Why can't I see that Bitcoin Cash is a scam?

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After posting recently that the Bitcoin Cash price was up 10x from its all-time low in dollar terms (it has since set an ATH 14.7x its all-time low), a respondent was puzzled as to why I did not know by now that Bitcoin Cash is a scam.

I replied with the question, “What is the scam?” I read the response and took the time to parse it into its several distinct claims. I addressed each, quoting from my existing publications as appropriate. Such claims are often rhetorically dense, combining multiple overlapping assertions in just a few short lines. This makes it useful to unpack all of the content and distinct issues before starting. Since these are all commonly seen, I thought this might be of wider interest.

Here are the claims as I parsed them:

  1. Bitcoin Cash is a scam (and why don’t I see that?)
  2. The reply claimed that it was a scam because (presumably, for example):
  3. Bitcoin.com sold Bitcoin Cash (presumably, it should only have sold Bitcoin because that is its domain name and doing otherwise might confuse users)
  4. Bitcoin Cash is an altcoin (which is both bad and makes it clearly not Bitcoin).
  5. Bitcoin Cash favors its payment system function over its store of value function.
  6. Bitcoin Cash cannot compete with centralized payment systems.
  7. The world needs sound money more than another payment system.

Here are my responses.

1&2) The word scam is 1960s slang for fraud. Fraud is defined as: “a) wrongful or criminal deception intended to result in financial or personal gain,  b) a person or thing intended to deceive others, typically by unjustifiably claiming or being credited with accomplishments or qualities.”

None of the instances provided show such a thing. Bitcoin Cash modified the rules of the BTC chain as of 1 August 2017 by raising its block size limit and not recognizing the then-recent SegWit change. This resulted in a planned chain split. This was all clearly stated by those doing it. What was actually done was to carry out precisely the declared purpose and content of the project.

3) The Bitcoin Cash blockchain and the various developers of its peer-to-peer software implementations must be distinguished from the various companies, exchanges, and wallet services that support Bitcoin Cash. A lot of people have spent a great many years correcting this same error with regard to BTC itself. The claim that "bcash [sic] is a scam" is structurally identical to the claims of Bitcoin skeptics over the years that "bitcoin is a scam," and shares many of the same errors of conflation and quality of thought-process as the original, familiar claim.

If a wallet did present its Bitcoin Cash related services in a way that actually confused users as to which chain they were buying or using, that would be a problem. The wallet services that I have looked at have each gone out of their way to warn and remind customers that BTC and BCH are separate chains and not to confuse them, because this could result in losses for their customers. If a particular company sold one coin claiming that it was another coin, that would indeed be fraud on the part of that company, subject to criminal prosecution for fraud under existing positive law. Even if any such actual fraud did happen in some specified case, however, such events would be irrelevant to whether the BCH peer-to-peer system itself "is" a scam, which is the claim under consideration.

The various developers of BCH-supporting peer-to-peer software created a clean split from the BTC chain with replay protection and a distinct name, code, and logo. I have seen no divergence that could be described as "fraudulent" between claims about BCH and what it actually is. Overly enthusiastic, perhaps. However, this degree of congruence between description and reality appears higher for proponents than for critics. For an actual fraud, this should be the reverse.

Regarding the “altcoin” charge (4), I set out the following initial viewpoint on August 5, days after the chain split:

The minimum requirement for a process to be called evolutionary is descent with modification. Thus far, Bitcoin has gradually evolved as a single chain with modifications to its software. This split, in contrast, is Bitcoin’s first speciation event. Both BTC and BCH build on and carry forward the Bitcoin chain in a valid unbroken lineage of blocks tracing back to the genesis block.
The best chain in Bitcoin is defined as a chain of valid blocks with the greatest accumulated proof-of-work difficulty. In this model, the validity test comes first, followed by the total difficulty assessment. The software variants behind each chain have recently implemented certain substantial rule changes that are not now recognized as valid on the other chain. The BTC chain, for example, does not recognize the BCH chain’s modified block size limit, and the BCH chain omits SegWit, which recently activated on the BTC chain. Bitcoin block history diverged after block #478558, which is the last “common ancestor” that the two chains share.
The term “altcoins” has been used to denote cryptocurrencies that are not Bitcoin. Both of these chains, however, are valid Bitcoin chains as defined above. From this standpoint, the commonly expressed opinion that BCH is a new altcoin may be viewed as a use of language for rhetorical and emotional, rather than cognitive and elucidative, functions. Sharing almost all specifications and over eight years of transaction history, each is far more Bitcoin than either is altcoin…
Proponents of each chain will naturally want to claim the banner of “true” succession, much as most religious sub-sects story themselves alone as the one truest representative of the ancient founder’s original teachings (rarely acknowledging the odd coincidence that all of the other sub-sects likewise tell just such a story about themselves).

5) Generally, I find this a false dichotomy. “Store of value” is a confused quasi-economic populist idea. And there are actually three separate issues: medium of exchange, payment system, and “store of value.” As for the first and the last, I wrote on October 11:

A medium of exchange use always takes place across time and involves addressing the inherent risk and uncertainty of the future. The variables under discussion are therefore the relative amounts held, the duration of holding, and the increments of future spending of the medium of exchange. In contrast, the idea of an alleged “store of value” use often employed in this debate as if it were a contrast to a medium of exchange use is imprecise and impressionistic. Just as money does not “measure” value, as Mises emphasized, but is rather exchanged for goods at some indefinite future time, “value” cannot be “stored,” as if it were a certain amount of food. This “store of value” idea is more a weak intuitive analogy than a rigorous economic concept. Underneath this illusion, there are only intertemporal exchanges that take place over different time scales and in different amounts.

As for payment systems, 6) if Bitcoin Cash “cannot compete against centralized payment systems,” then it will fail. Yet a failed endeavor is not automatically to be considered a fraudulent one. Most entrepreneurial projects fail. Their proponents were shown to be mistaken in their beliefs about future market trends. I have also argued that such competition must include reference to what I believe is another very significant value, which I described on October 11:

Bitcoin enables people to transact without third-party intermediation. Let us call it “permissionless transacting.” Every other kind of remote transacting requires some third-party facilitation, often by a bank. But the position of facilitator comes with the ability to refuse to facilitate, whether through corporate policy or because authorities order it. It also comes with the ability to track and create a permanent record of spending, including dates, parties, places, and amounts, destroying privacy.
With Bitcoin, states can certainly take steps to outlaw certain types of transactions, but unlike with banking systems, authorities cannot block transactions to begin with. They can only seek to prosecute criminalized acts after they are committed. In societies that purport to respect due process and the rule of law, this happens to be all that such authorities are supposed to be doing anyway.

7) The world needs sound money. Absolutely it does. This is Bitcoin's greatest potential contribution. However, since money is the most commonly used medium of exchange and a unit of account (economic calculation), it could not possibly become "money," sound or otherwise, without effective, available methods of transferring it. Payment systems that provide “permissionless transacting,” as just described, are also potentially quite valuable. Systems that combine both at the same time to varying degrees would be extremely valuable.

BTC and BCH chains and respective teams have diverged across several issues that relate to how best to actually accomplish such valuable objectives, with what steps, taken in which order of priority and on what time scales.

As I argued on August 5, it is probably to the net benefit of pre-fork BTC holders to allow these differing visions to progress along their respective paths and then see where each leads in a practical evolutionary process:

In contrast to action, speculation and modeling are far more subject to partiality, bias, and social and financial pressures in the selection, construction, and interpretation of models. Action can supplement or partly displace hot air. What will happen with SegWit? Watch and learn. What will happen on a live network with a higher protocol block size limit? Watch and learn. This opportunity for the addition of progressive sequences of reality checks on the respective chains might be positive in itself. The “test” this represents is highly imperfect, as discussed below, but is still probably better than unmitigated talk.

Interview: Bitcoin, blockchains, and economic theory

Dr. Andreas Tiedke, a businessperson, attorney, and author, asked me some questions about Bitcoin for the Mises Institute of Germany (misesde.org) community. The interview covers some fundamental issues in understanding how bitcoin works as well as observations on current issues. This was conducted first in English, which is below. My German did prove sufficient to read Dr. Tiedke's resulting translation, published here. Well done!
 Image: Tony Lozano.

Image: Tony Lozano.

AT: Do you know who Satoshi Nakamoto, the alleged inventor of Bitcoin, is? Do you think it is really Craig Steven Wright?

KG: Satoshi remained anonymous with great care, most likely for good reasons. His invention could be quite disruptive. He may also control a million or more bitcoins (and now a million BCH as well) from the early days of mining to get the network on its feet. This currently has a potential market value of several billion euros. These coins have never been moved. I have seen no evidence that leads me to believe he has changed his mind on anonymity.

AT: There is a legend about an early offer to deliver pizza for 10,000 bitcoins. Do you know whether it is true? The pizza baker must now be a millionaire (about 40 million euros)!

KG: Someone offered 10,000 BTC on a mailing list to anyone who would deliver pizza to him. Someone took him up and ordered pizza from a delivery place near the asker using a credit card, doing so from another country. The pizza buyer received the bitcoins, the asker received the pizza, and the pizza delivery place received only an ordinary credit card payment. Technically then, the pizza served as an intermediary for exchanging bitcoin for the credit card payment, as bitcoin could not be used at that time to buy the pizza directly. Nevertheless, this became a milestone in people’s minds in which Bitcoin interfaced with “the real economy.”

For monetary theory, it is important to understand that for Bitcoin’s first several months of existence—nearly a year—the tradable “bitcoin” units had no market value. It was just a technical experiment. Only later did the tradable units begin to gradually gain a market value.

AT: Some believe that the blockchain has two main disadvantages: First, transactions cannot be anonymous because every transaction is stored. Second, it will become too big in the future, also because every transaction is stored. Do they have a point?

KG: All transactions are anonymous in principle in that they lack any identifying information on persons or organizations. This contrasts with banking systems in which accounts must be associated with identities—except for the old Swiss numbered accounts. There are no accounts in Bitcoin itself, only addresses and transactions. New valid addresses can be generated from scratch anywhere, even using dice.

That said, Bitcoin’s blockchain is public and it is possible to “connect the dots” to uncover identities behind transactions. Each wallet has different privacy characteristics and there are privacy best practices, such as always using a new address for receiving.

An “evolutionary arms race” prevails between privacy features and blockchain analytics. The blockchain provides a permanent record of all that has occurred on it, so analysts can just keep going over all this data at their leisure to find associations. On the other hand, several development projects aim at improving privacy. Payment codes, for example, add a layer that enables payments to be made without revealing the underlying address. For more on the privacy characteristics of current wallets, see the Open Bitcoin Privacy Project.

As to whether a given blockchain would become “too big,” that is a subjective assessment. Too big to whom and for what? Generally, the costs of data storage, processing power, and bandwidth all plummet year after year, and developers are also working hard to revise software such that it makes more efficient use of given resources. These are all important contexts for considering this.

AT: What is bitcoin in your opinion? Is it money or an asset, a capital good?

KG: This is still a challenging issue. The best starting point is to say that bitcoin is something entirely new, never seen before. As we try to understand it using the terminology of economics or law, for example, those concepts themselves have to be questioned in an interactive process. Beyond economics, I also used this approach in a short book addressing the relationship between bitcoin and property rights theory. So my approach is not only “What is bitcoin?” But also: “Do our theoretical concepts need some refining in light of bitcoin?” The alternative is a tendency to pretend to force bitcoin into some existing box into which it does not actually fit.

Another useful principle to apply was one emphasized in the work of Ludwig von Mises—economic concepts have to do with the analysis of human action. So in looking at Bitcoin, I have emphasized that it is critical to distinguish the technical “layer” from the economic one. For example, Bitcoin existed as a technical system for nearly a year before its tradable units gained any market value. And it was nearly two years before it gained any appreciable use in the buying and selling of goods. So clearly these economic valuations emerged on top of what was already there, which was this technical layer. That means people began to figure out that they could begin to make certain economic uses out of this technical thing that was already running. Exchange values and trading venues gradually co-emerged.

I argued here that bitcoin gained market value for use as a medium of exchange, which means an economic good demanded not for its own sake, but to be held and exchanged for other goods or services at some indeterminate later time. Initial uses of the units before it gained any exchange value were extremely thin and require some analysis to even identify: for example, being valued as a collectible item, or as a by-product or symbol of participation in an interesting software project, a researcher plaything, in the earliest days.

Some have come to view bitcoin today as more of an asset. Rather than cash to use for day-to-day transactions, it is more a larger-value vehicle held in reserve. Of course, different people have used it in both ways and the same people also use it in both ways at different times. Both uses are possible so long as it maintains a positive exchange value and some reasonable liquidity. The value of the supply being unchangeable can overcome some degree of other inconveniences.

However, these categories are not exclusive, but on a continuum. A medium of exchange use always takes place across time and involves addressing the inherent risk and uncertainty of the future. The variables under discussion are therefore the relative amounts held, the duration of holding, and the increments of future spending of the medium of exchange. In contrast, the idea of an alleged “store of value” use often used in this debate as if it were a contrast to a medium of exchange use is imprecise and impressionistic. Just as money does not “measure” value, as Mises emphasized, but is rather exchanged for goods at some indefinite future time, “value” cannot be “stored,” as if it were a certain amount of food. This “store of value” idea is more a weak intuitive analogy than a rigorous economic concept. Underneath this illusion, there are only intertemporal exchanges that take place over different time scales and in different amounts.

AT: Why the division of Bitcoin and Bitcoin Cash?

KG: The BTC/BCH chain split was one outcome of a disagreement over a protocol limitation on the maximum size of each block added to the chain. I have written about political-economic considerations on the block size limit here, as well as a follow-up series addressing common criticisms starting here.

The “cash” side emphasizes that it is important for people to be able to transact in bitcoin without too much difficulty, and that this usability is an important component of its value. The “digital gold” side emphasizes the idea that such convenience is not especially important compared to a secure vehicle for long-term savings—adding that anyway, promised “layer 2” transacting options should supply these additional practical needs in the future, still denominated in on-chain bitcoin. A widespread belief underlying the conflict is that these are somehow contradictory visions rather than complementary ones.

AT: After the recent sharp rise in the bitcoin exchange rate, some people now warn against further investing in bitcoin and some even say this could be compared to the tulip mania in 17th century Holland. Your thoughts on this?

KG: This is exactly what the same people always say, year after year, and Bitcoin is still going strong, closing in on nine years with basically no downtime. I first came across this argument in spring 2013 in the run-up to about $250, but apparently it had already been expressed in 2011 in the run-up to about $30. It may be fair to argue at times that the bitcoin price is in a bubble phase, but it is another claim entirely to argue that the thing itself is a bubble—and nothing more.

My sense is that this kind of “nothing but a bubble” thinking is often associated with minimal to no understanding of how Bitcoin works on a technical level. In the absence of such understanding, these critics can only envision a vague nothingness in place of Bitcoin’s technical underpinnings. Yet since many clear descriptions are now available for free online from beginner to advanced, such claims seem to indicate a willingness to comment without learning.

AT: Some think that blockchain technology will have huge consequences for society in terms of decentralization. They say that this technology will give small, decentralized entities an edge over big centralized organizations. Some even say that the existence of big companies like Google or even states could be threatened by blockchain technology. Do they have a point?

KG: From my perspective, there are two main implications of the first blockchain. First, bitcoin units are a medium of exchange and potential form of money that has arisen from the private sector—actually the informal sector—not from the state. This deflates the old chartalist claim that money can only come from the state, or at least can survive only with the state’s blessing. In contrast, it took states years to even start to notice it.

Second, Bitcoin enables people to transact without third-party intermediation. Let us call it “permissionless transacting.” Every other kind of remote transacting requires some third-party facilitation, often by a bank. But the position of facilitator comes with the ability to refuse to facilitate, whether through corporate policy or because authorities order it. It also comes with the ability to track and create a permanent record of spending, including dates, parties, places, and amounts, destroying privacy.

With Bitcoin, states can certainly take steps to outlaw certain types of transactions, but unlike with banking systems, authorities cannot block transactions to begin with. They can only seek to prosecute criminalized acts after they are committed. In societies that purport to respect due process and the rule of law, this happens to be all that such authorities are supposed to be doing anyway—in contrast to the PreCrime Division in the science-fiction story Minority Report.

As for “decentralized” and “centralized” in Bitcoin discussions, these are first of all computer-science concepts. A network is either designed with a center, such as a conventional server/client system, or without one, in which case the center has been taken out of the design, thus “decentralized.” With Bitcoin, this mainly refers to adopting a peer-to-peer architecture and not having any central currency issuer that could manipulate supply.

I think these computer-science terms have come to be used in a vague mix-up with economics concepts such as monopoly and competition, scale and industry competitiveness. They can generate more confused ideas than useful analyses. Economies of scale in different industries, and other factors influencing relative firm sizes, are not necessarily going to magically transform because there now exists a non-state money lacking a central issuer that can be used without third-party facilitation.

AT: Could you explain what the essence of blockchain technology is? What makes it so great?

KG: I would recommend reading my article on this topic with respect to the technology and methods behind Bitcoin for a fuller picture, both of the scale of the invention and why people have such a hard time understanding it. In essence, Bitcoin combined at least four major elements, most of which were first developed within about the past 40 years. Most people do not understanding any of these elements, or maybe only one or two of them, and then vaguely. These are hash functions, digital signatures, peer-to-peer architecture, and open-source development. So of course people who understand few or none of the parts cannot hope to understand a whole that combined them into something far greater than their sum.

One key thing that a blockchain does is form an unforgeable record of past information, with new information continually being added at the end of the chain. Thus, while new information can be added, that already recorded cannot be erased or revised in the slightest way. This history cannot be rewritten. The fact that the tradable bitcoin units have a market value is also essential to financing the mining network in a decentralized way. The system’s security and the unit’s market value are interdependent.

There has been a movement to define “blockchain” as the “real” innovation of the Bitcoin system, with the bitcoin (monetary unit) part being just sort of one silly initial idea for using a blockchain. According to this view, it is the “many other applications” and different sorts of “tokens” that are really exciting. I think this is completely backwards.

While it is true that a blockchain design might have some useful applications other than digital cash and if these are indeed made to work in practice and gain real users, that would certainly be positive, a blockchain is an extremely cumbersome and expensive thing. This means there ought to be compelling reasons for using a blockchain rather than a simpler, faster, and cheaper design. The blockchain design was created to solve a very specific problem—how to create scarce digital cash with no central issuer. For most applications other than digital cash, however, a blockchain is probably wasteful, unnecessary, and over-hyped—unless proven otherwise through actual use as opposed to marketing pitches.

AT: It is said that the core of blockchain technology is the math behind it. The solution to the so-called “Byzantine Generals Problem”. Could you describe what this problem is and how blockchain technology solved the issue?

KG: The problem is how to get different people in different places to agree on the validity of a given piece of information without relying on communications that could be compromised and falsified at source, in transmission, or both.

The lynchpin of the solution that Satoshi found was in a characteristic of hash functions. A hash is a “one-way function.” Information goes in and one specific hash of that information comes out. However, the hash cannot be used in the other direction to reconstruct any of the original information.

In Bitcoin, miners have to find a hash that is below a certain value. Visibly, it has to begin with a certain number of zeros.

000000000000000000aebd4d821ad8ee2ef30c4aaccc7619ce309d8570f7fb9b

The “difficulty adjustment” changes this threshold. The miners have to increment a random number field and keep looking for resulting hashes until they find one that is below a certain value. It is unimaginably difficult to come up with a valid hash within the difficulty requirement to begin with. It takes billions of trial and error attempts to do so. However, it is trivial to check afterwards whether a given proposed hash is valid for the block.

So solving the hash of the next block (“mining”) is extremely difficult. And the solution cannot be forged or falsified because anyone on the network can quickly verify whether a proposed solution is valid. A valid solution serves as a proof that work must have been done to find it, and is therefore called a “proof of work.” There is no short-cut way to arrive at a valid hash other than doing the hashing work, which means investing in facilities and equipment and consuming electricity to brute force the hash for each specific block candidate.

So returning to the “Byzantine Generals” situation, with proof-of-work, an invalid message can always be revealed as such because it can be checked using the information in the message itself, after it arrives. The message as it arrives contains all the information needed to establish whether it is a valid message or not in relation to the chain it proposes to extend. There is no need to establish whether it was falsified in transmission. It does not matter if it was. It is still either valid or not as it presents itself wherever it arrives.

Another key trick to make this work is that each miner’s valid hash is only valid for that miner because his own reward address is already incorporated into his candidate block before the hash is found. That reward address is part of what is being hashed. Therefore, no others validating a proposed answer can just expropriate it for their own benefit. That particular answer they are examining already builds in the winning miner’s own address for collecting the block reward being sought.

AT: Bitcoin has a limit of 21 million bitcoins that can ever be mined. But in August, the Bitcoin blockchain was split into Bitcoin and Bitcoin Cash. So, isn’t the production potential limitless, then, like with central banks? And even out of the Bitcoin blockchain, limitless other digital coins could be created. Couldn’t this threat the value of the Bitcoins?

KG: This is a fascinating topic and I also wrote an article about it here. Essentially, both bitcoin (BTC) and bitcoin cash (BCH) are valid continuations of the previous Bitcoin blockchain, but the two are now permanently separated. They can never interact again as the same chain. It is a little like speciation in the natural world. Though long-separated groups of life forms share a common ancestor in the distant past, they have changed such that when descendants meet again later, they can no longer interbreed—and this is irreversible. In this case, a Bitcoin “speciation” event happened on August 1, 2017 when blocks were found that some versions of the software found valid and other versions did not find valid because of specific differences in the rules those respective versions were enforcing.

As for the claim that this split was inflationary, I will quote from my article on this, because I don’t think I can say it better a second time:

“Zero ‘new bitcoins’ have been created from a monetary-inflation standpoint. Control of any existing bitcoin unit before the split gave rise to corresponding control of one BTC and one BCH unit after the split. Since this reflected the precise and complete pre-existing constellation of unit control with no alteration for each and all former holders of the single-chain BTC, no redistributive Cantillon effects follow.”

Cantillon effects, for those unfamiliar with the term, refer to changes in the distribution of wealth among money holders when new money goes first to some users rather than others. In this case, every existing BTC unit became in the same moment one BTC unit and one BCH unit for each holder.

I have also argued that the fact that combined prices of BTC and BCH rose in the weeks that followed, and dramatically, may suggest net value added for holders. This could be because of a market perception that the various development teams can now proceed more smoothly with their respective scaling visions, and we can see what actually becomes of these efforts in reality, rather than being limited to models, talk, and promises.

Of course, anyone could split a chain at any time and continue it with certain modified rules, but it is an entirely different matter for such a chain to gain any economic value, and particularly any investment of scarce SHA256 mining power. The most likely outcome is just that no one mines a fork and it does not continue: extinction.

Yet both BTC and BCH chains have survived to the present time. BCH has maintained a market price that has ranged from $200–900, and is currently about $350. In quite recent memory, that was considered a high price for the pre-split BTC. This outcome was not at all a given.

An infinite number of new chain splits without any real economic justification or real-world support from miners should just result in an infinite amount of nothing happening, as each one dies off quickly or never really gets started. For daughter chains that do survive—in this case BTC and BCH both have—this survival itself may imply some perceived net value added for holders of the pre-split coin. The two are now competitors, along with all the other cryptocurrenices. This chain split was quite distinct from the crop of many hundreds of other cryptocurrencies, which are new chains started with their own rule-sets and fresh structures of coin ownership.

AT: Bitcoin detractors contend that the volume of Bitcoin trade is limited and the technology could not manage the number of transactions that take place with fiat money every day. What do you think?

KG: The volume of bitcoin transacting on the BTC chain has come to be artificially limited relative to demand by a 1MB block size limit that has been in place since 2010. BCH was one effort to address this by raising the protocol block size limit to 8MB. That is a level that is once again well above current regular demand, as it was for the limit’s entire previous history until recent years. Another effort to address transaction volume entails building cryptographic systems that enable trading that is “off-chain,” but purportedly preserves the quality of permissionless transacting denominated in bitcoin.

I do not see any contradiction between these models, as I have explained here, but since many involved do seem to treat these more as competing than complementary approaches—and have made a competitive sport of belittling and insulting those whose views differ on this matter—this has contributed to the chain split, possible future chain splits, and the overall level of political-style contention.

My own take is that on-chain and various existing and proposed off-chain options should be treated as dynamically limiting competitors in a relationship of synergy and competition. If an off-chain option actually offers superior characteristics in terms of cost and speed, it will naturally draw some business off the main chain, reducing on-chain traffic (and fees). This could enable certain types of traffic off chain that would not have taken place on chain.

At the same time, the off-chain options themselves require some on-chain transactions, for example, to open and close payment channels or to create a unit link with a sidechain. If such options come into wide use, they could in turn lift on-chain traffic themselves. So the factors operate in both directions and in unpredictable ways. On- and off-chain options can both create business for each other and take business away from each other in a complex and unpredictable interaction. The presence of both expands the sphere of end-user choices. In this kind of situation, on-chain and off-chain options ought to be free to compete with each other in practice, as opposed to “competing” within models and promising-contests.

I view the block size limit as it now stands as artificially favoring off-chain solutions in the context of this natural competition for traffic. Promoting the continuation of an industrywide ceiling on the provision of on-chain transaction-inclusion services has lifted the price of on-chain transacting well beyond what it otherwise would have been at this early stage of Bitcoin’s development. Numerous Bitcoin businesses have left the BTC chain due to this, at least for now.

Meanwhile, most of the promised off-chain second-layer ideas are not actually available for users yet. Nor is there any guarantee how much users will adopt these when they do arrive. These solutions work remarkably well in the minds of the people building and promoting them and in the imaginations of others who look forward to their arrival. However, such beliefs can never replace an actual market adoption test. Nevertheless, on-chain capacity has already been left restricted today relative to growing demand before promised alternative transacting solutions have a) arrived and b) actually been adopted by users.

One result has been a ballooning of the market value of other cryptocurrencies. As the retention of the current block size limit on the BTC chain has pushed actually working Bitcoin business models away, BTC has fallen from about 85–90% of the total valuation of all cryptocurrencies to 45–50%. This is so despite BTC’s overwhelming first-mover advantages in network effect and active developer talent. First-mover advantage is quite powerful, but it is not all-powerful.

AT: An article in the Swiss newspaper Neue Zuricher Zeitung covers a conference of economists in Vienna where Bitcoin critics met. Several arguments against the future of Bitcoin were made, amongst others from Adi Shamir, who is said to be one of the co-developers of the cryptographic basics on which Bitcoin technology was built. He states that there are not enough Bitcoins because the number is limited to 21 million. To my knowledge, Bitcoin is dividable nearly endlessly. And, as Murray Rothbard said, that once money has been established in the market, every quantity is “optimal." There is no social profit in increasing the money supply. What are your thoughts?

KG: As you point out, there are two separate issues, divisibility and inflation. First of all, the actual unit used within Bitcoin software is called a satoshi, and the maximum number of those is 2.1 quadrillion (2,100,000,000,000,000). That is 280,000 units per person on Earth at the current global population of 7.5 billion. A “bitcoin” is just an arbitrary accounting unit of 100,000,000 satoshis, and one that the Bitcoin system itself does not even recognize. Wallets and exchanges use the convention of a “bitcoin” only for intuitive convenience.

Off-chain systems such as payment channels could already increment even smaller amounts. It would also be possible to alter the Bitcoin software so that it directly recognizes units smaller than a satoshi, though there is no guarantee this would ever be done.

Other than these issues of divisibility, most people complaining about limited supply are just inflationists and I wrote about them here. The opposite of inflation is deflation, which for most practical purposes means that the monetary unit is gaining value rather than losing it. Although the total bitcoin stock will continue to expand for quite some time, its rate of expansion steadily declines, eventually reaching zero. Nevertheless, it can still be viewed as deflationary in the sense of having a rising purchasing power over time. The great Jörg Guido Hülsmann described why such rising value is so significant for society in Deflation and Liberty:

“Deflation…abolishes the advantage that inflation-based debt finance enjoys, at the margin, over savings-based equity finance. And it therefore decentralizes financial decision-making and makes banks, firms, and individuals more prudent and self-reliant than they would have been under inflation. Most importantly, deflation eradicates the re-channeling of incomes that result from the monopoly privileges of central banks. It thus destroys the economic basis of the false elites and obliges them to become true elites rather quickly, or abdicate and make way for new entrepreneurs and other social leaders…
Deflation is at least potentially a great liberating force. It not only brings the inflated monetary system back to rock bottom, it brings the entire society back in touch with the real world, because it destroys the economic basis of the social engineers, spin doctors, and brain washers. (pp. 40–41).”

Here is that word “decentralize” again, this time in an explicitly economic rather than computer-science context. Deflation “decentralizes financial decision making” means that people who spend their own saved money instead of spending borrowed money (or state handouts) have more autonomy and independence. This is because they do not have to seek the approval of creditors or VCs (or welfare bureaucrats) with regard to whether they get funding and how they use the funds. Yet this distinction also applies to any size of entity that is in a position to invest its own money instead of someone else’s, to act using savings rather than debt. A rising-value unit encourages savings while falling-value units—such as all fiat currencies—encourage debt and unhealthy dependence.

Bitcoin has arrived as the first rising-value medium of exchange seen in a long time. Inflation- and debt-addicted and dependent governments would certainly never have created such a thing.

BTC plus BCC showing strong combined gains as market attention shifts to next controversy

The combined price of bitcoin (BTC) and bitcoin cash (BCH) has risen about 75% since the formerly single Bitcoin split into two chains on August 1.  Events thus far appear to support my suggestion that the split could well be a net positive for holders of bitcoin prior to it.

In my August 5 article, “Descendants with modifications: Bitcoin’s new and possibly beneficial evolutionary test,” I argued that a marginal shift away from talk and toward innovative action could in itself prove a net positive. To at least some degree, an actual split would enable claims that one approach or another was superior to be replaced with practical reality checks across the board.

However, I also emphasized that the split was still a poor “test” from a scientific standpoint. Not only do the chains differ in headline qualities—one is activating SegWit and the other has revised its block size limit to 8MB (already two major variables in themselves)—but also in a whole list of other confounders. For example, the two chains differ in associated development teams and testing and review practices, which leads to contrasting levels of market confidence in the different code bases as a whole. This reflects far more than just the headline contrasts. In addition, the two started out with widely differing hashing power levels and coin prices. Nevertheless the split should provide some way to proceed with implementing respective visions of how innovation should progress, and to that extent could well beat a continuation of “unmitigated talk.”

Since that article appeared, the BTC price first rallied dramatically while the BCH price languished. One megabyte block size limit enthusiasts on social media sought to out-compete each other in boasting about how decisively they would “dump their bcash" (using a popular term of insult for bitcoin cash) as soon as they could. When trading in bitcoin cash finally came up to speed on exchanges, such commenters promised, BCH would crash as dumping of the latest new "altcoin/shitcoin" began in earnest. Since then, one by one, various cryptocurrency exchanges and wallets have announced support for BCH, with more to come.

In the event, the BTC chain still has its own dramas to live through. A stark reminder of this came with a blog post by BitPay instructing users in how to move to software that implements phase 2 of the “SegWit2x” or “New York” agreement, which calls for a revision of the BTC chain’s block size limit to 2MB in November, following phase 1, its recent activation of SegWit.

Full-fledged American-style “outrage politics" ensued against BitPay, as opponents of the block-size limit revision portion of the SegWit2x framework accused BitPay of fraud for not clarifying that moving to the BTC1 software it was recommending to its customers would split them off from the portion of the BTC network running Bitcoin Core software. Bitcoin Core software has merged code that disconnects Bitcoin Core nodes from BTC1 nodes. Few to no active Bitcoin Core contributors support the BTC1 project while a significant number of miners and bitcoin companies expressed support for the SegWit2x agreement.

It is unclear how this will be resolved. Intransigence and belligerence reign on social media between the vocal on the two "sides." Another chain split is possible, once again over exactly the same issue, the specific height of the block size limit. This next split, however, might be less clean than the last, which did have critical user protections in place, notably replay protection. A scenario in which BTC1 and Bitcoin Core navigate into an unclean chain split has the potential to leave Bitcoin Cash looking like the more stable option for the time being. With a limit revision already behind it for now, it could end up sitting on the hill overlooking the next BTC chain battle with a detached attitude of: "Bitcoin Cash user unaffected."

After the BitPay post brought this next controversy facing the BTC chain back onto the front burner of the market's attention, the BCH price promptly more than tripled from $300 to briefly peak at over $1,000, while the BTC price began to soften slightly.

The BTC + BCH total price, however, has continued to rise steadily for the time being (see chart). As of this writing, the combination remains more than $2,000 higher than before the chain split.

BTCBCC speciation chart.jpg

Looking ahead, much will depend on the interplay between hashing power, mining difficulty, and price. The dynamics of differences between the mining difficulty adjustments on the two chains could have some dramatic effects as mining power shifts in pursuit of profitability, resulting in follow-on differences in block discovery times.

As I concluded my discussion on August 5, so I will conclude this one: “The complex sequence of outcomes to ensue must now be seen in practice and over time.”

[Update: The original version used BCC for Bitcoin Cash throughout, but this code was already in use by another cryptocurrency. Since that time the Bitcoin Cash community has clearly shifted to BCH, so in this text I have changed to BCH where simple to do so (not in the title and graphics).]

Descendants with modifications: Bitcoin’s new and possibly beneficial evolutionary test

 Source: Charles Darwin. 1845. "Journal of researches into the geology and natural history of the various countries visited by H.M.S. Beagle."

Source: Charles Darwin. 1845. "Journal of researches into the geology and natural history of the various countries visited by H.M.S. Beagle."

The BTC/BCH chain split of 1 August 2017 could add value for holders of the former bitcoin during any period in which the summed value of each coin exceeds the value that the former single coin would have had. Holders of BTC before the split came to hold equal amounts of BTC and BCH after the split, prior to any subsequent individual trading.

Zero “new bitcoins” have been created from a monetary-inflation standpoint. Control of any existing bitcoin unit before the split gave rise to corresponding control of one BTC and one BCH unit after the split. Since this reflected the precise and complete pre-existing constellation of unit control with no alternation for each and all former holders of the single-chain BTC, no redistributive Cantillon effects follow.

This split looks like a better-case scenario, at least “less bad,” than several of the other fork types proposed and discussed over the past months.

At this early phase, bitcoin cash (BCH) trading remains nascent, as exchanges and wallet services work to serve customers in a post-split environment. Potential traders remain limited because many exchanges do not yet offer BCH account crediting or have temporarily disabled relevant withdrawal and deposit options.

Various partisans have already claimed that as soon as normalized trading is achieved the BCH price will either collapse or rally, or some sequence of both. Pre-split futures and post-split exchange data (such as it is) have thus far shown an approximately $250–500 range for BCH. The bitcoin (BTC) price hardly reacted from its recent pre-split range of approximately $2,600–2,800. Either way, relatively wide changes to the BCH price are likely to be the rule until at least some time after normalized trading options come on line and hashrates and difficulty levels settle out to a greater degree.

The summed prices of BTC and BCH have mostly exceeded the former BTC all-time high, hinting at possible net value added from the split. This could be illusory due to the poor trading environment, but this sum could also have been lower instead, particularly if viewed as a network, mining, and trading disruption: the BCH price range could have started lower than it did, the BTC price could have fallen unmistakably, which it did not—or both.

Looking ahead, hash rates and difficulty adjustments are other key points to watch. Although the BCH chain protocol revisions did add certain more flexible mining difficulty adjustment methods, it remains to be seen if this will be sufficient to prevent very long block times over the coming weeks, which, amid price declines, could further reduce mining profitability on the BCH chain for some time. The future allocation of hash power, pace of difficulty adjustment, and price all remain to be seen.

Separate from these temporary and news-oriented issues, in the balance of this article, I will interpret the chain split in more fundamental terms.

Potential net value added from innovation and experience effects

If a net value gain from the split is actually present and does persist, such an outcome would not be entirely mysterious. Innovation proceeds through action far more than talk. SegWit activation (BTC chain) and a substantial block size limit increase (BCH chain), respectively, both promise to partially replace months and years of talk with action and experience, which is, in general, bullish for innovation.

In contrast to action, speculation and modeling are far more subject to partiality, bias, and social and financial pressures in the selection, construction, and interpretation of models. Action can supplement or partly displace hot air. What will happen with SegWit? Watch and learn. What will happen on a live network with a higher protocol block size limit? Watch and learn. This opportunity for the addition of progressive sequences of reality checks on the respective chains might be positive in itself. The “test” this represents is highly imperfect, as discussed below, but is still probably better than unmitigated talk.

The misleading conventional understanding of innovation is that practice follows theory; that “basic science” comes first and then begets technological innovation. The historically far more common process of innovation has very often followed the opposite pattern. Some fundamental innovation attempts occasionally succeed (mostly they fail). After the rare successes, new theory and research come along to try to explain and formalize what entrepreneurs and tinkerers had already done (after the best pontifical efforts of old theory to prove that what had been done could not have been).

Descendants with modifications

The minimum requirement for a process to be called evolutionary is descent with modification. Thus far, Bitcoin has gradually evolved as a single chain with modifications to its software. This split, in contrast, is Bitcoin’s first speciation event. Both BTC and BCH build on and carry forward the Bitcoin chain in a valid unbroken lineage of blocks tracing back to the genesis block.

The best chain in Bitcoin is defined as a chain of valid blocks with the greatest accumulated proof-of-work difficulty. In this model, the validity test comes first, followed by the total difficulty assessment. The software variants behind each chain have recently implemented certain substantial rule changes that are not now recognized as valid on the other chain. The BTC chain, for example, does not recognize the BCH chain’s modified block size limit, and the BCH chain omits SegWit, which recently activated on the BTC chain. Bitcoin block history diverged after block #478558, which is the last “common ancestor” that the two chains share.

The term “altcoins” has been used to denote cryptocurrencies that are not Bitcoin. Both of these chains, however, are valid Bitcoin chains as defined above. From this standpoint, the commonly expressed opinion that BCH is a new altcoin may be viewed as a use of language for rhetorical and emotional, rather than cognitive and elucidative, functions. Sharing almost all specifications and over eight years of transaction history, each is far more Bitcoin than either is altcoin. Some new term may be required. For example, in a public draft article, Daniel Krawisz, a long-time altcoin critic, has quite recently suggested the term "bitcoin child" to specify any chain that traces its history back all the way to the Bitcoin genesis block, a category that now includes BTC and BCH, but no others.

Proponents of each chain will naturally want to claim the banner of “true” succession, much as most religious sub-sects story themselves alone as the one truest representative of the ancient founder’s original teachings (rarely acknowledging the odd coincidence that all of the other sub-sects likewise tell just such a story about themselves). Regarding coin names, it is sufficient if the tradable units of the two chains are named in such a way that those using them now or in the future do not encounter any practical confusion. Bitcoin (BTC) and Bitcoin Cash (BCH) appear sufficient for this. For continuity, Bitcoin dominance indices might choose to sum the valuation estimates for the two post-split Bitcoin chains, perhaps after trading normalizes and if it appears that both will persist for some time.

Of most practical relevance now is the quality and prospects of the existing chains, as they have actually come to exist, moving from the present into the future. Practical measures of their prospects center on hash rate and unit price trends.

Rather than relying primarily on such ever-shifting market criteria, however, I prefer to begin by examining what defines the respective chains themselves. If we are talking about mining, mining what? If we are talking about price, the price of what? Identification properly precedes evaluation. In this case, a comparative identification is natural given the context of descent with modification, in which common features far outnumber differentiators.

Which chain is the “truer” successor is, in principle, not especially important in direct analytical terms. It might be useful as sociological research into the study of the development and spread of beliefs, or somewhat more useful than that as a source of hints for investors as to likely relative popularity based on belief frequencies in relevant user populations (meme frequency).

Nevertheless, BCH’s critics have taken to consistently labeling it an altcoin (which it is not), and moreover asserting that it is impossibly distant from being any true and proper successor of the one real bitcoin, which they believe the BTC chain unquestionably is. In this context, it should at least be noted in counterpoint that from a strictly content standpoint—rather than a popularity standpoint—BCH is arguably a nearer successor to 2009–2015-6 BTC than a post-SegWit BTC.

First, the BCH chain block size limit functions for the time being as a high upper-end traffic-burst defense, which matches the originally stated role and years-long practical function of this limit. This is more consistent in economic terms with the former BTC throughout the majority of its historical development until relatively recent times. In contrast, it was a significant new development when the particular height of the block size limit began to function for extended periods as an economic output ceiling on the industrywide production of Bitcoin transaction-inclusion services. Regardless of one’s opinion on whether this new economic effect is desirable, it remains that it was a significant departure from most of Bitcoin’s past viewed in functional economic terms.

Second, BCH does not implement SegWit. Again, regardless of one’s particular opinion on the net desirability of SegWit, it will in fact arrive on the BTC chain—but not on the BCH chain—as a significant data-structural departure from the organization of the former Bitcoin’s blocks.

Both BTC (with the new SegWit and some other recent changes) and BCH (with its revised block size limit and some other recent changes) are direct successors of the Bitcoin that came before them and each differs in some substantive way from that former Bitcoin. Against a backdrop of continuous Bitcoin software modification and innovation over the years, this stands out as the first time protocol choice options have elicited sufficient sustained disagreement among participants that a chain split has in fact resulted. For the lower block-size limit camp, the key factor was the limit change being unacceptable to them; for the higher block-size limit camp, it was the failure to revise the limit, and for some SegWit activation as well, being unacceptable to them.

Some observers have expressed concern that this first Bitcoin chain split could set a precedent for additional splits in the future. This seems possible, but somewhat doubtful to me. First, it is unclear the extent to which this first split will prosper, and if it does quite poorly, this might discourage future attempts rather than encourage them. Second, months and years of debate, effort, proposals, and campaigns, all primarily centering around the block size limit issue, preceded this first chain split. This suggests this step has by no means come about lightly. Most importantly, I view the block size limit as quite unique and distinctive among Bitcoin protocol issues and think it unlikely that other issues are likely to rise to the level of sustained disagreement that would be required for another similar split. [That said, the 2MB hard fork already planned for November could lead to another split, but that plan predated the current split and some believe this split might even reduce the probability of the other one rather than enhance it.]

A poorly designed experiment, but all we get

The emergence of these two daughter variants of the former Bitcoin, which diverged from a common ancestor block on 1 August 2017, enables a certain evolutionary test in that both represent descent with modification following a speciation event. However, it is by no means a “clean” experiment, able to test the effect of changing a single variable. Alas, real-life evolutionary tests are usually “dirty,” reflecting the net effects of a complex interplay of context and interdependence. Even a single genetic change in an organism that does have some practical effect seldom has a simple, singular effect, but instead results in a certain cascade of effects, interactions, and adjustments.

As an experiment in the scientific sense, then, this chain split is badly confounded due to the many major variables differentiating the two chains. This includes, at least: the block size limit height difference, the presence/absence of SegWit, the respective quality levels and reputations of software development teams and software testing processes, differences in user traffic, and the extent and stability of relative hashing power. Most of these variables can impact both general user confidence (subjective) and bug probabilities (more objective). A good experiment, in contrast, would seek to change one variable at a time. This development does not do this—not even close.

A reasonable case can be made that the BTC/BCH split, such as it is, may be a net positive for holders of the previous “single bitcoin.” Bitcoin’s evolution continues for the time being along paths that have diverged into two chains differing across a set of multiple variables. This may well bring a certain marginal shift toward more practical experience opportunities and away from talk and modeling, which could in itself represent net value added from the event. Relative hashing power, unit prices, development efforts, and software quality levels are all likely to shift over time to various extents and directions not easy to predict (though always easy to “predict” afterwards). The complex sequence of outcomes to ensue must now be seen in practice and over time.

[Update: The original version used BCC for Bitcoin Cash, but this code was already in use by another cryptocurrency. Since that time the Bitcoin Cash community has clearly shifted to BCH.]

 

Block Size Political Economy Follow-Up 3: Differentiation from the 21-million Coin Production Schedule

Continues from Part 2.

One popular argument compares the Bitcoin block size limit to the coin production schedule that sets up a terminal maximum of 21 million bitcoins that can ever be created. Raising the block size limit, this argument continues, could set a precedent for changing the coin production schedule, and then what? Changing the block size limit opens up a slippery slope that could threaten to lead to the end of cryptocurrency standards and boundaries. Just as the coin limit is an essential value proposition of Bitcoin, so other types of limits must be conservatively protected as well.

How can this type of argument be considered?

First, note that this represents an approach opposite to the one I have taken. I have identified and discussed the block size limit as something uniquely and importantly different within Bitcoin from an economic standpoint. The above argument, in contrast, presents these different “limits” as quite similar to one another for this purpose and therefore ripe for analogizing.

Next, one might note how Bitcoin started with its production schedule already in place, whereas the block size limit was added about 20 months later and at just under 1,200 times larger than the average block size of the time. The limit’s original proponents defended it from critics as a merely temporary measure and thus of no real concern.

A common retort to such observations is, in effect, “that was then, this is now.” The project is at a more advanced stage. The current developers have more experience and a more mature view than the early pioneers. The system now carries far more value and the stakes are higher. Today, we can no longer afford to be so cavalier as to just put a supposedly temporary limit right into the protocol code where it could prove difficult to change later…

That is…we can no longer be so cavalier as to just remove such a previously cavalierly added temporary limit...That is…it is time to move on from reciting old founder tales and look to the present concerns.

And indeed, such matters of historical and technical interpretation are subject to many differing assessments. However, there is an altogether different and more enduring level on which to consider this matter. There are substantive economic distinctions between a block size limit and a coin production schedule that render the two remarkably different in kind and thus weaker objects for analogy than they could at first appear.

When “any number will do” and when it will not

This is because raising the total quantity of a monetary unit by changing its production schedule has completely different types of effects from changing the total quantity of a given service that can be provided. Producing an increased quantity of a given cryptocurrency is entirely unlike producing an increased quantity of transaction-inclusion services. This follows from a unique feature of monetary units as contrasted with all other economic goods and services. An arbitrary initial setting for the production of new coins (which operates to define an all-time maximum possible production quantity) works quite well for a cryptocurrency, but does so only for unique and distinctive reasons.

With money, barring certain divisibility issues of mainly historical interest, any given total quantity of money units across a society of users facilitates the same activities as any other such total quantity. This includes mediating indirect exchange (facilitating buying and selling), addressing uncertainty through keeping cash balances (saving; the yield from money held), and facilitating lending and legitimate commercial credit (not to be confused with “credit expansion”). The particular total number of money units across a society of money users is practically irrelevant to these functions. What is critical to a money unit’s value is users’ confidence that whatever this total number (or production schedule) is, money producers cannot arbitrarily alter it, especially upward, so as to rob money holders through devaluation.

 Subject to constraints of mineral reality.

Subject to constraints of mineral reality.

A hypothetical model of physical commodity money production on a free market differs in certain important respects from both cryptocurrency and fiat money and bank-credit models. We should therefore closely consider the meaning of arbitrary with regard to these distinct cases.

With precious metal coins produced by ordinary businesses on a free market, the number of units cannot be increased arbitrarily for reasons rooted directly in physical constraints. Each additional precious metal coin to be produced requires specific scarce materials and energy combined with various manufacturing and other business costs, from mining to minting. Each such coin is much like any other good produced and exchanged on the market in that it is a product to be used in the market as money as opposed to a product to be used in the kitchen as dinner. Material scarcity itself protects money users from rouge money producers by preventing arbitrary changes to the quantity of money units. Changes in quantity supplied reflect supply and demand for such coins, including marginal production costs, as with other products.

In sharp contrast to this, a state-run system of fiat money and bank credit supports “flexible” increases in the “money supply.” These are arbitrary in that, unlike hypothetical commercial precious metal coin makers, these legally privileged money producers can generate additional money units at little to no cost to themselves. Notes can be printed and differing numbers of zeroes can be designed into printing plates as the denomination at no difference in printing cost. Likewise, cartel-member bankers can issue “loans” of nothing, filling customer accounts with what has been aptly described as “fountain pen money,” limited to a degree by the current policies and practices of those managing the banking cartel (“regulators,” etc.). Legal frameworks provide some protection for users of such money, most of the time (except when they do not), but such protections are far weaker and less reliable than those from the harder constraints of mineral reality.

Against this backdrop, some cryptocurrencies, led by Bitcoin, feature a novel and innovative third way to protect money users from arbitrary increases in new add-on supply. A production schedule can be specified within the effective definition of what a given cryptocurrency is.

Now in considering the exact number of possible units of a given cryptocurrency, consider two almost identical parallel universes, A and B, which differ in only one respect. Assuming sufficient divisibility in both cases (plentiful unit sub-division is possible), 30 widgetcoins out of a 300-trillion widgetcoin supply across a given society in Universe A carry the same purchasing power as 60 halfwidgetcoins out of a 600-trillion halfwidgetcoin supply across a given society in Universe B.

In each universe, one can buy the same kilogram of roast beef, in one case with 30 units, in the other with 60. Since the 300-trillion versus 600-trillion total money supply is the only difference between these two universes, it makes no difference whether the roast beef is bought with 30 units in Universe A or with 60 units in Universe B. Since the people in the two universes are wholly accustomed to their own respective numerical pricing conditions, their psychological and felt interpretations of the value associated with “30” in the one case and “60” in the other, are likewise indistinguishable.

Naturally, many individuals and organizations in any universe dream of having “more money.” For example, considering that 20 units of a good is worth more than 10, it is easy to equate having more units with having more wealth. Twenty good apples represent an amount of wealth (ordinally) greater than 10 such apples do. This is also the case with holding quantities of the same monetary unit. Twenty krone represents more wealth than 10.

But the crucial point now arrives: the foregoing “more is better” with regard to money applies to the number of units in a given party’s possession, but does not apply—as it does with ordinary non-money goods and services—to the wealth of the society of money users as a whole. Viewed across an entire society, intuitive associations from personal and business experience between larger numbers and greater wealth do not translate into a way to raise overall wealth. Political funny-money schemes with names such as “monetary policy” and “credit expansion” instead produce only sub-zero-sum transfers of wealth from some monetary system participants to others. Such transfers produce win/lose results in which some gain at the expense of others, not to mention the additional net losses from the transfer process itself (thus sub-zero-sum).

With Bitcoin, when the initial design was set—but not afterwards—42 million units, or other possible numbers, would have been as serviceable as 21 million. After the system launched, however, no general benefits could follow from increasing the quantity of possible bitcoins beyond their initially defined schedule. Such a later increase would instead tend to 1) reduce the purchasing power of each unit below what it would have otherwise been, 2) transfer wealth to recipients of new add-on units away from all other holders of existing units, 3) raise uncertainty about the coin’s reliability, likely depressing its market value with an uncertainty discount, 4) create demand for an analog of a “Fed watching industry” that speculates on what might happen next with the malleable production schedule, and 5) give rise to an industry of lobbyists, academics, and other experts dedicated to influencing such decisions.

While the block reward framework does indeed also “transfer wealth” in a sense to miners from existing bitcoin holders as in item (2) above, it crucially does so only in a predefined way, knowable to all participants in advance. The block reward schedule, defined before launch, provides a form of compensation for mining services in the system’s early days. This has enabled the system to evolve and succeed from its launch to the present. This follows not from any arbitrary change to the production schedule, but merely from the ongoing operation of the production schedule initially set.

One free pass only

In sum, a peculiar characteristic of money units when viewed across an entire society of money users provided a one-time and unique economic free pass for setting an arbitrary number of possible bitcoins at 21 million. This free pass could only be valid before initial launch (prior to 2009, or at the very latest, prior to the evolution of any tradable unit value). Changing the schedule later, especially in such a way as to increase unit creation, would have completely different and wholly negative effects from a systemic perspective.

Now returning to non-money goods and services the case is quite different again. The foregoing unique monetary free pass is entirely absent, whether after launch or before it. When non-money goods and services are likewise viewed at the level of a given society as a whole, “almost any number will do” does not apply. An increased total quantity of a non-monetary good or service supplied can be in the general interest, not only in special interests. It can be win/win and not win/lose. If there are more apples or cattle to go around in a given society (as opposed to just more pesos), this does tend to lower the costs of acquiring those goods in a meaningful way. This does enhance wealth in society, not just transfer it around. It represents a real increase in production, not just a “flexible” money fraud as in the case of arbitrary inflation on the part of money producers.

Miners provide one such ordinary “non-money” service when including a given transaction in a candidate block. This is a scarce service provided (or not) to a specific end user by specific miners. It does not fall under the unique category of the total number of monetary units in a society of money users. The total possible number of bitcoins, however, does fall under this unique category. The two numbers differ in kind and for that reason make poor objects for analogy. Both may, indeed, be viewed as “limits,” but it is important to recognize the contrasting economic roles and natures of these two types of limits.

Block Size Political Economy Follow-Up 2: Market Intervention through Voluntary Community Rules

Continues from Part 1.

If a given block size limit is part of a given cryptocurrency at a given time, can economists legitimately say anything with regard to such a limit? Must this topic be left alone as a mere qualitative characteristic of a product that users have freely selected?

From one perspective, if user preferences are subjective matters of taste and opinion, nothing can be said other than that Ravi prefers this, Setsuko prefers that, and Heinrich prefers some other thing. If various users prefer a cryptocurrency with one block size limit or another, economists must remain silent and leave users to their purely subjective preferences, only taking note in abstract and neutral terms of the shape of these preferences. Personal preferences are “ultimate givens,” their specific content irreducible “black box” starting points for economists.

This appears to be a sounder critique. Block size limits are indeed characteristics of specific cryptocurrencies as products. Users may well differ in their subjective preferences on such matters for reasons not even fully understandable. Users differ in their values. Motivations can even include various grades of membership signaling. An economist speaking on such things, this criticism goes, merely “smuggles in” his own particular personal preferences or party affiliation “dressed up as” objective analysis.

Can any role for economic analysis here be rescued from this critique? It may help to take a step back and consider some other scenarios to gain perspective and then return to apply that perspective to the case under consideration.

First, consider two hypothetical cryptocurrencies, one with a block size limit that directly influences the ordinary structure of supply and demand in its transaction-inclusion market, and another that does not (this can equally be the same cryptocurrency, such as Bitcoin, at two different phases in its history). The first cryptocurrency’s code alters the operation of the market between transaction senders and miners, limiting the total quantity of services that can be supplied per time period. Certain economic and industry-structure effects follow. These effects apply to a coin with this characteristic, but not to one without it. What are those differences? Those differences were the central theme of the interview to which this series follows.

Yet subjective individual preferences do not alter the distinctions analyzed. Thus, even though the content of the preferences themselves may be a black box for economists, the two differing transaction-inclusion markets still have objectively describable economic distinctions independent of any such preferences. Dropping a stone from the Tower of Pisa is a choice, one with all manner of possible motivations, but the resulting acceleration of gravity is not altered by any personal opinion as to the nature and effects of such gravity.

Three intentional communities and their altcoins

Next, consider several hypothetical intentional communities. It is possible to establish and run such communities under various rule sets. Although intentional communities have often been to some degree communistic (“commune”), it is possible to set up other idealistic havens, perhaps some real-life attempt at an Ayn-Rand-style Galt’s Gulch or a Neal-Stephenson-style Thousander retreat. Participation is governed by a kind of “social contract,” but in this context the contract is more likely to be one that actually exists, including specified conditions to which participants have assented by joining and staying, possibly even signing a written agreement with terms of residence.

Let us assume that in all cases, no matter what the other internal rules and cultures, participants are not forced to either join or stay. This freedom of entry and exit corresponds to cryptocurrency participation choices.

Now consider three such voluntary intentional communities. Bernieland features a $20 minimum wage. MagicCorner bans "wage relations" altogether. Finally, Murrayville has no numerical restrictions on wage agreements. Even though all three are voluntary communities, only Bernieland and MagicCorner include labor rules that restrict wage rates. The voluntarily agreed community rules specify certain wage-market restrictions. These types of restrictions are traditionally analyzed under the rubric of market intervention by state agencies, which are often subsumed under the term “government.” Whether one wants to also call a complex around intentional community rules and enforcement measures a type of “government” or not is beside the point. There may be valid reasons for either using or not using that word, provided suitable definitions and qualifications are set out.

In this case, it is analytically valuable to be able to note how Murrayville is free of rules that specify restrictions on the existence or range of wages in its labor market. Murrayville might therefore be described within this context as having a labor market free of intervention—unlike Bernieland and MagicCorner. Considering this difference alone, one would expect Murrayville to therefore have the best functioning labor market of the three, with more ample employment opportunities for those aiming to work on a wage basis.

The fact that all participants in all three communities voluntarily join and agree to the respective terms of each does not alter the economic distinctions between their differing labor market rules. Even though all three communities are voluntary, it remains that only one has a minimum wage, another bans wages, and a third does neither.

Arguing that the term “intervention” can only apply to state agency actions does not aid in the economic analysis of wage rate restrictions within these voluntary intentional communities. One might try to suggest a better term to use here instead of intervention. However, since the effects of wage restrictions have already been analyzed under the rubric of state-made laws described as “interventions,” using established terms—with suitable qualifications, as was done—easily accesses the appropriate implications.

Now in an effort to compete for residents, each community launches its own altcoin. Berniecoin does not allow any transaction with a fee above 1.5 Bernielashes/byte to be mined. This seeks to create a price ceiling for transaction inclusion. No one can pay more within the protocol. No one can use greater wealth to supersede other transaction senders. MCcoin’s protocol includes no way for transaction fees to be included at all; no one can bid for priority by including a fee. Finally, Murraycoin does neither. Transactions with any fee, or none, can be sent, and each miner is free to include or exclude any of these. Each node is likewise free to either relay any of them or not, or to try to figure out some ways to monetize such services.

Once again, based on this alone, Berniecoin and MCcoin demonstrate forms of what has heretofore been best characterized as “market intervention” within their respective communities. In this case, their protocols specify this directly. Murraycoin alone is free of any such effective intervention in its transaction-inclusion market. The others have policies that place a ceiling on the payment of transaction fees. The voluntary nature of participation in all three does not alter this distinction. One cryptocurrency has a maximum transaction fee, another bans fees, and the third does neither. These respective encoded policies are indeed part of what users implicitly choose when they use one rather than another. Nevertheless, distinct economic and social implications follow from those differences, and do so apart from any beliefs or wishes as to the nature of such implications.

This price-ceiling example demonstrates the general applicability of market intervention analysis within the context of voluntary arrangements. With the issue of a block size limit that restricts normal transaction volume, the relevant concept is not a price ceiling, but an output ceiling.

How to have a cartel without forming one

A subtler misconstrual of my interview assumes that I argued that since a particular situation or dynamic exists, someone must have acted to bring it about. However, I made no mention of any specific persons or groups, nor did I attribute any intentionality or motive. If there is thunder, it does not necessarily follow that Thor must have hammered it out.

Instead, I identified a market. I noted an effective limit to industrywide service provision as actual market volume begins to interact with a limit long in place, but formerly inert for this purpose. I described some of the general effects of any such limit to the extent it actually begins to limit ordinary volume. I argued that these effects are negative, but also easy for observers and participants of all kinds to miss or underestimate because they entail hidden costs and distort industry structure evolution from paths it could have taken instead, but did not, thus rendering those possibly better alternative paths “not seen” in Bastiat’s sense.

Certain economic effects follow from output ceilings and these have commonly been analyzed in terms of cartel situations. Yet this implies no necessary argument that anyone has set out to form a cartel or to create any of these situations or dynamics. That would be a completely different argument, more journalistic in nature and evidence requirements.

Being encoded in a protocol is a new way for an output ceiling to exist. Normally—but not in this case—any given industry actor, either current player or potential entrant, could just violate such a ceiling unless facing some overt or threatened form of legal or quasi-legal enforcement. Consider post-war Japanese steel production. An industrywide output ceiling was maintained for many years to limit competition. The Ministry of International Trade and Industry “recommended” this as a “voluntary” measure for domestic steelmakers. Of course, when some rebels sought to exceed the limit, MITI simply refused to approve their requests for increased purchases of more iron ore and fuel, which it also oversaw. Only through MITI could such a limit be maintained.

This type of limit sets up an upside-down and sub-zero-sum dynamic in an industry. There are concentrated gains for the inefficient (who should otherwise probably quit and sell off assets), somewhat less concentrated losses for the more efficient (who are unable to expand as much), hidden losses for would-be entrants (who are never seen because they avoid entering a market with an arbitrary ceiling), and dispersed and nearly invisible losses for many anonymous end users (who mostly have little clue about any of this and how it is happening at their own expense). Once again, though, all this can be so regardless of anyone’s knowledge or intentions.

To say with regard to the block size limit that there exists an industry situation with effects like those of an enforced cartel does not necessarily also imply that 1) some people set out to create it, or that 2) all or even any such people actually benefit from it on balance, or that 3) any of them fully understands it. Each actor has his own intentionality and working models of causality, but all of this combines into social outcomes that result, but were not necessarily planned from the outset to take the forms taken. Describing such unplanned social effects, Adam Ferguson wrote in 1767 that, “nations stumble upon establishments, which are indeed the result of human action, but not the execution of any human design.”

That said, noting the social science concept of spontaneous emergence as one factor to consider does not also constitute a claim that certain effects have not been planned or that they do not actually produce special interest benefits for some at the expense of others. It only points out that any such intentions and plans as may or may not exist are not directly relevant to the comparative analysis of rule effects. The topics are distinct.

Continues with Part 3.

Block Size Political Economy Follow-Up 1: Software Choice, Market Differentiation, and Term Selection

An interview with me on the Bitcoin block size limit appeared on 4 May 2016 on Bitcoin.com. Below, I develop additional clarifications and examples partly inspired by a range of comments and reactions to it. This is meant to build on and develop ideas in the original interview. For ease of reference, here is a PDF version of that interview.

This is a three-part series. Part 1 below covers a range of issues including the need to differentiate the market that was discussed in the interview from other distinct markets and non-market choice phenomena such as free software selection. It also begins to discuss the use of the term market intervention in this context. Part 2 will then continue by arguing that neither the voluntary nature of cryptocurrency participation nor the subjective nature of user preferences nor any alleged motivations on the part of the various actors involved alters my analysis. Finally, Part 3 will focus on economic distinctions between the 21-million bitcoin production schedule and the block size limit, arguing that these are different in kind and thus poor objects for analogy.

 Chicago Board of Trade: People buying and selling form a market. Prices are key artifacts that market processes leave behind.

Chicago Board of Trade: People buying and selling form a market. Prices are key artifacts that market processes leave behind.

Two markets and a non-market choice sphere

One idea that showed up in comments was that I had expressed some view as to which Bitcoin software one ought to run. However, I did not address this at all. I have only published one previous preliminary article on the block size limit, on 20 June 2015, and this also did not mention implementation choice. Various views on this topic do not alter my analysis of the topics that I did address.

A related idea is that the current dominant software implementation already reflects “the choice of the market.” Therefore, any discussion of differences between a cryptocurrency having or not having a given block size limit is moot: the “market” has already spoken and this is evident in implementation share statistics.

It should be cautioned, however, that software choice reflects many considerations. Interpreting it as a proxy for a single issue is imprecise. Such choices may well reflect a generalized confidence in perceived quality and reliability. A user could therefore make a particular software choice either: 1) because of one specific code issue, 2) despite that same particular issue, or 3) regardless of it.

Such imprecision and ambiguity are among the reasons I did not discuss this matter at all. A more fundamental reason, however, is that it has no bearing on my analysis. Whether some percentage of a given population prefers Pepsi or Earl Grey tea does not alter the composition of the respective beverages in the slightest way, nor their respective effects on metabolism. Such things can be studied and assessed independently of the current statistical shape of user preferences.

In addition, choice of which free software to run does not really constitute a market, except in a metaphorical sense. Developers offer software products and users select and run such products. In a free software context, nothing is bought or sold between these groups. No price signals exist directly between users and developers.

In contrast, the central topic I addressed—the market for the inclusion of transactions on the Bitcoin blockchain—is indeed a market, one that involves quite different roles and actions than producing or running one version or another of free software. This is a market in which bidders send transactions, which takers (miners) either include or not in each respective candidate block. This market involves specific senders of specific transactions (not senders in general of transactions in general). At the other end, specific miners build each of their respective candidate blocks. In deciding whether to include any, all, or some transactions, fee/byte (bid) is salient. Node operators act as key intermediaries, like referring brokers, currently uncompensated. On-chain and off-chain transacting options, both existing and potential, coexist in this context in a complex blend of competition and synergy.

There are therefore at least several phenomena to differentiate. First, the buying and selling of bitcoin forms textbook markets on the order of commodities and forex markets. Those effectively controlling given bitcoin units can sell such control in exchange for some other money unit, product, or service, or give them away as gifts. Second, bidding for on-chain transaction inclusion and miner decisions to include or not include transactions in candidate blocks forms a distinct open-bid market for on-chain inclusion priority. Third, developers offering free software and users making decisions on which implementations to run for their various purposes does not constitute a market in the sense of a complex of buying and selling behavior.

Whatever one may choose to call these three phenomena, each is meaningfully distinct from the other, describing different sets of actions and roles. To claim that “the market has spoken” in the context of software choice is therefore far less informative that it might at first appear to be. Making such a claim requires specifying what exactly has allegedly spoken (it isn’t a market) and the content of this purportedly speaking thing’s alleged message (ambiguously mixed with considerations such as general perception of code reliability).

The term “market intervention”

Several commenters took issue with my use of the term market intervention in this context. It is true that market intervention has a negative connotation for many readers, though not all. Indeed, a great many persons eagerly advocate some form of governmental intervention in economic affairs as part of their ordinary political opinions. Still, one interpretation would be that I had set out to create negative connotations and thus arrived at my word choice using rhetorical criteria.

A different interpretation would be that I set out to select the most accurate available technical term to describe the phenomenon under consideration. I then specified what I meant in using this term and excluded certain inapplicable historical and institutional associations. This is my own first-hand interpretation of what I did in selecting this language. That it still has negative connotations for some may be natural in that what it describes has negative effects. However, word choice one way or another does not alter such effects.

Another related but more substantive criticism that appeared in several variants argues that a block size limit is just a qualitative characteristic of a cryptocurrency as a good. A given limit is baked into what the good is. As such, it cannot be construed using the model of economic intervention. If a characteristic is already in the product, how could it possibly be construed as intervention (from outside)?

However, I had already stressed in the interview how novel and unprecedented this situation is. My argument was that even though the legal and practical contexts of traditional interventionism conducted by state agencies are completely different, nevertheless, the economic effects are on this transaction-inclusion market as a government enforced industrywide output ceiling would be. This will be addressed further in Part 2.

A commenter suggested that I was arguing from history that the current block size limit was not part of “consensus.” Consensus, in this debate, often seems to transcend a mere computer science fact to also encompass an allusion to a hard Bitcoin Realpolitik. Any other considerations, such as the documented history of the block size limit, are irrelevant to this current reality.

However, I did not reference or use any concept of consensus at all. Nor did I question the reality of any given state of consensus on the network at any given time. What I did was analyze differences between possible states of code and then describe economic and social implications of such differences.

A loosely related idea was that my analysis was tantamount to advocating that cryptocurrencies should not maintain any limits or standards. If calling into question one sort of limit, such as the current Bitcoin block size limit, why not just question all limits? Why not just also advocate raising the maximum coin count? That, after all, is also a “limit,” so why not call keeping that in place an “intervention” too? This will be addressed in greater detail in Part 3.

The interview itself concerned one such limit and not any others. Why? I could have branched off to discuss the sociology of decision-making or described a software preference. But I did no such things. I could have discussed any other protocol characteristic or issue. Why did I discuss only this one? The answer is that I think this limit has unique economic features that are both important and poorly understood. Explaining this was therefore the focus.

Continues with Part 2.

Some misplaced explanations of bitcoins as tradable units

This is an excerpt from Chapter 8, “Some illusions of enlightened explanations,” in my book, Are Bitcoins Ownable: Property Rights, IP Wrongs, and Legal-Theory Implications.

As important as it is to gain at least a basic technical understanding of Bitcoin, attempts to describe what its tradable units “really” are, as elaborated from some allegedly more enlightened perch, can sometimes distract more than aid when applying economic and legal concepts. For example, pundits discussing whether bitcoin falls under what they each consider to be “money” or not sometimes explain that bitcoin is really just a “ledger entry” or a “protocol token,” a harmless technical artifact of a promising new “blockchain technology.”

Whatever the root of or strategy behind such discourse, however, a bitcoin buyer does not in fact seek a share in a distributed ledger or any other such tortured monstrosity. He wants to buy a bitcoin in the same sense that he might want to buy a grapefruit. He in no way sets out toward the market to buy a share of a global orchard cooperative that also happens to entitle him to one grapefruit that day.

Molecular diagram of grapefruit mercaptan. Tasty.Nor is it relevant that a grapefruit is “really” organic molecules, water, and some other substances. For that matter, a physicist might go further and insist that a grapefruit is “really” nothing but some occasional quarks suspended in vast stretches of empty space. All such misused reductionism is irrelevant to understanding the buying and selling of grapefruit. It likewise has no bearing on whether grapefruits can be eaten without being paid for and how or if people ought to react if they are.

Really just quarks and empty space (Wikimedia Commons, Aleph)Economic theory and legal theory are fields concerned with human acts, such as acquiring, holding, trading, and stealing. Action is marked by verbs. If one is interested in understanding the grapefruit market, one does not seek first to master grapefruit-tree cellular biology, let alone quantum mechanics. It is sufficient for economics to view those grapefruits actually being traded as the relevant goods, the production, pricing, and distribution of which are to be examined using economics methods.

This implies the importance of taking care in selecting which fields of knowledge, aspects of the phenomenon, and “layers” of reality are the most relevant to consider in understanding what bitcoin “really” is, including with regard to whether it is ownable.

One must also proceed with caution in applying analogies. For example, it is easy to view bitcoin as just like other digital blips buzzing around the internet. However, it should be emphasized that buying a bitcoin is not like buying other digital goods, such as a copy of a song file. One does not buy a copy of a bitcoin, but a bitcoin itself. A bitcoin seller no longer possesses the bitcoin in question after the sale (and contextually sufficient confirmations). When one buys (a copy of) a song file, in contrast, the possessor retains copies from which to make more copies.

Most digital goods, such as documents and song files, are nonrival. They can be copied. Multiple people can use multiple copies simultaneously. “Stealing a copy” leaves the original as it was. It is not gone after being “stolen.”

Likewise, not only can a whole blockchain be copied, but some key part of its value derives from its actually being so copied and distributed with redundancy to numerous independently operated locations. A signed bitcoin transaction is also a short digit string that can be copied, sent, and resent around the globe in fractions of seconds. These are nonrival goods, as are cryptographic signing keys. With nonrival goods, one person can have one copy and another person can have another copy and each person can control these respective copies independently and simultaneously.

However, this is not the case with bitcoins. A bitcoin cannot be copied in any such way. It is rival in the same sense as a physical object or spatial location. In addition, a bitcoin cannot be sufficiently described as “just a ledger entry” because a ledger entry records something. This formulation alone does not yet explain what it is that is recorded.

From a unit perspective, bitcoins function as a digital monetary commodity according to strict economic-theory definitions. From an integral perspective, the units are inseparable aspects of the Bitcoin blockchain. They cannot exist without it and it does not exist without them. There is a nondualistic relationship between bitcoin units and the Bitcoin blockchain; while they are distinguishable conceptually, they are not separable in reality.

Announcing new book on bitcoin and legal theory

The first of several concurrent research and writing projects has just hatched: Are Bitcoins Ownable? Property Rights, IP Wrongs, and Legal-Theory Implications.

This is a study in the foundations and implications of action-based jurisprudence, forged through applying it to bitcoin. This brings together for the first time the two major fields on which I have been writing over the past five years.

The context includes relationships among crypto-anarchist thought (such as contract assurance through software code), conventional legal administration (bureaucratic classificationism and rule through law), and ideal legal practice (actual promotion of justice), as well as related philosophical issues such as the combined use of multiple knowledge fields and the ethics of legal practice. Among the book’s central themes is whether and how the same principles that both support property rights in measurable objects and locations and argue against IP claims in copiable ideas and abstractions may apply to the unique new case of bitcoin.

Here is the back-cover description:

Bitcoin has fresh implications for economics and law at many levels. This book addresses whether bitcoins ought to be considered ownable under an action-based approach to property theory, which—like bitcoin itself—transcends the boundaries of existing positive law jurisdictions. Beyond instinctive answers is a rich opportunity to examine the many technical facts and legal-theory issues involved. Bitcoin has a unique new place among types of economic goods, between the physically and spatially defined goods of property theory and the copiable, abstract ideas, patterns, and methods associated with IP rights. It does not fall so easily into existing categories.

The author brings together here for the first time his work in an approach to legal philosophy grounded directly in the analysis of human action, which he has termed action-based jurisprudence, with his several years of writing about bitcoin from a monetary theory perspective and contributing through articles, presentations, and video productions to raising general public understanding of how Bitcoin works on a technical level.

This content (22,000 words) is licensed under Creative Commons and has been made available in commercial paperback and Kindle versions on Amazon as well as other ebook store versions, and a free PDF of the paper version to facilitate quick and full access to the text, previewing, sharing, text searching (beats an index), quoting, and citation by page number.

Ways to support this work and encourage future work like it include spreading the word and sharing, writing reviews on Amazon and elsewhere, posting quotations, and buying a commercial edition.

Most of all, enjoy. Hopefully, no reader’s views on the topics addressed will remain entirely unaffected. Mine were not.

Paperback edition at Amazon ($6.99)

Ebook stores ($2.99): Kindle edition (free under Kindle MatchBook program for buyers of paper version), iBooks, Kobo, Nook, Oyster, Page Foundry, andScribd.

PDF of paperback edition (Free supplement to commercial editions or consider sending an optional bitcoin tip)

Watch the five-minute video introducing the book on my Amazon author page, which can also be followed for future releases.

The paperback version is available at least on US, UK, and EU area Amazon sites, but not sure about elsewhere. The Kindle version is available on most national Amazon sites worldwide.

Preview: “The market for bitcoin transaction inclusion and the temporal root of scarcity”

What do you see in those blocks? Source: Wikimedia Commons: “Crown Fountain” by Tony Webster.I have been considering the Bitcoin block size debate for quite a few months (next to some other large projects), reading, learning, and applying principles. It is such an important and contentious issue that I have taken extra time before commenting at all to research and keep following the wide range of factors, opinions, and related issues.

In seeking to apply economic theory in new ways, and when addressing Bitcoin in particular with it, I try to take even more care than usual to first acquire a sufficient technical understanding so that I can usefully apply such theory to the case. The block size issue has set that bar still higher than it had been with other Bitcoin topics I have addressed.

I am convinced the roots of much of the contention are based primarily in economic-theory differences and only secondarily a technical or even social ones. Additional issues of governance and decision-making likewise come to the fore mainly when people are severely conflicted on what the right thing to do is and the issues then descend into “political” contests of influence and persuasion. There are also economic ways to understand the kinds of circumstances under which issues tend to become viewed as “political” in nature rather than not.

In short, if it were clear what ought to be done, that could be implemented with some work. Yet not only has widespread consensus on the right thing to do been slow to arrive, but the disagreements appear rooted more in differing opinions on economics, a specialized field entirely distinct from engineering, programming, and network design. Worse, too much of what passes for “economics” in the official mainstream today has been built upon a foundation of long-refuted non-sense. So using that is unlikely to help matters along either.

A 30-page written treatment is in the editing and review phase. For now—in response to numerous behind-the-scenes requests for comment—here is a summary preview of some of the essentials of my take on this as of now. The forthcoming paper contains citations, support, and step-by-step context building and also covers many more related topics than this summary can touch on.

Summary of some findings

The block size limit has for the most part not ever been, and should not now be, used to determine the actual size of average blocks under normal network operating conditions. Real average block size ought to emerge from factors of supply and demand for what I will term “transaction-inclusion services.”

Beginning to use the protocol block size limit to restrict the provision of transaction-inclusion services would be a radical change to Bitcoin. The burden of proof is therefore on persons advocating using the protocol limit in this novel way. This protocol block size limit was introduced in 2010 as an anti-spam measure. It was to be an expedient to be removed or raised at a later stage as normal (non-attack) transaction volumes climbed. It was not envisioned as having anything to do with manipulating transaction fees and transaction-inclusion decisions on a normal operating basis. The idea of using the limit in this new way—not the idea of raising it now by some degree to keep it from beginning to interfere with normal operations—is what constitutes an attempt to change something important about the Bitcoin protocol. And there rests the burden of proof.

If that burden is not met, the limit ought to be (have already been) raised—by some means and by some amount. Those latter details do veer more legitimately into technical-debate territory (2, 8, or 20MB? new fixed limit or adaptive algorithm? Phased in how and when? etc.), but all such discussions would be greatly facilitated by a shared context on the goal and purpose of any such limit having been placed into the code. A case for establishing some completely new reason to retain this same limit—other than as an anti-spam measure—would have to be made by its advocates if they were to overcome the default or “when in doubt” case. The context shows that this when-in-doubt default case is actually raising the limit, not keeping it unchanged.

Casual and/or rhetorical conflation of the block size limit with the actual average size of real blocks is rampant. This terminological laziness begs the key questions of: whether any natural operational economic constraints on block sizes exist (or could become even more relevant in the future), what those natural constraining factors might be, and what degree of influence they might have on practical mining business decisions. In strict terms, nothing can be done without some non-zero cost. For example, including a transaction in a candidate block carries some non-zero-cost and larger blocks propagate more slowly than smaller ones, other things being equal.

How can the real influences of such countervailing factors be discovered within a dynamic complex process? Markets and open competition excel at just this type of unending trial-and-error tinkering problem. However, setting a blanket restriction at an arbitrary numerical level on the output of transaction-inclusion services across the entire network distorts such processes, preventing accurate discovery and inviting both general economic waste and hidden zero-sum transfers.

Transaction-fee levels are not in any general need of being artificially pushed upward. A 130-year transition phase was planned into Bitcoin during which the full transition from block reward revenue to transaction-fee revenue was to take place. The point at which transaction-fee revenue overtakes block reward revenue should not have been expected to arrive any time soon—such as within only the first 5–10% of time that had been planned for a 100% transition. Transaction-fee revenue might naturally come to exceed block reward revenue in say, 20, or 30, or 50 years, or whatever it ends up being. Yet even that is still only a 50% milestone in the full transition process. Envisioning the long-term future of mining revenue should also factor in the clear reasons for anticipating steady secular growth in real bitcoin purchasing power.

Most fundamentally, scarcity is being treated in this debate largely using an intuitive image of “space in blocks.” However, scarcity follows from the nature of action as inevitably occurring within the passage of time. Actors would like to accomplish their objectives sooner rather than later, other things being equal. Time is the ultimate root and template for scarcity, because goods are only definable in relation to action and any action taken precludes some possible alternative action (“cost”). Scarcity of transaction-inclusion should therefore be understood in terms of relative time to confirmation—which is already today statistically influenced by fee levels.

Finally, discussions of whether bitcoin should or should not be used for “buying coffee” sound embarrassingly like Politburo debates. Market discovery through real supply, demand, and pricing over time allow socially best-possible levels of [average fee multiplied by transaction volume relative to real bitcoin purchasing power] at any given point in (in-motion) time, to be discovered dynamically. The same goes, at the same time, for the relative pros and cons for users of the entire possible existing and future spectrum of off-chain transaction options relative to on-chain ones. The protocol block size limit was added as a temporary anti-spam measure, not a technocratic market-manipulation measure. The balance of evidence still seems to indicate that it should remain restricted to its former role.

Bitcoin as a rival digital commodity good: A supplementary comment

Japanese commodity money before the eight century. Source: Wikimedia Commons, PHGCOM.One of the challenges of interpreting bitcoin has been whether it can be classified under certain existing conceptual rubrics such as “money” or “commodity” for purposes of economic analysis. Could it be some strange new kind of “commodity money”? Most people immediately and intuitively dismiss this as a possibility because it is not a physical “thing,” which they feel is a defining characteristic of commodity-ness.

Resort to a word such as “token” seems a convenient escape valve from this situation. However, this could also be misleading. A token in a “token money” context derives its value from having a fixed exchange rate against something else—a 100 pennies for a dollar, a plastic chip for a euro, etc. Bitcoin, in contrast, is traded directly as itself, with utterly no sign of any fixed exchange or substitution rates (see my Bitcoin, price denomination and fixed-rate fiat conversions” 22 July 2013).

My newest paper, “Commodity, scarcity, and monetary value theory in light of Bitcoin” in The Journal of Prices & Markets (Winter 2015) explores some of these issues in detail from a formal conceptual standpoint to check such immediate and intuitive responses. The paper takes the time to define and then apply core economic-theory concepts, including goods, scarcity, and rivalry, as well as classical lists of “commodity money” characteristics, to understanding bitcoin in terms of monetary theory.

True, commodities are usually tightly associated with materiality. However, an economic-theory sense of commodity ought to be differentiable from a physical-descriptive sense. Economics begins with the study of choice and action, as distinct from issues addressed in physical sciences. It may be that the presence of materialness in commodities has just been assumed due to the nature of the available historical examples.

For a supplemental “reality check” beyond the obscure economics library, I thought to simply go and read the Wikipedia article on “Commodity.” This should be reasonably unlikely to represent any arcane or partisan definitions from one school of economics rather than another, and should first of all represent a general-purpose range of typical current understandings of the term.

I extracted some economic-theory elements from the entry, omitting illustrative examples. The examples are mostly material items, but this is to be expected due to the overwhelmingly pre-bitcoin scope of economic history so far. Indeed, part of my argument is that bitcoin may be the first rival digital commodity good (defined in the paper), which would mean precisely that it is unprecedented, a new type of example. Between the few excerpts below, I relate these presumably mainstream characterizations of commodity-ness to bitcoin.

Extracts from Wikipedia entry on “Commodity”

The exact definition of the term commodity is specifically used to describe a class of goods for which there is demand, but which is supplied without qualitative differentiation across a market. A commodity has full or partial fungibility; that is, the market treats its instances as equivalent or nearly so with no regard to who produced them. As the saying goes, “From the taste of wheat it is not possible to tell who produced it, a Russian serf, a French peasant or an English capitalist.”

No one generally considers which mining pool mined the block that a bitcoin originated in when deciding whether to accept payment. 50 Cent, for example, is unlikely to refuse bitcoin payments for his albums from anyone using coins mined by pools other than 50 BTC.

In the original and simplified sense, commodities were things of value, of uniform quality, that were produced in large quantities by many different producers; the items from each different producer were considered equivalent.

Multiple producers: All the various Bitcoin miners produce interchangeable new coins.

One of the characteristics of a commodity good is that its price is determined as a function of its market as a whole. Well-established physical commodities have actively traded spot and derivative markets.

There are numerous bitcoin spot markets and even some derivatives markets.

Commoditization occurs as a goods or services market loses differentiation across its supply base. As such, goods that formerly carried premium margins for market participants have become commodities, such as generic pharmaceuticals and DRAM chips. There is a spectrum of commoditization, rather than a binary distinction of “commodity versus differentiable product”. Few products have complete undifferentiability.

Coin tracking is sometimes cited as a risk for weakening the completeness of bitcoin fungibility, so while fungibility largely holds, there is some risk of entering onto a “spectrum of commoditization” in which some differentiation could creep in under certain circumstances.

Overall, I thought the entry was surprisingly clear in defining commodity in terms of economic rather than material concepts. While most of the examples of commodity were material, the economic meaning was conceptually independent of materiality. As should be expected, the discussion was about economic issues such as quality differentiation, pricing, market organization, and trading patterns—not chemistry. If we are using a term in economic analysis, a strictly economic definition should be most suitable.

 

Sidechained bitcoin substitutes: A monetary commentary

Abstract

A 22 October 2014 white paper on cryptocurrency sidechains formalizes and advances the innovative sidechain concept and examines pros and cons in terms of both technical and economic factors. The current reply focuses on likely general factors in market valuations of bitcoin-pegged units on sidechains. This is an important topic for clarification as people begin to imagine and work to develop practical uses for sidechains. Assuming that the two-way peg will necessarily assure a matching, or even consistently discounted, market price relative to bitcoin could prove unrealistic. A scenario of independent floating market prices among sidecoins could prevail, with implications for the scope and types of sidechain applications.

Download the seven-page PDF of “Sidechained bitcoin substitutes: A monetary commentary.”

 

Bitcoin: Magic, fraud, or 'sufficiently advanced technology'?

Arthur C. Clarke’s third law famously states: “Any sufficiently advanced technology is indistinguishable from magic.” What Bitcoin makes possible can at first seem almost magical, or just impossible (and therefore most likely fraudulent or otherwise doomed). The following describes the basic technical elements behind Bitcoin and how it brings them together in new ways to make seeming magic possible in the real world.

Clarke’s second law states: “The only way of discovering the limits of the possible is to venture a little way past them into the impossible.” And this, we can see in retrospect, is basically what Bitcoin creator Satoshi Nakamoto did. Few at the time, even among top experts in relevant fields, thought it could really ever work.

It works.

One reason many people have a hard time understanding Bitcoin is that it uses several major streams of technology and method, each of which is quite recent in historical perspective. The main raw ingredients include: an open-source free software model, peer-to-peer networking, digital signatures, and hashing algorithms. The very first pioneering developments in each of these areas occurred almost entirely within the 1970s through the 1990s. Effectively no such things existed prior to about 40 years ago, a microsecond in historical time, but a geological age in digital-revolution time.

Some representative milestone beginnings in each area were: for open-source software, the GNU project (1983) and the Linux project (1991); for peer-to-peer networking, ARPANET (1979) and Napster (1999); for digital signatures, Diffie–Hellman theory (1976) and the first RSA test concept (1978); and for hashing algorithms, the earliest ideas (around 1953) and key advances from Merkle–Damgård (1979). Bitcoin combines some of the best later developments in each of these areas to make new things possible.

Since few people in the general population understand much about any of these essential components, understanding Bitcoin as an innovation that combines them in new and surprising ways, surprising even to experts within each of those specialized fields, is naturally a challenge without at least a little study. Not only do most people not understand how the Bitcoin puzzle fits together technically, they do not even understand any of the puzzle pieces! The intent here is not to enter into much detail on the content of any of these technical fields, but rather to provide just enough detail to achieve a quick increase in the general level of public understanding.

What Bitcoin is about in one word: Verification

It may help to focus to begin with not on the details of each field, but at how each part contributes strategically to Bitcoin’s central function. This is to create and maintain a single unforgeable record that shows the assignment of every bitcoin unit to addresses. This record is structured in the form of a linked chain of blocks of transactions. The Bitcoin protocol, network, and all of its parts maintain and update this blockchain in a way that anyone can verify. Bitcoin revises the Russian proverb, “doveryai, no proveryai,” “Trust, but verify,” to just “verify.”

If a single word could describe what the Bitcoin network does, it would be verification. For a borderless global currency, relying on trust would be the ultimate bad idea. Previous monetary systems have all let users down just where they had little alternative but to rely on some trusted third party.

First, the core Bitcoin software is open source and free. Anyone can use it, examine it, propose changes, or start a new branch under a different name. Indeed, a large number of Bitcoin variations with minor differences have already existed for some time. The open source approach can be especially good for security, because more sets of eyes are more likely to find weaknesses and see improvement paths.

Open source also tends to promote a natural-order meritocracy. Contributors who tend to display the best judgment also tend to have more of their contributions reflected over time. Unending forum discussions and controversies are a feature rather than a bug. They focus attention on problems—both real and imagined—which helps better assure that whatever is implemented has been looked at and tested from diverse angles.

Many computers worldwide run software that implements the Bitcoin protocol. A protocol is something roughly like a spoken language. Participants must speak that language and not some other, and they must speak it well enough to get their messages across and understand others. New protocols can be made up, but just as with making up new languages, it is usually rather unproductive. Such things only take off and become useful if enough others see a sufficient advantage to actually participate.

Second, as a peer-to-peer network, there is no center. Anyone can download core Bitcoin software and start a new node. This node will discover and start communicating with other nodes or “peers.” No node has any special authority or position. Each connects with at least eight peers, but sometimes many more. Some faster and always-on nodes relay more information and have more connections, but this conveys no special status. Any node can connect or drop out any time and join again later. A user does not have to run a full node just to use bitcoin for ordinary purposes.

It is common to say that Bitcoin is “decentralized” or doesn’t have a center. But then, Where is it? Thousands of active peering nodes are spread over most countries of the world and each one carries an up to date full copy of the entire blockchain.

Some nodes not only relay valid transactions and blocks, but also join the process of discovering and adding new blocks to the chain. Such “mining” activities both secure the final verification of transactions and assign first possession of new bitcoin to participating nodes as a reward. Understanding basically how mining works requires a look at the distinct functions of several different types of cryptography.

Bitcoin cryptography dehomogenized

Bitcoin relies on two different types of cryptography that few people understand. Both are counter-intuitive in what they make possible. When most people hear “cryptography,” they think of keeping data private and secure through encryption. File encryption can be used to help secure individual bitcoin wallet files, just as it can be used for the password protection of any other files. This is called symmetric key cryptography, which means the same key is used to encrypt and decrypt (AES256 is common in this role). Encryption may also be used for secure communication among users about transactions, as with any other kind of secure traffic. This is called asymmetric key cryptography, which means a public key encrypts a message and its matching private key decrypts it at the other end.

However, all of this is peripheral. Nothing inside the core Bitcoin protocol and network is encrypted. Instead, two quite different types of cryptography are used. They are not for keeping secrets, but for making sure the truth is being told. Bitcoin is a robust global system of truth verification. It is in this sense the opposite of the “memory hole” from George Orwell’s 1984; it is a remembering chain.

The first type of cryptography within Bitcoin is used to create a message digest, or informally a “hash.” Bitcoin uses hashing at many different levels (the most central one is an SHA256 hash run twice). The second type is used to create and verify digital signatures. This uses pairs of signing keys and verification keys (ECDSA sepc256k1 for signatures).

The keys to the kingdom

Despite intuitive appearances to users, bitcoin wallets do not contain any bitcoin! They only contain pairs of keys and addresses that enable digital signatures and verifications. Wallet software searches the blockchain for references to the addresses it contains and uses all the related transaction history there to arrive at a live balance to show the user. Some of the seemingly magical things that one can do with bitcoin, such as store access to the same units in different places, result from the fact that the user only deals with keys while the actual bitcoin “exists,” so to speak, only in the context of the blockchain record, not in wallets. It is only multiple copies of the keys that can be stored in different places at the same time. Still, the effective possession of the coins, that is, the ability to make use of them, stays with whoever has the corresponding signing keys.

While software designers are working hard to put complex strings of numbers in the background of user interfaces and replace or supplement them with more intuitive usernames and so forth, our purpose here is precisely to touch on some technical details of how the system works, so here is a real example of a set of bitcoin keys. This is a real signing key (do not use!):

5JWJASjTYCS9N2niU8X9W8DNVVSYdRvYywNsEzhHJozErBqMC3H

From this, a unique verification (public) key is cryptographically generated (compressed version):

03F33DECCF1FCDEE4007A0B8C71F18A8C916974D1BA2D81F1639D95B1314515BFC

This verification key is then hashed into a public address to which bitcoin can be sent. In this case:

12ctspmoULfwmeva9aZCmLFMkEssZ5CM3x

Because this particular signing key has been made public, it has been rendered permanently insecure—sacrificed for the cause of Bitcoin education.

Making a hash of it

Hashing plays a role quite different from digital signatures. It proves that a message has not been altered. Running a hash of the same message always produces the same result. If a hash does not match a previous one, it is a warning that the current version of the message does not match the original.

To illustrate, here is a message from Murray Rothbard. He wrote in Man, Economy, and State that:

“It must be reiterated here that value scales do not exist in a void apart from the concrete choices of action.” —Murray Rothbard, 1962

And here is the SHA256 digest of this message and attribution (the same algorithm that Bitcoin uses):

68ea16d5ddbbd5c9129710e4c816bebe83c8cf7d52647416302d590290ce2ba8

Any message of any size can go into a hash function. The algorithm breaks it down, mixes the parts, and otherwise “digests” it, until it produces a fixed-length result called “a digest,” which for SHA256 takes the above form, but is in each case different in content.

There are some critical properties of a good hash algorithm. First, the same message always produces the same digest. Second, it only works in one direction. Nothing about the message that went in can be reconstructed from the digest that came out. Even the tiniest change produces a completely different digest, with no relationship between the change in input and the change in output. This is called “the avalanche effect.” Third, the chances of producing the same digest from an altered message are miniscule. This is called “collision resistance.” It is impossible to craft an altered message that produces the same digest as the original unaltered message.

To demonstrate, here is the same quote without the two quotation marks.

It must be reiterated here that value scales do not exist in a void apart from the concrete choices of action. —Murray Rothbard, 1962

Which produces this digest:

0a7a163d989cf1987e1025d859ce797e060f939e2c9505b54b33fe25a9e860ff

Compare it with the previous digest:

68ea16d5ddbbd5c9129710e4c816bebe83c8cf7d52647416302d590290ce2ba8

The tiniest change in the message, removing the two quotation marks, produced a completely different digest that has no relationship whatsoever to the previous digest. In sum, a digest gives a quick yes or no answer to a single question: Is the message still exactly the same as it was before? If the message differs, the digest cannot indicate how or by how much, only that it either has changed at all or has not.

How could such a seemingly blunt instrument be useful? Bitcoin is one application in which hashing has proven very useful indeed. In Bitcoin, hashing is used in the lynchpin role of making it impossible to alter transactions and records once they have been recorded. Once the hashes are hashed together within the blockchain, record forgery anywhere is impossible.

Transactions and how miners compete to discover blocks

Wallet software is used to create transactions. These include the amount to be sent, sending and receiving addresses, and some other information, which is all hashed together. This hash is signed with any required signing keys to create a unique digital signature valid only for this transaction and no other. All of this is broadcast to the network as unencrypted, public information. What makes this possible is that the signature and the verification key do not reveal the signing key.

To keep someone from trying to spend the same unit twice and commit a kind of fraud called double-spending, nodes check new transactions against the blockchain and against other new transactions to make sure the same units are not being referenced more than once.

Each miner collects valid new transactions and incorporates them into a candidate in the competition to publish the next recognized block on the chain. Each miner hashes all the new transactions together. This produces a single hash (“mrkl_root”) that makes the records of every other transaction in a block interdependent.

Each hash for any candidate block differs from every other candidate block, not least because the miner includes his own unique mining address so he can collect the rewards if his candidate block does happen to become recognized as next in the chain.

Whose candidate block becomes the winner?

For the competing miners to recognize a block as the next valid one, the winning miner has to generate a certain hash of his candidate block’s header that meets a stringent condition. All of the other miners can immediately check this answer and recognize it as being correct or not.

However, even though it is a correct solution, it works only for the miner who found it for his own block. No one else can just take another’s correct answer and use it to promote his own candidate block as the real winner instead. This is why the correct answer can be freely published without being misappropriated by others. This unique qualifying hash is called a “proof of work.”

The nature and uses of message digests are counter-intuitive at first, but they are indispensable elements in what makes Bitcoin possible.

An example of a mined block

Here is an example of some key data from an actual block.

“hash”:”0000000000000000163440df04bc24eccb48a9d46c64dce3be979e2e6a35aa13”,

“prev_block”:”00000000000000001b84f85fca41040c558f26f5c225b430eaad05b7cc72668d”,

“mrkl_root”:”83d3359adae0a0e7d211d983ab3805dd05883353a1d84957823389f0cbbba1ad”,

“nonce”:3013750715,

The top line (“hash”) was the actual successful block header hash for this block. It starts with a large number of zeros because a winning hash has to be below the value set in the current difficulty level. The only way to find a winner is to keep trying over and over again.

This process is often described in the popular press as “solving a complex math problem,” but this is somewhat misleading. It is rather an extremely simple and brutally stupid task, one only computers could tolerate. The hash function must simply be run over and over millions and billions of times until a qualifying answer happens to finally be found somewhere on the network. The chances of a given miner finding such a hash for his own candidate block on any given try are miniscule, but somewhere in the network, one is found at a target average of about every 10 minutes. The winner collects the block reward—currently 25 new bitcoins—and any fees for included transactions.

How is the reward collected?

The candidate blocks are already set up in advance so that rewards are controlled by the winning miner’s own unique mining address. This is possible because the miner already included this address in his own unique candidate block before it became a winner. The reward address was already incorporated in the block data to begin with. Altering the reward address in any way would invalidate the winning hash and with it that entire candidate block.

In addition, a miner can only spend rewards from blocks that actually become part of the main chain, because only those blocks can be referenced in future transactions. This design fully specifies the initial control of all first appropriations of new bitcoins. Exactly who wins each next block is random. To raise the probability of winning, a miner can only try to contribute a greater share of the current total network hashing capacity in competition with all of the others trying to do the same.

As shown above with the Rothbard quote, a completely different hash comes out even after the slightest change to the message. This is why the protocol includes a place for a number that is started at zero and changed by one for each new hash try (“nonce”). Only this tiny alteration, even if the rest of the candidate block data is unchanged, generates a completely different hash each time in search of a winner. In the example above, it looks like this miner found a winning hash for this block at some point after the three billionth attempt (“nonce”:3013750715), and this was just for that one miner or mining pool, not including the similar parallel but unsuccessful attempts of all the other miners, and all this just for the competition for this one block.

The key point to understand is that finding a hash under the difficulty level is extremely competitive and difficult, but verifying afterwards that one has been found is trivial. The rest of the miners do so and move right along. They use the newly discovered hash of the previous block header (“prev_block”) as one of the inputs for their next crop of block candidates (which assures the vertical integrity of the single chain of blocks) and the race continues based on the remaining pool of unconfirmed transactions.

A powerful, self-financing, verification network

The Bitcoin mining network is, as of late September 2014, running at about 250 petahashes per second and rising at a logarithmic pace that will soon make this figure look small (rate tracked here). This means that about 250 quadrillion hashes are currently being tried across the network every second all the time. This is the world’s most powerful distributed computing network, by far, and has already been steadily extending this lead for quite some time.

Block rewards and transaction fees help promote the production and maintenance of this entire network in a decentralized way. Since block generation is random and distributed on average in proportion to hashing power contribution, it helps incentivize all contributors all the time. Many miners participate in cooperative mining pools so that at least some rewards arrive on a fairly regular basis.

The network is designed to be entirely self-financed by participants from the beginning indefinitely into the future. Early on, new coin rewards are larger and transaction-fee revenue smaller. Finally, only transaction-fee revenue is to remain, with a long and gradual transition phase built in.

If Bitcoin does remain successful over the longer term, by the time transaction-fee revenue predominates, there would likely be many orders of magnitude more transactions per block by which to multiply the average competitive fee per transaction.

This has been a summary look at a few of the key technical elements of Bitcoin. Hashing algorithms and digital signatures are especially counter-intuitive and relatively new inventions, but knowing what they make possible is essential for understanding how Bitcoin works. Each of Bitcoin’s major elements contribute to the central functions of verification, unforgeable record-keeping, and fraud prevention. These technical underpinnings and the functions they support sound about as far from the systematic deceptions of a fraud such as a Ponzi scheme as it would be possible to get.

Adapted and revised from Bitcoin Decrypted Part II: Technical Aspects and cross-posted to actiontheory.liberty.me.

 

A tale of bitcoins and $500 suits: Will a rising-value currency not be used?

A common objection to bitcoin is that as its value rises, and especially if it is generally expected to keep rising due to its restricted and inelastic production characteristics, “people will never spend bitcoins; they will just hold onto them waiting for the value to go up, and therefore bitcoin cannot succeed as a currency.”

This fallacy commits a number of errors of economic reasoning. For example, it takes one factor, a presumed desire to save bitcoin in the expectation that its exchange value will rise still higher in the future, and treats it as the only factor, even though many others are also in play. It also assumes that all people are the same all the time and that their value scales never change. It treats a person’s entire holding of bitcoin as an indivisible block, or “hoard” (Smaug’s?), ignoring the possibility of marginal decisions about the use of smaller amounts relative to a total balance and specific decision contexts.

Playing directly opposite this supposedly monolithic motivation to hold for the indefinite future is the shift in valuations of a good relative to the value of a given bitcoin holding. As the exchange value per unit rises, the total exchange value of any given holding rises with it. To illustrate how this factor goes directly against the deflationary disuse story, here is a tale of bitcoins and $500 suits.

If Hayek has 100 bitcoins when the bitcoin price is $5, buying one $500 suit would leave him with one suit and no bitcoin. However, the same purchase with bitcoin at $50 would leave him with one suit plus a remaining balance of $4,500 worth of bitcoin. At $500 per bitcoin, he could get the suit and still keep a bitcoin balance worth $49,500. And so the story goes. Finally, at $5,000 per bitcoin, he could buy that same suit and still retain $499,500 worth of bitcoin.

The trade-off Hayek faces between the suit and the proportion of a given bitcoin holding that must be traded to obtain it varies with exchange value. As bitcoin’s exchange value rises (supposedly its fatal flaw as a currency), the cost of the same one suit as a percentage of Hayek’s total bitcoin holding declines, in the foregoing example, from 100% to 10% to 1% to 0.1%, as a direct implication. The choice between buying a suit with 100% of one’s bitcoin balance or with 0.1% of that same bitcoin balance is most dissimilar and it should be clear which of these two conditions is more likely to “stimulate” a retail purchase.

As the value of bitcoin rises, the position of one suit relative to a given unit of bitcoin on a given person’s value scale will tend to change in such a way that the same holder of 100 bitcoins might be increasingly likely, not less, to purchase a suit. This does not mean that other countervailing factors, such as a desire to delay spending in anticipation of a higher future exchange value are not also present. It means that the most oft-cited factor is not the only one and moreover that other important factors point in exactly the opposite direction of the deflationary disuse thesis.

Cross-posted at actiontheory.liberty.me.

"Bitcoin 2014 Panel: History of Money & Lessons for Digital Currencies Today" with time-based outline

Following the Economic Theory of Bitcoin panel on 17 May 2014 at the Bitcoin Foundation Conference in Amsterdam, I also participated in this one-hour panel addressing the history of money and lessons for digital currencies today (my own contributions start at 41:40). The varied topics included lessons from the history of the Netherlands, problems with the deflationary spiral argument, parallels to the early history of the oil industry, competition and types of centralization, historical circulation of multiple monetary metals and relevance for altcoins, and the role and operation of central banks relative to market competition and centralization versus decentralization.

Moderator: Ludwig Siegele (Online Business and Finance Editor, The Economist)

Speakers: Tuur Demeester (Founder, Adamant Research), Konrad Graf (Author & Investment Research Translator), Simon Lelieveldt (Regulatory Consultant, SL Consultancy), Erik Voorhees (Co-Founder, Coinapult)

1) Introductions

00:00–05:50 Introductions by each panelist

2) History of money in Amsterdam (Lelieveldt)

06:10–10:58 Lelieveldt: Amsterdam monetary history; water and community power more outside usual royal vested interests. Amsterdam Exchange Bank cleaned up confusion of many coins in circulation. Guilder was a unit of account without existing as a physical coin anymore, making it a virtual unit of account at the time. Human mind can adapt to and use many different things as currency.

3) Putting the “deflationary spiral” to rest (Voorhees)

10:58–19:07 Hyperdeflationary bitcoin economy hasn’t fallen apart. Opposite: more bitcoins spent when value is rising (wealth effect). Academics cite deflationary spiral as truism, but bitcoin shifts the burden of proof back onto supporters of the idea. Calling the gold standard “rigid” was a justification for control. Increasing the number of monetary units about as useful as increasing the length of an inch.

4) Parallels from history of the oil industry (Demeester)

19:07–28:18 Invitation to academics to launch altcoins representing their favorite monetary policy. Nothing else as disruptive as bitcoin in the history of money, but parallels with history of oil. Not approved by intellectuals or establishment. New innovations raise customer expectations. Academics may avoid taking bitcoin seriously for fear of ostracism from old paradigm.

5) Centralization, impact of licensing on competition, wealth transfer (general)

28:18–41:40 Multiple panelists and audience: Don’t waste time thinking about what (you think) bankers and others think. Oil and the internet were both fragmented originally, but centralization followed. What about bitcoin? Distinction between market-based centralization and coercive, legally privileged centralization. Wealth transfer, innovation, and social opinion.

6) Was the “gold standard” really the free market money of the old days? (Graf)

41:40–49:52 “Money production” an industry that can be examined ethically. Mining a specific service performed with compensation, but literally creating money “out of thin air” an illicit wealth transfer. Gold arrived at leading position through multiple government interventions. Litecoin as silver a weak metaphor. Question simplistic summary images as representations of actual history. [Here is a more detailed write-up on this topic that I posted after the conference: Gold standards, optionality, and parallel metallic- and crypto-coin circulations (21 May 2014)].

7) Q & A and discussion (general)

49:52–62:00 Central banks and money creation. Money another good in the economy or separate? Bankruptcy helpfully eliminates damaging institutions. New money creation leads to visible effects, but unhelpful for society overall; transfers wealth from some people to others. Trigger events for financial collapse? Dominoes collapse starting with weaker economies, periphery. Watch for rising interest rates.

“Bitcoin 2014 Panel: Economic Theory of Bitcoin” with time-based outline

It was an honor to be among the participants in this panel on 17 May 2014 at the Bitcoin Foundation Conference in Amsterdam. We addressed several issues that tend to recur in discussions of economic theory and bitcoin. The main topics were the regression theorem and bitcoin; bitcoin and the role of units of account and pricing; multiple value standards and the economics of altcoins relative to bitcoin; fractional-reserve banking, lending, and direct versus other-party control; and deflation and fixed versus elastic money supplies. I have added a time-based outline after the embedded video below to facilitate noting and locating particular topics.

Moderator: Jon Matonis (Executive Director, Bitcoin Foundation)

Speakers: Konrad Graf (Author & Investment Research Translator), Robert Sams (Founder, Cryptonomics), Peter Surda (Economist, Economicsofbitcoin.com, Robin Teigland (Associate Professor, Stockholm School of Economics)

1) Introductions, opening comments, and overview

00:00–03:05 Matonis: Introduction of panelists

03:05–07:57 Brief openings by each panelist

07:57–09:06 Economics profession and bitcoin

09:06–11:41 Matonis: Overview of topics

2) Regression theorem and bitcoin

11:41–12:12 Matonis: Introduction of topic

12:12–18:32 Surda: Liquidity, organized markets

18:32–23:16 Graf: Technical versus economic; theory versus history layers

23:16–23:50 Sams: Doubts this is relevant to bitcoin

3) Unit of account, price display, and price intuition

23:50–25:02 Matonis: Introduction of topic

25:02–27:00 Teigland: Depends on who; networks, sub-communities, generation change

27:00–27:23 Matonis: Can bitcoin overcome the existing network effect?

27:23–28:01 Surda: Uncharted area, dollar likely to remain unless deep negative event for it

4) Multiple value standards, room for 300 crytocurrencies

28:01–28:49 Matonis: Introduction of topic

28:49–31:01 Sams: Need distinct specializations; mining costs limit

31:01–32:48 Graf: Strong tendency toward one unit; only other very strong factors could counter

5) Fractional-reserve banking and bitcoin

32:48–33:41 Matonis: Introduction of topic

33:41–38:08 Surda: Money substitutes, transaction costs, price differentials, “reserve” standards

38:08–39:57 Teigland: Other non-traditional financing systems, crowdfunding, P2P lending

39:57–41:34 Sams: FRB based on an illusion, one that cannot be created with bitcoin

41:34–44:12 Graf: Bitcoin allows opt-out from all “trusted” 3rd, 4th, 5th parties. Vote with your mouse.

44:12–46:47 Sams: Who owns what? a pervasive issue; first bitcoin lending likely dollar denominated

6) Deflation, only 21 million units, number of decimal points

46:47–48:37 Matonis: Introduction of topic

48:37–49:46 Teigland: People adapt over time to situations

49:46–53:38 Sams: Deflation arguments misplaced; overheld, underused; other crypto money supplies possible

53:38–55:36 Surda: No need to change the quantity of money, but more to investigate

55:36–58:29 Graf: “Rising-value currency;” any quantity of money will do for society as a whole

58:29–59:26 Sams: Elastic supply could help stabilize exchange rate relative to fixed supply

59:26–59:46 Surda: Unit of account function depends on liquidity not volatility

7) Q&A

59:46–60:55 Q1: Banks allowed to create money; unfair playing field?

60:55–62:28 A1: Sams: 100% reserve banking; taking away private money creation privilege

62:28–62:56 A1b: Teigland: Local alternatives, experimentation

62:56–63:19 Q2: Isn’t buying and holding bitcoins already an investment in all of bitcoin?

63:19–64:06 A2: Sams: To some extent, but could be more with different money supply rule

64:06–65:00 Q3: Fixed rate of supply ignores recent lessons of monetary theory

65:00–65:27 A3: Matonis: Already addressed; Surda: May need to unlearn some of those lessons :-)

Gold standards, optionality, and parallel metallic- and crypto-coin circulations

Source: Biswarup Ganguly, Wikimedia Commons. Copper coin, 1782-1799 CE, Tipu Sultan ReignWhen one hears the words “gold standard,” it is usually either from people who think it was a horrible thing or people who think it was a wonderful thing. However, many in both groups seem to agree that “the” gold standard represents the free market money of the good old days, or the bad old days, or perhaps even the future.

However, the inclusion of the word “standard” could already serve as a warning that this may have been just another convoluted sequence of confused government programs. Looking into this more closely may suggest lessons for cryptocurrencies today.

Several different international monetary orders from 1871–1971 were based on gold: the classical gold standard, the gold exchange standard, and the Bretton Woods system. Yet these came only after a long series of previous legal interventions in money of various types. When such legal measures were absent or weaker, things tended to differ. Professor Guido Hülsmann characterizes it broadly this way on p. 46 of The Ethics of Money Production:

In the Middle Ages, gold, silver, and copper coins, as well as alloys thereof, circulated in overlapping exchange networks. At most times and places in the history of Western Europe, silver coins were most widespread and dominant in daily payments, whereas gold coins were used for larger payments, and copper coins in very small transactions. In ancient times too, this was the normal state of affairs.

One dramatic way that monetary metals were driven out of circulation was the policy of bimetallism. People we might today call “regulators” legally fixed the exchange rate between silver coins and gold coins to make the market more “regular.” The actual result was the rapid loss of a major component of the money supply from circulation. Hülsmann on p. 130:

One famous case in which bimetallism entailed fiat inflation-deflation was the British currency reform of 1717, when Isaac Newton was Master of the Mint. Newton proposed a fiat exchange rate between the (gold) guinea and the (silver) shilling very much equal to the going market rate. Yet parliament, ostensibly to “round up” the exchange rate of gold, decreed a fiat exchange rate that was significantly higher than the market rate. And then some well-positioned men helped the British citizens to replace their silver currency with a gold currency.

Hülsmann then cites similar cases in the US in 1792 and 1834. Not only did price fixing not make the market more “regular” as intended, it caused severe disruptions, with many losers, some winners, and a certain period of monopoly metal circulation.

The parallel circulation of metals may in this way have represented relatively more of a “free market money” situation than government orchestrated gold standards that arrived only after long sequences of legal manipulations—and which just happened to also channel the majority of gold into the vaults of monetary-system orchestrators.

Lessons for parallel cryptocoin circulations?

Such parallel circulation has been used as an analogy to promote parallel cryptocurrencies in a complementary monetary role. How well does this analogy hold up?

Each metal filled a different market role from the others, with some overlap. Likewise, each altcoin advertises different features. How significant will users perceive such differences to be?

The main difference between copper, silver, and gold was a large distinction in a practical characteristic, one unmistakeably clear and important to the end user—exchange value per unit of weight. A single gold coin could do the work of a handful of silver ones or a hefty pile of copper ones, whereas buying a few potatoes with gold instead of copper would have been quite a technical challenge in the opposite way.

However, this particular factor—probably the most important one from the case of metals—does not apply to cryptocurrencies, which can be divided and combined freely and have no weight. Perhaps some other factors will prove significant enough to create a similar degree of differentiation, but the final say goes to the market test, not the engineering imagination. Another significant difference among cryptocurrencies is the amount of hashing power protecting each chain. This is a factor, in contast, for which minimal significant parallel exists in the case of monetary metals (the closest thing would probably be relative differences in forgeability).

In considering a given cryptocoin from a monetary viewpoint, it is important to investigate and consider its actual patterns of use. Having the word “coin” in the name does not make it a monetary unit. What does? One sign is the extent and scale to which users are holding a unit so as to buy goods and services with it. This might contrast, for example, with an income purpose (buying and selling the asset against another monetary unit in pursuit of monetary gains), or social-signaling purposes such as giving out microtips to online commenters. Each altcoin or appcoin might fill different roles and provide different kinds of value to users, perhaps within particular sub-cultures, or perhaps in the context of particular services. Coins can apparently fill some of these functions without having to gain much traction in a more general monetary role.

In contrast to this, a central function of holding cash and other liquid balances is to address the uncertainty of the future and this is a general function—the more general, the better fulfilled. For example, we may know that we will want to buy some things in the future, but not necessarily know exactly which things, when, where, and at precisely what prices. Cash balances, due to their flexibility, enable us to adjust to such constellations of uncertainties. In this sense, a unit that is more widely accepted is likely to come in handy in a wider range of such future situations than one that is less widely accepted (there are also other factors to consider besides generality of acceptance, such as whether the units are expected to tend to gain or lose value while being held in balances).

I suspect that only significant traction in such a general monetary use, such as bitcoin has begun to gain, could sustain a large increase in a given unit’s purchasing power over the longer term through the network-effect process I have termed hyper-monetization.

There is a strong tendency in a trading network toward the use of a single monetary unit. This theoretical insight has sometimes been extended to the historical claim that this is the natural role of gold, or the forward-looking claim that gold should fill this role in an ideal future. However, other factors also push back in the opposite direction toward parallel circulations and multiple options. Such factors could be natural, such as we saw with large practical differences among different monetary metals, or political, such as the legal favoring of some monies in combination with the geographic sectioning off of the total trading universe.

One option is not really an option

Finally, adaptive systems and species that survive for a very long time tend to have some redundancies in critical systems. There is no single more critical system for the functioning of civilization than indirect exchange using money and other monetary units. A repeated theme in the history of money, however, has been actions by rulers that have the effect, whether intended or not in any given case, of removing alternatives and opt-out paths for money users, leaving them highly vulnerable to whatever happens with the remaining monopoly unit.

If a society has a single dominant monetary unit for whatever reason, it would seem favorable from this larger vulnerability assessment or antifragility perspective for its members to have other viable options at least waiting in the wings in parallel operation. Use of a single money certainly has strong advantages, but while network effects and broadness of acceptance are very large factors, they should not be mistaken for being the only ones.

In particular, use of one unit with no alternatives available does not address the need for adaptation to unexpected events. The complete absence of freely chooseable and ready alternatives makes a society more vulnerable to the effects of large-scale shocks. Points often lost on central planners of all schools are that redundancies and parallel options tend to have unexpected very long-term survival value, that more options are often better than fewer, and that having only one “option” is similar to having no option at all.

Recommended related books:

Jörg Guido Hülsmann, The Ethics of Money Production (2008)

Nassim Nicholas Taleb, Antifragile: Things that Gain from Disorder (2012)

The helpful fable of the "bitcoin": Duality models revisited

Bitcoin is many things, all referenced under the same word. Confusion about its nature and valuation naturally arises from insufficient differentiation of these facets, combined with a general human tendency toward “either/or” thinking. Often, the situation is more “both/and,” which becomes clearer after looking through first impressions and simple or even misleading analogies.

A short section of Francis Pouliot’s 17 May 2014 post on the Bitcoin Foundation of Canada blog caught my attention: “The currency and the network, although conceptually different things, cannot be separated. Bitcoin the network is valuable in itself because of its characteristics and, because you need to obtain bitcoins in order to use it, so is Bitcoin the currency.”

This reflects the kind of unit/system duality approach that I have found helpful, and it started me considering some further implications (I discussed the application of unit/system duality and economic/technological duality concepts to Bitcoin in “On the origins of Bitcoin” (3 November 2013)).

Discrete tradable bitcoin units are one of the integral aspects of the Bitcoin network, which in turn is a live instantiation of the Bitcoin protocol (language/convention/consensus system). The value of the units is what enables the distributed financing of the entire network; the existence of this network enables the existence, security, and value of the units.

Along another conceptual axis, economic theory supports the interpretive understanding of what people do. What things are is addressed in this case as what I call the technological layer. These layers interact, but the methods appropriate to studying them differ. One is the domain of action theory, with concepts such as ends, means, and preference; the other, in this case, of computer science, networking, and cryptography.

Still, the technological layer of Bitcoin (the system) can give hints toward economic theory interpretations of the value of bitcoin (the tradable units). Additional economic insights might at times be inspired by checking back to see what is “really” going on in the technological layer, and then clarifying the relationships between the layers.

The helpful fable of the “bitcoin”

In applying economic-theory concepts to interpreting actions, the interpreter references the more specific constructs that the people in question use in their own acts. In this case, among Bitcoin users, this construct is the operative image of “bitcoins” or other such units as interchangeable, tradable digital objects.

Yet when dialing the technology layer up into a higher presence in awareness and overlaying it on the action-interpretation layer, “bitcoins” begin to look like something of a made-up image, albeit one that enables people to interact with the technology layer in a meaningful way. The image makes it intuitive for people to use the system to accomplish their own objectives—to create, hold, and adjust balances and to buy and sell products, services, or monies out of such balances.

The tradable units on the network are not bitcoins, and are in a sense not even satoshis (100,000,000 to a bitcoin). Satoshis are an abstract unit of account within the network, whereas the elements held and traded are “unspent outputs” of all possible sizes denominated in this abstract unit (or more convenient multiples thereof). Satoshis are not now generally useful in the form of a single unspent output of one satoshi. Unspent outputs, each defined in part as some number of satoshis, are assigned to an address in a state from which they can be reassigned to other addresses (including to change addresses as needed), provided the specified signatures and other transaction data are relayed to the network.

All of this can work for a general population of end users because none of them needs to understand any of it to use the network for their own purposes. Even those who do understand such details do not have to think in such literal terms when interacting with the network in the role of end user themselves. The fable of the existence of “bitcoins” helps facilitate the human-network interaction at a practical level.

So long as the practical effect of such an image fills this role without causing errors or deceptions, it is a purely pragmatic and instrumental issue. For example, it does not matter at this level if a car’s steering wheel turns the wheels on the road mechanically or sends electronic control signals to electric motors that actually steer the vehicle—provided that the practical result in either case is that the vehicle actually turns as intended in response to the human-generated directional signals.

A dualistic valuation

In this way, combining the unit/system duality and economic/technological duality approaches can lead to additional insights about the way people value Bitcoin/bitcoin. The network is only in a loose metaphorical sense valued “as a whole.” The principle practical way for users to value it is via their own possession of and ability to transfer specific tradable units. Such units are an integral characteristic of the system. Viewed together as a social phenomenon, this could suggest the superficial appearance of a mass user valuation of the system in general. However, an idealistic “in general” valuation or mere widespread sentiments of technological appreciation could not support a functioning monetary system; only individual user valuations of discrete units can do that, and it is from there no surprise that this is precisely what Bitcoin “the system” enables.

Unspent outputs denominated in satoshis and multiples of them form a key part of the end-user interface of the protocol/network. Users value these and incorporate them into their respective structures of action. The units (or rather, the interface construction of the units) cannot function as they do in this role without the system; nor can the system exist as it does—or be entirely self-financed in a distributed way as it is—without the scarce and discretely valued tradable digital objects denominated in the system’s own abstract accounting unit.

New paper: "Revisiting conceptions of commodity and scarcity in light of Bitcoin"

I have written a paper on Bitcoin in relation to fundamental theoretical concepts from economic theory, particularly “commodity,” as in the category of “commodity money,” the multiple meanings of “scarcity,” and “goods.” “Revisiting conceptions of commodity and scarcity in light of Bitcoin” (17 March 2014) [PDF] [ePub] is 21 pages of text, plus references.

This is a completely revised, updated, and reformatted version of an extended post that appeared almost exactly one year ago on 19 March 2013, entitled, “The sound of one Bitcoin.” That post was more in the style of a detective story, cataloging my personal step-by-step process in my first weeks of initially trying to make sense out of Bitcoin in terms of the economic theory that I had long studied.

A friend who knew I have been working on this revision asked recently if it was was mainly a refinement or if there were drastic changes from the original. I replied that while the basic ideas were the same, there were…drastic refinements. There are also connections to work that I have done in the intervening year since the original version came out.

Download here: [PDF] [ePub].

Newsweek uncovers its own lack of integrity in alleged “Satoshi Nakamoto” discovery reporting

Newsweek just released a story, “The Face Behind Bitcoin” (6 March 2014), claiming to have found Satoshi Nakamoto, the creator of Bitcoin. I remain doubtful. Whether they have or not, though, I think their story reflects a lack of professional integrity, which is why I am not personally even including a link to it.

The person they targeted clearly did not want to be identified, but the magazine nevertheless published photographs not only of the person, but also of where he lives, along with the identities and locations of his major family members. The same story could have been published with less identifying and location information out of respect for the obvious wishes of the primary person involved (as in: he called the police when the reporter showed up uninvited at his house).

Now as to whether this story is to be believed, the article does come off as convincing at first read, but on reflection, here are some reasons I have doubts.

Many of the points made about the person targeted in the article do match up to elements of what is known about Satoshi Nakamoto, the creator of Bitcoin. There is, however, one very large problem. Given all of the alleged sophistication and use of untraceable emails, why would such a person use a real name? It is possible, but would be a spectacular contradiction to everything else that is known about Bitcoin’s Nakamoto, and for that matter, the person targeted in the article.

The article is a collection of circumstantial evidence, an ex post effort to line up characteristics and dates. However, one should ask: Which characteristics and dates that did not match the story’s objective were omitted or went unnoticed? What is the total statistical set of persons in the world who would match up on characteristics and dates in a similar way?

Meanwhile, zero direct evidence of this man’s involvement in Bitcoin was presented, only multiple coincidences of interests and skills. Nevertheless, the article is written and titled as an unqualified direct truth claim: “this is.”

So far as I can see, every piece of evidence presented also matches the thesis that this is not the creator of Bitcoin. Moreover, the real-name relationship to the person targeted in the article tends to support the thesis that this is not him, rather than that it is him. Are we to believe that “the” Satoshi Nakamoto, out of an unending list of possible pseudonyms, would have instead used a real name right along with the rest of his consistently tight operational anonymity?

Either way, what there is overwhelming evidence for is that those responsible for this article, in pursuit of traffic and their print magazine relaunch, have displayed abysmal judgment and a lack of professional integrity by giving away specific location and identifying photographic information about this man, regardless of whether he was the inventor of Bitcoin or not.