Ever since the dawn of the Internet and of the information age, writers and visionaries have visualized the disruptive changes that such technologies would eventually have on our lives; they have imagined futures where we spend more of our lives online than offline, and where ubiquitous access to technology and connectivity would be a strong decentralizing force, placing power in the hands of the people.
One of the cornerstones of this vision is the need for a decentralized, distributed, and pseudonymous currency in order to digitally transmit value from person to person. You cannot truly transfer power into the hands of the people without giving them economic sovereignty, and they cannot have economic sovereignty so long as money and currency are tied to the real world and controlled by monopolistic central banks and governments.
Many various ideas have been tried over the years, such as RipplePay, eCache, and ecash. For various reasons, none of these systems have taken off. Why did they fail? Some of them were flawed because they relied on a centralized model, and others were flawed because they only work if humans are completely trustworthy, something that cannot always be relied upon. However, there is a new distributed currency which has been rapidly gaining in popularity, and it has the potential to succeed where others have failed. This new system is called Bitcoin.
What is Bitcoin?
Bitcoin is a pseudonymous, decentralized electronic currency, and it has been designed in such a way that it functions similarly to physical commodity money, such as gold. This implementation solves both the problem of centralization as well as the issue of trust. To see how, first we need to look at the properties of money, and why physical commodity currencies such as gold were chosen spontaneously as money by the people, and why they have held their value for so long.
What are some of the properties of good money?
Money should be easily divisible into arbitrary units of value in order to handle all sizes of transactions, from the small to the very large.
In order to be a reliable store of value, money must stand the test of time. Anything which decays or rots would not be a good choice.
A good money is fungible; that means that each unit is identical to every other unit. One dollar is equivalent to another dollar, and one kilo of gold is identical to another kilo of gold. Money can then act as a numeraire or measure of value, just like a meter is a measure of distance.
The ideal money is one which holds its value and does not steal value through arbitrary inflation and deflation. When it comes to fiat currencies, central banks are supposed to fulfill this role, and when it comes to physical commodities such as gold, this standard is enforced by the laws of the universe. It is physically impossible for someone to conjure up a cubic meter of gold out of thin air, which is why it can preserve its value so well.
For something to begin life as money, it should add value in order to seed its own growth. Gold added value through its beauty and artistic uses, and Bitcoin has the potential to add value through the properties of decentralization, openness, and pseudonymity. I mention openness as the project itself is open source, and the code, protocol, and implementation are all open to scrutiny and analysis.
I consider these to be among the most important properties that something needs in order to be accepted as money. It is ideal if the properties of money are inherent in the medium itself, such as with gold. Gold has all of these properties and more, and this is why it was not only chosen spontaneously by the people across different continents and cultures, but it is also why it has held its value for thousands of years. Fiat currencies have value through legal force and convention; gold has value due to the physical properties of the universe. Legal force waxes and wanes, and conventions can change, but the laws of the universe stay constant.
So, how does it work?
So far, I’ve explained what money is but I haven’t yet said how this applies to Bitcoin. How can a digital currency possibly be scarce? After all, digital storage and processing power are extremely cheap and getting cheaper by the day. What’s to stop someone from doing a simple copy & paste and inflating the currency to nothingness?
Bitcoin has employed a novel solution which uses encryption and brute-force power in order to preserve the scarcity of the currency. To start off the network, Bitcoin uses a concept known as “mining” — people devote their resources to solving a very difficult cryptographic math problem, and those who succeed generate some bitcoins. The difficulty of this problem is adjusted by the total production of bitcoins, so that the network as a whole produces a relatively constant rate of coins. The problem of cheating is essentially solved because a cheater cannot possibly hope to amass the amount of computational power needed to overpower the rest of the network. We trust online shopping and we trust encryption because we know that cryptographic keys are very difficult to break; so it is the same with Bitcoin.
The graph on the left is a chart of the overall Bitcoin supply over time. As you can see, the Bitcoin supply is currently in a period of inflation. This inflation acts as an incentive for people to participate in the network and “mine” bitcoins, and it is distributed in accordance with the expenditure of resources. This inflation will taper down over time and the currency will eventually reach a point of equilibrium where there is neither inflation nor deflation. The supply of bitcoins will never be inflated past 21,000,000 BTC, so mining will get progressively more difficult. At this point, the network will transition over to transaction fees. Since anyone can run a Bitcoin node, these fees should tend toward the marginal cost of running a node, and therefore should be quite low.
What can Bitcoin do?
Bitcoin has the potential to revolutionize the online payment industry, but furthermore, it could even place economic power back in the hands of the people. Hefty transaction fees currently discourage micropayments, but Bitcoin could completely change that, opening up a whole new micropayment industry in blogging, online gaming, and many other areas. Bitcoin is also open, peer-reviewed and decentralized, which means that its fortunes don’t change on the whim of a single dictator in charge, or even a single monopoly power. In fact, I fully expect there to be competing digital currencies in the future as Bitcoin continues to grow, and this competition will help ensure that quality of the money remains first and foremost.
Where to get it
Bitcoin can be downloaded from Bitcoin.org. There are currently clients available for Windows, Mac OS X, and Linux.
If I install this, will this eat up my CPU and share my files?
Bitcoin is not filesharing software, so it does not share your files. It only uses your CPU if you want to try to “mine” bitcoins, otherwise it uses practically no CPU at all.
Can I take my bitcoins to the local bank and get some cash in exchange?
I think it’s a little early for that. What you can do though is participate in one of the many exchanges and trade bitcoins for USD, EUR, or other various options.
So, I don’t get it — is the value of a bitcoin determined by the resources expended to produce a bitcoin?
Like anything else, the value of a bitcoin is determined solely by supply and demand. If the market value of a bitcoin is higher than the production cost, then it will be worthwhile to devote resources to mining more bitcoins. In this sense, the cost of mining will tend to approximate the value, but it does not drive the value. It is the combination of supply and demand that drives the value. It is entirely conceivable that at some point, the cost of mining a bitcoin will be astronomical, nearing infinity, yet the supply will be stable and the value of a bitcoin will be determined by demand. At this point, transaction fees will support the network and the value of a bitcoin should rise and fall in conjunction with its underlying economy.
If the value of Bitcoins rise, then isn’t this deflation?
I define inflation and deflation as changes in the monetary supply, and it is when we define them in this way that we can see the damage that they cause. If someone could just conjure up a billion dollars out of thin air and spend it at today’s prices, then they have effectively stolen value from everyone else. Likewise, the deflation that follows an unsustainable credit boom and the ensuing bubble burst can be painful. However, neither of these events are possible with Bitcoin because they are not under the control of a monopoly issuer and cannot be inflated the way that fiat currencies can. Instead, their value will be determined primarily by voluntary trade, which means by how much others value them.
Ok, so, what can I do with these Bitcoins?
The market for Bitcoins is still small, but it is growing every day. Popular services include VPN servers, VOIP, and web hosting, and many tangible goods are also available, such as books and T-shirts. You can check out many different services available at the Bitcoin trade page, and you can visit the Bitcoin faucet to get some free coins to get you started.
Bitcoin really took off last year; it rose from a market value of about $0.005 per BTC (bitcoin) to nearly $1 per BTC; this is an increase of value of over 200x! With over 5 million coins in circulation, Bitcoin is currently in a nascent point of growth, and the sky is the limit.
My Bitcoin account
If you liked this article and want to send some Bitcoins over, my address is: 17gqLL6RHpkHgSDG6RxA6QtRvwtcxasZDo. Any donations will be graciously accepted. 🙂
So, reader, what do you think about emerging digital currencies and Internet technology in general? I believe that nascent technologies such as Bitcoin and its future derivatives have the real potential to drive change and innovation in our world. When the news around the world is bleak and people are pessimistic about the economy and the world in general, I just look at the trends in technology and in our amazing progress forward, and I become an optimist again.