The Bitcoin Standard: The Decentralized Alternative to Central Banking

by Saifedean Ammous

The next chapter examines the history of obscure artifacts and objects that have been used as money throughout history, from the Rai stones of Yap Island, to seashells in the Americas, glass beads in Africa, and cattle and salt in antiquity. Each of these media of exchange served the function of money for a period during which it had one of the best stock‐to‐flow ratios available to its population, but stopped when it lost that property.

The solidus, first minted by Diocletian in AD 301, has changed its name to the bezant and the Islamic dinar, but it continues to circulate today. Seventeen centuries of people the world over have used this coin for transactions, emphasizing the salability of gold across time.

Although the period following the introduction of the florin witnessed an improvement in the soundness of money, with more and more Europeans able to adopt gold and silver for saving and trade, and the extent of markets expanding across Europe and the world, the situation was far from perfect. There were still many periods during which various sovereigns would debase their people's currency to finance war or lavish expenditure.

Given that they were used physically, silver and gold complemented each other: gold's high stock‐to‐flow ratio meant it was ideal as a long‐term store of value and a means of large payments, but silver's lower value per unit of weight made it easily divisible into quantities suitable for smaller transactions and for being held for shorter durations. While this arrangement had benefits, it had one major drawback: the fluctuating rate of exchange between gold and silver created trade and calculation problems. Attempts to fix the price of the two currencies relative to one another were continuously self‐defeating, but gold's monetary edge was to win out.

This is a historical lesson of immense significance, and should be kept in mind by anyone who thinks his refusal of Bitcoin means he doesn't have to deal with it. History shows it is not possible to insulate yourself from the consequences of others holding money that is harder than yours.

Contrary to the most egregiously erroneous and central tenet of the state theory of money, it was not government that decreed gold as money; rather, it is only by holding gold that governments could get their money to be accepted at all.

The roughly 10 million men who were mobilized for the war came back home and were almost seamlessly absorbed into the labor force, as economic production boomed, flying in the face of all Keynesian predictions and utterly obliterating the ridiculous notion that the level of spending is what determines output in the economy. As soon as governmental central planning had abated for the first time since the 1929 crash, and as soon as prices were allowed to adjust freely, they served their role as the coordinating mechanism for economic activity, matching sellers and buyers, incentivizing the production of goods demanded by consumers and compensating workers for their effort.

After the link between fiat money and gold was severed, paper monies have had a higher growth in their supply rate than gold, and as a result have seen a collapse in their value compared to gold. The total U.S. M2 measure of the money supply in 1971 was around $600 billion, while today it is in excess of $12 trillion, growing at an average annual rate of 6.7%. Correspondingly, in 1971, 1 ounce of gold was worth $35, and today it is worth more than $1,200.

During hyperinflationary periods, people in developing countries sell their national currency and buy durable items, commodities, gold, and foreign currencies.

Hyperinflation is a form of economic disaster unique to government money. There was never an example of hyperinflation with economies that operated a gold or silver standard, and even when artifact money like seashells and beads lost its monetary role over time, it usually lost it slowly, with replacements taking over more and more of the purchasing power of the outgoing money. But with government money, whose cost of production tends to zero, it has become quite possible for an entire society to witness all of its savings in the form of money disappear in the space of a few months or even weeks.

While a staunch defender of the role of gold as money during his time, Ludwig von Mises understood that this monetary role was not something inherent or intrinsic to gold. As one of the deans of the Austrian tradition in economics, Mises well understood that value does not exist outside of human consciousness, and that metals and substances had nothing inherent to them that could assign to them a monetary role. For Mises, gold's monetary status was due to its fulfillment of the criteria for sound money as he understood them: [T]he sound money principle has two aspects. It is affirmative in approving the market's choice of a commonly used medium of exchange. It is negative in obstructing the government's propensity to meddle with the currency system.24 Sound money, then, according to Mises, is what the market freely chooses to be money, and what remains under the control of its owner, safe from coercive meddling and intervention. For as long as the money was controlled by anyone other than the owner, whoever controlled it would always face too strong an incentive to pilfer the value of the money through inflation or confiscation, and to use it as a political tool to achieve their political goals at the expanse of the holders.

A sound money, on the other hand, makes service valuable to others the only avenue open for prosperity to anyone, thus concentrating society's efforts on production, cooperation, capital accumulation, and trade.

As Friedrich Hayek put it: I don't believe we shall ever have a good money again before we take the thing out of the hands of government, that is, we can't take it violently out of the hands of government, all we can do is by some sly roundabout way introduce something that they can't stop.

In its infancy, Bitcoin already appears to satisfy all the requirements of Menger, Mises, and Hayek: it is a highly salable free‐market option that is resistant to government meddling.

While microeconomics has focused on transactions between individuals, and macroeconomics on the role of government in the economy, the reality is that the most important economic decisions to any individual's well‐being are the ones they conduct in their trade‐offs with their future self.

The Use of Knowledge in Society, by Friedrich Hayek, is arguably one of the most important economic papers to have ever been written.

The point rather is to explicate clearly the difference between two ways of allocating capital and making production decisions: prices and planning.

Central bank planning of the money supply is neither desirable nor possible. It is rule by the most conceited, making the most important market in an economy under the command of the few people who are ignorant enough of the realities of market economies to believe they can centrally plan a market as large, abstract, and emergent as the capital market. Imagining that central banks can “prevent,” “combat,” or “manage” recessions is as fanciful and misguided as placing pyromaniacs and arsonists in charge of the fire brigade.

Perhaps one of the most astonishing facts about the modern world economy is the size of the foreign exchange market compared to productive economic activity. The Bank of International Settlements20 estimates the size of the foreign exchange market to be $5.1 trillion per day for April 2016, which would come out to around $1,860 trillion per year. The World Bank estimates the GDP of all the world's countries combined at around $75 trillion for the year 2016. This means that the foreign exchange market is around 25 times as large as all the economic production that takes place in the entire planet.

While the Keynesian economists have no explanation for why recessions happen other than invoking “animal spirits,” Austrian school economists have developed the only coherent theory that explains the cause of business cycles: the Austrian Theory of the Business Cycle.

It was after this war that the West suffered from what Barzun terms “The Great Switch,” the replacement of liberalism by liberality, the impostor claiming its mantle but in reality being its exact opposite.14 Liberalism triumphed on the principle that the best government is that which governs least; now for all the western nations political wisdom has recast this ideal of liberty into liberality. The shift has thrown the vocabulary into disorder. Whereas liberalism held the role of government as allowing individuals to live in liberty and enjoy the benefits, and suffer the consequences, of their actions, liberality was the radical notion that it was government's role to allow individuals to indulge in all their desires while protecting them from the consequences.

Unsound money is a particularly dangerous tool in the hands of modern democratic governments facing constant reelection pressure. Modern voters are unlikely to favor the candidates who are upfront about the costs and benefits of their schemes; they are far more likely to go with the scoundrels who promise a free lunch and blame the bill on their predecessors or some nefarious conspiracy. Democracy thus becomes a mass delusion of people attempting to override the rules of economics by voting themselves a free lunch and being manipulated into violent tantrums against scapegoats whenever the bill for the free lunch arrives via inflation and economic recessions.

To the extent that the digital coins exist, they are simply entries on a ledger, and a verified transaction changes the ownership of the coins on the ledger from the sender to the recipient. Ownership of the coins is assigned through public addresses, not by name of the holder, and access to the coins owned by an address is secured through the ownership of the private key, a string of characters analogous to a password.

What keeps Bitcoin nodes honest, individually, is that if they were dishonest, they would be discovered immediately, making dishonesty exactly as effective as doing nothing but involving a higher cost. Collectively, what prevents a majority from colluding to be dishonest is that if they were to succeed in compromising the integrity of the ledger of transactions, the entire value proposition of Bitcoin would be destroyed and the bitcoin tokens' value would collapse to nothing. Collusion costs a lot, but it would itself lead to its loot becoming worthless. In other words, Bitcoin relies on economic incentives, making fraud far costlier than its rewards.

Bitcoin's volatility derives from the fact that its supply is utterly inflexible and not responsive to demand changes, because it is programmed to grow at a predetermined rate. For any regular commodity, the variation in demand will affect the production decisions of producers of the commodity: an increase in demand causes them to increase their production, moderating the rise in the price and allowing them to increase their profitability, while a decrease in demand would cause producers to decrease their supply and allow them to minimize losses.

In Bitcoin, the only form of ownership that exists is through the ownership of the private keys.

Bitcoin does not have to be stored on a computer; the private key to a person's bitcoin hoard is a string of characters or a string of words the person remembers. It is far easier to move around with a Bitcoin private key than with a hoard of gold, and far easier to send it across the world without having to risk it getting stolen or confiscated.

The future use of Bitcoin for small payments will likely not be carried out over the distributed ledger, as explained in the discussion on scaling in Chapter 10, but through second layers. Bitcoin can be seen as the new emerging reserve currency for online transactions, where the online equivalent of banks will issue Bitcoin‐backed tokens to users while keeping their hoard of Bitcoins in cold storage, with each individual being able to audit in real time the holdings of the intermediary, and with online verification and reputation systems able to verify that no inflation is taking place. This would allow an infinite number of transactions to be carried out online without having to pay the high transaction fees for on‐chain transactions.

Based on the foregoing analysis, the real advantage of Bitcoin lies in it being a reliable long‐term store of value, and a sovereign form of money that allows individuals to conduct permissionless transactions. Bitcoin's main uses in the foreseeable future will follow from these competitive advantages, and not from its ability to offer ubiquitous or cheap transactions.

Should Bitcoin's share of the global money supply and international settlement transactions become a majority share of the global market, the level of demand for it will become far more predictable and stable, leading to a stabilization in the value of the currency.

In January 2017, the processing power behind the Bitcoin network is equivalent to that of 2 trillion consumer laptops. It is more than two million times larger than the processing power of the world's largest supercomputer, and more than 200,000 times larger than the world's top 500 supercomputers combined.

A global distributed network of independent dedicated miners now protects the integrity of the Bitcoin ledger. All of these miners have no conceivable purpose but verifying Bitcoin transactions and solving proof‐of‐work. Should Bitcoin fail for whatever reason, these ASICs would be rendered useless and their owners' investment would be lost, so they have a strong incentive to maintain the honesty of the network.

For someone to alter the record of the network they would need to invest hundreds of millions, if not billions, of dollars building new ASIC chips to alter it. Should an attacker succeed in altering the record, he would be highly unlikely to gain any economic benefit from it, as compromising the network would probably reduce the value of bitcoins to close to nothing. In other words, to destroy Bitcoin, an attacker needs to expend very large sums of money with no return at all. And in fact, even if such an attempt succeeded, the honest nodes on the network can effectively go back to the record of transactions before the attack and resume operation. The attacker would then need to continue incurring significant running costs to keep attacking the consensus of the honest nodes.

The ever‐growing number of security breaches that happen to computer networks and email servers across the world on a daily basis have occurred to systems which offer the attackers not much more than data or opportunities to score political points. Bitcoin, on the other hand, contains billions of dollars of value, but continues to operate safely and reliably because it was built, from day one, to operate in a highly adversarial setting, subject to relentless attack. Programmers and hackers worldwide have tried to tear it apart using all sorts of techniques, and yet it has continued to operate according to the exact essence of its specification.

A global team of volunteer software developers, reviewers, and hackers have taken a professional, financial, and intellectual interest in working on improving or strengthening the Bitcoin code and network. Any exploits or weaknesses found in the specification of the code will attract some of these coders to offer solutions, debate them, test them, and then propose them to network members for adoption. The only changes that have happened so far have been operational changes that allow the network to run more efficiently, but not changes that alter the essence of the coin's operation. These coders can own Bitcoin tokens, and so have a financial incentive to work on ensuring Bitcoin grows and succeeds.

At the time of writing, one of the most high‐profile debates surrounding Bitcoin concerns the question of scaling, or increasing the transaction capacity. Bitcoin's 1‐megabyte blocks mean that the capacity for transactions as it stands is around less than 500,000 transactions per day.

For Bitcoin to remain distributed, each node on the network must cost something reasonable for thousands of individuals to run it on commercially available personal computers, and the transfer of data between the nodes has to be at scales that are supported by regular consumer bandwidth.

It is inconceivable that Bitcoin could run the same scale of transactions on‐chain that a centralized system can support. This explains why transaction costs are rising, and in most likelihood, will continue to rise if the network continues to grow. The biggest scope for scaling Bitcoin transactions will likely come off‐chain, where many simpler technologies can be used for small and unimportant payments.

If Bitcoin's popularity continues to grow, there are some potential scaling solutions that do not involve creating any changes to the structure of Bitcoin, but which take advantage of the way transactions are structured to increase the number of payments possible. Each Bitcoin transaction can contain several inputs and outputs, and using a technique called CoinJoin, several payments can be grouped together into one transaction, allowing several inputs and outputs for only a fraction of the space that would have been needed otherwise. This could potentially raise the transaction volume of Bitcoin to the millions of payments per day, and as the transaction costs rise higher, this is more and more likely to become a popular option.

In conclusion, there are many possibilities for increasing the number of bitcoin transactions without having to alter the architecture of Bitcoin as it is, and without requiring all current node operators to upgrade simultaneously. Scaling solutions will come from node operators improving the way they send data on Bitcoin transactions to other network members. This will come through joining transactions together, off‐chain transactions, and payment channels.

All computer networks rely for their security on making some computers impenetrable to attackers and using these as the definitive record. Bitcoin, on the other hand, takes an entirely different approach to computer security: it does not bother to secure any of its computers individually, and operates under the working assumption that all computer nodes are hostile attackers. Instead of establishing trust in any network member, Bitcoin verifies everything they do. That process of verification, through proof‐of‐work, is what consumes large amounts of processing power, and it has proven very effective because it makes Bitcoin security dependent on brute processing power, and as such, invulnerable to problems of access or credentials. If everyone is assumed dishonest, everyone must pay a large cost to commit transactions to the common record, and everyone will lose these costs if their fraud is detected. The economic incentives make dishonesty extremely expensive and highly unlikely to succeed.

In theory, the 51% percent attack is very feasible technically. But in practice, the economic incentives are heavily aligned against it. A miner who successfully executes a 51% attack would severely undermine the economic incentives for anyone to use Bitcoin, and with that the demand for Bitcoin tokens.

Hardware Backdoors Another possibility for disrupting or destroying the Bitcoin network is through corrupting hardware that runs bitcoin software to be accessible by outside parties. Nodes that perform mining could, for example, be fitted with undetectable malware that allows outsiders to commandeer the hardware. This equipment could then be deactivated or remotely controlled at a time when a 51% attack is launched. Another example would be through spying technology installed on user computers allowing access to users' bitcoins by accessing their private keys. Such attacks on a mass scale could severely undermine confidence in Bitcoin as an asset and demand for it. Both types of attack are feasible technically, and unlike the previous two kinds of attacks, they do not have to succeed entirely in order to create enough confusion to hurt Bitcoin's reputation and demand. Such an attack on mining equipment is more likely to succeed given that there are only a few manufacturers of mining equipment, and this constitutes one of Bitcoin's most critical points of failure. However, as Bitcoin mining is growing, it is likely to start attracting more hardware makers to manufacture its equipment, which would reduce the disastrous impact on the network from the compromise of one manufacturer's operations.