Monday 17 December 2012

the economics of avoiding real resource consumption in cryptocurrency mining

Readers of this blog might be interested in my proposed alternative to the "proof of work" mining system that currently underpins Bitcoin. I call it "proof of burn". Its motive is to avoid the consumption of real resources (hardware, electricity,...) which proof of work entails. It nevertheless feels, to an individual miner, just as "expensive" as real resource consumption would be.

        Bitcoin Wiki article: "Proof of burn"

The question an economist should immediately feel like asking, on hearing this, is: OK, if those real resources have not been consumed (destroyed); and yet they've disappeared from the portfolios of miners just as if they had been consumed; then... who's receiving them?! And the fascinating answer (discussed in the "Economic implications" section of the Wiki article) is: they go to all coin-holders, in proportion to holding. In other words, a proof-of-burn cryptocurrency is something like a decentralised joint-stock company! (The coins are like "shares", yielding a stream of "dividends"!)

I believe this curious fact has the potential to strengthen cryptocurrency by increasing its value to holders. They not only get the benefits of a teleportable, unseizable, undilutable asset - benefits already widely known about and discussed - but the additional, more "traditional" benefit of whatever they estimate the discounted future value to be, of [their appropriate fractional share of...] all the future fees arriving into the hands of miners! (Minus, of course, the true competitive-equilibrium costs to miners [including profit as risk-aversion "cost"] of mining's various supporting activities. Maintaining a net connection, checking blocks and transactions are valid... that sort of thing.) I call this a "traditional" sort of benefit because it's just like putting a value on a company's shares by estimating its flow of future profits. It can be enjoyed even by coin-holders who aren't particularly interested in holding cryptocurrency qua cryptocurrency. (They just follow the "spend your dividend on a treat" strategy I discuss in the article.)

This strengthening of value is not "magic" - it's not "coming from nowhere" - it's coming from precisely the fact that real resource consumption/destruction (as would have happened under proof of work) is being avoided. And the coin-holding community reaps the benefits!

A final note: the same sort of thing happens under at least the leading versions of proof of stake too. But there, coin holders have to become miners themselves to get their flow of "dividends". Now, maybe that's a good thing in some ways: many people worry that in the future, there might be too few miners. It does mean, though, that non-expert coin-holders (i.e. non-miners) can't enjoy the benefit; and in my opinion, that probably means the strengthening of value will be less. At any rate, there's lots here for economists to think about!

Sunday 16 December 2012

What am I doing here?

Let me tell you something about me. I want to explain why I started this blog and what I intend to do with it.

My primary goal is not to persuade others. I just want to find the truth. I want to understand. I'm a selfish persistent bastard who will continue hammering on others disagreeing with me on things that interest me. I will go at great lengths to try to reach a conclusion, i.e. that either them or me admit they were wrong. Because contradictions cannot exist. I can go on for years.

Somehow, as a side effect though, it looks like if I am sufficiently vocal about it, I end up persuading others. I've been commenting about Bitcoin on various places, among other things on I've been researching Bitcoin for about 1.5 years, and I presented some of my findings at the London Bitcoin conference in September this year. Imagine my surprise when later that day another attendee approached me in a bar and told me that because of my comments on, he "converted" to Bitcoin. I had never met him before or even knew he existed.

So it looks like the market magic works. It transforms individual vices into a public good. My research of Bitcoin can, I believe, help people understand, just like it helped me to understand.

Last month, a part of my research ended up in my master's thesis. Some of you might have already downloaded it. I didn't have yet time to clean it up, I was rushing the deadline and there are some typos and various minor errors, and I have problems converting it into mobi. If you can hold on for a day or two, I will clean it up and make it available for download in multiple formats. It is a proper scholarly work, including quotations, a lot of empirical analyses and so on, and I try to explain Bitcoin to economists. I take a heavy Austrian approach in the theoretical part and I think it will help Austrian economists understand Bitcoin and why it is important. I also address some of the things that were mentioned in comments to my earlier posts.  Those who already read the original won't have to re-download, it will be just a cleanup, there won't be any real content changes.

Stephan Kinsella, with whom I discussed a lot of Bitcoin and IP-related topics and early drafts of my thesis, liked my thesis and recommended me to Jeffrey Tucker, the executive editor of Laissez Faire Books (and formerly heavily involved with the Mises Institute and the website). So, after a chat with Jeffrey, I'm also working on a more mainstream publication about Bitcoin that is not so heavy on science/economics, and LFB will publish it. So you guys have a lot to look forward to.

In addition to these two publications, there are a lot of topics that I thought a lot about, related to Bitcoin, money and property rights, and that don't fit into either publication. So far I have been posting all over the internet at comments to zillions of websites. I think that gathering everything under one umbrella, this website, might be better.

And that, ladies and gentlemen, is my motivation for this blog. Condemn me or praise me, but please take my arguments seriously.

Saturday 15 December 2012

Response to Philip Pilkington on Deflation

Philip Pilkington made a post criticising the idea that price deflation is if not beneficial, then at least non-neutral from economic point of view:
This post was also reposted by Michel Bauwens with respect to his objections to Bitcoin.

It is a rehash of old fallacies, and I believed others addressed them, however I want to present a more point by point rebuttal. Before however I address the points individually, I would like to explain the three core fallacies that Pilkington makes and are typical for the proponents of inflation.

  1. The first is the assumption that money is the only liquid asset. This is not true. First of all, there are foreign monies, which are also at the top of the liquidity scale, and there are financial instruments (e.g. company shares) and some commodities (e.g. precious metals) which have a high level of liquidity too.
  2. The second is the assumption that money is capital. This is also not true. Money is information about the availability and distribution of capital, but not capital itself. Capital are the heterogeneous capital goods available on the market, which can be used for production processes. Money cannot be consumed in either a consumption or production process (even for commodity monies the industrial demand is typical a small proportion of the whole demand), nor is it a necessary component of any such process. Rather money is a decentralised method for coordinating production and consumption.
  3. The third is the conflation of cyclical changes in the quantity of money (credit cycle) with secular decreases in the price level (money with an inelastic supply) by calling both of them "deflation".

The first argument Pilkington makes is that free market leads to concentration of power. It could not be more wrong with respect to money. We now live in a system of central banking, where the state intervention all but finalised the central planning of money. The production of money through market has been subverted and taken over by the state-banking cartel. Attempts to create money privately are penalised and in the extreme case made illegal (e.g. the case of Bernard von Nothaus or e-gold).

Then Pilkington argues that the position of advocates of deflation has an emotional and not a rational basis, and that it plays on the hoarding impulse. This is based on the fallacy one. If people want to hoard, they do not need to do so using money. They can just as well hoard other liquid assets that have a less elastic supply (e.g. gold), irrespective of whether gold is or is not money. So the argument fails. Unless, of course, the state decides to confiscate these assets too. In that case, the argument is a double fail.

Pilkington also makes the argument that hoarding is not saving. This is based on the fallacy two, that money is capital. By hoarding, the capital available in the economy is unchanged, there will merely be a downward pressure on the prices.

Then he makes the claim that according to the proponents of deflation, the malinvestments are somehow "unjust", again avoiding the economic fundamentals. The malinvestments are merely disequilibria between the availability of resources and the preferences of the consumers. These are obscured by the increases in the money supply. Eventually, the disequilibrium manifests itself through a price changes, or in the extreme hypothetical case, the capital goods are consumed and people will starve to death.

Injecting new money into the economy does not affect the availability of capital goods in the economy. It only changes our evaluation of these goods, by making it appear that some productions methods are profitable, even though in real terms they are not. The "stimulus" that occurs after an injection does not mean that a productive use for the capital has been found, rather that unproductive uses were made to appear as if they were productive. It's a trick.

Then he claims that in a deflationary period resources will remain unused. This is the fallacy 3, conflating of the bust period of the credit cycle with a steady long term behaviour. The best rebuttal of this argument I know of is presented by Vladímir Krupa in his semestral thesis about a falling price level. Allow me to quote/translate:
From the point of view of profitability of businesses it is irrelevant whether the overall price level falls, rises or stagnates, as long as the businessmen are able to correctly predict future prices. If they are able to predict the prices, the real profitability will in reality be the same irrespective of the direction of the movement of the price level. [emphasis added]
In a system with an inelastic money supply (e.g. a system based on gold with fractional reserve banking banned, or a system like Bitcoin where due to its low transaction costs it is unlikely that credit will be treated as a part of the money supply), people will be accustomed to a falling price level, and will arrange their business plans accordingly. A system with a credit cycle will suffer from unpredictable changes in the prices though. But even then, the contraction must stop at the latest when the banks reach 100% reserves.

Altogether the article of Pilkington has no economic foundation, and rather mixes various ideological objections with a random selection of historical data.

Thursday 13 December 2012

Response to Hülsmann & Hoppe from PFS 2012 Q&A session day two

Professors Hülsmann and Hoppe answer a question from the audience about Bitcoin around 32 minutes into the video here:

This is a quick response to them.

Hülsmann argues:
"It's anticipated in the system that under some circumstances you can create more units. So somebody is authorised. Because if you don't, if you just keep the current supply, then you get a very very strong price deflation as soon as Bitcoins spread. So somebody must be authorised to create more I suppose. So somebody has the keys to the whole thing, so which reason do we have to trust those keymasters more then minters of gold coins?"
First of all, the production function of Bitcoin is defined as an approximately geometric convergent series. An attempt to produce Bitcoins without fitting into this schema does not, by definition, produce Bitcoins, similarly as creating an atom which does not have 79 protons in the nucleus does not, by definition, produce gold. One might be tricked into thinking that something which does not (entirely) consist of atoms with 79 protons in the nucleus is gold, because it is prohibitively expensive to verify the number of protons in all the atoms of a physical object the size used for transactions, but this is an empirical problem (and for gold could be solved by nanotechnology as Robert A. Freitas argues). From a practical point of view, this problem does not occur with Bitcoin, as the verification is done by computers and from the perspective of a Bitcoin user is automatic. The blockchain lists all the produced bitcoins and is publicly available for anyone to verify, again, by definition. An attempt to create Bitcoins outside of the specification would be akin to an attempt to inject new characters to the English alphabet, let's say the "ü". It's evident for anyone that is familiar with the English language that "ü" is outside of the specification and they do not need to worry that someone will fiendishly inject it into the alphabet, screwing up their command of English.

So noone is, by definition, allowed to create Bitcoins outside of specification. The only thing that can happen is a creation of an incompatible blockchain fork, i.e. the creation of a new wannabe currency.

Hülsmann also commits a non-sequitur fallacy. It does not follow that price deflation allows to create new Bitcoins. Maybe Hülsmann is used to how it works with gold and assumes that if the market price rises above production costs, this increases the production rate. But Bitcoin does not work like that. The global production rate is, apart from minor statistical fluctuations, predefined. An increase in the production intensity does not result in an increase of the amount of the bitcoins produced, rather it raises the production costs. The production function of Bitcoin is less elastic than that of gold. The result is that marginal production costs follow the market price. I want to do a proper analysis comparing the marginal production costs and the market price to demonstrate this, but for the time being, only visual comparison is available by checking out the graphs provided by and

Empirical data shows that since the emergence of price of Bitcoin until now, it has appreciated by a factor of about 17,600 (from about 1/1,309.03 USD to about 13.51 USD at the time of writing), without any problems in the production function. Just about two weeks ago, the first block reward adjustment occurred and everything worked according to the specification.

Hoppe argues:
"I always ask people 'Can you explain to me quickly what Bitcoins are?'. And then I typically get such complicated answers that I think 'who in the world would ever want to hold something that a decently intelligent person like myself cannot understand?'"
This sounds intuitive, but it actually is not necessarily true. For starters, at the most generic level, Bitcoin is just a clearing system controlled by cryptography, combined with an internal inelastic production function. It's as if gold miners through the act of mining gold also provided clearing functionality. And indeed, Bitcoin as specie provides many functions that historically required money substitutes, and from economic point of view this is the most relevant aspect. I don't think at that level it is too complicated to understand (maybe it's complicated to explain).

On the other hand, gold, for example, is defined by the number of protons in the atomic nucleus. But people did not even know about protons until about a hundred years ago. That did not prevent them from using gold as money. I bet that professor Hoppe does not understand the details of valence, chemical or nuclear reactions to a significant extent. If someone started explaining gold to him from this scientific point of view, he might be confused just as he is about Bitcoin.