I meant to blog about this Liberty Street Economics piece on Bitcoin mining last week, but ran out of time.

Which is kind of apt because the economics in question kinda relate to running out of time in competitive terms.

As the authors Rod Garratt and Rosa Hayes found:

As the aggregate hash rate declines, the aggregate network profit should return to zero. We may, however, see increased concentration of mining power in locations with the cheapest energy costs.

My longstanding prediction about bitcoin and bitcoin mining has been that to survive it will have to eventually transform itself into the same old centralised system it claims to be disrupting, because it can’t compete cost efficiently any other way. It’s all about scaling. And currently Bitcoin is really poorly scaled.

Think of it this way. The “good” that banks are in the business of producing is an allocation unit which diverts consumption from idle hands to more productive hands, in a way that unleashes economies of scale in society and provides more consumption opportunities for society as a whole.

But it’s also the case that this particular “good” has literally no conventional cost of production. The only cost associated with money production (specifically credit) is trust.

Unlike money, trust is not abundant. It has to be earned over time. This usually requires proving to the public that you don’t just dish out allocation units to any Tom, Dick or Harry, let alone to yourself unjustifiably.

And it’s only once trust is earned that it can be exploited. From the perspective of a potential conman, that’s a very long-term con game, which requires a helluva lot of up front investment. Not ideal.

As an aside, this is what I once noted to a fintech panel about the product that is money:

“The product that banks are in the business of producing is money. But money is no ordinary product. For one thing, money is only valued if it’s distribution is controlled and rationed by an effective cartel. On that basis a newcomer can’t disrupt the incumbent system by simply engineering a better manufacturing technique. More product leads only to poor allocation and more risk, which in the long run leads to bankruptcy. A newcomer can perhaps work to manufacture the product more cheaply — by offering to take a smaller cut for themselves — but this is a challenge for an industry which is already operating on micro margins or dependent on cross-subsidisation from other more profitable services elsewhere. A newcomer might consequently attempt to substitute money with something else entirely or, alternatively, work to increase the amount of productive people in the system. But how do you achieve this without compromising on the right of social self-determination or liberty? The only way, arguably, is through data bondage or the granting of access rights to those who voluntarily subscribe to be controlled, tracked or monitored. But then you’re no longer a bank, you’re a highly politicised entity — one that demands even more trust from society than a bank.

Bitcoin attempted to “disrupt” the banking system by finding a mechanism to shortcut both trust-based money production and the long con game, which eventually allows for self-serving profitable exploitation of that trust.

So, rather than spending decades proving it could be trusted to allocate “claim units” to productive individuals who can grow the economy or are entitled to spend (the “long game”) it instead manufactured a rationed money creation process which artificially limited unjustifiable money creation in the here and now. It was able to earn trust among zero-value rent-seekers or wealth detractors, precisely because it constrained their own ability to over abuse the system by spreading the upfront cost associated with developing a trusted brand among many different participants.

So, if it usually takes 30 years at a cost of $4bn to develop the sort of brand and reputation that earns an individual entity money-creation trust on vested interests grounds, why not change the dynamics to earn that trust more quickly? Instead of having one entity spend $4bn over 30 years, why not have numerous entities collectively spend $4bn over 2 years to create the same skin in the game investment incentive?

Like an honour/trust among thieves effect, which has the additional advantage of bringing forward the trust advantage to the network. Except, guess how much more expensive the bitcoin system is to uphold over 30 years? And the degree to which it loses trust over time as the number of entities defending the network is reduced.

Second, there’s the pirate or parasitic code factor. This is the understanding that there’s only so much rent extraction the system can tolerate before the productive element of society, which everyone depends on, is killed off.

Bitcoin’s way of limiting egregious rent extraction and thus preserving the host was via the introduction of the “proof of work” mining system.

Now, in ordinary circumstances, a “credits for work” money creation-system isn’t that irrational at all. You are, after all, distributing redemption coupons only to those who can prove they’ve done something useful with their time.

Except in bitcoin’s case it’s the quality and purpose of the work — assigning energy and processing power to securing an anonymised cash distribution platform — which has to be questioned.

You see, there’s a difference between banks knowingly granting units in exchange for growth creation (lending to SMEs, development, home construction etc) and bitcoin miners being granted units in exchange for anonymising and preserving negative value creation.

The former grants units in exchange for positive value while the latter grants units in exchange for negative value. One is constructive and wealth enhancing. The other is destructive and wealth reducing — not to mention exploitative.

My current view is that financial crises come about when too many negative value units outnumber positive value units in the economy, something that can happen when banks/governments abuse the trust associated with their privileged money creation position, grant credit to the wrong types of businesses and siphon/create too many negative value units for themselves.

In bitcoin’s case, the ability to create exploitative negative value currency which adds little to no value to society has always been capped at a fixed sum. This was necessary to earn the trust of the system. But since this still represents a free lunch, economic theory dictates the arbitrage must be closed out very quickly — especially if barriers to mining production are not high. In other words, it’s unlikely that the value of a bitcoin can be worth more than the energy it costs to produce it for very long.

If and when bitcoin is worth more than the energy it costs to produce it, you can be sure that’s either because someone else is subsidising that cost by overpaying for a bitcoin to their own detriment — an arbitrage that won’t last for long because energy will be expended to capture every bit of that overvaluation — or because competition in the market isn’t perfect.

On the latter point, the fact that the Chinese government indirectly subsidises the energy costs of Chinese miners gives these miners an unfair advantage — and ensures marketshare must flow to them as the lowest marginal cost producers.

The only way to disrupt that advantage in the west has been by investing x amount in the manufacture of high-tech chips to beat Chinese miners on processing power grounds. But that’s an investment that requires an upfront payment at someone’s expense (some level of deferred spending today).

All things being equal — unless you can persuade a naive third party to put up the funds and then deprive them of the fruits of that investment (by say using the mining equipment/chips to mine for yourself at a higher rate of profit, before delivering to the customers with a delay) — chances are, because of the way the Bitcoin difficulty system is structured to ensure the total rent extraction sum stays constant, the ultimate return on investment must remain zero in the long run.

This is because any incremental gain from producing bitcoins more quickly will be offset with a difficulty hike, which will in the initial phase drive out all miners producing with inferior technology and high energy costs but lead to just about break-even returns for both those with high energy costs but superior tech and those with low energy costs and inferior tech.

It is in other words a race to zero, akin to that being experienced in the oil market today.

At best, the introduction of new tech allows a miner to produce bitcoin quickly enough to return his investment or repay his debt. Can it allow him to make a profit? Only if the wider distribution of that technology is restricted or if the technology is secretly used in the first instance by those who didn’t actually fund it.