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.

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.

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.”

 

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: 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 :-)

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].

Legal and economic perspectives in the action-based analysis of Bitcoin

Well before getting “distracted” by the theoretical interpretation of Bitcoin for most of 2013 and probably well beyond, one of my central projects, still ongoing, has been to explicitly apply the action-based methodology of Ludwig von Mises and Hans-Hermann Hoppe to the philosophy of law. This is a project that had already been greatly advanced by the work of Stephan Kinsella, in my view, and I have tried to make this approach even more explicit and systematic, naming it action-based jurisprudence. This has led to some additional clarifications, foremost, what I consider a clearer differentiation between the respective natures and roles of legal theory and ethics, as well as clearer divisions between legal theory, legal practice, and (forthcoming) criminology.

I recently came across some interesting comments that reminded me of how this background influenced the way I approached understanding Bitcoin right from the beginning. Jorge Casanova in a thread in Spanish, referenced my 2011 paper, “Action-Based Jurisprudence” (links to that and related work here) and makes some good points, tying this to larger themes. The key insight is that phenomena under investigation are wholes and it is our own methods that illuminate different aspects of them (rather than the aspects being as separable as they might casually appear from attempting to reference only one field). He also cites, as I did, the example of money, which cannot be understood well without applying both economic and legal concepts (whether done explicitly or unconsciously):

[Google translated]: “There is a nature of money as a whole, with economic and legal implications, but inseparable from each other since the phenomenon (the money, or the bank if any) is absolutely inseparable from its legal and economic nature as a whole.”

A couple of years after writing that first action-based jurisprudence paper, I have just recently used legal status as the basis for proposing a new approach to monetary typology that can account for Bitcoin, which appeared for the first time in the video “Bitcoin Decrypted” Part III (December 2013). In this model, the most relevant thing about the category of “commodity money” is that it is a market good that requires no particular legal status that differs from that of any other good. Other types of monetary objects often rely on some form of legal status to prop them up, and this usually entails some degree of artificial legal privilege.

Another important factor in “commodity” is that a commodity good is one that is interchangeable with other units and is basically as easy to either buy or sell at the going market price. This is distinguished from other items, foremost specialty items, for which the relative positions of buyers and sellers differs widely. For most—non-commodity—goods, it is easy to go to a store and buy something, but much harder to turn around and sell it again. New cars, for example, famously take on a substantial price discount as soon as they are “driven off the lot.” On a commodity market, however, the relative positions of buyers and sellers are much closer in terms of the relationship between price spreads and relative ability to have transactions executed in a timely way.

In contrast to these two factors (a legal one and an economic one), it seems to have become more typically understood that the important thing about “commodity” in monetary thought is its apparent reference to the tangibility or materiality of historical commodity monies. However, I argue that this is turning out to be an incidental historical characteristic, rather than a theoretically fundamental one (See On the origins of Bitcoin: Stages of monetary evolution” (PDF, 3 November 2013 revised edition).

It is interesting to note in this connection that tangibility is a type of physical characteristic. As such, it requires neither economic theory nor legal theory to define it. It can be defined in terms of the natural sciences, referencing certain physically measurable properties, or their absence.

Legal status, in contrast, must be understood on the back of some kind of legal theory, while degree of liquidity/marketability/saleability is an economic-theory conception. In sum, these two factors, legal status and liquidity, both properly belong to the (“praxeological” or action-based) social sciences, whereas questions of tangibility or materiality (or the identification of one metal as contrasted with another) are first of all natural-science questions. In the same sense, the identification of cryptographic properties such as those of cryptocurrencies is first of all a mathematical and cryptographic issue, likewise not a social-science issue, per se (only secondarily, in that acting people are reflecting such elements in their actions and value scales).

 

What follows is the original comment in Spanish for those who can read it or run it through an online translation widget, which seems to create something at least vaguely comprehensible in the case of Spanish to English (as opposed to the hilarity that ensues from Japanese to English machine translation):

No hay tal cosa como la economía por un lado y el derecho (o en un sentido más amplio el entorno institucional) por el otro. De hecho, resulta muy ilustrativo el sensacional trabajo de Konrad S Graf titulado “Action-Based Jurisprudence: Praxeological Legal Theory in Relation to Economic Theory, Ethics and Legal Practice” publicado en Libertarian Papers (Vol. 3, 2011)… y cuya primera parte me parece uno de los más brillantes razonamientos sobre teoría legal praxeológica que he leído hasta la fecha. En resumidas cuentas, Graf señala que la praxeología se divide en tres “niveles” (raíz, tronco y ramas, usando la metáfora de un árbol) y que las dos ramas fundamentales (cada una con varios elementos) son la teoría económica y la teoría legal, y señala además que hay determinados fenómenos (el primero de los cuales es el dinero y banca) que no pueden entenderse sin aplicar simultáneamente las implicaciones de ambas ramas, la económica y la legal. No es posible, al tratar el fenómeno monetario hablar de una naturaleza económica del dinero y de una naturaleza legal (o institucional) del mismo, ni tan siquiera en términos analíticos y teóricos. Existe una naturaleza del dinero como un todo, con implicaciones económicas y legales, pero indisociables entre sí pues el fenómeno (el dinero, o la banca en su caso) es absolutamente inseparable de su naturaleza jurídico-económica como un todo. Desde el momento mismo en que la praxeología no es solamente ciencia económica, sino que es ciencia de la acción humana en general (y a partir de los trabajos que venimos desarrollando personas como Josema C España y un servidor, estamos cada vez más cerca de hablar de todo un paradigma de filosofía primera incluso, lo que va aún más allá del método de una serie de ciencias en particular) no es posible disociar un elemento puramente económico del más general elemento de acción humana.

Hyper-monetization reloaded: Another round of bubble talk

‘Tis the season again when the Bitcoin exchange rate rises fast and “bubble” talk resumes among some journalistic and other Bitcoin skeptics. Around the height of the previous most dramatic Bitcoin exchange rate movements of March and April 2013, I posted an article called “Hyper-monetization: Questioning the ‘Bitcoin bubble’ bubble,” which was widely circulated at the time and still referenced now. What follows is a blend of brand-new material and thoroughly revised highlights from the earlier article.

The objective was, and is, not to give advice or make predictions, but to draw on theory to develop alternative perspectives on what exactly a “bubble” may or may not be in relation to the distinctive case of a brand-new rising-value medium of exchange. “Medium of exchange” is fancy economic jargon for something one can pay for goods and services with. I define a money as the common unit of pricing and accounting in a given context (see my “Bitcoin as medium of exchange now and unit of account later: The inverse of Koning’s medieval coins,” 14 September 2013).

Behind popular price-bubble discourse often lies a thinly or not-at-all veiled general debate on whether Bitcoin is a valid system. Some degree of bubble-talk functions as a pop proxy for this. In April, some Bitcoin critics were citing rapid price movements in support of the contention that Bitcoin, as such, was only a bubble. When this bubble popped, the story went, Bitcoin units would supposedly return to their “inherent” value, which they claimed to be…nothing.

Of course, Bitcoin failed to oblige them once again. Yet each time Bitcoin does not fulfill this pop empirical prediction, and instead eventually goes much higher in price later on, one nevertheless hears the same prediction repeated the next time around. In contrast, there are several ways to take a much longer-term view, one that is able to both account for price manias and also acknowledge the possibility that Bitcoin could be a valid system, and an ever more reliable one in the making.

Hyper-monetization reloaded

Many observers have likened the rise of Bitcoin to an asset bubble. Another less common word introduced in this context is hyper-deflation. Some say such a thing is horrible, others that it is great. I suggest a quite different interpretive concept to apply in addition: hyper-monetization.

I came across the term hyper-deflation, intended in a positive sense of rapidly rising value, when Bitcoin’s exchange rate was climbing fast from the low thirties to the high thirties over a few days in early March 2013. While a few specialists of a certain persuasion understand “deflation” to be a great thing for ordinary people, the word still has major problems. It has several possible definitions. It can refer to price-level changes or to quantity of money changes, depending on who is talking or when. It is assigned a quite negative interpretation in most conventional economics circles. Finally, it has a general public-relations problem. It just sounds depressing as a word. Whatever its real net effects on society might be, “deflation” just sounds like a bad thing no matter what. Which child most wants a deflated balloon?

The word hyper-monetization occurred to me as a more positive alternative to hyper-deflation, one that also provides an antonym to the catastrophic hyper-inflations that have repeatedly killed off fiat paper monies throughout history. The exact opposite of the death of an old money at the debt-dripping hands of state/bank alliance managers would be the birth of a new medium of exchange at the creative hands of the market.

The term de-monetization denotes the more general concept of a widely used medium of exchange ceasing to function as one. A total hyper-inflationary collapse is one way this can happen. Another is bimetallist legal-tender price-fixing schemes driving one precious metal, say silver, out of circulation in favor of another, say gold, or vice versa. Yet another historical example is when a pure fiat paper standard is created after monetary authorities permanently “suspend redemption” of legal tender notes into the precious metals that had been promised in exchange for such notes (that is, note-issuer default is “legalized”). Paper and account entries then remain as money, while the metals that had formerly “backed” them are de-monetized and trade as commodity assets, bought and sold in terms of what replaced them in the actual role of money. The rhetorical line from some well-meaning sound-money promoters that “gold is money” is simply untrue, except, of course, in regard to those times and places where it actually was.

The opposite process, “monetization” in this sense, denotes something that was not a money beginning to function as one. When euros took over the jobs of various European national currencies, euros were monetized and the previous national currencies de-monetized. The French franc and Italian lira do not now function as monies; they are historical relics.

Something that gains its own exchange value from scratch on the open market contrasts sharply with any such forced legal conversions. When a freely chosen unit monetizes through market processes, and does so quite rapidly, it might then reasonably be described as being in a process of “hyper-monetization” (for a detailed treatment of origin-of-money issues, see my recent paper, “On the origins of Bitcoin: Stages of monetary evolution,” revised version, 3 November 2013, PDF).

A problem with the “bubble” bubble

Bitcoin’s high price volatility is unquestioned. However, it is unsurprising for at least two reasons. First, it is not widely understood as a technology and is in a very early stage of development. Second, its exchange value (market price) tends to react to news that highlights regime uncertainty. It should be noted that this is a type of “government failure” in that the scope and variability of policy uncertainty across multiple jurisdictions greatly increases market uncertainty.

Something else to consider in relation to the eternally-recurring “Bitcoin is a bubble” claim is that in a normal asset bubble, certain key factors differ. To whichever height the prices of typical bubble assets such as houses climb, a given house remains the same good in a physical sense as when it exchanged for less money. In the case of a monetization event, in contrast, the actual utility of the trading unit—which is mainly its utility as a trading unit—may actually rise. This is due to monetary network effects, named in reference to the value that comes from the extent of the network of people willing and able to deal in a particular trading unit.

To imagine how this special case of medium-of-exchange utility growth might differ from an ordinary asset bubble in, for example, housing, it would be as if not only the prices of houses were rising during a buying rush, but in addition, their actual sought-after qualities as physical houses were improving as well. Such fantastic houses might sprout new rooms with no one building them. New paint jobs might appear mysteriously overnight without any painters having visited.

For a medium of exchange, a rising general usability for facilitating the purchase of goods and services (separate from the relative value of each unit) is not directly tied to its exchange rate against other monetary units. Still, this aspect is likely to positively influence such exchange rates. Conversely, rising exchange rates, if they generate news and wider attention, can then lead to enhanced network effects through increased recognition, creating a network-growth cycle.

For those who have been following Bitcoin news closely, for months on end there have been seemingly daily announcements of new ways and places for consumers to spend bitcoins, new or improved wallet services to manage bitcoins, new or improved payment processor services to receive bitcoins, and new exchanges at which to buy and sell bitcoins—all on a global basis. Bitcoin payment processor BitPay announced in September that it had 10,000 merchant customers, up 10x from 1,000 a year earlier. In the past 12 months, the number of wallet accounts listed at the popular Blockchain.info My Wallet service has risen 13.9x from 38,460 to 534,575. These are just two specific services and do not reflect horizontal expansion in the number of competing services or the direct use of the Bitcoin network to facilitate transactions on the part of consumers and merchants using directly controlled software without intermediated assistance from service companies.

“Is” a bubble versus “is in” a bubble phase

Bitcoin does have its manias and crashes. The hyper-monetization concept seems useful especially in a longer-term perspective for addressing the view that Bitcoin is nothing more than a speculative bubble. The most insistent proponents of this view elaborate along these lines: “Bitcoin has no ‘intrinsic’ value and is therefore ultimately destined to fall to its ‘inherent’ value, which is zero.

However, claiming that Bitcoin is a bubble (total dismissal of the system as such) is quite different from claiming, perhaps helpfully, that Bitcoin’s exchange rate may be showing signs of being in a temporary bubble phase or mania at a given point in time. That said, every significant rise in price cannot just be reflexively attributed to a mania. There is certainly more to this story and there are many specific matters of degree and interpretation. Among these is recognizing that a young currency such as this would naturally vary in price quite a bit more as it is being discovered in waves than later after it has gained more widespread adoption.

At a theoretical level, unlike a simple asset bubble mania, the more people begin using or expanding their use of a particular medium of exchange, the more its actual utility rises, and the more valuable it actually is in this function from the point of view of its users. The exchange value of a medium of exchange unit is related to, among other things, each holder’s expectations of being able to use the unit in future exchanges. How many people will accept the unit, how readily, and for what?

At least when it comes to the aspect of monetary network-effect growth in any season, ‘tis the more the merrier.

Strong positive response to "On the origins of Bitcoin"

The positive response to my recent paper, “On the origins of Bitcoin: Stages of monetary evolution” (23 October 2013), has been quite a surprise. Within the first hour, I had received word that the 30-page PDF had already been loaded onto an iPad in Texas and laser-printed in Brazil. Pretty soon, it had been posted on Reddit (r/bitcoin), where it was described as a “treatise.”

In less than the first two days, there have been nearly a thousand visitors to this link on my website. The paper has generated cascading retweets and tweets of recommendation and appreciation that total about 50, as far as I can estimate. Tuur Demeester, editor of the MacroTrends investment newsletter, has been tweeting quotes from it.

The highlight has to be a tweet from Jon Matonis, executive director of the Bitcoin Foundation, Forbes contributor, payments industry veteran, and long-time advocate for non-political currency options: “Konrad Graf earns his place in Bitcoin economic history.”

Well, with that, it must be time to call it a good week.

Update

Link updated from 23.10.2103 version to revised and expanded 03.11.2013 version

Download PDF: On the origins of Bitcoin: Stages of monetary evolution (03.11.2013)


"On the origins of Bitcoin," my new work on Bitcoin and monetary theory

Linked below is a new work I have just written on Bitcoin and monetary theory. It addresses in a more systematic way than I have before issues relating to the interpretation of the origins of Bitcoin in terms of the monetary regression theorem and the application of some central integral-theory principles to monetary theory.

Bitcoin has arisen as an entirely new and unexpected market phenomenon deserving of fresh treatments. Its arrival also provides opportunities to dig deeper into theoretical fundamentals themselves. While this work can be viewed as part of a much larger project in progress, I also have the sense that it can stand alone.

The title, On the origins of Bitcoin: Stages of monetary evolution, acknowledges the inspiration of the classic 1892 work, On the origins of money by Carl Menger, a landmark in the development of the market-evolution account of the origins of media of exchange and money. This “Austrian school” or “Vienna school” approach contrasts with what I dub the state-creatationism theory of the origin of money. It also contrasts with the tempting but unsatisfactory view that money is merely a “social illusion.”

In a nod to the software world out of which Bitcoin has arisen, I call it a first public beta, meaning that, while refinements are always possible and likely, I think the central intended functionality has been implemented. Revised versions and formats may follow.

Update

Link updated from 23.10.2103 version to revised and expanded 03.11.2013 version

Download PDF:On the origins of Bitcoin: Stages of monetary evolution (03.11.2013)

The labor, leisure, and happiness game: Psychology, praxeology, and ethics

[Revised for improved clarity and readability on 30 July 2018].

Philosophers, economists, and psychologists have sought to define the ultimate goal or “end” of human action. Is there something that can characterize, in general, what it is that people seek by acting?

Aristotelians, Objectivists, and other philosophical schools speak of ends in a moral “ought” context. That is the most common context in which such things have been spoken of throughout history. Schools of psychology have proposed central underlying motivations behind human behavior. These vary: power, sex, growth, insight, needs hierarchies, etc. Religious traditions each offer somewhat different accounts of the ultimate role or destiny of humankind, which has been divinely placed.

Against this backdrop, the arrival of Misesian action theory was revolutionary. It defined ends in a way that was free of moral, psychological, or spiritual qualifications. Ends were logically necessary characteristics of what action is. Any moral evaluation of particular ends or accounts of central psychological motivations or spiritual purposes were all separate and additional matters. A level exists at which action can be considered as such, separately from all such add-on differentiations.

The only surprising result would have been controversy not ensuring. Objectivists accused economists of the Austrian school of amoralism due to their anchorless “subjective” theory of value that provided no moral compass.

Well, yes. Providing a moral compass is not the purpose of the analysis. Action theory makes non-moral statements about action. These are must be statements rather than ethical ought statements or empirical maybe/let's check statements. All that Misesian action theory (praxeology) can legitimately claim on this matter is that action consists of employing means in the pursuit of ends—any ends.

Nevertheless, praxeological economists still attempted to comment on ultimate ends, the attempts reflecting their wider philosophical leanings. This crept in in discussions of “labor” and “leisure” in relation to “happiness” or other versions of a purported ultimate end.

Is there some universal end of all human action and if so what? Is it seeking happiness in general, happiness as “rationally understood,” or eudemonia (“human flourishing”)? Is it acting to remove states of dissatisfaction and uneasiness in search of an elusive ultimate state of rest (Ludwig von Mises)? Is it eliminating the root causes of recurring disappointment and suffering (Buddhism)? Or something else?

Each formulation seems to paint the relative value of “labor” and “leisure” in a different light. Yet this raises suspicions. One should not expect to find such differing implications from versions of a supposedly universal definition. Negative definitions of labor seem to favor rest, positive ones activity, and some spiritual ones equanimity regardless of particular conditions of activity versus rest.

This leaves another possibility. Is there any need for praxeology to carry a concept of one ultimate end at all? Actual actions are many and discrete, each consisting of specific means/ends structures in particular contexts. These many ends do not have to all be packageable under a single characterization. A bout of removing uneasiness, for example, could come right after a day of pursuing human flourishing (a Miseseso–Rothbardian tag team), all done by a Zen master unattached to the particular outcomes of any and all such ephemeral pursuits as labor and leisure.

Under what conditions do people actually find themselves either more or less happy? To look into this question, an important article by professor Roderick T. Long on Objectivist ethical theory and Austrian school subjective value theory, taken alongside two books on the psychology of happiness, shed light.

From Mises to Rothbard

In “Praxeology: Who Needs It?” (2005; PDF), Professor Long quotes Murray Rothbard on his differences with Ludwig von Mises’s “removing uneasiness” criteria. This is what Mises set out early in Human Action (1949) as the abstract general end of all action. Mises does also use striving for happiness on the same pages. However, he most often returns to the negative formulation of removing uneasiness. This shows up in his discussions of the relationships among labor, leisure, and (dis)satisfaction.

Long wrote: “Rothbard…describes how, in his economic treatise Man, Economy, and State (1962; MES), he took care to revise precisely this Misesian doctrine (310).” In correspondence quoted in Joseph Stromberg’s introduction to MES (p. xl), Rothbard had written:

The revision purged [Mises’s] original formulation of its definite philosophical pessimism, of the idea that human beings are constantly in a state of dissatisfaction and that man could only be happy in a state of inactive rest, such as in Paradise. Such a philosophical view is contrary to the natural state of man, which is at its happiest precisely when it is engaged in productive activity.

Long explained that:

Rothbard acknowledges the possibility of “satisfaction in the labor itself,” and so grounds the “disutility of labor” not in labor’s being inherently distasteful, but in the fact that “labor always involves the forgoing of leisure,” which is also a value…The fact that leisure has value for us explains why we prefer to economize on labor, thus allowing Rothbard to draw all the essential conclusions for which Mises thought he needed the mistaken Nirvana premise. (311)

Yet Rothbard’s view that people are happiest “precisely when…engaged in productive activity,” as opposed to when idle in paradise, is also an empirical psychological claim. As such, however, it does find support in psychological research on self-reported happiness. One qualification that will emerge, though, is that Rothbard's use of the word “productive” could lead to an unwarranted emphasis on the categorization of activity types, such as work versus hobby.

Get into the flow

Flow: The Psychology of Optimal Experience (1990) by Mihaly Csikszentmihalyi presents the results of research on tens of thousands of participants in different cultures. It found that higher degrees of self-reported happiness were associated with engagement in self-chosen, goal-directed activity structured with an optimal relationship between challenge and capability.

Self-reported happiness was higher the better persons were positioned to 1) select and revise their own goals and 2) dynamically adjust the balance between challenge and capability toward a moving zone the researchers labeled “flow.” Adjusting challenge can be relatively straightforward through choices of goal and performance criteria (quantity, quality, time, outcomes). Raising capabilities might involve taking the time to invest in capital (tools) or human capital (abilities) to increase effectiveness before further task engagement.

For example, cutting down a large tree with a dull hatchet could become frustrating. Taking the time to buy or borrow a chainsaw before cutting may turn into a more enjoyable overall experience. Moving right to managing a major logging operation with no experience in either managing or logging would most likely quickly lead to frustration, if not disaster.

In a hobby context, though hardly ever in a work context, one might lower capabilities in pursuit of the flow zone. Gamers, for example might sometimes choose to play with inferior in-game equipment, which would effectively raise their challenge level compared to selecting the best available equipment.

Golf, bowling, and some games have “handicap” scoring options. This reduces or evens out score gaps, enabling more skilled and less skilled players to more meaningfully compete in the same match, reducing boredom for the more skilled and frustration for the less skilled.

The flow research found that how activities were classified by type, such as labor, work, play, hobby, or leisure, did not impact the degree of happiness reported. Boredom, both at work and on vacation, showed up when capabilities were too far above challenges. One might look forward to finally having “nothing to do” on vacation—and then get bored with nothing to do. Frustration—both at work and in leisure or hobby activities—showed up when challenges were too far above capabilities. The challenge/capability balance influenced happiness. Categorizations of activities, such as labor versus leisure, did not.

Both at work and at leisure, research participants reported higher degrees of happiness when they had set their own goals. Even for goals that had originated elsewhere, such as with organizational leadership or a client, flow effects could still be found if the person made the decision to make those goals their own, as opposed to merely acquiescing and going along with orders.

The common element found to support higher degrees of self-reported happiness was each person having the final say on his or her own activities over both long-term strategic and short-term tactical scales. In my view, this recommends a set of social conditions that support individual-level autonomy, flexibility, and discretion. Individuals should be able to chose their own goals and how to pursue them. This includes minimizing the need to “apply for permission” before taking action, as well as maximizing individual discretion on which groups to join or leave. The only social institution capable of assuring such individual discretion and autonomy is one with consistent respect for rights of first appropriation and mutually consensual transfers of property.

The typical popular counter to such allegedly “atomistic” principles is that people are “social” creatures. However, this claim cannot justify the use of violence to orchestrate non-consensual relationships. It does not explain what is “social” about the advocacy and implementation of such violence. Actually being social entails not advocating, approving of, or implementing initiations of threats or violence.

Got game?

According to Reality is Broken: Why Games Make Us Better and How They Can Change the World (2011) by Jane McGonigal, good games are designed to capture the above dynamics by enabling the player to self-adjust challenge levels and cultivate rising capabilities as challenge levels rise. Even prior to this, the player first selects which game to play, when, and with whom. Gaming entails a wide range of autonomous dynamic decisions that influence the challenge/capability balance. What difficulty level does the player select? How long does the player work on a puzzle before turning to a help clue?

Games themselves are also designed to dynamically adjust this balance. Difficulty and strength of opponents typically rise as the player gains achievements, levels, rank, and equipment. Games also often provide adaptive feedback on progress toward clearly defined goals. These are each elements that modern game designers have raised to high levels.

The popularity of gaming helps illustrate the motivational power of each person being able to seek flow states through dynamic autonomous goal selection and challenge/capability balancing. McGonigal’s central theme is that games have come to be designed to tap into motivation in a way vastly superior to typical (de)motivational structures found in schools and corporations. Lessons for institutional improvement could be derived from the study of game design.

Moreover, if we are concerned with young people being obsessive about gaming and uninterested in school, we should naturally want to examine the extents to which goals are self-selected and the challenge/capability balance is adjustable individually in gaming versus school. The answer is near. Most good games offer high degrees of player autonomy and masterful challenge/capability balancing. Most schools are abysmal in both areas.

Promoting interest in "the real world" could therefore begin by increasing the range of autonomy that young people can practice in that real world, for example, by enabling them to engage in work again.

Why will kids work ingeniously and for unending hours for in-game gold? In gaming, they can work with whom they chose and keep the gold they earn. This contrasts with the more and more artificially constrained real world in modern interventionist economies, which increasingly outlaw young people from working at all. The message to young people is: if you want to work, earn, and create, it must be in the virtual world or not at all. The analysis of action from a praxeological standpoint applies just as well to in-game action as to out-of-game action.

Psychology, ethics, and praxeology: The distinctions revisited

The psychological research from Flow and the analysis of gaming can help remove extraneous implications from past attempts to formulate descriptions of the ultimate ends of action. Relationships among labor, leisure, and happiness do not exist. Happiness is influenced by self-chosen challenge/capability balance without regard to labels such as labor and leisure.

The distinctions between praxeology, ethical philosophy, and psychology should be clearly maintained, yet valid insights from each should not be ignored either. Praxeology says, “it is/must be so by definition.” Ethics says, “one should act this way rather than that way.” Psychology says, “we observe, notice, and hypothesize.”

Meanings of "rationality" also play into this topic and clarifying this is also helpful. Long clarified the nature of “rationality” as used in praxeology, including which claims praxeology can legitimately make regarding it. When a praxeologist claims that all action is rational, it is a claim that actors employ means to the attainment of ends. This only states an implication of what action is.

However, an ethicist’s or psychologist’s definition of “rational” must specify some narrower distinctions or be meaningless for their purposes. Those wearing psychologist or philosopher hats might well be interested in whether people deceive themselves in their judgments or make poor judgments. However, such distinctions must be left behind when donning the praxeologist’s peculiar new hat. Long writes:

In a sense, then, it is true that agents always act rationally; but the only sense of this claim to which Mises is [praxeologists are] entitled is that agents always act, not necessarily in a manner appropriate to their situation in all the ways they actually see it, or even in the most justified of the ways they actually see it, but rather in a manner appropriate to their situation in the way of actually seeing it that is constitutive of their action. (309–310).

This third formulation finally leaves no room for distinctions among “rational” (as contrasted with “irrational”) qualities of particular actions as judged by any narrower ethical or psychological criterion. Instead, the meaning of “rationality” for praxeologists is a universal-definitional one. As such, it is of no use to psychologists or ethicists who require narrower definitions to work with. Indeed, it is not especially useful to praxeologists at all and might be better abandoned as a relic from a time when this distinction was not yet clear enough.

This third formulation helps refine the lines between psychological interpretation, ethical advice and judgment (“this is rational, that is not”), and universalizable statements about action. Only the third formulation is undeniable for all cases of action without further inquiry into motivation, thought processes, or value scales. Only the third statement is/must be so as a logical implication of what action means. The rest is up to the other fields.

Bitcoin as medium of exchange now and unit of account later: The inverse of Koning's medieval coins

A new article by JP Koning at the Moneyness blog revisits the idea that two monetary functions can be separated: medium of exchange (that which is used to actually buy things) and unit of account (what prices are quoted in and accounts generally kept in). He does this through a historical account of the monetary milieu of some medieval European cities. This has direct implications for viewing contemporary monetary developments half a millennium later.

In “Separating the functions of money—The case of medieval coinage” (13 September 2013), Koning suggests that a common unit of account (the pound/shilling/pence system) for pricing existed alongside a plethora of actual coins of various and sundry sizes, qualities, and metals. Each had to be repeatedly assessed and reevaluated due to wear, fraud, and outright devaluation in terms of the common unit of pricing. This had to be done so that such objects could actually be applied toward paying in specific transactions. Meanwhile, he claims that actual coins corresponding to this unit of account may well have been rare or might not have existed at all at certain times, at least relative to the mass of actually circulating crudely formed hunks of various metals (crude as retroactively judged by subsequent industrial coinage standards).

This is a thought-provoking discussion and I am sure there is more to be assessed and debated about the historical details. Nevertheless, the basic theoretical idea is that the unit used for pricing and what people actually hand over in trade to pay asked prices do not necessarily have to be the same. This implies that the problem of barter comprises at least two distinct issues: 1) no common unit of pricing for cost accounting, economic calculation, and comparison shopping and 2) no commonly accepted unit to be employed in concrete acts of payment. Koning thus seems to present a transitional hybrid case in which (1) is more developed while (2) is still a work in progress, or has broken down.

As it turns out, we are now witnessing a rapidly evolving case of just such a separation of functions. The difference is that, for now, it is the exact inverse of Koning’s medieval coins.

The opposite of medieval

Those who pay in Bitcoin today overwhelmingly pay prices that are listed in the local fiat currencies of the politically-defined jurisdictions they find themselves trading within. There are already a few exceptions, such as the Trezor high-security hardware wallet (priced at 1 bitcoin) and some mining shares, but such examples remain rare.

In current Bitcoin transactions, despite pricing still being largely denominated in euros, dollars, and the like, the actual “coin” being tendered differs from the unit of account and pricing. This separation of functions is much easier, quicker, and more accurate today than it was in, for example, Basel, Switzerland 600 years ago, due to the combination of real-time global networking and public exchange markets for both Bitcoin (see the new CoinDesk Bitcoin Price Index) and other forex pairs. This means accounting and thinking about relative exchange values can easily be done for present convenience using existing pricing constellations.

According to Koning’s account of the medieval cases he describes (taken at face value for our purposes here), the unit of account itself may even have been virtual, while the actual media of exchange handed over in transactions were the various and sundry physical coins people had managed to acquire in their previous work and trading. In diametric contrast, with Bitcoin today, we have a “virtual” coin with global circulation that is mathematically perfect in its uniformity and fungibility. These ideally homogenous global “coins” now circulate next to a hodgepodge of national-monopoly units of account/payment which have all sorts of shifting real values. Specifically, almost all such “shifting” of paper currency values is downward, just at differing rates of descent.

The potential for role reversal and later convergence

If and as Bitcoin grows and its price volatility stabilizes with expanding adoption, market participants could in time come to use it as a global unit of account against which the various and sundry unstable fiat currencies continue their extended monetary Danse Macabre. Bitcoin-denominated prices could be paid in Bitcoin, of course, or they could also be paid in a local fiat money, if both traders agree. Fiat would substitute for the relatively stable Bitcoin at the current day’s exchange rate in a way precisely opposite to their current respective roles.

Beyond this, in a long-term Bitcoin success scenario, medium of exchange and unit of account functions would most likely tend to move further toward convergence—price in Bitcoin, pay in Bitcoin. This would tend to greatly enhance convenience for all the buyers and sellers of the world (meaning everyone). That is the sort of thing that the American founding generations of the late eighteenth century would have called “the common good.”

In a more recent Europe, as Philipp Bagus explains in The Tragedy of the Euro (2010), the monetary authorities of more inflationary national currencies were repeatedly embarrassed by the relative strength of the less inflationary deutschmark. They therefore sought a coordinated means of inflating through the euro system, so that rates of monetary depreciation could be “harmonized.”

Likewise, in a future world with a successful Bitcoin, the inflationary paper monies of the world (that is, all of them) may eventually become rather self-conscious if compared to a global rising-value currency. This time, however, the inflationists may have a harder time sparing themselves distress than they did in pressuring German politicians to end the deutschmark against the general sentiment of the German people.

This is because the Bitcoin “cat” is not only out of the bag; it has spawned a global tribe of at least 200,000 currently active network nodes located in nearly every corner of the earth, any one of which contains a complete copy of the block chain.

Much more difficult than herding politicians, is herding cats.

Recommended: Provocative and important new article on Bitcoin and altcoins

Daniel Krawisz has taken the time to do the cryptocurrency community a service and come down systematically, hard and at times hilariously on the many weak arguments in favor of various altcoins. In the process, his article reveals Bitcoin itself to be even stronger than it is often presented. He argues that the actual alleged threats to Bitcoin from the likes of double-spend attacks, 51% attacks and mining centralization are each much less realistic and significant in the real world than they are sometimes made out to be (although mining centralization is still something to keep an eye on).

His displayed combination of solid technical knowledge of the field with consistently sound economic reasoning is refreshing and valuable. This is more than a thorough critique of altcoins. It also functions as a fresh defense of Bitcoin against a number of typical technical and economic objections and concerns.

I had previously come to the working impression that if altcoins did gain any useful function, it would have to be in a niche application, or would simply be as a research platform to feed into Bitcoin development. Reading this article reinforced that view, and even suggests perhaps taking it further.

So go and read The Problem with Altcoins.

Bitcoin, price denomination and fixed-rate fiat conversions

People are apparently still talking about the monetary regression theorem and its relationship to Bitcoin. There still seems to be a lot of confusion out there around both. Using a confused version of the regression theorem to criticize a confused version of what Bitcoin is does not seem like a promising recipe. I have been trying to focus on finishing up a longer work on Bitcoin and Austrian theory, but here for now are a few updated comments that came out of an online discussion today.

One newer point that has emerged in my work in progress is that the regression theorem is a theoretical explanation of how something that was at one time not money could ever become money in the first place. However, the theorem is not made to be a criterion of judgment for determining what is or is not money after the fact. Upon observing something actually functioning as a medium of exchange, the economist’s task is to explain how it came about. The role of the regression theorem was to explain specifically how something could have ever gotten started in a medium-of-exchange role to begin with. Judging and dismissing are unrelated to the function of the actual regression theorem. It is supposed to be explanatory and illuminating.

One area of confusion seems to surround the relationship between Bitcoin and fiat money, specifically the idea that Bitcoin has somehow emerged from fiat money, something like the way the euro got started on the backs or the various European national currencies. I addressed this briefly in my 27 February 2013 article, but here are some further observations.

Such transitional conversions are done with fixed exchange rates set by law. The new currency takes up its value from the old one in an administratively managed process. This applies to historical metallic coin monies giving rise to paper money certificates through a fixed conversion rate (later dropping the convertibility) and it applies to retiring paper monies being used to launch a new paper money, as in the case of the euro. However, the attempt to apply this translation/transition model to Bitcoin runs into serious trouble because no such transitional official fixed exchange rates have ever existed for Bitcoin. Quite the contrary. Governmental actors are only beginning to so much as roughly understand Bitcoin years after it already entered active use. It emerged on the market from scratch as its own good, certainly not from any official fiat.

It could be objected that regardless of origins, Bitcoin is only able to keep functioning through its relationship to fiat money and fiat money pricing. It is a mere strange shadow of the existing systems. Goods and services are priced in fiat money and a Bitcoin equivalent is paid. Bitcoins can be bought and sold referencing current market pricing on the most liquid exchange, Mt. Gox. In other words, this argument implies, Bitcoin could not function without these props.

This raises a number of interlocking issues. Bitcoin is now useful for many reasons, among them transferring value that may or may not have been obtained through the sale of fiat money and that might or might not end up being used to buy other fiat money in the future. On the other hand, while there are certainly active speculative traders on the exchanges, there are also folks buying Bitcoin with fiat money with no intention of selling it again into fiat money, but only of using it to buy goods and services in the more or less distant future. There are merchants using Bitpay so they never have to “touch” Bitcoin, but there are also merchants giving discounts for payment in Bitcoin, and accumulating the Bitcoin. There are consumers holding Bitcoin ready to use and other consumers that might only obtain specific amounts of Bitcoin for some specific purpose and then return to a zero balance. There could be some Bitcoin miners who mainly only ever sell Bitcoin for fiat money, but never buy any with fiat money. Everything is possible.

One point the Austrian school has long emphasized in monetary theory is that while money is special in certain ways, it is also a good itself, not a mere veiled marker or representation of other values. It is a type of good distinguished from other goods and services mainly by its higher marketability.

It is true that Bitcoin users have benefited greatly from the existence of market economies with functioning price structures. Pricing is still done for the most part in local fiat currencies and will probably continue to be unless and until Bitcoin becomes more stable in purchasing power than the fiat money that users are comparing it to, each in his own decision-making context. Automatic software price conversion makes it possible for the system to piggyback on existing and familiar price structures in each local area with immense convenience.

Yet I do not think there is any fundamental reason that Bitcoin-denominated pricing of goods and services could not evolve from scratch if it hypothetically had to. Fortunately, it does not have to. If no money existed at all, it would be necessary to get it going. We just have the convenience of already being able to rely on existing market prices for goods and services and the further convenience of being able to reference real-time market prices from organized exchanges. An argument could be made for just taking the easy road and using them. I think this is all just to the good of contextualized convenience and not so theoretically fundamental. Still, there are already Bitcoin-priced goods and services, particularly starting within the Bitcoin economy. For example, the Trezor Bitcoin hardware wallet is on pre-order for the price of 1 BTC.

The extent to which Bitcoin users reference fiat pricing in commerce is probably what has given rise to some  conflation with what I think is the quite different process by which one fiat money is converted into another by the official declaration of a fixed conversion price. Paper euros probably could never have taken off unless the official exchange rates with their predecessor currencies had been declared by law and the predecessor currencies had also been phased out by law. Without such official (“fiat”) declarations, printed euro notes would most likely either have been worthless or negatively valued due to the need to pay to store or dispose of them.

Bitcoin never had any official conversion price (or official anything), so how could it have gotten started? Bitcoin could never have begun to function in any other roles, such as transferring value derived from paper money over distance and converting into other paper money, if some initial users were not willing to trade any valuable goods or services for Bitcoin itself to begin with. After it began to be traded for other goods and services, one could observe it functioning in various, increasingly useful roles on that basis, some in interaction with existing monetary systems, but so long as its market price remained zero, it could not begin to serve in any such trading roles.

I think the initial-value question is probably much more narrow and technical than it is sometimes made out to be when the name of the regression theorem is invoked (the name; not necessarily the understanding). That question is how to explain a movement from a zero indirect-exchange value to non-zero indirect exchange value. Reaching non-zero from zero, especially in a digital computing context, is all that is needed for the rest to follow.

Anyone still talking about the regression theorem and Bitcoin might do well to focus on detailed historical research from the year 2009 and 2010 at the latest. After that, the deal was already done, leaving room only for efforts at explanation of what had happened. The rest was up to adoption, entrepreneurship and network-effect growth.

Now in audio on YouTube: Bitcoin and regression theorem article

I just got a message today from Graham Wright with a YouTube link. So I went over and there was my first article on Bitcoin, concerning the regression theorem, already done in a great audio version with accompanying slides. What a great surprise, one made possible by the magic of Creative Commons. Here it is!

 

Another bump on the road: Bitcoin and bubbles revisited

Japanese “bumpy road” sign for MtGox. 路面凹凸ありOverload, delays, and the temporary closure of the MtGox exchange seem to have been proximate triggers for a sharp Bitcoin correction on April 10–12 from dizzy highs.

As trading graphs fell freely, some Bitcoin critics appeared gleeful to believe that their prophecies of the Bitcoin phenomenon being nothing more than a delusional bubble might be coming true. Commenters promptly took to the internet to gloat at the short-term losses of naïve traders and bask in their own contrasting wisdom.

In this new context of short-term sentiment, it may be useful to revisit and refine my recent critique of the dismissal of Bitcoin as being nothing more than a bubble or even a sort of Ponzi scheme. In Hyper-monetization: Questioning the “Bitcoin bubble” bubble (6 April 2013), I offered an alternative to the popular interpretation of the long-term rise of Bitcoin’s exchange value relative to fiat money. This was especially intended to address the view that Bitcoin is nothing more than a bubble. The most insistent proponents of this view elaborate along these lines: “Bitcoin has no ‘intrinsic value’ and is therefore ultimately destined to fall to its ‘inherent’ value, which is zero, completely wiping out any true believers still left around for its inevitable and welcome extinction from the universe.” Or something like that.

“Is” versus “in”

A more subtle approach to calling a “Bitcoin bubble” is also available, and has long been advanced by several people with more nuanced understandings of the system. First, Gavin Andresen, lead developer of the open-source Bitcoin Project, wrote nearly three years ago in a short post Bubble and crashes (9 July 2010) that he expected multiple recurring bubbles over the course of several years.

Bitcoin will get mentioned someplace with lots of readers, a bunch of those readers will like the idea and try to buy Bitcoins, their price will rise, which will draw even more people to “invest”, which will drive the price up even more…until people decide that the price isn’t going to rise any more and everybody rushes to sell before the price drops. I predict there will be between one and five Bitcoin bubbles (price will double or more and then crash back down below the starting price) in the next four years…I think it will be impossible to tell if a bubble & crash is “natural” or “the men in black helicopters” manipulating the system.

Second, Rick Falkvinge, who had also called a short-term bubble and a correction to $60–$65, has long identified currency exchange services as a weak link in the wider Bitcoin “ecosystem.” See his 12 April post What we learn from this Bitcoin correction. A commenter on that post wrote, “I would not call an 80% move a correction…” to which Falkvinge replied, “It is not the downslope that is abnormal, it is the upslope. A value that reverts to where it was two weeks ago is normally a mild correction.”

Finally, Peter Šurda who steadily focuses on the importance of liquidity, infrastructure development, and scaling over price, re-summarized in a 12 April Facebook comment that:

My empirical research shows a correlation between media frenzy and price, and between liquidity and price volatility, while my theoretical research concludes that the price will fluctuate more rapidly than with more liquid media of exchange (i.e. what we are accustomed to as money, or even highly liquid goods such as stocks or commodities). The fluctuations will continue until Bitcoin’s liquidity increases significantly.

Such approaches have essentially been warning that, “Bitcoin may well be in a bubble phase,” adding, “one of several large ones, just as we expected to occur along the way.” As a commentary on the price trend in late March and early April, this appears to have been a valuable assessment. These observers recognized in advance that the price seemed to be rising at a pace unlikely to be sustainable, driven perhaps by events in Cyprus and then a flood of popular media attention.

In sum, saying that “Bitcoin is a bubble” (total dismissal of the system as such) and that “Bitcoin is (or was) in a bubble phase,” are quite different claims. Now that another correction has arrived, this distinction can come into better focus.

The Bitcoin system is not the same as the peripheral trading services

The core of the Bitcoin system itself, which few people seem to grasp is something entirely different from the more visible currency exchanges and their price charts, seem to have been relatively untroubled. This includes nodes, mining pools, the blockchain, wallets, and even informal and P2P markets. Besides MtGox, with its 12-hour mini-holiday, from what I noticed, only some of the exchanges and data chart services were heavily challenged and went offline intermittently. Bitcoincharts, for example, reported a 25x spike in concurrent online users from 2,000 to 50,000, requiring “tweaking the backend” systems in response.

The primary proximate cause of the crash, then, seems to have been the inability of a (currently) key exchange service provider to keep up with demand fed by sudden media attention and buy-in frenzy in the run-up, triggering a classic emotional wave of panic selling, most likely the corollary of the previous heat of emotional buying. The existing trading infrastructure (which is not the same as the Bitcoin system infrastructure) was not ready to scale to such a rapid demand spike. This sharp correction might be viewed in part as the rather ungentle method by which the market realigned itself with the current real-world state of scaling capabilities and business planning skills at exchanges that have been working to build themselves from the ground up.

Creation versus destruction

In the case of a classical terminal hyperinflationary event, the authorities orchestrating it are better equipped and prepared. Ink and paper are ready. Printing presses run and are up to their tasks. More importantly, printing plate engravers are standing ready to carve additional integers, a relatively simple task of creating higher and higher denominations of notes. The technical infrastructure is in place for state money monopolists to completely destroy the value of a paper currency, using “zeroes” to drive it all the way to “zero” and extinction.

Building a new kind of media of exchange for a community of all-volunteer users from scratch through peaceful cooperation, entrepreneurship, coordination, debate, and market ecosystem building would appear considerably more challenging than destroying a paper currency. After all, being constructive often seems more challenging than being destructive; it requires greater ingenuity and long-term persistence and perspective.

 

For additional articles on this topic, visit my Bitcoin Theory page on this site.