Virtual Economy Research Network

The Ludvig von Mises institute, an advocate for the Austrian line of economic thought, recently published an article in which Matthew Beller analyzes the Second Life (SL) economy. I’m happy to see such work done on virtual economies, and published on a forum that I suppose also some mainstream economists read.

There are also some other analyses of the SL economy available. Randolph Harrison has previously written an article that’s somewhat related to the Beller’s article, both of them dealing with Linden Lab’s tendency to intervene in the “foreign exchange” markets of Linden Dollars, the internal currency of SL.

Beller analyzes the supply of L$, and notes that there’s a considerable amount of L$ created by Linden Lab without economic production or flow of real wealth into the SL economy. The author calls this the L$ budget deficit. Such budget deficit occurs when the weekly L$ stipends, handed out by Linden Lab to the premium members (or residents) of SL, exceed Linden Lab’s revenues. On the aggregate, 33 % of the current L$ supply has been created by running such budget deficits in the last year and a half.

Beller argues that this shows that Linden Lab has been inflating the L$ supply, and gives two possible future scenarios, both of which will lead into a slump of some sort:

1. Linden Lab will stop running significant deficits, which results in less L$ available to spend, which in turn results in slowing economic activity.
2. Linden Lab will continue running budget deficits until the residents will recognize the L$ frailty and there will be a “crack-up boom”, in this case a run away from L$ and for the US$. In this scenario, if Linden Lab wishes to maintain their peg on L$/US$, they would basically have to have considerable US$ reserves to be able to stop L$ from depreciating.

There’s a parallel here to Randolph Harrison’s blog posts about half a year ago. In the post, Harrison condemned Linden Lab’s exchange rate interventions. Though the main arguments in his post have to do with other issues, he also notes that Linden Lab have been constantly selling L$, maintaining their peg on the currency – where maintaining the peg has also meant collecting seigniorage.

According to his analysis, Linden Lab will have to start buying back L$ in the future. Using the time series of L$ purchased per user, which has had a declining trend, the author concludes that in order to maintain Linden Lab as a net seller of L$, the growth of the user base of has to reach rates that are, basically, impossible to reach.

There are two scenarios here, both dealing with the interventionist policies in SL, and both leading to similar consequences. As I see it, the first of the scenarios is laid on the idea that a L$ backed up by a US$ transaction will not in any way dilute the value of all L$ in circulation, whereas the L$ created without a US$ transaction will. To follow author’s logic, a reader should make the assumption that the continuing process of injecting non-US$-backed L$ in the economy will, at some point, inevitably lead into the users wanting to get rid of their L$ holdings.

In the second scenario, I figure the assumptions (or observations) behind the conclusions are the following:

• The producers of virtual items, and providers of services, desire, on the aggregate, cash their revenues out of SL – that is, they produce to make real-world profits
• The amount of spending in SL is decreasing compared to the desire to cash out
• The number of new users, assumed to spend on the aggregate, will have to grow unrealistically fast in order to maintain the demand of L$ above the supply

I think there’s good material in both of the analyses: they’re among the few transparent and analytical approaches to virtual economies I’ve seen so far. Both are quite pessimistic regarding the outcomes of currency intervention carried out by Linden Lab. If L$ starts to depreciate, according to one of the scenarios presented here or otherwise, I believe that Linden Lab will not start buying back L$ on a large scale – so an escalation to a major depreciation may actually take place quite easily.