The Economic Case for Conservative Bitcoin Development

A look at bitcoin's scaling debate and what the history of money can teach us about the best path forward for protocol development.

AccessTimeIconSep 19, 2017 at 9:00 a.m. UTC
Updated Sep 13, 2021 at 6:56 a.m. UTC
AccessTimeIconSep 19, 2017 at 9:00 a.m. UTCUpdated Sep 13, 2021 at 6:56 a.m. UTC
AccessTimeIconSep 19, 2017 at 9:00 a.m. UTCUpdated Sep 13, 2021 at 6:56 a.m. UTC

Ariel Deschapell is a full-stack javascript developer teaching at the Ironhack coding bootcamp in Miami, and a recent Henry Hazlitt fellow in Digital Development at the Foundation for Economic Education.

In this opinion piece, Deschapell discusses the tensions underlying bitcoin's scaling debate, arguing those who have approached the protocol's design with more caution are perhaps doing so with history on their side.

The way we think about bitcoin, its use cases and its subsequent road to adoption fundamentally underlies the scaling and governance debates at the heart of forks like bitcoin cash and Segwit2x.

As an unprecedented technology, bitcoin's refusal to fit into any predefined conceptual pigeonhole continues to give fits to regulators and traditional financial intermediaries alike. But, this presents a problem to its advocates too, who rely on their own idealistic notions and necessarily incomplete understandings of bitcoin.

Economically, the way we think about bitcoin is also shaped by the way traditional money and payment systems have evolved and developed. These systems are our only frame of reference, but in using them as such, we must make use of sound economic theory or risk many intellectual pitfalls.

At the center of these considerations is the idea of bitcoin as a new type of money. Given its use as a means of exchange in many online and in-person payment gateways, it seems to be an easy jump to call it money just like the U.S. dollar or Japanese yen. Bitcoin was originally proposed as a "peer-to-peer digital cash" after all, and its most ardent maximalists aspire to have it replace the national patchwork of fiat currencies as the primary means of exchange around the globe.

However, bitcoin is not money – at least not yet.

Believing otherwise based on its use and characteristics as a usable medium of exchange is an erroneous conclusion, and worse, it can lead to problematic and ultimately harmful implications for its future development.

To ultimately have the best chance of establishing bitcoin as money, we must understand the nature and origin of money, and in that context the technical challenges facing any cryptocurrency.

The origin of money

Long prior to bitcoin, the economist Ludwig von Mises ingeniously articulated and expanded upon the Austrian school of economic thought regarding the nature and evolution of money.

In what is known as the "regression theorem," Mises observed that all money originates as a universally valuable commodity before it ascends to becoming a medium of exchange, and then only subsequently, money proper. This was why the first widely used mediums of exchange were metals such as gold and silver.

These commodities were valued for their unique properties, ones which would also later make them very effective means of exchange and ultimately good money.

Gold and silver were both aesthetically attractive and relatively easy to clean. However, they were also malleable, easily divisible and completely uniform. Gradually, over thousands of years, these commodities supplanted barter as a much more efficient way to stimulate trade for ancient peoples.

In turn, this gave way to more convenient "banknotes," or claims on gold and silver in a vault, and of course, fiat money, as governments discovered the power of appropriating control of the money supply. Digital replacements for this legal tender came even later.

This evolution of money took place gradually over thousands of years – and bitcoin stands in stark contrast. From its inception, dividing and sending bitcoins to and from addresses was a fairly trivial task. Within a few years, spending it at a number of online websites and even brick-and-mortar stores was a straightforward affair.

To the casual observer, it may seem as if bitcoin disproved Mises's regression theorem: a purely conceptual number on a ledger that spawned from nothing and became a means of exchange almost overnight.

If only it was that simple.

The money test

At this point, it's necessary to identify what money is and why it matters.

As defined by Merriam-Webster:

"Something generally accepted as a medium of exchange, a measure of value, or a means of payment."

Wikipedia's definition:

"Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts in a particular country or socio-economic context."

The common denominator here is "generally accepted," a standard that is a bit arbitrary but nonetheless is hardly met by bitcoin today.

Yes, many goods and services can be bought with bitcoin. But this doesn't make it money any more than the hypothetical ability to spend wheat futures digitally would make wheat futures money.

It is technically possible to accomplish this much the same way as the majority of bitcoin commercial transactions work in practice: by instantly converting what the merchant receives into fiat currency, the real money still making this exchange possible.

Confusion on this point stems from our historical experience of currency (dollar, yen) and the systems used to facilitate their transfer of ownership (debit cards, checks, bank wires) being traditionally separate.

Bitcoin meshes the two into one. The protocol both establishes a provably scarce digital good and easily facilitates changes in their ownership regardless of geographic space. Yet, while this technological property gives the token significant utility and makes it easy to spend with the use of clever software and third parties, it does not make bitcoin money.

For bitcoin to be considered money, it must be generally accepted and used within a closed loop. Merchants must not only much more widely accept it as a payment option, but also feel fully confident in holding the actual bitcoin itself.

Establishing a store of value

After establishing that bitcoin cannot yet be considered money, suddenly the regression theorem becomes far more interesting and practical. If bitcoin is not money, then what is it? The only remaining answer is a valuable commodity, which brings us to the very beginning of the regression theorem.

Like gold and silver, bitcoin possesses unique properties that are valued by individuals. The fact that it remains entirely digital is not a problem conceptually, it only makes it unprecedented and therefore harder to grasp. But physicality isn't a necessary prerequisite for a good to have market value.

The only prerequisite is scarcity. Through the ingenuity of its blockchain architecture, bitcoins became the first provably scarce digital good.

The attractive properties of this digital good can be said to include its extreme divisibility, fungibility and its hard limit on supply. Still, other alternative currencies were created in the past with all these properties, including the Liberty Dollar and E-Gold. These attempts were quickly shuttered by governments in the interest of maintaining their monopoly on currency issuance.

Bitcoin was different for what quickly became and remains its foremost feature: its resistance to censorship.

This is the bedrock of bitcoin's usefulness as a store of value. The ability to hold wealth outside the system and largely outside of its reach is the original killer application for bitcoin. It is tied to the protocols functions of both establishing a scarce store of value and facilitating their transfer, regardless of physical space or the objection of any single third party.

However, to take this functionality for granted betrays a massive under-appreciation, if not complete misunderstanding, of the technology involved and its very real limits.

In software as with the world, security and safety are never a permanent state of affairs. Any computer network ever devised can be attacked, and attacked successfully at a high enough cost. Bitcoin's brilliance is that its incentive architecture and resulting infrastructure makes the cost to attack and successfully disrupt the network very high.

The fact that it has been running without interruption for close to nine years is nothing short of a software miracle that speaks to the ingenuity and brilliance of the system's design. However, past performances are never a guarantee of future results. This is even more so when it comes to something still as new and experimental as bitcoin.

The real challenge

To see why this is the case, we have to understand basic risk and threat analysis.

Imagine a computer system that, if compromised, gives an attacker $100. Now, if the cost to compromise that system is $10, then doing so is a worthwhile endeavor. However, if the cost to do so is instead $200, it clearly is not. In this simplistic example, the system can be considered hypothetically secure only in the latter case.

To date, it can be said the cost of disrupting bitcoin has always exceeded the value of doing so, as is evidenced by its successful continued operation. While quantitatively measuring the cost of compromising the bitcoin network is tricky at best, let's first assume that it remains fixed.

If bitcoin continues to grow and add value to its ecosystem, the potential returns to be made in disrupting it also continue to increase. If the cost of compromising it remains the same all the while, it must eventually become cost-effective for some entity of sufficient resources to indeed compromise it. By its ambitious nature, there is no shortage of large and resourceful entities which bitcoin's success continues to threaten.

Indeed the larger and more successful it becomes the greater the size, number, and motivation of such potential adversaries.

We've established that to become money bitcoin must be generally accepted and used within a closed loop. This is only possible if it first becomes a stable store of value, and even this long process has a necessary prerequisite: that bitcoin continues to be a secure store of value.

For it to ever have a chance at accomplishing this demands then that it must not only just maintain its security as it continues to scale to and increase in value. It must actually increase security as the network continues to scale and increase in value.

Cart before the horse

This is the central challenge facing bitcoin scalability.

It is not enough for it to simply handle more and more transactions cheaply. It must do so while preserving its most foundational feature, that of censorship resistance. Only by accomplishing that can it remain a trusted store of value on a fundamental technical level, and only after continuously proving this with more users and more wealth can it gain enough adoption and market confidence that it ultimately becomes a stable store of value. Then only subsequently can it become money

Only by accomplishing that can it remain a trusted store of value on a fundamental technical level, and only after continuously proving this with more users and more wealth can it gain enough adoption and market confidence that it becomes a stable store of value. Then only subsequently can it become money proper.

Assuming bitcoin is money first and foremost today, and concluding that it must immediately compete with the transaction times and fees of popular money transmitter apps like Venmo, is putting the cart before the horse.

Even worse, these assumptions have led to proposals that proactively sacrifice network security in favor of cheaper fees and other such secondary concerns.

This is the reason why I've previously written that the trade-offs from increasing the block limit as implemented by bitcoin cash and proposed by Segwit2x are not advantageous. There is problematic reasoning behind how such proposal increase the rate of adoption and very real long-run security concerns that remain unaddressed.

Of course, it is possible to disagree on these finer points. One can agree with the sentiment expressed here and also earnestly believe that the block size or other protocol changes won't fatally impact block propagation, node numbers or miner centralization. Open discussion, debate and even open competition is key to finding the best way forward.

However, given the undeniable and fundamental importance of bitcoin's censorship resistance in its value proposition, the burden of proof clearly rests on those who would change the protocol to show how such changes either do not impact the network's distribution and security, or why such a tradeoff is otherwise desirable or urgently necessary.

Censorship resistance is simply too important to risk, especially when more secure approaches to scaling are readily available.

An issue of perspective

Bitcoin is not a short-term project or investment. Neither is its continued success a sure thing.

Make no mistake, continuing to upgrade bitcoin to handle true widespread adoption while maintaining its censorship resistance is a monumental task fraught with many risks and unknowns. Accomplishing this would be nothing short of an unprecedented feat of software engineering and human coordination, and would likely have a larger societal impact than any single previous technological advancement in history.

There exist no shortcuts through the careful and intelligent development needed to make this dream a reality.

Those who are impatient for bitcoin's widespread adoption and use as money should look back at the history of traditional money for a sense of perspective. It took millennia for gold and silver to be established as universal means of exchange and money proper. It took centuries if not millennia more for these to be replaced by more abstract concepts such as banknotes and fiat currency.

By comparison, bitcoin is the first scarce digital good, and the first instance of a whole new asset class spontaneously appearing from the ether. With this in mind, the progress it has made in nine short years is both shocking and awe-inspiring.

Needless to say, it will take much longer than a decade for markets to fully embrace bitcoin with the same faith they have in fiat currencies today. But should it take even 100 years to accomplish this, it would remain a blink in the eye of history.

A blink, we are all lucky enough to get to see.

Disclosure: CoinDesk is a subsidiary of Digital Currency Group, which helped organize the Segwit2x bitcoin scaling proposal.

Bull and bear image via Shutterstock

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