Deficits, money supply and the Second Life business cycle
By Adam Reuters
A fascinating essay raises some serious questions about Linden Lab’s management of the Second Life economy. The bottom line: “It appears very likely that Second Life will experience at least some form of economic recession.”
Matthew Beller, a former employee of the Federal Reserve who currently works for the Securities and Exchange Commission in Los Angeles, notes that since the middle of 2006, when Second Life’s population really began to take off, Linden has been running a persistent and growing budget deficit within the virtual world’s economy.
“These deficits occur when the weekly L$ stipends Linden pays to premium residents exceed its revenues from land rentals and other administrative services it provides to residents,” he writes. “In order to fund the deficits, Linden creates new L$ and injects them into Second Life.”
In the real world, central banks make up for such deficits by issuing debt securities such as U.S. Treasury bills. In Second Life, Linden Lab simply creates new Linden dollars out of nothing.
“Linden’s monthly budget deficit might appear insignificant in the graph, but in fact Linden has been increasing the money supply by an average of 6% per month this way,” Beller writes. “Annualized, it is more than doubling it each year. During the past year and a half, Linden created L$876 million (US$3.2 million) through its deficits, which makes up over 33% of today’s L$ supply.”
Combine that expansionist monetary policy with Linden’s policy to keep the exchange rate at about L$270 to US$1 , and Beller sees trouble.
Drawing from the theories of economist Ludwig von Mises and the Austrian School, he predicts two possible outcomes, neither of them good — either the eventual end of Linden Lab deficits, resulting in an economic slowdown due to fewer L$ in circulation, or something more catastrophic.
The other possibility is that Linden will continue running deficits to the point that a sufficient number of residents and speculators will recognize the L$’s frailty. In what Ludwig von Mises referred to as a “crack-up boom,” everyone will scramble to redeem his L$ for “real goods,” which, in the case of Second Life, is probably the US$.
As more and more people sell their L$ on the LindeX, Linden might choose to maintain its L$270=US$1 peg for some amount of time, but operating under the assumption that it has not maintained 100% US$ reserves, it will eventually run out of US$ or decide to stop selling them, and the L$ will depreciate rapidly. In either outcome, residents will discover that they possess less wealth than they perceived they had during the time leading up to the crash.
Beller recommends that Linden Lab apply the free-market lessons of the Austrian School: “Abolish restrictions on content, strengthen the ability of residents to enforce their property rights, and, most important, tie the L$ to a real-world commodity money backed by 100% reserves.”
