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Bitcoin is quite topical at the moment so I have written this post in case you are interested.

What is money?

Before starting a discussion about a currency it is help first to understand what money is. To do this we need to go back three or four thousand years when most of our forebears lived in small communities.

Consider Jim-Bob, Jim-Bob raises goats and is very good at it. He spends all his time out with the goats and does not have time to make bread or repair his clothes. Jim-Bob eats some of his goats but all the kids are ready for slaughter in May and there is a limit to how many he can eat. He gives Sally 5 goats each May in exchange for a loaf of bread each day for the next year and Mary a goat leg in exchange for repairing his clothes when necessary. In his village there are 20 other families all offering different services and he has to remember who he owes goats to and who owes him goods and services.

Remembering all this is very difficult and everyone has the same problem. They could create a big book that records who owes whom, we call this a ledger and we will return to this latter in the article. However writing is not really their thing.

Instead they create coins, a big coin is whole goat and smaller coins represent different fractions of goat. Soon everyone forgets that coins actually represent goat-based-debts and everyone agrees that they are valuable. This make good sense because although Jim-Bob thinks about coins as goats, Sally thinks about them as representing bread and so on.

Every time people freely exchange goods value is created for both parties. In our example above Jim Bob values bread more than goats, Sally values goats more than bread. These coins (money) are a really good thing because they make trade so much easier and therefore we get more of it.

Money is a great thing but we immediately have a security problem. If people can manufacture coins with little effort then instead of doing work to earn them they will make them. To get around this problem the community decides to make its coins from gold because this requires a lot of work and because gold is scarce.

Since all communities all over world have pretty much the same problem they all start making coins from scarce metals. This coins all look different and we call them “currencies”.

The origin of banking and banknotes

The centuries go past and people keep digging up gold and making coins and doing work. Jim-Bob’s descendants have a pleasant problem. They have so many gold coins that they are worried that someone might steal them.

Fortunately for them Mr Schmidt the goldsmith can help them. He has a fortified shop and is happy to look after your gold for a small fee. For each gold coin you give him he gives you a paper note (a “bank-note”). You can take this note to him at any time during banking hours and he will give your gold coin back. People soon worked out that trading these banknotes was much easier than moving gold around.

Bank of England notes still bear the words “I promise to pay the bearer on demand the sum of five [ten/twenty/fifty] pounds” which dates from the time when they could be exchanged for gold coins of the same value. The Bank of England tells us that this is no longer possible and “Public trust in the pound is now maintained by the operation of monetary policy, the objective of which is price stability.”

We can see that today money has returned to original purpose of simply representing debts between people. It has no intrinsic value. These debts can either be represented by a wad of banknotes in sock or an entry in a bank’s ledger.

Banking transactions

We have seen that origin of banking was simply keeping your money safe but bankers quickly found that they could offer additional services. Consider the English wool trade. In the middle ages English sheep produced lots of wool for export to France. Taking gold across the channel in payment was a risky business so instead a customer could go into the French branch of an international bank and deposit gold. The French branch would send a message to the English branch and gold could be given to the English supplier.

Banking has been astonishing successful and every day billions of transactions are completed with the result that the average home contains goods from every corner of the world.

The problems with banking

Although basic banking is very successful it does not suit everyone. The people who have the most complaints with the current system are medium-scale criminals.

Consider the case of Carlos. Carlos is a medium-scale cocaine manufacturer based in a South-American country. He exports $100M of cocaine to the USA every year. Carlos’ Coke has the motto “you pay, we deliver”.

One of his Carlos’ customers is Charles. Charles runs “Charlies’ Charlie” a small cocaine distribution operation based behind the multiplex in Nowhere Ville, USA.

Carlos would like to spend his evenings relaxing while listening to his pet hippopotamuses. Instead he worries because he banks with Banco USA,

  • It is liable to pressure from the USA government and might take his money. All they have to do is write zero in his ledger and put all his money the USA ledger and he has lost everything
  • It is run by a bunch of crooks. He open his newspaper and find that it has bet all his money on loans to single mums in trailer parks and lost it.
  • It is utterly incompetent and its data centre is build in an earthquake zone under a big hydro-electric dam. If the ledger is washed away he will lose everything
  • These “hackers” that everyone talks about might break in and take his money
  • The USA Federal Debt is $19.3 trillion. They could try to solve the problem by printing money. If they do that his US dollars will be worth less due to inflation

Carlos dreams of a store of value that does not have any of these problems. Of course he could go back to using gold coins but Charlies’ Charlie is not going to pay him in gold and anyway how would he get it from Nowhere Ville to his South-American hide-out.

How to create your own currency

Carlos decides to create his own currency “Carlos Notes” with these good properties

  • No inflation
    • Carlos Notes will each have a serial number. Only the numbers 1-1000 Million will be allowed. No inflation – ever. He will keep a few hundred million Carlos Notes for paying the expenses of running the system.
  • No Government influence
    • Carlos will keep his own ledgers. Every person who uses Carlos Notes will have their own page in his book and be able to ask him to move money around.

Carlos is very happy with this solution but unfortunately Charlies’ Charlie and Hitmen for Hire and other associates are not. They don’t trust him. What if Carlos cheats on the ledger?

At this point Carlos has a brilliant idea. He will make the ledger public. Instead of being a book in his house it will be a file on the internet. Anyone will be able to read it and see the money move. Since no-one is using their real names privacy is not much of an issue.

  • A public ledger is a trusted ledger

This is great because now if Hitman for Hire want to accept a contract from Charlie’s Charlie they can check they have the money first. Charlie’s Charlie can also verify that Hitman for Hire has done lots of work for other (anonymous) customers.

The public ledger is very cool. Carlos Notes are a great store of value and medium of exchange.

The Carlos Notes community still has some concerns. What if someone deletes the ledger (the earthquake scenario above). Carlos solves this problem by paying a few people (10 say) to have copies of the ledger on the internet and to keep them updated with his changes to the primary ledger.

  • A distributed ledger is a safe ledger

At present only Carlos can update the public ledger. If he gets nicked by the Feds then the ledger cannot ever be updated and no-one can buy anything with Carlos Notes.

It turns out that this is a very difficult problem to solve and it is this solving this problem that is the genius of Bitcoin.

Carlos decides that anyone should be allowed to update the ledger and that he will pay them from some of his reserves that he kept for the purpose. But here is the clever bit.

If you want to update the ledger you must burn (yes burn!) $ 1000 on the first of the month. If you do this and then update the ledger honestly for a month on the last day Carlos will give you $1,001 in Carlos Notes.

You can see that this cleverly aligns the interests of those who update the ledger with the wider community. If they do anything to undermine the currency then they have lost all their “real” US dollars and have reduced the value of their own Carlos Notes.

So far, so good but what is to stop a crooked Ledger Updater (Bitcoin miner) from updating the ledger with fake transactions. The answer is that there are very many Ledger Updaters and which one updates the ledger with a particular transaction is allocated at random.

To achieve a random allocation everyone who wants to sign the ledger must guess the solution to a difficult mathematical problem. The person who guesses the right answer first get to update the ledger.

A thousand transactions are bundled up into a “block” and the Ledger Updater  adds this block to the existing blocks and then signs the transaction. This results in a chain of blocks – “blockchain” that is our trusted public ledger. Because the Ledger Updater does not know which block it will be signing and which transactions it will contain they cannot derive any benefit from acting dishonestly.

How Bitcoin works

Bitcoin works almost exactly the way that Carlos Notes does and is the currency of choice of criminals.

  • Randomness of ledger updating is assured by having to solve a cryptographic hash problem. The brilliant insight Satoshi Nakamoto the author of the Bitcoin system was that solving the hash should generate another Bitcoin to pay the solver for updating the ledger.
  • The money that is burnt is the electricity that solvers must expend to solve the hash. They have to spend this money even if they are not the first to solve the hash and this ensures their long-term commitment to the system. This cost is called “proof of work” and is to a degree analogous to the expenditure of those historical figures who created gold coins.

Social problems caused Bitcoin

The rights of the ordinary citizen can only be protected by the state and the state needs to be able to impede the activities of criminals and seize their money. In facilitating the avoidance of lawful controls instituted for the wider good Bitcoin undermines society and makes the world a worse place.

Unsurprisingly much of the Bitcoin community is dishonest and theft and fraud is rife. Don’t let your mother buy Bitcoin.

The Bitcoin system is deliberately inefficient with many miners simultaneously trying to solve the same problem and burning electricity to do so. Such deliberate waste and carbon production is concern.

Bitcoin is not a very useful currency

The total number of Bitcoins is limited which has some issues.

The total amount of wealth in the world is increasing so it is desirable to be able to print more money so that transactions are not impeded by a lack of cash. We also need a bit of inflation because it gives everyone an incentive to spend and invest and contributes to lowering unemployment due to wage rigidity.

Real currencies are widely accepted and easily exchanged at low risk. This is not true with Bitcoin.

So what is good about cryto-currencies?

Bitcoin has demonstrated to the world the immense value of distributed public ledgers – blockchains. These greatly reduce the risks inherent in a breach of trust or duty by a bank or government.

In Honduras blockchain technology will be used to create a public land registry that cannot be altered by corrupt officials and it would be possible for Non Governmental Organisations (NGO) and others to create their own registry of ownership or other transactions. In the UK Barclays bank will become the first major institution to process Bitcoin.

The future is bright for blockchain technology and like the laser that for many years was a solution without a problem we will see it being used in ways no-one has thought of yet.