Lyn Alden's Broken Money: The Best Bits
My review of the latest Bitcoin book
Lyn Alden recently published her book Broken Money. I first came across her couple of years ago when she wrote an article critiquing proof-of-stake and explaining Bitcoin's advantages. Back then I used to like Ethereum too but reading her article made me understand why Satoshi picked Proof-of-Work for Bitcoin. This spurred me to delve deeper into her new book.
Broken Money spans from the emergence of early forms of money among hunting tribes to the modern rise of cryptocurrencies. One key takeaway illustrates how transporting physical gold was painfully slow for most of history. This vulnerability allowed paper bank notes to eventually overtake gold in the 19th century, as paper money could utilize the new telegraph system to rapidly move value long distances. Bitcoin later addressed this Achilles heel of gold by inventing a digitally native "hard money" that can be transmitted instantly around the world by design.
This is the only time in history where, on a global scale, a weaker money won out in terms of adoption over a harder money. And it occurred because telecommunication systems introduced speed as a new variable into the competition. Gold, with its inherently slow speed of transport and authentication, couldn’t compete with the pound, the dollar, and other top fiat currencies with their combination of speed and convenience, despite gold being in scarcer supply. The combination of legal tender laws, taxation authority, and greater speed has allowed fiat currencies to outcompete their slower but scarcer precious metal counterparts all over the world in terms of usage. This mismatch or gap in speed has been a foundational reason for the greater and greater levels of financialization that the world has seen over the past century and a half. Monetary ledgers became increasingly detached from any sort of natural constraint or scarce units of settlement, because the only scarce monetary alternatives such as gold were too slow to present a complete alternative.
Birth of Bitcoin
After reading her book, I decided to make one change to my fictional novel about Satoshi Nakamoto. I realized it would enrich the story to include a failed attempt by Satoshi's roommate Julian to build an electronic version of gold-backed money (eGold) before Bitcoin. This would illustrate for readers why digitizing gold itself wasn't revolutionary enough. Satoshi HAD to invent a fully digital currency.
I highly recommend Broken Money to anyone curious about the compounding economic evolutions that set the stage for Bitcoin's entrance. Alden manages to humanize broad historical trends around currency, lending unique insight into both the drawbacks of past forms of money as well as the special attributes that make Bitcoin a candidate for the world's next global money.
Here are my highlights from this book:
These Federal Reserve decisions affect the monetary conditions for 330 million Americans and billions of people in foreign countries and yet are made manually and subjectively by a group of just twelve people.
I contend that the rise of populism throughout the United States, Europe, and several developing countries ever since the 2008 global financial crisis is in large part due to this fact. People on both the left and the right of the political spectrum can sense that something is wrong, that things are “rigged” against them, but can’t quite put their finger on why. A big piece of the puzzle is that the financial system as we know it isn’t working anymore.
My goal for writing this book is to help people better understand how money works, and why the global financial system is not functioning as well as it used to. The book is not just about why our financial system is not working well this year or this decade, but rather it is a deeper analysis of what money is, how we got to where we are now, and what the current foundational problems are.
Sumerian is the oldest known type of writing in existence, and the oldest known instances of Sumerian writing were clay ledgers that kept track of commodities. They showed pictures of various commodities and had dots next to them that represented quantities. In other words, the first ideas that humans are known to have written down with their early proto-scripts were lists of ownership, credit, or transactions.
Early in the famous movie The Godfather, a man asks Vito the mob boss for a favor, and Vito agrees to do it for him. The price Vito asks for in return, rather than money, is an unspecified favor sometime in the future. In other words, he wants flexible social credit. This is because this man needs something from Vito, Vito needs absolutely nothing from this man now, and yet Vito knows the man and recognizes that the man is part of his wider community. Vito is in the business of collecting favors and then calling them in when it is advantageous to him. Later in the movie, Vito indeed calls in the favor; he develops a need that this man is uniquely suited to provide, and it was a need that Vito didn’t have early in the movie. Vito’s story is of a man who tries to maximize his family’s relational wealth by maintaining an extensive ledger of favors, with these favors serving as a form of credit-based currency in the mob’s shadow economy.
In the study mentioned previously — “Wealth Transmission and Inequality Among Hunter-Gatherers” — the researchers noted that moveable property was usually individually owned in hunter-gatherer societies, while land tended to be more communally owned.
Gold miners add about 1.5% new gold to the estimated existing above-ground gold supply each year, and unlike most other commodities, most of the gold does not get consumed; it gets repeatedly melted and stored in various shapes and places.
Gold does not rot, rust, or corrode as readily as most other materials do. It is chemically inert and therefore barely forms any compounds. It can be re-melted countless times and can even be dissolved in certain types of acid and then filtered back out. It can be blown up and scattered, but those pieces don’t rust into nothingness like other materials would, and therefore the pieces are retrievable. Other than trace amounts that are thrown out in electronic circuit boards or sunk to the bottom of the ocean in shipwrecks, most gold ever mined is still in human control (and even those lost gold amounts are technically retrievable, at the right price). It’s practically indestructible.
Humanity has gotten better at mining gold with new technologies, but it’s inherently rare and we’ve already tapped into the easiest surface deposits. Only the deep and hard-to-reach deposits remain, which acts like an ongoing difficulty adjustment against our technological progress. One day we might eventually break this cycle with drone-based asteroid mining or deep-sea mining or some similar science fiction level of technology, but until that day comes, gold retains its high stock-to-flow ratio. Those environments are so inhospitable that the expense to acquire gold there would likely be extremely high.
People could deposit their gold into banks and receive paper credit representing redeemable claims on that gold. Banks, knowing that not everyone would redeem their gold at once, went ahead and issued more claims than the gold they held, beginning the practice of fractional reserve banking.
Within any society that uses a form of commodity money, the prior chapters showcased how it is nature that controls the ledger. Nature sets the boundaries for how hard the money is to make, and thus how resistant it is to debasement. Among participants that are of relatively equal technological development, nobody can cheat the ledger. Everyone must expend similar types of work to create new units of the money.
However, when an industrialized society encounters a pre-industrialized society, the industrialized society effectively controls the ledger of the pre-industrialized society. They have the technological capability to dilute the commodity money that the pre-industrialized society uses, whereas the reverse isn’t true. The understanding of this capability takes time to spread through the pre-industrialized society, which unfortunately gives the industrialized society time to exploit the pre-industrialized society for their valuable resources.
When one ape picks insects off the back of another, and then they reverse positions to reciprocate, that represents a very short-term form of debt and credit.
To remain in power, rulers seek to strengthen their political position, placate their subjects, and smooth over problems that inevitably arise throughout their reign.
The Book of Deuteronomy allows the charging of interest on foreigners but not to fellow Israelites.
In a free market, bankers will naturally compete for market share by charging different levels of fees. And inevitably, bankers will realize that most of the gold never gets withdrawn at once, and instead it just sits there. Imagine, for example, a banker who realizes that in the past ten years of running a full reserve bank, the biggest aggregate withdrawal that he ever had by customers was 40% of the gold at once. He therefore decides that if he has at least 80% of the depositors’ gold on hand, then he should be more than safe. He could put the other 20% of the gold to work by lending it out carefully for interest, earn some profits by doing so, and therefore offer a zero-fee service — which will allow his bank to collect far more deposits. He has invented fractional reserve banking.
A fractional reserve banking system is like a game of musical chairs; it functions for a while but if something ever stops the music, it can all fall apart quickly.
A centralized and globally interconnected banking system with a monopoly on fast long-distance transfers of value became too powerful and convenient for gold to keep up with, even if gold could still make for better private savings. The introduction of credit cards in the 1950s, e-commerce in the 1990s, and smartphone-based payments in the 2010s further cemented the importance of fast telecommunication-based payments.
This is the only time in history where, on a global scale, a weaker money won out in terms of adoption over a harder money. And it occurred because telecommunication systems introduced speed as a new variable into the competition. Gold, with its inherently slow speed of transport and authentication, couldn’t compete with the pound, the dollar, and other top fiat currencies with their combination of speed and convenience, despite gold being in scarcer supply. The combination of legal tender laws, taxation authority, and greater speed has allowed fiat currencies to outcompete their slower but scarcer precious metal counterparts all over the world in terms of usage. This mismatch or gap in speed has been a foundational reason for the greater and greater levels of financialization that the world has seen over the past century and a half. Monetary ledgers became increasingly detached from any sort of natural constraint or scarce units of settlement, because the only scarce monetary alternatives such as gold were too slow to present a complete alternative.
Out of nearly 200 countries in the world as of this writing, none of them use a gold standard. Switzerland was the longest remaining country on a gold standard, having dropped their gold standard in 1999. In most of the world it was gone far earlier during the 20th century. Something that existed in the past but does not exist anywhere in the present likely has a lack of fitness. The gold standard’s weak incentive structure along with the slow speed of gold itself hasn’t allowed the gold standard to exist in any form in the modern era. It became too easy for every country in the world to discard it, and so they did. And to the extent that people want to hold more scarce forms of illiquid savings than currencies, they now turn to real estate or corporate equities more-so than they turn to gold.
If we were to run this period of human development back a hundred times, I think almost every time we would end up in a similar place in terms of money, due to the path dependence of technological development itself. Once telecommunication systems were invented, bank-controlled ledgers dominated, and this gave nearly unassailable monetary power to the banks and central bankers that ran those ledgers.
Political decisions affect things locally and temporarily, while technological changes affect things globally and permanently.
Nature’s ledger (gold) has robust parameters for supply and debasement but doesn’t move and get verified fast enough in the telecommunication age. Mankind’s ledger (the dollar) moves and gets verified fast enough but doesn’t have robust parameters for supply and debasement. The only way to fix this speed gap in the long run would be to develop a way for a widely accepted, scarce, monetary bearer asset itself to also be able to settle over long distances at the speed of light.
The ability and willingness of governments to print money for war or other crises spread like a virus. Thanks to centralization and abstraction of money, governments were no longer constrained by the amount of gold in their vaults; they could tap into the savings of their entire citizenry. If one government could drain their citizens’ wealth quickly and non-transparently for war, then it increased their odds of winning — unless their opponent nations did the same.
Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency.
Throughout the war, countries around the world showed that their governments and central banks now had nearly complete control of the ledgers that people around the world used for savings and payments. Savings could be rapidly devalued in a non-transparent way and channeled toward what the government considers worthwhile to spend money on.
The involuntary devaluation of savings in an arbitrary and opaque way is another thing entirely, and this new capability represented a tremendous power shift from those who use the ledger to those who control the ledger.
“Who controls the ledger?” The answer, geopolitically, is that in the telecommunication age, whichever country has the most economic and military prowess is likely to have the primary control over the world’s ledger, unless or until there is a better solution, or until no single nation is large enough to force its will onto the rest of the world. The mightiest country’s ledger serves as the independent third-party unit of account for international transactions. South Korea and Saudi Arabia, for example, don’t have to trust each other’s ledgers if they want to trade with each other, but they do both need to trust the United States.
In many ways, the Bretton Woods monetary system and subsequently the Eurodollar/Petrodollar monetary system represent forms of monetary neocolonialism, with the United States in charge. Wealthy nations near the center of the system optimize their ledgers for their needs, especially in terms of suppressing inflation and volatility. However, destroying volatility usually carries a cost and it tends instead to be pushed somewhere else, or only temporarily suppressed until it comes out all at once. In this case, wealthy nations tend to push their inflation and volatility toward developing nations who sit at the periphery of the system, and those developing nations can do little other than take it. Developing nations are expected to attach themselves to the ledgers of the advanced nations, with no recourse for when those ledgers fluctuate in ways that harm them.
The primary reforms that the IMF requires when they hand out loans:
1. Currency devaluation.
2. Abolition or reduction of foreign exchange and import controls.
3. Shrinking of domestic bank credit.
4. Higher interest rates.
5. Increased taxes.
6. An end to consumer subsidies on food and energy.
7. Wage ceilings.
8. Restrictions on government spending, especially in healthcare and education.
9. Favorable legal conditions and incentives for multinational corporations.
10. Selling off state enterprises and claims on natural resources at fire sale prices.
The reader should notice that the United States and other wealthy nations often skip these steps when they have their own crises. Rather than trim spending on healthcare and education during a period of economic contraction, they expand it. Rather than raise taxes during periods of economic contraction, they tend to cut them as a form of stimulus. They often maintain protectionist trade policies for themselves, even as they tell developing countries to open their countries for foreign trade. While wealthy nations rarely turn toward financial austerity themselves, they expect developing nations to turn toward financial austerity whenever they face economic contraction, to play along with the global financial system as it is currently structured.
The combination of telling developing countries to shrink access to domestic bank credit while enticing multinational corporations to enter their market with various tax incentives, is particularly toxic. Shrinking domestic bank credit makes it harder for smaller, local businesses to survive and grow. Meanwhile, tax incentives and partnerships with multinational corporations gives those multinational corporations big opportunities to come into the market at a moment of weakness to take market share from those local businesses. This happens repeatedly in cycles.
Many developing countries around the world have received well over a dozen IMF loans since the institution was created. Old debts get restructured and refinanced and rolled over into new ever-expanding debts. In many cases, countries have paid back their loan value many times over due to high levels of interest, and still owe more money than they originally borrowed.
Furthermore, large portions of the original loans get quickly funneled back into U.S. and European companies, while sticking the developing country with the bill. For example, the World Bank may lend money to developing countries to build a railroad and a port, who then hire U.S. and European and Japanese infrastructure firms and pay them to design and build much of the work, using this money that they borrowed. The money flows as a loan from the developed countries, briefly to the developing countries, and then back to the developed countries’ corporations — while the developing countries get stuck with the debt, owed to developed countries. The railroad and the port are then used primarily to transport and export natural resources from the developing country to the developed countries that financed this, from which the local developing country population received little value but was saddled with the debt for the project. When the debt comes close to defaulting, the loan is generally restructured, and the local currency (and thus the savings and wages of their people) is sharply devalued.
What makes this worse is the fact that many of these developing countries have corrupt, authoritarian rulers. The IMF and World Bank frequently make deals with these authoritarians who control their own country’s local fiat ledger, and those authoritarians generally siphon off a significant chunk of money for themselves and their cronies to live in luxury while storing their wealth in offshore bank accounts and real estate. Most people in these countries have no say in the process, generally see little benefit from the deals, and yet get stuck with debt and austerity and currency devaluation that they never signed up for in the first place. Even if the authoritarian leader is eventually removed from power, the IMF still generally expects the country to repay the loans, even if they had no input into receiving those loans in the first place.
World Bank loans traditionally are project- or sector-specific, and have focused on facilitating the raw export of commodities (for example: financing the roads, tunnels, dams, and ports needed to get minerals out of the ground and into international markets) and on transforming traditional consumption agriculture into industrial agriculture or aquaculture so that countries could export more food and goods to the West.
After the 9/11 terrorist attacks on the United States, the United States responded with war. The military efforts initially focused on Afghanistan where the attack’s organizer Osama Bin Laden and his allies were hiding, but then expanded into Iraq as well — even though Iraq was not involved in the terrorist attacks and doesn’t even share a border with Afghanistan. Most Americans couldn’t locate either country on a map, conceptually mixed them together, and went along with the messaging of the government and the corporate media at the time about the “War on Terror.” At the peak level of support in 2003, Gallup polls showed that 76% of Americans supported going to war against Iraq. For an American to express disapproval regarding the war against Iraq was considered very unpatriotic to many people at the time.
Wars that are financed with debt denominated in fiat currency units that the central bank can print, are not transparently priced. If the war against Iraq came with a 10% special war income tax for all Americans, the level of public support would have surely been lower. If we had to pay for it transparently in real time, then maybe we would think twice and look more deeply into the matter before blindly committing to it. On the other hand, if the costs of war seem trivial or unclear to us, if we barely know the difference between Afghanistan and Iraq, and can’t locate either on the map, and the political leaders and media are saying it’s a good and patriotic idea and that it’s necessary for national security, then why not go to war?
There’s an old joke about a woman claiming that the world rests on a giant turtle. When asked what the giant turtle stands on, she says another giant turtle. When asked what that second giant turtle stands on, she exasperatedly says, “it’s turtles all the way down!”
In 1913 when the Federal Reserve was created, there was $19.31 billion in broad money. At the end of 2022, there was $21.4 trillion ($21,400 billion) in broad money, which is an increase of 1,118 times over, or an average of 6.6% per year when compounded for 109 years.
The population of the United States was 97 million in 1913 and about 333 million in 2022. This means that in 1913, there were 199 dollars per person in the system, and in 2022 there were over 64,800 dollars per person in the system. This is a per-capita broad money supply increase of 325 times over, or 5.5% compounded annually.
The scarcest things, such as luxury waterfront property and fine art from famous deceased artists, tend to go up in price as fast as the money supply does. That’s because these things are truly finite, and we don’t get more efficient at making them. As a result, as more money is created it pushes up the prices of those goods by nearly the same rate. As an example, one particularly well-documented Miami Beach waterfront property was originally sold for $100,000 in 1930 and by 2022 was worth around $30 million, which was a 6.4% compounded annual growth rate, and that was closely in line with the growth rate of the money supply over that long period.
Semi-scarce things such as gold, oil, beef, and median homes tend to go up in price at a 4-5% annual rate if money supply growth is 6-7%, because we get moderately better at producing them over time, due to better technology. A barrel of oil, for example, went from an average of $0.95 in 1913 to an average of $94 in 2022, which was only a 100-fold increase, or 4.3% compounded annually. The price of beef similarly increased at a 4.1% compounded annual rate from the 1930s through 2022.
Between 1913 and 2022, the consumer price index increased at a 3.2% compounded rate, and this index mostly represents a mix of semi-scarce and non-scarce things. Interest on bank accounts and Treasury bills failed to keep up with the consumer price index during that long period, let alone keep up with a basket of semi-scarce things like beef or oil or houses, and certainly did not keep up with truly scarce things like fine art or waterfront property.
If something like gold is money, then the common form of money is rather sound and there is less reason for investors to have second and third homes, large stock portfolios, and an assortment of collectibles. Of course, some people will have those things, but they will be more discretionarily and thoughtfully collected, and are likely to represent a smaller share of an investor’s net worth. However, in weak money environments where supply of money keeps growing and interest rates are below the prevailing inflation rate, then there is a strong incentive to avoid cash and instead to hold second or third homes, to buy stocks, and to own a large assortment of collectibles at inflated valuations. In the absence of good money, everything else that has some degree of scarcity gets monetized instead.
If gold were to double in price next year, most people in society wouldn’t have any noticeable negative impact on their life. But if houses get monetized and left empty for most of the year due to wealthy investors and upper-middle-class investors buying extra ones with cheap credit, then it can crowd out the middle class and working class from having access to affordable shelter.
People generally build their retirement savings accounts out of equities, rather than money. Therefore, equities of large publicly traded companies acquire a monetary premium compared to most private businesses. This gives large corporations a lower cost of equity capital, and thus gives them a structural advantage (among many other advantages) over smaller, private businesses.
Unusually high equity valuations can further distort capital formation and resource usage. Perpetually unprofitable, growth-oriented companies can exist for longer periods of time in their state of unprofitability, as people prefer to hold their equity, rather than to hold cash that fails to maintain its purchasing power. These companies can underprice their products and services, operate at a perpetual loss, and finance themselves by continually issuing new shares to employees as compensation and continually issuing new shares for investors to buy. The company then grows faster than normal market pricing would allow, due to these high-valuation monetized shares and persistently unprofitable prices for its goods and services. When this goes on for many years or even decades, it becomes challenging to determine what the true market values of their products and services are, since they are priced below their cost of production. This type of company, in an era of soft money, sucks in capital from investors that could otherwise be going to things with clearer pricing mechanisms, and thus can eventually lead to a period of supply shortages and price inflation elsewhere in the economy.
Monetizing things of utility, such as corporate equity and real estate due to a lack of good monetary alternatives, has tangible negative effects and contributes to unnecessary bubbles. It can increase the cost of things that should otherwise just be for utility (such as single-family homes); it gives large and liquid companies an extra edge over smaller companies; and it slows down the process by which business pricing serves as a method of communicating to consumers and investors what is scarce and what is not, which can lead to a misallocation of resources for prolonged periods of time.
People can work and earn new dollars, but a lot of those new dollars that they earn would just be replacing the declining purchasing power of their existing dollars. It’s like holding a bag of melting ice cubes and working to earn more melting ice cubes.
During the 2008 subprime mortgage crisis, the U.S. federal government authorized hundreds of billions of dollars of low interest loans to large banks amid the crisis to keep them liquid and solvent. Asset prices had crashed and hardly anybody had access to cheap credit at that time, but these banks were given artificially cheap credit by the government and could use it to swoop in and buy up assets and distressed competitors (who weren’t given such credit) at fire sale prices. In total, banks and their executives received a lot of support from the government while the middle-class homeowners received little or none. Being given massive amounts of below-market-rate credit by the U.S. federal government with printed money at a time of distressed asset prices and distressed competitors is an absolute goldmine of value. The U.S. Treasury secretary at the time of this disbursement was himself the former CEO of Goldman Sachs, and Goldman Sachs was one of the recipients of this selective credit. Employees of bailed-out Wall Street firms went right back to receiving huge bonuses, and executives of would-be bankrupt banks who made all sorts of bad loans in the years prior walked away with eight-figure retirement packages. Meanwhile, many homeowners on the other side of that ended up losing their homes, as they were given minimal fiscal support or credit support. Plenty of people made mistakes, but the rich and well-connected people were far more likely to be bailed out than the average person.
In a fiat currency system, this Cantillon effect is heightened. Selective bailouts and government-subsidized credit given out with newly created money at a time of acute liquidity crises benefit entities that are large and well-connected. In general, big entities (especially large banks and corporations) benefit from this system over small entities because they can reliably get access to cheap debt, which represents a short on the diluting currency and a method to buy more scarce assets with it. These entities, being close to the sources of money creation, have the benefit of access to capital markets and easy loans (during the good times) and bailouts (during the bad times). It’s a system with inherently centralizing aspects that tends to help existing winners continue to win more. And then winners can go on to become the biggest political donors and maintain their all-important access to the money printer when needed.
From the perspective of large financial entities, in addition to outcompeting smaller competitors directly, it makes a lot of sense to buy smaller competitors, refinance them, and/or leverage them up with cheap debt. For decades, large corporations and private equity firms did exactly this, making use of the fact that they had access to cheaper credit than smaller entities to buy those smaller entities and consolidate them, and it has been incredibly lucrative. When money is persistently weak, the smart strategy is to grow big and to get better and better access to cheap financing.
Overall, an environment of persistent currency debasement and selective access to cheap credit naturally favors larger entities over smaller entities and tends to centralize wealth and influence over time toward those that control those larger entities.
There’s a cycle as old as civilization, at the heart of both politics and economics: It’s about the exponential accumulation of debt and the inevitable financial resets that occur whenever debt reaches a societal breaking point. The reason the cycle is so old and repetitive is that the exponential nature of financial debt conflicts to some extent with human nature, while also touching on the deep societal questions of what we ultimately owe to each other.
Wealth and debt both tend to concentrate over time within a society. Someone making a low income must spend practically all their income on shelter and sustenance. Once someone can make some surplus income for one reason or another, either due to natural gifts or external good luck and has the temperament and knowledge to compound it, then they can do so exponentially. At that point, wealth begets more wealth. And at a high enough level, wealth can beget more political influence, to shift public finances more toward them, which begets even more wealth. They can also give their children more nutritious food and a top-tier education, along with any investment capital and high-end connections they might need, to start them with an accelerated boost and maintain what is akin to a dynasty that can compound on itself.
In older times, when most people worked in agriculture, failed harvests or other natural catastrophes would often result in them and their family members becoming debt slaves. People stuck in debt slavery often had limited means to ever get a surplus income and get out of their situation. After several failed harvests or other accumulating problems, a greater and greater share of a society would be in debt slavery, either literally or nearly so, while a vanishingly small percentage of people near the top held almost all the assets and credit. After a certain point, this situation risks manifesting itself in societal breakdown because many of those debt slaves can look around, realize how great their numbers are, and initiate a violent revolution. Credit is a human construct and begins to look especially arbitrary to people when it was primarily accumulated by past circumstances and ancestors. So, if enough people become angry and feel that things are unfairly stacked against them, they can show the handful of owners of that credit how fragile their claims to such credit really are.
For this reason, kings have been performing periodic partial debt jubilees on a regular basis stretching back to Hammurabi of Babylon and before, as well as other periods and places throughout antiquity. The goal is to partially reset the playing field occasionally before the playing field completely breaks.
We conclude that the concentration of wealth is natural and inevitable, and is periodically alleviated by violent or peaceable partial redistribution. In this view all economic history is the slow heartbeat of the social organism, a vast systole and diastole of concentrating wealth and compulsive recirculation.
As a way of opting for peaceable partial redistribution rather than risking violent revolution, some civilizations historically encoded this process into their laws or traditions on a regular basis. The Hammurabi Code, for example set limits on debt-slavery durations:
If any one fail to meet a claim for debt, and sell himself, his wife, his son, and daughter for money or give them away to forced labor: they shall work for three years in the house of the man who bought them, or the proprietor, and in the fourth year they shall be set free.
Furthermore, Babylonian kings would often forgive all consumer debts when taking power after the death or abdication of a predecessor. Certain business debts and so forth would remain in effect, but consumer loans to everyday people would be wiped clean, and debt slaves set free, often with a celebration and a literal breaking of the clay ledgers.
The wealthy find out that without broad societal agreement, their fragile claims on a highly interdependent society don’t amount to much. The poor find out that merely taking from the wealthy does not make themselves wealthy in their place.
Rather than blaming individual politicians for handling the budgets of countries poorly or blaming individual central bankers for handling private sector credit poorly, I instead point mainly toward sound money principals being nearly impossible to implement with the current level of monetary technology that we’ve had over the past century and a half. With the ability for central banks to print fiat currency as needed, and the speed of hard physical monies (e.g., gold) being too slow to present a realistic alternative payment system compared to fiat currency ledgers, it inevitably shifted political incentives toward constant fiscal deficits, constant credit growth, and constant currency devaluation, with little or no recourse for those who disliked this situation.
Even if a politician were to be genuinely concerned about government debts and deficits and campaign on this topic, they wouldn’t get very far in politics and wouldn’t be well liked by the broad public if they were to implement their preferred policies in office. They usually wouldn’t even be able to get broad enough support among fellow politicians or the broad public to begin implementing them. Meanwhile, the same thing happens to central bankers. Alan Greenspan, serving as the chairman of the Federal Reserve System from 1987 to 2006, was a significant gold enthusiast before his long tenure at the Federal Reserve, and yet during his tenure he promoted smooth and ever-rising debt growth even more than other Federal Reserve leaders. While we can of course blame partially corrupt individual politicians, instances of crony capitalism, and selective bailouts to well-connected entities financed by money-printing, the underlying problem is that all the incentives that are currently in place tend to filter this type of behavior to the top of the system, over and over.
In 2008, banks across the United States began to collapse, and the entire financial system was beginning to fracture down to its foundation. The Federal Reserve dropped interest rates all the way to zero for the first time in generations, but even that wasn’t nearly enough. They subsequently stepped in with an unprecedented number of emergency actions, and quickly doubled the entire monetary base within the course of a year. Meanwhile, Congress stepped in with emergency fiscal bailouts and loans to keep vast portions of the financial system from becoming insolvent at once.
On the surface, this occurred because many banks made risky loans, packaged them together into opaque securities, and had them stamped with perfect credit ratings by badly incentivized credit rating agencies, which allowed those opaque securities filled with bad loans to be levered up even more. But how could a few years of a housing boom and silly lending and securitization processes lead to a financial calamity of this scale? The answer is that there was a lot more going on underneath, which had been building through decades of prior short-term business cycles, and these excessive behaviors were merely coming to the surface.
At the end of 2007, there was $52.7 trillion in total U.S. debt, spread between federal debt, state debt, corporate debt, household debt, and other sorts of debt. This was all on a monetary base of just $837 billion. Each dollar of debt represents a claim to be paid dollars in the future, and in 2007, there was 63 times as much debt in the system as there was base money.
When debt is that high relative to the monetary base, the whole financial system is like a game of musical chairs that can never be allowed to stop. All of the IOUs that people have are just that — IOUs (and highly leveraged ones at that). Imagine a game of musical chairs with 63 children for every one chair, and then imagine the calamity that would ensue if it were all allowed to be marked to market at once, by turning the music off and seeing 62 kids become unable to get seats.
The problem wasn’t just a series of bad decisions by banks between 2004 and 2007, although that was a part of it. Instead, the problem had been structurally building for decades, through multiple shorter-term business cycles, because the financial system is designed in such a way that it needs to keep growing or it will collapse. Whenever the credit system contracted even briefly during the decades leading up to crisis, policymakers would cut interest rates, provide liquidity, and encourage even more credit creation. The ratio of claims for dollars to actual dollars was never allowed to clear out to more reasonable levels. And then, in 2008, everything began to fall apart.
Many people thought that the rapid increase in base money during the 2008 crisis would be hyperinflationary, and mark “the end of the dollar as we know it.” But they were wrong, and in a big way.
This is because it was mostly just banks that were bailed out in 2008, rather than everyone. Base money increased a lot, but broad money just kept growing at a moderate pace.
The 2000s, 2010s, and 2020s have thus far been an echo of what happened in the 1920s, 1930s, and 1940s.
•1920s and 2000s = booming private credit growth.
•1929 and 2008 = generational financial crises.
•1930s and 2010s = economic stagnation and rising populism.
•1940s and 2020s = geopolitical conflict and populist, deficit-driven inflation.
This is not because cycles magically happen; it’s because each part of the process directly feeds into the next part of the process, and it’s all enforced by the set of incentives that exist for participants and policymakers involved with the system.
In the 2010s, the Tea Party on the political right fought against ever-rising government debt and bank bailouts, while Occupy Wall Street on the political left fought against corporate cronyism and bank bailouts. I contend that these Tea Party and Occupy Wall Street movements were two sides of the same coin — a pushback against the country’s flexible ledger and the associated practice of using public debt and money-printing to save the large and well-connected entities at the expense of the everyday person.
In the United States, people were banned from owning gold between the 1930s and the 1970s and could be sentenced to 10 years in prison if they didn’t comply.
The invention of telecommunication systems allowed commerce to occur at the speed of light while any sort of hard money could still only settle at the speed of matter. Gold, despite being of sounder supply than the fiat dollar, takes considerable time and expense to transport and authenticate, and thus could never really present an alternative in a digital era. Once the fiat dollar came into being, those who manage it were able to discard gold as a supply constraint without much pushback and use the flexibility of their ledger to opaquely finance war, entitlements, and all sorts of things in ways that don’t add up in the long run. It was the first time where a weaker money globally won out over a harder money, and it occurred because a new variable was added to the monetary competition: speed. This speed gap between commerce and settlements empowered banks and central banks, and created an irresistible arbitrage that the whole world turned to, which led to a greater level of centralization for the public ledger than ever before.
“A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. Digital signatures provide part of the solution, but the main benefits are lost if a trusted third party is still required to prevent double-spending. We propose a solution to the double-spending problem using a peer-to-peer network.”
-Satoshi Nakamoto
In 1984, Nobel laureate economist Friedrich Hayek said in an interview:
“I don’t believe that we shall ever have a good money again before we take the thing out of the hands of government. Since we can’t take them violently out of the hands of government, all we can do is by some sly roundabout way introduce something they can’t stop.”
In 1996, Gold and Silver Reserve Inc. (G&SR) launched e-gold, which allowed users to open an online account on their website, and these accounts were denominated in grams of gold. Users could instantly transfer value to other accounts, including down to a fraction of a gram. At its peak, it reached over 5 million accounts and $2 billion worth of annual transfer volume. However, by the 2000s they began to face legal challenges. After the September 11 terrorist attacks, the U.S. federal government passed the Patriot Act, which among other measures tightened regulations around being a money transmitter business. The U.S. federal government ended up suing the company, and by 2009 the operation was shut down. This event emphasizes the problem of gold that I described in earlier parts of this book: To move around quickly, gold needs to be abstracted by a centralized custodial entity, and that entity can be corrupted or shut down.
In the late 1990s and early 2000s, several advancements were made around the topic of digital scarcity. In 1997 Adam Back created Hashcash, a proof-of-work system that was meant to limit email spam and denial-of-service attacks. The idea of proof-of-work is to use computation techniques that require significant computational power to produce some sort of digital token or certificate, which is then easy to verify as genuine by any party once the token or certificate is presented. Nick Szabo subsequently proposed Bit Gold, which was the idea of using this type of unforgeable costliness to create an online scarce asset. Hal Finney then incorporated both Hashcash and the idea of Bit Gold into a 2004 invention called Reusable Proof of Work (RPOW). Using a centralized server, Finney turned Hashcash into a reusable token, a type of verifiably scarce digital collectible, which he called RPOW tokens.There were other types of digital currency proposals around this time as well, but this specific Back-Szabo-Finney development path was particularly important.
The limitation that most of these monetary projects all shared was that they were centralized.
In 2008, an unknown developer or group using the pseudonym Satoshi Nakamoto implemented some of these techniques in a decentralized way. On October 31, 2008, Satoshi introduced a paper called “Bitcoin: A Peer-to-Peer Electronic Cash System” to a cryptographic mailing list that included several of the above-named individuals, among many others.
The paper, only nine pages long, was written in an academic form, with eight citations for a variety of cryptographic and timestamping techniques, including a citation for Adam Back’s Hashcash. Over the next few weeks, various cryptographers on the email list reviewed it and asked questions, mostly critically and skeptically, which were politely replied to by Satoshi. The emails are public record now and reading through them feels like reading a dissertation defense, with articulate questions and articulate answers between professionals.
At no point did Satoshi promise riches or come off like a salesman. He wrote like an academic, although he made it clear that the goal of this work was freedom, in the ethos of the cypherpunk movement.
For example, one person on the mailing list wrote, “You will not find a solution to political problems in cryptography.” Satoshi responded with, “Yes, but we can win a major battle in the arms race and gain a new territory of freedom for several years. Governments are good at cutting off the heads of centrally controlled networks like Napster, but pure P2P networks like Gnutella and Tor seem to be holding their own.”
Satoshi then released the open-source code on January 9, 2009, and mined the first set of blocks. In the genesis block, he referenced a topical newspaper headline about British bank bailouts during the heart of the global financial crisis:
The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.
Hal Finney publicly announced in a tweet on January 10 that he was running the Bitcoin software, and he subsequently received the first test transaction from Satoshi.
For the first two years of Bitcoin’s existence, through 2009 and 2010, Satoshi continued to provide updates for the code and discussed various concepts with early users, keeping with his calmly spoken and matter-of-fact persona. In late 2010, Satoshi disappeared and made no more public posts, leaving the project in the hands of others.
Bitcoin is a decentralized ledger, existing across the world in a decentralized cloud of computers, that is costly to attack and impossible to unilaterally change the rules for. There is no centralized server and no centralized issuer. It’s completely transparent, meaning that every line of code is public. Developers can collaborate to create and propose updates for it, but there is no way to push updates to users; updates can only be freely accepted by users and must be backward-compatible if they want to remain part of the existing network.
Ever since the invention and deployment of intercontinental telecommunication systems in the second half of the 19th century, transactions have been able to move around the world at the speed of light, while scarce, self-custodial bearer asset money (e.g., gold) could only be transported and verified at the speed of matter. This speed gap opened a massive arbitrage opportunity for banks and governments to use, because it gave them custodial monopolies over fast long-distance payments. Bitcoin represents the first significant way to settle scarce value at the speed of light, since once bitcoin are sent across the network and are settled under a few blocks on the blockchain, they are irreversible — unless over 50% of miners on the network (which are dispersed all around the world) try to reverse it. A bitcoin is a scarce asset that is not someone else’s liability, much like a gold bar, and this ability to quickly move a non-liability asset over long distances is something that the world has never had before.
Bitcoin can serve as a decentralized world clearing house, because rather than relying on abstraction and debt, the bearer assets themselves can be settled directly between entities within minutes.
It’s not an accident that it took approximately a century and a half after transactions were enabled to occur at the speed of light for bearer asset settlements to also occur at the speed of light. This process was path dependent, similarly to how the invention of the bicycle in some form would necessarily come before the automobile. Credit-based transactions over telecommunication systems only require simple data like Morse code to occur, and thus could be performed in the 19th century. Settlements of scarce value over telecommunication systems require far more complex computation, data structures, bandwidth, and mathematical proofs. Bitcoin and the broader ideas of digital scarcity and a decentralized digital settlement network were invented nearly as early as they could have been, based on the developmental timing of the underlying technologies that they rely on.
One of the fundamental building blocks for such a system is digital signatures. A digital coin contains the public key of its owner. To transfer it, the owner signs the coin together with the public key of the next owner. Anyone can check the signatures to verify the chain of ownership. It works well to secure ownership, but leaves one big problem unsolved: double-spending. Any owner could try to re-spend an already spent coin by signing it again to another owner. The usual solution is for a trusted company with a central database to check for double-spending, but that just gets back to the trust model. In its central position, the company can override the users, and the fees needed to support the company make micropayments impractical.
Bitcoin’s solution is to use a peer-to-peer network to check for double-spending. In a nutshell, the network works like a distributed timestamp server, stamping the first transaction to spend a coin. It takes advantage of the nature of information being easy to spread but hard to stifle.
The result is a distributed system with no single point of failure. Users hold the crypto keys to their own money and transact directly with each other, with the help of the P2P network to check for double-spending.
The Bitcoin network uses public-key cryptography. A user randomly generates a private key, which is simply an enormous number. You can generate a key by flipping a coin 256 times, for example, but in practice most people use software “wallets” to generate one for them. There are more possible private keys than there are atoms in a million galaxies, so the probability of randomly generating one or guessing one that someone else has already generated is vanishingly small. In more human-readable form, the private key can be stored or memorized as a twelve-word seed phrase. The private key can be used to create a public key and an address, and other users can send bitcoin to that address. The public key and address are derived from the private key, but the process does not go in reverse; nobody can derive the private key from the public key or address. The private key, known only to the user, allows the user to sign a transaction to send bitcoin (including fractions of bitcoin) from their address to someone else’s address.
Bitcoin was programmed by Satoshi to produce 50 new coins every ten minutes on average to a miner that creates a successful block, and then every 210,000 blocks (approximately every four years) that number of new coins per ten minutes is halved. After four years it became 25 coins every ten minutes, and then four years later it was 12.5, and then four years later it was 6.25, and so on. This declining block subsidy was programmed into the software from inception.
“Who controls the ledger?” for Bitcoin.
The primary answer is that the tens of thousands of users that run nodes control the ledger, and anyone with a basic laptop (or similar hardware) and a standard internet connection can join as a node operator. Node operators are the ones that store the full history of the ledger, and collectively maintain the software that runs the network and enforces network rules for new blocks being added to the blockchain by miners.
The secondary answer is that miners play an important role in updating the ledger. Miners use electricity and specialized processors to earn the right to add new transactions onto the ledger. A single miner or group of miners that somehow marshals together over 50% of all active computational power on the network could censor transactions or reverse recent transactions that users previously thought were final. They could censor specific transactions, or they could attack the network by mining empty blocks to censor all transactions going forward. If this happens, it’s not necessarily a permanent problem; more computational power could be brought online by users of the system, incentivized by a spike in transaction fees by censored users, to collectively regain over 50% of the network’s computational power.
Developers are influential but have no direct power over the ledger since they can’t force any node operator to accept a software update. If developers make an update that node operators don’t like, then that update won’t be accepted by them. In that case, node operators will just keep running their existing software, and eventually could support other developers to create different updates. Many node operators wait years after an update is released before using it, to ensure that it is fully stable and without bugs. Developers are, of course, still important for the network; their expertise at crafting backward-compatible updates that the users of the network want to use has helped Bitcoin become more secure and scalable over time.
Unlike banks, central banks, and fiat currency financial systems, there is no entity that can unilaterally debase the Bitcoin ledger. There is no central node that can create a million new coins for themselves. Nobody can take a user’s coins unless they get their private key (which can be further secured by passwords and/or multi-signature protection) or unless they coerce them to send over their coins. The ledger is transparent, objective, and secured by real-world resources in the form of electricity and specialized processors.
At first, bitcoin were mined and held as digital collectibles by enthusiasts, and there was no quotable price for them. The cost to acquire them was determined by hardware and electricity to run a computer and participate as a miner, and the amount of this input cost per coin varied depending on how many people were using their computers to mine it.
In 2010, the first bitcoin exchanges were created, which allowed a quotable market price to form. This was also the first year of practical use for bitcoin. When Wikileaks was de-platformed by PayPal and other centralized payment methods, it turned to bitcoin donations in their place. Bitcoin’s original use-case as censorship-resistant money came to the forefront with this event, and even Satoshi wrote at the time that he was concerned that this would bring negative attention toward them like a swarm of hornets before the network was robust enough to handle it. Days later, he ceased posting in public, and within a few months he vanished from email communications as well. And yet the Bitcoin network has continued to grow and evolve since then, for well over a decade.
Kind of like how a tank is designed to get from point A to point B through resistance but is not well suited for commuting to work every day, the Bitcoin network is designed to make global payments through resistance but is not well suited for buying coffee on the way to work. More broadly, the Bitcoin network is the world’s most immutable and decentralized database for storing the history of bitcoin transactions as well as other arbitrary data, and bitcoin are required to pay transaction fees to update that database.
How Satoshi described it in a forum post in 2010:
As a thought experiment, imagine there was a base metal as scarce as gold but with the following properties:
– boring grey in colour
– not a good conductor of electricity
– not particularly strong, but not ductile or easily malleable either
– not useful for any practical or ornamental purpose
and one special, magical property:
– can be transported over a communications channel
If it somehow acquired any value at all for whatever reason, then anyone wanting to transfer wealth over a long distance could buy some, transmit it, and have the recipient sell it.
In addition to sending them online, bitcoin in the form of private keys can be physically brought with you globally. You can’t bring a lot of physical cash or gold through an airport and across borders. Banks can block wire transfers into and out of their country or even within the country. But if you have bitcoin, you can bring an unlimited amount of value globally, on your phone, on a USB stick, or stored in a password-protected file in a cloud drive that you can access from many different countries — or simply by memorizing a twelve-word seed phrase (which is an indirect way of memorizing a private key). It’s challenging for governments to prevent that without extremely draconian surveillance and control, especially for technically savvy citizens.
Unlike other technologies such as electricity, washing machines, televisions, computers, and phones, a new type of emerging money most likely cannot be widely adopted quickly. This is because if too many people adopt it at once, it drives up the price and incentivizes leveraged buyers to enter it. This leverage eventually causes a bubble to form and to pop, which sets the price back and disillusions people for a while until it builds the next base and grows from there. Due to the attachment of leverage, Bitcoin cannot realistically have a fast and smooth adoption curve like non-monetary technologies can.
Monies tend to have network effects based on salability. The more liquid, widely held, and widely accepted a certain type of money is, the more useful that money becomes to each user, and thus more people want to hold it and accept it. All else being equal, the more conversion points between bitcoin and goods, bitcoin and services, and bitcoin and currencies there are globally, the healthier the Bitcoin network is. Even if a user doesn’t want to use bitcoin as a medium of exchange currently, the more assurances that a user has that they could find a buyer anywhere around the world, the more useful bitcoin is to hold as part of their long-term savings.
It’s often said that a blockchain is just an inefficient database, and that’s basically correct. Users in this context are willing to accept inefficiency relative to other types of software applications to ensure decentralization.
A blockchain, especially the truly decentralized variety, is a database that is small and tight enough that thousands of entities around the world can store it on their local devices and constantly update it peer-to-peer using an established set of rules. Each node provides validation to ensure that a new block is following the rules of the protocol, and they will only accept and propagate a new block to other nodes if the new block follows the rules. A very large number of user-run nodes helps ensure that the ruleset is immutable, whereas if there are only a handful of nodes, then it only takes a small quorum of people to rewrite the rules of the network.
To increase privacy, some degree of auditability needs to be sacrificed. One of the key things about Bitcoin is that any node can tell you the exact bitcoin supply and maintains the entire history of transactions and the full state of the ledger. That’s not possible to the same degree in a privacy-based blockchain. Cryptocurrencies that are private at their base layer make it easier for undetected inflation bugs to occur. In addition, if a privacy-based system doesn’t have a serious network effect, its privacy likely isn’t as good as advertised because the anonymity set is very small and is therefore somewhat trackable. Privacy is in large part a function of liquidity, and if liquidity is lacking in various privacy-focused ecosystems, then their privacy potential is limited. Various privacy techniques have been built into layers on top of the Bitcoin base layer, which allow for private usage of the network.
Trade-Off 3: Code Expressivity
To increase code expressivity (e.g., to execute complex smart contracts right on the base layer), a network must also increase the bandwidth, processing, and storage requirements of full nodes, which makes running a full node harder and thus risks centralizing the network over time, as previously described. In addition, base layer computational capabilities increase the complexity and number of possible attack surfaces on the network. It also opens more opportunities for miners or validators to front-run others and play games with transaction ordering, in a process known as “maximal extracted value,” and this tends to lead to centralized block constructors dominating the market.
Trade-Off 4: Energy Usage
In a proof-of-stake system, transactions are verified, and new coins are generated, by those who “stake” their coins, rather than by energy-intensive miners. Replacing the proof-of-work consensus with a lighter proof-of-stake consensus requires accepting a circular validation process. In other words, the existing coin holders are determined by the state of the ledger, and the state of the ledger is determined by the existing coin holders — a perpetual motion machine based on circular logic that doesn’t have high fault tolerance. Since there is no unforgeable costliness associated with the history of a proof-of-stake ledger, it is nearly costless to make an infinite number of copies of the blockchain with different transaction histories. If the network temporarily goes offline for any reason, there is no way other than governance decisions and/or centralized checkpoints to determine which ledger is the “real” one to restart from. A proof-of-work system uses energy as that external arbiter of truth, which creates a history with unforgeable costliness, and is what makes the system robust.
The requirements to run a node increase more slowly than the technological increases in bandwidth and storage, which means that a node gets easier and more accessible to run over time. As a result, Bitcoin is designed to likely get more decentralized over time, in contrast to most other cryptocurrencies that are likely to get more centralized over time.
If developers want to change something about Bitcoin, their changes cannot be forced onto users’ nodes. Bitcoin’s ruleset is determined by the network of existing nodes. Any changes to Bitcoin in practice must be backwards-compatible upgrades, which node-users can voluntarily upgrade into if they want to, while still being compatible with older nodes. Unless they can gain overwhelming agreement from the users, any attempted upgrades by developers that are not backwards-compatible with the existing node network are merely hard forks — they create separate new coins that lack a network effect and lack serious security.
Trying to do a hard fork from Bitcoin is conceptually like copying all the data from Wikipedia (it’s not that much) and hosting it on your own website, but then getting very little web traffic because you don’t have the millions of backlinks that point to the real Wikipedia or the volunteer army of people that constantly update the real Wikipedia. Your split version of Wikipedia would be inherently worse than the real one from the moment you copy it. Similarly, any minority hard fork of Bitcoin inherently has far fewer nodes and far less miner computation, making it less decentralized and less censorship-resistant from the start.
Proponents of newer cryptocurrencies often criticize Bitcoin for being old technology, when in reality it’s just strict about the trade-offs that it was designed with, and was built to maximize security and decentralization over other attributes. Protocol-level technologies, once established, tend to last a very long time. Internet Protocol was invented in the 1970s; Ethernet was invented in the early 1980s; Universal Serial Bus was invented in the 1990s. All of these protocols are still going strong, and will likely remain strong for decades to come, because they are foundational, and they upgrade over time. They have entrenched advantages from network effects and can upgrade in a way that preserves their backwards compatibility.
Bitcoin, in many respects, looks like these types of long-lasting protocol technologies with dominant market share. It’s foundational. It’s elegantly simple and robust.
If you and I do an in-person physical cash transaction, it’s directly peer-to-peer; we don’t shout our transaction to the whole world. Lightning replicates that cash concept on top of Bitcoin’s base layer and was enabled by the 2017 soft fork called SegWit.
The result is a much faster, more scalable, cheaper, and more private global payment system, albeit with some trade-offs and limitations compared to directly using Bitcoin base layer transactions.
A network that tries to scale transaction throughput on the broadcast-oriented base layer by radically increasing the block size and/or block speed makes no sense in terms of decentralization. The node requirements become absurdly high, which turns the network into a centralized, enterprise-scale database with just a handful of massive nodes.
Lightning Network 101 Explanation
Suppose you and your friends are spending a long evening at an expensive restaurant. Rather than pay for every plate or drink, most restaurants give you whatever you order throughout the experience and charge you at the end in one big transaction. However, that relies on the restaurant trusting you to some degree.
Suppose instead that the restaurant collects your credit card information at the start of the meal, and then anything you order gets added to your tab. At the end of the night, the waiter gives you the receipt, you sign it, and then they charge the credit card that you already provided.
By doing this, you and the restaurant have opened a payment channel with each other. There is a moment of friction when setting up the tab and a second moment of friction when closing the tab, but between those moments, there is no payment friction for individual plates or drinks because you just need to tell the waiter what you want, and it comes.
As an alternative to the Bitcoin network’s energy use, there have been several consensus models proposed and implemented, with proof-of-stake systems being the most common alternative. Proof-of-stake systems use existing coin holders as validators to add new blocks of transactions to the blockchain. There are some interesting aspects to these systems, but they make several huge trade-offs relative to proof-of-work systems.
In short, the input of energy into a blockchain is what allows the network to reduce governance as an input as much as possible. If blockchain designers eliminate energy as an input, they bring back a significant degree of governance into the network, which at least partially defeats the purpose of using a blockchain in the first place. Energy can be relied upon as a neutral arbiter of truth.
If miners drop off the network and new blocks on average start taking longer than ten minutes to produce, the network is automatically programmed to make the puzzle easier by a quantified amount, so that blocks go back to an every-ten-minute average schedule. In contrast, if a lot of miners join the network and blocks get added to the blockchain faster than every ten minutes on average, the network will make the puzzle harder. This is known as the “difficulty adjustment.” It occurs automatically every two weeks and is one of the key programming challenges that Satoshi Nakamoto solved to make the network work properly.
In the first half of 2021, China (which at the time was by far the largest country in terms of miner concentration) banned cryptocurrency mining and approximately half the global bitcoin mining network went offline and started moving elsewhere. Bitcoin’s payment network briefly slowed down, but otherwise kept working with 100% uptime. The difficulty adjustment then kicked in and brought the network back up to its target speed. Imagine if large cloud infrastructure providers like Amazon or Microsoft were told with one week’s notice that they had to move half of their server capacity internationally; they would likely experience uptime issues for their services for the rest of the year or longer as they moved and rebuilt half of their infrastructure. The Bitcoin network instead continued to operate with 100% uptime. And ironically, a considerable amount of mining came back online in China after the ban; even their authoritarian government has been unable to completely stamp it out.
Millions of machines are using electricity and specialized processors to apply processing power to guess the answer to cryptographic puzzles left by the most recent block. This may seem like a waste of energy, but it’s what keeps the system decentralized and reduces the need for human governance. Energy is the arbiter of truth, in this case. There is no central authority or oligopolistic set of validators that decides what constitutes a valid block or a valid set of transactions or which transaction occurred before another transaction; the blockchain with the most work in it is mathematically verifiable at any given time and is recognized as truth by the rest of the node network — all based on code. The blockchain with the most work put into it, and that also meets the consensus criteria that the Bitcoin node network checks, continually becomes recognized as the global consensus ledger.
Proof-of-work has the nice property that it can be relayed through untrusted middlemen. We don’t have to worry about a chain of custody of communication. It doesn’t matter who tells you a longest chain, the proof-of-work speaks for itself.
Energy expended per block not only secures the UTXOs [transactions] belonging in that block but also retroactively secures all global UTXOs that occurred in past blocks. The reason for this is because it would be impossible to revert past UTXOs without reverting the current block first. Each new block effectively “buries” all existing UTXOs under its weight.
Proof-of-stake is a system whereby holders of the cryptocurrency temporarily lock up or “stake” their coins, use them to vote on new block creation, and get rewarded with more coins for successfully creating new blocks. Instead of committing electricity and processing power to create new blocks on the blockchain, they’re proving that they have a significant stake of coins in the network and are using this as their transaction signing authority.
The primary advantage of a proof-of-stake consensus model is that it allows a small blockchain to increase the cost of brute-force attacking it compared to if it was utilizing a proof-of-work mechanism. Many small proof-of-work blockchains have a low cost to perform 51% attacks on, which allows the attacker to censor the network or reverse recent transactions. A small proof-of-stake blockchain, on the other hand, is difficult to attack externally with brute-force because the external attacker must buy a large percentage of the coins, which drives up the price and therefore makes it increasingly difficult for the attacker to gain enough coins to perform the attack.
A secondary advantage of a proof-of-stake consensus model is that by reducing the external cost of transaction ordering, they can redirect that saved expense toward burning coins. In other words, they can create outright deflationary monetary policies for their coins. The system can be designed so that it continually issues a significant number of new coins as a reward for validators, while burning (destroying) coins with extra transaction fees as well, thereby avoiding an inflationary monetary policy and potentially achieving a deflationary monetary policy, as long as the network remains in high demand with users willing to pay significant transaction fees.
However, a proof-of-stake system has numerous downsides, with far more attack surfaces compared to a proof-of-work system. By detaching themselves almost entirely from the physical realm, proof-of-stake blockchains turn themselves into perpetual motion machines based on circular logic, with low fault tolerance. When I first explored proof-of-stake as a concept it seemed very interesting, but the more I dug into it, the more I realized how important proof-of-work is in contexts where immutability really matters.
The primary (and insurmountable) shortcoming of a proof-of-stake system is that the history of its ledger has no unforgeable costliness. The ledger just consists of a series of signed transactions by validators (coin holders). Anyone can therefore create a nearly infinite number of alternative histories of transactions, i.e., alternative ledgers, and there is no way for someone to look at them and independently determine which one is the “real” history. There is no way to prove who the validators historically were, and what transactions they historically signed.
The closest way to know what the real history was in a proof-of-stake system is for a node to never, ever, go offline. If they ran their node from the inception of the network until the present time, never once going offline, and watching each block be produced from genesis, then they may be able to declare that they know the full and real history of the ledger. But how do they prove this to others? Do they become the central authority, and thus defeat the purpose of a decentralized blockchain?
The ability for a node to leave and rejoin the network without relying on trust was important enough to Satoshi that he mentioned it in the abstract at the top of his original 2008 Bitcoin whitepaper.
Proof of work is not only useful but absolutely essential. Trustless digital money can’t work without it. You always need an anchor to the physical realm. Without this anchor, a truthful history that is self-evident is impossible. Energy is the only anchor we have.
Proof of work = trust physics to determine what happened.
Proof of stake = trust humans to determine what happened.
Proof-of-work is simple because it speaks for itself; there is no need to punish bad miners that try to validate the wrong chain or make invalid blocks that don’t fit the rules of the node network. Their punishment is simply that they spent electricity on blocks that weren’t valid or weren’t included in the longest eventual chain, and thus lost money. They self-inflict their own wound, and thus it rarely happens on purpose. There is a tangible connection between the blockchain and real-world resources.
The combination of proof-of-work and difficulty adjustments was a true innovation that allowed for the decentralized and unforgeable ordering of transactions. In other words, Satoshi Nakamoto created a true timechain with an unforgeable history, rather than merely a blockchain. Proof-of-stake consensus mechanisms instead recreate corporate equity structures in a digital realm, including their need for partially centralized governance due to lack of true fault tolerance. Proof-of-stake as a consensus mechanism allows for the operation of a blockchain, but not a true timechain.
Larger bitcoin miners save some money on overhead costs relative to the size of their operation, but only up to a point. In contrast, many of the cheapest forms of stranded electricity and productive usages of waste heat are only found in small amounts, which is advantageous for smaller miners. As a result of both factors, cryptocurrency miners in a proof-of-work system tend to not centralize very much. Instead, they tend to remain decentralized and ever-changing.
In contrast to all of this, proof-of-stake tends to be rather centralizing and persistent. Once a large coin holder gathers a significant number of coins, becomes a validator, and starts earning more coins, they begin an exponential journey toward increasing their share of the network. In contrast to a proof-of-work miner which has high and fluctuating real-world expenses, a proof-of-stake validator’s expenses for maintaining their coins and validator are nearly zero. They can continue to collect new coins from validating and use those new coins to generate even more coins.
If a proof-of-work blockchain is struck by a 51% censorship attack by a group of miners, then this is indeed a problem, but a reversible one. Other people, such as the various censored entities on the network, can construct or acquire new processors, plug them in, increase the overall amount of processing power on the network, and reduce the attackers’ total processing power to less than 51% of the network. There is no limit to how much additional processing power can come in and un-censor the network, other than real-world resources external to the network. In other words, for a proof-of-work blockchain, a 51% censorship attack is a “check” but not a “checkmate.”
When Satoshi Nakamoto created Bitcoin and put it out into the wild in January 2009, he did so anonymously and without raising capital. He merely published a white paper, various emails, and then the open-source software. It’s actually quite notable that he gave away all the key insights before he published the software itself, which demonstrates that he wasn’t operating under a profit motive.
Satoshi didn’t grant himself any coins. He didn’t arbitrarily hand coins out to his friends. He didn’t create an investment contract, raise capital as a security, and give those capital providers initial coins. Instead, he merely put out an open software client, and every single spendable coin had to be earned by a user contributing processing power to the network, or from buying the coin from a user who did.
Your social media account is an item in a corporation’s database; it can be deleted or changed, and you have no say in this. You have no way to audit what information they hold about you in their database.
Prior to the invention of proof-of-work and especially prior to the invention of Bitcoin, everything that was digital was almost freely copyable. In fact, that was the main feature, rather than a bug. That’s where software’s massive productivity enhancement comes from; the digitization of things allows for the increased proliferation of those things at a negligible marginal cost.
If someone expends time and resources to create a book, song, picture, movie, game, application, or other digital thing, then the difference in cost to distribute it to a hundred people, a thousand people, a million people, or a billion people, is almost negligible.
This impressive feature does, however, create some problems. For example, software companies have spent decades trying to figure out how to make sure only paying customers get access to their products and have used various things like software license keys or cloud-based accounts to minimize unlicensed usage. Similarly, the easy and global spread of digital music files forever changed the economics of the music industry. Digital piracy has been a concern for content producers of all types for decades.
Internet spam became another problem. If it is costless to send an email, post a message, or create an account, then how do we prevent someone from abusing this feature, or writing a program to do it repeatedly at superhuman speed? That type of spam is what Adam Back invented Hashcash back in the 1990s to try to solve; digital interaction was so frictionless that he invented the proof-of-work concept to purposely give it a little bit of friction back, to impose a micro-cost on certain digital actions when it is appropriate to do so.
Most people don’t realize this, but Satoshi opened a portal from the physical realm into the digital realm. And energy began to flow into cyberspace, bringing life to a formally dead realm consisting only of shadows and ghosts. Bringing conservation of energy and matter, objectivity, truth, time, and consequence into the digital realm, delivering property rights, freedom, and sovereignty that is separate from the physical and the political realm, to humanity.
Today, the Bitcoin network’s electricity consumption is estimated to emit less carbon dioxide than random things we don’t think about, like tumble driers or zinc production. If the world was 10% more efficient at turning off our always-on electronic devices when not in use, it would save more electricity than the Bitcoin network consumes.
If Bitcoin becomes wildly successful with trillions of dollars of utility for users, we could potentially see it consume an amount of energy per year that is comparable to the aluminum production industry. In other words, despite reaching a massive scale and serving numerous purposes as a global monetary network, it would still be comparable in energy usage to various other random industries that we don’t generally become morally panicked about.
Scaling By Layers and the “Cost Per Transaction” Fallacy
The Bitcoin network can do a maximum of several hundred thousand base layer transactions per day. That’s about five transactions per second. The theoretical limit has increased moderately over time due to occasional upgrades that improve transaction density.
This transaction limit is often unfavorably compared to credit card networks, which can process tens of thousands of transactions per second. Due to that, critics often point out that Bitcoin’s energy usage per transaction is very high, and thus the network is inefficient and should be avoided for environmental reasons.
The first problem with that reasoning is the fact that Bitcoin uses energy whether transactions are occurring or not, due to the block subsidy that miners earn when they produce a new block, regardless of how many transactions are in that block. The way to think about it is that a large portion of that energy is used simply for securing the network against transaction censoring or deep block re-organizations, and therefore keeping it attractive as a settlement network and store of value while it’s still in its nascent state. One block might have 1,200 transactions. The next block might have 2,500 transactions. The block after that might have 1,800 transactions. Meanwhile, the same number of miners are hooked up to the network between those subsequent blocks, using the same amount of electricity. Whether blocks are full or not, they’re using roughly the same amount of electricity. And each new block is further securing all prior transactions stretching back to the genesis block.
You can think of this concept like running your dishwasher each night. Whether it’s 30% or 90% full when you run it, it still uses about the same amount of resources per run. The marginal extra dish or utensil doesn’t materially affect the dishwasher’s energy usage, and thus the “water per dish” metric isn’t particularly relevant.
Bitcoin miners are unusual energy consumers in the sense that they can go to wherever the energy source is, as long as they can get some sort of basic low-bandwidth internet connection, including a satellite connection if needed. That means they use energy in quite efficient and unusual ways, and we don’t usually see bitcoin miners near cities where electricity tends to be more expensive.
For many years, China was an interesting example of bitcoin mining mobility. The province of Sichuan has a lot of overbuilt hydroelectric capacity. During the wet season, they produce more clean electricity than they can possibly use, and so it is wasted. It is stranded power.
Since bitcoin miners can go to where the energy source is, they used to flock to Sichuan during the wet season to make use of that otherwise wasted energy. This was not because they are altruistic environmentalists, but simply because it is cheap and nobody else was making use of it. Electricity that would otherwise be wasted and generate no revenue for the operator, can be sold for extremely cheap levels to someone who can find a use for it, such as bitcoin miners in this case.
Many types of petroleum deposits come with associated natural gas.
If there is enough of this gas, it can be collected and sent via pipeline or other transport networks to be used as a primary energy source, since of course natural gas is extremely useful for electricity and heating. However, if it’s a small amount, then it’s not economical enough to build a pipeline or otherwise collect that gas.
So, what happens? It gets vented or flared into the atmosphere, and therefore wasted. Venting means just letting the gas out into the atmosphere, mainly as methane (which is a stronger greenhouse gas than carbon dioxide). Flaring means the gas is burned for no productive purpose, and thus converted into carbon dioxide and emitted into the atmosphere. It’s a complete waste, either way, and yet still contributing to global greenhouse gases.
In terms of scale, the World Bank uses satellite data to estimate that 144 billion cubic meters of natural gas is vented or flared per year throughout the world. That wasted energy alone is enough to power the entire Bitcoin network several times over.
Some people ask, “can’t we capture this methane without bitcoin miners?” but the problem is that without proper economic incentives, it just doesn’t happen. People can theorize about what should happen, but then don’t do it themselves.
One of the problems with solar and wind power is that the cost of energy storage is very high. Bitcoin mining makes it profitable to overbuild renewable sources of energy production, since it allows that surplus supply to be monetized. Every community that wants reliable power needs overbuilt electric capacity anyway, and for wind, solar, and hydro that’s even more important because they are variable. However, overbuilding is usually not very cost effective, unless it can be used for something profitable and useful when it’s not otherwise needed.
Bitcoin miners are a unique solution to that problem by making overbuilding profitable, and thus play the indirect role of an energy storage solution.
Most of the energy consumed by bitcoin miners is released as heat. A computer processor is basically a heater that happens to perform calculations while it heats. One of the ways to make bitcoin mining cost effective, in addition to finding the cheapest (and thus stranded) sources of electricity, is to use the heat for productive purposes.
A person or company can literally replace a space heater or pool heater with a bitcoin miner, although they do have a higher up-front cost in exchange for generating revenue while they heat. On a larger scale, space heaters and greenhouse heaters can be replaced by bitcoin miners as well.
Satoshi himself observed this back in 2010, since discussions around Bitcoin’s environmental impact were brought up right from the beginning. Here is how Satoshi envisioned it:
The heat from your computer is not wasted if you need to heat your home. If you’re using electric heat where you live, then your computer’s heat isn’t a waste. It’s equal cost if you generate the heat with your computer. If you have other cheaper heating than electric, then the waste is only the difference in cost. If it’s summer and you’re using A/C, then it’s twice. Bitcoin generation should end up where it’s cheapest. Maybe that will be in cold climates where there’s electric heat, where it would be essentially free.
My primary hesitation from the very beginning was that it seemed to me like anyone could just copy the code and create a different blockchain money. With precious metals, each one is scarce, and there are only a handful of different types. With blockchain monies, anyone with a bit of coding experience can copy one of the existing ones, change a few variables, and release it. Therefore, although there will only ever be 21 million bitcoin, the concept can experience supply inflation and dilution by the introduction of countless new blockchain monies.
Ever since the network’s early history, there was a growing divide between people who wanted to increase the block size and people who wanted to keep it small. Increasing the block size allows the network to process more transactions per unit of time (not considering layer two solutions and sidechain solutions, which weren’t fully developed yet). However, increasing the block size also increases the bandwidth and data storage and processing power required to run a full node, and thus puts it out of the reach of the everyday user on a laptop. If users can neither mine nor operate a full node themselves, they must trust large-scale network providers, and Bitcoin would cease to be a permissionless, decentralized peer-to-peer system. It would permanently weaken the consensus function of the node network.
Even Satoshi himself played a dual role in this debate as early as 2010; he’s the one that personally added the block size limit after the network was already running, but also discussed how it could potentially be increased over time for better scaling as global bandwidth access improves. After the seeds of this disagreement were laid from the protocol’s inception, and with Satoshi long gone, it was from 2015 through 2017 that the Blocksize War went into full conflict.
The first risk that I identified was that of market dilution. If people keep making new cryptocurrencies, then what stops the entire market from being heavily diluted and fractured? There is no assurance that one or two cryptocurrencies will emerge as the most salable, and therefore accumulate most of the monetary premium among the infinite number of potential coins.
In practice, however, Bitcoin has been the largest cryptocurrency by market capitalization for 14 consecutive years, and only Ethereum has come anywhere close to it at certain points of time. Nothing else is remotely on the same scale. Once a well-designed cryptocurrency becomes large, its security and depth of liquidity overshadows everything else.
Protocols in general tend to consolidate toward one dominant standard and maintain that hold for decades or longer, due to network effects. There were competing protocol stacks for the internet, for example. However, once a protocol emerges as dominant, it generally becomes a virtuous cycle of more and more usage. The introduction of any competing protocol starts at a massive disadvantage, because it is not compatible with most applications and devices on the market. Only if a new protocol is an order of magnitude superior would it have any chance of competing against an established protocol; it can’t just be marginally better. Plus, the dominant protocols can and do upgrade over time in a backwards-compatible way, which is how they remain relevant over long periods of time.
Bitcoin is purposely simple by design and therefore maintains a smaller, tighter, and more auditable codebase than other cryptocurrencies, but its history is not perfect.
For this reason, when developers release a new update, many node operators are purposely slow to update to it. Developers cannot “push” updates to node operators, which is what makes the system functionally decentralized and immutable, and therefore minimizes the power that developers have. Node operators get to decide if they will update, and in practice it’s best to wait a while for more code reviews and more time in operation to ensure that it’s without critical bugs. If a small portion of the node network updates and a bug is found, they can just roll back to the prior version.
Bitcoin is stateless money, and many parts of “the State” don’t necessarily like the fact that it exists.
Governments around the world have various banking laws that allow them to monitor bank transactions and freeze accounts. More importantly, governments benefit from seigniorage; they can fix budget deficits by printing more currency to fill the difference, and thus dilute everyone’s savings by a little bit at a time in a non-transparent manner. Governments whose debt is denominated in their own currency can never nominally default against their will; they can always create more currency. Their constraints in practice are inflation and public unrest, and their currency can unravel if enough people lose faith in it.
Many authoritarian countries are unattractive places for citizens to keep their wealth, and so citizens want to move their wealth offshore to freer countries with better rule of law for safekeeping. These authoritarian governments therefore do their best to limit capital outflows by controlling the currency and the banking system.
Stateless money allows people to save in a monetary asset that is not issued by a government, and that has a large cost to censor (gaining and maintaining over 50% of the processing power of the global network). It provides a method for portable, self-custodial, peer-to-peer value transfer outside of the banking system. Rather than only wealthy people having offshore bank accounts, Bitcoin gives access to the functional equivalent of an offshore bank account to anyone with a smartphone, except without counterparty risk.
Bitcoin and stablecoins threaten the money-printing privileges of many countries, starting with the weakest and going up from there. Governments, however, have various methods to push back on this.
Firstly, governments can sever known cryptocurrency exchanges or brokers from their nation’s banking system, through legislation or through informal pressure. A government or central bank can tell all banks that they are not allowed to let customers transfer money to any cryptocurrency exchange or broker or provide banking services to a cryptocurrency-related company. This is very easy for a government to enforce, is a form of capital control, and it limits the speed with which value can flow out of the nation’s banking system and into bitcoin, stablecoins, or other cryptocurrencies. During the end of long-term debt cycles when sovereign debt needs to be inflated away, capital controls are a common practice by governments. As a country’s public ledger (fiat currency) gets heavily diluted, lawmakers do their best to force people to remain within the ledger as it burns down rather than fleeing to other ledgers.
However, even the more severe practice of completely banning banks from sending fiat currency to cryptocurrency exchanges isn’t a complete solution for governments, because people can still exchange value peer-to-peer. One prominent example is Nigeria, which has severed cryptocurrency exchanges and brokers from its banking system, but still has one of the highest cryptocurrency adoption rates in the world among its population. A Nigerian can still send money to another Nigerian, and that second Nigerian can send them bitcoin in return.
Just like alcohol usage under prohibition, bitcoin usage is hard to stamp out entirely; it can only be pushed into the black market and made difficult to use.
Bitcoin miners use the SHA-256 hashing algorithm to generate new blocks of transactions for the blockchain. Any normal processor can technically do this, including laptop CPUs for example. In the early days of the network, that was how it was done. However, as bitcoin mining became a large industry, engineers developed more specialized processors to optimize its efficiency. For well-defined processing tasks, application-specific integrated circuits (“ASICs”) are far more efficient than a general processor at solving that task once they are designed and produced.
Nowadays, the only way to mine bitcoin in practice is to get ASICs that are specifically designed to do it. There is no amount of general computing that can economically mine bitcoin. If Amazon, Microsoft, and Google were to turn the entirety of their combined cloud server infrastructure toward mining bitcoin or trying to perform a 51% censorship attack on the network, they wouldn’t even make a dent. The millions of specialized ASICs around the world that spend all day mining bitcoin are orders of magnitude more powerful for this specific task, which is to guess numbers as quickly as possible for as little electricity per guess as possible.
Therefore, there are some risks associated with the processing equipment involved in bitcoin mining.
Firstly, there are only a handful of top-end chip foundries in the world, which is where various semiconductor products including ASICs are made. On top of that, there are only a handful of companies that currently design SHA-256 ASICs. Therefore, there is a supply chain bottleneck risk associated with making and obtaining bitcoin mining processors.
As of this writing, several large and well-capitalized companies are currently working to diversify the design and fabrication of SHA-256 ASICs. So, this risk can be mitigated, but combined with the prior risk about government bans, supply chain bottlenecks are a realistic threat to monitor.
Secondly, if some entity manages to create a sharply superior ASIC and retains a monopoly on its use, they could pose a censorship threat by outclassing the rest of the processing power on the network. The improvements in ASICs are slowing down, and processors in general (not just ASICs) are likely getting close to the physical limits of Moore’s law, where it becomes harder and harder to make meaningful improvements. Transistors are so small now that they are starting to bump into atomic limits. It’s hard to envision a much better ASIC that could overwhelm the rest of the network, but the possibility must be considered since there could be some major stepwise development in computing.
Similarly, quantum computing is a long-term possibility. The development and deployment of sufficiently advanced quantum computers may be able to determine a private key from a public key, which is not remotely possible for traditional processors. If that occurs, then it would begin breaking the security assurances of the Bitcoin network. There are, however, possible upgrades to prevent this. Specifically, quantum-hard algorithms can be utilized.
The annual military budget of the United States is over $800 billion, and China’s annual military budget is over $250 billion. It currently requires billions of dollars to attempt a sustained 51% censorship attack on the Bitcoin network, and these entities have the capital to do it if they were to try it. Such a proposal probably wouldn’t go over well politically (imagine the negative publicity in the United States if it was known that the Pentagon was spending billions of taxpayer dollars, at a time of record fiscal deficits, to attack the Bitcoin network), and the network could respond to the threat with higher transaction fees to pay more miners to come online and un-censor it. But such an attack is not outside of the realm of possibility. Even just spending a few billion dollars to spam the network for years, making it harder and more costly to use, is something that a large government or military can do. Doing so, however, would enlarge and strengthen the bitcoin miners via higher transaction fee revenue, who can advocate for the network politically and through other means. High base-layer fees also tend to accelerate the adoption of second layer technologies to make more efficient use of block space.
Overall, we can imagine several risks occurring together to combine into a rather serious threat. Governments could ban or severely restrict usage of the Bitcoin network, force various financial institutions to sell their holdings to crash the price, and drive the technology into the black market. From there, they could go after the supply chain and do their best to prevent the construction and distribution of new SHA-256 ASICs. If bitcoin’s price remains low for a long time, many miners would become unprofitable and disconnect from the network until the difficulty adjustment reduced enough to find a new steady state. This would sharply reduce the cost of attempting a 51% censorship attack, and at that point perhaps some large government entity would spend the resources to do it, for the sake of eliminating the threat of stateless money entirely.
Lagarde mentioned France’s existing limit for cash payments, which is part of their effort to reduce cash usage but is somewhat hard to enforce. Several countries have laws limiting the amounts of cash that businesses can accept, and France has one of the lowest limits. Second, Lagarde referred to a terrorist attack from nearly a decade ago as a potential reason to disallow citizens from having any uncontrolled anonymous transactions whatsoever. Over the past fifty years, less than 0.001% of the French population has been killed in terrorist attacks, and yet it’s her go-to reason for the importance of top-down centralized surveillance and control of all transactions in the country.
If we envision an ideal form of money, we envision very different things depending on who we are and what we aim to do. From the perspective of a central bank or government agency, the ideal money is one that they have absolute control over. They want it to gradually devalue over time, be easily surveilled and programmable by the issuer, and able to be frozen by the issuer at will for reasons that they consider to be justified. Central bank digital currencies are being and will continue to be advertised as systems that make financial services more accessible to people and that give enhanced tools to law enforcement personnel to catch criminal activity. However, the very technology that enables those features also gives governments and corporations an enhanced ability to crush public dissent and control the lives of their citizens, which is relevant in a world where over half of the global population lives under authoritarian or semi-authoritarian regimes and where there are 160 different currency monopolies. From the perspective of an individual user, the ideal money is one that is resistant to debasement, that can’t be easily seized or controlled by third parties, that offers enhancements to transactional privacy, and that is globally portable and globally accepted.
This era represents a fork in the road. One direction provides a stepwise upgrade to those who wish to continue the multi-century trend of further and further centralization of the financial system. The other direction reverses that trend, fractures the existing forces of centralization, and gives more financial autonomy back to individual users who wish to take it.
Privacy used to be expensive to violate. Prior to the widespread usage of the internet, smartphones, surveillance cameras, and other technologies, the only way to violate someone’s privacy was to physically spy on them, search their person, or search their property. And because of this, the person who had their privacy violated had a good chance of knowing that it was violated.
In the digital age, it’s increasingly easy and inexpensive for governments, corporations, or individuals to violate someone’s privacy, and without that person knowing. For governments and corporations, a combination of public and private information on billions of people can be harvested automatically on all the major financial and communication platforms. That data, once collected, can be organized by various Big Data techniques including machine learning, and algorithmically monitored or made easily searchable to users of the database. Centralized treasure troves of this data are frequently hacked and made available on the dark web as well.
Humans have an instinct to not want to be watched. We close our curtains at night. We are bothered if a stranger looks at us for too long in public. Our restrooms have doors on them; our voting booths have curtains on them. We are rightly concerned about our own cameras or microphones being hacked, allowing someone to watch us or listen to us when we are unaware.
Privacy is important in a free society but is even more critical in an unfree society. In unfree countries, someone who has the “wrong” political opinions, sexual life, or religious affiliation may face persecution by the government or other members of society even if what they are saying, what they are doing, or what they believe causes no direct harm to others. There will always be people who believe they know what the best way to live is, and that they somehow have the right to force others to live that way.
Unfortunately, as surveillance technology becomes more powerful over time, people can’t realistically ask their governments or corporations for privacy. The answer will be “no” and the reasons for that keep changing over time. In the United States, during the 1970s and 1980s the reason for why privacy had to be systemically violated was the war on drugs. In the 2000s the reason shifted toward the war on terror. In the 2020s the reason shifted toward the war on trafficking and alignment with enemy nation states. There will always be a reason presented as to why nobody can have privacy, to ensure that a small percentage of people don’t abuse it for criminal purposes.
Instead, if people want privacy, they must build powerful counter-technologies that allow people to retain some of their own privacy and force the laws and activities to reshape themselves around that new technological reality. Just like people build physical walls around their persons and their physical possessions, which require expending energy and legal effort to bypass, they must build digital walls around their digital data for the same purpose.
Starting on the first day of January 2020, for example, Germany’s government lowered the threshold on how much physical precious metals may be purchased by an individual without doing an identity check from 10,000 euros to only 2,000 euros worth of gold — ostensibly to combat money laundering. Germans can buy all sorts of things for over 2,000 euros without showing identification, but not gold. In late 2019, leading up to this change, there were long lines of people queuing at bullion shops to purchase precious metals with privacy before the tighter identification thresholds went into effect.
Similarly, during the past decade France banned cash transactions over 1,000 euros. The stated goal was to combat terrorist financing and money laundering. Several other countries have similar restrictions on cash.
Alphabet’s data collection capabilities are particularly noteworthy. With their main Google website, by far the most-used search engine in the world, they can track your search history. With Chrome, the most-used browser in the world, they can track where you go online. If you upload a document to their cloud, they can scan it and determine if it violates their terms of service. If you use Gmail, they can scan your email history and real-time communications. If you have an Android-based phone, especially if you don’t have certain privacy settings enabled, they can track your location, your app usage, and other fine details. Imagine the amount of information that people have given to one corporation — the ability to read their emails, documents, search history, what websites they go to, their app usage, and perhaps their real-time physical location.
The Prism program allows the NSA, the world’s largest surveillance organisation, to obtain targeted communications without having to request them from the service providers and without having to obtain individual court orders.
With this program, the NSA is able to reach directly into the servers of the participating companies and obtain both stored communications as well as perform real-time collection on targeted users.
Extensive government surveillance, especially when used in automatic and ubiquitous ways rather than targeted ways based on probable cause, is implicitly based on the premise that everyone must give up most or all their privacy to central authorities to ensure that nothing bad happens. Because people are generally not very quantitative in nature, and instead tend to be more responsive to emotional arguments, most people go along with such intrusions.
For example, over the past several decades less than 0.05% of global deaths have been from terrorism. In most countries outside of the Middle East and Africa, the percentage is lower than 0.01%. That means fewer than one in ten thousand people die from terrorism in most countries. And yet, countless laws are shaped around granting governments additional powers to prevent terrorism.
The 2001 Patriot Act was an example of legislation that gave more power for government surveillance and control techniques to prevent terrorism, and it was received well at the time because it came shortly after the infamous 9/11 terrorist attacks. With this type of legislation, people hand over a part of their privacy, indefinitely, during the peak of an emotional response to a recent event. Decade after decade, event after event, this centralizing tendency chips away at individual rights to privacy and begins to shape culture to align with the idea that people who want privacy must be up to something bad.
In a free and open society, there is generally debate and pushback around priorities, and an arms race between criminals and law enforcement. Naturally, we want terrorists, human traffickers, violent street criminals, mob members, murderers, thieves, fraudsters, and other dangerous individuals to be caught and prosecuted, and therefore most people happily provide resources to law enforcement to achieve those ends. However, the procedures and technologies used by law enforcement to catch dangerous criminals can also be used by governments to suppress speech, surveil human rights activists and pro-democracy activists and political opponents, and maintain authoritarian control over their subjects — which is why it’s important to have limitations on their powers.
Whenever given the opportunity, governments around the world frequently grant themselves crisis powers, and then extend some, or all, of those powers indefinitely. Only in countries with a deep culture of respecting individual liberty, democracy, and government accountability, has there generally been enough societal pushback to elect leaders that dismantle prior powers and actively decrease government overreach.
In the modern era, people should assume that virtually all information about them is collected into corporate databases, that their government can access the databases, and that the databases are vulnerable to external breaches by non-state or foreign-state hackers or inside leakers. It is most likely the case that your sensitive personal data has been leaked multiple times on the dark web, and that your personal data is easily accessible to intelligence analysts as part of their surveillance apparatus.
When everything is put together, it can lead to a rather Orwellian outcome. What may sound like a dystopian science fiction movie could become an increasing reality in many jurisdictions, especially jurisdictions of the more authoritarian variety.
Some technologies are inherently centralizing, while others are inherently decentralizing. An example of a decentralizing technology was the printing press. It was a necessary ingredient for the Protestant Reformation, the American Revolution, the French Revolution, and all sorts of major changes to society. It enabled large countries to shift their governance models from theocracy and monarchy toward democracy, since it enabled the inexpensive distribution of information and ideas over long distances.
Prior to the invention of the printing press, books had to be copied by hand. It was a labor-intensive (and therefore expensive) process. Written information was expensive, literacy rates were low, and therefore information was highly centralized. In terms of Christianity, people were not expected to have their own Bibles or interpret the contents for themselves; the church priests had the expensive Bibles and interpreted them for their churchgoers. After the invention of the printing press, it became much cheaper to reproduce books, pamphlets, and other writings. A person could more easily own or access a copy of the Bible, interpret it for themselves, and then mass-produce and distribute pamphlets articulating their views. Similarly, a person could more easily spread political pamphlets against rulers in charge of their society and organize the public around a set of new ideas or grievances. Or a person could write and distribute stories that inspire new ideas and shape the culture around them.
Encryption is a newer decentralizing force and an asymmetric defense because it is cheap to deploy but expensive to attack. The top encryption methods today cannot be broken even by the best supercomputers. No matter how many billions of dollars that governments and corporations use to try to break strong encryption, they can’t do it. And as computers get stronger at breaking earlier encryption methods, new and more powerful encryption methods arise. A physical analogy for this is that encryption is like a bunker that can’t be destroyed by any bomb currently in existence, no matter how powerful.
With the rise of the internet in the 1980s and 1990s, along with the digitization of money, many technology-focused people began to raise concerns regarding how this technology could be used in oppressive ways and how tools need to be developed to push back on those types of oppressive technologies. These individuals, often known as “cypherpunks,” specifically advocate the usage of encryption as one of the main tools toward these ends.
What allows some countries to persist as democracies and others to repeatedly degrade into autocracies, is the presence of independent institutions and checks on power, or the lack thereof.
In the United States, for example, we have a constitution at the base layer and then three branches of government with defined rules on how they interact with each other. It’s not a perfect system, but it has done reasonably well and lasted for centuries through all types of different presidents and technological eras. If democracy relies on always having the right people in power, then it’s destined to fail quickly. Institutions such as separate branches of government and founding documents that are held higher than any individual are what give the democratic system a degree of staying power. Strong and independent institutions make it so that for democracy to be lost, it requires a long period of chipping away at it rather than just one bad election.
In 1991, a computer scientist and cryptographer named Phil Zimmermann created a program called “Pretty Good Privacy” or PGP for short. He published the open-source code, and it became the first widely available implementation of public-key cryptography that could be used by the public for ensuring that online messages were private between the sender and the receiver.
In 1993, the U.S. federal government began a criminal investigation against Zimmermann for allegedly violating the Arms Export Control Act. The government considered software encryption to be a form of munitions, and they considered Zimmermann’s code being shared freely to be a form of munitions export.
In 1995, Zimmermann responded by publishing a book via MIT Press called PGP Source Code and Internals, which contained the full source code of his program. The reasoning was that although his code could supposedly be suppressed via the Arms Export Control Act as a munition, if he publishes it in a book then it is protected by the First Amendment to the U.S. Constitution, which grants freedom of speech and overrides lesser laws that would interfere with freedom of speech. Software code is merely a collection of words and numbers, and in this case, it was a defensive technology rather than one that could directly harm others.
People would even put encryption-related code on t-shirts and wear them around, with warnings displayed on the shirts indicating that these shirts are classified as munitions and may not be exported. These sorts of protests 1) used some of the more foundational laws like the First Amendment in their favor, and 2) generally showed the absurdity of restricting information by taking such restrictions on information to their logical conclusions, since they imply the existence of so-called dangerous t-shirts.
In 1996, the U.S. federal government dropped their charges against Zimmermann. They also went on to liberalize their munitions export restrictions around cryptography. End-to-end encryption subsequently played a very large role in enabling safe e-commerce from the late 1990s to the present day, as people share payment details online while trying to protect their payment details from bad actors. Sometimes, David does beat Goliath.
Financial censorship against protestors or political opposition is a common tool in authoritarian and semi-authoritarian regimes, but shades of it occasionally pop up in democracies as well, usually around wars or other extreme events. When choosing to support or oppose the usage of such tools in a given context, one must keep in mind that any power the government has can be used in the reverse context as well. For real freedom to exist, it must be held above any specific interest, rather than something that is easy to take away from groups that we may not like. In other words, due process should occur for the most virtuous groups and the most odious groups alike.
The Bitcoin network was built and initially adopted by people of the cypherpunk movement, which, as previously mentioned, refers to those advocating widespread use of cryptography and privacy-enhancing technologies as a route to social and political change. From that base, a broader subset of libertarian-minded people became enthusiastic supporters of the network as well.
If some group can create money at a cost that is significantly below the current market value, then they have gained the power of seigniorage, and therefore control the ledger entirely or in part. In contrast, if nobody can create money for free, such as in a world of collectible commodity proto-monies between tribes of similar technical proficiency, then nobody has the power of seigniorage, and nature alone controls the ledger.
In fiat currency systems, sovereign governments and central banks can create money nearly for free, which everyone else is supposed to treat as valuable within a jurisdiction, even as it is continually diluted.
Gold has long been turned to as a form of defense and savings, but it’s not a useful transactional money in the digital age. The Bitcoin network presents a newer and faster alternative, where nobody can create bitcoin for free, and thus nobody has the power of seigniorage. Similarly, nobody can censor transactions unless they control over 50% of the network’s active processing power. And it can move globally without the need for central banks as bottlenecks. However, the network is still in its relative infancy, and it remains to be seen how robust it will be in the face of bigger attacks from large governments that may try to protect their own centralized monetary systems as they become destabilized from their own entropy over time.
The idea of separating money and state is not about eliminating the state. Instead, the idea is about creating a decentralized monetary technology that, if it were to be widely adopted and resistant to attacks, would put the state more on a level playing field with everyone else.
We cannot know the future. The best that we can do is analyze the present, envision what we think the future should be like, and then play our individual roles to move toward that vision. In my view, open-source decentralized money that empowers individuals, that is permissionless to use, and that allows for a more borderless flow of value, is both powerful and ethical. The concept presents an improvement to the current financial system in many ways and provides a check on excessive power, which makes it worth exploring and supporting.