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Home > Macroeconomic Issues Viewpoints > Bitcoin and the Authorities, Monetary, Political and Regulatory: Houston, We May Have a Problem

Macroeconomic Issues Viewpoints

Bitcoin and the Authorities, Monetary, Political and Regulatory: Houston, We May Have a Problem

by Anthony Harrington

Table of contents

Background

The global financial crash of 2008 and its consequences—namely the extraordinary measures taken by central banks in the United States, the European Union, the United Kingdom, and Japan, plus of course, China, Russia, and dozens of other countries—did not do a great deal to further the cause of fiat money (currencies that a government has declared to be legal tender but which are not backed by a physical commodity). The surge in inflation that some anticipated from central banks getting involved in quantitative easing and massively inflating their balance sheets has yet to materialize, but although monies have not gone wildly off the scale, trust in paper money backed only by government promises is at an all-time low. Andy Haldane, writing for the Institute for New Economic Thinking, highlights the central role played by trust in the money system thus:1

“Finance is built on trust. It is based on promises about tomorrow, often paper promises backed by nothing other than words on a page. When trust in those promises breaks down, so too does the financial system. That is the lesson of thousands of years of history.”

Enter Bitcoin

Financial history, Haldane points out, is pockmarked with hyperinflation and currency crises, periods when trust in government-backed money has evaporated. Small wonder then that the open source community, which has a reputation for original and maverick thinking, as well as for building on individual brilliancies and moments of genius, has come up with a digital currency that absolutely writes third-party manipulation of the value of said currency out of the script. Bitcoin is the first decentralized peer-to-peer payment network that is driven purely by users and has no central authority or middlemen. It is a crypto-currency, using public key/private key encryption to control the creation of bitcoins and transactions processed. Even the currency’s originator, an anonymous programmer who called himself Satoshi Nakamoto, has disappeared from the scene, leaving Bitcoin as a pure open-source project.

From a user’s perspective, bitcoins are easy to use, and the way the virtual currency works means that large sums can be sent across national boundaries very rapidly with very low transaction costs. Users do not have to know a thing about the way bitcoins work to use the system. They have a bitcoin “wallet” on their device, be it a smart phone, tablet, laptop, or PC, and they can transact with anyone who will accept bitcoins as payment. Bitcoin exchanges will sell you bitcoins for cash or redeem them for cash at whatever the going rate happens to be. This is not the place for a full account of the mechanics of how Bitcoin works, but a brief account is necessary to understand the challenges that Bitcoin poses for regulatory and law enforcement agencies.

From the perspective of the Bitcoin “ecosystem,” a great deal of complexity and knowledge is required to play a meaningful part in the development of Bitcoin. However, it is above all a consensus network, which means that new modifications only work if any change is agreed by everyone. No developer can “skew” the project to serve his or her private interests. As the Bitcoin Foundation notes, the protocols and software that constitute Bitcoin are published openly, and any developer around the world can review the code or make their own modified version of the Bitcoin software. However, that modification will only be part of Bitcoin if everyone agrees it.

The heart of Bitcoin is the open or public ledger, called the “block chain”. This is a record of every transaction ever processed since the first bitcoin was “minted”. Every single subsequent bitcoin transaction is entered in the ledger, and the entry includes checking to see that the user has not tried to spend the same bitcoin twice over. The truly astonishing thing about Bitcoin is that this checking process—the business of maintaining the authenticity and validity of the ledger—is not carried out by a central authority, but is outsourced to a large number of “bitcoin miners”. The miners compete with each other in a race to authenticate each transaction, and the winner’s reward is the ability to “mine”, i.e. create, a set amount of new bitcoins. Authenticating or “confirming” transactions, in bitcoin-speak, gets progressively more difficult as the volume of transactions increases, and bitcoin miners now need specialized hardware to crank the mathematics involved.

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Further reading

Books:

  • Hayek, F. A. The Fatal Conceit: The Errors of Socialism. Vol. 1 of W. W. Bartley, III (ed.), The Collected Works of F. A. Hayek. Chicago, IL: University of Chicago Press, 1989.
  • Mauldin, John, and Jonathan Tepper. Endgame: The End of the Debt Supercycle and How It Changes Everything. Hoboken, NJ: Wiley, 2011.
  • Mises, Ludwig von. The Theory of Money and Credit. Auburn, AL: Ludwig von Mises Institute, 2009.
  • Reinhart, Carmen M., and Kenneth S. Rogoff. This Time Is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press, 2009.
  • Taleb, Nassim Nicholas. The Black Swan: The Impact of the Highly Improbable. 2nd edn. New York: Random House, 2010.

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