Four Reasons Bitcoin Is Worth Studying

As Adam Ozimek points out Bitcoin has so far
largely been greeted with eye-rolling by
professional economists. One reason is that the
cryptocurrency’s most enthusiastic advocates
tend to subscribe to a hard-money, end-the-Fed
worldview that is unpopular among elites. That has caused the latter to reflexively take the
opposite view, treating Bitcoin as primarily a
monetary policy experiment and predicting its
doom. My sympathies are with the pros here. Fiat
currency isn’t perfect, but I think alternatives
like the gold standard would be worse. But
Bitcoin is a more than a gold standard for the
Internet age. It’s the world’s first fully
decentralized payment system, combining the irreversibility of cash with the convenience of
electronic payment. There’s never been anything
quite like it before, and as a result it poses a
number of interesting intellectual puzzles. Here
are four examples. Monetary economics What gives money its value? One popular theory
says that modern fiat currencies get their value
by “government fiat”: the government declares a
currency to be the official one, requires that
currency be used to compute and pay taxes, and
thereby confers value on what would otherwise be worthless slips of paper. Bitcoin is a clear challenge to that view. It has no
“backing” from any government or other large
institution, yet the stock of outstanding bitcoins
is now worth more than $1 billion. The conventional response is to dismiss Bitcoin
as merely a bubble, with no intrinsic value at all.
But that view makes it hard to explain the events
of late 2011. The value of Bitcoins fell from $32
in June to $2 in November. Then the price
started going up again, rising to $4 in December 2011 and to $7 in January. That should surprise you. Even after watching
the value of their previous investments decline
by a factor of 16, a critical mass of Bitcoin
enthusiasts was prepared to pour millions of
dollars into the currency. It’s possible, of course,
that all those people were delusional. But it’s at least possible they saw something the rest of the
world didn’t. Certainly, that was the conclusion I
came to. I rethought my previous skepticism and
bought some Bitcoins of my own in early 2012. Even if you think the current value of of more
than $140 is a bubble, it’s clear that Bitcoin has some genuine applications. The number of daily Bitcoin transactions has soared from around
1000 at the beginning of 2011 to about 50,000
today. Figuring out the “fundamentals” that
drive the currency’s long-term value seems like
an interesting theoretical puzzle. Political philosophy The great technological feat of Bitcoin is its
solution to the “double spending problem.” The
cryptographic protocols needed for one
currency holder to “sign over” his currency to
another have been well-understood for decades.
But no cryptographic operation can prove you haven’t given the same coins to someone else.
Before Bitcoin, the only known way to address
this issue was to have a centralized transaction
register. Control over that list was inevitably a
point of control for the currency as a whole. Bitcoin uses a clever scheme to maintain a fully
decentralized transaction register, preventing
double-spending without giving anyone de facto control over the system. The global, shared
register of Bitcoin transactions is called the
blockchain, and it’s organized into “blocks.” One
block is added approximately every 10 minutes.
Each node in the Bitcoin network creates a
candidate block and then races to solve a difficult mathematical puzzle that takes its block
as an input. The winner of the race gets to add its
block to the blockchain, and in that block it can
credit itself a fixed number of new bitcoins
(currently 25 BTC) as a reward for participating
in this process. All bitcoins now in circulation were originally created by this process, which is
known as mining. When a new block is announced, the other nodes
in the network confirm that the proposed block
follows all of the rules of the Bitcoin protocol. If
it doesn’t, the block is discarded and the other
nodes continue working on their own candidate
blocks. A few weeks ago, a node that had upgraded to
version 0.8 of the client software generated a
block that nodes running version 0.7 and earlier
didn’t recognize as valid. This produced a “fork”
in the network, with each half generating blocks
the other half viewed as illegitimate. If this situation had continued unchecked, it
would have led to chaos, because it would have
allowed hackers to spend the same bitcoins
twice: once in the 0.7 version of the blockchain
and again in the 0.8 blockchain. Fortunately, the
most influential members of the Bitcoin community moved quickly. They made a
judgment call that it would be easier to get 0.8
nodes to downgrade than to get the older nodes
to upgrade. They persuaded those who had
upgraded to 0.8 to downgrade, abandoning the
blocks they had created since the fork and accepting the 0.7 branch as the official one. It was important to move quickly because the
stakes were growing higher with every passing
hour. Every few minutes another block was
added to the blockchain, earning its creator
about $1000. For many of the miners,
abandoning the 0.8 branch meant giving up thousands of dollars in cold cash. The longer the
fork had lasted, the bigger the financial hit they
would have needed to take to heal the rift. A core part of Bitcoin’s appeal is that it’s not
under anyone’s control. Supposedly, nobody has
the authority to change the Bitcoin money
supply, cancel or reverse transactions, or
otherwise change the attributes of the protocol.
But in practice that’s not really true. In the wake of last month’s fork, the elites in the Bitcoin
community effectively changed the rules in a
matter of hours. In principle, there’s no reason
those same elites couldn’t make other changes to
the Bitcoin protocol. There’s a direct parallel here to issues of
political legitimacy in a nation state. In principle,
most democratic nations have constitutions that
bind the behavior of government officials. In
practice, a cabal of elites can and regularly do
change those rules with minimal input from the rank and file. Yet the discretion of elites is not
unlimited. In the case of both Bitcoins and
nation states, it’s easy to make changes that will
be intuitively appealing to the broader public.
But even a broad coalition of elites may not be
able to make changes that are strongly opposed by rank and file members of the community. Economies of scale and competition
policy When Bitcoin is described as a decentralized
system, a key assumption is that no single party
controls a majority of the network’s computing
power. The randomized process for deciding
who gets to create the next block effectively
works on a “one CPU cycle, one vote” principle. If any single party gained 51 percent of the
network’s computing power, it could effectively
take control of the network, ignoring blocks
produced by the other 49 percent of the nodes.
A successful attacker could not only claim 100
percent of the mining profits for itself, it would also gain the power to block transactions it
didn’t approve of by simply not including them
in its blocks. Early in Bitcoin’s life, this wasn’t a cause for
concern because the barriers to entry was very
low. Anyone could download the Bitcoin client
onto his computer and run it. But a technological
arms race has made Bitcoin mining an
increasingly esoteric business. Today, the leading miners use custom-built Bitcoin mining
gear that costs thousands of dollars. Indeed, this
high-end hardware is so much more energy-
efficient that conventional PCs are no longer
energy-efficient enough to make Bitcoin mining
As a result of this and other factors, Bitcoin
mining has become increasingly centralized.
Bitcoin miners have organized themselves into
“pools” that cooperate and share the spoils
among their members in proportion to the
computing power they contribute. If this chart is to be believed, the top two pools control 53
percent of the Bitcoin network’s computing
power. In principle, these two pools might be able to
join forces and execute a 51 percent (or 53
percent) attack on the rest of the network. But
doing so might prove foolish in the long run,
since that kind of power grab might undermine
public confidence in the currency’s long-term viability, since a mining cartel might have the
power to change the rules of the Bitcoin protocol
in ways that benefit themselves at the expense of
ordinary users. Data Imagine if Visa were to give researchers a
complete record of every transaction it had ever
processed. That database would provide the raw
material for numerous studies on consumer
spending patterns, the business cycle, and much
more. The decentralized nature of the Bitcoin protocol
means that every transaction is automatically
published to the world. To be sure, there are
some limitations to its value for research
purposes. Users can and often do make up new
addresses for each transction, making it hard to tell which transactions were made by the same
person. And the blockchain doesn’t include
annotations on why each Bitcoin transaction was
made. Still, a clever researcher should be able to
extract a significant amount of useful
information. For example, many companies and
individuals publish official addresses for
receiving funds. Also, in many cases it will be
possible to make inferences about which funds are related by observing when funds are
combined and spent together. And at a
minimum, you can study things like the volume
of Bitcoin transactions over time, the average
transaction size, the fraction of bitcoins that are
in active circulation at any one point in time, and so forth. Nothing quite like Bitcoin has ever existed
before. Even if you think the current price of
Bitcoin represents a ludicrous bubble (for what
it’s worth, I don’t), it’s still likely to be a fertile
laboratory for testing our economic intuitions. Disclosure: I own some Bitcoins. Update: A friend who knows more about economics than me says that Kiyotaki and
Wright’s account is considered the standard
account of fiat money’s value in the profession.
Source :ForbesTech

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