2. How and Why Bitcoin Works
2
How and Why Bitcoin works
BITCOIN HAS BEEN DESCRIBED as libertarian in nature, but not all libertarians and those in favor of a gold-backed currency appreciate it however, and some, in point of fact, actively despise it. In our experience, some fundamental concepts related to Bitcoin are not well understood by these. To fully understand Bitcoin, knowing how and, just as importantly, philosophically why it works is essential. How can a distributed system composed of several different groups and managed by several individuals at the same time maintain its integrity and avoid the condition termed “tragedy of the commons” by Garrett Hardin? In this economic condition, individuals, acting independently and rationally according to self-interest, behave contrary to the whole group’s long-term best interests by depleting common resources. A typical example is where a group of farmers share a common pasture for grazing their cattle. Overuse and depletion of the common resource, the pasture, can occur since it is in no one farmer’s individual self-interest to conserve it by limiting his cattle’s consumption of the pasture.
Let’s begin with a discussion of how Bitcoin works. To appreciate and understand most of this book, some basic understanding of Bitcoin’s key concepts is necessary. This chapter will provide that and will conclude with a perspective on why Bitcoin, as a payment system, has been proven so far to be a viable solution. To complete our discussion, we will elaborate Bitcoin’s economic implications.
At its core, Bitcoin incorporates the following concepts:
• A public ledger (called Bitcoin’s block chain). Consider this as essentially a giant book that is publicly available and contains the bookkeeping records of all transactions ever made in the Bitcoin system, with new pages constantly being added.
• A cryptographic algorithm called asymmetric encryption used for authorization of the transactions.
• A distributed network of computer nodes (also commonly known as miners) that verify and validate Bitcoin transactions and update the public ledger.
Let’s explore these concepts in greater detail.
Bitcoin’s block chain: public bookkeeping
All members of the Bitcoin network share its public ledger, the block chain. Imagine a giant accounting book with each page listing a series of transactions. A new page containing the latest Bitcoin transactions sent by payers across the world is added approximately every 10 minutes. This giant book is constantly available on the Internet to anyone who runs the Bitcoin software. Note that software programs called Bitcoin wallets can run on smartphones or personal computers and allow a user to make payments over the Bitcoin network.
In the context of Bitcoin, the pages forming the ledger are called blocks because they represent “blocks” of data. The block chain, composed of many individual blocks, grows constantly in length and contains all transactions performed in Bitcoin since its launch in January 2009.
A Bitcoin transaction request contains the following:
1. The Bitcoin address of the payer, which contains the source of funds for the payment,
2. The recipient’s (payee’s) Bitcoin address, and
3. The amount of bitcoins being transferred.
Since the block chain contains the history of all outgoing and incoming payments associated with the payer’s Bitcoin address, miners, who also manage the Bitcoin network, can validate that the payer has sufficient funds to cover the payment. At any time, anyone can view the amount of bitcoins linked to (or, in an abstract way, held in) any specific Bitcoin address. See for yourself. Go to blockchain.info and enter the following address.
1GaMmGRxKCNuyymancjmAcu3mvUnVjTVmh
Under “Search”, the number of bitcoins associated with this address will be returned.
Although the owner’s identity cannot be known from his Bitcoin address without his having provided this information, any transfers in and out of his account, as well as his current balance, are publicly available for viewing.
Asymmetric encryption: who gets to spend those bitcoins
Encryption keys are associated with a transaction such as the one described above. Bitcoin employs a system of asymmetric encryption (also known as public-key cryptography), so called because the encryption algorithm requires a pair of keys, each consisting of a long series of digits. One is public and controls the decryption operation, while the other, the private key, governs the encryption operation, or vice versa.
It is easy for the algorithm to create a private key and to derive its corresponding public key. However, determining a private key from the corresponding public key is computationally unfeasible, thus allowing the public key to, as its name implies, be made public. With the public key, the payee can retrieve the transaction information, allowing the transfer of bitcoins to proceed. The following Figure 2 conceptually illustrates Bitcoin’s double key system, which provides part of the basis for Bitcoin’s operation.
FIGURE 2: SYMMETRIC ENCRYPTION ILLUSTRATED
The Bitcoin software’s algorithm allows only the owner of the private key to “spend” bitcoins associated with that Bitcoin address. The recipient, or payee, shares his Bitcoin address with the payer. Since only the recipient knows the private key linked to his address, only he will be able to access, spend, or transfer those bitcoins at a later time.
Within Bitcoin, a sender digitally signs a Bitcoin transaction with his private key. Bitcoin transactions actually contain the public key (assume this is the Bitcoin address for now). Using this public key, the system verifies that the digital signature is valid and thereby confirms that the sender is indeed the private key’s owner. This system allows the owner to “spend” the bitcoins associated with his Bitcoin address in the public ledger, and the public ledger (i.e., the block chain) will be updated with a new page (i.e., block) containing this transaction. The addition of this new transaction to the block chain effectively tells the Bitcoin network to credit those bitcoins to the recipient’s address and debit them from the sender’s Bitcoin address. Private keys are made of a long series of digits stored and managed by password-protected Bitcoin wallets (i.e., software on the user’s computer, mobile device, or other web application).
A network of miners acting as minters, bookkeepers, and regulators of the system
So far, we have talked about what transactions look like and how they are validated. If Bitcoin were a centrally operated system, the story would end here: A single entity would be responsible for this task. However, Bitcoin is a decentralized system, and, as such, this task is shared among a collection of voluntarily participating nodes (miners) distributed across the world. Understanding how a system that includes bookkeeping and payment transfer authorization could be operated by different entities in such a way as to support his or her own self-interest is essential. This characteristic of the system is one of the key understandings to which I alluded earlier as one that is often missed by critics of Bitcoin.
Miners, the nodes responsible for operating the Bitcoin network, verify that transactions are valid and update the block chain with new blocks consisting of the latest transactions on a regular basis. The Bitcoin software run by miners on their individual computers incorporates the Bitcoin protocol with its set of rules and agreements.
Overall, the Bitcoin network requires that the block chain (public book ledger) be continually updated with the addition of new blocks (pages in the ledger book). Approximately every 10 minutes, a new block is added with the list of the latest transactions. Although all miners are working on the next block, only one will be selected to have his specific version of the block added to the block chain. Indeed, each miner is operating in his self-interest when he creates his own version of this next block and so personally collects the transaction fees associated with that block of transactions. Although the core parameters of Bitcoin transactions are unaltered (payer, payee, amount), most of them include transaction fees, disbursed by the payer and to be credited to the account of the miner whose block is selected for inclusion in the block chain. This miner will therefore update each of these transactions and will credit the fees associated with those transactions to his very own Bitcoin address.
In addition to transaction fees, miners whose blocks are added to the block chain also earn additional credits with newly minted bitcoins. They create an extra transaction that adds these to their own bitcoin accounts. This is called a block reward. Currently, Bitcoin’s protocol allows miners to allocate themselves 25 new bitcoins per block created. This is in addition to the sum of transaction fees. Initially, at Bitcoin’s launch, 50 bitcoins (BTC) were allocated as the block reward per block, which is halved approximately every four years.
With the new bitcoins credited to his address, the miner whose version of the block is selected for inclusion in the block chain clearly benefits from finding a solution before his fellow miners do. How this selection process works will be explained shortly. For now, however, view it as solving a mathematical problem by executing a very expensive computing task. The solution is difficult to find but, once found, its correctness is easy to verify. The first miner to find the solution to his block is allowed to publish this version to the entire network of miners.
These miners receive the block and its solution and then work to authenticate and validate it, that is, certify that the solution found by the first miner to the block is correct. The Bitcoin protocol sets the difficulty of the problem in such a way that an average of around 10 minutes are required for the solution to be found.
If the miner solving the block were to credit himself with more than the 25 new bitcoins currently allowed, the other miners would reject that miner’s block and would continue working on finding the solution for their own versions of it. Each block is slightly different and therefore each has a different solution.
In what might seem counterintuitive, when a miner solves the computing task, all other miners accept defeat, agree to include this miner’s block as the next block in the block chain provided it is able to be validated, and begin work on the next block. This work involves each miner’s adding all the most recent transactions that have come in since the creation of the previous block to a new block, which will in its turn be solved and added to the never-ending block chain.
The manner in which Bitcoin operates explains why the miner who was first to arrive at a solution will credit himself with only the amount of block rewards allowed by the Bitcoin protocol. Doing so ensures acceptance of his block by the other miners and receipt of its associated rewards (i.e., transaction fees). Equivalently, the other miners achieve no gains by rejecting the block even though it is valid. The Bitcoin payment system will hold its value only when it is functioning properly. If miners were to reject all blocks but their very own, no consensus would ever be reached, the value of the overall system would be destroyed, and none of the miners would be able to benefit. In such a case, whatever amounts of bitcoins the miners hold would then become worthless. Therefore, all miners benefit if all respect the Bitcoin protocol established within the shared Bitcoin software. Thus, Bitcoin embodies the inverse of the tragedy of the commons described earlier.
Now let’s delve into the details of what we earlier described as the expensive computing task required to solve the mathematical problem of a block. For a miner to have his block selected, he must have solved a problem associated with the block. This selection process is called “proof-of-work” as it implies the miner had to work for it. To fully understand the mechanism involved, we need to first understand a cryptographic concept known as a hash function. Then, we can explain how it is used in the context of a miner’s proof of work.
Cryptographic hash function—a digital “fingerprint”
Cryptographic hash is a complex algorithm that performs a very basic task–transforming text of arbitrary length (an entire book, a document, a sentence, or even a single word) into a fixed-length string of numbers that appears random. The following Figure 3 provides some examples. The output of a hash function, or simply hash, is usually called the message digest and can be considered the document’s “fingerprint”.
FIGURE 3: THE HASH ALGORITHM IN ACTION
In the figure above, note that the input “There are 2 dogs in the backyard” leads to a completely different digest than “There are 3 dogs in the backyard”. Simply changing one character leads to an output with all digits completely different. The digest outputs in this figure are expressed as hexadecimal numbers. Unlike the decimal system we commonly use, the hexadecimal system has a base of 16. It employs sixteen symbols to represent the sixteen numbers in the system. Symbols 0 through 9 represent the numbers 0 through 9, and letters A through F represent the numbers 10 through 15. Thus, hexadecimal F represents the number 15. The hexadecimal number 5A36 is therefore equal to (5 x 163) + (10 x 162) + (3 x 161) + (6 x 160), which equals, in the decimal numbering system, to 23,094. Experiment with switching from Hex to Dec on your own computer’s calculator to see how it works.
A Bitcoin user has no control over what the output (the digest in Figure 3) will look like. Also, given a specific digest output, finding an input that would generate it is nearly impossible. Thus, generating a digest is easy, but deriving the original text from the digest is impossible. Employing the analogy of the human fingerprint, given a single fingerprint, we would find it impossible to identify the person who left it unless that person had been fingerprinted beforehand.
Earlier we mentioned that all miners can easily verify that a solution is correct once it has been found but that finding it is the difficult part. That’s why cryptographic hash is ideal for Bitcoin’s purpose. Miners, in their attempts to solve a block, must reproduce a specific pattern displayed by the contents of the digest. Since reproducing a specific output within the digest is impossible, they must increment a digit in the text and recalculate the hash again and again until they stumble upon the specific pattern in the digest that is required by the Bitcoin protocol. This process is analogous to varying the number of dogs (“2 dogs”, “3 dogs”, “4 dogs”) in the example in Figure 3 to create different digests. For instance, say that the current Bitcoin protocol specified that the contents of the digest display a pattern beginning with “00”. By varying the number of dogs in the example, the corresponding hexadecimal number in the digest will eventually satisfy this requirement, indicating a solution to the block.
Miners looking for the solution must usually calculate the hash millions of times to find the right pattern, but only a single hash calculation by other miners is necessary to validate it once it is found.
Bitcoin’s hash algorithm, which creates the contents of the digest from the input text, makes the system described above possible. Thus, an ideal cryptographic hash function has four main properties1:
• Computing the hash value corresponding to any given message is simple.
• Generating a message that has a given hash is impossible.
• Modifying a message without changing the hash is impossible.
• Finding two different messages having the same hash is impossible.
The following example, taken from Wikipedia, illustrates the hash function in use.
Alice poses a tough math problem to Bob and claims she has solved it. Bob would like to try it himself, but would also like to ensure that Alice is not bluffing. Therefore, Alice writes down her solution, computes its hash and tells Bob the hash value (whilst keeping the solution secret). Then, when Bob comes up with the solution himself a few days later, Alice can prove that she had the solution earlier by revealing it and having Bob hash it and check that it matches the hash value given to him before. (This is an example of a simple commitment scheme; in actual practice, Alice and Bob will be computer programs, and the secret would be something less easily spoofed than a claimed puzzle solution).
Hash functions form part of the process enabling users to digitally sign a document or text in Bitcoin. In the context of Bitcoin’s proof-ofwork, which will be discussed below, the two most useful characteristics of the hash functions are the following:
• The impossibility of generating a message from a given hash
• Generating an entirely new hash by changing only one character in the message
Several types of hash algorithm have been created, and Bitcoin uses two of them: SHA-256 for the proof-of-work and RIPEMD-160 for the Bitcoin address. The hash function is at the heart of the proof-of-work, which we’ll discuss next.
Miner’s Proof of work
At any given time, each miner is actively engaged in creating the next block to be added to the block chain by resolving a difficult problem, which is called a proof-of-work. The first miner to solve the proof-ofwork is rewarded with freshly minted bitcoins (25 bitcoins as of this writing) and with the cumulative transaction fees associated with the transactions included in the block being created. Transaction fees, typically a nominal amount, are added by payers when they send their transactions. By around the year 2140, all bitcoins will be mined, and miners will be rewarded solely with transaction fees.
The proof-of-work can thus be thought of as a race between bitcoin miners to discover the SHA-256 hash of the block they are trying to create that will have a certain characteristic. As we saw earlier, the hash output is simply a very large number expressed in hexadecimal. The miner’s goal, the problem that must be solved, is to generate a hash output that is below a certain value. The first miner to compute a value having this characteristic wins, and his version of the block will, after validation by the other miners, be added to the block chain discussed earlier in this chapter.
For simplicity, imagine that the hash output was actually a number between 0 and 1,000,000 and that the first miner to get a hash output of less than 10,000 wins. The 10,000 acts as a threshold, and each block within Bitcoin contains a number whose sole purpose is to obtain the threshold.
The number within the Bitcoin block that is tested against the threshold value is known as the “nonce”. Each miner increments its nonce by a certain amount until the hash output for its block is below the threshold. As we said earlier, each miner’s block has different information and therefore a different hash output for the same “nonce”. This process is illustrated in Figure 4.
FIGURE 4: PROOF-OF-WORK ILLUSTRATED
The Bitcoin protocol, operated by the software running on each miner’s computer, adjusts the difficulty level of the problem so as to take around 10 minutes before the first miner solves it. The purpose is to have the block chain updated on a regular basis with a new block containing the latest transactions sent during the prior 10 minutes. This value is somewhat arbitrary and, as will be seen in later chapters, Satoshi devoted some of his discussions to this topic.
The previous discussion compared the nonce to a threshold. Because the hash’s numbers, termed the proof-of-work, are in a hexadecimal, or base 16, numbering system, this translates to the first X number of bytes being the digit 0, where X is adjusted periodically to keep the difficulty level of the proof-of-work fairly constant.
For example, assume that block #282,435 of the block chain has the following SHA-256 output:
0000000000000000c6647dad26b01b28f534223450d75d3b6b2882855039b673
Recall that in the base 16 number system, there are symbols representing the sixteen numbers 0 through 15; the symbols representing 0 through 9 in this system are 0 through 9 as in the decimal, or base 10, system, and numbers 10 through 15 of the hex system are represented by A through F. The hexadecimal number above is comprised of 64 digits. Since the terms to the left in a hexadecimal number represent higher powers of 16 hence larger numbers, to make the hash output smaller, the leading digits within the hash output must be 0. This is why stating that the hash output requiring to be below a certain threshold translate to have a certain number of leading digits be 0. Viewed in either way, proof-of-work is finding a nonce that will generate a hash output below the threshold established by the Bitcoin protocol at the time.
In the example in Figure 4—Proof-of-work illustrated, only with the first sixteen digits of the output equaling 0 could the hash output fall below the threshold set by Bitcoin’s protocol. Therefore, the miner who obtained this number first and so “won” that block had to keep changing the “nonce” number until a hexadecimal number having at least the desired number of leading 0s was generated. As in a lottery, the miners buying the most “tickets” (i.e., generating the most numbers of SHA-256 output) have a better chance of finding a number having the correct number of 0s. This requirement of the Bitcoin system has led to a race to create hardware capable of generating more hash per second. The lucky miner who first discovered the hash for block #282,435 of the block chain incremented the nonce to 505,482,605 stated in decimal, meaning this miner had to generate over 500 million “hash” before finding one with the correct number of leading zeroes.
As stated previously, the Bitcoin protocol’s goal is to have a block of transactions created approximately every 10 minutes. For a given level of difficulty, if more miners join—or more precisely, as more hash are calculated per second—the chances of discovering the required digest (hash output) in less than 10 minutes increases. After a certain number of blocks, the Bitcoin protocol evaluates how fast blocks are being generated; if sooner than 10 minutes on average, the level of difficulty is increased (i.e., the number of leading 0s increases, decreasing the probability of any single miner’s obtaining a digest having that characteristic); if longer, the difficulty is decreased (i.e., the number of leading 0s decreases, increasing the probability of obtaining it).
Once a miner discovers a nonce providing the correct hash output, the block is broadcasted, and other miners verify it, accept it, and begin work on the next block. Thus, Bitcoin operates like an ongoing lottery game restarting every 10 minutes. Who will be the lucky miner to find a nonce with the correct characteristics?
Figure 5 illustrate the concept behind the proof-of-work. Note that there is more information in the blocks than shown; it has been reduced for simplicity.
FIGURE 5: WINNER OF PROOF-OF-WORK
Miners’ consensus & orphan blocks
As stated earlier, Bitcoin relies heavily on consensus in order to function. This concept, which will be discussed further in Chapter 9, comes into play when two miners solve their blocks at about the same time. When this occurs, the two miners both broadcast their blocks including solutions across the Bitcoin system. All other miners receive and retain both but their work on their next block will be based upon which of the two current blocks they receive first. Say 50% of the miners receive the block from Miner A first and the others receive Miner B’s block first. This situation is illustrated for block #29302 in Figure 6 below.
This situation is analogous to a race going into overtime. Which of the two blocks becomes part of the true block chain will depend upon how quickly the next block is solved and by whom, a miner who received A’s block or one who received B’s block. At this point, two versions of the block chain exist, with half the miners having miner A’s version of block #29302 and the other having miner B’s version. Which of these two versions will survive depends on which version the miner solving the next block, #29303 in Figure 6, has on his computer. When block #29303 is solved, this version of the block chain becomes the longest of the two and hence the official one. All miners then drop the other version of the block chain, which becomes what is known as an orphan block. This process is illustrated in Figure 7.
FIGURE 6: A BLOCK SPLIT
Why does Bitcoin work?
So far we’ve covered how Bitcoin works, but not why. To understand this, knowledge of a few additional concepts, open source software for instance, is necessary. These concepts are as follows and are explained below:
FIGURE 7: THE LONGEST CHAIN WINS
• Bitcoin is open source software.
• Bitcoin software establishes the operating directives the miners and wallet clients must follow.
• Bitcoin software also defines and operates a communication protocol.
• Distributed file sharing of the block chain allows for open bookkeeping.
Open source software is computer software whose source code is available for anyone to see. Moreover, it operates under a special license that allows anyone to modify and to use it. With the source code, a programmer can recreate the program (the binary file that runs on computers) and modify it at will. Thus have sprung up many imitators of Bitcoin, other virtual currencies differing from it only cosmetically and, for the most part, incorporating no significant innovations, with the exception of a very few like Namecoin. The majority of these alternative virtual currencies are based on changing the rate at which blocks are created, the total number of coins in circulation, and the cryptographic hash algorithm used.
A software’s code being open source allows an expert to analyze it and to validate its integrity, that is, confirm that it does what it purports to do. A prominent example of open source software is Linux, which has displaced Microsoft Windows in market share in the server industry. Because it is open source, problems are found and fixed much more rapidly than if it were proprietary since multiple programmers are continually examining and improving the code. Linux has so far demonstrated that the greater good and selfinterest can work in concert, at least with respect to managing open source software. This openness ensures a high level of integrity not achievable in proprietary software, where only the reputation of the company responsible for the software guarantees that it does what it is supposed to do.
Bitcoin also operates over the Internet using a defined protocol of operations that miners and wallet clients must follow. Wallet clients— software programs that are apps on smartphones or programs on personal computers—are what is used when someone is sending a payment transaction, which miners then validate prior to their being incorporated in the block chain. A single miner deviating from the protocol would have his operation rejected by the rest of the miners and would not be allowed to contribute to the operation of the network.
One typical argument raised against Bitcoin concerns the limit on the maximum number of bitcoins that will ever be created, which Satoshi Nakamoto set at 21 million. Once reached, what could prevent someone from increasing this limit? Nothing really, but he would need the cooperation of the majority of miners for this change to be accepted. Even were the majority of miners to agree to lift this restriction, if all did not agree, then a split in the block chain would result. Those in favor of lifting the restriction would use one version of the block chain while those not in favor would use a different version. In effect, we would have two virtual currencies rather than one, the “original Bitcoin” and a “Quantitative Easing Bitcoin”. Over the long term, one would hold its value longer and better and would therefore become the preferred version while the other would drop in value. What would be your guess as to which one would hold its value longer and retain the interest of users of Bitcoin? Personally, I have a very good idea which one.
The Bitcoin development community is very conservative with regard to changes, and, at least so far, the preferred means of instituting major change has been the creation of new virtual currencies, some of which have no limits as to number of coins.
A final characteristic underpinning Bitcoin is that, not only is the software open source, but so is its bookkeeping. Some have termed the block chain “triple-entry bookkeeping” as it revolutionizes accounting. Anyone can inspect the block chain and verify that the accounting does follow the current established requirements and specifications of the Bitcoin protocol. The distributed file sharing of the block chain means that anyone running the Bitcoin software is connected to the Bitcoin network and has access to the block chain.
To gain a greater understanding of the brilliance of the conceptual basis of Bitcoin, I highly recommend reading Satoshi Nakamoto’s white paper. The information I have provided here should make the paper more accessible. A reproduction of this paper is included at the end of this book.
http://bitcoin.org/bitcoin.pdf
We hope this chapter has helped you understand the core concepts. You should now be capable of reading the Bitcoin paper and the remainder of this book with considerably more ease.
Implications of Bitcoin
Bitcoin’s impact as a monetary system is tremendous. One advantage is the ability it gives people to “wire” currency across the planet as simply as sending an email. This is particularly advantageous to immigrant workers who wish to send money to their relatives in their countries of origin. In contrast, companies that wire money across borders charge high fees to do so. There are fees associated with converting from national currencies to BTC and back again, but these conversion fees are small in comparison to wiring costs.
Another benefit touched on earlier regards online shopping and online donations. I’m confident that the current system of paying with credit cards will be completely changed in the future. Credit card payments require giving extensive information about the payer, including billing address and the 3-digit code on the back of credit cards. In essence, this is the Bitcoin equivalent of giving your private encryption keys to the merchant. The high number of frauds resulting from this security weakness has manifested itself in the form of high fees and chargeback with which merchants have to cope. Credit card companies spend a huge amount of cash every year in dealing with fraudulent charges. These costs are transferred to merchants, who, in turn, transfer them to consumers via higher prices for goods and services.
Another major impact of Bitcoin is on the monetary front, specifically in the system’s ability to be money and not just a currency. A currency has the following properties1 :
• Is a medium of exchange (used as an intermediary in trade)
• Is a unit of account (can be counted, is quantifiable)
• Is durable (long duration)
• Is divisible (so to have smaller units)
• Is portable (so as to be easily transportable)
• Is fungible (mutually interchangeable, 1 unit of a specific value can replace another identical unit)
Money has all the properties listed above and, in addition, one other:
• The ability to preserve its value over the long term.
Unlike money, a currency is subject to inflation. In the early 1900s, inflation was defined simply as the action of inflating something, as in the case of a currency, by printing more of it. Today’s dictionary defines it as a general increase in prices. However, rising prices are a symptom of a devaluating currency, which occurs when more of it is present than there was before. It is interesting but not surprising that this transition in definition corresponds to a time over which paper currencies became further and further detached from gold and silver, a development which leads to higher prices. Our ancestors saw, for instance, food prices remain virtually unchanged throughout their lifetimes. However, today’s population has been conditioned to view rising prices as an immutable fact of life, like gravity. It is as if, in a place where it rains all the time, nobody has made the connection between clouds and rain. But who could blame them since they have never seen a blue sky? In the same manner, most people today do not perceive rising food prices as caused by currency inflation, with sometimes a lag of several years for the rising prices to manifest themselves. This was the case with the currency inflation of the 1960s only manifesting itself in the following decade, the 1970s.
To maintain its purchasing power over the long term (i.e., to not be subject to inflation), the money supply must be limited. Gold and silver have been the money of choice for thousands of years. Their supply on this planet is limited and requires anyone who intends to acquire more of it to trade energy and time for them through mining. You could say that the effort expended in mining a precious metal is analogous to proof-of-work in the Bitcoin system. Contrast this real work with simply printing more dollar bills. Paper currencies were initially adopted to act only as a convenient substitute (derivative) for precious metals, thus facilitating transactions. Paper currencies, being easily reproducible, have always been subject to inflation, as goldsmiths – and later bankers – used fractional reserve banking to lend more (i.e., print more paper currency) than they actually had gold in storage. This has led to the frequent “bank run” crises littering the history books.
Before the advent of computers and networking, transactions were limited to precious metals and paper currencies. Since then, electronic communications have introduced a new way of performing transactions of which gold and silver could never be directly a part. Until now, only centrally controlled and electronically transmittable currencies existed, allowing the controllers free rein in deciding the size of the underlying currency’s supply. President Nixon demonstrated this clearly when he removed the dollar’s convertibility into gold on foreign exchange markets. The Vietnam War and Lyndon Johnson’s “great society” were funded by diluting the US dollar via the electronic printing press. It took time to manifest itself via the rising prices of commodities, but once it did, the price of gold in dollars has effectively been higher than the fixed $35 per ounce of gold that prevailed before the dollar was unlinked from the gold standard. It then became a free-floating, constantly inflating currency, like any other national currency in existence today.
As we discuss in Chapter 7, paper currencies (fiat) allow governments to fund deficit spending by stealing from the value of the currency in circulation. The poor and, to some extent, the middle class are the most affected by currency inflation while the rich use debt and various financial derivatives to acquire companies and income-producing commercial real estate. They know the debt will be devalued along with the currency, providing an artificially obtained additional gain. The first way to address the “war on poverty” is to get rid of currency inflation and return to a form of money whose value holds over the long term. But do not expect government to propose or even entertain a proposal involving this course of action.
Currently, many magazine and newspaper articles on Bitcoin present its “deflationary” nature as its main negative. By deflation, they mean that prices measured in BTC will decline. In reality, this is Bitcoin’s primary benefit. They report that people will be “hoarding” bitcoins rather than spending them in the economy. First of all, imagine that tomorrow bitcoins were to become the currency of choice for your country. Being human, you would still have to eat and to provide for a shelter; hence you would have to make these two expenses. What the comments in these articles demonstrate is a misconception about what money is. By saving rather than spending—“hoarding” is merely a pejorative term for saving—people are delaying consumption to a later time. We have seen this type of behavior exhibited recently by some so-called “bitcoin millionaires”, who, at some point, become comfortable enough to spend some of their bitcoins on luxury items. In an economic system based on money—currency that holds its value over the long term—savers are not competing for resources with manufacturers, builders, factories, and those extracting commodities (i.e., marketable items) by deferring spending. By resources, we mean any form of energy, commodities, time, and labor, particularly specialized labor. Imagine the case of a person who decides to save by staying home rather than hooking up his trailer and traveling cross-country for vacation. By not traveling, he allows the gasoline he would have expended in traveling to be used by, for instance, a manufacturer to transport material for building a new plant. Printing dollars do not create more barrels of oil, more gigawatts of electricity, or more hours in a day. I’ve illustrated this concept with rather simple examples, but I hope you can see that a currency like Bitcoin, with the ability to hold its value derived from its limited supply, has major ramifications.
In this chapter, we’ve covered the technology behind Bitcoin, the software concept underlying it, and we’ve touched on an alternative view of economics to which Satoshi Nakamoto himself likely adhered. Now that you have a good understanding of what Bitcoin is all about and how it works, turn the page and meet Bitcoin’s creator, Satoshi Nakamoto!
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