Why Bitcoin Shouldn’t Be Scaled: How Bitcoin Will Become A Commodity Money That Inspires Our Existing Financial System To Reach A Global Monetary Equilibrium Juice Follow May 19, 2017 · 15 min read

Introduction

In 2009 an anonymous persona that went by the name Satoshi Nakamoto released an open source software onto a mailing list. The proposal was innocent and as humble in its birth as its creator came across while leading community forum that developed the project. However 8 years later the project has grown far beyond its humble beginnings. Bitcoin has been gaining steadily on all world currencies (notably including the USD) for many years and now has more than a $30 billion dollar market cap. Bitcoin has a valuation against any traded currency in the world and has basically doubled its market cap in 2017. This writing proposes that bitcoin should be expected to become a new gold standard that will naturally bring our existing financial system into a monetary equilibrium exposing a new standard metric for value.

Bitcoin’s Civil War

Bitcoin is a secure solution for a p2p transferable e-cash with a predetermined supply. However it does have significant limitations. It’s most significant and noticeable limitation (especially from the user’s perspective) is that the bitcoin network can only handle ~3–7 transactions/second.

Nick Szabo has been writing about the history and evolution of economics for over 20 years. Some of his writing seeks to extend our understanding of how money might arise to a proto-age of economics. Other essays project the possibility of a future of money involving different forms of computational security. In his essay Money Block-Chains and Social Scalability Szabo explains:

In computer science there are fundamental security versus performance tradeoffs. Bitcoin’s automated integrity comes at high costs in its performance and resource usage. Nobody has discovered any way to greatly increase the computational scalability of the Bitcoin blockchain, for example its transaction throughput, and demonstrated that this improvement does not compromise Bitcoin’s security.

Bitcoin’s community is seemingly divided into two sides. On one side there is active developers, computer scientists, and enthusiasts that understand the importance of trading scalability of bitcoin for the greater good of the security of the system. On the other side of the argument there is a faction of users that are interested only in scaling bitcoin and often at the cost of different forms of security that preserve the integrity and security of the network.

The former group are generally argue for bitcoin as a store of value that would function much like gold has historically, whereas the latter argue for bitcoin as a coffee type money that would be cheap enough, and could handle enough transactions, to facilitate every individual’s daily needs.

Szabo goes on to explain exactly what the latter group has not taken the time to understand:

These necessary tradeoffs, sacrificing performance in order to achieve the security necessary for independent, seamlessly global, and automated integrity, mean that the Bitcoin blockchain itself cannot possibly come anywhere near Visa transaction-per-second numbers and maintain the automated integrity that creates its distinctive advantages versus these traditional financial systems.

The “Coffee-Money” group often quotes the first line from the whitepaper proposal that was written by Satoshi (who departed from the project in 2010 without a trace to his or her real identity) asserting bitcoin as a digital gold rather than a coffee money is not inline with the originally intended vision:

A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.

To the contrary, however, cash doesn’t have a standard perfectly defined definition. To some people cash refers to physical money whereas in other usage cash might simply refer to any transferable unit of account. Cash could also refer to “fiat” implying a government mandated currency. In regard to the first line of the bitcoin.pdf there is nothing in it to imply that bitcoin as a high value settlement system violates Satoshi intended vision or any generally accepted definition of an electronic version of cash.

In fact by the definition laid out by Tatsuaki Okamoto and Kazuo Ohta in their paper Universal Electronic Cash bitcoin, regardless of its tx/s limitation, perfectly fits the given definition of an ideal electronic cash:

What then is the ideal cash system? The criteria describing the ideal cash system are as follows: (a) independence: The security of electronic cash cannot depend on any physical condition. Then the cash can be transferred through networks. (b) Security: The ability to copy (reuse) and forget the cash must be prevented. © Privacy (Untraceability): The privacy of the user should be protected. That is, the relationship between the user and his purchases must be untraceable by anyone. (d) Off-line payment: When a user pay the electronic cash to a shop, the procedure between the user and the shop should be executed in an off-line manner. That is, the shop does not need to be linked to the host in user’s payment procedure. (e) Transferability: The cash can be transferred to other users. (f) Dividiability: One issued piece of cash worth value C (dollars) can be subdivided into many pieces such that each subdivided piece is worth any desired value less than C and the total value of all pieces is equivalent to C.

The “Coffee Money” group argues that if bitcoin’s tx/s is limited to the extent it is today then bitcoin will eventually cease to serve the average individual which will in turn make it worthless. This writing argues the opposite-scaling bitcoin to serve as an everyday money serves no purpose and therefore carries no value. Instead, if bitcoin’s current properties and limitations were preserved it might have a chance to serve greater role in the existing global financial system.

The latter group does not have the understanding of macroeconomics to understand how this might might happen or why it is significant. The rest of this writing explores this possible scenario.

Free Banking Versus Central Banking Theories

To understand the significance we must explore the relationship between central banking theory and free banking theory and the historical conflict between the proponents of each. Central banking, often cited as Keynesian based theory after John Maynard Keynes, functions on the belief that money should should be manipulated by a central authority in such a way that it is used to tend to the economic growth or recession of an economy or nation. The idea is that by increasing the money supply in times of recession a central bank can incite spending and infrastructure development spurring an economy to pull out of a recessive period.

Free banking theory believes the opposite is true, in fact economic philosophers such as FA Hayek can often be quoted as explaining that such manipulation of money supply is far more likely to be the cause of boom bust cycles than a cure for recessions. Hayek argues the belief that a central authority has enough information and foresight to understand and predict the nature of the underlying economy is in itself a “Fatal Conceit”.

Furthermore, as extensively demonstrated in a thought experiment by George Selgin an economy left to naturally govern its own money supply actually naturally evolves to protect itself from the disastrous conditions that central banking theorists wish to avoid (and free banking proponents believe that central banking theorists cause).

Selgin’s analogue explains that competition from a free market of banks and banking naturally serves to evolve the quality of banking and currency options the participants of the economy have access to ensuring optimal practices arise as they are favored by the general public who know have alternative options.

In regard to international economics the problem of central banking or the optimal supply of currency can be more complex, for example, as the Triffin Dilemma highlights there is a:

…conflict of economic interests that arises between short-term domestic and long-term international objectives for countries whose currencies serve as global reserve currencies.

Depending on the circumstances a nation such as the USA, that in recent times has supplied much of the world world with a de facto reserve currency, might have to manage conflicting interests in regard to the supply or quality of their respective currency.

Both perspectives of monetary theory basically agree that there exists an optimal relationship between the supply of a currency and the output of the underlying economy. Keynesians might then argue there must be a central supplier and controller of it whereas Free market theorists would argue the optimal supply comes about when there is not sole controlling agent but rather many competing currencies each with their own controlling agents.

Technology As The Resolution of Differing Monetary Theories: The End of A Monopoly

Whenever there is a long lasting debate between unresolvable viewpoints we might assume each has at least some merit and rather turn to a higher order perspective for resolution. From a historical perspective it might not seem so obvious how bitcoin could resolve the division between central banking and free banking theories but if it did we could understand why such division would be so strong and long lasting.

The implication would be that there is no other way around our the limitations of our current global financial system to a higher order but with the introduction of a certain technology. Few historical or present day economic philosophers seem to consider the possibility of the truth of this aside from John Nash who directly discusses this and Nick Szabo who seems to indirectly imply the truth of it.

The result of the resolution of the division of the two theories would be something like:

The introduction of bitcoin to our existing system, over time will allows different banks as currency suppliers to tend to their supply in a Keynesian style nature of central banking (without a monopoly).

The ending of the money printing monopoly is key here. In most countries it is explicitly stated that only the governments or central banks are allowed to create and supply money. Under the new paradigm banks still target certain rates with money supply controlling measures but they are also forced onto a stage of competition with other competing currencies.

The evolution of these circumstances beyond monopolistic controlled are explored not only by Selgin, but also most notably FA Hayek in The Denationalization of Money and John Nash in his essays and lectures entitled Ideal Money. Each of these philosophers come to the similar conclusion that system would self optimize with the premise that there is no monopolistic control over the supply of currency.

This premise is now reality as there is now currently more than hundreds of different electronic currencies like bitcoin that have a total market cap of over $60 billion up from about $1.5 billion in 2013.

Since bitcoin effectively provides the premise of these authors and proponents of a free banking system it can really said that no amount of arguing or insight otherwise could free us from the limitations of central banking. Much like the vast amount of man hours and economic evolution that need to go into the invention and production of a simple pencil, human civilization could not have designed and produced a catalyst to free market banking any sooner than it did.

From this view Keynesian theory is not at all insane or suppression like free banking theorists often suggest but rather is simply growing outdated and needs modification in the face of technological evolution. Free market banking also needs to be updated with the suggestion that there can be no such circumstances without a politically neutral technology or commodity such as bitcoin that breaks the monopoly on money supply.

What will be explained over the subsequent sections is that in effect Keynesian theory, with the introduction of bitcoin, produces a free banking market driven equilibrium.

Bitcoin’s Gold Like Properties

Most people tend to think gold is valuable because of its aesthetic qualities and its scarcity. But bitcoin is neither shiny or as scarce as people tend to believe. In his series of articles on mining the vast deep Szabo explains that there are political and technological limitations to our ability to mine metals whether deep in the ocean or in space. It’s very likely that we will soon begin to overcome these limitations which could have a dramatic effect on the supply and value of otherwise rare commodities such as gold. In Ideal Money Nash explains further:

It is a coincidental fact that the inherent nature of mining and mining technology makes it possible for the prices of certain commodities that are produced as a result of the devotion of labor and capital to the effort of mining to increase less (or decrease more) than might be expected. There is a “dimension paradox”: Agricultural products are produced by using the two-dimensional resource of the earth surface, so the “disappearing frontier” creates a limitation. In contrast, some mining, particularly for elemental metals, can essentially be done in three dimensions, although, of course, there are increasing costs for deep digging. So, really there is lots and lots of gold, silver, platinum, tungsten, and so forth out there and more can be found by digging deeper.

That is to say the scarcity of gold is really relative to the cost of production. In this sense gold has a natural throttle as the cost of producing it increases the deeper we dig. This makes gold’s supply effectively politically neutral and relatively predictable (to other commodities). This predictability makes gold a good candidate for a measure of value which is why historically it has been naturally arisen as a settlement standard between nations and civilizations.

Bitcoin has this quality too although its underlying mechanism for ensuring a predictable supply is slightly different. Using computers, bitcoin miners compete for a finite amount of bitcoins-a 21 million supply produced over a period of ~120 years. Starting at ~10.5 million for the first 4 years, bitcoins supply steadily decreases by half every 4 years. In order to mine bitcoins miners spend energy trying to solve computationally exhaustive problems. If bitcoin’s price skyrockets and mining profitability increases more miners would join the effort increasing the computing power of the network. The genius insight behind bitcoin is that the difficulty of the computationally hard problems is adjusted every 2 weeks to compensate for the increase or decrease in computing power of the network so that on average blocks take 10 minutes to be solved.

This automatic adjustment rule allows for the cost of production of bitcoin to be fairly predictable over time thus rendering its nature much like gold for the monetary reasons we covet it as a standard of value.

Asymptotically Ideal Money

I think of the possibility that a good sort of international currency might EVOLVE before the time when an official establishment might occur.~John Nash, Ideal Money

Most economists will immediately point out that bitcoin cannot actually be perfect money. Central banking and free banking theorists alike seem to agree that a money supply must fluctuate with the output and need of the underlying economy.

John Nash has a specific definition of Ideal Money is money which is stable in value (over a very long period of time). Such a money’s supply would also need to be manipulated to much its underlying economy and so bitcoin cannot meet John Nash’s definition of Ideal Money either. This leads us to Nash’s revision of Ideal Money:

So here is the possibility of “asymptotically ideal money”. Starting with the idea of value stabilization in relation to a domestic price index associated with the territory of one state, beyond that there is the natural and logical concept of internationally based value comparisons. The currencies being compared, like now the euro, the dollar, the yen, the pound, the swiss franc, the swedish kronor, etc. can be viewed with critical eyes by their users and by those who maybe have the option of whether or not or how to use one of them. This can lead to pressure for good quality and consequently for a lessened rate of inflationary depreciation in value.~Ideal Money

By breaking the monopoly on money supply and inciting the circumstances and events as laid about by George Selgin in his treatise on free banking theory, bitcoin would inspire the asymptotic evolution of Ideal Money, which would ultimately lead to what Selgin refers to as a monetary equilibrium (synonymous with John Nash concept of Ideal Money).

It’s notable to point out that such events would only unfold if the internationally accessible currency (ie bitcoin) introduced had the gold like qualities that cause the markets to favor it as a standard of value as Nash alluded to:

I think of the possibility that a good sort of international currency might EVOLVE before the time when an official establishment might occur. To be quite respectable, in a Gresham-advised sense, money needs only to be AS GOOD as other material commodities that might be hoarded.~Ideal Money

If bitcoin was to serve as the catalyst for this event then its gold like qualities must be preserved which specifically refers to the preservation of its long term value proposition

Interestingly a US congressional report on bitcoin serves to perfectly highlight the relevance of bitcoin to the visions of Nash and Selgin:

…if the scale of use were to grow substantially larger, there could be reason for some concern. Conceptually, Bitcoin could have an impact on the conduct of monetary policy to the extent that it would (1) substantially affect the quantity of money or (2) influence the velocity (rate of circulation) of money through the economy by reducing the demand for dollars. … if the increase in the use of Bitcoin leads to a decrease in need for holding dollars, it would increase the dollar’s velocity of circulation and tend to increase the money supply associated with any given amount of base money (currency in circulation plus bank reserves held with the Fed). In this case, for the Fed to maintain the same degree of monetary accommodation, it would need to undertake a compensating tightening of monetary policy.

Considering Bitcoin With No Other Utility Than Serving As A Settlement/Commodity Money

Bitcoin, as a digital gold, would arise to become a settlement layer for large banks, nations, and meta-players in the global economy. George Selgin refers to this as a commodity money, which is still valued but not often (but still can be!) used by individuals of the general public. Hal Finney seems to be the first vocal proponent for bitcoin to fulfill this purpose:

Bitcoin itself cannot scale to have every single financial transaction in the world be broadcast to everyone and included in the block chain. There needs to be a secondary level of payment systems which is lighter weight and more efficient. Likewise, the time needed for Bitcoin transactions to finalize will be impractical for medium to large value purchases. Bitcoin backed banks will solve these problems. They can work like banks did before nationalization of currency. Different banks can have different policies, some more aggressive, some more conservative. Some would be fractional reserve while others may be 100% Bitcoin backed. Interest rates may vary. Cash from some banks may trade at a discount to that from others. George Selgin has worked out the theory of competitive free banking in detail, and he argues that such a system would be stable, inflation resistant and self-regulating. I believe this will be the ultimate fate of Bitcoin, to be the “high-powered money” that serves as a reserve currency for banks that issue their own digital cash. Most Bitcoin transactions will occur between banks, to settle net transfers. Bitcoin transactions by private individuals will be as rare as… well, as Bitcoin based purchases are today.

There is one further consideration in regard to the possibility that bitcoin could play the role of a digital gold and become a new standard of value for our global financial system. Selgin points out that eventually freebanking will naturally evolve to become so efficient that some or much of the commodity money used for high level settlement will no longer be needed for such use which in turn frees it up to be used for other possible applications. If bitcoin, for example, replaced gold’s monetary role this would free gold up for other uses (ie space exploration technology). This highlights a relationship between the different possible utilities a chosen commodity money could have or could evolve to have and the value proposition attached to it.

In other words if a commodity money begins to evolve to have more (or less) uses, or a society develops alternative uses for the commodity the changes would alter the value proposition.

This suggests if bitcoin is to serve as a digital gold or value standard which would bring the global financial system into order then it would be optimal for it to have no other utilities and for as many of its current limitations and parameters to be set in stone for all time.

A small note this is true only for the currency but not necessarily for the block-chain ledger history of transactions which might have many application that won’t necessarily affect the underlying value proposition.

Interestingly bitcoin has evolved its own internal settlement layer that functions much like the higher level clearing houses as describe by Selgin in Ruritania. When the transaction capacity of bitcoin is reached the overflow of transactions are pooled in what is called the mempool. In order to choose which transactions are to be put through first they are order by user paid fees associated with the transaction.

Proponents of bitcoin as a “coffee money” argue this is not for the average user as it suggests over time bitcoin’s “fee market” will increase the cost of a transaction to the point where it is too costly for the average individual.

Those educated in economic theory, especially as described by Adam Smith, would understand a fee market to be the fairest, most moral, most efficient, and most valuable way to determine who values the transaction space the most. Hayek would also likely agree as much of his thesis suggests that only the markets can optimally price and distribute commodities-there is no better mechanism.

Bitcoin’s mempool is a perfect microeconomic example of how bitcoin would function as a settlement layer for high value participants in our global economy.

Conclusion

Bitcoin’s community is said to be in a state of turmoil and unending debate. But sometimes unending conflict is really ultimately the sign of a need for technological progress which is far easier to understand in hindsight rather than foresight. Those that are arguing bitcoin should be scaled at all costs lest it become irrelevant are not at all considering economics and especially the macroeconomic implication of bitcoin as a commodity money which would serve as a settlement layer for nations and central banks for our existing legacy financial system.

If bitcoin’s properties as a gold are preserved then we should expect it to arise as a strong standard of value which will incite the existing nationally produced fiats to asymptotically gravitate towards what George Selgin calls a monetary equilibrium and which John Nash calls Ideal Money.

This equilibrium suggests there is in fact a ceiling for quality of money which Nash defines as being stable in value over a very long period of time. The birth of such an equilibrium will expose an underlying and otherwise inaccessible concept signaling the arrival of a new metric-a unit value which this writing proposes to be called a “Nash”.