The end of this month (31 October 2018) will mark the 10th anniversary of the online posting of the now-famous white paper by “Satoshi Nakamoto” outlining the concept of “Bitcoin: A Peer-to-Peer Electronic Cash System.” This is an opportune occasion to compare what Bitcoin has achieved with what Satoshi wanted to achieve. While Bitcoin’s rise to a market valuation of over $100 billion is certainly a remarkable accomplishment of one sort, the founder had other aims.
Three problems with the status quo
In announcing the new project in February 2009 Satoshi emphasized three institutional problems with the status quo payment system that Bitcoin would address. First, inflation from central banks that issue fiat money:
The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.
Second, a lack of privacy and security from commercial banks:
We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.
Third, the high cost of bank-mediated payments:
Their massive overhead costs make micropayments impossible.
How well has Bitcoin addressed these three problems?
Inflation risk and purchasing power volatility
Satoshi wanted to create a currency with less risk of inflation and devaluation. It is of course true that the history of fiat currencies is full of breaches of trust in purchasing-power stability. Central banks issuing fiat money have chronically, and sometime acutely, diluted the value of their currencies by expanding them too rapidly. Bitcoin’s source code, which predetermines the quantity path of the stock of Bitcoins, does solve that problem. There can be no unexpectedly rapid expansion. This code provides a valuable object lesson in how to write a constitutional monetary rule that is fully automatic and free from discretion.
However, Bitcoin’s fixed quantity path creates a different problem that inhibits its widespread use as currency. With the number of Bitcoins unresponsive to demand shifts, all the burden of adjustment falls on the price (purchasing power). As a result the market price of Bitcoin is enormously volatile week-to-week and even day-to-day. This makes it very risky to hold or accept BTC as a payment medium for monthly bills that are denominated in anything other than BTC (e.g. in US dollars, other fiat currencies, or commodity index baskets).
Satoshi recognized that demand growth would cause secularly rising value, but said little about the problem of high-frequency volatility of value. He did not design Bitcoin to have an automatically demand-responsive supply, because he did not know how to do it without creating the need for a trusted authority:
[I]ndeed there is nobody to act as central bank or federal reserve to adjust the money supply as the population of users grows. That would have required a trusted party to determine the value, because I don’t know a way for software to know the real world value of things. If there was some clever way, or if we wanted to trust someone to actively manage the money supply to peg it to something, the rules could have been programmed for that.
What Satoshi didn’t know how to do is still not known. The desirability of a stable-valued cryptocurrency has, however, has stimulated dozens of “stablecoin” projects in recent years. There are two main types: (a) coin supply managed by an “algorithmic central bank” that automatically (given a data feed) varies quantity to stabilize purchasing power, and (b) coin supply made endogenous by pegging the coin to a relatively stable fiat currency, to gold, or to a commodity basket. A recent report on “The State of Stablecoins” has identified 57 projects, of which 23 are up and running. Tether USD, imperfectly pegged to the US dollar, is by far the largest of the live projects. Of the 57, twelve use the “algorithmic central bank” approach, the remainder being “asset-backed” either by fiat currency collateral or by cryptoassets. The problem remains unsolved of feeding a program with real-world data in a tamperproof way, or of running a currency peg without any risk to customers from dishonesty or incompetence by the party holding the reserves.
Satoshi suggested—somewhat inaccurately—that Bitcoin would behave like gold under a gold standard:
In this sense, it’s more typical of a precious metal. Instead of the supply changing to keep the value the same, the supply is predetermined and the value changes.
In fact, as I have noted before, the classical gold standard system provided a great deal of long-run elasticity to the quantity of money. A rising purchasing power of gold incentivized the owners of existing mines to dig deeper and increase their output, and encouraged prospectors to seek new sources of gold. The accumulation of increased gold flow over time pushed the purchasing power back to its nearly flat long-run trend. The gold standard thereby historically constrained the inflation rate to near zero in the long term.
F. A. Hayek’s vision of competing non-commodity private monies imagined that issuers would maintain purchasing power stability by actively managing supply. A new project called Initiative Q takes basically this approach: not a cryptocurrency governed by a program, but a private non-commodity money whose quantity is governed by a human board that pledges to stabilize its purchasing power. Full disclosure: I have been a paid consultant on this project.
Satoshi anticipated a feature of Bitcoin’s fixed supply path that has played an important role in its enormous appreciation, and in its high volatility:
As the number of users grows, the value per coin increases. It has the potential for a positive feedback loop; as users increase, the value goes up, which could attract more users to take advantage of the increasing value.
In this way attracting speculators who want an appreciating store of value (and don’t care much about short-term volatility) is at root incompatible with attracting potential currency-users who want short-term value predictability. Having attracted speculative “hodlers,” it is harder to expand the set of Bitcoin users much beyond them.
Retail use of Bitcoin remains small, from all available indicators. The largest BTC retail payment processor, Bitpay, reported in October 2017 that its merchants are receiving “$110 M+ in bitcoin payments per month,” which multiplies out to $1.32 billion per year. For comparison, VISA reported in June 2018 an annual payment volume of $11 trillion, or $11,000 billion.
Coinmap.org lists 13,365 brick-and-mortar Bitcoin acceptance points worldwide, which is of course a tiny subset of retail establishments. Checking the map for Fairfax County, VA, I find that there are only seven sellers of goods and services listed, plus another 7 Bitcoin ATMs.
Satoshi wanted to create a payment system with greater privacy. Bitcoin does enable users to send funds outside the financial panopticon that is the regulated banking system, where “Know Your Customer” and “Anti- Money Laundering” edicts require banks to surveil customer account use and report certain kinds of activity. This escape hatch has allowed ordinary people to protect their wealth from restrictions such as exchange controls and from confiscatory taxes. For example, Bitcoin became suddenly popular in Cyprus when the government imposed controls on international bank transfers and proposed to take 10 percent of bank balances during a banking crisis in 2013.
However, the way Bitcoin’s distributed ledger system shares addresses and size information about every transaction provides less privacy than would a design sharing less information. Bitcoin is not anonymous, only pseudonymous, and the pseudonyms can be pierced. This shortcoming has inspired a number of “privacycoin” projects. The best known live projects are Monero, Dash, and Zcash (for head-to-head contrasts of these and three others see here). Two interesting up-and-coming projects, using a newer-generation blockchain technology called MimbleWimble, are Beam and Grin.
As far as making micropayments at negligible cost, the Bitcoin blockchain has turned out to be infeasible for doing so. It becomes quickly congested as it approaches the modest volume of 7 transactions per second. This technological limitation was discussed by insiders (Hal Finney, Nick Szabo) as early as 2010, but did not come to wider attention until massive congestion arose with Bitcoin’s expansion in popularity in 2017, bringing a sharp rise in fees for moving your transaction to the front of the queue. Developers are now working on “sidechains” for small payments—most famously the Lightning Network—that will settle only periodically on the main BTC blockchain. So there may be a technical workaround retaining the Bitcoin standard. The MimbleWimble projects represent another approach: because their blockchains are designed to transmit much less information among miners, they should not only provide greater privacy, but also handle many more transactions per second.
Bitcoin should not be regarded as the last word in private money, but should be appreciated as a remarkable technological breakthrough. Ten years after its launch, we must recognize it as the innovation that has launched financial and non-financial blockchain industries that are still in their early days. Bitcoin has established its value as an asset, and its usefulness as a medium of exchange for a certain subset of transactions. It is the main unit of account and payment medium, preferred to fiat monies, for markets in other cryptocurrencies below the top five. Whether it will achieve common use as a medium of exchange remains doubtful. The inbuilt volatility of its purchasing power makes it unlikely to displace the incumbent fiat currencies barring an inflationary explosion. Even in that case, gold seems likely to prove more popular. Whether a credible stablecoin built on Bitcoin’s shoulders, or some completely different approach, will achieve critical mass as a private money remains to be seen.