Bitcoin Under the Liberal Microscope: How It Really Works and Why It Does Matter

bitcoins

[Editor’s Note: For more of Cherie Braden’s analysis of similar subjects like prediction markets, see The Wisdom of Profiteers: Prediction Markets and Democracy]

Yeah, I know, it’s been covered. The headlines have been filthy with it since March. Bitcoin is a medium of exchange. Maybe it’s a currency (opinions vary). Maybe it’s a Casa Bonita birthday party for libertarians. Maybe it’s the manifest destiny of money (OMG). More coverage doesn’t always mean better understanding, and the mainstream media have mostly aimed to answer the question, “Should you invest in bitcoin?” But there’s more to Bitcoin than investment potential (or lack thereof). I aim to explain what it is, how it really works, and why it deserves attention and a touch of respect—though not necessarily fanfare—from liberals.

The supreme difficulty I encountered while attempting to create a realistic picture of what Bitcoin might mean to non-libertarians was a lack of informed criticism: outsiders like Paul Krugman have vilified Bitcoin as a mere speculator’s game, without bothering to understand its positive import, and insiders tend to be too zealously optimistic to realistically consider its shortcomings/drawbacks. Academic perspectives on the topic are few and mainly limited to those of supporters like Peter Surda and network analysts curious about Bitcoin’s anonymity claim.

There are plenty of reasons not to conduct large transactions in bitcoin. As much as fiscal policy in our fiat currency is geared toward benefiting its largest stakeholders and middlemen, individual transactions by the little guy are dependent on consumer protection provided by laws and financial institutions. If you decided to buy a car with bitcoin, and the car turned out to be a lemon, you’d be screwed: moving into a system of trade unregulated by our legal system, and with irreversible transactions, means giving up certain legal recourse. FinCEN’s new involvement with bitcoin exchanges, requiring them to register as Money Services Businesses, is an intervention that only extends as far as the involvement of the US dollar in the buying and selling of bitcoin, but does not regulate Bitcoin itself.

On the other hand, the Bitcoin protocol offers some protections that our present system doesn’t. As I see it, Bitcoin’s most promising potential for those of us who aren’t techies is its emphasis on security. Cryptography can’t create a trust-free market as many bitcoiners claim (and I’ll elaborate on that in a moment), but it does do one amazing thing for consumer-bitcoiners. You know how in our current banking system you give out access to your bank account left and right? Personal checks display your account number for all to see. Credit card numbers are much like account numbers – anyone who has physically seen your card can record the information on it and potentially use it later. When we make online purchases with credit cards or account numbers, we’re trusting people with information that would allow them to withdraw money from our accounts later. Have you ever cancelled automatic debit for a monthly bill only to have the company continue charging you for several months afterward? I certainly have. Fortunately we have fraud protections for demanding our money be returned, but sometimes it takes a lot of frustrating hours on the phone before that happens. These are bureaucratic messes that should never happen in the first place, and they result from a fundamental flaw in our payment system: no one should ever be able to access your bank account. A payment system that requires consumers to open the doors to their bank accounts in order to make purchases nonsensically  favors merchants (who already have the upper hand in capital) over consumers.

Bitcoin’s protocol solves this problem with public key/private key cryptography. With bitcoin, you never give your account number to anyone. Merchants don’t take money from your bank account; rather, you put it into theirs (or in their wallet, to be more accurate).

*For more information on inefficiencies in our present banking system, I liked “The Rise of Customer-Oriented Banking – Electronic Markets Are Paving the Way for Change in the Financial Industry” by Rainer Alt and Thomas Puschmann.

How It Works

There’s no summarizing the mechanics of Bitcoin both briefly and thoroughly, but I’ll do my best (and here’s an infographic that might help). Bitcoin is a distributed ledger system. When you “have” a bitcoin, it doesn’t mean you’re in physical possession of an object, or even a cryptographic object. The bitcoin ledger (aka the blockchain) is a record of transactions between addresses and a record of the generation of new coins (assigned to their corresponding miner’s address). These “addresses” are public keys: private keys are not stored in the blockchain and are never made public. A key isn’t the equivalent of a bank account, rather it’s a system of identifying the owner of a bitcoin. A private key represents a balance, and it does this because its associated public key is represented in the blockchain as having received that balance at some point in the history of bitcoin transactions (of all bitcoin transactions ever).

The blockchain is called a blockchain because it is a series of information blocks that detail transactions. Blocks are discovered by miners at a rate of about one every ten minutes. Put simply, each block contains a cryptographic problem to be solved, and miners compete with each other to solve the problem – specifically to input a series of letters and numbers from the previous block and output a hash that corresponds with the input. Once the new hash is generated and the network agrees that it is correct, the miner is given credit for generating the next block in the chain. The miner who solves a block is tasked with including in it a record of transactions that have taken place since the generation of the previous block – but the miner is not required to include a transaction unless it was accompanied by a fee.

When I make a payment in bitcoin, I include a voluntary transaction fee (typically 0.0005 BTC, but see here for specifics). My transaction fee ensures that the next block mined will include a record of my transaction (in other words, ensures that my transaction will have taken place). When a miner solves a block, he has two rewards: the first is the sum of all fees associated with transactions included in the block, and the second, at present, is a reward of a certain number of “new” bitcoin for solving the block – the new bitcoin generation is why the process is referred to as mining. Over time, new bitcoin generation is set to diminish, thus encouraging more block solvers (mining nodes) to adopt Bitcoin in the present, to maintain a steady record of transactions, while minimizing inflation in the long haul—the bitcoin crowd are kind of obsessed with inflation. According to the original game plan for Bitcoin, generation of new coins will cease at 22 million, and block rewards will eventually consist only of transaction fees. In theory, transaction fees alone will be eventually be enough incentive for miners to mine, because more people using Bitcoin will make for more transactions.

So let’s say I have a friend who pays me half a bitcoin. In order to receive the half-bitcoin, I first have to create a public/private key pair. I then reveal the public key to my friend, and my friend submits half a bitcoin to the public key address, along with a .0005 BTC transaction fee to ensure that our transaction takes place by being recorded in the next block solved. He submits the coin by providing cryptographic proof that he is in possession of a private key that reflects a balance of at least .5005 BTC (what he’s paying me plus the fee). He never reveals the private key, and his cryptographic proof cannot be used to find the private key (this part is beyond my understanding, but you can read about it here).  Once our transaction is accepted into the next block, the blockchain will reflect that the public key I gave my friend has received .5 bitcoin. This is “proof” that the private key that “fits” cryptographically with my public key has a balance of at least .5 bitcoin. I use a bitcoin wallet to manage that key – the wallet keeps track of my key and reads the blockchain to tell me its balance. I could have twenty people each submit half a bitcoin to the same public key, after which it would contain 10 bitcoin.

But a bitcoin wallet can consist of as many public/private key pairs as I wish, with any amount of balance per private key. I could use different public keys to receive money from different people. This is the anonymity factor of Bitcoin – I can use software to generate a public/private key pair to use for a payment without ever associating my name with that pair. And this brings us back to Bitcoin’s implications.

Seeing the Transparency

Bitcoiners love to tout the protocol’s transparency, which seems rather confusing mentioned alongside the claim to anonymity. Simply put, Bitcoin has transparency in that the number of bitcoin issued is always public information. At any given moment, we can know the exact total number of bitcoin that have been generated during the life of Bitcoin. We can also look at the blockchain to measure Bitcoin’s liquidity (we can observe how many bitcoin are trading hands in transactions)—the idea being that at any given moment an individual has the power to gauge her marketshare. This is in contrast to our opaque money system, wherein the total amount of currency circulating is not easily accessible to anyone who cares to look. Transactions in our system take place behind closed doors, trackable by controlling entities, but not by individuals.

But where Bitcoin makes the market itself more transparent, it makes individual transactions opaque. Because anyone can generate any number of private and public keys, it’s extremely difficult to tell which hands money is passing between. This has some positive implications even for non-libertarians. Libertarians tend to think “all economic problems are due to government interference in the automatic operation of the market mechanism” (Ann Davis, “The New ‘Voodoo Economics: Fetishism and the Public/Private Divide,” referring to bourgeois conceptions of the market), so a libertarian perspective on the value of Bitcoin might include the benefits of detaching the market from the government.

Many of us who don’t believe markets self-regulate in the interest of all people can still get on board with the idea that current regulations are rewarding the wrong players. An unregulated market in a world of unequally distributed private property would be destructive to the goal of social equality, as markets tend to reward players with greater resources/capital and push out the smallest stakeholders over time (check out Amartya Sen’s Development as Freedom for an eye-opening account of world trade).

Bitcoiners also advocate the protocol as trust-free, or as trusting in numbers instead of humans, but there’s more trust involved than many are willing to admit. Storing your private keys in an online wallet requires trust in a service. Storing them in an offline wallet requires trust in the wallet software. Even if you store them in a text file, unless you’re a cryptographer yourself, you probably trusted a piece of software to generate a new key (rather than give you a key its developer knows and will use once there’s a balance on it). Signing bitcoin transactions means trusting software, too. The anonymity means trusting that the system is sufficiently distributed and genuinely liquid, and trusting that sellers will act honorably without legal supervision. Buying bitcoin with fiat dollars means trusting an exchange. People factor into the equation constantly, just as with fiat currency.

Bitcoin as Civil Disobedience?

Fiat/regulation vs. Bitcoin/deregulation is a false dichotomy from a social-equality perspective, as many of the regulatory mechanisms policed by our nation-state actually amplify the power of large stakeholders, who are already empowered to the extent that present markets are laissez-faire. Consider the patent power of large corporations in every sphere. Consider the healthcare industry’s monopoly over medical treatment with a prescription system that requires high-cost office visits to obtain medications even for lifelong, unchanging conditions. The barrier to entry for an individual of modest means in our present market is very, very high. So for an individual to buy pharmaceuticals anonymously with bitcoin doesn’t require a libertarian anti-regulation motive: opposition to unfair regulation is sufficient.

Now, I don’t mean to encourage you to start buying your anti-depressants from Silk Road. I have no personal experience with black-market bitcoin purchases, but as I mentioned earlier, evading our present system also comes with its dangers. What legal incentive does a totally anonymous seller have to protect your life and safety as a consumer? Sites that function much like Ebay (an example is Bitmit) are said to create a seller-reputation incentive to deliver quality goods to customers through buyer reviews, but just as with Amazon, reviews can be faked. Besides a lack of consumer recourse against bad sellers and bad deals, participating in black-market trade also obviously puts the consumer in legal jeopardy should she be caught. These are risks I would not take and would not encourage anyone to take, but plenty of people are taking them, which means the theoretical pressure they place on the failures of our present system are relevant.

The Economic Import

Seeking academic theory to apply to Bitcoin and illuminate the theoretical pressure requires a little creativity. The phenomenon of dollarization in third-world countries has been widely researched and may be a gateway for understanding the impact of parallel, separately regulated, currencies on an economy. But dollarization is about adopting a more valuable currency alongside (and sometimes to the exclusion of) a less valuable one, and U.S. bitcoiners are doing just the opposite. Dollarization research is also different in that the less-valuable currency’s circulation is geographically defined, whereas Bitcoin circulates alongside multiple fiat currencies  –  an alternate currency within the context of one nation-state would react to central bank decisions concurrently with fiat money’s reaction, but the international character of Bitcoin currency might make for an actual new market (although it could be argued that the U.S. dollar’s pro-Bretton Woods status as primary reserve currency would prevent Bitcoin from disentangling from shocks to the dollar).

Another underexplored facet of digital currencies is their long-term potential for cutting out middle-men and minimizing financial-sector infrastructure. Although Bitcoin at present uses miniscule amounts of energy in mining compared to the entire fiat-banking infrastructure (stories like this don’t take fiat energy costs into account), I am not convinced that this would remain the case were Bitcoin widely adopted, but research on the topic is scant. A study done by University of Muenster economists (downloadable here) points out inefficiencies in a proof-of-work monetary system, but it compares two hypothetical closed systems and doesn’t address the actual cost of our entire fiat infrastructure.

Already,  SWIFT is showing interest in the world of digital currency, and the appearance of online Bitcoin wallets, bitcoin payment systems,  plus the need for consumer-protecting regulation guarantees, suggest that the existing inefficient payment network structure could “swallow up” bitcoin and give us more of the same. With no chargebacks in Bitcoin, it’s conceivable that some sort of Bitcoin fraud insurance or anti-fraud guaranteed wallet service could become a need for consumers making irreversible payments. If Bitcoin really is inherently superior to fiat money in terms of infrastructure efficiency, research should be done to model this, taking into account current and potential expansion in the Bitcoin financial sector and current fiat infrastructure.

In essence, bitcoiners are trading the failures and benefits of one system for the failures and benefits of another more volatile system. They’re trading one transparency (name-attached, accountable transactions) for another (market transparency).

Because of the anonymity presently involved in Bitcoin, we have no way of knowing exactly what portion of the market is controlled by whom. What appears to be a distribution across millions of public keys could be a concentration in the hands of a very few people manipulating the lion’s share of the money, (then again, large players in our fiat market aren’t always obvious). The low transaction fees – one of the big selling points advertised by bitcoiners – are not guaranteed to remain low forever. Bitcoin enthusiasts I’ve discussed this with seem to place faith in the virtues of free markets when they attest that miners will always have incentive to competitively price the minimum fee for including a transaction in a newly mined block. They also claim that the barrier to entry for Bitcoin will remain low because new miners who accept lower transaction fees can always join the game. Being a miner means having a lot of computing power at your disposal – more as more blocks are created, because hash generation is designed to become more complicated with each new block (each successive block will have a slightly longer string of characters to be hashed). The bitcoiner argument for a low barrier to entry is that individuals can always join mining pools, aggregating their computing power to generate blocks collectively and share the spoils. But it’s possible that individual entities with immense monetary backing could design superior hardware for hashing that would astronomically outdistance the aggregate power of resources to which small players have access, in which case the power to set transaction fees would not necessarily remain competitive. If we reached a point at which individuals were heavily invested in Bitcoin, and at which the value of their bitcoin could not be equaled by trading back into a regular currency (say the goods available on the bitcoin market become significantly less expensive than those available on the fiat market given the fiat-to-bitcoin trade value), Bitcoin users would be at the mercy of the aforementioned superhashers and whatever transaction fees they set. Obviously this is all conjectural, but because Bitcoin is an unproven currency, conjecture is really all we have right now. I don’t see any reason not to experiment with it in the interest of brainstorming reforms for our own payment system, but anonymity, the irreversibility of transactions, volatility, and the lack of consumer protections all make it a far riskier medium of exchange than fiat money.

So What Is It Definitely Worth?

To my way of thinking, increased security is the one definite solution suggested by Bitcoin – the one immediate takeaway that isn’t contingent on some uncertain future. It isn’t clear what the impact of Bitcoin’s various pressures on fiat failures will be, and it isn’t clear how successful it will be, long term, as a currency (for many, many other reasons besides the ones I mentioned). But payer-side transaction control is in itself game-changing, disruptive technology. We should be demanding cryptographic security. We should not have to give the access “key” to our bank accounts to anyone. And we should be interested in digital currencies for, at the very least, security innovation through the use of cryptographic technology.

Trackbacks

  1. […] [Editor's Note: For Cherie Braden's analysis of Bitcoin, see Bitcoin Under the Liberal Microscope: How It Really Works and Why Does It Matter] […]

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