the oddly familiar world of bitcoin economics

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…