The Bitcoin Standard: The Decentralized Alternative to Central Banking

by Saifedean Ammous

This simple phenomenon explains much of modern economic reality, such as the large number of industries that make money but produce nothing of value to anyone. Government agencies are the prime example, and the global notoriety they have earned for their employees' incompetence can only be understood as a function of the bezzle funding that finances them being completely detached from economic reality. Instead of the hard test of market success by serving citizens, government agencies test themselves and invariably conclude the answer to all their failings lies in more funding. No matter the level of incompetence, negligence, or failure, government agencies and employees rarely ever face real consequences. Even after the rationale for a government agency's existence has been removed, the agency will continue operating and find itself more duties and responsibility. Lebanon, for instance, continues to have a train authority decades after its trains were decommissioned and the tracks rusted into irrelevance.20

This discussion can continue to include many other fields and disciplines in modern academia, where the same pattern repeats: funding coming from government agencies is monopolized by groups of likeminded scholars sharing fundamental biases. You do not get a job or funding in this system by producing important scholarship that is productive and useful to the real world, but by furthering the agenda of the funders. That the funding comes from one source only eliminates the possibility for a free marketplace of ideas.

In a society with sound money, banking is a very important and productive job, where bankers perform two highly pivotal functions for economic prosperity: the safekeeping of assets as deposits, and the matching of maturity and risk tolerance between investors and investment opportunities. Bankers make their money by taking a cut from the profits if they succeed in their job, but make no profit if they fail. Only the successful bankers and banks stay in their job, as those that fail are weeded out. In a society of sound money, there are no liquidity concerns over the failure of a bank, as all banks hold all their deposits on hand, and have investments of matched maturity. In other words, there is no distinction between illiquidity and insolvency, and there is no systemic risk that could make any bank “too big to fail.” A bank that fails is the problem of its shareholders and lenders, and nobody else. Unsound money allows the possibility of mismatching maturity, of which fractional reserve banking is but a subset, and this leaves banks always liable to a liquidity crisis, or a bank run.

Worse, the lack of liquidity in one bank could lead to a lack of liquidity in other banks dealing with this bank, creating systemic risk problems.

But the presence of a central bank able to bail out the banks creates a major problem of moral hazard for these banks. They can now take excessive risks knowing that the central bank will be inclined to bail them out to avert a systemic crisis. From this we see how banking has evolved into a business that generates returns without risks to bankers and simultaneously creates risks without returns for everyone else.

In a society in which capital investments are financed from savings, capital is owned by those with a lower time preference, and they allocate it based on their own estimation of the likelihoods of market success, receiving rewards for being correct and losses for being wrong. But with unsound money, savings are destroyed and capital is instead created from inflationary bank credit, and its allocation is decided by the central bank and its member banks. Instead of the allocation being decided by the most prudent members of society with the lowest time preference and best market foresight, it is decided by government bureaucrats whose incentive is to lend as much as possible, not to make profit, as they are significantly protected from the downside.

The larger the firm, the easier it is for it to secure low-interest funding, giving it a large advantage over smaller independent producers. In a society where investment is financed from savings, a small mom-and-pop diner competes for customers and financing with a fast-food giant on an equal footing: customers and investors have a free choice in allocating their money between the two industries. The benefits of economies of scale are up against the benefits of the personal attention and relationship between cook and customer of the small diner, and the market test decides. But in a world where central banks allocate credit, the larger firm has an advantage in being able to secure funding at a low rate which its smaller competitors cannot get.27 This helps explain why large-scale food producers proliferate so widely around the world, as their lower interest rates allow them higher margins. The triumph of bland, mass-produced junk food cannot be understood outside the great benefits that large scale affords to producers. In a world in which almost all firms are financed through central bank credit expansion, there can be no simple way of discerning which industries are growing because of the injection of bezzle steroids, but there are some telltale symptoms. Any industry in which people complain about their asshole boss is likely part of the bezzle, because bosses can only really afford to be assholes in the economic fake reality of the bezzle. In a productive firm offerin...

Difficulty adjustment is the most reliable technology for making hard money and preventing the stock-to-flow ratio from declining, and it makes bitcoin fundamentally different from every other money. Whereas the rise in value of any money leads to more resources dedicated to its production and thus an increase in its supply, as bitcoin's value rises, more effort to produce bitcoins does not lead to the production of more bitcoins. Instead, it just leads to an increase in the processing power necessary to commit valid transactions to the bitcoin network, which only serves to make the network more secure and difficult to compromise. Bitcoin is the hardest money ever invented: growth in its value cannot possibly increase its supply; it can only make the network more secure and immune to attack.

The harder it was to produce new quantities of the money in response to price rises, the more likely it was to be adopted widely and used, and the more a society would prosper because it would mean individuals' efforts at producing wealth will go toward serving one another, not producing money, an activity with no added value to society because any supply of money is enough to run any economy.

Bitcoin's shared ledger can be likened to the Rai stones of Yap Island discussed in Chapter 2, in that the money does not actually move for transactions to take place. Whereas in Yap the islanders would meet to announce the transfer of the ownership of a stone from one person to the other, and the entire town would know who owned which stone, in bitcoin members of the network would broadcast their transaction to all network members, who would verify that the sender has the balance necessary for the transaction, and credit it to the recipient. 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.5

Beyond digital scarcity, bitcoin is also the first example of absolute scarcity, the only liquid commodity (digital or physical) with a set fixed quantity that cannot conceivably be increased. Until the invention of bitcoin, scarcity was always relative, never absolute. It is a common misconception to imagine that any physical good is finite, or absolutely scarce, because the limit on the quantity we can produce of any good is never its prevalence in the planet, but the effort and time dedicated to producing it. With its absolute scarcity bitcoin is highly salable across time.

In all human history, we have never run out of any single raw material or resource, and the price of virtually all resources is lower today than it was in past points in history, because our technological advancement allows us to produce them at a lower cost in terms of our time. Not only have we not run out of raw materials, the proven reserves that exist of each resource have only increased with time as our consumption has gone up. If resources are to be understood as being finite, then the existing stockpiles would decline with time as we consume more. But even as we are always consuming more, prices continue to drop, and the improvements in technology for finding and excavating resources allows us to find more and more.

Ingenious ideas are rare, and only a small minority of people can come up with them. Larger populations will thus produce more technologies and ideas than smaller populations, and because the benefit accrues to everyone, it is better to live in a world with a larger population. The more humans exist on earth, the more technologies and productive ideas are thought of, and the more humans can benefit from these ideas and copy them from one another, leading to higher productivity of human time and improving standards of living.

The non-aggression principle is the foundation of Rothbard's anarcho-capitalism, and on its basis, any aggression, whether carried out by government or individual, cannot have moral justification. Bitcoin, being completely voluntary and relentlessly peaceful, offers us the monetary infrastructure for a world built purely on voluntary cooperation. Contrary to popular depictions of anarchists as hoodie-clad hoodlums, bitcoin's brand of anarchism is completely peaceful, providing individuals with the tools necessary for them to be free from government control and inflation. It seeks to impose itself on nobody, and if it grows and succeeds, it will be for its own merits as a peaceful neutral technology for money and settlement, not through it being forced on others.

The ability of any individual to run a bitcoin node and send his own money without permission from anyone, and without having to expose his identity, is a noteworthy difference between gold and bitcoin. 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. Whereas governments confiscated people's gold savings and forced them to trade with money supposedly backed by that gold, people are able to keep the bulk of their bitcoin savings in storage away from government's hands and only use smaller amounts to transact through intermediaries. The very nature of the bitcoin technology puts governments at a severe disadvantage compared to all other forms of money and thus makes confiscation much harder.

If bitcoin continues to appreciate significantly, it will provide the central bank more flexibility with their monetary policy and international account settlement. But perhaps the real case for central banks owning bitcoin is as insurance against the scenario of it succeeding. Given that the supply of bitcoins is strictly limited, it may be wise for a central bank to spend a small amount acquiring a small portion of bitcoin's supply today in case it appreciates significantly in the future. If bitcoin continues to appreciate while a central bank doesn't own any of it, then the market value of their reserve currencies and gold will be declining in terms of bitcoin, placing the central bank at a disadvantage the later it decides to acquire reserves.

While central banks have mostly been dismissive of the importance of bitcoin, this could be a luxury they may not afford for long. As hard as it might be for central bankers to believe it, bitcoin is a direct competitor to their line of business, which has been closed off from market competition for a century.

Hypothetically, should bitcoin become the only money used around the world, it will no longer have large room for growth in value. At that point, demand for it will simply be demand for holding liquid money, and the speculative investment aspect of the demand we see today would disappear. In such a situation, the value of bitcoin would vary along with the time preference of the entire world's population, with increasing demand for holding bitcoin as a store of value leading to only small appreciation of its value.

Such questions cannot be answered definitively at this point, and only the real world will tell how these dynamics will unfold. Monetary status is a spontaneously emergent product of human action, not a rational product of human design.

Although solving these problems might initially seem a wasteful use of computing and electric power, proof-of-work is essential to the operation of bitcoin.1 By requiring the expenditure of electricity and processing power to produce new bitcoins, PoW is the only method so far discovered for making the production of a digital good reliably expensive, allowing it to be a hard money.

Bitcoin is straightforward to use, but virtually impossible to alter. Bitcoin is voluntary, so nobody has to use it, but those who want to use it have no choice but to play by its rules. Changing bitcoin in any meaningful way is not really possible, and should it be attempted, will produce another pointless knock-off to be added to the thousands already out there. Bitcoin is to be taken as it is, accepted on its own terms and used for what it offers. For all practical intents and purposes, bitcoin is sovereign: it runs by its own rules, and there are no outsiders who can alter these rules.

Further, users can generate the private keys to their addresses on offline computers which they will never connect to the Internet. The extra-paranoid can even generate their addresses and private keys on offline computers which are then immediately destroyed. Coins stored on these virtual private keys will survive any kind of attack on the network.

In practice, however, the possibility of a global return to sound money and liberal government is extremely unlikely as these concepts are largely alien to the vast majority of politicians and voters worldwide, who have been reared for generations to understand government control of money and morality as necessary for the functioning of any society. Further, even if such a political and monetary transformation were possible, bitcoin's diminishing supply growth rate is likely to continue to make it an attractive speculative bet for many, which would in itself cause it to grow further and acquire a larger monetary role.

There is nothing about bitcoin's design that suggests it would be good for any of the multitude of use cases that other coins claim they will be able to do, and no coin other than bitcoin has delivered any differentiating capabilities or features which bitcoin does not have. Yet they all have a freely trading currency which is somehow essential for their complex system for performing some online applications. But the notion that new web apps require their own decentralized currency is the desperately naïve hope that somehow unsolving the problem of lack of coincidence of wants could be economically profitable. There is a reason real-world businesses don't issue their own currency, and that is that nobody wants to hold currency that is only spendable in one business.

“Blockchain technology,” to the extent that such a thing exists, is not an efficient or cheap or fast way of transacting online. It is actually immensely inefficient and slow compared to centralized solutions. The only advantage that it offers is eliminating the need to trust in third-party intermediation. The only possible uses of this technology are in avenues where removing third-party intermediation is of such paramount value to end users that it justifies the increased cost and lost efficiency. And the only process for which it actually can succeed in eliminating third-party intermediation is the process of moving the native token of the network itself, as the code of the blockchain has no integrated control over anything taking place outside it.

For any other computing process to be run using blockchain technology, it would need to fulfill two criteria: First, the gains from decentralization need to be compelling enough to justify the extra costs. For any process which will still require some form of trust in a third party to implement any small part of it, the extra costs of decentralization cannot be justified. For implementing contracts dealing with real-world businesses under legal jurisdictions, there will still be legal oversight relating to the real-world implementation of these contracts that can override the network consensus, making the extra cost of decentralization pointless. The same applies for decentralizing databases of financial institutions that will remain as trusted third parties in their own operations with one another or with their clients. Second, the initial process itself needs to be simple enough to ensure the ability to run the distributed ledger on many nodes, without the blockchain becoming too heavy to be distributed. As the process continues to repeat over time, the size of the blockchain will grow and become more and more unmanageable for distributed nodes to hold a full copy of the blockchain, ensuring that only a few large computers can operate the blockchain and rendering decentralization obsolete.

The bitcoin blockchain has placed a 1-megabyte limit on the size of each block, which has limited the pace at which the blockchain has grown. That limit allows simple computers to be able to maintain and run a node. Should the size of each block increase, or should the blockchain be used for more sophisticated processes such as those touted by blockchain enthusiasts, it would become too large to be run on individual computers. Centralizing the network over a few large nodes owned and operated only by large institutions defeats the entire point of decentralization.

Trustless digital cash has so far been the only successful implementation for blockchain technology precisely because it is a clean and simple technological process to operate, leading to its ledger growing relatively slowly over time. This means that being a member of the bitcoin network is possible for a residential computer and connection in most of the world.

Bitcoin has a blockchain not because it allows for faster and cheaper transactions, but because it removes the need to trust in third-party intermediation: transactions are cleared because nodes compete to verify them, yet no node needs to be trusted.

This all became apparent with the first implementation of smart contracts on the Ethereum network, the Decentralized Autonomous Organization (DAO). After more than $150 million was invested in this smart contract, an attacker was able to execute the code in a way that diverted around a third of all the DAO's assets to his own account. It would be arguably inaccurate to describe this attack as a theft, because all the depositors had accepted that their money would be controlled by the code and nothing else, and the attacker had done nothing but execute the code as it was accepted by the depositors. In the aftermath of the DAO hack, Ethereum developers created a new version of Ethereum where this inconvenient mistake never occurred. This re-injection of subjective human management is at odds with the objective of making code into law, and questions the entire rationale of smart contracts. Ethereum is the second largest blockchain after bitcoin in terms of its processing power, and while the bitcoin blockchain cannot effectively be rolled back, that Ethereum can be rolled back means that all blockchains smaller than bitcoin's are effectively centralized databases under the control of their operators. It turns out code is not really law, because the operators of these contracts can override what the contract executes. Smart contracts have not replaced courts with code, but they have replaced courts with software developers with little experience, knowledge, or accountability i...

Applying blockchain technology in heavily regulated industries such as law or finance, with currencies other than bitcoin, will result in regulatory problems and legal complications. Regulations were designed for an infrastructure much different from that of blockchain and the rules cannot be easily tailored to fit blockchain operation, with the radical openness of having all records distributed to all network members. Further, a blockchain operates online across jurisdictions with different regulatory rules, so compliance with all rules is difficult to ensure.

The market test shows that the redundancies of transaction recording and proof-of-work can only be justified for the purpose of producing electronic cash and a payment network without third-party intermediation. Electronic cash ownership and transactions can be communicated in very small quantities of data. Other economic cases which need more data requirements, such as mass payments and contracts, become unworkably cumbersome in the blockchain model. For any applications which involve intermediaries, the blockchain will offer an uncompetitive solution. There cannot be wide adoption of blockchain technology in industries reliant on trust in intermediaries, because the mere presence of intermediaries makes all the costs associated with running a blockchain superfluous. Any application of blockchain technology will only make commercial sense if its operation is reliant on the use of electronic cash, and only if electronic cash's disintermediation provides economic benefits outweighing the use of regular currencies and payment channels.

Good engineering begins with a clear problem and attempts to find the optimal solution for it. An optimal solution not only solves the problem, but by definition does not contain within it any irrelevant or superfluous excess. Bitcoin's creator was motivated by creating a “peer-to-peer electronic cash,” and he built a design for that end. There is no reason, except for ignorance of its mechanics, to expect that it would be suited for other functions. After nine years and millions of users, it is safe to say his design has succeeded in producing digital cash, and, unsurprisingly, nothing else. This electronic cash can have commercial and digital applications, but it is not meaningful to discuss blockchain technology as a technological innovation in its own right with applications in various fields. Blockchain is better understood as an integral cog in the machine that creates peer-to-peer electronic cash with predictable inflation.