One of my New Year's Resolutions is to learn more about crytocurrencies like Bitcoin and blog about them occasionally.
Let's start off with Paul Krugman,
Nobel Prize-winning Economist Paul Krugman on Tax Reform, Trump, and Bitcoin Business Insider 12/15/2017. The section about bitcoin comes in the latter part of the video. But Jacqui Frank et al have provided us the transcript of that section, PAUL KRUGMAN: Bitcoin is a more obvious bubble than housing was
Business Insider 12/15/2017:
Josh Barro: Finally, I want to ask you about Bitcoin. Does the runup in bitcoin prices make any sense to you?
Paul Krugman: No.
Barro: What's going on here?
Krugman: Bitcoin, nobody understands it. Which is for the time being a positive. It comes with this -
Barro: A positive for the prices?
Krugman: For the price of it. It's got this mystique about it, because it's some fancy technological thing that nobody really understands. There's been no demonstration yet that it actually is helpful in conducting economic transactions. There's no anchor for its value. You know, unlike pieces of paper with dead presidents on them, those are anchored by the fact that you can use them to pay taxes. There's not anchor for bitcoin. But bitcoin has developed this mystique. The price is going up, partly, it's tied up with Libertarian stuff ... I'm told that there are apocalyptic, the-end-is-coming guys who are accumulating bitcoin because once we turn into a Mad Max wasteland, having a digitally distributed – nevermind. So ... I think it really doesn't make a whole lot of sense. And the psychology of it is clearly — if you're using the shoeshine boy test, my barber asked me about bitcoin. The feeling that people are caught up in something that they really don't understand, is overwhelming. [my emphasis in italics]
Krugman succinctly introduces several important aspects about Bitcoin right there. Investing in it is a pure gamble. It's not an actual currency in that it's not backed by anything, except in this case by pure faith in speculation itself. It's a techie thing. And nobody really understands it in a comprehensive way because it's new and complicated. And it has advocates who indulge in the most discredited kinds of "libertarian" economic ideology. Oh, and investing your money in it at this point is basically a pure gambling operation.
Scientific American for January includes three articles on cryptocurrency under the rubric, "The Future of Money":
- Alexander Lipton and Alex "Sandy" Pentland, "Breaking the Bank"
- John Pavlus, "The World Bicoin Created"
- Natalie Smolenski, "The Evolution of Trust"
Blätter 2017:12 carried two articles giving some basics of Bitcoin, under the general title "Bitcoin: Der gefährliche Hype" ("Bicoin: The dangerous hype"):
Justin Kirkland has a helpful guide,
Okay, Here's What You Actually Need to Know About Bitcoin Esquire 12/27/2017.
And Roula Khalaf uses the Bitcoin craze to do a little millennial-bashing, an unwholesome current habit of people who are annoyed at growing older, in
A bitcoin bubble made in millennial heaven Financial Times 01/10/2018.
What is Bitcoin? A cryptocurrency. Like any currency, it acts as a medium of exchange and a store of value.
What is a cryptocurrency? Here a brief descdription from a sidebar to Pavlus's article: "A form of digital currency that relies on the mathematics of cryptography to control how and when units of the currency are created and to ensure secure transfer of funds." It uses encryption and is based on the blockchain technology.
What is a blockchain? It's a software platform that uses various separate computers to create a "distributed ledger." It provides a way of validating information in a way that is not dependent on a central institution such as a single corporation or a central bank. Blockchain technology is not used only for cryptocurrencies. Pavlus discusses its current use by governments, universities, financial institutions and individuals, and its potential for far more widespead use for self-driving vehicles, medical data handling, and creating a multiple-node "global supercomputer" function. Blockchain systems are used for many other things than cryptocurrenies, though the latter may be the best known at this point, though not necessarily the most important.
But Bitcoin and other current cryptocurrencies are based on blockchain technology. As Pavlus puts it, "What people call 'blockchain' is a technology that makes Bitcoin possible — an infrastructure that can be used for tracking many types of transactions. Blockchain technology exists without Bitcoin — but not the reverse. Think of Bitcoin as a kind of application that runs 'on' the blockchain, much like Web sites run on the Internet."
William Mougayar in
The Business Blockchain: Promise, Practice and Application of the next Internet Technology (2016) defines a cryptocurrrency based on the blockchain is characterized in particular by four aspects:
- Peer-to-peer electronic transactions and interactions
- Without financial institutions
- Cryptographic proof instead of central trust
- Put trust in the network instead of in a central institution
Kirkland notes that Bitcoin "was invented to be unhackable, untraceable, and safe for investors."
Unlike normal currencies, Bitcoin is not backed by a store of material stuff like gold nor by the full faith and credit of a government, like national currencies and the euro. That's what Krugman means when he says that Bitcoin has "no anchor for its value." It's based essentially on faith. It has values in facilitating trade or transmission of values from one person to another because other people accept it and all participants have some level of faith that other users will continue to accept it as having value. We might call it a faith-based currency.
Rudolf Hickel describes it this way, "The one and only thing that counts is the trust in each digital curreny." ("Einzig und allein das Vertrauen in die jeweilige Digitalwährung zählt.")
Khalaf writes, "One person ventured that blockchain was the casino and bitcoin the chips — an apt description since investing in cryptocurrencies is very much like gambling."
A cryptocurrency could be tied to a hard asset or basket of assets. Lipton and Pentland distinguish between a Bitcoin-type peer-to-peer network and what they call "peer-to-peer Tradecoin network." They write, "As with Bitcoin, transactions would be made directly between users and are publicly recorded in a blockchain. But consensus is maintained by designated validators. Tradecoin’s value is backed by real assets supplied by sponsors, so its price is relatively stable." Tradecoin is the name they use for a project of theirs at MIT. They describe its basic concept this way: "it will be indelibly logged on a blockchain and anchored at all times to a basket of real-world assets such as crops, energy or minerals."
But here is where economics raises questions. Once a cryptocurrency is anchored in this way, it would then present the risk that if it were used on a wide enough scale to have macroeconomic effects, it could wind up having the same kind of negative effects that the gold standard had in Europe during the Great Depression, or that the euro had in the "periphery" countries of the eurozone in the Great Recession, or that the dollar peg had in Argentina in the 2001 financial crisis there.
So it's not at all clear to me what the advantage of cryptocurrency on a large scale would be compared to national currencies backed by the legal "full faith and credit" of their governments or to the current digital banking and payment systems.
Security is one big feature that cryptocurrency advocates tout. Pavlus notes, "Some experts say that a cryptocurrency like Bitcoin has value because of its security (the Bitcoin blockchain has never been hacked—yet)."
Still, that security is based on faith in the blockchain network. The idea is that because there are so many nodes in the peer-to-peer network that hacks on one or several of them would not be able to override the verification mechanism. If that doesn't sound entirely reassuring after over a year of hype about Russian hackers, there really is good reason for reservations. For one thing, other cyptocurrencies have been hacked, as Pavlus explains, "... even coins with impressive technical bona fides can be risky. The DAO—a “decentralized autonomous organization” running on Ethereum that raised over $100 million in 2016 — "had a bug" (in [MIT's Christian] Catalini’s understated terms) that allowed hackers to make off with $50 million worth of Ether," another cryptocurrency.
A $50 million hack sounds like quite a security gap! Especially since it apparently represented 50% of the total value of the Ether cryptocurrency. Pavlus quotes Gün Sirer of Cornell advising that peer-to-peer validation structure runs on the “assumption that a majority of nodes in their network are benign,” i.e., operating with integrity according to the rule of the blockchain. Bitcoin does not rely on encryption for security, it relies as the distributed ledger that the nodes constitute.
And it's worth paying close attention to what is being discussed when we heard that "Bitcoin" hasn't been hacked. It's one thing to say that the Bitcoin blockchain itself has not been hacked. But to buy Bitcoins in the first places, users have to rely on accessory software applications. Natalie Smolenski advises:
The application layer is where untold confusion and often outright bad faith can reign. The history of Bitcoin, for example, is littered with cryptocurrency exchanges and wallet providers who left gaping security flaws in their applications, leading to high-profile hacks and accusations of embezzlement. In the case of the Ethereum network, vulnerabilities have resulted in the theft or loss of millions of dollars in its Ether cryptocurrency, with virtually no recourse for users. In general, using any application built by a trusted third party to hold your blockchain-based digital assets is still a highly insecure proposition.
This is the crux of blockchain’s catch-22: the public won’t use blockchains without user-friendly applications. But user-friendly applications often achieve that ease through centralization, which replicates the conditions of control that blockchains sought to circumvent. [my emphasis]
And that centralization provides a more convenient point of attack for hackers than the widely distributed peer-to-peer network of the blockchain itself.
And Hickel writes, "In August 2016 alone, hackers stole Bitcoins with a market value of 58 million euros." ("Allein im August 2016 haben Hacker Bitcoins mit einem Marktwert von 58 Mio. Euro gestohlen.") Presumably these were stolen from the ancillary applications that aren't part of the the Bitcoin
blockchain but are in reality a integral part of the process of acquiring and using Bitcoins. Daniel Leisegang provides some additional details:
Nicht die (Noten-)Banken, sondern die technischen Strukturen sollen also das Vertrauen in die Digitalwährung begründen. Dieses Versprechen ist jedoch überaus zweifelhaft. Denn in den vergangenen Jahren verloren zahlreiche Bitcoin-Nutzerinnen und -Nutzer Millionen an Euro – unter anderem, weil Cyberkriminelle Programmierfehler ausnutzten. So wurde im August 2016 die Bitcoin-Börse Bitfinex gehackt und um rund 58 Mio. Euro erleichtert. Bereits gut zwei Jahre zuvor – im Februar 2014 – vermeldete die in Tokio ansässige Handelsplattform Mt. Gox den Diebstahl von Bitcoins im Wert von damals 480 Mio. Euro. Als das Unternehmen kurz darauf Konkurs anmeldete, verloren die Nutzer ihr dort noch verbliebenes Geld endgültig.
[Not the (cash-) banks but rather the technical structures should be the basis of trust in the digital currencies. Nevertheless, this promise is very much doubtful. Because in past years, numerous Bitcoin users lost millions of euros - among other things, because cyber-criminals exploited program flaws. So in August 2016, the Bitcoin stock market Bitfinex was hacked and around 50 million euros were lifted. Already two years earlier - in Feburary 2014 - the Tokyo-based trading platform Mt. Gox reported the theft of Bitcoins valued at 480 million euros. When the businesspeople shortly thereafter filed for bankruptcy, the users ultimately lost their money remaining there.]
The economics behind the whole thing are pretty shaky. Some libertarians were enthusiastic about cryptocurrencies because it seemed to be in line with their free-market faith and offered the possibility of a currency independent of governments. The possibility of using them to evade taxes and otherwise break the law might possibly contribute to their enthusiasm. And since libertarians often seem to be goldbugs, the possible similar functions of cryptocurrencies to the gold standard may be part of the attraction.
Bitcoin isn't based on any material standard or government guarantee. But it does have built-in limits to the number of Bitcoins that can be created.
And how are they created? The process is called "mining." Yes, mining. The "miners" have to set up new Bitcoins through a complex process of calculation and verification within the Bitcoin blockchain. Leisegang writes, New Bitcoins have, because of that [the complex creation process] come to be generated almost exclusively in giant commercial computer centers - the so-called
Mining Pools. ("Neue Bitcoins werden daher inzwischen fast ausschließlich in riesigen, kommerziellen Rechenzentren generiert – den sogenannten
Mining Pools.")
If you are wondering how that affects the libertarian goal of a decentralized currency, you're asking the right kind of question. According to Leisegang, four large mining organizations are doing around 70% of the Bitcoin mining. This kind of concentration offers easier opportunities for theft or hacking.
Aside from monopoly power, the mining process also uses a surprisingly large amount of energy power. As Leisegand explains, this is part of the reason that more than half of the Bitcoins are mined in China, which has relatively cheap power available. (China is reportedly putting new restrictions on the use of Bitcoin.)
Bitcoin also has restrictions built in that limits each round of Bitcoin mining to a smaller number of Bitcoins than the preceding one. Which means that eventually, the mining process hits a limit at which no more Bitcoins could be created. And that kind of restriction on the available currency units could have a similar effect to the same kind of limitation imposed by the gold standard. Lipton and Pentland explain:
[Bitcoin] also has serious logistical constraints. For example, the number of transactions that can be handled per second is approximately seven, compared with the 2,000 on average handled by Visa. It’s an energy suck, too: mining — the process by which nodes of the cryptocurrency network compete to securely add new transactions to the blockchain—depends on a huge amount of electricity. In high energy-cost countries, miners go bust if they cannot afford the utility bills for the computing power. While exact numbers are not known, it is believed that Bitcoin consumes as much electricity as eBay, Facebook and Google combined. [my emphasis]
Frances Coppola has been a critic and skeptic of the Bitcoin craze. She states her perspective succinctly in the following tweet. The "Lightning" to which she refers is another kind of software solution that aspires to allow Bitcoin to overcome some of its current limitations:
She discusses the Lightning network in more detail in
Probability for geeks Coppola Comment 01/09/2018.
