A currency has three important functions. It provides a medium for exchange, a measure for the cost of goods, and a store of value. It is one of the most important technologies ever invented and like all technologies might be improved. It is also a matter of intense public concern, because the power over money brings with it immense political power.
The computational revolution is bidding to transform our relation to money by replacing fiat money with a digital currency. Fiat money consists of token issued by the government, like the dollar. Its success depends on trust in the government to maintain the currency as a stable store of value. But governments face political temptations to debase the currency for political ends. Just ask people in Argentina how well the peso has operated as a store of value. Even the dollar has dramatically fallen in value, as in the inflation of the 1970s. Moreover, fiat currencies of today often impose substantial transactions costs in the process of exchange. Banks make substantial profits from these transactions.
Thus, a stable currency outside of the control of the state without substantial transaction costs might well both make the economy more efficient and limit the power of government. It could be a wonder of the modern world. That is the potential promise of a digital currency—a form of money that is created and exchanged in cyberspace. The most famous such currency is Bitcoin and Nathaniel Popper has written a superb book, Digital Gold, chronicling its birth and wild rise. In the next post, I will review the book, which has a cast of characters to rival the most improbable of picaresque novels.
But first a short and necessarily simplified summary of the complex mechanics of Bitcoin: Bitcoin is the brainchild of Satoshi Nakomoto, a figure himself still shrouded in mystery. Nakomoto figured out how to solve the greatest problem with a digital currency—how to determine who possessed it without relying on any central authority, because any single authority would be difficult to trust. His brilliant idea was to link the creation of the currency to verifying transactions in the currency. To simplify: When someone wants to transfer Bitcoin to another person he sends the Bitcoin from his digital wallet (a kind of encrypted computer file) to the other person’s digital wallet. The digital wallets are identified by public keys, but the sender can release the Bitcoin by a private key known only to him. The transaction is then broadcast publicly so it can be verified in way that everyone can know that the sender has the private key but cannot see the actual key. The verification process requires the solving of complex computer equations that are linked to the particular transaction. Through solving the equations with computers individuals called “miners” can then verify that the transaction. For those who want more detail than possible in a brief post, please consult this excellent primer on Bitcoin.
The miner who most likely verifies the transaction by adding it to the “block chain” (a public ledger) of all Bitcoin transactions, and gets paid in Bitcoins for his work. Other miners agree by essentially majority vote as measured by computation power which miner has triumphed. Thus, the creation of new currency is linked to the process of verifying it. In other words, the process itself gives incentives to deploy the substantial computer processing that keeps the system going and is so large that it cannot be taken over by any single person.
The computer program that creates the currency determines the amount of payments and indeed reduces the amount of payment overtime. The program assures that the total number of Bitcoin available will asymptotically approach 21 million as the payment for verifying transactions is reduced.
Thus, Bitcoin is fascinating concept. It is a technology of pure law, where the law is the algorithm devised by its founder. Unlike the Federal Reserve or other central banks, there is no human discretion to vary the money supply for political or other reasons. The supply is even more fixed than gold, because gold is a commodity subject to the vagaries of physical mining. In a subsequent post, we will consider the prospects of a technology of pure law also becoming one of liberty.