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Bitcoin is Not a Currency: It’s Surreal Economics

The popular bitcoin exchange Mt. Gox closed on Monday after a leaked “crisis strategy” document revealed that approximately 750,000 bitcoins had been stolen from online vaults. Customers were infuriated, but few were surprised. For weeks, Mt. Gox had been delaying withdrawals, and the company had moved out of its offices in Tokyo. Members of the Internet avant-garde, wearing Google Glass and holding MacBooks, were protesting outside of the closed offices as early as February 13.

Bitcoin claims to be “an innovative payment network and a new kind of money,” using cryptography to control the dispersement and transfer of funds. [Editor’s Note: Capitalized “Bitcoin” refers to the currency network, while lowercase “bitcoin” refers to the currency itself.] Many Silicon Valley enthusiasts, including investor Marc Andreessen, have hailed Bitcoin as a “sweeping vista of opportunity.” Others, such as Nobel Prize-winning economist Paul Krugman, think that Bitcoin is “evil.”

Krugman may be hyperbolic, but his concern is well-founded. Last December, he said:

I have had and am continuing to have a dialogue with smart technologists who are very high on Bitcoin—but when I try to get them to explain to me why Bitcoin is a reliable store of value, they always seem to come back with explanations about how it’s a terrific medium of exchange. Even if I buy this (which I don’t, entirely), it doesn’t solve my problem.

Krugman’s problem is that bitcoins do not meet the economic definition of a currency. To properly function, currencies need to do three things. First, currencies need to provide a unit of account. Bitcoin does that. Second, currencies need to function as a reliable medium of exchange. After the Mt. Gox theft, this function is, at best, tenuous. Finally, currencies need to store value. Bitcoins definitely do not do that.

Gold is a great store of value, because if all else fails, people can make pretty things with it and take advantage of its electrical conductivity. The U.S. dollar is (theoretically) a great store of value, because the Federal Reserve can buy dollars back to maintain a stable market price. Bitcoin has no secondary purpose, like gold, and it has no central bank, like the dollar. Consequently, the value of bitcoins fluctuates wildly, because the price is set by Internet speculators, like The Social Network‘s Winklevoss twins. The chart below shows the closing price of bitcoins, measured in U.S. dollars, over a one year period.

bitcoin price chart

In just one month, between November 2013 and December 2013, the price of a bitcoin skyrocketed from approximately $200 to over $1,000. Post Mt. Gox, the price is hovering around $550. Now compare Bitcoin to Brazil’s Real, which economists and Brazilians consider to be very unstable.

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Brazilians have mocked their currency as “surreal,” because its value has shifted by 20% over a one year period. Some Brazilians even printed fake currency featuring surrealist Salvador Dali to make the point. Maybe Krugman’s sinister description is not an exaggeration: a bitcoin’s value can fluctuate 1,000% in a single year, which is comically volatile compared to the Real.

Slate and others have suggested that the Mt. Gox theft and price fluctuations are just part of Bitcoin’s “growing pains,” as it becomes a legitimate currency. That approach is highly optimistic, especially given the market reaction to Mt. Gox.

Imagine that 6% of all U.S. dollars–the amount of bitcoins missing from Mt. Gox–were mysteriously stolen from banks and from under mattresses around the globe, and imagine that there was little hope that victims would get their money back. Do you think that people would want to convert more of their wealth into dollars?

The obvious answer is “no.” But after collapsing to $450 on Tuesday, the price of bitcoins has soared above $550 in 24 hours. Investors are still buying bitcoins… in droves. That’s not a market correction–that’s insanity. Bitcoin’s not a currency–it’s a speculative commodity.

When Andreessen describes Bitcoin’s potential, he’s right about many things. Although Bitcoin has been associated with the defunct black market website Silk Road, bitcoins are not primarily used to buy illegal products. (Actually, they’re not really used to buy anything, but that’s beside the point.) Bitcoins also offer an inexpensive and easy way to make transactions online, and the code itself solves the complex “Byzantine Generals’ Problem,” allowing new forms of authentication for digital signatures, contracts, and more.

But Andreessen’s arguments do nothing to alleviate Krugman’s concerns, and they should not convince anyone, except speculators, to invest in bitcoins. The technology may be exciting, and the promise may be genuine, but bitcoins are not currency; it’s unlikely that they ever will be. Instead, Bitcoin is a libertarian economic experiment that went viral. That doesn’t sound like a good investment.

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Joe Wlos
Joe Wlos
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Joe studies political science at Grinnell College in Iowa. His writing focuses on the convergence of politics, law, and technology. He is a co-founder of the College News Cooperative and is proud to be a co-founder of ITPT with his friend and former editor Solomon.

9 Comments

Somebody's relative

2014-02-26 22:20:52 Reply

Bitcoin isn’t a commodity. It’s a Ponzi scheme.

    Joe Wlos

    2014-02-27 18:32:55 Reply

    Joe Wlos

    You’re right, in that Bitcoin today shares some characteristics of a Ponzi scheme. However, even Bitcoin’s internal lingo mimics commodity trading–Bitcoin enthusiasts “mine” for a limited number of coins, just as companies mine or drill for limited numbers of natural resources.

Albert Golo

2014-02-27 22:13:58 Reply

You don’t even know the meaning of the term “Ponzi Scheme” because in no rational or logical or factual way does it at all correspond to the Bitcoin protocol.

    Solomon Miller

    2014-02-27 22:54:52 Reply

    Solomon Miller

    I’m with Albert. A Ponzi scheme is defined as fraudulent and premised on bad faith. Bitcoins are up front about their lack of inherent value. The code guarantees stability and popular use creates transactional value. I doubt it will last, but if the bubble bursts and people lose money, at least they knew what they were getting in to. No one’s losing their life savings on bitcoins.

    Joe Wlos

    2014-02-27 23:02:19 Reply

    Joe Wlos

    I wouldn’t call it a Ponzi Scheme either, but it’s similar in some aspects. Posner writing at Slate explains well: http://www.slate.com/articles/news_and_politics/view_from_chicago/2013/04/bitcoin_is_a_ponzi_scheme_the_internet_currency_will_collapse.html

      Albert Golo

      2014-02-28 08:05:44 Reply

      A ponzi scheme, you morons, requires paying off investors with money from new investors while one entity pockets most of the funds. Bitcoin DOES NOT DO THIS. No value? I bought the laptop I am using right now with btc. I mined those btc.

      The value is going up again and appears to be quite stable around 600 USD.

      None of you have the slightest idea of what you are railing against, you are profoundly ignorant of even the basics of the subject.

Albert Golo

2014-02-28 08:07:25 Reply

Cryptographic Code Obfuscation: Decentralized Autonomous Organizations Are About to Take a Huge Leap Forward
by VITALIK BUTERIN on FEBRUARY 8, 2014
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Disclosure: the author of this article is involved with the Ethereum project.

There have been a number of very interesting developments in cryptography in the past few years. Satoshi’s blockchain notwithstanding, perhaps the first major breakthrough after blinding and zero-knowledge proofs is fully homomorphic encryption, a technology which allows you to upload your data onto a server in an encrypted form so that the server can then perform calculations on it and send you back the results all without having any idea what the data. In 2013, we saw the beginnings of succinct computational integrity and privacy (SCIP), a toolkit pioneered by Eli ben Sasson in Israel that lets you cryptographically prove that you carried out some computation and got a certain output. On the more mundane side, we now have sponge functions, an innovation that substantially simplifies the previous mess of hash functions, stream ciphers and pseudorandom number generators into a beautiful, single construction. Most recently of all, however, there has been another major development in the cryptographic scene, and one whose applications are potentially very far-reaching both in the cryptocurrency space and for software as a whole: obfuscation.

The idea behind obfuscation is an old one, and cryptographers have been trying to crack the problem for years. The problem behind obfuscation is this: is it possible to somehow encrypt a program to produce another program that does the same thing, but which is completely opaque so there is no way to understand what is going on inside? The most obvious use case is proprietary software – if you have a program that incorporates advanced algorithms, and want to let users use the program on specific inputs without being able to reverse-engineer the algorithm, the only way to do such a thing is to obfuscate the code. Proprietary software is for obvious reasons unpopular among the tech community, so the idea has not seen a lot of enthusiasm, a problem compounded by the fact that each and every time a company would try to put an obfuscation scheme into practice it would quickly get broken. Five years ago, researchers put what might perhaps seem to be a final nail in the coffin: a mathematical proof, using arguments vaguely similar to those used to show the impossibility of the halting problem, that a general purpose obfuscator that converts any program into a “black box” is impossible.

At the same time, however, the cryptography community began to follow a different path. Understanding that the “black box” ideal of perfect obfuscation will never be achieved, researchers set out to instead aim for a weaker target: indistinguishability obfuscation. The definition of an indistinguishability obfuscator is this: given two programs A and B that compute the same function, if an effective indistinguishability obfuscator O computes two new programs X=O(A)and Y=O(B), given X and Y there is no (computationally feasible) way to determine which of X and Y came from A and which came from B. In theory, this is the best that anyone can do; if there is a better obfuscator, P, then if you put A and P(A)through the indistinguishability obfuscator O, there would be no way to tell between O(A) and O(P(A)), meaning that the extra step of adding P could not hide any information about the inner workings of the program that O does not. Creating such an obfuscator is the problem which many cryptographers have occupied themselves with for the last five years. And in 2013, UCLA cryptographer Amit Sahai, homomorphic encryption pioneer Craig Gentry and several other researchers figured out how to do it.

Does the indistinguishability obfuscator actually hide private data inside the program? To see what the answer is, consider the following. Suppose your secret password is bobalot_13048, and the SHA256 of the password starts with00b9bbe6345de82f. Now, construct two programs. A just outputs00b9bbe6345de82f, whereas B actually stores bobalot_13048 inside, and when you run it it computes SHA256(bobalot_13048) and returns the first 16 hex digits of the output. According to the indistinguishability property, O(A) and O(B) are indistinguishable. If there was some way to extract bobalot_13048 from B, it would therefore be possible to extract bobalot_13048 from A, which essentially implies that you can break SHA256 (or by extension any hash function for that matter). By standard assumptions, this is impossible, so therefore the obfuscator must also make it impossible to uncover bobalot_13048 from B. Thus, we can be pretty sure that Sahai’s obfuscator does actually obfuscate.

So What’s The Point?

In many ways, code obfuscation is one of the holy grails of cryptography. To understand why, consider just how easily nearly every other primitive can be implemented with it. Want public key encryption? Take any symmetric-key encryption scheme, and construct a decryptor with your secret key built in. Obfuscate it, and publish that on the web. You now have a public key. Want a signature scheme? Public key encryption provides that for you as an easy corollary. Want fully homomorphic encryption? Construct a program which takes two numbers as an input, decrypts them, adds the results, and encrypts it, and obfuscate the program. Do the same for multiplication, send both programs to the server, and the server will swap in your adder and multiplier into its code and perform your computation.

However, aside from that, obfuscation is powerful in another key way, and one which has profound consequences particularly in the field of cryptocurrencies anddecentralized autonomous organizations: publicly running contracts can now contain private data. On top of second-generation blockchains like Ethereum, it will be possible to run so-called “autonomous agents” (or, when the agents primarily serve as a voting system between human actors, “decentralized autonomous organizations”) whose code gets executed entirely on the blockchain, and which have the power to maintain a currency balance and send transactions inside the Ethereum system. For example, one might have a contract for a non-profit organization that contains a currency balance, with a rule that the funds can be withdrawn or spent if 67% of the organization’s members agree on the amount and destination to send.

Unlike Bitcoin’s vaguely similar multisig functionality, the rules can be extremely flexible, for example allowing a maximum of 1% per day to be withdrawn with only 33% consent, or making the organization a for-profit company whose shares are tradable and whose shareholders automatically receive dividends. Up until now it has been thought that such contracts are fundamentally limited – they can only have an effect inside the Ethereum network, and perhaps other systems which deliberately set themselves up to listen to the Ethereum network. With obfuscation, however, there are new possibilities.

Consider the simplest case: an obfuscated Ethereum contract can contain a private key to an address inside the Bitcoin network, and use that private key to sign Bitcoin transactions when the contract’s conditions are met. Thus, as long as the Ethereum blockchain exists, one can effectively use Ethereum as a sort of controller for money that exists inside of Bitcoin. From there, however, things only get more interesting. Suppose now that you want a decentralized organization to have control of a bank account. With an obfuscated contract, you can have the contract hold the login details to the website of a bank account, and have the contract carry out an entire HTTPS session with the bank, logging in and then authorizing certain transfers. You would need some user to act as an intermediary sending packets between the bank and the contract, but this would be a completely trust-free role, like an internet service provider, and anyone could trivially do it and even receive a reward for the task. Autonomous agents can now also have social networking accounts, accounts to virtual private servers to carry out more heavy-duty computations than what can be done on a blockchain, and pretty much anything that a normal human or proprietary server can.

Looking Forward

Thus, we can see that in the next few years decentralized autonomous organizations are potentially going to become much more powerful than they are today. But what are the consequences going to be? In the developed world, the hope is that there will be a massive reduction in the cost of setting up a new business, organization or partnership, and a tool for creating organizations that are much more difficult to corrupt. Much of the time, organizations are bound by rules which are really little more than gentlemen’s agreements in practice, and once some of the organization’s members gain a certain measure of power they gain the ability to twist every interpretation in their favor.

Up until now, the only partial solution was codifying certain rules into contracts and laws – a solution which has its strengths, but which also has its weaknesses, as laws are numerous and very complicated to navigate without the help of a (often very expensive) professional. With DAOs, there is now also another alternative: making an organization whose organizational bylaws are 100% crystal clear, embedded in mathematical code. Of course, there are many things with definitions that are simply too fuzzy to be mathematically defined; in those cases, we will still need some arbitrators, but their role will be reduced to a limited commodity-like function circumscribed by the contract, rather than having potentially full control over everything.

In the developing world, however, things will be much more drastic. The developed world has access to a legal system that is at times semi-corrupt, but whose main problems are otherwise simply that it’s too biased toward lawyers and too outdated, bureaucratic and inefficient. The developing world, on the other hand, is plagues by legal systems that are fully corrupt at best, and actively conspiring to pillage their subjects at worst. There, nearly all businesses are gentleman’s agreements, and opportunities for people to betray each other exist at every step. The mathematically encoded organizational bylaws that DAOs can have are not just an alternative; they may potentially be the first legal system that people have that is actually there to help them. Arbitrators can build up their reputations online, as can organizations themselves. Ultimately, perhaps on-blockchain voting, like that being pioneered by BitCongress, may even form a basis for new experimental governments. If Africa can leapfrog straight from word of mouth communications to mobile phones, why not go from tribal legal systems with the interference of local governments straight to DAOs?

Many will of course be concerned that having uncontrollable entities moving money around is dangerous, as there are considerable possibilities for criminal activity with these kinds of powers. To that, however, one can make two simple rebuttals. First, although these decentralized autonomous organizations will be impossible to shut down, they will certainly be very easy to monitor and track every step of the way. It will be possible to detect when one of these entities makes a transaction, it will be easy to see what its balance and relationships are, and it will be possible to glean a lot of information about its organizational structure if voting is done on the blockchain. Much like Bitcoin, DAOs are likely far too transparent to be practical for much of the underworld; as FINCEN director Jennifer Shasky Calvery has recently said, “cash is probably still the best medium for laundering money”. Second, ultimately DAOs cannot do anything normal organizations cannot do; all they are is a set of voting rules for a group of humans or other human-controlled agents to manage ownership of digital assets. Even if a DAO cannot be shut down, its members certainly can be just as if they were running a plain old normal organization offline.

Whatever the dominant applications of this new technology turn out to be, one thing is looking more and more certain: cryptography and distributed consensus are about to make the world a whole lot more interesting.

Albert Golo

2014-02-28 08:40:42 Reply

it is not in any way a “ridiculous” idea, it is in fact the main protocol the next phase of the internet will be based around.

The Bitcloud protocol uses Bitcoin-style accounting to allocate those microtransfers, along with Bitcoin-style proof-of-work (they call it “proof-of-bandwidth”) and the authors suggest that the potential for profit by individual members will create enough capacity to replace a large number of centralized commercial services (“Youtube, Dropbox, Facebook, Spotify, ISPs”) with “distributed autonomous corporations,” that obviate the need for centralized control in order to supply anonymous, robust, free services to the public.

The idea is an interesting thought-experiment, at least. The idea of “agorics” — using market forces to allocate resources on the Internet — is an old one, and I remain skeptical that this produces optimal outcomes. That’s because its proponents seem to treat market efficiency as axiomatic (“everyone knows markets work, and that’s why we should make them the basis of network resource allocation”) and their proposals are substantially weakened if you don’t accept the efficient market hypothesis.

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how much money can you make bitcoin mining

2014-04-21 02:47:23 Reply

What

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