The economics of Bitcoin and Blockchains

First, the Macro perspective: Bitcoin, currency and inflation.

Bitcoin, the crypto-currency created in 2009 by the pseudonymous Satoshi Nakamoto, is quite a marvel built on expertise in (at least) five disciplines–from computer science: databases, distributed systems, cryptography, and from economics: currency and contracting. A lot has been written about the computer science elements of Bitcoin and its underlying distributed cryptographic database, the Blockchain. This is why I will try to focus on the economics behind the next big thing.

One can neatly divide the two perspectives on crypto-currency into macro and micro, so I will split this story into two part: Let’s talk about the macroeconomic aspects of Bitcoin and currency first, and tackle the microeconomic aspects of the Blockchain and contracting in the next story.

Crypto-currency and crypto-cash

Bitcoin was invented as a form of currency — a means of payment — that combines the two advantages of being both electronic and cash.

Cash in our offline world lives on in the form of banknotes and coins, and is a major headache to almost everyone involved in commerce. But it has two major advantages: it is local (I carry it right here with me in my wallet), and it is anonymous (the drug store — or possibly sex shop — clerk will never know who bought the rubber ducky unless I introduce myself or pay by electronic means (credit card, debit card, etc.) Cash helps avoiding embarrassment and tracking.

Vendors, banks, corporates, etc., love electronic payment of course. Imagine paying cash at the gate for your business flight and getting paid back in cash by your employer. One big reason why they love it is because it leaves an electronic paper trail. But that is also the reason why many of the radical libertarian folks in the crypto-currency world, including Satoshi, are suspicious of it. One player who might be interested in that paper trail is the government, and for political (or more nefarious) reasons the crypto-libertarians don’t like that at all. So one of the key advantages of Bitcoin is that it does its utmost to keep the outsider (government or anyone else) from tracing the transaction back to the participants. (The transactions, on the other hand, are public and searchable in a public ledger — the blockchain — roughly in the form “E1212d33Q paid 12.87621 bitcoins to F734GFh3493”.) This semi-anonymity will become important in part 2 when we talk about the micro perspective and contracting.

The two key advantages Bitcoin has over its many unsuccessful predecessor cybercoins is that it is — to a certain degree — able to avoid two death traps of electronic currency: inflation and double-spending. Indeed double-spending control is widely considered the revolutionary step Bitcoin provided: e-cash is digital, it is easy to copy-and-paste digital objects, so what’s keeping me from making a copy of my Bitcoin cash before I spend it, so I can spend it again (and again, and again)? The short answer is the Blockchain. This will be discussed in part 2 so let’s move quickly to the other one: inflation control. Now we’re deep in the Macro muck.

Very broadly speaking, currency has three jobs: to make paying for things easy and secure (a flow), to be able to put it into an account — or a pillow — and rest assured it’s still there and valuable when I need it years later (a stock), and to keep track of all of this for yourself or someone else (a report). In short, these three things are called medium of exchange, store of value and unit of account. Inflation, or even just short-term currency speculation, kills the second one, so any crypto-currency designer has to think about inflation before unleashing the invention onto the world. Satoshi did this in two ways: first, by making it hard to “mine” Bitcoin and second, by controlling the number of Bitcoins that can be “mined”. Mining is literally a figurative term, borrowed from mining for gold. Real Bitcoin miners are massive computer farms with huge power bills.

The ease of payment has so far helped Bitcoin become somewhat popular in radical libertarian and geek circles (and folks that hang out in the Darknet to buy illicit things; the three groups tend to overlap), but this has also kept Bitcoin from becoming a trusted store of value and unit of account. Bitcoin was designed for a zero-trust environment, so building these two things takes time.

Crypto-inflation and crypto-speculation

First, let’s look at mainstream adoption and inflation. One of the marvels of the economic world is that we can use almost anything as currency as long as everyone agrees that it is it. (That’s why it’s called fiat money, not from that car maker but from fiat = latin for let there be… money.) For instance, if it weren’t so cumbersome to carry them around, we could create a payment system solely based on Picasso paintings —but at one point we would also have to start cutting them to pieces. Bitcoin is the radical implementation of that idea. If we once accepted that only governments can issue fiat money, we now have to accept that pseudonymous figures on the internet can do the same, and by virtue of accepting that Bitcoin works as currency we can use it as currency. We simply have to believe that if we accept Bitcoin as payment, someone will eventually take them off our hands at the same or a higher valuation.

Technology adoption processes, as Zvi Griliches discovered and Geoffrey Moore popularized, tend to follow a simple S-shaped curve (a sigmoid): a slow ramp-up when only early adopters buy into the technology, a phase of fast growth (scaling up) when the mainstream joins in, and finally a longer residual adoption phase when the technology stragglers catch up. This curve more or less assume stable or falling prices for the technology — as is to be expected when it’s produced in increasing numbers. The curve can get a bit more complicated if prices increase during the scale-up due to supply shortages — sometimes companies get caught by surprise. But what happens when the price itself is the commodity?

We’re a bit in unchartered territory here and Satoshi, a computer scientist rather than an economist, clearly did not think it through. His key insight to keeping inflation under check is to artificially restrict the bitcoin supply. Miners get rewarded for running the Bitcoin system through bitcoin payments. On a very long scale these rewards get smaller and smaller until in 2140 they will cease altogether. One key control is built into the system to keep the price — technically, the exchange rate to standard non-cryptocurrencies like the Euro or US Dollar — somewhat stable: the complexity of mining (the “proof of work”) is adjusted based on supply computing power, to create roughly ten blocks in the Blockchain per minute.

In truth this does very little to keep currency speculation in check — indeed the speculative aspect of Bitcoin might be the most attractive part of the offering right now. Even though Bitcoin has gone through some wild swings in valuation — mostly due to catastrophic security breaches like the Mt. Gox disaster — it has been a boon investment to early adopters. Of the three key qualities of a currency: means of exchange, store of value, and unit of account, the second one might be the biggest driver of adoption right now, except not in the intended way: the value of Bitcoin is far from stable right now, it is almost purely speculative, driving a crypto gold rush. A gold rush, needless to say, is essentially the opposite of a piggy bank.

The problem with this is that speculative adoption is the very opposite of mainstream adoption, and this is the reason why Bitcoin as means of exchange has been rather muted so far, and Bitcoin as unit of account almost non-existent. How many companies do their accounting in Bitcoin? But the problem of this non-linearity in mainstream adoption is only to get worse if Bitcoin is adopted more and more as means of exchange. A fast scale-up will almost surely result in the fast appreciation of the exchange rate of Bitcoin, throwing a massive banner in the works of e-commerce. If e-commerce vendors then opt out because they cannot keep the volatility under control, the non-linearity in adoption will quickly take on a familiar format: the hype-disappointment cycle. By taking steps to keep inflation — the cost of goods in currency goes up— in check Satoshi has created the opposite problem: the price of his crypto-currency vs. normal currencies has been highly inflationary.

Crypto-currency areas and crypto-tribes

I should be clear that I don’t share the pessimism of other economists like Paul Krugman or John Quiggin regarding the chances of Bitcoin to become a regular means of exchange and store of value. The true time bomb of Bitcoin waits for us after it has been widely adopted. To understand this risk we have to look into another key area of research in currency: that of optimal currency areas, or economic geography applied to currency.

This seems to be a rather arcane research topic but if you are living in Europe it is hard to escape the consequences of it. The Euro area itself is a big gamble that the currency area is bigger than the European nation states — most of which are the bruised leftovers from colonial and feudal times. Despite early successes for the Euro as a means of exchange across borders, the Euro system is creaking and on the verge of collapse. The reason for this is transfers, or rather, the high costs of enabling transfers.

We intuitively think of currency areas being identical to nation states, but that is rarely ever the case: the U.S. Dollar is used, officially or unofficially, in many other countries. Ideally, a currency area captures an area of similar economic productivity, and exchange rates make up for productivity differences. When I was a kid, we would go to Italy on vacation almost every year, and in the time before globalization getting an Italian gelato was still a rare treat. Each year the price in Lire went up a bit, but in the same time the exchange rate of the Lira vs. the Deutsche Mark had gone down, so for us the price for a gelato had stayed mostly the same, just the flavors got better…

But like Germany and Italy are unequal in economic productivity — for reasons that go back hundreds of years and have extremely little to do with shiftlessness — different areas inside a country are also unequal in productivity: as a very general rule, cities are more productive than rural areas, coastal areas are more productive than landlocked areas, temperate areas are more productive than humid areas, etc. (exceptions abound of course). The only accepted way to keep this working and keep a common currency area is transfers: payments from rich areas to poor areas, often through elaborate government schemes. But transfers are much-hated, especially if they seem to entrench shiftlessness. For a government it is a never-ending balancing act to keep the transfers flowing to keep the economy intact and keep up appearances that these transfers will cease if the recipients don’t shape up.

But — to come back to crypto-currency — Bitcoin and friends don’t have a government to take care of those transfers. Indeed, Bitcoin was invented to make government obsolete. So transfers are not only not designed into the Bitcoin system, Bitcoin as a political (radical libertarian) project is out to kill transfers off for good. So the end of the road for Bitcoin, Ether, or any other crypto-currency that gains widespread adoption, is the end of the nation state as an economic unit — for better or worse. Crumbling nation states are moments of global crises. We should hope for — but not bank on — this crisis to blow over without violence.

What is left for us is to speculate what comes after, in a world without hard-coin currencies. For one, clearly we should not expect that the world will agree on a single crypto-currency, even though a dominant design might emerge. A single currency is like a single tectonic plate holding up all continents: a nice idea in theory but not really workable in practice. Instead we should expect tribes to coalesce around similar interests and similar economic productivity. How these tribes will be able to throw off the shackles of geography — and how geographic areas will survive with economic unity — remains to be seen.

Macroeconomics, microeconomics, crypto-economics

After this big sweep over the grand prospects of Bitcoin, the next part will dig deep into the nitty gritty of the inner workings of the crypto–economy. For this I will dive down into Microeconomics or even deeper, and have a closer look at the Blockchain as the engine that drives Bitcoin and ask, among other things, the question if Blockchain can survive without cryptocurrency. Expect more ramblings in a week or so.

This article originally appeared here.

Photo credit: btckeychain via Visual hunt / CC BY

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