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01 Jan 2014

A few more thoughts on Bitcoin Money

In no parrticular order:

Anonymous frictionless transactions are not new and are not very interesting

That's what cash is. I give you cash, perhaps you give me change, we're done. It's true, you can do Bitcoin transactions at a distance, but in the real world, where people pay for $2 cups of coffee by swiping their plastic rather than taking cash out of their wallets (the leather kind), demand for anonymous frictionless transactions seems pretty low. I have some other thoughts about bitcoins vs. cash below, but first, that's doubly irrelevant because ...

Bitcoins are neither anonymous nor frictionless

The friction is the mining fee. If you pay for something with bitcoins, your transaction has to be published in the blockchain before a counterparty will accept it. To create a blockchain entry, you have to do a proof-of-work calculation demonstrated by a hash value with a specific bit pattern, which rewards you with new bitcoins, currently 25 per new hash. Once you have that hash value, you can also include any new transactions you know about when you publish it. If you are not a bitcoin miner, to get it your transaction published, you send it to a bunch of bitcoin miners, and hope that one of them will include it in their next block. Miners are under no obligation to include anyone else's transactions, so to encourage them to do so, transactions can include a mining fee to be kept by the miner who publishes it. Early on, most miners would publish transactions with no fee, but these days if you don't offer a fee, you'll wait a long time. A typical fee these days is 0.0001 btc, which is currently worth about 8¢. (For comparison, Dwolla charges 25¢ for transactions over $10, nothing for under $10. Paypal is free if the funds come from your balance or a bank account.) A typical block has 300 transactiona, so at 0.0001 per transaction, that only adds .03 btc per block, meaning that the revenue from mining fees is still insignificant.

Because of the way Bitcoin works, mining fees are only going to go up. By design, the Bitcoin creation rate slows down and will eventually stop, as the number of coins created per mining hash drops. Miners will still have to create the hashes to publish new blockchain blocks, and the cost of mining isn't likely to go down much, due to the automatic adjustments that keep the creation rate around one block every 10 minutes. I gather that at the current rate of 25 btc per block, mining about breaks even, so if a btc is worth $1000, it costs about $25,000 to mine a block. Let's optimistially assume that the transaction rate will go up by a factor of 10 so there are 3000 transactions per block. To generate a similar amount of revenue from those transactions, each one will have to offer a a mining fee that is worth about $8.00. Even if my estimates are off by an order of magnitude, 80¢ per transaction is still hardly frictionless.

For anonymity, wallets are in principle meaningless strings of bits, but since the blockchain is public, people can and do analyze all the transactions, and identify nearly anyone they want to by matching up the wallets involved in transactions with known parties. If you're really, really careful and disciplined, e.g., separate wallets for each transaction and no transfers among your wallets, you can probably avoid being identified, but that's hard enough that most people don't.

Since bitcoins are so easy to track, I also expect that ...

Blacklists will effectively block bad transactions

There have been an awful lot of bitcoin thefts and the rate is, if anything, increasing. While there's no way to undo a transaction once it's in the blockchain, it is not terribly difficult to track bitcoins that have been stolen or are otherwise undesirable, e.g., paid from a site like Silk Road. (Yes, I know about tumblers. We can assume to a first approximation that anything that goes through a tumbler is undesirable, too.) If there were blacklists that people used to reject transactions with stolen bitcoins and other transactions that would be reversed in a normal financial system, that would make theft and fraud a whole lot less attractive. While this would make the people who run the blacklists a sort of central authority, we've dealt with the exact same problem with anti-spam blacklists of IP addresses, and found that the benefit from using well run anti-spam lists is so great that in practice everyone uses them.

And based on some recent observations, ...

Bitcoin enthusiasts have a remarkably poor understanding of both economics and Bitcoins

In response to one of my previous Bitcoin articles, someone said he'd use bitcoins if they'd avoid the 3% foreign exchange fee on his credit card. (I suggested he look at Capital One.)

In the comments on Paul Krugman's article quoting me, there was a long discussion of deflation, in which people argued that it wasn't a problem because bitcoins are infinitely divisible. Disregarding the detail that they aren't (the smallest unit is 1/100000000 btc), this completely misses the problems caused by deflation, notably that people hoard cash rather than spending it and commerce grinds to a halt.

In another article where someone was complaining about how long it takes for Bitcoin transactions to clear, other people dismissively referred to various online services that say they'll do Bitcoin transactions instantly. But the slowness is inherent in the Bitcoin protocol--it can take up to 10 minutes for the block with your transaction to be published, and a while after that before enough other miners include that block into their chain so the recipient knows there won't be a conflicting payment to someone else with the same bitcoins. This happens whether you're paying someone standing next to you or someone halfway around the world. What the "instant" services do is to front for you, promising that the bitcoins are there and the transaction will show up in the blockchain eventually. That's an entirely useful service, but a few moments thought will reveal that if you're willing to trust such a service, you might as well use Dwolla.

And finally, there's the whole inflation and debasement of the currency bit. People apparently imagine a bunch of guys sitting around the table in a long-ago monetary nirvana, who then twirl their moustaches, puff their cigars, and say "Hey! Let's debase the currency!"

We hear Hyperinflation! Weimar!, but the people saying it know nothing of the events of the time, the impossible burden of post-WW I reparations or the French occupation of the Ruhr, nor of Heinrich Brünings's miserable deflation ten years later that led to the rise of you-know-who. Yeah, hyperinflation is bad, but it doesn't occur at random. See this interesting paper on the fiscal shocks that invariably precede it.

Finally, if you are familiar with the economic history of the United States, Bitcoins have a lot in common with pre-1913 US dollars. The dollar was tied to gold (the previous choice of gold and silver having been rather offhandedly changed to just gold in 1870), and there was no central bank, so prices were volatile but payments in gold were instant, irrevocable, and could be anonymous. There were lots of banks that issued paper that was nominally equivalent to gold or Treasury bonds, which sometimes it was and sometimes it was until the bank went bust and its paper turned out to be worthless, not unlike the various online bitcoin services, many of which work great until they mess up and all the bitcoins disappear.

The creation of the Federal Reserve in 1913 was a direct response to the Panic of 1907, but there were two long term problems that created broad support for a central bank in the business and banking community. One was domestic, that there was an endless cycle of booms and busts and bank panics. The other was international, that the dollar was so volatile and US banks so unreliable that nobody outside the US was willing to write contracts in dollars, putting US merchants at a competitive disadvantage. The preferred currency was the UK pound, which the Bank of England had been managing to some extent since the 1600s, and quite actively in the 1800s as described in the classic Lombard Street.

Nothing fundamental has changed since then, and it is utterly implausible to believe that something, no matter how technically clever, that has all the economic flaws of the 1800s gold standard is the money of the future.


  posted at: 20:40 :: permanent link to this entry :: 0 comments
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