Note: This article has been kindly translated into Chinese. (中文链接)

Artificial blocksize caps are a market intervention just as egregious as the Fed setting the interest rate, with equal damage to Bitcoin’s sound money properties — rendering the 21M BTC cap meaningless.

Bitcoin backers have grown accustomed to thinking of Bitcoin as “inflation-proof” because of the iron-clad issuance schedule for its monetary tokens, culminating in the famously final total of 21,000,000 BTC sometime in the next century. Libertarians and other sound money advocates immediately recognize why Bitcoin is revolutionary, once they are able to grasp the nature of money as a ledger and how that makes Bitcoin truly as good as gold.

Yet the real epiphany hits when the former goldbug sees the script get flipped: Gold itself is in fact just a low-tech “sneakernet” ledger where unfakeable, scarce pieces of metal are traded as proof of ledger holdings instead of cryptographic signatures. Bitcoin simply upgrades this process with more reliable scarcity into faster, lighter, hideable, deniable, teleportable, unforgeable money. Libertarians hail it as a true sea change in personal liberty and the very fabric of society with the potential to disintegrate existing power structures at the seams.

“You’ve got to get a piece of this landgrab,” they say. “You’ve got to secure your portion of the ledger early on, before everyone jumps in.”

The key word here is scarcity.

But why? What benefit does scarcity in the form of a 21-million coin cap really confer? Of course, the answer goes, if a significant number of bitcoins could be issued contrary to the original schedule, over and above 21 million, its sound money property would be in jeopardy. It would be no better than the Federal Reserve with its willy-nilly inflationary policies.

Yet here one detail has been skipped over. Issued to whom? As everyone knows, the new Bitcoins are issued to the miners — thereby diluting the value of all bitcoin holders’ bitcoins slightly — as a reward for their services to the network. Said another way, bitcoin holders who have “secured their percentage of the ledger in this epic landgrab” forfeit a small part of that percentage to the miners every time a block is mined.

For instance, the Winkelvoss twins came out as owning 1% of the entire Bitcoin ledger as of early 2013. At the time, this figure represented about 100,000 BTC, because there were a little over 10,000,000 BTC issued. Now there are 16,000,000 BTC outstanding, meaning their stake in the current ledger has fallen to a little over 0.6%, a 40% loss in the proportion of the total ledger they own — a 40% shrinkage of their total land ownership of the slowly accreting Bitcoin island, as the traditional analogy goes.

The Bitcoin Island (any resemblance to Ireland is entirely coincidental). Winkelvossia is set to shrink another 25%, yielding a quarter of its remaining lands to the miners by the year 2140.

That 40% loss wasn’t just “inflated away.” It went to the miners. Thus it is equally valid to view the situation as follows:

The Bitcoin island didn’t really grow; there isn’t really any inflation so to speak. There is just a miner tax. The island is the same size, but the Winkelvoss twins lost 40% of their property size to the miners. This is of course no problem, as they knew all this going in! However, I hope the reader can see that this is just as accurate a conception as the more familiar one. Why view it this way, though? Because it is more revealing as to what is actually going on.

Seen this clearer way, the block reward (now 12.5 BTC per block) is indeed a miners’ subsidy for their services. Since it was known from the beginning, this is all perfectly in keeping with the predictable issuance schedule of sound money. A certain known percentage of your stake in the Bitcoin island will go to the miners on a known schedule.

The other fact that was known from the beginning was that miners are allowed to charge fees to include transactions in a block. This is an additional yielding of landmass to the miners as is understood by all. It was always understood that this was necessary to incentivize miners to include transactions, as well as to scale mining subsidy as fee-paying transaction volume grew, since higher volume of high-priority transactions would mean Bitcoin had become a bigger deal economically and therefore needed even more protection from attack.

In the early days, critics were quick to point out that the miners could charge whatever fees they wanted to. Some socialists who don’t understand how economics work even contended the miners would charge exorbitant fees, like $500 per transaction, and people would be forced to pay. Was that not essentially an infinitely expandable additional miners’ subsidy?

“What meaning did the 21M cap have if miners could assess arbitrarily high fees on your ‘digital gold’ and you have to just stand there and take it?” they naively asked.

Fortunately most Bitcoiners are familiar with the counterintuitive aspects of free-market economics: unfettered competition among miners results in a bidding war. Even if some miner were to charge $500, other miners would undercut each other in a continual price war, the lowest bidder taking the entire pot of accumulated transaction fees. In this way, transaction fees reach the market clearing rate, where the fee rate on a given transaction approaches the marginal cost to a miner of including it in the next block. This isn’t a perfect system in terms allocating system expenses, but it certainly works to prevent price gouging. Again, Econ 101: any miner trying to charge even a little bit more for the exact same service will just be undercut by another miner and lose that potential income.

Therefore, in the final analysis, Bitcoin holders could rest assured that their savings — their percentage of the total Bitcoin island landmass — would be a predictable percentage at a predictable time, and furthermore that the tolls exacted when they move their money will be reasonable as they will be determined solely by free market competition. Perfectly predictable holdings and an un-gameable free market in fees that ensured fees were tied to actual miner costs. This was sound money incarnate.

Enter the blocksize cap.

The hard-coded cap on the maximum allowable size of blocks in the Bitcoin network stands at 1MB, and as everyone following the blocksize debate knows, this number had no discernable effect on fees per transaction until recently. You can be sure this fact isn’t itself a point of controversy precisely because one school has continually lamented it and the other school has continually lauded it. However, as is also a matter of record (and basic economics), rejoiced at by the former school and lamented by the latter, the fees per transaction have risen markedly since the transaction volume has started filling up the 1MB blocks.

No longer is the price per transaction determined by the free market, but instead by a hard-coded limit that intervenes in the market. This results in more money being paid to the miners for their services per transaction than otherwise would have.

Here I must make a gentle note to non-economists: this doesn’t mean more total money went to the miners, a common error — for the same reason that a 5-star steak restaurant doesn’t make more total money than McDonald’s. There are less total transactions than there would otherwise have been, as people start to economize, which is again an intended effect of the school of thought that celebrates this “fee market” (note that a free fee market already existed, hence this one should be distinguished by calling it something like an “artificial fee market” or a “developer-regulated fee market,” much like the many government-regulated markets out there in a standard mixed economy). This isn’t any kind boon for the miners, any more than it would be a boon to McDonald’s if the government came in and told them they have to triple all their prices.