Lecture 4: Smart Contracts as a Solution to a Coordination Problem

Smart contracts act as a mechanism to coordinate decentralized markets where privately issued debt functions as a medium of exchange. Without such coordination, these markets are prone to financial crises, as participants cannot effectively manage intertemporal obligations and risk across fragmented locations.

• Policy objective — Implementation of optimal resource allocation using privately issued securities while mitigating risks in fragmented, decentralized systems [00:41].

• Consumption benchmark — Economic theory suggests that households should behave as if they are in a mutual insurance society, where individual consumption tracks aggregate income rather than individual income shocks [08:45].

• Smoothing limitations — Empirical data from agricultural households reveals that while risk-sharing occurs, it is incomplete, leaving participants exposed to volatile events [14:24].

• Coordination failure — Markets using private debt as a medium of exchange face potential crises if participants in different locations fail to align, leading to sudden price drops when debt cannot be redeemed [1:00:56].

• Smart contract architecture — Ethereum functions as a generalized state machine that includes code and data storage, allowing for programmed contract execution, unlike Bitcoin, which primarily limits itself to transaction validation [1:10:15].

• How does Ethereum differ from Bitcoin regarding state machine functionality?

• In what way does the lack of coordination contribute to financial crises in an economy relying on private debt?