the oddly familiar world of bitcoin economics

December 10, 2011

Wired Magazine has an interesting history lesson on the virtual currency bitcoin, both the good and the bad as well as some stabs at the dark at its most likely pseudonymous creator, Satoshi Nakamoto. While I’m not an expert in security, I took enough coursework in the subject to find my way around infosec papers and after reading the article, quickly made my way to read the blueprints for bitcoin. It’s certainly a nifty system and it’s an interesting approach to authentication of virtual currency data. There’s no need for a central mint because as the number of bitcoins grows, they generate a large distributed proof-of-work trail which is rather difficult to spoof or overshadow single-handedly or even with a team. The paper also presents both computational and social engineering ideas to get users to play by the rules and minimize the chance of cheaters or hijackers in the system, which I found to be a nice touch. The source code for the system, readily available online in Java, C++, and C#, looks fairly solid. But bitcoin does have its share of problems and as the Wired story notes, they don’t stem from bugs in the technology stack or the encryption methodology, but from the people using it.

Perhaps one of the most interesting things about bitcoin is that it’s not just an attempt to redesign currency in the age of primarily electronic monetary exchanges and change how we think about money for the first time in nearly a century. It may not have been intended to be as much of a philosophical and political statement as it was a new approach to managing financial assets, but that’s what it became for a number of people who had deep mistrust of banking in general, especially central banks and organizations like the IMF and the WTO. To them, the idea of printing money rather than pinning it to physical assets such as gold, meant that all money was basically worthless debt and the inflation generated by "quantitative easing" was just begging for trouble because the central bankers were playing fast and loose with virtual cash. And there is some validity to that. If inflation soars as your income remains either stagnant or fail to meet the pace with inflation, everything starts to become more and more expensive. This is actually what’s happening through the Great Recession. Prices for everything are rising but wages are not growing, putting more and more strain on the middle class and the poor and that’s generally a serious red flag about the state of the economy at large. Without globalization and companies’ ability to sell in other markets, the recession may have turned into a depression.

Enter the bitcoin. With a set maximum of 21 million units and a predictable downward curve of growth, simply mining more coins on demand won’t work and there is no central issuing authority to regulate the coin flows, which must ease the minds of more libertarian bitcoin users who think that the Fed is a essentially a criminal enterprise scamming the nation and the banks are in on it. With the system being peer to peer, it’s truly up to the wide open, unregulated market to decide what happens. And that’s where the problems come into play. It may seem tempting to think that the wisdom of crowds will win out and there needs to be no regulation since things will eventually sort themselves out, but as I’ve pointed out before, this assumes that game theory is a good model for how humans make financial decisions. Research shows that it’s most certainly not, and a whole lot of books about the kind of greed, shortsightedness, and glibness displayed by bankers throughout the subprime boom can testify to that quite well. So what happens when you give the crowd full control of new currency? The users who can mine the most and hoard the most gain control of it, and that’s exactly what has been happening with bitcoin. Several large mining pools and online exchanges are basically in charge of the currency’s fate and considering that the tighter the bitcon supply, the more a coin will be worth, they have every incentive to hoard whatever they mine or whatever they control, creating new vulnerabilities along the way, the kind of vulnerabilities that not even the most complex and effective encryption algorithm can solve.

Nakamoto never intended to have large bitcoin pools concentrated in few hands or to have users hand over a large virtual wallet to online repositories which functioned exactly like the banks that were meant to be made obsolete by the P2P nature of the currency. Users who handed over their coins to MyBitcon and Bitomat found out the hard way that you really can’t trust anybody online when the former site went dark until its owner came back to say he was hacked and all the bitcoins were now lost, and the latter which said it overwrote its wallets by accident. It didn’t help matters that the owner of MyBitcoin seems to have been running the whole site from some unspecified location in West Indies and tried to stay as far under the radar as possible. Likewise, there is a persistent PR nightmare of the currency being hijacked by those seeking to buy illegal services, drugs, or other illegal goods via the dark net, using its anonymity-enabling features to make payments without a trail for law enforcement to follow. While money laundering can technically be done with any currency and doesn’t say anything about the design of the bitcoin, it does mean that politicians will now seek to bring it to heel and take away some of its true P2P features or make it a crime not to expose your identity when paying in bitcoin. That would mean that security holes will actually have to be created, putting more virtual wallets at risk.

But the bitcoin experiment gives us an interesting insight into how an unregulated market works. Created by a mysterious stranger, a night owl very possibly of British origin, and distributed as an experiment in currencies for a new century, it was intended to be a tool for the people, ran by the people rather than a central bank. And while it started out as a heady free for all, it quickly became very structured with pseudo-banks, exchanges, a clutch of large mining operations able to throttle or boost the bitcoin supply, and all the ingredients for several major players and early adopters to gain monopolies and dominate the entire bitcoin ecosystem. I can’t say it was such a surprising turn of events because in unregulated markets, early adopters and players who have a disproportionate amount of resources will try to create lucrative monopolies by controlling the market. Back at the dawn of the 20th century, the same exact thing happened throughout the economy. Virtually every industry was dominated by a monopoly or an oligopoly of trusts which either destroyed or absorbed any competitor on the horizon, and fixed prices to ensure their perpetual profitability. From the trajectory of the bitcoin, this might well be replayed on the web a century later and the results could be very similar, with a call for trust-busters to come in and free up the bitcoins through digital regulations, or by creating another few million units…

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  • dave

    Sorry, but the second half of this article is just trash. Your prejudice against the idea of unregulated markets is clouding your ability to be objective.

  • Steven

    Care to back that up with some factual information from vetted sources, Dave?

  • Erik Voorhees

    There are a number of problems with this article’s reasoning.

    1) Mining pools and exchanges don’t “control” the currency in any way. The pools especially, are not pools of capital, they are pools of production. These pools do not control any significant amount of currency, as they consist of individual miners who typically withdraw coins as fast as their mined. I guess the word “pool” confused the author? Exchanges, similarly, have no long-term control. They consist of individual account holders who may deposit and withdraw at whim, not some monolithic entity.

    2) The fact that some users choose to store coins at ewallet sites is not at all like a traditional “bank,” which engages in fractional reserve lending. Ewallets operate in a competitive market and must compete for the trust of users. Just because a couple such wallets (literally maybe two?) ended in tragedy doesn’t mean the concept of an ewallet is unsound. Just because you can get scammed on ebay or craigslist doesn’t make those services invalid.

    3) Nobody can “throttle or boost the bitcoin supply.” Author is confused, or is being disingenuous and misleading.

    4) Bitcoin does not rely on “the wisdom of crowds”… it doesn’t rely on anyone’s wisdom, that’s the whole point. It relies on mathematics.

    5) Enough with the derision toward people who save money. Stop labeling them “hoarders” just because they choose to produce more wealth than they consume.

  • Jim

    Since there is no central authority dont expect to see any trust busters knocking on bitcoins door. There is no door. If you have a problem with bitcoin take the open source code and start your own blockchain. Many writers seem to miss the fact that bitcoin is the worlds first decentralized currency.

  • Jimmy

    One year from now I don’t want to hear anyone complaining that they didnt get into bitcoin early enough. Right now its 3 bucks a coin. Can’t wait for 100 a coin. Muhahahaha!

  • Greg Fish

    Your prejudice against unregulated markets is clouding your ability to be objective.

    @Dave. By the way, it’s after that part that you’re supposed to try and show me why my arguments were wrong using references to serious economic works on the subject, a suggestion helpfully pointed out by Steven. It’s the easiest thing in the world to cry bias and say that someone is prejudiced. Proving them wrong through examples and facts is a lot tougher, but much more educational and impressive.

    The pools especially, are not pools of capital, they are pools of production.

    @Eric. So what they mine isn’t actually worth anything or gets drawn out by the miners which somehow makes it worth less? How would creating bitcoins, which have value, mean that the mined coins cannot be placed in capital pools? Are the miners giving it all away? Not sure where that part appears in the paper. Basically, your argument is a bit like saying that gold miners are just producing gold, and that holding on to this new gold is not going to help raise capital.

    Now, true, in the real world gold has to be converted into hard currency to be liquid, but in the bitcoin world, the mining pools mine the bitcoins which can then be used to buy goods and services, i.e. have the liquidity to be used as capital. Were bitcoins from an active mining pool created in such a way that they must change hands to gain value, I would concede your point. However, to the best of my knowledge, they can be part of a work chain right after they’re mined.

    Ewallets operate in a competitive market and must compete for the trust of users.

    The point was not that ewallets are invalid as an idea, but that giving your money to an online service comes with its dangers and that accumulating large ewallets does get awfully close to banking since said coins can be used by those holding them. I know a lending industry has not sprung up around bitcoins yet, but give it time.

    Nobody can “throttle or boost the bitcoin supply.”

    If I mine a lot of bitcoins and keep them for myself, there are less available for trade or exchange because bitcoins are fixed. When the 21 million limit is hit, there’s now not a single coin left to be mined so holding on to a few million of them in an ewallet for the future means that those bitcoins are effectively out of circulation and there are fewer of them overall. That’s just simple math. If you have 21 million of something and millions are taken away, there’s less units overall.

    Stop labeling them “hoarders” just because they choose to produce more wealth than they consume.

    How exactly does one produce wealth by keeping it away from everyone? Bitcoins, like all money, are only worth something as long as you buy real goods with them, and we all agree that they’re valuable. Otherwise, they’re just a number in an ewallet. You can produce wealth by investing it in something. You can’t produce it by keeping your cash under a mattress.

    If you have a problem with bitcoin take the source code and start your own blockchain.

    @Jim. But with only 21 million coins to ever be made and the idea behind it to see the largest block as the main one, what exactly do I win by this? If I can exceed the limit by creating my own bitcoin implementation, doesn’t this violate the economic principle of the entire ecosystem which relies on a fixed number of coins to fight inflation? How is what you’re suggesting different from just printing money, which drives inflation?

  • It seems to me it is a little early in Bitcoin’s life to be drawing any large-scale lessons from it. There’s a reason I say that Bitcoin is still an experiment.

    For example, right now, the Mt. Gox exchange handles something like 80% of currency trades in and out of bitcoin, but I’m about 70% sure that in… oh, five years it will handle less than 20%.

    And in 5 years I wouldn’t be at all surprised if most mining was done using the peer-to-peer pools that are just getting started, because fees will be much lower. Then again, I wouldn’t be at all surprised if 5 years from now most Bitcoin mining is done by huge companies in places where electricity is cheap or the heat generated by Bitcoin mining can be put to good use.

    I bet most of today’s Bitcoin Oligarchs will NOT be the big power-players 5 or 10 years from now. That’s the beauty of a truly free market, and the reason I’m excited about Bitcoin– anybody anywhere in the world with an Internet connection can be tomorrow’s Bitcoin Baron if they have a great idea, the willingness to work hard to make it happen, and the luck of it being the right idea at the right time.

    If I’m wrong and in 5 years Mt.Gox and the DeepBit mining pool rule Bitcoin then feel free to gloat and remind me of how right you were.

  • Jim

    In response to your statement on a hard number of 21 million coins: What makes bitcoin different from gold is 1 bitcoin is divisible by eight decimal places. Bitcoin was designed to be able to send 0.00000001 bitcoins. Right now the transaction fee is higher but it can be adjusted. Gold is also divisible but you cant easily perform a micro transaction. If bitcoin is inflated then a bitcoin is easily divisible unlike other currencies or commodities.

    The way to combat bitcoin is not to trust bust it but to create a better alternative. If the govt wants a controlled virtual currency that is not anonymous then they will have to fork bitcoin and start a new chain. I think this is futile though since what makes bitcoin unique is it decentralized and anonymous nature.

  • Rebus Toweling

    Bitcoin as it stands does not address what reasonably should be requirements. I certainly hope that the current implementation is a prototype, but it seems like we are at a phase of having many true believers who regard it as a finished work. To let the internal requirements of this clever exercise in game theory be a binding paradigm is definitely not thinking outside the Bitcoin Box.

  • Dumbass

    One year later: Bitcoin is worth $15 a coin. If you didn’t spend any of your coins, you’ve made a 500% profit.