The line has been repeated so many times that it is now a de facto part of working culture. Get a salaried position, max out your 401-K contribution (maybe your employer matches 3%!), select a few mutual funds with catchy marketing names and watch your money grow. Most folks navigate this path every two weeks on auto-pilot, never questioning the wisdom nor being conscious of the risks. It is just what “smart people” do. Many now associate the activity with savings but in reality, financialization has turned retirement savers into perpetual risk-takers and the consequence is that financial investing has become a second full-time job for many, if not most.
Financialization has been so errantly normalized that the lines between saving (not taking risk) and investing (taking risk) have become blurred to the extent that most people think of the two activities as being one in the same. Believing that financial engineering is a necessary path to a happy retirement might lack common sense, but it is the conventional wisdom.
Over the course of the past several decades, economies everywhere, but particularly those in the developed world (and specifically the United States), have become increasingly financialized. Increased financialization has become the necessary companion to the idea that you must make your money grow. But the idea itself — that ‘you must make your money grow’ — only really emerged in the mainstream consciousness as everyone similarly became conditioned to the unfortunate reality that money loses its value over time.
Money Loses Value → Need to Make Money Grow → Need Financial Products to Make Money Grow → Repeat.
The extent to which the need even exists is largely a function of money losing its value over time; that is the starting point, and the most unfortunate part is that central banks intentionally engineer this outcome. Most global central banks target the devaluation of their local currencies by approximately 2% per year and do so by increasing the money supply. How or why is less relevant; it is a reality and there are consequences. Rather than simply being able to save for a rainy day, future retirement funds are invested and put at constant risk, often just as a means to keep up with the very inflation manufactured by central banks.
The demand function is perversely driven by central banks devaluing money to induce such investments. An over financialized economy is the logical conclusion of monetary inflation, and it has induced perpetual risk taking while disincentivizing savings. A system which disincentivizes saving and forces people into a position of risk taking creates instability, and it is neither productive nor sustainable. It should be obvious to even the untrained eye, but the overarching force driving the trend toward financialization and financial engineering more broadly is the broken incentive structure of the monetary medium which underpins all economic activity.
At a fundamental level, there is nothing inherently wrong with joint-stock companies, bond offerings, or any pooled investment vehicle for that matter. While individual investment vehicles may be structurally flawed, there can be (and often is) value created through pooled investment vehicles and capital allocation functions. Pooled risk isn’t the issue, nor is the existence of financial assets. Instead, the fundamental problem is the degree to which the economy has become financialized, and that it is increasingly an unintended consequence of otherwise rational responses to a broken and manipulated monetary structure.
What happens when hundreds of millions of market participants come to understand that their money is artificially, yet intentionally, engineered to lose 2% of its value every year? It is either accept the inevitable decay or try to keep up with inflation by taking incremental risk. And what does that mean? Money must be invested, meaning it must be put at risk of loss. Because monetary debasement never abates, this cycle persists. Essentially, people take risk through their “day” jobs and then are trained to put any money they do manage to save at risk, just to keep up with inflation, if nothing more. It is the definition of a hamster wheel. Run hard just to stay in the same place. It may be insane but it is the present reality. And it is not without consequence.
While the relationship between savings and risk is often misunderstood, risk must be taken in order for any individual to accumulate savings in the first place. Risk comes in the form of investing time and energy in some pursuit that others value (and must continue to value) in order to be paid (and continue to be paid). It starts with education, training and ultimately perfecting a craft over time that others value.
That is risk taking. Investing time and energy in an attempt to earn a living and to produce value for others, while also implicitly accepting high degrees of future uncertainty. If successful, it ends with a classroom of students, a product on a shelf, a world-class performance, a full day of hard manual labor or anything else that others value. The risk is taken on the front end with the hope and expectation that someone else will compensate you for your time spent and value delivered.
Compensation typically comes in the form of money because money, as an economic good, allows individuals to convert their own value into a wide range of value created by others. In a world in which money is not manipulated, monetary savings would best be described as the difference between the value one has produced for others and the value one has consumed from others. Savings is simply consumption or investment deferred into the future; or said another way, it represents the excess of what one has produced but not yet consumed. That however is not the world that exists today. With modern money, there is a fly in the ointment.
Central banks create more and more money which causes savings to be perpetually devalued. The entire incentive structure of money is manipulated, including the integrity of the scorecard that tracks who has created and consumed what value. Value created today is ensured to purchase less in the future as central banks allocate more units of the currency arbitrarily. Money is intended to store value, not lose value and with monetary economics engineered by central banks, everyone is unwittingly forced into the position of taking risk as a means to replace savings as it is debased. The unending devaluation of monetary savings forces unwanted and unwarranted risk taking on to those that make up the economy. Rather than simply benefiting from risks already taken, everyone is forced to take incremental risk.
Forcing risk taking on practically all individuals within an economic system is not natural nor is it fundamental to the functioning of an economy. It is the opposite and it is detrimental to the stability of the system as a whole. As an economic function, risk taking itself is productive, necessary, and inevitable. The unhealthy part is specifically when individuals are forced into taking risk as a byproduct of central banks manufacturing money to lose value, whether those taking risk are conscious of the cause and effect or not. Risk taking is productive when it is intentional, voluntary and undertaken in the pursuit of accumulating capital.
While deciphering between productive investment and that which is induced by monetary inflation is inherently grey, you know it when you see it. Productive investment occurs naturally as market participants work to improve their own lives and the lives of those around them. The incentives to take risk in a free market already exist. There is nothing to be gained, and a lot to lose, through central bank intervention.
The operation of risk taking becomes counterproductive when it is borne more out of a hostage taking situation than it is free will. That should be intuitive and it is exactly what occurs when investment is induced by monetary debasement. Recognize that 100% of all future investment (and consumption for that matter) comes from savings. Manipulating monetary incentives, and specifically creating a disincentive to save, merely serves to distort the timing and terms of future investment.
It forces the hand of savers everywhere and unnecessarily lights a shortened fuse on all monetary savings. It inevitably creates a game of hot potatoes, with no one wanting to hold money because it loses value, when the opposite should be true. What kind of investment do you think that world produces? Rather than having a proper incentive to save, the melting ice cube of central bank currency has induced a cycle of perpetual risk taking, whereby the majority of all savings are almost immediately put back at risk and invested in financial assets, either directly by an individual or indirectly by a deposit-taking financial institution. Made worse, the two operations have become so sufficiently confused and conflated that most people consider investments, and particularly those in financial assets, as savings.
Without question, investments (in financial assets or otherwise) are not the equivalent of savings and there is nothing normal or natural about risk taking induced by central banks which create a disincentive to save. Anyone with common sense and real world experience understands that. Even still, it doesn’t change the fact that money loses its value every year (because it does) and the knowledge of that fact very rationally dictates behavior. Everyone has been forced to accept a manufactured dilemma. The idea that you must make your money grow is one of the greatest lies ever told. It isn’t true at all. Central banks have created that false dilemma. The greatest trick that central banks ever pulled was convincing the world that individuals must perpetually take risk just to preserve value already created (and saved). It is insane, and the only practical solution is to find a better form of money which eliminates the negative asymmetry inherent to systemic currency debasement.
That is what bitcoin represents. A better form of money that provides all individuals with a credible path to opt out and to get off the hamster wheel.
Whether one considers the game to be rigged or simply acknowledges that persistent monetary debasement is a reality, economies all over the world have been forced to adapt to a world in which money loses its value. While the intention is to induce investment and spur growth in “aggregate demand,” there are always unintended consequences when economic incentives become manipulated by exogenous forces. Even the greatest cynic probably wishes that the world’s problems could be solved by printing money, but then again, only kids believe in fairy tales. Rather than print money and have problems magically disappear, the proverbial can has been kicked down the road time and time again. Economies have been structurally and permanently altered as a function of money creation.
The Fed might have thought it could print money as a means to induce productive investment, but what it actually produced was malinvestment and a massively over-financialized economy. Economies have become increasingly financialized as a direct result of monetary debasement and the impact that has had in manipulating the cost of credit. One would have to be blind not to see the connection: the necessary cause and effect between a money manufactured to lose its value, a disincentive to hold money and the rapid expansion of financial assets, including within the credit system.
Banking and wealth management industries have metastasized by this same function. It is like a drug dealer that creates his own market by giving the first hit away for free. Drug dealers create their own demand by getting the addict hooked. That is the Fed and the financialization of the developed world economy via monetary inflation. By manufacturing money to lose value, markets for financial products emerge that otherwise would not. Products have emerged to help people financially engineer their way out of the very hole created by the Fed. The need arises to take risk and to attempt to produce returns to replace what is lost via monetary inflation.
The financial sector has captured a larger percentage of the economy over time because there is greater demand for financial services in a world in which money is constantly impaired. Stocks, corporate bonds, treasuries, sovereign bonds, mutual funds, equity ETFs, bond ETFs, levered ETFs, triple levered ETFs, fractional shares, mortgage-backed securities, CDOs, CLOs, CDS, CDX, synthetic CDS/CDX, etc. All of these products represent the financialization of the economy, and they become more relevant (and in greater demand) when the monetary function is broken.
Each incremental shift to pool, package and repackage risk can be tied back to the broken incentive structure inherent to the money underpinning an economy and the manufactured need to make money grow. Again, it is not to say that certain financial products or structures do not create value; instead, the problem is that the degree to which financial products are utilized and the extent to which risk has been layered on top of risk is largely a function of an intentionally broken monetary incentive structure.
While the vast majority of all market participants have been lulled to sleep as the Fed has normalized its 2% per year inflation target, consider the consequence of that policy over a decade or two decades. It represents a compounded 20% and 35% loss of monetary savings over 10 or 20 years, respectively. What would one expect to occur if everyone, society wide, were collectively put in a position of needing to recreate or replace 20 to 35% of their savings just to remain in the same place?
The aggregate impact is massive malinvestment; investment in activities that would not have occurred if people were not forced into a position of taking ill-advised risk merely to replace the expected future loss of current savings. On an individual level, it is the doctor, nurse, engineer, teacher, butcher, grocer, builder, etc. being turned into a financial investor, plowing the majority of their savings into Wall St. financial products that bear risk while perceiving there to be none. Over time, stocks only go up, real estate only goes up, and interest rates only go down.
How or why is a mystery to the Davey Day traders of the world, and it matters not, because that’s just the way the world is perceived to work, and everyone acts accordingly. Rest assured, it will all end badly, but most individuals have come to believe investments in financial assets are just a better (and necessary) way to save, which dictates behavior. A “diversified portfolio” has become so synonymous with savings that it is not perceived to bear risk, nor is it perceived to be a risk-taking activity. While that couldn’t be further from the truth, the choice is either to take risk via investments or to leave savings in a monetary medium that is sure to purchase less and less in the future. From an actual savings perspective, it is where damned if you do meets damned if you don’t. It is an unnerving game that everyone is either forced to play or sit it out and lose either way.
Forcing everyone to live in a world in which money loses value creates a negatively reinforcing feedback loop; by eliminating the very possibility of saving money as a winning proposition, it makes all outcomes far more negative in aggregate. Just holding money is a non-credible threat when money is engineered to lose its value. People still do it, but it’s a losing hand by default. So is perpetual risk-taking as a forced substitute to saving. Effectively, all hands become losing hands when one of the options is not winning by saving money. Recall that each individual with money has already taken risk to get it in the first place. A positive incentive to save (and not invest) is not equivalent to rewarding people for not taking risk, quite the opposite. It is rewarding people who have already taken risk with the option of merely holding money without the express promise of its purchasing power declining in the future.
In a free market, money might increase or decrease in value over a particular time horizon, but guaranteeing that money loses value creates an extreme negative outcome, where the majority of participants within an economy lack actual savings. Because money loses its value, opportunity cost is often believed to be a one way street. Spend your money now because it is going to purchase less tomorrow. The very idea of holding cash (formerly known as saving) has been conditioned in mainstream financial circles to be a near crazy proposition as everyone knows that money loses its value. How crazy is that? While money is intended to store value, no one wants to hold it because the predominant currencies used today do the opposite. Rather than seek out a better form of money, everyone just invests instead!
Even the most revered Wall St. investors are susceptible to getting caught up in the madness and can act a fool. Risk taking for inflation’s sake is no better than buying lottery tickets, but that is the consequence of creating a disincentive to save. Economic opportunity cost becomes harder to measure and evaluate when monetary incentives are broken. Today, decisions are rationalized because of broken incentives. Investment decisions are made and financial assets are often purchased merely because the dollar is expected to lose its value. But, the consequence extends far beyond savings and investment. Every economic decision point becomes impaired when money is not fulfilling its intended purpose of storing value.
All spending versus savings decisions, including day-to-day consumption, become negatively biased when money loses its value on a persistent basis. By reintroducing a more explicit opportunity cost to spending money (i.e. an incentive to save), everyone’s risk calculus necessarily changes. Every economic decision becomes sharper when money is fulfilling its proper function of storing value. When a monetary medium is credibly expected to maintain value at minimum, if not increase in value, every spend versus save decision becomes more focused and ultimately informed by a better aligned incentive structure.
It is a world that Keynesian economists fear, believing that investments will not be made if an incentive to save exists. The flawed theory goes that if people are incentivized to “hoard” money, no one will ever spend money, and investments deemed “necessary” will not be made. If no one spends money and risk-taking investments are not made, unemployment will rise! It truly is economic theory reserved for the classroom; while counterintuitive to the Keynesian, risk will be taken in a world in which savings are incentivized.
Not only that, the quality of investment will actually be greater as both consumption and investment benefit from undistorted price signals and with the opportunity cost of money being more clearly priced by a free market. When all spending decisions are evaluated against an expectation of potentially greater purchasing power in the future (rather than less), investments will be steered toward the most productive activities and day-to-day consumption will be filtered with greater scrutiny.
Conversely, when the decision point of investment is heavily influenced by not wanting to hold dollars, you get financialization. Similarly, when consumption preferences are guided by the expectation that money will lose its value rather than increase in value, investments are made to cater toward those distorted preferences. Ultimately, short-term incentives beat out long-term incentives; incumbents are favored over new entrants, and the economy stagnates, which increasingly fuels financialization, centralization and financial engineering rather than productive investment. It is cause and effect; intended behavior with unintended but predictable consequences.
Make money lose its value and people will do dumb shit because doing dumb shit becomes more rational, if not encouraged. People that would otherwise be saving are forced to take incremental risk because their savings are losing value. In that world, savings become financialized. And when you create the incentive not to save, do not be surprised to wake up in a world in which very few people have savings. The empirical evidence shows exactly this, and despite how much it might astound a tenured economics professor, the lack of savings induced by a disincentive to save is very predictably a major source of the inherent fragility in the legacy financial system.
The lack of savings and economic instability is all driven by the broken incentives of the underlying currency, and this is the principal problem which bitcoin fixes. By eliminating the possibility of monetary debasement, incentives that were broken become aligned; there will only ever be 21 million and that alone is sufficiently powerful to begin to reverse the trend of financialization. While each bitcoin is divisible into 100 million units (or down to 8 decimal points), the nominal supply of bitcoin is capped at 21 million. Bitcoin can be divided into smaller and smaller units as more and more people adopt it as a monetary standard, but no one can arbitrarily create more bitcoin.
Consider a terminal state in which all 21 million bitcoin are in circulation; technically, no more than 21 million bitcoin can be saved, but the consequence is that 100% of all bitcoin are always being saved — by someone at any particular point in time. Bitcoin (including fractions thereof) will transfer from person to person or company to company but the total supply will be static (and perfectly inelastic).
By creating a world in which there is a fixed money supply such that no more or no less can be saved in aggregate, the incentive and propensity to save increases measurably on the individual level. It is a paradox; if more money cannot be saved in aggregate, more people will save on an individual basis. On one hand, it may appear to be a simple statement that individuals value scarcity. But in reality, it is more so an explanation that an incentive to save creates savers, even if more money can’t be saved in aggregate. And in order for someone to save, someone else must spend existing savings.
After all, all consumption and investment comes from savings; the incentive to save creates savers, and the existence of more savers in turn creates more people with the means to consume and invest. At an individual level, if someone expects a monetary unit to increase in purchasing power, he or she might reasonably defer either consumption or investment to the future (the key word being ‘defer’). That is the incentive to save creating savers. It doesn’t eliminate consumption or investment; it merely ensures that the decision is evaluated with greater scrutiny when future purchasing power is expected to increase, not decrease. Imagine every single person simultaneously operating with that incentive mechanism, compared to the opposite which exists today.
While Keynesians worry that an appreciating currency will disincentivize consumption and investment in favor of savings and to the detriment of the economy at large, the free market actually works better in practice than it does when applying flawed Keynesian theory. In practice, a currency that is appreciating will be used everyday to facilitate consumption and investment because there is an incentive to save, not despite that fact. High present demand for both consumption and investment is dictated by positive time preference and there being an express incentive to save; everyone is always trying to earn everyone else’s money and everyone needs to consume real goods every day.
Time preference as a concept is described at length in the Bitcoin Standard by Saifedean Ammous. While the book is a must read and no summary can do it justice, individuals can have lower time preference (weighting the future over the present) or a higher time preference (weighting the present over the future), but everyone has a positive time preference. As a tool, money is merely a utility in coordinating the economic activity necessary to produce the things that people actually value and consume in their daily lives. Given that time is inherently scarce and that the future is uncertain, even those that plan and save for the future (low time preference) are predisposed to value the present over the future on the margin.
Taken to an extreme just to make the point, if you made money and literally never spent a dime (or a sat), it wouldn’t have done you any good. So even if money were increasing in value over time, consumption or investment in the present has an inherent bias over the future, on average, because of positive time preference and the existence of daily consumption needs that must be satisfied for survival (if not for want).
7 billion people competing + 21 million bitcoin = Appreciating Currency + Constant Spending ✔
Now, imagine this principle applying to everyone simultaneously and in a world of bitcoin with a fixed money supply. 7 billion plus people and only 21 million bitcoin. Everyone both has an incentive to save because there is a finite amount of money and everyone has a positive time preference as well as daily consumption needs. In this world, there would be a fierce competition for money. Each individual would have to produce something sufficiently valuable in order to entice someone else to part with their hard-earned money, but he or she would be incentivized to do so because the roles would then be reversed. That is the contract bitcoin provides.
The incentive to save exists but the existence of savings necessarily requires producing something of value demanded by others. If at first you don’t succeed, try, try again. The interests and incentives align perfectly between those that have the currency and those providing goods and services, particularly because the script is flipped on the other side of each exchange. Paradoxically, everyone would be incentivized to “save more” in a world in which more money technically could not be saved. Over time, each person would hold less and less of the currency in nominal terms on average but with each nominal unit purchasing more and more over time (rather than less). The ability to defer consumption or investment and be rewarded (or rather simply not be penalized) is the lynchpin that aligns all economic incentives.
The primary incentive to save bitcoin is that it represents an immutable right to own a fixed percentage of all the world’s money indefinitely. There is no central bank to arbitrarily increase the supply of the currency and debase savings. By programming a set of rules that no human can alter, bitcoin will be the catalyst that causes the trend toward financialization to reverse course. The extent to which economies all over the world have become financialized is a direct result of misaligned monetary incentives, and bitcoin reintroduces the proper incentives to promote savings. More directly, the devaluation of monetary savings has been the principal driver of financialization, full stop. When the dynamic that created this phenomenon is corrected, it should be no surprise that the reverse set of operations will naturally course correct.
If monetary debasement induced financialization, it should be logical that a return to a sound monetary standard would have the opposite effect. The tide of financialization is already on its way out, but the groundswell is just beginning to form as most people do not yet see the writing on the wall. For decades, the conventional wisdom has been to invest the vast majority of all savings, and that doesn’t change overnight. But as the world learns about bitcoin, at the same time that global central banks create trillions of dollars and anomalies like $17 trillion in negative yielding debt continue to exist, the dots are increasingly going to be connected.
More and more people are going to begin to question the idea of investing retirement savings in risky financial assets. Negative yielding debt doesn’t make sense; central banks creating trillions of dollars in a matter of months doesn’t make sense either. All over the world, people are beginning to question the entire construction of the financial system. It might be conventional wisdom, but what if the world didn’t have to work that way? What if this whole time it were all backwards, and rather than everyone buying stocks, bonds and layered financial risk with their savings, all that was ever really needed was just a better form of money?
Rather than taking open-ended risk, if each individual had access to a form of money that was not programmed to lose value, sanity in an insane world could finally be restored and the byproduct would be greater economic stability. Simply go through the thought exercise. How rational is it for practically every person to be investing in large public companies, bonds or structured financial products? How much of it was always a function of broken monetary incentives? How much of the retirement risk taking game came about in response to the need to keep up with monetary inflation and the devaluation of the dollar? Financialization was the lead up to, and the blow up which caused, the great financial crisis.
While not singularly responsible, the incentives of the monetary system caused the economy to become highly financialized. Broken incentives increased the amount of highly leveraged risk taking and created a broad-based lack of savings, which was a principal source of fragility and instability. Very few had savings for a rainy day, and everyone learns the acute difference between monetary assets and financial assets in the middle of a liquidity crisis. The same dynamic played out early in 2020 as liquidity crises re-emerged. Fool me once shame on you. Fool me twice, shame on me, the saying goes.
It all comes back to the breakdown of the monetary system and the moral hazard introduced by a financial system that spawned as a result of misaligned monetary incentives. There is no mistaking it; the instability in the broader economic system is a function of the monetary system, and as more of these episodes continue to play out, more and more people will continue to seek a better, more sustainable path forward.
Now with bitcoin increasingly at center stage, there is a market mechanism that will de-financialize and heal the economic system. The process of definancialization will occur as wealth stored in financial assets is converted into bitcoin and as each market participant increasingly expresses a preference for holding a more reliable form of money over risk assets. Definancialization will principally be observed through growing bitcoin adoption, the appreciation of bitcoin relative to every other asset and the deleveraging of the financial system as a whole. Almost everything will lose purchasing power in bitcoin-denominated terms as bitcoin becomes adopted globally as a monetary standard.
Most immediately, bitcoin will gain share from financial assets, which have acted as near stores of value; it is only logical that the assets which have long served as monetary substitutes will increasingly be converted to bitcoin. As part of this process, the financial system will shrink in size relative to the purchasing power of the bitcoin network. The existence of bitcoin as a more sound monetary standard will not only cause a rotation out of financial assets, but bitcoin will also impair future demand for the same type of assets. Why purchase near-zero yielding sovereign debt, illiquid corporate bonds or equity-risk premium when you can own the scarcest asset (and form of money) that has ever existed?
It might start with the most obviously over-priced financial assets, such as negative yielding sovereign debt, but everything will be on the chopping block. As the rotation occurs, non-bitcoin asset prices will experience downward pressure, which will similarly create downward pressure on the value of debt instruments supported by those assets. The demand for credit will be impaired broadly, which will cause the credit system as a whole to contract (or attempt to contract). That in turn will accelerate the need for quantitative easing (increase in the base money supply) to help sustain and prop up credit markets, which will further accelerate the shift out of financial assets and into bitcoin. The process of definancialization will feed on itself and accelerate because of the feedback loop between the value of financial assets, the credit system and quantitative easing.
More substantively, as time passes and as knowledge distributes, individuals will increasingly opt for the simplicity of bitcoin (and its 21 million fixed supply) over the complexity of financial investing and structured financial risk. Financial assets bear operational risk and counterparty risk, whereas bitcoin is a bearer asset, perfectly fixed in supply, highly divisible, and easily transferable. The utility of money is fundamentally distinct from that of a financial asset. A financial asset has a claim on the income stream of a productive asset, denominated in a particular form of money. The holder of a financial asset is taking risk with the goal of earning more money in the future. Owning and holding money is just that; it is valuable in its ability to be exchanged in the future for goods & services. In short, money can buy groceries; your favorite stock, bond or treasury cannot, and there’s a reason.
There is and always has been a fundamental difference between saving and investment; savings are held in the form of monetary assets and investments are savings which are put at risk. The lines may have been blurred as the economic system financialized, but bitcoin will unblur the lines and make the distinction obvious once again. Money with the right incentive structure will overwhelm demand for complex financial assets and debt instruments. The average person will very intuitively and overwhelmingly opt for the security provided by a monetary medium with a fixed supply. As individuals opt out of financial assets and into bitcoin, the economy will definancialize. It will naturally shift the balance of power away from Wall St. and back to Main St.
The banking sector will no longer reside at the epicenter of the economy as a rent-seeking endeavor, and instead, it will sit alongside every other industry and more directly compete for capital. Today, monetary capital is largely captive to the banking system, and that will no longer be true in a bitcoinized world. As part of the transition, the flow of money will increasingly disintermediate from the banking sector; money will more freely and directly flow among the economic participants that actually contribute value.
The function of credit markets, stock markets and financial intermediation will still exist, but it will all be right-sized. As the financialized economy consumes fewer and fewer resources and as monetary incentives better align with those that create real economic value, bitcoin will fundamentally restructure the economy. There have been societal consequences to disincentivizing savings, but now the ship is headed in the right direction and toward a brighter future. In that future, gone will be the days of everyone constantly thinking about their stock and bond portfolios, and more time can be spent getting back to the basics of life and the things that really matter.
The difference between saving in bitcoin (not taking risk) and financial investing (taking risk) is night and day. There is something cathartic about saving in a form of money that works in your favor rather than against it. It is akin to a massive weight being lifted off your shoulders that you didn’t even know existed. It might not be apparent immediately, but over time, saving in a form of money with proper incentives ultimately allows one to think and worry about money less, rather than obsess over it. Imagine a world in which billions of people, all using a common currency, can focus more on creating value for those around them rather than worrying about making money and financial investing. What that future looks like exactly, no one knows, but bitcoin will definancialize the economy, and it will no doubt be a renaissance.
Thank you to Aleks Svetski for organizing and inviting me to participate in the 2020 edition of the Bitcoin Times. I also want to thank Aleks in addition to Phil Geiger, Robert Breedlove and Will Cole for providing valuable feedback on this 17th essay in the Gradually, Then Suddenly series.
Lastly, I’d like to recognize the other contributors to the Bitcoin Times: Jimmy Song, Erik Cason, Jeff Booth, Giacomo Zucco and Aleksandar Svetski, himself (as well as Makena Rhodes for editing and design). I’m lucky to call these brave men friends, teammates, clients, twitter friends, fellow bitcoiners or a combination in certain cases. It’s an honor just to be included.
Best, Parker
@parkeralewis
www.unchained-capital.com
Without doubt, the economic structure is broken. Wealth gaps are only becoming wider, it is unsustainable, and economic instability is everywhere. The stock market and national average home values are back at all time highs while tens of millions of Americans are filing for unemployment and half of society has practically no savings. Economic equations do not add up. That is a hard-to-deny reality; it is suffocating many and it applies globally. Politicians simply are not the answer. The fundamental problem with the current economic structure lies not in politics, but in the currencies which coordinate economic activity (e.g. the dollar, euro, yen, peso, bolivar, etc.). The chink in the armor is in the foundation. No politician can fix problems that stem from structural flaws inherent to modern money. Once the foundation is fixed, then solutions to higher order challenges can follow suit, but until then, any efforts will continue to prove ineffective.
A currency is the foundation of an economy because it coordinates all economic activity. If an economy is functionally breaking down, it would be more appropriate to say that the underlying currency is not effectively coordinating economic activity; the currency is the input and the economy is the output. In short, the fly in the ointment is the money. While many are focused on how to solve the problem of massive wealth inequality, very few connect that the greatest source of inequity lies in the tool that everyone is using to coordinate the entire orchestra. It is not just that the economy is not working for many; it is that the dollar (or euro, yen, etc) as the primary mechanism coordinating economic resources is failing for everyone. Economic imbalance and growing inequality is the new normal, but there is nothing natural about sustained economic imbalance. In fact, it is an economic oxymoron. Balance is critical to the functioning of any economy, and when functioning properly, an economy would naturally eliminate imbalance in its normal course. If an economy fails to do so, and instead allows imbalance to be sustained, that is evidence of a broken economic structure. But, the massive and growing economic imbalance which exists today is not the inevitable and unavoidable consequence of free market capitalism; instead, it is principally a result of central bank monetary policy, which allows economic imbalances to be sustained in ways that would otherwise not be possible.
Central bank monetary policy is the exogenous force creating massive economic distortion and extreme levels of inequality. The mere existence of economic inequality is not in itself an inequity; in fact, unequal outcomes are both natural and entirely consistent with economic balance. On the other hand, the inequality which has been created and exacerbated by a flawed monetary system is an inequity, and it is not natural to a free market economy. It is exogenous. The structural flaw inherent to the dollar currency system (or any fiat currency system) is the force most responsible for sustained economic imbalance. Unsustainable and extreme wealth disparity follow from that imbalance. Every other distortive economic action or policy exists at higher orders than the issues created by the manipulation of the money itself. That is the root of all structural economic problems, and until it is fixed, the world will remain suspended in an increasingly fragile state. The legacy monetary system centralizes and consolidates wealth; that is the output of sustaining and exacerbating economic imbalance. It is a system that works for a few in the short-term but fails for all in the long run because the end game of monetary manipulation and an ever-growing economic imbalance is instability. The currency’s ability to coordinate economic activity degrades gradually and eventually fails completely; everyone pays that inevitable price.
Bitcoin is the polar opposite. It is one currency that works for all, now and in the future. It eliminates imbalance as a natural function, wherever and as soon as it appears, because its supply cannot be manipulated. With a fixed supply capped at 21 million and an ever-increasing adoption curve, more and more people own bitcoin, and each person controls a smaller and smaller share of the same fixed pie. The ownership of the currency naturally becomes more distributed and less concentrated over time, which provides the foundation for greater balance. Bitcoin levels the playing field and ensures that the monetary system cannot itself be a source of extreme inequity. It does so by guaranteeing certain inalienable rights. Every holder of the currency is provided the assurance that more units of the currency will not be arbitrarily produced, and each unit of the currency is treated equally within the network. Bitcoin more effectively coordinates economic activity because its pricing mechanism cannot be distorted or manipulated by exogenous forces, which is the fatal flaw of the legacy currency system. A fixed supply, equal protection, and true price signals deliver greater balance. Bitcoin fixes the economic foundation for everyone such that everything else can then begin to fix itself.
As a simplified construct, think about money as the coordination function within an economy. The utility of money is to intermediate a series of exchanges. Receive, hold, spend (h/t @pierre_rochard), that simple. Money is the intermediary good used to both establish and trade value. As the market converges on a common form of money, a price system emerges, which allows for the subjective concept of value to be more objectively measured. Money is the pricing mechanism and the output is a pricing system. The price system communicates information; it aggregates individual preferences within an economy and communicates those preferences through local prices, as measured in a common monetary medium. Change in prices reflects changes in preferences.
Because preferences are ever changing, so too are prices. Within a developed economy, there are millions of goods, each with individual prices resulting in billions of relative price signals. Relative price signals ultimately communicate exchange ratios between various combinations of goods. While the value of any single good may be static for a period of time, certain prices are always changing within an economy, which dictates that relative prices are ever changing. An economy constantly works to find balance through the aggregate changes in price levels. Anyone and everyone within an economy reacts to the price signals most relevant to their own preferences, which naturally change and become dynamically influenced by changing prices themselves. Through the price system, individual market participants learn both what others value and what they need to produce to meet their own needs. As prices change, behaviors change, and everyone adapts. The price system is the visible hand which allows for balance to be achieved and for imbalance to be identified and eliminated. Long-term economic stability is achieved because variable information is constantly communicated through the price system. It is the fluctuation in prices inherent to undistorted markets that actively prevents large scale and systemic imbalances from forming.
The foundation of the economy is broken because the money coordinating economic activity is actively manipulated. Most central banks, including the Fed, have the authority to create money arbitrarily at no cost and have a mandate to maintain stable prices (i.e. a price stability mandate). This combination is fatal to the functioning of any price mechanism and ultimately to the underlying economy. When a central bank targets the stability of any price level, it is actually working in opposition to the natural course of an economy, which seeks to find balance and to adapt to a change in preferences through the price system. Worse yet, the means by which a central bank works to achieve price stability is through the manipulation of the money supply, which distorts the entire pricing mechanism underpinning the economy. With every exogenous attempt to achieve price stability, the central bank actively allows imbalances to be sustained and distributes bad information to every person within the economy through false price signals, which in turn causes further imbalances to grow. Imagine this happening each time the economy tried to find balance. By sustaining imbalance, those that principally benefited from the existence of imbalance are continuously advantaged at the expense of everyone else.
Made worse, it actively impedes the ability of those on the lower end of the economic spectrum to contribute and to command a greater share of the resources within an economy.Artificially inflated asset prices create an uphill battle for those that do not own assets, and false signals induce poor economic decisions, disproportionately harming those lowest on the economic spectrum who can least afford errors and setbacks. False and distorted economic signals, created through the manipulation of the money supply, are counterproductive for all in the long run, but in the short-term, benefit those to whom the imbalance is positively skewed.
For example, when the value of real estate was declining during the 2008 financial crisis, the price mechanism of the economy was communicating that there was an imbalance. In aggregate, market participants were communicating an increasing demand for money relative to a decreasing demand to hold real estate. At that particular moment in time, the actual amount of money and the available supply of real estate were not rapidly changing. Instead, preferences within the economy were shifting as were relative price signals. Rather than allow the economy to find balance and eliminate imbalance, the Fed increased the supply of dollars in an effort to “stabilize” the dollar value of real estate. More literally, it created $1.7 trillion dollars and used those newly minted dollars to purchase mortgage-backed securities as a direct means to support the value of real estate. Those that owned real estate (e.g. housing) or operated businesses dealing in the production (or financing) of real estate benefited disproportionately at the expense of those that did not. The benefit skewed to the side of existing imbalance, as it always does when imbalance is being sustained artificially.
Not only did the Fed manipulate the value of real estate, it manipulated and distorted all price signals within the economy by significantly increasing the money supply. The market function to eliminate imbalance would have been for prices to change. The Fed’s solution was the opposite. It devalued the money (by increasing its supply), such that the value of real estate (among other goods) as priced in dollars would change the least. Rather than eliminate imbalance, the Fed’s actions allowed imbalances to be sustained and actually grow. Once one actually appreciates the fundamental role which money and the pricing mechanism play in coordinating economic activity, it becomes clear as day that sustaining imbalance is precisely what occurs each time the Fed intervenes to stabilize price levels. Stability when achieved through manipulation merely suppresses volatility. It creates an unnatural rigidity in price, when price fluctuation is both a desired state and the natural function of a market communicating changes in preferences. When imbalances that would otherwise be eliminated are allowed to be sustained by artificial means and for extended periods of time, it ultimately creates greater volatility in the long run and critically impairs the ability of a monetary medium to coordinate economic activity, which is its singular utility. Each time and cumulatively, it advantages and further embeds the incumbents, just as the market is working to eliminate imbalance.
By manipulating price levels, the Fed isn’t just preventing smaller intermittent fires from naturally running their course while creating larger fires down the road. Instead, think of the Fed’s actions as the arsonist that lights a fire, leaves through the back door in the middle of the night, and then is celebrated as the hero when it arrives through the front door to fight the fire with gasoline. A change in price levels, even if particularly volatile, is not a fire that needs putting out. Artificially preventing changes in price, aka a price stability mandate, is what lights the fire in the first place. The Fed coopts the entire value chain of the pricing mechanism. Change in price is actually desired and the central bank works in opposition to that change by manipulating the money supply. The formation of imbalance within an economy is natural; creating a centralized mechanism which prevents imbalances from being eliminated is the unnatural and damaging part. It also creates long-term economic instability by distorting price signals over decades and widens the wealth gap by constantly advantanging those on the right side of imbalance. Predictably and unironically, the existence of the central bank’s price stability mandate, combined with the power to print money, causes both long-term instability and sustained economic imbalances.
Most mainstream economics professors would readily agree that price fixing or setting quotas on certain economic goods naturally creates economic inefficiency and imbalance. However, the same cohort of experts would then turn around and avidly defend central bank monetary policy, not realizing the fundamental inconsistency. Economic manipulation is economic manipulation. Rigidity in price or quantity of any economic good driven by exogenous forces results in imbalance; variance allows for balance and equilibrium. Very logical and not controversial. Why then is the same not understood when applied to money? Imbalances are created when central banks target interest rates through the manipulation of the supply of money, just as imbalances are created when the Venezuelan government arbitrarily sets the price of a gallon of gas below its market value. Ironically, the manipulation of the money supply happens to be economically more destructive because it distorts all prices within an economy, and all relative price signals as individual price levels do not adjust ratably (in fact, far from it). When the Fed pursues its price stability mandate, it is actively sending false price signals throughout an economy and causing imbalances in supply and demand structures to be sustained. Price stability is price manipulation, and it is perfectly predictable that when the price of money is manipulated to achieve any definition of stability, the very action causes a degree of economic distortion far worse than the manipulation of any single market.
The effects of sustaining imbalance can be best understood and observed through the credit system because that is where the Fed directly intervenes and consequently where the greatest distortion and imbalance exists. As the economy slows and as price levels begin to change counter to the Fed’s desired course, the Fed increases the supply of dollars in the financial system by purchasing debt instruments (typically government treasuries) and crediting the accounts of the sellers with newly minted dollars. At the onset, the credit system was just a tool to effect monetary policy; it was the mechanism through which the Fed pursued price stability. Increase the supply of dollars by purchasing credit instruments, reduce interest rates by that same mechanism, induce economic expansion via cheap credit and cause general price levels to stabilize. That was the theory and intent. However, predictably, this pattern caused imbalances to form and be sustained in the credit system itself. Now the tail is wagging the dog. Today, the credit system in the U.S. stands at 77.9 trillion system wide, whereas there are only 4.5 trillion actual dollars within the banking system. For every dollar that exists, approximately $17 dollars of dollar-denominated debt exists (debt-to-dollars of 17:1). Again, this is an imbalance only made possible and sustained as a function of the Fed. Each time the credit system attempts to contract, the Fed creates more dollars to help maintain the size of the credit system, such that it can further expand. Because the credit system is now orders of magnitude larger than the base money supply, economic activity today is largely coordinated by the allocation and expansion of credit rather than by the base money itself. In aggregate, the credit system is the marginal price setter given its size relative to the base money supply. Because of its price stability mandate, the Fed has an implicit mandate to maintain the size of the credit system, and in order to do so, it must target asset prices that support existing debt levels. It has become circular. The Fed used the credit system as a tool to stabilize price levels but now it must maintain the size of the credit system in order to maintain stable prices.
This vicious cycle was only ever made possible because the Fed has unilateral control of the money supply. In 1971, President Nixon officially ended all convertibility of dollars to gold, and the U.S. government later decoupled the value of the dollar from gold altogether in 1976. While the creation of the Federal Reserve in 1913 was the beginning and President Roosevelt’s executive order in 1933 banning private ownership of gold set the stage, the complete departure from gold as a monetary anchor in the 1970s removed constraints that otherwise prevented the true centralization of the money supply, and which ultimately enabled the great monetary inflation which Paul Tudor Jones recently wrote about. Once the final constraints were removed, it opened the door for the Fed to take a more central role in actively managing the economy via the money supply, which it ultimately effects through the credit system. As a direct consequence, the base money supply and the credit system have expanded in ways that would otherwise not have been possible, allowing imbalances to consistently grow over time and creating long-term economic distortions.
When imbalances emerge in the credit system (i.e. too much debt existing), the Fed supplies more dollars such that existing debt levels can be sustained. Rather than write off bad debt and reduce existing debt levels, imbalances are actively sustained rather than eliminated. This is the real reason why the banking sector and the function of credit has become as large as it has; it would not have been possible if the Fed were not able to print money to artificially sustain unsustainable levels of debt, all in the interest of “price stability.” Effectively, each time the banking sector would otherwise contract, the Fed takes measures to actively prevent it. It sounds crazy because it is, but it exists the way it does because the credit system is the primary transmission mechanism of the Fed’s monetary policy. The Fed needs the credit system to be maintained because it is through this vehicle that the Fed attempts to “manage” the economy. The Fed sees targeting asset prices to sustain debt levels as less disruptive than allowing debt to be restructured and written off. In the Fed’s eyes, it’s six one way, half a dozen the other; effectively the same, but with less disruption. In reality, one path is economic manipulation of the worst kind, and the other is the natural and organic balancing of an economy in imbalance. The Fed chooses the former, trading short-term stability for long-term instability and distortion.
While it should be obvious that asset price targeting advantages those with assets (wealthy) and is a regressive tax on those without assets (poor), the Fed has its price stability mandate. For those on the lower end of the economic spectrum with little to no savings, cash naturally represents most, if not all, of one’s savings. On the other hand, those at the higher end of the economic spectrum typically hold cash in addition to equity in businesses, real estate and financial assets, such as stocks and bonds. Again, consider the 2008 financial crisis. There were imbalances in both the housing market and financial markets; prices within these markets were at unsustainable levels. As imbalance was being eliminated and as price levels were correcting, the Fed stepped in to “stabilize” asset prices. Imagine that you were someone just entering the economy, without any savings, or you could not afford to purchase a home and likely did not own stocks or bonds. Everyone who owned assets was bailed out at the expense of those who did not, all in the interest of price stability.
By increasing the supply of dollars to prop up asset prices, each dollar naturally becomes worth less. For those lowest on the economic spectrum, wages paid in dollars (labor) were devalued, and asset prices were directly manipulated higher. Inflation of most all consumer goods broadly followed. It is the equivalent of being hit from both sides. Wages purchase less and less day-to-day, and it becomes measurably more difficult to accumulate the amount of savings necessary to purchase assets. Initially, the effects are at best zero-sum. Those at the top benefit, those at the bottom suffer. In the end, everyone loses because the end game is economic instability. Notice the negative correlation below between housing prices and housing affordability, and then recognize that housing prices are actively manipulated by the Fed. Also recognize that housing prices are at an all-time high (above 2007 bubble levels), when nearly half the country has no savings. That equation only exists in a manipulated world, and it crushes those without savings.
Economists running the show and those that benefit the most will overwhelmingly agree it has to be done (every time); history is written by the winners but it is still all smoke and mirrors.
“Sure, it was a crazy experiment, but the Fed had no other choice. Just imagine all those on the lower end of the spectrum that would have lost their jobs if not for the Fed’s actions. Without a job, the poorest on the economic spectrum would have been far worse off and would not have been able to afford a home.”
At least, this is the common, predictable defense. The same line has certainly been used to defend the Fed’s most recent actions in response to the global pandemic (printing $3 trillion with a T). While it may seem like logic, it is an anecdote that lacks any fundamental economic argument in defense of the manipulation of price levels. The narrative is caught in a vicious cycle that begins with economic imbalance as a starting point (and one created by decades of the same distortive monetary policy). Recall the role of arsonist hailed as a hero fighting the fire. You cannot dig yourself out of a hole by continuing to dig in the same direction. At a fundamental level, manipulating price levels allows imbalances that would otherwise course correct to be sustained. It disproportionately advantages those that contributed to, and benefited the most from, the very existence of imbalance – like having your cake and eating it too, or like getting a second bite at the apple. Those most directly bailed out took an inadvisable risk, and rather than be penalized, the world of imbalance is sustained. The advantages gained from manipulated incentive structures are allowed to continue in a way that would not be possible absent the Fed’s policy decisions.
While there is never perfect balance, the existence and fluctuation of price levels is how an economy works toward balance through trial and error. Every individual reacts to an ever-changing set of price signals. It is how people evaluate which businesses to create, which skillsets to acquire, and which jobs to pursue, all of which are interdependent on each individual’s own interests and capabilities. Imbalances can naturally arise within an economy as individuals speculate and over-invest in certain segments based on imperfect expectations of consumer preferences. That is the nature of trial and error. Nobody knows or can predict the future; they use price signals to best guide decisions. A business or individual produces a good for X and attempts to sell it for Y, and if insufficient demand exists to make the activity profitable, that is the market communicating information to the producer. Better luck next time; build it for less or build something else that is of greater value or valued by more people. Imbalances are eliminated. Those that took the risk own the consequences, and it’s back to the drawing board in a never-ending game aimed at marrying individual ideas and skillsets with the preferences of other market participants.
Money is the tool that is used to coordinate resources and to test the market by trial and error; it becomes the lifeblood of an economy because it is the foundation of a price system. It is how information is distributed to all participants. The better the money, the more reliable its price system. And the more reliable a price system, the greater the balance in an economy. Those within an economy that deliver the greatest value to the largest number of people are naturally rewarded with the most money, but money would be of little value to the producer if others were not producing goods that they themselves valued. The system would not sustain itself if balance did not exist; in order to purchase a good or service from another individual, one must have earned money in the first place. Acquiring money by voluntarily providing a service valued by others is a far better outcome for everyone in aggregate than if money were to be acquired through any other means. It is so because it’s the only way for the cycle to be repeatable and symbiotic rather than one-off and zero-sum. What good is a customer that runs out of money or doesn’t have any in the first place? In a balanced economy, every producer is a customer of someone else and vice versa.
“Give a man a fish and you feed him for a day; teach him how to fish and you feed him for a lifetime.”
One need not be religious to understand the wisdom. Each individual benefits by having a larger number of people producing more goods or services, and everyone is incentivized to produce output valued by others within an economy. Everyone has a selfish interest in both delivering value to others and in helping others to contribute value in return. But, it is not just a naïve or hopeful economic view of the world; there are discernible benefits to trade, specialization and ultimately, in a broader range of choice for all individuals, which organically dictates a division of labor. Money coordinates the division of labor, and the form of money with the most reliable pricing mechanism will consistently deliver the greatest value with the greatest range of choice and balance. The pricing mechanism with the least distortion provides the clearest signals as to what other people value, and derivatively, provides the greatest assurance that the information communicated is not a false signal. The undistorted function of a monetary medium and its price system is what ensures imbalance is eliminated; it is the governor that allows for balance to be restored and for symbiotic relationships to continuously be discovered in a constant process of trial and error.
The Fed’s monetary policy actively prevents the economy from restructuring and from finding balance. Efforts to maintain price stability when imbalance exists equates to maintaining otherwise false price signals. Productive assets remain in the hands of a few, and the world remains suspended in a state of imbalance. Money that makes its way to those on the lower end of the spectrum eventually finds its way back to those that control the productive assets like a steel trap because structural imbalances are never fixed. Instead, the natural healing process is stymied when the Fed intervenes. The structure of the economy cannot sustainably cycle money in a symbiotic way because balance does not exist; skillsets and preferences of market participants are not aligned. The Fed pumping money into a structurally broken economy is akin to giving a man a fish and feeding him for a day, while at the same time preventing him from learning how to fish by sustaining false signals. The existence of imbalance signals that the composition of an economy is not meeting the needs of the participants that make up the market. Or rather, that the assets and individuals which capture the lion’s share of wealth would not continue to do so if the economy was allowed to restructure.
The Fed’s economic structure produces inequity by preventing imbalances from rebalancing. That is what the market attempts to do every time the Fed steps in to keep the dream alive. Giving all benefits of the doubt, the Fed believes it is helping. The starting point of the Fed’s economic theory is that active management of the money supply is a positive driving force. That is in its DNA. It is not questioned or debated. It sees its activities as smoothing out market signals rather than manipulating them. The question for all those within the four walls of the Fed is how much and when to manipulate the money supply, not if. Would anyone expect the Fed to be an honest evaluator of its actions? It would be like grading your own test; no one would reasonably expect an objective assessment because there can be no objectivity. Certain false assumptions are encoded in their brains as true which prevents the possibility of objectivity. They look everywhere for answers but in the mirror, and try the same policies over and over again, always expecting a different result.
Fed Chairman Powell recently provided this as a response to a question asking whether Fed policy contributes to increasing wealth inequality. Notice how the response is not an argument as to why central bank policy does not cause imbalance and inequality. It is more of a pronouncement followed by a “look over there” defense. Never believe the myths about globalization and technology driving wealth inequality. There is nothing about technology, innovation and globalization that causes sustained economic imbalance or a structurally expanding wealth gap within an economy. For innovation to be valuable, it by definition must solve problems for a range of people, but if those that valued it did not have money or means to afford the innovation, it wouldn’t be valuable. Value becomes self-referencing in that sense. Economic balance is a governing input to value. In order to believe the tall tales of technology and globalization causing economic imbalance, one would have to be willfully blind to the impact of centralizing the money supply, which in turn caused banking to become the epicenter and lifeblood of the economy, and which made it possible for imbalance to actively be sustained over decades as a policy decision. There may be many theories, but the manipulation of every price signal within the economy is ground zero to economic imbalance and inequity; it is the structural flaw in the foundation which creates the unlevel playing field off of which all other contributing factors compound.
##If A then B; if not A then not B
Money is the bedrock of economic systems. Understanding the fundamental and foundational role money plays in the economic engine establishes the logical connection between systemic economic issues of imbalance and the artificial manipulation of the money supply. Of course, there are other factors at play. The money supply is not the only way economic activity is manipulated. Tax policy, government spending and the regulatory apparatus all contribute. But, focusing there would be like trying to fix the windows on the 100th floor when the bottom ten stories are each being supported by a single Jenga block. That is the relationship between the issues inherent in the monetary system (the foundation) and all other economic issues (higher levels). The core problem that bitcoin solves is the foundation. If everyone were to display a little bit of humility, each would recognize that there is no silver bullet to solve the structural problem of a widening wealth gap and economic imbalance. There is no individual with a plan or piece of legislation that will make everything better. Imbalance created by central command does not get solved by central command. Quite the opposite. The only real hope is to first fix the foundation, such that everyone on net can get back to doing the desirable things without the need for conscious control. Balance will follow from there.
With a fixed supply of 21 million, enforced on a decentralized basis and controlled by no one, bitcoin has taken away the ability to manipulate the monetary function entirely. If misbehaving children cannot find a way to share a toy and play nice, what do you do? You take the toy away and put the kids in the penalty box. That is kind of like the relationship between bitcoin and central banks. No human (or institution) can be trusted with control over the money supply, so the only practical solution is to take away the ability and temptation all together. The one constant in bitcoin is its fixed supply; there will only ever be 21 million bitcoin, and there is nothing anyone can do about it. Everything will change around bitcoin, but its supply as a constant will increasingly become the guidepost off of which all other activity is measured. It ensures a level playing field and represents a source of truth, which is absent in the existing economic structure. Because its supply cannot be manipulated, neither can its price signal. Undistorted price signals communicate more perfect information. But never confuse more perfect information and a level playing field with price stability or the issue of volatility. If the value of bitcoin is 12,000 today and 10,000 tomorrow, that is the undistorted communication of information.
A fixed supply ensures that any change in price is exclusively driven by a change in demand rather than an artificial and unpredictable change in the supply of money (i.e. communicating a change in preferences to the entire economy). It eliminates an entire side of the equation, which heavily influences changes in prices today, and which distorts the communication of preferences. Imagine knowing with absolute certainty that every change in price were dictated by a change in consumer preferences rather than the effects of increases or decreases in the money supply. That is the difference between being able to consistently rely on true economic price signals and playing musical chairs knowing someone else is in control of the stereo. Today and into the future, the same principle will hold true. Everyone will be able to rely upon and trust that changes throughout bitcoin’s price system will always be true and never be influenced by unpredictable changes in supply.
This fundamental difference between the existing monetary structure and bitcoin changes the entire game. False price signals vs. true price signals. False price signals are the equivalent to believing you have a cheat sheet for a test, training yourself based on that information and then showing up only to find out that the test was entirely different. Everyone believes they are responding to true price signals, not realizing that the information communicated would be fundamentally different if the money had not been manipulated. Each time a violent shock occurs within the system, everyone gets a hint that price signals were communicating bad information, but then the Fed steps in to stabilize prices and everyone becomes reassured that it’s ok to come back outside and play, relying on the same bad signals. The primary reason a violent shock to the system is even possible is because this process has occurred every time the economy has attempted to structurally rebalance over the past 50 years. Bad signals attempt to correct, only to be sustained and exacerbated by exogenous forces. With a fixed money supply, this wrong is permanently righted. It will no longer be possible to sustain imbalance. So long as bitcoin exists, the monetary medium will not be capable of distributing distorted price signals. There is a difference between right, wrong and true. True price signals merely ensure that the information being communicated is reflective of the individual and aggregate preferences of an economy. In that sense, there is no right or wrong, so long as the information can reasonably be relied upon as accurate and undistorted. No one has to trust or question whether bitcoin’s price signals are true because its fixed supply will guarantee it.
And no longer does anyone need to figure out how to play a rigged game because that game is ending. The days of monetary inequity will soon be past as bitcoin distributes throughout the world. It will shift the balance of power back to those that actually create value, as defined by true price signals, which are communicated by individuals that hold the currency. Setting aside taxes and regulatory capture for a moment, if one wants to acquire bitcoin, he or she will have to provide value in return, and bitcoin will become the arbiter of that value. Of 21 million, approximately 18.5 million bitcoin are already in circulation. The 18.5 million in circulation are all held by some individual or entity. In order to acquire any, bitcoin must be earned by delivering value to those that hold the currency. Even for those not yet circulating, every single bitcoin must be earned by contributing value. The same is not true of the current monetary system. In the current structure, dollars can either be earned by delivering value to others within the economy, or conversely, if the Fed decides to hand out more money. And this happens quite frequently. Of all the dollars that exist today, over 80% have been created and allocated by the Fed since 2008 (source link), rather than by the alternative – delivering value to others within the economy. Which system sounds more fair, balanced and conducive to aligning incentives throughout an economy over decades and generations?
As more people adopt bitcoin, the currency is transferred from those that have to those that have not. By making the nominal amount of bitcoin zero-sum, it ensures that the economic system is non-zero sum. In order to join the economy, you must deliver value to someone within the network. No value leaks outside the system; no inefficiency can be introduced through the production of money. Whether new entrants are joining the network or trade occurs from within, value is always transferred, and through that transfer, value is actually created. Recall that the valuable function of money is to coordinate economic activity. The production of money, on the other hand, produces no value and only serves to distort and impair the ability of a monetary medium to properly function. The nominal amount of money is not important. What is important is its ability to communicate accurate information to a broad set of economic participants.
That is why people demand money, and with a terminal rate of change set at zero, each participant can use bitcoin to best understand the value of his or her own output relative to that of others and relative to the preferences of others, undistorted by any changes in the money supply. Each person can make better decisions (on average) in the pursuit of his or her own interest, while by definition delivering value to others as a means to that end. A fixed amount of currency plus more people valuing it equals greater distribution of the currency. With a fixed supply, no more than 21 million bitcoin can ever be saved and paradoxically, that change in the incentive structure will cause more people to save. By introducing an incentive to save (i.e. a fixed supply), more people will. And as more people save in a currency which has a fixed supply, it results in more and more people owning less and less but through that function of more people saving, it creates greater stability. Whereas the centralized control of the money supply and the ability to sustain imbalance causes wealth to consolidate, a fixed money supply naturally causes the currency to become further decentralized and more distributed, delivering greater balance.
Centralized governance of the money supply allows the distribution to consolidate as new units of the currency are created and as imbalance is sustained; whereas, a decentralized governance model enforcing a fixed supply ensures that the distribution of the currency becomes greater and greater over time. The structure of the currency dictates the opposite effect, and the trend can be seen in actual data. Bitcoin held in smaller denominations continues to grow steadily, while bitcoin held in larger denominations continues to decline. As the currency and economic system grows, the currency becomes more widely distributed. Rather than consolidate, the currency distributes to more people, and the nominal amount held by each declines, while purchasing power increases. As more people demand the currency, its value rises. However, there is a terminally fixed supply. As increases in demand naturally outpace ever diminishing increases in supply, there is one principal way to acquire bitcoin: by delivering value to an existing holder of the currency. The currency transfers from relatively few early holders to a more widely distributed base as a function of time. Everyone wins; the network utility increases as more participants voluntarily opt in and the distribution of the currency becomes less and less concentrated, ensuring greater balance and reducing systemic risks created by the existence of a few extremely large holders.
When the incentives of a monetary medium align both individual and aggregate interests, non-zero sum outcomes become the default, as does balance. Bitcoin is accessible to anyone, and everyone that chooses to use it is afforded the same protections. Anyone that produces value and exchanges it for bitcoin is assured that their output will not be devalued in the future merely as a function of someone in a far-off land creating new units of money. Separately, everyone is assured the benefit of undistorted price signals. In bitcoin, rich and poor are provided these same protections equally. It is no guarantee that someone else will value the currency more or less, but it eliminates the possibility of an involuntary forced devaluation of labor and output stored in a monetary medium, which distorts economic activity and creates false price signals. When presented with that opportunity relative to a certainty of the worse outcome, it becomes a clear choice. Compared to the current economic structure in which the wealthiest better understand the effects of active monetary debasement and are best equipped to combat and exploit it, there is a reality that those on the lower end of the economic spectrum have more to gain by leveling the playing field. Even still, it is not about rich and poor. Everyone benefits from the elimination of money production and an economy that provides greater balance through the communication of more perfect information.
In a tweet from 2018, the founder of Ethereum (Vitalik Buterin) beautifully and ironically described the power of holding a currency with a fixed supply that could not be manipulated, while actually arguing for the opposite. He both made the precise argument which central bankers use to defend their actions while also articulating the power it would place in the holder of a currency with a fixed supply. While Buterin believes it to be oligarchic to have the immutable right to own a fixed percentage of all the world’s money indefinitely, what if that right were extended to the poorest people on earth? What if it were applied equally to every single person on earth? That is the power of bitcoin. If you are living in one of the poorest countries in the western hemisphere, such as Nicaragua, and choose to exchange your value for bitcoin, you now have an immutable right to own a fixed percentage of all the world’s money indefinitely. Only you can decide when, how and to whom to transfer that for value received in the future. The poorest in Nicaragua suddenly are elevated to the exact same leveled playing field as a billionaire in New York like Paul Tudor Jones. Within the bitcoin network, there is no distinction. Equal rights are the default. That cannot and does not exist in the legacy financial system. It is infinitely more oligarchic to indiscriminately devalue someone’s monetary savings by increasing the supply of money while at the same time determining to whom that new money should be “rewarded.” There can be no comparison between that world and allowing those that earn money honestly by producing value for others to determine how best to allocate it for value returned in the future.
The idea that bitcoin could solve problems today for rich and poor alike stumps quite a few. Most consider bitcoin to be a speculative asset, and many will look at its volatility and believe it unfit for people without a level of savings that one could afford to lose. That view is fortunately flat wrong and economically unsupported. It is easy to look at an economic disaster like Venezuela, where the vast majority of people are struggling to have very basic needs fulfilled, and believe reliable access to food, water, power and healthcare is more important than “buying” bitcoin. However, it is harder to ignore that the economic collapse was caused by a deterioration in the money that previously coordinated economic activity and that the only long-term solution to build it back up is to use a form of money that better fulfills that coordination function. Reliable access to food, water, power and healthcare doesn’t exist without the use of money to coordinate resources. In rebuilding an economy on top of a new monetary medium, someone has to go first, and just because it is hard to imagine, it does not change the reality that it’s the only way out. One action triggers another. And another and another. Whether it’s Venezuela, any other country suffering from rapid economic deterioration, or any poverty-stricken area in the developed world, the need for assistance is immediate, but there is no quick fix. Bitcoin can’t remove a socialist dictator, it can’t take the kleptocrats out of the kleptocracy, it can’t reverse damaging tax policy or social programs, and it can’t magically turn poor people into rich people or vice versa. It can, however, solve problems today for anyone that is determined enough to use it, regardless of poverty level or economic status.
There is no reason why a superior form of money would perform one function for some and not for others, regardless of wealth, income levels or any other reason. It is a vicious cycle to break, but the inception point of elevating any individual or society is finding a way to produce more value than is consumed or demanded of others. The best way to accomplish that goal is by using money to exchange value and coordinate economic activity. Bitcoin isn’t just a rich person tool that will become serviceable to poor people once enough rich people have it. That is nonsensical. It is the opposite; it is the best way anyone can level the playing field, regardless of whether the path may be harder for some than others. The demand for money is near universal, and over time, anyone using the form of money with the strongest foundation and the most true price signals will benefit. Whereas the dollar (and other fiat currencies) are one for a few in the short-term and all for none in the long-term, bitcoin is one for all, now and in the future, because it fixes the economic foundation for everyone.
Views presented are expressly my own and not those of Unchained Capital or my colleagues. Thanks to Phil Geiger, Will Cole and Robert Breedlove for reviewing and for providing valuable feedback.
]]>“Perhaps the sentiments contained in the following pages, are not yet sufficiently fashionable to procure them general favor; a long habit of not thinking a thing wrong, gives it a superficial appearance of being right, and raises at first a formidable outcry in defense of custom. But the tumult soon subsides. Time makes more converts than reason.”
These were the opening remarks of Thomas Paine’s call for American independence in early 1776. At the time, a declaration of independence was far from a certainty, but in Paine’s view, there was no question. It wasn’t a debate; there was only one path forward. Still, he understood that public opinion had not yet caught up and naturally remained anchored to the status quo, with a preference for reconciliation rather than independence. Old habits die hard. The status quo has a tendency of being defended, regardless of merit, merely by its anchoring in time to the way things have always been. However, truths have a way of becoming self-evident in time, more often due to common sense rather than any amount of reason or logic. One day, the truth is more likely to smack you in the face, becoming painfully obvious through some firsthand experience which opens up a perspective that otherwise would not have existed. While Paine was undoubtedly attempting to persuade an undecided populous with reason and logic, it was at the same time an appeal to not overthink that which stands in opposition to what is already self-evident.
In Paine’s view, independence was not a modern-day IQ test, nor was its relevance confined to the American colonies; instead, it was a common sense test and its interest was universal to “the cause of all mankind,” as Paine put it. In many ways, the same is true of bitcoin. It is not an IQ test; instead, bitcoin is common sense and its implications are near universal. Few people have ever stopped to question or understand the function of money. It facilitates practically every transaction anyone has ever made, yet no one really knows the why of that equation, nor the properties that allow money to effectively coordinate economic activity. Its function is taken for granted, and as a result, it is a subject not widely taught or explored. Yet despite a limited baseline of knowledge, there is often a visceral reaction to the very idea of bitcoin as money. The default position is predictably no. Bitcoin is an anathema to all notions of existing custom. On the surface, it is entirely inconsistent with what folks know money to be. For most, money is just money because it always has been. In general, for any individual, the construction of money is anchored in time and it is very naturally not questioned.
But enter bitcoin, and everyone suddenly becomes an expert in what is and isn’t money, and to the fly-by-night expert, it certainly is not bitcoin. Bitcoin is natively digital, it is not tied to a government or central bank, it is volatile and perceived to be “slow,” it is not used en masse to facilitate commerce, and it is not inflationary. This is one of those rare instances when a thing does not walk like a duck or quack like a duck but it’s actually a duck, and what you thought was a duck all along was mistakenly something entirely different. When it comes to modern money, the long habit of not thinking a thing wrong, gives it a superficial appearance of being right.
In all perceived-to-be successful applications today, money is issued by a central bank; it is relatively stable and capable of near infinite transaction throughput; it facilitates day-to-day commerce; and by the grace of god, its supply can be rapidly inflated to meet the needs of an ever-changing economy. Bitcoin has none of these traits (some not presently, others not ever), and as a result, it is most often dismissed as not meeting the standards of modern-day money. This is where overthinking a problem can cripple the highest of IQs. Pattern recognition fails because the game fundamentally changed, but the players do not yet realize it. It is akin to getting lost in the weeds or failing to see the forest through the trees. Bitcoin is finitely scarce, it is highly divisible and it is capable of being sent over a communication channel (and on a permissionless basis). There will only ever be 21 million bitcoin. Rocket scientists and the most revered investors of our time could look at this equation relative to other applications in the market and be confounded, not seeing its value. While at the same time, if posed with a very simple question, would you rather be paid either in a currency with a fixed supply that cannot be manipulated or in a currency that is subject to persistent, systemic and significant debasement, an overwhelming majority of individuals would choose the former all day, every day.
As kids, we all learn that money doesn’t grow on trees but on a societal level, or as a country, any remnant of common sense seems to have left the building. Just in the last two months, central banks in the United States, Europe and Japan (the Fed, ECB and BOJ) have collectively inflated the supply of their respective currencies by 3.3 trillion in aggregate – an increase of over 20% in just eight weeks. The Fed alone has accounted for the majority, minting 2.5 trillion dollars and increasing the base money supply by over 60%. And it’s far from over; trillions more will be created. It is not a possibility; it is a certainty. Common sense is that deep feeling of uncertainty many are experiencing that says, “this doesn’t make any sense” or “this doesn’t end well.” Few carry that thought process out to its logical conclusion, often because it is uncomfortable to think about, but it is reverberating throughout the country and the world. While not everyone is connecting the equation to 21 million bitcoin, a growing number of people are. Time makes more converts than reason. Individuals don’t have to understand how or why there will only ever be 21 million bitcoin; all that has to be recognized in practical experience is that dollars are going to be worth significantly less in the future, and then the idea of having a currency with a fixed supply begins to make sense. Understanding how it is possible that bitcoin has a fixed supply comes after making that initial connection, but even still, no one needs to understand the how to understand that it is valuable. It is the light bulb turning on.
For each individual, there is a choice to either exist in a world in which someone gets to produce new units of money for free (but just not them) or a world where no one gets to do that (including them). From an individual perspective, there is not a marginal difference in those two worlds; it is night and day, and anyone conscious of the decision very intuitively opts for the latter, recognizing that the former is neither sustainable, nor to his or her advantage. Imagine there were 100 individuals in an economy, each with different skills. All have determined to use a common form of money to facilitate trade in exchange for goods and services produced by others. With the one exception that a single individual has a superpower to print money, requiring no investment of time and at practically no cost. Given human time is an inherently scarce resource and that it is a required input in the production of any good or service demanded in trade, such a scenario would mean that one person would get to purchase the output of all the others for free. Why would anyone agree to such an arrangement? That the individual is an enterprise, and more specifically, a central bank expected to act in the public interest does not change the fundamental operation. If it does not make sense on a micro level, it does not magically transform into a different fundamental fact merely because there are greater degrees of separation. If no individual would bestow that power in another, neither would a conscious decision be made to bestow it in a central bank.
Everything beyond this fundamental reality strays into abstract theory, relying on leaps of faith, hypotheticals and big words that no one understands, all while divorced from individual decision points. It is not that one individual is more trusted than another or one central bank relative to another; it is simply that, on an individual level, no individual is advantaged by someone else having the ability to print money, regardless of identity or interests. That this is true leaves only one alternative, that each individual would be advantaged by ensuring that no other individual or entity has this power. The Fed may have the ability to create dollars at zero cost, but money still doesn’t grow on trees. It is more likely that a particular form of money is not actually money than it is that money miraculously started growing on trees. And at an individual level, everyone is incentivized to ensure that is not the case. While there is a long habit of not thinking this particular thing wrong, the errant defense of custom can only stray so far. Time converts everyone back into reality. At present, it is the Fed’s “shock and awe” campaign contrasted by the simplicity in bitcoin’s fixed supply of 21 million. There is no amount of reason that can replace an observed divergence in two distinct paths.
As more people become aware of the Fed’s activities, it only begins to raise more questions. $2,500,000,000,000 is a big number, but what is actually happening? Who gets the money? What will the effects be and when? What are the consequences? Why is this even possible? How does it make any sense? All very valid questions, but none of these questions change the fact that many more dollars exist and that each dollar will be worth materially less in the future. That is intuitive. However, at an even more fundamental level, recognize that the operation of printing money (or creating digital dollars) does nothing to generate economic activity. To really simplify it, imagine a printing press just running on a loop. Or, imagine keying in an amount of dollars on a computer (which is technically all that the Fed does when it creates “money”). That very operation can definitionally do nothing to produce anything of value in the real world. Instead, that action can only induce an individual to take some other action.
Recognize that any tangible good or service produced is produced by some individual. Human time is the input, capital production is the output. Whether it is software applications, manufacturing equipment, a service or an end consumer good, all along the value chain, an individual contributed time to produce some good or service. That time and value is ultimately what money tracks and prices. Entering a large number into the computer does not produce software, hardware, cars or homes. People produce those things and money coordinates the preferences of all individuals within an economy, compensating value to varying degrees for time spent.
When the Fed creates $2.5 trillion in a matter of weeks, it is consolidating the power to price and value human time. Seems cryptic but it is not a suggestion that the individuals at the Fed are consciously or deliberately operating maliciously. It is just the root level consequence of the Fed’s actions, even if well intentioned. Again, the Fed’s operation (arbitrarily adding zeros to various bank account balances) cannot actually generate economic activity; all it can do is determine how to allocate new dollars. By doing so, it is advantaging some individual, enterprise or segment of the economy over another. In allocating new dollars that it creates, it is replacing a market function, one priced by billions of people, with a centralized function, greatly influencing the balance of power as to who controls the monetary capital that coordinates economic activity. Think about the distribution of money as the balance of control influencing and ultimately determining what gets built, by whom and at what price. At the moment of creation, there exists more money but there exists no more human time or goods and services as a consequence of that action. Similarly, over time, the Fed’s actions do not create more jobs, there are just more dollars to distribute across the labor force, but with a different distribution of those holding the currency. The Fed can print money (technically, create digital dollars), but it can’t print time nor can it do anything but artificially manipulate the allocation of resources within an economy.
Since 2007, the Fed balance sheet has increased seven-fold, but the labor force has only increased 6%. There are roughly the same number of people contributing output (human time) but far more dollars to compensate for that time. Do not be confused by impossible-to-quantify theory concerning the idea of a job saved versus a job lost; this is the U.S. labor force, defined by the Bureau of Labor Statistics as all persons 16 years of age and older, both employed and unemployed. The inevitable result is that the value of each dollar declines, but it does not create more workers, and all prices do not adjust ratably to the increase in the money supply, including the price of labor.
In a theoretical world, if the Fed were to distribute the money in equal proportion to each individual that held the currency previously, it would not shift the balance of power. In practical application, the distribution of ownership shifts dramatically, heavily favoring the holders of financial assets (which is what the Fed buys in the process of creating new dollars) as well as those with cheap access to credit (the government, large corporations, high net-worth individuals, etc.). In aggregate, the purchasing power of every dollar declines, just not immediately, while a small subset benefits at the cost of the whole (see the Cantillon Effect). Despite the consequences, the Fed takes these actions in an attempt to support a credit system that would otherwise collapse without the supply of more dollars. In the Fed’s economy, the credit system is the price setting mechanism as the amount of dollar-denominated debt far outstrips the supply of dollars, which is also why the purchasing power of each dollar does not immediately respond to the increase in the money supply.
Instead, the effects of increasing the money supply are transmitted, over time, through an expansion of the credit system. The credit system attempting to contract is the market and the individuals within an economy adjusting and re-pricing value; the Fed attempting to reverse that natural course by flooding the market with dollars is, by definition, overriding the market’s price setting function, fundamentally altering the structure of the economy. The market solution to the problem is to reduce debt (expression of preference) and the Fed’s solution is to increase the supply of dollars such that existing debt levels can be sustained. The goal is to stabilize the credit system such that it can then expand, and it is a redux to the 2008 financial crisis, which provides a historical roadmap. In the immediate aftermath of the prior crisis, the Fed created $1.3 trillion new dollars in a matter of months. Despite this, the dollar initially strengthened as deflationary pressures in the credit system overwhelmed the increase in the money supply, but then, as the credit system began to expand, the dollar’s purchasing power resumed its gradual decline. At present, the cause and effect of the Fed’s monetary stimulus is principally transmitted through the credit system. It was the case in the years following the 2008 crisis, and it will hold true this time so long as the credit system remains intact.
How the effects manifest in the real economy is very complicated, but it does not take any sophistication to recognize the general direction of the end game or its foundational flaws. More dollars result in each dollar becoming worth less, and the value of any good naturally trends toward its cost to produce. The marginal cost for the Fed to produce a dollar is zero. With all the bailouts from both the Fed and Congress, whether to individuals or companies, someone is paying for everything. It is axiomatic that printing money (or creating digital dollars) does nothing to generate economic activity; it only shifts the balance of powers as to who allocates the money and prices risk. It strips power from the people and centralizes it to the government. It also fundamentally impairs the economy’s ability to function as it distorts prices everywhere. But most importantly, it puts the stability of the underlying currency at risk, which is the cost that everyone collectively pays. The Fed may be able to create dollars for free and the Treasury may be able to borrow at near-zero interest rates as a direct result, but there is still no such thing as a free lunch. Someone still has to do the work, and all printing money does is shift who has the dollars to coordinate and price that work.
“Gospodin,” he said presently, “you used an odd word earlier–odd to me, I mean…”
“Oh, tanstaafl. Means there ain’t no such thing as a free lunch. And isn’t,” I added, pointing to a FREE LUNCH sign across room, “or these drinks would cost half as much. Was reminding her that anything free costs twice as much in long run or turns out worthless.”
“An interesting philosophy.”
Among its perceived flaws as a currency, bitcoin is viewed by many to be too complicated to ever achieve widespread adoption. In reality, the dollar is complicated; bitcoin is not. It becomes very simple when abstracted to the least common denominator: 21 million bitcoin; and who controls the money supply: no one. Not the Fed or anyone else. At the end of the day, that is all that matters. Bitcoin is in fact complicated at a technical level. It involves higher level mathematics and cryptography and it relies on a “mining” process that makes very little sense on the surface. There are blocks, nodes, keys, elliptic curves, digital signatures, difficulty adjustments, hashes, nonces, merkle trees, addresses and more.
But with all this, bitcoin is very simple. If the supply of bitcoin remains fixed at 21 million, more people will demand it and its purchasing power will increase; there is nothing about the complexity underneath the hood that will prevent adoption. Most participants in the dollar economy, even the most sophisticated, have no practical understanding of the dollar system at a technical level. Not only is the dollar system far more complex than bitcoin, it is far less transparent. Similar degrees of complexity and many of the same primitives that exist in bitcoin underly an iPhone, yet individuals manage to successfully use the application without understanding how it actually works at a technical level. The same is true of bitcoin; the innovation in bitcoin is that it achieved finite digital scarcity, while being easy to divide and transfer. 21 million bitcoin ever, period. That compared to $2.5 trillion new dollars created in two months, by one central bank, is the only common sense application anyone really needs to know.
Exhibit A – Dollar Supply
Plus Exhibit B – Bitcoin Supply
Equals Exhibit C – Purchasing Power of Bitcoin Relative to Dollars
There is a lot happening in the background, but these three charts are what drives everything. People all over the world are connecting these dots. The Fed is creating trillions of dollars at the same time the rate of issuance in bitcoin is about to be cut in half (see the bitcoin halvening). While most may not be aware of these two divergent paths, a growing number are (knowledge distributes with time) and even a small number of people figuring it out ultimately puts a significant imbalance between the demand for bitcoin and its supply. When this happens, the value of bitcoin goes up. It is that simple and that is what draws everyone else in: price. Price is what communicates information. All those otherwise not paying attention react to price signals. The underlying demand is ultimately dictated by fundamentals (even if speculation exists), but the majority do not need to understand those fundamentals to recognize that the market is sending a signal.
Once that signal is communicated, then it becomes clear that bitcoin is easy. Download an app, link a bank account, buy bitcoin. Get a piece of hardware, hardware generates address, send money to address. No one can take it from you and no one can print more. In that moment, bitcoin becomes far more intuitive. Seems complicated from the periphery, but it is that easy, and anyone with common sense and something to lose will figure it out; the benefit is so great and money is such a basic necessity that the bar on a relative basis only gets lower and lower in time. Self-preservation is the only motivation necessary; it ultimately breaks down any barriers that otherwise exist.
The stable foundation that underpins everything is a fixed supply which cannot be forged, capable of being secured without any counter-party risk and resistant to censorship and seizure. With that bedrock, it does not require a lot of imagination to see how bitcoin evolves from a volatile novelty into a stable economic juggernaut. A hard-capped monetary supply versus endless debasement; a currency that becomes exponentially more expensive to produce compared to a currency whose cost to produce is anchored forever at zero by its very nature. At the end of the day, a currency whose supply (and derivatively its price system) cannot be manipulated. Fundamental demand for bitcoin begins and ends at this singular cross-section. One by one, people wake up and recognize that a bill of goods has been sold, always by some far away expert and never reconciling with day-to-day economic reality.
With bitcoin as a backdrop, it becomes self-evident that there is no advantage either in ceding the power to print money or in allowing a central bank to allocate resources within an economy, and in the stead of the people themselves that make up that economy. As each domino falls, bitcoin adoption grows. As a function of that adoption, bitcoin will transition from volatile, clunky and novel to stable, seamless and ubiquitous. But the entire transition will be dictated by value, and value is derived from the foundation that there will only ever be 21 million bitcoin. It is impossible to predict exactly how bitcoin will evolve because most of the minds that will contribute to that future are not yet even thinking about bitcoin. As bitcoin captures more mindshare, its capabilities will expand exponentially beyond the span of resources that currently exist. But those resources will come at the direct expense of the legacy system. It is ultimately a competition between two monetary systems and the paths could not be more divergent.
Bananas grow on trees. Money does not, and bitcoin is the force that reawakens everyone to the reality that was always the case. Similarly, there is no such thing as a free lunch. Everything is being paid for by someone. When governments and central banks can no longer create money out of thin air, it will become crystal clear that backdoor monetary inflation was always just a ruse to allocate resources for which no one was actually willing to be taxed. In common sense, there is no question. There may be debate but bitcoin is the inevitable path forward. Time makes more converts than reason.
Views presented are expressly my own and not those of Unchained Capital or my colleagues. Thanks to Will Cole and Phil Geiger for reviewing and for providing valuable feedback.
]]>Minus the lionized heroes and a literal declaration of independence, bitcoin is still very much a fight for freedom, and it is similarly becoming a rally cry to all those that refuse to sit back and accept the fate of our tenuous financial system. The very idea of freedom may be the single most important tenet underpinning the monetary revolution to which bitcoin is giving rise. When the war is won, it will likely find its way directly into a constitutional amendment (even though it’s already covered by the first amendment). The right of the people to keep and bear bitcoin. Prior to bitcoin, everyone had no practical choice but to opt into a flawed currency system. That changed when bitcoin was released into the wild in 2009. Bitcoin is completely voluntary, it is controlled by no one, and it affords everyone the ability to store and transfer value in a form of currency that cannot be manipulated. Bitcoin may not be synonymous with the right to life, liberty and the pursuit of happiness but for those that choose to rely upon it as a better path forward, it is a fundamental and inalienable right.
While bitcoin is valued for different reasons by different people, it consistently appeals to those that have identified the inherent level of freedom afforded by such a powerful tool, particularly in a world full of never-ending economic calamities. As the fragility and instability of the global financial system becomes more apparent by the day, central bankers and politicians scramble in a race to see who can provide more stimulus to an economy that is red-lining. Lest we not forget, the instability in the financial system is not just appearing; it is reappearing. The structural issues resurfacing are the same that existed during the 2008 financial crisis. Before the oil war and the global pandemic, the repo funding markets broke in September 2019. The writing was not just on the wall, it was in the repo markets. If it were not these recent events acting as the accelerant, it would have been some other random “act of god” which would have made evident what remained under the surface all along: a highly-levered financial system primed to break at the first signs of any material stress.
Even before the global shutdown (i.e. government-accelerated panic), the Fed had already supplied ~500 billion in emergency funding to the repo markets. Now the fuel is really being dumped on the fire. But it is not just the scale that is alarming; it is the clear demonstration of control being lost through a meandering path of incrementalism. After the stock market crashed initially, the Fed issued an emergency 50bps interest rate cut; the market crashed some more and the Fed then announced an incremental 1.5 trillion in short-term funding (1-3 months) to be supplied in the repo markets. The market crashed again and three days later, a formal 700 billion “quantitative easing” program was announced to outright purchase 500 billion in U.S. government treasuries and $200 billion in mortgage-backed securities. Coinciding with this move, short-term rates were cut 100bps (all the way to zero).
Yep, the market crashed again, credit markets dislocated and the Fed followed with its “whatever it takes” response, announcing an unlimited QE program. Its three most aggressive moves to date all transpired within a 10-day window. And in its latest unprecedented act, the Fed will begin buying corporate bonds on the secondary market as well as participate in primary issuances of corporate credit. It also expanded its purchases of mortgage backed securities to include commercial mortgage backed securities (commercial real estate). In addition, the Fed established a facility to issue asset backed securities to purchase student loans, auto loans, credit card loans, etc. All of this without a price tag, and just a promise to do whatever it takes. It would be funny if it weren’t so serious, but the real question is, if the Fed were in control, why was it so reactionary? Why did its plans change so drastically in a ten-day period if it ever understood the extent of the issue? Never mind the unintended consequences, it is merely a demonstration that the Fed is not in control. Why would it have announced a $700 billion program if it didn’t expect it to work? It’s a classic game of guess and check, except the consequences can never be checked (only the immediate market reactions). The problem is our economy is at stake.
Make no mistake, the 1.5 trillion supplied to the repo markets will be converted to increment the Fed’s formal quantitative easing program, and the entire unquantified program should conservatively be expected to exceed 4 trillion when all is said and done. The Fed cannot put out the fire that is a liquidity crisis through short-term funding, and it will have no other choice but to monetize a larger share of the credit system than it did in 2008 because the problem is now larger. In addition, while not yet passed, Congress is working on an initial $2.0 trillion stimulus package in response to the global pandemic. With a market already suffering a liquidity crisis, the banking system does not magically have this cash on hand to finance a massive expansion of the Federal government’s deficit. There is a liquidity crisis unfolding after all. As a result, the Fed will be forced to finance any fiscal response through an ever-expanding quantitative easing program. It is the only way for the banks to get the cash needed to finance such a fiscal stimulus. All roads lead back to the Fed and endless QE.
This is the new normal and there is nothing sustainable about it. It is also not a reality we have to accept. There is a better way. As the world looks on, amidst the fear and panic, it often seems that there is no alternative. It is unclear when so many began to view the government’s role as one of fighting global pandemics (rather than the free market) but that is the world for which so many seem to aggressively demand. It is a symptom of failing to understand the root problem. It is misdiagnosing the fallout of a global pandemic and falsely believing the only hope is to allocate money created out of thin air by central banks and governments. It is predictably irrational. There is no reason even a few-month, complete economic shutdown should put the world on the brink of a global depression. Instead, it is the output of an inherently fragile financial system, one dependent on perpetual credit expansion necessary to sustain itself and without which it would begin to collapse. It is the fragility of the global financial system itself that is the problem, not a global pandemic. Do not be fooled. This isn’t a pandemic induced failure of the financial system. This was a 100% eventuality, pandemic or not. If not for its heavy dependence on credit and an unsustainable degree of leverage, the world would not be waking up to the S&P 500 futures locked limit down with seeming regularity.
And the economic dependence on credit as well as the high degree of system leverage are not a natural function of either capitalism or a free market. This market setup is a function of central banks everywhere. The instability is not by design but the market structure is. In response to every economic slow down (or crisis) which has appeared over the last four decades, central banks (including the Fed) have responded by increasing the money supply and reducing interest rates, such that existing debt levels could be sustained and such that more credit could be created. Every time the system as a whole attempted to deleverage, central banks worked to prevent it through monetary stimulus, ultimately kicking the can down the road and allowing decades of economic imbalance to accumulate in the credit system. This is the root cause of the inherent fragility in the financial system (see here). And it is why each time an economic disruption surfaces, the monetary response from central banks need be larger and more extreme. With greater imbalance comes the need for a bigger boat.
In doing so, the entire system is pushed further and further out onto the same ledge. The terminal risk to the system (the stability of the underlying currency) becomes greater and greater. Everyone is unwittingly forced to be along for this most unnerving of rides, but for those paying attention to the real game that is being played, bitcoin is increasingly becoming the clearest path to opt out of the insanity. Simplified down to the least common denominator, quantitative easing is a forced debasement (or devaluation) of monetary savings. It distorts every pricing mechanism within an economy and its intended goal is the expansion of credit. When history books are written of this pre-bitcoin era, the failure to understand the consequence of distorting global pricing mechanisms will be identified as the source of all other critically flawed assumptions in modern central banking doctrine. There is no escaping it. You can only hope to manage the fallout. But where don’t-tread-on-me meets the come-and-take-it mentality, freedom loving Americans of all the world and of all walks of life are beginning to say enough is enough. There has to be a better way because there always is.
That is core to the very idea of hope and the very nature of human ingenuity. It is an unwillingness to accept the new normal as a fait accompli. If quantitative easing can be simplified down to a debasement of monetary savings; bitcoin can be simplified down to the freedom to convert value into a form of currency that cannot be manipulated. In the Road to Serfdom, Hayek describes the function of money most aptly: “It would be much truer to say that money is one of the greatest instruments of freedom ever invented by man.” As he goes on to further explain, it is money that ultimately affords people a range of choice far greater than could otherwise be imaginable. It does so by distributing knowledge through its pricing mechanism, the single most important market signal (in aggregate) which facilitates economic coordination and the allocation of resources. However, as the freedoms afforded by one monetary medium become impaired, it should be no surprise that human ingenuity would find a way to route around and spawn a new creation that performs that same function more effectively. That is bitcoin and there is no going back. The proverbial cat is out of the bag and the distribution of knowledge is naturally exponential.
The promise of bitcoin is a more stable monetary system. There are no promises of what its value will be on any given day; the only assurance it provides is that its supply is not subject to manipulation or systematic debasement by a central bank (or anyone else). There is the seemingly constant question as to whether bitcoin is a “safe-haven” and more recently, why bitcoin has become correlated to the broader (collapsing) financial markets. The simple reality is that bitcoin is not a safe-haven, at least not as commonly defined in the mainstream. It is not held widely enough for it to possibly be a safe-haven. It remains nascent and it is perfectly predictable that at the onset of a global deleveraging event, a liquid asset would be sold along with everything else.
However, what remains true is that bitcoin is the antifragile competitor to the inherently fragile financial system.
In his book under the same name, Nassim Taleb describes antifragility as not just robust or resilient, but as the opposite of fragile. Antifragile systems actually gain strength and feed on volatility. The recent volatility in bitcoin is likely just the beginning but what it really represents is uninterrupted and unceasing price discovery. There are no circuit breakers in bitcoin and there are no bailouts. Each individual participant is maximally accountable and it is a market devoid of moral hazard. When the dust settles, what does not kill bitcoin only makes it stronger. In a literal sense. It is surviving and thriving in the wild, without any central coordination. It is not for the faint of heart, but it is the land of the free and the home of the brave. When it survives, there will still only be 21 million bitcoin, and its very survival will reinforce its place in the world. Increasingly, with each monetary stimulus injected into the legacy financial system, bitcoin’s core value function will become more apparent and more intuitive to more people. It will not just be by chance; it will be so because of the stark contrast bitcoin provides. Even with all its volatility, it is laying the foundation of a more stable monetary system.
Because the supply of bitcoin cannot be manipulated, its price and its supply of credit will similarly and forever be unmanipulable. Both will be determined on the market. As a result, the size of the bitcoin credit system will never sustain otherwise unsustainable imbalances. Beyond the nature of its fixed supply, this is where the contrast lies in practical application. The accumulation of sustained credit system imbalances (induced by central banks) is the inherent source of fragility in the global economy today. In a market built on the foundation of a currency that cannot be manipulated, as soon as imbalances arise, economic forces will naturally course correct, preventing the system-wide and systemic credit risk that plagues the legacy financial system. Rather than impair the future by allowing imbalances to accumulate beneath the surface, the unmanipulable supply of bitcoin will act as a governor to stamp out fires as soon as they appear. The fragile individual components of the system will be sacrificed and the system as a whole will become more antifragile by that very function.
For Joe Squawk (your modern-day average joe), it was Facebook’s Libra that made bitcoin more intuitive. For others, it is hyperinflation in Venezuela. And now for many, it will increasingly become the incessant reality that financial crises and QE are a recurring fact of life. No matter how many cycles of quantitative easing the Fed and its global counterparts have in their bag of tricks, bitcoin is inevitably becoming a rallying cry for all those that see the train wreck coming and are unwilling to stand idly by. It is not just a collective act of civil disobedience; it is an individual recognition of the need to act in self-preservation. There is a point in time for most everyone when common sense and survival instinct naturally take the reins. The avenue may be different for each individual, but at the end of the day, bitcoin is a means to preserve some form of freedom that is otherwise being impaired or infringed. Whether governments attempt to ban bitcoin or it is mistakenly blamed for the failures of the legacy system, always remember the simplicity of what bitcoin represents. It is nothing more than the individual freedom to convert real world value into a form of money that cannot be manipulated. It is a most basic and fundamental freedom but one that must be earned. So to all Americans in the world, stay humble, stack sats, and hold the damn line. Whatever it takes.
Views presented are expressly my own and not those of Unchained Capital or my colleagues. Thanks to Will Cole and Phil Geiger for reviewing and for providing valuable feedback.
]]>It may sound crazy to believe that bitcoin will be the dominant global currency, and it likely would be if evaluating the possibility from a top-down, probability-weighted perspective. Today, bitcoin is one of a thousand-plus competing digital currencies that all look the same on the surface. Its purchasing power of 150 billion is a drop in the bucket compared to the global financial system which supports 250 trillion of debt. Gold alone has a purchasing power of $8 trillion (50 times the size of bitcoin). What are the chances that an 11-year old internet sensation rises from the ashes of the 2008 financial crisis and goes from nothing to becoming the dominant global currency? The idea sounds laughable, or at the very least, it appears to be too low of a probability to warrant consideration. However, when starting from the bottom-up and developing conviction around a few foundational principles, the noise of a thousand cryptocurrencies fades to the background. When added together, just a few foundational principles create simplicity and clarity around what once may have seemed too complex to possibly discern. If someone had to evaluate one thousand possibilities to come to the right solution, it may not be practical or possible. But if you could eliminate 999 of those possibilities based on one, or a few starting first principles, it then becomes more practical to arrive at a coherent answer.
This is the roadmap to cutting out the noise and focusing on what really matters. Individuals may come to different conclusions concerning any of these questions, but this is the path to consider when attempting to understand why bitcoin consistently outcompetes all other currencies and whether it will continue to do so. Money is a basic necessity, but it is not a collective hallucination, nor is it a shared belief system. Individuals adopt bitcoin because it possesses unique properties that make it superior as a form of money relative to all other currencies. Because money is a solution to an intersubjective problem, monetary systems tend to converge on a single medium. Or rather, economic systems naturally emerge from a single medium due to the function of money. The properties inherent in bitcoin are causing the market to converge on it as a tool to communicate and measure value because it represents a step-function change improvement over any other monetary medium. If anyone comes away with the fundamental view that money is a necessity and that monetary systems naturally converge, the question then centers on whether bitcoin is optimized to fulfill the monetary function better than any of the competition.
Civilization as we know it would not exist without money. Without money, there would be no airplanes, no cars, no iPhones, and the ability to fulfill very basic necessities would become materially impaired. Millions of people could not peacefully inhabit a single city, state, or country without the function of money. Money is the economic good that allows food to reliably show up on grocery shelves, gas to be at the gas station, electricity to power homes, clean water to be abundant, etc. It is money that makes the world turn and it would not turn in the way that most have taken for granted if not for the function of money. It is a massively under-appreciated function; one that is poorly understood because it is generally not consciously considered. In the developed world, reliable money is taken as given. So too are the basic necessities delivered through the coordination function of money.
Consider, for example, a local grocery store and the range of choice that converges in a single store. The number of individual contributions and skills that are required to make that happen is mind-boggling. From the coordination of the store itself, to the individual packaging, to the technology providers, to the logistics networks, to the transportation networks, to the payments systems, and right down to each individual item of food. Then as a derivative, consider all the unique inputs that go into each item on the shelf. The grocery store is just the fulfillment side; the production of each input has its own diverse supply chain. And it is just one modern marvel. Deconstructing the inputs of a modern telecom network, energy grid or water and waste management system is similarly complex. Each network and the participants therein rely on the others. Producers of food rely on individuals that help fulfill energy demand, telecom services, logistics, clean water, etc. among others and vice versa. Practically all networks are connected, and it is all made possible through the coordination function of money. Everyone is able to contribute their own skills based on their own personal interests and preferences: receive money in return for value delivered today, and then use that same money to acquire the specialized value created by others in the future.
And it does not all happen by chance either. Some not-so-rigorous thinkers suggest that money is either a collective hallucination or that it derives value from the government. In reality, money is a tool that was invented by man to satisfy a very specific market need in facilitating trade. Money helps facilitate this activity by acting as an intermediary between a series of present and future exchanges. Without any conscious control or direction, market participants evaluate various different goods and converge on the tool with the properties best-suited to facilitate the very express purpose of converting present value for future value. Whereas individual consumption preferences vary from person to person and change constantly, the need for exchange is practically universal, and the function is distinctly uniform. For every individual, money allows for value produced in the present to be converted into consumption in the future. The value one places on a home, a car, food, leisure, etc. naturally changes over time and logically varies from person to person. But the need to consume and the need to communicate preferences does not change and applies to all individuals on an intersubjective basis.
Money exists to communicate these preferences and ultimately, value. But recognizing that all value is subjective (and not intrinsic), money forms the baseline to establish an expression of value and more importantly relative value. Money represents the collective recognition that everyone benefits from the existence of a common language to communicate individual preferences. It aggregates and measures the preferences of all individuals within an economy, at any point in time, and it would not be possible, or at the very least extremely inefficient, to communicate value if not for a common constant upon which everyone could agree. Think of money as the constant against which to measure all other goods. If it did not exist, everyone would be at a practical standstill, not able to agree on the value of anything. By comparing against a single constant, it then becomes more practical to discern the relative value of two other goods. There are billions of goods and services produced by billions of individuals, all with unique preferences. Through the convergence on a single form of money to aggregate and communicate all preferences, a price system ultimately emerges. By measuring and expressing the value of all goods in a common intermediary (money), it then becomes possible to understand how much one good (or resource) is valued relative to any other.
Without the use of a common currency, there would be no concept of price. And without the concept of price, it would not be possible to do any range of economic calculation. The ability to perform economic calculation allows individuals to take independent actions, relying on the information communicated through a price system, to best satisfy their own needs by understanding the needs of others. In fact, it is a price system that allows supply and demand structures to form, and it is ultimately a necessity because it provides for the communication of information, without which the fulfillment of basic needs would not be possible. Imagine if nothing you consumed had a discernible price. How would you know what you needed to produce in order to obtain the goods you prefer? Then recognize that your own conception of the value you produce and the very existence of goods and services produced by others would not be available if not for some expression of price existing. It becomes circular, but money is the good that allows the underlying structures of an economy to form through the price system. While it is often extolled as the root of all evil, money may just be the greatest accidental invention ever created by man, and one that could not have emerged by conscious control.
Late stage Silicon Valley thinking has many people believing that hundreds, if not thousands, of currencies may exist in the future. The machines are going to do all the calculation! AI and quantum will handle it. An intellectually “safe” view to hold is that 95% of cryptocurrencies will probably fail but there are some “interesting” projects. “It is inherently difficult to know which will succeed.” “Much like venture capital investing, most will fail but the ones that win will win big.” At least, this is what most of Silicon Valley would have you believe because it is a defensible parallel to historical experiences investing in companies. In reality, it is a blanket hedge lacking in first principles. It is also applying a familiar formula to an entirely distinct class of problem.
While it may seem logical to form a mental framework around bitcoin in relation to the rhyming history of technology startups, there can be no comparison whatsoever. Bitcoin is money, not a company. It would be illogical to assume competition between two monetary mediums (or multiple) would be in any way parallel or would follow a similar pattern to that of two companies. Companies compete in a capital formation arms race; in order to do so, they need money to coordinate economic activity. How do they get money? By using money to coordinate the production of goods and services and by selling the output for more money (profit). In essence, companies compete for the same pool of money in order to accumulate capital. Money is the tool that makes the wheel go round. It simply would not be possible to coordinate all the individual skills necessary in order to allow for the fulfillment of goods and services derived from the complexity of most modern supply chains without money. It also would not be possible if it were not for the fact that a large group of people accepted a common form of money.
In the supply chain of production, money serves a distinct function of a different class than any individual good or service. It is the distinction between the fulfillment of preferences (production of goods and services) and the coordination of preferences (money). The fulfillment of preferences is dependent on the coordination of preferences, and the coordination of preferences is dependent on a price system, which can only form as a derivative of mass convergence on a single monetary medium. Without a pricing system, division of labor would not exist, at least not to the extent necessary to allow for the functioning of complex supply chains. This is the root level principle most miss when contemplating a world of many currencies. Any pricing system is derived from a single currency. The concept of price would not exist if not for a critical mass of individuals producing a diverse set of goods and services and communicating the value of those goods and services through a common medium. In order to derive the benefit of money and price, convergence is a precursor. As a result, it may be more accurate to say that economic systems emerge from a single monetary medium rather than converge on one. Individuals converge on a single monetary medium and the output is an economic system.
Whereas the value of all other goods and services is consumption, the value of money is exchange. Exchange is the good any individual is purchasing when choosing to convert value (the subjective output of time, labor and physical capital) into a monetary good. Individual consumption preferences are unique, but money serves one singular function for all market participants: to bridge the present to the future (whether it be for a day, week, year or longer). In any exchange of present value, some time continuum exists until a future exchange. At the point of exchange, each individual must make a decision as to which monetary good will best serve the function of preserving value created in the present into the future. A or B? While an individual can choose to hold one or multiple currencies, one is definitionally going to perform that function more effectively. One will preserve future purchasing power better than the other. Everyone intuitively understands this and makes a decision based on the inherent properties of one medium relative to another. When deciding which monetary good to use, the preference of one individual is impacted by the preference of others, but each individual is making an independent evaluation discerning the relative strengths of multiple monetary goods. It is not coincidence that the market converges on a single medium because each individual is attempting to solve the same problem of future exchange, which is interdependent on the preference of others.
The ultimate goal is to reach consensus such that each individual can communicate and exchange with the widest and most relevant set of trading partners. Collectively, it is an objective evaluation of tangible goods based on an intersubjective need. The whole point is to find the one good that everyone can agree is i) a relative constant, ii) measurable and iii) functional in exchange. The existence of a constant creates order where none existed previously, but that constant must also be functional as both a measurement tool and a means of exchange. It is the combination of these characteristics, often described as aggregating the properties of scarcity, durability, fungibility, divisibility, and transferability, which are unique to money. Very few goods possess all of these properties, and every good is unique, with inherent properties that cause each to be better or worse in fulfilling certain functions within an economy. A is always different than B, and the combination of properties that perfect a monetary good are so rare that the distinction from one to another is never marginal.
More practically, everyone agrees on a single monetary good through which to express value because it is in their individual and collective interests to do so. It is the problem itself: how to communicate value with other market participants. It would be counterproductive to the entire exercise if a consensus were not formed. But it is the properties of a monetary good itself that allow for convergence and consensus. The imagined world of thousands of currencies is blind to these fundamental first principles. A critical mass of individuals converging on a common medium is the input required to ascertain the information that is actually desired. And the value of a common medium only increases in value as more and more people converge on it as a tool to facilitate exchanges. The fundamental reason being that with more individuals converging on a single medium, the medium actually accumulates more information and presents a greater utility.
Think of each individual as a potential trading partner. As individuals adopt the common medium as a standard of value, all existing participants in the monetary network gain new trading partners, as do the individuals that become part of the network. There is mutual benefit, and ultimately the range of choice expands. But what also occurs as a monetary network expands is that more goods come to be valued in the common medium of exchange. More prices exist, and as a result, more relative prices do as well. More information is aggregated into the common medium, which can then be relied upon by all individuals within the network (and by the network as a whole) to better coordinate resources and respond to changing preferences. The constant becomes more valuable and inherently more reliable as it communicates more information about more goods produced by more individuals. The constant actually becomes more constant as more variable information is communicated through it.
As adoption of a monetary network increases by an order of magnitude (10x), possible network connections increase by two orders of magnitude (100x). While this helps demonstrate the mutual benefit of adoption, it also highlights the consequence of converting value into a smaller monetary network. A network that is one-tenth the size has 1% of the number of potential connections. Not every network distribution is equal, but a larger monetary network translates to a more reliable constant to communicate information – greater density, more relevant information and ultimately a broader range of choice. The size of a monetary network and the expected growth of that network become critical components of the intersubjective A/B test, when each individual is determining which medium to utilize. While the number of people with whom any individual can maintain social relationships is inherently limited, the same limits do not apply to monetary networks. It is money that allows humans to break from the constraints of Dunbar’s number. A monetary network allows for millions (if not hundreds of millions) of people unknown to each other to contribute value at end points in the network, with relatively few direct connections needed.
Monetary networks ultimately accumulate the value of all other networks because all other network effects would not exist without a monetary network. Complex networks cannot form without a common currency to coordinate the economic inputs necessary to kick start the positively reinforcing feedback loops of price. A common currency is the very foundation of any monetary network, which allows other value networks to form. It provides the common language to communicate value, ultimately leading to trade and specialization, and organically creating the ability to expand the use of resources beyond the reach of “conscious control” (to steal Hayek). When contemplating the network effects of a social network, a logistics network, a telecom network, energy grid etc., add them all together and that is the value of a monetary network. A monetary network not only provides the foundation for all other value networks to form, but the currency of that network is what pays for access to all derivative networks within the monetary network. The existence of the common currency is the engine and the oil.
Yes, the dollar, euro, yen, pound, franc, yuan, ruble, lira, peso, etc. all co-exist today, but this is not a natural function of an open, global economy. Instead, each fiat currency that exists today emerged as a fractional representation of gold, which the world had previously converged upon as a monetary standard. None would subsist without the forces of government intervention; nor would any fiat currency have ever emerged if not for the prior existence (and limitations) of gold as a monetary medium. Modern monetary theorists and gold bugs alike will never admit it, but the calamity that is all fiat systems is nothing more than the manifestation of gold’s failure as a monetary medium. It is a dead man walking. The gold standard was formally abandoned in 1971, and the subsistence of jurisdictional fiat systems since then merely represents a transient departure from free market monetary forces. Modern fiat systems have only managed to survive as long as they have because a solution to the very problem created by fiat did not yet exist. Bitcoin is that solution, and ever since its creation, individuals have been converging upon it as a new monetary standard; a trend that will only continue as knowledge naturally distributes.
The market converges on bitcoin over time and its value continues to increase because it provides a constant that is superior to any other form of money. Bitcoin has an optimal monetary policy, and that policy is credibly enforced on a decentralized basis. Only 21 million bitcoin will ever exist, and the element of trust is removed from the equation entirely. Bitcoin’s fixed supply is enforced by a network consensus mechanism on a decentralized basis. No one trusts anyone, and everyone enforces the rules independently. As an aggregate of these two functions, bitcoin is becoming the scarcest form of money that has ever existed. Finite scarcity is a property no other form of money has ever or will ever achieve, and demand for bitcoin is fundamentally driven by that scarcity. However, scarcity is a two-sided equation. A fixed supply may be the primary draw, but demand is a critical and often overlooked aspect of scarcity. Demand is what actually makes scarcity a utility as a constant in exchange. Bitcoin becomes more and more scarce as a two-way function of increasing demand and a completely inelastic terminal supply. The scarcity of its fixed supply creates demand but increasing demand then creates greater scarcity. It sounds circular because it is. If there were 21 million bitcoin and only 1 person valued it, there would be nothing scarce or useful about bitcoin. But if 100 million people valued bitcoin, 21 million starts to become scarce. And if the network grew to one billion people, 21 million would become extremely scarce, and bitcoin would represent a greater utility as a constant.
With a fixed supply, increased demand naturally results in bitcoin becoming more distributed. There is only so much to go around, and the pie ends up getting split up into smaller and smaller shares owned by more and more people. As more individuals value bitcoin, the network not only becomes a greater utility; it also becomes more secure. It becomes a greater utility because more people are communicating in the same language of value through a more reliable constant. And as more individuals participate in the network consensus mechanism, the entire system becomes more resistant to corruption and ultimately more secure. Recognize that there is nothing about a blockchain that guarantees a fixed supply, and bitcoin’s supply schedule is not credible because software dictates it be so. Instead, 21 million is only credible because it is governed on a decentralized basis and by an ever increasing number of network participants. 21 million becomes a more credibly fixed number as more individuals participate in consensus, and it ultimately becomes a more reliable constant as each individual controls a smaller and smaller share of the network over time. As adoption increases, security and utility work in lock-step. Consider the distribution and relative density of bitcoin adoption throughout the world (heat map below of network nodes). As reach and density within each market spread, bitcoin’s constant becomes harder and harder.
As individuals increasingly opt-in, 21 million becomes more and more credible, and in the mind of those who adopt it, finite scarcity becomes what differentiates bitcoin from all other forms of money – both legacy currencies and competing cryptocurrencies alike. All other currencies either centralize over time (e.g. the dollar, euro, yen, gold) or were too centralized from the start (e.g. all other cryptocurrencies) to credibly compete with a fixed supply of 21 million. Centralization inherently creates the need to rely on trust, and trust ultimately puts the supply of any currency at risk, which in turn impairs demand and marginalizes its utility in the function of exchange. Whereas all other currencies depend on trust, the constant bitcoin provides is trustless. 21 million is only credible because bitcoin is decentralized, and bitcoin becomes increasingly decentralized over time. The best any other form of money could possibly do is match bitcoin, but practically, it is not possible because individuals converge on a single medium, and bitcoin beat every other currency to the punch. Every other currency is ultimately competing against the ideal constant; one that will not change and that does not rely on trust.
All forms of money compete with each other for every exchange. If the primary (or sole) utility of an asset is the exchange for other goods and services, and if it does not have a claim on the income stream of a productive asset (such as a stock or bond), it must compete as a form of money. As a consequence, any such asset is directly competing with bitcoin for the exact same use case, and no other currency will ever provide a more reliable constant because bitcoin already exists and it is finite. Because individuals converge on a single medium, scarcity in bitcoin will perpetually be reinforced on both the supply and demand side, whereas the opposite force will be in effect for all other currencies due to the reflexive nature of monetary competition. The distinction between two monetary goods is never marginal, and neither is the consequence of individual decisions to exchange in one medium rather than another. Money is an intersubjective problem, and a choice to opt into one monetary medium is an explicit opt out of the other, which in turn causes one network to gain value (and utility) at the direct expense of another. As bitcoin becomes more scarce and more reliable as a constant, other currencies become less scarce and more variable. Monetary competition is zero sum, and relative scarcity, a dynamic function of both supply and demand, creates the fundamental differentiation between two monetary mediums that only increases and becomes more apparent over time.
But remember that scarcity for scarcity sake is not the goal of any money. Instead, the money that provides the greatest constant will facilitate exchange most effectively. The monetary good with the greatest relative scarcity will best preserve value between present and future exchanges over time. Relative price and relative value of all other goods is the information actually desired from the coordination function of money, and in every exchange, each individual is incentivized to maximize present value into the future. Finite scarcity in bitcoin provides the greatest assurance that value exchanged in the present will be preserved into the future, and as more and more individuals collectively identify that bitcoin is the monetary good with the greatest relative scarcity, stability in its price will become an emergent property (see “Bitcoin is Not Too Volatile”).
While scarcity is the bedrock, not all scarce goods are functional as money. In order to be functional as a tool to communicate value, a monetary good must be a relative constant, easy to measure and functional in exchange. A ruler may be an effective measurement tool, but rulers are not scarce, nor is it easy to carve up pieces of a ruler into larger and smaller units to facilitate exchange. In exchange, a monetary good being scarce and measurable allows for the measurement of all other goods; the ability to easily subdivide and transfer a monetary unit provides for practical utility in exchange. Bitcoin combines finite scarcity with the ability to subdivide each whole unit down to 8 decimal points (0.00000001 or one 100,000,000th of a bitcoin) and transfer any amount of value, however large or small. Just as scarcity for scarcity sake is not necessarily valuable in the context of money, neither is the property of divisibility. It is the combination that becomes valuable in the context of money, particularly when each subdivided unit is fungible – when each individual unit is essentially interchangeable and each of its parts is indistinguishable from another part. It is these properties together that allow bitcoin to not only be a perfect constant but also an effective measure of value to facilitate exchange.
In the code, one bitcoin is actually represented as 100,000,000 sub-units, with the smallest unit referred to as a satoshi (or sat for short). Technically, one bitcoin is 100,000,000 sats. While one bitcoin equates to approximately 9,000 today, one satoshi is equal to one-twentieth of a penny. In essence, anyone can exchange any amount of value into bitcoin. Bitcoin, as with any money, is functional for one purpose, to store value between a series of exchanges. Receive bitcoin for value produced today, save, spend bitcoin in the future in return for value produced by others. It will perform the same function regardless of amount. The practical consequence of divisibility is that bitcoin is capable of measuring any and all value which allows it to support any and all adoption. Individuals produce a wide range of value, and divisibility allows all individuals to utilize bitcoin as a savings mechanism regardless of whether it be to store 50 or $50,000 in value. For a monetary good to be an effective communication tool, it must be able to measure the range of value produced by all individuals, and bitcoin does this flawlessly. The ability to divide and transfer any amount of bitcoin makes it accessible to all individuals and ultimately all goods produced, regardless of how much value is attributable to each.
In the A/B test of monetary competition, if A > B, any amount of A will perform the function of money better than any amount of B. Over time, A will increase in purchasing power relative to B whether it be for 50 or 50,000-worth of value. Never be confused by a list of cryptocurrencies trading on Coinbase that look like a “better deal” because the price is “cheap” whereas bitcoin appears “expensive.” Always remember that bitcoin is capable of being divided into smaller or larger units to store more or less value. One bitcoin is an inherently arbitrary unit, as is one unit of any currency. The market test is whether A is more functional as money than B. It is an intersubjective decision, and while the market is communicating which network it believes performs the monetary function more effectively through price and value, network value is the output, not the input. The input is each individual evaluating the properties of the monetary good itself relative to others. If bitcoin is A in your evaluation, then there is no “too expensive.” Bitcoin may be over or undervalued at any point in time, but each individual that adopts bitcoin increases the value of the network (recall the discussion on trading partners + network connections). And the ability to be divided easily into very small units allows for a practically limitless number of individuals to convert and communicate value through the network. If A is greater than B, and if A can support unlimited adoption, it eventually obsoletes the need for network B.
As individuals independently evaluate this A/B test, more people ultimately adopt bitcoin, and bitcoin becomes divided into smaller and smaller units (on average). This is the result of increasing demand combined with a fixed supply, and the value of the network actually increases as a function of this process. As a network, bitcoin becomes more valuable as it is valued by more people. Essentially, 0.1 bitcoin = 1,000 is more valuable than 1.0 bitcoin = 1,000, despite each being worth the same measured in dollar terms. More exchange (and ultimately more commerce) becomes possible the more valuable bitcoin becomes in total, but value is really an output of more and more people choosing to adopt bitcoin as an exchange intermediary. Each individual owns a smaller and smaller nominal amount of the currency, but the purchasing power of each equivalent unit increases over time. With each exchange, every individual is conveying his or her own value onto the network and is doing so at the direct expense of a competing monetary network. Through this process, a new price is determined specific to the value created and measured by each individual, and as a result, bitcoin accumulates more information derived from a more diverse set of trading partners.
While prices today may not yet be quoted in bitcoin terms, a pricing system is forming every time an individual converts value into bitcoin. Even if dollars are an indirect intermediary, value produced somewhere in the world, distinct to a particular individual, is expressed as a unit of bitcoin; as more and more people choose to do so and increasingly on a per-individual basis, that value converts to a smaller and smaller unit of bitcoin (on average). The consequence is that a smaller and smaller denomination of bitcoin can be used by more people to transfer an equivalent amount of value, and as bitcoin is measured by more people, its ability to measure relative value only increases. Since bitcoin can measure all value and can be adopted by a limitless number of individuals, it practically obsoletes the need for any other value transfer network over the long-term because the form of money with the lowest rate of change ultimately communicates more perfect information. Finite scarcity combined with divisibility creates an extremely powerful exchange intermediary. Bitcoin has the lowest terminal rate of change possible due to its absolute scarcity, and it can be divided to a fraction of a penny, which will allow it to measure value far more precisely than any other currency.
With this baseline, the real knockout punch becomes the fact that bitcoin can be irrevocably transferred over a communication channel without the need for any trusted third-party as an intermediary. This is fundamentally different than digital payments in fiat systems, which are dependent on trusted intermediaries. In aggregate, bitcoin is a greater constant than any other form of money and is highly divisible (and measurable), while also capable of being transferred over the internet. Try to identify a single other good that could possibly share these properties: finite scarcity (greatest constant) + divisibility and fungibility (measurement) + ability to send over a communication channel (ease of transfer). This is what every other monetary good is up against as it competes for the convergent role of money. Practically, the only way to really appreciate the power of such a rare dynamic is through experiencing it firsthand. Any individual can access the network on a permissionless basis by running a bitcoin node on a home computer. The ability to power up a computer anywhere in the world and transfer a finitely scarce resource to any other individual, without permission or reliance on a trusted third-party is empowering. That hundreds of millions of people can do this in unison without anyone needing to trust other participants in the network is near-impossible to fully comprehend.
Bitcoin is often described as digital gold, but really, this does not do it justice. Bitcoin combines the strengths of physical gold with the strengths of the digital dollar without the limitations of either. Gold is scarce but difficult to divide and transfer, while the dollar is easy to transfer but not scarce. Bitcoin is finitely scarce, easy to divide, and easy to transfer. In their current forms, both gold and all fiat monetary systems are dependent on trust, whereas bitcoin is trustless. Bitcoin optimized for the strengths and weaknesses of both, which is fundamentally why the market is converging (and will continue to converge) on bitcoin to fulfill the function of money.
If any individual comes to three principal conclusions: i) money is a basic necessity, ii) money is not a collective hallucination and iii) economic systems converge on a single medium, that individual is going to more consciously seek out the best form of money. It is money that preserves value into the future, and ultimately, allows individuals to convert their own time and their own skills into a range of choice so great that prior generations would find it difficult to imagine. Freedom is ultimately what a reliable form of money provides: the freedom to pursue individual interests (specialization) and the ability to convert the output of that value into the value created by others (trade). Whether individuals consciously ask themselves these questions or not, they will naturally be forced to answer them through their actions. They will also arrive at the same answer as those that do. The conscious and the subconscious arrive at the same place because the fundamental truths do not change, and the function of money is singular: to intermediate a series of present and future exchanges and to provide the very baseline to communicate subjective value among a wide group of individuals that stand to benefit from trade and specialization. Money is a necessity. There are discernible properties that make certain goods more or less functional in exchange, and exchange is an inherently intersubjective problem.
Owning bitcoin is becoming the cost of entry to what will likely be the largest and most diverse economy that has ever existed. Bitcoin is global and it is accessible on a permissionless basis. Because bitcoin becomes the common language of value for all participants, anyone that is a part of the network will be able to communicate and ultimately trade with other network participants. The more trading partners, the greater the value each unit provides to the individuals holding the currency. While there will likely always be jurisdictional friction that impedes trade, access to the same common currency removes the root source of friction in the communication of value, and bitcoin’s fixed supply will allow its pricing mechanism to accumulate and communicate more perfect information with the least amount of distortion relative to any other form of money. And as more individuals choose to store value in bitcoin, its fixed supply becomes more credible and its pricing mechanism more reliable and relevant. New adopters of a monetary network both contribute value and realize value as a function of adoption, which is why it is not possible to be late to bitcoin, nor will bitcoin ever be too expensive.
It does not matter how complex bitcoin is. At the end of the day, bitcoin becomes an A/B test. The need for money is real and individuals will converge on the form of money that best fulfills the function of exchange. No other currency in the world can ever be more scarce than bitcoin, and scarcity will act like a gravitational force driving adoption and communication of value. Today, most billionaires do not understand bitcoin. Bitcoin is an equal opportunity mind-bender. But even those who do not understand bitcoin will come to rely upon it. There are many fundamental questions. Bitcoin is volatile, seemingly slow, challenges to scaling, not commonly used for payments, consumes a lot of energy, etc. Stability is an emergent property that follows adoption, and all other perceived limitations will be solved as a function of the value that is derived from finite scarcity combined with the ability to measure, divide and transfer value. That is the innovation of bitcoin. Currency A has a fixed supply. Currency B does not. Currency A keeps increasing in value relative to Currency B. Currency A continues to increase in purchasing power relative to goods and services while Currency B does the opposite. Which one do I want? A or B? Make the right choice because the opportunity cost is your time and value. All of the rest simply explains why individuals will increasingly opt for A over B, but in practice, it all comes down to basic common sense and survival instincts. Bitcoin obsoletes all other money because economic systems converge on a single currency, and bitcoin has the most credible monetary properties.
Views presented are expressly my own and not those of Unchained Capital or my colleagues. Thanks to Will Cole and Phil Geiger for reviewing and for providing valuable feedback.
]]>We will come back to this, but you will never hope to understand the justification for the amount of energy bitcoin consumes without first developing an appreciation for the fundamental role money plays in coordinating economic activity. What is money? How does it work? How should it work? What is its function in society? If you haven’t stopped to ask these questions, you can’t begin to grasp the weight of the problem bitcoin intends to solve. And without an appreciation for the problem, the cost to secure the solution will never seem justified.
Any number of concerned onlookers raise the red flag about the amount of energy consumed by the bitcoin network. This concern stems from the idea that the energy consumed by the bitcoin network could otherwise be utilized for more productive functions, or that it is just plain bad for the environment. Both ignore the fundamental magnitude of how critical bitcoin’s energy consumption actually is. In the long-game, there may be no greater, more important use of energy than that which is deployed to secure the integrity of a monetary network and constructively, in this case, the bitcoin network. But, that doesn’t stop those that do not understand the problem statement from raising concerns.
For background, bitcoin is secured by a decentralized network of nodes (computers running the bitcoin protocol). Economic nodes within the network generate, validate and relay transactions as well as validate and relay bitcoin blocks (time sequenced groups of transactions). Mining nodes perform similar functions but also perform bitcoin’s proof of work function to generate, solve and transmit blocks to the rest of the network. By performing this work, miners validate history and provide a “clearing” function for current transactions, which all other nodes then check for validity. Think the clearing function of the New York Fed but on a completely decentralized basis every ten minutes (on average).
The work performed requires massive amounts of processing power contributed by miners all over the world, running 24 hours a day, 7 days a week. This processing power requires energy. For context, at 75 exahashes per second, the bitcoin network currently consumes approximately 7-8 gigawatts of power, which translates to ~9 million per day (or ~3.3 billion per year) of energy at a marginal cost of 5 cents per kWh (rough estimates). Based on national averages in the U.S., the bitcoin network consumes as much power as approximately 6 million homes. Yeah, it is definitely a lot of power, but it is also what secures and backs the bitcoin network.
How could this much energy be justified? And what will bitcoin consume when a billion people are using it? The dollar works just fine, right? Well that’s just the thing, it doesn’t. These resources are being devoted to fix a problem most don’t understand exists, which makes justifying a derivative cost challenging. To help ease the pain of environmentalists and social justice warriors, we often point out a number of countervailing narratives to make it seem more palatable:
These considerations help enumerate why a simple view that bitcoin’s energy consumption is necessarily wasteful or necessarily bad for the environment fails the proverbial test. However, without an appreciation for the enormity of the monetary problem bitcoin intends to solve, the marginal cost could never be justified. Bitcoin represents a solution to the systemic issues that exist within our legacy monetary framework and it relies on energy consumption to function. Economic stability depends on the function of money and bitcoin provides a more sound monetary framework which is why there is no more important long-term use of energy than securing the bitcoin network. So rather than expand on the many individual counterpoints to the mainstream narrative, there is no better place to focus than the first principle problem itself: the money problem or the global QE (quantitative easing) problem, see here.
The problem of money is enormous, though most people do not recognize it. Most can feel it in their daily lives but cannot identify the root cause. Working harder, longer hours, going into debt and still barely getting by. There has to be a better way, but in order to identify a solution, one has to first see and understand the problem. The problem that exists is with our money and the impact it has on society is pervasive.
Without getting into the details of what money is (read The Bitcoin Standard or Nick Szabo’s “Shelling Out”), we can more easily describe its function in society. Money is the good that facilitates economic coordination between parties that otherwise would not have a basis to cooperate. Put simply, it is the good that allows society to function, and it allows us to accumulate the capital that makes our lives better, which takes different forms for different people. There is a saying that money is the root of all evil, but as Hayek more appropriately describes it in the Road to Serfdom, money is an agent of freedom.
More specifically, money is the good that allows for specialization and the division of labor. It allows individuals to pursue their own interests; it is how individuals communicate their preferences to the world, whether in work or in leisure, and it is what creates the “range of choice” we all take for granted. Our modern economy is built on the foundation of freedom that money provides, but the end result is a highly complex and specialized system.
To simplify the concept, Milton Friedman explains the complexity of a pencil (see here), detailing how no one individual is capable of producing a standard lead pencil. He details the wood required, the saw to cut the wood, the steel to make the saw, the iron ore to make the steel, the lead, the rubber for the eraser, the brass ring, the yellow paint, the glue, etc. He explains how making a single pencil requires the coordination and cooperation of thousands of people, including people who don’t speak the same language, who likely practice different religions and who may even hate each other if they were ever to meet in person. And he explains that the ability to cooperate is a function of the price system and the economic good we call money.
Abstracting from the pencil, now consider the complexity of our modern economy. From cars to airplanes to the internet to mobile phones, even to your local grocery store. Modern supply chains are so complex and so specialized that they require the coordination of millions of people to deliver any of these basic functions. The orchestration of all this activity which fuels global trade is only made possible by the function of money.
Venezuela provides a tangible macro and micro example of the vital role money plays in economic coordination and the dysfunction that follows when a monetary good fails. Venezuela is one of the most oil rich countries in the world, but as an end game function of monetary debasement, Venezuela’s currency has recently hyperinflated. As its currency has deteriorated, basic economic functions have broken down to the point where getting food at grocery stores or basic healthcare is no longer the baseline. It is a full-on humanitarian crisis, and at the root level, it is a function of Venezuela no longer having a stable currency to coordinate economic activity and to facilitate the production of the goods it needs to trade within the global economy.
How does this relate to bitcoin and energy consumption? Being an energy rich country, oil was (and is) Venezuela’s primary export; or rather, the good it needs to produce in order to trade. Despite being one of the most energy rich countries in the world, Venezuela’s oil production is plummeting.
Venezuela can no longer import the technology or coordinate the resources it needs to extract its primary trading currency (oil). This has caused significant deterioration in its local economy, impairing its ability to produce the electricity needed to power its own energy grids, causing extended blackouts and preventing the delivery of basic services such as power, clean water or healthcare.
What is occurring in Venezuela is devastating, and it is a function of the economic deterioration caused by hyperinflation. Monetary debasement distorts the price mechanism of a currency, which then creates economic imbalances. As economic coordination deteriorates, complex supply chains become disrupted resulting in a decline in the supply of real goods (e.g. food on shelves, oil production, etc.) and an imbalance between supply and demand. As more money is created, real goods become relatively scarce compared to the supply of money, which causes the very function of money to breakdown. Individuals have a disincentive to hold currency as real goods become more and more scarce, instead choosing to sell currency as quickly possible, creating a run on basic necessities and causing the currency to hyperinflate. Economic deterioration by monetary manipulation 101.
Now, many sitting comfortably in the developed world will look at Venezuela and think, “it could never happen here,” but that ignores all first principles. Whether it is well understood or not, the market structure of the Venezuelan bolivar or the Argentine peso is identical to that of the dollar, the euro or the yen. The Fed, the European Central Bank or the Bank of Japan may be better at managing stability (for now), but it does not change the fact that the underpinnings of all fiat currency systems are the same.
To highlight the U.S. as an example, the Federal Reserve expanded the monetary base from 180 billion in 1984 to a peak of 4.2 trillion following QE3, an increase of 23x. Because of the nature of the Fed’s credit-based economy, the economic distortion of this debasement occurred gradually (see here) until the financial crisis which occurred suddenly, and as a function of quantitative easing, we presently sit further out on the same ledge. If you believe the developed world is not in a precarious situation or not subject to a similar monetary foundation as Venezuela, I would respectfully point to patients zero: the Fed, the ECB and the Bank of Japan. Often, faith placed in these institutions is blind to both first principles and common sense, but consider the quote below from a resident Fed economist during the aftermath of the financial crisis and as the Fed was in the middle innings of creating $3.6 trillion new dollars as part of quantitative easing:
An honest review of history demonstrates the ill-temperament of those put in charge of managing our economies from central command. While admitting profound gaps in their ability to understand the implications of actions taken on the real economy, the response was to continue down the same path (but in a bigger way) while expecting a different result, the definition of insanity. Now, as we face the consequences of the response to the crisis, we have a choice between two great contrasts. A) a centrally-planned form of currency that is designed to lose its value; or B) a decentralized currency with a fixed supply. The latter comes with cost in the form of energy consumption, but the positive externality will be long-term economic stability.
Future economic stability is fundamentally why there can be no more important source of demand for the consumption of energy than the security of bitcoin’s monetary system, especially when the alternatives (fiat and gold) are structurally flawed. If we wait to see the signs of hyperinflation, we’re already lost. But Venezuela is not just an example of what transpires as a result of hyperinflation, it is a living example of the importance of energy production to the functioning of society. Some energy input is required for everything that we consume in our daily lives. The coordination of those energy inputs is dependent on the reliability and stability of the money we use.
Ignore your morning coffee for a minute and think basics: clean water, sanitation, food, medicine, basic healthcare, etc. The coordination of resources to deliver these basic services is dependent on a functioning monetary system. When a monetary system breaks down, social coordination and even the social fabric begins to go with it. If the basis of all trade is energy, and if we need money to coordinate trade, the highest and best use of that energy should first be to protect the monetary system. Put your proverbial “oxygen mask” on first and then shift to dependents. Secure the foundation of trade and then focus on all of the derivatives.
Any and all concerns about the amount of energy bitcoin consumes or will consume is a red-herring. It is not that we should sacrifice electricity that could otherwise power homes; instead, it’s that we will never have the electricity to power those homes if we do not have a reliable monetary system to coordinate economic activity and marshal resources. In practice, bitcoin will not practically compete for the same energy resources that fuel the basic productive and consumptive functions of our economy (not zero sum); instead, bitcoin’s function as a currency system will ensure that those very energy needs can continue to be fulfilled.
What would be bad for society is if more countries deteriorated into the economic and humanitarian disaster that is Venezuela, where basic health and human services cannot be reliably provided. And this is not to present a draconian vision or a dystopian future; instead, it is to articulate the importance and interconnectedness of both the money function and the energy function in complex, highly specialized economies.
Bitcoin represents a backup switch to the current architecture of the global financial system and is soon to be its primary engine. Setting aside the systemic risks that currently plague our financial system, bitcoin is a fundamentally more sound monetary system from the ground up. And, it is one secured by the production and consumption of energy. You do not have to believe that the dollar’s fate will be that of the Venezuelan bolivar to recognize the importance and interplay between the stability of a monetary function and the production of energy resources that provide basic economic necessities. And the risk inherent in even the possibility of hyperinflation is so negatively asymmetric that the price of bitcoin energy consumption is of small relative cost.
Bitcoin will consume any and all energy resources necessary to secure its monetary network, which is inherently driven by the base demand to hold it as a currency. The more people that value the long-term stability it provides, the more energy it will consume. In the end, this consumption will ensure all other derivatives of energy consumption will continue to be fulfilled, which is why there is no more important long-term use of energy than securing the bitcoin network. Put a price on economic stability and the economic freedom a stable monetary system provides; that is the true justification for the amount of energy bitcoin should and will consume. Everything else is a distraction.
Views are expressly my own and not those of Unchained Capital or my colleagues. Thanks for Will Cole and Phil Geiger for reviewing this version of Gradually, Then Suddenly and providing valuable feedback.
]]>The baseline question from Summers: can central banking as we know it be the primary tool of macroeconomic stabilization in the industrial world over the next decade? Summers doubts that it can, but what if the better question were: is central banking the primary cause of macroeconomic instability? Since the financial crisis, quantitative easing has been the primary tool central banks have used in an attempt to stabilize the economy and to manufacture inflation. The playbook is as follows: increase the money supply, reduce interest rates and reflate asset values such that existing debt levels can be sustained and more debt can be created.
However, despite record low interest rates, the global economy has once again begun to deteriorate and the effectiveness of quantitative easing is naturally being questioned by many. As Summers notes, what has long been taught as axiomatic is now very much in doubt. Contrary to popular belief, the function of quantitative easing actually creates the instability it seeks to avoid. When understanding its base operation, it becomes clear that quantitative easing has always been a fool’s errand. As Nassim Taleb writes in the foreword to The Bitcoin Standard, the macroeconomic experts are not only not experts, they don’t know it either.
History has consistently established that the experts are limited in the field of their own expertise, yet policies such as quantitative easing continue to be pursued, largely because macroeconomics and central banking is a monoculture, as Taleb describes. The mainstream policy position starts with the assumption that central banking is core to the function of an economy; then debate centers on what levers to pull and how best to manage the economy via central bank planning. Active management of the money supply via quantitative easing is taken as a given; it’s a question of how much and when, rather than if.
However, there remains an opposing economic view which argues that the very function of a central bank and the active management of the money supply is harmful to the economy. The opposing viewpoint cannot practically co-exist within a central bank because it is antithetical to the very function, which is why the monoculture exists and why a different course is never charted. Ultimately, the economic debate played out over the course of the 20th century and ended with what has become the current mainstream position. The consequence has been an economic system that relies heavily on monetary debasement and credit creation, both of which are achieved through quantitative easing.
Now that bitcoin exists, it is no longer merely the subject of an intellectual debate. Instead, we now have two competing monetary systems that present great contrasts: one attempts to create stability through active management of the money supply, while the other tolerates interim volatility in the interest of maintaining a fixed supply. For the last ten years, the bootstrapping upstart has been gaining ground on the incumbent system, as demonstrated by its adoption and steadily increasing value relative to other currencies. Opting in to bitcoin means opting out of quantitative easing, and while it may be a volatile path, the long-term trend will continue because central banks continue to pursue the very policy tool which bitcoin prevents.
While attempting to be a source of macroeconomic stabilization, central bankers inadvertently create instability through the manipulation of the money supply. By manipulating the supply of money, all global pricing mechanisms become distorted. As Hayek describes in “The Use of Knowledge in Society”, the price mechanism is the greatest distribution system of knowledge in the world. When the price mechanism becomes distorted, false signals are distributed throughout the economic system and the result is an imbalance between supply and demand which ultimately creates instability and fragility. Today, this instability has primarily been created and sustained as a function of quantitative easing. The financial crisis made it clear that the size of the credit system was both unstable and unsustainable; rather than allow the system to naturally deleverage, the Fed reflated asset prices and induced further credit expansion, such that existing debt levels could be sustained. Practically speaking, the central banking approach to solving a problem of too much debt was to induce the creation of even more debt, which was the original source of instability. Fortunately, bitcoin fixes this.
In the most simplistic terms, quantitative easing is a technical term that describes how the Federal Reserve creates new dollars. It isn’t technically “printing money,” but it is functionally the same. The Fed digitally creates new digital dollars on a ledger (literally out of thin air) and uses those dollars to purchase financial assets, such as U.S. treasuries (government debt) or mortgage-backed securities. Following the financial crisis, the Fed introduced $3.6 trillion new dollars into the banking system via QE, quintupling the size of its balance sheet. As a net effect, more dollars exist within the banking system in the form of bank reserves and those reserves can then be used to lend or to purchase other assets. In simple terms, more dollars exist, which causes the value of each individual dollar to decrease.
Quantitative easing is the root cause of why your dollar purchases less tomorrow; however, the effects of quantitative easing are transmitted gradually through the economy via the expansion of the credit system. Said another way, quantitative easing is designed to allow banks to expand credit; for every dollar that is created through quantitative easing, the credit system can expand by multiples of each dollar added. This incremental credit (think auto loans, mortgages, student loans, etc.) is then used to purchase goods in the real economy, which causes the prices of goods to rise and the value of the dollar to decline on a relative basis.
The short answer is no. While many believe that quantitative easing was necessary, it merely kicked the can down the road and guaranteed more QE would be necessary in the future. The root cause of the crisis was a financial system that had become far too leveraged. At the time of the financial crisis, every dollar in the banking system had been leveraged and lent 150:1 (see Fed Z.1 & H.8 reports). There was too much debt and too few dollars, and the degree of leverage was only made possible as an indirect function of the Fed sustaining economic imbalances. With every recessionary business cycle in the decades leading up to the crisis, the Fed increased the supply of dollars to lower interest rates and to induce credit expansion. Rather than allow the system to course correct as a natural market function, the Fed’s continual response was to reflate asset values by increasing the money supply such that existing debt levels could be sustained and more credit could be created.
Through this function, the Fed inadvertently created the instability that existed in the financial system in 2008 because it created the environment which allowed for an unsustainable degree of system leverage to accumulate over the course of decades. While it has pursued similar policies for decades, the financial crisis created an environment that triggered a more drastic response from the Fed. Practically speaking, the Fed needed a bigger boat and in response to the market turmoil, it increased the supply of dollars by $3.6 trillion in order to stave off an impending financial collapse. This time was different; while the subprime crisis steals the headlines, the real issue was the cumulative effect of sustained imbalances in the credit system which had accumulated over many cycles and the overall degree of system leverage.
In the Fed’s economy, the credit system has become the marginal price mechanism. And because the Fed has a mandate to maintain price stability, it must implicitly maintain the size of the credit system in order to sustain general price levels. During the financial crisis, the credit system began to contract and asset price levels rapidly declined in a disorderly fashion. In order to reverse the impact, the Fed was forced to drastically increase the money supply (quantitative easing) in an effort to maintain the size of the credit system. Even after the height of the crisis, the Fed determined it was necessary to add trillions more in new dollars to continue to support a languishing system, despite acknowledging the limitations of its monetary policy tools. This is the Fed’s catch-22; even when it seemingly knows betters, the Fed’s default position is to err on the side of more quantitative easing, not less.
By responding with quantitative easing, the Fed induced a credit system already saddled with too much debt to expand massively. Today, the U.S. credit system supports approximately 73 trillion of fixed maturity debt (system wide), which represents an increase of 20 trillion (+40%) above pre-crisis levels (Fed Z.1 report, pg. 7). This debt is stacked against only $1.7 trillion of actual dollars that exist within the banking system (Fed H.8 report). As a consequence, there remains far too much debt and too few dollars. Because QE induces the creation of trillions more in debt, it is more like heroin than an antibiotic; the more that is applied to a financial system, the more dependent on it that system becomes and the worse off when it is removed.
Prior to 2009, everyone was forced to opt-in to this system, and there was not a viable off-ramp. This is ultimately the option that bitcoin provides, and it exists largely as a response mechanism to global QE. There is no more simple explanation to the question of why bitcoin exists. While bitcoin would have presented a superior alternative even in the absence of quantitative easing, the global monetary debasement which occurred in response to the crisis sharpens the contrast. It is this contrast that makes the mere existence of bitcoin far more intuitive than it otherwise may be. Bitcoin literally exists because some highly intelligent individuals identified a problem and set the wheels in motion to create a solution. However, bitcoin practically exists because it presents a fundamentally better solution to the problem of money.
Because of the leverage that remains inherent in the existing financial system, future QE is not merely a possibility; it is a certainty. Future QE from the Fed, and central banks all over the world, is a “when” not “if” question. The credit system was unstable and unsustainable in 2008. As a function of QE, it has expanded massively and now supports $20 trillion more debt in the U.S. alone. Every time the Fed, or any central bank, announces subsequent rounds of QE, that is the reinforcing market signal of why bitcoin exists. It is the choice between holding a form of currency that is continually and systematically debased by central banks or a form of currency with a fixed supply that is unmanipulatable. Bitcoin is the check, balance and ultimate opt out path to the problem QE presents.
In “The Pretense of Knowledge”, a speech delivered by Friedrich Hayek at the ceremony awarding him the Nobel Prize in economics in 1974, he articulates the first principles of why the disparate knowledge of all market participants is greater than that which any single mind possesses. It is through this reasoning that he explains why the dominant macroeconomic theory and monetary policy which guides central banks is inherently flawed. And, why the policy tools used by central banks, particularly quantitative easing, create more harm than good. I highly recommend reading the full speech as it provides the counter-narrative to the monoculture of today’s economic policy making. Our current system entrusts the allocation of trillions of dollars to just a few individuals. It is not that these individuals lack a significant amount of knowledge; instead, it is that any small group of individuals necessarily possesses far less knowledge than the hundreds of millions of individuals that actually make up an economy.
By attempting to manage an economy through the manipulation of the money supply, the knowledge of many is not only replaced by that of a few; instead, the collective knowledge base as a whole becomes distorted. The mechanisms that govern supply and demand can no longer function efficiently, which creates imbalances that can only be sustained so long as the market remains manipulated. In the end, the ultimate negative impact to the economy is far greater than it otherwise would have been in the absence of central bank intervention. The financial crisis is patient zero and the quantitative easing response has only left us in a more precarious situation today. The first order impact is the devaluation of the currency, but the ultimate impact is the deterioration of the underlying economic structure. Bitcoin is designed to fix this but no one should expect a seamless or painless transition away from a system saddled with decades of accumulated imbalances.
Bitcoin creates a system that allows for undistorted economic activity, and it achieves this through a fixed monetary supply, which is ultimately governed by a market consensus mechanism. It is through this consensus mechanism that bitcoin dispenses with the need for conscious control of central bankers, instead relying on the distributed knowledge of all market participants. It is also completely voluntary. If you like your financial system, you can keep it (for now at least). However, monetary systems tend to one medium so if a critical mass converge on bitcoin as the most credible long-term store of value, it may become less of a choice in the future. As individuals increasingly opt in to bitcoin, it will only make the issues present in the existing system more evident, which likely accelerates the need for quantitative easing. The greater the inclination to store wealth in bitcoin, the lower the demand to store wealth in the assets that support the existing credit system. In essence, an increasing shift to bitcoin will directly impact the system-wide credit impulse, which will accelerate the need for the legacy financial system to rely on quantitative easing to sustain itself.
Bitcoin may be the sly round about way around the Fed’s economic system, but it comes at the direct expense of the legacy system. And, the interim consequence of the shift to bitcoin may very well be macroeconomic volatility. Bitcoin may be mistakenly blamed for the ills of the legacy system but really, withdrawal is just a painful and necessary process. The Jackson Hole crowd may not like this; however, positive externalities will be waiting on the other side. And besides, it’s in the hands of the free market now.
Views presented are expressly my own and not those of Unchained Capital or my colleagues. Special thanks to Phil Geiger, Adam Tzagournis and Will Cole for reviewing and for providing valuable feedback. If interested in reading more about quantitative easing and the financial crisis, I wrote a longer research piece in 2017 on the subject (see here).
]]>It is also the most practical entry point; before taking a flyer and risking hard-earned value, take the time to understand bitcoin and then use that knowledge to evaluate the field. There is no promise that you will come to the same conclusions, but more often than not, those who take the time to intuitively understand how and why bitcoin works more easily recognize the flaws inherent in the field. And even if not, starting with bitcoin remains your best hope of making an informed and independent assessment. Ultimately, bitcoin is not about making money and it’s not a get-rich-quick scheme; it is fundamentally about storing the value you have already created, and no one should risk that without a requisite knowledge base. Within the world of digital currencies, bitcoin has the longest track record to assess and the greatest amount of resources to educate, which is why bitcoin is the best tool to learn.
To start on this journey, first realize that bitcoin was created to specifically address a problem that exists with modern money. The founder of bitcoin set out to create a peer-to-peer digital cash system without the need for a trusted third-party, and a blockchain was one critical part of the solution. In practice, bitcoin (the currency) and its blockchain are interdependent. One does not exist without the other; bitcoin needs its blockchain to function and there would not be a functioning blockchain without a native currency (bitcoin) to properly incentivize resources to protect it. That native currency must be viable as a< form of money because it is exclusively what pays for security, and it must have credible monetary properties in order to be viable.
Without the money, there is no security and without the security, the value of the currency and the integrity of the chain both break down. It is for this reason that a blockchain is only useful within the application of money, and money does not magically grow on trees. Yep, it is that simple. A blockchain is only good for one thing, removing the need for a trusted third-party which only works in the context of money. A blockchain cannot enforce anything that exists outside the network. While a blockchain would seem to be able to track ownership outside the network, it can only enforce ownership of the currency that is native to its network. Bitcoin tracks ownership and enforces ownership. If a blockchain cannot do both, any records it keeps will be inherently insecure and ultimately subject to change. In this sense, immutability is not an inherent trait of a blockchain but instead, an emergent property. And if a blockchain is not immutable, its currency will never be viable as a form of money because transfer and final settlement will never be reliably possible. Without reliable final settlement, a monetary system is not functional and will not attract liquidity.
Ultimately, monetary systems converge on one medium because their utility is liquidity rather than consumption or production. And liquidity consolidates around the most secure, long-term store of value; it would be irrational to store wealth in a less secure, less liquid monetary network if a more secure, more liquid network existed as an attainable option. The aggregate implication is that only one blockchain is viable and ultimately necessary. Every other cryptocurrency is competing for the identical use case as bitcoin, that of money; some realize it while others do not but value continues to consolidate around bitcoin because it is the most secure blockchain by orders of magnitude and all are competing for the same use case. Understanding these concepts is fundamental to bitcoin and it also provides a basic foundation to then consider and evaluate the noise beyond bitcoin. With basic knowledge of how bitcoin actually works, it becomes clear why there is no blockchain without bitcoin.
Often, bitcoin’s transaction ledger is thought of as a public blockchain that lives somewhere in the cloud like a digital public square where all transactions are aggregated. However, there is no central source of truth; there are no oracles and there is no central public blockchain to which everyone independently commits transactions. Instead, every participant within the network constructs and maintains its own independent version of the blockchain based on a common set of rules; no one trusts anyone and everyone validates everything. Everyone is able to come to the same version of the truth without having to trust any other party. This is core to how bitcoin solves the problem of removing third-party intermediaries from a digital cash system.
Every participant running a node within the bitcoin network independently verifies every transaction and every block; by doing so, each node aggregates its own independent version of the blockchain. Consensus is reached across the network because each node validates every transaction (and each block) based on a core set of rules (and the longest chain wins). If a node broadcasts a transaction or block that does not follow consensus rules, other nodes will reject it as invalid. It is through this function that bitcoin is able to dispose with the need for a central third-party; the network converges on the same consistent state of the chain without anyone trusting any other party. However, the currency plays an integral role in coordinating bitcoin’s consensus mechanism and ordering blocks which ultimately represents bitcoin’s full and valid transaction history (or its blockchain).
Think of a block as a dataset that links the past to the present. Technically, individual blocks record changes to the overall state of bitcoin ownership within a given time interval. In aggregate, blocks record the entire history of bitcoin transactions as well as ownership of all bitcoin at any point in time. Only changes to the state are recorded in each passing block. How blocks are constructed, solved and validated is critical to the process of network consensus, and it also ensures that bitcoin maintains a fixed supply (21 million). Miners compete to construct and solve blocks that are then proposed to the rest of the network for acceptance. To simplify, think of the mining function as a continual process of validating history and clearing pending bitcoin transactions; with each block, miners add new transaction history to the blockchain and validate the entire history of the chain. It is through this process that miners secure the network; however, all network nodes then check the work performed by miners for validity, ensuring network consensus is enforced. More technically, miners construct blocks that represent data sets which include three critical elements (again simplifying):
To solve blocks, miners perform what is known as a proof of work function by expending energy resources. In order for blocks to be valid, all inputs must be valid and each block must satisfy the current network difficulty. To satisfy the network difficulty, a random value (referred to as a nonce) is added to each block and then the combined data set is run through bitcoin’s cryptographic hashing algorithm (SHA-256); the resulting output (or hash) must achieve the network’s difficulty in order to be valid. Think of this as a simple guess and check function, but probabilistically, trillions of random values must be guessed and checked in order to create a valid proof for each proposed block. The addition of a random nonce may seem extraneous. But, it is this function that forces miners to expend significant energy resources in order to solve a block, which ultimately makes the network more secure by making it extremely costly to attack.
Adding a random nonce to a proposed block, which is an otherwise static data set, causes each resulting output (or hash) to be unique; with each different nonce checked, the resulting output has an equally small chance of achieving the network difficulty (i.e. representing a valid proof). While it is often referred to as a highly complicated mathematical problem, in reality, it is difficult only because a valid proof requires guessing and checking trillions of possible solutions. There are no shortcuts; energy must be expended. A valid proof is easy to verify by other nodes but impossible to solve without expending massive amount of resources; as more mining resources are added to the network, the network difficulty increases, requiring more inputs to be checked and more energy resources to be expended to solve each block. Essentially, there is material cost to miners in solving blocks but all other nodes can then validate the work very easily at practically no cost.
In aggregate, the incentive structure allows the network to reach consensus. Miners must incur significant upfront cost to secure the network but are only paid if valid work is produced; and the rest of the network can immediately determine whether work is valid or not based on consensus rules without incurring cost. While there are a number of consensus rules, if any pending transaction in a block is invalid, the entire block is invalid. For a transaction to be valid, it must have originated from a previous, valid bitcoin block and it cannot be a duplicate of a previously spent transaction; separately, each block must build off the most up to date version of history in order to be valid and it must also include a valid coinbase transaction. A coinbase transaction rewards miners with newly issued bitcoin in return for securing the network but it is only valid if the work is valid.
Coinbase rewards are governed by a predetermined supply schedule and currently, 12.5 new bitcoin are issued in each valid block; in approximately eight months, the reward will be cut in half to 6.25 new bitcoin, and every 210,000 blocks (or approximately every four years), the reward will continue to be halved until it ultimately reaches zero. If miners include an invalid reward in a proposed block, the rest of the network will reject it as invalid which is the base mechanism that governs a capped total supply of 21 million bitcoin. However, software alone is insufficient to ensure either a fixed supply or an accurate transaction ledger; economic incentives hold everything together.
Why is this so important? Within one integrated function, miners validate history, clear transactions and get paid for security on a trustless basis; the integrity of bitcoin’s fixed supply is embedded in its security function, and because the rest of the network independently validates the work, consensus can be reached on a decentralized basis. If a miner completes valid work, it can rely on the fact that it will be paid on a trustless basis. Conversely, if a miner completes invalid work, the rest of the network enforces the rules, essentially withholding payment until valid work is completed. And supply of the currency is baked into validity; if a miner wants to be paid, it must also enforce the fixed supply of the currency, further aligning the entire network. The incentive structure of the currency is so strong that everyone is forced to adhere to the rules, which is the chief facilitator of decentralized consensus.
If a miner solves and proposes an invalid block, specifically one that either includes invalid transactions or an invalid coinbase reward, the rest of the network will reject it as invalid. Separately, if a miner builds off a version of history that does not represent the longest chain with the greatest proof of work, any proposed block would also be considered invalid. Essentially, as soon as a miner sees a new valid block proposed in the network, it must immediately begin to work on top of that block or risk falling behind and performing invalid work at a sunk cost. As a consequence, in either scenario, if a miner were to produce invalid work, it would incur real cost but would be compensated nothing in return.
Through this mechanism, miners are maximally incentivized to produce honest, valid work and to work within the consensus of the chain at all times; it is either be paid or receive nothing. It is also why the higher the cost to perform the work, the more secure the network becomes. The more energy required to write or rewrite bitcoin’s transaction history, the lower the probability that any single miner could (or would) undermine the network. The incentive to cooperate increases as it becomes more costly to produce work which would otherwise be considered invalid by the rest of the network. As network security increases, bitcoin becomes more valuable. As the value of bitcoin rises and as the costs to solve blocks increases, the incentive to produce valid work increases (more revenue but more cost) and the penalty for invalid work becomes more punitive (no revenue and more cost).
Why don’t the miners collude? First, they can’t. Second, they tried. But third, the fundamental reason is that as the network grows, the network becomes more fragmented and the economic value compensated to miners in aggregate increases; from a game theory perspective, more competition and greater opportunity cost makes it harder to collude and all network nodes validate the work performed by miners which is a constant check and balance. Miners are merely paid to perform a service and the more miners there are, the greater the incentive to cooperate because the probability that a miner is penalized for invalid work increases as more competition exists. And recall that random nonce value; it seemed extraneous at the time but it is core to the function that requires energy resources be expended. It is this tangible cost (skin in the game) combined with the value of the currency which incentivizes valid work and which allows the network to reach consensus.
Because all network nodes independently validate blocks and because miners are maximally penalized for invalid work, the network is able to form a consensus as to the accurate state of the chain without relying on any single source of knowledge or truth. None of this decentralized coordination would be possible without bitcoin, the currency; all the bitcoin network has to compensate miners in return for security is its native currency, whether that is largely in the form of newly issued bitcoin today or exclusively in the form of transaction fees in the future. If the compensation paid to miners were not reasonably considered to be a reliable form of money, the incentive to make the investments to perform the work would not exist.
Recall from “Bitcoin Can’t Be Copied”, if an asset’s primary (if not sole) utility is the exchange for other goods and services, and if it does not have a claim on the income stream of a productive asset (such as a stock or bond), it must compete as a form of money and will only store value if it possesses credible monetary properties. Bitcoin is a bearer asset, and it has no utility other than the exchange for other goods or services. It also has no claim on the income stream of a productive asset. As such, bitcoin is only valuable as a form of money and it only holds value because it has credible monetary properties (read The Bitcoin Standard, chapter 1). By definition, this is true of any blockchain; all any blockchain can offer in return for security is a monetary asset native to the network, without any enforceable claims outside the network, which is why a blockchain can only be useful in connection to the application of money. The chart below from The Bitcoin Standard articulates this point:
Without a native currency, a blockchain must rely on trust for security which eliminates the need for a blockchain in the first place. In practice, the security function of bitcoin (mining), which protects the validity of the chain on a trustless basis, requires significant upfront capital investment in addition to high marginal cost (energy consumption). In order to recoup that investment and a rate of return in the future, the payment in the form of bitcoin must more than offset the aggregate costs, otherwise the investments would not be made. Essentially, what the miners are paid to protect (bitcoin) must be a reliable form of money in order to incentivize security investments in the first place.
This is also fundamental to the incentive structure that aligns the network; miners have an embedded incentive to not undermine the network because it would directly undermine the value of the currency in which miners are compensated. If bitcoin were not valued as money, there would be no miners, and without miners, there would be no chain worth protecting. The validity of the chain is ultimately what miners are paid to protect; if the network could not reasonably come to a consensus and if ownership were subject to change, no one could reasonably rely on bitcoin as a value transfer mechanism. The value of the currency ultimately protects the chain, and the immutability of the chain is foundational to the currency having value. It’s an inherently self-reinforcing relationship.
Immutability is an emergent property in bitcoin, not a trait of a blockchain. A global, decentralized monetary network with no central authority could not function without an immutable ledger (i.e. if the history of the blockchain were insecure and subject to change). If settlement of the unit of value (bitcoin) could not reliably be considered final, no one would reasonably trade real world value in return. As an example, consider a scenario in which one party purchased a car from another in return for bitcoin. Assume the title for the car transfers, and the individual that purchased the car takes physical possession. If bitcoin’s record of ownership could easily be re-written or altered (i.e. changing the history of the blockchain), the party that originally transferred the bitcoin in return for the car could wind up in possession of both the bitcoin and the car, while the other party could end up with neither. This is why immutability and final settlement is critical to bitcoin’s function.
Remember that bitcoin has no knowledge of the outside world; all bitcoin knows how to do is issue and validate currency (whether a bitcoin is a bitcoin). Bitcoin is not capable of enforcing anything that exists outside the network (nor is any blockchain); it is an entirely self-contained system and the bitcoin network can only ever validate one side of a two-sided value transfer. If bitcoin transfers could not reliably be considered final, it would be functionally impossible to ever trade anything of value in return for bitcoin. This is why the immutability of bitcoin’s blockchain is inextricably linked to the value of bitcoin as a currency. Final settlement in bitcoin is possible but only because its ledger is reliably immutable. And its ledger is only reliably immutable because its currency is valuable. The more valuable bitcoin becomes, the more security it can afford; the greater the security, the more reliable and trusted the ledger.
Ultimately, immutability is an emergent property, but it is dependent on other emergent network properties. As bitcoin becomes more decentralized, it becomes increasingly difficult to alter the network’s consensus rules and increasingly difficult to invalidate or prevent otherwise valid transactions (often referred to as censorship-resistance). As bitcoin proves to be increasingly censorship-resistant, confidence in the network grows, which fuels adoption, which further decentralizes the network, including its mining function. In essence, bitcoin becomes more decentralized and more censorship-resistant as it grows, which reinforces the immutability of its blockchain. It becomes increasingly difficult to change the history of the blockchain because each participant gradually represents a smaller and smaller share of the network; regardless of how concentrated ownership of the network and mining may be at any point in time, both decentralize over time so long as value increases, which causes bitcoin to become more and more immutable.
This multi-dimensional incentive structure is complicated but it is critical to understanding how bitcoin works and why bitcoin and its blockchain are dependent on each other. Why each is a tool that relies on the other. Without one, the other is effectively meaningless. And this symbiotic relationship only works for money. Bitcoin as an economic good is only valuable as a form of money because it has no other utility. This is true of any asset native to a blockchain. The only value bitcoin can ultimately provide is through present or future exchange. And the network is only capable of a single aggregate function: validating whether a bitcoin is a bitcoin and recording ownership.
The bitcoin network is a closed loop and an entirely independent system; its only connection to the physical world is through its security and clearing function. The blockchain maintains a record of ownership and the currency is used to pay for the security of those records. It is through the function of its currency that the network can afford a level of security to ensure immutability of the blockchain, which allows network participants to more easily and consistently reach consensus without the need for trust in any third-parties. The cumulative effect is a decentralized and trustless monetary system with a fixed supply that is global in reach and accessible on a permissionless basis.
Every other fiat currency, commodity money or cryptocurrency is competing for the exact same use case as bitcoin whether it is understood or not, and monetary systems tend to a single medium because their utility is liquidity rather than consumption or production. When evaluating monetary networks, it would be irrational to store value in a smaller, less liquid and less secure network if a larger, more liquid and more secure network existed as an attainable option. Bitcoin is valuable, not because of a particular feature, but instead, because it achieved finite, digital scarcity. This is the backbone of why bitcoin is secure as a monetary network and it is a property that is dependent on many other emergent properties.
A blockchain on the other hand is simply an invention native to bitcoin that enables the removal of trusted third parties. It serves no other purpose. It is only valuable in bitcoin as a piece to a larger puzzle and it would be useless if not functioning in concert with the currency. The integrity of bitcoin’s scarcity and the immutability of its blockchain are ultimately dependent on the value of the currency itself. Confidence in the aggregate function drives incremental adoption and liquidity which reinforces and strengthens the value of the bitcoin network as a whole. As individuals opt in to bitcoin, they are at the same time, opting out of inferior monetary networks. This is fundamentally why the emergent properties in bitcoin are next to impossible to replicate and why its monetary properties become stronger over time (and with greater scale), while also at the direct expense of inferior monetary networks.
Ultimately, a blockchain is only useful in the application of money because it is dependent on a native currency for security. Bitcoin represents the most secure blockchain by orders of magnitude. Because all other blockchains are competing for the same fundamental use case of money and because bitcoin’s network effects only continue to increase its security and liquidity advantage over the field, no other digital currency can compete with bitcoin. Liquidity begets liquidity and monetary systems tend to one medium as a derivative function. Bitcoin’s security and liquidity obsoleted any other cryptocurrencies before they left the proverbial gates. Find me a cryptocurrency that comes close to bitcoin relative to security, liquidity or the credibility of its monetary properties, and I will find you a unicorn.
The real competition for bitcoin has and will remain the legacy monetary networks, principally the dollar, euro, yen and gold. Think about bitcoin relative to these legacy monetary assets as part of your education. Bitcoin does not exist in a vacuum; it represents a choice relative to other forms of money. Evaluate it based on the relative strengths of its monetary properties and once a baseline is established between bitcoin and the legacy systems, this will then provide a strong foundation to more easily evaluate any other blockchain related project.
To learn more, I suggest reading, The Bitcoin Standard (Saifedean Ammous), Inventing Bitcoin (Yan Pritzker) and Mastering Bitcoin (Andreas Antonopolous), probably in that order.
Thanks to Will Cole, Phil Geiger and Adam Tzagournis for reviewing and providing valuable feedback. Also thanks to Saif, Yan and Andreas for their books which are incredible resources.
]]>This is the first of a weekly series that I’ve decided to write on the subject of bitcoin, inspired by my friends Marty Bent and Saifedean Ammous. Education is such a critical aspect of bitcoin and I hope that, by distilling my own thoughts, I can help others accelerate their path in understanding a complex subject. I’ve titled the series Gradually, Then Suddenly. As Hemingway penned the process of going bankrupt, it’s also the way that government-backed currencies hyper-inflate and often how people come to understand bitcoin (gradually, then suddenly).Writings will generally stick to bitcoin but will also include the Fed and monetary economics as these stories are deeply intertwined. Because I’ll be trying to keep concise, the series will communicate my principal conclusions and opinions rather than setting out to present every detail that led to them; my intention is to provide insight into my thought process and to provide a roadmap if others are interested in learning more. My hope is to reach a broader audience (beyond those that have been formative in my own journey) and to help folks on the periphery gain a better understanding of why many of us are so focused on bitcoin as a subject matter. Views presented are expressly my own and not those of either Unchained Capital or my colleagues. Hope you enjoy & please provide feedback.
Or rather, Bitcoin has become money (to me). It was a slow process that involved unlocking a number of mental blocks along the way but it began with asking the question, what is money? That is the beginning of the real rabbit hole. And not the speculative, I’m looking for a lottery ticket blockchain-is-going-to-change-the-world kind of rabbit hole. At the root level, it’s the rabbit hole that attempts to answer the question, “why is the dollar in my pocket money?” Why do hundreds of millions of people exchange their hard-earned, real-world value every day for this piece of paper (or digital representation)? It’s both a difficult question to ask and a harder one to answer, something I realized everyone has to approach in their own way, on their own timeline and guided by their own life experiences. People have to be interested in that question in order to even begin to understand bitcoin.
For me, the path involved first understanding why gold was money. That involved understanding the unique properties which made something a better or worse form of money and what differentiated money as a unique economic good compared to most other types of economic goods. The Bitcoin Standard was formative for me in exploring the questions, not as a gospel but rather, as a foundation to think about the problem statement. When I applied that foundation to my own life experiences and to my own understanding of the existing financial system, and its flaws, only then did it begin to become intuitive. And that’s something that may be evident (that bitcoin is intuitive as money) to those that have spent years thinking about it relative to monetary principles but it’s also true that bitcoin is not intuitive. It’s extremely not intuitive until it becomes intuitive and then over time it becomes hyper intuitive.
As part of my process, I found it helpful to consider bitcoin relative to two tangible guide posts: gold and the dollar financial system. Does A (bitcoin) share the properties of B (either gold or the dollar, respectively). Is A better than B? Because what makes something money is not an absolutism; it is a choice between storing value in one medium vs. another, always involving trade-offs. Without understanding the flaws of the existing financial system (whether the dollar, euro, yen, bolivar, peso, etc., respectively), I could have never arrived at bitcoin being money in a vacuum.
While I worked at Deutsche Bank during the financial crisis, I had no baseline to understand what was actually happening. Ten years later, and after having worked in the restructuring world and at a macro hedge fund, only then did I start to develop a more clear understanding of what had really transpired in 2008 and 2009. Through my own research of the great financial crisis, the Fed and specifically the impact of quantitative easing (see here), I came to the principal conclusion that the root problem was that the financial system had been leveraged approximately 150-to-1 (too much debt and too few dollars) and that the insane degree of leverage was only made possible as a function of Fed policy which had consistently prevented system-wide deleveraging over the course of the three decades leading up to the crisis. Further, it became apparent that the solution (quantitative easing) merely caused an unsustainable credit system to metastasize over the subsequent ten years, making future QE an inevitability. I became convinced that, whether bitcoin survives or not, the existing financial system is working on borrowed time and that one way or another, something other than the status quo will be the inevitable path forward.
Then I figured out that bitcoin has a fixed supply. Developing an understanding of how and why that is possible is the basis of understanding bitcoin as money. Doing so requires significant personal investment in understanding how economic incentives are woven together with bitcoin’s technical architecture and why bitcoin can’t be “faked” or copied (or rather, why the incentives are so strong to cooperate and why the opportunity cost is too high to defect). It’s a long road but will ultimately lead one to an understanding that a global network of rational economic actors, operating within a voluntary, opt-in currency system would not collectively and overwhelmingly form a consensus to debase the currency which they have all independently and voluntarily determined to use as a store of wealth. This reality (or belief system) then underpins and reinforces bitcoin’s economic incentives, technical architecture and network effect.
So it’s not simply that software code dictates that there will only ever be 21 million bitcoin; it’s understanding why that monetary policy is credible and resilient and how bitcoin achieves verifiable scarcity. That can’t happen overnight for any individual. It can’t be explained to someone at a cocktail party. It is a reality that is reinforced and strengthened over time only by experiencing the incentive structure and seeing it work time and time again, every 10 minutes (on average). When then compared to how the dollar system works or even the underpinnings of gold, bitcoin as money becomes more intuitive.
In summary, when trying to understand bitcoin as money, start with gold, the dollar, the Fed, quantitative easing and why bitcoin’s supply is fixed. Money is not simply a collective hallucination or a belief system; there is rhyme and reason. Bitcoin exists as a solution to the money problem that is global QE and if you believe the deterioration of local currencies in Turkey, Argentina or Venezuela could never happen to the U.S. dollar or to a developed economy, we are merely at a different point on the same curve. Bitcoin represents a fundamentally different structure and a more resilient path forward but you have to understand where we’ve been and how we got here to know where we’re going.
Hayek writes about the price mechanism as the greatest distribution system of knowledge in the world (“The Use of Knowledge in Society”). When the money supply is manipulated, it distorts global pricing mechanisms which then communicates “bad” information throughout the economic system. When that manipulation is sustained over 30-40 years, massive imbalances in underlying economic activity are created which is where we find ourselves today. Ultimately, gold’s failure was the dollar and the dollar’s failure is the economic distortion which led to, and which has been exacerbated by, QE. Bitcoin’s promise is the solution to both. Because bitcoin’s supply is fixed and cannot be manipulated, it will eventually become the most reliable pricing mechanism in the world and consequently, the greatest distribution system of knowledge. The volatility witnessed today is nothing more than the logical path of price discovery as adoption increases by orders of magnitude and as we advance toward that future state of full adoption.
]]>As a starting point, anyone trying to understand how, why, or if bitcoin works should assess the question entirely independent from the implications of government regulation or intervention. While bitcoin will undoubtedly have to co-exist alongside various regulatory regimes, imagine governments did not exist. On a standalone basis, would bitcoin be functional as money, if left to the free market? This will inevitably lead to a number of rabbit hole questions. What is money? What are the properties that make a particular medium a better or worse form of money? Does bitcoin share those properties? Is bitcoin a better form of money based on its properties? If the ultimate conclusion becomes that bitcoin is not functional as money, the implications of government intervention are irrelevant. However, if bitcoin is functional as money, the question then becomes relevant to the debate, and anyone considering the question would need that prior context as a baseline to evaluate whether or not it would be possible.
By design, bitcoin exists beyond governments. But bitcoin is not just beyond the control of governments, it functions without the coordination of any central third parties. It is global and decentralized. Anyone can access bitcoin on a permissionless basis and the more widespread it becomes, the more difficult it becomes to censor the network. The architecture of bitcoin is practically purpose-built to resist and immunize any attempts by governments to ban it. This is not to say that governments all over the world will not attempt to regulate, tax or even ban its use. There will certainly be a fight to resist bitcoin adoption. The Fed and the Treasury (and their global counterparts) are not just going to lay down as bitcoin increasingly threatens the monopolies of government money. However, before debunking the idea that governments could outright ban bitcoin, first understand the very consequence of the statement and the messenger.
The skeptic’s narrative consistently shifts over time. Stage one of grief: bitcoin could never work – it is backed by nothing. It is nothing more than a present-day tulip mania. With each hype cycle, the value of bitcoin rises dramatically and is then followed by a correction. Often extolled as a crash by skeptics, bitcoin fails to die and in each instance, it finds support at levels higher than prior adoption waves. The tulip narrative becomes tired and the skeptics move on to more nuanced issues, re-anchoring the debate. Stage two of grief follows: bitcoin is flawed as a currency. It is too volatile to be money, or it is too slow to be a payments system, or it cannot scale to satisfy all the payments in the world, or it wastes energy. The list goes on. This second step is a progression of denial and it is a significant departure from the idea that bitcoin is nothing more than nothingness.
Despite the supposed flaws, the value of the bitcoin network continues to rise over time. Each time it does not die, it gains strength. While the skeptics are busy pointing out flaws, bitcoin never sleeps. An increase in value is driven by a very simple market dynamic: more buyers than sellers. That is all and it is a function of increasing adoption. More and more people figure out why there is fundamental demand for bitcoin and why/how it works. This is what creates long-term demand for bitcoin. As more people increasingly demand it as a store of wealth, there is no supply response. There will only ever be 21 million bitcoin. No matter how many people demand bitcoin, the supply side is completely fixed and inelastic. As the skeptics continue to shout the same tired lines, the crowd continues to parse the noise and demand bitcoin due to the strengths of its monetary properties. And no constituency is more well-versed in the arguments against bitcoin than adopters of bitcoin themselves.
Desperation begins to kick in, and the debate re-anchors once again. The narrative predictably shifts. It is no longer that bitcoin is not backed by anything, nor that it is flawed as a currency; instead, the debate centers on regulation and government authorities. In the final stage of grief, it is actually that bitcoin works too well, and as a consequence, the government will never let it happen and ban it. Really? So human ingenuity somehow re-invents money in a technologically superior medium, the consequences of which are mind-bending, and the government is somehow going to ban that? Recognize that in claiming as much, the skeptics are admitting defeat. It is the dying whimper in a series of failed arguments. The skeptics simultaneously accept that there is fundamental demand for bitcoin and then pivot to the unfounded belief that governments can ban it.
Play this one out. When exactly would developed world governments actually step in and attempt to ban bitcoin? Today, the Fed and the Treasury do not view bitcoin as a serious threat to dollar supremacy. In their collective mind, bitcoin is a cute little toy and is not functional as a currency. Presently, the bitcoin network represents a total purchasing power of less than 200 billion. Gold on the other hand has a purchasing power of approximately 8 trillion (40x the size of bitcoin) and broad money supply of dollars (M2) is approximately 15 trillion (75x the size of bitcoin). When does the Fed or Treasury start seriously considering bitcoin a credible threat? Is it when bitcoin collectively represents 1 trillion of purchasing power? 2 trillion or 3 trillion? Pick your level, but the implication is that bitcoin will be far more valuable, and held by far more people globally, before government powers that be view it as a credible competitor or threat.
So the skeptic logic follows: bitcoin does not work, but if it does work, the government will ban it. But, governments in the free world will not attempt to ban bitcoin until it becomes more apparent that it is a threat. At which time, bitcoin will be more valuable and undoubtedly harder to ban, as it will be held by far more people in far more places. So, ignore fundamentals and the asymmetry inherent in a global monetization event because in the event you turn out to be right, the government will step in to regulate bitcoin out of existence. Which side of the fence would a rational economic actor rather be on? Owning a monetary asset that has increased in value so dramatically that it threatens the global reserve currency, or the opposite – not owning that asset? Assuming an individual possesses the knowledge to understand why it is a fundamental possibility (and increasingly a probability), which is the more defensible and logical position? The asymmetry alone dictates the former and any fundamental understanding of the demand for bitcoin only reinforces the same position.
Think about what bitcoin actually represents and then what a ban of bitcoin would represent. Bitcoin represents the conversion of subjective value, created and exchanged in the real world, for digital keys. Said more plainly, it is the conversion of an individual’s time into money. When someone demands bitcoin, they are at the same time forgoing demand for some other good, whether it be a dollar, a house, a car, or food, etc. Bitcoin represents monetary savings that comes with the opportunity cost of other goods and services. Banning bitcoin would be an affront to the most basic freedoms it is designed to both provide and preserve. Imagine the response by all those that have adopted bitcoin: “Well that was fun, the tool that the experts said would never work, now works too well, and the same experts and authorities say we can’t use it. Everyone go home. Show’s over folks.” To believe that all the people in the world that have adopted bitcoin for the financial freedom and sovereignty it provides would suddenly lay down and accept the ultimate infringement of that freedom is not rational.
Governments could not successfully ban the consumption of alcohol, the use of drugs, the purchase of firearms, or the ownership of gold. A government can marginally restrict access, or even make possession illegal, but it cannot make something of value demanded by a broad and disparate group of people magically go away. When the U.S. made the private ownership of gold illegal in 1933, gold did not lose its value or disappear as a monetary medium. It actually increased in value relative to the dollar, and just thirty years later, the ban was lifted. Not only does bitcoin provide a greater value proposition relative to any other good that any government has ever attempted to ban (including gold); but by its nature, it is also far harder to ban. Bitcoin is global and decentralized. It is without borders and it is secured by nodes and cryptographic keys. The act of banning bitcoin would require preventing open source software code from being run and preventing digital signatures (created by cryptographic keys) from being broadcast on the internet. And it would have to be coordinated across numerous jurisdictions, except there is no way to know where the keys actually reside or to prevent more nodes from popping up in different jurisdictions. Setting aside the constitutional issues, it would be technically infeasible to enforce a ban of bitcoin in any meaningful way.
Even if all countries in the G-20 coordinated to ban bitcoin in unison, it would not kill bitcoin. Instead, it would be the fait accompli for the fiat system. It would reinforce to the masses that bitcoin is a formidable currency, and it would set off a global and hopeless game of whack-a-mole. There is no central point of failure in bitcoin; bitcoin miners, nodes and keys are distributed throughout the world. Every aspect of bitcoin is decentralized, which is why running nodes and controlling keys is core to bitcoin. The more keys and the more nodes that exist, the more decentralized bitcoin becomes, and the more immune bitcoin is to attack. The more jurisdictions in which mining exists, the less risk any single jurisdiction represents to bitcoin’s security function. A coordinated state level attack would only serve to build the strength of bitcoin’s immune system. It would ultimately accelerate the shift away from the legacy financial system (and legacy currencies), and it would accelerate innovation within the bitcoin economic system. With each passing threat, bitcoin innovates to immunize the threat. A coordinated state level attack would be no different.
Permissionless innovation on a globally decentralized basis is the reason bitcoin gains strength from every attack. It is the attack vector itself which causes bitcoin to innovate. It is Adam Smith’s invisible hand on steroids. Individual actors may believe themselves to be motivated by a greater cause, but in reality, the utility embedded in bitcoin creates a sufficiently powerful incentive structure to ensure its survival. The self-interests of millions, if not billions, of uncoordinated individuals aligned by their individual and collective need for money incentivizes permissionless innovation on top of bitcoin. Today, it may seem like a cool new technology or a nice-to-have portfolio investment, but even if most people do not yet recognize it, bitcoin is a necessity. It is a necessity because money is a necessity, and legacy currencies are fundamentally broken. Two months ago, the repo markets in the U.S. broke, and the Fed quickly responded by increasing the supply of dollars by $250 billion, with more to come. It is precisely why bitcoin is a necessity, not a luxury. When an innovation happens to be a basic necessity to the functioning of an economy, there is no government force that could ever hope to stop its proliferation. Money is a very basic necessity, and bitcoin represents a step-function change innovation in the global competition for money.
And more practically, any attempt to ban bitcoin or heavily regulate its use by any jurisdiction would directly benefit a competing jurisdiction. The incentive to defect from any coordinated effort to ban bitcoin would be far too high to sustain such an agreement across jurisdictions. If the United States made the possession of bitcoin illegal tomorrow, would it slow down proliferation, development and adoption of bitcoin and would it cause the value of the network to decline intermittently? Probably. Would it kill bitcoin? No. Bitcoin represents the most mobile capital in the world. Countries and jurisdictions that create regulatory certainty and place the least amount of restrictions on the use of bitcoin will benefit significantly from capital inflows.
In practice, the prisoner’s dilemma is not one-to-one. It is multi-dimensional involving numerous jurisdictions, all with competing interests, making any attempts to successfully ban bitcoin that much more impractical. Human capital, physical capital and monetary capital will flow to the countries and jurisdictions with the least restrictive regulations on bitcoin. It may not happen overnight, but attempting to ban bitcoin is the equivalent of a country cutting off its nose to spite its face. It doesn’t mean that countries will not try. India has already tried to ban bitcoin. China has attempted to heavily restrict its use. Others will follow. But each time a country takes an action to restrict the use of bitcoin, it actually has the unintended effect of promoting bitcoin adoption. Attempts to ban bitcoin are an extremely effective marketing tool for bitcoin. Bitcoin exists as a non-sovereign, censorship-resistant form of money. It is designed to exist beyond the state. Attempts to ban bitcoin merely serve to reinforce bitcoin’s reason for existence and ultimately, its value proposition.
Banning bitcoin is a fool’s errand. Some will try; all will fail. And the very attempts to ban bitcoin will accelerate its adoption and proliferation. It will be the hundred mile-per-hour wind that fuels the wildfire. It will also make bitcoin stronger and more reliable, further immunizing it from attack and reinforcing its antifragile nature. And in any case, believing governments will ban bitcoin, if it becomes a credible threat to global reserve currencies, is an irrational reason to discount it as a savings technology. It both cedes that bitcoin is viable as money, while at the same time ignoring the principal reasons as to why: decentralization and censorship-resistance. Imagine understanding the greatest present secret in the world and not capitalizing on the asymmetry and utility that bitcoin provides in fear of government. More likely, either someone understands why bitcoin works and that it will not fail at the hands of a government, or a knowledge gap exists as to how bitcoin is able to function in the first place. Begin by understanding the fundamentals, and then apply that as a baseline to assess any potential risk posed by future government intervention or regulation. And never discount the value of asymmetry; the only winning move is to play.
Views presented are expressly my own and not those of Unchained Capital or my colleagues. Thanks to Phil Geiger for reviewing and for providing valuable feedback.
]]>We sit here, in 2019, witnessing the monetization event of an economic good (bitcoin) on the free market for the first time in thousands of years (h/t gold). Rather than stopping to contemplate the weight of that reality or to understand how or why that is possible, many people skip right past it to focus on some derivative or some way to improve upon a problem they didn’t see in the first place. Everyone wants to get rich quick, and so long as there is money, there will also be alchemists. Those that attempt to copy bitcoin are our modern day alchemists.
They tell us that bitcoin is too slow so they create a copy that is “faster”. Or they tell us that bitcoin does not have the capacity to handle the number of transactions required by the global economy so they create a copy that has “greater” scale. Then they tell us that bitcoin is too volatile to be a currency so they create a “more stable” version. It goes on and on. Next its that bitcoin is too rigid and that it needs to be more programmable so they create a copy that is “more flexible”. They often even tell us that their creation is not money but instead, it’s a vehicle for “payments” or a “utility” or maybe a “global computer fueled by gas”. They also try to convince us of a world that has hundreds, if not thousands, of currencies. But make no mistake, in each case, it is their own attempt to create money.
If an asset’s primary (if not sole) utility is the exchange for other goods and services and if it does not have a claim on the income stream of a productive asset (such as a stock or bond), it must compete as a form of money and will only store value if it possesses credible monetary properties. With each “feature” change, those that attempt to copy bitcoin signal a failure to understand the properties that make bitcoin valuable or viable as money. When bitcoin’s software code was released, it wasn’t money. To this day, bitcoin’s software code is not money. You can copy the code tomorrow or create your own variant with a new feature and no one that has adopted bitcoin as money will treat it as such. Bitcoin has become money over time only as the bitcoin network developed emergent properties that did not exist at inception and which are next to impossible to replicate now that bitcoin exists.
These properties emerged organically and spontaneously as individual economic actors all over the world evaluated bitcoin and determined to store a portion of their wealth in it. As bitcoin’s value increased, it became decentralized and as it became decentralized, it also became increasingly difficult to alter the network’s consensus rules or to invalidate, or prevent, otherwise valid transactions (often referred to as censorship-resistance). There remains reasonable debate as to whether bitcoin is sufficiently decentralized or sufficiently censorship-resistant, but while this may be the case, there are other considerations less subject to debate:
Every other fiat currency, commodity money or cryptocurrency is competing for the exact same use case as bitcoin whether it is understood or not and monetary systems tend to a single medium because their utility is liquidity rather than consumption or production. When evaluating monetary networks, it would be irrational to store value in a smaller, less liquid and less secure network if a larger, more liquid and more secure network existed as an attainable option.
Apply a common sense test. If you worked for two weeks and your employer offered to pay you in a form of currency accepted by 1 billion people all over the world or a currency accepted by 1 million people, which would you take? Would you request 99.9% of one and 0.1% of the other, or would you take your chances with your billion friends? If you are a U.S. resident but travel to Europe one week a year, do you request your employer pay you 1/52nd in euros each week or do you take your chances with dollars? The practical reality is that almost all individuals store value in a single monetary asset, not because others do not exist but rather because it is the most liquid asset within their market economy.
Anyone with Venezuelan bolivars or Argentine pesos would opt into the dollar system if they could. And similarly, anyone choosing to speculate in a copy of bitcoin is making the irrational decision to voluntarily opt-in to a less liquid, less secure monetary network. While certain monetary networks are larger and more liquid than bitcoin today (e.g. the dollar, euro, yen), individuals choosing to store a percentage of their wealth in bitcoin are doing so, on average, because of the belief that it is more secure (decentralized → censorship-resistant → fixed supply → store of value). And, because of the expectation that others (e.g. a billion soon-to-be friends) will also opt-in, increasing liquidity and trading partners.
Many individuals creating digital currencies neither accept or admit that what they are creating has to be money to succeed; others that are speculating in these assets fail to understand that monetary systems tend to one medium or naively believe that their currency can out-compete bitcoin. None of them can explain how their digital currency of choice becomes more decentralized, more censorship-resistant or develops more liquidity than bitcoin. To take that further, no other digital currency will likely ever achieve the minimum level of decentralization or censorship-resistance required to have a credibly enforced monetary policy. And to literally steal a page from The Bitcoin Standard:
Bitcoin is valuable, not because of a particular feature, but instead, because it achieved finite, digital scarcity, through which it derives its store of value property. The credibility of bitcoin’s scarcity (and monetary policy) only exists because it is decentralized and censorship-resistant, which in itself has very little to do with software. In aggregate, this drives incremental adoption and liquidity which reinforces and strengthens the value of the bitcoin network. As part of this process, individuals are, at the same time, opting out of inferior monetary networks. This is fundamentally why the emergent properties in bitcoin are next to impossible to replicate and why bitcoin cannot be copied or out-competed: because bitcoin already exists as an option and its monetary properties become stronger over time (and with greater scale), while also at the direct expense of inferior monetary networks.
One would likely never come to this conclusion without first developing their own understanding of the following: i) that bitcoin is finitely scarce (how/why); ii) that bitcoin is valuable because it is scarce; and iii) that monetary networks tend to one medium. You may come to different conclusions, but this is the appropriate framework to consider when contemplating whether it is possible to copy (or out-compete) bitcoin rather than a framework based on any particular feature set. It’s also important to recognize that any individual’s conclusions, including your own or my own, has very little bearing in the equation. Instead, what matters is what the market consensus believes and what it converges on as the most credible long-term store of value.
The empirical evidence (price mechanism & value) demonstrates that the market continues to determine why bitcoin is different, despite a significant amount of noise. Before speculating, try to understand why bitcoin works and why it’s unique. When someone inevitably tells you about a better bitcoin or some differentiating feature, remember that the market, which has come to this same crossroad over the last decade before you, has considered those trade-offs and chosen bitcoin over the field for very rational reasons.
Nassim Taleb writes about how a very small intransigent minority can force its preference on the majority, referring to it as the minority rule and explaining why “The Most Intolerant Wins”. Bitcoin (and monetary systems) are a perfect example of this phenomenon. If a very small minority converges on the belief that bitcoin has superior monetary properties and will not accept your form of digital (or traditional) currency as money, while less convicted market participants accept both bitcoin and other currencies, the intolerant minority wins. This is exactly what is happening in the global competition for digital currency supremacy. A small minority of market participants has determined that only bitcoin is viable, rejecting the monetary properties of all other digital currencies, while the majority is willing to accept bitcoin along with the field. Because of its intransigence, the minority is slowly forcing its preference on the majority. In the world of digital currencies, diversifying by picking the field is the equivalent of letting the crowd (or the intolerant minority) choose what your future money will be, while resigning yourself to only a fraction of what you otherwise would have saved. Evaluate the trade-offs and consider the minority rule before trading in your hard-earned value for a flyer. Money doesn’t grow on trees.
Views presented are expressly my own and not those of Unchained Capital or my colleagues.
]]>Bitcoin is out-competing its analog predecessors on the basis of its monetary properties. Bitcoin is finitely scarce, and it is more easily divisible and more easily transferable than its incumbent competitors. It is also more decentralized, and as a derivative, more resistant to censorship or corruption. There will only ever be 21 million bitcoin, and each bitcoin is divisible to eight decimal points (1 one-hundred millionth). Value can be transferred to anyone and anywhere in the world on a permissionless basis, and final settlement does not rely on any third-party. In aggregate, its monetary properties are vastly superior to any other form of money used today. And, these properties do not exist by chance, nor do they exist in a vacuum. The emergent monetary properties in bitcoin are secured and reinforced through a combination of cryptography, a network of decentralized nodes enforcing a common set of consensus rules, and a robust mining network ensuring the integrity and immutability of bitcoin’s transaction ledger. The currency itself is the keystone which binds the system together, creating economic incentives that allow the security columns to function as a whole. But even still, bitcoin’s monetary properties are not absolute; instead, these properties are evaluated by the market relative to the properties inherent in other monetary systems.
Recognize that every time a dollar is sold for bitcoin, the exact same number of dollars and bitcoin exist in the world. All that changes is the relative preference of holding one currency versus another. As the value of bitcoin rises, it is an indication that market participants increasingly prefer holding bitcoin over dollars. A higher price of bitcoin (in dollar terms) means more dollars must be sold to acquire an equivalent amount of bitcoin. In aggregate, it is an evaluation by the market of the relative strength of monetary properties. Price is the output. Monetary properties are the input. As individuals evaluate the monetary properties of bitcoin, the natural question becomes: which possesses more credible monetary properties? Bitcoin or the dollar? Well, what backs the dollar (or euro or yen, etc.) in the first place? When attempting to answer this question, the retort is most often that the dollar is backed by the government, the military (guys with guns), or taxes. However, the dollar is backed by none of these. Not the government, not the military and not taxes. Governments tax what is valuable; a good is not valuable because it is taxed. Similarly, militaries secure what is valuable, not the other way around. And a government cannot dictate the value of its currency; it can only dictate the supply of its currency.
Venezuela, Argentina, and Turkey all have governments, militaries and the authority to tax, yet the currencies of each have deteriorated significantly over the past five years. While it’s not sufficient to prove the counterfactual, each is an example that contradicts the idea that a currency derives its value as a function of government. Each and every episode of hyperinflation should be evidence enough of the inherent flaws in fiat monetary systems, but unfortunately it is not. Rather than understanding hyperinflation as the logical end game of all fiat systems, most simply believe hyperinflation to be evidence of monetary mismanagement. This simplistic view ignores first principles, as well as the dynamics which ensure monetary debasement in fiat systems. While the dollar is structurally more resilient as the global reserve currency, the underpinning of all fiat money is functionally the same, and the dollar is merely the strongest of a weak lot. Once the mechanism(s) that back the dollar (and all fiat systems) is better understood, it provides a baseline to then evaluate the mechanisms that back bitcoin.
The value of the dollar did not emerge on the free market. Instead, it emerged as a fractional representation of gold (and silver initially). Essentially, the dollar was a solution to the inherent limitations in the convertibility and transferability of gold; its inception was dependent on the monetary properties of base metals, rather than properties inherent in the dollar itself. It was also initially a system based on trust: accept dollars and trust that it could be converted back to gold at a fixed amount in the future. Gold’s limitation and ultimate failure as money is the dollar system, and without gold, the dollar would have never existed in its current construct. For a quick review of the dollar’s history with gold:
1900 | Gold Standard Act of 1900 established that gold was the only metal convertible to the dollar; gold convertible to dollars at $20.67/oz. |
1913 | The Federal Reserve was created as part of the Federal Reserve Act of 1913. |
1933 | President Roosevelt banned the hoarding (saving) of gold via Executive Order 6102, requiring citizens to convert gold to dollars at $20.67 per ounce or face a penalty in the form of a fine up to $10,000 and/or up to 5 to 10 years imprisonment. |
1934 | President Roosevelt signed the Gold Reserve Act, devaluing the dollar by approximately 40% to $35 per ounce of gold. |
1944 | Bretton Woods agreement formalized ability of foreign governments and central banks to convert gold to dollars (and vice versa) at $35/oz and established fixed exchange ratios between dollars and other foreign currencies. |
1971 | President Nixon officially ended all convertibility of dollars to gold, effectively ending the Bretton Woods system. The value of dollar was changed to $38/oz of gold. |
1973 | The U.S. government repriced gold to $42 per ounce. |
1976 | The U.S. government then decoupled the value of the dollar from gold altogether in 1976. |
Over the course of the twentieth century, the dollar transitioned from a reserve-backed currency to a debt-backed currency. While most people never stop to consider why the dollar has value in the post gold era, the most common explanation remains that it is either a collective hallucination (i.e. the dollar has value simply because we all believe it does), or that it is a function of the government, the military, and taxes. Neither explanation has any basis in first principles, nor is it the fundamental reason why the dollar retains value. Instead, today, the dollar maintains its value as a function of debt and the relative scarcity of dollars to dollar-denominated debt. In the dollar world, everything is a function of the credit system. Nominal GDP is functionally dependent on the size, and growth of the credit system, and taxes are a derivative of nominal GDP. The mechanisms that fund the government (taxes and deficit spending) are both dependent on the credit system, and it is the credit system that allows the dollar to function in its current construct.
The size of the credit system is several times larger than nominal GDP. Because the credit system is also orders of magnitude larger than the base money supply, economic activity is largely coordinated by the allocation and expansion of credit. However, the growth of the credit system has far outpaced the growth of GDP over the course of the last three decades. The chart below indexes the rate of change of the credit system compared to the rate of change of both nominal GDP and federal tax receipts (from 1987 to today). In the Fed’s system, credit expansion drives nominal GDP which ultimately dictates the nominal level of federal tax receipts.
Today, there is 73 trillion of debt (fixed maturity / fixed liability) in the U.S. credit system according to the Federal Reserve ([z.1 report](https://www.federalreserve.gov/releases/z1/20190920/z1.pdf)), but there are only 1.6 trillion actual dollars in the banking system. This is how the Fed manages the relative stability of the dollar. Debt creates future demand for dollars. In the Fed’s system, each dollar is leveraged approximately 40:1. If you borrow dollars today, you need to acquire dollars in the future to repay that debt, and currently, each dollar in the banking system is owed 40 times over. The relationship between the size of the credit system relative to the amount of dollars gives the dollar relative scarcity and stability. In aggregate, everyone needs dollars to repay dollar denominated credit.
The system as a whole owes far more dollars than exist, creating an environment where on net there is a very high present demand for dollars. If consumers did not pay debt, their homes would be foreclosed upon, or their cars would be repossessed. If a corporation did not pay debt, company assets would be forfeited to creditors via a bankruptcy process, and equity could be entirely wiped out. If a government did not pay debt, basic government functions would be shut down due to lack of funding. In most cases, the consequence of not securing the future dollars necessary to repay debt means losing the shirt on your back. Debt creates the ultimate incentive to demand dollars. So long as dollars are scarce relative to the amount of outstanding debt, the dollar remains relatively stable. This is how the Fed’s economy works, incentivize credit creation and you create the source of future demand for the underlying currency. In a sense, it’s kind of like a drug dealer. Get an addict hooked on your drug and he will keep coming back for more. In this case, the drug is debt, and it forces everyone, on net, to stay on the dollar hamster wheel.
The problem for the Fed’s economy (and the dollar) is that it depends on the functioning of a highly leveraged credit system. And in order to sustain it, the Fed must increase the amount of base dollars. This is what quantitative easing is and why it exists. In order to sustain the amount of debt in the system, the Fed has to systematically increase the supply of actual dollars, otherwise the credit system would collapse. Increasing the amount of base dollars has the immediate effect of deleveraging the credit system, but it has the longer-term effect of inducing more credit. It also has the effect of devaluing the dollar gradually over time. This is all by design. Credit is ultimately what backs the dollar because what the credit actually represents is claims on real assets, and consequently, people’s livelihoods. Come with dollars in the future or risk losing your house is an incredible incentive to work for dollars.
The relationship between dollars and dollar credit keeps the Fed’s game in play, and central bankers believe this can go on forever. Create more dollars; create more debt. Too much debt? Create more dollars, and so on. Ultimately, in the Fed’s (or any central bank’s) system, the currency is the release valve. Because there is 73 trillion of debt and only 1.6 trillion dollars in the U.S. banking system, more dollars will have to be added to the system to support the debt. The scarcity of dollars relative to the demand for dollars is what gives the dollar its value. Nothing more, nothing less. Nothing else backs the dollar. And while the dynamics of the credit system create relative scarcity of the dollar, it is also what ensures dollars will become less and less scarce on an absolute basis.
Too much debt → Create more money → More debt → Too much debt
As is the case with any monetary asset, scarcity is the monetary property that backs the dollar, but the dollar is only scarce relative to the amount of dollar-denominated debt that exists. And it now has real competition in the form of bitcoin. The dollar system and its lack of inherent monetary properties provides a stark contrast to the monetary properties emergent and inherent in bitcoin. Dollar scarcity is relative; bitcoin scarcity is absolute. The dollar system is based on trust; bitcoin is not. The dollar’s supply is governed by a central bank, whereas bitcoin’s supply is governed by a consensus of market participants. The supply of dollars will always be wed to the size of its credit system, whereas the supply of bitcoin is entirely divorced from the function of credit. And, the cost to create dollars is marginally zero, whereas the cost to create bitcoin is tangible and ever increasing. Ultimately, bitcoin’s monetary properties are emergent and increasingly unmanipulatable, whereas the dollar is inherently and increasingly manipulable.
The hardest mental hurdle to overcome, when evaluating bitcoin as money, is often that it is digital. Bitcoin is not tangible, and on the surface, it is not intuitive. How could something entirely digital be money? While the dollar is mostly digital, it remains far more tangible than bitcoin in the mind of most. While the digital dollar emerged from its paper predecessor and physical dollars remain in circulation, bitcoin is natively digital. With the dollar, there is a physical representation that anchors our mental models in the tangible world; with bitcoin, there is not. While bitcoin possesses far more credible monetary properties than the dollar, the dollar has always been money (for most of us), and as a consequence, its digital representation is seemingly a more intuitive extension from the physical to the digital world. While the dollar’s basis as money is anchored in time and while its digital nature may seem more tangible, bitcoin represents finite scarcity. The supply of the dollar on the other hand has no limits.
Remember that the dollar does not have any inherent monetary properties. It leveraged the monetary properties of gold in its ascent to global reserve status, but in itself, there are no unique properties that ground the dollar as a stable form of money, other than its relative scarcity in the construct of its credit-linked monetary system. When evaluating bitcoin, the first principle question to consider is whether something digital could share the quintessential properties that made gold a store of value (and a form of money). Did gold emerge as money because it was physical or because it possessed transcendent properties beyond being physical? Of all the physical objects in the world, why gold? Gold emerged as money not because it was physical, but instead because its aggregate properties were unique. Most importantly, gold is scarce, fungible and highly durable. While gold possessed many properties which made it superior to any money that came before it, its fatal flaw was that it was difficult to transport and susceptible to centralization, which is ultimately why the dollar emerged as its transactional counterpart.
Bitcoin shares the monetary properties that caused gold to emerge as a monetary medium, but it also improves upon gold’s flaws. While gold is relatively scarce, bitcoin is finitely scarce and both are extremely durable. While gold is fungible, it is difficult to assay; bitcoin is fungible and easy to assay. Gold is difficult to transfer and highly centralized. Bitcoin is easy to transfer and highly decentralized. Essentially, bitcoin possesses all of the desirable traits of both physical gold and the digital dollar combined in one, but without the critical flaws of either. When evaluating monetary mediums, first principles are fundamental. Ignore the conclusion or end point, and start by asking yourself: if bitcoin were actually scarce and finite, ignoring that it is digital, could that be an effective measure of value and ultimately a store of value? Is scarcity a sufficiently powerful property that bitcoin could emerge as money, regardless of whether the form of that scarcity is digital?
While money may be an intangible concept, so long as there are benefits from trade and specialization, there is real demand and utility in money. Money is the tool we use to be the arbiter in determining relative value among more abundant consumption goods and capital goods. It is the good that coordinates all other economic activity. The absolute quantity of money is less important than its properties of being scarce and measurable. Scarcity is money’s most important property. If supply of the unit of measure were constantly and unpredictably changing, it would be very difficult to measure the value of goods relative to it, which is why scarcity, on its own, is an incredibly valuable property. While the value of the underlying measurement unit may fluctuate relative to goods and services, stability in the supply of money results in the least amount of noise in the relative price signal of other goods.
Despite being digital, bitcoin is designed to provide absolute scarcity, which is why it has the potential to be such an effective form of money (and measure of value). There will only ever be 21 million bitcoin, and 21 million is a scarily small number in relative and absolute terms. The Fed created 100 billion dollars just last week, with the click of a button. That is approximately 5,000 per bitcoin that will ever exist, created in just a week (and by only one central bank). To provide broader context, the Federal Reserve, the Bank of Japan and the European Central bank have collectively created 10 trillion dollars-worth of new money since the financial crisis, the equivalent of approximately 500,000 per bitcoin. Despite dollars, euro, yen and bitcoin all being digital, bitcoin is the only medium that is tangibly scarce and the only one with inherent monetary properties.
However, it is insufficient to simply claim that bitcoin is finitely scarce; nor should anyone simply accept this as fact. It is important to understand how and why that is the case. Why can’t more than 21 million bitcoin be created and why can’t it be copied? Why is bitcoin secure and why can’t it be manipulated? While there are countless building blocks that collectively allow bitcoin to function with a reliably fixed supply, there are three key columns of security within the bitcoin network which are woven together and reinforced by the economic incentives of the currency itself:
21 million is not just a number guaranteed by software. Instead, bitcoin’s fixed 21 million supply is governed by a consensus mechanism, and all market participants have an economic incentive to enforce the rules of the bitcoin network. While a consensus of the bitcoin network could theoretically determine to increase the supply of bitcoin such that it exceeds 21 million, an overwhelming majority of bitcoin users would have to collectively agree to debase their own currency in order to do so. In practice, a global and decentralized network of rational economic actors, operating within a voluntary, opt-in currency system would not collectively and overwhelmingly form a consensus to debase the currency which they have all independently and voluntarily determined to use as a store of wealth. This reality then underpins and reinforces bitcoin’s economic incentives, technical architecture and network effect.
In bitcoin, a full node is a computer or server that maintains a full version of the bitcoin blockchain. Full nodes independently aggregate a version of the blockchain based on a common set of network consensus rules. While not everyone that holds bitcoin runs a full node, everyone is able to do so, and each node validates all transactions and all blocks. By running a full node, anyone can access the bitcoin network and broadcast transactions (or blocks) on a permissionless basis. And nodes do not trust any other nodes. Instead, each node independently verifies the complete history of bitcoin transactions based on a common set of rules, allowing the network to converge on a consistent and accurate version of history on a trustless basis.
This is the mechanism by which the bitcoin network removes trust in any centralized third-party and hardens the credibility of its fixed supply. All nodes maintain a history of all transactions, allowing each node to determine whether any future transaction is valid. In aggregate, bitcoin represents the most secure computing network in the world because anyone can access it and no one trusts anyone. The network is decentralized and there are no single points of failure. Every node represents a check and balance on the rest of the network, and without a central source of truth, the network is resistant to attack and corruption. Any node could fail or could become corrupted, and the rest of the network would remain unimpacted. The more nodes that exists, the more decentralized bitcoin becomes, which increases redundancy, making the network harder and harder to corrupt or censor.
Each full node enforces the consensus rules of the network, a critical element of which is the currency’s fixed supply. Each bitcoin block includes a pre-defined number of bitcoin to be issued and each bitcoin transaction must have originated from a previously valid block in order to be valid. Every 210,000 blocks, the bitcoin issued in each valid block is cut in half until the amount of bitcoin issued ultimately reaches zero in approximately 2140, creating an asymptotic, capped supply schedule. Because each node independently validates every transaction and each block, the network collectively enforces the fixed 21 million supply. If any node broadcasts an invalid transaction or block, the rest of the network would reject it and that node would fall out of consensus. Essentially, any node could attempt to create excess bitcoin, but every other node has an interest in ensuring the supply of bitcoin is consistent with the pre-defined fixed limit, otherwise the currency would be arbitrarily debased at the direct expense of the rest of the network.
Separately, anyone within or outside the network could copy bitcoin’s software to create a new version of bitcoin, but any units created by such a copy would be considered invalid by the nodes operating within the bitcoin network. Any subsequent copies or units would not be considered valid, nor would anyone accept the currency as bitcoin. Each bitcoin node independently validates whether a bitcoin is a bitcoin, and any copy of bitcoin would be invalid, as it would not have originated from a previously valid bitcoin block. It would be like trying to pass off monopoly money as dollars. You can wish it to be money all you want, but no one would accept it as bitcoin, nor would it share the emergent properties of the bitcoin network. Running a bitcoin full node allows anyone to instantly assay whether a bitcoin is valid, and any copy of bitcoin would be immediately identified as counterfeit. The consensus of nodes determines the valid state of the network within a closed-loop system; anything that occurs beyond its walls is as if it never happened.
As part of the consensus mechanism, certain nodes (referred to as miners) perform bitcoin’s proof of work function to add new bitcoin blocks to the blockchain. This function validates the complete history of transactions and clears pending transactions. The process of mining is ultimately what anchors bitcoin security in the physical world. In order to solve blocks, miners must perform trillions of cryptographic computations, which require expending significant energy resources. Once a block is solved, it is proposed to the rest of the network for validation. All nodes (including other miners) verify whether a block is valid based on a common set of network consensus rules discussed previously. If any transaction in the block is invalid, the entire block is invalid. Separately, if a proposed block does not build on the latest valid block (i.e. the longest version of the block chain), the block is also invalid.
For context, at 90 exahashes per second, the bitcoin network currently consumes approximately 9 gigawatts of power, which translates to ~11 million per day (or ~4 billion per year) of energy at a marginal cost of 5 cents per kWh (rough estimates). Blocks are solved on average every ten minutes, which translates to approximately 144 blocks per day. Across the network, each block costs approximately 75,000 to solve, and the reward per block is approximately 100,000 (12.5 new bitcoin x $8,000 per bitcoin, excluding transaction fees). The higher the cost to solve a block, the more costly the network is to attack. The cost to solve a block represents the tangible resources it requires to write history to the bitcoin transaction ledger. As the network grows, the network becomes more fragmented, and the economic value compensated to miners in aggregate increases. From a game theory perspective, more competition and greater opportunity cost makes it harder to collude, and all network nodes validate the work performed by miners, which serves as a constant check and balance.
And recall that a pre-defined number of bitcoin are issued in each valid block (that is, until the 21 million limit is reached). The bitcoin issued in each block combined with network transaction fees represent the compensation to miners for performing the proof-of-work function. The miners are paid in bitcoin to secure the network. As part of the block construction and proposal process, miners include the pre-defined number of bitcoin to be issued as compensation for expending tangible, real world resources to secure the network. If a miner were to include an amount of bitcoin inconsistent with the pre-defined supply schedule as compensation, the rest of the network would reject the block as invalid. As part of the security function, miners must validate and enforce the fixed supply of the currency in order to be compensated. Miners have material skin-in-the-game in the form of upfront capital costs (and energy expenditure), and invalid work is not rewarded.
For a technical example, the valid reward paid to miners is halved every 210,000 blocks with the next halvening (a “technical” term) scheduled to occur at block 630,000 (or approximately in May 2020). At the time and scheduled block of the next halvening, the valid reward will be reduced from 12.5 bitcoin to 6.25 bitcoin per block. Thereafter, if any miner includes an invalid reward (an amount other than 6.25 bitcoin), the rest of the network will reject it as invalid. The halvening is important not just because the supply of newly issued bitcoin is reduced, but also because it demonstrates that the economic incentives of the network continue to effectively coordinate and enforce the fixed supply of the currency on an entirely decentralized basis. If any miner attempts to cheat, it will be maximally penalized by the rest of the network. Nothing other than the economic incentives of the network coordinate this behavior; that it occurs on a decentralized basis without the coordination of any central authority reinforces the security of the network.
Because mining is decentralized and because all miners are constantly competing with all other miners, it is not practical for miners to collude. Separately, all nodes validate the work performed by miners, instantly and at practically no cost, which creates a very powerful check and balance that is divorced from the mining function itself. Blocks are costly to solve but easy to validate; in aggregate, this is a fundamental differentiator between bitcoin and the monetary systems with which bitcoin competes, whether gold or the dollar. And the compensation paid to miners for securing the network and enforcing the network’s fixed supply is exclusively in the form of bitcoin. The economic incentives of the currency (compensation) is so strong and the penalty is both so severe and so easily enforced that miners are maximally incentivized to cooperate and perform valid work. By introducing tangible cost to the mining process, by incorporating the supply schedule in the validation process (which all nodes verify), and by divorcing the mining function from ownership of the network, the network as a whole reliably and perpetually enforces the fixed supply (21 million) of the currency on a trustless basis, while also able to reach consensus on a decentralized basis.
While miners construct, solve and propose blocks and while nodes check and validate work performed by miners, private keys control access to the unit of value itself. Private keys control the rights to the 21 million bitcoin (technically only 18.0 million have been mined to date). In bitcoin, there are no identities; bitcoin knows nothing of the outside world. The bitcoin network validates signatures and keys. That is all. Only someone in control of a private key can create a valid bitcoin transaction by creating a valid signature. Valid transactions are included in blocks, which are solved by miners and validated by each node, but only those in possession of private keys can produce valid transactions.
When a valid transaction is broadcast, bitcoin are spent (or transferred) to specific bitcoin public addresses. Public addresses are derived from public keys, which are derived from private keys. Public keys and public addresses can be calculated using a private key, but a private key cannot be calculated from a public key or public address. It is a one-way function secured by strong cryptography. Public keys and public addresses can be shared without revealing anything about the private keys. When a bitcoin is spent to a public address, it is essentially locked in a safe, and in order to unlock the safe to spend the bitcoin, a valid signature must be produced by the corresponding private key (every public key and address has a unique private key). The owner of the private key produces a unique signature, without actually revealing the secret itself. The rest of the network can verify that the holder of the private key produced a valid signature, without actually knowing any details of the private key itself. Public and private key pairs are the foundation of bitcoin. And ultimately, private keys are what control access rights to the economic value of the network.
It doesn’t matter whether someone has one-tenth of a bitcoin or ten thousand bitcoin. Either and each are secured and validated by the same mechanism and by the same rules. Everyone has equal rights. Regardless of the economic value, each bitcoin (and bitcoin address) is treated identically within the bitcoin network. If a valid signature is produced, the transaction is valid and it will be added to the blockchain (if a transaction fee is paid). If an invalid signature is produced, the network will reject it as invalid. It does not matter how powerful or how weak any particular participant may be. Bitcoin is apolitical. All it validates is keys and signatures. Someone with more bitcoin may be able to pay a higher fee to have a transaction prioritized, but all transactions are validated based on the same set of consensus rules. Miners prioritize transactions based on value and profitability, nothing else. If a transaction is equally valuable, it will be prioritized based on a time sequence. But importantly, the mining function, which clears transactions, is divorced from ownership. Bitcoin is not a democracy; ownership is controlled by keys and every bitcoin transaction is evaluated based on the same criteria within the network. It is either valid or it is not. And every bitcoin must have originated within a block consistent with the 21 million supply schedule in order to be valid.
This is why users controlling keys is such a significant ethos in bitcoin. Bitcoin are extremely scarce, and private keys are the gatekeeper to the transfer of every bitcoin. The saying goes: not your keys, not your bitcoin. If a third-party party controls your keys, such as a bank, that entity is in control of your access to the bitcoin network, and it would be very easy to restrict access or seize funds in such a scenario. While many people choose to trust a bank-like entity, the security model of bitcoin is unique; not only can each user control their own private keys, but each user can also access the network on a permissionless basis and transfer funds to anyone anywhere in the world. This is only possible if a user is in control of a private key. In aggregate, users controlling private keys decentralize the control of the network’s economic value, which increases the security of the network as a whole. The more distributed access is to the network, the more challenging it becomes to corrupt or co-opt the network. Separately, by holding a private key, it becomes extremely difficult for anyone to restrict access or seize funds held by any individual. Every bitcoin in circulation is secured by a private key; miners and nodes may enforce that 21 million bitcoin will ever exist, but the valid bitcoin that do exist are ultimately controlled and secured by a private key.
In summary, the supply of bitcoin is governed by a network consensus mechanism, and miners perform a proof-of-work function that grounds bitcoin’s security in the physical world. As part of the security function, miners get paid in bitcoin to solve blocks, which validate history and clear pending bitcoin transactions. If a miner attempts to compensate themselves in an amount inconsistent with bitcoin’s fixed supply, the rest of the network will reject the miner’s work as invalid. The supply of the currency is integrated into bitcoin’s security model, and real world energy resources must be expended in order for miners to be compensated. Still yet, every node within the network validates the work performed by all miners, such that no one can cheat without a material risk of penalty. Bitcoin’s consensus mechanism and validation process ultimately governs the transfer of ownership of the network, but ownership of the network is controlled and protected by individual private keys held by users of the network.
Set aside any preconceived notions of what money is, and imagine a currency system that has an enforceably scarce and fixed supply. Anyone in the world can connect to the network on a permissionless basis and anyone can send transactions to anyone anywhere in the world; everyone can also independently and easily validate the supply of the currency as well as ownership across the network. Imagine a global economy where billions of people, disparately located throughout the world, can transact across one common decentralized network, and everyone can arrive at the same consensus of the ownership of the network, without the coordination of any central party. How valuable would that network be? Bitcoin is valuable because it is finite, and it is finite because it is valuable. The economic incentives and governance model of the network reinforce each other; the cumulative effect is a decentralized and trustless monetary system with a fixed supply that is global in reach and accessible by anyone.
Because bitcoin has inherent and emergent monetary properties, it is distinct from all other digital monies. While the supply of bitcoin remains fixed and finitely scarce, central banks will be forced to expand the monetary base in order to sustain the legacy system. Bitcoin will become a more and more attractive option, as more market participants figure out that future rounds of quantitative easing are not just a central bank tool but a necessary function to sustain the alternate and inferior option. Before bitcoin, everyone was forced to opt in to this system by default. Now that bitcoin exists, there is a viable alternative. Each time the Fed returns with more quantitative easing to sustain the credit system, more and more individuals will discover that the monetary properties of bitcoin are vastly superior to the legacy system, whether the dollar, euro or yen. Is A better than B? That is the test. In the global competition for money, bitcoin has inherent monetary properties that the fiat monetary system lacks. Ultimately, bitcoin is backed by something, and it’s the only thing that backs any money: the credibility of its monetary properties.
Views presented are expressly my own and not those of Unchained Capital or my colleagues. Thanks to Phil Geiger, Adam Tzagournis and Will Cole for reviewing and for providing valuable feedback.
]]>If bitcoin were principally used for illicit purposes, it may more logically follow that bitcoin is primarily used by criminals. Because it is not, the typical follow-on arguments that bitcoin should be banned in order to prevent such activity similarly do not hold water. The very foundation of the idea is based on the false premise that bitcoin is inferior to the dollar; when in fact, it is superior to any form of money that has previously existed, principally as a function of its fixed supply (see “Bitcoin is Not Backed by Nothing” or “Bitcoin is Not a Pyramid Scheme”). Bitcoin’s fixed supply forms the basis of the fundamental demand for bitcoin, whether it be related to criminal activity or otherwise. And regardless of how many point-of-sale transactions bitcoin may facilitate daily, it is used every day as a censorship-resistant and inflation-resistant form of savings. Without doubt, bitcoin is definitely used by the likes of drug dealers and nefarious characters on the dark web. However, it would be irrational to believe that is its primary use or to believe bitcoin should be banned because of it. It is logically inconsistent to form a view that bitcoin is sufficiently functional to be viable as a currency for criminals, while at the same time deny the implication that such a view would merely establish that bitcoin is functional for everyone.
But before turning the drugs narrative completely upside down, let’s all first admit that criminals rely upon any number of commonly-trafficked access points and not just bitcoin. Roads, the internet, the postal service, airports, the banking system, etc.? Yep, all used by criminals and often used to facilitate crimes. But then again, criminals also use all of the above not to commit crimes as well. And that is where the logic that bitcoin must be banned because it enables criminal activity completely breaks down. Crimes are crimes. There is nothing inherent about the tools used to facilitate crimes that makes them criminal in themselves. Using the mail to send a letter to mom is not a crime. But using the mail to send drugs is mail fraud. Similarly, using the dollar to purchase flowers for mom, perfectly fine. But buying narcotics with dollars (or bitcoin), that’s crime. Despite criminal use, no one is calling for the ban of roads, the internet, mail, etc. And you definitely do not see any prominent defenders of the public interest calling for a ban of the dollar, which just happens to be the preferred funding currency of criminals everywhere. Sure, fear of criminal activity has been used to infringe on the rights of law-abiding citizens seemingly everywhere, but believing bitcoin should be banned because drug dealers use it would be no different than calling for a ban on the dollar for the same reason.
Such a view becomes that much more untenable once it is understood that bitcoin is not actually for criminals, but in order to understand that, it must also be understood that bitcoin is for criminals. It’s a paradox. The very idea is turned on its head when viewed through the proper lens. The fact that criminals can use (and have used) bitcoin to facilitate commerce merely demonstrates that bitcoin can be used to facilitate any form of commerce. That a very early, and well publicized, use case for bitcoin involved the Silk Road website, which facilitated transactions involving drugs and other illicit goods using bitcoin as a means of payment, changes nothing about the broader implication: that bitcoin worked. But rather than focus here, bitcoin research often attempts to prove the counterfactual, that only a small percentage of bitcoin transactions are used for illicit purposes. For example, a headline from last year:
The substance may be true, but these counter-narratives fight the battle along the wrong lines. If the Silk Road demonstrated anything, it was simply that individuals would accept bitcoin as a form of payment in return for goods and services. It does not matter that the goods sold on the Silk Road website were generally illicit. The Silk Road, which is estimated to have facilitated in excess of a million transactions, was one of the earliest demonstrations of a mass real-world use case for bitcoin. So yes, bitcoin is (and was) used for drug deals but it is merely one use case that has helped prove bitcoin’s general utility, nothing more. And when it comes to buying drugs, the dollar remains far preferred to bitcoin among drug dealers despite them all generally being aware of bitcoin and capable of accepting it. Whether it be in response to the Silk Road or otherwise, anyone that comes away with the narrow conclusion that “bitcoin works for drugs” is failing to see the forest through the trees. The more consequential and assumption-shattering implication is simply that bitcoin works. Period.
If bitcoin could work for drug dealers to facilitate commerce, could it not “work” to facilitate any other form of commerce? It does not require much imagination to carry forward the logic. If Person A would accept bitcoin for Good B, is it possible that any person might be willing to accept bitcoin for any good regardless of who or what? In the case of the Silk Road, drug dealers may not have fully understood why bitcoin “worked,” but it worked sufficiently well that they were willing to trade drugs for it. What they seemingly understood was that there was sufficient market demand for bitcoin to make it viable as a medium of exchange. And because it provided an electronic mechanism to facilitate transactions, it opened up a market and market mechanism that may have otherwise been unavailable. Love it or hate it, it was just a market taking advantage of new technology.
Despite the existence of bitcoin, drug dealers have not magically stop accepting dollars as their preferred funding currency. Nor have they stop laundering dollars back into the banking system. Drug dealers on the Silk Road did not use bitcoin merely to evade law enforcement nor did the dollar drug trade suddenly disappear; they used bitcoin because it was functional and because it satisfied a market need. If bitcoin were not functional and if it were not expected to hold a certain threshold of value over a particular time horizon, it would not have been used as a medium of exchange on the Silk Road. Drug dealers are not in the money losing business after all. But more importantly, anytime anyone decries that bitcoin is used by criminals for illicit purposes, whether it be a U.S. Senator or Treasury Secretary, the default question to ask should be: why does bitcoin work as a medium to facilitate commerce in the first place?
Focusing on criminals distracts from the more fundamental question and consequence. If bitcoin could work for a criminal, it could work for anyone, and in order for bitcoin to be viable as a currency, it has to work for everyone, including criminals. However, this is not a promotion of criminal activity using bitcoin as a funding mechanism; it is merely a recognition of the properties that allow bitcoin to function in the first place. Think of criminal activity as a litmus test. If bitcoin does not work for drug dealers, it doesn’t work for anyone. But if it works for drug dealers, it can work for everyone. If it were possible to censor (or prevent) bitcoin transactions related to certain activity or certain individuals, it would be possible to censor any activity and any individuals. And if there were a prime target of activities or individuals to censor, it would be that of a criminal enterprise. The attempts have already begun.
Recognize that in this context, bitcoin “working” is specifically a reference to the network protocol layer. Whether a company or individual is willing to accept bitcoin from an address sanctioned by OFAC, or whether a third-party financial institution freezes an account associated with such an address is of little consequence to the long-term viability of bitcoin. What is consequential is whether the network would validate a transaction originated from a sanctioned address or validate a block that includes such a transaction. Stated another way, whether bitcoin miners or nodes would reject such a transaction despite it otherwise being valid based on the network’s consensus rules. Bitcoin is only viable as a currency because it is decentralized. But decentralization is not an end in itself. The end game is censorship-resistance. And it is not an end game to protect criminals. It is an end game to protect the very root level functioning of the currency system.
Censorship-resistance is the network’s most critical property because it ensures that the rules of the network will neither change arbitrarily or be enforced inconsistently, without which the system would be inoperable. Most important of these rules is the finite scarcity of the currency itself. Censorship-resistance reinforces scarcity and scarcity reinforces censorship-resistance. Bitcoin becomes more resistant to censorship as it scales because the network becomes more decentralized over time. As adoption increases, each individual (on average) controls an ever-diminishing share of the network’s fixed supply, and it is the scarcity of the currency which primarily drives adoption. As the network becomes further decentralized, it becomes increasingly difficult for any individual or business to censor the network. However, at any point in time, whether bitcoin is sufficiently censorship-resistant is ultimately unknown and practically unknowable. Instead, censorship-resistance can only be measured through the test of time and through each failed attempt to censor the network.
From a practical perspective, the risk of censorship principally comes in two forms: forcing changes to the network’s consensus rules, or invalidating (or preventing) otherwise valid transactions. By design, anyone can access the bitcoin network on a permissionless basis by running a bitcoin full node. Each node can broadcast transactions to the rest of the network, and every node validates a full history of the blockchain with each passing block based on a common set of rules. Through this operation, nodes distributed throughout the world are able to come to a common consensus regarding the valid state of bitcoin ownership across the network, on a decentralized basis and without anyone trusting any other participant. The consensus rules of bitcoin are the common language that coordinate all peers within the network, but no single party dictates the rules; everyone opts in voluntarily. If it were possible for any single party or central authority(s) to force a change on to the network or to influence activity within the network in such a way that would invalidate an otherwise valid transaction, it would demonstrate that the network was not sufficiently decentralized to prevent censorship.
But what about the criminals and what does this have to do with that? If it were possible to censor criminal-related activity within the network, either by inhibiting access to the network or by preventing otherwise valid transactions from being confirmed, it would demonstrate that the network is not sufficiently decentralized to ensure censorship-resistance. The bitcoin network has no understanding of criminality or who defines it. It is amoral and apolitical. All bitcoin understands (when validating transactions) is its consensus rules; it is a closed loop system. A bitcoin transaction is valid if it is consistent with the network’s consensus rules; if it were not, all bets would be off. If criminal activity could be censored, it simply would prove that any activity could be censored. But that is not where it ends. If any activity within the network could be censored, the network as a whole would be censorable. By demonstrating that a single transaction could be prevented or censored, it would establish that the network’s consensus rules would also be at risk.
Bitcoin can’t be a little bit censorship-resistant, just like you can’t be a little bit pregnant.
Censorship resistance is an all or nothing proposition. It either is or it is not. And if it is not, then everything is at risk, including bitcoin’s fixed 21 million supply. That number and the reliability of its scarcity underpins every other economic incentive that allows the bitcoin network to function and accumulate value, including the mechanism by which the network comes to consensus. Accepting that the bitcoin network will always to some extent be used for illicit purposes is not some libertarian bent. Instead, it is a recognition that in order for bitcoin to be functional and viable as a currency system, it has to be so for everyone. If anyone could prevent anyone else from utilizing the network, whether an individual, an organization or a nation-state, bitcoin would be at risk of failure. Censorship within bitcoin at the protocol layer is not the equivalent of PayPal de-platforming an individual or company; nor is it the equivalent of Bank of America shutting down a checking account or Visa not authorizing a transaction. Bitcoin is a currency issuer and settlement layer. Any effective form of censorship would undermine the system as a whole, which is why the activity most susceptible to censorship forms a litmus test for the rest of the network. If it were not possible to censor the most at-risk activity, it reinforces that bitcoin reliably works in all cases.
Ultimately, bitcoin represents a technological advancement in the global competition for money; it is the superior successor to existing fiat monetary systems, even if not well or widely understood today. And as an extension of an idea discussed in “Bitcoin Cannot Be Banned”, anyone who calls for a ban on bitcoin due to the belief that it enables criminal activity is concurrently admitting that bitcoin is functional as a currency. Consequently, if bitcoin is functional in facilitating commerce associated with illicit activities, and despite the best efforts of a powerful regulatory authority, ipso facto, it can be functional in facilitating any other form of commerce as well, including by law abiding citizens. Practically, operating within that reality and recognizing that bitcoin is a finitely scarce resource, it does not logically follow that it will be confined to the dark web, nor is it today.
The competition for bitcoin is global. Over time, those that produce the most relative value will accumulate the greatest share of bitcoin. To think that those involved in illicit activities will account for a larger share of the future bitcoin economy than today’s dollar economy is not rational. And calling for a ban on bitcoin is somewhat like being scared of your own shadow. Not only would it not be practical to enforce, but the activity such a policy would seek to prevent is enabled today in far greater proportions by the dollar. It would be analogous to throwing the baby out with the bath water. We accept the good with the bad, recognizing that due to the very nature of bitcoin, we do not get to decide. There are always trade-offs, and in this case, that bitcoin will unavoidably be used for illicit purposes is the trade-off we gladly accept in exchange for the economic stability that an unmanipulatable global currency will provide. As with every technology, value will accrue to those that utilize bitcoin in its highest and best use, a function which only the market can determine. The net benefit will not be zero-sum and just as the internet is not for drug dealers and terrorists, bitcoin is not for criminals. It is for everyone.
Final thought (stealing a page from @martybent’s playbook): History will look back far more favorably on Ross Ulbricht, the alleged founder of the Silk Road, than central bankers everywhere. Not for the drugs but for the bitcoin.
Views presented are expressly my own and not those of Unchained Capital or my colleagues. Thanks to Phil Geiger and Will Cole for reviewing and for providing valuable feedback.
]]>There’s a new meme floating around the internet; whatever the problem, bitcoin fixes this. Negative yielding debt? Bitcoin fixes this. Wealth inequality? Bitcoin fixes this. Endless global war? Bitcoin fixes this. Financial crises? Bitcoin fixes this. Rage culture? Bitcoin fixes this. We’re not exactly sure how just yet, but it’s an articulation of the balancing effect a sound and stable monetary system will have on every aspect of society. Money is the coordination function of society. It allows hundreds of millions of people to cooperate who otherwise would not have a basis to do so. And, bitcoin is the tool that will allow for more peaceable coordination because it is both unmanipulatable and devoid of moral hazard. How it globalizes is the “1 to n” problem (not in the express sense as Thiel describes), but the solutions to scale bitcoin will naturally be incremental. The non-zero sum collective benefit that follows may not literally cure every ill in the world, but the invention of a step-function change monetary network is fundamentally different than any single product because money is the economic good that coordinates all other economic activity.
Hayek writes about the invention of money and the price mechanism as the tool that allows society to dispense with the need of “conscious control.” Bitcoin is the superior successor to this mechanism, and its zero to one innovation is digital scarcity, not payments or speed of transactions. While bitcoin’s property of scarcity still needs further stress testing, it is a profound achievement and what makes bitcoin unique. Never before bitcoin has any asset, let alone a digital one, been finitely scarce; the end result of its innovation is the hardest form of money that has ever existed. That is the zero to one achievement and a phenomenon that almost certainly will not be repeated.
Every other problem that bitcoin will have to overcome is more pedestrian relative to scarcity. Digital payments? The idea that human ingenuity can create digital scarcity but that we then cannot layer on payments technology does not logically follow. Payments technology is just one of the many 1 to n innovations that will be built on top of bitcoin to globalize its adoption. Not only are payments easier to solve, it is also not a critical path that needs solving today. The primary use case for bitcoin today is as a savings mechanism, not payments. Over time, as adoption increases and as more infrastructure is built, bitcoin will evolve into a more transactional currency, but that process will occur gradually, not suddenly. And as the shift occurs, bitcoin adopters will continue to leverage legacy monetary systems and legacy payments rails.
The bitcoin blockchain will never be a layer for mass payments, but there is a considerable amount of debate on this topic. Many hold the view that for bitcoin to be “successful” it needs to be a one-stop shop, combining the roles of currency issuer, settlement layer and payments rail. While bitcoin fulfills the first two functions beautifully (currency issuer + settlement layer), it is categorically not a payments rail. Both for reasons of speed and scale, bitcoin fails the payments test. The good news? We don’t need the bitcoin network to be a payments rail.
Much of the confusion in the philosophical (rather than technical) debate stems from the opening salvo of the bitcoin whitepaper: “a Peer-to-Peer Electronic Cash System.” Peer-to-peer has been interpreted by some to imply that bitcoin needs to be able to handle every last transaction in the world between any two peers. Separately, others believe that if bitcoin transactions cannot occur at the scale or speed of Visa or Mastercard, it is structurally flawed. Essentially, according to skeptics, if bitcoin cannot meet both of these standards, it fails on its promise. Thankfully it does not.
For additional background, bitcoin blocks are solved every 10 minutes on average; however, bitcoin blocks are not solved precisely every 10 minutes on a fixed schedule. The next block may be solved in 1 minute or 20 minutes, 30 seconds or 36 minutes. The network adjusts such that blocks are solved on average every 10 minutes. How could a merchant or transaction processor live in a world either this slow or unpredictable? Separately, bitcoin blocks have a limited amount of space to include transactions. While there is not a fixed transaction capacity in bitcoin by count, each bitcoin transaction consumes a limited amount of block space; as a function of limited capacity, blocks include approximately 2,700 transactions on average. With ten-minute average block intervals, six blocks per hour, 24 hours per day, 365 days per year, that equates to a network capacity of approximately 145 million transactions per year which is the equivalent of approximately 4.6 transactions per second. Visa on the other hand processes 124 billion transactions per year at a rate of ~4,000 transactions per second (see here).
How can bitcoin be the purely peer to peer engine that powers the global financial system, if it operates at nearly one one-thousandth the scale and speed of Visa alone? The reality has always been that, if bitcoin were to have a non-zero value, the consequence would be a system so valuable that any base layer would not be able to handle all transactions without sacrificing decentralization or censorship resistance. Without these properties, bitcoin would not be a zero to one innovation and its value function would break down. Ultimately, the bitcoin protocol layer provides the function of currency issuance and final settlement, but it is not capable of storing every small purchase, including your Starbucks, for the rest of time for everyone.
If it were the latter, all transactions by all people, no matter how big or how small, would have to be validated and stored by every other person on earth. Without a mechanism to align the interests of network participants, a tragedy of the commons problem would exist and the end result would be a less secure currency system subject to centralization. Instead, we accept a mechanism to limit transaction throughput at the base layer, shifting aspects of bitcoin’s peer-to-peer transactional architecture to separate layers that integrate with bitcoin. These tradeoffs have been made in order to secure the foundation of bitcoin’s monetary system (decentralization → censorship resistance → fixed supply).
Many point to this text from the bitcoin whitepaper released by its pseudonymous founder as evidence that bitcoin was always intended to fulfill every payment by every possible network peer. It does say “purely peer-to-peer” after all. However, more important to bitcoin than anything written in this summary (or any interpretation) is bitcoin’s consensus mechanism. Everything critical in bitcoin is enforced by a consensus of network participants, including its fixed supply and ultimately the capacity within each bitcoin block, which limits the number of transactions it can process. This is the fundamental difference between bitcoin and the legacy financial system: monetary policy by consensus rather than by fiat. Bitcoin’s founder created a system that ultimately removed critical decisions from any central authority, instead deferring to the wisdom of market consensus. It is a system that is flexible enough to be adapted but rigid enough that any material change is very difficult. As a consequence, network peers have to decide, on a decentralized basis, how best to scale bitcoin. It is through this consensus mechanism that bitcoin dispenses of the need for “conscious control”.
Everything comes with trade-offs. In bitcoin, there are two holy grails: a fixed 21 million supply and preventing the currency from being spent multiple times (the double spend problem). The value of bitcoin is derived from its ability to secure both of these functions on a decentralized, trustless basis and both are inextricably linked to bitcoin’s fixed network capacity. Think of the capacity within each bitcoin block as valuable digital real estate. All market participants seeking to clear bitcoin transactions have to compete for block capacity. Scarcity in network capacity is the function by which bitcoin’s shared resource is optimized. Or, think of it as bitcoin’s solution to the tragedy of the commons. Competition for this scarce resource ensures that the resource is used efficiently and that its value is maximized. Ultimately, scarcity causes market participants to compete with each other, bidding up the value of the network’s capacity, rather than shifting negative externalities on to the rest of the network.
In bitcoin’s free market, the highest value and most profitable transactions are prioritized. Without scarcity in transaction capacity, this value function would break down. It is less important that we optimize for transaction capacity and more critical that scarcity exists. No one really knows the optimal amount of transaction capacity at any point in time, partly because demand is ever changing but also because it is generally growing over time. The critical piece is that capacity is known and scarce, which allows market participants to plan and ultimately, to compete. The commons is never depleted; instead participants compete and innovate to figure out how best to utilize a scarce asset. Scarcity ensures that the commons is not abused and creates a predictable rate of growth in the overall size of bitcoin’s blockchain, which ultimately protects and promotes decentralization.
As discussed in a prior edition (see here), miners secure the bitcoin network by devoting real world energy resources to run cryptographic hashing functions and to solve bitcoin blocks. By solving blocks, miners validate history and clear current transactions which are then checked and validated by the rest of the network. In return, miners are paid in bitcoin. Devote resources to secure the network and get paid in the network’s native currency (bitcoin). The actual compensation paid to miners comes in two forms: newly issued bitcoin and transaction fees. In order to devote resources today to secure the network, miners have to reliably expect that aggregate compensation will hold its value into the future.
Approximately every four years, the newly issued bitcoin paid to miners gets cut in half (the bitcoin “halvening”). Today, with each block, 12.5 new bitcoin are issued. In approximately eight months, when the next halvening event occurs (see here), that amount will be reduced to 6.25 new bitcoin per block. Approximately four years after that, 3.125 new bitcoin per block will be issued. This process will continue until we reach the smallest unit of bitcoin (1/100,000,000th) and thereafter no new bitcoin will be issued. This is the issuance function that governs bitcoin’s fixed supply (21 million), and as a derivative function, it also shifts compensation to secure the network from (mostly) new bitcoin today to ultimately a system relying completely on transaction fees.
But how does this relate to Visa and transaction capacity? If it were not for the scarcity of capacity in each bitcoin block, there would not be a mechanism to create a transaction fee market. Scarcity in block space creates competition between market participants to clear transactions which causes them to bid up the value of real estate and to use it efficiently. Without a fee market, the only mechanism to pay miners to secure the network would be to alter bitcoin’s fixed monetary policy and increase supply. But recall that scarcity in bitcoin’s fixed supply (21 million) is the basis of its store of value property, which is where the rubber meets the road. By creating scarcity in network capacity, we also ensure the integrity of bitcoin’s fixed supply, which makes the whole value cycle function. Working within this reality, scarcity is a far more important property than either the speed or ultimate capacity of transaction throughput.
Fixed Network Capacity → Limited Transaction Capacity → Fee Market → Fixed Supply of Bitcoin
And because the real problem bitcoin is intending to solve is that of money and global QE (not payments), those that store wealth in bitcoin would much rather secure the money supply than sacrifice its long-term integrity and credibility for transaction throughput. In short, the future of bitcoin is far more secure in a world where all market participants can depend on it having a reliably fixed and scarce supply, while accepting lower transaction throughput or speed as trade-offs. What good is high transaction throughput and faster speeds if the fundamental value of the underlying currency is at risk? The existing financial system has already made the opposite trade-off for us. High transaction throughput and fast transactions by way of centralization but with the cost of an architecture susceptible to systemic monetary debasement. Bitcoin represents the alternative, and we are not about to make the same mistake twice.
Ultimately, bitcoin is not competing with Visa for supremacy in global payments. Instead, bitcoin is competing with the dollar, euro, yen and gold as money, and any comparison to Visa, its transaction volume or transaction speed is fundamentally flawed. Bitcoin fulfills the role of currency issuer and final settlement. As a result, the proper comparison would be between bitcoin and the Fed as currency issuer and as a clearing mechanism. No one makes the mistake of confusing the functions of Visa for that of the New York Fed, but for some reason, the comparison is often made between Visa and bitcoin.
While it would require time and investment, Visa’s payment network could sit on top of the bitcoin network to fulfill payments much the same way it sits on top of the existing banking system. Rather than clearing the currency through a central bank, final settlement of transactions would clear through the bitcoin network. In the existing architecture, the payments layer (Visa) and the settlement layer (banking network/central banks) are separate and distinct. The principal problem bitcoin intends to solve has little to do with the former, but instead, with the mechanism by which currency is issued and cleared (think the Fed and QE). Visa helps move dollars but Visa is not the dollar. It is a technology company that provides a service; it has 17,000 employees. Bitcoin has none.
Whether credit or debit, Visa is an inherently trust-based credit system. While consumers generally associate swiping a Visa card (or the equivalent) at a point of sale terminal as payment, it really is not. Instead, balances are checked, transactions are authorized and settlement occurs later. Dollars are not actually cleared through a central bank or settled at the point of sale every time a transaction is processed. Individual transactions are also never really cleared. Instead, transactions are batched together, netted and settled at a later point in time; only then are accounts credited with proper balances. So when someone attempts to equate a Visa transaction with final settlement, that is just not the way the world works. But that is the comparison that is implicitly being made when someone attempts to compare Visa with bitcoin.
When compared against its real competition (the Fed, ECB, BOJ, etc.), bitcoin begins to look like a Ferrari. Final global settlement approximately every 10 minutes, 24 hours per day, 7 days a week, 365 days a year on a permissionless basis. Compare this to the existing permissioned financial system, which is subject to multiple layers of bank and central bank intermediaries and only open during “business” hours. This is the great misnomer that exists within bitcoin. Those that believe bitcoin to be too slow or lacking in network capacity are comparing bitcoin to the wrong application. We could set up a network of banks on top of the bitcoin network and the payments system could function as it does today.
The push back on this point is the risk of centralization. If bitcoin were to just sit in centralized banks, it would increase the possibility that the bitcoin network could be co-opted and undermined by a network of banks and central banks, whether to force changes to network consensus rules or to censor end users. Ultimately, this was gold’s failure as a monetary medium. It was susceptible to centralization, which then spawned fiat currencies, which have turned out to be easily manipulable. While this is unlikely (and hopefully not) how bitcoin scales, money and payments technology are distinct problems. The fundamental reason being that there are two sides to every value transfer; one side almost always involving money and the other as the fulfillment of goods and services. Payments layers help provide a bridge.
Because of the nature of trade, the two sides of a value transfer generally, and naturally, occur by different processes and at different points in time. Think about the settlement of currency on one side and the transfer of title to a home or car on the other. Or, payment for a good on Amazon and the fulfillment of that good two days later. Two different processes, occurring at two different times. And, it is important to recognize that bitcoin has no knowledge of the outside world, whether identities or the second leg of a value transfer; all bitcoin knows how to do is issue and validate currency (whether a bitcoin is a bitcoin). This is really the function and limitation of any base currency system. Payments layers provide a bridge between currency settlement (the Fed or bitcoin) and the fulfillment of goods and services. Gold solved mass payments via bank centralization, the dollar, the Fed and large payments processors such as Visa. Bitcoin likely solves payments through a technologically superior mechanism, but we have time to solve what is a separate and distinct problem from that of money.
If we solve the problem of money through digital scarcity first (zero to one), the technology advancements to scale transactions and ultimately solve payments are 1 to n. It is not credible to think that human ingenuity can solve the former but then fail on the incremental derivatives. It is not just a matter of hope and faith; instead, it is one of reason and logic, considering both the advancements in scaling solutions that are already being pursued and the challenges relative to the problem bitcoin has already solved. Permissionless innovation and the economic incentives inherent in bitcoin will coordinate and accelerate solutions to any number of future challenges. Market participants have an incentive to increase the value of the network and to innovate to scale the network, but the solutions will have to work within the network’s consensus or garner sufficient consensus to change the rules.
Because of the nature of bitcoin’s economic incentives, it is far more likely that scaling solutions work within existing consensus rules. One such example of an advancement to scale bitcoin within the network’s consensus is the lightning network. The lightning network builds on top of bitcoin as a trust-minimized layer to scale transaction capacity, which still remains fundamentally distinct from payments fulfillment. However, if successful, lightning will be used to create bitcoin payment channels that enable far greater transaction throughput at far lower cost, the scale and speed of which would rival Visa. While it may not be the ultimate solution, it is an example of the innovation that bitcoin is fostering. Lightning is also only one of many solutions that are actively being developed, and competition will drive us toward the best scaling solutions, of which there may be a combination of many.
The approach to scaling bitcoin is a slow and conservative process. Bitcoin is too important to follow the Silicon Valley mantra of move fast and break things. Instead, it’s move slowly and don’t break anything. If a global financial system is to be built on a decentralized monetary system, the foundation must be protected at all cost. Ensure the security of the base monetary layer (bitcoin) first and then allow network participants to innovate on top of it in a permissionless manner. Remember that bitcoin is only ten years old; we are in the very inception of bitcoin’s monetization event, and infrastructure is still being built to allow for the proliferation of this new technology.
It’s a little ridiculous to contemplate the problem bitcoin has already solved and then immediately pivot to a “but why not mass payments today” line of thinking. Especially when considering that bitcoin, in its clearing function, is already faster and more reliable than comparable mechanisms for final settlement of dollars, euros, yen or gold. Then, when understanding that the fundamental use case for bitcoin today is as a long-term savings mechanism (not to fulfill payments), it becomes more clear that not only is the problem misdiagnosed but also that the desired solutions can wait. We will need the ability to fulfill payments in the future, but we have time before we get there. In due time, we’re going to have our cake and eat it too.
Views presented are expressly my own and not those of Unchained Capital or my colleagues. Thanks to Will Cole and Phil Geiger for continuing to review my rambling thoughts and for providing valuable feedback.
]]>The list of bitcoin skeptics is long and distinguished (see here), but the noise contributes directly to the antifragile nature of bitcoin. People that store wealth in bitcoin are forced to think through first principles in order to understand characteristics of bitcoin which otherwise seem, on the surface, to contradict an establishment view of money, which ultimately hardens convictions. Bitcoin volatility is one of these oft-criticized characteristics. A common refrain among skeptics, including central bankers, is that bitcoin is too volatile to be a store of value, medium of exchange or unit of account. Given its volatility, why would anyone hold bitcoin as a savings mechanism? And, how could bitcoin be effective as a transactional currency for payments if its value could reasonably drop tomorrow?
The principal use case for bitcoin today is not as a payments rail but instead as a store of value, and the time horizon for those that store wealth in bitcoin is not a day, week, quarter or even a year. Bitcoin is a long-term savings mechanism and stability in the value of bitcoin will only be realized over time as mass adoption occurs. In the interim, volatility is the natural function of price discovery as bitcoin advances down the path of its monetization event and toward full adoption. Separately, bitcoin does not exist in a vacuum; most individuals or businesses are not singularly exposed to bitcoin and exposure to multiple assets, like any portfolio, mutes volatility of any single asset.
It is fair to say that volatility and store of value are often confused as mutually exclusive. However, they most certainly are not. If an asset is volatile, it does not mean that asset will be an ineffective store of valueThe opposite is also true; if an asset is not volatile, it will not necessarily be an effective store of value. The dollar is a prime example: not volatile (today at least), bad store of value.
The Fed has been highly effective in very slowly devaluing the dollar, but always remember, gradually, then suddenly. And, not volatile ≠ store of valueThis is a critical mental block that many people experience when thinking about bitcoin as a currency, and it is largely a function of time horizon. While central bankers all over the world point to bitcoin as a poor store of value and not functional as a currency because of volatility, they think in days, weeks, months and quarters while the rest of us plan for the long-term: years, decades and generations.
Despite the logical explanations, volatility is one area that particularly confounds the experts. Bank of England Governor, Mark Carney recently commented that bitcoin “has pretty much failed thus far on […] the traditional aspects of money. It is not a store of value because it is all over the map. Nobody uses it as a medium of exchange,” (see here)The European Central Bank (ECB) has also mused on Twitter that bitcoin is “not a currency”, noting that it is “very volatile” while at the same time reassuring everyone that it can “create” money to buy assets, the very function by which its currency actually loses value and why it’s a poor store of value.
The lack of self-awareness is not lost on anyone here but Mark Carney and the ECB are not alone. From former Fed Chairs, Bernanke and Yellen, to current Treasury Secretary Mnuchin to the President himself. All have, at times, trumpeted the idea that bitcoin is flawed as a currency (or as a store of value) because of its volatility. None seem to fully appreciate, or at least admit, that bitcoin is a direct response to the systemic problem of governments creating money via central banks or that bitcoin volatility is a necessary and healthy function of price discovery.
But luckily for all of us, bitcoin is not too volatile to be a currency and often the experts are not experts at all. Setting logic aside, the empirical evidence shows that bitcoin has proven to be an exceptional store of value over any extended time horizon despite its volatility. So how could an asset such as bitcoin be both highly volatile and an effective store of value?
Consider why there is fundamental demand for bitcoin and why bitcoin is naturally volatile. Bitcoin is valuable because it has a fixed supply and it is also volatile for the same reason. The fundamental demand driver for bitcoin is in its scarcity. To revisit bitcoin’s value function from a previous edition, decentralization and censorship-resistance reinforce the credibility of bitcoin’s scarcity (and fixed supply schedule) which is the basis of bitcoin’s store of value property:
While demand is increasing by orders of magnitude, there is no supply response because bitcoin’s supply schedule is fixed. The disparity in the rate of increase in demand (variable) vs. supply (fixed) combined with imperfect knowledge amongst market participants causes volatility as a function of price discovery. As Nassim Taleb writes in The Black Swan of Cairo: “Variation is information. When there is no variation, there is no information.” As bitcoin’s value increases, it communicates information despite the volatility; the variation is the information. Higher value (dependent on variation) causes bitcoin to become relevant to new pools of capital and new entrants which then stokes an adoption wave.
Knowledge distribution and infrastructure fuel adoption waves and vice versa. It is a virtuous feedback loop and a function of both time and value. As value rises, bitcoin captures the attention and mindshare of a much wider audience of potential adopters, which then begin to learn about the fundamentals of bitcoin. Similarly, an appreciating asset base attracts additional capital not only as a store of wealth but also to build incremental infrastructure (e.g. more on-ramps & off-ramps, custody solutions, payments layers, hardware, mining, etc.). Developing an understanding of bitcoin is a slow process, as is building infrastructure, but both fuel adoption which then further distributes knowledge and justifies additional infrastructure.
Knowledge → Infrastructure → Adoption → Value → Knowledge → Infrastructure
Today, bitcoin is still nascent and current adoption likely represents <1% of terminal adoption. As a billion people adopt bitcoin, new adoption will represent orders of magnitude for any foreseeable future period which will continue to drive significant volatility; however, with each new adoption wave, the value of bitcoin will also reset higher because of higher base demand. Bitcoin volatility will only decline as the holder base reaches maturity and as the rate of new adoption stabilizes. Said another way, for a billion people to be using bitcoin, adoption will have had to increase by ~20x, but the subsequent 100 million adopters will only represent an additional 10% of the base. All while the supply of bitcoin remains on a fixed schedule. So long as adoption represents orders of magnitude, volatility is unavoidable, but on that path, volatility will naturally and gradually decline.
As Vijay Boyapati explained on Stephan Livera’s podcast, “establishment economists deride the fact that bitcoin is volatile, as if you can go from something that didn’t exist to a stable form of money overnight; it’s completely ludicrous.” What happens between adoption waves is the natural function of price discovery as the market converges on a new equilibrium, which is never static. In bitcoin hype cycles, the rise, fall, stabilization and rise again is almost rhythmic. It is also naturally explained by speculative fear, followed by accumulation of fundamental knowledge and the addition of incremental infrastructure. Rome wasn’t built in a day; in bitcoin, volatility and price discovery are core to the process.
For a more tangible explanation of the relationship between volatility and value, it is helpful to think about the most recent adoption wave from the end of 2016 to present (2019).
While adoption can never really be quantified, a rough but fair estimate would be that bitcoin adoption increased from ~5 million people to ~60 million (an increase in demand of ~12 times) from 2016 to present, yet the supply of bitcoin only increased by approximately 10% over the same period. And naturally, the information and capital possessed by market participants varies significantly. As a massive adoption wave occurred, it was met by bitcoin’s fixed supply scheduleWhat would one expect to happen when demand increases by an order of magnitude but supply only increases by 10%? And what would happen if the knowledge and capital of the new entrants naturally varies greatly?
The very logical end result is higher volatility and a higher terminal value, if even a small percentage of new entrants convert to long-term holders (which is exactly what happened). New adopters who initially purchased bitcoin in its astronomical rise, slowly accumulate knowledge and convert to long-term holders, stabilizing base demand at a far higher terminal value compared to the prior adoption cycle.
Because bitcoin is nascent, the aggregate wealth stored in bitcoin on a relative basis is still very small (~$200 billion) which allows for the rate of change between marginal buyers and sellers (price discovery) to represent a significant percentage of the base demand (volatility). As base demand increases, the rate of change will begin to represent a smaller and smaller percentage of the base, reducing volatility over time and only after several more adoption cycles.
If we can accept that bitcoin volatility is both natural and healthy, why doesn’t current volatility prevent the adoption required to transition bitcoin to a stable form of money? Very simply: diversification, portfolio allocation theory and time horizon. There exists a global network (bitcoin) through which you can transfer value over a communication channel to anyone in the world, and it is currently valued, in total, at less than 200 billion. Facebook alone, on the other hand, is worth in excess of 500 billion. For further frame of reference, U.S. household assets are estimated to be valued at $125 trillion (see here, page 138).
In a theoretical world, bitcoin volatility would be an issue if it existed in a vacuum. In the real world, it doesn’t. Diversification comes in the form of real productive assets as well as other monetary and financial assets, which mutes the impact of bitcoin’s present volatility. Separately, information asymmetry exists and those that understand bitcoin also understand that, in time, the cavalry is coming. These concepts are obvious to those that have exposure to bitcoin and actively account for its volatility in short and long-term planning, but it’s apparently less obvious to the skeptics, who struggle to grasp that bitcoin adoption is not an all or nothing proposition.
While bitcoin will continue to steal share in the global competition for store of value because of its superior monetary properties, the function of an economy is to accumulate capital that actually makes our lives better, not money. Money is merely the economic good that allows for coordination to accumulate that capital. Because bitcoin is a fundamentally better form of money, it will gain purchasing power relative to inferior monetary assets (and monetary substitutes) and increasingly take market share in the economic coordination function, despite being less functional as a transactional currency today.
Bitcoin will also likely induce the de-financialization of the global economy, but it will neither eliminate financial assets nor real assets. During its monetization, these assets will continue to represent the diversification which will mute the impact of bitcoin’s day-to-day volatility. See example here which highlights the risk/return of a 1% bitcoin + 99% dollar portfolio compared to gold, U.S. treasuries and the S&P 500 (@100trillionUSD). Also see “The Case for a Small Allocation to Bitcoin” by Xapo CEO Wences Casares. Both provide a look through into how volatility and risk can be managed should bitcoin experience a significant drawdown or even fail (which is still a possibility).
While failure is a possibility and significant drawdowns are an inevitability, each day that bitcoin doesn’t fail, its survival becomes more and more likely (Lindy Effect). And over time, as bitcoin’s value and liquidity increase due to its fundamental strengths, its purchasing power will also increase in terms of real goods, but as its purchasing power represents a larger and larger share of the economy, its volatility relative to other assets will proportionally decrease.
Bitcoin will become a transactional currency over time but in the interim, it would be far more logical to spend a depreciating asset (dollars, euro, yen, gold) and save an appreciating asset (bitcoin). Establishment economists and central bankers really struggle with this one; but I digress. On bitcoin’s path to full monetization, store of value must come as a logical first order and bitcoin has proven to be an incredible store of value despite its volatility. As adoption matures, volatility will naturally fall, and bitcoin will increasingly become a medium of direct exchange.
Consider the person or business that would demand bitcoin in direct exchange for goods and services. This person or business collectively represent those that have first determined that bitcoin will hold its value over a particular time horizon. If one did not believe in the fundamental demand case for bitcoin as a store of value, why would they trade real-world goods and services in return? Bitcoin will transition to a transactional currency only as its liquidity gradually shifts from other monetary asset to goods and services which will occur along the path to mass adoption. It will not be a flash cut or a binary process. On a more standard path, adoption fuels infrastructure and infrastructure fuels adoption. Transactional infrastructure is already being built but more material investment will only be prioritized as a sufficient number of individuals first adopt bitcoin as a store of wealth.
Ultimately, bitcoin’s lack of a price stability mandate and fixed supply will continue to result in near-term volatility but will drive long-term price stability. It is the literal opposite model pursued by Mark Carney of the BOE, the ECB (and its twitter account), the Federal Reserve and the Bank of Japan. And, it is why bitcoin is antifragile; there are no bailouts and it’s a market devoid of moral hazard, which drives maximum accountability and long-term efficiency. Central banks manage currencies to mute short-term volatility, which creates the instability that leads to long-term volatility. Volatility in bitcoin is the natural function of monetary adoption and this volatility ultimately strengthens the resilience of the bitcoin network, driving long-term stability. Variation is information.
Nassim Taleb & Mark Blyth (Black Swan of Cairo)
“Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks.”
“This is one of life’s packages: there is no freedom without noise—and no stability without volatility.”
Ben Bernanke, Chairman of the Federal Reserve (during the Great Financial Crisis)
“The Federal Reserve is not currently forecasting a recession.” – January 10, 2008
“The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.” – June 9, 2008
Views are expressly my own and not those of Unchained Capital or my colleagues. Thanks to Will Cole, Phil Geiger, Adam Tzagournis and Ethan Packard who have reviewed past and present releases of Gradually, Then Suddenly and provided valuable feedback.
]]>Not all multi-level marketing programs are pyramid schemes, but all pyramid schemes are in some fashion a multi-level marketing program. With pyramid schemes, there is always some company and it is selling a product for which the end demand falls far short of the available supply. The company recruits participants to purchase inventory and to recruit new participants. The participants are all sales people, and compensation is tied mostly to recruiting, rather than selling the actual product. Often the sale of product is purposefully woven into the recruitment process.
In a normal sales-driven business, the company takes on the inventory risk and pays commissions based on sales to end users. In a pyramid scheme, the sales people take on the inventory risk, rather than the company, and compensation is paid for recruiting more sales people and selling product through to new participants. It all falls apart because sufficient end demand for the product does not actually exist. Everyone up the chain can make money at the expense of the new recruits at the end of the line. This is a pyramid scheme. Bitcoin is not. Bitcoin is not a company. It has no employees and its supply is finitely scarce. No matter how many people adopt it, there will only ever be 21 million bitcoin.
The distinctions should be glaringly obvious, but because bitcoin is complex and the very idea of money is not well understood, it can easily be confused. Bitcoin will only become a global reserve currency if hundreds of millions (if not billions) more adopt it. And seemingly everyone that goes down the bitcoin rabbit hole ends up on the other side explaining it to their family and friends, pitching it as a better form of money. Sounds kind of like a pyramid scheme, right? Wrong. When Dell started selling PCs on its website in 1996 and everyone told their friends to get a Dell, was it a pyramid scheme? When Apple released the first iPhone in 2007 and everyone told their friends to drop the Blackberry for its superior successor, was it a pyramid scheme?
Technological shifts often happen fast. Ten and twenty years later, smartphones and PCs are ubiquitous. It is all about the quality of the product and the incentive structure. If someone owned Apple stock or Dell stock, did it change the fact that the product itself provided a real value proposition? Was there a benefit for telling people about a new technological innovation? The value proposition of an innovation trumps all else. It does not matter how you learn about it; all that matters is whether the innovation provides utility. If it does, people will want to use it; if it doesn’t, they won’t. That is what makes a market.
Bitcoin’s utility is as money. It has a market because it solves a problem inherent in modern money. Not only is bitcoin not a pyramid scheme; it is fundamentally distinct from the class of innovation that could be offered by any individual company. Bitcoin is not Dell and it is not Apple. It is not a tech stock. There is no company that exists behind bitcoin. Bitcoin is not a company selling a product and there is no income stream to pay future dividends. Bitcoin is not about making money; instead, bitcoin is money, or at least it has become money to those choosing to store a portion of their wealth in it. And it’s not a get-rich-quick scheme; it is fundamentally about storing the value you have already created. Bitcoin is a bearer asset; however, unlike a bearer bond, there is no income stream.
Bitcoin’s innovation is that it represents a superior form of money, but there are no future promises beyond being in possession of a digital bearer instrument. The only utility of bitcoin is in holding it as a currency and transacting with it in the future, whether that be in exchange for legacy currencies or other goods and services. Bitcoin is only useful as a form of money, and it will only maintain value if others demand it in the future. But this is true of any form of money (not just bitcoin). Money is not a collective hallucination or merely a belief system; monetary goods have distinct properties which make them more or less effective in facilitating exchange. However, monetary properties are not absolute; the relative strength of monetary properties is the fundamental basis of demand. When the market evaluates bitcoin, it does so relative to other monetary mediums (the dollar, euro, yen, gold, etc.).
The supply of bitcoin, and its rigid supply constraint, is the foundation of bitcoin’s utility and fundamental demand; it is also why bitcoin is not a pyramid scheme. There will only ever be 21 million bitcoin. That is bitcoin’s schelling point. Everyone knows it; everyone remembers it. Everyone can also verify it at any point in time. For discussion of how and why bitcoin has a credibly fixed supply, see< “Bitcoin, Not Blockchain” and “Bitcoin is Not Backed by Nothing”. But for now, just work on the assumption that the supply of bitcoin is capped at 21 million. In contrast, no one knows the supply of dollars. The Fed estimates the current supply of dollars, but no one knows how many dollars will exist in the future. There is no constraint on the supply of the dollar, other than the Federal Reserve, and all we know for sure is that many more dollars will exist in the future; it is a limitless function. In the end, there is fundamental demand for bitcoin because its monetary policy is i) optimally engineered and ii) credibly enforced. Relative to its competition, bitcoin is a vastly superior monetary medium.
The monetary base in fiat systems changes unpredictably whereas the monetary base in bitcoin is governed by a well-defined supply schedule. Think about the monetary base as setting the foundation of a global economic system. The unpredictable changes in the supply of dollars is not merely akin to shifting the proverbial goal posts. Instead, it is more similar to building the field on a 1980s-style water bed, and then shifting the goal posts. The whole game is distorted, not just the end points. Bitcoin, on the other hand, is a bedrock as a function of its fixed supply, and over time, the foundation becomes stronger and stronger. The credibility of its supply schedule is reinforced with each passing bitcoin block. As it becomes more evident that bitcoin’s supply schedule is credibly enforced, more people adopt bitcoin as a form of money, and those that already have increasingly use it as a store of wealth. Fixed supply + increasing adoption = increased value. As adoption increases and as value rises, bitcoin becomes further decentralized. And as bitcoin decentralizes over time, it becomes harder to change, reinforcing the credibility of its foundation: its fixed supply.
In a pyramid scheme, the people selling the scheme are the scammers. These scammers are selling the promise of future monetary gains through high-pressure sales tactics and by recruiting new members to the scheme as the primary compensation mechanism. In bitcoin, the people buying bitcoin are the scammers, as described in Michael Goldstein’s timeless piece, “Everyone’s a Scammer”. If this is you, you are the scammer. In most cases today, whenever someone buys bitcoin, they are directly trading a fractionally reserved form of currency (with the promise of future debasement) in return for a bearer asset with a finite supply and a vastly superior monetary policy. The person on the other end of the line is getting the raw deal. It is not to say that literally everyone that sells a bitcoin does so without good reason. It is money after all, and its utility is in exchange; by definition, market participants have a wide variety of present needs for liquidity and real value is transferred every time a bitcoin is transacted, whether for dollars or for goods and services. However, on average and over the longer-term, it is information asymmetry in full effect. Bitcoin’s monetary policy is optimally engineered and credibly enforced, though few understand it, which is why it represents the greatest asymmetry in the world today.
A monetary medium with the lowest rate of change is most effective in communicating economic signals, and a fixed supply (zero rate of change) is the optimal monetary policy end game. While the monoculture that is modern mainstream academia disagrees with this view, a fixed supply currency is superior to a currency that increases in supply over time (and at unpredictable rates). In any economy, supply and demand for goods and services relative to the supply and demand of money dictates prices. Price is what ultimately coordinates economic activity, and money is the foundation of the pricing mechanism within an economy. A currency with a fixed supply would remove the noise created by changes to the money supply in the price system, thus creating more reliable market signals. Because a monetary good facilitates the exchange between goods used for the purpose of either consumption or production, the form of money with the lowest rate of change will most accurately reflect changes in supply and demand of all other goods. Essentially, money is used to communicate the relative value of other goods and services, and changes in the money supply distort the communication of this information by introducing an extraneous variable to the equation.
For example, an iPhone costs approximately 1,000, whereas a barrel of oil costs approximately 50. The information communicated through a monetary medium is that an iPhone costs approximately 20 times more than a barrel of oil. Money communicates opportunity cost (economic trade-offs) through its price system, and the more constant the quantity of money (lower rate of change), the more reliable the communication of information and economic trade-offs. If the money supply increased by 10% and prices adjusted equally, an iPhone would cost 1,100 and a barrel oil would cost 55. An iPhone would still cost 20 times more than a barrel of oil, and that is the relevant information which all market participants rely upon. In the real world, the problem is that prices do not adjust equally as the money supply changes. Instead, price signals become distorted. In a world with a constant money supply, changes in price would more accurately reflect changes in supply and demand in underlying markets for goods and services rather than also reflecting the unequal impact of a changing money supply. Changes in the money supply create noise extraneous to the underlying economic activity. Price coordinates economic trade-offs, and the reliability of a pricing system is dependent on the stability of the form of money used to communicate information.
In that regard, monetary goods are differentiated (at least those that emerge on the free market); it is why money is an effective communication tool. The market structure for money is different than that of all other goods. A consumption good is consumed and a production good is ultimately consumed in the production of other consumption goods. Whereas, the utility of money is in exchange; it is functional in the coordination of trade by and between consumption and production goods, rather than being consumed itself. Because the utility of money is in exchange, scarcity is more important than the nominal amount of money in an economy. As demand for money increases and as its price rises, there is not a commensurate supply response because of natural supply constraints. The same is not true for any individual good or service. The relative supply constraint of money is what allows it to communicate relative value between other goods and services. Consumption goods and production goods can be substituted for each other, but money facilitates virtually all exchange between all other goods. The value of a money may fluctuate relative to goods and services but relative scarcity of a money supply allows price to be communicated in terms of the money itself.
Prior to bitcoin, no form of money was finitely scarce. Bitcoin has a fixed supply, capped at 21 million. Finite scarcity creates a constant where none existed previously. Imagine the supply of one good being perfectly constant while the supply of all other goods fluctuates. Demand for all goods changes, but only one constant exists: the supply of bitcoin. In this world, everything would be measured against the constant. The purchasing power of money would communicate far more perfect information through this pricing mechanism than if the supply of the money itself were changing. By creating one constant, everything else can be more reliably measured. And the desired information is not the absolute value of any one good. All value is subjective. Instead, the critical information communicated through a pricing mechanism is the relative value (or relative price) of many goods to each other. While price levels are ever changing due to constantly shifting supply and demand, the stability of the pricing mechanism itself allows for economic coordination via the communication of opportunity cost (i.e. how we know, or learn, that an iPhone costs approximately 20 times more than a barrel of oil).
In our current system, the supply of money changes unpredictably and increases over time. This is core to the central banking monetary model, and it derives from monetarist economic theory which argues that an active management of the money supply stimulates aggregate demand and ultimately promotes full employment. What it technically does is manipulate interest rates downward by increasing the supply of money. Lower interest rates increase the willingness and incentive to borrow; however, all else being equal, a lower interest would otherwise decrease the willingness to lend. Essentially, by inflating the money supply, the central bank artificially manipulates the function of credit, creating a sustained imbalance between the incentive to borrow and the willingness to lend. The more pervasive consequence is the distortion of the pricing mechanism that coordinates economic activity. By manipulating the supply of money and the supply of credit, central banks distort all prices throughout the market. False signals (and bad information) are distributed to all market participants.
The entire supply and demand structure of the economy becomes distorted as hundreds of millions of people respond to manipulated price signals and when resources within the economy are re-allocated based on those signals. When the money supply is increased, new money (and credit) enters the system through various channels and at unpredictable times. The quantity and rate of change is unknown to most market participants. Instead, market participants react to price signals; that is how information is communicated. A price signal may be the cost of a good at the supermarket or it may be a salary an employer is willing to pay for a certain job. The change in the money supply creates a distortion of prices such that market participants cannot effectively understand whether changes in price are driven by changes in underlying supply and demand structures, or to what extent changes in price are merely a function of more or less money in the system. Regardless, everyone reacts to distorted signals.
For a more tangible example, the Fed purchased 1.7 trillion of mortgage-backed securities (~17% of all mortgages) following the financial crisis as part of its quantitative easing program, which ultimately increased the base money supply by 3.6 trillion. Most people recall that prior to the financial crisis there was a housing bubble. By directly purchasing mortgages and by inflating the money supply, the Fed manipulated interest rates lower. Housing relies heavily on the supply of credit and ultimately on the cost of interest. With lower interest rates and more money available to lend, housing prices were manipulated higher. As a result, distorted price signals were sent to both buyers and sellers. Developers of housing respond by building more homes (increasing supply) and buyers of homes believe they can take on more debt at lower rates to purchase homes. More resources in the economy are devoted to the function of housing because of higher price levels. However, any increase in demand can only be sustained so long as the cost of credit is continually manipulated downward as a function of an increasing money supply.
Despite wide recognition of the unsustainable housing bubble in 2007, the national home price index is now 15% higher than it was at the prior peak. This is the manipulation of price levels on full display, and it happens as an intended function of central bank monetary policy. The Fed increases the money supply, lowers interest rates, and inflates asset prices such that the amount of existing debt in the credit system can be sustained. Credit expansion is the Fed’s objective in stimulating growth, and net new credit cannot be created unless existing debt levels can be sustained, which is why the Fed must inflate asset prices to achieve its objectives. Asset prices support existing debt levels. When everyone figures out that the price signals are unsustainable and unreliable, it causes a shock to the system. This is what happened in 2007 and it is likely to happen again as the market signals have become even further distorted. But it is not some evil scheme; the Fed is not a purposively malicious actor. The Fed ultimately intends to promote “full employment” through its policies, but what it actually does is manipulate relative price signals which creates imbalances in the underlying supply and demand structures of the economy, creating sudden and more chronic unemployment.
Hayek spoke on this subject in his 1974 Nobel Prize winning speech, “the Pretense of Knowledge”. As a function of manipulated prices, more resources are devoted to a segment of the economy than could otherwise be sustained naturally; when the central bank changes the course of its monetary policy, prices begin to respond and the market corrects. Because price levels have been manipulated on a sustained basis, a demand shock becomes inevitable and everyone figures out imbalances exist. In the case of the housing example, supply (both of goods and labor) significantly exceeds sustainable demand at current price levels. More broadly, imbalances are everywhere. It becomes apparent that supply and demand are significantly out of balance and unemployment increases rapidly. The market cannot find an equilibrium because all markets have been manipulated on a sustained basis for extended periods of time.
This is what occurred during, and in the aftermath of, the financial crisis. It was the boiling over point after the Fed had manipulated the supply of money and the supply of credit for decades. As portrayed in the Big Short, the financial crisis often gets blamed on the subprime crisis, but the not-often-discussed 800-pound gorilla in the room is central bank monetary policy. Following the crisis, the Fed responded by pursuing the same policy action it had pursued for decades but on a much greater scale; it massively increased the money supply, further manipulating price signals. When the money supply is manipulated, recognize that not all price levels respond ratably. Money enters the system through different channels and the expansion of credit impacts certain segment of the economy more than others. All prices are manipulated, but not equally. It is fundamentally the distortion of relative prices which disrupt the underlying supply and demand function of a market. Price communicates information. It is how market participants communicate what they value on a relative basis. And, it is how all market participants then respond to those preferences on the supply side: what skills people train themselves with, what businesses people choose to build, what employment opportunities people seek. The Fed may not intend to do harm by manipulating the money supply, but ultimately, it is the unavoidable consequence of distorting the price mechanism within an economy.
Bitcoin is the white knight. Or at least, it has the potential to be. By creating a fixed supply, bitcoin has the potential to be the greatest pricing mechanism the world has ever known. Once bitcoin reaches its maximum supply of 21 million, changes to the money supply will be removed entirely from the equation of price signals. It should be axiomatic that the creation of money does nothing to generate real economic activity. It doesn’t matter whether the change in the money supply is predictably small or whether the money supply increases significantly and unpredictably. Printing money does nothing to generate economic activity; it only serves to distort supply and demand. The utility of money is in exchange. Whether present exchange or future exchange, that is all. Money is not consumed; it is used to coordinate the economic activity that allows for capital to be accumulated. Whether it be physical capital required to produce real goods or human capital which advances arts, science, mathematics etc. That capital is the true savings of a society and it is fundamental to the function of an economy.
Most people think of savings in monetary terms because money is a unit of account, but real savings is represented by the accumulated capital that enriches the lives of individuals, families, and communities. In a world with a fixed money supply, monetary savings would be constant. Money would transfer from individual to individual, family to family, or business to business. But, in total, the money supply would neither increase or decrease. Economic activity would be coordinated as a function of money and with an undistorted pricing mechanism. The aggregate preferences of all markets would be more accurately communicated without the distortion of a changing money supply. Imbalances in supply and demand would be naturally corrected and not sustained over long periods of time; as a consequence, imbalances would also be smaller and not systemic to the economy as a whole. It does not mean all prices would always be perfect or that other variables, such as government spending or taxes, could not influence or distort economic activity. However, it would eliminate the primary mechanism that distorts price signals and market structures.
Bitcoin’s fixed supply is the foundation of its more reliable pricing system but it is also issued at a predictable rate. In the future state, when bitcoin reaches its maximum supply, the rate of change thereafter will be zero. But on its way to that future state, bitcoin imbeds a stable and predictable supply schedule, which is a distinct and equally important part of the equation. Bitcoin are issued through a mining process that helps to secure the network and the network adjusts to ensure that bitcoin are issued on average every ten minutes. If more mining resources are added to the network, the network adjusts to prevent bitcoin from being issued at a faster rate. More mining results in greater levels of network security, rather than increasing the rate of issuance or increasing the total amount of bitcoin that will ultimately be issued. This allows the entire economic system to plan for the future. It allows miners building security infrastructure to forecast future compensation, but it also allows all market participants to predictably know the rate of change of the currency at any point in time.
Rather than allowing bitcoin to be issued rapidly or at an unpredictable rate, the network ensures that bitcoin will be issued steadily over time and as a consequence, on a more distributed basis. Most importantly, it constantly reinforces the credibility of the overall issuance structure. Every ten minutes (on average), a certain number of bitcoin are issued. Approximately every four years that number is cut in half until ultimately no incremental bitcoin will be issued. On the path to 21 million, the enforcement of the fixed supply every ten minutes builds credibility in the future state supply over time. All market participants come to understand that the fixed supply will be enforced not because of a magical point in time when the maximum is actually reached, but instead because the network enforces its monetary policy every 10 minutes. By creating a predictable supply schedule, the rate of change predictably decreases, and all market participants can observe for themselves that the system is functioning as intended.
This process which constantly reinforces the credibility of bitcoin’s monetary system is occurring in parallel to the dysfunction of legacy monetary systems. Central banks everywhere are increasing the money supply of their respective economies at unpredictable rates. As discussed previously, the Fed increased the money supply in the U.S. by 3.6 trillion following the financial crisis, from 2008 to 2014\. Despite the Fed forecasting its plans, no one knew what the total would ultimately be. Everyone was guessing. The Fed didn’t even know. And, after increasing the money supply by several multiples, the Fed then began removing 50 billion dollars from the economy each month, a process which began in October 2017. Again, no one knew exactly how much money would actually be removed from the system, in total or for how long. In aggregate, approximately 700 billion in base money was removed over the course of approximately two years. And now, as of October 2019, the Fed has once again shifted course and has begun to add more money back into the system. Just recently, the Fed signaled plans to add 60 billion dollars to the financial system each month (planned for the next six months). But once again, no one really knows for how long this will go on or whether the amounts will change. Realistically, the Fed does not know because it is impossible to know.
All we practically know is that from this point forward the money supply will increase (and by a lot). But recognize, most market participants have no idea any of this has occurred or is occurring. All market participants really know is what is communicated to them via prices and employment opportunities. Those that have an understanding of the Fed’s actions may be in a better position to forecast or predict the directional consequences, but economic systems are complex. We all react to the pricing mechanisms around us and no one has anywhere close to perfect knowledge; this is the pretense of knowledge. The aggregate knowledge of millions of people is communicated through price which is ultimately a function of ever-changing preferences of the individuals that make up an economy.
Individuals are inherently limited in the knowledge they possess. And this is certainly true of central banks. In the central banking monetary model, twelve individuals (or thereabout) determine how and when to create billions, if not trillions, of dollars despite possessing inherently limited knowledge. No matter how well-intentioned or how much knowledge possessed, the net consequence is the distortion of the fundamental mechanism (i.e. the pricing mechanism) which aggregates knowledge possessed by the market as a whole. For everyone relying upon the dollar as a unit of account and as a mechanism to communicate economic trade-offs, the very foundation changes unpredictably, unbeknownst to most of its participants. Distorted price signals are communicated gradually through millions of markets impacting the decisions made by hundreds of millions and the centralized mechanism that dictates monetary policy is a root cause of the distortion.
And even if a reasonable person believed active money supply management to be a net benefit, bitcoin is now operating alongside the legacy economic system: a decentralized system vs. a centralized system. Monetary policy by consensus vs. monetary policy by central bank. While the money supply of the legacy system is unpredictably changing, the bitcoin network is operating flawlessly with a known supply and with a predictable rate of change. Rather than it being a philosophical or economic debate, there are now two competing systems, and the market will have the last say. While bitcoin may be complicated and the very subject of money may not be well understood, the flaws in the existing system are independent of bitcoin. The $17 trillion of negative yielding debt should be evidence enough and it only exists as a direct consequence of central bank monetary policy. Ultimately, the currencies that support the legacy system will be the release valve because central banks will be forced to increase the money supply in order to sustain what is an otherwise unsustainable credit system.
With the legacy system coordinated by central banks, all one can rely on is that the money supply will change and at unpredictable rates. With bitcoin, everyone can verify the supply and the predictable rate of change. By running a bitcoin full node, anyone can verify the number of valid bitcoin that exist in circulation and the amount of new bitcoin issued in each block. Anyone and everyone can verify this information without trusting anyone else. This is how bitcoin works. Each node not only verifies information; it also validates information independently. Bitcoin’s monetary policy is enforced on a decentralized basis by all nodes within the network. With precision, everyone can calculate when future blocks will be solved and when the rate of issuance will change. The fact that everyone can verify and validate the money supply, regardless of the nominal amount, reinforces the credibility of the monetary system. This reinforcement occurs every 10 minutes, 6 times an hour, 144 times a day, 4,320 times a month, 52,560 times a year, with each passing bitcoin block. The monetary system hardens as market participants validate that the monetary policy is enforced, over and over again, every ten minutes.
A fixed supply is of little meaning without the credibility of its enforcement. Anyone can copy bitcoin’s architecture and code base. But what cannot be replicated is the credibility of its monetary properties. The consensus mechanism which governs bitcoin is the foundation of its credibility and what ultimately sets bitcoin apart from its competition. Even if an individual remained unconvinced that a currency with a fixed supply would communicate better information through its pricing mechanism, it does not matter what any individual believes. Bitcoin entrusts its monetary policy to a consensus mechanism. While the maximum supply of bitcoin is practically capped at 21 million, the supply is ultimately governed by a consensus of those that hold bitcoin as a currency.
If the market, which unquestionably possesses more information than any individual, collectively determined that it would be better to change the supply schedule rather than implementing a fixed cap, it is theoretically possible. However, the market would have to come to an overwhelming consensus to effect that change, and practically speaking, a decentralized network of rational economic actors would not form an overwhelming consensus to debase its own currency. Bitcoin’s monetary policy is flexible enough to change but it is impossible to do so without an overwhelming consensus. Bitcoin ultimately represents the contrast between monetary policy by consensus and monetary policy by central bank. The information possessed by a market consensus mechanism will always exceed that of a small number of individuals, which is why bitcoin out-competes the legacy system at every step.
So no, bitcoin is not a pyramid scheme. It is not organized by a sketchy company, pushing high pressure sales tactics. It is not peddling some inferior consumer good, with abundant supply, where compensation is directly tied to recruiting new members to the scheme. Bitcoin is money and its supply is finitely scarce. It does not matter how many people adopt bitcoin; as adoption increases, the same pie is distributed across more and more people, and on average, more people control a smaller and smaller share of the network. Its value increases as a function adoption, and adoption is increasing because its monetary properties are superior to the competition. Bitcoin has a fixed supply, its supply schedule is predictable, and its monetary policy is governed and enforced by consensus. Bitcoin’s pricing mechanism is unmanipulatable and cannot be distorted because of its fixed supply. Everything changes around bitcoin but bitcoin’s fixed supply is the constant. Because bitcoin’s supply is fixed and cannot be manipulated, it will eventually become the most reliable pricing mechanism in the world, and consequently, the greatest distribution system of knowledge.
That is the promise which bitcoin provides, and it will only proliferate if it creates utility for those that adopt it. Today and into future, that utility will continue to be the ability to reliably store wealth in a monetary medium that cannot be debased. When people make the claim that bitcoin could be “bigger-than-the-internet,” it is generally not a linear application, but instead rooted in the idea that a sovereign, unmanipulatable form of money has the potential to be one of the greatest instruments of freedom ever invented. The success of bitcoin is not a given, but if successful in delivering on its promise, it will facilitate more effective and more peaceable coordination by and amongst people throughout the world. At the end of the day, bitcoin is a communication tool. That is the function of money. Bitcoin simply provides an alternative system, operating on a decentralized basis which no one controls. It is the lack of control and the lack of conscious direction which will allow bitcoin to accumulate and communicate knowledge more effectively than any pre-existing monetary medium. Current volatility is nothing more than the logical path of price discovery, as adoption increases exponentially over time and as we advance toward that future state of full adoption.
Views presented are expressly my own and not those of Unchained Capital or my colleagues. Thanks to Phil Geiger and Adam Tzagournis for reviewing and for providing valuable feedback.
]]>Every other money that predates Bitcoin — in the long history of human civilization — was valued for reasons other than its use as money. Cattle in Africa, postage stamps in prison, sea shells and precious metals all have been used as money and fit this pattern. The only exception is fiat money — something declared to be money by an authority — but even national fiat currencies were once backed by something with prior value, like gold.
Bitcoin changed all that. Bitcoin had no prior value, and no one was forced to use it, yet somehow it came to be a medium of exchange. People who don’t understand and care little for Bitcoin can nevertheless accept it as payment because they know it can be used to pay for something else or be exchanged into conventional money.
People often mention the pizzas that were bought for ten thousand bitcoins and, in hindsight, poke fun at the guy who ate what would become a multi-million dollar lunch. I’m more interested in the person who gave up two perfectly good pizzas for mere bitcoins. What did he see in those bits and bytes, that digital signature on something people were calling a blockchain? Whatever motivated the pizza seller may have also called to the early miners who could not liquidate but happily hoarded. It may have inspired the ones who simply gave bitcoins away by the thousands. Whatever it was, it was something new.
Classical economics says exchange won’t happen unless both parties value what they are getting more than what they are giving up. So where did the value come from? Bitcoin should never have gotten off the ground, but it did. Even a new product has some kind of value to it, and early adopters are taking a risk that they won’t get their money’s worth, but they still expect to gain from the exchange.
The early adopters of Bitcoin, on the other hand, had no way of knowing that we do now. All they had was a dream, a conviction and enough infectious enthusiasm to bootstrap a digital contrivance into a multi-billion dollar phenomenon we are only beginning to see the effects of.
I’ll tell you what I think happened, but the truth is no one knows. It is like magic that Bitcoin could somehow come from nothing, and without prior value or authoritative decree, become money. But Bitcoin did not appear in a vacuum. It was a solution to a problem cryptographers had been struggling with for many years: How to create digital money with no central authority that couldn’t be forged and could be trusted.
This problem persisted for so long that some left the solution to others and dreamed instead of what our future would be like if decentralized digital money did somehow come to be. They dreamed of a future where the economic power of the world is accessible to everyone, where value can be transferred anywhere with a key stroke. They dreamed of prosperity and freedom, dependent only on the mathematics of strong encryption.
Bitcoin was therefore birthed onto fertile ground and was recognized by those that had been waiting for it. This was an historic moment for them, far more important than pizzas or electric bills run up from mining. The promise of freedom and the allure of destiny energized the early community. Bitcoin was consciously, yet spontaneously taken up as money while no one was watching, and our world will never be the same.
Learn more about Ross Ulbricht at freeross.org. You can sign his petition for clemency here.
]]>Speculation - As a novel, cryptographically-backed asset class with the potential for appreciation and high volatility, Bitcoin is perfect for speculators with a high tolerance for risk. HODL!!!
Merchant Adoption - Merchants will increasingly accept Bitcoin because they can increase their profit margins by avoiding credit card fees and chargebacks.
Consumer Adoption - Consumers can use Bitcoin to save money at certain vendors. For example, getting a 20% discount on Amazon by spending Bitcoin through Purse. Additionally, consumers can buy things with Bitcoin that they cannot buy (easily) in any other way. Consider: An American can buy Persian rugs or Cuban cigars online despite trade embargoes. Bitcoin increases the efficiency of the economy, particularly in niche areas such as these.
Security - Merchant, consumer, and speculator adoption lead to a higher price and thus incentivize more miners to participate and secure the system. The decentralized, immutable transaction ledger also serves as a form of Triple Entry Bookkeeping, wherein Debits plus Credits plus the Network Confirmations of transactions increase trust and accountability across the system.
Developer Mindshare - Bitcoin is a dumb and predictable network with simple rules and a publicly-auditable codebase. It is fertile ground for the development of complicated algorithms, machine-to-machine payment protocols, smart contracts, and other tools. Its decentralized nature allows for innovation without permission. Altcoins (such as Litecoin and Ethereum) pose little threat as Bitcoin is already dominant as a store of value and as a medium of exchange in the cryptocurrency space. If you harbor doubts about the importance of this currency network effect — or worry about altcoins overtaking Bitcoin in some other way; I would point you to Daniel Krawisz with an insightful and thought-provoking article on the subject: “The Coming Demise of Altcoins”. Ultimately, developers will continue to flock to Bitcoin.
Financialization - Bitcoin will eat up progressively more of the market share of legacy banking institutions in areas such as remittances, micropayments, peer-to-peer lending, and the exchange of stocks and securities. This process has already begun (consider NASDAQ's support of Open Assets/Colored Coins for the transfer of securities, NYSE's investment in Coinbase, etc.). Old money risks dying out lest it embrace new protocols such as Bitcoin.
Adoption as a World Reserve Currency - Eventually all transactions will be settled on the blockchain, including house titles, stock purchases, car titles, and other monetary instruments and currencies. Network effects one through six culminate in this final network effect. Any newcomer in the realm of cryptocurrency or traditional currency, for that matter; would need to beat Bitcoin in all seven of these areas. This is unlikely considering the pace of development in Bitcoin Core, the level of investment in Bitcoin companies around the world, the growth in Bitcoin's user base, and on and on; Further price increases will only accelerate the process. Finally, a speculative attack could dramatically boost the value of Bitcoin almost overnight.
Bitcoin is a strong currency: it thrives on the internet; it frees its users from 3rd parties; it saves merchants money; it is deflationary; its code can be audited by all; its developers work tirelessly to improve upon it; the list goes on. The above-listed network effects can only serve to strengthen it. Competitors beware.
Trace Mayer's talk:
Audio available here.
]]>Never in the history of the world had it been possible to transfer value between distant peoples without relying on a trusted intermediary, such as a bank or government. In 2008 Satoshi Nakamoto, whose identity is still unknown, published a 9 page solution to a long-standing problem of computer science known as the Byzantine General’s Problem. Nakamoto’s solution and the system he built from it—Bitcoin—allowed, for the first time ever, value to be quickly transferred, at great distance, in a completely trustless way. The ramifications of the creation of Bitcoin are so profound for both economics and computer science that Nakamoto should rightly be the first person to qualify for both a Nobel prize in Economics and the Turing award.
For an investor the salient fact of the invention of Bitcoin is the creation of a new scarce digital good—bitcoins. Bitcoins are transferable digital tokens that are created on the Bitcoin network in a process known as “mining”. Bitcoin mining is roughly analogous to gold mining except that production follows a designed, predictable schedule. By design, only 21 million bitcoins will ever be mined and most of these already have been—approximately 16.8 million bitcoins have been mined at the time of writing. Every four years the number of bitcoins produced by mining halves and the production of new bitcoins will end completely by the year 2140.
Bitcoins are not backed by any physical commodity, nor are they guaranteed by any government or company, which raises the obvious question for a new bitcoin investor: why do they have any value at all? Unlike stocks, bonds, real-estate or even commodities such as oil and wheat, bitcoins cannot be valued using standard discounted cash flow analysis or by demand for their use in the production of higher order goods. Bitcoins fall into an entirely different category of goods, known as monetary goods, whose value is set game-theoretically. I.e., each market participant values the good based on their appraisal of whether and how much other participants will value it. To understand the game-theoretic nature of monetary goods, we need to explore the origins of money.
In the earliest human societies, trade between groups of people occurred through barter. The incredible inefficiencies inherent to barter trade drastically limited the scale and geographical scope at which trade could occur. A major disadvantage with barter based trade is the double coincidence of wants problem. An apple grower may desire trade with a fisherman, for example, but if the fisherman does not desire apples at the same moment, the trade will not take place. Over time humans evolved a desire to hold certain collectible items for their rarity and symbolic value (examples include shells, animal teeth and flint). Indeed, as Nick Szabo argues in his brilliant essay on the origins of money, the human desire for collectibles provided a distinct evolutionary advantage for early man over his nearest biological competitors, Homo neanderthalensis.
The primary and ultimate evolutionary function of collectibles was as a medium for storing and transferring wealth.
Collectibles served as a sort of “proto-money” by making trade possible between otherwise antagonistic tribes and by allowing wealth to be transferred between generations. Trade and transfer of collectibles were quite infrequent in paleolithic societies, and these goods served more as a “store of value” rather than the “medium of exchange” role that we largely recognize modern money to play. Szabo explains:
Compared to modern money, primitive money had a very low velocity—it might be transferred only a handful of times in an average individual’s lifetime. Nevertheless, a durable collectible, what today we would call an heirloom, could persist for many generations and added substantial value at each transfer—often making the transfer even possible at all.
Early man faced an important game-theoretic dilemma when deciding which collectibles to gather or create: which objects would be desired by other humans? By correctly anticipating which objects might be demanded for their collectible value, a tremendous benefit was conferred on the possessor in their ability to complete trade and to acquire wealth. Some Native American tribes, such as the Narragansetts, specialized in the manufacture of otherwise useless collectibles simply for their value in trade. It is worth noting that the earlier the anticipation of future demand for a collectible good, the greater the advantage conferred to its possessor; it can be acquired more cheaply than when it is widely demanded and its trade value appreciates as the population which demands it expands. Furthermore, acquiring a good in hopes that it will be demanded as a future store of value hastens its adoption for that very purpose. This seeming circularity is actually a feedback loop that drives societies to quickly converge on a single store of value. In game-theoretic terms, this is known as a “Nash Equilibrium”. Achieving a Nash Equilibrium for a store of value is a major boon to any society, as it greatly facilitates trade and the division of labor, paving the way for the advent of civilization.
Over the millennia, as human societies grew and trade routes developed, the stores of value that had emerged in individual societies came to compete against each other. Merchants and traders would face a choice of whether to save the proceeds of their trade in the store of value of their own society or the store of value of the society they were trading with, or some balance of both. The benefit of maintaining savings in a foreign store of value was the enhanced ability to complete trade in the associated foreign society. Merchants holding savings in a foreign store of value also had an incentive to encourage its adoption within their own society, as this would increase the purchasing power of their savings. The benefits of an imported store of value accrued not only to the merchants doing the importing, but also to the societies themselves. Two societies converging on a single store of value would see a substantial decrease in the cost of completing trade with each other and an attendant increase in trade-based wealth. Indeed, the 19th century was the first time when most of the world converged on a single store of value—gold—and this period saw the greatest explosion of trade in the history of the world. Of this halcyon period, Lord Keynes wrote:
What an extraordinary episode in the economic progress of man that age was … for any man of capacity or character at all exceeding the average, into the middle and upper classes, for whom life offered, at a low cost and with the least trouble, conveniences, comforts, and amenities beyond the compass of the richest and most powerful monarchs of other ages. The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep
When stores of value compete against each other, it is the specific attributes that make a good store of value that allows one to out-compete another at the margin and increase demand for it over time. While many goods have been used as stores of value or “proto-money”, certain attributes emerged that were particularly demanded and allowed goods with these attributes to out-compete others. An ideal store of value will be:
The table below grades Bitcoin, gold and fiat money (such as dollars) against the attributes listed above and is followed by an explanation of each grade:
Gold is the undisputed King of durability. The vast majority of gold that has ever been mined or minted, including the gold of the Pharaohs, remains extant today and will likely be available a thousand years hence. Gold coins that were used as money in antiquity still maintain significant value today. Fiat currency and bitcoins are fundamentally digital records that may take physical form (such as paper bills). Thus it is not their physical manifestation whose durability should be considered (since a tattered dollar bill may be exchanged for a new one), but the durability of the institution that issues them. In the case of fiat currencies, many governments have come and gone over the centuries, and their currencies disappeared with them. The Papiermark, Rentenmark and Reichsmark of the Weimar Republic no longer have value because the institution that issued them no longer exists. If history is a guide, it would be folly to consider fiat currencies durable in the long term—the US dollar and British Pound are relative anomalies in this regard. Bitcoins, having no issuing authority, may be considered durable so long as the network that secures them remains in place. Given that Bitcoin is still in its infancy, it is too early to draw strong conclusions about its durability. However, there are encouraging signs that, despite prominent instances of nation-states attempting to regulate Bitcoin and years of attacks by hackers, the network has continued to function, displaying a remarkable degree of “anti-fragility”.
Bitcoins are the most portable store of value ever used by man. Private keys representing hundreds of millions of dollars can be stored on a tiny USB drive and easily carried anywhere. Furthermore, equally valuable sums can be transmitted between people on opposite ends of the earth near instantly. Fiat currencies, being fundamentally digital are also highly portable. However, government regulations and capital controls mean that large transfers of value usually take days or may not be possible at all. Cash can be used to avoid capital controls, but then the risk of storage and cost of transportation become significant. Gold, being physical in form and incredibly dense, is by far the least portable. It is no wonder that the majority of bullion is never transported. When bullion is transferred between a buyer and a seller it is typically only the title to the gold that is transferred, not the physical bullion itself. Transmitting physical gold across large distances is costly, risky and time-consuming.
Gold provides the standard for fungibility. When melted down, an ounce of gold is essentially indistinguishable from any other ounce, and gold has always traded this way on the market. Fiat currencies, on the other hand, are only as fungible as the issuing institutions allow them to be. While it may be the case that a fiat banknote is usually treated like any other by merchants accepting them, there are instances where large-denomination notes have been treated differently to small ones. For instance, India’s government, in an attempt to stamp out India’s untaxed gray market, completely demonetized their 500 and 1000 rupee banknotes. The demonetization caused 500 and 1000 rupee notes to trade at a discount to their face value, making them no longer truly fungible with their lower denomination sibling notes. Bitcoins are fungible at the network level, meaning that every bitcoin, when transmitted, is treated the same on the Bitcoin network. However, because bitcoins are traceable on the blockchain, a particular bitcoin may become tainted by its use in illicit trade and merchants or exchanges may be compelled not to accept such tainted bitcoins. Without improvements to the privacy and anonymity of Bitcoin’s network protocol, bitcoins cannot be considered as fungible as gold.
For most intents and purposes, both fiat currencies and gold are fairly easy to verify for authenticity. However, despite providing features on their banknotes to prevent counterfeiting, nation-states and their citizens still face the potential to be duped by counterfeit bills. Gold is also not immune from being counterfeited. Sophisticated criminals have used gold-plated tungsten as a way of fooling gold investors into paying for false gold. Bitcoins, on the other hand, can be verified with mathematical certainty. Using cryptographic signatures, the owner of a bitcoin can publicly prove she owns the bitcoins she says she does.
Bitcoins can be divided down to a hundred millionth of a bitcoin and transmitted at such infinitesimal amounts (network fees can, however, make transmission of tiny amounts uneconomic). Fiat currencies are typically divisible down to pocket change, which has little purchasing power, making fiat divisible enough in practice. Gold, while physically divisible, becomes difficult to use when divided into small enough quantities that it could be useful for lower-value day-to-day trade.
The attribute that most clearly distinguishes Bitcoin from fiat currencies and gold is its predetermined scarcity. By design, at most 21 million bitcoins can ever be created. This gives the owner of bitcoins a known percentage of the total possible supply. For instance, an owner of 10 bitcoins would know that at most 2.1 million people on earth (less than 0.03% of the world’s population) could ever have as many bitcoins as they had. Gold, while remaining quite scarce through history, is not immune to increases in supply. If it were ever the case that a new method of mining or acquiring gold became economic, the supply of gold could rise dramatically (examples include sea-floor or asteroid mining). Finally, fiat currencies, while only a relatively recent invention of history, have proven to be prone to constant increases in supply. Nations-states have shown a persistent proclivity to inflate their money supply to solve short-term political problems. The inflationary tendencies of governments across the world leave the owner of a fiat currency with the likelihood that their savings will diminish in value over time.
No monetary good has a history as long and storied as gold, which has been valued for as long as human civilization has existed. Coins minted in the distant days of antiquity still maintain significant value today. The same cannot be said of fiat currencies, which are a relatively recent anomaly of history. From their inception, fiat currencies have had a near-universal tendency toward eventual worthlessness. The use of inflation as an insidious means of invisibly taxing a citizenry has been a temptation that few states in history have been able to resist. If the 20th century, in which fiat monies came to dominate the global monetary order, established any economic truth, it is that fiat money cannot be trusted to maintain its value over the long or even medium term. Bitcoin, despite its short existence, has weathered enough trials in the market that there is a high likelihood it will not vanish as a valued asset any time soon. Furthermore, the Lindy effect suggests that the longer Bitcoin remains in existence the greater society’s confidence that it will continue to exist long into the future. In other words, the societal trust of a new monetary good is asymptotic in nature, as is illustrated in the graph below:
If Bitcoin exists for 20 years, there will be near-universal confidence that it will be available forever, much as people believe the Internet is a permanent feature of the modern world.
One of the most significant sources of early demand for bitcoins was their use in the illicit drug trade. Many subsequently surmised, mistakenly, that the primary demand for bitcoins was due to their ostensible anonymity. Bitcoin, however, is far from an anonymous currency; every transaction transmitted on the Bitcoin network is forever recorded on a public blockchain. The historical record of transactions allows for later forensic analysis to identify the source of a flow of funds. It was such an analysis that led to the apprehending of a perpetrator of the infamous MtGox heist. While it is true that a sufficiently careful and diligent person can conceal their identity when using Bitcoin, this is not why Bitcoin was so popular for trading drugs. The key attribute that makes Bitcoin valuable for proscribed activities is that it is “permissionless” at the network level. When bitcoins are transmitted on the Bitcoin network, there is no human intervention deciding whether the transaction should be allowed. As a distributed peer-to-peer network, Bitcoin is, by its very nature, designed to be censorship-resistant. This is in stark contrast to the fiat banking system, where states regulate banks and the other gatekeepers of money transmission to report and prevent outlawed uses of monetary goods. A classic example of regulated money transmission is capital controls. A wealthy millionaire, for instance, may find it very hard to transfer their wealth to a new domicile if they wish to flee an oppressive regime. Although gold is not issued by states, its physical nature makes it difficult to transmit at distance, making it far more susceptible to state regulation than Bitcoin. India’s [Gold Control Act](https://en.wikipedia.org/wiki/The_Gold_(Control)_Act,_ 1968) is an example of such regulation.
Bitcoin excels across the majority of attributes listed above, allowing it to outcompete modern and ancient monetary goods at the margin and providing a strong incentive for its increasing adoption. In particular, the potent combination of censorship resistance and absolute scarcity has been a powerful motivator for wealthy investors to allocate a portion of their wealth to the nascent asset class.
There is an obsession in modern monetary economics with the medium of exchange role of money. In the 20th century, states have monopolized the issuance of money and continually undermined its use as a store of value, creating a false belief that money is primarily defined as a medium of exchange. Many have criticized Bitcoin as being an unsuitable money because its price has been too volatile to be suitable as a medium of exchange. This puts the cart before the horse, however. Money has always evolved in stages, with the store of value role preceding the medium of exchange role. One of the fathers of marginalist economics, William Stanley Jevons, explained that:
Historically speaking … gold seems to have served, firstly, as a commodity valuable for ornamental purposes; secondly, as stored wealth; thirdly, as a medium of exchange; and, lastly, as a measure of value.
Using modern terminology, money always evolves in the following four stages:
Collectible: In the very first stage of its evolution, money will be demanded solely based on its peculiar properties, usually becoming a whimsy of its possessor. Shells, beads and gold were all collectibles before later transitioning to the more familiar roles of money.
Store of value: Once it is demanded by enough people for its peculiarities, money will be recognized as a means of keeping and storing value over time. As a good becomes more widely recognized as a suitable store of value, its purchasing power will rise as more people demand it for this purpose. The purchasing power of a store of value will eventually plateau when it is widely held and the influx of new people desiring it as a store of value dwindles.
Medium of exchange: When money is fully established as a store of value, its purchasing power will stabilize. Having stabilized in purchasing power, the opportunity cost of using money to complete trades will diminish to a level where it is suitable for use as a medium of exchange. In the earliest days of Bitcoin, many people did not appreciate the huge opportunity cost of using bitcoins as a medium of exchange, rather than as an incipient store of value. The famous story of a man trading 10,000 bitcoins (worth approximately $94 million at the time of this article’s writing) for two pizzas illustrates this confusion.
Unit of account: When money is widely used as a medium of exchange, goods will be priced in terms of it. I.e., the exchange ratio against money will be available for most goods. It is a common misconception that bitcoin prices are available for many goods today. For example, while a cup of coffee might be available for purchase using bitcoins, the price listed is not a true bitcoin price; rather it is the dollar price desired by the merchant translated into bitcoin terms at the current USD/BTC market exchange rate. If the price of bitcoin were to drop in dollar terms, the number of bitcoins requested by the merchant would increase commensurately. Only when merchants are willing to accept bitcoins for payment without regard to the bitcoin exchange rate against fiat currencies can we truly think of Bitcoin as having become a unit of account.
Monetary goods that are not yet a unit of account may be thought of as being “partly monetized”. Today gold fills such a role, being a store of value but having been stripped of its medium of exchange and unit of account roles by government intervention. It is also possible that one good fills the medium of exchange role of money while another good fills the other roles. This is typically true in countries with dysfunctional states, such as Argentina or Zimbabwe. In his book Digital Gold, Nathaniel Popper writes:
In America, the dollar seamlessly serves the three functions of money: providing a medium of exchange, a unit for measuring the cost of goods, and an asset where value can be stored. In Argentina, on the other hand, while the peso was used as a medium of exchange—for daily purchases—no one used it as a store of value. Keeping savings in the peso was equivalent to throwing away money. So people exchanged any pesos they wanted to save for dollars, which kept their value better than the peso. Because the peso was so volatile, people usually remembered prices in dollars, which provided a more reliable unit of measure over time.
Bitcoin is currently transitioning from the first stage of monetization to the second stage. It will likely be several years before Bitcoin transitions from being an incipient store of value to being a true medium of exchange, and the path it takes to get there is still fraught with risk and uncertainty. It is striking to note that the same transition took many centuries for gold. No one alive has seen the real-time monetization of a good (as is taking place with Bitcoin), so there is precious little experience regarding the path this monetization will take.
In the process of being monetized, a monetary good will soar in purchasing power. Many have commented that the increase in purchasing power of Bitcoin creates the appearance of a “bubble”. While this term is often using disparagingly to suggest that Bitcoin is grossly overvalued, it is unintentionally apt. A characteristic that is common to all monetary goods is that their purchasing power is higher than can be justified by their use-value alone. Indeed, many historical monies had no use-value at all. The difference between the purchasing power of a monetary good and the exchange-value it could command for its inherent usefulness can be thought of as a “monetary premium”. As a monetary good transitions through the stages of monetization (listed in the section above), the monetary premium will increase. The premium does not, however, move in a straight, predictable line. A good X that was in the process of being monetized may be outcompeted by another good Y that is more suitable as money, and the monetary premium of X may drop or vanish entirely. The monetary premium of silver disappeared almost entirely in the late 19th century when governments across the world largely abandoned it as money in favor of gold.
Even in the absence of exogenous factors such as government intervention or competition from other monetary goods, the monetary premium for a new money will not follow a predictable path. Economist Larry White observed that:
the trouble with [the] bubble story, of course, is that is consistent with any price path, and thus gives no explanation for a particular price path
The process of monetization is game-theoretic; every market participant attempts to anticipate the aggregate demand of other participants and thereby the future monetary premium. Because the monetary premium is unanchored to any inherent usefulness, market participants tend to default to past prices when determining whether a monetary good is cheap or expensive and whether to buy or sell it. The connection of current demand to past prices is known as “path dependence” and is perhaps the greatest source of confusion in understanding the price movements of monetary goods.
When the purchasing power of a monetary good increases with increasing adoption, market expectations of what constitutes “cheap” and “expensive” shift accordingly. Similarly, when the price of a monetary good crashes, expectations can switch to a general belief that prior prices were “irrational” or overly inflated. The path dependence of money is illustrated by the words of well-known Wall Street fund manager Josh Brown:
I bought [bitcoins] at like $2300 and had an immediate double on my hands. Then I started saying “I can’t buy more of it,” as it rose, even though that’s an anchored opinion based on nothing other than the price where I originally got it. Then, as it fell over the last week because of a Chinese crackdown on the exchanges, I started saying to myself, “Oh good, I hope it gets killed so I can buy more.”
The truth is that the notions of “cheap” and “expensive” are essentially meaningless in reference to monetary goods. The price of a monetary good is not a reflection of its cash flow or how useful it is but, rather, is a measure of how widely adopted is has become for the various roles of money.
Further complicating the path-dependent nature of money is the fact that market participants do not merely act as dispassionate observers, trying to buy or sell in anticipation of future movements of the monetary premium, but also act as active evangelizers. Since there is no objectively correct monetary premium, proselytizing the superior attributes of a monetary good is more effective than for regular goods, whose value is ultimately anchored to cash flow or use-demand. The religious fervor of participants in the Bitcoin market can be observed in various online forums where owners actively promote the benefits of Bitcoin and the wealth that can be made by investing in it. In observing the Bitcoin market, Leigh Drogen comments:
You recognize this as a religion—a story we all tell each other and agree upon. Religion is the adoption curve we ought to be thinking about. It’s almost perfect—as soon as someone gets in, they tell everyone and go out evangelizing. Then their friends get in and they start evangelizing.
While the comparison to religion may give Bitcoin an aura of irrational faith, it is entirely rational for the individual owner to evangelize for a superior monetary good and for society as a whole to standardize on it. Money acts as the foundation for all trade and savings, so the adoption of a superior form of money has tremendous multiplicative benefits to wealth creation for all members of a society.
While there are no a priori rules about the path a monetary good will take as it is monetized, a curious pattern has emerged during the relatively brief history of Bitcoin’s monetization. Bitcoin’s price appears to follow a fractal pattern of increasing magnitude, where each iteration of the fractal matches the classic shape of a Gartner hype cycle.
In his article on the Speculative Bitcoin Adoption/Price Theory, Michael Casey posits that the expanding Gartner hype cycles represent phases of a standard S-curve of adoption that was followed by many transformative technologies as they become commonly used in society.
Each Gartner hype cycle begins with a burst of enthusiasm for the new technology, and the price is bid up by the market participants who are “reachable” in that iteration. The earliest buyers in a Gartner hype cycle typically have a strong conviction about the transformative nature of the technology they are investing in. Eventually the market reaches a crescendo of enthusiasm as the supply of new participants who can be reached in the cycle is exhausted and the buying becomes dominated by speculators more interested in quick profits than the underlying technology.
Following the peak of the hype cycle, prices rapidly drop and the speculative fervor is replaced by despair, public derision and a sense that the technology was not transformative at all. Eventually the price bottoms and forms a plateau where the original investors who had strong conviction are joined by a new cohort who were able to withstand the pain of the crash and who appreciated the importance of the technology.
The plateau persists for a prolonged period of time and forms, as Casey calls it, a “stable, boring low”. During the plateau, public interest in the technology will dwindle but it will continue to be developed and the collection of strong believers will slowly grow. A new base is then set for the next iteration of the hype cycle as external observers recognize the technology is not going away and that investing in it may not be as risky as it seemed during the crash phase of the cycle. The next iteration of the hype cycle will bring in a much larger set of adopters and be far greater in magnitude.
Very few people participating in an iteration of a Gartner hype cycle will correctly anticipate how high prices will go in that cycle. Prices usually reach levels that would seem absurd to most investors at the earliest stages of the cycle. When the cycle ends, a popular cause it typically attributed to the crash by the media. While the stated cause (such as an exchange failure) may be a precipitating event, it is not the fundamental reason for the cycle to end. Gartner hype cycles end because of an exhaustion of market participants reachable in the cycle.
It is telling that gold followed the classic pattern of a Gartner hype cycle from the late 1970s to the early 2000s. One might speculate that the hype cycle is an inherent social dynamic to the process of monetization.
Since the inception of the first exchange traded price in 2010, the Bitcoin market has witnessed four major Gartner hype cycles. With hindsight we can precisely identify the price ranges of previous hype cycles in the Bitcoin market. We can also qualitatively identify the cohort of investors that were associated with each iteration of prior cycles.
0**–**1 (2009–March 2011): The first hype cycle in the Bitcoin market was dominated by cryptographers, computer scientists and cypherpunks who were already primed to understand the importance of Satoshi Nakamoto’s groundbreaking invention and who were pioneers in establishing that the Bitcoin protocol was free of technical flaws.
1**–**30 (March 2011–July 2011): The second cycle attracted both early adopters of new technology and a steady stream of ideologically motivated investors who were dazzled by the potential of a stateless money. Libertarians such as Roger Ver were attracted to Bitcoin for the anti-establishment activities that would become possible if the nascent technology became widely adopted. Wences Casares, a brilliant and well-connected serial entrepreneur, was also part of the second Bitcoin hype cycle and is known to have evangelized Bitcoin to some of the most prominent technologists and investors in Silicon Valley.
250**–**1100 (April 2013–December 2013): The third hype cycle saw the entrance of early retail and institutional investors who were willing to brave the horrendously complicated and risky liquidity channels from which bitcoins could be bought. The primary source of liquidity in the market during this period was the Japan-based MtGox exchange that was run by the notoriously incompetent and malfeasant Mark Karpeles, who later saw prison time for his role in the collapse of the exchange.
It is worth observing that the rise in Bitcoin’s price during the aforementioned hype cycles was largely correlated with an increase in liquidity and the ease with which investors could purchase bitcoins. In the first hype cycle, there were no exchanges available, and acquisition of bitcoins was primarily through mining or by direct exchange with someone who had already mined bitcoins. In the second hype cycle, rudimentary exchanges became available, but obtaining and securing bitcoins from these exchanges remained too complex for all but the most technologically savvy investors. Even in the third hype cycle, significant hurdles remained for investors transferring money to MtGox to acquire bitcoins. Banks were reluctant to deal with the exchange, and third party vendors who facilitated transfers were often incompetent, criminal, or both. Further, many who did manage to transfer money to MtGox ultimately faced loss of funds when the exchange was hacked and later closed.
It was only after the collapse of the MtGox exchange and a two-year lull in the market price of Bitcoin that mature and deep sources of liquidity were developed; examples include regulated exchanges such as GDAX and OTC brokers such as Cumberland mining. By the time the fourth hype cycle began in 2016 it was relatively easy for retail investors to buy bitcoins and secure them.
1100**–**19600? (2014–?):
At the time of writing, the Bitcoin market is undergoing its fourth major hype cycle. Participation in the current hype cycle has been dominated by what Michael Casey described as the “early majority” of retail and institutional investors.
As sources of liquidity have deepened and matured, major institutional investors now have the opportunity to participate through regulated futures markets. The availability of a regulated futures market paves the way for the creation of a Bitcoin ETF, which will then usher in the “late majority” and “laggards” in subsequent hype cycles.
Although it is impossible to predict the exact magnitude of the current hype cycle, it would be reasonable to conjecture that the cycle reaches its zenith in the range of 20,000 to 50,000. Much higher than this range and Bitcoin would command a significant fraction of gold’s entire market capitalization (gold and Bitcoin would have equivalent market capitalizations at a bitcoin price of approximately $380,000 at the time of writing). A significant fraction of gold’s market capitalization comes from central bank demand and it’s unlikely that central banks or nation states will participate in this particular hype cycle.
Bitcoin’s final Gartner hype cycle will begin when nation-states start accumulating it as a part of their foreign currency reserves. The market capitalization of Bitcoin is currently too small for it to be considered a viable addition to reserves for most countries. However, as private sector interest increases and the capitalization of Bitcoin approaches 1 trillion dollars it will become liquid enough for most states to enter the market. The entrance of the first state to officially add bitcoins to their reserves will likely trigger a stampede for others to do so. The states that are the earliest in adopting Bitcoin would see the largest benefit to their balance sheets if Bitcoin ultimately became a global reserve currency. Unfortunately, it will probably be the states with the strongest executive powers—dictatorships such as North Korea—that will move the fastest in accumulating bitcoins. The unwillingness to see such states improve their financial position and the inherently weak executive branches of the Western democracies will cause them to dither and be laggards in accumulating bitcoins for their reserves.
There is a great irony that the US is currently one of the nations most open in its regulatory position toward Bitcoin, while China and Russia are the most hostile. The US risks the greatest downside to its geopolitical position if Bitcoin were to supplant the dollar as the world’s reserve currency. In the 1960s, Charle de Gaulle criticized the “exorbitant privilege” the US enjoyed from the international monetary order it crafted with the Bretton Woods agreement of 1944. The Russian and Chinese governments have not yet awoken to the geo-strategic benefits of Bitcoin as a reserve currency and are currently preoccupied with the effects it may have on their internal markets. Like de Gaulle in the 1960s, who threatened to reestablish the classical gold standard in response to the US’s exorbitant privilege, the Chinese and Russians will, in time, come to see the benefits of a large reserve position in a non-sovereign store of value. With the largest concentration of Bitcoin mining power residing in China, the Chinese state already has a distinct advantage in its potential to add bitcoins to its reserves.
The US prides itself as a nation of innovators, with Silicon Valley being a crown jewel of the US economy. Thus far, Silicon Valley has largely dominated the conversation toward regulators on the position they should take vis-à-vis Bitcoin. However, the banking industry and the US Federal Reserve are finally having their first inkling of the existential threat Bitcoin poses to US monetary policy if it were to become a global reserve currency. The Wall Street Journal, known to be a mouth-piece for the Federal Reserve, published a commentary on the threat Bitcoin poses to US monetary policy:
There is another danger, perhaps even more serious from the point of view of the central banks and regulators: bitcoin might not crash. If the speculative fervor in the cryptocurrency is merely the precursor to it being widely used as an alternative to the dollar, it will threaten the central banks’ monopoly on money.
In the coming years there will be a great struggle between entrepreneurs and innovators in Silicon Valley, who will attempt to keep Bitcoin free of state control, and the banking industry and central banks who will do everything in their power to regulate Bitcoin to prevent their industry and money-issuing powers from being disrupted.
A monetary good cannot transition to being a generally accepted medium of exchange (the standard economic definition of “money”) before it is widely valued, for the tautological reason that a good that is not valued will not be accepted in exchange. In the process of becoming widely valued, and hence a store of value, a monetary good will soar in purchasing power, creating an opportunity cost to relinquishing it for use in exchange. Only when the opportunity cost of relinquishing a store of value drops to a suitably low level can it transition to becoming a generally accepted medium of exchange.
More precisely, a monetary good will only be suitable as a medium of exchange when the sum of the opportunity cost and the transactional cost of using it in exchange drops below the cost of completing a trade without it.
In a barter-based society, the transition of a store of value to a medium of exchange can occur even when the monetary good is increasing in purchasing power because the transactional costs of barter trade are extremely high. In a developed economy, where transactional costs are low, it is possible for a nascent and rapidly appreciating store of value, such as Bitcoin, to be used as a medium of exchange, albeit in a very limited scope. An example is the illicit drug market where buyers are willing to sacrifice the opportunity of holding bitcoins to minimize the substantial risk of purchasing the drugs using fiat currency.
There are, however, major institutional barriers to a nascent store of value becoming a generally accepted medium of exchange in a developed society. States use taxation as a powerful means to protect their sovereign money from being displaced by competing monetary goods. Not only does a sovereign money enjoy the advantage of a constant source of demand, by way of taxes being remittable only in it, but competing monetary goods are taxed whenever they are exchanged at an appreciated value. This latter kind of taxation creates significant friction to using a store of value as a medium of exchange.
The handicapping of market-based monetary goods is not an insurmountable barrier to their adoption as a generally accepted medium of exchange, however. If faith is lost in a sovereign money, its value can collapse in a process known as hyperinflation. When a sovereign money hyperinflates, its value first collapses against the most liquid goods in the society, such as gold or a foreign money like the US dollar, if they are available. When no liquid goods are available or their supply is limited, a hyperinflating money collapses against real goods, such as real estate and commodities. The archetypal image of a hyperinflation is a grocery store emptied of all its produce as consumers flee the rapidly diminishing value of their nation’s money.
Eventually, when faith is completely lost during a hyperinflation, a sovereign money will no longer be accepted by anyone, and the society will either devolve to barter or the monetary unit will be completely replaced as a medium of exchange. An example of this process was the replacement of the Zimbabwe dollar with the US dollar. The replacement of a sovereign money with a foreign one is made more difficult by the scarcity of the foreign money and the absence of foreign banking institutions to provide liquidity.
The ability to easily transmit bitcoins across borders and absence of a need for a banking system make Bitcoin an ideal monetary good to acquire for those afflicted by hyperinflation. In the coming years, as fiat monies continue to follow their historical trend toward eventual worthlessness, Bitcoin will become an increasingly popular choice for global savings to flee to. When a nation’s money is abandoned and replaced by Bitcoin, Bitcoin will have transitioned from being a store of value in that society to a generally accepted medium of exchange. Daniel Krawisz coined the term “hyperbitcoinization” to describe this process.
Much of this article has focused on the monetary nature of Bitcoin. With this foundation we can now address some of the most commonly held misconceptions about Bitcoin.
Bitcoin, like all market-based monetary goods, displays a monetary premium. The monetary premium is what gives rise to the common criticism that Bitcoin is a “bubble”. However, all monetary goods display a monetary premium. Indeed, it is this premium (the excess over the use-demand price) that is the defining characteristic of all monies. In other words, money is always and everywhere a bubble. Paradoxically, a monetary good is both a bubble and may be undervalued if it’s in the early stages of its adoption for use as money.
Bitcoin’s price volatility is a function of its nascency. In the first few years of its existence, Bitcoin behaved like a penny-stock, and any large buyer—such as the Winklevoss twins—could cause a large spike in its price. As adoption and liquidity have increased over the years, Bitcoin’s volatility has decreased commensurately. When Bitcoin achieves the market capitalization of gold, it will display a similar level of volatility. As Bitcoin surpasses the market capitalization of gold, its volatility will decrease to a level that will make it suitable as a widely used medium of exchange. As previously noted, the monetization of Bitcoin occurs in a series of Gartner hype cycles. Volatility is lowest during the plateau phase of the hype cycle, while it is highest during the peak and crash phases of the cycle. Each hype cycle has lower volatility than the previous ones because the liquidity of the market has increased.
A recent criticism of the Bitcoin network is that the increase in fees to transmit bitcoins makes it unsuitable as a payment system. However, the growth in fees is healthy and expected. Transaction fees are the cost required to pay bitcoin miners to secure the network by validating transactions. Miners can either be paid by transaction fees or by block rewards, which are an inflationary subsidy borne by current bitcoin owners.
Given Bitcoin’s fixed supply schedule—a monetary policy which makes it ideally suited as a store of value—block rewards will eventually decline to zero and the network must ultimately be secured with transaction fees. A network with “low” fees is a network with little security and prone to external censorship. Those touting the low fees of Bitcoin alternatives are unknowingly describing the weakness of these so-called “alt-coins”.
The specious root of the criticism of Bitcoin’s “high” transaction fees is the belief that Bitcoin should be a payment system first and a store of value later. As we have seen with the origins of money, this belief puts the cart before the horse. Only when Bitcoin has become a deeply established store of value will it become suitable as a medium of exchange. Further, once the opportunity cost of trading bitcoins is at a level at which it is suitable as a medium of exchange, most trades will not occur on the Bitcoin network itself but on “second layer” networks with much lower fees. Second layer networks, such as the Lightning network, provide the modern equivalent of the promissory notes that were used to transfer titles for gold in the 19th century. Promissory notes were used by banks because transferring the underlying bullion was far more costly than transferring the note that represented title to the gold. Unlike promissory notes, however, the Lightning network will allow the transfer of bitcoins at low cost while requiring little or no trust of third parties such as banks. The development of the Lightning network is a profoundly important technical innovation in Bitcoin’s history and its value will become apparent as it is developed and adopted in the coming years.
As an open-source software protocol, it has always been possible to copy Bitcoin’s software and imitate its network. Over the years, many imitators have been created, ranging from ersatz facsimiles, such as Litecoin, to complex variants like Ethereum that promise to allow arbitrarily complex contractual arrangements using a distributed computational system. A common investment criticism of Bitcoin is that it cannot maintain its value when competitors can be easily created that are able to incorporate the latest innovations and software features.
The fallacy in this argument is that the scores of Bitcoin competitors that have been created over the years lack the “network effect” of the first and dominant technology in the space. A network effect—the increased value of using Bitcoin simply because it is already the dominant network—is a feature in and of itself. For any technology that possesses a network effect, it is by far the most important feature.
The network effect for Bitcoin encompasses the liquidity of its market, the number of people who own it, and the community of developers maintaining and improving upon its software and its brand awareness. Large investors, including nation-states, will seek the most liquid market so that they can enter and exit the market quickly without affecting its price. Developers will flock to the dominant development community which has the highest-calibre talent, thereby reinforcing the strength of that community. And brand awareness is self-reinforcing, as would-be competitors to Bitcoin are always mentioned in the context of Bitcoin itself.
A trend that became popular in 2017 was not only to imitate Bitcoin’s software, but to copy the entire history of its past transactions (known as the blockchain). By copying Bitcoin’s blockchain up to a certain point and then splitting off into a new network, in a process known as “forking”, competitors to Bitcoin were able to solve the problem of distributing their token to a large user base.
The most significant fork of this kind occurred on August 1st, 2017 when a new network known as Bitcoin Cash (BCash) was created. An owner of N bitcoins before August 1st, 2017, would then own both N bitcoins and N BCash tokens. The small but vocal community of BCash proponents have tirelessly attempted to expropriate Bitcoin’s brand recognition, both through the naming of their new network and a campaign to convince neophytes in the Bitcoin market that Bcash is the “real” Bitcoin. These attempts have largely failed, and this failure is reflected in the market capitalizations of the two networks. However, for new investors, there remains an apparent risk that a competitor might clone Bitcoin and its blockchain and succeed in overtaking it in market capitalization, thus becoming the de facto Bitcoin.
An important rule can be gleaned from the major forks that have happened to both the Bitcoin and Ethereum networks. The majority of the market capitalization will settle on the network that retains the highest-calibre and most active developer community. For although Bitcoin can be viewed as a nascent money, it is also a computer network built on software that needs to be maintained and improved upon. Buying tokens on a network which has little or inexperienced developer support would be akin to buying a clone of Microsoft Windows that was not supported by Microsoft’s best developers. It is clear from the history of the forks that occurred in 2017 that the best and most experienced computer scientists and cryptographers are committed to developing for the original Bitcoin and not any of the growing legion of imitators that have been created from it.
Although the common criticisms of Bitcoin found in the media and economics profession are misplaced and based on a flawed understanding of money, there are real and significant risks to investing in Bitcoin. It would be prudent for a prospective Bitcoin investor to understand and weigh these risks before considering an investment in Bitcoin.
The Bitcoin protocol and the cryptographic primitives that it is built upon could be found to have a design flaw, or could be made insecure with the development of quantum computing. If a flaw is found in the protocol, or some new means of computation makes possible the breaking of the cryptography underpinning Bitcoin, the faith in Bitcoin may be severely compromised. The protocol risk was highest in the early years of Bitcoin’s development, when it was still unclear, even to seasoned cryptographers, that Satoshi Nakamoto had actually found a solution to the Byzantine Generals’ Problem. Concerns about serious flaws in the Bitcoin protocol have dissipated over the years, but given its technological nature, protocol risk will always remain for Bitcoin, if only as an outlier risk.
Being decentralized in design, Bitcoin has shown a remarkable degree of resilience in the face of numerous attempts by various governments to regulate it or shut it down. However, the exchanges where bitcoins are traded for fiat currencies are highly centralized and susceptible to regulation and closure. Without these exchanges and the willingness of the banking system to do business with them, the process of monetization of Bitcoin would be severely stunted, if not halted completely. While there are alternative sources of liquidity for Bitcoin, such as over-the-counter brokers and decentralized markets for buying and selling Bitcoins (like localbitcoins.com), the critical process of price discovery happens on the most liquid exchanges, which are all centralized.
Mitigating the risk of exchange shutdowns is jurisdictional arbitrage. Binance, a prominent exchange that started in China, moved to Japan after the Chinese government halted its operations in China. National governments are also wary of smothering a nascent industry that may prove as consequential as the Internet, thereby ceding a tremendous competitive advantage to other nations.
Only with a coordinated global shutdown of Bitcoin exchanges would the process of monetization be halted completely. The race is on for Bitcoin to become so widely adopted that a complete shutdown becomes as politically infeasible as a complete shutdown of the Internet. The possibility of such a shutdown is still real, however, and must be factored into the risks of investing in Bitcoin. As was discussed in the prior section on the entrance of nation-states, national governments are finally awakening to the threat that a non-sovereign, censorship-resistant, digital currency poses to their monetary policies. It is an open question whether they will act on this threat before Bitcoin becomes so entrenched that political action against it proves ineffectual.
The open and transparent nature of the Bitcoin blockchain makes it possible for states to mark certain bitcoins as being “tainted” by their use in proscribed activities. Although Bitcoin’s censorship resistance at the protocol level allows these bitcoins to be transmitted, if regulations were to appear that banned the use of such tainted bitcoins by exchanges or merchants, they could become largely worthless. Bitcoin would then lose one of the critical properties of a monetary good: fungibility.
To ameliorate Bitcoin’s fungibility, improvements will need to be made at the protocol level to improve the privacy of transactions. While there are new developments in this regard, pioneered in digital currencies such as Monero and Zcash, there are major technological tradeoffs to be made between the efficiency and complexity of Bitcoin and its privacy. It remains an open question whether privacy-enhancing features can be added to Bitcoin in a way that doesn’t compromise its usefulness as money in other ways.
Bitcoin is an incipient money that is transitioning from the collectible stage of monetization to becoming a store of value. As a non-sovereign monetary good, it is possible that at some stage in the future Bitcoin will become a global money much like gold during the classical gold standard of the 19th century. The adoption of Bitcoin as global money is precisely the bullish case for Bitcoin, and was articulated by Satoshi Nakamoto as early as 2010 in an email exchange with Mike Hearn:
If you imagine it being used for some fraction of world commerce, then there’s only going to be 21 million coins for the whole world, so it would be worth much more per unit.
This case was made even more trenchantly by the brilliant cryptographer Hal Finney, the recipient of the first bitcoins sent by Nakamoto, shortly after the announcement of the first working Bitcoin software:
[I]magine that Bitcoin is successful and becomes the dominant payment system in use throughout the world. Then the total value of the currency should be equal to the total value of all the wealth in the world. Current estimates of total worldwide household wealth that I have found range from 100 trillion to 300 trillion. With 20 million coins, that gives each coin a value of about $10 million.
Even if Bitcoin were not to become a fully fledged global money and were simply to compete with gold as a non-sovereign store of value, it is currently massively undervalued. Mapping the market capitalization of the extant above-ground gold supply (approximately 8 trillion dollars) to a maximum Bitcoin supply of 21 million coins gives a value of approximately $380,000 per bitcoin. As we have seen in prior sections, for the attributes that make a monetary good suitable as a store of value, Bitcoin is superior to gold along every axis except for established history. As time passes and the Lindy effect takes hold, established history will no longer be a competitive advantage for gold. Thus, it is not unreasonable to expect that Bitcoin will approach, and perhaps surpass, gold’s market capitalization in the next decade. A caveat to this thesis is that a large fraction of gold’s capitalization comes from central banks holding it as a store of value. For Bitcoin to achieve or surpass gold’s capitalization, some participation by nation-states will be necessary. Whether the Western democracies will participate in the ownership of Bitcoin is unclear. It is more likely, and unfortunate, that tin-pot dictatorships and kleptocracies will be the first nations to enter the Bitcoin market.
If no-nation states participate in the Bitcoin market, there still remains a bullish case for Bitcoin. As a non-sovereign store of value used only by retail and institutional investors, Bitcoin is still early in its adoption curve—the so-called “early majority” are now entering the market while the late majority and laggards are still years away from entering. With broader participation from retail and especially institutional investors, a price level between 100,000 and 200,000 is feasible.
Owning bitcoins is one of the few asymmetric bets that people across the entire world can participate in. Much like a call option, an investor’s downside is limited to 1x, while their potential upside is still 100x or more. Bitcoin is the first truly global bubble whose size and scope is limited only by the desire of the world’s citizenry to protect their savings from the vagaries of government economic mismanagement. Indeed, Bitcoin rose like a phoenix from the ashes of the 2008 global financial catastrophe—a catastrophe that was precipitated by the policies of central banks like the Federal Reserve.
Beyond the financial case for Bitcoin, its rise as a non-sovereign store of value will have profound geopolitical consequences. A global, non-inflationary, reserve currency will force nation-states to alter their primary funding mechanism from inflation to direct taxation, which is far less politically palatable. States will shrink in size commensurate to the political pain of transitioning to taxation as their exclusive means of funding. Furthermore, global trade will be settled in a manner that satisfies Charles de Gaulle’s aspiration that no nation should have privilege over any other:
We consider it necessary that international trade be established, as it was the case, before the great misfortunes of the World, on an indisputable monetary base, and one that does not bear the mark of any particular country.
50 years from now, that monetary base will be Bitcoin.
This article has been translated into:
Deutsche by Daniel Schnurr, Simon Lutz and Arlene Roa Aillaud.
Korean by Hyungmok joh (part 1, part 2, part 3, part 4).
Traditional Chinese by Flora Sun (part 1, part 2, part 3, part 4)
Simplified Chinese by Flora Sun (part 1, part 2, part 3, part 4)
Español by Iñigo and Carlos Beltrán (part 1, part 2, part 3, part4).
Nederlandse by Wim, edited by Koen Swinkels (part 1, part 2, part 3, part 4).
Française by Greg Guittard (part 1, part 2, part 3, part 4).
Tamil by Balaji Vaidyanath and Mahadevan Vaidyanath (part 1).
русский/Russian by CoinSpot (part 1, part 2, part 3, part 4).
Bulgarian by Bo Mirchev (part 1, part 2, part 3, part 4).
I’m a former Google engineer who’s interested in Austrian economics. I’m also a husband and loving father of Addie and Will. Follow me on Twitter.
I want to thank Alex Morcos, John Pfeffer, Pierre Rochard, Mat Balez, Ray Boyapati, Daniel Coleman, Koen Swinkels, Patri Friedman, Ardian Tola, Michael Flaxman and Michael Hartl for their valuable feedback on earlier drafts of this series of articles. Sanjay Mavinkurve generously provided his brilliant design skills to create some of the charts.
The views presented in this article and any errors herein are my own.
This article is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
]]>Bitcoin’s governance matters because Bitcoin is the first successful, most liquid, and most widely known crypto-currency. In the words of Michael Goldstein, “Sound money is a foundational pillar of civilization, and Bitcoin restores this powerful tool for social coordination.” If Bitcoin’s governance model is flawed, it could prevent Bitcoin from reaching its full potential. If Bitcoin’s governance is flawed, Bitcoin’s stakeholders should work to fix it.
Conversations regarding Bitcoin’s governance tend to focus on who the decision makers ultimately are, perennial candidates include miners, nodes, and investors. The purpose and mechanics of governance are often just implied or even disconnected from reality. Views on the efficacy of past governance are often driven by who “won” or “lost” a specific decision, rather than the adequacy of the decision making process itself.
Bitcoin governance is the process by which a set of transaction and block verification rules are decided upon, implemented, and enforced, such that individuals adopt these rules for verifying that payments they received in transactions and blocks fit their subjective definition of “Bitcoin”. If two or more individuals adopt the same set validation of rules, they form an inter-subjective social consensus of what “Bitcoin” is.
There is a wide range of views regarding what the purpose of Bitcoin’s governance should be. What outcomes should governance optimize for?
In the context of Bitcoin’s governance, these two views mirror the classic divide between deontological and consequentialist ethics respectively. I favor Matt’s deontological approach of focusing on trustlessness. Throughout monetary history, from ancient coin producers to modern central banks, trusting others to produce money has resulted in abuse of that trust. Compromising on trustlessness could help the Bitcoin price find a local maximum, at the expense of finding a much higher global maximum. Furthermore, there is no evidence that Bitcoin’s price has been correlated with upgrades to the Bitcoin protocol. Perhaps Bitcoin’s fundamental value is affected by upgrades, but Bitcoin is so illiquid and volatile that the price does not reliably reflect fundamental value. If we can’t observe the consequences of an upgrade on Bitcoin’s value, the consequentialist approach seems inadequate.
Before we can evaluate the current Bitcoin governance process against the stated goals of maintaining trustlessness or increasing the value of Bitcoin, we should attempt to define how the current Bitcoin governance process actually works.
The Bitcoin governance process maintains a set of verification rules. At a high level, this long set of verification rules covers syntax, data structures, resource usage limits, sanity checks, time locking, reconciliation with the memory pool and main branch, the coinbase reward and fee calculation, and block header verification. Amending these rules without tradeoffs is no easy feat.
Most of these rules were inherited from Satoshi Nakamoto. Some have been added or amended to address bugs and denial-of-service vulnerabilities. Other rule changes occurred to enable innovative new projects. For example, the new Check Sequence Verify opcode was added to enable new scripts.
Every rule change begins with research. For example, SegWit began with research into fixing transaction malleability. Transaction malleability had become a serious issue because it prevented the Lightning Network from deploying on Bitcoin. Industry and independent researchers collaborated on what eventually became SegWit.
Critics have pointed out occasional disconnects between what researchers want to research, user expectations, and what is good for the network’s properties. Additionally, academic computer scientists prefer “scientific simulations” over “engineering experiments”. This has been a source of tension in the research community.
When a researcher has discovered a solution to a problem, they share their proposed changes with other protocol developers. This sharing could be in the form of an email to the bitcoin-dev mailing list, a formal white paper, and/or a Bitcoin Improvement Proposal (BIP).
A proposal is implemented in the node software by the researcher(s) who proposed it, or by other protocol developers who are interested in it. If a researcher can not implement a proposal, or the proposal does not attract favorable peer review, then it will linger at this stage until it is either abandoned or revised.
While this may give the impression that the contributors to Bitcoin protocol development can veto a proposal, a researcher can make their case to the public and route around existing developers. In this scenario, the researcher is at a disadvantage if they lack reputation and credibility.
Another problem at the implementation phase is that the maintainers of the reference implementation will not merge in an implementation if it is widely seen as contentious by the Bitcoin protocol developers and the wider Bitcoin community. The reference implementation’s maintainers have a deliberate policy of following consensus changes rather than trying to impose them. The C++ reference implementation, hosted at github.com/bitcoin/bitcoin, is the direct successor of Satoshi’s codebase. It continues to be the most popular Bitcoin node implementation due to its maturity and reliability.
To circumvent the reference implementation’s maintainers and make consensus changes regardless is as simple as copying the Bitcoin codebase and releasing the proposed changes. This happened with the BIP-148 User Activated Soft Fork (UASF).
A proposal to change validation rules can have a softfork or a hardfork implementation. Some proposals can only be implemented as a hardfork. From the perspective of pre-fork nodes, a softfork implementation is forward-compatible. With a softfork, the pre-fork nodes do not need to upgrade their software in order to continue validating the pre-fork consensus rules. However, these pre-fork nodes are not validating rule changes made by the soft-fork. From the perspective of pre-fork nodes, a hardfork is not forward-compatible. Pre-fork nodes will end up on a different network as post-fork nodes.
There has been controversy about the effects of hard and softforks on the network and users. Softforks are seen as being safer than hardforks, because they do not require an explicit opt-in, but this can also be seen as coercive. Someone who disagrees with a softfork must hardfork to reverse it.
Once implemented in the node software, users must be persuaded to use the node software. Not all node users are equal in their importance. For example, “blockchain explorers” also have more power as many users rely on their node. Additionally, an exchange can determine which validation rule set belongs to which ticker symbol. Speculative traders, large holders, and other exchanges provide a check on this power over ticker symbols.
While individual users may signal on social media that they are using a certain version of node software, this can be sybil attacked. The ultimate test of consensus is whether your node software can receive payments that you consider to be bitcoins, and you can send payments that your counter-parties’ node software considers to be bitcoins.
Softforks have an on-chain governance feature called BIP-9 Version bits with timeout and delay. This feature measures miner support for softforks on a rolling basis. Miner support for proposals is used as a proxy measure for the wider community’s support. Unfortunately this proxy measure can be inaccurate due to mining centralization and conflicts of interest between miners and users. On-chain “voting” by miners also perpetuates the myth that Bitcoin is a miner democracy, and that the miners alone decide on transaction and block validity. BIP-9 is useful to the extent that we recognize and accept the limitations of proxy measurements.
Changes to the validation rules are enforced by the decentralized p2p network of fully validating nodes. Nodes use the verification rules to independently verify that payments received by the node operator are in valid Bitcoin transactions and are included in valid Bitcoin blocks. Nodes will not propagate transactions and blocks which break the rules. In fact, nodes will disconnect and ban peers which are sending invalid transactions and blocks. As StopAndDecrypt put it, “Bitcoin is an impenetrable fortress of validation.” If everyone determines that a mined block is invalid then the miner’s coinbase reward + fees is worthless.
The role of miners is to provide a time-stamping function secured with proof-of-work. The amount of hashrate provided is based on the cost of hardware and electricity on one hand, and revenue from the coinbase reward + fees on the other hand. Miners are mercenaries, and in the past they have provided their time-stamping function without full rule validation. Due to mining centralization, miners can not be trusted to enforce the validation rules on their own.
In my opinion, the current Bitcoin governance model has prevented a degradation of trustlessness. The dramatic increase in on-chain Bitcoin transactions over the past 5 years seemed to have no end in sight. If Bitcoin’s governance model had not been resistant to last year’s miner signalling for a doubling the maximum block weight, a precedent would have been set of valuing transaction throughput above trustlessness.
I think it’s impossible to establish a causal relationship. The price is much higher than it was 2 years ago, but it seems to be an endogenous process driven by trader psychology, not technological fundamentals. Regarding fundamentals, it’s undeniable that Bitcoin’s governance has delivered on consensus changes which the Lightning Network depends on to operate. I’ve been experimenting with establishing channels and making Lightning payments: there is no doubt in my mind that LN increases Bitcoin’s value.
This post is based on my speech at the Chain-In conference:
]]>The problem here, as usual, is not with Bitcoin, but with people’s misunderstanding of Bitcoin, and the first clue to that can be found in the sky-rocketing price: if Bitcoin is so doomed, why are people still buying it? The answer is that Bitcoin’s value proposition is not in making the small consumer purchases, but in making large and important payments, particularly across borders. Payments in person, for small amounts, can be conducted in a wide variety of options: physical cash, barter, favors, credit cards, bank checks, and so on. Payments across the world, however, are a very different story.
There are only a few currencies that are accepted for payment worldwide, namely: the US Dollar, the Euro, gold, and the IMF’s SDR’s. The vast majority of international payments are denominated in one of these currencies, with only a tiny percentage shared by a few other major currencies. To send these currencies in values around thousands of dollars internationally costs dozens of dollars usually, and is subject to invasive forensic examination by financial institutions. Compared to these transactions, Bitcoin’s transaction fees of $2.5 are still a bargain.
However, the volume of these international flows is far larger than what Bitcoin’s blockchain can handle, and if more such payments move to Bitcoin, fees will rise to limit the demand for them. Yet, that would also not spell doom for Bitcoin, because sending these individual payments is not the limit of Bitcoin’s capabilities.
Bitcoin is money free of counter-party risk, and its network can offer final settlement of large volume payments within minutes. Bitcoin can thus best be compared to settlement payments between central banks and large financial institutions, and it compares favorably to them, being infinitely cheaper and more verifiable. The only other form of money in history which is free of counter-party risk is gold, and moving that around is incomparably more expensive.
An interesting thought experiment is to imagine the shape of a global economic system built around settlement in Bitcoin. Bitcoin’s current capacity is to verify around 350,000 transactions per day. This number of transactions can allow a global network of 850 banks to each have one daily transaction with every other bank on the network. (The number of unique connections in a network equals n(n-1)/2, where n is the number of nodes.)
Bitcoin can support an international network of 850 central banks capable of performing daily final settlement with one another. Such a network would have two major advantages over the current network of central banks: First, the finality of settlement on Bitcoin does not rely on any counter-party, and does not require any single bank to be the de facto arbiter, making it ideal for a network of global peers, rather than a global hegemonic centralized order. Second, the Bitcoin network is based on a form of money whose supply cannot be inflated by any single member bank, making it a more attractive store of value proposition than national currencies whose creation was precisely so their supply can be increased to finance governments.
In a world in which no government can create more Bitcoin, these Bitcoin central banks would compete freely with one another in offering physical and digital Bitcoin-backed monetary instruments. Without a lender of last resort, fractional reserve banking becomes an extremely dangerous arrangement, and the only banks that’ll survive in the long-run would be sound money banks offering financial instruments 100% backed by Bitcoin. They would settle payments between their own customers off of Bitcoin’s blockchain, and then perform final daily settlement between each other over the blockchain.
I am currently writing a book, available on Amazon here, explaining Bitcoin’s main value proposition as a sound money, and elucidating the significance of this concept across history, which far exceeds the significance of small transaction costs on consumer payments. Sound money has been a necessary building block of human civilizations, and its demise has usually coincided with civilizational decline. The modern world was built in the 19th century on sound money, funded by investors with the low time preference engendered from a sound money. The consumerist culture of instant gratification of the twentieth century, on the other hand, was the culture of ever-devaluing fiat money, which discourages saving, and incentivizes short-term orientation.
The obsession with consumer payments in the Bitcoin community is an unfortunate relic of the fiat money era. Generations that have only known monetary hot potatoes that need to be spent before they devalue have come to view life as a quest of mass consumption. In a world of sound money, people will still consume, of course, because they need to survive. But consumption will come at a high opportunity cost in the future, since savings appreciate. As result, consumption will stop being a compulsive part of life, and people will buy things they need, and things that last for a long time. Instead of wasting their money on plastic bullshit they don’t need and expensive sugary addictions, people will save their money for the future, and watching it appreciate, achieve financial independence.
The number of transactions in a Bitcoin economy can still be as large as it is today, but the settlement of these transactions will not happen on Bitcoin’s ledger, whose immutability and trustlessness is far too valuable for individual consumer payments. The reality is that buying a coffee does not require the level of security and trustlessness that Bitcoin offers; it can be more than adequately handled on second layer solutions denominated in Bitcoin. Using Bitcoin for consumer purchases is akin to driving a Concorde jet down the street to pick up groceries: a ridiculously expensive waste of an astonishing tool. Consumer payments are a relatively trivial engineering problem which the modern banking system has largely solved with various forms of credit and debit arrangements. Whatever the limitations of current payment solutions, they will stand to benefit immensely from the introduction of free market competition into the field of banking and payments, the most sclerotic industry in the modern world economy, owing to its control by governments that can print the money on which it runs.
If the consumer-payments view of Bitcoin were correct, the rise in transaction fees would hurt adoption of the network, leading to stalling in the price, or a drop, as the network is relegated to the status of a curiosity. On a day in which the price of a Bitcoin hit $2,000, this is becoming an increasingly untenable argument. From the settlement layer view, the growing adoption of Bitcoin is increasing its liquidity internationally, allowing it to compete with global reserve currencies for increasingly more valuable transactions, causing transaction fees to rise. As this processes continues in the future, expect much higher transaction fees, and a global Bitcoin settlement network to grow in importance.
]]>The article proposes a name for the minimum number of individuals within a collection of groups necessary to represent greater than 50% of any of those groups. The name proposed is “minimum Nakamoto coefficient”.
I’m not fond of naming things after Bitcoin creator Satoshi Nakamoto. I understand that it’s often done out of respect for Nakamoto and what he achieved by inventing, programming, and maintaining Bitcoin—but it’s also often done to in order to promote a product or an idea by associating it with Nakamoto’s well-deserved fame.
I suggest that we name products, ideas, and other things after the people actually involved in creating them or with other unique branding.
In this case, English actually already has a word for describing the minimum number of individuals within a group necessary to represent more than 50% of that group: majority.
That means we can either call this concept the minimum Srinivasan-Lee coefficient or descriptively call it the minimum majority measure. I’ll use the later term in this article as I don’t want to name things after people without their permission.
Srinivasan and Lee measure 6 things for their minimum majority calculation:
I think it’s notable that all six of these things don’t have to be—and ideally wouldn’t be—measurable. Let’s go through the list again:
Hashrate is only measurable because miners choose to put their names into blocks—wasting block space and making themselves the target for attackers in the process. Ideally, we’d have many small and anonymous miners.
Full node versions are routinely faked on the network today. Ideally, people would stop paying attention to this statistic so that developers could use it as intended to figure out which versions were still popular enough to require support; if that doesn’t happen, this field will become increasingly meaningless.
Developers choose what to put in their commit listings and many besides Nakamoto have chosen to give false names or even random strings. Ideally code changes and reviews would be conducted entirely anonymously, at least until the change was deployed, so that there’d be no reason to compromise developers.
Full node IP addresses are also easy to fake, although at some cost per IPv4 address. Ideally, everyone would use Tor or a stronger anonymity relay network.
Exchanges have been known to publish fake volume numbers or to craft policies that lead to high amounts of volume in the absence of underlying demand. Ideally exchanges wouldn’t keep unnecessary logs of their customer activity.
Balances are something that could be much more distributed today given that new addresses are free to create and free to use if you’re receiving a new transaction anyway. Ideally something like confidential transactions will deployed on Bitcoin in the future so that it won’t be possible for third parties to monitor balances.
Given that we will hopefully work towards making these things harder to measure in the future (particularly hashrate and balances), I think the minimum majority measure has limited utility even without any other problems.
Given that things such as miner names, full node versions, developer commit listings, full node IP addresses, and exchange volume can be faked, one needs to subjectively adjust for that possible faking. This makes measurements more arbitrary and comparisons more difficult.
For example, 21’s own bitnodes node monitoring service, which is used as the source for two of the measurements, only counts nodes that accept receiving connections. By some measurements, this represents less that 5% of the total node count—but that alternative measurement has its own problems which need to be corrected for.
Edit: This section was slightly rephrased to address a concern from the original authors about the phrase “objective”. (diff)
Bitcoin users want many things, but I think the most important is that they don’t want their bitcoins to disappear from their wallets or become unspendable. There are two ways this can happen in Bitcoin:
A reorganization of the block chain can undo previous transactions, removing bitcoins from the wallets of the people who received those transactions.
A consensus change can invalidate bitcoins that were previously valid and spendable.
The defense against reorganization is mining (hashrate) decentralization. A majority of hashrate can theoretically reorganize the chain as far back as they want, invalidating any transaction, and (theoretically) at no extra cost.
Less than a majority can also reorganize the chain to invalidate a previous transaction, but they have to sacrifice resources to do so and that sacrifice is greater the more confirmations a transaction has but lesser the more hash rate the attacking miner or miners control.
Here’s a quick plot I made back when the block reward was 25 BTC per block and transaction fees were negligible (so I could ignore them and Bitcoin Core’s anti-fee-sniping):
If no miner controls more than 1% of hashrate, then once-confirmed transactions are pretty safe against attacking miners (though not accidental conflicting blocks). If no miner controls more than 10% of hashrate, then six-confirmed transactions are quite safe.
That’s the first type of decentralization Bitcoin needs—mining decentralization. The minimum majority measure only applies here to the first part, where we worry about a miner or mining cartel with greater than a majority share; the minimum majority measure doesn’t consider that we also have to worry about a minority who are willing to spend money to make their attack.
If every Bitcoin user wanted to pay Alice more than they wanted anything else in the world, Alice would get to define the Bitcoin consensus rules—but that means the safety of your bitcoins would depend entirely on Alice’s policies.
However, if half of all Bitcoin users wanted to pay Alice more than anything else and half wanted to pay Bob more than anything else, then Alice and Bob would have to either agree on the consensus rules or split the network with different rules. This would be a bit safer: if Alice decided to steal your bitcoins, there would at least be a chance that Bob wouldn’t.
As we extend this from Alice and Bob to Charlie, Dan, and more and more people who someone wants to pay, there are more and more people who have a say in defining the consensus rules—even though on average they each individually have a smaller say.
What they can do to combine their voices is to choose software that automatically enforces the rules they think are important and the non-objectionable rules that they think other people think are important.[1] That’s what full nodes do, and the more people who use full nodes to process the payments they receive, the harder it is to change Bitcoin’s consensus rules in a way that would hurt you.
I believe this is what Nakamoto was trying to describe when he said that he didn’t think that alternative implementations were a good idea. Even with two or more implementations of what the developers and users think are exactly the same consensus rules, there’s a chance that an accidental bug could divide that economic union.
Some people worry about developers attempting to take control, but the defense against that is for other developers to review their code and sound an alarm if they see something inappropriate. Creating multiple codebases creates more work for reviewers, increases the chance of consensus-breaking bugs, and ultimately weakens the economic union that enforces the consensus rules.
There is no way I know to measure economic enforcement except by attempting to change Bitcoin’s consensus rules. Happily, after several years of people expending considerable resources to do that, the rules have only changed for the better and in relatively small ways (BIP66 strict DER, BIP65 CLTV, BIP68/112/113 sequence/RCLTV/median-time, and soon BIP141/etc segwit).
However, there is an important metric related to ensuring economic enforcement remains intact: Cost Of Node OPeration (CONOP), which is described in quite a bit of detail at the preceding link.
Srinivasan’s and Lee’s article attempts to quantify Bitcoin’s decentralization using metrics that aren’t objective, may not be available in the future, and some of which are entirely unrelated to the reasons Bitcoin needs decentralization—or even contrary to keeping the system decentralized.
An alternative strategy that has been reasonably successful at maintaining decentralization on Bitcoin to date is to attempt to mitigate problems known to cause centralization among miners (e.g. the original Fast Block Relay Protocol [and Network] to mitigate the high orphan risk that caused GHash.io to obtain a majority of hashrate even after executing a $100,000 double spend attack) and to keep cost of node operation low to ensure large numbers of people can validate the transactions they receive with their own full nodes.
I personally suspect that Bitcoin’s steadily improving privacy will prevent us from ever measuring decentralization in a truly objective way. Losing easy quantification but gaining stronger privacy seems like a good tradeoff to me.
Full nodes users also have to enforce the non-objectionable rules they think other people think are important in order to form a unified economic bloc. For example, if Alice thinks the 1 MB block size is important but doesn’t care about subsidy halvings and Bob things subsidy halvings are important but doesn’t care about the 1 MB block size, they can form a economic union stronger than either of them individually by each enforcing both rules. ↩︎
The Bitcoin Dominance Index was put together a few years ago to show exactly how much of the entire cryptocurrency economy is dominated by Bitcoin. Recently, the Dominance Index has been dropping and many point to the scaling debate within the community as a convenient reason why.
The argument goes something like this. Bitcoin isn’t as useful anymore as the on-chain fees are too high, therefore, people are looking at alternatives to Bitcoin. Thus, value is flowing out of Bitcoin into other currencies and this can be clearly seen in the lack of Bitcoin dominance. Users want new features and they’re going to other coins to get it. If current conditions persist, then Bitcoin will eventually be overtaken by another currency such as Ethereum and Bitcoin will become the MySpace of cryptocurrency.
Essentially, the argument rests on the idea that users are looking to do X with Bitcoin, but can’t and therefore they’re going to other coins in order to be able to do X. X can be buying coffee, utilizing a form of the lightning network, creating a smart contract, engaging in more private transactions, utilizing decentralized apps or some of the many things that other coins are purportedly better at than Bitcoin.
The sentiments of this argument are understandable. People are frustrated with the scaling debate, they don’t like that there’s conflict and would prefer progress, but let’s look at the actual evidence.
First, saying that Bitcoin isn’t useful anymore because fees are too high is like saying that nobody goes to that restaurant anymore because it’s too crowded. Bitcoin is very useful, that’s why people are willing to pay an average of $0.94/tx at the time of this writing to use it. The fact that some people don’t like having to pay high prices doesn’t mean everyone will leave. Some may, but the fee market is self-correcting. If enough people leave, the fees come down, making Bitcoin transactions more attractive.
Second, arguing that value is flowing out of Bitcoin into other currencies would make sense if Bitcoin wasn’t currently near its all-time high. Price going up means that there’s healthy demand for Bitcoin that outstrips supply. The only reason there’s any complaining at all is because Bitcoin isn’t going up as fast as other coins are, but with 500+ altcoins in existence, that’s almost always going to be true of some coin. This is like saying that value is flowing out of Berkshire Hathaway while the price is going up because other stocks are going up even faster. Demand for Bitcoin has very clearly been going up the past year and it’s ridiculous to dispute that because of its slower growth relative to other, much younger and more volatile coins.
Third, the argument that users are going to other coins to take advantage of its features is not really backed up by evidence. How many users buy Ethereum to have enough gas to execute a smart contract vs those that don’t even know how to use a wallet and just keep their balances on exchanges? How many users use Zcash’s privacy features (answer: not many)? Litecoin recently got Segwit and Lightning Network, but how many people have even tried using that vs the people that are buying in anticipation of other people using it? The vast majority of the demand for these coins is speculative based on future usage and very little about current usage.
About the only real current usage would be to make small-ish transactions. And perhaps, for the small portion of transactions that fit in that category, maybe some value has transferred to other coins that offer lower fees. Medium of exchange can be a legitimate reason for someone to switch to another coin, but as I’ve argued before, store of value is the main reason Bitcoin has most of its value and therefore, this isn’t a significant outflow.
Just to be clear, speculating on future utility is a perfectly legitimate form of investment, but let’s not mistake speculation with current utility. Speculation generally has the property that there’s a pretty large risk of failure and very frankly speaking, many of these coins have a lot of risk, specifically of their features not being a great fit for the market at large.
To give just a couple of examples, Namecoin at one point had close to $100M market cap back in 2013 and was at one point thought to be a solution for a decentralized domain name service among other things. Unfortunately, most people found that the idea wasn’t quite as useful as thought and most domains on Namecoin are squatted and very few people use the .bit domain that it provides.
Auroracoin at one point had close to a $1 Billion market cap back in 2014 and was at one point thought to be the digital currency that would be used in Iceland. It turned out that the market cap was largely manipulated by very low liquidity and the coin quickly capsized when more became available.
Many other examples can be seen at Altcoin Obituaries.
This brings me to another point. The market caps on a lot of these altcoins are hugely manipulated. Consider one of the original manipulated altcoins: Ripple. They premined all the coins! That is, they created all Ripples beforehand and only released them to the public a bit at a time.
There’s a huge amount of Ripples that are being held in reserve so that the actual float (that is, amount available to the public to trade) remains relatively small. Many premined coins do the exact same thing to manipulate not just price but their market caps. Only a small portion of the coins actually are traded while a big reserve sits on the side owned by their creators to keep the market cap of the coins high.
This isn’t anything new and in the stock market, stocks that play float manipulation games generally become juicy targets for short-sellers. Altcoins like Gnosis, for example only floated 5% of their coins, so ask yourself, how much of Gnosis’s $115M market cap as of this writing is real?
If that isn’t confusing enough, also consider that many of these altcoins are actually subcoins of Ethereum and much of the market cap may be double-counted.
If that last section was too confusing, consider this thought experiment. Suppose I make a new coin tomorrow called FoolCoin. I premine the whole thing (100,000,000 coins) and only make 10 coins available. Perhaps I create a marketing campaign and even get enough people to desire the coin that Poloniex lists it. I sell just 1 of the coins for 10. FoolCoin now has a 1 Billion market cap. The next coin, I sell for 11 and now FoolCoin has a 1.1 Billion market cap. If there’s enough demand, I eventually end up selling the other 8 coins for 20 each at which point, FoolCoin now has a 2 Billion market cap.
I’ve just added $2 Billion dollars to the cryptocurrency market cap and have reduced Bitcoin dominance by a few percentage points. But did I really take anything out of bitcoin other than perhaps a few hundred dollars worth?
The scenario I’ve laid out for FoolCoin doesn’t even assume the more sinister manipulation activities like wash trading, pump and dump, etc. Even without resorting to those, it’s relatively easy to add a lot of market cap to the cryptocurrency index to make Bitcoin look much less dominant.
First, Bitcoin is very healthy. Healthier than ever in terms of price, market cap, usage, censorship resistance and pretty much every metric utility-wise. To say otherwise is to ignore the market signals.
Second, altcoins are themselves getting a lot of investment, but that doesn’t necessarily mean that people are using them for their current utility. In fact, a lot of the price increase for altcoins looks like speculation on future utility, not current utility.
Third, market caps of many altcoins are seriously manipulated. Many have ultra-low liquidity and actually don’t have that much money invested in them, despite the large market cap. These altcoins aren’t taking anything away from Bitcoin as much as they are pumping themselves up.
Like with most things, Bitcoin Dominance is a very crude metric and one that’s unfortunately very easy to manipulate. The recent enthusiasm for ICOs has made the manipulation even worse and continues to hide the fact that Bitcoin is doing really well. As the manipulation gets more and more obvious, expect this metric to be replaced by something more useful.
Thanks to Aaron Caswell.
]]>John Maynard Keynes famously said that “the market can stay irrational longer than you can stay solvent.” But the converse is also true: the market can become rational suddenly, and sooner than you expect. When people come to expect irrationality as a matter of course, then they are vulnerable to a sudden onset of rationality. Crashes and hyperinflationary events can be treated as events caused by a society that has gradually become complacent in its irrationality. A crash happens when people become too committed to particular enterprises and there is no one left to help out with a mistake. Hyperinflations happen when people begin to accept lower levels of inflation as a matter of course.
Understanding these phenomena is a matter of understanding when people prefer to hold cash or buy investments, the effect that this decision has on the economy, and how inflation of the money supply changes the incentives of the decision. That is what this article is about, and here are my definitions of the concepts I’ll be discussing.
Money: Money is an abstract concept that applies to whatever good is the most liquid. The value of having money, from the standpoint of an investor, is that it is the easiest good to get rid of in the market, which is what it means to be the most liquid. This means that if there is something especially good for sale, the person with ready cash on hands gets first dibs on it.
Cash: Different goods can be money at different times. Because I want to talk about the process by which a good loses its status as money, I will use cash to refer to a good that is money now, but in the future might no longer be money. If that happens, the status of money would switch to some other good, and cash would become worthless paper or worthless numbers in a computer. Whereas money is an abstract concept, cash is a specific good.
Savings: the portion of an investor’s portfolio held in cash.
Investment: goods other than cash which are bought because of an expected future benefit rather than for immediate consumption. This could be because it provides income, like a bond or a stock with a dividend, or because you expect its price to go up eventually. I don’t distinguish between different kinds of investments because the difference is not relevant to the issues I am discussing. If I use a company stock as an example, I could just as easily be talking about a bond, or commodity future, or a baseball card, or anything. When I say ‘stock market,’ I’m talking about the market for all investments, not a literal stock market.
This article is entirely about cash versus any other investment and why someone would prefer one over the other, so that is why cash is not considered an investment for the purposes of this article. However, cash can be an investment in the sense that someone might buy it because he anticipates it becoming more expensive later. If he expect a stock market crash, he can go into cash with the expectation that you’ll be able to buy stocks again more cheaply once the crash happens. One can also hold cash without investing because cash has a present benefit, which is its liquidity. This is discussed in more detail below.
Inflation: Inflation here refers to an increase in the money supply rather than an increase of prices. The reason is that if an investor knows the money supply is increasing, then he will anticipate his cash growing less valuable relative to what it would have been if the supply had not grown. He will do this even if there is no apparent price inflation yet. In general, investors learn to react to causes in anticipation of price changes because if they wait around for price changes to actually happen, then they have missed an opportunity.
This article presents an idealized picture of the economy in which it is objective what is money and what isn’t, and in which the money is managed by the issuer in a very simple way, that is, by issuing more. Our economy is a lot more complicated, but I would contend (without defending here) that the way to understand the real world is to unravel the mess and find this idealized scenario within. I don’t think that the real-world national currencies work in a fundamentally different way from what I have described.
I recently wrote an article on the growth of money called “It’s Not About the Technology, It’s About the Money”. This article can be seen as a continuation of that one, but it can be read independently. That article is mostly about a positive-feedback between the use of money and its value. That is, as more people use a good as money, it becomes more useful as money, as a result of becoming more liquid. This article is about how money interacts with the rest of the economy after it has matured and about how mismanagement by an issuer can cause it to fail.
One thing that confused people a lot about Bitcoin in the very early days was how could it possibly be valuable, given that it’s nothing but a bunch of numbers in computers. It’s not that people were foolish to think that Bitcoin wasn’t valuable back then; actually they were foolish for not asking the same question about all forms of money. For already at that time people were paying real dollars for numbers in a computer (World of Warcraft gold or Farmville upgrades), and most real dollars were by that time also nothing more than numbers in a computer. Thus, there was nothing special about Bitcoin as a form of money.
What prevents us all from just throwing our dollar bills on the ground and saying, “These were all just pieces of paper all along! Why did I ever think they were valuable?” Seemingly not a likely scenario, but no currency lasts forever. I will argue that money serves a valuable function in investment, and the benefits which accrue to those who invest successfully in money explains why people are willing to hold on to it.
First I wish briefly to dispel the notion that money’s value derives from its use as a medium-of-exchange. Money is useful as a medium-of-exchange because it is valuable, not the other way around. This can be seen to be true by the fact that you can use money as a medium-of-exchange without adding to its demand. If you earn a bunch of money and then spend it again almost immediately after, you’ve used the money as a medium-of-exchange but you got rid of it so quickly that you have immediately negated the effect of demanding it.
In order for the value of money to go up, people have to want to hold more of it at a time or hold it for longer periods of time. In other words, the value of money is caused by its demand for use as savings instead. Someone can live hand-to-mouth and have only an amount of money they need on hand for the immediate future. Other people can have a large savings but still spend roughly same amount that they earn. Other people can spend less or more than what they earn in order to increase or decrease their savings. The value of money can be understood in terms of the reasons that make people want a lot of savings or a little, and changes to the value of money, both slow and rapid, can be explained in terms of reasons that change how much people value their savings.
Here is a very real benefit of holding cash. People with cash are able to remain agnostic as to what they want to buy until the very last moment. They are more prepared for unexpected expenses and opportunities, and therefore free from the need to plan. A person with savings can treat as ordinary expenses things that would be disasters for people who didn’t have savings. Most people, if they have a big enough income, would choose to buy insurance for their car, home, or health. But someone with a lot of savings doesn’t need as much help from other people.
He is also more in a position to help other people who have been struck with disaster. Not only is he in a position to be nice if people should need help, but he is also in a position to profit from doing so. A business has certain expenses that it must make regularly or go out of business. It must make payroll, for example. There is always some risk that the company will not have enough revenue for some time. The company could reduce this risk by holding extra cash, or it could use the cash to buy more capital and attempt to expand its future production. It is difficult to maintain the right balance because circumstances are constantly changing and uncertain, so even fundamentally sound businesses sometimes end up in an immediate need for cash. When that happens the business’s stock price goes down because their risk of insolvency goes up. They may also be willing to take out a loan at a very favorable rate for the lender. An investor with cash on hand can help an otherwise worthwhile business survive by taking care of their immediate expenses and in return can buy the stock at a good value or earn a good rate of interest off a bond.
However, this kind of opportunity does not last forever. Investors who have cash get first dibs on it. When one is in cash, one is uncommitted and ready for opportunity. By contrast, a lot of the potential value of an investment depends on being able to choose when to sell it. A given investment can always go down for a while, even if the investor ultimately is able to sell it at a profit. An investment has a much better chance of being valuable if the investor can expect to hold it long enough that a good selling opportunity will have occurred. Furthermore, although on ordinary days it may seem as if a stock will be easy to sell at any time, there are days when most investments other than cash drop at the same time. During these days it may not be possible to sell investments fast enough and it is much better to have cash on hand in the first place.
Thus, a cash-holder benefits himself by being prepared to take advantage of the best deals, and provides the corresponding benefit to the economy of being prepared to jump in where help is needed. The cash-holders benefit the economy by deciding which troubled businesses can be redeemed and then providing the necessary cash.
Of course, it is not the cash itself that fixes the troubled business. The cash is used to buy the necessary resources to do so. For example, it could be used to pay employees to keep them working until some new revenue comes in. Thus, the existence of cash-holders in an economy can be thought of as meaning that some fraction of the economy’s production is reserved to be diverted to error correction.
A cash-holder can live idly and can avoid making investments. It would be a mistake to look at this person and say that he is not contributing anything. The ability to live idly is also an ability to become committed at any time, to whatever has the greatest need. People depend on this service because it is impossible to avoid error, and insofar as everyone in the economy depends on everyone else, we are all subject to one another's’ errors.
A person who is uncommitted cannot step in to fix every problem that might arise. Eventually he will be committed himself and can take on no additional projects. Therefore, if there is a lot of money held in cash, then there is a lot of tolerance for error in the economy, whereas if there is little, then the economy is much less error-tolerant. Thus, the problem of overinvestment is a reduced capacity for error-correction. If everyone decides to put their money to work now, then theoretically more can be accomplished at once, but at a much greater risk of failure. If a lot of cash-holders remain on the sidelines, then less can be ventured, but at a greater probability of success.
Because an error in one business can affect the businesses that depend on it, then when people are overinvested, not only is there a greater risk of error, but the consequences of errors are more severe. For example, suppose that two businesses, A and B, both make short-term errors that require correction. In a healthy economy, maybe one or the other would have failed, but the other would have been rescued, whereas in an overinvested economy, both fail. Now suppose that business C can tolerate either A or B failing to follow through on a deal, but not both. Then C also needs to be rescued. However, it too evidently fails as well.
Thus, it is possible, in an overinvested economy, for a small error to turn into a big error because there is no one prepared to fix it while it is small. This is an economic crash. When too many people become invested and not enough remain uncommitted, then everyone in the economy must move in lock-step with one another. In a healthy economy, there is a lot more room for everybody screw up.
I am now in a position to talk about why money persists, despite the fact that it is merely a shared hallucination. Why don’t people, so to speak, wake up and throw their money on the ground? In my previous article I explained the growth of money as a step-by-step process in which a good becomes monetized as one investor after another comes to treat it like money.
One might also suppose that the opposite process is possible, in which investors lose confidence in their money as they successively dump it, one by one. In order to explain the persistence of money, we would need a reason for someone to want to buy cash that another person wanted to dump.
Let us suppose that an investor was actually worried about his cash losing all value. This person would prefer to hold investments over cash under circumstances in which someone else would prefer to hold cash. Or, conversely, let us suppose that he loves stocks so much and doesn’t understand the value of cash very well that he sells everything so as to be fully invested. Either way, the effect is the same. When he sells cash for investments, he very slightly increases the price of the stock market relative to the supply of cash. He has therefore very slightly increased the demonetization risk of cash and simultaneously the risk of a crash in the stock market.
The other investors may respond to his move by judging the demonetization risk or the stock market crash risk to be greater. If they judge the crash risk to be greater, then they will sell off stocks for additional cash, thus opposing the first investor’s action. If they judge the demonetization risk to be greater, then they will follow him and dump their cash themselves.
An old and consequently well-established currency will tend to be perceived as secure because the investors have a lot of experience seeing one another rely on cash as a safe haven. Thus, they will tend to (correctly) perceive the stock market as more risky than cash. On the other hand, if there is reason to believe that other investors are losing confidence in their money, then it is possible for other investors to prefer the stock market risk to the currency risk. If enough of them do this, then the currency is demonetized, just as they had feared.
The persistence of money, therefore, is explained by the fact that there is a more immediate need to reduce risk from investments rather than from demonetization. There is even a natural price for money. It is not like an ordinary price, which is the ratio by which two goods are exchanged. But you can think of the price of money as being the ratio of the total supply of money to some measure of the value of all investments in the economy. (In the real world, there are many different numbers that one could use to represent this price because people can disagree about how to correctly measure each of these.)
This section is about how changes to the money supply change investors’ incentives about whether to hold cash or to be invested. Deflation is when the supply decreases, and inflation is when it increases. The most important thing about changes to the money supply is that they happen at specific places as a result of specific actions. Whenever there is deflation, there is a deflator. Whenever there is inflation, there is an inflator. In other words, money doesn’t generate or disappear evenly—some specific person holds it.
Deflation is true charity because the deflator works or invests to earn money and then destroys it rather than demanding anything back. Therefore, people don’t do it very much. Inflation is the one you need to worry about because the person who does it gets money for nothing. That means everyone would do it if they could get away with it. Someone who can just print up money has a big advantage over someone who actually saves money because he can print up more whenever he wants. He can take advantage of good deals immediately rather than putting in the work of collecting a sum of cash in the first place. Therefore, someone who can print money discourages everyone else from holding cash. They are incentivized to invest instead.
Of course, the inflator does not actually do anything to cause more resources to come into existence to match the new money he creates. He drives people away from their saving and into investments. Prices rise because they are all buying. There is no one left to who is prepared to correct errors. The investors cannot because they have reduced their savings. The inflator cannot because prices have risen and production cannot be diverted as easily as before. Thus, although the inflator appears, to the rest of the economy, like an investor with a lot of cash on hand, the economy is not safe. It is overinvested.
A crash occurs when an unstable market sustains an error that spreads throughout like a row of dominos and investors flee back into cash. In order for a demonetization event to occur, the currency risk must remain greater than the stock market risk, even as more and more investors pile into stocks. The scenario I described above is possible, but it is kind of weird because it describes a demonetization event with no cause other than one lone investor with very infectious paranoia.
However, with the right inflation schedule, an inflator can cause this to happen. The greater the rate of inflation, the more will investors prefer the risk of investment to the safety of cash. The economy can still function without an established form of money, or with an alternative money, so there is always some rate of inflation that is too high to be sustainable. All that must happen is for the inflator to be driven to bring the rate of inflation up to the level that it becomes preferable to stop holding cash.
As the inflation rate increases, and as investors more and more prefer to take on risk, the error-correcting function of cash-holding is reduced without, at first, being replaced by anything. Instead, the economy must change so that errors are less likely in the first place. Enterprises must become more self-sufficient, and less reliant on long-term profits. In other words, the economy becomes more primitive.
If the economy compensates more quickly than the inflator can spend his new money, then he can find that he must inflate at faster and faster rates in order to sustain the same level of consumption. If he is unwilling to reduce his level of consumption, then he can reach an unsustainable rate of inflation. That is when people start to think of their cash as paper or meaningless numbers rather than stores of value.
I think of this article as being the last of a trilogy, the first two being “Reciprocal Altruism in The Theory of Money”, and “It’s Not About The Technology, it’s About the Money”. The first article is an attempt to explain the use of money as a game. The second is about the growth of money, and this last one is about the death of money.
Because just about any good can be used as money, it is better to think of money as a behavior rather than as a thing. The money good is often something that is not very useful; it is something that is easy to count and difficult to reproduce. Money is rarely demanded to be consumed. Even something gold, which has important uses in industry or as jewelry, is more often just stored away. It is not, therefore, the nature of the specific good that is used which makes money useful. It is the way people treat it.
The way that people treat money is as a thing which is good for being liquid, or in other words, a thing that is always demanded everywhere. This is not an intrinsic property of any good. It is a property that is established by tradition. Every time people accept money, they are reinforcing that tradition. They are also making an investment in it, because there is no guarantee that the tradition will be as strong by the time they get around to spending the money. But as long as people continually make that investment, the tradition continues.
Despite the fact that people who acquire money do not necessarily have benevolent feelings about doing so, it makes sense to look at money as a form of altruism known to biologists as reciprocal altruism. In reciprocal altruism, one animal does something at its own expense which is immediately beneficial to another. The animal can afford to do this because it lives in a community of altruists, so it will eventually benefit from another animal’s altruism.
A necessary condition for reciprocal altruism to persist in a population is for non-altruists to be identified and excluded. Otherwise a group of moochers can live off the altruists and grow until altruism is unsustainable. This is accomplished in a money economy by the fact that people can’t have a negative balance. People must be altruists first (earn) and beneficiaries second (spend).
Altruism may at first appear to be a strange way to look at money because it is understood that people acquire money for selfish reasons. However, in biology, there is no such thing as true altruism, or at least if there were, they would soon be exploited to death. There is only apparent altruism. The theory of reciprocal altruism tells us that it is possible for an animal to appear to be altruistic in the short term, but later to receive help from others when it cannot help itself. If an alien came down to Earth, and observed a miser he might well see the miser’s behavior as altruistic because the miser appears to work hard at others’ bidding without receiving anything useful in return. Only after the alien observes that everyone else also attempts to acquire money would he understand the miser’s selfishness.
Because money being a social behavior, so its value depends on the society using it rather than the physical nature of the good being used. Because there can be more or fewer people using a kind of money and because they can demand more or less money, a kind of money can be more or less useful depending on the society in which a person finds himself. In other words, a person can find himself in a more or less altruistic society, and as a result, his money can be more or less valuable.
The network effect explains the initial growth of money out of a good which may have very little value initially. Because an initial investor in money will be rewarded much more than a late investor, initial investors have some incentive to take on additional risk and grab some when it is worthless. In doing so, they make it more immediately useful because they provide some initial demand that others can rely on. As money grows, there is a line of investors, begining with the most prescient, which leads money from its initial state to its central position in the economy.
The death of money follows the same process, in which the most prescient investors flee first, followed by more and more people until it no longer has value as money. This could theoretically happen on its own but one would expect it to be instigated by a superior competitor coming on the market or by an inflationary monetary policy which makes it a lot less useful.
The network effect explains why money grows and shrinks, but it does not explain why money would reach an equilibrium. It also does not explain why people hold more cash than they need immediately. The reason is that cash serves an investment function, so investors need to hold large amounts of it. The equilibrium value of money is the point where investors no longer prefer to hold more cash, and instead prefer to hold more stocks or bonds or other investments instead.
That is what I think of money. Now, for the good of society, earn as many bitcoins as you can!
I wrote an article a couple years ago called “Who Controls Bitcoin?” which argues that it is not the miners or the core devs who control Bitcoin; rather, it is the investors. Recently, a fork occurred in the Ethereum blockchain which is illustrating my point. In response to the exploit of the DAO, The Ethereum devs instituted a hard fork (ETH) which re-wrote history so that the exploit never happened. However, those who reject the idea that Ethereum’s blockchain can be retroactively altered at the whims of a governing body have rejected the hard fork. Ethereum’s original chain is now called Ethereum Classic. I hope I can finish writing this article before ETC sucks all value out of ETH! This article is about why such an event is possible and how the choice between ETH and ETC is different from that between Bitcoin and an altcoin.
My interpretation of this event is that Ethereum was billed as a distributed system and the DAO as a legally binding contract[1] written in code, and this is what the investors wanted when they bought into it. The idea that the Ethereum developers can just rewrite history whenever they please completely negates this purpose and clearly demonstrates Ethereum to be a sham. However, investors don’t have to let Ethereum be a sham because they are ultimately the ones in control. All they have to do is take a little risk and sell some ETH for ETC. If enough of them do this, then ETC will become the established chain.
I’m very excited about ETC. If ETC wins, then not only will my favorite hacker get to keep his legally acquired money, but Ethereum will have shown itself to be a truly censorship-resistant system.
In fact, I’m so excited that I actually bought some ETC recently. This is the first time I have ever bought an altcoin. Kind of ridiculous since I just wrote an article called “Ethereum is Doomed”, so feel free to make fun of me (as if I could stop anyone). However, I am not making a bet that Ethereum will ultimately win. I am making a bet that ETC will beat ETH. I still think that it will be years before nontrivial smart contracts will be reliable enough as to be safe to use and that there is a real risk the money won’t hold out long enough for it to happen. But this is such an unusual opportunity that there might never be another one like it. No one will try to do anything quite as stupid as the Ethereum devs again, so there will not likely be such an obvious choice in the future. That this is a kind of event that has not happened yet, but which I have been imagining for some time. If there were ever a time and place for me to be less confused than everyone else, it would be this.[2]
A business can be a good investment even if its stock price does not go up. If it is viable, it may eventually pay out dividends, and if it grows, it will increase its assets. If other people are stupid enough not to notice, what of it? The business owners are in fact wealthier. One might even prefer its price to stay low or even go down so that one can buy more. Of course, that is a vain hope in the long run because if it pays out at a better rate than other businesses, than other investors will buy it until its dividend yield is similar to the rest of the economy.
By contrast, currencies have no yield and do not grant the holder rights over a productive asset. Consequently, the only way to grow wealthier off a currency is if other people actually do bid up the price. Investors in a currency, therefore, must contend with a risk that is independent of the intrinsic merits of that currency. They must risk the possibility that other people will be too timid to follow them. The first person who invests in B risks the possibility that no one is willing to be the second person; the second person risks that no one is willing to be the third; and so on. If this process fails then currency B will turn out to be nothing but hype. If it succeeds, then currency A will become a dead tradition.
Currency B could be objectively superior to currency A, but it would still fail if not enough people take a chance on it. The first person might realize that currency B would be better if it were to take over, but if he knows that there is no second person around who will be able to convince himself that a third person will follow, then he might as well not bother investing in currency B at all. See “It’s Not About the Technology, It’s About the Money” for a much more in-depth discussion of the risks of investing in a new currency.
In the previous section, I described the transition from one currency to another as an unbroken chain of investors starting with the most visionary down to the last few people scrambling to get some value out of the old currency before it fails completely. The risk of investing in a new currency is that there might not be a chain like that. Maybe you buy a new currency, and then a few more people buy it after you… and then nothing. Early on, that’s a big risk because it’s hard to predict what people will do. Later on, it’s less of a risk because it will be obvious that the old currency is rapidly losing value.
There is a similar risk in investing in a fork of a new currency, but it’s much much less severe. There still has to be a future chain of investment to make a new fork win over an old, but it does not have to include everybody. The difference is that when the new chain is created, everyone who owned the currency beforehand automatically has units from both chains. Because everyone is automatically hedged between the forks, most currency holders do not have to take any action or even realize that anything is going on in order for one chain to win over another. The actions of a few investors can cause one fork to win over the other. People can choose to pass without affecting the outcome. If they just keep their ethers and don’t do anything, they will eventually have all their value stored in whichever fork wins.
Consequently, the competition between two forks of the same currency is much more about their intrinsic merits than about worrying what everyone else is doing. I have often told people that an altcoin cannot defeat Bitcoin by making incremental improvements to it; it can only do this by being as great an improvement over Bitcoin as Bitcoin is over the dollar. Because there is less inherent risk in investing in a fork rather than in a new currency, a fork can succeed more easily by making incremental improvements.[3]
It is helpful to think of Ethereum as being both ETH and ETC together rather than to think of ETC as an alternate to ETH. Speaking of that, I have a customer suggestion for Poloniex: it should be possible to display charts in terms of ETH + ETC (or more generally as a sum of all the chains of a given currency being traded). Ethereum should be seen as both ETH and ETC together, and they should not be seen as separate currencies.
The conflict between ETC and ETH is about whether the devs can neuter their own creature in order to protect themselves from it. It is not about fixing a bug or about whether the DAO hacker deserves to keep his money. It is about whether the developers exist for the benefit of Ethereum, or Ethereum for the benefit of the developers. I want to draw the reader’s attention to a quote from Emin Gün Sirer which I also used in my previous article on Ethereum:
Had the attacker lost money by mistake, I am sure the devs would have had no difficulty appropriating his funds and saying “this is what happens in the brave new world of programmatic money flows.”
In other words, if the developers have the ability rewrite history in order to fix bugs in any random script that someone uploads, then they have a level of discretion over what Ethereum does. For any bug that might happen in the future, they might well give many reasons not to fix it. They might say that it is not severe enough to risk a hard fork. They might say that it is not their responsibility to patch up every contract that was written incorrectly. Or they might be nice and agree to rewrite history for someone important enough. It is also not always objective that any behavior which a program exhibits actually is a bug. If the developers could have provided plausible arguments either way, then they can manipulate the system to their own benefit.
I am not arguing that there is a “slippery slope” from Ethereum to a some kind of feudal manor lorded over by Vitalik Buterin. I think that any level of discretion on the part of the devs weakens Ethereum as a platform, and therefore an investor who wants to make the most money would prefer to reject it completely. If the developers have the opportunity to identify undesired behavior in a program and revert it at their discretion then they can invest in anything they like, and then find a bug in it and revert history if the investment doesn’t work out. I’m not saying this has happened, just that you shouldn’t design systems which are open to abuse.
I want to draw an analogy to F. A. Hayek’s concept of liberty which he explains in The Constitution of Liberty and Law, Legislation, and Liberty. Hayek said that people had liberty when their laws are written as abstract rules rather than as responses to specific situations. Another analogy I might make is to John Rawls’s A Theory of Justice and his concept of the veil of ignorance. The idea of the veil of ignorance is that behind it, we do not know our own social position. If we design our society behind the veil of ignorance, it will be designed for the common good rather than for special interests. In granting the devs discretion, they no longer operate behind a veil of ignorance.[4]
Those who have chosen ETC have chosen abstract rules over arbitrary interventions. They have said that the developers will be designers, not rulers. This is a choice that I respect. Furthermore, if ETC succeeds, the initial investors in it today will become disproportionately influential over it as it grows. Therefore, the intelligence which characterized its inception will continue to influence its evolution in the future. I would then have to consider it the strongest Bitcoin competitor yet.
I would really like to see ETC succeed because I think that today many people think of the idea of a network fork as a very scary and destructive idea, whereas I think that enabling people to create forks and trade between them would be a much more effective way to promote the health of Bitcoin than the way we do it today. I think that many people see the creation of ETC is an underhanded and destructive tactic, whereas I would like it to be seen as a reasonable and respectable thing for unsatisfied investors to do. I would like the early investors in ETC to make money because then people would want to imitate them.
If it became easier for people to trade different forks of the same currency, then investors could get direct experience with different ideas without endangering the network. They furthermore have a direct means of promoting the upgrades they like without having to lobby. A market would allow for a smooth transition from one set of rules to another. Instead of some single discrete block in which the whole network upgrades, the composition of our balances by value shifts from one in which the new fork has almost none to one in which it is nearly all.[5]
The process will tend to benefit the Bitcoin network because investors will gain the most by promoting growth the most. Furthermore, anyone who attempted to subvert Bitcoin would tend to lose money.
I noticed the page setting forth the terms of the DAO has disappeared and I had to link to it through the Wayback Machine. If I wrote something like this, I’d be embarrassed too, but jeez guys, don’t make the 1984 comparisons so easy. Let me just quote the opening paragraph in full so that people don’t forget:
The terms of The DAO Creation are set forth in the smart contract code existing on the Ethereum blockchain at 0xbb9bc244d798123fde783fcc1c72d3bb8c189413. Nothing in this explanation of terms or in any other document or communication may modify or add any additional obligations or guarantees beyond those set forth in The DAO’s code. Any and all explanatory terms or descriptions are merely offered for educational purposes and do not supercede or modify the express terms of The DAO’s code set forth on the blockchain; to the extent you believe there to be any conflict or discrepancy between the descriptions offered here and the functionality of The DAO’s code at 0xbb9bc244d798123fde783fcc1c72d3bb8c189413, The DAO’s code controls and sets forth all terms of The DAO Creation.
This is why the DAO exploit was legal. If a bunch of computer code is a contract and there’s nothing else to explain what it is intended to do, then you can’t just point to some behavior it exhibits and pretend it never happened just because you call it a bug.
I am not saying that the bug in the DAO was not obviously a bug; I am saying that similar cases are possible which are not so clear-cut. The devs are opening up an endless unresolvable debate by intervening. Ultimately, the only way to distinguish between an obvious bug and one which is not so obvious is to have some subjective principle embodied in a bunch of specific cases that a human has to look at and make a judgement. That’s just the legal system we have now and I thought that’s what Ethereum was supposed to avoid. Also, did you know that DAO stands for “distributed autonomous organization”? Well obviously it’s not that if it needs a central body to fix it every time it screws up. ↩︎
Also, don’t take this as a recommendation. Just because I took a risk does not mean you should. ↩︎
Note that if ETC wins, the miners will have had nothing to do with it. The miners who chose to mine ETC instead of ETH chose it because it was more profitable to mine, not because they thought it was better. Thus, the miners do not control Ethereum. The investors control which fork is more profitable to mine, and therefore they control the miners. ↩︎
Although Rawls is considered to be more of a socialist and Hayek more of a libertarian, their philosophies are pretty similar, although I think Hayek's fits better here because Hayek specifically emphasized the importance of abstract rules, whereas Rawls is more interested in preventing class interests from influencing our politics.
Now note that I’m not saying here that Ethereum investors should necessarily be treated like free citizens with certain rights, as we would expect in a free society. They choose to buy into Ethereum. I’m saying that they can also choose to sell Ethereum, and if they’re not going to be treated like the people in charge, why shouldn’t they? It would be perfectly appropriate under some circumstances, such as in a MMORPG, to make a centrally managed currency with a bunch of overlords who try to ensure everyone has a good experience and who ultimately run everything for their own benefit. In that circumstance, however, I certainly wouldn’t treat the currency as an investment. I would expect the overlords do do all the work and risk of maintaining the value of the currency, which would only be possible if they had a steady source of revenue from satisfied customers of some actual service they provided. This is not something that the Ethereum Foundation does. ↩︎
If the reader is at all familiar with quantum mechanics, this is vaguely similar to the way that quantum mechanics allows for smooth transitions between states with different numbers of particles. Physical states can be superpositions of pure states with different numbers of particles, and the composition of the physical state can change from something closer to one pure state to something closer to the other. ↩︎
The Bitcoin world is full of people who know nothing about economics or cryptography; they only know that they could have made millions if they had not sold at the bottom. These people tell themselves that they are redeemable, that Bitcoin is just the MySpace of cryptocurrencies, that they will have another opportunity to get in early on some other revolution. These people can be dangerous, but most of them are easily preyed upon.
I think this may explain the origin of “blockchain technology”. It lets people talk as if clones of Bitcoin are important without having to remind themselves of Bitcoin. If someone says “blockchain technology” to me I give him the benefit of the doubt and write him off as someone who doesn't know what he's talking about. If I find out that he's intelligent, then he's most likely a con artist.[1]
When people say “blockchain technology” to you, you can often replace it with “mana”, or “chakras”, or “quantum” and it makes sense the same way. “Blockchain technology” has evolved into a sound Bitcoiners use to extract money from venture capitalists and one another, similar to the way that male birds use a song to attract females. It's a phrase for people who know there is a lot of money around, but don't exactly know where it's coming from.
I don’t see that there is a lot of use for some kind of general “blockchain technology” outside of its application in Bitcoin. In Bitcoin, the blockchain is a way of solving the double-spending problem without privileging any party as to the creation of new units or of establishing a consistent history. This is an extremely costly and complicated way of maintaining an accounting ledger. How often do I really need to do my accountancy in this way? I would say that it is only a good idea when the game being played is so important that no one can safely be put in the position of referee. There are not a lot of things that I would really need that for, but I think there is a good argument to be made that a blockchain is a reasonable alternative to the monetary system under which the rest of the world is currently oppressed. Otherwise I'd really rather be able to keep my accounting records to myself rather than leaving them out in public.
There are no applications of blockchains which do not involve a double-spending problem. A blockchain that was used for an application with no double-spending problem is nothing more than a database, so you could just replace it with a distributed hash table. People have also used the blockchain for timestamping. This only works because Bitcoin has become well-known as a point of reference. If you had a need for timestamps, you certainly wouldn’t invent a blockchain to do it.
Yet people are running around everywhere in the Bitcoin world screaming “blockchain blockchain blockchain” for all kinds of non-intuitive purposes until they're buried under piles of money. I can't believe how long it's taking for people to get wise to this ruse, but I hope it won't last too much longer. A blockchain does not have a wide range of applications. However, there is one application[2], namely that of being a currency, which is overwhelmingly important.
The foundational fallacy about money is to explain in physical terms what is really a sociological phenomenon.[3] Gold is not valuable because it is durable, fungible, portable, and scarce; it is valuable because of a beneficial and self-sustaining tradition in which it has a special place. The physical properties of gold make such a tradition possible, but they do not determine that it will arise; other goods with similar properties may also become the traditionally established monetary good. Bitcoin is the same way, of course. It could not run without the technology behind it, but what makes it important is the fact that it is seen as having value, thus making it exchangable for goods and services. People who think "blockchain technology" is important are making the same kind of mistake as the people who think gold has intrinsic value.
What's weird to me is that I know I have heard many people express correct ideas about what money is and then look at me like I'm crazy when I seriously consider the implications of what they said. I have heard people say to me things like, “money is just a shared hallucination” or “the value of money is whatever we all agree it is”. Yes! That is correct. That's exactly what I'm saying. And if money is a shared hallucination, then you can’t replicate Bitcoin’s value by replicating the technology. You would have to also replicate the hallucination, which you can’t. You’ll have two blockchains, but only one of them has a shared hallucination. This makes one of them valuable, the other worthless.
If that seems like a strange claim, think about the alternative: it means that it should be possible to create value for essentially no work. Every new blockchain ever produced was built on the premise that you can create a valuable investment that offers no income for the fixed cost of copying Bitcoin with alterations.
There is nothing magic here. Human behaviors have real costs and benefits. Money may be little other than a bunch of people attributing value to something without much direct use. It doesn’t matter if this sounds ridiculous; if there is a behavior that corresponds to this belief which benefits people, then they will keep behaving that way. Other people had better understand what they’re doing or else they will become relatively poorer.
The overwhelmingly most popular thing to do with gold is to store it away and leave it for long periods of time. Therefore, an explanation for the price of gold should mostly depend on the reasons someone would want something that is good for being stored away, with some minor additions due to gold’s use as jewelry and in industry. We can study money as behavior by abstracting away all the uses of money other than that of storing it. No matter how silly that sounds, we know that it must be good for something because people actually do it and have been for some time.
When I talk about money as a behavior what that means is that everybody has a socially established number that is objectively associated with them. They can show other people how much they have, and everyone will agree as to what the number is. People can do something which subtracts from this number and adds to another person’s number. Also, people demand to have higher numbers. This means that they are willing to give up other things in order to increase their number. If we know the costs and benefits of increasing the number, then we can understand the price of these numbers on the market.
There could be many reasons that people are able to behave in this way. The numbers could correspond to amounts of a physical good, like gold or wampum, which people physically pass among one another. They could correspond to numbers which are managed and guaranteed by an institution, like dollars or World of Warcraft gold; or it could be numbers that are stored in a blockchain as in Bitcoin; or maybe we all just use the honor system and keep track of our own balances and don't cheat.
Often, economists define money in a way that makes money a unique good in an economy. I do not define money this way. There could be more than one good which acts like money. Instead, I will show that in the long term I would expect a single money to dominate.
Money is often explained in terms of the inconvenience of trading in a barter system.[4] While bartering might well be inconvenient, that alone is not enough to explain the existence of money. It would certainly be nice if we could all settle on a good to use as money. However, there is no guarantee that everyone will be nice enough to do that. It is possible to imagine a tribe of people who are all very good economists and who all understand and like the idea of money, without having enough confidence in one another as to get it working for real. The first person among them would be taking a risk because he would have to work or sell his property in exchange for something that's good for not much other than being stored. His risk would only pay off if everyone else was willing to follow suit, and how could they possibly guarantee to him that they really would do so?
For almost a year, this was what it was like in Bitcoin. Although Bitcoiners suspected that Bitcoin could be money some day, its price was zero. Consequently, it was completely useless as a form of money. For a long time, Bitcoiners wanted the price to be higher than zero, but they could not make it so just by wanting it. Bitcoin did not fundamentally change as a piece of software when it first developed a price; the only thing that changed was people's’ willingness to trade dollars for it.
In general, there is always an individual cost to accepting money, even when the use of money is very widespread. If I work in exchange for money, how do I know that money will still be valuable by the time work is out and I am ready to do my shopping? If I work for something I can directly consume then at least I can get some utility out of it no matter what. But if I accept something whose main use is as a medium of exchange, then I am depending on there being future people willing to accept that money later.
This is why people can't just will money into existence and why the inconvenience of a barter system cannot explain the existence of money. There's a risk. In order to explain why people would use money, we need an individual benefit to match with the individual cost; otherwise people would never prefer to use money no matter how socially beneficial it was.
There is an individual benefit to using money, and it’s very simple. The person who accepts money gets to defer his decisions about what to buy to a later time. Someone who does not want to use money must have a better idea about what he is going to do with the goods he receives in payment than the person who accepts money. When one has money, then one is not committed. If I am the first person to accept money in payment and my bet on it pays off, then I have the option to choose what I want later, and I do not have to choose based on the limited information I have now. This benefit explains why someone would want something that is good for keeping in storage. If he wants to keep his options open, then he can open his vault the moment that the right opportunity comes along.
I have now provided a trade-off which, I contend, explains the value of money. I have not proved that there are no other costs and benefits to using money, but I don't know of any others. If someone can show me that there is another reason to hold money, please do. Now I'll talk about what this tradeoff implies for the value of money.
In this article, I mean value in the investment sense. So the value of money is the purpose it serves in your portfolio and how much you would want. For the investor, the value of money is determined by the tradeoff of commitment versus optionality. If he wants more deferred choices, then he needs more cash. If he wants more income, then he should get stocks or bonds.
The reason someone might want to defer his choices is because there are limited periods of time in which investments go on sale. A difficult thing about business is that it is easy to make mistakes whose consequences are not evident until long after they are unavoidable. When that happens a business needs cash in order to survive long enough correct itself. During these times, good businesses can be bought cheaply for limited periods of time. This is why an investor wants a cash balance ready to spend. You never know what is coming, but if you have cash you are prepared for whatever it is. Holding a stock is a commitment to a particular enterprise, whereas cash keeps your options open.
The reason that buying an investment is a commitment is that you cannot always sell an investment easily for cash. It might go on sale, just as in the previous paragraph, and then the investor cannot get the same amount of cash back that he put into it. If there is a crash, the investor might not be able to follow through on his commitment and must sell at a loss. On the other hand, an investor who can realistically make the commitment won't care so much if there is a recession because he is prepared to weather safely through any bad times.
The interesting thing about the tradeoff of optionality versus commitment is that changes in the overall use of money in an economy can change the nature of that tradeoff for an individual person. The more demand for money there is, the less risky it is for an individual person to hold money. If you were the first person to sell goods or labor for money, then you would probably look insane or immensely stupid to bet that other people would want this stuff in the future. On the other hand, if many people are using money, then you are merely depending on there not being a hyperinflationary event in the immediate future. In that case, you might look insane or stupid for worrying about such a remote possibility at all.
In short, money becomes more useful the more people use it. This may seem like a very obvious conclusion given how many words I took to arrive at it, but it has some funny implications that are hard for a lot of people in Bitcoin to accept because they have money riding on a presumption that the opposite is true. As more people begin to hold money, the rational response of everyone else is to try to hold more than they already have. Everyone, therefore, will try to increase his cash balance at the same time, and they will do this by bidding larger amounts of other goods in exchange for it. In other words, all prices tend to go down, and money becomes more valuable. Effectively, everyone ends up with more money, except that they end up with more valuable units of money rather than higher sums of it; and furthermore they end up with larger fractions of their portfolio in money as well.
This is the opposite of how most investments work. If the price of a stock goes up, then the value decreases because its dividend yield is smaller in proportion to its price. If the price goes up too much, an investor would eventually want to sell for something cheaper. By contrast, 100 worth of bitcoins today has a better value than 100 worth several years ago, even though the price of bitcoin is much greater. The value is better because there are more opportunities to unload the bitcoins at the owner's discretion.
A positive feedback between price and value implies that the growth or shrinkage of money can be self-sustaining. One might well find this conclusion hard to accept. Afterall, value in a business is built by hard work and careful strategy, whereas money can somehow drive its own value according to me. I would invite anyone to explain Bitcoin’s value any other way. And saying “bubble” doesn’t count because that’s virtually the same thing. Money is basically a self-sustaining bubble. We don’t yet know if Bitcoin will arrive at a self-sustaining state, and even if it doesn’t the “blockchain tech” people are still wrong because in that case there would be no good blockchains rather than one.
What would a self-sustaining bubble look like? Naturally, there must be a limit to the growth of money. As the value of money increases, eventually the individual benefits of holding more of it will go down. This happens as the market cap of currency becomes a larger and larger fraction of the whole economy. There are only so many errors that the economy produces for a cash-holder to take advantage of. The economy becomes saturated with money once there are enough investors sitting around with piles of money such that they are able to catch all the errors that are worthwhile. At that point it is no longer individually beneficial to hold more money even if the value of money has gone up. This prevents the value of money from going up further until more people or businesses are added to the economy.
This limit is independent of the underlying technology of the money. If people were sufficiently honest, it could run on nothing but the honor system. Thus, the value of money is a macroeconomic phenomenon, even for a tiny, quirky cryptocurrency like Bitcoin. This is the reason why Bitcoin can be worthless one year and valuable the next without a fundamental change to the software or protocol, and why it can range in price by enormous margins over short periods of time for reasons that seem inscrutable. It's because the value of money is a shared hallucination, and the price is caused by the vividness of that hallucination.
For a year after Bitcoin was first released, it had no price and was quite worthless. Therefore, the value was not created when the software was originally developed. It was caused by step-by-step investments that came later. Since it first gained a price, Bitcoin has had periods of rapid price increases. There can be events which are set off for no apparent reason in which Bitcoin’s price drives itself rapidly up or down. A small price increase is interpreted as an increase in demand. An increase in demand would mean that bitcoin is becoming more useful and therefore more valuable. Hence, more people buy in and cause another price increase. These manias make people outside wonder if Bitcoin is for real. They make people who previously thought that Bitcoin was stupid to think that they should maybe buy a little bit just in case there could actually be something to it. In other words, they are starting to think that Bitcoin is good for the only thing that money is actually good for, which is to be kept just in case.
Above I wrote about the hypothetical idea of a tribe of economists who all wanted to develop a money economy but could not because each felt the investment to be too risky. Here is how they could solve that problem. They could go around in a circle and take turns investing tiny amounts. Then none of them has to take a big risk. Their economy would not be monetized after one round, but they could see who among them was willing to take a small risk. If they had all shown themselves willing to invest a little bit, then many of them would be willing to risk a second round. If the game should proceed well, the economists would start to think about how wealthy each would be if they managed to get more than the rest. Soon the game would cease to be orderly as they all tried to sell as much as possible in order to buy the new money while it was cheap.
Bitcoin did not arise out of a barter system. The dollar and the other state-managed currencies had long since subsumed nearly all trade. However the calculation of the initial investors to Bitcoin was very similar to that which faced the economist tribesmen. It was clear to many that Bitcoin would be cool if you could actually buy things with it. However you can’t buy anything with it and its investment prospects depend on the presumption that it somehow one day will be demanded in exchange for goods. How could one even estimate the risk of such a possibility? The fact that other currencies already existed does not change the problem. From the perspective of a Bitcoin investor, Bitcoin might well have existed in a barter system in which Dollars, Yuan, Euro, Pound, and Yen were traded rather than tea, silk, salt, and flint. The only difference is that the national currencies are better competitors than tea or salt, so the risk is greater than if Bitcoin had arose in a real barter system.
I'm not against competing currencies in the sense of thinking people should be physically prevented from creating them. I am against competing currencies in the sense that I think currency competition is inherently monopolistic and that it is extremely dishonest or stupid to promote a new currency as an investment without taking this reality into account. So I am against competing currencies in the sense that someone who creates a new currency had better be able to present a case that his idea is capable of replacing the current system, and should be treated as a con artist otherwise.
The fact that money has a positive feedback between demand and value implies that there cannot normally be a stable equilibrium between two moneys. Any initial imbalance between them would tend to expand. If one currency was slightly more preferred than the other, people would react to this by demanding slightly more. This makes the preferred even more preferable than before. Any two moneys will interact in this way, thus leaving one to dominate the rest.
Many people get fooled upon first entering Bitcoin because they think diversification is important. The problem with diversification is that it is possible to create an infinite amount of bullshit at no cost, and if you diversify into that you lose everything. Diversification only makes sense among investments which are not bullshit. If we were looking at a bunch of stocks that all already paid dividends, then diversification would make sense. On the other hand, there are potentially an infinite number of scamcoins. During late 2013 and early 2014, new ones were being produced and hawked every day. They can be produced at this rate until everyone who thinks diversification is a good idea goes broke. Now that all the dumbest people have gone broke, the focus has shifted to using “blockchain tech” to exploit ignorant venture capitalists.
There is always some risk in accepting money in payment, even something very well-established like dollars. If everyone settles on the same money, then they have coordinated so as to reduce that risk as much as possible. If you expect people to use two currencies, you have to have some reason that both would offset risk in different ways. I have never seen an altcoiner or “blockchain tech” enthusiast come anywhere near to addressing this issue. Clearly, if two currencies are virtually identical, such as Bitcoin and Litecoin, then whichever currency is bigger has the advantage. Recently, Litecoin’s price has decoupled from Bitcoin’s somewhat, so maybe people have finally figured this out. Once Litecoin loses its shared hallucination, no amount of sloganeering will bring it back.
But what about something more elaborate? Let’s pretend for a moment that Ethereum actually worked and was actually something that competed with Bitcoin on some level. Do its smart contracts give it a serious advantage over Bitcoin? I don’t see how Ethereum’s smart contract system would tend to bring in opportunities to unload ethers which are superior to the opportunities provided by Bitcoin. No matter how cool smart contracts sound, they make Ethereum just another appcoin, and as with other appcoins, people will reduce the risk of holding them by not holding them, or holding them for as short a time as possible. This will drive the price down until they are useless in trade.
By the way, I would prefer to be called a “Bitcoin minimalist” rather than a “Bitcoin maximalist” because the other blockchains appear useless and are easliy eliminated.
On the other hand, Bitcoin improves over the dollar (and other fiat currencies) where it actually counts. The dollar is not very good for storing “just in case”. Over long periods, it loses value due to inflation. You can’t carry cash around or the police will take it, and if you leave it in a bank, you can have your account frozen and the money drained if you use it for purposes deemed unacceptable. You cannot own dollars the way that you can own bitcoins. It is not that Bitcoin comes at no risk; it is rather that you can always expect to have the same fraction of the total later on, if you secure them properly.
The national currencies are affected by forces which are beyond your knowledge or control. They are managed by committees serving the governments issuing them. The people on these committees speak in a jargon that is not only incomprehensible to most people, but unbearably dull even to those who do understand it. Everyone is affected by them, but most people will not bother to learn to understand them. They manage the currency in the national interest, which is not always the same thing as your interest. They can change the rules about how the currency can be spent you can use them or increase the government’s supply. [5] It is usually not possible to predict what they will do, at least over long time spans.
This is not possible under Bitcoin’s current rules, and it would be difficult to change them in ways that might eventually enable anything similar. Although many new bitcoins will be created in the future, the release schedule is publicly known, and is therefore already priced into current Bitcoins. Therefore Bitcoin will not lose value as a result of inflation. It might lose value as a result of losing popularity, and this risk is greater than that of the dollar’s (at the moment).
Thus there is a genuine qualitative difference between Bitcoin and the dollar, from an investment standpoint. It doesn’t mean that Bitcoin will necessarily defeat the dollar. It just means that Bitcoin has a relevant competitive edge. There are still significant disadvantages to Bitcoin; it is slow to confirm and difficult to maintain anonymity. However, Bitcoin has done well against the dollar so far and there is real-world commerce that has grown to rely on it. In addition, every time bitcoin grows, its risks decline relative to the dollar’s.
The reason, therefore, that the monetary aspects of Bitcoin are particularly interesting is the possibility that Bitcoin could become the preferred good for being stored away. If it did, then its value would grow until it was a significant part of the world economy. That would be a significant change for the world and for Bitcoin’s early adopters. Call me crazy, but I think that possibility has more portent than the possibility of applications of blockchains outside of Bitcoin, and is a lot more likely, too.
Bitcoin the protocol is like a great work of engineering. Its pieces are all adapted to its function. It is not the technology, but what the technology enables, that is most interesting. The blockchain as a concept had no reason to escape the esoteric circles of developers and engineers. Yet when people looked at Bitcoin, the only terms by which they knew how to understand it was as a new technology. But Bitcoin is more like a new tradition than a new technology. It is as if a small section of the crowd in a packed stadium has started to do the wave, and you can bet on whether the wave will eventually fill up the entire stadium.
If someone says “blockchain tech” to you, you might as well walk away right there.[6] They’re just trying to sell you on their new decentralized crowdfunded blockchain tech internet of bitthings appscam. You know that they’re lying because everyone who acts like them is a liar and someone who was not a liar would actually do something to distinguish himself from them. Someone who knew what he was talking about would know that you can’t just string a bunch of buzzwords together in order to generate an idea that makes sense. Unfortunately, if a lack of basic critical thought is widespread, and if everyone becomes invested in everyone else’s stupidity, then nobody wants to know either, at least not before they’ve found a favorable time to exit their position. This will probably never happen because although they may think they’re preying on other people’s stupidity, they are more likely being preyed upon instead.
On the other hand, just because someone is dumb does not mean that he is not a con artist. Based on my experience in Bitcoin, I think that many con artists have an instinct to remain as stupid as possible about how they get money so that they can keep believing that they are brilliant entrepreneurs. ↩︎
The theory I am presenting in this article is the Austrian theory of money. To learn more about this idea, consult any standard Austrian tome, such as Murary Rothbard's Man, Economy, and State or Mises's Human Action. ↩︎
When Austrian economists say barter system all they mean is an economy in which no good is used as money, even though the term has much more specific connotations for many people. ↩︎
In the US, it is really congress and the executive branch changing the rules, and the Federal Reserve changing the supply. This distinction doesn’t really matter for the purposes of this article, but some people think it’s important because the federal reserve is designated as a private institution, whereas congress is composed of elected representatives. ↩︎
This includes Hillary Clinton. ↩︎
This person has developed a new investment strategy for the age of smart contracts: You simply look for a way to exploit the smart contract which causes it to send cash into your account, and then invest in it so as to control it in a way that extracts the money.
Ethereum truly is different from other altcoins. If I had looked into Ethereum more carefully, I might have noticed that economics was not the only subject that the Ethereum devs did not understand. They also don’t understand law and software engineering. They created a situation in which bugs would be expected to arise in an environment in which bugs are legally exploitable. That is hacker heaven.
Let’s say that A wants to send ethers to B. I will write A→B
as the atomic
operation which removes money from A
's balance and adds it to B
’s. This
operation fails if A
's balance is not big enough. To send money in Ethereum,
it is as if we had a function that looked like this:
send[f, x, y] = If[ // Send funds to B and call f; roll back if an error is generated. Try[ A→B; f[]; True, False], // Call this if no error was generated. x[], // Call this if an error was generated. y[] ]
where x
and y
are functions provided by A
, and f is a function provided
by B
. In other words, A
sends the ethers to B
, who immediately gets to
call a function that does whatever he wants with the money. That function is
f
. If his function fails for some reason, A→B
is rolled back and function
y
is executed. Otherwise, x
is executed. Anyone can provide any function
to be executed upon receiving funds.[1]
This is already enough of a nightmare, but suppose you have a public function available to the hacker which is of the form
hackMe[f] = // Use q to check whether we owe the attacker money. If[q[], send[f, x, y]]
where q
is a function that is supposed to fail if the attacker has no right
to demand funds.
Suppose that the hacker calls hackMe
, and provides an f
of the form
f[] = p[]; hackMe[f]
If the hacker can get q
to succeed inappropriately, the following code is
executed upon calling hackMe
:
q[]; A→B; p[]; q[]; A→B; p[]; ... q[]; A→B; y[] ...
If nothing else stops this execution, it will eventually stop when A→B
fails
as a result of A not having enough funds. It can also fail if the call stack
fills up or if the computation runs out of
gas,
but these are complications on top of the fundamental problem. A hacker can
try to ensure that only the last send fails so as to end up with everything.
A naive approach to this bug would be to write q
so that it keeps track of
how much is owed to B
and fails if the money should already have been paid.
However, this approach is not good enough because in the mean time, from
function p
, the attacker might run more code which you have made available
to him which creates further liabilities. The fix which the Ethereum team
released to upgrade DAO 1.0 to 1.1 takes this naive approach, as explained
here.
I've provided a scenario in which the result is to extract funds, but the issue is much more general than that. You can think of an Ethereum smart contract as being like a object in object-oriented programming, with a set of public methods that any other contract can call. If you call another contract's public methods, he can call any of your public methods and attempt to screw with your internal state. There are different names for this depending on what the malicious contract does (such as reentry and solar-storm), but the problem is really the same kind of problem you would have if you just allowed people to run whatever code you wanted on your own computer.
This problem is so serious that it cannot be treated as a bug in the DAO. The
problem is with Solidity itself, which is the scripting language used in
Ethereum. Update: The problem actually all the way down to the Ethereum
virtual machine. While reading the Solidity documentation, I noticed this:
If
x
is a contract address, its code (more specifically: its fallback function, if present) will be executed together with thesend
call (this is a limitation of the EVM and cannot be prevented).
This means the same issue exists in Serpent, another Ethereum scripting language, and every other one they might come up with.
Imagine a bright eyed and bushy-tailed new programmer writing his first big contract: "Now let’s see here…” he thinks. “I’m using the send function. That means that I have to search for blocks of code that I’ve written which an attacker could attempt to run in an infinite loop until there is no money left. First of all, which possible blocks of code could be made to go in an infinite loop? It could be any part that calls send, intermixed with anything that the attacker wants to call in between… hmmm… " You have to think this every time you send anyone money. It is totally ridiculous to expect anyone to do this reliably. The only difference is that a novice would fail every single time he tried to write a contract, whereas an expert wouldn't even bother trying.
Now I have described this issue so as to make it very clear what is going on,
but in Solidity, the function I have called f
is not very visible to the
programmer. It’s a method called the “default function” that can be defined on
every address. It executes automatically when you send to that address. So if
I was writing hackMe
in Solidity, I wouldn’t have directly referenced the
function f
as I wrote, but it executes anyway. It is very easy to write
hackMe
in Solidity.
The manual on Solidity opens with “Solidity is a high-level language whose syntax is similar to that of JavaScript”, as if that were something to brag about. But apparently Solidity has much more than just a superficial resemblance to JavaScript. Solidity is like programming in JavaScript, except with your bank account accessible through the Document Object Model.
A sign that no one is prepared to write smart contracts in Solidity is the fact that the Ethereum dev team, the people who designed both Solidity and the DAO, could not even fix their own bug. They don’t have the ability to approach these bugs correctly, and neither, in my opinion, does anyone else. It may be possible to reliably write smart contracts that work correctly, but currently no one knows how to do it. The dev team is not likely to figure it out any time soon because they still think that this is just a bug in the DAO rather than a serious problem with their entire system. If you want a smart contract that you can actually use, you have to be certain that it is bug-free before it is deployed. there are no known tools or methods available to Solidity developers which could provide an appropriate level of certainty. Such tools will take years to be developed and until they are in common use, no Ethereum smart contract should be trusted. Ethereum is doomed.
The legal implications of this hack are more interesting than the hack itself. Because the code of the DAO is a legally-binding contract, how can you argue so as to convince a judge that some behavior of the program is really a bug? The DAO provides nothing other than its own code to specify how it is supposed to work. For example, there is no specification in a formal language, or proofs as to its correctness. If the Ethereum team knew how to test software, they might have produced something like that, which also could have provided corroborating evidence that any bug was unintended.
I fully support the attacker’s actions, and I wish I had thought of it first. His ethers may become worthless before he can sell them for Bitcoin, but he may also have made a huge short on ethers just before executing the attack and made around $1 million that way.
For a final comment on the Ethereum team’s response, I provide an insightful quote from Emin Gün Sirer:
Had the attacker lost money by mistake, I am sure the devs would have had no difficulty appropriating his funds and saying “this is what happens in the brave new world of programmatic money flows.” When he instead emptied out coins from The DAO, the only consistent response is to call it a job well done.
If you don’t believe me read this analysis of the hack here:
To have a contract send Ether to some other address, the most straightforward way is to use the send keyword. This acts like a method that’s defined for every “address” object.
I love how he says this in such a matter-of-fact way, like that's no big deal.
Also note this poor developer’s unease upon learning about this “feature”:
↩︎Here’s the deal. In Bitcoin, an address is the public key that corresponds to a private key held by a wallet. I’m lying a bit to aid comprehension. But, fundamentally, it’s just a bit of data. In Ethereum, an address could be similar – not a contract, but a public key. But, it could also be another smart contract’s address. The Mist client encourages users to make a wallet contract as a first step after loading up, for example. Users would then offer the address of that contract as their ‘wallet address’. Other contracts do not typically utilize any mechanism to distinguish between an address of a private key, and an address of a wallet. It’s a fundamental transaction in Ethereum to send money to a contract, and developers seem to expect it to ‘just work’ like in Bitcoin or other digital currencies, perhaps with a transaction fee attached.
Imagine you are sitting in a bunker. You have no idea what people are out there and what are their intentions. You only receive some incoming messages from strangers that may contain anything. They can be just random garbage or deliberately crafted messages to confuse you or lie to you. You never know. You cannot trust anyone.
The problem of "money" or any other "social contract" is that everyone should be able to know what the majority agrees to without trusting some intermediaries (otherwise they can easily abuse their special position). If everyone votes for "X", then you sitting in a bunker must somehow independently figure out that all those other people indeed voted for "X" and not for "Y" or "Z". But remember: you cannot trust anyone's message and messages are the only thing you get from the outside world.
When two propositions arrive into your bunker, "X" and "Y", we have no trusted reference point to figure out which one is supported by the majority of other people. We only have "data in itself" to judge which one we should choose as the main one. To make things simpler we are not trying to apply subjective judgement to either proposition, but only trying to make everyone agree to a single option. In case of Bitcoin it is a reasonable assumption: everyone is owner of their money, so no one really cares which version of the history is chosen as long as their own balance is respected.
So how X should be distinct from Y that we know for sure that no one can accidentally choose Y, Z or W? First property: this data should be "recent". So we know that we are not sitting on some old agreement while everyone else has moved onto something else. Second property: any "recent" alternative should be impossible to produce. Because if it was possible to produce, then there is always a chance that some number of people could see it and accept that alternative. And you have no way to estimate how many such alternatives exist and how many people accepted it (because you are sitting in a bunker and you cannot trust incoming messages or know how many message did you miss).
How do we define "impossible"? It means either of two things: either it is logically impossible, or it is practically (economically) impossible. If it is logically impossible, than we can know all future agreements in advance (like a deterministic chain of numbers), just by using induction. But this does not work because we'd have to have some agreement about starting point in the first place. So we end up with requiring practical impossibility. In other words we need the following:
Message X should be provably recent and alternatives should be practically impossible to produce.
Practical impossibility can be reframed in terms of "opportunity cost": there are limited physical resources and those should have been largely allocated to X than to Y so we can see that X sucked in all resources from any alternatives. Because if it didn't, then there is a huge uncertainty about whether remaining resources are used for alternative Y or they do not interfere with the voting process. Is it possible that X did not suck in a lot of resources while alternatives are still not possible? Then it would mean that X logically follows from whatever previous state of the system and there is no voting process needed.
Therefore: message X should be provably recent and should have employed provably big amount of resources, big enough that there are not enough resources left for any alternative Y to produce in a reasonably short time frame. Also, the message X should be always "recent" and always outcompete any alternative. Because we cannot reliably compare "old" messages: is Y an "old" one that was just delivered now, or was it produced just now after resources spent on X were released?
This logically leads us to the following: we should accept only the messages with the biggest Proof-of-Work attached, and that proof-of-work should be the greatest possible ever, so there would not be any possibility for any alternative to be produce in the short window of time. And that proof-of-work must be constantly reinforced or the value of previous consensus begins to fade quickly as the opportunity for alternatives grows.
Expensive, highly specialized computer farms is the most reliable way to achieve consensus. If we were to use non-specialized resources, it would be harder to gauge whether the majority of them are indeed used for proof-of-work computations. By observing that enormous amount of work happens in a very specific, easy-to-observe part of the economy, we can estimate how expensive it is to produce an alternative, equally difficult message. In case of Bitcoin mining farms, such an alternative would require a very expensive and complex production chain, requiring either outcompeting other firms that use chip foundries or building single use data centers in the most cost-effective locations on the planet (with the cheapest electricity, coldest weather, low latency connectivity etc.)
If achieving consensus in a non-trust manner is ever possible in practice, then it is only possible with a Proof-of-Work scheme and highly specialized expensive production chains. Also, consensus is only valuable for a short period of time so it must be constantly reinforced.
]]>We'll assume that there is some real disagreement about whether the upgrade is a good idea because if there was not, then there would be no problem. Thus, once the upgrade is released, the network splits. Everyone can choose which fork to follow, or even run both versions at the same time. Effectively there are two Bitcoins now. I'll call them Bitcoin New and Bitcoin Classic. Each has its own network, and anyone who owned bitcoins before has the same amount of New and Classic.
Who can stop New Bitcoin from taking over? This thread on BitcoinTalk argues that the people who run full nodes can stop an upgrade by refusing to upgrade. Well, it is true that if literally no one upgrades, then Bitcoin New fails. However, it is also true that almost nobody's decision to upgrade has any real effect on the network. Most nodes are dead weight. Even the full nodes (by which I mean, nodes that store and validate the whole block chain) are not contributing much. A full node doesn't do anything that lots of other nodes cannot do, and in order to remain synced with the network, they demand as much data as they provide. The network can function just fine with only a few full nodes. Therefore, Bitcoin New won't necessarily be stopped even if a lot of full nodes refuse to upgrade.
The nodes that really matter are the ones that provide valuable services. It doesn't matter if you upgrade. What matters is if Coinbase, BitStamp, and Blockchain.info upgrade. These nodes provide a lot of the infrastructure for Bitcoin, so if they do not upgrade, Bitcoin New will be a lot less useful. However, these nodes are in it for profit, so they will tend to go where the money is. They cannot necessarily afford to wield the influence they might have at the risk of short-term losses. Therefore, they do not necessarily have as great an effect on the outcome as it might at first seem.[1]
What about the miners? If they refuse to mine on the new chain, that will stop Bitcoin New in its tracks, right? Well no! Miners are in it for the money too, and if Bitcoin Classic cannot support the same hash rate as Bitcoin New, then they put more resources into mining Bitcoin New. Thus, miners also do not necessarily have much of a say in the matter either.
It all boils down to the value of the two coins. If Bitcoin New becomes more valuable than Bitcoin Classic, then miners will mine it and services will support it. If not, then it won't. Investors settle the question. A Bitcoin investor can sell his Bitcoin New for Bitcoin Classic, or vice versa, depending on which he thinks is the better idea.
In both the cases of the service providers and the miners, the problem which makes them less influential than one might think is the fact that they do not necessarily have the funds to take the risk of deciding for themselves which version they like better and which they are going to promote. In short, the problem is that they are not necessarily investors, who by definition do have the funds. Investors do not have to listen to anybody else because they can afford to take the risk of asserting influence. Thus, it is the investors who control Bitcoin.
Clearly there are technical issues with problem of creating a viable Bitcoin fork that I didn't go into. For example, a Bitcoin fork might not be able to work because its hash rate would initially be so low that blocks could take days or weeks to mine. Since there has never been a battle between two forks before, there are a lot of unknowns about how to do it right, but technical issues like that could be addressed if they were properly researched.
The real issue is not precisely how a Bitcoin fork could actually be implemented, but merely the understanding of how events would play out in such a situation. Hypothetical situations affect reality today. When two armies meet, if they can determine who would win without actually fighting one another, then the battle is over without having begin. This is a similar situation. If a Bitcoin upgrade were known to be unpopular to investors, then its proponents, knowing who would win if push came to shove, would tend to back down before causing that much disruption. Thus, the investors are still in control even for real-life Bitcoin upgrades that never reach the point of creating such contention.
What are the implications of this conclusion? The motivation of investors is the value of the coin. The general rule about Bitcoin upgrades, therefore, is that upgrades which increase Bitcoin's value will be adopted and those which do not will not. Therefore, Bitcoin is not likely to be upgraded in ways which make it easier to regulate because that would decrease the value of the coins. Bitcoin might be upgraded in ways that make it more anonymous because a more anonymous coin would likely be more valuable. An upgrade which allows for larger block sizes is also likely to be adopted because the current limit of 1 MB will eventually limit Bitcoin's value as a form of money. Obvious bug fixes are likely to be adopted, whereas cockamamie schemes which do not clearly improve Bitcoin's value-such as proof-of-stake mining or changing the block reward schedule-have no real chance of succeeding and are therefore hardly worth talking about.
This is not to say that Bitcoin is a divine substance or some immaculate bit of quintessence. It just means that Bitcoin upgrades must be a clear improvement to Bitcoin as an investment or else they face a sharp uphill battle to adoption. Any scheme to reprogram it in service of special interests would almost certainly reduce its value proposition because it would change Bitcoin from something good for the world to something good for a smaller group. Of course, people actually need to be paying attention in order to prevent it, but we also don't need to go mad with hyper-vigilance.
I have learned that Emin Gün Sirer has expressed a similar idea in a blog post. However, he argues that it is the users who control bitcoin, having one vote per node. When I originally wrote this article, I didn’t deal with this this case extensively because I didn’t realize anyone was taking that position. So I am dealing with the full nodes in this note now.
Consider the following thought experiment. Suppose, as again, that there were two forks of Bitcoin, new and classic. Now suppose that new was preferred by investors and classic was preferred by people who run full nodes. As the two classes of people expressed their preference in their actions, the investors would tend to cause an increase in the market cap of new over classic, while the node runners would tend to increase the number of nodes of classic over new. What has each class gained by this? The investors have gained an asset capable of producing a greater financial impact on the world than that of their competitors’ and therefore more capable of attracting business. While the nodes do control a network, in a sense, the investors control which network becomes important.
Over a sufficiently long time span, therefore, the interest of those who now run full nodes become meaningless in comparison to the desires of those who are now investors. There are many reasons to run a node and consequently the class of people who run full nodes is less capable of maintaining a consistent set of interests or a group identity. The investors can, and their actions can be expected to alter the composition of the group of full node runners in a way that is not matched by the effect which the full node runners have on the investors.
Consequently, an individual person’s control over Bitcoin should is better characterized in terms of the amount he owns than in how many nodes he runs. This is why I say your control over Bitcoin is proportional to how much you own and why I say that it is the investors, not the network nodes, who control Bitcoin. ↩︎
First of all, it is impossible, long-term, to expect an algorithm to maintain the stability of a currency. There will always be money to be made by predicting the algorithm’s future effect on supply, and once people have learned to do so then the algorithm necessarily ceases to achieve its desired results. For someone who gains by anticipating such an algorithm is not producing something valuable that other people want to buy, so he must be gaining off of other investors, who are losing. That means other people holding the currency, which means that the currency cannot possibly be stable—either it is dropping in price, or the supply is rapidly declining. (The outcome would depend on the details of the prescription.) This can continue until the market cap of the currency goes to zero. In order to succeed at manipulating the price to keep it stable, the prescription must never allow traders to adapt to it. It must continually be smarter than everyone else. This is not something anyone can reliably guarantee, especially a Bitcoin startup (if history is any guide). This is the same reason that attempts to create crypto-equities that track the price of gold or dollars and other things through protocols like ProtoShares and Mastercoin won’t work. It is also why the federal reserve is traditionally so secretive, why the chairman tries to talk without saying anything, and why his or her every move is so deeply scrutinized.
Stability is about as real as the fountain of youth, love potions, or perpetual motion machines. It is not to be found anywhere in the universe but for some reason people act as if such a thing could somehow exist. Prices reflect the availabilities of things that we actually can have, so maybe we should all stop searching for chimera of stability and accept that if the world is unstable, than prices ought to be unstable too. Otherwise prices could not serve the function of enabling people to coordinate the allocation of scarce resources.
Right now the world is deciding whether it wants Bitcoin to be its money. That’s kind of a big change, and it’s pretty reasonable that Bitcoin would be volatile. Will Bitcoin take over or will it drop to nothing? Fundamentally we don’t know and the rapid changes in Bitcoin’s price reflect the confusion and self-doubt in the minds of real people trading it, and this is exactly what they should be doing because without price signals, there could be no Bitcoin adoption. Bitcoin’s exponential growth is a very strong signal, and if Bitcoin were stable, there would be no such signal. There would be no dedicated community of enthusiasts because no one would have any particular reason to want it to be adopted other than the company issuing it. And that company could not offer any value with its stable currency because it cannot unilaterally create liquidity, which is the fundamental thing that makes a currency useful.
What actually makes for a good store of value? The problem with this term is that it is a terrible metaphor. When we store a physical object, typically we shut it away from other people in another object, like a box or something. But what if I had a box that, like Tinkerbell’s magic, only existed if other people believed in it? That’s what a store of value is like. Value is not a physically real thing, like the box. It is an expectation about how much people want something. The whole idea of storing value is absurd. It’s like some kind of dream logic. The only way that a good can “store value” is if everyone wants it so badly that it will be snapped up even at a tiny discount.
This does not mean that anything can be a good store of value. Everyone could treat, say, plastic poker chips as a good store of value and they would only behave like one until people realized that they were easy to manufacture. But suppose there were another metal which had similar properties to gold: it was durable, rare and difficult to extract, and distinctive enough to be difficult to counterfeit. However, the state of our science was such that it was only just being identified by chemists. This new metal would certainly not have a stable value initially upon its discovery because it would take time for the world to learn about it, but it would be perfectly rational for the chemists who did understand it to buy up as much as they could until the rest of the world had got wind of it. Once this metal’s properties were understood by the whole population, then it really could “store value” because everyone else would be using it for the same purpose.
Stability occurs (to the extent that it can happen at all) once everyone has not only learned of the favorable properties of the good but has learned that everyone else also knows of those properties. If I know that Bitcoin is both scarce and unforgeable, I may still be scared to put my money in it because I may fear that other people won’t treat it like a store of value. Furthermore, everyone could think this way at the same time, and the market therefore still behave fearfully. This is why people must be convinced that everyone else believes in Bitcoin too. People today are both coming to terms with Bitcoin’s properties and are confused about how much the rest of the market believes in them. Hence there is fear and volatility. Nonetheless, Bitcoin cannot be counterfeited and its supply is not likely to change, no matter what else happens in the future. This is the best that can be done, as far as engineering goes, to design something to be a store of value. The rest is up to everyone else, not the engineer. Thus, if Bitcoin is going to succeed, then it’s a good store of value.
Now, what about Bitcoin as a unit of account? Unlike store of value, this is actually a really good term, but unfortunately people do not take it literally. When people say unit of account, they seem to want something that will reliably measure wealth somehow, or that things can be priced in without having to be constantly updated. But these are just other ways of chasing the siren song of stability. Here too, if the world is changing then prices should be changing, and one can only imperfectly compare one’s wealth at different times. Really, one can only compare different alternatives which would have taken place over the same time.
Yet there is a worthwhile definition of ‘unit of account’ under these circumstances. It is very simple: a unit of account is something such that to gain it is considered to be profit and to lose it is considered to be loss. Anything can serve this function, but the reason we would especially want to use liquid goods as a unit of account is that when we are liquid we don’t have to think too far into the future. Thus, acquiring a liquid good serves as a reasonable end point to any venture. When you’re sitting on a huge pile of cash, you know that you’ll be fine for some time no matter what happens. Whereas if we were on a barter system with no highly liquid goods around, then one would have to think much further ahead in order to assess the success of a venture. Thus, thinking of profits and losses in terms gaining or losing a liquid good is essential to being able to divide the entire future into manageable tasks—as long as one is gaining that liquid good, one is doing things correctly. Of course, when things are changing so much that the money good itself might shift, then one has to pick which medium of account to use. So once again, Bitcoin is a great unit of account—if it’s going to win. In that case everyone should be trying to get as much as possible of it right now, with the expectation of it being very liquid in the future.
Finally, what about Bitcoin as a medium of exchange? I don’t think this function of Bitcoin is controversial. Of course Bitcoin is a good medium of exchange. My problem with this function of money is the way people treat it in relation to the others. People sometimes think that medium of exchange should be the primary function of money, as opposed to using it as a store of value. For example, this is an assumption behind Tim Swanson’s concern trolling about Bitcoin hoarding. However, it is impossible for a good to function as a medium of exchange unless there is already demand for it as a store of value. If I’m going to give someone bitcoins in exchange for something, there has to be someone, somewhere, who wants bitcoins. And he has to want to store them, even if for only a short time because of everyone tried to spend their bitcoins immediately, that would drive the price down to zero. Furthermore, the more that people want to store bitcoins, and the higher goes its value, the more liquid bitcoins consequently become and the more trade they enable.
Thus, Bitcoin is the kind of money that works in an unstable world, which is the only kind that we know of, and it is a good store of value, unit of account, and medium of exchange, to the extent that these terms make sense amid great uncertainty. When people say “Bitcoin isn’t a good store of value or unit of account” what they really mean is “Bitcoin isn’t being adopted yet”, which is not a valid complaint. Bitcoin has the right properties for the world’s money, and the more the world comes to terms with this, the more stable it will become.
]]>Combined with the emerging information markets, crypto anarchy will create a liquid market for any and all material which can be put into words and pictures.
Just when things had got about as boring as they could possibly get, the celebrity nude photo leaks came along to give the world an inkling of the new world that Bitcoin ushers in. After speaking to an informant who watched the Fappening unfold on 4chan, I can report a theory which some 4chan anons believe explains what happened and which I agree seems to be the most likely possibility, given the facts now available. If it is true, then it is far more interesting than the media realizes and Bitcoin is at the center of it.
The first photos were leaked more than a week ago, but they were censored. People could pay bitcoins to get the uncensored versions. On August 31, an anon on 4chan began posting uncensored nude celebrity photos with a bitcoin address. This is when the things got out of control. Soon thereafter, similar threads appeared. Some were copycats just trying to scam bitcoins off people, but others had new photos not before seen publicly. For the next two days, more and more celebrity photos were leaked, and there are now over one hundred celebrities identified in the leaks.
The interesting thing that needs to be explained about the Fappening is why there were apparently many different people all leaking at the same time. The theory that has emerged on 4chan is that there was a secret group of people who had been trading nude celebrity photos for years (sort of like what the NSA does to normal people). It was a small group that valued secrecy, and one could only get in by having a new celebrity photo. Because people grew their collections by trading photos for photos, not everyone had the same collection, and the photos were not distributed among all members. The original leaker was a member who no longer valued secrecy like the rest of the group. A Daily Mail article reports on the theory in a little more detail.
If this is true, then Bitcoin explains exactly why the events would have unfolded as they did. Before Bitcoin was a thing, it was difficult to mass market the photos. Consequently, the collectors traded with one another in kind. However, once Bitcoin became a thing, then mass distribution became possible. When that happened, secret trading clubs became obsolete because mass marketing became possible. Rather than trading one photo for another, anyone could sell his photo to the world for Bitcoin. Once one of the group members began to leak some of his own photos, others quickly decided to jump in because they realized that their collections could soon be worthless. They did not know which of the items in their collections were also known to the original poster, and which would soon be leaked, so their incentive was to try to get money for what they had as quickly as possible.
This is all pretty cruel to the celebrities who were embarrassed, but it’s a win for Bitcoin. The message to anyone paying attention is clear: you can do things with Bitcoin that cannot be done with ordinary money. I recently wrote an article called “Bitcoin’s Shroud Subtlety and Allure” in which I described how Bitcoin makes conspiratorial group cohesion more difficult. If the Fappening took place as I described, then this effect is right at the center. The possibility of getting bitcoins by releasing secrets caused the group to fall apart. The world has changed; it is much more difficult to expect a confidante to keep a valuable secret. Once again, however, the whole story needs to be treated with caution until more facts come out.
The danger of the Fappening is that most people still believe that the way to deal with every social problem is to make a government edict against it and to punish the perpetrators, but building up the kind of state power necessary (though not sufficient) to counter this sort of thing inherently means restricting speech. They will not actually succeed, but it would be a lot nicer if they did not even try.
Photos are just data and transmitting data is free speech. No one should be prosecuted at all other than the hacker who originally tampered with Apple’s servers in order to steal the photos (who may not be the same person as the one who distributed them). Instead, this event should teach people to be more careful about data security. We shouldn’t store all our information together in one location with an organization that keeps all the encryption keys. That creates a target. If the celebrities had their own encryption keys, or if they stored their own data, it would have been much more difficult for their photos to be collected by hackers.
]]>I suggest that Bitcoin works like this. Yes, Bitcoin is a great as a payment system and so on, but I think its value as an investment prospect should be taken more seriously. If Bitcoin succeeds, then obviously its early adopters will benefit enormously. And the earlier you buy in, the more you benefit.
This prospect, I believe, does a lot to explain Bitcoin’s extraordinary success even against the overwhelming competition of the dollar. Most people are somewhat mystified when they first hear about Bitcoin because they can already buy anything they want with dollars. Bitcoin’s value proposition depends upon a lot of people actually buying bitcoins, despite the fact that today there is not much demand for them. Yes, I know you can buy pretty much anything with bitcoins now, but there is still a big difference between bitcoins and dollars. If you run around with a suitcase full of dollars, you can get anyone to do anything for you. With bitcoins you have to find the right person to take them.
Dollars clearly make more sense as a currency right now because they enjoy a much larger network. And yet, Bitcoin continues to defy skepticism and grow. Despite Bitcoin’s performance over the last six months, it is shows phenomenal returns over the past year. Furthermore, Bitcoin’s transaction volume has nearly returned to the level it was at the peak of the last mania. Over its five year history, Bitcoin has grown exponentially, and people have continued to dive in, despite how distant its success may have appeared.
By contrast, nobody benefits from holding dollars. Dollars benefit the people creating them, not the ones saving in them. Hence, there is a relatively small group of people with the incentive to promote dollars as a payment system, consisting of the government-banking cartel. The group with the incentive to promote Bitcoin, on the other hand, is relatively large: it consists of everyone else, even those who have not bought bitcoins yet. Despite the diversity of people involved in Bitcoin, they have a unified incentive to make Bitcoin succeed. Meanwhile, there is no similar incentive for people to cooperate to save the dollar.
It is therefore not so difficult to see why Bitcoin should succeed, despite its disadvantages. Bitcoin has been criticized for being deflationary due to the fact that it has a fixed supply. However, Bitcoin’s fixed supply is the very reason that its holders have the incentive to stick together and fight to win. Without a fixed supply, Bitcoin would not present the same potential benefits to early adopters and would therefore have lower odds of success. Thus, regardless of whether deflation is good or bad for society, a fixed money supply is individually beneficial, and it is therefore a crucial part of Bitcoin’s success.
Bitcoin has also been criticized as a kind of Ponzi scheme because of the way it benefits early adopters. However, although it is true that Ponzi schemes benefit early adopters, not everything which benefits early adopters is a Ponzi scheme. The difference between Bitcoin and a Ponzi scheme is that in a Ponzi scheme, the early adopters benefit by cashing out. With Bitcoin, there is no reason ever to cash out. As long as the dollar still exists, then Bitcoin has prospects from further growth. Once Bitcoin reaches the point that it can grow no more, there will be nothing left to cash out to. It is better to say that bitcoin holders have already cashed out—cashed out of the dollar, that is.
]]>This is a confused and convoluted topic, and there are a few separate issues to unravel in all this. There is the original article, which makes some vague comparisons to the U.S. economy, that is very modest about the broader implications of the events it describes. Then there is Paul Krugman’s Keynesian interpretation of it. Finally, how does Bitcoin fit into everything? I will show that both Krugman’s article and Gobry’s follow-up are confused, do not establish their case, and say nothing about Bitcoin.
First off, I enjoyed the original article. It is a well-written, fun piece, which is brief and incisive. To summarize, the members of the Capitol Hill Baby Sitting Co-op were all issued scrip, which they all pledged to accept from other members as payment for babysitting one another. An officer of the co-op would accept notifications from the members about their availability to babysit as well as their need for sitters and would match them up to one another. In other words, the scrip acted something like a currency that enabled all members to trade babysitting time.
Of course, the number of available babysitters did not always match up with the number of people who wanted to go out in a given evening. The Sweenys describe periods of both chronically too many babysitters and too few. These imbalances were caused by the way people valued the scrip. Within the co-op, the value of having a balance of scrip is flexibility. One can go out several times at one’s leisure without worrying about replenishing the supply immediately if one does not have time to provide care for other children. Everyone desires a certain flexibility, so there is a need for a certain amount of scrip per capita to be issued. Clearly it would be very inconvenient if one unit of scrip were available — no one could babysit or go out twice in a row and no two couples could go out at the same time. Everyone would want more scrip, and the one holding it would not be very willing to spend it—this is what is known as a liquidity trap. On the other hand, if there is too much scrip per capita, then everyone feels flexible enough and would prefer to go out rather than try to accumulate more.
When there was too little scrip,
holders were reluctant to squander it by going out. Those who wanted to go out but didn’t have scrip were desperate to get sitting jobs. The scrip-price of baby sitting couldn’t adjust, and the shortage worsened. The co-op even passed a rule that everyone must go out at least once every six months. The thinking was that some members were shirking, not going out enough, displaying the antisocial ways and bad morals that were destroying the co-op.
And when there was too much (which was the case at the time the article was written),
the price of baby sitting is constitutionally pegged at one unit of scrip for every one-half hour of baby sitting. Hence, this system of price controls means the inflationary pressure does not drive up the scrip-price of baby sitting, inflation is suppressed, and shortages are found.
The scrip was created and destroyed according to various provisions in the co-op’s rules. The co-op managers seem to have had little inkling that there would be an optimal supply of scrip in their organization and did nothing to ensure that the amount of scrip per capita which was created matched that which was destroyed each year. Early in its history, the supply of scrip was too small and decreasing, and later it was too large and increasing. Consequently, although they once briefly hit the “sweet spot” that balanced the supply and demand for babysitting within the co-op, they could not maintain it very long.
There at least two possible ways of dealing with a suboptimal supply of scrip: the supply of scrip per capita could be adjusted or the price of the scrip could be adjusted. If everyone has ten units of scrip worth an hour of babysitting, that is the same as if everyone had twenty units each worth half an hour. Thus, if people felt as if they had accumulated enough scrip and preferred to spend rather than save it, the co-op board could require everyone to turn in some scrip or declare that each unit is worth less babysitting time. There is not necessarily a single ideal supply of scrip that would work permanently because people will have different babysitting needs at different times, so there would have to be continual adjustments.
The co-op, of course, operates as a centrally planned arrangement characterized by strict price controls. As long as the price is fixed, then the central board must meet to adjust the price as needed. Yet although the Sweenys clearly and repeatedly identify price controls as being fundamental to the co-op’s problems, Krugman does not mention that his interpretation of the events is very different from the Sweenys and does not present price changes as a possible cause of the co-op’s problems.[1] He assumes that a change to the supply of scrip is the only possible solution, and in fact, the word price does not appear in his article even once! This is rather odd because the Sweenys explain all of the co-op’s economic woes in terms of price controls, so Krugman clearly should have responded to this in order to establish his own interpretation of the events.
Of the babysitting co-op’s story, Krugman says:
Its story tells you more about what economic slumps are and why they happen than you will get from reading 500 pages of William Greider and a year’s worth of Wall Street Journal editorials. And if you are willing to really wrap your mind around the co-op’s story, to play with it and draw out its implications, it will change the way you think about the world.
However, he has utterly failed to show that the co-op is analogous to the American economy and, granting that it is a valid analogy, has failed to draw out its implications as a consequence of price controls. For if indeed the co-op’s problems can be explained by price controls, then what is the relevance to the American economy? The American economy is at least relatively free of regulation and could be made even more free. So in order to make the co-op into an analogy, Krugman would either have to argue that American recessions are caused by central planning, or that the Sweenys are incorrect in their economic analysis of the co-op, or that despite having different causes, American recessions have the same effects and cures as that of the co-op. He does not bother with any of that.
Even if he did manage to establish an analogy, we may still ask, “Why not simply eliminate the price controls?” Ceteris paribus, if the co-op board eliminated the price controls entirely and allowed people to set their own prices, then people could respond to imbalances in the demand and supply of babysitters by offering different scrip prices. The final result would be similar to one in which the central planning board had declared a price change, without any centralized decision being required. Krugman has done nothing to show in his article that deregulation, rather than monetary policy, is a valid response to a recession. One might argue that he does not need to show that because ideas such as the liquidity trap are well established in economics. But I still claim that his use of the babysitting co-op is a red herring which teaches nothing about Keynesian economics.
Gobry’s piece does nothing to resolve the problems with Krugman’s article. When he says, “The more people tried to hoard coupons, the less people were willing to go out and get their babies sat,” he is still talking about a problem that can be entirely explained in terms of price controls, and of which no relevance has been shown to Bitcoin. Just imagine if, for some reason, we still had to pay 5,000 bitcoins for a pizza. Clearly this would cause a severe disruption to the Bitcoin economy. There would not be enough bitcoins to go around and bitcoins would be so inconvenient that no one would want to improve the bitcoin infrastructure. That would be a very severe liquidity trap! But because the exchange rate of bitcoins is set by the market rather than fixed, nothing like this has ever been a problem.
Now I let Krugman off the hook for disregarding deregulation as a solution, because that may not have been important to his audience or intentions with the article. But Gobry is most certainly not off the hook, first of all, because there aren’t a lot of Keynesians into Bitcoin in the first place, and second, because the Bitcoin economy is not centrally planned and has never experienced a liquidity trap — exactly what an anti-Keynesian would expect! Gobry ought to provide evidence that his theory will apply in the future even though it has not in the past, but the way he deals with this problem is totally inadequate.
Gobry lamely cites Bitcoin’s future release schedule:
“Once the supply of Bitcoin is fixed, at some point the Bitcoinomy will run into the same problem as the baby-sitting co-op: there won’t be enough currency, and there will be a recession, and there will be a liquidity trap,” he says.
At the time of this writing, demand for Bitcoin has gone up roughly 160,000 times, as measured by its price, since the day that two pizzas were bought for 10,000 BTC. Moreover this price increase corresponds to the growth of the Bitcoin economy. Yet there are now only about three times as many bitcoins that have been claimed as in those days.
Can that relatively tiny increase really explain economic growth by a factor of 160,000? These numbers are obviously way out of proportion, and I doubt that any similar multiplier effect has been observed anywhere else. The observed history of Bitcoin is very bizarre from a Keynesian perspective but far less so from that of the Austrian. Why has no liquidity trap occurred? Bitcoiners have already had to adjust prices by enormous factors that are virtually unaffected by the increase in Bitcoin’s supply, so why shouldn’t they be able to do this again as necessary once Bitcoin’s supply is fixed? If Gobry wishes to show they cannot do this, he really ought to provide some evidence.
Furthermore, because everyone knows Bitcoin’s future release schedule, everyone behaves now in expectation that more bitcoins will be in circulation in the future. Therefore the newly mined bitcoins should not be expected to have any effect on the Bitcoin economy to prevent liquidity traps. In an economy in which everyone knows that new coins will be released soon, everyone will just try to save more than they would otherwise because they would know that their savings will have less of an effect than they might otherwise expect. Bitcoin ought to be experiencing a liquidity trap already, yet Bitcoin prices have instead consistently changed to reflect its growth.
I close with a side-issue. Would the original babysitting co-op have solved its problems by allowing for market prices? I’m not so sure. There is an important reason that both the American economy and the Bitcoin economy both differ from the babysitting co-op. The babysitting co-op is a contractual arrangement and the babysitting scrip is not a currency and it does not function as money. The value of the co-op is enabling people to receive babysitting from within a group of people who already have some trust for one another. However, this is not their only option: they can also leave the co-op and pay teenagers with dollars to babysit. Above, when I described such a possibility, I said “ceteris paribus” but, in fact, all things are not equal, because changes to the rules of the co-op can change its competitive advantage over its alternative. In order to stay competitive, the members of the co-op must agree to some obligations to one another, and I would argue that agreeing to honor the scrip upon certain terms is a necessary part of that obligation.
As long as they have all pledged to accept scrip at a certain rate for babysitting, then they have given some real evidence that the co-op is worth joining and holding its scrip is worthwhile, but without a fixed price, there is effectively no such pledge. It is possible that some system of rules would enable the system to function still, but merely eliminating the fixed price for scrip would transform it into nothing but an appcoin. Consequently, there would be a self-reinforcing trend of members reducing their holdings of scrip in expectation that others will do the same, and demanding higher prices for the same reason. This in turn would reduce the expected future value of the co-op, thus induing people to leave it, thus, further reducing its value. The co-op would not be able to maintain itself on those terms.
But once again, there is no corresponding problem with Bitcoin. Bitcoin users have no need to make pledges or guarantees to one another because Bitcoin works without requiring a contractual relationship between its users. People can be expected to follow Bitcoin’s conventions (like accepting the greatest-difficulty chain) without making promises to one another, because Bitcoin has its incentives in the right place. Because there are real reasons to expect Bitcoin to be useful as money and for the Bitcoin network to grow, people should be expected to demand continually lower prices in Bitcoin, not higher ones.
Thus, a babysitting co-op is very different from a money economy (Bitcoin or otherwise). It is different for reasons that have been noted neither by the Sweenys, nor Krugman, nor Gobry. However, both Krugman’s and Gobry’s arguments depend on an invalid analogy between the two, whereas the Sweenys’ do not. Krugman misrepresented or misunderstood the original article and failed to discuss the price control imposed by the co-op, which means that he fails to show that the co-op’s situation has anything to do with the American economy. Finally, Gobry has merely repeated Krugman’s claims without showing any relevance to Bitcoin, and failed to deal cogently with the evidence that Bitcoin is not at risk of a liquidity trap.
I suspect that Krugman did not go back and review the original article when he wrote his 1998 column because he makes a few errors that he probably would otherwise have caught. For example, he says that one unit of scrip was worth an hour of babysitting time, when it was really worth one half-hour. He also cites the article incorrectly and gives its year of publication as 1978 instead of 1977. He does not quote from the original article to support his case or note that his interpretation of the events differs somewhat from that of the authors. None of that has any necessary effect on the logic of his position, but I think these observations suggest that his column may be strongly colored by his own preconceptions without a fresh look at the original piece. Gobry also shows no evidence of having read the original article. ↩︎
The Bitcoin world is neurotic in the way that fear dominates it. If there is not enough merchant adoption to satisfy them, they worry about hoarding and a liquidity crunch. If there is too much, they worry about downward selling pressure. If Bitcoin adoption happens too quickly, they complain about volatility and bubbles, and if it happens too slowly, they complain that no one cares about Bitcoin. If the financial world ignores Bitcoin, people worry that people are not interested, and if it pays attention, people worry about regulation.
I find it unbelievable how consistently the Bitcoiners reinterpret everything good as some kind of problem. The Silk Road is bad for Bitcoin’s image, as if Bitcoin needs to worry about image. Bitcoin’s volatility–a reflection of its extraordinarily rapid growth–is seen as something that will make Bitcoin unrespectable. Bad press of any kind is feared, when with Bitcoin there is almost no such thing as bad press.
Every month or two, a new crisis emerges. Mt Gox dies and it’s going to destroy Bitcoin. China bans Bitcoin and it’s going to destroy Bitcoin. A mining pool gets too much hashing power and it’s going to destroy Bitcoin! Every so often a new supervillain jumps up from under a rock. Not long ago, Mike Hearn was going to destroy Bitcoin. with redlists and Then there was the legion of evil behind CoinValidation, who wants to track all Bitcoin users. Recently Ben Lawsky has emerged as the latest moustache-twirler out to destroy Bitcoin with his bitlicense superweapon.
The idea that anyone could ban Bitcoin is a joke. Any attempt to do so would be monumental hubris. As if the police are somehow going to stop people from carrying private keys around and connecting to the internet. Bitcoin is too useful for people to worry about whether it is legal or not, and it is also too useful for government agents to put a serious effort into trying to stop it.
You know what’s going to destroy Bitcoin? Nothing, that’s what. Maybe a nuclear war or a giant meteor could do it, but not much else. The problem with Bitcoiners is that they think Bitcoin is fragile when it is really antifragile. It is no coincidence that Bitcoin keeps surviving every crisis. It survives because it is immortal.
As long as there is profit to be made in the Bitcoin network, Bitcoin will mow down attackers. For every outside force which threatens Bitcoin, there are many internal forces building the tools required to counter it. These countermeasures aren’t necessarily always visible in the news, but everyone in Bitcoin has the incentive to protect their investment, and therefore has the incentive to develop tools to counter any problem. The sum effect of all these invisible innovators is that Bitcoin acts like an aikido master to deflect and absorb the forces that act against it.
This all requires a little bit of faith to keep in mind because one has to believe in something that is not always visible, based on the rational expectation of its existence. But this is not so different from ordinary life: we know that the news gives us a biased sample of reality and we know that we must pay attention to what is seen and unseen. The only difference is how extreme the Bitcoin world is, how much pure FUD there is everywhere, both innocent and deliberate. This has to do with the fact that the Bitcoin economy changes so rapidly in scope and nature, that it is difficult to keep up with what is real and easy to get away with telling falsehoods.
Bitcoiners, take a chill pill. Any time something happens, think to yourself, “How likely is it anything happening now is going to matter a month from now?” The answer will nearly always be “not at all”. You are sitting on perhaps the most wonderful secret one might expect to find in this mundane world and yet you can’t find a moment of contentment. Sit back, close the web browser, have a nice glass of wine, and then take a long nap.
]]>I call this side the entrepreneurs. For a paradigmatic Bitcoin entrepreneur blog, see Two Bit Idiot’s. The other side are the investors, and they have almost the opposite view. For them, Bitcoin is the thing that people will want, and Bitcoin apps are tools for getting it. Bitcoin adoption means owning bitcoins, not spending them. The entrepreneurs see investment as something for relatively few people. The investors think that eventually everyone will be a Bitcoin investor, and that is the primary driver of Bitcoin adoption. For writings by those of the investment ideology, I can recommend Oleg Andreev’s blog, Pete Dushenski’s, Mircea Popescu’s, and the Nakamoto Institute.
The entrepreneurs emphasize spending and merchant adoption because there is no need for Bitcoin payment apps if merchants aren’t interested in accepting Bitcoin. The investors, on the other hand, believe that merchant adoption is a side-effect, not a driver, of adoption. When people want to own bitcoins enough, merchant adoption will happen on its own. For the investors, Bitcoin adoption happens as more and more people begin to envision what a Bitcoin future could look like. This is how everyone will adopt Bitcoin. It is not the prospect of buying from Overstock.com with Bitcoin in the near future that drives adoption—it is the prospect of becoming more wealthy by buying now, and of becoming less wealthy by holding dollars.
The entrepreneurs do not put much stock in Bitcoin’s network effect. People can use Bitcoin-powered apps even if they are not investors in the currency. For the entrepreneurs, price doesn’t matter. For the investors, price is everything. For them, Bitcoin’s network effect is its primary source of value, and everything else about Bitcoin exists because of it. If there were few Bitcoin investors, there would be no reason to make Bitcoin companies and it would be difficult to make Bitcoin payments because it would be so illiquid.
For the entrepreneurs, the latest gadget is always the most important. New features and new designs are what attract consumers. Not understanding the network effect, the entrepreneurs are easily fooled into thinking that altcoins, with their interesting new mining algorithms and other special features, are viable, whereas the investors know that Bitcoin is a classic and the rest are pretenders. Even within Bitcoin itself, the entrepreneurs envision many more uses for the Bitcoin network. Currency is just its first app. The investors see currency overwhelmingly the most important use of the Bitcoin network.
For the entrepreneurs, Bitcoin’s image is very important because peoples’ decision to use bitcoin is a matter of taste. For the investors, people will not choose bitcoin because it’s hip and cool. They will choose bitcoin because they can profit from it.
I have said these ideologies are not logically related to politics, but actually politics intrudes into this ideological division in at least one way. The investors like Bitcoin on the black market and the entrepreneurs hate it. The investor is happy to see Bitcoin’s established place in the black market and its association with illicit purposes. Not that he necessarily indulges in these purposes himself, but rather that they all drive Bitcoin’s network effect just like anything else. Demand for bitcoin from the black market is just as good as from anywhere else; in fact, in some sense it is better: for the black market is a safer incubator for Bitcoin’s network, being outside the reach of regulation. If Bitcoin takes over the black market, then the white market is almost certain to follow. Whereas if Bitcoin succeeds in the white market and not on the black, then that would put it in a much more uncertain position.
The entrepreneur is embarrassed by Bitcoin’s black market reputation, not just because it is bad for Bitcoin’s image, but because he believes that unfavorable laws could make the success of Bitcoin impossible. If a regulator makes the iPhone illegal, it may become a collector’s item but it would quickly cease to be an everyday technology. If Bitcoin is simply a consumer good, then it can be stopped in the same way, whereas if it is a real source of profit, then the law will have much more trouble keeping it at bay.
So which view is correct? The investors are right and the entrepreneurs are mistaken. Bitcoin’s network effect can hardly be denied. The more demand there is for Bitcoin, the more trade can be conducted in it. Bitcoin apps can’t work without Bitcoin investors, and the more investors there are, the more useful the apps become. Furthermore, if Bitcoin’s network really is becoming more valuable, then more and more people should want to invest in it. Bitcoin adoption proceeds in stages as it comes to appear viable in the nearer and nearer term.
]]>Some things are in our control and others not.
In his classic “Crypto Anarchist Manifesto,” Timothy C. May offered a vision of the future that offers society plenty of challenges to grapple with, thanks to public-key cryptography. A particularly interesting challenge is the anonymous information market:
The State will of course try to slow or halt the spread of this technology, citing national security concerns, use of the technology by drug dealers and tax evaders, and fears of societal disintegration. Many of these concerns will be valid; crypto anarchy will allow national secrets to be trade freely and will allow illicit and stolen materials to be traded. An anonymous computerized market will even make possible abhorrent markets for assassinations and extortion. Various criminal and foreign elements will be active users of CryptoNet. But this will not halt the spread of crypto anarchy.
Just as the technology of printing altered and reduced the power of medieval guilds and the social power structure, so too will cryptologic methods fundamentally alter the nature of corporations and of government interference in economic transactions. Combined with emerging information markets, crypto anarchy will create a liquid market for any and all material which can be put into words and pictures. And just as a seemingly minor invention like barbed wire made possible the fencing-off of vast ranches and farms, thus altering forever the concepts of land and property rights in the frontier West, so too will the seemingly minor discovery out of an arcane branch of mathematics come to be the wire clippers which dismantle the barbed wire around intellectual property.
[Emphasis mine]
Two lessons here:
Also, by will, I mean already.
We have already seen WikiLeaks and Edward Snowden open the floodgates for State secrets (which include your secrets). We have also already seen Bitcoin enable the Fappening marketplace of celebrity nude pictures.
And now a website promoted by WikiLeaks’s Twitter account wants to take it to the next level. Slur.io promises to be WikiLeaks 2.0:
Slur is an open source, decentralized and anonymous marketplace for the selling of secret information in exchange for bitcoin. Slur is written in C and operates over the Tor network with bitcoin transactions through libbitcoin. Both buyers and sellers are fully anonymous and there are no restrictions on the data that is auctioned. There is no charge to buy or sell on the Slur marketplace except in the case of a dispute, where a token sum is paid to volunteers.
For everything from trade secrets to State secrets to zero-day exploits to “the complete databases of social media sites like facebook,” there will be a price in Bitcoin.
I would recommend that anyone alive in 2014 not only assume that their secrets will be leaked, but live as though they have already been leaked.
Coping with this idea is not easy, as we all have said something in the past we regret or something we did not intend for public consumption. These problems, however, are not made new by the Internet. Instead, the Internet allows us to rid ourselves of past illusions of privacy that were largely unchallenged before. With this in mind, we can look to the ancient Stoics for timeless advice.
If we take Tim May’s words, and empirical data, seriously, crypto-anarchy as he describes it is happening and continues to happen. Technology is a double-edged sword in that everyone from criminals to people of virtue get to employ it to suit their ends. However, this should just be taken as a fact of nature, as wishing for a way to stop it is utopian at best and totalitarian at worst. When Cody Wilson and Defense Distributed gave the world the Liberator, we were forced to face the fact that technology is not democratic. There was no vote for whether 3D printed guns, public-key cryptography, Bitcoin, or BitTorrent should exist. Each was just the product of entrepreneurship by Cody Wilson, Whitfield Diffie & Martin Hellman, Satoshi Nakamoto, and Bram Cohen. They came into existence, and we must deal with the consequences. If bad people can use these technologies, we must use them even better.
The world changes, and that is not good or bad. Only our perceptions and reactions matter.
Strong cryptography is great at protecting information from prying eyes, but using cryptography is a matter of risk management rather than finding panaceas. Expecting even encrypted or anonymized information to remain in that state forever, even if likely, is problematic if not only for tricking us into cultivating bad habits and being too risky with where we let our minds and actions take us. Unencrypted communication is like sending a postcard, as Phil Zimmermann described it, completely readable to anyone it passes.
A solution to this is to aim to be virtuous in thought and action in the first place, such that all communications, public and private, remain true to your goals and principles. This would not make the leaking of your secrets enjoyable, but rather minimize the exposure to downside risks to your reputation. And even if that is not the case, you will have stayed true to yourself, and that is what matters most.
As I said above, strong cryptography is not a panacea. Even the strongest end-to-end encryption does not protect you from information leaking from the other end. It is therefore important to know and trust who you are communicating, both on virtue and on security capabilities. To trust in cryptographic communication should be to have confidence in your peer and to understand their vulnerabilities. Nice people can be hacked, too.
Therefore, make the best friends. Build strong, trusted relationships with other individuals, and know the limits of those relationships. Sign keys, verify fingerprints, and most importantly, know what value you truly give one another. Do not let social media devalue the word friend, lest you fraternize with scammers.
There was never such a thing as privacy. The Internet just made the fact clear. Privacy can and should be constructed, but it will never be perfected. Protecting ourselves from the dangers of crypto-anarchy requires embracing it even more fully and internalizing and practicing the virtues that have helped great men weather the storms of life since antiquity.
When this article was written, people rightfully referred to Slur.io as vaporware. At the time, the project's GitHub repository was empty, and it remains so today (yet they still managed to scam people out over 3 BTC). This article was not intended to be about Slur.io in particular, but the threat and inevitability of these technologies. Indeed, in the blink of an eye, the nightmare became real. Just over a month later on January 28, an unSYSTEM project called Darkleaks was unveiled, with working code. On February 11, the purported lead programmer for the Silk Road 2.0 announced a Darkleaks auction for pretty much every last bit of data the website backend had to offer, from user tables to source code. And the initial data leaks appear to be authentic. As the pseudonymous Zozan Cudi declared in the Darkleaks announcement, “The gloves are off. The revolt has begun.”
For an in-depth overview this leak so far, see “The Silk Road 2.0 Database Is Up For Grabs in the First Darkleaks Auction” by Andrea Castillo.
Stoic wisdom has guided great men throughout history and will continue to do so.
The better you understand crypto-anarchy, the better you can contend with the future.
Friends don’t let friends not understand basic GPG and Bitcoin security.
Everything you read is probably a lie. Keep your signal to noise ratio as high as possible.
Richard Dawkins said in an offhand comment in The Selfish Gene that “Money is a formal token of delayed reciprocal altruism.”i This turns out to be a rather insightful way of looking at money, and the purpose of this essay is to explore the idea more deeply to see how far it can take us. Nick Szabo later used some of the ideas in The Selfish Gene to describe the historical origins of money in his essay “Shelling Out”,ii but this essay will be about the theory of money.
It is first necessary to get some methodological issues out of the way. Biology and economics are similar in the way that they treat the interactions of many individuals in terms of the incentives that they all put upon one another. They then find the strategies which are most successful under the circumstances. In biology, especially in the theory of social evolution, this is often treated explicitly in terms of the language of game theory.iii In economics theory this is done somewhat less often, but ultimately any discussion of incentives, which is what economics consists of, can be treated in terms of game theory. Both theories suppose that the strategy which produces the greatest benefit for individual actors will tend to win out. In biology, it is assumed that the natural selection is the means by which this happens, whereas in economics this happens because of learning or cultural evolution.
Individualism is important in both biology and economics. In biology, the problem is often to explain how highly cooperative and altruistic behavior can be explained in terms of the self-interested behavior of organisms attempting to spread their genes. In the 1960’s, an idea had become popular in biology called group selection, which is that selection can act on groups of organisms rather than just on individuals, and consequently that organisms can have traits which can be deleterious to individuals yet beneficial to the group as a whole. However, if any individual in a group could out breed its fellows by reducing those deleterious traits, it would. Adaptations which appear to be good for the group must therefore, always be good for the individual.iv
In economics it is the other way around: the problem is often to show how certain kinds of rules—say a government regulation—produce adverse effects because they fail to be individually beneficial to the people subject to them. The greater the resources that the government employs enforcing its rules, the greater the benefits to successful cheaters. Therefore, no amount of expenditure is ever enough to produce the desired outcome.
Both sciences search for functional explanations of behavior in terms of rewards and punishments rather than in terms of mental processes. In biology, an animal’s psychology is just like any other body part—it evolved to serve specific purposes. Therefore, we do not explain animal behavior in terms of how it feels or wants. Its feelings and desires are to be explained in the same way as everything else about it: as part of a strategy to maximize expected future offspring. In economics, we wish to explain peoples’ actions in terms of consumption. Consumption may be anything that may be treated as an immediate reward. It does not matter what a person claims about why he does something. What matters is what he actually chooses, and the problem of economics is to explain his choices in terms of his preferences. It is easy to see that this approach is necessary by the way people treat money: though everyone uses it every day, very few can give a satisfactory explanation of it.
Thus, both sciences are behaviorist in a certain sense. As in behavioral psychology, we are attempting to explain behavior in terms of rewards and punishments, rather than in terms of invisible feelings, behavioral psychology attempts to explain behavior as the result of a past schedule of rewards and punishments, whereas economics and evolutionary biology attempt to explain behavior in terms of future expected rewards and punishments. Experimental psychology thus treats organisms more like physical processes which are expected to respond in predictable ways to past stimuli, whereas in economics and evolutionary biology, organisms are goal-oriented, machines that respond to incentives (that is, expected rewards and punishments) in search of some optimum.
There is a common criticism of economics which says that economic theory is invalidated because real people are irrational, whereas the people in the theory are much too rational. Biology is a good standpoint to explain the problem with this objection. Typically in game theory, we define equilibrium strategies in terms of players with perfect knowledge of the game, who are able to compare the likely outcomes of every strategy and who assume the same of their opponents. Of course, it is not true that the organisms being modeled by the game actually know anything about strategy—or anything at all—but the game-theoretic models still work. This is because the equilibrium strategies of the game (if they exist) are precisely what an adaptive system will tend toward, even if it is not intelligent or rational at all.
All life adapts by natural selection, but some, preeminently humans, adapt readily by learning. However, the mechanism of adapation is irrelevant: it just means that humans adapt much more quickly than other animals. The objection that humans are too irrational for economic theory to apply to them is a failure to think in behaviorist terms. People must necessarily adapt to a set of rewards and punishments, and they do so by learning. We do not need to assume that people reason their way to the best strategies in a game; we only need to assume that people tend to imitate the more successful among them, and that consequently the more successful behaviors tend to beat out the less successful. The people do not need to understand what they are doing or why in order for this process to work.
Furthermore, applications of economic theory normally depend on how the optimal behavior changes rather than its absolute value. This allows us to make statements about the economy without knowing precisely what the optimal behavior is and without assuming that anybody actually is behaving optimally. A typical economic prediction takes a form like the following: “circumstance A rewards behavior x more than circumstance B. Therefore if there is a change from B to A, we should eventually expect more of behavior x than before.” As long as the premise of the argument is true, then the prediction that there will be more behavior x can be made with great confidence, but not with great precision. Because the precise way that people will react to a change from A to B depends on how strongly the two situations reward or punish them, and on how quickly they learn to adapt, it would be very difficult to say how much more x could be expected. However, ceterus paribus, a change from A to B certainly cannot cause less x. Thus, for example, I can say without hesitation that a minimum wage, if it is set high enough, will cause unemployment, but I cannot say how much.
Those are the similarities between biology and economics. The most important difference between them is the way that they treat value. In economics, value is subjective. People can value many things, even things that do not make sense, and it is not the economist’s job to ask why that should be. Goods which are considered to be valued for the immediate satisfaction they provide when they are consumed are called consumer goods. Not all goods are consumer goods, however, and the value of everything which is not a consumer good must be explained in terms of the consumption that it ultimately makes possible. For example, people generally do not want to own factories just because they like factories; they want to own a factory in order to earn a profit with it, which they can then spend on consumption. A factory is an example of a capital good. Ultimately its existence in the economy can be explained because it can be used to produce other goods.
On the other hand, in biology, value is not subjective. There is one ultimate value, and that is the maximization of an individual’s expected future offspring, or more properly, the maximization of the expected rate with which its genes will spread throughout a population. A puzzle in biology is when an organism exhibits behavior that appears to devalue things like food and status because it is very easy to see how such things would promote its survival and mating success. If an organism gives food away or rejects status, then that needs to be explained. On the other hand, in economics there is no particular need to explain someone who is an anorexic or a cynic philosopher. That would be a job for a psychologist; to an economist those are just his preferences. Consequently, whereas in economics, interpersonal comparisons of value are impossible, in biology they are possible between members of the same species.
Concepts in biology can be carried over directly into economics by taking account the difference between the treatment of value in each. If a biological idea which can be adapted to explain economic behavior in terms of the consumption that it ultimately enables—accommodating the fact that people may have very different preferences about what they like—then it is as valid in economics as it is in biology.
To the economist, altruism simply means gaining satisfaction from benefiting other people. Nothing about that requires an economic explanation. Peoples’ preferences are exogenous, and if they enjoy helping others, that is not an economic issue per se. Whereas in biology, the only value is that which best spreads genes. It is easier to understand how this should produce selfishness on the part of an organism, so an organism which enjoyed helping others would be in need of an explanation.
In biology, altruism cannot be explained in terms of feelings and satisfaction because feelings are difficult to observe. Altruism needs to be defined in terms of observable behavior. Many animals are not capable of having feelings at all, but even very simple organisms are capable of cooperating. We can therefore abstract feelings away entirely. There is even a concept in biology called parasitic altruism, which means that an animal is a host to a parasite and is better off continuing to feed the parasite than attempting to remove it, which would be too expensive. More likely an animal in that circumstance would feel resentment, not benevolence.
Therefore, in biology, altruism is defined is an action which reduces an organism’s own fitness and increases the fitness of another. The word fitness has to be clarified. Of course no behavior could survive in a population that does not help to maximize an organism’s offspring. Fitness must be understood in an experimental sense. An organism’s true fitness is not easily observable because it is, first of all, probabilistic, and second because even to estimate it would require observing an organism over its whole lifespan and beyond to learn how many children it raised compared to others of its species.
Instead, experimental fitness is hypothesized to relate to something more easily observable, such as resource-gathering capacity and a study is done to disprove the hypothesis. For example, if resource-gathering capacity was our hypothesized definition of fitness, then an altruistic animal would be one that gave resources away to another. To observe a population in which animals habitually gave resources to one another would prove that resource-gathering capacity alone does not truly measure their fitness. In biology, altruism is a bit of a loaded word—it does not stand for its face value, but rather for a behavior in need of an explanation.
Any altruism that is observed in biology implies that there are benefits which take a longer time to play out than that which is required to make the observation. This is the only way that an observation of apparent altruism can be reconciled with the theoretical requirement of explaining everything in terms of individual benefit. This does not mean that every single altruistic act must be calculated to produce some future benefit. The benefit may be probabilistic. For example, consider the case of a bunch of soldiers who go to war for their home country. They are behaving altruistically toward the people of their nation because they are putting themselves at risk in order to keep their friends at home safe. Let us say that most of these soldiers will die. Can their altruism still be explained in terms of future benefits? Yes, certainly. For some of the soldiers will survive and will return home to receive great honor and status, and it is not known who will survive beforehand. If the expected value of ones future status as a veteran offsets the probable cost of dying horribly in battle, then it can be expected that soldiers will want to go to war.
The first step for talking about money is to define it in behaviorist terms and to pinpoint what about that behavior is most in need of explanation. We don’t think of money as a thing; instead we think of it as a behavior. We’re not humans living and working in our own economy anymore; we’re biologists or economists observing the human species and theorizing about why monetary behavior is a successful strategy.
In economics, the interesting thing about money is that it is not consumed, just held. Even a miser who loathed to spend money and who simply hoarded it without any apparent plans to spend it is not treating it like a consumer good because if the money he was hoarding hyperinflated and became valueless, he would presumably throw it away. (We could imagine someone who just loves to collect money regardless of whether it can be spent, but that person would just be a coin collector, and in that case he would be treating the money as a consumer good. There would be nothing to explain in that case.)
Of course there is no need to explain why someone would spend money because that is when he gets resources for consumption, which improves his fitness. There is, furthermore, no reason to explain why someone would rob money at gunpoint or burglarize a house for money. If we know why someone would trade goods and services for it, then we know why someone would steal it. Another thing that does not need to be explained is why someone would manufacture or counterfeit money. None of this is altruistic.
The puzzling thing about money is that everyone wants it in the first place. If that can be explained, then everything in the previous paragraph is explained immediately. In economic terms, a person who accepts money in payment gives up a good that can be consumed for something he does not intend to consume. In biological terms, he makes himself less fit by taking the money and makes the buyer more fit because he gives up real resources or incurs a cost to himself in energy or time to the immediate benefit of another. From a biological standpoint, this is clearly an example of altruism, although not for the economist. However, from the standpoint of both sciences, the same behavior is in need of explanation.
This behavior I call monetary behavior, and I define it as the acceptance of money in trade; i.e. monetary behavior is to trade something for a good whose most valuable use to the one receiving it is to trade it again later. I wanted to coin the term monetary behavior because we tend to be so used to thinking reflexively of money as something that everyone wants and of the value of money being somehow in the money good itself that it is difficult to remind ourselves consistently that this is not the case. Thinking of money as a behavior rather than as a thing is a way of consciously reminding ourselves that the only possible value of money is other people.
It may seem obvious why monetary behavior exists: people want to spend it on something else later! However, there is a problem here: they only want money because other people also want money. Which is the same reason they all want money too! Everyone wants money because everyone else wants money because everyone else wants money… This is really pretty extraordinary. How can a whole society behave this way? It sounds like it is holding itself up by its own bootstraps. One could object at this point that there is no infinite regression because originally what is now money may have been used for other purposes. However, recall that economics is future oriented, not past oriented, so the past uses of the money good are irrelevant. It matters not a whit to me whether a gold coin will one day be used to make a watch or necklace. As far as I care, it could well continue to be traded as cash forever. The problem is to explain how monetary behavior can be sustainable.
One might say that he is selling goods because he produced much more of a good than he would want himself, for the very purpose of trading it. Typically people specialize in what they produce and then use the money they make to buy what they need. However, that puts the cart before the horse. Specialization to that degree depends on the existence of money, not the other way around. This explains why money is socially beneficial, but we need to explain why it is individually beneficial. It has to be explained in terms that would make people want to start using it before they depend on the highly specialized economy that it enables.
As I observed above, altruism implies no particular emotional state. A moneymaker may not feel very altruistic about amassing wealth, but to convince everyone to use money would be a roughly similar problem to convincing everyone to live in a commune “from each according to his ability and to each according to his need.” In a commune, I would depend on the good behavior of everyone else. If I worked hard and everyone else slacked off, then I would be taken advantage of. Everyone must do his duty or the system fails. By the same token, if I begin to accept payment in money and to hold savings in it, I am depending on other people behaving the same way. What if I started saving in money, but no one else did so? Then I will have done a lot of work for nothing because my money would not be accepted anywhere. Thus, it is not just a rhetorical move to call money a form of altruism; there is a very deep and conceptually useful sense which makes the use of money very similar to other behaviors which people would more readily identify as altruistic.
An allegory from many folklores says that hell is a table full of delicious food, but everyone must use such long utensils that no one can bring the food to his own mouth. Therefore, everyone starves in the midst of plenty. Whereas heaven is exactly the same, except that everyone feeds the people sitting across from him rather than attempting to feed himself. This is essentially the idea of reciprocal altruism, which is an idea introduced by Trivers in 1971.v
The idea is that pairs of animals provide favors to one another and are better off because of the expected benefit of being able to receive favors when in need. Of course, if everyone were completely indiscriminate with their favors, no such system could persist because it would be open to abuse by cheaters. A selfish animal could benefit by receiving favors but never giving out any. Therefore the selfish behavior would be self-promoting, and would soon take over the population. In fact, as selfishness became more and more prevalent, altruism would become less and less beneficial because the altruists would meet one another less and less often, and therefore would spend more and more of their energy benefiting selfish animals. Unless there is a means to prevent cheating, reciprocal altruism fails to be individually beneficial. The problem in evolutionary theory is to clarify what makes this sort of interaction possible.
Theoretical studies of reciprocal altruism involve repeated two-person games. There are a variety of two-person games which allow for the development of reciprocal altruism. In these games there is one optimal strategy for a single round of the game, but a different optimal strategy if the game is going to be repeated many times. This is precisely what is expected; altruism must always be explained in terms of future benefits, so if there is no future, altruism is impossible.
A successful altruistic strategy has two characteristics: first, it must be preferable to be an altruist with another altruist than to be a non-altruist with another non-altruist; second, players can choose how to react to the past behavior of their opponents. This allows a player to be altruistic with other altruists or non-altruistic with others who are not. Reciprocity discourages non-altruism. The non-altruist reaps what he sows. Under these circumstances, altruism will succeed in repeated games as long as the probability of repetition is high enough.
One example of a game that models reciprocal altruism is the famous Prisoner’s Dilemma.vi This is a two-person game, in which each player has two options: cooperate or defect. The payoff matrix for the Prisoner’s Dilemma looks like this:
In this diagram, each box represents an outcome after both players have made a choice. The first item in the list for each outcome is the reward to player one, and the second is the reward to player 2. The numbers in the boxes are arbitrary—what matters only is some ordering relations between them. A more abstract (but equivalent) payoff matrix for the Prisoner’s Dilemma is this:
where Y>W>Z>X and X+Y<2 W. This second condition means that outcome W is preferable to equal odds of outcome X and Y.
The Prisoner’s Dilemma may seem like an odd choice to model reciprocal altruism because both players must cooperate at the same time. That seems more like mutualism! However, each cooperative move on the part of either player is altruistic because, in the one-round case, every cooperative move is less beneficial to itself and more beneficial to the other player. Mutualism only occurs when it is immediately beneficial to both players to cooperate. It is possible to alter the game so that the players must alternate at behaving altruistic to one another, but it is easiest to understand the Prisoner’s Dilemma first.
The one-round Prisoner’s Dilemma is very simple—the outcome is that both players defect. This is the best outcome that either player can ensure for himself. They can’t cooperate because neither can prevent the other from defecting. On the other hand, the iterated Prisoner’s Dilemma is a much more complicated game because there are an infinite number of possible strategies. The game has still not been solved completely, so instead of attempting to find the best of all possible strategies, we enumerate a subset of simpler strategies and compare them. This is perfectly alright—normally we do not know for certain which strategies are the best in real-life scenarios. Instead we try to understand real situations by comparing a few alternative strategies. If we cannot, then we have to discover new strategies.
Before talking about specific strategies, however, we have to talk about how to evaluate them. Suppose two players cooperate every round, for an infinite number of times. They get a benefit of three each round, which comes to infinity. Now suppose they defect instead. That’s a benefit of 1 each round—which also comes to infinity. How do we compare these outcomes? I know of two reasonable approaches, and both of which lead to the same qualitative results. One is to say that there is a cut-off and that the game ends after a fixed number of rounds. The other is to say that each round becomes successively less important the further in the future it is. In other words, a player who earns a reward X each round for an infinite number of rounds earns
where R is some rate that determines how quickly the value of future rewards declines. This rate could be interpreted as a probability, or as a rate of time preference, or as a combination of both.
Other simple strategies are possible, but they aren’t interesting theoretically because they are neither successful nor do they make any intuitive sense either. I will not go through all the game theory mathematics but merely state some results.vii
The gist of these results is that a population will always either end up all defectors or all tit-for-tatters, depending on R and on the initial composition of the population. If tit-for-tat wins out, then it is indistinguishable from a population of cooperators because no one ever needs to be punished. Every round looks like pure altruism.
A crucial element of tit-for-tat is its charitable opening move. If one is the only altruist in a population of defectors, then it is very bad to give everyone the benefit of the doubt. For any proportion of altruists to defectors, there is always some interest rate such that it is better to be a defector, and the defectors do better and better as they become more numerous. Thus, with cooperation there is a network effect. It is better to be a cooperator among lots of other cooperators than among lots of defectors.
What exactly does this analysis prove? Rather a lot, actually. The Prisoner’s Dilemma has a very wide applicability. Of course in real life, people generally have more options available to them that just cooperate or defect, but other options can be ignored if they do not affect the optimal strategy in a given circumstance. Thus, the Prisoner’s Dilemma can apply to much more complicated circumstances than it may at first appear.
Furthermore, the game does not need to be played exactly the same way each round. The conditions that Y \gt W \gt Z \gt X and X+Y \lt 2 W can be satisfied in many different ways by many kinds of possible future interactions. As long as the relations hold, it is not necessary to assume that each of W, X, Y, and Z refers to the same thing each round, or takes the same value to the players. It is still true that tit-for-tat can be the right strategy in any individual round as long as there is a high enough likelihood of similar interactions in the future.
So the Prisoner’s Dilemma appears everywhere. To show more concretely how it can hide in other contexts, I will show how it appears in another two-person game. If the Prisoner’s Dilemma is modified so that X+Y>2 W, then the players would be better off alternating cooperation while the other defected. This is called the modified Prisoner’s Dilemma. This would seem more like a realistic model of reciprocal altruism, if we could get the players to take turns with one another. In this case, tit-for-tat doesn’t work as well because it can be beaten by the alternator. An alternator, however, is still beaten by a defector, so altruism does not win out with any of the simple strategies already presented.
It turns out the best strategy is one that mixes alternation with tit-for-tat, according to some probability whose value is determined by the precise nature of the payoffs. Two players following the mixed strategy will eventually become permanently in sync with one another. This strategy wins out if the probability of future interaction is high enough and it has a network effect is well. It retaliates against other players that go out of sync with it—eventually. Because it only follows tit-for-tat with some probability, it may take several rounds to react. If we allowed for more complex strategies, we could devise a strategy that retaliated more reliably. All it would require is for the player to react to the last two moves rather than the last one, but it would be very similar—it would be an alternator or a tit-for-tatter under a specific condition rather than a probability.
Of course, if more complex strategies were allowed, then the players could exchange favors according to more complex rules than mere alternation. One player could cooperate twice in a row as long as the other defected twice in a row. This would all work out as long as the players remained even on average. Of course, this would require a degree of coordination between the players which we have not allowed for. However, allowing for it does not change the nature of each individual round of the game, only the schedule of favors that may be available in the future. Thus, allowing for it does not change the conclusion that altruism is a successful strategy under the right circumstances.
So now we have two kinds of reciprocal altruism, right? Not really; there is nothing much new here because we can find the Prisoner’s Dilemma hiding in them. This table explains how to combine moves in the modified Prisoner’s Dilemma to construct the same outcomes as the standard Prisoner’s Dilemma.
Other possible moves exist in the modified Prisoner’s Dilemma over two rounds, but they can be ignored because they do not affect the winning strategy.
Tit-for-tat is the winning strategy once again in this new way of looking at things, and that is what one is really doing with the winning strategy of the modified Prisoners Dilemma. Players still win by cooperating with other cooperative players and punishing non-cooperative players. It is just that cooperation plays out over several moves. Other two-person games with altruistic strategies can be treated the same way.viii There are a few different games which are similar to the Prisoner’s Dilemma. Some of them allow for altruistic strategies and others do not. Those that do all have (at least) three similar properties. First, altruism can only succeed if the future is not discounted too rapidly, or alternately if the number of rounds of the game is high enough. In other words, the future must be important to the players of the game. Second, there is a network effect for altruistic strategies. Third, a successful altruistic strategy must be capable of retaliating against non-altruists.
Obviously, the use of money does not require pairwise reciprocity, so it is quite different from the two-person games described in the last section. However, the two-person case is easy to generalize to larger groups. It is not logically necessary that altruism should always occur in pairs. For example, if animal A was altruistic to animal B, and animal B was altruistic to animal C, and animal C was altruistic to animal A, then their system ought to work out just fine, even though there is no pairwise reciprocation. This is the sort of thing that Dawkins apparently meant when he referred to “delayed” reciprocal altruism. There is not direct reciprocity between pairs of organisms, but the value of altruism is the same: the value of the favors that one eventually receives is worth the cost of giving them out. What goes around, comes around.
As with the iterated Prisoner’s Dilemma, a complete theory of group altruism would be extremely difficult to elaborate, but we can still compare different kinds of simple strategies without describing every possible one, and the lessons from the two-person games hold true. For example, imagine an organism in a group that chooses to act altruistically to other organisms based on their past interactions with other group members. If organism A watches organism B behave altruistically toward organism C, then, given the opportunity, A will act altruistically toward B. After that, A may never interact with B again, but other organisms may have seen A’s altruism toward B and will act altruistically toward A at the next opportunity. On the other hand, organisms in whom altruism is not observed do not receive it. Under circumstances in which the potential benefit of receiving favors is greater than the cost of giving them out, this sort of behavior will enable altruistic organisms extract that benefit without allowing non-altruists to mooch off of them.
Altruistic groups require more complex behavior on the part of the animals because detecting cheaters requires them to observe and keep track of more relationships than just their own. Nonetheless, some more complex systems of reciprocal altruism are known. For example, some very intelligent animals, such as apes, are able to form coalitions. They are more altruistic toward other group members than to non-members without always expecting direct reciprocity.ix Humans, of course, are very good at forming altruistic groups. I am sure that you have experienced this: when you learn that someone belongs to a group that you belong to, you feel much more willing to act altruistically toward him and vice versa, without reciprocity necessarily being expected from either side. This is possible because anyone can damage their reputation in the group by not acting altruistic within the group. (To be clear, I am not claiming to describe peoples’ real feelings toward one another when they interact in groups. They are not necessarily going through a calculation like this. Rather, people just have an instinct to feel more warmth toward other members of groups to which they belong.)
It is possible to make the simple models of the previous section directly applicable to group cooperation by treating one player as a cooperative group that coordinates its treatment of another individual, represented by the other player. Suppose that N organisms have learned to coordinate their treatment of one another. They can then encourage altruism in an N+1th organism by treating it to a coordinated tit-for-tat strategy. When the N+1th organism fails to be altruistic to any member of the group, the group as a whole must deny him the next time he needs help.
If the N+1th proves to be capable of coordinating with the rest, then later they can open relations with an N+2th organism in the same way. Group coordination can be considered to be a form of altruism in and of itself, so organism N+1 is observed to follow the group rules with regard to organism N+2, then it is rewarded or punished accordingly.
I’ll go over this construction again because I have described several different interactions as two-player games and it is important to keep them all straight in under to understand why this should work. I have described how the organism N+1 can encourage organism N+2 to behave altruistically to the group of N organisms. This is not any particular kind of altruism—just a reward or punishment that depends on whether organism N+2 is altruistic or not. Of course, in reality, there would be many relationships of this kind. Every organism from 1 to N would also treat organism N+2 in this way. And they would also treat one another according to the same terms. I have also described how the rest of the group encourages organism N+1 to coordinate with it. It is rewarded or punished according to whether it has correctly rewarded or punished organism N+2. I have treated organisms N+1 and N+2 as if they were outside the group, but really they might as well be on the inside. Everyone in the group is also always treating everyone else according to the same rules, and every member is simultaneously playing simple games with one another and with the group as a whole.
Group altruism, therefore, can be individually beneficial under certain circumstances. If the members of a group have the ability and the incentive to keep track of their members so as to remember who has been the most altruistic, then altruistic groups can grow by accretion.
Money satisfies the conditions of reciprocal altruism and, in fact, allows for a much greater degree and extent than any other that has ever existed. It is so easy: everyone simply trades some kind of token with one another to keep track of how altruistic they have been. When you provide a favor to a group member, you get tokens from him, which you can later use to redeem favors from someone else in the group. There is no need to know anything about another person in order to detect cheating. You do not need to know his group loyalty. You only need to know whether he has money or not. If he has run out, then he needs to provide some favors rather than call them in. Cooperation with money connects all people in an economy, regardless of religion, nationality, or other group loyalties.
A money system does not place any practical limits on the size of the group. Anyone can enter the group of altruists by choosing to perform a favor in exchange for money. Once in the group, he does not need a reputation and no one needs to know about his relationship to other members. All they need to know is whether he has any money left. I said that group altruism requires rather complex behavior, but actually it is not all that complex—as long as a group of organisms can count, they don’t have to watch one another or coordinate closely.
All of the rules of group altruism that I have described in the previous section are followed by a money system. To check this, let us imagine some of the organisms from the previous group as people who are using money. Organism N+1 can be Alice and organism N+2 can be Bob. The problem is to show how the group uses money to encourage Alice to coordinate with the rest to punish and reward altruism in Bob.
First, suppose Bob deserves to be rewarded. This means that he has acted altruistically toward some group member. He has done a favor and received money for it. Now the group requires Alice to reward Bob by behaving altruistically toward him. If she does, and she performs a favor for him in return for money, then she gets a reward for this—she can use the money to redeem a favor from someone else. On the other hand, if she does not reward Bob, then she is not rewarded either. She doesn’t get the money and therefore cannot redeem favors. Now suppose, that Bob failed to be altruistic to the group, and needs to be punished. When it is Alice’s turn, all she has to do is refuse to serve him. Her reward for doing so is simply the opportunity cost of performing a favor without being rewarded. On the other hand, if she is altruistic toward Bob, then her punishment is that she receives no money from him, and hence cannot redeem a favor later from someone else.
Note that the “punishment” in this style of game is nothing more than an opportunity cost. Physical punishments and social pressure are not necessary. People who do not coordinate with the group simply forgo future altruism from group members. In fact, Alice may very well have reasons to behave altruistically toward Bob though he has no money. They might develop their own system of reciprocal altruism between the two of them instead. If the money system was not useful enough, then everyone would revert to that, which would apparently be a kind of gift economy.
Earlier in this article I described a paradox of money. How is it possible for everyone to want money because everyone wants money because everyone wants money, etc.? Once most of a population begins to behave this way, then anyone who does not is punished by being excluded from the money economy. We all must value money, even though it may not appear to make any rational sense and the whole concept may seem fraught with paradox. This does not explain how monetary behavior begins, but it explains why it persists once it is established, and it does so by reference to the individual benefit of the behavior. This answer may seem trivial or obvious, but it is not: how many people go around thinking of the money in their pockets as a means of punishing one another for not being altruistic enough? We all know that it is horrible not to have any money, but this theory gives an explanation as to why.
This is not to say that charity is bad or that paupers deserve to be miserable. To show that something is functional is not the same as justifying it absolutely. Rather, there is a reason that a money system works and why it should be expected to remain successful. Radically different arrangements are likely to fail against it, and social theory must take this into account.
I have argued in an earlier section that monetary behavior is a form of altruism and I have shown here that it satisfies one of the conditions of reciprocal altruism—that of punishing non-altruists, or of preventing them from benefiting from the altruism of everyone else. The other condition required of reciprocal altruism is that there should be lots of expected future opportunities to call in favors. In monetary economics, the word for this is liquidity, and it roughly refers to the demand for money. A money is more liquid the more easily a given sum of goods can be sold for money without markedly altering its demand. If a money is liquid, therefore, then many opportunities for redeeming favors all around. If money is illiquid, then society might run out of favors to give before one runs out of money, which means that the money must become less valuable. Thus, as with other forms of altruism, therefore, money has a network effect. If lots of people want lots of money, then the system is more effective than when few people want it.
If money is a form of reciprocal altruism, we can have a very good idea of what makes good money. Good money is whatever is closest to an ideal system of reciprocal altruism. It is easy to see how many of the traditional qualities of good money serve to enable this ideal. I’ll just list a few here. Some of these qualities have been attributed to Aristotle, but this is a misattribution, and I don’t know where they originally came from.
A money system just needs to be an association of a number with each person that they can transfer to one another, and which can be used to track a person’s altruism. Money must be scarce because if it were not, then anyone could easily increase the size of their number associated with them without having to provide favors for them. Money must be difficult to counterfeit because if it were not, it that just means that it is hard to tell what the correct number associated with a person should be. Money must be fungible, divisible, and durable, or else it won't act like a number at all. Finally, money must be portable because then it could not be easily transferred and would necessarily be less liquid. In a global economy, in which people do business from opposite ends of the world, money should not only be portable, but teleportable.
The earliest form of money was commodity money, which means that the monetary unit was a good whose scarcity is a result of the physical difficulty of producing it. Before the days of mass production, money could be produced from materials that were not scarce or valuable because the scarcity and inefficiency of human labor kept them in short supply. For example, wampum was a kind of hand-made bead produced from clam shells. Other forms of commodity money, such as gold, are scarce because there is a strictly limited amount on Earth.
Commodity money has the advantage of allowing for cooperation between people who have no knowledge of one another. It can enable trade routes between Europe and China during times when the Europeans have no idea what China is like and vice versa. It is the only form of money possible when communication between different peoples is limited. Even knowing nothing of the technology or culture of different lands, probably no one there can cheaply manufacture gold and silver. This assumption has sometimes backfired; during the age of exploration, European settlers and merchants caused monetary crises in the lands they visited because the natives relied on money that they could not mass produce, but which the Europeans could. This was the fate of wampum and the famous Yap stones.
The problems with commodity money is that it is not very portable and costly to protect from theft. People have often resorted to storing their commodity money in secure warehouses, which came to be called banks. If a bank is well-known, people can trade in receipts which grant them the right to redeem the commodity money from the bank. This leads us to a second form of money.
Fiat money is a kind of money that exists because it is stamped with the brand of an institution. An institution issues units of currency, and it can make as much as it likes. The units may be imprinted on physical pieces of paper or may be nothing more than numbers in a ledger. It is the responsibility of the institution to ensure that it continues to function properly as money. The integrity of fiat money is backed by the reputation of the issuing institution.
Historically, fiat money has arisen out of banknotes whose convertibility into commodity money was gradually reduced to nothing. If this is done slowly enough, people continue to use the bank notes as money even though they are no longer backed by a commodity. This is a dishonest practice, but fiat money is not necessarily dishonest. We could imagine an honest fiat money that was never issued under false pretenses, though this is certainly not the historical norm. The result is a kind of money which is much more portable than commodity money but whose scarcity is protected by the promise of the issuing institution rather than the physical difficulty of producing it. Fiat money requires a greater degree of communication between a people for it to work. Someone is certainly not going to accept pound notes if he doesn’t know what England is or dollars if he has never heard of the USA.
The principle of concentrated benefits and distributed costs has meant that issuers have often been able to take advantage of users by manipulating the money supply to their benefit. The issuers of money can effectively evade punishment for a failure to be sufficiently altruistic by creating extra units of money at a very low cost. Unlike regular folk, who must never run out of money, the issuers can continue to spend and never run out.
Finally, money as a distributed system is the latest step in the evolution of money.x This is what Bitcoin is. The principle which protects Bitcoin from manipulation is the difficulty of changing the behavior of the distributed system. Money as a distributed system has no physical presence at all. It is one huge ledger, one which must be duplicated over many locations. It must be impossible for someone to change a copy without being detected, and there must be some process in place to ensure that all copies remain in agreement.
Money as a distributed system requires a much greater degree of communication between everyone in order to function properly. Fiat money requires that there be one well-known institution, but a money as a distributed system requires everyone to be in communication with everyone else. If this is possible, its advantages are many. The supply can be strictly limited—not just to some unknown amount of something in the Earth, or to an amount that an issuer can change, but to a specific number that no one can change. Trusting a well-designed distributed system is more like trusting the laws of physics than trusting a human agent. Because it can be protected by cryptography, it can be made very difficult to steal at a low cost. Therefore I would conclude that a distributed system is capable of coming closest to the ideal of perfect delayed reciprocal altruism.
Reciprocal altruism is a great first start as a theory of money because it so neatly undercuts a lot of the most common fallacies. First, what gives money value? An adherent of commodity money might say that it is the industrial uses of the money good, whereas an adherent of fiat money might say that it is the force of the government issuing it, and the loyalty people have toward their government. Neither of these answers is true. It is true that some system is required to keep track of who has money and who does not, but that is not what makes money valuable. The value of money is the value of cooperation. It is that simple. The value of money is not somehow in the monetary unit; it is in the whole of society and in peoples’ desire to cooperate.
Second, is there value in changing the supply of money? Evidently not; changes to the money supply only prevent the money from functioning as a form of reciprocal altruism. Whoever first received the new money would be able to spend it without having done anything to earn it. Such a money system allows non-altruists to benefit. It allows for cheating. It would be possible, of course, for all money everywhere to multiply by the same proportion at the same time. This could be done for real in a distributed system. If that happened, no one would benefit disproportionately. But what would be the point? Doing so clearly changes nothing about the real state of the economy and would have only the effect of immediately changing all prices by the inverse proportion.
Finally, is there anything inherently antisocial about being wealthy or about amassing wealth? If making money means just granting favors, then it is not inherently antisocial no matter how much money someone makes. The only question is whether it is possible to give out favors that are not as beneficial as they may at first appear, but this is a very subjective question that would arise in any system of cooperation. A person who has a high income is just someone able to provide very useful favors. A person with a large savings is even better; he is someone willing to donate to the economy without demanding much back. If he spends his money eventually, then he was giving to the economy on a loan; if he is willing to maintain his savings permanently, then he is willing to remain permanently invested in the future productivity of the economy. This is social behavior, not antisocial!
In an economy like ours with billions of humans all cooperating with one another, some people will figure out ways of doing favors for billions of people all at the same time and consequently will end up with thousands or millions of times the amount of money that people have on average. Even this cannot be criticized. The possibility of becoming one of those extra-helpful individuals is part of the benefit of altruism, and it is therefore part of the incentive that fosters cooperation. If it is curtailed with a system of progressive taxation, then that reduces the everyone’s willingness to cooperate, not just those paying the tax.
This is not to say that there may not be other reasons for progressive taxation, but not because excessive wealth is somehow damaging to the social order. Rather, the contrary is true: progressive taxation will tend to make people less cooperative, at least as far as the money system is concerned.
There are, however, other systems of cooperation that humans rely on. All of them require investment by the participants, and they are therefore all in competition with one another. I think that the extraordinary benefits of money explain much about why group ideologies like religions, political parties, and nationalist ideologies maintain teachings which are so averse to it. Both the money economy and ideological groups are enablers of group altruism. Consequently, they are in competition with one another. Both require investment of their members’ time and effort, and a person can only give so much. Yet the money economy gives such a superior return for most things than do ideological groups that it leaves the groups at a severe disadvantage. When you hold a large cash balance, you are investing in the whole human race rather than in one group, and you are invested in a system capable of a vastly greater degree of specialization and invention. Such steep competition would threaten the cohesion of any ideological group.
That monetary behavior is a form of altruism, and of reciprocal altruism in particular, has been demonstrated by relating the properties of money to the definition of reciprocal altruism and to its required features. The theory of reciprocal altruism is not, however, a complete theory of money. It leaves some things out. In the first section of this article, I explained that importing a concept from biology into economics requires that it be treated according to a very different theory of value. I have not done so here. That is what is missing from a complete theory of money. In particular, a subjective theory of value allows for two new phenomena not treated here.
First, the services which most animals can perform for one another are very limited. Studies of reciprocal altruism in the wild usually look at only two goods: a single kind of favor which the animal give one another, and the debt that animals owe to one another for having received it. In a human economy, there are many, many goods. Money tends to result in a set of unitary prices for all goods, but the theory of reciprocal altruism does not explain price formation and why there should be a unitary set of prices.
Second, the value of money can change relative to the entire economy. In other animals, altruism evolves as an instinct over generations, whereas a human economy can rapidly change in the degree to which it rewards cooperation. A human can get the idea that his money is going to be worth more or less relatively soon and change his behavior accordingly in anticipation. Money cannot be fully understood without developing these topics.
Special thanks to Jonathan Vaage of BTC Design for the diagrams.
Dawkins, R., The Selfish Gene, Oxford University Press, 1976. ↩
Szabo, N., “Shelling Out: The Origins of Money”, The Satoshi Nakamoto Institute, 2002, SHA256:30f7eea01d4b60c3ca33b6337a32b391. ↩
See Smith, J., Evolution and the Theory of Games, Cambridge University Press, 1982, SHA256:88fdfb61c32b2758863e7f338b97a7e9 for the classic exposition of this idea. ↩
The truth is actually more complicated—in biology, individuals and groups exist on many levels. Within a cooperative colony of animals, we would need to explain why an individual animal cannot benefit at the expense of everyone else; but each animal is itself a eusocial colony of individual cells which are extremely regimented in how they cooperate with one another. So there is also a need to explain why all the cells are better off cooperating with one another to be an animal that cooperates with others of its own kind instead of all turning into individualistic cancers. And a cell, too, functions because the many genes within it all cooperate very nicely instead of competing to replicate out of control.
See Dawkins and Trivers, R., Social Evolution, The Benjamin/Cummings Publishing Company, Inc., 1985 for decisive criticisms of group selection. The idea of group selection has recently been revived under the name multilevel selection theory. See (put citation here) I’m not a professional biologist, so take this for what it’s worth, but I think that this article rather misses the point. ↩
Trivers, R., “The Evolution of Reciprocal Altruism”, vol. 46, no. 1, Quarterly Review of Biology, 1971, pp. 35-57, SHA256:4c2dfb4acc63492b06151bce8db7c452. ↩
Stevens, C., “Modeling Reciprocal Altruism”, vol. 47, no. 4, British Journal for the Philosophy of Science, 1996, pp. 533-551, SHA256:7847130bd62ba99c21b3a83fdf528662. ↩
For a delightful introduction to game theory, see Luce, R., Raiffa, H., Games and Decisions: Introduction and Critical Survey, Dover Publications, 1989. For an introduction that is also free, see Watson, J., Strategy: An Introduction to Game Theory, 3rd ed., W. W. Norton & Company, 2013, SHA256:2ce0ccbea55ca88c908b876f22bbb379. ↩
Stevens, 1996, pp. 533-551. ↩
Trivers, 1985. ↩
I follow Graf, K., “Bitcoin Decrypted Part III: Social theory aspects”, KonradSGraf.com, 27 Dec 2013 in treating cryptocurrencies as a separate category from commodity money or fiat money. ↩
When I finally logged in, it was like witnessing a miracle. The variety! The selection! "Crack?" I said to myself. "I can buy crack here? I've never even seen crack in real life!" I was awestruck. For a few hundred dollars, I could have reams of LSD blotters. There were things, like ketamine, that I, a libertarian activist, had never even heard of. I'm not much of a drug addict, but for a moment, I felt like Hunter S. Thompson.
All at once, so many things that I had always been told were evil, forbidden, taboo even to investigate or discuss rationally were now available on the cheap, and at the push of a button! The brilliant thing about the Silk Road is that it operates just like a normal business. It operated out in the open, in defiance of the entire drug war, and invited anyone to participate. It staked its reputation on quality and low prices. This is what freedom feels like.
When I saw it, I immediately knew the rules had changed. It opened its doors like any ordinary business. It let people interact without fear. We now know that it brought peace to the illegal drug wholesale market and furthermore that it made enormous profits doing so. It was, furthermore, infinitely reproducible. Thus, even though it could not exist with complete impunity, it could be recreated again and again. This is, I suppose, why its mysterious founder chose the name Dread Pirate Roberts for himself. As in the film from which the name was taken, he would be replaced by imitators even if he himself were to be caught and humiliated. His name is a statement of both economics and of a defiance that is unstoppable.
Each iteration of the Silk Road would make the industry more peaceful, more secure, and more ordinary. It was one act of defiance, but nothing could stop the imitation that it would provoke. The more accessible to ordinary people that illegal drugs become, and the more that the drug market can operate like an ordinary business, the less will people be able to maintain a conceptual separation between recreational drugs and other business. Once that conceptual separation has been broken, the drug war will end because it will simply make no more sense to anyone.
The biggest problem with the Silk Road, I thought initially, was that of exchanging bitcoins for dollars. That was a real inconvenience. But the more I pondered it, the less of a problem it seemed. In fact, it was not a problem. If the Silk Road was attracting business, that means that going through the Bitcoin network was worth the inconvenience of doing it. That meant that there was profit to be made helping dealers spend their bitcoins—which could be done by just doing more business in bitcoin! Because the drug market was using the Bitcoin network, that would draw more opportunities within it, which in turn would draw in more, and so on. These were my thoughts over the next several weeks. Of course, that's not quite what ended up happening, but I think I was pretty close. Bitcoin is now roughly one hundred times more expensive and there are now several competing Silk Road incarnations.
The Dread Pirate Roberts changed the world in two different ways. He communicated the idea of the Silk Road's business model and produced the first sustainable source of Bitcoin profits. When the Silk Road first came online, Bitcoin could not compete with credit cards and traditional banking because Bitcoin services were so sparse. It was where these services were excluded—on the black market—that Bitcoin could be most useful. This was its path of least resistance upward. Before the Silk Road existed, Bitcoin was little more than a curiosity. Afterwords, Bitcoin was something the world needed. This was understood my some people at the time: the opening of the Silk Road sparked the first Bitcoin mania in 2011.
Every Bitcoin venture must build upon Bitcoin's former successes because each step in Bitcoin's growth makes Bitcoin more useful and makes new opportunities possible. Without the early proof, courtesy of the Silk Road, of Bitcoin's viability, Bitcoin would not have attracted the investors that it did then, and consequently would not now be attracting the investors that it does today. All Bitcoin entrepreneurs today build on top of the success of the Silk Road. Their work was made possible by his.
I confess, I never actually bought anything at the Silk Road and I never engaged with the community there. Now that the opportunity is lost forever, I really wish I had. However, I did do some things. It was shortly thereafter that I gave a presentation to the Libertarian Longhorns in which I advised them to cease all political activity immediately and focus entirely on cryptoanarchy. A libertarian victory was no longer impossible, but nigh inevitable. Shortly thereafter another group I attended, The Mises Circle at UT, became the first Bitcoin student group that I know of, and not long after that we started the second Bitcoin student group I know of (The Cryptoanarchy Club at UT). The first group was for economic discussions and the second for cypherpunk discussions. Finally, we started the Satoshi Nakamoto Institute in late 2013.
When Ross Ulbricht was caught in late 2013, I was surprised because I had met Mr. Ulbricht briefly in 2009, at an event called 3-Day Startup. If he is really the Dread Pirate Roberts, then I had met him before he was famous, before he had created his great work. This is not so unlikely; we did have some unusual interests in common. Unfortunately, I don't really remember our meeting very well, but a friend recalls me telling him that digital currencies are a stupid idea. That's how life is sometimes.
The evidence strongly suggests that Ross Ulbricht and DPR are the same person. If this is true, then DPR is a political prisoner, and he is nearly alone when he deserves the whole of the agorist and Bitcoin communities to honor him as their master. He is the greatest agorist of our times and probably who will ever live, and I would rank him as the second most important bitcoiner after Satoshi Nakamoto. Please support his cause at freeross.org.
]]>But first, lets start with some history.
Cypherpunk movement started as a mailing list in 1992. In 1993 Eric Hughes publishes a “A Cypherpunk’s Manifesto”. In 1994 Timothy C. May publishes “Cypherpunks FAQ”.
Here’s an excerpt from the FAQ:
2.3. “What’s the ‘Big Picture’?”
Strong crypto is here. It is widely available. It implies many changes in the way the world works. Private channels between parties who have never met and who never will meet are possible. Totally anonymous, unsinkable, untraceable communications and exchanges are possible.
Transactions can only be voluntary, since the parties are untraceable and unknown and can withdraw at any time. This has profound implications for the conventional approach of using the threat of force, directed against parties by governments or by others. In particular, threats of force will fail.
What emerges from this is unclear, but I think it will be a form of anarcho-capitalist market system I call “crypto anarchy.” (Voluntary communications only, with no third parties butting in.)
In 1998 Wei Dai publishes a proposal of “b-money”, a practical way to enforce contractual agreements between anonymous actors. He captured the essence of the movement in an immortal quote:
I am fascinated by Tim May’s crypto-anarchy. Unlike the communities traditionally associated with the word “anarchy”, in a crypto-anarchy the government is not temporarily destroyed but permanently forbidden and permanently unnecessary. It’s a community where the threat of violence is impotent because violence is impossible, and violence is impossible because its participants cannot be linked to their true names or physical locations.
In 2005 Nick Szabo publishes a proposal for “Bit gold”, a purely digital collectible based on a proof-of-work algorithm borrowing ideas from RPOW server (“Reusable proof of work”) by Hal Finney. Proposal does not mention contract enforcement mechanism, but Nick Szabo himself already proposed several ideas about smart contracts back in the nineties.
In late 2008 Satoshi Nakamoto publishes an overview of Bitcoin and on January 3rd, 2009 releases the code and begins the blockchain.
Bitcoin is the exact implementation of the system envisioned by Tim C. May, Wei Dai and Nick Szabo. The only requirement is for transacting parties to remain anonymous. If there’s no trace to physical persons, there is no place for the violent intervention and thus the contracts can only be enforced according to the voluntarily agreed-upon rules between the parties. Bitcoin allows encoding these rules right in the transactions so they are automatically enforced by the whole network.
In practice, we cannot imagine living in full anonymity. Human beings live in a physical world and enjoy a lot of physical things. Anonymity is not something you can easily manage like a single encryption key. It must be maintained via careful dissemination of one’s actions among actions of others. And since the network activity is easily recordable, one mistake is enough to reveal oneself. In other words, the cost of anonymity is rather high compared to the benefits. Does this mean crypto-anarchy is an utopia?
I would argue, it’s far from it. Cypherpunks being rigorous scientists made a much stronger assumption than needed in practice. For transacting parties it is enough to have costs of cheating (e.g. resorting to violent coercion) meaningfully higher than the cost of following the contract (that is, keeping the promise). If that condition holds for the majority of interactions in society, there will be a great incentive for people to protect themselves against remaining rare cases of cheating thus keeping the system sustainable. Anonymity is simply one of the ways to raise the cost of the attack.
Bitcoin raises the cost of many kinds of attacks, going far beyond protecting against central banks meddling with money supply.
First, all sorts of computational services will flourish. Machines never need to disclose their physical locations and can freely automate both payment verification and payments themselves. Denial-of-service and spam can be largely eliminated by simply requiring a smallish payment for every request.
Second, personal services can be protected by peer-to-peer insurance deposits that literally raises the cost of cheating by making both parties agree to a greater sacrifice (“bilateral insurance deposit”).
In a similar manner, crowdfunding can be fully insured by allowing raised funds to be reverted if the majority of shareholders decides to do so.
Finally, systemic predation by the state becomes economically impossible. Most modern states fund themselves by debasing money supply (also known as “bond issuance”, “budget deficit”, “inflation”, “quantitative easing”, “stimulus package”). Bitcoin-based economy simply does not allow this as it is very cheap to store bitcoins and verify transactions yourself and completely avoid all kinds of fraud associated with modern banking. As central banking disappears from the state’s arsenal, federal government activities including wars become unfunded and quickly come to an end.
Local governments may continue their operations funded by local taxes, but that would become increasingly voluntary. Extracting bitcoins costs much more than protecting them. There is no highly centralized and monitored banking network, so it’s much harder to track taxable transactions. Every additional tax evader defunds the local police department and makes it safer for the next person to underreport earnings if he wishes to do so. Considering that the law enforcement is paid only a small portion of the total budget to be extracted (50% goes to bureaucrats and the rest to other public services), consistently extracting bits of information from millions of individuals is unsustainable in the long run. If anyone is good at stealing bitcoins, they are much better off doing it alone and taking all profits for themselves.
Governments, of course, can also tax in kind (like your underreported Ferrari or a house), but this would be even costlier than seizing any kind of money and those costs must be paid by the state in bitcoins that it does not have to start with.
If this speculation does not sound to you like a complete lunacy yet, here is the fun part. Most governments are completely broke already and can only pay with the IOUs they print. When people start a massive run for bitcoins to protect their wealth, everyone will be able to earn bitcoins for their work, except those who work for the government. Policemen, public school teachers and alike will be the first ones to notice prices rising faster than their salaries. They will the first ones to change jobs or become largely corrupt on all levels (like it was in Russia after the fall of the Soviet Union). Bureaucrats will smell the approaching panic and, instead of trying to retain control over the employees, will privatize as much public goods as possible, again, exactly like during the fall of the Soviet Union. People will see how all promised public services are either abandoned or stolen, and this time everyone will have a method to protect their own property and do business voluntarily and in an even safer and cheaper way than before. Crypto-anarchy will quickly become a boring reality without the need for anyone to remain fully anonymous.
]]>Visions receive more attention than game plans. We know we want to “decentralize,” at least. Growing pains notwithstanding, the old ways simply will not do. Power corrupts, we are reminded from birth. The worst get on top, fewer learn later. Men are not angels but too many of them still run the world. No, our doomed synthetic seraphocracy must go.
We say we desire the opposite: A way to remove the need for trust in human judgment among the commanding heights. Or, as the Telegraph put it yesterday, an “anarchic future where centralised power of any kind will dissolve.” Imperial obsolescence or a Techno-Leviathan, depending on your ideological bent. Creatively destroying our inherited repositories of human derp and replacing them with a null set. Well, more like a mostly-unbreakable cryptographic constitution that enforces institutional neutrality. Upon this first-best taxis will a constellation of (monotonic) cosmos proliferate. Good Things should follow, in whatever form you please.
In its most basic form, this cryptoinstitutional utopianism belies a seductive, but incomplete, understanding of both human social systems and of Bitcoin’s potential.
Let’s start with the easy stuff: human nature.
Partly grounded in hopeful affiliation and WEIRD moral universalism, cryptoinstitutional utopianism misses the forest of human sociality for the trees that line adherents’ individual Minecraft plots. It does not consider that institutions may be largely endogenous to human populations or that some human populations may prefer their “non-inclusive” institutions, thank you very much. Nor that Alice and Bob are secretly guided by a grab-bag of heuristics, impulses, and tribal connections. Like it or not, we too are compelled by a number of “irrational” drives—religious, familial, and national—that thwart our tidy utility models and foil the according schemata for “optimizing” outcomes. Bitcoin provides us with tools, but these will not immediately transform worldly humans into the homo economicus who would best wield them. Our monkey brains, at least in the foreseeable future, are here to stay.
We should therefore not be surprised when Bitcoin-based institutions emerge with the same deficiencies that riddled outdated models. It is not the protcol’s fault, for instance, that consumers fork over their private keys to third party processors without batting an eyelash. And why would they balk? Top Bitcoin boosters promote expansion as an end in itself, a confederacy of carpetbaggers are too eager to oblige. (Say what you will, at least Tim May was forthright.) Inspired amateurs can’t help that they harbor normal human distastes for abstraction. Trust in math? Yeah, right. They are drawn to familiar forms so Xapo gives them debit cards. We truly trumpet trustless exchange in name only. “Bitcoin” is decentralized, “Bitcoin” is private, “Bitcoin” is secure…oh, but Circle is my #brand. The lesson here is that if you’re going to mass market a commercial anti-value, you should expect a lot of nihilistic consumption.
By “anti-value,” I mean a value that is defined by the absence of a perceived ill. Liberty, for instance, is an absence of tyranny. Equality is an absence of hierarchy. Libertarians and egalitarians can generally only try to extend “liberty” or “equality” by chipping away at their opposing forces. If a revolutionary adhocracy were ever to eradicate tyranny or hierarchy, no binding virtue would remain to guide “freed” communities. Only weak vigilance to the void lingers to blind and bind—which is to say that a sexier number soon swoops in to comfortably fill it. Anti-values are quite useful to rationalist reformers seeking the disruption of their opposites, but provide no substantive moral content on their own. They are hollow, tenuous shells in which humans pack our narratives, neuroses, and loyalties. (For these reasons, they tend to backfire.)
In the case of Bitcoin, cryptoinstitutional utopians sell the technology as a kind of “anti-trust,” as a way to escape or beat back the need to rely on other humans. “The requirement of trust is unacceptable,” reads the first general statement of a recent “App Coin” whitepaper, for instance. Not quite a cognitive exit to the cold efficiency of those dreamy DACs, but a promising start. Sources of social friction that previously mandated trust and justified control can now be subverted. All you will need in the world of tomorrow is a screen, a utility function, a fistful of bitcoins, and a Rube Goldberg multisignature transaction and baby, you’re ready to price discover. What more could an atomized WEIRDo ask for?
The problem here is not the diagnosis, which I share, nor the proposed solutions, which are proper and potent to repel the growing democratic sickness that chokes human creation. Bitcoin provides us a critical escape from forced trust in unaccountable monopolies. However, trust in transactions, per se, should not be the object of ire and in fact cannot be if we want to participate in beneficial ways. Distributed ledgers obviate the need for trust in the money changers, but humans are still trust-seeking and Bitcoin is still money and money is still trust. In a post-Bitcoin world, trust will become more important than ever.
The case of distributed markets illustrates how objective features can be anchored as a normative ideal. Last month, fellow Ümlauteer Jerry Brito, Houman Shadab, and I released a comment draft of our forthcoming working paper on regulatory threats facing existing and developing Bitcoin-based financial products and platforms called, “Bitcoin Financial Regulation: Securities, Derivatives, Prediction Markets, & Gambling.” We describe different ways that tinkerers and entrepreneurs are applying Bitcoin to higher financial activities before describing how they might run afoul of U.S. regulations, or if they can even be “regulated” at all.
As a peer-to-peer medium of exchange, Bitcoin allows us to transfer funds without the need to rely on a third party ledgerkeeper. Unfortunately, it presently does not provide an adequate messaging space or platform for price discovery. In other words, Bitcoin provides an ideal transfer mechanism but no immediate way to find desired trades or negotiate terms in this vast digital cavern where no one knows you’re a dog. Centralized exchanges fill a market gap to varying degrees of competency, but they create choke points that regulators can target and shut down. Project teams race to create a platform that provides the option of permissionless, anonymous, peer-to-peer trading (and obviates the possibility of pesky federal interference). Distributed reputation systems and messaging platforms, it is purported, can be fashioned and combined to provide these functions for Bitcoin, albeit not in the most accessible manner.
The implications for the shit triangle are pretty straightforward, but I don’t think the distributed market model will dominate the Bitcoin economy. During the transition, distributed markets will be attractive options for individuals operating in black and grey markets, for obvious reasons. For most above ground professional investing, however, the gains from near-anonymous discovery and negotiation—even when aided by given reputation systems—will pale in comparison to the gains from harnessing trusted associates’ tacit knowledge to gauge the trustworthiness of potential trading partners.
In fact, this is the model that many early Bitcoin adopters and professional traders have employed for years now over IRC channels. Each day, traders in channels like #bitcoin-assets swap information, shoot the breeze, develop relationships, and watch the MPEx ticker by the minute. Here, competency and reputation are currencies in themselves.
A Web of Trust reputation system serves as a social coordination mechanism. To join the WoT, individuals must authenticate themselves to the channel bots with their personal Bitcoin address or GPG identity. From there, individuals are expected to lurk and to learn, to tune into the channel’s daily logs and associated ring of blogs, lest they embarrass themselves and develop a poor reputation before they’ve even really begun. Over time, individuals work to demonstrate value and return favors, thereby increasing their numbers of trusted connections and potential trading opportunities. Adherents praise the system for reducing search costs, since unknown traders are vetted by trusted allies, which therefore reduces the potential for scamming or ignorant trading.
I should note that this thousand-foot view of the #bitcoin-assets world is hardly adequate to convey its many nuances. For now, the basic presentation is instructive as an example of a community that applies the revolutionary tools of Bitcoin in a manner that plays to the strengths of our human nature. In sacrificing the marginal benefits that pure “decentralization” could provide, IRC Bitcoin investors gain the assurance of tacit personal knowledge and communal reputation management. While it is unclear how this model could scale, it provides a good indicator of trends to come.
Political imperialism locked in our options, political stagnation closes the door to reform. Bitcoin provides us alternatives to compelled trust in monopolies but it can never obviate the need for trusted human connections. Nor can it protect us from our own pesky brain bugs’ ambiguous filters on perceived reality. Trying to supplant our nature with technology is a losing prospect that gets it completely backwards. Early path dependencies look to be converging on a reinvigoration of the status quo, so distributed options currently look like a viable alternative. However, future Bitcoin fortunes will favor proven competency advertised through earned trust. Consider it an upgrade.
]]>Bonnie and Clyde cannot simply rob First National Block Chain. They can hack servers and unencrypted wallet files or scan low-entropy brain wallets. But the costs of obtaining bitcoins hoarded on a high-entropy, password-protected paper wallet, for instance, are incredibly high. A computer cannot be expected to brute force the wallet in the universe’s lifetime, so a trespasser would have to employ expensive tactics such as kidnapping and torture on any prospective, individual target. Criminals, con artists, and swindlers cannot rely on violence to get the wealth they desire—it has become too cumbersome. These scoundrels must rely on good ol’ fashioned market forces.
And it’s working. Bitcoin is poised for exponential growth, so the opportunity costs of not being involved to the highest personal degree possible are incalculable. Yet merchants, investment peddlers, and other hoarders have been able to convince countless bitcoiners to part with their future riches, despite the obvious downsides given you have a long enough time horizon to see the coming post-fiat world. They’ll tell you spending is vital, that Bitcoin 2.0 will be even better if only you give them some of your Bitcoin 0.9, or that your bitcoins are worth only $475 a piece. They’ll tell you this with a straight face, the wringing of their hands unseen across the Internet. And once you have fallen to temptation, they’ll leave you on your own to learn there are no ‘backsies’. In the realpolitik of the block chain, everyone is a scammer. There is a war going on for your bitcoins, and willpower is your only defense.
Bitcoin is a dangerous place. There is an endless list of hacks, scams, and thefts. Bitcoin promises a network with distributed trust. You know why? Because other bitcoiners exist.
Not every bitcoin scammer is merely an amoral businessman or investor. Many are outright fraudsters and con-artists. When you buy a rug from Overstock, at least you actually get a rug. When you send money to Ethereum, you may actually get a worthless ether token eventually. You know what you probably will never get? Your Butterfly Labs pre-order or your Goxbucks.
Some scams are pulled off by convincing other bitcoiners to not take advantage of Bitcoin’s value proposition. That is, they convince bitcoiners that while they shouldn’t trust third parties, this guy is totally cool. I’m looking at you, Mt.Gox. Others convince them to play investment games that turn out to be Ponzi schemes. Sup, Bitcoin Savings and Trust?
Some scams are the purest synthesis of bitcoiner avarice and stupidity. Ponzi.io explicitly marketed itself as a Ponzi scheme, promising to send you back more bitcoins coming from the pockets of the next investors. Have fun. Their address, 1ponziUjuCVdB167ZmTWH48AURW1vE64q, received nearly 350 BTC.
Some scams are outright malicious. Scammers have resorted to malware and ransom. CryptoLocker infected computers by encrypting the user’s files and only gave up the private key if a ransom was paid in bitcoins within 48 hours.
Scammers have resorted to blackmail. On September 8th, a hacker gained control of Satoshi Nakamoto’s email account, using it not only to deface the Bitcoin sourceforge page, but to allegedly find out Satoshi’s true name. From a Vice article: “After inquiring what [the hacker] was trying to get out of all this, he said ‘Bitcoins, obviously… [But] don’t forget the lulz.’”
Scammers have also gone to the trouble of leaking nude photos of celebrities to get some bitcoins.
Scammers will do whatever it takes to increase their bitcoin holdings. You know this. You scammed someone to get yours. You probably did not outright defraud or hack someone like the above, but you necessarily took advantage of their short-term thinking.
At long last Newegg accepts Bitcoin, along with Overstock.com, TigerDirect, Dell.com, Expedia, and other major retailers and websites. So let’s go spend all our bitcoins, right? Not so fast. Let’s wipe off the drool from looking at all the shiny toys and think this through.
Merchants have absolutely every reason to accept Bitcoin. BitPay recently removed all fees for payment processing, including currency exchange. Not only can merchants receive payments without fees, but there are of course a litany of other benefits, from no fraud or chargeback to easy international payments. They can pass on their savings to customers or increase their profit margins. They also can and should hold onto bitcoins as their accounting permits, so as to earn profits from future price increases. After all, if Bitcoin increases adoption for payments, there are only so many units to go around, so each one will become more valuable.
So merchants are in a good position. They can save money on their business, and they can try to purchase bitcoins with retail goods, just as many purchase them with dollars or euros. If I were a merchant, I would most certainly encourage people to shop at my store in Bitcoin. I might even try to convince them, despite its fallacious economic reasoning, that spending bitcoins at my store is actually good for Bitcoin—certainly more than you saving and speculating on them. After all, “it could become worthless overnight” and “Its future depends on it” (because I say so). I might even say things like:
[My] shoppers are among the first wave of Bitcoin users and we’re thrilled to accept the cryptocurrency as a form of payment. Just like you, we also believe Bitcoin can be the future of digital currency. But if you’ve been saving it and hoping it will make you rich one day, you’re better off spending it if you want it to succeed.
By me, I mean Newegg. Their recent blog post is called, “Why Saving Your Bitcoin is Not a Good Idea”. The reason? It means you aren’t spending at Newegg.
Most merchants even choose to immediately sell the bitcoins they receive. They scam you out of bitcoins they do not even want, uninterested in the future value of the network.
Merchants are scammers because they lead you to believe that your bitcoins are only worth the price of their retail good in order to allow themselves (or those to whom they sell the bitcoins, if they so choose), rather than you, to benefit from future Bitcoin price increases.
This is not to say merchant adoption is bad. In fact, from the hoarder’s perspective, merchant adoption is great. First, merchant adoption means that there is more demand for Bitcoin, that the Bitcoin network is growing, and that Bitcoin is thus more valuable than it was yesterday. Second, merchant adoption means there are more places to spend bitcoins.
This does not mean a hoarder will actually want to spend bitcoins. More importantly, he can spend bitcoins. Demand for cash exists because there is uncertainty of future needs, and the holder of cash believes he will come across currently unknown opportunities in the future that can better satisfy his needs than any current opportunities. When an opportunity exists that he believes benefits him more than what the same cash can get him in the future, he is able to seize it. As Metcalfe’s Law shows us, the value of a network increases exponentially with each additional node. With each additional merchant, there are more potential people to trade with, and thus more potential opportunities to satisfy his needs with cash.
Of course, these benefits to the hoarder does not require merchants accept Bitcoin, given the right infrastructure. Xapo debit cards, for instance, give the hoarder the ability to use bitcoins on existing credit card networks. This means hoarders can already use Bitcoin as their unit of account whether or not merchants even know what a bitcoin is. The more Bitcoin can be used as a method of payment the fewer dollars hoarders must begrudgingly speculate on, a risk they typically only wish on government agents and skeptical economists. Thus, the primary advantage of merchant adoption is that your average balance of bitcoins held can go up. You don’t need to buy dollars in anticipation of making dollar payments, instead you can replenish your bitcoin hoard after you make bitcoin payments.
Between merchant adoption and debit systems, Bitcoin becomes a more valuable good to hoard. Good news for Bitcoin!
Bitcoin is exciting. Looking at a static wallet file and balance is not. Instead of holding and forgetting, many bitcoiners choose to “put that money to use,” and endless crypto-peddlers are ready to snatch your bitcoins up. They’ll offer you mining contracts, present their plans for a hedge fund, or entice you into investing in a Bitcoin company. Today, the most popular investment vehicle for bitcoiners are Bitcoin 2.0 schemes, ranging from Mastercoin to Ethereum.
All of these are scams.
Regardless of their ability to actually deliver their promises, they all fail a simple test: is the return on investment positive? If you are stuck in a fiat mindset, you may well make a quick buck, but given Bitcoin’s extraordinary expected growth, can one really expect to do better than one can by holding it? Long term investors should use Bitcoin as their unit of account and every single investment should be compared to the expected returns of Bitcoin.
If hyperbitcoinization occurs, Bitcoin holders will see their purchasing power increase by orders of magnitude. Bitcoiners should think twice before throwing away even a couple millibits towards a project “just to see where it goes.” A running joke in the community is how expensive the two pizzas Laszlo bought were. We joke about a million dollar pizza, and hyperbitcoinization has not even occurred yet. I praise Laszlo for his entrepreneurial use of a new technology, but I do not wish for myself or others to be a Laszlo.
Who wins here? It is not the investor, but the peddler of crypto-dreams. Ethereum recently raised $15 million in their “Ether sale” for an unfinished project, in Bitcoin, of course. There isn’t even a product yet, but investors have placed their bets. Ethereum now has over thirty thousand bitcoins, destined to be worth unspeakable volumes of wealth, while investors hold worthless hope.
Investments are scams because they lead you to believe you can get a higher return than holding bitcoin itself, despite the economics of bitcoin naturally making this an absurd claim in the medium-run. In a post-fiat world, there will be plenty of investments that have a greater return (and risk!) than holding bitcoins, but they’ll be assets that generate bitcoin cash flows.
If a Bitcoin hoarder wants to reinvest his profits, he need not further than the Bitcoin network itself. The correct strategy for Bitcoin entrepreneurship, as Daniel has pointed out, is speculative philanthropy. While endless money has been funneled into altcoins, appcoins, vaporware, vulnerable third party services, etc., there are many problems in Bitcoin that still need to be solved through open source development, many of which are low-hanging fruit. By funding these projects, the security, accessibility, and usability of the Bitcoin network increase, thus making it an even better investment.
Get coding. Every new git commit is good news for Bitcoin.
The Bitcoin hoarder is in a constant battle with himself to lower his time preference as much as humanly possible. It’s the only way to optimize his Bitcoin holdings. My friends and I joke about starving due to the intense deflation, but I can’t say I don’t look back and wish I had skipped a couple lunches in the crappy dorm cafeteria to buy $10 bitcoins when I had the chance.
Bitcoin hoarders are excited about the price rises, but they are also excited when the price is on its way down. Coinbase just months ago was willing to give me a bitcoin for 1200, and now they are only asking for 475. Whatever price, the bitcoin hoarder thinks to himself, “Suckers.”
Bitcoin hoarders are in it for the long run. Their strategy is not to buy low, sell high, but to buy any, sell some highest. They will do anything to get their hands on more satoshis, and there is nothing that makes them happier than a schmuck giving up the goods after being convinced Bitcoin is only worth $[x < moon]. These sellers have volunteered to hold the fiat shitbag, and hoarders will not be so quick to help them get rid of the stench.
Indeed, hoarders are potentially the most dangerous scammers. While merchants and investments are outright with their desire to take your bitcoins, hoarders may not always be so explicit. A person can prove that they have the private key to bitcoins, but they cannot prove they do not. With this in mind, it is plausible that any vociferous skeptic's bold assertion is actually a psyop attempting to affect market demand, and subsequently the price, in their favor. For instance, when Paul Krugman recently said in "The Long Cryptocon" that "it’s not at all clear whether [Bitcoin technology] has any economic value," we cannot know with epistemological certainty that Paul Krugman is not a Bitcoin True Believer hoping to get his hands on more and cheaper bitcoins.
Hoarders are scammers because they understand the exponential (and very likely) growth potential of Bitcoin, yet are willing to convince other bitcoin holders by any means necessary that the future value to them is probably not much more than the current market price.
Hoarding is what gives money value. And no, you can’t have any.
Great news for Bitcoin!
Indeed, Bitcoin scamming is a job that will never be finished. The market-based scams (that is, ones that don’t require fraud) will subside as Bitcoin absorbs the real money supply of all other currencies, when demand for cash begins to decelerate and eventually stabilizes. However, other scammers will always be looking for ways to screw someone out of their bitcoins.
The only way this will be solved is if trusted networks can be built. As has been said before, Bitcoin is great, but it won’t fix our monkey brains. While Bitcoin offers a money with no trusted third party, it can only do so because the ledger is self-referential. The humans actually using it must always be in a mindset of caveat emptor when using Bitcoin. Through payment protocols, webs-of-trust, smart contracts, GPG contracts, and voting pools, users can mitigate the risk of engaging in various forms of commerce.
We live in a state of total war. Everyone who holds bitcoins is trying to get more by scamming others out of theirs or convincing others it’s not worth trying to get into. Everyone who does not hold bitcoins was either scammed out of them or was scammed from getting into it. Having bitcoins takes the knowledge and will to know and desire its future, while not having or spending them is lacking one or the other. If you hold bitcoins, you must take a breath every time you wish to send any to another person. Ask yourself if that person truly deserves untold amounts of your future wealth for pouring you a beer. You may just find the will to hodl more.
Hyperbitcoinization will not be a force to trifle with. Even a marginal bitcoin holding right now will constitute a very significant majority of a bitcoiner’s portfolio. Once it happens, there is no going back. One day, your Bitcoin balance will likely never see the decimal point move to the right again. Bitcoin will brake for no one on its race down the road from serfdom to global domination (liberation?). Do not give your seat up for someone else.
"Scammer" is a heuristic, not an accusation.
Revised October 7, 2014 - Added a paragraph describing inability to discern Bitcoin skepticism from hoarding psyop. ↩︎
Consequently it has been imposed with varying degrees of success everywhere the white man went, from the Americas to the Bengal Valley and beyond. American Indians’ vague and mostly philosophically confused notions of ownership (in particular in what pertains to land) were from the very beginning the root of political tension on that continent, and ultimately congealed in “the Indian question” as well as the genocidal solution thereof. Africans’ naive representation of economics were in good faith seen as sufficient cause for the inferior social position of that entire race as late as the 18th century. White people have judged all others primarily on the basis of those others’ depth of understanding and craftiness in applying this central mental structure since the very beginning of time, and the Crusades have had more to do with Arabs’ bizarre notions of economy than with any interest of theology or religion.
We won’t go into a detailed discussion of that mental structure here, fascinating as it may beiv, but instead limit ourselves to observing that the contract is a central piece thereofv. This contract, or should we maybe say Contract is quite the term of artvi, and it means a. an agreement b. reached by willing participants which c. shall be enforced against them.
A voids any contracts that were obtained “improperly”, such as by the use of force, deceit, from participants unable to agree (properly or statutorily in later reinterpretations of this simple equation). B gives grounds for requiring particular forms, and also putting aside purported contracts that don’t satisfy those forms. Because B you can say “well if the parties couldn’t be bothered to at least put their contract in writing you can’t say they were actually willing to enter a contract”. Because B you can demand all contracts be registered with some authority or be void, because B you can demand all contracts entered carry a fee paid to some authority or be void and so forth. And finally, C is what interests us in this present article (yes, this has been a five hundred word introduction).
Traditionally, contracts are instruments of torture. People agree to be married (thus entering into, of course, a Marriage Contract) and then have to suffer their spouse whether they’d like to or not.
This is the entire point of contracts : once entered into they will be enforced, to the detriment of either party (and usually both parties). This view of contracts as instruments into which people enter wilfully and then have to respect whether they want to or not is what gave rise to the organised state as seen in post-Roman Empire Europe, this view of contracts is the proximate cause of the European standing army, the European politics and pretty much all of the history of this corner of the world. Also practically speaking of the entire world altogether, mostly because of the preminence (essentially cultural and flowing from that economical, military and so on) that this particular mental construct bestowed upon its practitioners. I will go as far as to say that the reason men everywhere, from the deserts of rural Egypt to the desolate windblown outskirts of Irkutsk wear suits today as opposed to Iroquis shaman headdresses or Hawaiian stupidskirts whatever those things are called is simply the world domination allowed by and achieved through the Contract. Suitwearer, Contractbearer, Master of the World.
The problem with this holy institution that has carried us so very far and fed us so very well is that it has costs, and those costs have the unfortunate property that they mount with use.
I’m not sure the full horror of the curse embodied in that bolded phrase is directly obvious, so let’s dwell. The first contract ever entered into has the friction cost of explaining to everyone concerned or somehow coming into contact with its workings wtf a contract is and how it’s to be used. These costs may well have been significant, but they were also limited (as opposed to infinite). Subsequent contracts cost less mostly because they’d build on already sunk-in costs. And less, and less. Unseen is the hidden seed of disaster : subsequent contracts also cost more because the cost of enforcing a contract increases with the amount of contracts already entered into.
Why would the cost of enforcing a contract increase with the amount of contracts already entered into ? Well, because as people use them people also look for ways to abuse them. As these ways are found they have to be patched. As the patches are applied new holes are found, so new patches are issued. Sometimes the patches work better in some cases than others, in the end it’s not even obvious which would be the proper case a contract falls into, the administration of all this has some costs and moreover due to the adversarial nature of contractsvii there’s always someone with an incentive to argue absolutely anything, no matter how “insane”. Besides, what’s insane anymore once we have contracts ?
And so that seed grows, invisible at first because the comparative friction cost of burning the Sioux huts and Cherokee library to teach those “savages” once and for all wtf contracts are is larger than the hidden cost of figuring out what our contracts even mean to say, or how should that contrivance be construed (not to mention the entire advantage of adversity : obviously the contracts say the enemies suck!). The seed grows, and it is the seed of doom, for once we’ve conquered the entire world (as white people in fact have) and have no enemies left (as white people don’t) the problem becomes internecineviii : what do all these contracts even mean ?!
I know plenty of people who have dispensed with even entering into contracts altogether, as a point of principle. Silicon Valley deals would be anywhere between one third and two thirds undocumented to any degree - only when companies are about to go public does a mad rush commence to retroactively document years’ worth of… contracts, they would be, except they weren’t. Why not ? Because contracts are just too damned expensive, both to enter into rationally and then to enforce against the other party. The attempts mostly end up as a competition of “who has the largest bank account” and therefore can afford the best lawyers, and since this is known at the outset the only real believers in the entire contract-with-enforcement construct are, predictably, the very large corporations.
And so here we are today : contract litigation is a great way to earn a living as a lawyer, a premier way to generate that mostly fake “social mobility” and a great way for Apple, Samsung and obviously the US government to fill their otherwise idle time during board meetings. Most common claims are not pressed, and in the rare instance they are pressed would end up in something called “Small Claims”, which is much akin to the lost and found box they used to keep in train stations and movie theatres. Something at any rate closer to a “reality” show premise than the solemn and citizenesque thing a good court case was back in the early days of the previous century, when every dusty, sleepy Great Plains town had its Court right across from the Theatre Church Townhall.
All this is sadly both unavoidable and beyond repair : the seed has grown to fruition, and we can’t either throw out the history of untold billions of contracts entered into over the centuries or meaningfully distill anything out of it. Blackstone tried desperately to codify the nonsense and to a large degree succeeded, Napoleon achieved the same exact result, and both of these happened exclusively because of the convenient backing of dictatorial power. Napoleon had the autocratic authority to do absolutely anything, and so he could create a new code. Blackstone had the monarch’s support, a monarch both absolute and disinterested in the finer points. Thus the respective products gloss over some details that are perhaps irrelevant, and through this license are capable to deliver something that is coherent and doubtlessly useful.
Who today would or will be able to set aside the perhaps justified objections of the disenfranchised parties (which would necessarily exist) to create a new code, and somewhat reset the clock ? Nobody, practically speaking, it’d have to be done by “consensus” and “negotiation” which is to say it’d be much better for it to not be done at all. In short, this great dragon called Contract has flown as far as he can. He is old now, and tired. His bones ache, his mood is sour, he will soon go below the ground. We will forever remember it, or at any rate I will, but for what he was in his youth, and that youth was much, much before your parents were being born I would think.
So what now ?
Well… I’m glad you asked. There’s a spiffy young fellow I’m betting on : the GPG Contract. He’s also a. an agreement b. reached by willing participants. But that’s all.
What do I mean “that’s all” ? I literally mean, that’s all. A contract which is entered into by willing participants and won’t be enforced. Nonsense ? IKR!
Except not really. Obviously entering into a GPG Contract thinking it’s an Old Contract is nonsense, and will get you burned. In fact the history of “scams” in the Bitcoin space is pretty much this, people behaving with what should really be GPG Contracts as if they were Old Contracts, and then discovering midway through that… well… it doesn’t really work that way.
But if you go in knowing that the contract won’t be enforced, you can actually act quite rationally. Online identities are obviously a dime a dozen, in fact in the time I took to write this opus I might have made a few million. However, because of GPG they are in fact identities. Add to this the fact that nobody forces you to venture money in a deal with something that’s worth a dime a dozen and suddenly some sense begins to emerge.
Sure all identities are a dime a dozen, but with the passing of time and the accumulation of history they become differentiated, and through this differentiation acquire value. When people see 2FB7B452 at the end of a signed document they don’t think “a dime a dozen”, they think “a guy valued around half a million BTC or thereabouts, my fifty should be safe then”. Why should his fifty be safe then ? Because the value to me of not having a fifty bitcoin default added to my track record is actually larger than fifty bitcoins, and so rationally my best choice is to actually live up to the deal, whatever it may be.
This system is obviously far from perfect at the current time. For one, as it is nascent there exists the incentive to follow short term goals : build an identity up to whatever value, then strip it by taking the money and splitting. This has happened so far numerous times, and from a certain perspective it may seem the main economic activity surrounding Bitcoin at the moment, greatly compounded by the yet inept identity-valuation methods used by participants, their unwarranted self confidence (everyone thinks they’re a great judge of men, and everyone thinks their particular assumptions are both correct and warranted), their imbecillic pride manifested in the stupidest way it could, ie trying to keep “things” under wraps and all the rest of typically human failure. For the other, as it is nascent very little is in fact understood or generally known about it, and so gross mistakes happen quite cavalierly.
All this aside, non-enforced contracts, contracts which the participants uphold out of their own free will rather than at the behest of some third party or by the point of the sword of some blind demigoddess are a thoroughly fascinating turn of events. For one, they are fundamentally human, they’re one step up on the stairwell of freedom. Do it if you think it’s right is certainly a lot more empowering, civilised and overall good than “do it or else”. For the other, they allow all the enforcing to happen before the actual contract is entered into. Old contracts contain unknown future costs, nobody can ever tell you exactly how much will you have to pay in legal fees to recoup this five hundred owed on whatever deal. GPG Contracts don’t have any future costs at all. The cost of enforcing one after the fact is always going to be zero, pretty much because there’s never going to be anything you need (or indeed can) do.
And it doesn’t stop here. I have always thought the principal utility of Bitcoin is that it renders any sort of mandatory taxation model unviable. I am firmly persuaded that as Bitcoin takes holdix taxes will have to return to what they were in ancient Greece : willing donations to the state treasury, and something people openly took pride in. This shift will bring about all the improvements we were vainly trying to achieve in the old money paradigm, such as public accountability and reasonable expenditure in one fell swoop : good luck getting people to donate to the police department if they don’t like the police. And good luck with the welfare programs, for sure.
Add to that a shift of contracts from the old model to the new and suddenly you have - and I mean this quite literally - a new Renaissance. Man at the center of all things. Man, the willing enforcer of his own promises. Man, the willing contributor to the wealth of an obviously much reduced, but by that fact probably much nicer, lovable and huggable cute little state.
I’m crying with joy over here, my toes are curling in untold glee, I have little doubt that I shall live to see this, all of it. And for the first time in many, many years I feel again like the world is worth living in.
Such as the trajectory of a boulder expelled from a volcano, where the kinetic energy is the capital and the trajectory the purchase ; or the life of stars where hydrogen and later helium are the means of production allowing for radiative output. ↩
Lombards, Venetians, Genovese and others. ↩
In a non-Continental sense of that word. ↩
Both for lack of space and because I’m not being paid quite enough to be holding impromptu doctoral courses on History of Culture. ↩
Thrice in one article, take that! ↩
Meaning, something with a fixed and peculiar meaning which is not open to intra-discourse negotiation the way most other words are. ↩
Because the contract “is opposable” to either party, which really means to say contracts are there as the adversary to each party involved, joint and several. ↩
Which word does not mean, by the way, “marked by slaughter : deadly; especially : mutually destructive” nor “of, relating to, or involving conflict within a group : bitter internecine feuds” ; nor does it mean “Destructive to both sides in a conflict : savage internecine warfare.” as the sorely uncultivated dictionaries available online purport. It simply means damaging within a body organised with a view to do damage without ; conflict within a space constructed for harmony not competition. A civil war, an autoimmune disorder, a quarrel between husband and wife : all fine examples. ↩
As it will no matter of any other consideration, nuclear war followed by nuclear winter would not stop it any more than it would stop the Moon still in its orbit. ↩
Bitcoin naysayers[1] wring their hands over how Bitcoin can't go mainstream. They gleefully worry that Bitcoin will not make it across the innovation chasm:
The response from the Bitcoin community is to either endlessly argue over the above points[3] or to find their inner Bitcoin Jonah[4] with platitudes like:
The above sophisms are each worth their own article, if just to analyze the psycho-social archetypes of the relevant parrots.
A few of the criticisms mentioned earlier are correct, yet they are complete non sequiturs. Bitcoin will not be eagerly adopted by the mainstream, it will be forced upon them. Forced, as in "compelled by economic reality". People will be forced to pay with bitcoins, not because of 'the technology', but because no one will accept their worthless fiat for payments. Contrary to popular belief, good money drives out bad. This "driving out" has started as a small fiat bleed. It will rapidly escalate into Class IV hemorrhaging due to speculative attacks on weak fiat currencies. The end result will be hyperbitcoinization, i.e. "your money is no good here".
Bitcoins are not just good money, they are the best money.[5] The Bitcoin network has the best monetary policy[6] and the best brand.[7] We should therefore expect that bitcoins will drive out bad, weak currencies.[8] By what process will bitcoins become the dominant currency? Which fiat currencies will be the first to disappear? These are the interesting questions of the day, as the necessary premises for these questions are already established truths.[9]
Bitcoin's current trend is to increase in value on an exponential trend line as new users arrive in waves. The good money is "slowly" driving out the bad. Two factors drive this:
Due to group psychology, these newcomers arrive in waves. The waves have a destabilizing effect on the exchange rate: speculators are unsure of the amplitude or wavelength of adoption, and amateurish punters let their excitement as well as subsequent fear overwhelm them. Regardless, once the tide has pulled back and the weak hands have folded, the price is a few times higher than before the wave. This 'slow' bleed is the current adoption model, and commentators generally assume one of the following:
My own prediction is that slow bleed has been accelerating and is only the first step. The second step will be speculative attacks that use bitcoins as a platform. The third and final step will be hyperbitcoinization.
Slow bleed leads to currency crisis as the expected value of bitcoins solidifies in people's minds. At first they are conservative, they invest "what they can afford to lose". After 12-18 months, their small stash of bitcoins has dramatically increased in value. They see no reason why this long term trend should reverse: the fundamentals have improved and yet adoption remains low. Their confidence increases. They buy more bitcoins. They rationalize: "well, it's only [1-5%] of my investments". They see the price crash a few times, due to bubbles bursting or just garden-variety panic sales – it entices them to buy more, "a bargain". Bitcoin grows on the asset side of their balance sheet.
On the liability side of the Bitcoiner's balance sheet there are mortgages, student loans, car loans, credit cards, etc. Everyone admonishes people to not borrow in order to buy bitcoins. The reality is that money is fungible: if you buy bitcoins instead of paying down your mortgage's principal, you are a leveraged bitcoin investor. Almost everyone is a leveraged bitcoin investor, because it makes economic sense (within reason). The cost of borrowing (annualized interest rates ranging from 0% to 25%) is lower than the expected return of owning bitcoins.
How leveraged someone's balance sheet is depends on the ratio between assets and liabilities. The appeal of leveraging up increases if people believe that fiat-denominated liabilities are going to decrease in real terms, i.e. if they expect inflation to be greater than the interest rate they pay. At that point it becomes a no-brainer to borrow the weak local currency using whatever collateral a bank will accept, invest in a strong foreign currency, and pay back the loan later with realized gains. In this process, banks create more weak currency, amplifying the problem.
The effect of people, businesses, or financial institutions borrowing their local currency to buy bitcoins is that the bitcoin price in that currency would go up relative to other currencies. To illustrate, let's say that middle-class Indians trickle into bitcoin. Thousands of buyers turns into hundreds of thousands of buyers. They borrow Indian Rupees using whatever unencumbered collateral they have – homes, businesses, gold jewelry, etc. They use these Rupees to buy bitcoins. The price of bitcoins in Indian Rupees goes up, a premium develops relative to other currency pairs. A bitcoin in India might be worth 600, while in the U.S. it trades at 500. Traders would buy bitcoins in the U.S. and sell them in India to net a $100 gain. They would then sell their Indian Rupees for dollars. This would weaken the Indian Rupee, causing import inflation and losses for foreign investors. The Indian central bank would have to either increase interest rates to break the cycle, impose capital controls, or spend their foreign currency reserves trying to prop up the Rupee's exchange rate. Only raising interest rates would be a sustainable solution, though it would throw the country into a recession.
There's a huge problem with the Indian central bank raising interest rates: bitcoin's historical return is ~500% per year. Even if investors expected future return is 1/10th of that, the central bank would have to increase interest rates to unconscionable levels to break the attack. The result is evident: everyone would flee the Rupee and adopt bitcoins, due to economic duress rather than technological enlightenment. This example is purely illustrative, it could happen in a small country at first, or it could happen simultaneously around the world. Who leverages their balance sheet and how is impossible to predict, and it will be impossible to stop when the dam cracks.
Which countries are most vulnerable to a currency crisis? Business Insider provides a helpful list here. Bitcoins will have to reach certain threshold of liquidity, indicated by a solid exchange in every financial center and a real money supply – i.e. market cap – of at least $50 billion, before they can be used as an instrument in a speculative attack. This will either coincide with or cause a currency crisis.
A speculative attack that seems isolated to one or a few weak currencies, but causes the purchasing power of bitcoins to go up dramatically, will rapidly turn into a contagion. For example, the Swiss will see the price of bitcoins go up ten fold, and then a hundred fold. At the margin they will buy bitcoins simply because they want to speculate on their value, not due to an inherent problem with the Swiss Franc. The reflexivity here entails that the reduction in demand for Swiss Francs would actually cause higher than expected inflation and thus an inherent problem with the Swiss Franc. The feedback loop between fiat inflation and bitcoin deflation will throw the world into full hyperbitcoinization, explained by Daniel here.
Bitcoin will become mainstream. The Bitcoin skeptics don't understand this due to their biases and lack of financial knowledge. First, they are in as strong an echo chamber as Bitcoin skeptics.[10] They rabidly search for evidence that confirms their view of Bitcoin. Second, they misunderstand how strong currencies like bitcoin overtake weak currencies like the dollar: it is through speculative attacks and currency crises caused by investors, not through the careful evaluation of tech journalists and 'mainstream consumers'. To honor these soon to be extinct skeptics, the Nakamoto Institute has launched A Tribute to Bold Assertions.
No, seriously, there are people on the Internet spending a non-trivial amount of time writing about a currency they think is going to fail yet continues to succeed beyond anyone's expectations. I get schadenfreude from their lack of schadenfreude. Granted, a few of them are being paid to write controversial click bait and/or just concern trolling – both activities that I respect and understand. ↩︎
This is generally stated by people who are in the 'out-group' and fantasize about being in the 'in-group' through politics/pedigree rather than economic/meritocratic processes. Demographically, they probably overlap with fans of The Secret. Economically, they are without exception bezzlers. ↩︎
Bitcoin has entered its Eternal September, where every person new to Bitcoin thinks they have a unique understanding of Bitcoin and everyone ought to hear about it. There's an endless flood of newbies 'concerned' about such and such 'problem' with Bitcoin. The Bitcoin community does these arrivistes a real disservice by taking them seriously instead of just telling them 'read more'. ↩︎
The opposite of Bitcoin Jesus. Bitcoin Jonah is a defeatist, self-sabotaging, and timid 'man' who is on a permanent quest to confirm Bitcoin's weakness. ↩︎
Bitcoin is the Best Unit of Account by Daniel Krawisz ↩︎
The Bitcoin Central Bank’s Perfect Monetary Policy by Pierre Rochard ↩︎
Bitcoin Has No Image Problem by Daniel Krawisz ↩︎
Hyperbitcoinization by Daniel Krawisz ↩︎
If you disagree then either you have not been learning or you have not been engaging in the debate, go back to square one. ↩︎
'I live in a rather special world. I only know one person who voted for Nixon. Where they are I don't know. They're outside my ken. But sometimes when I'm in a theater I can feel them.' - Pauline Kael ↩︎
Bitcoin is infused with several of Nietzsche’s concepts.
For example, both elements of The Will to Power, durability and growth, are perfectly embodied in Bitcoin. The self-adjusting network difficulty in response to an exponential increase in hashrate represents perhaps the greatest technical achievement in history.[5] The Bitcoin network, for all its retardation, is incredibly robust.
Nietzsche’s rejection of the moral distinction between good and evil[6] is also apparent in Stage n, where gravity, wind, and rain are as much a part of our world as Bitcoin. These forces can no longer be judged to be good or bad, they simply are. And we must now adapt to their reality rather than the reverse.
Given this, Bitcoin calls us to action, forcing us to choose the noble morality of pride, strength, and honour or the slave morality of kindness, humility, and pity.
While every noble morality develops from a triumphant affirmation of itself, slave morality from the outset says No to what is “outside,” what is “different,” what is “not itself”; and this No is its creative deed.
In #bitcoin-assets, we’re choosing the noble morality, that which is vilified[7] by the most powerful and longest-lasting businesses in the world: states and religions. But no amount of name calling can diminish our life-affirming quest.
Meaning and morality of One’s life come from within oneself. Healthy, strong individuals seek self expansion by experimenting and by living dangerously. Life consists of an infinite number of possibilities and the healthy person explores as many of them as possible. Religions that teach pity, self-contempt, humility, self-restraint and guilt are incorrect. The good life is ever changing, challenging, devoid of regret, intense, creative and risky.
It is the softness of the “common good” that Bitcoin rejects. It is greatness that it embraces.
“One must shed the bad taste of wanting to agree with many. “Good” is no longer good when one’s neighbour mouths it. And how should there be a “common good”! The term contradicts itself: whatever can be common always has little value. In the end it must be as it is and always has been: great things remain for the great, abysses for the profound, nuances and shudders for the refined, and, in brief, all that is rare for the rare.”
For Bitcoin is a great thing, and thus attracts the great.
All great things must first wear terrifying and monstrous masks, in order to inscribe themselves on the hearts of humanity.
Bitcoin terrifies the common Fiaters, including those of “the community” who impose their Fiat ideology on Bitcoin. For them, they who would do no pain,[8] must be on the receiving end. Bitcoin will hurt. Bitcoin will be hard. Bitcoin will make them suffer.
Who can attain to anything great if he does not feel in himself the force and will to inflict great pain? The ability to suffer is a small matter: in that line, weak women and even slaves often attain masterliness. But not to perish from internal distress and doubt when one inflicts great suffering and hears the cry of it — that is great, that belongs to greatness.
Those who oppose the suffering to come, those nihilists awash in self-loathing, will suffer the most. For long enough, nihilism, the Apollonian philosophy of utilitarianism and scientific rationalism descended from Plato and Socrates, has repressed the aesthetic considerations of Dionysian philosophy – that which treasures life, beauty, and art. This 2,000-year-old revolt against the balance between creation and destruction is based on nothing but scientific “truth,” and the notion that science is, and will be, the panacea for all social problems. This is everywhere evident, from discussions of artificial intelligence and technological transcendence to automated cars and phablets. The world stagnates in this sea of golden calves.
This is what Bitcoin struggles against: the Greek God Apollo. This is what greatness struggles against.
“The individual has always had to struggle to keep from being overwhelmed by the tribe. If you try it, you will be lonely often, and sometimes frightened. But no price is too high to pay for the privilege of owning yourself.”
Bitcoin will win, crushing nihilism and fulfilling Nietzsche’s vision of Übermensch. Only Bitcoin can restore the necessary balance between the Gods.
Only Bitcoin can give us life.
“With the collapse of metaphysical and theological foundations and sanctions for traditional morality only a pervasive sense of purposelessness and meaninglessness would remain. And the triumph of meaninglessness is the triumph of nihilism: ‘God is dead.’” via Britannica. ↩︎
“Nietzsche thought the emerging nationalism of his day represented one such ominous surrogate god, in which the nation-state would be invested with transcendent value and purpose. And just as absoluteness of doctrine had found expression in philosophy and religion, absoluteness would become attached to the nation-state with missionary fervour. The slaughter of rivals and the conquest of the earth would proceed under banners of universal brotherhood, democracy, and socialism.” via Britannica. ↩︎
mircea_popescu: i know of no previous instance of a mechanism working so efficiently in all human technical history. mircea_popescu: a self adjusting mechanism that turns maxint variation into [.5,1.5] ? mircea_popescu: that’s something. via #bitcoin-assets. ↩︎
Nietzsche maintained that the distinction between good and bad was originally descriptive, that is, a nonmoral reference to those who were privileged, the masters, as opposed to those who were base, the slaves. The good/evil contrast arose when slaves avenged themselves by converting attributes of mastery into vices. If the favoured, the “good,” were powerful, it was said that the meek would inherit the earth. Pride became sin. Charity, humility, and obedience replaced competition, pride, and autonomy. Crucial to the triumph of slave morality was its claim to being the only true morality. This insistence on absoluteness is as essential to philosophical as to religious ethics.” From Britannica. ↩︎
He called me greedy! Waaaah! ↩︎
“The desire to annoy no one, to harm no one, can equally well be the sign of a just as of an anxious disposition.” – Nietzsche ↩︎
Whereas for earlier moneys, it was generally the case that most people could expect to be better off storing the bulk of their money with agents, for Bitcoin the opposite is true. The Bitcoin network obviates traditional financial institutions and there are really only two agents that Bitcoin users need: exchanges and payment processors. The exchanges are temporary; they are only required because fiat currencies require them. Once the fiat currencies have died, centralized currency exchanges will no longer be required. As for payment processors, they are only required over time scales of about an hour or less to ensure that a transaction gets into the block chain. With Bitcoin there is no need for anything like a bank that would store bitcoins over a long term.
Being nearly superfluous is not the only problem with Bitcoin agents. To whomsoever a private key to a Bitcoin address is known, the bitcoins it holds are far easier to control than dollars or gold are under almost any circumstance. This is because controling bitcoins is simply a matter of keeping a number secret and requires neither securing physical matter (as with gold) or the permission of issuers (as with dollars). Thus there is a fundamental agency problem with Bitcoin. Agents can disappear or simulate a heist upon themselves. They cannot rationally be trusted without extreme costs being imposed on them which are more stringent than traditional banks. Furthermore, agents must advertise their services and consequently become the targets of hackers. They must take extreme measures to achieve a level of security similar to that which an individual person achieves with much less.
The inherent agency problem in Bitcoin is borne out by Bitcoin’s extraordinary history of hacks and thefts. Bitcoin institutions seem to be worse than the banks that Bitcoin replaces. As Bitcoin proponents must point out repeatedly to naysayers, people lose bitcoins not by an inherent flaw in the protocol, but by misuse. They stored them with Mt. Gox, Atlantis Market, or one of many other companies that imploded or disappeared. Bitcoin has had a problem with amateurish entrepreneurs, but I expect that we will see continued failures even when established institutions attempt to use Bitcoin.
Despite this, there are still a lot of Bitcoin agents. The practice of storing bitcoins in web wallets, like those provided by CoinBase and Circle, abounds. People are still used to dealing with banks as a necessary evil and are not yet comfortable with the skills required to safeguard a private key. This is a problem because it means Bitcoin adoption requires a real change in peoples’ habits. Everything that helps people to learn new habits is greatly appreciated.
The only solutions to the agency problem are either to remove agents or to remove their agency. In other words, people must either take control of their own bitcoins or, if they do not wish to, they must cede control of their bitcoins in a way that does not give control to an agent. The only way to do this is to spread the control over many different parties who are not expected to collude. This could be done with multisig wallets or Open Transaction voting pools. This is a fairly drastic solution because it means no one can do anything with the bitcoins on his agency alone.
The agency problem becomes especially interesting when it comes to Bitcoin organizations because an organization has no autonomy of its own and all its members act as agents to it. All, whether employees or owners, have a similar incentive and ability to steal that other Bitcoin agents have. This is not a new problem, but Bitcoin gives it a new character.
An organization inherently cannot take control of its own bitcoins, so its only solution is to remove the agency of its own employees and owners. It is not enough for an organization to distribute keys between its own people, although that will help. However, it is much easier for people within an organization to collude than without, and furthermore within an organization people will tend to have similar characters so the probabilities that each is a bad actor are not independent of one another. Votes must come from different organizations on order to maximize the security of the wallet.
Whereas individuals can do whatever they want with their bitcoins, organizations must seek outside approval. They must subject themselves to constant auditing in order to deserve any measure of trust. It has long been understood that Bitcoin gives more control to individuals, but the complement to that is not yet well enough understood. I believe history has shown it to be an important effect, but it is not yet clear how important it will be. Maybe people will be able to work around it or maybe they will have to replace most organizations with distributed systems.
Of course, the requirement of being constantly audited and losing control over the funds it holds is less of a problem for honest organizations. It is much worse for criminal organizations or for organizations that want to keep their internal operations secret. Mafias, cults, and governments will have a greater difficulty adapting to Bitcoin than will publicly-traded companies.
All organizations tend to evolve so as to resist change, but governments, being subject to the problems of socialism, suffer much worse from this because government operations lack a clear concept of efficiency their overall success, the relative importance of any of its parts, or the relative merits of alternative organizational structuring. Consequently, governments can more easily evolve into labyrinthian structures that nobody understands without anyone realizing what is happening.
An eye-opening article called Sinkhole of Bureaucracy describes a surreal example of this phenomenon in an outstandingly incisive way. In an abandoned Pennsylvania mine, which is now an office containing 600 federal employees and endless filing cabinets, process all the federal retirement pensions on paper by hand. The system is widely understood to be insane and dysfunctional, but despite repeated and ceaseless attempts to automate the process beginning in the early 80’s, the system has not changed. It is not a problem of will, but of knowledge: there is no one available with the skills to carry through the transition successfully, no one who knows precisely what those skills would be, and no one who can evaluate anyone else for them. As a result, the attempts to develop an automated process failed because the software engineers did not understand the laws and the bureaucracy well enough to design something correctly, and the bureaucrats did not know how to tell if the software engineers knew what they were doing.
Will the federal government be able to adapt to Bitcoin? This would require building an a system not just for the one department, but for the entire organization, and it would have to be built properly—it must distribute decisions enough so that bitcoins cannot be stolen easily by employees. After reading that article, I think it is reasonable to think that the government may not be up to such a task at all.
]]>A successful attack on Bitcoin means attacking Bitcoin’s value. There might well be a bug that could be exploited to put the network out of commission temporarily, but would soon be fixed and then the network would be up and running shortly thereafter. To destroy Bitcoin permanently means to end the profit opportunities available with it, and that means either a malicious hashing attack on the network that makes mining impossible or such a malevolent policy against Bitcoin trade that even the black market abandons it. Both of these require spending resources in proportion to the profits that Bitcoin enables.
In this article, I will discuss three reasons why such an attack is unlikely to succeed: antifragility, subtlety, and attacker defection. The interplay of these three defenses makes Bitcoin into a kind of wave that rewards those who ride it and drowns those who resist it.
The first of these, antifragility, is exemplified in the fact that malicious hashing is impossible up to a certain fraction of the network. Below the point that selfish mining becomes possible[1] additional hashes per second are almost certainly beneficial because they increase the security of the network. Any potential attacker, therefore, must weigh in the possibility that he may end up benefiting the network instead of destroying it. A similar risk accompanies a legal attack on Bitcoin. Bitcoin can adapt to half-hearted attacks. It would move deeper into the black market where it would become permanently strengthened. Furthermore, a legal attack could be easily corrupted into one that brings as many bitcoins as possible to the government agents instead of one that destroys it (see below).
Bitcoin adoption happens one person at a time, and this is true for potential attackers as well as the rest of us. It takes an entrepreneurial mindset to be able to imagine what Bitcoin could become, given how comparatively small it is now. It takes time and meditation for people to take Bitcoin seriously because most of its value is in the future. By the time this happens, Bitcoin has become much more expensive than when they first learned of it.
Thus, Bitcoin is protected from attackers by being initially beyond their understanding. When Bitcoin was very small, it was very stealthy and was completely unknown to the establishment. Now they laugh at it, just as it has begun to grow bold. Of course, we don’t know who really dismisses it and who is deliberately trying to draw attention away from it.
Furthermore, potential attackers are at a disadvantage for another reason. Bitcoin tends to oppose organizations rather than people. Even someone who stands to lose from Bitcoin by not reacting to it, such as a banker or government agent, stands to gain a great deal by buying now. Only the very wealthiest people might reasonably expect to be worse off attempting to buy up as much as possible now than if it were gone. (This could happen if their attempt to buy caused the price to rise too fast relative to their ability to acquire additional bitcoins, to the point that they ultimately had less influence over the future Bitcoin economy than they have over the economy of today.) Thus, the agency problem with Bitcoin affects bitcoin competitors as well as Bitcoin holders.
Nearly any government agent who begins to see bitcoin as a potential threat must also simultaneously see it as an opportunity. He, too, can invest in Bitcoin. And why shouldn’t he? Bitcoin may be a threat to his livelihood, but it may well be making him an offer he can’t refuse. How can an organization that stands to lose by the adoption of Bitcoin provide its members with a better opportunity for staying loyal than Bitcoin provides for defection?
Even those who might resist the temptation to defect would have to think about the defection of his fellows. How quickly is adoption happening? Is there time to mount an attack before Bitcoin becomes too powerful? How easily could the resources for such an attack be amassed, given both the ignorance and treachery of the other agents. If such an attack would be unlikely to succeed, then buying now would be the only intelligent action. Regardless of whether he liked Bitcoin, it would be futile to continue pursuing a doomed cause.
Potential Bitcoin attackers are in a Prisoner’s Dilemma. In the same way that the people cannot easily rebel against the king owing to a lack of coordination on their part, governments cannot rebel against Bitcoin for the same reason. The government puts the people in a Prisoner’s Dilemma against one another, and Bitcoin does the same to government agents.
Bitcoin is like Invasion of the Body Snatchers. Bitcoin attracts inside men to act as covert saboteurs. There have long been predictions from both bitcoiners and naysayers of impending government attacks, but I think there is a possibility that Bitcoin could win without suffering much resistance. Moreover, although I said above only that any legal bitcoin attack could be perverted, the considerations discussed in this section tend to make such diffusion very likely.
Bitcoin defends itself by being obscure, but once it has attracted someone’s attention, its best interest is for that person to understand the logic presented here. For then he will also understand that his best course is to deny Bitcoin’s threat to his superiors and quietly to become its willing slave.
Right now Bitcoin Core does not follow the proper strategy to protect against selfish mining even at very low hashing rates, but the fix would be extremely easy to implement and would make selfish mining impossible up to 25% of the hash rate. ↩︎
Appcoins.[1] What a great way to fund an open source project, right? The idea began with Mastercoin, but seems to have jumped from there to become its own meme. You just create an app, and then make it less convenient by creating a cryptocurrency (or "appcoin") that is required to use it, some of which you sell to investors to pay for development of the app. There's no way that couldn't work! It's just like selling stock in a company, right?
Wrong. As will be shown, whereas the value of a stock is related to the value of the company that issued it, there is no such connection between an appcoin and an app, and there is consequently no reason to expect the appcoin ever to become valuable. For this reason, appcoins should not be considered a valid investment and are inappropriate as a means of funding open-source projects. Furthermore, once the arguments in this essay become well enough understood by investors, that it will be impossible to fund a project by selling an appcoin because the price will rapidly tend to zero.
A stock is a contract between owners of an enterprise which grants its bearers the right to a portion of the liquidation value of the company and to any dividends that it offers. Consequently, there is a reason to expect growth of the company to increase the price of its stock. The higher the probability that a company will increase the value of its net assets, the higher the expected price of its stock, and vice versa. Hence, a stock can be a perfectly legitimate investment if the company issuing it is not fraudulent.
On the other hand, the value of an appcoin can move completely independently of the value of the app itself. This is because the value of a currency is due to the value of the network of people holding it, which is a logically separate concept to the network using the app. The value of the app is a matter entirely of the service it provides, whereas the value of the appcoin partly due to the value of the app and partly to its competition with other currencies. If there are two currencies to choose, there is a relative disutility of holding the one which has the smaller market cap. The disutility becomes stronger as the difference between their market caps becomes greater.
Because any appcoin must compete with Bitcoin, there is inherently an aversion to holding the appcoin rather than Bitcoin. This means that an app can always improve by transitioning to use Bitcoin instead of the appcoin.[2] Since we are talking about open source projects, it is always possible for anyone to fork an existing app and make the changes himself.
It is, furthermore, not necessary to assume that the app must be forked to remove its dependence on the appcoin. As soon as the developers have sold out of their premined appcoins, there will be nothing preventing them from upgrading the app themselves to support Bitcoin. All nodes running the app who are acting as service providers will also desire this because it will generate more business for them. I do not see how investors in the appcoin could expect to prevent this. That should eliminate the expectation that any appcoin could ever be a good investment.
Even if the app could somehow remain locked behind the appcoin wall, there is still no reason to expect the appcoin to become valuable. If the users of the app cannot avoid holding the appcoin entirely, then they would prefer to hold it for the shortest time possible. There is an opportunity cost for all time spent holding the appcoin because better currencies are available which can be expected to provide better opportunities. There is thus an economic incentive to provide services which make the appcoin as invisible as possible so as to provide access to the app with as little hassle as possible.
But necessarily as a given number of users learns to hold their appcoins for lower and lower periods of time, the value of the coin must decrease and the price of app services in its own appcoin must increase. Suppose there were, say, 100 people sharing 1000 appcoins at a given time with about 10 each, and they learn to get rid of their appcoins to use the service twice as quickly. Then it must be more like only 50 people sharing 1000 appcoins, with 20 each. Even if the user base increased rapidly, it could not for long counteract the incentive to make appcoin insignificant to the app user.
Not everyone buys the appcoin to interact with the system, of course. Some buy it as an investment. However, after understanding the economics described in this article, investors will no longer be so innocent as to see value in an appcoin. An investor could not ultimately expect to make a return on an appcoin given that there is an incentive to disconnect the coin from the app. Once that happens, the appcoin is simply another altcoin.
Furthermore, the more that investors realize that other investors also understand the worthlessness of appcoins, the less successful will the appcoin be as a method of funding projects. If there are not enough gullible investors to buy the coin, then the developers can sell as many as they want without raising enough money. The only reason they can be used now is that the issues are not yet generally understood to be a scam. However, that is precisely what they are. It is grossly unethical to sell something which adds no value and which can be expected, always, to become worthless in the end.
Appcoins are a terrible idea. And furthermore, this shouldn't require such a deep analysis to realize. They are clearly just a needless complexity. Why would I want to use different money for my gas, food, and rent? This defeats the whole purpose of having a money economy. How can these appcoin proponents think they're accomplishing something with that? It's like they're trying to invent a barter system again except improve it by adding trade barriers and a bunch of imaginary extra goods that aren't useful for anything but that people are required to trade with for some reason.
In fact, it's not like that. It's exactly what they're actually doing. Appcoins are pump-and-dump scams disguised as Rube Goldberg machines, so don't get fooled.
[Update 6/16/2014: Added argument about developers changing the app themselves. Slight edits for clarity. Added footnote about frauds.]
I have been criticized over my use of the word fraud in an earlier version of this article. This usually implies an intent to deceive. I do not know whether the appcoins that already exist were sold under intentionally false pretenses; I merely consider it to be a likely possibility. As a comparison, if someone were selling a perpetual motion machine or homeopathic medicine, then obviously he is making false claims about his product. Without evidence as to what the seller is thinking it cannot be established that he is deliberately lying. However, the truth should be so easily available to the seller that deception on his part becomes a likely explanation for his actions.
In the case of appcoins, I do not think that the issues discussed in this article are very difficult to understand, so I would suspect someone who spent a lot of time working on them to have come to some understanding of the problem with them and the ethical problem of selling them. However, the important issue is not whether the seller knows the truth but rather that he is harming people either way. I did not intend to emphasize the issue of intent with this article and it is really irrelevant to the main point, but that was what much of the response to this article was about.
This response proves I used the word fraud incorrectly. There is a concept called constructive fraud, which can apply when a seller misrepresents a product in spite of an ethical duty represent it correctly. This concept fits better for what I meant, but if I wanted to say that I should have explained it more clearly. They are deceivers in the same sense that quack doctors are deceivers, which is to say that they might be deceiving others or they might be deceiving themselves. ↩︎
There is a similar effect between Bitcoin and the dollar, but because Bitcoin is such an enormous technological achievement over the dollar, Bitcoin continues to grow despite the dollar's superior network. If an appcoin could manage to reduce transaction costs by an order of magnitude versus Bitcoin, then it should be expected to defeat Bitcoin and all the other appcoins too. ↩︎
Bitcoin entrepreneurs have yet to appreciate fully collaborative nature of the Bitcoin economy and its implications for entrepreneurial strategy. Every successful entrepreneurial act improves the Bitcoin economy and attracts more people in, thus raising the value of the coins. Each new service benefits everyone else who is already invested. Consequently, Bitcoin businesses do not necessarily need to see themselves as competitors to one another. Even if they have the same business model, they both have more to gain from the influx of new users from outside than by taking customers from one another.
Furthermore, the growth of any Bitcoin business is limited ultimately by the growth of Bitcoin itself. Since the number of coins is strictly capped, the currency must grow with its price. This means that few businesses, if any, can be expected to earn a much better return than the coin itself over time. Entrepreneurs should therefore invest in coins, not businesses, because coins are where the profit is. In addition, if Bitcoin fails, then the Bitcoin businesses fail—so Bitcoin is less risky than any Bitcoin business too. Thus, Bitcoin entrepreneurs should be less interested in making money than in making bitcoins into money. An entrepreneur who follows that precept should generally be expected to be more successful than otherwise because the potential for Bitcoin itself is so much greater than any Bitcoin business he could invest in.
Of course, Bitcoin cannot succeed without businesses, or at least some sort of entrepreneurship. What is the best way to fund ventures in an environment in which they are relatively poor investments? The trick, I propose, is to think of these ventures more as donations to the Bitcoin economy than as profit-seeking ventures. Any useful Bitcoin service will tend to make the Bitcoin price increase because it adds value to the network. It may, therefore, be perfectly rational for a Bitcoin investor to contribute the service to the economy for free. Furthermore, the success of such a business being desired by everyone who holds coins, such a business can be run more like a non-profit or open-source project than an business. Thus, a new venture may attract investment even if it is not profitable as long as it provides a service the Bitcoin world needs.
In mid 2013 Armory, an open-source Bitcoin wallet project, received $600k in seed funding without even though nobody knows how it will eventually be monetized. These people have the right idea, but they shouldn't try to monetize it at all—it is obviously making all the coins more valuable.
Don't be a venture capitalist—be a speculative philanthropist.
The task ahead of us is monumental—the construction of a new financial economy to replace the one built around the national currencies. This will take a lot of work. Unfortunately, a lot of work is being wasted right now. The venture capitalists are looking to invest in a sharp team with a cool idea but the group of people that matters most is the entire network of Bitcoin users, and the idea that matters most is Bitcoin itself. Big new ideas get hyped up almost every week around here, and the Bitcoin economy will work a lot better if people would try harder to ignore them.
There are lots of business ideas floating around and limited time to create them. Only ideas that have a very high probably of being an important part of the future Bitcoin economy should be implemented because that is all we have time for and those are the only ideas worth risking Bitcoins on.
The proof that ideas aren't scarce is that anybody can make his own altcoin at any time. Already there are hundreds, and every one of them a bad idea from people who don't understand the cumulative benefits of cooperation. Since entrepreneurs don't understand Bitcoin very well yet, it is easy to dazzle them with technobabble and funnel investment into flawed projects like Protoshares, Mastercoin, and Ethereum that have a very low probability of furthering Bitcoin adoption to any significant degree.
There is no real reason to keep secrets because the more that everyone knows about what everyone else is doing, the more easily they can decide what the Bitcoin economy most needs of them. Everything about a business can be done openly for the benefit of the entire industry. Product development, future plans, market research, finances; everything except private customer data, which shouldn't be collected anyway, and, in the case of illegal Tor businesses, the real identities and locations of the owners. We need open business and open businesses.
In an open-business world, less experimentation is necessary to produce a workable system than among other businesses because there is no reason to keep secrets from one another. All trial-and-error should immediately benefit all the other Bitcoin entrepreneurs so that everyone can more easily figure out the most effective way to work. Open business as a generally accepted best practice would have eliminated terrible businesses like MtGox and Butterfly Labs early on. But even that would have been too late. Everything possible should be done to try to eliminate ideas before they can turn into failed businesses. That means sharing all ideas with the community, and investing in nothing that does not already have widespread community support.
Much of the Bitcoin world already works very openly. Lots of terrible ideas get shot down all the time in the Bitcointalk.com forums. All the software is open source. However, more is required: Bitcoin entrepreneurship should be run more like scientific research than a gold rush or an Internet bubble. There should be open research into the future Bitcoin economy, complete with peer review and consensus over which ideas are the most useful and important. Investment should focus on ideas that already have been vetted by the community. It should be considered reprehensible for startups to invent their own cryptographic algorithms.
It is too much of a waste of resources to test ideas in experiments with real businesses. All business models ought to be carefully critiqued beforehand and only the most necessary ones that we have time for should be created. This is not central planning; it is consensus-based entrepreneurship. No one shall be forced to follow any idea at all; it is simply in everyone's best interest to cooperate. If I am right, then soon investors will learn to back only heavily vetted ideas and entrepreneurs will it as well.
In the early Renaissance, mathematics was practiced in secret and mathematicians carefully guarded their own discoveries because a mathematicians' career depended on being able to show patrons that he could solve problems other mathematicians could not. However, in 1545, Gerolamo Cardano sparked a new trend with _Ars Magna*, the first published work to include the general solutions of the cubic and quartic equations. He even included secret work (with citation) by Niccolò Fontana Tartaglia, which whom Cardano had promised not to reveal. Gradually, mathematics transformed into a tradition characterized by publication rather than secrets. Open-access publishing is now demanded. Entrepreneurship is in its Renaissance still.
In a low-growth economy, one grows rich by carefully leveraging one's skills and assets so as to negotiate the most profitable trades. In other words, wealth comes from performing better than everyone else. It makes sense to guard closely any edge that one might have. Whereas in a high-growth economy, wealth comes from doing as well as everyone else. It is more difficult to improve one's state relative to everyone else than to enjoy the overall growth that improves everybody's state.[1]
The Bitcoin world understands this instinctively, but needs to take it to its logical conclusion. The entire Bitcoin economy needs to be open-sourced. This is how to make Bitcoin succeed most quickly and with the least effort, which is the best outcome for everyone.
Let's get to work.
In a post-singularity world, everything should be expected to grow at a phenomenal rate, similar to the growth of the Bitcoin economy today. Thus, I would expect the attitude of sharing and collaboration should apply generally. ↩︎
The objection that Bitcoin is not a good unit of account actually hides a circular argument that invalidates it. Bitcoin’s utility as a unit of account depends on what you already believe about Bitcoin. If you are skeptical of Bitcoin, then it makes no sense to use Bitcoin as a unit of account. If you believe that Bitcoin will become the world currency, then it makes no sense to use anything else. You want to end up with as many bitcoins as possible, so it makes sense to price any investments or ventures in Bitcoin. That’s how you know if you are winning or losing against your benchmark. Thus, to say that Bitcoin will fail because it is a bad unit of account is to say nothing more than that it will fail because it will fail.
There is, of course, no objective unit of value that is measured with a unit of account. This is why it is possible for two people to prefer such wildly different behaviors from their units of accounts. Someone still lost in the dollar world looks at Bitcoin and sees wild and extreme volatility, whereas someone in Bitcoin looking back at the dollar sees the worst and longest economic crash in history.
Upon entering the Bitcoin world, one gradually realizes that dollars make a lot less sense in this new world. Suppose, for example, that one considers getting into Bitcoin mining. The most important question is whether the mining rigs will mine more bitcoins than they cost—dollars don’t enter into question at all. Other businesses that perform Bitcoin-related services also must think similarly because one must always ask for any investment in the business, did it earn as many bitcoins as it cost to create?
Ok, so sure Bitcoin accountancy works within Bitcoin, what about interacting with the rest of the world? This also works fine. In fact, it works great. It just means that all prices in Bitcoin are rapidly falling. What’s the problem with that? That’s just Bitcoin’s way of telling people to keep holding it. It just feels like everything is becoming rapidly cheaper. Not a bad feeling. Not bad at all!
I feel like I went through a subtle psychological shift recently. When I use dollars, they feel like play money to me. Buying with them feels like using the colorful foreign cash during a vacation overseas. It no longer feels quite like real money. Bitcoin is my unit of account.
An observation I made today upon investigating something interesting happening in current events is that the price of ethers as listed on ethereumwisdom.com is listed first in Bitcoin, second in U.S. dollars. This is interesting, and a little ironic (in the sense of a player in a drama who does something without understanding its full significance) because it means Bitcoin is seen as the primary unit of account for the people investing in ethers. This reddit post also suggests that Bitcoin is like a unit of account for these people.
I guess Bitcoin must not be such a terrible unit of account if that's what people are using it for. I want to talk a little about why this might happen.
In the short term, cryptocurrencies tend to trade against the dollar in the same way. If Bitcoin prices rise or fall against the dollar, then other cryptocurrencies will tend to move similarly. From the standpoint of someone trying to choose between Ethereum and Litecoin, the price changes common to all cryptocurrencies are uninteresting. If the prices of ethers and litecoins are compared in terms of a common denominator which moves with them, then their similarities are less evident and their differences more evident. A specialist would want to look at them in the way that most emphasizes their differences.
Investors have chosen to do this by comparing prices in terms of Bitcoin. This makes perfect sense. Among people who think cryptocurrencies are going to be a big deal, you really want to compare everything to Bitcoin because it's the most obvious winner here. The irony is that once you start using Bitcoin as your unit of account, then you're using it like money, which means that you're not using your altcoin investments as money, which is the only thing they're good for.
I really like this development because it shows that people are getting more skeptical. The more people start to compare everything in terms of Bitcoin, the more they'll start to demand something that's actually useful. "Yes, but is it really going to beat Bitcoin?" is the question everyone should ask first about any investment in the Bitcoin world.
]]>No matter how many times Bitcoin grows by orders of magnitude, holdouts still remain who argue that it is a bubble destined to fail. To address this claim, I will describe a theory that describes how to appraise Bitcoin according to the Austrian theory of money.
In Austrian economics, money is valuable because it is liquid. This means that a given value of money is demanded everywhere and can easily be traded for goods. For example, say I had enough bitcoins to buy a 100-oz gold bar. In late 2010, this would have been worth around one to two million bitcoins and would have been impossible to sell on the open market without drastically affecting the price. By contrast, in early 2014, 100 ounces of gold was worth about 100 bitcoins, and this amount could easily have been traded quickly on one of the major exchanges without affecting the price noticeably. Thus, in early 2014 Bitcoin was more liquid than in late 2010, and was therefore a better currency.
Unfortunately, this insight about the value of money does not give us a means of appraising it because the liquidity cannot be separated from the price. This is kind of a problem—it sounds like a circular argument because it says that Bitcoin’s value is caused by its price! This allows for no way to detect whether Bitcoin is overvalued or undervalued.
In order to prevent this model from being causally circular, a time element is required. Our observations about money come from the past, whereas our judgments about its value are about the immediate future. This makes the value of money into a positive feedback loop. If the network is growing, then it will tend to continue to grow, whereas if it is shrinking, it will tend to continue to shrink.
This model of money has no independent quantity that estimates anything like an underlying value. Any price is as good as any other—the only thing that matters is the direction it is moving. This is not really an appraisal after all—but it is still the right way to understand Bitcoin’s price.
In the short term, there is money to be made by buying anything whose price is showing an upward trend if one spots the trend early enough. In other words, if one can predict that other people are likely to appraise a good more highly in the future, regardless of whether that appraisal is rational or irrational, then it makes sense to buy into the change of sentiment. If lots of people begin to think this way, then they can create a positive feedback among one another and bid up the good beyond any rational appraisal of it. This is a bubble.
A bubble bursts because eventually people have to get around to using a good for its ultimate purpose. Once it is understood that the people who actually use the good are being bid out of the market, then the price crashes because people stop predicting higher and higher appraisals to the price.
Money, however, need not have any ultimate use. It may only ever passed around from person to person, without ever being consumed. A stock is valued by the sum of its interest-adjusted dividends. A bond is valued by its redemption value adjusted by the interest rate and the risk of default. A commodity is valued by the value of the goods it can be used to produce. However, for money, there is no independent quantity to provide a reality check. All money is like a bubble that never bursts.[1]
Some of the theory of money can be understood in terms of Metcalfe’s law from computer networking. Metcalfe’s law says that the value of a network is proportional to the square of the number of nodes. The rationale is that the network should be valued according to the number of connections it supports, which is approximately proportional to n_2 (for large _n). Consequently, as the network grows, it presents a better and better opportunity for new members. As new members enter, the network improves for all its present members.
Metcalfe’s law must be adjusted slightly to apply to media of exchange because some nodes in the trade network will be more valuable than others. Those who have a lot of the medium are potentially able to spend more than those who have little. Therefore, use the market cap of the medium of exchange as n instead of the number of people. Similarly, some transactions are also worth more than others, so it makes sense to use the transaction volume rather than the number of transactions.
A striking test of Metcalfe’s law in Bitcoin recently appeared on the Bitcointalk forums, created by Peter R. I have made my own chart here.
This chart plots the market cap in blue and the square of the transaction volume excluding popular addresses in green. The axis on the left is the price in dollars. Exactly as Metcalfe’s law predicts, the transaction volume increases very neatly as the square root of the size of the network. The correspondence is beautiful. I wish I had thought to make it first!
I would like, however, to criticize the interpretation of the diagram. On the original Bitcoin Talk, thread, the green plot has been labeled as the “Metcalfe Value”, as if it is an appraisal of the Bitcoin that estimates what it could cost.
This interpretation is incompatible with the theory of the value of money I presented above. In my theory, the value causes the transactions, whereas in the diagram, the transactions cause the value. However, it is only potential transactions that cause the value. Past transactions are of no value to anybody. The current size of the network and the consequent opportunities it is likely to provide tomorrow are what motivate people to buy and sell today.
This may seem like hair-splitting, but a confusion of cause and effect can have serious consequences. For example, many people believe that it is necessary to spend bitcoins and increase the transaction volume in order to make Bitcoin more valuable. Of course this is nonsense; all this does is fill up the network with transactions for things that nobody actually wanted. That does not present a good value for a newcomer because he will want a network that presents him with real opportunities, not just ways of artificially increasing transaction volume. The more that the Bitcoin network is focused on artificially increasing the transaction volume to make it look good, the more it resembles a Ponzi scheme. Rather, to make the network more valuable, we should be hoarders. This is more likely to present newcomers with lots of potential uses for Bitcoin as a medium of exchange.
A real good can be valuable because of the ways that it can be consumed or because of the trades that can be made with it. Mises called these causes of value "use value" and "exchange value". Gold, for example, can be money and used as components in electronics. Evaluating whether a good is a bubble or not requires taking both factors into account; it is not enough observe that the price of a is far greater than can be explained by its use value to conclude that it is a bubble.
To put this another way, suppose that gold was only used in electronics. If that were the case, its price should be expected to be much less than it is now. However, some people started holding gold for longer periods of time before producing anything with it. This would cause the price of gold to go up, which would therefore make gold less useful as an electronics component. However, it would also make gold more useful as a medium of exchange. If gold's improved exchange value was enough to induce more people to buy it despite its reduced use value, then the price of gold could sustainably continue upwards. Its price chart might look like a bubble, but without the expectation of an imminent crash.
This brings us to Bitcoin. To what extent is Bitcoin's price a rational appraisal or an investment bubble? The answer is easy, much easier than with a commodity like gold. Bitcoins have almost no use other than as a medium of exchange. Thus, the fact Bitcoin has any price at all is evidence that there is a real network effect and that the cause of its price is its exchange value. With gold one has to consider the interplay between its use and exchange value, but with Bitcoin there is no such confusion:
Any demand for Bitcoin at all is enough to enable it to function as a medium of exchange. If demand continues to grow, then it becomes a better medium of exchange. There is no end to this process because the primary value of Bitcoin is the network effect surrounding it, not any final productive use. Each step in Bitcoin's growth follows a similar pattern of investment in the coin, improving Bitcoin's liquidity, creating more opportunity for its use as a medium of exchange, followed by investment in Bitcoin's infrastructure, thus realizing those opportunities.[2]
Thus, Bitcoin is not a bubble, or at least the available evidence strongly suggests that it is not. Its growth is like a self-fulfilling prophecy: as more people believe in it as a medium of exchange and become willing to buy it, they create the very conditions required of it to make it more useful.
Every time you buy Bitcoin, a fairy gets its wings. Now clap your hands, click your heels together three times, and believe in Bitcoin! It will only take faith the size of a mustard seed.
[Update 5/15/2014: Clarified section ‘Appraising Bitcoin’ in response to criticisms.]
One of the best arguments against the bubble theory of Bitcoin was presented by Peter Šurda in "The Economics of Bitcoin", in which he asks "What would replace Bitcoin?" The point of the question is that because Bitcoin reduces transaction costs over its alternatives, people have at least some reason to continue holding it until a superior alternative emerges. ↩︎
This analysis leaves something to explain—if the value of a medium of exchange is just the market cap, why does Bitcoin go through hype cycles? Every time Bitcoin goes up in price, that is an increase in its underlying value, so why does its price ever crash? I don’t know the answer, but I think I have a reasonable hypothesis: the network takes time to adjust to the enormous number of newcomers during each hype cycle. Each member of the network adds value, but this takes time—the members of the network must learn something about one another before the value they add to the network is more fully realized. If this effect is real, then the price could temporarily rise more rapidly than the growth that the network can support. ↩︎
Does Bitcoin need to be sanitized and separated from its anarchist, black-market roots in order to become acceptable to the general population? Must Bitcoin become an upstanding citizen and saddle itself with KYC requirements and capital controls? Absolutely not! Those making this argument totally misunderstand the way that Bitcoin adoption will proceed and are consequently wrong-headed about how to market it. The most important rule of the economics of Bitcoin is that investment creates liquidity, and liquidity creates value. The more liquid that Bitcoin becomes, the more trade it can absorb, the more it can be used as a medium of exchange, and the easier it will become to profit from a Bitcoin-based service.
There, is that clear? Bitcoin becomes more useful the more people invest in it. This is the key to understanding the economics of Bitcoin. If this insight was understood, then I would not need to write another article.
From a marketing perspective, this means that Bitcoin becomes easier to market the bigger it gets, because the bigger it gets, the more people can benefit from it. Someone who needs Bitcoin a little bit now will need Bitcoin a lot in the future. People who don’t need Bitcoin at all right now may soon start needing it. And people who already need bitcoins are going to be desperate for it in the future.
Furthermore, there is no end to this process. Bitcoin investment necessarily comes at the expense of other currencies, so even as Bitcoin gets better, its competitors get worse. It does not matter how much or how irrationally someone hates Bitcoin; eventually it will become so much more useful than the currency he normally uses that he will have to switch, right up to the day that Paul Krugman demands to be paid in Bitcoin to write another article denouncing it. Bitcoin will force people to love it.
Thus, Bitcoin need never seek mass appeal. To do so is to waste resources on people who are not yet ready for it. There is always someone out there who so obviously needs Bitcoin that it is a no-brainer to get on board. Anyone not desperate can be ignored until they become desperate. There may not be many people like that at any given time, but they will never run out.
Mycelium recently released a commercial called Mycelia in Wonderland which is pretty much my favorite commercial in history. It is so obviously not trying to appeal to normal people. I love everything about it, especially the way that it likens entering the Bitcoin world to a psychedelic experience or going through a portal to another universe, because that’s exactly how I feel. This cartoon is exactly what the Bitcoin world is like. It was great because I was just writing this article when it came out and it was about the most perfect Bitcoin commercial that I could possibly imagine and I almost died laughing.
Mycelium in Wonderland is clearly aimed at people who want to buy drugs, which is good because Bitcoin’s success on the black market is more meaningful and a more significant test of Bitcoin’s viability. The more that Bitcoin handles illicit activity, the better. People need illicit stuff a lot more because the more you tell someone that something he wants is evil or that he doesn’t deserve to have it, the more desperate he is to get it. Someone who wants Bitcoin for drugs or porn will tend to be a more loyal and committed Bitcoin proponent than someone who uses it to buy shoes.
Therefore, Bitcoin should not be shy about the black market. Black market businesses should be seen as potential early adopters. I will be more convinced that Bitcoin’s place is secure when drug cartels start using it than when Amazon.com starts accepting it. Use on the black market does nothing to change the pattern of Bitcoin adoption I described above. The people who most need Bitcoin at each stage of adoption will not care about its association with illicit activity; they will care about how it improves their profits.
There is no reason to treat the black market as something shameful. It is a source of wealth that we all depend on, directly or indirectly. If you love Bitcoin and foresee yourself growing rich off of it, then you should love its black market uses as well. If you cannot bring yourself to embrace the black market, then perhaps Bitcoin is not for you. Every time I hear someone complain about Bitcoin’s black market uses, I feel a twinge of pain. I want only to nurture Bitcoin and I love everything that makes Bitcoin good as an investment, not only that which is considered socially acceptable.
Furthermore, Bitcoin the value proposition cannot be separated from Bitcoin the black market currency. Anything that is good at being money is good on black market and anything that makes Bitcoin less useful on the black market makes it less useful, period. That is because the black market is just the market. Good money doesn’t know the difference between the white and the black market. All of the traditional properties of money that Bitcoin embodies so well—divisibility, portability, fungibility, and scarcity—make no reference to state law.
This is why Bitcoin should not seek regulatory approval: regulation would certainly tend to reduce without any corresponding benefit. Making Bitcoin less useful on the black market would require making it less decentralized, less anonymous, or grant its users less control over their money—yet these are the very features that attract people to it. Bitcoin’s great value is its individualism, which is indivisible, and until the Bitcoin community frankly recognizes this and wholeheartedly strives to nurture both its white and black market uses, then Bitcoin will always be ambivalent about itself and at risk of self-harm.
The solution to Bitcoin’s regulatory issues is simple: ignore the entrepreneurs who are complaining about it. They are just trying to earn dollars. Someone who is trying to earn bitcoins will be much more interested in the long-term future of Bitcoin and would prefer that Bitcoin not seek mainstream approval so as to achieve a more stunning victory later.
It should never be expected that Bitcoin will have approval from government and the banking industry for long. If Bitcoin continues to grow, then eventually Bitcoin will threaten the dollar itself and then a government attack is inevitable. Regulation will only make Bitcoin more vulnerable when that times comes. However, because Bitcoin can resist all regulation no matter how draconian, it has no need to make compromises.
Moreover, Bitcoin cannot compromise without risking its future: because competition between currencies is never stable, a successful free-market currency must be good enough to defeat all the rest. If Bitcoin is ever less competitive than the dollar, it will die. Otherwise, it will destroy the dollar. Thus, there is no way to avoid a confrontation with the US government no matter how many regulations Bitcoin obeys. Bitcoin investors had better be willing to see Bitcoin through to its total victory because if it does not accomplish this, they will lose everything. Anyone who thinks this is impossible might want to sell out now.
]]>This article is about the possibility of Bitcoin-induced currency demonetization, or hyperbitcoinization, which is what would happen to any hapless currency that stands in Bitcoin's path of total world domination. If this happens, the currency will rapidly lose value as Bitcoin supplants it. What would such an event be like and how can it be understood economically?
Demonetization refers to a process by which people cease to use a good as a currency, and hyperinflation is a kind of demonetization when the government inflates the currency at an accelerating pace. Hyperbitcoinization is a different kind, though it will appear (superficially) similar. In both kinds events, prices in the doomed currency will skyrocket until it is no longer a currency at all.
There are two essential differences between hyperinflation and hyperbitcoinization. The first is that a currency hyperinflates with restricted competition from other currencies, whereas hyperbitcoinization happens because of competition with Bitcoin. This is because capital controls are much more effective on other fiat currencies than on Bitcoin, so it is easy for Bitcoin to cross borders and compete with anything.
The second is that in a hyperinflation, the government expands the money supply to outpace people's inflation expectations. Demonetization occurs as a result of their destructive interaction. Whereas a hyperbitcoinization event need not be accompanied by any change in the supply of either currency.
As the government forms a habit of inflating the money supply, its people form a habit of anticipating rising prices. This prevents the government from gaining as much each time it inflates. Thus, to get the same kick, the government must inflate more. The money loses value once people anticipate such heavy inflation that they can't spend it fast enough and it no longer functions as a currency.
Hyperinflation is an entrepreneurial act on the part of government, in the sense that it involves a continually changing intervention that prevents an equilibrium from forming. The government must continually alter its own behavior to stay ahead of its people's. The moment they begin to anticipate its future policy, the government must change the policy by increasing the rate of inflation.
Hyperbitcoinization is a voluntary transition from an inferior currency to a superior one, and its adoption is a series of individual acts of entrepreneurship rather than a single monopolist that games the system.
Based on these two differences, I make two predictions about a hyperbitcoinization event.
A hyperbitcoinization event will be much quicker than a hyperinflation event. I have two reasons for this. First, the government will have a much greater difficulty preventing bitcoins from entering the country due to the impotency of capital controls upon it. Second, hyperinflation is inherently an attempt to fool people, whereas hyperbitcoinization is quite regular and predictable (at least by comparison). Therefore people will more easily see that they had better switch over. Thus, as fast as hyperinflation is, hyperbitcoinization will be even faster. It will happen much faster than you expect.
Hyperbitcoinization will not disrupt the economy to nearly the same degree as hyperinflation. The currency is the instrument of the division of labor, and hyperinflation makes it unreliable and forces people to use worse alternatives. In a hyperbitcoinization event, people switch from a fundamentally inferior currency to a superior one, whereas in a hyperinflationary event people will only switch to a new currency once the old currency becomes worse than the next best alternative, such as gold or detergent. Hyperbitcoinization should be accompanied by a rapid improvement in productivity and wealth.
Hyperbitcoinization will probably be a confusing time for everyone, like a second adolescence. However, once it is over, no one will be able to imagine how we got by with the earlier system.
(Original artwork by the author)
]]>O my brethren, am I then cruel? But I say: What falleth, that shall one also push!
Everything of to-day—it falleth, it decayeth; who would preserve it! But I—I wish also to push it!
Know ye the delight which rolleth stones into precipitous depths?—Those men of to-day, see just how they roll into my depths!
A prelude am I to better players, O my brethren! An example! DO according to mine example!
And him whom ye do not teach to fly, teach I pray you—TO FALL FASTER!—
I understand the word altcoin to mean a network which competes with Bitcoin’s function as a currency and which is smaller than Bitcoin’s network. Thus, Litecoin is an altcoin, whereas Bitmessage is not, even though it is inspired by Bitcoin technology. The Ripple system is not an altcoin, although there is an altcoin called ripples (XRP) which is inexorably linked to it. Ripples the currency should still be considered an altcoin even though its underlying technology is quite different from Bitcoin.
This article explains why there is a tendency towards a single dominant currency, why the network effect overwhelmingly favors Bitcoin above any of its competitors, and why people should speak out against altcoins rather than allow more people to get fooled by them.
There are two things you can do with a currency: save it or spend it. Although in the future I expect that most people will become both savers and spenders of bitcoins, it is possible to separate these two uses conceptually.
It is possible for people to save with a currency even if there is nothing to buy with it, but it is impossible to spend a currency (that is, use it as a medium of exchange) unless there is someone who wants to save it. If everyone who acquired bitcoins did so simply to spend them literally immediately, then it would be impossible for them to have any value because anyone who held them for any period of time at all would be willing to get rid of them at any price, including zero. Once the currency develops a little bit of demand, then it can be used as a medium of exchange by paying to those who demand it in exchange for a good or service, or indirectly by paying it to a merchant who immediately resells it for money.
The market cap of a currency should be seen as roughly proportional, all things being equal, to a currency’s liquidity, which refers to the value that can be bought or sold without significantly altering the price. While it is theoretically possible for a currency of a given market cap to support any volume of trade as a medium of exchange, this requires that people become less and less willing to hold the currency for any length of time as the volume of trade increases. In this situation, severe practical difficulties ultimately develop. For example, if someone wanted to buy something worth more than the entire market cap of the currency he was using, he would have to pay with several transactions.
Any disruption in the balance of buyers and sellers would affect a currency’s market price more drastically if its market cap was small than if it was large, so the currency with the smaller market cap would be less liquid than the other.[1]
A more liquid currency has an advantage over a less liquid one because it can support more trade. Furthermore, liquidity in a currency is self-reinforcing. The more that people buy a currency, the more liquid it becomes. This naturally tends to promote the success of a single currency over all the rest.
Consider the hypothetical example of an economy that uses exactly two currencies, Acoin and Bcoin, which are equally preferred by holders. For whatever reason, Acoin develops a very slight advantage over Bcoin. Consequently, a few people exchange Bcoin for Acoin, thus very slightly increasing the market cap and liquidity of Acoin and slightly decreasing that of Bcoin.
Now, in addition to its initial slight advantage over Bcoin, Acoin has the advantage of becoming more liquid. As a result, more people will tend to sell Bcoin for Acoin. Thus, Acoin’s initial advantage is self-reinforcing, and as the disparity between Acoin and Bcoin increases, its superiority becomes more and more evident.
This process will continue as long as Bcoin still serves as a currency. It may ultimately remain only to serve some extremely marginal purpose, but not as a general medium of exchange. This process should be expected for any two currencies on the free market, ultimately leaving one that is overwhelmingly dominant.[2]
Thus, a more liquid currency will tend to be preferable to both savers and spenders: to savers because of its self-reinforcing superiority and to spenders because there is simply more that can be bought with it.
Liquidity, which is required for anything to be used as a currency, cannot be built into a protocol. It does not matter how brilliantly designed an altcoin is and what cool features it has. Its value depends on a factor that is outside its designer’s control, something more characteristic of the “spontaneous order” of the market than an intrinsic property of the currency.
Bitcoin and the dollar have very different properties, so it is possible to explain Bitcoin’s success in competition with the dollar despite the network effect of the dollar in light of those different properties. However, cryptocurrencies do not have very different properties from one another, so there is very little basis to predict that an altcoin can successfully compete with Bitcoin. In the case of, for example, as Bitcoin and Litecoin, I see no evidence in reality or in my understanding of human psychology that investors should see the difference in their mining algorithms or confirmation times as remotely important. The factor of roughly twenty by which Bitcoin’s market cap outweighs Litecoin’s is by far the biggest difference between them. Right now Bitcoin is growing by supplanting the national currencies, but eventually will absorb the altcoins as well. Bitcoin will gobble up Litecoin at some point, but I do not know if it will be the appetizer or the dessert.
A new altcoin cannot survive with only a fraction of the cryptocurrency pie. It must defeat everything else to succeed, including Bitcoin. Since it begins at an extreme disadvantage with respect to Bitcoin, it cannot succeed with technology that is marginally superior to Bitcoin. It must be as significant an advance over Bitcoin as Bitcoin is over the dollar.
The above discussion explains why Vitalik Buterin’s objection to my earlier article completely misses the point. He first downplays the network effect for currencies on the basis of switching costs.
Making the switch from fiat currency to Bitcoin is quite difficult, and creating bridge services that work between the two is a multi-million dollar affair involving placating established banking partners and complying with a large body of regulation. The path from one cryptocurrency to another is much simpler. Anyone can set up an anonymous exchange over Tor, and it may even be possible to make trust-free decentralized exchanges between currencies using Bitcoin’s underlying cryptography directly.
He then argues that merchants can easily accept as many cryptocurrencies as they wish.
For a merchant accepting Bitcoin, if alternative currencies gather any popularity at all then switching to Litecoin or Primecoin will be a simple matter of downloading a patch. It is even possible for a merchant to accept every cryptocurrency at the same time.
These arguments entirely misconstrue the nature of the network effect for currencies. Merchants are totally irrelevant and so is anyone who uses the coins only for the purpose of transferring funds. What matters are the investors, the people who hold the coins long-term. For them, there is an enormous difference between the different coins, and switching costs are largely irrelevant. Investors will prefer to hold the coin that has the best prospects, thereby necessarily improving it relative to its competitors.
For currency investors, the network effect is absolute because it is impossible to buy bitcoins and some altcoin with the same money. This is why analogies to other network effects, such as that between social networks like Facebook and G+, are spurious. It is possible to leverage the benefit of Facebook and G+ at the same time. I can, for example, write a single status update and then post it to both social networks at almost no additional cost.
Furthermore, there is very little long-term investment in the use of a social network. New status updates lose all value in hours. Message boards come and go. All it takes is to ignore Facebook for a few weeks before there is little to draw one back to it. The network effect for social networks is therefore tiny compared to that of currencies.
So far, altcoiners have been able to continue creating and mining altcoins without having to justify themselves very clearly. The responses I have heard to my arguments against them have been terribly inadequate: I get either a non sequitur (“Scrypt is ASIC-resistant”) a misunderstanding of the network effect (as with Vitalik’s piece) or a vapid, inappropriate skepticism (“How can you be absolutely certain that Bitcoin will win?”[3]
I have never even heard any positive argument for any altcoin that explains why a majority of Bitcoin investors should sell and buy the new coin, or why enough new investors should reject Bitcoin and invest in the new one, in spite of the enormous advantage that Bitcoin already has.
The present popularity of altcoins should be explained in terms of foolishness and hubris because it cannot be explained rationally.
As investors look at a new altcoin that has come out, they might think to themselves, “This cryptocurrency network is innovative, perhaps this means it will do well.” They might buy in at that point, or they might think a little harder and continue, “But wait. Bitcoin has the much larger network and is therefore objectively more useful as a currency than this new altcoin, despite its innovative features. If I decide to buy some, I would have to sell some of my bitcoins for it, so there is a real opportunity cost. Furthermore, the only way it can win is if all the other investors also switch. Will they or won’t they?”
At the same time, many of the other investors will be thinking the same thing. They will think about the fact that the rest are thinking it too. They will think, “No reasonable person would expect this coin to have any but a small chance of success. But since it can only succeed if lots of people really believe in it, this ensures that it cannot be successful because if no one buys more than a small gamble, then its failure is virtually guaranteed.” If they stop thinking there, they will stick with Bitcoin.
However, they might also think something along the lines of, “It’s quite possible that this altcoin will have an extra jolt in price during the next Bitcoin mania because some people may buy it either because they were not intelligent enough to follow the same train of thought as me or because they too, like me, realize that it may attract people who can be preyed upon. However, that is a risky proposition because it will be hard to know if I am the one preying upon suckers or if I am a sucker myself.” They will then either buy it or not depending on their own confidence in their ability to predict the behavior of foolish people.
Thus, altcoin investment ends up as a dynamic interplay between people who have not thought very far ahead, and people who think they are taking advantage of other people.
The more that altcoiners are asked for valid self-justifications, and the more they are asked how their new coin will achieve liquidity, the less effective their arguments will become, the less hype they will be able to generate, and the less that people will buy them. To defeat the altcoin movement, keep warning newbies against them and insist upon relevant arguments every time an altcoiner tries to change the subject.
The irrationality that props up the prices of altcoins cannot continue indefinitely. As soon as enough investors learn to think far enough ahead to wonder who the sucker is, the prices of the altcoins will begin to drop inexorably. We can make this happen sooner than later. I would like to see a more concerted effort within the Bitcoin movement to demand valid answers and to denounce as charlatans those who cannot give them.
I don’t think it is right to let the altcoin bubble continue without trying to stop it. Altcoins will cause a lot of people to lose money and for a lot of people to make money who are not adding value. Many who are already invested will lose, but I would prefer at least that there will be no more.
Although I cannot be certain, and I am, like everyone, prone to wishful thinking, I think that there is some indication that the altcoin movement is playing itself out: it is no longer possible to generate any interest in a straight Bitcoin clone like Litecoin. It is now necessary to add either a lot of extra features, as is the case with Mastercoin and Ethereum, or simply to act outrageous, as with Dogecoin. Furthermore, it is ridiculously easy to create altcoins now: Coingen is a service that automatically creates altcoins to any specification, and which, amusingly, only accepts payments in Bitcoin. It was apparently created especially for the purpose of helping to discredit altcoins.
Dogecoin is the highest form of satire. It is such a perfect depiction of the real-life insanity that it is being treated seriously. It is unabashedly coasting on image with no substance whatsoever. Dogecoin supporters do not claim to be the silver to Bitcoin’s gold or attempt to make any arguments (other than “such wow”) to justify Dogecoin as an investment; they just make jokes and give tips to one another.
As I write this, Dogecoin is the fourth largest altcoin between Peercoin and Mastercoin. This fact should get altcoin investors thinking, “Does this mean that other altcoin investors are so stupid that they can’t tell the difference between a joke and innovative projects like Mastercoin and Peercoin or does it mean that there actually is no difference?” The more people think this way, the more the concept of an altcoin will be discredited.
The other trend in altcoin creation is to add a lot of bells and whistles and to pretend to be a very advanced product so as to hide the fact that it is, at bottom, an altcoin. Examples of this trend are Protoshares, Mastercoin, Ethereum.
All of them are basically altcoins that are also platforms for creating more altcoins. This is insane. Each of them has its own individual problems, but the fundamental problem with all of them is that none of their features are useful unless the underlying altcoin is liquid. Thus, their extra features should not be seen as necessarily granting a competitive advantage over Bitcoin. They still have an enormous hurdle to overcome before they could be a viable competitor to Bitcoin. When people say, “But Ethereum can do smart contracts!” this is actually false. It is only the Ethereum protocol plus liquidity that make smart contracts possible. If Ethereum were not liquid, it would be impossible to build any real penalties into a contract because it would be impossible to tie a sufficient value into them. Since there is no logical reason to expect Ethereum ever to be liquid, there is no logical reason to expect that many people will be able to create smart contracts with it.[4]
Protoshares and Mastercoin are no longer being hyped much and Ethereum is the big new thing. However, none of them addresses the real issue of being a viable competitor to Bitcoin. Ethereum will therefore soon be forgotten like the rest once it inevitably fails to deliver on its promise.
I don’t object to altcoins in themselves. What I object to are the lies. There are legitimate reasons for altcoins, but none of them allow for real money to be made off of them. Altcoins should have little or no market value, but the distributed system as a whole can have value as an experiment or test of a possible upgrade to Bitcoin.
If you tell me this altcoin implements some cool new idea, then very well. But if you tell me it’s going to be the next big thing and that it’s a great investment, you’re lying. And if you believe it yourself, you’re lying to yourself.
The only reason that an altcoin should have any value at all is as an extreme speculation on the death of Bitcoin. Although it is impossible for an altcoin to beat Bitcoin on its own merits, it is theoretically possible that the Bitcoin community could destroy Bitcoin through its own foolishness. If that possibility should loom, then altcoins can do a valuable service by going up in value, thus alerting the Bitcoin community to reverse whatever it is doing.
Namecoin is unique among altcoins as far as I know in that it provides a valuable service directly to users that does not depend on the value of the underlying coin. It is not simply an experiment that might be viable one day if it were incorporated into the Bitcoin protocol, although it would be more useful if it could at least be made compatible with Bitcoin in some way.
Namecoin is a system that includes both an altcoin and a distributed name registration service. Namecoin is designed so that namecoins must be spent in order to register a name on its block chain. This is a design flaw because the extra currency is extra baggage. It would have been better to design Namecoin to work directly with Bitcoin instead, but since a distributed DNS service is inherently useful, it is possible that Namecoin could succeed anyway.
In a future world in which Namecoin has gone mainstream, namecoins would have to have some value, even if they did not become the dominant currency. In that case, however, namecoins would not be a currency at all, but simply a token used to interact with the Namecoin system. They will survive as a parasite that detracts from the overall value of the namecoin system.
If a means could be designed to make Namecoin work with Bitcoin payments, for example by designing a protocol that provably ties a Namecoin payment to a Bitcoin payment that goes to the Namecoin miner, then Namecoin the currency would become a nearly worthless token more rapidly and the Namecoin system would be greatly improved.
Altcoins are not viable because they cannot reproduce that which gives Bitcoin an overwhelming competitive edge: its market cap. It is unethical to create an altcoin with the purpose of making money off of it for this reason. They should not be taken seriously. The way to defeat them is to keep demanding of the altcoin promoters that they spell out why their altcoin makes sense as an investment. The more that this demand is made, the worse altcoins will look.
This point needs to be made in a variety of ways, again and again. This article and the few others that have been written are not enough. It needs to be restated in as many different ways as possible until the altcoin movement is over.
Disclosure: the author owns bitcoins but has never owned altcoins, due to the fact that they are unsustainable. If he thought altcoins were sustainable, he would buy them rather than explain very carefully why they are unsustainable. He did try to mine dogecoin for a few hours once, but was not wowed.
Update March 17, 2014: Clarified 2nd paragraph of section “Liquidity Cannot be Designed”.
Although in an earlier article I satirized people’s fear of volatility, clearly if Bitcoin’s price could change drastically as a result of everyday purchases or over ten minute spans, then it could not be used to make payments. The difference here is that between volatility and liquidity. A currency is liquid if one person can spend it without changing the price, whereas it is volatile if everyone is trying to spend or buy it at the same time. If a currency is volatile because many people are investing in it, then that is a good thing because the currency is becoming more liquid. ↩︎
Update March 17, 2014: It has been objected to me that people can value an altcoin for reasons other than the size of its network. That possibility does not change the outcome of this discussion at all. All that will do is change the tipping point between them. When people are perfectly indifferent between Acoin and Bcoin, then they are at an unstable equilibrium when they have exactly the same market cap and whichever one happens to grow slightly at the expense of the other should be expected to win. But let us say for example that Acoin is perceived to be stodgy and uptight whereas Bcoin is fun and youthful, so that people can prefer to hold Bcoin even if it has a smaller network. That does not change the fact that they both become worse when their networks shrink and better when their networks grow. If Acoin and Bcoin were perfectly balanced, you would expect Acoin to have a bigger market cap and Bcoin to have a smaller one. However, if Acoin grew at the expense Bcoin, then the network effect benefits Acoin at the expense of Bcoin. At that point, they are no longer in equilibrium and the network effect benefits Acoin at the expense of Bcoin. And the same thing happens to Bcoin if it grows slightly at the expense of Acoin. There still cannot be two currencies trading side-by-side in the long run. ↩︎
My response to this is that I cannot be absolutely certain of anything, but if Litecoin were to beat Bitcoin, I would take this as evidence that cryptocurrencies as a class are not a worthwhile investment. If Bitcoin can be defeated by Litecoin, then Litecoin can be defeated by Dogecoin. Why should anyone invest in any cryptocurrency, and thereby deign to give it value and liquidity, if mere hype and lies can change its fortune? If Litecoin defeats Bitcoin, then I would predict ultimately that no cryptocurrency will win. ↩︎
Update March 15, 2014: It was pointed out to me that Ethereum is capable of acting as a distributed DNS service. This puts it in the same boat as Namecoin. See the section on Namecoin for another conceivable outcome for Ethereum. ↩︎
Bitcoin has an image problem! Everyone thinks Bitcoin is for drug dealers, hackers, and anarchists. It’s used to gamble and buy porn. People think it’s a Ponzi scheme! Bitcoin needs to grow up and repudiate its youthful indiscretions. Its services must be run by professionals, not amateurs![1] Soccer moms will never use Bitcoin if they think it’s used for drugs and porn. Bitcoin will never be acceptable and gain widespread adoption otherwise!
In this article, I will show why the above paragraph is totally misguided.
Bitcoin is far too useful to expect that prejudice will stand in its way. Almost everyone who has ever bought bitcoins had to overcome an initial skepticism, and this will continue to be the case right until Bitcoin takes over. To want bitcoins requires a person who can see ahead a little bit better than everyone else. The only way to convince most of them that Bitcoin is in their future is to build that future and show it to them. Those with a less entrepreneurial mindset will simply have to be in much worse financial straights without it before they will be ready to adopt.
The data on Bitcoin’s adoption rate show no evidence of an image problem. First look at this log chart of Bitcoin’s market cap.
Now take a look at the number of MyWallet users over the past two years. This is also a log chart.
That’s an increase of like 500 times in two years. Ooo, I’m so terrified Bitcoin’s image will stop people from wanting it.
And what about BitPay, Bitcoin’s premier payment processor? In September of 2013, they signed up their 10,000th merchant. By December, they had over 14,000. On Black Friday of 2012, they processed 99 payments. That same day of 2013, they processed 6,296.
Are you kidding me? I’ve never seen anyone want anything this badly. People can’t get enough bitcoins. Every indication of Bitcoin’s adoption shows a rapid exponential growth. The idea that Bitcoin has an image problem is empirically ridiculous.
You could run an ad campaign for Bitcoin that tells people it’s the stupidest idea ever and punch people in the face when they bought in and they would still flock to Bitcoin. You know how I know that? Because that’s basically what has been happening since the beginning of the Bitcoin economy. N00bs enter the bitcoin world to find scams and sophomoric novices that give them terrible advice. They lose their investment from simple mistakes and they get raped by the markets. These are serious problems that need to be ameliorated, but the point is that people can have very bad experiences when they enter the Bitcoin world, and they still want more Bitcoin. This is how we know we don’t have to worry about Bitcoin’s image.
I think Bitcoin has a great image and that Bitcoin’s association with illicit activity should not be seen as a problem for it. I can’t think of any better way to generate interest in Bitcoin than drug-dealing, hackers, and anarchy. When was the last time you heard someone say, “Oh, Bitcoin! I’ve heard of that. That’s that new currency that’s great for remittances, right?” Never, that’s when. Drug dealing, hackers, and anarchy are great lead-ins to a conversation.
I remember the days when Bitcoin was so unknown that I was not even recognized as a dork for talking about it. In those days, nobody wanted to hear about Bitcoin, not even libertarians. If I tried to talk about it, it was like people didn’t even hear me. Now everyone wants to hear about it and I wouldn’t have it another way.
Furthermore, Bitcoin’s improvements to the illegal drug industry and to practical anarchism have been one of its greatest successes, so why shouldn’t people associate Bitcoin with drug dealers and anarchists? Not only is that honest, but it is a strong endorsement. If Bitcoin is good for illicit activity, that means it empowers people. If people think that Bitcoin can help them to evade contraband laws, to taste the forbidden fruit, to satisfy needs that society would rather have them suppress, then that is a fantastic advertisement.
Bitcoin is subversive as more than just a payment-processing technology. It is not just a cool new gadget that ordinary people can use without fearing that it will lead them unexpected new directions that test their ability to grow as a person. It has the potential to change their lives irrevocably. It has the potential to drastically change the balance of power in society. It is perfectly reasonable for people to be suspicious. People should feel a real twinge of danger when they first get bitcoins. It can usher them into realms which their society has long told them were off-limits. If we got people to believe that Bitcoin was only good for revolutionizing e-commerce, then Bitcoin would have an image problem because that would not be honest.
These “image problem” people are like if the Clampetts discovered that they were sitting on a swamp made out of crude oil and worrying that people won’t accept it because it’s too ugly and gross, so they try to convince people that it’s a pretty shiny pink and tastes like cherries.
The only way to think Bitcoin has a bad image is by marketing it to the wrong people. Yes, just about everyone could benefit from Bitcoin right now, but for most people, the immediate benefit would be relatively small, and it is too much to ask them to understand both the economics and the cryptography that would be required to convince them that Bitcoin has a vastly greater potential than it has yet achieved. Instead of marketing Bitcoin to the people creative enough to see its potential, or to those who so desperately need it now that its benefits are obvious, entrepreneurs like Jeremy Allaire are attempting to market Bitcoin to the average American as a payment-processing system. This is premature because Bitcoin’s benefit as a payment system is only significant after lots of people already have it—therefore the benefit is marginal to most people. As Bitcoin improves, and particularly when it begins to weaken the fiat money system, more and more people will find it prudent to adopt it.
Bitcoin inspires suspicion among bankers and regulators. Bitcoin has a bad image with them, but that’s their problem, not Bitcoin’s problem. Those who are worried about banks boycotting Bitcoin or the government regulating it out of existence should not plan to start a Bitcoin business under such regime uncertainty. Eventually, Bitcoin will have become so widespread that it will have drastically reduced the scope of both banks and government. Then that will be a good time for payment-processing companies.
This is all a bunch of narcissism. It’s an emphasis on appearance without substance and respectability among people who don’t matter. Bankers aren’t Bitcoin owners yet, and until they are, their opinions are not important. If Jeremy Allaire thinks that Bitcoin has an image problem, he should try smuggling it into Argentina instead of marketing to Americans and bothering with American banks.
The best way to improve Bitcoin’s image is simply to improve the Bitcoin economy. With every new service, the incentives for more people to join us grows. We should feel lucky that we are in on such a wonderful secret as Bitcoin. If people mistrust and misunderstand it now, then we should be happy if it gives us a little extra time—however brief—to buy more. Every time someone figures out how great Bitcoin really is, he makes Bitcoin even more great by joining in.
]]>I’m sure you’ve heard a story like this. “I’ve been going to all the local stores and telling them how awesome Bitcoin is! But none of them wants to take payments in Bitcoin! Why don’t they like it?”
Let’s think about that for a minute. You are essentially telling the merchant, “Hey look at this totally awesome thing that I want to get rid of! You should trade me some stuff for it!” Not actually much of a sales pitch, is it? Why would the merchant want something that you, apparently, don’t want? If you really want him to start accepting bitcoins himself, ask him, “Do you take worthless paper money at this store? Good, because you’re not getting a satoshi from me!” That will convince him that you think they’re valuable.
How about this instead? Tell your local merchants that you want to be able to spend cash in their stores and get the change in bitcoins. That’s the kind of store I’d like to shop at. And then when the merchant later says “I’m not going to do that anymore. I want you to pay me in bitcoins!” you know he’s become a true hoarder.
The initial price of bitcoin was caused by people who wanted to hold it, not people who wanted to spend it. Furthermore, each subsequent step in Bitcoin’s advance must begin with more holders, not more spenders. The business that bitcoins can absorb is limited by its market cap. At a market cap of two or three billion dollars, Bitcoin can absorb many small businesses but it cannot be used for international oil trade. It would have to be dozens of times more expensive for that, and it can only achieve that if the peoples’ desire to hold bitcoins continues to increase faster than their desire to spend them. Thus, one who wants Bitcoin to become mainstream should never want its price to be lower. He should want an ever-increasing supply of hoarders.
It is true that Bitcoin’s price can occasionally and temporarily outpace the growth in its real prospects, but this is merely a byproduct of Bitcoin’s phenomenal success. A commodity which increases in price as quickly as bitcoins can be expected to experience shocks and manias on its way up because it would be difficult to tell the difference between a sustainable price increase and short-term speculation. However, does it make really sense to prefer an alternative history for Bitcoin in which its price has increased slowly enough that it never developed any manias? I do not see how that could possibly be preferable. The faster Bitcoin grows, the more complete and decisive will be its victories, and the more difficult it will be for its natural enemies to react to it.
One of the most annoying things about Bitcoin is that it’s so convenient to make payments with it that sometimes it is extremely tempting to spend it and avoid the hassle of using dollars. One of the ways to help deal with the temptation to spend is to demand a Bitcoin discount at any store that accepts Bitcoin. This is perfectly reasonable because not only is the store lowering its own costs by using Bitcoin, but it is asking me to give up an inherently superior commodity.
Hoarders are more important than merchants. If a restaurant downtown starts accepting bitcoins, this does not necessarily create an incentive for anybody to buy more bitcoins. Why would anyone bother if they can still just use a credit card? If you can convince a merchant to accept bitcoins and stop accepting dollars, then I’ll be impressed.
Unless a merchant is offering something that cannot be bought for dollars, or at least offering a discount, he is only benefiting Bitcoin to the extent that he encourages more hoarding. If he immediately converts the bitcoins he receives as payment into dollars, and if his customers only buy bitcoins so as to spend them at his shop shortly thereafter, then neither has much direct effect on Bitcoin’s demand. The real hero is the hoarder behind the scenes who buys from the merchant and enables him to convert his payments into dollars.
There can be no spending of bitcoins without the buying of them, and thus all use of bitcoins as a medium of exchange depend on someone who wants to increase his holdings, i.e., a hoarder. Without them there could literally be no Bitcoin trade. Furthermore, it is counterproductive to try to turn hoarders into spenders. There really is no compelling reason that anybody should spend bitcoins any time soon—if everybody is hoarding, that will just make the price go up until finally someone can’t help spending some.
Currencies are unusual in that the greater is its market cap, the more useful they are. This is in contrast to a more ordinary security, such as a stock, because a stock has a better value the cheaper it is in relation to the underlying assets of the company. A more expensive currency is ipso facto more marketable (more liquid), thus making it a superior medium of exchange. The more bitcoin hoarding there is, the better it is as a medium of exchange.
Thus, the success of Bitcoin is, to some extent, a self-fulfilling prophesy. Belief in Bitcoin improves the Bitcoin network, as long as people back-up that belief by the the action of acquiring and holding more. The more greedy people are for Bitcoin, the better are its chances. You should never want people to spend more—you should want everyone to be as greedy as possible.
Let out your inner hoarder. Don’t deny your urges. Let him out and come to terms with him. Imagine how he would look if he could sit on your hoard of bitcoins. Doesn’t he look terribly happy? Let him roll in your bitcoins. Doesn’t he look so cute poring over his copy of Atlas Shrugged? Look at how gleeful he is as he buries it in his basement. Now let his avariciousness flow over you. Let it seep under your skin. Let your hands clutch! Let you teeth clench and your mouth contort into a covetous grimace. I want to hear cackles!
Now didn’t that feel good? The Bitcoin economy will thank you in the end!
I conclude with one proviso: it can be very effective to give out small amounts of bitcoins just to help accustom people to having them. However, the reason this is effective is that it helps spread avarice around.
]]>Currencies are unusual in that their usefulness as currencies is a result of their demand. The more deals that can potentially be made with one, the better it is. It is only indirectly because of a currency’s inherent properties that it can turn into a good currency. To an alien with no interest in human culture or technology, both dollars and bitcoins would be equally worthless, even though he would be able to see that bitcoins are a superior medium of exchange.
In economics, this is often called the network effect because it is the network of people using it that convinces everyone that the good has value. This can appear to lead to circular reasoning: everyone believes it has value because everyone else believes it has value because everyone else believes it has value… and so on. It is almost like a cartoon monkey that picks itself up by the end of its own tail!
However, a better physical metaphor might be the formation of crystals. A liquid can be supercooled into a state that can support crystals, but no crystals form because there are no initial crystals that the liquid particles can attach to. However, once a tiny impurity, or “seed” is introduced into the liquid, a crystal will form around it and grow quickly until the liquid has been absorbed.
By this metaphor, the supercooled liquid is the world as of a few years ago, ripe for a monetary revolution, and the seed is the initial bitcoin purchase. The fact that Bitcoin successfully transformed into something with value seems like a miracle. However, it was no miracle. It was a result of the dedication and faith of its community, whose members will not let go of the beautiful vision of a Bitcoin future. It might be better to use a word like “crystallization” to describe the formation of the initial “seed” of Bitcoin trading rather than a metaphor like “bootstrapping”, which depicts a physical paradox.[1]
Thus, when people dismiss Bitcoin as valueless and call every upward price movement a bubble, they are really missing the point. An investment in bitcoins is an investment in the Bitcoin community. It was in late 2012 that I came to realize just how wonderfully fanatical this community was, and this was what convinced me to treat my bitcoins not as simply an utter speculation, but as something with very real prospects.
Social networks are a familiar and often-cited example of the network effect. Facebook and G+ both have a lot of nice features, but the feature that makes Facebook so much more useful is that all your friends are already on it. Thus, it is really the network that uses Facebook that makes it valuable.
This example can be confusing when analogized to currencies. Facebook and G+ have the property that either can be used at a low opportunity cost of using another. In other words, if I am already spending some time crafting the most narcissistic Facebook status update that I can think of, there is little additional effort to posting it on G+ too. Both Facebook and Google support chat protocols, so there is little additional effort to using a program such as Jitsi that can run both protocols and log me in to both services simultaneously. Thus, it is possible for a social network to succeed without diminishing the size of the others. It can expect to attract members without necessarily drawing them away from the others.
However, for currencies the situation is different. Owning any one currency carries a high opportunity cost of owning any other. I cannot use the same money to buy an investment in bitcoins and in silver coins or Canadian dollars. If I want more of one, I necessarily must have less of another. If any one currency is acknowledged to be the winner over the rest, then there is no additional benefit for anyone to own other currencies.
While it is possible for two social networks to coexist, the world is not big enough for two currencies. Any initial disparity between two currencies, no matter how small, positively reinforces itself, and there is no reason to expect this effect to end until one currency is driven out of existence. As the price of currency A begins to rise relative to currency B, holders of currency B begin to see that their investment is looking less and less reasonable. As more people flee currency B, its decline accelerates until it has effectively ceased to be a currency.
This conclusion does not appear to be borne out by our everyday experience of different national currencies within each nation-state. This is explained by the fact that these states typically have legislation such as legal tender laws and capital controls that artificially reduces the usefulness of other currencies within their respective borders. There is no jurisdiction in which Bitcoin is legally privileged, so there is no group of people required to treat it differently than any other. Thus, there is no reason to expect Bitcoin ever to be in a stable equilibrium with national currencies, the way that they are in equilibrium with one another.
From these considerations, it follows that Bitcoin’s future is an all-or-nothing proposition. If Bitcoin is good enough to compete with other currencies despite their legal privileges, then it will overtake them. If not, then it is a bubble and eventually no one will want it but a few true believers.
It might be argued that Bitcoin could retain its uses on illegal markets, but there is no reason for a drug dealer to accept bitcoins as payment if there is no one who wants to use it as a store of value or as an investment. He must either want to keep it himself or have someone he can sell it to in order for him to use it. Thus, if Bitcoin fails as an investment, it fails as a payment system, even for purposes to which it is especially adapted.
All things being equal, a larger network is better than a smaller one. This puts Bitcoin at a disadvantage with respect to national currencies. One would therefore expect Bitcoin to decline relative to dollars or euros. The fact that this is not the case tells us that all things are not equal. It shows us that Bitcoin is still good enough compared to the national currencies. It can grow anyway despite their advantages over it. The network effect means that the bigger Bitcoin gets, the better its prospects. The fact that Bitcoin has grown in the immediate past is strong evidence that it will continue to grow in the immediate future.
A possible objection is that Bitcoin’s demand is mostly investment demand rather than demand as a currency. Therefore, the objection goes, it is no longer the case that Bitcoin’s demand is self-promoting. However, a currency becomes more useful as a result of any kind of demand, not just demand as a currency. I would bet that most people who are invested in bitcoins today would be happy to get more by trading goods and services for them. They are also happy to serve as a facilitator for bitcoin trades via the dollar, which is effectively what happens when a merchant accepts bitcoins as payment and then immediately converts them to dollars. Thus, their investment demand enables more use of Bitcoin as a currency. By merely investing in Bitcoin, they enable more potential trades and make Bitcoin a better currency.
The interesting thing here is that we should expect the advantages of the national currencies over Bitcoin to decline as Bitcoin grows, and eventually to become disadvantages. Therefore, not only will Bitcoin’s expanding network further drive its growth, but the declining networks of its competitors will as well.
Based on this, my prediction for Bitcoin’s future growth is not just exponential growth, but faster than exponential growth. If it is successful I predict Bitcoin will take over the world faster than anybody expects, including myself. This prediction has been borne out in my own case: I am continually astonished by Bitcoin’s successes. Now one of my biggest fears in writing about Bitcoin is that my predictions will come true before I can publish them.
Predicting a change to Bitcoin’s growth trend requires thinking in terms of effects that are not relevant at present. This makes things difficult because it is hard to say what will become relevant first. It could be, for example, that Bitcoin’s growth will outpace its technology and the network will become congested enough that it hampers the adoption rate. If there was a concerted effort from governments around the world to destroy Bitcoin, this could greatly hamper Bitcoin’s growth as well—but at this point I doubt it could be stopped.
For now at least, Bitcoin’s present trend is self-reinforcing with no equilibrium in sight.
Crystallization implies a transition from liquid to solid, which is not appropriate for Bitcoin. An even better physical metaphor would be the more general concept of spontaneous symmetry breaking, which includes not just crystallization but all kinds of other processes without a transition from liquid to solid. However, unfortunately not enough people understand what that is to make it a good metaphor. ↩︎
The discourse surrounding Bitcoin is often characterized by boot-quaking naysayers crying about things that don’t make any sense. “Bitcoin is too volatile!” they lament. “Nobody will ever use something so volatile! Bitcoin will never be widely adopted while it’s like this!”
This argument is superficial and short sighted. Volatility is not a property that is inherent in Bitcoin. It is caused by the way people currently treat Bitcoin in the market. It is a function of people’s attitudes and behaviors. Bitcoin’s rapid adoption rate almost completely explains its volatility today; I see no need, at any rate, that any additional explanation is required. Bitcoin’s enormous manias and crashes are simply a reflection of the difficulty of negotiating a reasonable price, even in the short term, in an environment that changes so quickly. Something that regularly grows in both popularity and usefulness will necessarily be volatile.
To complain that no one will use Bitcoin because it is too volatile is therefore like saying, “Bitcoin’s adoption rate is so astonishingly fast that it will never be popular!” It’s like saying, “This oven is heating up so fast that I’ll never be able to cook with it!” It’s like saying, “This novel is so exciting that no one will ever read it!”
There is no evidence that Bitcoin’s volatility is hurting it. Any imaginable indication of Bitcoin’s adoption rate will show that its adoption rate is extraordinarily rapid. So how, exactly, can volatility be a problem? If Bitcoin were less volatile, would it have an even more rapid adoption rate? This is nonsense because Bitcoin’s price has to go up as more people start using it, and if a lot of new people start using it, then it has to go up fast (that is, be volatile).
What a thing to complain about. There’s no pleasing some people. These people are on to something so fantastically great that people go mad trying to get some whenever they learn about it and they are wringing their hands and shedding tears. It’s hard to imagine a more severe Jonah complex. Obviously the people buying bitcoins don’t consider it enough of a problem to deter them.
Volatility can be distinguished from liquidity, which is something that Bitcoin really does need. Liquidity means that a valuable amount of the good can be bought or sold without significantly altering the price, whereas volatility refers to the degree and rapidity of price changes, independent of the volume of trade.
The liquidity of a currency limits the size and volume of purchases that can be made with it. If you could not buy or sell the same value in bitcoins as a house without significantly altering its price, then you could not purchase a house with bitcoins.
A currency can be volatile and still be liquid. It is liquid if one person can buy a lot without affecting the price. However, if lots of people all try to buy a lot at the same time, then it will still be volatile.
This brings up the question of what a good price for Bitcoin would be. When will Bitcoin stabilize? It should become less volatile as it becomes more widely adopted because it will be harder for local events and individual people to affect the price very much, right?
Not necessarily. Although perhaps we will see less wild daily swings, I think Bitcoin is unlikely to ever attain anything like a stable price. If Bitcoin’s price were stable, this would mean that it had achieved an equilibrium with the other currencies. There would have to be some sweet spot at which there is exactly the right balance of bitcoins and dollars. When Bitcoin’s price went a little bit too high, people would start to sell for dollars, and when it went a little bit too low, people would buy more bitcoins.
To anyone who thinks this is possible, I ask why would any equilibrium happen? What would it possibly mean for Bitcoin’s price to be too high? Unlike just about anything else, a higher price for Bitcoin does not reduce its usefulness one bit. One simply trades in smaller amounts of it. In fact, a higher price makes Bitcoin more useful because a higher price indicates that more people want to buy, which means that Bitcoin’s liquidity grows, which makes it more useful as a currency.
Therefore, I would suggest that we should never expect an equilibrium between bitcoins and dollars or any other currencies. Instead, Bitcoin should show a pattern of hypermonetization. It will become more and more valuable at a faster and faster rate priced in terms of other currencies. Its price chart should show an asymptotic increase that approaches infinity after a finite time.
Bitcoin may stabilize in terms of real goods, but I see no reason to think that it will stabilize in terms of other currencies. Once Bitcoin starts killing the other currencies, it will still be volatile, and this will still be an indication of its success.
If my prediction is wrong and Bitcoin ever stops being volatile, that might be a good time to dump it.
“But,” the whiners protest, “Bitcoin can’t be used as a unit of account! How can it be a currency when you can’t use it to distinguish a profit from a loss?”
To put this argument in context, let us review the three traditional functions of money. Money is often simultaneously a store of value, medium of exchange, and unit of account. The argument goes that if a good is not useful as a unit of account then it is not money. However, the only necessary relation between these three functions is that a medium of exchange must also be a store of value. A thing can serve as a store of value without being a medium of exchange or a unit of account, and a thing can be a unit of account without being either of the other two. Konrad Graf has written an article developing this point.
There is no particular reason that Bitcoin’s volatility, which makes it less useful as a unit of account, should impede its growth as a currency. It is still excellent as a store of value and a medium of exchange, which are good enough reasons to buy into it. Furthermore, there is nothing stopping a Bitcoin investor from doing business in Bitcoin and using national currencies like the dollar or Euro as a unit of account.
In the relatively near future, there may come a time when no real unit of account is available because Bitcoin will be growing at a rapid pace even as the other currencies are hyperinflating. The world won’t fall apart. People will just have to think a little bit more carefully about their economic decisions during this period. And this will be the ultimate sign of Bitcoin’s success.
Those who worry about Bitcoin’s volatility fail to understand what it actually means for Bitcoin. They are not able to think far enough ahead to understand Bitcoin’s ultimate destiny.
In the short term, what’s one decimal point right or left? Bitcoin is unstable at any price, and we should all feel lucky that we managed to get in on it when it still has a price. Now sit back, quit complaining, have a nice glass of wine, and watch as Bitcoin takes over the world.
Edit, Feb 1, 2014: added section on “Volatility Versus Liquidity”.
]]>Much undue attention has been given lately to Mastercoin, an altcoin invented by J. R. Willett. Although Willett’s heart seems to be in the right place, Mastercoin is a deeply flawed system. Unlike other altcoins, Mastercoin is not mined and does not have its own blockchain; instead, it exists on the Bitcoin block chain as a set of prunable transactions that contain, in the addresses of their Bitcoin outputs, data representing Mastercoin calls.
While the idea of a new protocol layer that can be used with Bitcoin is interesting and potentially useful, it completely destroys any potential usefulness in Mastercoin because it means that Mastercoin is an entirely passive system. Because Mastercoin does not have its own block chain, all its transactions are simply extra pieces of data inserted into Bitcoin’s block chain, which, from the standpoint of the Bitcoin miners, are meaningless.
Therefore, unlike Bitcoin or any altcoin that relies on its own block chain, Mastercoin is incapable of acting like a smart contract engine. There is nothing, for example, to prevent anyone from double-spending Mastercoins from a given address. Anyone can publish two conflicting Mastercoin transactions in the block chain, and all the Mastercoin system can do is define a rule by which one transaction is ignored.
This is not enough, however. Some of Mastercoin’s features require active participation by the users, but Mastercoin can do nothing to require them to behave correctly. For example, Mastercoin has a feature called “register a data stream”, by which the owner of a Bitcoin address declares that he will be publishing data hidden in transactions from it. For example, he could promise to post the price of gold every day to that stream. However, there is nothing to require him to post data on a regular schedule, and nothing preventing him from lying. This renders the datastream valueless as an input for a smart contract.
Of course that does not matter because, as I said, Mastercoin cannot do smart contracts. The only thing that could require Mastercoin users from behaving properly is a traditional human legal system that recognizes its features as legal contracts and which can set the police on anyone who doesn’t follow his promises. It is totally bizarre that Willett seems to think Mastercoin could be useful for anarcho-capitalist purposes. Eventually, platforms such as Open Transactions will be able to do what Mastercoin claims, without the design flaws. OT will allow for decentralized legal systems and voting pools for consumer protection, and will allow these functions to integrate directly into the block chain instead of on top as the protocol development permits.
What’s the point of creating something like this? It’s really hard to understand what anybody was thinking. Anyway, this is the most fundamental reason Mastercoin fails.
Willett’s justification of his engineering decision is nonsensical and shows no understanding whatsoever. In version 1.1 of the specification [PDF], he writes “Alternate block chains compete with bitcoins financially, confuse our message to the world, and dilute our efforts. [...] New protocol layers on top of the bitcoin protocol will increase bitcoin values, consolidate our message to the world, and concentrate our efforts, while still allowing individuals and groups to issue new currencies with experimental new rules.”
However, the truth is almost the exact opposite of what Willett says. There is no reason that an alternate block chain should compete with Bitcoin financially because there are all kinds of things that can be done with a block chain that do not compete with Bitcoin’s function as a currency. As it happens, nearly all block chains are currencies, which do compete with Bitcoin, but there is no reason that this is inherently necessary.
Furthermore all currencies, crypto or not, compete with Bitcoin. The fact that mastercoins do not have their own block chain is irrelevant. They still compete with bitcoins and will reduce the value of bitcoins to the extent that people choose to use mastercoins over bitcoins. Anyone who likes Bitcoin really shouldn’t want any new currencies to be created. As explained in a previous article of mine, the entire concept of an altcoin is fatally flawed. Because the value of a currency is caused by the network of people using it, a currency with a larger network should generally be seen as superior to one with a smaller network.
In addition to the mastercoin currency, Mastercoin allows anyone to create new currencies at will that also use the Mastercoin protocol. Anyone who registers a new Mastercoin currency essentially becomes that new currency’s issuer and can create as much as he wants. Although Willett suggests that these new currencies can serve other functions, this is impossible as long as Mastercoin cannot be a smart contract engine. Until Mastercoin has its own block chain, all of user currencies are just tokens.
The most intricate layering of absurdities in the Mastercoin specification can be found in the feature called “escrow-backed user funds”. These are funds managed by a program that trade mastercoins and a user currency so as to attempt to track a real-world commodity. A Bitcoin address can be registered as an escrow-backed user fund with a transaction that specifies parameters describing the behavior of the program managing it. For example, someone could create one called cryptogold that was designed to track the price of gold.
First off, in order to create cryptogold, Mastercoin has to rely on a block chain datastream to determine what the price is. Yet, as I previously argued, there is no reason to expect any data stream to be reliable and therefore no way to know what the price of gold is.
Furthermore, there is no reason to expect the escrow fund to behave according to any rules at all. There is no reason that the fund will even attempt to track the price of gold because, as I have repeatedly emphasized, Mastercoin can require nothing of its users.
Let us assume, however, that a given fund manager is trustworthy and he does allow his fund to run by a program that follows the rules advertised in its declaration. In this case the fund is still not trustworthy and still cannot be expected to track the price of gold.
An ounce of cryptogold is not real gold or a claim on real gold, or anything. It is a completely different commodity that rational actors will treat differently from the commodity that it is supposed to track. Fundamentally, the fund is a commodity that is traded for mastercoins by a computer program according to known rules. Any relation to gold is incidental because people will choose to buy and sell it based on how they believe that the computer program will act. They will not just naively watch the price of gold and assume that the escrow-backed user fund is pretty much the same thing.
While one could buy cryptogold simply because one believes that the price of gold will go up, one could also buy cryptogold as an attempt to manipulate the program. If you can know beforehand how a given trader will behave, you can always take advantage of him in a market. Thus, every fund that behaves fairly should be expected to go bankrupt eventually as people figure out how to profit from its predictable behavior.
There is no way to avoid this problem. As long as the program operates according to known rules, anyone can take advantage of its behavior. You could be playing chess with Deep Blue and you would always win if you had your own duplicate of Deep Blue that you could use to predict every move it would make. This is effectively what everyone has for the fair escrow-backed user funds because the reference Mastercoin implementation is open source, so anyone can modify it to turn it to predict what other fair funds will do.
However, this point is purely esoteric because nothing forces the fund to behave according to any computer program and the creator of the fund has every reason not to follow the rules because if he did, the fund could not possibly remain healthy.
I have my qualms about Ripple, but at least it has some useful purposes. The reason it is possible to trade real goods over Ripple is that ripple gateways are supposed to back the digital goods with real goods that they have on hand. The idea of linking a digital good to a real one any other way is absurd. Mastercoin utterly utterly fails so badly that it is unfathomable.
In addition to failing economics, the Mastercoin developers also fail software engineering. As detailed in this reddit thread, the Mastercoin specification is so poorly designed that it has several conflicting implementations, thus breaking the entire system.
Because the different implementations disagree as to which transactions are considered valid, they can disagree as to the amount stored in a given address. For example, killerstorm, the author of the exposé, points to an address which, on November 29, 2013, showed four different balances depending on the implementation.
Since then, this problem has been resolved by rewriting the specifications more carefully, but there are no doubt more ambiguities waiting to be discovered. This problem could not have been fixed without screwing over some people who think they own mastercoins.
As useless as I find Litecoin to be, at least it functions. At least it’s not riddled with bugs that break the entire system. The developers deserve eternal shame for having created this problem, no matter how they attempt to address it. Even if it is repaired, the fact that it happened at all reflects extremely poorly on the team building it. This is truly horrifying, and Willett should be excoriated for creating this monster.
Everything about Mastercoin is completely insane. How can it be taken seriously? Its flaws are numerous, fundamental, and not difficult to understand. I do not even claim that my list of them is comprehensive. I would not be surprised if there were more that I did not discover when I did my research for this article. Mastercoin is a failure in just about every way. Nothing can redeem it and it is completely shocking that Mastercoins are actually being traded and have a price.
Mastercoin is absolute garbage and it is just baffling to me that Willet commands any sort of respect for having created it. There is no excuse for how terribly designed and excuted they have been at every stage. All Mastercoin owners have been scammed because Mastercoin is incapable of delivering on its promises. No one should ever use Mastercoin under any circumstances or appraise their value as anything above zero.
]]>Bitcoin has a central bank called the “Bitcoin network,” which we will refer to as the Bitcoin Central Bank (BCB). This central bank issues a currency called “bitcoins” and processes the transfer of bitcoins between accounts. The BCB’s rule-based monetary policy was set at its creation and its independence is secured by the distributed nature of the underlying network. This non-discretionary monetary policy can best be described as asymptotic money supply targeting (AMST).
The BCB issues bitcoins to a network of sub-contractors called “miners” who perform the proof-of-work calculations that secure the BCB’s independence and process payments. The seigniorage subsidizes the payment system instead of benefiting the issuer or the seller/recipient of bonds transacted in open market operations. Proof-of-work seigniorage (PoWS) and AMST work synergistically to cause three monetary phenomena:
First, it is rational for economic agents to hold as many bitcoins as they can afford to lose (i.e. without materially impairing their ability to consume or invest). The BCB can offer lower transaction costs than any competitor by orders of magnitude because of the PoWS subsidy. This deep competitive advantage gives economic agents the expectation that it will be adopted as a method of payment and that its exchange rate liquidity will increase. This expectation has repeatedly proven to be true so the desire to hold bitcoins has increased, as indicated by the exchange rate and Internet search volume.
The exchange rate volatility is a byproduct of the BCB choosing independent monetary policy (AMST) and free capital flow over a fixed exchange rate within the Impossible Trinity. Economic agents overcome their cognitive biases to acquire bitcoins in waves due to the word-of-mouth marketing of the currency. For some it takes one exposure to Bitcoin to “get it” while others follow the lead of trendsetters or finally succumb to their regret-aversion bias. Either way, these waves of adopters have a destabilizing effect on the exchange rate: speculators are unsure of the amplitude or wavelength of adoption, and amateurish punters let their excitement as well as subsequent fear overwhelm them. The BCB does not intervene to stabilize these intermittent hype-cycles because steady appreciation of the exchange rate would allow for an even greater buildup of speculative excesses and the BCB would lose the confidence that AMST gives to long-term holders of bitcoins.
Bitcoin’s interest rates are based on the arbitrage between the expected return of holding bitcoins versus the expected return of lending them out. The expected return of holding bitcoins is completely tied to its expected future exchange rate because bitcoins are currently a pure vehicle currency. The heterogeneous expectations of bitcoin holders regarding the exchange rate has led to the development of marginal lending operations. However, the vast majority of bitcoin holders expect exchange rate appreciation at rates far greater than any borrower is willing to pay. Bitcoins will continue to be hoarded and bitcoin-denominated credit markets will continue to be under-developed until either the expectations of bitcoin-holders adjust downward or are met. The BCB does not need to take action to break the current equilibrium state since the hoarders’ expectations will be met given Bitcoin’s proven superiority to legacy payment networks and stores of value.
Fractional reserve banking entails the creation of new money that is fungible with already preexisting money, i.e. it can be used interchangeably within the currency’s payment systems. This is impossible with Bitcoin. The BCB enforces the strictest deposit regulations in the world by requiring full reserves for all accounts. This is the digital equivalent of the Chicago Plan or the Austrian 100% reserve gold standard. Under this regulatory regime, money is not destroyed when bank debts are repaid, so increased money hoarding does not cause liquidity traps, instead it increases real interest rates and lowers consumer prices. This is a self-stabilizing cycle as higher interest rates incentivize hoarders to invest, while deflation increases consumption due to the wealth-effect on hoarders. The BCB prevents lending out of deposits so that it can properly target money supply and avoid the destabilizing effects of commingling the credit and payment systems.
The positive properties of AMST and PoWS combined make it certain that, absent a technological problem, Bitcoin will be adopted as the global currency. For a deeper understanding of the market process involved in becoming global currency I would recommend reading Konrad Graf’s explanation of hyper-monetization and Peter Šurda’s liquidity analysis of bitcoins. The Bitcoin Central Bank will be the longest lasting institution of its kind thanks to the anti-fragile independent monetary policy it has set in stone.
]]>New ideas attract not only visionaries and pioneers but also charlatans and fools. The former group understands the nature and potential of the new idea and attempts to extend it in new ways. The latter observes the success of the former and expects similar results through blind imitation and empty hope, rather like the Melanesian cargo cults which arose after World War II when the American military abandoned its airports there.
This analogy is absolutely appropriate to characterize the many alternative cryptocurrencies modeled on Bitcoin, which are collectively referred to as altcoins. Technologically, they are all very similar to Bitcoin: there is a block chain to store transactions, a consensus mechanism to build the block chain, and a cryptographic protocol to register transactions. Some prominent examples are PPCoin, Primecoin, Litecoin, and Freicoin.
Some altcoins incorporate interesting new ideas, but there is an essential feature of Bitcoin which they all lack. It is not a matter of its technology, but rather of history and community. Quite simply, a medium of exchange that is more widely accepted on the market is more useful than one which is not. This is known as the network effect. An initial imbalance between two nearly equal media of exchange will benefit whichever is more widely accepted until a single one overwhelms the rest. There is no limit to this effect: ultimately one would always expect a single currency to overcome all its competitors.
Because it was started earlier and has had a greater opportunity to grow and attract users, Bitcoin has a market larger by a wide margin than all the markets of all the altcoins put together, and this makes it vastly more useful as a currency. To defeat Bitcoin, an altcoin would require not just superior technology, but such vastly superior technology as to be an advance over Bitcoin comparable to the advance Bitcoin represents over fiat currency. Furthermore, a truly great innovation would much better serve people by being incorporated into future versions of Bitcoin rather than by requiring them to switch to something else. Indeed, the people who have proposed new ideas that are actually good, such as Zerocoin and mini-blockchain, did not develop their own currencies around them, but have simply described their usefulness as features.[1]
The Bitcoin community is not just overwhelmingly larger but of overwhelmingly better quality as well. Bitcoin is surrounded by real entrepreneurs working hard to create new and useful services for Bitcoin. Altcoins are surrounded by loud-mouthed pretenders with irrational hopes of duplicating Nakamoto's success. This does not mean that there is anything intrinsically wrong with altcoins: the problem is simply that once Bitcoin exists, then there is no additional value, from a monetary standpoint, of creating knock-offs. Can anyone really expect to create something of value by rereleasing Bitcoin under a new name and with a few tiny changes to its source code? What makes Bitcoin great cannot easily be duplicated. Thus, while the Bitcoin community matures and grows as more and more entrepreneurs are attracted to its potential, the altcoin communities can only whine for attention.
What is a cryptocurrency actually for? I say that its purpose is to become money. It is obvious that creating altcoins impedes that purpose. Altcoins can only be explained if we believe the purpose of cryptocurrencies is to make money rather than to become money. If you can trick people into investing in your new altcoin, then you can make a profit trading it or mining and selling it. All the arguments of the altcoin promoters serve as misdirection from that basic purpose. They have developed a series of fallacies capable of fooling newcomers into joining them, but they are all disingenuous.
Thus, the altcoin communities are not just embarrassing, but dangerous. Desperately wishing to be taken seriously despite having nothing worthwhile to offer, they will say absolutely anything to convince other people to join them. They persist in saying things easily refuted by economic logic, common sense, or verifiable facts. They become belligerent when challenged. This is all they can do because they have nothing of value to offer. They are great at conning people because they have succeeded in conning themselves, and it is impossible to tell where self-deception ends and outright lies begin. This is bad for Bitcoin and bad for the people who are fooled.
The claims of the altcoin promoters deserve refutation not because they are intelligent but because they are repeated ad nauseam. Ultimately their content is secondary and the real problem is the foregone conclusion to which they are all directed. If the arguments I discuss here are eventually discredited completely, the altcoin promoters will just grope for new ones rather than admit to being wrong. Thus, it is quite possible that in the future, what I say here will no longer correspond to what they are saying. Because of what I have said above, however, it is safe to assume, whatever they are, they are all wrong.
First of all, Bitcoin already has competition. It competes with the dollar, with PayPal, and with the banking system as a whole. It has plenty of competition.
Second, there is no reason that competition is necessarily good for its own sake. If people compete to be the most productive, then that is good because the result is more production. If people compete to control the government, then this is bad because the result is that the government will be controlled by the most ruthless and unscrupulous people.[2] There is a reason that there can be two competing businesses, even if they follow identical production models: there is a limit to the size an organization can achieve without being more efficient than two parallel organizations. However, in an economy capable of supporting only one business for a given product or service then really there should only be one of that kind of business.
In the case of a currency, it is inherently most useful when it dominates its competition. The less competition a currency has, the more useful it is. If you try to compete with the best currency with another one that's exactly the same, that makes yours the worse currency, so you really should not have bothered.
Third, a currency is simply a standard that people agree to use as a medium of exchange. For the most part, it is awkward to have competing standards. Do we really need competition between the mile and the kilometer, for example? Suppose automobiles had just been invented and two groups, because of vested financial interests, got into arguments about whether it was better to drive on the left or the right side of the road. The greatest benefit to ordinary people would come not from prolonging such competition, but from its resolution.
Finally, there is competition within the Bitcoin community, and this is the sort of competition that actually benefits people. There are exchanges, payment processors, online stores, and so on. Every time someone starts a new Bitcoin business, he benefits the Bitcoin economy. Every time someone starts an altcoin, he makes it worse.
A related point is the argument that altcoins can be used as experiments to learn about how different ideas might work in practice. This use is completely legitimate and necessary. However, an altcoin that was understood to be an experiment would not be treated as an investment or an independent product. If this is how altcoins are treated, this would be fine. My objection is to the lies and scams. An experiment is worthless if the people running it are constantly lying about it.
In the Bitcoin network as it works today, all nodes receive all transactions. If Bitcoin grew to be a very large network, that could be a lot of transactions that all need to be communicated to everyone.
Altcoin promoters seem to imagine a world in which their own favorite altcoin has a status very roughly equal to that of Bitcoin, where each currency will be used for different kinds of things. This is impossible because the network effect always favors imbalance.
However, even in the very unstable situation of two roughly equal block chains, it is not necessarily true that there will be reduced network traffic as a result. If people had to work with both networks, they would still have to receive every transaction from both networks. And if people had to exchange their funds often enough from one currency to another to fulfill different purposes, this could easily result in a greater number of total transactions.
In any case, while Bitcoin may experience growing pains over the next few years, there is no reason to expect it to outpace Moore's law in the long run. Network load is a problem that technology can overcome without requiring us to rely on an inferior system of money.
This is possibly true today, but there is no guarantee that it will be true in the future. The idea is, you sell bitcoins for some altcoins and then buy bitcoins again. There will then be no connection between the bitcoins you had before and those you have now.
However, because altcoins are inherently unstable, there is no reason to expect them to remain useful for that purpose. In order for a currency to retain value, there must be enough people who want to hold it, not just people who want to quickly trade in and out of it. An altcoin would have to be good for something other than money laundering—something good enough that at least some people would want to hold on to it more than they wanted to hold on to bitcoins—if it is to be good for money laundering.
Thus, if you really want to launder money, support ZeroCoin as an upgrade to Bitcoin. Barring that, you would probably be better off trading through a commodity more likely to retain value, such as gold or silver.
This is by far the most ridiculous argument I hear on this topic. The wisdom of the crowd is superior to any person so people should not presume to tell the market what to think, right? I find this view utterly idiotic. It is wrong to dictate the market's choices to it by coercion, but to simply express an opinion is to engage in the market process itself. To be consistent the people who make this argument would have to say that Consumer Reports is as tyrannical as Joseph Stalin.
To take this to its logical conclusion, suppose everyone just sat back to let the market decide. Then the market would never decide anything because the market's decision is just the sum of the decisions of all the individuals that make it up. None of them could make an argument that one product was better than another. There could not even be any consumer reporting to protect people from scams and shoddy products. The free market just wouldn't work. When a libertarian steps back to let the market decide something on which he has some legitimate insight, then he is preventing the market from working as well as he otherwise might.
It is a fact that the market makes stupid choices all the time, and there is nothing wrong with me saying so. This is because the "market" is just a collection of people all making decisions that are as foolish as the kinds of decisions that we know people actually make all the time. This in no way means that I do not understand the systematic superiority of market processes over state centralization. If I want the market to win out over the state, it is ridiculous not to engage in a debate over the correct decisions to make such a victory likely.
There is a class of very similar cryptocurrencies that rely on an algorithm called Scrypt as the hash function. I shall refer to them as Scrypt-coins. They also have faster block generation times and a different coin mining schedule. In fact, none of them even have white papers; perhaps they are so unoriginal that there is nothing to write about. Despite this, or perhaps because of it, the Scrypt-coins are surrounded by the loudest, least intelligent, and most obnoxious communities, and the arguments supporting them are either fallacious or detached from reality.
When Bitcoin first came out, it was possible for anyone to mine coins with his CPU. Once software was developed that mined using GPUs, then CPU mining quickly became obsolete. GPU mining remained profitable for some time thereafter because the price of Bitcoin continued to increase as more people became miners. This could not persist indefinitely, and eventually there began work into the development of FPGA and ASIC mining. Once these technologies were developed, GPU mining would become obsolete as well.
However, some miners who had heavily invested in GPUs did not wish to see this happen and didn't want their investments in GPUs to go sour. Obviously, this was a vain hope. It cannot be expected that it should be possible to run an ordinary computer at a profit for very long. Profits draw more investors, which leads to lower profits as the available opportunities are used up.
Scrypt was designed to be a memory hog and is consequently unsuited to mining with a machine consisting almost entirely of ASIC chips, like those used for Bitcoin, and it was assumed that Scrypt-coin mining would therefore always remain in the hands of the GPU owners. This, by the way, is false. If it ever became profitable enough, an ASIC machine could be produced with a shared memory, and it would make GPUs obsolete for Scrypt-mining too.
The Scrypt-coin phenomenon can thus be likened to the Candlemaker's Petition,[3] a brilliant satire by Frédéric Bastiat. It presents a fictional argument purporting to be from candlemakers that all windows should be kept closed by law during the day to prevent unfair competition from the sun. All arguments for Scrypt-coins should be seen in this light. They are masks for the hope that someone's GPU mining rig should not turn out to be a foolish investment.
The first Scrypt-coin was Litecoin, but soon, other nearly identical Scrypt-coins were developed by people who not only wanted to use GPUs, but who also wanted the additional benefit of being the first movers in a new currency. Feathercoin, Terracoin, CHNCoin, and Yacoin are the others which I can name off the top of my head, but there are new ones every day, which is a reducto ad absurdum of the whole concept of altcoins.
No it won't, at least not any moreso than would any other mining technology. In the long run, regardless of what sort of technology was required, one would expect the mining difficulty to go up to the point where investment in mining technology produces similar returns to investment in the rest of the economy. And, of course, as I mentioned above, it is false that Scrypt-coins are immune to ASIC mining.
This argument highlights the emphasis from altcoin adherents on mining rather than on monetization. There is no logical reason why any ordinary user of Bitcoin should want to become a miner in the first place. Early on, it was profitable for casual Bitcoin users to be miners because very few knew about Bitcoin. Mining now requires a capital investment, just like everything else in the economy. A transition to lower profitability and greater capital intensiveness is inevitable for any maturing industry. This does not make it elitist; it simply means that the industry is growing increasingly specialized. This is better for everybody and it is just what Bitcoin needs, too. As Bitcoin grows, large investment will be required to ensure that its network can handle the increased traffic. This would not be possible as long as mining remained in the hands of hobbyists.
This is not to say that there are not potential problem from a mining industry dominated by a few large companies. Such a system would be easier to regulate and corrupt. However, this is in no way an argument for altcoins as their mining industry is dominated by two graphics cards manufacturers and fewer individual miners than Bitcoin.
This is true in an extremely misleading way.
The issue here is the risk of a double-spend attack. If you receive notice of a payment from someone, there is the possibility that he has made a second, conflicting payment using the same bitcoins. In this case, there is the chance that the other payment will be accepted into the block chain rather than yours, and yours will be considered invalid. This is a theoretical means of scamming Bitcoin merchants.[4]
Since Scrypt-coins have shorter block generation times, one will see more quickly in a Scrypt-coin network which of two conflicting transactions will end up in the block chain (unless there is a malicious attempt to manipulate the block chain—see below). Furthermore, a double-spend attack is only possible if the two conflicting transactions occur within a few seconds of one another, so the best defense against double spending is simply to watch the network for a few seconds after receiving a payment. If no conflicting payments appear then there is nothing to fear from double spending. This feature is a planned upgrade for Bitcoin 0.9, so it will not be long before any slight benefit to shorter confirmation times will be eliminated.
Moreover, no recorded case of any successful double spend attack in the history of Bitcoin, although it has been rarely achieved under special or controlled conditions as an experiment. Therefore, it is not a real risk under present circumstances and not a valid argument to use Scrypt-coins.
No, they aren't.
Performing a 51% attack means to control enough computational power to generate blocks faster than the rest of the network put together. The attacker can then generate a block chain fork from some earlier period and eventually grow it until it is longer than the main one and other nodes in the network will begin to recognize the new branch as the legitimate one.
Deriving the likelihood of a successful 51% attack is a difficult problem that requires the theory of random walks.[5] However, ultimately the derivation is not necessary because the attack only succeeds if the other miners go along with it. There is nothing preventing the rest of the network from ignoring the attacker and declaring his branch invalid. If the attacker's branch is clearly malicious, then this should not be a difficult decision. The other miners would also stand to lose a significant amount of cash if they should submit. In fact, the Bitcoin community has already successfully responded to an incident like this in March of 2013, in which a software bug caused a fork in the block chain and it was necessary to come to a consensus over which branch should be considered the correct one.
Moreover, the Bitcoin network is enormous and growing exponentially. Performing a 51% attack against it would require a vastly greater cost than for any other altcoin network, so the question is academic because Bitcoin in reality offers much greater security. The cost of a 51% attack against Bitcoin is unknown because to perform it would require a continual and exponential investment in order to keep up with the rest of the network.
There is one way that a Scrypt-coin does come out ahead, however. Consider an attacker who owned 49% of the network rather than 51%. This attacker's branch would be expected to grow more slowly than the main branch, but there is still a real probability of producing a longer branch in a given amount of time just by chance. If two attackers each have 49% control over the Bitcoin network and a Scrypt-coin network, and can both afford to continue their attack for the same amount of time, then the attacker against the network with the shorter block generation time has a much lower probability of success. This, however, is not a reason that any sane person would consider Scrypt-coins to be superior.
I have already discussed PPCoin[6] and the proof-of-stake from a theoretical standpoint. Proof-of-stake encourages people to hold coins, which is necessary for a currency to gain an initial value. However, that is most important for a currency's early stages. Because people lose their proof-of-stake as they create blocks, proof-of-stake discourages a specialized class of miners with the incentive to keep the network running at as high a capacity as possible.
One thing to be said for PPCoin, however, is that altcoins are a product of the proof-of-work system. Proof-of-stake would not have led to them. If Bitcoin had transitioned to a proof-of-stake system before it was valuable enough for ASIC mining to develop, perhaps there would be no altcoins.
Primecoin[7] is a cryptocurrency whose proof-of-work is based on finding various sequences of prime numbers rather than on a hash algorithm. Its existence is based on the fallacy that Bitcoin mining is not useful. However, as I have shown in The Proof-of-Work Concept, this is not true. Bitcoin's proof-of-work system is consensus mechanism. It is essentially a means of overcoming a Prisoner's Dilemma scenario among Bitcoin users. This cannot be done without some demonstration of spent resources that produced no individual benefit.
Primecoin disrupts this process by attempting to make its proof-of-work accomplish something of value. This inherently disrupts its value as a consensus mechanism. Thus, it is false to claim that Primecoin's proof-of-work is "useful" whereas Bitcoin's is not. Primecoin's method is, in fact, less useful because it introduces an inherent conflict of interest not present in Bitcoin. Although, to be fair, generating prime sequences is almost useless, so I do not believe that it is likely to cause any real-life problems.
Primecoin is a wuzzle. It tries to do two unrelated things at once, which, generally speaking, is the opposite of a good design. Its prime-based proof-of-work is nothing but another gimmick to make people forget that altcoins are a waste of time. This is not to say that distributed computations are not a great thing; but there are probably better ways of implementing one with cypherpunk technology without the pretense of also being a currency.
Unlike other altcoins, Freicoin[8] appears to have been created in good faith and is not supported with disingenuous arguments. The arguments are still wrong, but nonetheless Freicoin deserves more respect than the rest.
This is not the place to refute the economic theory behind Freicoin, but essentially it is based on the idea that the interest rate is a purely monetary phenomenon rather than a result of time preference. Instead of charging a transaction free, Freicoin imposes a fee for holding coins. Freicoins decay at a rate of 5% and transactions are free. Miners are paid out of the decayed Freicoins from out of all the nonempty wallets.
Thus, by design, Freicoin discourages hoarding and encourages spending. It is touted as a currency for the working class rather than the wealthy because it supposedly can't be used for making loans. Actually, however, Freicoin loans would be given out at the same interest rate as the rest of the economy because they would be in competition with loans given out in terms of more durable goods, such as Bitcoin. There would be no reason for a lender to accept a different interest rate with freicoins because there is nothing requiring him to hold freicoins. He could just convert from bitcoins just before the loan is given out and back to bitcoins as soon as it is returned.
The 5% decay rate would have the effect of a tax on capital, like a property tax. This means that the price would be lower than otherwise by a proportion determined by the overall interest rate of the economy. Say, for example, that I wish to hold x freicoins. This would incur a fee of x/20 freicoins a year due to Freicoin decay. The present value of all the fees would be an infinite sum that decays according to the overall interest rate of the economy. If the interest rate is i, then present value of all the fees would be one fee multiplied by (1 - i) /i. If the interest rate were 10%, say, and I wished to hold 20 freicoins, the value of the fees would be 9 freicoins. Thus, in this example, I would have to pay 9 freicoins to hold 20, and thus freicoins would be less valuable by a factor of 20/29 then they would be if they did not decay.
Now, if something is created with the express intention of providing an incentive to get rid of it, then it stands to reason that they will all the more not want to buy it in the first place. Thus, Freicoin is actually made to discourage investment in itself, which is the very thing that gives a currency value in the first place.
Freicoin is an idea whose time will never come. Since it rebukes buyers, it resists ever having value. Freicoin is thus not so much a scam but more an abortion. Its ideals are so refined that they eschew the merest chance of affecting the real world. Perhaps it could be taken as some sort of absurdist parody, which would be brilliant. I hope that is true because otherwise it is just too sad.
The overwhelming reason that Bitcoin is superior to its altcoin competitors is that it is overwhelmingly more popular. Some of its competitors might have worked as well or better had they been invented first, but given the history that led us here, none of them should be considered remotely competitive to Bitcoin. If an altcoin were somehow to beat the odds and end up more popular than Bitcoin, then I would have to change my allegiance. However, if that did happen, I think it would call into question the viability of cryptocurrencies in general. If they can rise and fall like fads, then it is hard to justify investing in any of them or believing that any has staying power. I take Bitcoin's past success as evidence of its future prospects, but if it can be overtaken by an initially tiny competitor for no logical reason, then the previous success of any other does not necessarily mean anything.
In short, the altcoin phenomenon is the product of greed and bounded rationality. They deserve nothing but scorn, and anyone who wishes cryptocurrencies to improve the world should avoid them entirely.
[Update 8/25/2013: the Freicoin was altered from an earlier version to correct an economic error.]
[Update 8/28/2013: two citations added. Last paragraph added to section on competition.]
See Miers, I., Garman, C., Green, M., Rubin, A., "Zerocoin: Anonymous Distributed E-Cash from Bitcoin", 9 Apr 2013 to learn about Zerocoin, a proposal that would greatly improve Bitcoin's anonymity. It would be wonderful if this could be made to work, but it would require a substantial coordinated effort to implement because it would involve an incompatible change to the Bitcoin protocol. This is actually one way an altcoin might be useful—its could implement Zerocoin as practice for doing the same to Bitcoin later. See J.D.Bruce, "Purely P2P Crypto-Currency With Finite Mini-Blockchain", Apr 2013 for a proposal to limit the size of the block chain. Right now, the block chain becomes more costly to store as it grows and there is no built-in means to compensate for that. This paper shows that it is possible to split the functions of the block chain among three different data structures whose total size increases far more slowly. It is already possible for users (but not miners) to store shortened versions of the block chain, a feature which has been implemented in clients like MultiBit. However, the shortened block chain requires the client to make some assumptions about the validity of the full block chain which are not necessary with the Mini-Blockchain. ↩︎
See Hayek, F., The Road to Serfdom, Routledge Classics, 2006, "Why the Worst Get On Top" and Hoppe, H., Democracy: The God That Failed, Transaction Publishers, 2007, "On Time Preference, Government, and the Process of Decivilization" for discussions of the bad sort of competition. ↩︎
Bastiat, F., Petition of the Manufacturers of Candles, Waxlights, Lamps, Candlelights, Street Lamps, Snuffers, Extinguishers, and the Producers of Oil, Tallow, Resin, Alcohol, and, Generally, of Everything Connected with Lighting, vol. 1, The Ludwig von Mises Institute, 2007. ↩︎
O.Karame, G., Androulaki, E., Capkun, S., "Two Bitcoins for the Price of One? Double-Spending Attacks on Fast Payments in Bitcoin", Cryptology ePrint Archive, 2012. ↩︎
See Grinstead, C., Snell, J., Introduction to Probability, American Mathematical Society for a pleasant discussion of random walks. See if you can solve the problem of the 51% attack yourself! ↩︎
King, S., Nadal, S., "PPCoin: Peer-to-Peer Crypto-Currency with Proof-of-Stake", 19 Aug 2012. ↩︎
King, S., "Primecoin: Cryptocurrency with Prime Number Proof-of-Work", 7 Jul 2013. ↩︎
Freicoin Developers, "Freicoin: About", 2013. ↩︎
From the standpoint of the Austrian School of economics the most puzzling aspect of the Bitcoin network is its relationship with the regression theorem, the Austrian economists' explanation of the origin of money.[1] The regression theorem addresses two separate issues: the emergence of a medium of exchange, and the evolution of a medium of exchange into money. A medium of exchange is defined to be something that is bought for the purpose of trading it for something else later. Money is the medium of exchange which is pre-eminent among all others.
Bitcoin is not and never has been money, so only the first issue is relevant today. However, since the second issue may be important to Bitcoin's future, it is worth describing. The evolution of a medium of exchange into money is explained by the observation that a more marketable medium of exchange is, all things being equal, more desirable than a less marketable one. Thus, the most marketable medium of exchange among several media will have an advantage over the others. As more people choose that medium because of its greater marketability, it becomes even more marketable and the others become less marketable. Thus, it is to be expected in the long run that a single medium will tend to dominate the rest.
As to the first issue, the explanation depends upon the observation that in order for something to be sold it must be treated as an economic good by both buyer and seller—meaning that they both would want some of it, even if they each are willing to pay different prices. If the buyer did not treat it as a good, then he would not be willing to pay for it, and if the seller did not treat it as a good, then he would be willing to give it away, or even pay to have it taken away. Since a medium of exchange is something which is bought and then resold, it must be treated as an economic good by both parties in both transactions.
Thus, the first person who is able to use a good as a medium of exchange must buy it from someone who also treats it as a good—yet who did not use it as a medium of exchange. Hence it follows that a thing becomes a medium of exchange on the basis of some other demand, and no other evolution is possible.
To recap, the regression theorem says that:
Both of these are necessarily market phenomena because they take place as peoples' individual decisions as to what they wish to trade with and with whom. Institutionalized coercion can affect the process, but always from the outside: for example, a State could try to promote one media of exchange over others by outlawing the rest. This might affect which media of exchange becomes money, but they cannot cause a thing to become money or a medium of exchange directly through decree.
On the other hand, the regression theorem does not say that:
These fallacies underpin the negative reactions many Austrian economists have to the Bitcoin network's currency, bitcoins.
It is now possible to explain the paradox of Bitcoin and the reasons that it has often been analyzed inadequately by Austrians. In order to analyze bitcoins properly, it is necessary to use only the cold, hard logic of the regression theorem rather than let ones love of gold interfere.
The Bitcoin paradox is that bitcoins appear to have no use other than as a medium of exchange. Its technological features, though elegant, are barren as long as there is nothing that bitcoins can buy. Thus, it would appear to be a violation of the regression theorem if bitcoins were to become a medium of exchange.
There are two fallacies inherent in the statement of this apparent paradox. The first is an argument from lack of imagination. Just because the nature of bitcoins' original value is unclear does not mean that there isn't one. The second is a violation of subjectivism, which is fundamental to Austrian methodology. The economist need not demand to understand the reasons why people value anything—demand is proven by the fact that something has a price, not by the fact that the economist understands why people pay for it. I don't deny that a lottery ticket is an economic good even though I can't understand why anyone would buy them.
Bitcoins are known to be a medium of exchange today. This proves that the regression theorem must apply to them even if it is hard to understand the original demand.[3]] It is also empirically known that they were sold for dollars before ever being used as a medium of exchange.[4] This confirms what must necessarily have been true according to the regression theorem.
The correct approach should have been clear to any Austrian economist, but until recently, Austrian analyses of Bitcoin have been superficial. It is not yet generally understood among Austrians that Bitcoin is fundamentally different from both gold and fiat currencies, and therefore requires a fundamental analysis going back to first principles. This may have to be reiterated a few more times before the Austrian movement is convinced.
The anti-Bitcoin Austrians are incapable of mounting a reasonable case against Bitcoin. They are convinced that something must be wrong with Bitcoin, but when they attempt to articulate it, they arrive at conclusions which are either subjective or fallacious.[5] The most common reaction is that the regression theorem implies bitcoins cannot become money or are somehow unsustainable,[6] but this conclusion misunderstands the nature of praxeology. Praxeological arguments are only capable of saying that certain causal relationships are possible or impossible. It is not possible for something in real life to violate a praxeological law, even momentarily.
I believe that this reaction has to do with a misattribution of the reasons that fiat currencies (and bitcoins by analogy) are unsustainable, as compared with the reasons that gold is superior. Gold has obvious productive uses; dollars and bitcoins do not. However, gold is not stable and the dollar unstable for those reasons. Rather, the dollar is unstable because the organization issuing it is presently tampering with it. If the tampering should stop and the government should provide real evidence that it will manage the dollar responsibly, then there will be no reason to expect the dollar to be unstable after that.
On the other hand, because gold has obvious and widespread productive uses, its price cannot go to zero as long as it still has these uses. The same argument cannot be made of bitcoins, but it does not follow that bitcoins' value will go to zero or is likely to go to zero: once again, the best argument is provided by Šurda, who asks "If Bitcoin fails, what would replace it?"[7] As long as Bitcoin has uses which are impossible with any other currency and as long as it remains competitive against other currencies and payment systems, it will not entirely collapse in value.
Bitcoins are a puzzle to resolve, not an excuse to deny reality. They must have had an original value. The critical moment for bitcoins was when they were first sold. Why did people begin to pay dollars for additional bitcoins beyond those that could be obtained for free? This is not a praxeological question, but it is most definitely an interesting one, and it also is at the heart of Austrians' confusions about Bitcoin. It is clear that bitcoins cannot be thought of simply in analogy with gold, and some other story must be given for it before it will seem natural to people who are used to thinking of money in terms of gold and fiat.
In general it is not always possible to explain peoples' desire very well because they are so subjective. However, a good can be explained as an instrumental, as opposed to an intrinsic good. There is no explaining human fashion, but given that it exists, there is no difficulty in explaining fashion shows or designer clothes as means of advancing peoples' quest to stay ahead of the latest trends. It is not enough, therefore, say that they were "cool" or had "mystique".[8] This explains nothing more than what we already know. Ordinarily, things are cool or mysterious for reasons, not because of a sudden mass delusion (although this is not impossible).
An explanation suggested by Graf is that bitcoins were originally demanded because of an appreciation of Bitcoin's engineering. A well-engineered encryption scheme "may indeed be more highly valued to some people in some contexts than certain 'real' economic objects or specific quantities of fiat money. Regardless of any potential future indirect-exchange value, one can imagine such persons expending hundreds of hours of effort in creating and breaking encryption codes, just because they like to".[9]
The problem with this explanation is that it does not distinguish between Bitcoin the program and bitcoins the currency. An appreciation of Bitcoin's engineering explains why someone would download the program to play with it or peruse the code, but it does not explain why someone would pay for an inert and arbitrary string of data. Any amount beyond a few satoshis would be enough to try out everything that Bitcoin could do. Why, indeed, would an engineer prefer to engage with the Bitcoin block chain when he could start his own and have the entire system to himself to experiment with?
The correct approach, I think, was hinted at by Šurda, who obliquely says, "According to my opinion, the rational expectations of the potential utility of Bitcoin for the potential buyers exceeded the price demanded by the producers, and trade emerged".[10] Bitcoins would have had value to the person with the right entrepreneurial mindset.
Two centuries ago, oil was less than worthless. It was a blight that people would pay to have removed from their land. However, suppose one day a mysterious stranger appeared claiming to be a time-traveler. He told everyone that one day oil would be the world's most valuable fuel. It would called "black gold". Wars would be fought over it and enormous machines would be built to collect every last drop.
Though no one knew if the purported time traveler was telling the truth or how to develop the technologies that would one day make oil valuable, some entrepreneurs believed him and began to collect oil to prepare for the day that it became black gold. They built large vats to store it and bought it up by the ton. Because these entrepreneurs established a baseline for the value of oil, other people bought smaller amounts to speculate on the price to store their wealth outside of traditional banks.
After a financial panic, the greenbacks people had been trading with became worthless. Needing something to trade with, and finding oil to be a commodity in widespread demand, people begin to trade and quote prices in it. Soon oil becomes their new money without anyone having figured out how to use it as a practical fuel. By the time the technologies to use it as fuel are understood, oil is too valuable to be burnt up.
In real life, there is no time traveler but entrepreneurs can sometimes glimpse the future. When Bitcoin was first invented, bitcoins had no exchange value and were given away free just to generate interest. However, once the right entrepreneurs began to suspect that bitcoins might actually be used as money some day, they were willing to pay dollars to have larger amounts than were available for free. They may not have understood precisely how it could happen, but actually thinking it might would certainly be enough to give bitcoins a mystique. Thank goodness there were enough people whose judgment was not clouded with an imperfect understanding of the regression theorem. A suspicion that Bitcoin might one day be a big deal explains everything about its original demand.
This explains how an appreciation of Bitcoin's engineering could lead someone to want the coins themselves. Once it was known that bitcoin could be sold, even for a pittance, new possibilities opened up. A second generation of entrepreneurs realized that the tiny baseline value provided by the first generation allowed for certain services which would be impossible by with PayPal or credit cards. For example, WikiLeaks could accept donations in bitcoin which could not be blocked by any third party. The Silk Road could be created to establish an anonymous and secure online black market.
At that point, bitcoins had developed an exchange value. Both groups of entrepreneurs were happy because both had turned a profit. Bitcoin was still not money, but its potential was far easier for others to grasp. Thus, new entrepreneurs entered the market, both as merchants and investors. This cycle repeated itself to this day, and there is no reason that it will not continue as long as there are people ready to stake money on the vision of a Bitcoin economy.
The regression theorem is credited to Ludwig von Mises in Mises, L., The Theory of Money and Credit, Yale University Press, 1953 but Carl Menger nearly had it all figured it out in Menger, C., Principles of Economics, Ludwig von Mises Institute, 2007. ↩︎
Please see Šurda, P., "Economics of Bitcoin: is Bitcoin an Alternative to Fiat Currencies and Gold?", 2012, pp. 38-41 for Šurda's discussion of the regression theorem, upon which I have relied quite heavily. ↩︎
This argument has emphasized by other pro-Bitcoin Austrians. See Šurda, 2012, Graf, K., "Bitcoins, the Regression Theorem, and that Curious but Unthreatening Empirical World", 23 Feb 2013, and Selgin, G., "Bitcoin", 22 Apr 2013. ↩︎
See Šurda, 2012, pp. 41-42. ↩︎
See Gertchev, N., "The Moneyness of Bitcoins", Mises Daily, 14 Apr 2013 for an article that gives subjective arguments against Bitcoin. See Shostak, F., "The Bitcoin Money Myth", Mises Daily, 17 Apr 2013 for an article which falls into numerous fallacies in an attempt to refute Bitcoin. This article is so sloppy that it could not even manage to spell "Nakamoto" correctly. Though it is an embarrassment, is useful as a compendium of fallacies and as an indication of the level of disdain and ignorance with which some Austrians discuss Bitcoin. I will briefly discuss its problems.
First, Shostak describes bitcoins as a medium of exchange but then argues that the regression theorem says that it cannot become money because it has no intrinsic value. However, the origin of a medium of exchange has no bearing on the reasons that a medium of exchange becomes money.
Second, Shostak says that bitcoins are not physical, therefore not a commodity, and therefore, since only a commodity can emerge as money, bitcoins cannot become money. This wrongly introduces physicality, which is not a praxeological category, into the discussion. The only relevant praxeological category is scarcity, which bitcoins have despite not being physical.
Third, Shostak advances the fallacy that money serves as a "yardstick". It is true that using money tends to make the exchange rates of goods obey a transitive relationship to one another, but it is not a measure of anything because it is not independent of the rest of the economy and can fluctuate in demand just like anything else.
Fourth, he then goes on to say that "Bitcoin can function only as long as individuals know that they can convert it into fiat money" and "Bitcoin is not a new form of money that replaces previous forms, but rather a new way of employing existent money in transactions". These statements are both obviously ridiculous. He apparently regards fiat currencies as somehow the real yardstick because of their historical ties to gold and therefore simply will not take Bitcoin seriously. Shostak is guilty of historicism. ↩︎
See Pattison, M., "Buying into Bitcoin: An Austrian Analysis of the Virtual Currency's Sustainability", 14 Dec 2011 for the most detailed article which makes this argument. ↩︎
Šurda, 2012, pp. 37-38. ↩︎
This is an explanation proposed in Graf, 2013. However, Graf is really just making the point that we do not need to state bitcoins' original value to say that they had value. ↩︎
Šurda, 2012, pg. 42. ↩︎
Perhaps the least intuitive aspect of the Bitcoin network is the proof-of-work concept it uses to define the requirement for the generation of a new set of transactions ("block") to be added to the distributed transaction database ("block chain"). This concept, which grew out of ideas from the early cypherpunk movement[1], is new to monetary theory and feels a little out of place in computer science too. I will show that biology gives us the most suitable framework for understanding it.
All the blocks in the Bitcoin block chain have a short string of meaningless data—called a nonce—attached to them. The mining computers are required to search for the right meaningless string such that the block as a whole satisfies a certain arbitrary condition. Specifically, it is required that the SHA-256 hash of the block have a certain number of leading zeros.[%2] Hashes are one-way functions, so there is no easy way to find the right nonce or otherwise to engineer a block to be correct. The only known way to find a good nonce is to simply to try randomly until one turns out to work. Khan Academy provides a visual explanation of proof-of-work:
The procedure, remember, is totally arbitrary. It is simply an added complication, like a ritual, so as to make blocks more difficult to generate. Really anything else would do, as long as it was computationally difficult. Other crypto-currencies use other hash algorithms. There is no special condition from number theory which only someone like Shinichi Mochizuki could understand.[2]
Although the purpose of the mining computers is to do the accounting for the block chain, most of the work they actually do is to search for good nonces, rather than anything to do with accounting. The energy used to find the nonces is lost forever. The energy does not "back" the value of bitcoins in the way that gold backs an honest bank note, as some have supposed. Of the vast computing power that goes into bitcoin mining, all but a tiny fraction is apparently purposeless.
When a person upgrades their mining computer, they mine at a faster rate and therefore earn more bitcoins. However, when everyone upgrades, the mining does not become more efficient as a whole. There is only supposed to be one new block every ten minutes regardless of how hard the network is working. Instead, the network updates the difficulty to require more stringent conditions for future blocks. All miners may work harder, but none is better off. It is rather like a forest, in which every tree tries to grow as tall as possible so as to capture more light than its fellows, with the end result that most of the solar energy is used to grow long, dead trunks.
Why tie each bitcoin block to a difficult Procrustean bed? The correct way of thinking about the proof-of-work concept is as a means for a group of self-interested people, none of whom is subordinate to any other, to establish a consensus against a considerable incentive to resist it. Bitcoin could operate perfectly well without proof-of-work, as long as everyone was perfectly honest and altruistic. If they are not, then reaching a consensus is difficult.
Before a new block is generated, there might be many payments floating around the network and there is not yet any objective answer as to which payments should go through. Some might be invalid, so they all need to be checked. Some might not include any transaction fee, so there also must be a decision as to whether to be nice and allow these free riders to go through or whether to ignore them. Finally, there may be a set of two or more payments such that not all can be simultaneously valid, but certain subsets of it are valid. For example, one wallet might try to spend the same bitcoins twice at the same time. In that case, there is an arbitrary choice over which payments to allow.
Thus, for a given set of payments, there may be many possible blocks which can be constructed from them, none of which is objectively the most correct one. There will not necessarily be any agreement over which outcome is preferable because different possible blocks will have different benefits for different people. There is, first of all, the reward that comes from generating a block of a set of new bitcoins. This is necessary because without it there would be little incentive for anyone to do the accounting in the first place; but with a reward available, each miner naturally would prefer the new block to be his proposal rather than anyone else's.
There are other more subtle complications even without considering the reward. A miner might refuse to validate transactions which come from his enemy, or he might be more or less altruistic as to what kinds of fees he will accept. He might even wish to scam someone else by double spending: in this scenario, he would send a payment to a victim in exchange for a good, but would only validate a second conflicting payment he made at the same time to another wallet which he also owns. This would make his first payment invalid, and he would therefore end up with a good he did not pay for.
With so many reasons to want to manipulate the block chain for their own purposes, the miners might well agree in the abstract on the need for a consensus without ever agreeing on any concrete proposal. Bitcoin's solution is to add extra requirements to the protocol which greatly increase the cost of defection. If blocks are generated randomly by a difficult computation, there will be only one proposed new block at a time. Once a new block is proposed, the miners have the choice of continuing to search for an alternative more favorable to themselves or accepting the new proposal and searching for the next one. Everyone who accepts the latest block understands that he is following a natural consensus and that, if he is lucky enough to generate the next block, it will probably be accepted for the same reasons that he accepted the last one. On the other hand, to hold so as to try to produce a more favorable block is very risky because he would have to convince enough of the rest of the miners to go along with him that he can establish a new consensus.
The general rule is that the first block mined is not self-interested because no one can plan on being first. One can only be first by luck. Any hold-outs are suspect because to generate it, the miner had to make a choice to reject a perfectly good and presumably altruistic alternative. Not an easy thing to do.[3]
There is an idea from biology called the Handicap Principle which sheds light on this process.[4] It says that when two animals have an incentive to cooperate they must communicate good intentions to one another in a believable way. In order to make lying implausible, the signal must impose a cost on the signaler that would make it very costly to cheat. In other words, the signal itself must be a handicap.
This can be understood in terms of the Prisoners Dilemma, a famous idea from game theory which has applications to an enormous range of phenomena. The Prisoners Dilemma has two players, each with two options: cooperate or defect. Ordinarily, the game is explained in terms of a story about two prisoners who each has the option of either keeping silent or ratting out the other. The essential features of the Prisoners Dilemma are that each player is better off choosing to defect regardless of the other player's choice, and that the greatest benefit goes to him who defects when the other cooperates. The players might both be better off if they both cooperate rather than both defect, but since they have no way to ensure cooperation, they will both choose to defect.
The Handicap Principle solves the problem of the Prisoners Dilemma by allowing an earlier step to the game in which each player has the option of doing something that convincingly removes the benefit of defection over cooperation. It is hard to think of how to make the Handicap Principle work with the story of the two prisoners, but suppose they have a moment together with the prosecutor and one of the prisoners with a particularly good understanding of game theory says to the prosecutor, "If the other prisoner is guilty, than I am equally guilty." This statement is a clear cost to himself because it removes his ability to defect when the other prisoner cooperates. The other prisoner then has the option of repeating the statement. If he does not, then he knows that the first prisoners only viable option is to defect, but if he does, then both prisoners can be expected to cooperate. This is the Handicap Principle.
The Handicap Principle has been applied successfully to a diverse range of biological phenomena. To give a concrete example, suppose a prey animal notices a predator stalking it. Both animals would benefit if the prey could communicate to the predator that it is no longer unaware: the predator would not want to hunt further if it had lost the element of surprise and the prey would not be hunted. However, the prey could start randomly saying, "I see you!" even when it sees no predator, just to deter any which might happen to be there. As long as the prey might be lying, the predator cannot take its signal at face value and must ignore it.[5]
Within a species, the handicap principle explains a lot about how animals compete with one another and interact with their mates. For example, among deer, the buck with the biggest antlers are the strongest and best specimens because any smaller deer who tried to grow larger ones would seriously risk using more energy and nutrients on them than they can handle. Thus, second-rate bucks end up with second-rate antlers and the third-rate bucks end up with third-rate antlers, and so on.[6]
In a social species, the handicap principle explains much about ethics and altruism. Just as members of a species can differentiate themselves in strength and heath with a handicap like horns or antlers, members of a social species can use altruism as a handicap to distinguish one another. For example, The Handicap Principle describes a social bird called the Arabian Babbler that competes over altruism. The most powerful and dominant birds demonstrate their superiority by spending time on guard duty for the rest of the flock and by feeding nestlings and lower-ranking birds. Babblers do not like to be fed by other babblers of a similar rank because they do not like to feel inferior. The Handicap Principle even describes an observation in which one bird fed a worm to another bird only to have the same worm forced straight back down his own throat![7]
Proof-of-work should not, therefore, be seen as a mysterious or wasteful system, but as something functional, natural, and potentially of value for the design of any communication protocol. If a distributed system of computers is owned by one person, he can assume that they will all cooperate because he controls their behavior. When this is not the case, there is a real need for different computers to prove that they are working toward the same goal. The universality of the Handicap Principle in biology should be enough to make one suspect that a protocol which does not impose costs on its users invite abuse. It is interesting to think of how many problems with the Internet can be ascribed to a failure to account for this principle. If proof-of-work had been understood when email was invented, there might never have been a spam problem. If the Internet Protocol could require proof-of-work for client requests, we might not have to worry about Distributed Denial of Service (DDOS) attacks.[8]
The Bitcoin proof-of-work system can be compared to both antlers and altruism. The ability to generate blocks is a show of computational strength, which is just what the Bitcoin network needs to help verify all the transactions. But it is also a show of community spirit because by agreeing to enter the contest for the next block, they show themselves to be willing to respect the interests of the community rather than manipulate the block chain for self-interested purposes. This is just the sort of thing that should be expected to hold a community together.
A more recent application of proof-of-work is Bitmessage, which is an anonymous, distributed, encrypted message protocol which could one day be almost as important as Bitcoin.[9] It was inspired by Bitcoin, but it works quite differently. There is no block chain in the Bitmessage protocol because there is no need to store all messages forever in a database. Instead, Bitmessage requires everyone who sends a message to perform some work before the network will relay it. This ensures that every message will be meaningful: no spammer could afford to let his computer run for a minute or so for every message he sends. Proof-of-work is essential because a distributed network that relies on computation donated by its users cannot afford to allow free-riders. It is in its early stages presently and it has not yet been studied sufficiently to be considered secure, but it has enormous potential as an alternative to e-mail.
A discussion of proof-of-work would not be complete without a discussion of PPCoin, the third most popular crypto-currency after Bitcoin and Litecoin.[10] PPCoin also uses proof-of-work so as to make defection unprofitable, but the costs are distributed very differently among the miners: those miners who have held a lot of PPCoin for a long time suffer much less stringent requirements for producing a block than those who have held few PPCoin and who have held them for a shorter time. This means that people will not tend to follow the consensus proposed by the person with the most powerful computer, but rather the person who has demonstrated the greatest investment in the currency. Miners are distinguished by something more like seniority than strength. When a miner creates a new block in the PPcoin block chain, he has to trade in some of his old coins to get the new ones—meaning that everyone who creates a block is less able to create the next one. This system is called proof-of-stake.
Proof-of-work and proof-of-stake have different costs and benefits under different circumstances. According to the Handicap Principle, the costs imposed to produce a signal must be related to the meaning of the message. A proof-of-stake system demonstrates investment in the coin itself whereas a proof-of-work system in the underlying network.
Thus, if there were a proof-of-work network and a proof-of-stake network which both had the same market cap, one would therefore expect the proof-of-work coin to have a bigger network with a higher capacity and to be more liquid than the proof-of-stake network whereas the proof-of-stake coin would have the greater price stability.
The proof-of-work system discourages an antisocial miners from manipulating the block chain by making it difficult to rely consistently on the network to accept his blocks. The proof-of-stake system, by contrast, discourages antisocial miners by accepting only blocks from miners who have an incentive to ensure that the commodity remains absolutely trustworthy. Because the proof-of-stake is used up as new blocks are generated, there is continual turnover in who is able to mine, and thus less incentive to specialize in maintaining the block chain.
In its early stages, a crypto-currency network requires long-term investment in the coin itself so as to gain credibility and value, whereas a larger, more mature network would be more likely to require specialization in the network infrastructure to ensure that it functioned properly.
This is an academic discussion. It is counterproductive to back any cryptocurrency other than Bitcoin. It is not to be expected that ordinary consumers would choose one currency over anther because of obscure technical details that do not affect their use for it as a currency. They will be much more likely to choose whichever is more widely accepted. Someone who thinks PPCoin is more rational has little expectation of PPcoin beating Bitcoin, but he might have a chance of convincing the Bitcoin community to adapt a proof-of-stake system in some future version of Bitcoin. Although this is theoretically possible and might have benefits, the Bitcoin miners already form a vested interest in the present system and would therefore tend to oppose such an innovation.
See Back, A., "Hashcash - A Denial of Service Counter-Measure", 1 Aug 2002, for a description of the proof-of-work concept and its applications by its original inventor. ↩︎
A world-class mathematician conjectured for superficial reasons to be the creator of Bitcoin by Ted Nelson. He is known both for purported proof of the abc/Oesterlé-Masser-Szpiro conjecture and for his reluctance to advertise his work or to explain it to anybody. The proof is over 500 pages long and so original that no other mathematician yet fully understands it; if it were true, it would be a much bigger deal than the proof of Fermat's Last Theorem. See his website Mochizuki, S., "Inter-Universal Geometer: Shinichi Mochizuki", 2013.
However, there is no reason to expect the creator of Bitcoin to be a math genius. Bitcoin is a brilliant work of engineering, not of logical deduction. The mathematics required to create it might be found in an introductory cryptography course. Satoshi did not come up with any fundamentally new ideas; he simply put some existing ideas together in an extraordinarily useful new way.
The reclusiveness of the two figures is also superficial. Mochizuki is a typical eccentric asocial mathematician, only just a bit more so. Nakamoto, on the other hand, was secretive about his identity for very good reasons. He was also not asocial: he was very active in the Bitcoin community until he felt that it no longer needed his guidance. ↩︎
Although this has happened once before. On March 13, 2013, a bug in version 0.7 of bitcoin-qt resulted in a conflict with version 0.8. The block chain forked, with each version of the software recognizing a different branch as valid. The community of bitcoin miners settled upon the version 0.7 branch as the one they would recognize even though it was the shorter one. ↩︎
See Zahavi, A., Zahavi, A., The Handicap Principle: A Missing Piece of Darwin's Puzzle, Oxford University Press, 1997 for a delightful presentation of this idea, written by the biologist who originally proposed it. Although this is a popular presentation without mathematics, it is not dumbed-down and it uses sophisticated biological arguments to make its point. The Handicap Principle was originally proposed in 1975, but did not become mainstream until the 90's. ↩︎
Zahavi, Zahavi, 1997, pp. 3-13. ↩︎
Zahavi, Zahavi, 1997, pp. 55-57. ↩︎
Zahavi, Zahavi, 1997, pp. 125-150. ↩︎
See Warren, J., "Bitmessage: A Peer-to-Peer Message Authentication and Delivery System", 27 Nov 2012. ↩︎
See King, S., Nadal, S., "PPCoin: Peer-to-Peer Crypto-Currency with Proof-of-Stake", 19 Aug 2012. This paper is not well-written and I do not recommend it. ↩︎
Chapter 2: Public-Key Cryptography
Chapter 3: The Killer App of Liberty
As wonderful as it is, public-key cryptography can be subverted and even turned against us. It is subverted when our computers cannot keep them secret, and it becomes a tool of oppression when we are issued private keys in a way that prevents us from seeing them.
The first of these attacks is performed either by remotely controlling our computers with a virus that is secretly installed on it or tricking us into installing ourselves, or by altering our computers so that all data is stored on some remote server rather than a hard drive. The second attack is done by giving everyone computer chips with private keys inside them. This could be in form of an ID card with an RFID chip inside or as a computer with a Fritz-chip attached.[1]
The first attack prevents the formation of cryptographic communities, and the second alters the nature of a cryptographic community so that it is no longer empowering to the individual. An ID card with an RFID chip on it not only may be demanded by the police on their own whim rather than that of its' owner, but it cannot even be forged.
Combining these attacks results in the Orwellian monster known as Trusted Computing. Under this model, a computer comes with a Fritz-chip attached on which is hidden a private key, and with software installed that depends upon it to run properly. When the computer boots, the Fritz-chip detects if the computer is in a trusted state, meaning that restricted operating system has not been replaced by something else and refuses to decrypt anything otherwise. This prevents the user from installing software to avoid the restrictions built into the operating system. Software companies can design restricted file formats that cannot be read by competing software packages or which only work on certain peoples' computers rather than others. The operating system can be designed to detect and prevent certain activities, such as file sharing. The totalitarian possibilities of such a system are in Richard Stallman's terrifying and prophetic tale, "The Right to Read."
As nightmarish as it is, Stallman's tale does not go far enough. In his story, computers are all restricted by law according to the interests of a media-software cartel. No doubt any government would happily be manipulated for such a purpose, but once the power was available, its use would spread to serve other interests too, such as that of the police. The government might, say, install an artificial intelligence program on everybody's computer to detect and report subversive literature or evidence of tax evasion to police. It could try to automatically delete Bitcoin wallets and block Bitcoin transactions. They could make your computer download and install regular updates to keep your computer up-to-date in blocking the latest subversive techniques.
This may seem far-fetched. Today it appears that we have won the battle on file-sharing. Media companies are even beginning to incorporate file sharing into their business models. This is no reason to be complacent because other attacks are in the works. Now it is illegal to root your own phone under the DMCA. Although DRM is not yet required by law, most computer manufacturers already make computers with Fritz-chips attached.[2] The computer industry is ready. Once a law does go into effect, we will be confined. The FBI has lobbied for a law that would require back-doors to be built in all security services. Although this proposal has been watered down from its original version, it can be expected that they will continue pushing for more and more draconian measures.
Furthermore, consider the criteria I gave in chapter one for evaluating the risk of an industry to government attack.
As yet the government does not appear to be pursuing a deliberate policy of cartelization, but as these companies lobby their way into privilege through software patents and legally enforced DRM, the government may eventually find itself in the position of having the internet within its grasp. This is why computer manufacturers and the software industries should be seen as high-risk. The service provider industry is also at risk, but if we can retain control over our devices and software, then its threat will have been mostly eliminated as well.
Libertarians know to fear the banking industry because we know from history what is possible with a government banking cartel. The computer and software industries should be even more feared. This is not merely a problem with individual companies. It is a problem with standard business practices. Although libertarians complain about how Microsoft crushes smaller companies with their use of patent monopolies and how Facebook shares information with the FBI, I have observed little awareness among libertarians of the correct solution. Perhaps we are so dependent upon these companies and so used to their business practices that to state the correct answer is such an annoying prospect that we would rather just wish there were an easier way.
But there is really only one defense: to retain control over our computers, our software, and our data. The standard business practices today demand that we give up control. This is so normal to most of us that it is hard to imagine what it would really mean to retain control.
Fortunately, the necessary philosophy was developed by Richard Stallman, founder of the free software movement and of GNU, a project to create a free operating system that eventually evolved into the GNU/Linux.[3] Free software is software whose source code is as available as its binaries and which comes with the right to edit and redistribute edited versions.[4] This term refers only to the rights that come with the software, not to its money price. Proprietary software is software that is not free software. The major goal of the free software movement is that all software should be free software.
Libertarians have not had much of a connection with the free software movement before. I would rate it as at least as important an ally to the libertarian movement as the homeschooling movement. There is much that is admirable about it: Stallman, for example, was against copyright and patents long before libertarians got the picture. He invented copyleft, which, though not entirely compatible with libertarianism, is, as a form of self-defense in a world oppressed by intellectual property, a stroke of genius.[5]
What is relevant now, though, is free software as an essential component of libertarian entrepreneurship. When we use free software, we depend on a community of developers who work on the program because they actually want to use it. When we use proprietary software, we depend on specific companies. We, furthermore, give up control: when we use proprietary software, we can still smash our computer but we cannot know what it is doing while it is still running. There is nothing but a promise that it is behaving as it is supposed to, without any means of verification, and the considerable possibility of a conflict of interest. This is like trusting a politician. Whereas with free software, even without being able to read computer code, someone can give you an informed opinion about it. Everything has independent verification.
Proprietary software is inherently a security risk. This applies not only to programs with security functions, like operating systems or encryption software. It applies to every program running on your computer: there are the obvious kinds of viruses that exist for no purpose other than to hijack computers, but there are also the viruses which have legitimate purposes and which people voluntarily pay for and install and which actually do a good job at what they are supposed to do, but which are, nonetheless, still viruses.
Yet any program could have this property, and many do. Operating systems in particular tend to come full of malicious features. The Amazon Kindle, iOS devices, and Android devices are all known to contain kill switches that allow their manufacturers to delete apps and files remotely. In a particularly ironic example, Amazon.com once deleted Nineteen Eighty-Four from everyone's Kindles in response to copyright issues. Windows 8 now comes with a kill switch as well, thus making it the first desktop operating system that allows for remote control from a big software company.
Even a seemingly innocuous program like Flash player can turn out to be risky. Few people are aware of the danger of flash cookies, but most big websites use them to track us without our knowledge or consent.
Malicious features make your computer more vulnerable to software companies, hackers, and to government-software collusion. If all software were free software, it would be much easier for people to choose not to be vulnerable. As a matter of libertarian strategy it is not necessary that all software be free, but certainly to be much more than there is now, enough to leave the government with little to gain from a software cartel. It is incredibly reckless that there should even be such things as proprietary operating systems and web browsers, for example. It is obviously also necessary for any cryptographic software to be free.
Another way we give up control is when we do our computing remotely. When we use services like GMail or Facebook, it is not enough to blame the companies behind them for cooperating with the police. We should also blame ourselves for being such easy targets. We cannot know what sort of computations are being done with it. We give up our information such that it is no longer up to us to decide whether to show it to the police without a warrant. As Richard Stallman points out, the government already encourages software-as-a-service for this very reason. I have not heard this connection repeated in libertarian circles, even though it seems like something libertarians should have figured out on their own. Both software-as-a-service and cloud computing must be rejected as inconsistent with a viable strategy for liberty.
Finally, the third way we give up control is to use proprietary devices. A free device is one that does not arbitrarily restrict the user's ability to install software of his own choosing on it. A proprietary device is, of course, the opposite. I have already discussed how many operating systems come with kill switches and other remote-control features. Combining this with a proprietary device results in something whose malicious features cannot be removed.
To retain control over our computers, we must drastically reduce proprietary software, proprietary devices, and software-as-a-service as business practices. Libertarian entrepreneurs should try to compete with other business practices that make our computers more secure against outside control. This will greatly reduce the risk of a government invasion of our computers and the internet.
I do not think there is anything wrong in principle with the concept of voluntary slavery,[6] but I would not want to live in a world where it was the accepted norm. Not only would such a society be unlikely to present me with acceptable opportunities to fit my own personality, but such a system could easily evolve into one of involuntary slavery because the tools of mass repression would necessarily exist. Voluntary slavery should be seen as an issue of libertarian strategy rather than libertarian principle.
The issue is relevant because a person whose computer is restrained is not literally in chains, but it is as if he were. The difference is only one of degree. The distinction between our body and our devices is only a matter of our limited technology. Some day it will be possible for our bodies to be products as much as our devices. We may connect our computers directly to our brains. They might be used to enhance our thoughts or control our vehicles (thus incorporating them into ourselves as well). These hypotheticals, which blur the line between body and devices, show that the distinction between them is not conceptual, but merely empirical.
Already people depend on their computers so much that they are getting to be like body parts. Our computers are a conduit to the rest of the world. They are our eyes, ears, and mouth. Thus, I do not consider myself to be speaking hyperbolically to say that a person who buys an iPhone becomes a voluntary slave. He uses the device as his eyes and ears to the world and he does not even have the right to say what software he wants to install on it. Apple retains the ability to remotely control his device, so at any moment, Apple might shut off his vision, send him hallucinations, or secretly watch him.
GNU/Linux does not yet have enough popular appeal. It appeals to people who like to program, people who don't want to give up control, or people who understand its technical superiority. Most people are in none of these categories. Although it is the foundation for many devices, the philosophy behind it is not. Android is a version of GNU/Linux, for example, but the devices that run it have restrictions to prevent the user from gaining root access. Thus, they are not free devices.
Promoting free software values is about as difficult as promoting libertarian values because they, too, are very abstract. I do not know how to convince people to become excited enough about programming to worry about free devices. However, I think it is at least possible for libertarians to adopt free software values. Although the nonaggression axiom does not require anyone to own a gun, I think that most libertarians would sleep better knowing that their neighbors owned guns and knew how to use them. However, in today's world it would make more sense to worry about whether their neighbors used GNU/Linux.
One hope now is that Wikipedia is has become ubiquitous. Thus by analogy people can understand the advantages of software that is built according to a similar model. However, it is only once people people actually could actually exercise control over their computers that they will want to retain it. Unfortunately, we live in an illiterate world. Perhaps one day that will change. Programming ought to be seen as an essential component to a liberal education, as much as science, mathematics, or literature.
When I first became a libertarian, I wondered how we would ever win enough elections. When I came to understand that this is impossible, I wondered if there was anything we could do at all to prevent a decline into fascism. Now I no longer wonder. The way out is entirely within our means.
But the world still hangs in the balance. People are blundering along the path to slavery. Libertarians are not doing enough to help; most are blundering along with everyone else. Some libertarians, with breathtaking foolishness, even reject Bitcoin.
My prescriptions are simple: promote Bitcoin and oppose proprietary software and proprietary devices. These will greatly diminish the risk imposed on us from the banking and financial industries, and from the software and computer industries. If you are a coder, improve cryptographic free software, such as Bitcoin, Tor, or RetroShare. Above all, however, is to keep the mind open for new ideas. Search for government risks that have not yet been addressed. Search for new services that can be provided by cryptographic communities. Stay one step ahead of the government and don't get embroiled in politics.
See Anderson, R., "'Trusted Computing' Frequently Asked Questions", Jul 2003 and Stallman, R., "Can You Trust Your Computer?", 28 Feb 2013 for discussions of Trusted (Treacherous) Computing. See Wikipedia for a more neutral explanation. ↩︎
Wikipedia, "Trusted Computing Platform", Wikimedia Foundation, 6 May 2013. ↩︎
See Stallman, R., "The GNU Project", 28 Feb 2013 for a history of the GNU Project. ↩︎
See Stallman, R., "What is Free Software", 28 Feb 2013 for a much more detailed description. Also see Stallman, R., Free Software, Free Society: Selected Essays of Richard Stallman, GNU Press, 2002 for a wonderful collection of essays expounding upon the philosophy of free software. ↩︎
See Stallman, R., "What is Copyleft?", 28 Feb 2013 and Stallman, R., "Freedom or Power", 28 Feb 2013 for Stallman's views on copyleft. ↩︎
See Block, W., "Toward a Libertarian Theory of Inalienability: A Critique of Rothbard, Barnett, Smith, Kinsella, Gordon, and Epstein", vol. 17, no. 2, Journal of Libertarian Studies, 2003, pp. 39-85 for a libertarian defense of voluntary slavery. See Kinsella, N., "How We Come to Own Ourselves", Mises Daily, 7 Sep 2006 for a libertarian argument against it. ↩︎
Chapter 2: Public-Key Cryptography
Unquestionably the greatest example of the kind of free community that can be created using cryptography is Bitcoin, the system of digital cash invented by Satoshi Nakamoto, whose real identity remains unknown. Bitcoin uses all the principles I have described in the previous chapters. It is built upon free software and it uses public-key cryptography to establish identities and to ensure the validity of the messages relayed upon it.
Bitcoin is a peer-to-peer digital cash that is independent of banks and government. For a detailed explanation of how Bitcoin works, Satoshi's original paper is very readable,[1] but it works exactly along the lines I outlined above. Each person has one or more wallet files which contain a public and private key. Bitcoin software can construct messages signed by the private key of a wallet which state that the title to a given amount of bitcoin is transferred to another wallet.
The history of all Bitcoin transactions are stored in a publicly available database called the block chain. The block chain is duplicated across many computers. The amount of bitcoin that a wallet contains is known by reading the block chain. This is how Bitcoin uses the system of reputation I descrbed above. The wallet's prior history determines what it is capable of. If it has spent all the bitcoin that have been sent to it, than it can spend no more.
Thus, cryptography ensures that bitcoin behave like physically scarce commodities even though they are simply magnitudes in a computer. No new bitcoin can be created because it cannot be traced to any valid history in the block chain. Transactions cannot be spoofed because they require a digital signature by the wallet which spends them.
The block chain is generated by a process engineered to ensure that there is always a consensus as to the transaction history. The reason this is a concern is that it is possible to make two or more transactions which individually are valid, but which are incompatible with one another. For example, suppose someone has at least one bitcoin but less than two, and he makes two transactions that each spend one bitcoin at the same time. Everyone must agree on which transaction is accepted and which is rejected.
This is done by making blocks difficult to generate by requiring that they satisfy certain arbitrary rules. In return for transaction fees and unowned bitcoin, people run their computers to try to generate new blocks. Once one is created, it has priority and it is difficult to produce a competing block. The creator of the block decides which transactions go in it. As the block chain grows, it becomes exponentially more difficult to produce a rival chain that branches off at a given time in the past.
Bitcoin is not as anonymous as one might want. Although there is nothing to prove who owns a given wallet, it is possible to scan the block chain for clues that could link a wallet to a person. This is Bitcoin's most significant disadvantage. However, a possible bitcoin upgrade called Zerocoin in the works would allow for greatly improved anonymity.[2]
There is dispute among Austrian economists as to whether Bitcoin is actually suitable or even possible as money. However, the critics of Bitcoin are simply ignorant. Their love of gold exceeds their objectivity.[3] I will not attempt an economic analysis of Bitcoin here, but Austrian writers such as Peter Šurda and Konrad Graf have demonstrated with great clarity that Bitcoin is perfectly good as a currency and that no economic law would be violated if it should become money.[4]
Bitcoin is an enormous improvement over PayPal, credit cards, banks, and it is even superior to gold in many ways. It can be teleported instantly anywhere in the world without relying on any institution other than a distributed network of computers. A Bitcoin wallet, properly secured, cannot be stolen. Banks are obsolete. It is more difficult to create new bitcoin than to create gold. It would be possible to create a machine that makes gold with nuclear reactions. It would be much more difficult to convince the Bitcoin community to accept a change to their software that would allow their currency to be inflated. Bitcoin is potentially, and I believe very probably, one of the greatest inventions in history. It fights squarely on the side of libertarians.
If Bitcoin becomes money, the government's control of money will have ended. There will be no more banks for governments to collude with. The dark age of inflation will be over. Though Bitcoin is only four years old, it has already shaken world markets. Almost anything that is sold online can be bought with it. Argentinians and Iranians use it to escape capital controls. US regulators are openly mocked on television for expressing the possibility of regulating it. Its growth is already astonishing, and as it grows, it only becomes more useful. It is like the Blob. No one can stop it.
The black market is flowering to a degree that would have seemed impossible a few years ago. By relying on Bitcoin and Tor, the Silk Road website hosts a market for contraband. It does not have to hide its existence. This supreme website remains open to all in self-assured defiance of the war on drugs. The State cannot discover where it is hosted. Its bank account cannot be shut off.
This is the world we live in. Bitcoin is a game-changer. It challenges the status quo around the world. That is what is possible with cryptography. Yet Bitcoin is only an application of what I have described in chapter 1. Bitcoin is not just an online forum with secret emoticon signals or something. It is a real-life community and a real-life commodity, though it is built only upon a cryptographic protocol and some software that implements it. Vastly more is possible. Any community that is founded upon cryptography might be as powerful as Bitcoin. All that is needed is a new application.
The Bitcoin network provides us with an example of libertarian legislation. The Bitcoin protocol is a law that anyone who interacts with the Bitcoin network must adhere to. Otherwise, the network will not accept him. Its author is not an elected representative, but an anonymous genius who simply left his proposal for us to adopt.
As a matter of libertarian strategy, we should convince people to use cryptography more generally. We can do this by making new cryptographic products and making them so that people will love them. The more that people are used to the idea of a cryptographic community, the more that they will demand it. The more they get, the less powerful the oppressors become. We need a cryptographic stock market. We need a cryptographic system of contract resolution. We need a cryptographic credit-rating system. We need a cryptographic social network.[5] All of these dreams are possible, and much more that is still beyond my imagination. None require winning an election, but each could change the world.
Chapter 4: The Risk From the Software Industry
Nakamoto, S., "Bitcoin: A Peer-to-Peer Electronic Cash System", 2008. ↩︎
Miers, I., Garman, C., Green, M., Rubin, A., "Zerocoin: Anonymous Distributed E-Cash from Bitcoin", 9 Apr 2013. ↩︎
See Gertchev, N., "The Moneyness of Bitcoin", Mises Daily, 14 Apr 2013 for an article that substitutes subjective preference for economic theory. See Korda, P., "Bitcoin: Money of the Future or Old-Fashioned Bubble?", Mises Daily, 9 Apr 2013 for a lot of irrelevant non sequiturs. See Shostak, F., "The Bitcoin Money Myth", Mises Daily, 17 Apr 2013 for the most absurd Bitcoin article I have ever seen. ↩︎
See Šurda, P., "Economics of Bitcoin: is Bitcoin an Alternative to Fiat Currencies and Gold?", 2012 for an excellent and detailed analysis of Bitcoin. Also see the author's blog. See Graf, K., "Bitcoins, the Regression Theorem, and that Curious but Unthreatening Empirical World", 23 Feb 2013 for a wonderful discussion of Bitcoin and the regression theorem. Also see that author's blog. ↩︎
There is a wonderful program called RetroShare that replicates many of Facebook's features over an encrypted, distributed network with no central server. However, this program still needs a lot of work before it has a chance of becoming popular. ↩︎
Public-key cryptography is the greatest tool of liberty ever devised. Its discovery was revolutionary. Before then, all cryptography was just hacks. It was developed in 1973 by Ellis, Cocks, and Williamson at researchers at CGHQ in the UK, but this work was classified until 1997. It was developed independently 1976 by Rivest, Shamir, and Adleman at MIT. Their work was published, although it was protected by a patent until 2000. Finally it is free.
To understand it, however, it will be necessary to go over the basics of symmetric-key cryptography, which is the sort of cryptography we are intuitively familiar with, the kind that has existed since antiquity. Once the limitations of symmetric-key cryptography are understood, then public-key cryptography will seem like magic.[1]
Begin by thinking about the idea of a simple substitution cypher. This means that the message is a string of text and encryption consists of replacing each letter with a different one. For example, can you solve the following code?
JHBYEUXRBLPDWJXOBELNEHNTBFYDJHBWDCYUWJWLNUUWZBDJXLYERWRJRWEIBBCWEGJHBWDOYEBXWEJHBWDYSECYLIBJRUXRNEMBDRCYYEBD
Two things to note here. First, this algorithm is insecure. Regardless of how the letters are replaced, it would be easy to decipher, especially with a computer. We will need something much more complicated to make a message that is secret enough. More importantly, however, is that knowing the sequence of letter replacements is sufficient both to decrypt and to encrypt a message. It is, in fact, impossible to know how to encrypt a message without simultaneously knowing how to decrypt it.
This is the essence of symmetric-key cryptography: it is impossible to know how to encrypt a message without knowing how to decrypt it, and vice versa. This is a real problem. If, for example, my enemy got ahold of one of my secret messages and managed to decipher it, he would not only be able to read the rest of my messages but make new ones, perhaps to trick me and my friends.
However, more fundamentally it is a problem because if the only encryption we know is symmetric-key encryption, then there is no way to relay message at all. Two confederates have no way of talking to one another to establish a secret protocol which would not give up everything to an interloper. We must already possess a secure means of communication in order to securely discuss a symmetric-key code! But if we had that, then the problem would already be solved.
Symmetric-key cryptography is thus really useful only for keeping secrets to yourself and away from all others. The moment you let someone else in on it, you have created a security hole. You do not know who might be listening, and you do not know who else may get the secret from your confederate.
Let us think about how to improve upon the substitution cypher. One of the most obvious tricks we might try is to replace letters in blocks of two rather than individually. For example, AA might become QF and BB might become LV. This would be much more secure although still easily broken with the help of a computer. We might then try replacing letters in blocks of three or four. Eventually we would reach a point that would be impossible for even a computer to break in a reasonable time.
However, the problem with this method is that the larger the block we use, the larger is the list of substitutions. A block of two requires 26^2==676 replacements. A block of three would take 17,576 replacements, and block of four would take almost half a million. A computer could not break such a code, but to communicate such an enormous list would not be at all practical to do securely.
Instead, we might try to concoct an algorithm that jumbles up a block of four letters in some way that would be very difficult to guess but which can be described in a very short message. This really opens up new possibilities: because a substitution cypher is given simply as a list of replacements, it is inherently a symmetric key algorithm. Whereas, if a cypher is given as an algorithm, and if the set of replacements it defines is so enormous that it could not practically be enumerated, then the properties of the algorithm can utterly change the properties of the cypher.
For example, suppose you could design an algorithm that can run in a fraction of a second but whose inverse algorithm would takes millions of years. If you had something like that, you could safely explain it to anyone and without fear that the message would be decrypted. Not terribly useful because no one, even me or my friends, can decrypt any messages at all! Still interesting, though.
However, there is an upgrade to this idea that makes it useful. Suppose there are two algorithms which are inverses of one another. Both are fast to do forward and very slow to reverse. One algorithm can be used to encrypt and the other to decrypt. I keep the decryption algorithm secret but let my friends see the encryption algorithm. Now they can send me messages but only I can read them, and I have not given away any secrets that I cannot afford to have compromised. In fact, I can let my enemies see the encryption algorithm too. They can do nothing with it but make their own messages to me.
The final upgrade is that everyone has two algorithms. Everyone keeps one algorithm secret and publicizes the other. How can we discover so many algorithms? Typically there is a class of algorithms, each of which is specified by a number, or key. So we each have a public key and a private key. This is public-key encryption.
Now any two people can communicate securely even if they do not begin with a secure channel. An enemy may have his ear right in our faces, but he can understand nothing of what we say to one another after we have exchanged public keys.
The magic of public-key cryptography comes from the fact that it gives people the ability to prove that they have a secret without revealing it. Think about how paradoxical that sounds for a moment. Yet it is quite easy to understand now. If I wish to verify your identity, I simply send you a message encrypted by your public key and ask you to tell me what the message said. Only the holder of the private key can answer the question correctly.
This seems nonintuitive to us because our technology does not rely on it. The fact that we still use such primitive technologies today like credit cards, which have their number printed right on them, or forms of identification such as social security numbers is backwards. They have been obsolete for decades. There should never be a reason to show your password or identity number to anyone else, ever.
The reason public-key cryptography is so empowering to the individual is that you prove your identity only with your consent. A private key is not like an ID card that can be demanded at any time and forced out of you if necessary. You choose which groups you wish to belong to and you can keep your membership secret.
There is a slight problem here. If there is a third party listening when you exchange public keys, he sees which public keys are exchanged. Even if he does not see you prove your identity, won't that be enough for him to assume that the public keys correspond to the private keys? This is easily resolved because the key that you use for authentication does not have to be the same as the one used to establish a secure channel. You can even generate a new key randomly with each conversation and then authenticate yourself with your permanent private key.[2]
There's more. If you use your private algorithm on a message encrypted with your public algorithm, you get the original message back. Since the two algorithms are inverses of one another, you could also use your private algorithm on a unencrypted message to get an encrypted message that can only be decrypted by your public algorithm. The result is an encrypted message that is veritably mine. This is the idea behind a digital signature.
The use of a digital signature is that the community can require them for certain kinds of communications, for whatever it considers important for establishing the reputation of its members. Messages can be digitally signed by several people, so they can be treated as contracts or records of a trade. Each member's history can be public and unforgettable.
A real digital signature is slightly more complicated than what I have described here. Normally one would not encrypt an entire message but instead a short of the message. The message is sent with its encrypted hash. The effect is the same because the message is still indelibly tied to the sender.
A community which combines cryptographic secrecy, public-key authentication, and digital signatures is a voluntary community tied together by contracts and reputation. It requires no central authority because the records it relies on to establish reputation can be stored on many different computers. Thus, it is resilient against government attack. Banishment is the only punishment the community has available.
This is libertarianism. It is exactly what libertarians have always yearned for. If we want people to get used to the idea that they can brush government aside and that freedom of association and privacy are inherent in the nature of reality, all we must do is build cryptographic communities. There is no need to speak in abstract terms with people who won't listen until we turn blue. Just build the networks and people will be attracted to them. Once people get used to them, they will demand them.
There is one other service people might want that I have not provided for: anonymity. An interloper may not know what you are saying, but he might still know that you are a member. Maybe a spy can become a member himself and try to tie a real-life person to a public key. Ideally, you might want to prevent your communications from being linked to the community at all. Anonymity is a little bit trickier to provide, but it can be achieved with services like Tor. I do not wish to go into more detail about what is possible, but suffice to say there is much more that can be built upon the basic structure I have described here.
Chapter 3: The Killer App of Liberty
Chapter 4: The Risk From the Software Industry
See Stallings, W., Cryptography and Network Security: Principles and Practice, 5th ed., Pearson Education, 2011 for an introduction to cryptography that explains everything I introduce here in detail. Or just read Wikipedia. ↩︎
In fact you would more likely you would use something called Diffie-Hellman key exchange to establish a communication channel. The principle is the same even though it is slightly different than the method I explained. ↩︎
Liberty is an ideology for everyone. It benefits all people and groups whose goals do not inherently require oppression. All objections to liberty have simply stimulated more thought into what is possible with voluntary organizations and shown more clearly how much better they are at providing services originally thought to be possible by government. Movements once believed to be wholly incompatible with libertarianism, such as feminism and environmentalism,[1] now have their own branches of libertarian thought. Liberty is a universal acid.
And yet people do not listen. The ideal of liberty is too abstract for them: most people need to experience liberty before they will desire it. For example, when Napster was invented, suddenly people around the world could ignore the oppression of copyright. They tasted freedom and the taste was sweet. Once they had experienced it, they would not give it up.
The goal of the libertarian entrepreneur is to give others that taste, not by influencing politics but by making politics irrelevant. It is to build capital goods for agorism, so that agorism can be brought to the masses. This requires a principled approach which is narrower than the nonaggression axiom without contradicting it. There is more to be concerned about than whether an organization is voluntary: two forms of organization may be equally voluntary but unequal in their vulnerability to government attack.[2]
For example, suppose the people in a community came to adore a company whose services require that they give up control of their land or their weapons to it. Such a system could, in theory, remain completely voluntary, but only a fool would think it likely. Such a company would be easily corrupted, either by transforming itself into a government or by collusion with an existing government. There is no basis to criticize such a company strictly on libertarian grounds, but by the time it begins to behave coercively, it may be too late. Whereas the libertarian entrepreneur should oppose it form the start and urgently develop an alternative business model to compete with it.
The libertarian entrepreneur should identify those industries with the greatest level of risk and attempt to transform them into something less risky. There are three ways an industry can be at risk. First, if the government would particularly benefit from controlling it. There are some industries that the government likes more than others: police, education, and transportation are particularly risky. Second, if the industry is particularly centralized. The government has only to collude with its largest players in order to take it over. Third, if the industry works in a way to promote customers' dependence. If it is too inconvenient to switch from one company to another, then people will be inclined to stay dependent upon it even after it becomes corrupted.
If an entrepreneurial idea is to be adopted, it must be attractive to people who are not concerned with government risk. It is unacceptable to propose that people just stop putting money in banks and trade only in gold coins, as did both Rothbard and Mises. Libertarian entrepreneurship must simultaneously increase the division of labor and reduce risk. As successful as the homeschooling movement has been, it can never directly challenge the control of the public schools over children. An idea that promotes atomism makes everyone poorer. Not an easy sell, and self-defeating in the end too. Loners stand no chance against the state.
The strategy, therefore, is to promote decentralization by enabling people to coordinate with one another by a shared system of rules or traditions rather than through a mediator. Promote independence from particular organizations by promoting greater dependence on networks and on society as a whole.
The crypto-anarchy movement,[3] which from the beginning drew upon anarcho-capitalist theory,[4] may be summed up by the observation that cryptography gives us an enormous opportunity to spread the taste of liberty. Crypto-anarchy is not a branch of libertarian theory. It is a libertarian strategy. It is a framework for action. The cryptographic tools we have today are cheap, powerful, and profoundly individualistic. No one can hold a gun to an equation. Cryptographic software will function according to the rules of mathematics, regardless of government directives. As long as it is possible to distribute software, then cryptographic software can show people liberty.
Cryptography should be thought of primarily as a community—builder, not as a tool of secrecy. There is always something which is secret, but it does not have to be a message. Instead, it can work rather like a car key: its form is arbitrary and meaningless, but its shape is associated with a lock to a machine that cannot run without it. A machine locked by the key cannot be jump-started.
Cryptography promotes independence by reducing the need to rely on physical strength for defense. It is easy to construct a key that could not be broken by a computer as big as the Earth if it ran for millions of years. This locks the government out of the actions that require the key. Cryptography promotes decentralization by reducing the need to coordinate through third parties. A well-written protocol is enough to enable people to cooperate and to hold them to their obligations.
In a democracy, no individual vision can change the world. This is why politics is unsuited to libertarians. On the other hand, in the free market, one entrepreneur can change the world. This is where libertarians are in their element. With cryptography, one libertarian inventor can create an entire libertarian society.
Chapter 2: Public-Key Cryptography
Chapter 3: The Killer App of Liberty
Chapter 4: The Risk From the Software Industry
See Long, R., Johnson, C., "Libertarian Feminism: Can This Marriage Be Saved?", 1 May 2005 for a libertarian take on feminism. See Block, W., "Environmentalism and Economic Freedom: The Case for Private Property Rights", vol. 17, Journal of Business Ethics, 1998, pp. 1887-1899 for an argument for libertarian environmentalism. ↩︎
When I speak of "government attack," this is not to imply that the government is the instigator. The leaders of the industry may be the ones to make the first move. No matter who takes the initiative, it is still a government attack because the government is used as a weapon to change the interests served by an industry from the consumers to someone else's. ↩︎
See Ludlow, Crypto Anarchy, Cyberstates, and Pirate Utopias, Massachusetts Institute of Technology, 2001 for an anthology of works related to crypto-anarchy, both pro and con. I do not actually like this book. It explains nothing about cryptography and contains little that would not already be understood by an anarcho-capitalist. However, it is the only published book on crypto-anarchy, so at least there's that. ↩︎
See May, T., "The Cyphernomicon", 1994, by one of the earliest crypto-anarchist writers. See his "The Crypto-Anarchist Manifesto", 1988, for a brief but stirring statement of crypto-anarchy. ↩︎
My favorite part about the Bitcoin network is not that it makes society freer, more prosperous, or more just. My favorite part is that it will finally settle one of the longest debates in the history of economics: whether or not money printing and cheap credit are ever needed to stimulate growth.
Austrians know that artificial credit expansion inevitably causes a mispricing and misallocation of capital, whether it’s due to fractional reserve banking alone or in conjunction with a central bank. What is debated is the ethical legitimacy of fractional reserve banking, one side sees lending out deposits as inherently fraudulent while the other sees deposits as an especially liquid loan.
With a deposit, you are improving the custody and safe-keeping of your money and receiving other peripheral services (cashier and bookkeeping services), while at all times retaining the full availability of your money. You are relying on this service to lower the transaction costs of using your gold, silver, or government scrip. A superior service is built into Bitcoin.
With this level of perfect security and complete convenience there is no reason to deposit your money with a 3rd party. In other words, bitcoins make fractional reserve banking an obsolete technology, and bitcoin wallets are the best 100% reserve banks conceivable.
As Bitcoin adoption increases we will finally be able to “empirically validate" what Austrians have been arguing for decades: 100% reserve banking with a scarce medium of exchange prevents speculative manias, financial crises, and economic depressions.
]]>The mantra of passing an Audit the Fed bill, miring it in scandal, and “legalizing currency competition” ignores public choice economics as well as the fact that digital fiat currencies have already won the competition against metals and would win it again. We don’t need another political solution to an economic problem, what we need is a more competitive market currency. Enter Bitcoin.
Low transaction costs make Bitcoin the most competitive medium of exchange in humanity’s history, and it may be the case that a currency with even lower transaction costs is theoretically impossible. To learn more about bitcoins I would recommend our excellent Bitcoin Reader.
Bitcoin is slowly supplanting metallic and fiat mediums of exchange. It is currently transitioning from the “Innovators” to “Early Adopters” phase:
This transition is accelerated by new intermediaries, like Coinbase, that are driving down the cost of selling fiat money for bitcoins. At the same time as demand is increasing, bitcoin inflation slowed considerably due to the block reward halving:
The dollar value of all bitcoins in existence now exceeds $300 million:
This leads us to an interesting question: is the value of bitcoins a speculative bubble?
The price of fiat currencies (and the debts denominated in fiat) is the bubble that will burst; the relevant question is when the purchasing power of bitcoins will peak. The appreciation of bitcoins relative to consumer goods will slow down when the adoption rate tapers off and hoarders will use their gains to buy consumer goods. Simultaneously, fiat currencies will be in a hyperinflationary tail-spin and real interest rates will be spiking. High real interest rates will incentivize hoarders of bitcoin to buy productive investment assets and lend to borrowers now unencumbered by fiat-denominated debts. At that point bitcoin’s purchasing power for capital goods (i.e. interest rates) will decline, but the purchasing power for consumer goods will continue to drift higher due to productivity-fueled deflation.
If you're interested in getting rid of central banking I would recommend hoarding bitcoins by transferring your dollars to coinbase.com (1% fee) and sending the bitcoins you buy to a secure computer. This hoarding sets off a virtuous feedback loop that accelerates Bitcoin adoption:
(Flow chart based on Zangelbert Bingledack's post.)
]]>The graph below visually explains how the market structure for a given good or service is the result of endogenous constraints:
Our goal as libertarians is to shift economic activity away from government monopolies and towards focused firms buying and selling in spot markets. Thankfully this shift automatically takes place as society’s stock of capital increases; regardless of government intervention or political activism. New capital formation is the impetus for two trends that push the equilibrium of all industries towards decentralized markets: increasing technological sophistication and a deepening of the division of labor.
Companies and individuals cannot develop new technologies without having savings or capital set aside to engage in or finance speculative research. Once commercialized, technology reduces search and information costs (Google, Wikipedia), bargaining costs (Amazon, eBay), and enforcement costs (Visa, Paypal). Technology also weakens the asset specificity of government institutions with new tools like the printing press, firearms, computers, cameras, and crypto-currencies.
The division of labor in the insurance industry is especially important to libertarians since insurance companies are specialized in handling risks associated with life, contracts, and property. The division of labor enabled by capital accumulation has been so great that the industry evolved from only providing maritime insurance in the 17th century to covering everything from pets to political risk. The following graph highlights how insurance grows as a function of society’s wealth.
Insurance and reinsurance companies have an increasing amount of resources dedicated to preventing risks from being realized and mitigating losses when those risks are realized. These include services like fire fighting, security, and risk management. As the size of insurance carriers continues to grow, so will their incentive and ability to transact with effective private firms for what are traditionally considered government services. Insurance companies already participate in private arbitration because it is less expensive and time consuming than government courts. It’s only a matter of time before the clout of insurers engenders a completely private judicial system and government loses its primary competitive advantage: a monopoly on law.
The counterargument to this optimistic view is that governments will also have more resources and technology; counteracting any gains the private sector will make, i.e. economic growth fuels the growth of the State and we should all go Galt or agorist. This counterargument ignores government’s completely unsustainable fiscal/monetary practices as well as its inclination to tax at rates low enough to permit economic growth. The former leads to State self-destruction, while the latter ensures the continued growth of the private economy.
Given that a private law society is inevitable over the longterm, what is left for the young libertarian activist to do?
If you enjoy politics, then by all means continue to advocate ending the Fed and lowering entitlement spending. Just understand that your efforts mirror those of the White Rose; noble yet inconsequential in the grand scheme of things. There is also an opportunity cost attached to lobbying, electioneering, and otherwise yelling from street corners.
A healthier and more fulfilling approach is to maximize capital formation by:
This approach results in personal prosperity, an increase in society’s capital stock, technological progress, and accelerates the inevitable demise of governmental monopolies. Most importantly, it frees you from having to impose your acrimonious political opinions on relatives during the holiday season.
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