January 2013 Journal
WORDS is a monthly journal of Bitcoin commentary. This issue collects the January 2013 writing in the WORDS archive. For the uninitiated, getting up to speed on Bitcoin can seem daunting. Content is scattered across the internet, in some cases behind paywalls, and content has been lost forever. That’s why we made this journal, to preserve and further the understanding of Bitcoin.
Bitcoin “mining” is a misnomer
By Oleg Andreev
Posted January 8, 2013
Bitcoin “mining” is a process of creating hard-to-compute chain of transactions to make sure nobody tries to spend money twice. It is important because the chain is not stored on a trusted server, but rather copied thousands of times among all the computers in the network. The resulting structure is called a “blockchain”, that is a chain of blocks of transactions. As it is nearly impossible to change the history of payments (and therefore cancel transactions or double-spend bitcoins), users stay confident that the history of transactions looks the same to everyone. This is the central part of the Bitcoin protocol: a solid and distributed mechanism to verify validity of payments.
People who spend electricity to create blocks are called “miners”. They are paid for their trouble by transaction fees (offered voluntarily by others) and block rewards that are source of the new bitcoins. There is a limited number of bitcoins and all of them are distributed among the first several million blocks available to everybody to “mine”. That’s why the process of building the blockchain is called “mining”.
However, the term makes sense only within the earliest history of Bitcoin when there were almost no economy and no transactions, but only a bunch of geeks computing almost empty blocks for reward that they were trading for fun and a couple of cents. If you tried to find any info on Bitcoin in 2010, you would find mostly the info about mining. Back then a pizza was sold for 10000 BTC (https://en.bitcoin.it/wiki/History) and the whole project looked like a game.
Today there is a much more interesting economy, daily transaction volume is almost $3 million and rapidly growing, more than 50% of all bitcoins are mined already and the per-block reward has already been halved in December 2012 (as defined by the protocol). Blockchain is used for real transactions — purchases, currency transfers, investment, bets and all other things we use money for. Miners are making very real money which is a strong incentive to carefully include and validate all transactions to keep the value of the system growing.
So today it is a good time to remind ourselves and everyone that the Bitcoin is not about “mining” money. It is about verifying payments in a very secure manner, without trust in any authority, very quickly and efficiently. Mining is just a temporary effect of bootstrapping the next era in human kind.
You don’t create anything of value
By Oleg Andreev
Posted January 9, 2013
When people ask about how bitcoins are created, you reply that they are “mined” by computing millions of cycles of the same algorithm until a certain result is achieved. Basically, you spend time + electricity to generate new coins.
Then they ask you is it true that you do not create anything of value? And you honestly say, well, yes. Electricity is wasted on generating random numbers without any practical use, so there is no “intrinsic” value being put in the resulting coins.
This is of course not true. I can also burn electricity watching YouTube all day, but that won’t make other people pay me. The truth is what “miners” do is validating and securing transactions. That’s their main job that others are willing to pay for. That’s why Bitcoin has value.
Why is unlocking new coins tied to the block creation (“mining”)? Because, it’s the only logical place to do that. If you have a method to generate money, then people are supposed to do that like crazy provided that someone still processes transactions (which is the only reason to have any interest in the currency in the first place). So if I say, you should do these calculations to get new money, but to make transactions do those other calculations, nobody would care. But when you combine those two things in one single process, then you have a system with a “positive feedback”: people get reward directly and immediately for providing services for themselves and anyone joining later on.
So the value of Bitcoin is not in the cost of electricity, but in the ability to make safe and quick transactions and having a limited money supply. And the miners are not digging money from nothing, they are doing a service to everyone and are being paid for that.
Bullshit people say about Bitcoin
By Oleg Andreev
Posted January 10, 2013
When you listen to a guy talking about Bitcoin, there are several things that come up frequently and that are not true. Unfortunately, even popular video on WeUseCoins.org says those things. So lets try to see what’s wrong.
1) “Bitcoin is a currency that is created by computers.”
As I explained in the previous posts, “mining” is absolutely secondary to Bitcoin. The most important thing is a decentralized history of exchanges that people can trust. That’s what makes Bitcoin interesting. You have much more freedom and much more protection to sign a contract with another human being. Without a single corporation, government, police and lawyers. And your contract will have to be acknowledged by everyone else contributing their own contracts. So all participating people are locking each other into mutual agreements in a very clever way, that nobody can escape them without paying for that. The word “currency” is absolutely a second part of the story. Since people normally want many different agreements, Bitcoin provides a numerical value on its contracts. Which makes it possible to trade them and use as a monetary instrument.
So it is not created by computers. It is automated by computers, but it is created and maintained by real people who want to trade with each other peacefully and efficiently.
2) “Bitcoins are sent directly to other people without someone in the middle.”
Of course, Bitcoins go through someone. And this someone is a “miner”, who validates transaction, puts it into the block and spends a lot of electricity to make sure some random person does not attempt to spend money twice or fool everybody around. It is a miner who gets transaction fees and also unlocks bitcoins as a reward for the clearing service.
The difference with a banking system, of course, is that miners do not have guns and thus cannot impose additional arbitrary rules without paying for them themselves. There are many of them, so you always can choose the one you like more. And that choice is already automated and optimized, so you don’t have to worry about it.
3) “There are no prerequisites.”
Of course there are. There is a protocol which is harder than any law in the world. If you don’t play along, nobody will give you a penny. You cannot press or threat people to change the rules. You absolutely have to play by the rules to get a cake. And everybody has to do exactly the same. No man can come in and say “this idea is interesting, but I’d like to adjust certain things in my, sorry, in everybody’s favor” - won’t happen.
4) “The total amount is limited, so the value always grows and you get richer.”
That’s true that supply is limited. But it’s not true that this is a reason why value is growing. Supply could have been linearly growing all the time, and it still could be a good deal (it’s just the fees would be higher). Or maybe not. The only truth here is that “growins value” is nothing but people’s desire to use Bitcoin more than yesterday because it is more efficient/cheaper/cooler/whatever than other alternatives. If one day it’s not the case, then the value will “go down” despite of the limited supply. Remember that nobody would need Bitcoin in the first place if there were no thieves on the streets and in the Central Bank. Everybody can just write their obligations on a piece of paper. So if that day suddenly comes, then Bitcoin will become nothing but a useless numbers.
Also, if suddenly people start saving Bitcoins and not selling them for anything in anticipation of future growth, guess what would happen? Nothing. Until somebody needs to buy something. You are not not buying computer this year because next year it will be more powerful and/or cheaper. At some point you need stuff to be done, so it will be done. And if Bitcoin owners do not do anything useful to each other, there is no point in having them. That’s why speculation is hard and only few cold-headed people are doing it more or less successfully. Others are enjoying building stuff and making themselves and everybody around richer and happier.
Market forces and Fractional Reserve Banking
By Peter Surda
Posted January 21, 2013
Ralph Musgrave made a blog post “Lawrence White Tries to Argue for Fractional Reserve Banking” where he criticises some of the arguments made by Lawrence White in testimony on his fractional-reserve banking. I tend to agree with many of the things Ralph wrote, but here I’ll concentrate one one aspect where I disagree.
Ralph writes:
“In fact there is no reason to suppose that “payment services” provided by a fractional reserve bank are any cheaper or “more economic” than those provided by a full reserve bank. That is, the ACTUAL COSTS (clearing cheques, issuing bank statements, etc) are the same in both cases. However, fractional reserve offers depositors interest on their deposits. And if you deduct that interest from the costs of payment services, then of course the cost of those services could be said to be reduced. But the reality is that this is just cross-subsidisation of one bank activity by another.” [emphasis original]
Ralph missed several things here.
Storage costs
The first one (which I cannot find explicitly in White’s testimony), is that holding less than 100% reserves decreases storage costs. Even if the “excess” reserves were used in a different manner than loaned out, FRB would still have lower operating costs. Storage costs are a subset of what I call “maintenance costs of money substitutes”. One might argue that if a withdrawal request arises in excess of reserves, the transaction costs of facilitating redemption (e.g. sale of assets) would be higher in an FRB. But the operational issues of redemption are not a feature specific to FRB. Even in a full reserve system, as long as branch operations are allowed, it is still possible that someone wants to withdraw more than the available reserves in that specific branch. The withdrawal would still have to be postponed and either the reserves transported from another branch, or some assets sold (the latter might be still chosen even in a full reserve banking if it has lower transaction costs, which is entirely possible).
Bank notes
The second thing is mentioned by White:
The other bank payment instrument, redeemable banknotes circulating in round denominations, simply cannot exist without fractional reserves. Banknotes are feasible for a fractional-reserve bank because the bank doesn’t need to assess storage fees to cover its costs. It can let the notes can circulate anonymously and at face value, unencumbered by fees, and cover its costs by interest income. An issuer of circulating 100% reserve notes would need to assess storage fees on someone, but would be unable to assess them on unknown note-holders. There are no known historical examples of circulating 100% reserve notes unemcumbered by storage fees.
Now, I have a minor addition here, it is hypothetically possible to create a bearer instrument with demurrage (e.g. stamps) even on a 100% reserve banking. Whether there is a practical merit in that I will leave open, but I’ll ignore it for the time being, in order to explain the argument of White. So, let me reformulate White’s argument: In a metallic monetary system, as long as people prefer bank notes to coins, FRB will emerge. This is a straightforward logical necessity. Irrespective of what people think about legitimacy of FRB, in this particular case it is an unavoidable consequence of consumer demand. Why might people prefer bank notes to coins? I’ll address that right away.
Why are substitutes substitutes?
Here it gets a bit tricky, because anti-FRB-ists, when criticising FRB, tend to “objectivise the boundaries of goods”. They argue that an instrument issued by the bank is treated by the users of that good as a substitute because they think it’s the same good (i.e. it is a claim, an ownership title). But this is a non-sequitur. The best refutation of this assumption are so called “complementary currencies”, in particular those of type “mutual credit”. Mutual credit are a form of circulating medium of exchange which is derived from a “normal” money (e.g. the USD or EUR), but they are not based on deposit banking. Some of the more popular examples are WIR and TEM.
In other words, a subsitute medium of exchange (money substitute) does not need to be a claim. Mutual credit is not even convertible into the base money. This leaves the question open: why are then some goods accepted as a substitute medium of exchange? The Austrians know this, but magically, when talking about FRB, they forget about it. They are accepted as substitutes because they decrease transaction costs. Practically all of the anti-FRB Austrians realise this, but only when not talking about FRB: Rothbard, Hoppe, Salerno, de Soto.
So what are money substitutes? Money substitutes are copies of the monetary base. They are persistently causally related to the original (e.g. by a peg, by using the same name, etc.), and they act as substitutes from economic point of view. And, at the latest since Kinsella’s Against Intellectual Property, the Austrians increasingly come to the realisation that copying is not per se a violation of property rights. Analogously, creating an instrument which is subsequently then accepted as a substitute by the market is not, per se, a violation of property rights either.
Cross-subsidising
Now that we have clarified what are money substitutes, we can look at cross-subsidising. The instruments issued by the banks are copies. They have two important features that distinguish them from the originals:
- They have lower transaction costs
- They allow credit expansion
Here the error of anti-FRBists becomes apparent. They do not realise that the instruments are goods separate from the original. They draw the boundaries of goods based on their own desires, not based on how these goods are treated by the market. The result of banking is a new good, that unifies lower transaction costs with credit expansion. Even if they don’t like it, this is the economic fundament of the banks’ activities.
Since this new good, this copy, satisfies both the demand for lower transaction costs and credit expansion, these two activities economically manifest themselves as one. The merging of these two activities by the bank is simply a response to this unified demand. As long as this new good, copy, satisfies both demands, the activities of the bank are economically inseparable. Therefore, there is no cross-subsidising, similarly as the manufacturing of tires is not cross-subsidising the manufacturing of chassis as long as people demand the whole car, even if some people have a fetish for the tires and want to ban car assembly.
How to fix this?
Unlike the freebanking branch of the Austrian school, I actually agree with the gold standard branch that credit expansion [EDIT: and I mean any credit expansion] leads to distortions, such as the business cycle. So I’m at odds with both of them, as I argue that credit expansion [EDIT:I originally wrote FRB but that is inaccurate, it should be credit expansion] is economically detrimental, yet not a violation of property rights, but a consequence of market forces. I could just end here, leaving everyone baffled and annoyed. But this blog is called “Economics of Bitcoin”. And here it comes in.
To explain why, I’ll first start with a quote by none other than professor White, in Competitive Payments Systems and the Unit of Account:
“Coinage reduces transaction costs compared to simple exchange, because of authentication and weighing. Bank liabilities also reduce transaction costs. But these are empirical factors, and not something inherent in all possible monetary systems.” [emphasis added]
Now, putting it all together, if the transaction costs of monetary base are sufficiently low, money substitutes do not emerge, and thus there is no credit expansion. Bitcoin shows that such a system is empirically possible. It “fixes” credit expansion without “fixing” FRB. Is that a hack? No. Money substitutes are a hack, and credit expansion is a result of that. Bitcoin shows that a proper solution is possible.