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January 13, 2019

Cryptocurrency: The Bitcoin Standard

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“Money is the information and measurement system of an economy, and sound money is what allows trade, investment, and entrepreneurship to proceed on a solid basis, whereas unsound money throws these processes into disarray.The Bitcoin Standard by @Saifedean

Money is our most important social asset. Without money, there would be no incentives to create, innovate and excel.  Throughout history, we have seen empires rise and fall based on their ability to translate their system of currency into a prosperous medium of exchange, both locally and globally.  At times when citizens lose faith in a given currency, chaos ensues and has even led once prosperous nations into the Darks Ages of feudalism.  That’s why this post will be an analysis of money through the lens of Bitcoin, the polarizing cryptocurrency that got the world’s attention with it’s infamous runup to $20,000 per coin in December 2017.  Using the Bitcoin Standard by @Saifedean for historical context, we will go deep into the philosophical tenets that underpin the cryptocurrency and extrapolate back to the real world to understand why it could be so relevant in the future.

From the Collapse of Rome to the Belle Époque

To gain context as to why Bitcoin is relevant in the modern day and why it could become more relevant in the future, it is good to take a look at the basics of monetary history, dating back to the Roman Empire, and how the rise and fall of certain empires correlated to their respective currencies.

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New York Public Library

Gold and silver functioned for millennia, dating back to the days of the Roman Empire,  as the main currency vectors: a store of value (principally gold) and a medium of exchange (principally silver).

“The denarius was the silver coin that traded at the time of the Roman Republic, containing 3.9 grams of silver, while gold became the most valuable money in the civilized ares of the world at the time and gold coins were becoming more widespread. Julius Caesar, the last dictator of the Roman Republic, created the aureus coin, which contained around 8 grams of gold and was widely accepted across Europe and the Mediterranean.” (pg 25, Roman Golden Age and Decline)”

Rome’s decline, and eventual collapse in 476 AD, began during the reign of the infamous Nero emperor who began ‘coin clipping,’ reducing the amount of gold and silver in the currencies and thereby devaluing the currencies and reducing the purchasing power of the people.  Caracalla (AD 211-217) and Diocletian (AD 284-305) continued the devaluation process and began instituting price controls and tax increases to try and maintain the perception of strength; however, this approach backfired:

“As taxes increased and inflation made price controls unworkable, the urbanites of the cities started fleeing to empty plots of lands where they could at least have a chance of living in self-sufficiency, where the lack of income spared them having to pay taxes.” (pg. 27, Roman Golden Age and Decline)

Roman-Civil-War-aureus-Salvus Roman-Civil-War-denarius-Vesta

Armstrong Economics

While Rome burned to the ground, Constantine the Great moved east and established Constantinopole at the meeting point of Asia and Europe, birthing the bezant and the Byzantium Empire.

“While Rome burned under bankrupt emperors who could no longer afford to pay their soldiers as their currencies collapsed, Constantinopole thrived and prospered for many more centuries with fiscal and monetary responsibility” (pg. 28 Byzantium and the Bezant)

After the economic and military collapse of the Roman Empire, feudalism emerged.  Gold became concentrated in the hands of feudal lords, and citizens of Rome became serfs. Copper and bronze coins began to circulate, but carried no value.  A Dark Age ensued, as wealth generated across generations was destroyed; however, these conditions eventually gave way to the Renaissance, which began in Florence in 1252:

“Florence’s rise made it the commercial centre of Europe, with its florin becoming the prime European medium of exchange, allowing banks to flourish across the entire continent. Venice was the first to follow Florence’s example with its minting of the ducat, of the same specifications as the florin, in 1270, and by the end of the fourteenth century more than 150 European cities and states had minted coins of the same specifications as the florin” (pg 30, The Renaissance)

The Renaissance became known as one of the most prolific creative and artistic periods in human history, giving way to the creation of new economic models, philosophical models, and the cultural rebirth of the Italian city-states.

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The revolutionary trajectory of money as a medium of exchange would continue to advance with technological breakthroughs in communications (the telegraph) and transportation (trains), making it easier for banks to communicate and to transact without having to move physical coins. In fact, it was in Italy where the system of double-entry accounting was invented.  Bills, checks, and receipts began to replace physical coins.

Advances in economics and monetary policy led to the creation of the first gold-standard currency in 1717 by the British, and a major revolution in the trajectory of money as a store of value:

“The economic supremacy of Britain was intricately linked to to its being on a superior monetary standard, and other European countries began to follow it. The end of the Napoleonic wars heralded the beginning of the golden age of Europe, as, one by one, the major European nations began adopting the gold standard.” (pg. 31 The Renaissance)

Wars in the 19th century further influenced money, with a boom for gold-backed European paper currencies (ie. the British Pound, the German Deutschmark) leading to the decline of silver-backed, coin-based currencies:

“India finally switched from silver to gold in 1898, while China and Hong Kong were the last economies in the world to abandon the silver standard in 1935.” (pg. 32, The Renaissance)

From the end of the Franco-Prussian War in 1871 until the early 1900s, the world enjoyed a peaceful and prosperous era known as La Belle Époque in Europe or The Gilded Era in the US.   We will look more deeply into the tumultuous events of the 20th century that led us on our path to where we are today in relation to currency, economics, and monetary policy.

Armed with even a brief monetary history dating back to the Roman Empire, we can see that monetary policy and the conditions surrounding its issuance, use and tradeability have been key factors in the rise and fall of nations.

Central Banking and Bitcoin

We can see what the anecdotes above from “The Bitcoin Standard” have to do with monetary history, but the question is, what does that have to do with Bitcoin?

 

“Bitcoin is a secure peer-to-peer (P2P) digital payments protocol that allows two groups to transact across a decentralized network using the Bitcoin token and requiring no intermediaries. “

Bitcoin is a partially a technological innovation involving miners, mathematics, and of course the infamous blockchain (more on that below). It is also partially a social innovation around currency, behavioral incentives, and consumer psychology. As a result, its design is deeply rooted in monetary theory, economics, and philosophy. Ancient history and modern financial events (the GFC in 2008) forged both Bitcoin’s intent and design.

Launched in 2008 by the still-unknown Satoshi Nakomoto, Bitcoin mixes technology with monetary policy, creating a new type of asset never before seen in human history – a decentralized cryptocurrency.  While for some Bitcoin is a currency, others a commodity, and others a type of crypto-equity, it is best encapsulated as a piece of open-source, secure software for banking and commerce.  Except that on this piece of software, the rules are hard-coded, no transaction can be censored or reviewed, and the value is derived from the network of decentralized nodes, not from any State or institution’s seal of approval.  Bitcoin matters because it is the antithesis to Central Banking, where the State prints billions of dollars in a black hole and distributes it to citizens via the banks as debt.  Bitcoin is a cryptographic ledger that moves ‘money’ into circulation via a mathematical algorithm and meritocratic rewards system (Proof of Work), creating a rebel paradigm for money as we know it today.

Embedded in the psyching of the ‘bitcoin maximalists’ – Bitcoin most ardent proponents who believe Bitcoin will become the dominant Cryptocurrency standard – is Austrian economics.  The philosophical origin of Austrian economics dates back to the late 1800s’ and the German Historical School, in an era that followed the Austro-Prussian War.  Prominent Austrian economists in the 20th century include Freidrich Hayek, and Ludwig von Mises, and are generally seen as pro-free market, pro-individual property rights, anti-Central Bank, and anti-inflationary currencies.

“As the founder of the “neo-Austrian School” of economics, Mises’s business cycle theory, which blamed inflation and depressions on inflationary bank credit encouraged by Central Banks, was adopted by most younger economists in England in the early 1930s as the best explanation of the Great Depression.” Ludwig Von Mises

hayek

Foundation for Economic Education

It is the above context that underpins Bitcoin’s structure and philosophical leanings.  The currency is anti-inflationary, with only 21 million bitcoins ever to be ‘mined’ on a sliding scale. Approximately 17 million bitcoins have been mined so far, with the last Bitcoin expected to be mined by 2140.  Along with hard-coded rules into the algorithm behind Bitcoin that prevent any centralized tampering or policy changes, Bitcoin is essentially a modern experiment in Austrian Economics.

This is in direct contrast to the current model of monetary policy and Central Banking, which is based on Keynesian Economics.  Keynesian economics was created by British economist John Maynard Keynes who came to prominence after the First World War with his objections to the Treaty of Versailles, which demanded German reparations payments for the War and essentially crippled the German state through the 20s and ultimately led to the rise of Hitler and the Nazi party.  Keynes rose during the Great Depression and 1930s as a critic of the Gold Standard, due to his beliefs that it limited the power of the State to print money, thus limiting the State’s ability to intervene during periods of economic recession and reignite the economy.  Since monetary and fiscal policy in the US, UK and Europe was ineffectual during the late 20s and early 30s, Keynes core theory was modeled around increased taxation (to raise government revenues) and monetary inflation to prevent hoarding, a major problem in that era:

“Keynes challenged a key free-market principle that saving is always good because it provides the money for investing in businesses. Keynes agreed saving was a good idea during normal economic conditions. But he argued that it hurt the economy in a depression. If people hoard their cash in a depression, he said, they will obviously spend less. This only worsens “effective demand” and feeds into the downward economic spiral.” Constitutional Rights Foundation

Keynes

Foundation for Economic Education

Keynes theories paved the way for a new era of government economic policy, underpinned by deficits, state intervention in the economy, taxation, and inflationary monetary policy.  Keynes was influential in economic policy in the 1930s, and 40s, including the Bretton Woods agreement to make the US Dollar the global reserve currency backed by gold.  He died in 1946, yet Keynesian economics became the dominant view for government policy for decades to come; however, these theories lie in diametrical opposition to the views held by Austrian economists such as Hayek:

“Keynes’ chief opponent was Friedrich A. Hayek, an Austrian free-market economist and harsh critic of socialism. Hayek rejected Keynes’ argument for massive government spending to end a depression. Instead, Hayek called for individuals to save more, directly contradicting Keynes’ “paradox of thrift.” Saving more, Hayek argued, would enable greater private investment in business.” Constitutional Rights Foundation

Thus, when looking back at the history of the Gold Standard and major boom/bust cycles in the global economy, we can see that Bitcoin, as a modern experiment in Austrian economics, has both philosophical and technological elements that must be considered when analyzing the potential for a Bitcoin Standard in the future.

A large part of Bitcoin’s value, at least for maximalists, is attributed to the cryptocurrency’s scarcity and the embedded philosophical principles of Austrian economics.  Many attribute a currency’s value mainly to its backing by the State, and the acceptance of it by all entities within the State as legal tender; yet we have seen in the history laid out above that this doesn’t always correlate to a strong currency that holds its value over time.  For those who have lived in a stable economic environment for their entire life, like the USA or Canada, this is hard to fathom.  But for those who live in countries where a currency has been massively devalued (ie. Argentina) or in some cases completely destroyed (ie. Venezuela), these ideals do carry relevance over the next century as we begin to debate the possibilities of a Bitcoin Standard.

1870-1971

From the Gold Standard to The Bitcoin Standard?

Will Bitcoin become the next Gold Standard?

Probably not.

But at this point in time, amidst the upcoming chaos in global bond and currency markets, both the technological and philosophical tenets that underpin Bitcoin as a rebel paradigm will become more and more relevant, even if we don’t end up with Bitcoin playing any role in the inevitable shift towards a new global currency.

Before getting into what a few of those key future roles Bitcoin may play in influencing the direction of the global economy, let’s take a look at the basics of the technological innovations that shaped it into the first decentralized payments network.

As mentioned above, Bitcoin is built on a blockchain, a term that has become synonymous with ‘decentralized ledger’ and ‘tokens.’  But in regards to Bitcoin specifically, you can’t divorce the unit of account (Bitcoin the currency) from the bitcoin blockchain.  A blockchain is literally a chain of blocks, but the bitcoin network brought new innovations to make all transactions both traceable and immutable (unalterable), while at the same time preventing the notorious double-spend problem.  Here are a few design features that allowed that to happen,

  • Hashing is a mathematical proof function that allows data inputs for all transactions (timestamp, transacting parties, transaction size, etc) to be published as uniform ‘hashed’ outputs onto the blockchain. All miners perform the hashing function, which is somewhat complicated to explain mathematically, that leads to the publishing of the global transaction data for a given time period onto the blockchain. In essence, hashing is the stamp of approval; the first miner to correctly publish the correct hash (generated from a series of random numbers) receives a bitcoin reward (currently 12.5BTC) and the block gets published;
  • Miner Consensus is achieved for the block to be hashed.  In order for data to be verified as ‘true’ by the bitcoin blockchain, miners must reach a consensus on the transactions that were published.  Because of the Proof of Work system, where miners use expensive computer power to verify transactions in exchange for the potential to win block rewards and generate transaction fees, they are all incentivized to publish true data.  Once the ledger is validated, it is published onto the (publicly viewable) bitcoin blockchain in a specific block, which is generated every ~10 mins;
  • Tamperproof Security is achieved by nodes, whose only job is to validate transaction data.  The only way for someone to alter the transaction history would be to take over more than 51% of the network of nodes, something that would be very difficult to achieve. As a result of this structure, double spending is nearly impossible on Bitcoin; nobody can lie and send the same X Bitcoin to multiple parties while claiming they only used it once. This innovation was what helped make Bitcoin the first prominent form of digital cash even though other initiatives had launched before it.

Blockchain4

+ Blockchain and Digital Currency

The value of these innovations cannot be overstated.  Combined, they bring the potential to revolutionize payment networks and money. These are elements in a payment network that have never been possible before Bitcoin. They have led to the creation of a 1000+ copycat coins, commercial banks creating their own blockchains, and now Central Banks and the IMF are talking about creating their own State-backed cryptocurrencies. So why couldn’t one of these other cryptocurrencies become The Standard?

Because they are not Bitcoin. Many of the copycat coins are in fact securities, as they were pre-mined and given in large quantities to the founding teams. Anything that is created by commercial banks or Central Banks will be subject to their arbitrary terms of censorship, ‘flexible’ inflation policy, and potentially rollbacks (ie. hard forks). What makes Bitcoin stand alone is its hard-coded rules and decentralized governance structure. Even though Bitcoin mining is relatively concentrated, a small group influence the direction of Core protocol development, and trading is subject to manipulation by ‘whales,’ Bitcoin still operates in a spontaneous order. Comparatively, it is a large step forward from the current state of affairs and provides real-world insights into the complexities of behavioral economics, rather than just theory.

The chances of the Bitcoin Standard becoming the new Gold Standard are minuscule. But the very existence of Bitcoin as a rebel paradigm and its continued growth as a decentralized peer-to-peer payments network will continue to fuel R&D into new monetary and economic models. That fuel will undoubtedly lead to new protocols and standards that merge modern technology with traditional economics to unleash what we really need in the upcoming decades, a global economic, cultural, and social Renaissance.
 
 

In the event that Bitcoin becomes a mere memory in the upcoming decades, here are three areas that it could help the global economy in the years ahead:

  • as a hedge against Government Fiat Currencies that are collapsing, like the Venezuelan Bolivar. The more the Bitcoin infrastructure develops, the more efficient that Bitcoin becomes as a type of digital gold; valuable, moveable, and convertible into any currency. This could help many move from an unstable fiat currency into Bitcoin, or from their unstable currency to Bitcoin to more a stable fiat currency (like USD) in places where that is otherwise impossible;
  • as a hedge against a Bond Market Blowout. As bond markets seem likely to blow out in the years ahead, effectively making certain sovereign bonds worthless, that money will have to travel somewhere. Bitcoin becomes valuable as a hedge because it is perceived as a non-Government commodity/currency whose relevancy is likely to increase as confidence in sovereign bond and currencies decreases;
  • as a Merchant Payment Network outside of Visa/MasterCard/SiliconValley that won’t censor individuals based on political beliefs and alliances. In heavily polarized political regions, this could become increasingly relevant, ensuring economic sustenance for people or groups that are targeted by more powerful groups.
 
None of this is to argue price, but rather utility. Hedging against tail-risk outcomes is considered utility, but that doesn’t always correlate to price increases.
 

Simply put, there are too many permutations and what-ifs to predict Bitcoins ultimate destiny. But its relevance will likely remain high in many for years to come, and the underlying innovations under the hood of Bitcoin will pave the way to future innovations that will likely revolutionize commerce and money worldwide.

 

 

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