Bitcoin – and digital currencies – retrace the troubled history of banknotes

Commenting on Thomas Lowenthal’s original article at ArsTechnica on Bitcoin and the dangers involved in introducing a new currency.

The closest parallel to a pure digital currency play is the travails of paper money. Coinage is at least based on the value of the coin making up the face value. Paper money has no such associations which is why the gold bugs still want to return to the standard.

Money is only valuable when backed by a government that can use sufficient force to ensure that it will be used for all trade, debts and promissory notes. When a person asks, “You and what army?” a government can easily respond.

The reason paper money failed so often (going back to the first paper money issued in China … oooh, 1,300 or so years ago?) was that either the scrip was private (issued by banks / money lenders) or governments were insufficiently unified. When people suffered doubts then merchants would just refuse to accept the scrip, inflation would go supernova and the currency would fail.

The alternative is Dutch Disease, where the scrip is seen as more valuable than it really is and you get a bubble (dotcom stocks – or buying LinkedIn stocks today).

The problem with Bitcoin is a bit esoteric. Another of ArsTechnica’s writers (Tim Lee) has waded in on the potential for scrip issuers to collude and debase the currency. Ignore all the tech jargon and Bitcoin works very similarly to the US currency system. Money supply is set, but individual banks are permitted to “create” new money based on their internal reserves. The liberty which banks have to create scrip is managed by the Federal Reserve who decide whether more money needs to be created (to support growth) or less (to reduce inflation). If the Fed does a good job, all is well. If they do a terrible job you get runaway inflation or, worse, asset-price bubbles.

Bitcoin doesn’t have a version of the Federal Reserve. Because of the distributed model, and lack of oversight or punitive punch (i.e. there is no army), Bitcoin vendors can collude to create more cash in circulation than the original algorithms would permit. Bubble, boom, crash.

11 replies »

  1. While it is true in theory that the Bitcoin miners could create more Bitcoins than originally intended, you would need to have at least 50% of the computational power of the network. At the present instant the cumulative power of the Bitcoin network is greater than the top 500 supercomputers in the world, combined. And rising fast.

    And as a side effect of taking over the network, it would crash the value of Bitcoin anyway, no one would touch the currency after that. So the investment of several millions of dollars of computer hardware would have no return whatsoever.

  2. Wow… Please do your homework before you publish an article. You are obviously ignorant of what bitcoins are and how exactly the currency works.

  3. All that needs to happen for a currency to be recognized is, well, for people to start recognizing it.

    Also – this attack is not possible. Trust is not an element of the Bitcoin system. Each node must submit proof that the transaction is legitimate, and none of these proofs are accepted by the other nodes until they have proven on their own that the transaction is legit.

    The entire history of the Bitcoin economy is used as an encryption key. This means that in order for any transaction to be approved, the node needs a (correct) history of all economic transactions. The “fake” coins would only be accepted by nodes and PCs running the “fake” client because all the other clients would see that more than 50 BTC were made available at once. Since the non-fake nodes would reject the transaction, the “fake” Bitcoins would be useless – they would not make it into this history of transactions, and therefore they would only ever be accepted by the fake software.

    Creating a “fake” software would create a separate network because after accepting one “fake” transaction, the “fake” software would have a different history than the real Bitcoin network – so currency created on one network would never be accepted by the other.

  4. “Ignore all the tech jargon and Bitcoin works very similar to the US currency system. Money supply is set, but individual banks are permitted to “create” new money based on their internal reserves. The liberty which banks have to create scrip is managed by the Federal Reserve who decide whether more money needs to be created (to support growth) or less (to reduce inflation). If the Fed does a good job, all is well. If they do a terrible job you get runaway inflation or, worse, asset-price bubbles.”

    That’s not how bitcoin works at all. It’s based on every computer running the software having to follow the protocol or else not being able to interact with the rest of the network. This results in it being impossible to change the protocol and create more bitcoins than is mathematically determined by the software.

    Banks (computers) can’t just create their own bitcoin. No one would accept their money. The only thing people would trust is bitcoins that exist in the network.

  5. Blockchain-forking is not a trivial or ‘easy to collude’ enterprise. Given that the total hashing capacity of the network is easily greater than most (if not all) of the supercomputers in existence, you’d have a very hard time trying to ‘doublespend’ or alter the client to ‘reward’ you more coins.

    Please read the whitepaper, it is detailed rather thoroughly how this is an exponentially difficult situation to maintain for an attacker.


    Common Misconceptions Debunked:

    It may prevent embarrassing articles like the one here if you’d learn a bit more how bitcoin works.

  6. Tim Lee’s article on forking the scrip seems reasonable and possible. Humans have been trading using currency for thousands of years and every variation on the same themes pop up again and again.

    Blockchain-forking would seem similar to the question I was once asked in a history of money class, “Why is the King of Spain’s gold worth more than the King of England’s?” Answer, because the King of Spain was more powerful than the King of England.

    As for having a complete trace of all financial transactions. Yay, you’ve reinvented double-entry bookkeeping. Ensuring that an individual transaction is discrete is about the least one would expect of a currency.

    The danger is not in any of these things. The danger is in the perfectlyl legal and ordinary random process of consumer transactions. Central banks maintain the stability of a currency.

    When a corner cafe sells you something for $50, the owner wants to go to his suppliers and get $50 worth of stock. Not $40. When currencies vary wildly up and down it tends to limit trade. The winners are happy but the losers are not.

    Central banks build up reserves to control money supply and can print or destroy money to maintain the balance. The shocking thing about current US dollar instability is how much worse things would be if not for active mediation.

    Yet bitcoin is not an actively managed currency. Its supply is a probabilistic model. Already the demand (thanks to publicity) has led to bitcoins doubling their value against the dollar. That will lead to further speculation and greater demand as people trade on the currency itself, driving its value up.

    If this continues unabated the currency will soon become too expensive to use. That will result in panic selling and currency collapse. And there isn’t anyone to stop this, only an algorithm.

    Managing the integrity of the money itself is only one part of maintaining confidence in a currency. It’s no different to redesigning the printed dollar to make it more secure. Managing supply and demand, however, is infinitely more difficult.

    Thousands of years after introducing currency as a means of exchange human beings are still trying to figure out how to keep things from going tits-up. The problem hasn’t been solved at all. So what exactly is the algorithm doing? Modelling the stuff we don’t know?

  7. “Tim Lee’s article on forking the scrip seems reasonable and possible.”

    Forking is possible but impractical. No one will accept any bitcoin belonging to the forked scrip. There is a network of thousands of merchants and traders that make the main fork useful, not to mention a huge amount of security in the way of computing power by miners creating a proof of work to secure the transaction history of bitcoin.

  8. As an earlier poster said, you need to read the white paper, or maybe ask someone who understands it to explain it to you, because you obviously do not.

    You should be embarrassed to have written such a poorly thought out article.

  9. When the BTC currency increases in value, it may turn some users off and they will move away from using it. With less demand, the price per unit may fall. That’s called the free market, not a bubble. With time more and more agents should come online buying and selling creating a stronger secondary market. Instead of 6 primary market agents, you have 60 and a more reasonable, slower moving price change. Right now, it’s Bitcoin mania and in explosive markets some make a lot, and some lose. Again, welcome to the free market. I’ll take this any day over the Fed devaluing my paper money by 80% over the last 30 years. Personally I feel that if one Bitcoin is good, many clones are better and hope the market develops in that direction.