Bitcoin: Recursive Jackassery

(sources: TechCrunch, Gizmodo, Wired, Ben Laurie, Jason Calcanis, Nerd Merit Badges)

The HOT NEW THING in peer-to-peer crypto-currency! Bitcoins are currency backed by math! It’s like the gold standard, but instead of beardy prospectors, we use video cards!!! Everybody freak out, it’s the Cryptonomicon come to life! It’s like Lindens, but without the doll clothes! It’s the most dangerous open-source project in the history of electrons! Death and Taxes called this new currency “a seismic event“; Adam Cohen says it’s nothing but a giant scam; Jason Calacanis calls it “the most dangerous project we’ve ever seen.”

They’re wrong. It’s interesting, and somewhat innovative, and down the line it might even be the start of something important…but right now it’s a Ponzi scheme.

What is Bitcoin?

Bitcoin is an anonymous online currency whose transactions and monetary supply are verified by digital cryptography and maintained by an open-source peer-to-peer network. Computers on the Bitcoin network can also “mine” new Bitcoins, which are generated at a fixed rate. And, crucially, no more than 21 million will ever exist. (~7 million are currently extant.)

Bitcoins are in fact worth something.  Right now you can sell them for ~$7 a pop at any of several Bitcoin exchanges. The EFF accepts Bitcoin donations. Creating a secure distributed currency infrastructure is no mean feat; creating one that people actually use is more impressive still. Of course, the two industries most accepting of Bitcoins are internet gambling and internet porn, with illegal drugs a close third.  Anything involving money laundering and arbitrage is likely to be high up the list as well, but a number of good netizen sites (EFF, web design, etc) like Bitcoins as well.

What makes them attractive to criminals and libertarians alike?

  • Your coins can’t be frozen
  • Your coins can’t be tracked
  • Your coins can’t be taxed
  • Transaction costs are extremely low

The tech

The supply of Bitcoins over time has been limited at a total of 21 million, and it’s generated by Bitcoin “miners” over time by using CPUs and GPUs to solve a cryptographic problem — hashing some data against a function. If your computer manages to generate a hash that’s numerically lower than a defined value, then you shout it out to the rest of the network, and get to pocket the newly-minted Bitcoins, while also signing a series of transactions and making sure they’re legitimate.

While that sounds like generating money, and it is, it also performs the important role of securing the protocol — the computer that gets to pick what a valid transaction is different every time, meaning that to manipulate transactions, you’d have to control an enormous amount of computing power.

The economics

At the time of writing, the time and equipment costs required to generate Bitcoins in any significant number make the task uneconomical, but Bitcoin senders can voluntarily pay a transaction fee so that their transaction is sped up, meaning there’s a bit more incentive for users to validate transactions.

Right now, that value is hovering around the eight dollar mark, although some argue that figure is artificially high due to the interest that the currency is generating among speculators. Demand has gone up far faster than supply, which is kept at a pre-determined rate, decreasing every so often. In total, only 21 million Bitcoins will ever be generated, as the rate of supply will tend to zero as it reaches that figure.

As of May 2011, there are slightly over six million Bitcoins in existence, and several trading exchanges.

The security

Bitcoins are designed to be expensive to make: they rely on proof-of-work.  If you are going to deploy electronic coins, why on earth make them expensive to create? That’s just burning money – the idea is to make something unforgeable as cheaply as possible. This is why all modern currencies are fiat currencies instead of being made out of gold.

It is far more sensible to use signatures over random numbers as a basis, as asymmetric encryption gives us the required unforgeability without any need to involve work. This is how Chaum’s original system worked. And the only real improvement since then has been Brands’ selective disclosure work.

If you want to limit supply, there are cheaper ways to do that, too. And proof-of-work doesn’t, anyway (it just gives the lion’s share to the guy with the cheapest/biggest hardware).

As the attacks on PlayStation Network have recently demonstrated, it’s very easy for someone with suitable incentive to rent cloud VMs for crunching computational complexity. Worse, this is cheapest for the most nefarious type of person, those that use stolen credit card information for paying for cloud VMs.

The economic analysis

The system is rigged so that no more than 21 million Bitcoins will ever exist—so the mining process will yield less and less as time goes on, and more people sign up. This makes the whole system a lot sweeter for early adopters.

“I mean, it’s nice for the early adopters, so long as new suckers keep coming along. But in the long run it’s just a pointless waste of stuff we can never get back.” – Ben Laurie

Why would any American or European business adopt Bitcoin in the first place? It’s an elegant and disruptive solution desperately looking for a problem. There’s nothing wrong with the dollar, euro, or yuan. As Victor Grishchenko cogently points out in his analysis, “Any competing e-money system needs to offer at least the same level of security, coverage, liquidity and privacy, which is hardly the case with Bitcoin at this moment.” In the developed world, Bitcoin is a non-starter. At best it might eke out an existence as a distributed local currency for hardcore libertarians.

…but the developing world is another matter. Consider Zimbabwe, recently plagued by hyperinflation so rampant that prices doubled every few weeks and gasoline could only be purchased on the black market with hard currency. They’ve since given up and simply adopted foreign currency wholesale. Meanwhile, mobile electronic payments are taking off in a big way all over sub-Saharan Africa. It isn’t much of a stretch to imagine Zimbabwe in ten years’ time—or a whole group of developing nations with a history of crippling inflation—adopting a new currency that is independent, incorruptible, and anti-inflationary by design. In short, something a whole lot like Bitcoin.

Like any technology, Bitcoin has the power to destroy as well as save.  While it could help improve the standard of living in the developing world, it could also magnify the damage done by the spammers, Internet scammers, and criminals both analog and digital who currently operate in these countries.

The op-ed

The cynic in me tells me that Bitcoin was started by a brilliant computer scientist who happened to have control of a massive botnet as a way to monetize it. Even if that’s not the case, the “one vote per CPU” model makes botnet herders king, and I don’t want an economic system like that.

To the extent that it works, it works because anything can be used as “money,” seashells, cigarettes, grains of sand.  Money is anything that is accepted as having value, or more precisely, which acts as a store of value.  What is the intrinsic value of a dollar?  Virtually nil.  So this Bitcoin currency works only because there are people willing to provide service or goods in return for the Bitcoin.

Now, why won’t it work?  Because it is a Ponzi scheme.  Because it has a finite limit coded into it, the value now is less than it will be later (deflation).  The amount of goods and services in the world will continue to grow, but the “Bitcoin” supply will not, so in the future each Bitcoin will have to store a greater amount of value than it does today.

It’s a Ponzi scheme because if you get in early you get cheap Bitcoins that have only one direction to increase in value — up.  That, or all rational people will realize that they are being had, and the value of the Bitcoins will drop to zero.  But in the meantime, those people who are using them are acquiring real goods and services for Bitcoins which have no value.  It’s a win-win for anyone who has them now and can either convince some or all others to accept them.  As in all good Ponzi schemes, the person who loses is the last one in before the bottom drops out — i.e. the last person who buys or accepts a Bitcoin before no one else will.

Inflation is not entirely a bad thing and is infinitely preferable to deflation.  Ask anyone who lived through the deflation from the 1870s through the 1940s in the U.S.  Farmers were absolutely killed — they had to spend money to buy seed, but by the time they could harvest and get a crop to market from that seed, the price of money had gone up and they ended up receiving less money for the finished crops than they had paid for the seed!  (Farmers generally buy seed on credit.  So they borrow 100 dollars to buy seed, and six months later they have pay back the 100 dollars.  Only now, 100 dollars is actually worth 120 dollars because of deflation. They have worked 6 months only to lose 20 dollars.)

The only people who win in a deflationary environment are the people who already have sufficient money that they can survive while hoarding it as it increases in value.  Also, once a deflation mind-set sets in, the economy collapses because who in their right mind spends money today that will be even more valuable tomorrow?  So, Ponzi scheme again — with built in deflation, the people who already have Bitcoins already have all the cards.

As far as toppling the world economy, that’s a bizarre position to take.  What happens every time there is a new country that introduces its own currency?  Does it topple the world economy?  What happens every time a country gives up an independent currency?  Again, no toppling.  The Bitcoin, as long as it is accepted by anyone that is, will have zero impact on the global economy.

I mean, even if you agree it has value, all of them in the world only amount to a value of $49 million?  Paris Hilton spends that in an afternoon.  Microsoft makes or loses that amount on an hourly basis of stock price volatility.  That’s 500 decimal places behind the zero in terms of the total amount of currency being traded in the world today.  No impact, now or ever, except for the few people who use them and eventually get burned.

The only way it stays stable is if it operates in a completely static environment in which the amount of product available for sale (goods or service) stays flat.  I could see that in some sort of IT type of environment where costs of a service (such as server space) are always dropping at a rate fairly stable with the growth in the amount of space needed.

By the way, as salaried government employees, nothing would serve us personally better than a deflationary environment.  Our wages are steady and we have more money already than we need to survive, so we could hoard.  Each year the price of things we needed (or just wanted) would be going down.  Of course, the economy would quickly collapse, but since we aren’t really dependant on the health of a particular industry or economic sector, we would be insulated.  This is how vast wealth was concentrated during the Great Depression — those who had enough to survive could wait out those who didn’t, and eventually buy things from them (land, houses, businesses, whatever) at fire sale rates.

Anyway, if you read the FAQ on the Bitcoin site you will see that artificial scarcity has already set in — they tell you initially that you can “mine” Bitcoins by having your computer solve equations, and then way down at the bottom they tell you that the average wait to solve an equation is now several years.  So the only way to get Bitcoins now is to accept them as payment for a real good or service, or buy them (i.e. trade another currency for them.)  Ugh.

I hate Ponzi schemes, but they are impossible to destroy.  And with all the anti-government furor these days, anytime the government shuts a Ponzi scheme down everyone shrieks that they are doing it because the new scheme was going to set everyone free any minute now and the government didn’t want that to happen.  If the government doesn’t catch it, when the bottom falls out (housing market derivatives, anyone?) then everyone screams that the government did it intentionally to defraud poor hardworking average citizens…  it is a no-win situation protecting people from their own greed.