The Case for Bitcoin

If Bitcoin succeeds, future generations will remember it as the greatest investment opportunity in recorded history.

The Forbes list of billionaire dynasties will be completely rewritten, with new names such as the Winklevi clan shifted to the front.  A few lucky individuals will become billionaires simply because they tried out this new bitcoin mining app their comp sci dorm buddy told them about way back in 2010.  Yes, we are talking about a radical and perhaps somewhat random wealth redistribution (although in that aspect at least the pattern is familiar to students of history).

Sounds unlikely?  Perhaps, at least for now.  If we look at the current bitcoin exchanges as a sort of prediction market, we can roughly estimate the net odds traders are currently giving for that scenario.  If the BTC becomes the major world reserve currency, then each bitcoin should be worth vaguely on the order a million 2013 dollars (~20 trillion total $ medium-high power fiat money / 20 million BTC).  So currently the markets are giving about 0.01% odds on that bet.

If you think those odds of the BTC-wins scenario are much higher, such as closer to say 1% or 10%, then you should take that bet and join the Winklevi and fellow TechnoLibertarians in the proud > 1.0 BTC club  (for there can only ever be 20 million people who own more than 1 BTC).

The seductive logic of a bet with such massive upsides partially explains how BTC (or any would be money) bootstraps itself into existence up from probability epsilon (a sort of real Pascal Wager).  Then the network effect kicks in: as the inflow of small bets boosts up the price, this rise in valuation itself becomes some additional evidence for the long term monetization hypothesis (because a good speculative trade is always recursive in terms of other agent’s speculations).  This process can become a virtuous cycle, eventually leading to the Bitcoinmana that has taken the $/BTC up from 0.1, 1, 10, 100 in just a few years.

Exponential rockets such as this tend to attract the attention of professional evangelist-hucksters who can sell rocket ride tickets on Fox Business, promoting Bitcoin to a wider TV-audience of uninformed traders.  Everyday joes may not have the time or inclination to read up on cryptocurrency, but they can fit a simple line to a graph and dream of F.U. quantities of filthy lucre.

But isn’t this just a speculative bubble?  Well yes, but not just.  Or rather it’s a speculation that BTC will become a global money standard – for this is how new forms of money are born into the world: as some sort of mutual game theoretic optimum, a Schelling point in the space of future trade options.

Money arises as the solution to a global optimization problem that maximizes the efficiency of a complex network of spatiotemporal trade paths while minimizing risks and costs.  At any time the markets are continuously exploring many different forms of money/savings instruments with varying tradeoffs: and necessarily creating ‘bubbles’ in the process.  Every once in a long while this ecosystem undergoes rapid evolutionary transitions.

The missing part of this simple ‘Bubble’ explanation for Bitcoinmania or Bitcoin hyper-monetization is why any original traders thought Bitcoin had any value in the getgo, or rather why they even considered, for a moment, that it ever had a chance above epsilon of becoming the new global money standard.  Why would it be better than the dollar, euro, or gold?

The Fundamental Value of Bitcoin

Here then is the argument from fundementals:  Imagine a single benevolent, omniscient tyrant (God, or an AI super-intelligence, etc) could simply simulate the global optimization in it’s mind directly.  This then eliminates all the recursive game-theory elements (bubblemania aspects): the tyrant then effectively evaluates different monetary systems based on their longer term net efficiency, according to its criteria.  The fundamental maximum value of Bitcoin then is the net difference in total economic utility (measured by say adjusted world GDP, to first approximation) between a Bitcoin based economy and the current regime.  If we have an idea of what that value is, we can then estimate the expected return or immediate value of Bitcoin as an option on that future weighted by our assessment of its likelihood.

Spatio-temporal Trade Effeciency

Bitcoin is a vision of a more efficient currency.  The efficiency I refer to is not just algorithmic, but economic in nature.

Economists used to write in their textbooks: “Money is a matter of functions four, a medium, a measure, a standard, a store.”  Those four functions have more recently been streamlined to three, but I will further reduce all of this to a single concept: money is a spatio-temporal medium of exchange.  By this broad definition, almost anything owned has some ‘money-ness’ to it, depending on our expectations concerning how we can use and or retrade it in the future.  Everything from cowrie to salt to tulips has functioned as a form of money in at least a few pockets of space and time.  In each case the items in question had some ‘intrinsic’ productive/consumptive values which perhaps helped boostrap them into moneyness.

Today such notions of intrinsic productive/consumptive value are irrelevant from the global optimization perspective, for all that matters in the end when comparing potential forms of money is their net efficiency in facilitating trades across space and or time.  Paper fiat money is the case in point: it evolved in the market from gold deposit slips having tremendous practical advantages over metallic coinage, but has no intrinsic productive/consumptive value.

First, let us consider the aspect of spatial efficiency.  Here Bitcoins have rather obvious advantages:  facilitating transactions over the internet to anyone in the world without exchange rate conversions, high fees, long waiting periods, etc: thus: high spatial efficiency, approaching optimal.  So Bitcoin could displace Mastercard/Visa and seriously displace large swaths of finance.  This is a net good.  It is difficult to measure the quantity of this improvement, but to first approximation it should be proportional to the market cap of all the companies it would make redundant, ie somewhere to the tune of a few hundred billion dollars, perhaps up to a trillion.

Bitcoins also have high temporal efficiency due to the simple ingenious algorithm which governs their supply.  Bitcoins grow on a asymptotic inflationary schedule.  This schedule has the following advantages for facilitating temporal trades (savings): the total supply has a known hard limit, the inflation schedule is known and perfectly predictable (removing the huge uncertainty of fiat), and finally the fast but exponentially tapering inflation schedule is exactly what is needed to foster the currencies adoption – because newly created bitcoins are distributed as a reward for the ‘miners’ who verify transactions and secure the network.

Some critics (including economists who should have known better) have claimed that BTC is deflationary, which besides being technically incorrect (BTC inflated by about 200% in 2010 and down to about 15% in 2013, and it will eventually reach an inflation rate of 0%, but the supply will never significantly decrease), is also apparently used as some sort of dirty word.  I suspect that Krugman and ilk use the ‘deflationary’ epithet because they are basically employees/propagandists of the threatened institution: Fed/Banks, and their rival products cannot compete in terms of temporal efficiency: simply because states reserve the right to create new fiat to pay their bills.

The more technically correct and potentially interesting criticism from mainstream economics focuses on BTC’s inherent inelastic inflation schedule: in the Keynesian view the supply of money should be dynamically controlled by a central authority to help absorb business cycle shocks.  This theory is based on an entire edifice of economics that arose out of the experience of the great depression and similar credit collapse debt deflations.  Bitcoin in raw form is immune to such shenanigans simply because it is high powered money: the equivalent of cash or Fed Deposits, not the demand deposit credit/debt based money the banking system currently uses.  As Bitcoin grows we can expect there will be at some point a new ecosystem of debt based instruments built on top of BTC, but this new ecosystem will be global and technological, more like Prosper, less like of BoA.

Criticizing Bitcoin based on economic tools used to analyze the great depression is like criticizing Nvidia’s new Titan video card based on a theory of Charles Babbage’s Difference Engine.

Gold has a constrained supply, so it can be reasonably temporally efficient, but it is completely inefficient spatially – which is how fiat came to be in the first place, as ‘banksters’ offered a product (paper notes) with much better spatial efficiency   As a result gold only exists today in the modern monetary ecosystem in digital form, as a contract.  So it’s just another computer ledger, but a number which we should trust because the computer ledger can’t be faked/fudged/misrepresented .. because each number in it exactly corresponds to a real unit of gold held in a bank somewhere, because . . . .  somebody said so.  Fiat currency started that way, as banknotes for gold redemption.  There have been attempts to revive that idea in the digital age (such as egold), but they have all been plagued by the centralized point of failure problem.

This brings us to the final and most important advantage Bitcoin offers the world: it solves the trust problem, in both the algorithmic sense as a solution to the Byzantine Generals Problem (which really is a big deal in computer science), and in the more typical economic sense.

The core of any implementation of money is a ledger: a simple database of account balances and a trade protocol to carefully(and atomically) add N to account X and subtract N from account Y.  That’s bank software, and the core of it really is that easy.  The difficulty is trust.

In economic terms, the ledger really is the most important damn thing in the world.  How can you trust the ledger?  With a physical currency this is straightforward (as long as the physical token is very costly to fake).  Physical currencies are good in that department, but they pretty much suck in every other way compared to purely memetic currencies (such as paper or digital).

The world’s current dominant fiat currencies all use some form of complex centralized ledger.  The US has a godawful complicated scheme involving the Fed, the Treasury, a hierarchy of banking minions, and a bunch of redundant databases.  But in the end it all boils down to a centralized ledger and trust concentrated in some specialized branch of the government.

There are at least three significant problems with this scheme: first, there are about 190 generally recognized sovereign states, and almost as many currencies and ledgers.  Thus giving rise to the significant previously discussed spatial inefficiencies moving money around the world – in the form of taxes, fees, tariffs, exchange rates, and so on.

Trust is also the core cause of inflation or the poor temporal inefficiency of fiat.  Libertarians, Liberals and Conservatives may cite different flavors of economics in explaining why fiat currency is inflationary, but there is little argument over the result: saving in fiat currency is discouraged – not only because it is worth less and less over time due to expanding supply, but also because the rate of increase itself is unpredictable.  In our current system it’s a much better long term trade to borrow a few decades of labor and purchase real estate (which has a naturally fixed supply and stable demand) than to simply save currency.  Mainstream economists (which I suppose only some of which are shills) praise inflation, because, they say, it encourages spending.  Somehow causing people to spend more now than they would otherwise choose to, and plan less for the future than they would otherwise choose to is supposed to be a good thing.

When pondering how we got into a situation in which a little over a 51% majority of the population ‘owns’ a house by ‘borrowing’ decades worth of future salary (against steadily decreasing median wages) from government controlled banks at near-zero or even negative effective real interest rates, it’s just too tempting not to quote Alexander Tyler: “A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves money from the  public treasure.”

Bitcoin is rather idiot-proof in this sense.  In a Bitcoin world the total future max supply of BTC is known: ~20 million units, similar to how the total supply of land area on Earth is limited, so in a BTC world the currency can be expected to perform similar to housing (on average).

The future supply and thus value of fiat (whether Dollar, Euro or Bhat) is determined by future elected officials, which naturally creates some serious issues of trust.  Historically these trust issues have caused wars.  China trades cheap goods for Future-Dollars, a trade which involves a great deal of delicate political and economic faith in the future US government – because China is treading the sweat of its populace now for an unpredictably but generally decreasing share of USGovCorp.

So in a nutshell fiat currency is basically stock in the relevant corporatocratic states, and trust in fiat boils down to trust in the financial future of the issuing entities (because they always reserve the right to generate new fiat in various forms to pay future bills).

And somewhat predictably: they are screwing up (to varying degrees and for various reasons).  The Euro is screwed and everyone knows it, most of the rest are screwed and just don’t know it yet.  The case for such pessimism concerning the future of various current statist powers is complex and beyond the scope of this post, but in short it revolves around the huge debt/credit edifice and welfare state whose existence is predicated on long term economic assumptions that will be absolutely shattered by the impending Technological Singularity  (but alas that is a topic for another time).

Gold has the desirable temporal efficiency but it is completely inefficient in the spatial dimension, so it becomes a digital fiat scheme: with all the same trust issues.  The governments of the world are not going to voluntarily give up their fiat and switch to gold.  Bitcoin solves this problem by not giving them much of a choice.  It is like a digital gold standard on steroids, but more importantly: it actually has a shot at success.

In Proof of Work we Trust

Bitcoin combines the high spatial efficiency of digital money with the high temporal efficiency (via supply stability) of a gold standard.  But how does it solve the trust problem?

The seed was a novel idea from the mysterious Satoshi Nakamoto.  (Sometimes to truly understand a thing, it really is best to understand it’s beginning.) The paper neatly summarizes an ingenious and practical proof-of-work solution to the core technical problem of distributed trust.

In the minds of a few lucky readers on a particular cryptography mailing list, Satoshi’s nifty idea blossomed into the current vision of a secure, efficient, distributed digital currency.  One currency to rule them all and in the darknet bind them.

For those for whom the paper is TLDR, I’ll briefly summarize what isn’t spelled out in the abstract.

Bitcoin solves the trust issue without trust.  No one particular person/group/node is trusted to maintain the ledger for everyone else.  Instead each node simultaneously maintains a copy of the ledger itself.  The database/ledger, called the blockchain, is itself just the entire transaction history, so it’s straightforward to verify the validity of each transaction.  And now the final hat trick: given multiple competing versions of the ledger/blockchain, each node picks the ledger/blockchain which has the provably highest net computational cost to construct over its whole history.  The cost is verified using Proof of Work: NP-hard computational problems that have a particular structure such that verifying a candidate solution is trivially fast, but finding a novel good solution is exponentially difficult.  Solutions to these problems can not be faked without enormous computation.

This solution to double-spending/counterfeiting can be likened to a physical manuscript ledger where each transaction must be beautifully illustrated, and the true ledger is known as the one with the largest number of perfect illustrations.  The illustrations (the proofs of work) are completely pointless and this is intentional – requiring that real economic resources (computation) are wasted to verify the ledger is the key setting up a stable deterrence.

In practice the network can be arbitrarily more secure, for in the rare case where some hacking group actually manages to collect more computational horsepower than the rest of the network in an attempt to forge a new ledger, humans and or AIs can rather easily notice the resulting highly improbable large fork, investigate, and then pick the correct ledger.  Yes, this requires trusting the development community, but there’s a strong reason for trusting a transparent entity (open source, aligned incentives).  Indeed, the network has already dealt with at least one such fork (but caused by software error rather than malicous hackers).

Down the road there are numerous proposals to improve all technological aspects of Bitcoin, from scalability and usability to security.

The summary of all this is that Bitcoin works.  It has tremendous potential and future headroom.

It is secure and can scale up to global levels of volume in the years ahead.  More than just a protocol, Bitcoin is a flexible platform.  When the time comes it could be extended to handle other temporal forms of money (such as debt instruments), property(such as real estate), and other  increasingly complex contracts (its scriptable!).  Looking farther ahead, we could even automate much of our legal infrastructure.  When AI’s start cooperating and hiring each other, this is the type of infrastructure they will want.

A growing set of diverse political groups: libertarians, techno-futurists, occupiers etc are all skeptical of the current financial system for various reasons and envision a more just, efficient alternative to fiat fractional reserve banking.  Bitcoin could be the solution.  All it will take is a sufficient amount of belief, as each convert shifts a little more earnings into the BTC economy it grows and attracts more converts.

Ponzi schemes, bubbles and hypermonetization events all start as some form of mind virus that spreads throughout the human social network.  The difference is in how they end.  A hypermonetization event is a simply a bubble that does not end (or rather ends with everyone converting).

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