The Bitcoin Guessing Standard

Bitcoin is a software program designed by Satoshi Nakamoto (which is believed to be a pseudonym). His objective, at least on the surface, was to create electronic cash; a new hard money. This is why it is often referred to as digital gold. Satoshi Nakamoto, in his design of Bitcoin, was influenced by the prior work of Hal Finney. Critically, with regard to creating electronic tokens, Finney took seriously the cost theory of value. In turn, when Nakamoto wrote his white paper, regarding Bitcoin, he embraced Finney’s notion that processing power and electricity expended would drive the value of an electronic coin. To date, Bitcoin has failed to become an effective electronic currency. Rather, it seems Bitcoin was designed to become an expensive electronic asset more so than becoming money. Bitcoin enthusiasts, regardless, point to its lofty valuation as evidence Bitcoin will become the world’s decentralized money. This is a mistaken view as Bitcoin has become a currency yet will fail to become money.

The Concept of Digital Hard Money (Digital Gold)

Hal Finney, a Caltech educated computer scientist, was known for developing a reusable proof-of-work system which was critical to the development of Bitcoin. Hal Finney was the first recipient of a bitcoin. His writings on reusable proofs of work (RPOW) are archived at the Satoshi Nakamoto Institute. Finney’s RPOW system allowed proof-of-work tokens to be passed from person to person.

In Finney’s writings, regarding RPOW Theory, it is evident he believed in the cost theory of value; whereby the value of a token is driven by the cost of the processing power and electricity used to create a token. With enough effort and expense, Finney believed digital gold could be created. The following two paragraphs are from Hal Finney’s RPOW Theory:

Security researcher Nick Szabo has coined the term bit gold to refer to a similar concept of tokens which inherently represent a certain level of effort. Nick’s concept is more complex than the simple RPOW system, but his insight applies: in some ways, an RPOW token can be thought of as having the properties of a rare substance like gold. It takes effort and expense to mine and mint gold coins, making them inherently scarce. Gold coins can then be passed from person to person, and each recipient can verify the authenticity of the coinage.

In a similar way, RPOW tokens take a certain level of effort and expense to be created. They all start with a hashcash collision which, at the higher levels, will take hours or even days of computing time to create. RPOW tokens can be validated and verified upon receipt by exchanging them at the RPOW server for a new RPOW token. This allows them to be passed from person to person much like coins.

The cost theory of value was embraced by Nakamoto in his development of Bitcoin. Here’s what Nakamoto wrote in his white paper:

By convention, the first transaction in a block is a special transaction that starts a new coin owned by the creator of the block. This adds an incentive for nodes to support the network, and provides a way to initially distribute coins into circulation, since there is no central authority to issue them. The steady addition of a constant amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended.

Shortly after Bitcoin was released, on January 3, 2009, Hal Finney wrote a congratulatory email to Satoshi Nakamoto. Here is the email string:

Satoshi Nakamoto writes:

Announcing the first release of Bitcoin, a new electronic cash system that uses a peer-to-peer network to prevent double-spending. It’s completely decentralized with no server or central authority.

See bitcoin.org for screenshots.

Download link

Congratulations to Satoshi on this first alpha release.  I am looking forward to trying it out.

Total circulation will be 21,000,000 coins.  It’ll be distributed to network nodes when they make blocks, with the amount cut in half every 4 years.

> first 4 years: 10,500,000 coins

> next 4 years: 5,250,000 coins

> next 4 years: 2,625,000 coins

> next 4 years: 1,312,500 coins

> etc…

It’s interesting that the system can be configured to only allow a certain maximum number of coins ever to be generated. I guess the idea is that the amount of work needed to generate a new coin will become more difficult as time goes on.

One immediate problem with any new currency is how to value it. Even ignoring the practical problem that virtually no one will accept it at first, there is still a difficulty in coming up with a reasonable argument in favor of a particular non-zero value for the coins.

As an amusing thought experiment, imagine that Bitcoin is successful and becomes the dominant payment system in use throughout the world. Then the total value of the currency should be equal to the total value of all the wealth in the world. Current estimates of total worldwide household wealth that I have found range from $100 trillion to $300 trillion. With 20 million coins, that gives each coin a value of about $10 million.

So the possibility of generating coins today with a few cents of compute time may be quite a good bet, with a payoff of something like 100 million to 1! Even if the odds of Bitcoin succeeding to this degree are slim, are they really 100 million to one against? Something to think about…

Finney’s email makes note of two key features. Bitcoin will be limited to 21 million coins and the software requires progressively more work to create each coin over time. Moreover, Finney refers to Bitcoin as a currency. With the cost theory of value underpinning a software program designed to increase the cost of producing coins over time, and the number of coins which can be produced is limited to 21 million, it strongly appears Bitcoin was designed to squeeze Bitcoin’s price higher in a relatively short period of time. With Finney’s thought experiment deriving an eventual value of $10 million per coin, was the intention of Bitcoin to become a useful currency or simply a valuable asset enriching early miners, adopters, and holders?

Speaking of time, Bitcoin is designed to have a “mine life” of 131 years. The last bitcoins will be mined by the year 2140. To date, about 89% of bitcoins have been mined. For 89% of bitcoins to have been mined, in the first twelve years of its existence, it certainly appears Bitcoin’s program was front-end loaded to benefit the aforementioned early miners, adopters, and holders.

Bitcoin Mining and Proof-of-Work

For additional background, as conveyed in Nakamoto’s white paper, the following list provides an outline as to how the Bitcoin network operates:

New transactions are broadcast to all nodes.
Each node collects new transactions into a block.
Each node works on finding a difficult proof-of-work for its block.
When a node finds a proof-of-work, it broadcasts the block to all nodes.
Nodes accept the block only if all transactions in it are valid and not already spent.
Nodes express their acceptance of the block by working on creating the next block in the chain, using the hash of the accepted block as the previous hash.

Understand that a hash is a number. A hash function takes in an input string of information, of any length, and gives an output hash of a fixed length. Bitcoin uses the SHA-256 cryptographic hash algorithm. SHA-256 was created by the National Security Agency.

Proof-of-work is where mining expense enters the scene. A miner (node) does not solve a complex mathematical equation. Proof-of-work entails a miner guessing at a number called a nonce. So, here is the process:

A miner guesses a nonce
The block’s content is hashed with the guessed-at nonce
If the resulting hash is numerically equal to or smaller than the Bitcoin network’s target hash, the successful miner has found a new block
The successful miner, finding the new block with the requisite proof-of-work, is allowed by the rest of the network to be rewarded with newly created bitcoins; which are created out of thin air

Today, the reward is 6.25 bitcoins per block.

Presently, miners must make quintillions of guesses, to find a winning nonce, in order to be rewarded with bitcoins. This requires brute-force processing power and copious amounts of electricity. Bitcoin enthusiasts scoff at gold and the gold standard. For they have found something far superior: the guessing standard. If this isn’t financial alchemy, then nothing is.

Bitcoin miners currently use more electricity than does the country of Norway. Considering Nakamoto’s design of Bitcoin, it would appear Bitcoin’s strong price action validates the cost theory of value. However, the cost theory of value was debunked when Carl Menger published his Principles of Economics in 1871. Something else is driving Bitcoin’s price.

Bitcoin is a Currency but Will Fail to Become Money

For those unfamiliar with Ludwig von Mises’s regression theorem, Mises described how money spontaneously emerged. Gold was chosen, on the market, as money. It became a medium of exchange and remained so for thousands of years.

Over time, humans found gold to serve as more than just a medium of exchange. It was found to be a store of value; maintaining a stable purchasing power over a very long period of time. Such stability made gold an ideal unit of account (in Murray Rothbard’s Man, Economy, and State, Rothbard mentions “…business accounting is traditionally geared to a world where the value of the monetary asset is stable.” – pg. 993). Gold also functioned as a standard of deferred payment.

Bitcoin has become a medium of exchange. On May 22, 2010, someone paid 10,000 bitcoins to purchase two pizza pies worth $25. The emergence of Bitcoin, as a medium of exchange, does not violate the aforementioned regression theorem. Laura Davidson and Walter Block wrote an excellent journal article, for the Quarterly Journal of Austrian Economics, titled “Bitcoin, the Regression Theorem, and the Emergence of a New Medium of Exchange.” In the closing sentences of this article, Davidson and Block state:

Will bitcoin ever become liquid enough to become generally accepted, and hence money? It is unique among all previous media of exchange in that it incorporates numerous novel features, many of which offer up their services only when it is used as a medium of exchange. This means that as it becomes more widely adopted, it is probable its liquidity will increase, not just because more people will accept it for its monetary uses, but also because more people recognize the advantages of its non-monetary uses. Whether or not it can ever become money remains to be seen.

To be sure, this is a fair conclusion. However, when comparing Bitcoin to existing currencies, it is highly volatile and downright lousy. Would a Bitcoin enthusiast, or anyone, ever want to take out a loan denominated in bitcoins? A bitcoin-denominated loan market is highly unlikely to emerge; meaning it will not become a standard of deferred payment. How about preparing a business financial statement using bitcoins as a unit of account? The resulting financial statement would be a useless management tool; yet another failing of Bitcoin. If Nakamoto strived to create digital gold, one would assume Bitcoin would have been programmed to have its coins emerge with the properties that made gold an excellent money. Why such obvious failings? It goes back to the contention Bitcoin was designed to have its price pumped up in a relatively short period of time without consideration as to the qualities humans look for in sound money. Perhaps this is a get-rich-somewhat-quickly scheme? There is no disputing Bitcoin is a currency; yet, to date, its failings are glaring.

As for Bitcoin failing to become money, Jesus Huerta de Soto’s masterful book Money, Bank Credit, and Economic Cycles provides sound reasoning as to why Bitcoin’s monetary central plan will flop. Just because Bitcoin is a decentralized payment system, that generates its own electronic currency, does not change the fact that Bitcoin’s software program is a central plan. Huerta de Soto would call this a “leap in the dark”:

We should also remember Mises’s monetary regression theorem, according to which the price or purchasing power of money is determined by its supply and demand, which is in turn determined not by its purchasing power today, but by the knowledge the actor formed on its purchasing power yesterday. At the same time, the purchasing power of money yesterday was determined by the demand for money which developed based on knowledge of its purchasing power the day before yesterday. We could trace this pattern back to the moment when, for the first time in history, people began to demand a certain good as a medium of exchange. Therefore, this theorem reflects Menger’s theory on the spontaneous emergence and evolution of money, but in this case there is a retroactive effect. Mises’s monetary regression theorem is of capital importance in any project for reforming the monetary system, and it explains why in this field there can be no “leaps in the dark,” attempts to introduce ex novo monetary systems which are not the result of evolution and which, as in the case of Esperanto with respect to language, would inevitably be condemned to failure. (footnote pgs. 737-738 Money, Bank Credit, and Economic Cycles)

Bitcoinmania

It cannot be disputed Bitcoin has generated a tremendous following; with its current price in excess of $50,000 per bitcoin. Bitcoin’s meteoric rise, nonetheless, is an accident of history. Arguably, Bitcoin’s price explosion corresponds to the explosive growth of dollars recently conjured by the Federal Reserve. Hence, Bitcoin’s dramatic price appreciation is the embodiment of a modern-day tulipmania. As Doug French states in his article The Truth About Tulipmania:

The story of Tulipmania is not only about tulips and their price movements, and certainly studying the “fundamentals of the tulip market” does not explain the occurrence of this speculative bubble. The price of tulips only served as a manifestation of the end result of a government policy that expanded the quantity of money and thus fostered an environment for speculation and malinvestment. This scenario has been played out over and over throughout history.

Just like tulips, Bitcoin has become an object of obsession for which a speculative bubble has emerged. Accordingly, it is unlikely Nakamoto’s integration of the cost theory of value, into his design of Bitcoin, has much to do with pumping up the price of Bitcoin; although this clearly was the intention. Bitcoin is that exotic asset, which caught a massive bid, as the Federal Reserve created trillions of dollars out of thin air. Thus, Bitcoinmania was born.

Conclusion

Bitcoin was not designed to be digital gold. The characteristics of gold, when it was money, are well known. Using the cost theory of value, Bitcoin was designed to have its price pumped up early in its existence to benefit early adopters, miners, and holders. It has become a currency, yet it is not a very good one; and it is literally built upon brute-force guesswork. Bitcoin has experienced a price explosion not due to the design of its program but as an accident of history; where Bitcoin happens to be the object of a mania fueled by reckless Federal Reserve policy. Using Dr. Huerta de Soto’s analysis, Bitcoin will fail to become money. In the end, it would be fitting to change Bitcoin’s name to Esperantocoin.

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