~A Nashian Extension of Hal Finney’s theory of Bitcoin Backed Banks~

A Not So Secret History of Bitcoin

We will explore the origins of a certain source of contention surrounding Bitcoin and how Bitcoin will unfold with respect to our global financial system. This contention refers to the introduction of a transactional throughput limitation that Satoshi committed to bitcoin’s source code:

Originally, Bitcoin’s block size was limited by the number of database locks required to process it (at most 10000). This limit was effectively around 500–750k in serialized bytes, and was forgotten until 2013 March. In 2010, an explicit block size limit of 1 MB was introduced into Bitcoin by Satoshi Nakamoto. He added it hidden in two commits[1][2][3] in secret. This limit was effectively a no-op due to the aforementioned forgotten limit.

In 2013 March, the original lock limit was discovered by accident (Bitcoin Core v0.8.0 failed to enforce it, leading to upgraded nodes splitting off the network). After resolving the crisis, it was determined that since nobody knew of the limit, it was safe to assume there was consensus to remove it, and a hardfork removing the limit was scheduled and cleanly activated in 2013 May. From this point forward, the 1 MB limit became the effective limiting factor of the block size for the first time.

Shortly after Satoshi introduced the 1mb limit early contributor Jeff Garzick declared, “We should be able to at least match Paypal’s average transaction rate…” and posted a “patch of code” to which Theymos a forum moderator and contributor responded, “Applying this patch will make you incompatible with other Bitcoin clients.”

Theymos’ observation is apolitical in direct interpretation but reading between the lines it is theymos flagging it as a fork to the community. Being Satoshi’s project he was more assertive:

+1 theymos. Don’t use this patch, it’ll make you incompatible with the network, to your own detriment.We can phase in a change later if we get closer to needing it.

The dialogue that ensures is significant:

Jgarzik: IMO it’s a marketing thing. It’s tough to get people to buy into a system, if the network is technically incapable of supporting high transaction rates.

FreeMoney: Satoshi just said it can be changed, so technically the network is capable.

Jgarzik:It is also an incompatible change, as you see…..

A little more context is useful. Garzick posted his patch in December of 2010, earlier in September he posted this suggestion:

To accurately reflect that processing a transaction has certain resource costs across the network, I propose that tx fee be required for every transaction after X datetime (where X is a few months in the future).

We can see he is thinking about the economic reality of the cost of verifying transactions and how to create a metric for it. FreeMoney poses the problem as a question, “Jgarzik, do you have a guess as to the resource costs of a normal transaction?” Satoshi gives his opinion as to how the cost could be addressed. Notice he makes a general statement, ‘we should always allow at least some’ but that he doesn’t have an accurate proposal:

Another option is to reduce the number of free transactions allowed per block before transaction fees are required. Nodes only take so many KB of free transactions per block before they start requiring at least 0.01 transaction fee.

The threshold should probably be lower than it currently is.

I don’t think the threshold should ever be 0. We should always allow at least some free transactions.

There is careful language here. To some to ‘always allow’ free transactions means that anyone should be able to get into a block for free. This can’t possibly be the intention because the discussion here is about where the limitation should be set, not whether or not it exists or should exist. This is however depending on the scope of the variables you wish to debate about. Without explaining further, in order to proceed with only reasonable readers, we simply state that at some point something needs to be “bounded” in order to pay the cost of energy expended to secure the network. The question is what should be limited and in what way.

Satoshi goes on in a post the next day, and the timeline becomes relevant:

Currently, paying a fee is controlled manually with the -paytxfee switch. It would be very easy to make the software automatically check the size of recent blocks to see if it should pay a fee. We’re so far from reaching the threshold, we don’t need that yet. It’s a good idea to see how things go with controlling it manually first anyway.

It’s not a big deal if we reach the threshold. Free transactions would just take longer to get into a block. Here Satoshi puts forth an idea and reveals his intentions behind the usage of the phrase to ‘always allow’.

This causes MoonShadow to ask, “ What is the current threshold, and how does a client know to pay for this in advance?”

A Hidden Paradigm

In today’s scaling debate the center of it has been around whether or not the 1mb limit Satoshi added should be removed or not. It’s a question of where or not the transactional throughput should be bounded and how this bounding should be coded.

But the debate doesn’t reference a previous threshold and most people interested and involved in the discussions, if they weren’t early developers of the project, don’t know about an earlier threshold. This is because the node/miner paradigm is new.

In the white paper nodes both mine and verify transactions:

The steps to run the network are as follows:1) New transactions are broadcast to all nodes.2) Each node collects new transactions into a block.3) Each node works on finding a difficult proof-of-work for its block.4) When a node finds a proof-of-work, it broadcasts the block to all nodes.5) Nodes accept the block only if all transactions in it are valid and not already spent.6) Nodes express their acceptance of the block by working on creating the next block in the chain, using the hash of the accepted block as the previous hash.

There aren’t nodes that aren’t miners expressed in the paper nor are the miners that aren’t nodes references. But in actuality today there are mining pools that arose by which many different mining machines reference a single node implementation and many people run nodes to verify their transactions without hashing for new blocks.

It is commonly understood that Satoshi didn’t foresee this division or perhaps we can say he never discussed his design in relation to this evolution. But at least in hindsight it’s easy to say once there is competition for profits that not all users can be miners.

An older paradigm is revealed when Satoshi explains, “paying a fee is controlled manually with the -paytxfee switch”. At that time everyone was a miner and a node therefore game-theoretically there was the question “how should we arrange our implementation to pay ourselves in a way that protects from spam attacks”. But as the mining race grew to the extent that most users were no longer also miners the game theoretical paradigm changed and the question became, “How can we the users pay the cost to keep the network secure.” And this cost and the payment of it is implicitly in relationship with the miners.

The Bitcoin Mining Race

Interestingly the mining race that ensued with Bitcoin was predicted by Nick Szabo in his essay Bitgold:

The main problem with all these schemes is that proof of work schemes depend on computer architecture, not just an abstract mathematics based on an abstract “compute cycle.” (I wrote about this obscurely several years ago.) Thus, it might be possible to be a very low cost producer (by several orders of magnitude) and swamp the market with bit gold. However, since bit gold is timestamped, the time created as well as the mathematical difficulty of the work can be automatically proven. From this, it can usually be inferred what the cost of producing during that time period was.

It is understood that the difficulty adjustment algorithm Satoshi implemented is meant to address these issues Szabo foresees and many describe the DAA as Satoshi’s genius contribution. Here Satoshi explains the implications of the DAA in regard to miners seeking profits:

The price of any commodity tends to gravitate toward the production cost. If the price is below cost, then production slows down. If the price is above cost, profit can be made by generating and selling more. At the same time, the increased production would increase the difficulty, pushing the cost of generating towards the price.

In technical terms from the whitepaper:

…proof-of-work difficulty is determined by a moving average targeting an average number of blocks per hour. If they’re generated too fast, the difficulty increases.

The DAA was a limitation added to deal with the improvements of bitcoin mining technology but this limitation then only passed the scaling problem on to the question of how users should socialize the incentive for miners to secure the network.

A New Dichotomy For a Legacy Problem

It should be obvious this would be a non-cooperative evolution in the development of bitcoin. This change would feel violent or offensive to some caught between the old and new paradigm. Miners have the want to maximally profit and users have the want for minimizing the cost of security therefore who should direct the development?

This problem extends from Satoshi’s whitepaper as a solution to address the double-spending problem:

We have proposed a system for electronic transactions without relying on trust. We started with the usual framework of coins made from digital signatures, which provides strong control of ownership, but is incomplete without a way to prevent double-spending. To solve this, we proposed a peer-to-peer network using proof-of-work to record a public history of transactions that quickly becomes computationally impractical for an attacker to change if honest nodes control a majority of CPU power.

The whitepaper makes the conjecture that nodes:

…vote with their CPU power, expressing their acceptance of valid blocks by working on extending them and rejecting invalid blocks by refusing to work on them. Any needed rules and incentives can be enforced with this consensus mechanism.

The question from the origins of Bitcoin was always how to pay the distributed computing network for the security required to store and transfer value within it.

The Economic Implications of Bitcoin’s Security Trade Offs

The dialogue where Garzick proposed his patch continued on the same day:

Martin: No, it’s incompatible if just a few people change their behaviour. To roll out a change to the network you need to get most of the clients understanding both the old and the new protocol, and then when you have a majority you turn on the new protocol.

This is where the old paradigm is needed for proper context. It is only just being understood that there is a game-theoretical problem of network upgrading. Garzick reveals he is already acting in response to his future considerations of the strategies that might play, out or rather that would be available, depending on what limitations the code implies:

You just described a whole-network upgrade. I’d call that an incompatible change Smiley

The effort to raise the transaction rate limit is the same as the effort to change the fundamental nature of bitcoins: convince the vast majority to upgrade.

The Satoshian Trap

Satoshi’s next post is very significant historically for the present day scaling debate as many users that oppose the block size limitation use this as evidence that Satoshi opposed it ultimately as well:

It can be phased in, like:

if (blocknumber > 115000)maxblocksize = largerlimit

It can start being in versions way ahead, so by the time it reaches that block number and goes into effect, the older versions that don’t have it are already obsolete.

We can see however at face value Satoshi is buying the solution more time at the expense of the problem that Garzick has revealed. The next three posts reinforce this context:

Kiba: If we upgrade now, we don’t have to convince as much people later if the bitcoin economy continues to grow.

Appamatto: I agree, especially since generators are both the source of blocks and “votes” in the network. Since a block restriction would allow generators to charge higher transaction fees, they might “vote” against an increase in the max size in the future.

It seems unlikely to be a real problem though.

Caveden: Honestly, I’d like to get rid of such rule. I find it dangerous. But I can’t think of an easy way to stop flooding without it, though.

The Rage Split

This seemingly innocent limitation that Satoshi added as a possibly temporary measure which wasn’t a necessary response to an actual ongoing attack later became a source of great tension in the community of people concerned about bitcoin’s development notably with Mike Hearn, just over 2 years later, who was trying to raise awareness about the implication of the limitation in regard to its transactional throughput:

By default Bitcoin will not created blocks larger than 250kb even though it could do so without a hard fork. We have now reached this limit. Transactions are stacking up in the memory pool and not getting cleared fast enough.

What this means is, you need to take a decision and do one of these things:

Start your node with the -blockmaxsize flag set to something higher than 250kb, for example -blockmaxsize=1023000. This will mean you create larger blocks that confirm more transactions. You can also adjust the size of the area in your blocks that is reserved for free transactions with the -blockprioritysize flag.

Change your nodes code to de-prioritize or ignore transactions you don’t care about, for example, Luke-Jr excludes SatoshiDice transactions which makes way for other users.

Do nothing.

If everyone does nothing, then people will start having to attach higher and higher fees to get into blocks until Bitcoin fees end up being uncompetitive with competing services like PayPal.

If you mine on a pool, ask your pool operator what their policy will be on this, and if you don’t like it, switch to a different pool.

3 years later Hearn posted an email from Satoshi. First Satoshi lays out the mining race with respect considerations of moore’s law:

The existing Visa credit card network processes about 15 million Internet purchases per day worldwide. Bitcoin can already scale much larger than that with existing hardware for a fraction of the cost. It never really hits a scale ceiling. If you’re interested, I can go over the ways it would cope with extreme size. By Moore’s Law, we can expect hardware speed to be 10 times faster in 5 years and 100 times faster in 10. Even if Bitcoin grows at crazy adoption rates, I think computer speeds will stay ahead of the number of transactions.

Satoshi goes on to explain what he envisions as a fee market:

I don’t anticipate that fees will be needed anytime soon, but if it becomes too burdensome to run a node, it is possible to run a node that only processes transactions that include a transaction fee. The owner of the node would decide the minimum fee they’ll accept. Right now, such a node would get nothing, because nobody includes a fee, but if enough nodes did that, then users would get faster acceptance if they include a fee, or slower if they don’t. The fee the market would settle on should be minimal. If a node requires a higher fee, that node would be passing up all transactions with lower fees. It could do more volume and probably make more money by processing as many paying transactions as it can. The transition is not controlled by some human in charge of the system though, just individuals reacting on their own to market forces.

Although there is not claim of authenticity from the author here it is noted that the email was written from the context of the old paradigm transitioning into the new as it ends:

Eventually, most nodes may be run by specialists with multiple GPU cards. For now, it’s nice that anyone with a PC can play without worrying about what video card they have, and hopefully it’ll stay that way for a while. More computers are shipping with fairly decent GPUs these days, so maybe later we’ll transition to that.

The Birth of the Theory of Bitcoin Backed Banks

Thus we can see that Hal Finney’s Theory of Bitcoin Backed Banks came out with considerations of the possible limitations of the transactional throughput bitcoin might face. Finney’s theory is a reference to George Selgin which is notable because he comes from the same circles of discussion around earlier attempts of digital money:

Selgin is considered a Bitcoin OG (“Original Gangsta”), having taken part in the original cypherpunk mailing list (with Wei Dei and Nick Szabo) that led to Bitcoin’s invention, which Hal Finney and Nick Szabo say he helped to inspire.

Of Selgin and his free bank theory Nick Szabo, of whose theory of collectibles we explore in another writing, has said:

Dr. Selgin was on the mailing list with Wei Dai and myself where in 1998 cryptocurrency (bit gold, and a bit later b-money) was invented. His description of free banking was very inspirational and informative.

The lesson I drew from that and other aspects of history that the real money in these circumstances was gold — that is what people wanted at the end of the day. If the gold window closed, the trust-based part of the system collapsed.

Trust and security considerations are far more important than speculations about aggregate human behavior. Psychologists have a hard time making their experiments on individuals repeatable. Macroeconomists speculate about vast numbers of interacting individuals, no repeatability.

High inflation causes savers and creditors large tangible harms, as we see today in Venezuela, Iran, Sudan, Nigeria, Argentina, &c. But alleged harms caused by much lower levels of “bad deflation” are very causally remote from monetary decisions — it’s ideological speculation.

Szabo finished by concluding:

While macroeconomic debates are very popular in the fiat central banking world, where monetary decisions are highly political, they are nevertheless ideological speculations not science.

The Relationship Between Scaling and Bitcoin’s Relevance

Finney’s view of Bitcoin as a Selginian commodity money as a result of trading off base layer scalability for security runs in contrast to the scalable driven baselayer development path meant to rival Visa. This is why Hal proposes his theory.

From Mike Hearn’s view Satoshi meant for Bitcoin to scale to a visa level throughput however its not very clear that continually raising the limit was meant to be the permanent solution or just a temporary stalling of the initial bootstrapping in order to develop the system before it hit its transactional limits and grows into the next phase.

Nevertheless, it seems proper that considerations as to how bitcoin should be scaled, make relevant the external factors of what the implications are to bitcoin and the existing global financial system in which it will compete to exist with (whether it supplants it or co-exists in equilibrium ).

Deciding how to scale Bitcoin means considering the implications of it with regard to its relationship with our existing and future global financial system.

We have already inquired into a comparison between the nature of Ruritania versus what we called cryptoexchangelandea. We will now begin to discuss the scaling tradeoff implications with regard to bitcoin and the global financial system. It will be argued that limiting the transactional throughput on the base layer with a fee market will cause Ruritanian rules to come into effect for bitcoin and we will explore the implications of this.

Selgin’s Synthetic Commodity Money

Here we turn to a more recent work from Selgin to understand a concept he calls “synthetic commodity money”. Seglin notes the two characteristics of money being scarce and having non-monetary usefulness are unnecessarily seen as a trade-off because of our current day paradigm of money:

The inadequacy of the standard fiat-money commodity-money dichotomy becomes evident upon considering how the conventional definitions of each sort of money actually refer to not one but two distinct characteristics: a commodity money has nonmonetary use value and is naturally or inevitably scarce; a fiat money has no nonmonetary use value and is scarce only by design.

Thus Selgin takes these traits of money and extends them out as a matrix to illuminate a hidden type of money he calls ‘synthetic commodity money’-money that is scarce and has no monetary use. This type of money by definition has the scarcity properties of a commodity like gold but has no other non-monetary use case. The relevance of course is that such a money COULD serve as the commodity money for Ruritania but it is not well understood how it could arise to be a money in the first place if it doesn’t gain its market valuation from the gauntlet of trading in the market. More formally stated:

Such money consists of objects or units which, though lacking nonmonetary value, are absolutely rather than contingently scarce. More generally a synthetic commodity money is money that lacks nonmonetary value but is nevertheless reproducible only at a positive and rising marginal production cost, if indeed it can be reproduced at any cost at all.

Selgin goes on in more detail about what a synthetic commodity money implies and constitutes:

Because the real resource cost of a given real stock of synthetic commodity money need not be any greater than that of a comparable stock of fiat money, a synthetic commodity standard is free from the cost disadvantages of a genuine commodity standard. Because its scarcity, though immutable, is nevertheless contrived, that scarcity isn’t subject to changes stemming either from raw-material discoveries or from technological innovations. Because a synthetic commodity money has no alternative, nonmonetary uses, there is no such thing as a varying nonmonetary demand for it that can alter its purchasing power. Finally, like that of a genuine commodity money but, unlike that of a fiat money, the supply of a synthetic commodity money isn’t subject to politically-motivated or capricious modification.

Notes On Transmutation

Here we make a step towards a more formal consideration of the type backwards/forwards recursion we have been referring to in the previous essay. Although at this time there is a lack for better wording Selgin refers gives an example of this concept here:

While no government has ever deliberately established a synthetic commodity money, and though it is not even clear what steps would be required to officially establish such a money — that is, what steps a government might take in order to truly deprive itself of the means for authorizing new forms of money — synthetic commodity money is not just a hypothetical possibility. One recent, unplanned instance of such money was the so-called Iraqi Swiss dinar.

Prior to the 1990 Gulf War, Iraq’s official currency consisted of paper dinars printed in the U.K using Swiss-engraved plates. During the war, sanctions imposed on Iraq prevented it from importing more of these notes. Hussein’s government in turn chose after the war to decry its former currency, issuing so-called “Saddam” dinars in its place. Saddam dinars were subsequently issued on an enormous scale, both officially and by counterfeiters, for whom the poor-quality notes were an easy target, causing it to depreciate rapidly. But Swiss dinars, as the old notes came to be known, continued to circulate in the northern, Kurdish regions of Iraq; and they, in contrast, held a remarkably stable purchasing power and exchange rate relative to U.S. dollar despite gradually deteriorating from constant use.

By 1998 the Saddam-Swiss dinar exchange rate had risen to 100:1, where it hovered for several years before rising to as much as 300:1 in the course of the 2003 invasion. Eventually the Coalition Provisional Authority, in its effort to stabilize Iraq’s official currency, pegged it to the Swiss dinar at a rate of 150:1, while eventually providing for renewed production of official notes using the original Swiss plates, with their denominations modified to correspond to those of the former Saddam dinars. The new dinars were also distinguished from the old (synthetic commodity) Swiss dinars in being printed in a different color (King 2004, pp. 7ff.).

In the above example in an initial context what was issued as a central banked fiat money, because the issuer was at some point literally unable to issue more prints, the money was picked up by a later evolving economy as if it were scarce and thus (synthetic) commodity money. Thus we have the transmutation of a currency’s roles depending on its context. We feel this is an important point going forward but also an important consideration in regard to the history of money and requires further inquiry.

Here we note it should be explored the concept of Szabo’s closed loop economic cycles (we now call Kula Rings) in comparison with electrical induction to describe the transfer of ‘economic’ energy from one Kula Ring to an emerging one where one type of money or commodity from one system might provide a different type of money for a different system even though it’s the same medium. The implied increase of efficiency then can be modeled as if the commoditization of a new energy source. We also mean for transmutation to be applied to the biological realm implying this theory to be unifying.

The Transmutation of the Global Financial System

We have already traversed the concept of commodity money between Ruritania and cryptoexchangelandea to show that what functions like gold or the base money in Ruritania could be consider as like what bitcoin would be to the private digital currencies exchanges would issue in cryptoexchangelandea-the settlement medium.

In the real world, the existing global financial system is made up of central banks. Each nation or the Euro has their own central bank which has a domestic monopoly on the money supply. Each major currency issued and controlled by a central bank represents this. We can contrast this with the Ruritanian setting Selgin paints and draw out our axioms required for natural Ruritanian order:

The competitive issue of currency-and of redeemable bank notes in particular-is, on the other hand, a relatively unfamiliar and unexplored possibility, and one that most economists dismiss. The reason for this is not far to seek: monopolization of the supply of currency is essential to modern central banking operations.

In regard to the private banks consider they only need to act with in their own competitive self interest, this is an axiom congruent with game theory, and quite reasonable to assume of central banks today:

Therefore, in discussing the operations of central banks, it generally assumes that they are governed solely in the interest of consumers. As a result, the argument must be somewhat biased in favor of centralized control, since it is assumed that free banks operate only for the sake of private profit.

What Selgin identifies however as the key difference is the central banks sole control over the money of the land:

One important contemporary financial institution is nonetheless absent from the Ruritanian system: to wit, the central bank. This is because market forces at work in Ruritania do not lead to the natural emergence of a monopoly bank of issue capable of willfully manipulating the money supply.

This means Ruritanian rules don’t apply to centrally banked currency areas. However we wish to ask “Which central bank controls the currency supply of the global currency area?” And if there is a single controlling issuer are they aware that Satoshi has issued his own currency?

The Search For an Ideal Basis for Money

Selgin lists popular alternative proposals to central banks in his Theory of Free Banking:

Some of the more popular alternatives for central bank monetary policy are: 1. money supply changes aimed at stabilizing some index of prices; 2. money supply changes aimed at pegging some interest or discount rate; 3. money supply changes aimed at achieving “full employment”; and 4. money supply changes aimed at achieving a fixed percent rate of growth of the monetary base or of some monetary aggregate. Each of these alternatives involves a knowledge surrogate or policy guideline which substitutes for knowledge surrogates present under free banking.

Considering the first proposal, basing central banked base layer money on an index of commodity prices with intention being to stabilize them (issue more units with the price trend decreases and less when it increases). In a sense this would be an attempt at contingently creating a commodity base layer for the currency area and we can note if the smaller banks in the system cannot also create their own money then Ruritanian rules do not apply.

However, we can transmute such a proposal to our financial system on a global scale rather than a national one, and thus ask if the introduction of a global currency pegged to a set of commodity prices might serve the basis for the national currencies as if each central bank was a private bank that is in fact in control of its own supply.

To this end Selgin would have some complaints, namely that the composition of the index would need different considerations over time:

…assuming that a value can be chosen for each “coefficient of importance,” will it have to be modified regularly according to changes in the relative prominence of particular goods? Would the coefficient of importance of slide rules be the same today as it might have been twenty years ago?

Moreover he notes it’s not possible to determine which price movements are quite natural market forces or symptoms of the system not being in its monetary equilibrium as described to unfold with Rurantian order:

When there are changes in the volume of real output, a rise or fall in prices of the affected goods reflecting the change in their average cost of production is the only means for avoiding unwarranted profit and loss signals while also allowing the goods market to clear. A price index does not itself reveal whether its movements reflect changes in the conditions of real output or are symptoms of monetary disequilibrium

Selgin’s conclusion on this matter is that the want for an externally maintained price stability has a feedback problem with put it at odds with a money supply in natural equilibrium:

But if this is true of the results of free banking it cannot be true of any monetary policy that prevents price changes having their source in changes in the conditions of production. The fundamental theoretical shortcoming of price-level stabilization is that it calls for changes in the money supply where none are needed to preserve equilibrium.

The Key Distinction

The key distinction here is intent. The intention to stabilize prices implying the adjustment of the composition of them based on the trends over time implies a feedback error.

But simply to create a rule that central banks adhered to globally which in effect limited their intervention would serve a different purpose.

The price index is a non-starter but the concept of limiting rules remains useful in mirroring a commodity like basis for a money. This is a critical distinction that we will revisit when we show John Nash means to also show this limitation to a price index of what he calls an ICPI when he talks about creating a limiting constitution held globally by central banks.

An Introduction to Hyperbitcoinization As a Scaling Implication

At the extreme of the scaling debate we can consider the idea of Bitcoin somehow having a near infinite transactional throughput capacity such that it could serve the entire world’s transactions. We can consider how such a Bitcoin might evolve to supplant the existing currencies and whether or not it would, given it was somehow scaled to have the technological capabilities of doing so.

One such theory proposed is colloquially known as Hyperbitcoinization where, “…any hapless currency that stands in Bitcoin’s path of total world domination. If this happens, the currency will rapidly lose value as Bitcoin supplants it.”

Hyperbitcoinization is contrasted with a hyperinflation event where the former causes devaluation and dissolution of competing currencies regardless of their issuance:

There are two essential differences between hyperinflation and hyperbitcoinization. The first is that a currency hyperinflates with restricted competition from other currencies, whereas hyperbitcoinization happens because of competition with Bitcoin. This is because capital controls are much more effective on other fiat currencies than on Bitcoin, so it is easy for Bitcoin to cross borders and compete with anything.

The second is that in a hyperinflation, the government expands the money supply to outpace people’s inflation expectations. Demonetization occurs as a result of their destructive interaction. Whereas a hyperbitcoinization event need not be accompanied by any change in the supply of either currency.

A Gold Like Bitcoin Standard

We contrast this event with an apparent strategy that accidentally arises in Warren Weber’s report for the Bank of Canada A Bitcoin Standard where he considers the consequences of central banks moving on to a gold-like bitcoin standard. Weber’s orientation for a Bitcoin standard is outline as follows:

If a country adopted the gold standard, its monetary authority was supposedly to follow certain “rules of the game.” The usual specification of the “rules” applied to how monetary authorities should adjust their bank rates in the face of persistent gold inflows or outflows. The “rule” was that a country’s monetary authority was supposed to take actions to supplement that effects that the gold inflows or outflows were having on the country’s balance of payments.

Weber explains how differing nations could have differing policies on the actual gold standard of its time but only because of the cost to arbitrage it:

Under the gold standard, interest rate policy worked through bank rates (discount rates), or, more correctly, it worked because monetary authorities in different countries could set bank rates that were different from each other. That is, countries had some latitude to raise or lower their bank rate to raise or lower interest rates generally in their country, and in this way affect the domestic economy.

One might think that monetary authorities would not have this ability because gold arbitrage would work to equate interest rates across countries. Gold would flow to the country where it would earn the highest rate of return and that would limit the differences in interest rates among countries on the gold standard. However, gold arbitrage could not eliminate differences entirely because gold arbitrage was costly. These costs are the same ones that gave rise to k in the discussion of gold points. It was the presence of these costs that gave monetary authorities some independence in setting interest rates in their country.

This becomes an interesting observation as we consider the implication of bitcoin on the global scale. At its limit when there is no cost of arbitrage the gold standard Weber describes implies converging interest rates (whereas in contrast if we consider the cost of arbitrage on a scale to infinity where interest rates have no such corridor which is another way of representing not having a gold standard).

Weber’s conclusion speaks to the reason he feels a Bitcoin standard would be unlikely to sustain but it also speaks to a counter-strategy to hyperbitcoinization SHOULD central banks be facing a threat to their survival:

…. there could political pressure and demands for central banks or governments to offer a intrinsically useful fiduciary currency to compete with bitcoin. By a intrinsically useful fiduciary currency, I mean that it would be one backed by some commodity or basket of commodities. If central banks or governments could credibly commit to redeem this currency on demand and if they were willing to give up their own monetary units and adopt a uniform one, then this might be widely accepted as a medium of exchange and might drive out bitcoin to a great extent. My reason for including the elimination of individual country monetary units is to make clearing simpler and to facilitate the use of the currency across country lines. In others words, the bitcoin standard might not be stable because a Euro-like commodity backed money could provide the benefits of the bitcoin standard without its inherent stability issues.

A Non-Cooperative Birth To a Ruritanian Style Global Economy

It might become important then if Bitcoin’s globally observed exchange price were to gain a perpetual momentum that central banks do in fact realize they have a counter-strategy which would keep their respective currencies relevant and on par value with Bitcoin.

If this type of scenario were to happen we can see that the equilibrium result would be that Bitcoin, being both held on central bank balance sheets, and targeted as if it were a BPI Bitcoin price index’, would then have forced a transition of the global economy into a setting where not only Ruritania rules apply but are in full and mature effect.

In this end Bitcoin’s value trend can be no better than the money of the central banks that hold and target it.

This becomes an important observation but from an awkward or non-standard angle. Consider a criticism on the effects a Ruritanian commodity money based standard:

This brings us to another criticism frequently leveled at single commodity standards: that they are subject to “shocks” in the supply of the money commodity. In previous chapters it has been assumed that the supply of commodity money is constant. This would be a correct description of conditions under free banking if the only inducement to increase production of commodity money were an increase in its relative price, given that the complete substitution of inside money for outside money in persons’ balances makes such an increase in the relative price of commodity money unlikely. But increased production of commodity money may also occur because of a fall in its cost of production, due perhaps to some technological innovation or to a discovery of new sources (if the commodity is a natural resource) with lower marginal extraction costs than those already in use.

Selgin notes the constancy of prices from the view of the users of the elastically supplied inside money and his notes on the commodity money production (ie supply rate) affecting prices are not applicable to a bitcoin based standard because of the difficulty adjustment algorithm. Selgin does note that a single commodity standard can effectively do the same thing as a basket but at a reduced cost:

All this implies that monetary reform proposals aimed at achieving money of constant purchasing power are superfluous. One such proposal recommends the use of inside money that is a claim to an assortment or “basket” of commodities. Besides being more complicated and costly to administer, a multiple-commodity standard actually has no advantage over free banking with a single-commodity standard as a means for eliminating debtor-creditor injustice, so there is no reason for considering it.

The end result implying the end of the present day function of central banks:

Once the supply of currency is assumed to be taken care of, the central bank can simply withdraw from the scene, and a policy of “free deposit banking” (without competitive note issue) is all that is needed to ensure the maintenance of monetary equilibrium

Suppose that we take this assumption a step further and postulate a demand for currency that is absolutely constant and equal to the stock of central bank currency in circulation. How does the new assumption affect the problem facing the central bank? The answer is that it makes it disappear entirely.

What is most interesting is we have resolved the difficulty of creating reliable and useful price signals but without introducing a political component to implement and maintain them thus allowing the outcome to have a commodity money basis a ala George Selgin but in the form of a ‘rule set’ that central banks would in principle be able to apply (inflation target a BPI).

The Scientific Implications of The Scaling Debate

In regard to the scaling debate some people might not like the idea of saving the current central banking paradigm even if it is just as it temporarily fades away. Since hyperbitcoinization is based on the idea of Bitcoin supplanting all transactions and existing major currencies there it is not really an option that seems to speak to that end.

But also we can note that having bitcoin as a limited and more costly to use money in regard to its transactional throughput doesn’t violate any principles of Selgin’s commodity money nor what we will point out later as Nick Szabo’s collectibles qualities.

With scaling limits bitcoin would not serve as a high functioning currency but it would still have the “hoard-worthy” qualities we ascribe to gold. It would be limited such that it wouldn’t serve the average user but could still serve higher and higher value transactions unboundedly.

Notes On Modeling The Acceptance Of New Currencies And Agency

In ‘Menger’s theory of money: some experimental evidence’ Seglin and Klien puts forth a set of rules for a game which is meant to represent Carl Mengers origins of money scenario in order to test the extent of the market needed for a commodity to be work its way to become accepted by virtually all agents as the most saleable good.

The agents query the market and receive a probabilistic return based on the percentage of adoption of each commodity as the most saleable and update their preferences accordingly thus affecting the totality of the market.

We defer to the paper for details but here we note that John Nash has a research program and history of modeling the formation of agencies and coalitions in the context cooperative games and we think it would be useful to consider a transmutation and generalization of Selgin and Kliens efforts with respect to Nash’s work.

Nash’s work is an exploration of the forming of agencies with the ultimate formation being a grand coalition. We see this as analogous to the agreement implied in the adoption of a currency. Furthermore, and with respect to Bitcoin we see the choice of node implementation as a form of agency. Thus Nash’s research work may prove useful in both respects.

Conclusion

In an early post Satoshi declares Bitcoin is an implementation of Wei Dai’s b-money proposal and Nick Szabo’s Bitgold proposal The scaling debate grew out of considerations of the implications of trade-offs with respect to the future real world economy and global financial system. These considerations are documented dialogues from the cypherpunk era which include discussions and papers from Hal Finney, Nick Szabo, George Selgin, Wei Dai (who Satoshi cited).

We can now ask if Bitcoin’s transactional throughput limitations were considered acceptable provided they did not limit Bitcoin’s ability to serve the role of a Selginian commodity, what kind of qualities would we want to preserve?

When considering the favorability of gold as a Ruritanian base layer commodity money Selgin notes a special quality of the production of it:

…production follows a curve that maximizes time-discounted income per unit of capital invested. It neither extracts all the ore at once nor extends the mine’s life to the maximum technologically feasible. Once this is understood, the claim that gold has a “backward-rising” supply curve, which supposedly detracts from its desirability as outside money, can be shown to be incorrect. It is true that when the price of gold goes up, gold production at first often decreases. This happens because certain factors of ore production, most notably the crushing and refining equipment, are fixed in the short run. When gold production becomes cheaper a lower grade of ore becomes newly profitable to mine; hence if the equipment is always working at full capacity, it will produce less gold than before. Were the lowergrade ore not mined then, it might never be, since a rise in production costs would make its extraction unprofitable. Any other mining strategy would also be uneconomical, for it would extract a lower time-discounted value of gold than is profitable. If the cost of production remained low, though, it would pay to bring new deposits into production, build new refineries, etc., thus increasing gold supply.

The supply factor of gold are slightly misleading as there is both a cost to extract the ore but also a cost to refine the ore down to pure gold. If extraction of ore (which includes gold AND waste) is always at full capacity there is always a choice of the ‘grade’ of ore to extract. In times of high gold prices it makes sense to go after the expensive to mine grade. This extends the life of the mine but also creates a ‘damping’ effect on periods of increased demand.

If Satoshi were to want to model Bitcoin to gold with respect to the Selginian qualities he wouldn’t necessarily mimic the extraction/refining process but in comparison and real world competition with gold it would make sense to mimic the supply curve Selgin describes which is effectively a type of scarce predictability not prone to supply shocks:

Most of the easily accessible gold seems to have been mined already. For this reason gold mining today is more institutional than it was in the past, making its supply even less prone to supply shocks.