Bitcoin Obliterates "The State Theory Of Money"

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■Bitcoin Obliterates "The State Theory Of Money"

Once you get past the childish title, the recent bitcoin piece from Karl Denninger raises some issues that warrant consideration from bitcoin economists. Denninger is an intelligent student of the capital markets and his essay deserves a serious reply.

The economic contribution of his essay is that it represents the thesis advanced by German economist Georg Friedrich Knapp in The State Theory of Money (1924), an expose advocating the Chartalist approach to monetary theory claiming that money must have no intrinsic value and strictly be used as tokens issued by the government, or fiat money. Today, modern-day chartalists are from the school of thought known as Modern Monetary Theory (MMT).

Without getting into the intrinsic value debate, this is where I strongly depart from Denninger, because if we accept the thesis that all money is a universal mass illusion, then a market-based illusion can be just as valid or more valid than a State-controlled illusion. What Denninger and Greenbackers and MMT supporters reject is the notion that monetary illusions themselves are a competitive marketplace, falsely believing that only the State is in a ‘special’ position to confer legitimacy in monetary matters.

Regarding this issue of State-sanctioned legitimacy, bitcoin as a cryptographic unit seeks and gains legitimacy through the free and open marketplace. It is not a governmental instrument of legal tender that requires regulatory legitimacy and coercion by law in order to gain acceptance.

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Therefore, the path to widespread adoption of bitcoin hinges on three primary market-based developments: (a) robust and liquid global exchanges similar to national currencies that can offer risk management via futures and options, (b) more user-friendly applications that mask the complexities of cryptography from users and merchants, and (c) a paradigm shift towards “closing the loop” such as receiving source payments and wages in bitcoin to eliminate the need for conversion from or to national fiat.

Even after graciously accepting Denninger’s definition of what the ideal currency would be (which I don’t) and searching for any economic nuggets of value, his arguments can be distilled into four main criticisms of bitcoin as a monetary instrument. First, bitcoin does not provide cash-like anonymity. Second, bitcoin transactions take too long for confirmations to be useful in everyday transactions. Third, bitcoin exhibits irreversible entropy. Fourth, the decoupling of the stateless bitcoin from the obligation of monetary sovereigns is considered a fatal weakness.

Now that we identified the objections, let’s take these in order.

On the first point surrounding bitcoin anonymity, Denninger only embarrasses himself with this criticism. By default, bitcoin may not offer anonymity and untraceability like our paper cash today, but it is better described as user-defined anonymity because the decision to reveal identity and usage patterns resides solely with the bitcoin user. This is far superior to a situation where users of a currency are relegated to seeking permission for their financial privacy which is typically denied by the monetary and financial overlords. Also, his capital gains tax issue is a non-starter because it’s a byproduct of a monopoly over money.

His second criticism of a lack of utility in the ‘goods and service preference’ due to timing of sufficient block chain confirmations has some merit. However, advances have been made in the use of green addressing techniques that solve the confirmation delay problem by utilizing special-purpose bitcoin addresses from parties trusted not to double spend.

Denniger’s third criticism that bitcoin exhibits irreversible entropy is confusing. Typically, entropy refers to a measure of the unavailable energy in a closed thermodynamic system that is also usually considered to be a measure of the system’s disorder. In the case of bitcoin, I suspect Denninger is taking it to mean the degradation of the matter in the universe because of his explicit comparison to gold. While it is true that bitcoins lost or forgotten are ultimately irretrievable, I view that as a feature not a bug because it is the prevailing trait of a digital bearer instrument. Two bitcoin digital attributes that make it superior to physical gold are its ability to create backups and its difficulty of confiscation. Furthermore, the number of spaces to the right of the decimal point (currently eight) is immaterial to bitcoin’s suitability as a monetary unit.

Now for the big and final one. Denninger asserts that monetary sovereign issuers possess not only the privilege, but the obligation, of seigniorage, which Denninger refers to as bi-directional since sovereigns have the responsibility of maintaining a stable price level during times of both economic expansion and economic contraction. As a product of Hayekian free choice in currency, market-based bitcoin is decentralized by nature and poses a false comparison to the century-old practice of central bank monetary manipulation. Fear not deflation.

Governments have appropriated the monetary unit for their own benefit by declaring it the only preferred monetary unit for payment of taxes to the State. Believing that governments have sincere and good intentions in administering the monetary system is akin to believing in fairy tales. Control of the monetary system serves one and only one interest — the unlimited expansion of the sovereign’s spending activity to the detriment of the unfortunate users of that monetary unit. Decentralized Bitcoin obliterates this sad state of affairs.

Denninger’s biased and establishment preference for a monetary sovereign serves only to harm his analysis because it undeniably closes him off from alternative, and usually superior, free-market monetary arrangements. More damaging, however, is the fact that it places him outside of the mainstream in free banking circles and squanders his remaining quasi-libertarian credibility as a champion of markets.

■Four Reasons Bitcoin Is Worth Studying

As Adam Ozimek points out Bitcoin has so far largely been greeted with eye-rolling by professional economists. One reason is that the cryptocurrency’s most enthusiastic advocates tend to subscribe to a hard-money, end-the-Fed worldview that is unpopular among elites. That has caused the latter to reflexively take the opposite view, treating Bitcoin as primarily a monetary policy experiment and predicting its doom.

My sympathies are with the pros here. Fiat currency isn’t perfect, but I think alternatives like the gold standard would be worse. But Bitcoin is a more than a gold standard for the Internet age. It’s the world’s first fully decentralized payment system, combining the irreversibility of cash with the convenience of electronic payment. There’s never been anything quite like it before, and as a result it poses a number of interesting intellectual puzzles. Here are four examples.

Monetary economics

What gives money its value? One popular theory says that modern fiat currencies get their value by “government fiat”: the government declares a currency to be the official one, requires that currency be used to compute and pay taxes, and thereby confers value on what would otherwise be worthless slips of paper.

Bitcoin is a clear challenge to that view. It has no “backing” from any government or other large institution, yet the stock of outstanding bitcoins is now worth more than $1 billion.

The conventional response is to dismiss Bitcoin as merely a bubble, with no intrinsic value at all. But that view makes it hard to explain the events of late 2011. The value of Bitcoins fell from $32 in June to $2 in November. Then the price started going up again, rising to $4 in December 2011 and to $7 in January.

That should surprise you. Even after watching the value of their previous investments decline by a factor of 16, a critical mass of Bitcoin enthusiasts was prepared to pour millions of dollars into the currency. It’s possible, of course, that all those people were delusional. But it’s at least possible they saw something the rest of the world didn’t. Certainly, that was the conclusion I came to. I rethought my previous skepticism and bought some Bitcoins of my own in early 2012.

Even if you think the current value of of more than $140 is a bubble, it’s clear that Bitcoin has some genuine applications. The number of daily Bitcoin transactions has soared from around 1000 at the beginning of 2011 to about 50,000 today. Figuring out the “fundamentals” that drive the currency’s long-term value seems like an interesting theoretical puzzle.

Political philosophy

The great technological feat of Bitcoin is its solution to the “double spending problem.” The cryptographic protocols needed for one currency holder to “sign over” his currency to another have been well-understood for decades. But no cryptographic operation can prove you haven’t given the same coins to someone else. Before Bitcoin, the only known way to address this issue was to have a centralized transaction register. Control over that list was inevitably a point of control for the currency as a whole.

Bitcoin uses a clever scheme to maintain a fully decentralized transaction register, preventing double-spending without giving anyone de facto control over the system. The global, shared register of Bitcoin transactions is called the blockchain, and it’s organized into “blocks.” One block is added approximately every 10 minutes. Each node in the Bitcoin network creates a candidate block and then races to solve a difficult mathematical puzzle that takes its block as an input. The winner of the race gets to add its block to the blockchain, and in that block it can credit itself a fixed number of new bitcoins (currently 25 BTC) as a reward for participating in this process. All bitcoins now in circulation were originally created by this process, which is known as mining.

When a new block is announced, the other nodes in the network confirm‎ that the proposed block follows all of the rules of the Bitcoin protocol. If it doesn’t, the block is discarded and the other nodes continue working on their own candidate blocks.

A few weeks ago, a node that had upgraded to version 0.8 of the client software generated a block that nodes running version 0.7 and earlier didn’t recognize as valid. This produced a “fork” in the network, with each half generating blocks the other half viewed as illegitimate.

If this situation had continued unchecked, it would have led to chaos, because it would have allowed hackers to spend the same bitcoins twice: once in the 0.7 version of the blockchain and again in the 0.8 blockchain. Fortunately, the most influential members of the Bitcoin community moved quickly. They made a judgment call that it would be easier to get 0.8 nodes to downgrade than to get the older nodes to upgrade. They persuaded those who had upgraded to 0.8 to downgrade, abandoning the blocks they had created since the fork and accepting the 0.7 branch as the official one.

It was important to move quickly because the stakes were growing higher with every passing hour. Every few minutes another block was added to the blockchain, earning its creator about $1000. For many of the miners, abandoning the 0.8 branch meant giving up thousands of dollars in cold cash. The longer the fork had lasted, the bigger the financial hit they would have needed to take to heal the rift.

A core part of Bitcoin’s appeal is that it’s not under anyone’s control. Supposedly, nobody has the authority to change the Bitcoin money supply, cancel or reverse transactions, or otherwise change the attributes of the protocol. But in practice that’s not really true. In the wake of last month’s fork, the elites in the Bitcoin community effectively changed the rules in a matter of hours. In principle, there’s no reason those same elites couldn’t make other changes to the Bitcoin protocol.

There’s a direct parallel here to issues of political legitimacy in a nation state. In principle, most democratic nations have constitutions that bind the behavior of government officials. In practice, a cabal of elites can and regularly do change those rules with minimal input from the rank and file. Yet the discretion of elites is not unlimited. In the case of both Bitcoins and nation states, it’s easy to make changes that will be intuitively appealing to the broader public. But even a broad coalition of elites may not be able to make changes that are strongly opposed by rank and file members of the community.

Economies of scale and competition policy

When Bitcoin is described as a decentralized system, a key assumption is that no single party controls a majority of the network’s computing power. The randomized process for deciding who gets to create the next block effectively works on a “one CPU cycle, one vote” principle. If any single party gained 51 percent of the network’s computing power, it could effectively take control of the network, ignoring blocks produced by the other 49 percent of the nodes. A successful attacker could not only claim 100 percent of the mining profits for itself, it would also gain the power to block transactions it didn’t approve of by simply not including them in its blocks.

Early in Bitcoin’s life, this wasn’t a cause for concern because the barriers to entry was very low. Anyone could download the Bitcoin client onto his computer and run it. But a technological arms race has made Bitcoin mining an increasingly esoteric business. Today, the leading miners use custom-built Bitcoin mining gear that costs thousands of dollars. Indeed, this high-end hardware is so much more energy-efficient that conventional PCs are no longer energy-efficient enough to make Bitcoin mining profitable.

As a result of this and other factors, Bitcoin mining has become increasingly centralized. Bitcoin miners have organized themselves into “pools” that cooperate and share the spoils among their members in proportion to the computing power they contribute. If this chart is to be believed, the top two pools control 53 percent of the Bitcoin network’s computing power.

In principle, these two pools might be able to join forces and execute a 51 percent (or 53 percent) attack on the rest of the network. But doing so might prove foolish in the long run, since that kind of power grab might undermine public confidence in the currency’s long-term viability, since a mining cartel might have the power to change the rules of the Bitcoin protocol in ways that benefit themselves at the expense of ordinary users.

Data

Imagine if Visa were to give researchers a complete record of every transaction it had ever processed. That database would provide the raw material for numerous studies on consumer spending patterns, the business cycle, and much more.

The decentralized nature of the Bitcoin protocol means that every transaction is automatically published to the world. To be sure, there are some limitations to its value for research purposes. Users can and often do make up new addresses for each transction, making it hard to tell which transactions were made by the same person. And the blockchain doesn’t include annotations on why each Bitcoin transaction was made.

Still, a clever researcher should be able to extract a significant amount of useful information. For example, many companies and individuals publish official addresses for receiving funds. Also, in many cases it will be possible to make inferences about which funds are related by observing when funds are combined and spent together. And at a minimum, you can study things like the volume of Bitcoin transactions over time, the average transaction size, the fraction of bitcoins that are in active circulation at any one point in time, and so forth.

Nothing quite like Bitcoin has ever existed before. Even if you think the current price of Bitcoin represents a ludicrous bubble (for what it’s worth, I don’t), it’s still likely to be a fertile laboratory for testing our economic intuitions.

Disclosure: I own some Bitcoins.

Update: A friend who knows more about economics than me says that Kiyotaki and Wright’s account is considered the standard account of fiat money’s value in the profession.

■Bitcoin Is A Disruptive Technology

medicalquack Nice article and just goes to show you can do anything with software:) I borrowed that from the guy who wrote the sub prime software that all the banks use [...]

A financial network is a technological platform that people build businesses on top of. And the traditional banking and credit card networks are closed platforms. If you want to build an e-commerce site, a payment network like Paypal, or any other service that deals in dollars, you need to convince incumbent financial institutions to do business with you. Getting such a partnership is difficult and involves a lot of red tape.

There’s a good reason for the high barrier to entry: electronic transactions in the conventional banking system are generally reversible. If someone makes a fraudulent charge to your credit card, you can dispute the transaction and in most cases the bank or the merchant, not the customer, will cover the cost. That’s convenient for consumers, but it requires the financial system to be a fairly close-knit web of trust. Allowing a new member into the club creates risks for everyone else. So the incumbents are understandably reluctant to deal with anyone who isn’t well-known and well-capitalized.

Bitcoin is different. Because transactions are authenticated cryptographically and cannot be reversed, there’s no need to restrict access to the network. There’s no risk to accepting payments from complete strangers. That means people don’t need anyone’s permission or trust to go into business as a Bitcoin-based merchant or financial intermediary. Accepting Bitcoins also allows merchants to avoid much of the administrative overhead, like dealing with chargebacks, that come with a conventional merchant account.

Of course, what looks like a plus for merchants can look more like a minus for consumers. Consumers generally like the conventional banking system’s strong consumer protections. We like the fact that we’re not on the hook for fraudulent banking transactions, and that the FDIC will make us whole if the bank holding our money goes bottom-up.

And Bitcoin looks inferior to the conventional banking system in other ways too. Visa and Mastercard are accepted at millions of locations around the world. Only a handful of merchants accept Bitcoins. Conventional banks have elaborate websites with features like direct deposite of paychecks and automatic bill-paying. Dealing with Bitcoin is too intimidating for all but a tiny minority of tech-savvy enthusiasts.

If you’ve read Clay Christensen’s The Innovator’s Dilemma, the last three paragraphs should ring a bell. The book’s argument helps to explain why a seemingly inferior payment network like Bitcoin has generated so much excitement.

The term Christensen coined, “disruptive innovation,” has become so overused as to become a cliche. But he gave it a fairly precise meaning with a lot of explanatory power. A disruptive technology is one that’s simpler and cheaper than what’s already on the market. Often, disruptive technologies are also inferior to what’s already on the market. They tend to be dismissed as impractical toys by industry incumbents.

The PC is a classic example of a disruptive innovation. The first PCs were much less capable than mini-computers and mainframes that were already on the market at the time. They had less powerful hardware and software and little if any customer support. And if you’d asked a hobbyist circa 1978 what PCs were good for, he probably wouldn’t have had a good answer.

But the low cost and simplicity of PCs meant that a lot more people could play around with them. One of those tinkerers, Dan Bricklin, invented the spreadsheet, the PC’s first “killer app.” And over time, people gradually figured out how to use these cheap, simple computers to perform functions that had previously required a computer that cost ten times as much. Most “servers” today are just souped-up PCs, and they’re orders of magnitude cheaper than computers that existed before 1975.

The Bitcoin economy today looks a lot like the PC market circa 1978. Most people today look at Bitcoin and see an impractical curiosity. They’re happy with the banking services they’ve already got and can’t imagine why anyone would want to use an alternative currency that’s much less widely accepted and offers many fewer consumer protections.

But a minority of nerds are playing around with it. Interesting applications keep popping up. There are Bitcoin-based banks, casinos, drug emporia, derivatives markets, retailers, and much more. Many of the new applications seem weird or marginal, and most of them probably won’t amount to anything. But one of them might prove to be Bitcoin’s Visicalc.

When people dismiss Bitcoins because they can’t think of how they’d use it, they’re missing the fact that Bitcoin is a platform, not a product in its own right. When ordinary users started buying computers, it wasn’t because they thought it would be cool to own a computer. They did it because they wanted to do spreadsheets or word processing or email. Similarly, ordinary users aren’t going to start using Bitcoins just because it’s a cool technology. If normal users start using Bitcoin, it will be because they’re interested in gambling, or cheap international money transfers, or some other applications that hasn’t been invented yet. And Bitcoin’s intermediary-free architecture means that many more people can try their hand at building the platform’s killer app.

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