous economy’s currency, but that’s for another discussion :wink:

Question for you Nicolas: on slide 15, tx fees move up to 1% during the theoretical recession. What is your assumption here for switching costs away from Terra, and how is that calculated in the model? Surely increased fees will have an effect on usage.

Thanks and great work!! :slight_smile:

Hey. Thanks for your feedback. You are raising some excellent points.

In our context this is how I see the connection between the quantity theory of money and seignorage. Think of GDP*Price as the total transaction volume in the terra network, then seignorage is being determined by the interplay of transaction growth and velocity. The lower the velocity (which is to say that people hold Terra for longer periods of time) or the higher the growth of transaction volume, the higher our ability to issue more money, while keeping the peg stable.

The fact that the coin is pegged means that there is an additional constraint to seignorage. Which is to say that the monetary policy by targeting a stable exchange rate implicitly takes into account changes in both Terra as well as the external fiat economy.

Regarding the fees, you raise a great point, which I didn’t have time to clarify during my talk. The vast majority of the tax burden is currently being carried by our e-commerce partners. They usually operate under 2.5-3% transaction fees, so any fee increase up to that point is already priced in their model and therefore has little to no behavioural implications. So the tax hike represents a net transfer from the supply side of the economy (e-commerce platforms) to luna holders. The only limiting factor is that we can never charge more than the competition, which puts a natural bound on the extent that fiscal policy can be used to stimulate the economy. Finally, as terra gets more widely adopted and more people use it outside of e-commerce, then tax increases will have more of a behavioural impact, so the trade-offs should be carefully reevaluated.

My understanding is that in Korea a lot of payment options actually offer around 1.3%; we should double check this. Regardless, bank transfer options is much less of course, which is the same operation that Chai uses for its users under the current implementation.

I think this is where I don’t agree with the model in your presentation–if it has no behavioral impact, there is no governance model where fees are not already at that rate at all times, as it provides better returns to stakeholders.

Important point, and fully agreed! :+1:

My understanding is that in Korea a lot of payment options actually offer around 1.3%; we should double check this. Regardless, bank transfer options is much less of course, which is the same operation that Chai uses for its users under the current implementation.

I believe the average transaction fee for e-commerce platform is in the range I mentioned. In any case that’s something the BD team closely monitors. For the purposes of the argument, the assumption is that we have significant space to move tx fees, while still being competitive.

I think this is where I don’t agree with the model in your presentation–if it has no behavioral impact, there is no governance model where fees are not already at that rate at all times, as it provides better returns to stakeholders.

That would be correct assuming a recession can never happen. Having tx fees away from the upper bound during an expansion, gives us fiscal space to absorb shocks during a recession. It follows a similar logic for why central banks should not have interest rates permanently stuck at zero (since they need to have some room for cuts for in case a recession hits). At least that’s how I view it.

  1. Why would moving the rate up to 1% during a recession absorb shocks better than keeping the rate at 1% before and during the recession, given the change has no effect on usage?
  2. The fed acknowledges that changes in interest rates have an effect on consumer behavior, while this Terra model does not.
  3. Even if it were somehow to give additional “fiscal space to absorb shocks,” how would you incentivize stakeholders to vote for tx fees away from the upper bound, and how would they know what rate should they choose?

Increasing rates in recessions/decreasing in expansions stabilizes Luna cash flow, hence demand at the current price.

Per earlier point, the tx fee lever influences Luna demand (not Terra). Since Luna is the effective collateral, changing fees improves the ability of the system to keep Terra stable.

The protocol has actually solved that problem for them : )
Read the WP under section “long term stable rewards”, or the policy section of the treasury module under core.

Right but the increase in demand for luna when the protocol raises the tx rate to 1% would still have come in at that same price level if the tx rate was at 1% prior to the recession, too…You see what I’m saying? Why would an increase in tax rate from .1 to 1% provide a higher price support than if the protocol was already at 1%, given there is no effect on Terra usage? It would just mean the price of Luna was meaninglessly lower to start with, but the support would come in at the same price level…

I don’t see inherent value in providing stable mining rewards. The protocol should always charge the highest competitive rate if it doesn’t affect usage. If you’re not you’re just missing out on returns for stakeholders, and I think stakeholders are always incentivized to set the rate at the one that gives them the highest returns, not a rate that give them stable returns.

This assumes path independence in price, which is untrue in practice for most assets, especially in low-liquidity environments. If transaction volume drops 50% over a month and fees are maxed out, you would expect a price shock which would be largely absorbed if you could double fees to maintain stable cash flow. The price drop would be precipitated by the fact that Luna volatility is reflexive during contractions – a price drop implies larger Luna dilution to buy back the same amount of Terra, causing further price decline and so on. In that sense, Luna’s price is expected to be highly path-dependent.

Luna’s primary (arguably only) function is to serve as robust collateral for Terra. It is not to deliver returns to stakeholders. Returns are a likely byproduct of its design – after all as Terra’s market cap increases Luna needs to be more valuable to be robust collateral. But returns are not the objective.

Therefore the argument reduces to the claim that Luna is more robust collateral if its cash flow is more stable. The logic behind this is as follows:

  1. Luna price volatility is reflexive during contractions, which is when it is put to test as collateral.
  2. Therefore reducing price volatility increases robustness.
  3. Reducing cash flow volatility reduces price volatility.
  4. Cash flow stability makes Luna easier to value (the protocol targets a specific cash flow growth rate and calibrates fees to achieve it). Straightforward valuation reduces price volatility.
  5. Therefore, more stable cash flow makes Luna more robust collateral.

This is an interesting point. Perhaps long-term stakeholders should have limited ability to set fees? Until cash flows stabilize and a solid track record is established I think governance around fees is justified.

That’s a very clear explanation and a strong argument for keeping the fundamentals stable. Thanks for writing it out Nick.

My response:

  1. Allocation of excess tx value is passively going to supposedly indifferent merchants; tx fees ultimately affect usage

I’m trying to tease out the fact that under a .1% tx rate, there is .9% of available tx fee value that is passively going to merchants who are supposedly indifferent to this value; however, there are other members of the economy who are not indifferent to this value. It doesn’t have to be distributed to stakeholders in the form of rewards, so you can keep Luna cash flow stable still, but I’m sure if the .9% was given to someone else, say consumers buying on the e-commerce platform, or a payment gateway using Terra (Chai), their behavior would change.

This proves that even if merchants are indifferent to the .9%, the economy as a whole is not indifferent, and thus fluctuations in tx fees do, in fact, have an impact on use and behavior. This is the ultimate point I’m trying to make, and if this is the mechanism holding it all together, Luna and Terra are quite vulnerable to the downward spiral you mention, especially when Terra’s adoption expands beyond e-commerce partners—a 1% tx fee isn’t exactly competitive for the future of digital cash.

  1. Misaligned voter incentives and unnecessary voting

Furthermore, as we discussed in our previous posts, if the system already calibrates fees to the optimal level, why do you need voting? It only creates systemic downside risk.

  1. Vulnerabilities even within current scheme

Even for the current phase where adoption is dominated by e-commerce, there are significant vulnerabilities. For example, some competitor might see that they could make terra collapse by undercutting the Terra tx fee during a Terra recession and steal market share. Terra and Luna become vulnerable to a downward spiral as the system is not able to offer stable rewards. The cherry on top is if that same competitor is simultaneously shorting Luna, making this attack even more profitable.

  1. Luna trades on more than fundamentals, and its value is not easy to determine

Luna’s discounted cash flow in a vacuum may be fairly straightforward to value, but Luna has and will continue to trade on more than fundamentals. There is always unseen upside and downside that fluctuates temporally. What if a competitor undercuts Luna like in the above example? What if Do or Dan suddenly quits? What if the Korean government outlaws Terra or defines Luna as a security? How do people price in the fact that Luna can have additional value as a programmable asset that anyone can write their own smart contracts on? What if Luna takes on Bitcoin’s title of a speculative “store of value” asset that can’t be seized by a central authority? No one knows the answer to these questions, but investors can and will speculate .

Then, my question is what does it mean for the system if Luna’s valuation is not as straightforward as you think?