The Evolution of Money

by David Orrell

  The task of adding a new block is made artificially difficult by requiring miners to perform a so-called proof-of-work, which is comparable to tossing a coin millions of times (electronically, of course) until they get a certain number of heads in a row. The computing power required to do this puts a price on the blockchain and makes it economically unattractive to try and trick the system by producing a fraudulent version. As a reward for successful completion of this work, miners also receive a certain number of freshly created bitcoins. This represents a seigniorage fee, and because the addition of new coins dilutes the worth of existing ones, the expense is shared over the network. The difficulty of the task is progressively ramped up so that the blockchain is updated at the same rate of one block every ten minutes no matter how fast computers get.

  Mining is expensive because to do it efficiently now requires dedicated facilities—heavily air-conditioned warehouses stacked with racks of computers—along with large amounts of electricity.5 Environmentally friendly, it is not. Popular locations include Iceland (cheap geothermal energy) and Washington State (cheap hydropower). This expense can be seen as the cost of maintaining trust in the network, measured in computers and gigawatts, but it may also prove to be a competitive disadvantage for Bitcoin, as discussed later.

  The issuance of new bitcoins, like the discovery of gold, therefore has a random component but favors large miners. The money supply is thus diversified to a degree and allowed to gradually expand. However, the system is designed so that the maximum number of bitcoins in existence does not exceed the apparently arbitrary limit of 21 million. We are currently about two-thirds of the way there, and the limit is expected to be reached around 2140, after which miners will receive only transaction fees, which are currently small or even zero. As this limit approaches, fees will therefore have to increase, though by how much is a subject of debate.6 In principle, users could collectively decide to change the rules and introduce more coins, but only if 51 percent of the computing power in the network agreed (a potential vulnerability, should the system be taken over by a consortium).

  The system has therefore been cunningly designed to enable cheap, secure transactions in a completely decentralized way. Napster could be shut down because it ran off a centralized server, but Bitcoin lives on the Internet. From the point of view of a judge, listening to FBI testimony, it probably resembled some kind of sinister conspiracy, which is ironic given that many of its proponents feel the same way about the conventional banking system. The “stamp” on a bitcoin is provided not by a government or central bank but by the network-confirmed and time-stamped blockchain. A bitcoin by itself has no inherent worth; like a fiat currency such as the dollar it attains value through the markets it has itself created. Unlike a traditional currency, it is not (yet) issued by the state or accepted as payment for taxes. Because its code is open source, anyone can download it and play around with it, and as discussed later, Bitcoin has already spawned a number of copycats and variants, known as “altcoins,” but Bitcoin is currently far larger than any of its competitors and is holding onto its first-mover advantage.

  The addresses of the first coins, from the Genesis block on, are written there in the blockchain, and it is relatively easy to figure out which anonymous figures they belong to and to see whether they have moved. Satoshi Nakamoto no longer stays in touch with the Bitcoin community—his last known e-mail was in April 2011—but he is believed to be a Bitcoin millionaire, which at the currency’s peak was a dollar billionaire. (Nakamoto can mean “central” and Satoshi “intelligence” in Japanese, so it all points to the CIA.) Whether his creation will pass the test of time remains to be seen, but cybercurrencies as a whole seem unlikely to go away soon—and not just as a means to buy contraband or avoid taxes.

  Wild West

  One group that Bitcoin appeals to is the masses of migrant workers (see box 8.2), whose remittances totaled $530 billion in 2012 and who—if they were a single economy—would place twenty-second, ahead of Iran or Argentina. As Bitcoin’s founder pointed out, the main disadvantage of the conventional banking system is the massive overhead costs, which appear as transaction fees. These are particularly high for cross-border exchange. Specialized firms such as Western Union and banks alike charge around 10 percent, and as high as 20 percent in some instances, to send these funds home. Add exchange rate costs, and the total cut can reach 30 percent. The process also takes a few days. With Bitcoin, in contrast, users swap the original currency for bitcoins for a fee of typically 1 percent, transfer it to the intended destination, and swap it again for the local tender—all in a matter of minutes.7

  Another group that naturally gravitates toward cybercurrencies are citizens of nondemocratic or outright authoritarian countries. In Venezuela, for example, Bitcoin is gaining a foothold for a number of reasons. One is rebellion against the system, against the order of things where access to consumer goods and hard currency is limited to the affluent. Another is that, with hyperinflation of over 50 percent, bitcoins do not seem so risky.8 It also helps that Bitcoin miners have access to cheap, subsidized electricity.

  Finally, there are also the 2.5 billion adults who are collectively referred to as the “unbanked” (which sounds like the financial version of unwashed). Given that this group amounts to over half the adult population, it is an attractive target for cybercurrencies. Even in the United States, 12 percent don’t have bank accounts, which makes it hard to either save or borrow.9 Of course, it might seem that the unbanked will also be unreceptive to new technologies—but as discussed in chapter 8, this is far from the case, which is why countries in Africa have spearheaded mobile banking. They can skip over the legacy banking system in the same way they skipped over landlines and went straight to mobile. One reason Bitcoin has captured the imagination of so many people is that it holds the promise to democratize finance and change lives for the better. There is a kind of utopian fervor around Bitcoin meet-ups that is in marked contrast to the jaded careerism that characterizes most of the financial sector.

  Given the novelty of the whole concept, most countries do not know what to do with it, while seeing it both as a potential and a threat. Some countries, such as Switzerland, Germany, and Cyprus, have been supportive. A group of forty-five Swiss members of Parliament called for the evaluation of the opportunities that Bitcoin yields for the country’s banking system in 2013. Germany labeled it private money and treats it as such. The Cypriot University of Nicosia, one of the largest accredited English-language universities in the Euro-Mediterranean region, became the first university to accept tuition in bitcoins (the Cyprus banking crisis, which led to confiscation of savings accounts in 2013, may have been a motivating factor). In the United States, the Treasury Department released a statement recognizing “the innovation virtual currencies provide, and the benefits they offer society,” which was enough to boost the price to a record of $1,242 in November 2013—thus briefly surpassing by 2 cents the price of an ounce of gold.

  The Chinese had a different view, and soon spoiled the party when they barred financial companies (though not the public) from making Bitcoin transactions. Bitcoin, like other cryptocurrencies, ignores physical boundaries and restrictions that come with them, such as limits to capital flows. Once Beijing realized that Bitcoin created a backdoor through which money was being siphoned out of the country, it opted for an abrupt stop, since the Chinese economy needs to keep money in the domestic banks that fuel its rapid expansion with their credits. The attempt to rein in Bitcoin has not scared off the general public in China; at the time of this writing, nearly 80 percent of transactions are yuan–bitcoin, most of them speculative (one reason for the large number of trades is that Chinese exchanges often don’t charge trading fees).10 However, it triggered a fall in the virtual currency’s price of about one-third from its peak.

  Things got even worse after the collapse of the Mt. Gox Bitcoin exchange. Mt. Gox originally began as a platform for a card-trading game (the name does not refer to
a mystical mountain, but comes from Magic: The Gathering Online Exchange). When Bitcoin began to take off, Magic’s founder, Jed McCaleb, switched to trading bitcoins. The site moved to Japan and became the leading Bitcoin exchange, at its peak handling over 75 percent of trades, until early 2014, when it turned out someone had magicked away about 850,000 bitcoins, which by then was worth around $500 million. The security flaw apparently lay with the exchange, rather than the design of Bitcoin, but again it sent the price plunging.

  To chronic naysayers, this was a clear sign that Bitcoin was done, or nearing its end as a subject of any notable interest beyond the geek community that gave birth to it in the first place. However, every idea has to suffer through its childhood illnesses. And for most of its end users, such as those sending remittances abroad, such price perambulations are a secondary concern, since they only hold the currency for a matter of minutes.

  Under the Table

  In his “Crypto Anarchist Manifesto,” published well before Friedman’s 1999 interview on the topic, Tim May wrote with some prescience about the social and economic impact of cryptographic methods: “The State will of course try to slow or halt the spread of this technology, citing national security concerns, use of the technology by drug dealers and tax evaders, and fears of societal disintegration.”11 Indeed, much of the public discourse around Bitcoin, fueled regularly by some central bankers and government officials, seems to stress the connection between cybercurrencies and illegal activities such as drug dealing, tax evasion, funding for terrorism, and organized crime. This is why it is so important to understand what Bitcoin is and what it is not.

  One thing that Bitcoin is not, is cash. “King” cash offers the certainty one can rely on even during the financial earthquake, as the market proverb goes. It seems solid, understandable, accountable, which is why many economies, including the most advanced ones, such as Germany, still largely rely on it; in the current period of rapid time and space compression, wherein more and more familiar things are turning into series of zeros and ones, banknotes and coins simply evoke a cozy feeling that resembles fond memories, like grandma’s apple pie. Cash is a money object that you can hold in your hand and feel in your pocket.

  However, many of the attractive properties that cash is supposed to have are largely an illusion. Given the inflationary character of fiat currencies, meaning the ingrained principle that a certain level of inflation is good and is thus targeted by central banks, to hold onto cash is like holding a candy cane in the rain; no matter how well you protect it, it will disappear, so enjoy it while it lasts, and enjoy it fast, the environment tells you. At least with Bitcoin, the biggest meddler of all, the central bank, is out of the picture. As Nakamoto put it in a 2009 post that echoed Nicolas Oresme in the Middle Ages: “Escape the arbitrary inflation risk of centrally managed currencies!”12

  While Bitcoin has a reputation as being used by criminals, cash remains the medium of choice for most underground dealings, and its use has shown no sign of being supplanted by cybercurrencies. In the United States, for instance, cash use increased by 20 percent from 2011 to 2014, which means that there is around $1.2 trillion in cash outside American banks and the average American has about $4,000 stacked under the mattress. It has been estimated that the American economy loses more than $100 billion due to the evasion of taxes on unacknowledged incomes.13 In Britain, some 70 percent of banknotes in circulation are said to be used for tax evasion, drug deals, bribery, and so on.14 The study showing that 99 percent of banknotes in circulation in London are tainted with cocaine can only be considered a punch line in this context.15

  Cash use for small general transactions, meanwhile, is being gradually supplanted by electronic payment systems. In 1776, Adam Smith announced that paper money outnumbered the coins in circulation; according to the UK Payments Council, 2015 would be the first year in which more is spent electronically than with both coins and notes.16 Moreover, there are economies in which cash is on the very fringe of the monetary spectrum. In Sweden, transactions involving notes and coins equal a mere 3 percent of the national economy, and the country is expected to go completely cashless by 2030.17 Some have argued that we should do away with coin and paper money altogether, though it isn’t just criminals who would miss the liberating anonymity of cash.18

  Banknotes (and coins), as well as gold and diamonds, thus enable organized crime as much as cybercurrencies do. Bitcoin, no doubt, attracts especially those who browse the dark Web to score or sell illegal matter or engage in illicit deeds. Its lack of complete anonymity explains why there is demand for an alternative in the dark pockets of the World Wide Web that is being met with altcoins such as Darkcoin and Zerocoin. These are based on the same protocols as Bitcoin, but are designed to compromise attempts at blockchain tracing via, for instance, encrypted swaps of coins among two or more users. It appears that at least some of the potential clients are paying attention. At the end of 2014, one could thus pay for LSD, cocaine, or counterfeit euros in Darkcoin on sites like Nucleus and Diabolus.19

  Digital Gold

  Another common criticism of Bitcoin is that it has no “intrinsic value” and is a poor store of wealth.20 This is justified both by its currently volatile exchange rate and the fact that the entire system, which after all is based only on information encoded in the blockchain, could suddenly disappear into the ether, like a group illusion that suddenly shatters. But even gold, as discussed earlier, is ultimately considered valuable on the basis that it has been considered valuable for thousands of years (unlike other metals, such as copper, gold’s industrial applications are limited). This is obviously a good reason for keeping the stuff, but essentially it is still a statement about fashion—just one that happens to have lasted with its ups and downs over a remarkably long time. Cybercurrencies will be worthless if the global Internet crashes and never recovers, but in that event gold might be rather useless as well: it is too soft and thus could not be used to forge simple instruments should some apocalyptic prophecy materialize and we all go back to being self-sufficient and relying on simple techniques of toolmaking. (What will be useful? Social skills, probably.)

  Bitcoin seems to be distinct from something like gold because it has no physical counterpart that you can hold in your hands (although you can buy “coins” with the Bitcoin data embedded in them). Indeed, the appeal of gold probably has as much to do with its reassuring heft as with its beauty: with a density nineteen times greater than that of water, a standard gold bar has a length of only seven inches but weighs 27.5 pounds. Bitcoins weigh nothing in themselves, but they still have a physical presence. This was demonstrated when someone mistakenly threw out a computer hard drive containing 7,500 bitcoins, purchased in 2009 when they were almost free. Somewhere in a Welsh landfill, if the story is right, lies a few million dollars, worth of digital gold.21 The distinction between physical matter and digital information is blurry, since both ultimately consist of atomic configurations: what counts is possession. And while the apparent immateriality of a bitcoin may to many be its greatest disadvantage, it is at the same time its greatest strength.

  Moving or making payments with gold is difficult, not just because it is heavy, but also because of the security risks. Someone has to keep an eye on the stuff as it goes from point A to point B. The same holds true for any kind of monetary transaction, which adds significant costs. For example, while credit card purchases can be made electronically over the Internet, credit cards were never designed with that in mind. The process is clunky and involves a number of middlemen who charge transaction fees that amount to between 2 and 3 percent. Their involvement is necessary to make sure the money has left your account and is deposited in the seller’s account. Middlemen also provide both credit and a degree of consumer protection, so goods can sometimes be returned and transactions reversed. However, the purchaser needs to supply information such as address, credit card number, and the CVV number on the back of the card, and the process is not completely secure. Underwri
ting fraud is one reason credit card fees are expensive. The other is that the process is dominated by the Visa/MasterCard duopoly, together with their associated banks, so until recently there has been little competition.

  Bitcoin transactions, in contrast, are tracked in the blockchain and do not require additional information to be submitted, making fraud more difficult, though certainly not impossible. For example, bitcoins can be stolen by hackers or malware that searches computers for the text file containing the private key to a wallet (a number of companies supply secure wallets and authentication schemes that give an added layer of protection). As discussed earlier, gold has historically been used as money not just for its beauty and scarcity but also because its properties—stability, fungibility, and divisibility—make it rather like number. But in a number-based society, why not just use code?

  If anything, Bitcoin’s biggest problem may be that it is too much like gold. As with ounces of gold, the total number of bitcoins is capped (subject again to a quorum of the mining community not agreeing to change the cap), so the system is not designed to adapt to the supply of goods and services. In fact, the number of bitcoins would actually shrink over time as some are permanently lost, in Welsh landfills or elsewhere. A Bitcoin economy, if it grows, will therefore tend to be deflationary, which will encourage hoarding, since the currency should—speculative swings aside—become progressively more valuable with time. Under the gold standard, banks gained extra flexibility through fractional-reserve banking, that is, lending more money than they had on their books; however, with Bitcoin there is less incentive for people to store their money with banks that will lend it to someone else. Over time, control of the currency could therefore accumulate in the hands of a small elite. One imagines a future version of William Jennings Bryan refusing to “crucify mankind upon a cross of digital cybercurrency.”