Supply Chain Problems? Bitcoin Don’t Care

There’s a cream cheese shortage in New York bagel shops. Used cars are selling for almost as much as new cars. And parents are going to extreme lengths to get their hands on Magic Mixies Cauldrons, the “it” toy of this holiday season.

You’ve heard it ad nauseum: The global economy is beset with supply chain problems. These have contributed – along with central banks’ massive monetary expansion programs – to an inflation outbreak that on Wednesday led the U.S. Federal Reserve to signal a faster-than-expected curbing in monetary expansion.

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In essence, global goods markets can’t respond efficiently enough to the disruptions in demand and supply to which the COVID-19 pandemic has contributed. As much as Moose Toys would love to get a Magic Mixies Cauldron into the hands of every child who wants one before Christmas, they can’t crank out or distribute them fast enough.

It’s a reminder that despite just-in-time inventory systems, an abundance of market information, highly automated factories and other advances brought by digitization, physical problems such as the availability of cargo containers, warehouses or willing workers continue to cap producers’ ability to respond quickly to market signals.

Now think about the past year for bitcoin mining. The industry also had two massive shocks to capacity in short succession – both from China – which contributed to periodic inflationary pressures in the form of higher transaction fees.

But the Bitcoin network adjusted rapidly to the changed circumstances, with the network hashrate – a measure of the total number of hash calculations conducted every second – now having fully recovered and while Bitcoin transaction fees are low and stable.

In this column we’ll examine why Bitcoin’s market adjustment mechanisms are more efficient than traditional markets.

Please don’t @ me, crypto critics. This is not a naive “Bitcoin fixes this” essay. I don’t have an answer for fixing global supply chains. I simply think it’s useful to explore how Bitcoin’s design fosters its unique adaptive capacity and how that’s pointing to new ways in which other systems, such as our energy system, can intersect with it.

There were two major declines in the Bitcoin hashrate this past year. The first occurred in mid-April, when accidents at coal mines in Xinjiang province temporarily deprived many Chinese bitcoin miners of power. The second was the more long-lasting outcome of the permanent bans that Chinese provincial governments started imposing on mining activity in mid-May and continued throughout June. (See the chart in the “Off the Charts” section for illustration.)

In the first instance, average fees briefly spiked to record levels above $50 per transaction.

Here’s why fees rose at that time: The sudden reduction in total computational capacity among miners – which compete to “discover” the randomly generated number that will give one of them the right to add a new block of transactions to the blockchain and claim its attached bitcoin rewards – meant it was taking longer, on average, for the network to add new blocks. Measured against time, there was a reduced amount of blockspace, which meant buyers and sellers of bitcoin must now more aggressively compete for a reduced amount of blockspace. The result: They pay higher fees to miners.

This scenario will only last so long, however, because the Bitcoin protocol is designed to adapt to shifting hashrates and bring the market into equilibrium.

Every 2,016 blocks, the Bitcoin protocol alters the algorithm’s difficulty, adjusting it up or down depending on how long it took, on average, for the network to find the previous 2016 blocks. If the hashrate has fallen, difficulty declines, which speeds up block creation. That brings it back to the average 10 minutes per block that the system is designed to sustain over time and ends the squeeze on fees. The opposite occurs when the hashrate has risen.

Even before this adjustment kicks in, the permissionless nature of bitcoin mining, combined with the allure of profits, leads to a more organic adaptation to conditions in a way that reflects its efficiency as a market.

In just six weeks in spring and early summer, Chinese authorities shut down a whopping 90 million terahashes per second of hash power, representing half the network. Yet, by year’s end, enough facilities had been set up elsewhere in the world to have fully recovered that lost capacity. The network, whose size is a proxy for how costly it is for someone to launch a 51% attack, is now not only back near record highs but spread disparately across the U.S., Kazakhstan, Russia, Canada, Iran, Malaysia, Germany and Ireland, among other countries. Bitcoin is now more secure and more decentralized.

Meanwhile, it only took until late July for average transaction fees to have come down to around $2, their lowest level in a year. They’ve now stabilized there, despite bitcoin’s market capitalization being more than five times what it was in July 2020.

(What’s especially impressive is that miners were able to overcome similar, real-world supply chain problems as those that are making a mess of American consumers’ holidays. There are currently big bottlenecks in the production of microchips, the most important vital component of mining equipment.)

We’re witnessing how the hyper-competitive nature of Bitcoin is spurring constant innovation – all the more so now that the hashrate, and difficulty, are back near record highs.

The hitherto rapid efficiency advances for application-specific integrated circuits (ASIC) – the uber high-compute chips on which bitcoin mining depends – are now reaching a physical limit. That means miners, forever faced with relentless competition, are forced to find other means of extracting profits, primarily in developing and promoting more efficient renewable energy solutions.

They’re forging symbiotic relationships with power providers and grid operators, which are starting to use miners as on-off switches to better manage the otherwise expensive peaks and troughs of load variance in their electricity systems. (For a good read on this, see Nic Carter’s piece on mining’s role in renewable energy development in Texas from two months ago.)

Bitcoin might not be able to find you some cream cheese, but it offers a valuable lesson in markets and innovation.