The question is how and why does Bitcoin work? Well, there are many answers to this question, ranging from a number of areas of interest. I’ll leave the computer science to those more qualified than me and instead I’m going to talk about an equally fun and exciting topic: the economics of Bitcoin.

The Times, 03/Jan/2009

Let’s start from the beginning, or rather, the genesis. As many of you may already know, the genesis block contains a symbolic message. Satoshi Nakamoto added to the coinbase parameter this text ‘The Times 03/Jan/2009 Chancellor on brink of second bailout for banks’.

The message isn’t just a timestamp to prove the creation date, but also a comment on the financial system, fiat currencies and fractional-reserve banking. It’s pretty clear that Nakamoto held libertarian views, which is, at least partly, the reason why the monetary policy of Bitcoin has been structured the way we know today.

Bitcoin has a controlled supply. For each block added to the blockchain,the miner is rewarded with a set number of bitcoins. This figure decreases by 50% every 210,000 blocks, which translates in 4 years more or less. The algorithm of this decreasing-supply simulates the rate at which commodities like gold are mined. The first 4-year period saw the creation of 10.5 million BTC, then the reward was halved a first time and second time, without modifying any other metric. The current block reward is 12,5 BTC. The continuation of this algorithm will trend towards the logarithmic limit of 21 million.

The supply is set to grow gradually up to a terminal point. The growth rate cannot be manipulated and it’s predictable by all market participants. The fixed monetary base is one of the most important features of Bitcoin. Its deflationary nature has drawn the attention of many critics (mostly keynesian economists). Keep in mind that these are the same ‘experts’ who believe that the national debt doesn’t matter because ‘we owe it to ourselves’.

Their argument is that deflation is bad for the economy because it incentivises individuals and businesses to save money instead of investing in businesses and creating jobs. This conclusion has no economic reasoning whatsoever.

When deflation occurs, all stages of production are affected, which means that profit ratios stay the same. It’s true that goods and services have a lower price, but the cost of producing them decreases proportionally as well. Real economic variables are not affected by the quantity of money. What effectively changes is the distribution of wealth, while the aggregate wealth of the population remains unchanged. With that being said, deflation can lead to certain benefits as opposed to the known flaws of inflation in the current economic scheme.

‘’Deflation puts a brake — at the very least a temporary brake — on the further concentration and consolidation of power in the hands of the federal government and in particular in the executive branch. It dampens the growth of the welfare state, if it does not lead to its outright implosion. In short, deflation is at least potentially a great liberating force. It not only brings the inflated monetary system back to rock bottom, it brings the entire society back in touch with the real world, because it destroys the economic basis of the social engineers, spin doctors, and brain washers.[…] If our purpose is to maintain and — where necessary — to restore, a free society, then deflation is the only acceptable monetary policy.’’

This quote comes from Deflation and Liberty, by Jörg Guido Hülsmann available for free at https://mises.org/library/deflation-and-liberty-1. The book, a short and sweet 50-page monograph, was written in 2003, 6 years before the creation of Bitcoin. I want to include some of the most important points made by the author, senior fellow of the Mises Institute, in order to show the environment in which Bitcoin economics are to be taken into consideration.

Paper money has caused an unprecedented increase of debt on all levels: government, corporate, and individual. It has financed the growth of the state on all levels, federal, state, and local. It thus has become the technical foundation for the totalitarian menace of our days. […]Most economists point out the costs of inflation in terms of loss of purchasing power — estimates run as high as a 98 percent reduction of the U.S. dollar’s purchasing power since the Federal Reserve took control of the money supply.

Inflation is an unjustifiable redistribution of income in favor of those who receive the new money and money titles first, and to the detriment of those who receive them last. In practice the redistribution always works out in favor of the fiat-money producers themselves (whom we misleadingly call “central banks”) and of their partners in the banking sector and at the stock exchange. And of course inflation works out to the advantage of governments and their closest allies in the business world. Inflation is the vehicle through which these individuals and groups enrich themselves, unjustifiably, at the expense of the citizenry at large. If there is any truth to the socialist caricature of capitalism — an economic system that exploits the poor to the benefit of the rich — then this caricature holds true for a capitalist system strangulated by inflation.

Check out this video to understand how the Federal Reserve creates new currency, what treasury bonds are and why this ‘system’ will backfire.

And because it shields the political and economic establishment of the country from the competition emanating from the rest of society, inflation puts a brake on social mobility. The rich stay rich (longer) and the poor stay poor (longer) than they would in a free society. It would not be uncharitable to characterize inflation as a large-scale rip-off, in favor of the politically well-connected few, and to the detriment of the politically destitute masses. It always goes in hand with the concentration of political power in the hands of those who are privileged to own a banking license and of those who control the production of the monopoly paper money. It promotes endless debts, puts society at the mercy of “monetary authorities” such as central banks, and to that extent entails moral corruption of society.

One of the most important argument made in the book is that the production of money, in a free society, must be competitive, which means that everyone who wishes to can take part in the process can do so. It also needs to be the product of free association. Everyone must benefit from the production of money without violating the property rights of others. We can safely say that fiat currencies do not meet these conditions, but Bitcoin does.