Bitcoin for the Befuddled (2015)

Chapter 5. WHY BITCOIN IS A BIG DEAL

There is no question that Bitcoin is a novel technology, and certainly the idea of a universal stateless currency is audacious. However, many doubt that Bitcoin will make a lasting impact on the world’s economies. Indeed, you may be wondering: Is Bitcoin a world-altering technology or merely a technological gimmick? In this chapter, we’ll discuss both sides of this question. Because reviewing the past is often the first step in understanding the future, let’s start by briefly delving into the history of Bitcoin and digital currencies in general.

The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.

—Satoshi Nakamoto, first post on the P2Pfoundation forum about Bitcoin, February 11, 2009

I think that the Internet is going to be one of the major forces for reducing the role of government. The one thing that’s missing, but that will soon be developed, is a reliable e-cash. A method whereby, on the Internet, you can transfer funds from A to B, without A knowing B or B knowing A.

—Milton Friedman, American economist and Nobel laureate, 1999 interview conducted by the National Taxpayers Union Foundation

Are you kidding?! In the future, when people look back at the early days of Bitcoin, they’ll say, “It was so obvious that the ability to move money anywhere, instantly, at near-zero cost would be a huge success.” Bitcoin is to money what the Internet was to communication.

—Adam Draper, founder and CEO of Boost, Curt Hopkins’s “Venture Capitalists Take a Chance on the ‘Bitcoin Revolution,’” The Daily Dot, March 19, 2013

Stay away. Bitcoin is a mirage. It’s a method of transmitting money. [...] A check is a way of transmitting money, too. Are checks worth a whole lot of money just because they can transmit money? Are money orders? [...] The idea that it has some huge intrinsic value is just a joke in my view.

—Warren Buffett, chair and CEO of Berkshire Hathaway, CNBC’s Squawk Box, March 14, 2014

A Brief History of Digital Currencies

The birth of the Internet led many, including economist Milton Friedman, to assume that the invention of some sort of digital money would soon follow. Arguments in favor of digital money were numerous. One obvious benefit realized early on was that it might help prevent counterfeiting:

The advent of high-quality color copiers threatens the security of paper money. The demands of guarding it make paper money expensive. The hassles of handling it (such as vending machines) make paper money undesirable. The use of credit cards and ATM cards is becoming increasingly popular, but those systems lack adequate privacy or security against fraud, resulting in a demand for efficient electronic-money systems to prevent fraud and also to protect user privacy.

—Jörg Kienzle and Adrian Perrig in “Digital Money: A divine gift or Satan’s malicious tool?” (1996)¹

However, the creation of a secure digital money system must overcome many obstacles that might not be readily apparent. For example, anything stored in digital form can be copied and duplicated infinitely—so how can you prevent users from duplicating their money? Also, the money must be stored in a secure form that can’t be easily stolen or tampered with but can be backed up in the event of hardware failure.

Initially, these and other obstacles were tackled by people like David Chaum, one of the early pioneers of digital money. Chaum studied problems in cryptography while completing his PhD at the University of California, Berkeley, and was particularly interested in ways people could transfer money digitally and anonymously. He went on to create DigiCash in 1992, a company whose mission was to establish a digital, anonymous cash system (called e-cash). The system used a concept called blind signatures to guarantee the anonymity of its users, but a central company or bank was needed to ensure that each unit of ecash wasn’t spent twice. Chaum’s was not the only digital money company. By the mid-1990s, several private companies were developing electronic cash systems, mainly hoping to facilitate online purchases in the then nascent Internet. In addition to DigiCash, others—including First Virtual Holdings, Cybercash, and even a division of Microsoft—were significantly invested in developing digital money solutions. At the time, the use of credit cards to make payments via the Internet was rare, and these efforts were seen as critical to enabling e-commerce.

But almost all attempts to create digital money had the same Achilles’ heel: A trusted middleman was needed to keep track of everyone’s transactions. Unfortunately, many companies like DigiCash had much difficulty garnering that kind of trust from consumers and banks (whose cooperation they also needed). The reluctance was understandable: If a company operating a digital money system collapsed due to a catastrophic event, the value of the currency units could vanish overnight.

Obviously, it’s precarious for an entire currency to have a fragile single point of failure. Even the perception of such a point of failure can ruin its prospects as a meaningful currency. In the 1990s, the existential threat to digital currency companies was that a government agency might force them to close. Digital currencies were such recent inventions that the regulations to manage them were absent or ambiguous. Consequently, digital currency companies did not have a good idea of what the government would or would not consider acceptable.

DigiCash was challenged by many obstacles when it tried to meet various national regulatory requirements. In particular, regulators would not allow the e-cash anonymity feature to remain; mechanisms needed to be built in to allow law enforcement to trace the movement of money to prevent money laundering, which undermined one of the primary advantages of e-cash. These impediments, combined with slow adoption, forced DigiCash to declare bankruptcy in 1998. Other companies faced even worse fates. Gold & Silver Reserve Inc., which maintained a gold-backed digital currency called e-gold, was shut down. Its proprietors were indicted by the US Department of Justice for violating money-laundering regulations.

Ultimately, the regulatory burdens and lack of consumer demand for digital money led companies to abandon the concept. By the late 1990s, Visa and MasterCard had worked out the technical details of secure online credit card payments. With their already large market share, credit cards became the preferred method for consumers to make online purchases. Hence, many of the posited benefits of a stand-alone digital currency were never realized.

For a decade after the fall of DigiCash, it seemed clear that the idea of a purely digital currency was untenable due to the need for a trusted central party, which in turn was prone to failure (whether due to financial or legal problems).

The Dawn of Bitcoin

In 2008, a design was finally released for a practical digital currency that did not rely on the brittle dependency of a centralized third party: Satoshi published his white paper on Bitcoin.

The key factor distinguishing Bitcoin from its predecessors was that Bitcoin was not a company (or a product of a company) but merely a set of rules, a protocol, that dictated how digital transactions should be handled by a network of computers. Anybody could read the rules and follow them, but no individual could “own” or change them.² Because Bitcoin had no central point of failure, it didn’t need a government’s permission to exist: There was no Bitcoin company to shut down or central organizer to incarcerate. Essentially, the Bitcoin protocol was just the clever use of mathematics to transmit value between people.

In the 1990s, many digital cash companies were playing a game of legalistic chess with governments, trying to make moves to carve out a legal niche for their products without running afoul of anti–money laundering laws. However, without exception, they all lost at this game. For good or ill, Bitcoin “solved” this problem by simply upending the chessboard: In a system without a central mediator, it wasn’t possible to charge a specific person with money laundering.

Additionally, with Bitcoin, no single party could simply decide to shut down the system. As long as there was one person in the world who continued to run Bitcoin-mining software, the whole system would keep running. This represented a clear break from past digital currencies, and so a buzz surrounding the technology began building as soon as the first Bitcoin client became available in 2009.

Given the past history of money-laundering charges against digital currency providers, it is perhaps not surprising that Satoshi decided to remain anonymous. Even though he had no control over the operation of the Bitcoin network by design, a risk would always be present that someone could charge him (falsely) with “operating Bitcoin.” Cleverly, he sidestepped this risk by declining to reveal his identity.

Bitcoin’s First Four Years

Written under the pseudonym Satoshi Nakamoto and distributed on a cryptography mailing list in October 2008, a paper titled “Bitcoin: A peer-to-peer electronic cash system” was the first public mention of Bitcoin. This eight-page document outlined the basic design of Bitcoin but did not delve into any of the implementation details. In online discussions that followed, Satoshi claimed that he³ had been working on Bitcoin’s design since 2007. Shortly after publishing the paper, Satoshi released the first version of a program that implemented the idea, dubbed Bitcoin-Qt 0.1, and invited others to download and try running it. The first block in the blockchain, often referred to as the genesis block, was added by Satoshi on January 3, 2009. When he added the block to the blockchain, he inserted a short message, which all miners can do. In the genesis block, Satoshi wrote, “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” This was the January 3, 2009, headline on the front page of The Times, a British newspaper. By including this message in the genesis block, Satoshi proved that he couldn’t have added it to the blockchain before that date. Some think that the message choice also revealed a bit about Satoshi’s motivations for creating Bitcoin.

Because the code was open source, anyone could download, review, or modify it. Soon a small band of volunteers joined Satoshi in contributing new features and fixing bugs (however, the fundamental design never changed). Many cryptographers and programmers began to participate in Bitcoin’s development, including notable computer scientists like Hal Finney, who were longtime contributors to digital currency research (among other topics).⁴ Although Satoshi communicated frequently via forum posts and emails with early Bitcoin users and developers, he never revealed personal details about himself. One of the main contributors, Gavin Andresen, earned Satoshi’s trust over time and gradually took control as the unofficial lead developer of the Bitcoin project. On December 12, 2010, Satoshi posted a comment about the latest update to the Bitcoin software (now v0.3.19):

There’s more work to do on DoS [denial of service], but I’m doing a quick build of what I have so far in case it’s needed, before venturing into more complex ideas.

He was never heard from again.⁵ To this day, nobody knows Satoshi’s true identity, although countless people have published theories on who he might be, often naming either notable cryptographers or brilliant reclusive mathematicians. Not surprisingly, everyone who has been fingered as the inventor of Bitcoin has denied it.

In Bitcoin’s first year, anyone could generate several hundred bitcoins a day by mining on an ordinary laptop computer. At that time, however, it wasn’t obvious that bitcoins had any value. Even some of the early enthusiasts who appreciated Bitcoin as an important intellectual achievement didn’t believe their bitcoins were worth keeping after being mined. Many deleted their wallets when they were done playing with the software. From 2009 to early 2010, it was not meaningful to speak of the “price” of a bit-coin. Nobody had traded anything of value for one (at least publicly), so Bitcoin remained a mere mathematical parlor trick.

But in early 2010, small-scale currency exchanges opened, and bitcoins began trading for less than a penny each. An important moment occurred on May 18, 2010, when a forum user, laszlo, offered to send 10,000 bitcoins to anyone who would order two large pizzas for him (see Figure 6-1). This is considered the first recorded exchange of goods for bitcoins. At the time, many felt that laszlo was getting the better end of the deal. But when bitcoins reached parity with the US dollar on February 9, 2011, the joke was on laszlo; he had spent what had become $10,000 worth of bitcoins on some pizzas.

Bitcoins continued to increase in value, and on April 3, 2013, a Porsche in Texas was sold for 300 bitcoins at the rate of about $130 per bitcoin. Less than a year later, another sports car, the 2014 Lamborghini Gallardo valued at a little over $200,000, was purchased for 216 bitcoins, corresponding to about $925 per bitcoin (Figure 6-1).

By the end of 2013, more than a hundred million dollar’s worth of goods had been exchanged. Thousands of small merchants and a dozen or so major retailers and online businesses had begun accepting bitcoins as payment. The bitcoin exchange rate that year went as high as $1,000 per BTC, which was a 500,000-fold increase from when the pizzas were purchased in mid-2010. Major Bitcoin currency exchanges were seeing trading volumes of $500 million per month.

Although these Bitcoin adoption numbers were remarkable in their own right, Bitcoin also impacted the world at large in less quantifiable ways. Let’s explore the influence Bitcoin has had next.

Figure 6-1: Photographs of the pizzas purchased by laszlo for 10,000 bitcoins in May 2010 (left) and the 2014 Lamborghini Gallardo purchased for 216 bitcoins in December 2013

Bitcoin’s Early Impact

Although Bitcoin is still a very new technology, we can already point to several notable achievements, not only in computer science but also in economics and politics.

It Is the Largest Distributed Computing Project in History

Less than three years after its inception, Bitcoin had already eclipsed famous distributed computing projects, such as SETI@home, in terms of total computing power.⁶ Two years later, that computing power had further grown by a thousand times. By April 2014, if you combined the strength of the world’s top 500 supercomputers, the result would be a computer less than 0.05 percent as powerful as the Bitcoin network. This incredible growth, particularly in recent years, was made possible by the large-scale manufacturing of special-purpose computer chips designed solely for Bitcoin mining. In addition to the enormous increases in computing power, the very existence of factories producing hundreds of thousands of single-purpose Bitcoin-mining computer chips has been remarkable. (We’ll discuss the potential negative environmental impact of Bitcoin mining later in this chapter.)

It Is a Massive Economic Experiment with Already Surprising Results

Prior to 2009, most people would have reasonably assumed that computergenerated tokens, which anyone could create with free software, could never have meaningful value. This assumption turned out to be dramatically false. Bitcoin’s value grew by 1,000 percent each year for five consecutive years (from less than a penny each in 2009 to over $1,000 by the end of 2013). Within five years, the total value of all bitcoins in circulation was greater than the money supply of the national currencies of more than 100 countries.⁷ The low fees and higher security associated with Bitcoin, compared to credit card–based payment systems, gave merchants good reasons to accept it. As of September 2014, at least 40,000 online retailers were accepting Bitcoin,⁸ as well as over 5,400 brick-and-mortar stores.⁹

Although the long-term viability of Bitcoin as an economic tool is still in question, the fact that it has attained value at all has challenged many people’s notions about the nature of money. Not surprisingly, economists have been paying attention to Bitcoin, and research is being published analyzing the economics of Bitcoin. More than 2,100 scholarly articles on the economics of Bitcoin had been written as of September 2014.¹⁰

It Has Prompted Serious Discussions Within Governments About the Role of Digital Currencies

Although some companies had dabbled in the issuance of digital currencies to their customers prior to Bitcoin (sometimes even currencies that exist only in a computer game), these actions didn’t attract the attention of governments or large financial institutions, except for some law enforcement actions. Bitcoin, on the other hand, has stirred heated debates among politicians, regulators, and bankers. Several US Senate hearings have been dedicated to discussing the subject. Central banks in dozens of countries have issued statements or reports specifically in regard to Bitcoin, and so have major banks and financial institutions. In November 2013, for instance, the United States held congressional hearings on the regulation and the future of Bitcoin, and these received widespread publicity.

Bitcoin has drawn society’s attention to the potential promises and perils of digital currencies in a largely digital world. Even if Bitcoin disappears, its creation has already influenced future legislation and policies toward digital currencies.

The Future Potential of Bitcoin

A quote that has been attributed at various times to several people, including Niels Bohr and Yogi Berra, is the maxim “Prediction is very difficult, especially about the future.” Nonetheless, in a book about Bitcoin, we would be remiss if we didn’t explore its potential in the future.

First, we’ll look at the existential risks for Bitcoin—situations that could cause bitcoins to become worthless. Second, we’ll look at the two main roles that Bitcoin could play in a future world, either as a method of storing value or as a method of exchange. Third, we’ll consider some quantitative assessments of a successful future economy built around Bitcoin.

What Are the Existential Risks to Bitcoin?

For Bitcoin to survive long term, it must have advantages over existing currencies, or its adoption rate will stall. Also, because it is a software technology, Bitcoin needs to instill confidence that its network cannot be destroyed by computer bugs or hacks. Additionally, Bitcoin won’t survive if it can be extinguished by outside entities, such as governments or corporations. Finally, it won’t survive if it is somehow replaced by another, possibly better form of money (perhaps another cryptocurrency). Let’s look at each of these existential risks to Bitcoin in succession.

Does Bitcoin Have Advantages over Existing Currencies?

Many have argued that Bitcoin is just a fad, and after the fad is over, people will realize that Bitcoin has no advantages over paper money. As Paul Krugman has asserted in regard to Bitcoin, “So do we need a new form of money? . . . We have huge economic problems, but green pieces of paper are doing fine—and we should let them alone.”¹¹

However, a strong case can be made that Bitcoin does have significant advantages over traditional currency. An ideal currency has certain properties that make it as useful as possible. Those properties include portability, divisibility, durability, scarcity, and fungibility. Let’s look at each property in turn:

• Portability: In a perfect world, money should be light, compact, and easily transported. By this measure, bitcoins easily trounce paper currency: Bitcoins weigh nothing, are stored effortlessly even in large quantities, and can be moved across the world within minutes. Of course, as part of a world financial system, electronic mechanisms are available for storing and transporting traditional currencies in digital form, improving the portability of those currencies as well. However, in terms of simplicity, cost, and speed of portability, Bitcoin has clear advantages at this time.

• Divisibility: Everyone knows the frustration of needing to pay someone a small dollar amount but only having a large bill and no change. This problem cannot exist with bitcoins since bitcoins are completely divisible to fractions of a penny. Because computers are efficient at crunching numbers, it’s no surprise that they can handle the task of dividing Bitcoin amounts in any way necessary to make change.

• Durability: By design, every bitcoin is stored within the Bitcoin block-chain, a computer file that is stored on many thousands of computers across the world. As long as a person doesn’t lose the private key that protects their money, that person’s bitcoins are indestructible. On the other hand, the US Federal Reserve estimates the life span of a dollar bill at 5.9 years.¹²

Of course, another aspect of durability is that the value of a bitcoin must be maintained into the future. Although the value of a bitcoin in the future is unpredictable and volatile day to day, it has generally increased from year to year. One can certainly argue, however, that durability of Bitcoin in terms of maintaining its value is not a certainty until the network of users grows much larger.

• Scarcity: The primary innovation of Bitcoin is the decentralized creation of scarcity for a digital asset, which is necessary for bitcoins to retain any monetary value. Therefore, like paper money, bitcoins can maintain a limited supply. However, with paper money you need to trust the government (i.e., the owner of the printing presses) to maintain this scarcity over time and hence prevent inflation.

• Fungibility: It’s important for any dollar bill—or any bitcoin—to be equally valid for payment. If a recipient of money constantly needs to worry about whether they have received “good money” or “bad money,” the utility of the currency is damaged. As you know, paper money can be traced physically by tracking the serial numbers on bills or electronically through tracing mechanisms built into our modern electronic payment system. Similarly, bitcoins are traceable by following coins through the public blockchain. Hence, neither traditional currency nor Bitcoin has a clear advantage in terms of fungibility.

With regard to some of the properties that determine the utility of currency, Bitcoin scores quite favorably, especially in term of portability and scarcity. Therefore, it is unlikely that Bitcoin will ever fail solely because it offers no advantages over traditional money.

Can Bitcoin Be Destroyed via Bugs or Hacks?

Another commonly proposed reason for which Bitcoin may be extinguished at some point is that it might have bugs and can be hacked. Clearly, if a hacker was able to obtain an arbitrary number of bitcoins from thin air or found a way to transfer bitcoins from other people’s wallets at will, Bitcoin would quickly disappear into obscurity.

However, it is currently unlikely that such a bug exists. Many reputable security researchers have studied Bitcoin and have been impressed by the quality of its code. For instance, Dan Kaminsky, a respected security expert, wrote an article for Business Insider in April 2013 titled “I Tried Hacking Bitcoin and I Failed.” In the article, he talks in glowing terms about Bitcoin’s security model.

However, the most important reason to believe that the Bitcoin system is unlikely to contain serious flaws is based on an economic argument: If anyone figured out how to hack the core network, they could become phenomenally rich. Such a person could potentially extract billions of dollars from the network before the value of the currency collapsed. The simple fact that no person has done this yet, despite the enticing incentives to do so, makes a strong case against the existence of any such flaws in the currency.

Can Bitcoin Be Destroyed by Governments or Corporations?

In the early days of the Internet, we became accustomed to the idea that we would connect to a central server (run by Google, Amazon, Yahoo!, etc.) using a web client in order to browse online. This model for using the Internet is commonly called a client-server architecture. However, since those days, many new Internet-based applications have started using a peer-to-peer architecture. In this decentralized model, a software application finds other “like-minded” peer applications on the Internet and connects with these peers to operate the application. Early applications that used this approach include BitTorrent (for movie downloading) and Gnutella (for music discovery/downloading). Bitcoin also uses a peer-to-peer network in its design.

Peer-to-peer systems have many advantages over traditional client-server systems, including improved durability and performance. Because of these advantages, it is likely that these systems will become increasingly ubiquitous.

One benefit of using peer-to-peer systems over traditional architectures is their indestructibility: As long as a peer-to-peer app user can find other peers to connect to, the network will continue to exist, and it can do so without any central point of failure. For this reason, it is extremely unlikely that a government or other entity could ever completely extinguish the Bitcoin network, no matter how powerful that entity is.

Of course, the government of a country could decide to declare the use of Bitcoin illegal, and such declarations could greatly impact the value and utility of Bitcoin. However, short of someone completely shutting down the Internet, Bitcoin will continue to exist despite any such declarations. Also, since Bitcoin is inherently global, there is a limit to the impact the laws of a single government can have on its value and utility. Draconian laws passed against Bitcoin in one country may merely shift its use and development (and associated jobs!) to other countries.

Can Bitcoin Be Supplanted by Another Cryptocurrency?

All of us had a front-row seat when Google appeared out of nowhere with its superior search engine technology and left a long list of defunct, and now almost forgotten, search engines in its wake. Does anyone remember the search engine powerhouses of Lycos or Altavista? Is it possible that Bitcoin will similarly fade into obscurity when some new, better cryptocurrency comes along?

Developers who contribute to the core Bitcoin protocol tend to be very conservative. Not only does no developer want to take the blame for introducing a bug into a multibillion-dollar system, but even if a more radical feature was added, the Bitcoin community would be unlikely to accept it. Arguably, this is exactly what you want to hear if you are one of the people who have, in aggregate, billions of dollars relying on a well-functioning Bitcoin network. It’s in everyone’s interest to be extremely careful in making any fundamental changes to the core Bitcoin system. Even so, this conservative approach heightens the danger that an upstart currency could emerge, à la Google, and eat Bitcoin’s lunch.

Of course, we have no way of knowing what fantastic features a new currency would need such that it could supplant Bitcoin. However, three main reasons exist to believe that Bitcoin may be able survive the onslaught of newcomers: network effects, the nature of cryptocurrency volatility, and the recent development of cryptocurrency-pegging technology.

The network effect is the simple concept that people want to use a currency only if other people will accept it as payment. The more users a currency has, the more useful it is. This creates a natural barrier for the adoption of new currencies (and certainly has hindered the adoption of Bitcoin relative to traditional currencies in its first few years). Currently, Bitcoin has the largest adoption of any cryptocurrency, so newer ones would need to have easily distinguishable advantages over Bitcoin to overcome its network advantage. But how does volatility factor in?

From an economics standpoint, any asset that becomes newly available to an open market needs to first undergo a price discovery process. This was part of the reason for the Internet bubble in 2000: People simply didn’t know the value of the stocks of eBay, Yahoo!, and other tech companies because similar companies had not existed in the past. Eventually, as people became more familiar with Internet-focused corporations, it became clearer how to reasonably assign a price to each company’s stock.

Bitcoin has been undergoing a similar price discovery process, which is still in its very early stages: The price of a bitcoin has been swinging wildly up and down since the currency’s inception. As more and more users have started to use it, however, the volatility has modestly decreased (i.e., the swings, in relative terms, have become less violent). If Bitcoin volatility continues to decrease, this trend may give Bitcoin a significant advantage over future cryptocurrencies: Because Bitcoin is guaranteed to be the oldest cryptocurrency, new currencies might be unable to catch up in this “volatility race,” and Bitcoin will always remain less volatile than upstarts.

If Bitcoin maintains advantages in terms of network effects and volatility, it may make sense for new cryptocurrencies to use pegging to link themselves to the Bitcoin network instead of trying to replace the Bitcoin network entirely. Recently, two well-known cryptocurrency developers and entrepreneurs, Adam Back and Austin Hill, have suggested that the value of new cryptocurrencies could be directly linked one-to-one with the value of a bitcoin by using cryptography to allow coins to “ jump” between block-chains using clever algorithms. If this idea succeeds, it may be possible to create cryptocurrencies with new technological advancements into side chains of Bitcoin. Side chains are separate blockchains with different rules that share the same pool of coins as Bitcoin, allowing the new currency to share the same volatility (or lack thereof, potentially) and network benefits as Bitcoin proper.

If the side chain idea (or a similar peg-based idea) is successful, future cryptocurrencies would benefit from Bitcoin’s existence and even augment it rather than replace it. For these reasons, Bitcoin might never be entirely replaced by other cryptocurrencies. That being said, if a cryptocurrency is created that really is so much better than Bitcoin that we all switch, that wouldn’t really be a bad outcome, would it?

Now that we’ve discussed the existential risks, let’s explore what Bitcoin’s future might look like.

What Role Might Bitcoin Play in the Future?

The two main uses of a currency are as a means of storing savings and as a payment mechanism. If we want to hypothesize about the future impact of Bitcoin, we need to compare and contrast these two roles of money and explore which role the currency can take on—because the role that Bitcoin plays can make a big difference in terms of the value of the Bitcoin economy, as well as the value of an individual bitcoin.

Using Bitcoin for Savings

Bitcoin potentially has much to offer as a mechanism for storing savings. The reason is that its total supply is precisely known. Also, if used properly, it cannot be easily seized or stolen. You might imagine that in the future, it could become a preferred vehicle for saving your wealth instead of cash, precious metals, or real estate.

In this role, Bitcoin’s use may be most comparable to that of gold, currently the most popular decentralized medium for storing savings. If we could estimate how much wealth is currently saved in gold, it would indicate the scope of possibility for Bitcoin to be used in a similar way.

Can we estimate how much wealth is currently stored as gold? As this book goes to press, it is estimated that all the gold above ground (as opposed to gold yet to be mined) is valued at about $9 trillion. Roughly half that amount is used for jewelry, and the rest is in gold bars or coins, which are used simply as a store of value. Let’s conservatively assume that everyone who possesses gold jewelry does so purely for its beauty, not as a form of savings. That leaves $4.5 trillion worth of gold used purely as a means of savings.

So if bitcoins were ever widely adopted for saving wealth, the Bitcoin economy would eat into the market share of a $4.5 trillion gold economy.

Another way to estimate the amount of money currently in savings is to look in aggregate at how much wealth exists in the world. Today, the average net worth of a person (combining all the billionaires with the destitute poor) is about $25,000. This value consists of savings held in cashand wealth held in other types of assets. Hence, the total wealth currently kept in savings worldwide is about 7 billion times that much, or approximately $175 trillion.

If Bitcoin were ever to become a popular store of value, it would represent some fraction of that $175 trillion. Even if only 1 percent of the world’s wealth was stored in the form of bitcoins, the total value of the Bitcoin economy would be in the multitrillion-dollar range. Since we know that there will only ever be at most 21 million bitcoins in circulation, each bitcoin would need to be worth hundreds of thousands of dollars in order for Bitcoin to store 1 percent of the world’s wealth.

Using Bitcoin as a Medium of Exchange

If Bitcoin becomes primarily used as a medium of exchange (i.e., a payment mechanism), people would keep only as many bitcoins on hand as they needed for purchases and would keep the bulk of their savings in other places. Currently, most people use traditional currencies this way. They spend US dollars (or euros, yen, etc.) to make purchases, but they save the majority of their wealth in bonds, stocks, mutual funds, or other assets that don’t lose value due to steady inflation.

Because Bitcoin transaction fees are low, the payment network is not proprietary, no identity information is unnecessarily revealed, and the transaction security is based on modern cryptography, Bitcoin is potentially a superior medium of exchange compared to national currencies.

To estimate the impact Bitcoin might have if it were used widely as a payment mechanism, we need to estimate how much money (of any type) is currently in active circulation across the world for payment purposes. Specifically, we need answers to two key questions:

1. How many expenses does a person have to pay on a regular basis?

2. How long will it take a given bitcoin to be reused within the economy as it passes from person to person?

To answer question 1, we can use the fact that the current median yearly income of a person in the top-earning billion people in the world is roughly $15,000. Let’s assume that from this income, $3,000 is put toward savings and that this person spends $1,000 a month.

To answer question 2, let’s estimate that it currently takes about a month for a dollar to be respent. In other words, if you buy a hamburger at a restaurant today for $10, let’s assume that it will take about a month before those same$10 are spent by the restaurant owner.

Using these assumptions, we can roughly estimate that approximately $1,200 needs to be in circulation per person at any moment. For 1 billion people, a total of $1.2 trillion worth of currency needs to be in circulation as a medium of exchange for the world economy to function.

If Bitcoin became a widely adopted medium of exchange, some part of this $1.2 trillion payment economy would be executed in bitcoins. Again, because of the hard limit of 21 million bitcoins, we know that if bitcoins were used for just 1 percent of the world’s transactions, then each bitcoin would need to be worth tens of thousands to hundreds of thousands of dollars.

Clearly, Bitcoin has a long way to go in terms of adoption before it reaches these staggering numbers (if it ever does). We will always use many different assets as a form of savings (stocks will never go away, for example, no matter how popular Bitcoin gets), and we will use many different payment mechanisms. That being said, nothing stops Bitcoin from being used to some degree as both a medium of exchange and a form of savings, and the more widely it is used, the more useful and convenient it will be to its users.

In this section, we have discussed the potential value of Bitcoin under certain adoption scenarios, but we have little basis for predicting just how much it will be adopted. Depending on the adoption level we assume, we could forecast virtually any value of a future bitcoin, from hundreds of dollars to millions. Somewhat ridiculously, if we assume almost all of the world’s savings are stored in Bitcoin, we can even imagine a billion-dollar bitcoin, because the amount of savings and assets in the world is so incredibly immense!

For this reason, it doesn’t make sense to try to assign a precise estimate to the value of bitcoins in the future. The best we can do is suggest that Bitcoin has potential as a technology, and in the future it could be a big deal—that is, if it doesn’t first fail in the many possible ways we’ve considered.

UNIT OF ACCOUNT

It’s theoretically possible in the distant future that a currency like Bitcoin could be used to denominate the prices of goods as an international standard. Using Bitcoin as a unit of account is certainly an intriguing idea, and this purpose is commonly mentioned in economic texts as an important role of money, but it would have negligible economic impact on the future world economy. The reason is that using Bitcoin as a pricing standard, in itself, doesn’t directly affect how many bitcoins or other goods are bought or sold, simply because you can “measure” items in Bitcoin without needing to own them.

The Dangers of Decentralized Digital Money

After discussing the many potential benefits of a currency like Bitcoin, we would be remiss if we didn’t also examine the potential dangers of this technology. Here, we’ll consider the ways that Bitcoin might be harmful to society if it is widely adopted. Even if the technology is sound, some ethical reasons might exist for opposing Bitcoin.

Bitcoin and Illegal Activity

Given the early and eager adoption of Bitcoin by illegal product marketplaces, such as the infamous Silk Road website that allowed customers to buy drugs and other illegal products via mail order, it has been argued that Bitcoin’s privacy features enable criminals. Arguably, there’s some truth to this debate: Just as water always seeks the lowest level, criminals will always seek tools that give them the most anonymity and protection against law enforcement.

However, in 2013, the US government successfully found and prosecuted the alleged creator of Silk Road and arrested alleged drug dealers selling products on the site. The swiftness with which Silk Road was dismantled seems to have been a strong deterrent for other marketplaces trying to adopt Silk Road’s business model. For now at least, only limited evidence suggests that Bitcoin offers criminals any meaningful protection from the law.

Additionally, arguing that technologies that promote anonymity are somehow suspect from a purely moral perspective creates dangerous precedents. With the recent widespread use of public cameras, facial recognition technologies, social networking sites, and GPS-enabled cars, it is becoming more difficult for people to maintain their privacy each year. This erosion of privacy has its own downsides, compromising personal liberties.

For this reason, a counterargument can be made that encouraging and destigmatizing the use of privacy-enhancing technologies like Bitcoin may actually be positive for society. The idea that it’s acceptable and normal to use tools that protect privacy is called anonymity by default. If you agree that valid reasons exist to remain anonymous in many situations and that anyone doing so doesn’t “have something to hide,” you will appreciate the privacy protections afforded by the Bitcoin currency.

There is also the simpler argument that Bitcoin is merely a useful tool and so it has an enabling effect to anyone who uses it, even criminals. Certainly cars, phones, computers, and the Internet are all used by criminals to accomplish illegal activity, but we wouldn’t ban those technologies solely to hinder criminal activity.

The Energy Costs of Bitcoin

Another ethically contentious facet of Bitcoin is that miners expend enormous amounts of energy when mining for bitcoins. These energy costs are significant, and some people have argued that this makes Bitcoin wasteful and harmful to the environment.

However, this argument does not take into account the massive costs that are expended by our existing financial system for security. Every armored van, security officer, and bank vault that is used to protect traditional currency uses resources, and if we moved to a currency that leverages modern cryptography for security, many of these traditional security mechanisms that physically deter thieves from accessing this money may in theory no longer be necessary.

Additionally, credit card issuers charge high fees (upward of 2 percent per transaction in the United States), and a large chunk of these fees are used for fraud-prevention purposes. If we widely adopted Bitcoin, that would greatly reduce such fraud, so this 2 percent resource drain on the entire credit card economy would be decreased.

The bottom line is that the energy cost of Bitcoin mining is a necessary component of the Bitcoin currency system, and it serves a real and useful function. Naturally, if a person starts a priori with the assumption that Bitcoin is not useful, no argument will suffice to convince such a person that the energy expended to protect the Bitcoin network is anything but a waste. However, in this book we’ve described many benefits of Bitcoin that provide some justification for its use of energy.

PROOF-OF-STAKE: A LESS WASTEFUL WAY TO SECURE A CRYPTOCURRENCY?

Bitcoin mining uses a concept called proof-of-work to secure the system. In this system, new blocks (and bitcoins) are awarded randomly to miners based proportionally to the number of hashing calculations they perform. However, some developers have attempted to build cryptocurrencies that adopt a different concept called proof-of-stake, which awards blocks in a manner proportional to the amount of currency a miner holds (or proportional to a similar metric, such as the number of coins owned multiplied by the days the coins have remained unspent). Two currencies that use this approach are Peercoin^* and NXT.^**

A proof-of-stake mining reward doesn’t require the same considerable energy expenditure required by a proof-of-work currency, like Bitcoin. However, it isn’t clear whether proof-of-stake-based currencies are as secure as proof-of-work-based ones. Just as proof-of-work-based systems are “vulnerable” to a 51 percent attack, proof-of-stake-based systems have their own vulnerabilities (51 percent attacks are described in detail in Chapter 8). Although we know that a 51 percent attack in a proof-of-work-based system requires extraordinary resources and is economically irrational for the attacker, attacks on proof-of-stake-based systems may be easier than on proof-of-work-based system. Peercoin mitigates this issue by combining proof-of-stake with some additional proof-of-work to maintain stronger security. NXT addresses this issue by adding nuances to the consensus mechanism to decide which blocks are valid, potentially sacrificing some decentralization in the process.

The bottom line is that no consensus yet exists among cryptocurrency experts as to the practicality of proof-of-stake. Even so, it is an interesting concept with the attractive benefit of dramatically reducing the energy requirements for operating cryptocurrency.

* http://www.peercoin.net/

** http://www.nxtcommunity.org/

Bitcoin and the Dangers of Deflation

Another common criticism that is leveled against Bitcoin is that, since the total number of bitcoins is capped at 21 million, their value will continually increase and nobody will actually want to spend them, making the currency useless (or worse, leading to dangerous deflation).

This argument relates to the economic concept of Keynesian economics,¹³ which maintains, among other ideas, that frequent injection of new currency into the economy helps promote its growth. Regarding Bitcoin, Keynesians will argue that the inability of governments to print more currency units would seriously damage economic growth.¹⁴ They contend that the scarcity enforced by Bitcoin’s cap would drive nominal deflation, which is when the price of everyday goods denominated in bitcoins would drop over time, causing the circulation of the currency to freeze up and forcing the economy into a depression. The rationale is that individuals would postpone their purchases in anticipation of lower prices for goods in the future.

Bitcoin supporters counter the Keynesian arguments with ideas based in the philosophy of Austrian economics. This economic philosophy argues, among other ideas, that the price of a unit of currency has the ability to adjust appropriately on its own, guaranteeing that purchases and savings in an economy will remain at desirable levels, no matter how many units of currency exist at any point in time in the economy.

Bitcoin and Government Stability

Some contend that a successful Bitcoin system would be harmful because it could destabilize governments. It has been debated that Bitcoin is part of a larger movement, recently termed radical decentralization, which maintains that all decentralization (including the functions of the government) is desirable and possible. This idea is a direct extension of the philosophies of Friedrich Hayek, who reasoned that local control is usually preferable to central control, because local people have more knowledge about local conditions and can therefore behave more efficiently in most situations. However, it is true that governments benefit from having control over their currency supply. Governments encounter challenges when they attempt to raise funds via direct taxation, and printing money to fund government projects is known as “taxing by inflation,” which is both easier for governments to do and harder for citizens to stop. The loss of this means of raising money for government projects (including military defense) could reduce the financial viability of some governments.

However, Bitcoin is not the only recent technology that is decentralized by design: BitTorrent, Gnutella, Tor, and Freenet are similarly immune to central control. Clearly, computers allow us to explore the idea of decentralization, and its merits and potential faults, in ways that were not possible before the Internet revolution. Many of these decentralized systems were thought to pose risks to government stability (especially the Internet in countries with oppressive laws against free speech), but we accepted them anyway due to the enormous benefits they brought to society. The loss of control by governments, in the case of the Internet, was compensated (and then some) by increased economic productivity. Computer engineers are continually pushing the boundaries of what’s possible with decentralized networks, trying to drive financial contracts (such as software projects like Ethereum¹⁵) or communication systems (such as Bitmessage¹⁶) toward decentralized systems as well. Only time will tell what kind of impact these systems will have on governments, good or ill.

In the next chapter, we’ll explore some of the underlying technology in Bitcoin in more detail, starting with Bitcoin cryptography.