Make no mistake we are witnessing a revolution in economics. Developments in market design are changing the way people interact in the presence of scarce resources and will undoubtably influence the way we think about economics. This is an economic revolution that has been directed by scholarly endeavours, is being driven by the revolutionary zeal of a large number of talented individuals, and has been sustained by the obvious propensity to decentralisation of novel economic systems that are unencumbered by traditional social stratification.
The ideas underpinning the revolution do not seem to have been greatly influenced by the works of professional (academic) economists. By the by, professional economists have been tangentially engaged as witnesses to this revolution. I don’t fully understand why this has been the case. A year ago, economics, through the Nobel Memorial Prize in Economics, celebrated its own important achievements in market design, arguably ignoring the greatest achievements in the area: the design of a decentralised fiat currency, its implementation in the Bitcoin currency network, and the emerging ideas underpinning distributed networks featuring anonymous markets for the exchange of goods and services.
In this post I’ll talk about the implementation of the Bitcoin fiat-money and a challenge facing the emergence of anonymous markets for real goods and services.
The development of crypto-currency and its implementation in Bitcoin can be traced to a number of working papers. The Bitcoin network is a distributed method for storing and verifying transaction history. Essentially it is a decentralised way for preventing double spending of currency by remembering certain details of transactions. In the same year (1998) that Narayana Kocherlakota published his economic theory paper “Money is Memory,” Wei Dai described an anonymous electronic cash system that he called “b-money,” and Nick Szabo developed his bit-gold system. Both of the latter proposals influenced the theoretical design of Bitcoin, which in a sense implements Kocherlakota’s ideas regarding money. Obviously motivated by the financial crises (indeed the Chancellor of the Exchequer’s response to the collapse of banks) the anonymous, now probably very rich, Satoshi Nakamoto published his working paper “A Peer-to-Peer Electronic Cash System” which was rapidly coded in January 2009. One Bitcoin today is worth around $520 USD:
The main innovation in the Bitcoin decentralised currency system is the network of miners. This is a robust mechanism for governing the Bitcoin network. The mining network plays the role of a decentralised “central” bank, public record keeper, and may eventually have a regulatory role. The network of miners is setup with the idea that anyone can be a miner, but mining is costly, and you get as many votes on the mining “board” as the amount [of CPU power] that you have invested into mining.
One role of mining in the network is to record transactions between Bitcoin users. Mining is the decentralised memory mechanism for Bitcoins. Transactions between individual Btcoin users are broadcast to the all the network. The broadcasts are recorded by the miners who must solve a computationally difficult problem, with easily verifiable solution, to be able to add records to Bitcoin’s public ledger of transactions (block chain). The successful miner is paid a transaction fee for recording transactions.
The number of Bitcoins in existence will never exceed 21 million. At present the total number of Bitcoins in circulation is around 12 million. Mining (record keeping) also increases the quantity of Bitcoins overtime. In addition to a transaction fee the successful miner is payed a subsidy of new Bitcoins. The marginal cost of “mining” these new Bitcoins is exponentially increasing in time, but given the exponential growth in the dollar value of Bitcoins the dollar profit of mining a Bitcoin seems to be stable. This is not unexpected since presumably the exchange rate of a Bitcoins cannot be greater than the dollar marginal cost of mining it. If it is less than the marginal cost of mining the Bitcoin, then a deflationary process makes mining more lucrative [attrition may effectively decrease supply, for instance neglected wallets or an owner of Bitcoins forgets their password or dies without revealing the password for their wallet or the FBI confiscates a Bitcoins wallet-password.] As far as I can tell from reading bitcointalk.org the marginal cost of mining Bitcoins presently is comfortably between $500 and $600,
so I don’t expect dramatic increases in the USD value of Bitcoins.*
The Bitcoin public ledger records the history of all transactions. However, transactions in Bitcoins are essentially anonymous. These transactions are made between Bitcoin wallets and a user may generate as many Bitcoin wallets as they need, which is usually done anonymously. The public ledger of transactions records all the transactions made by all wallets and the balance in each wallet is calculated accordingly. A problem for anonymity only arises if a real name is associated with a wallet, for instance if you bought Bitcoins with a dollar-credit card. There are a number of relatively simple solutions for this problem. The easiest of these is to deposit your Bitcoins from the known wallet into a shared wallet (a Bitcoin bank) and then withdraw into a number of new anonymously generated wallets.
Though Bitcoin is by now a mature system that is increasingly well understood, the pressing theoretical challenge is in the development of a decentralised market place for real goods. Presently, the marketplaces that use Bitcoin are centralised in the sense of being owned by a guarantor. In these marketplaces anonymous sellers advertise their goods, the anonymous buyers buy the goods using Bitcoins, and the seller sends the good after the Bitcoin transaction to the buyer. With Bitcoins, transactions are final and there is no facility for transaction reversal. In contrast, if you pay for a book using Paypal and the book does not arrive at your doorstep, then you can request a reversal of the transaction. Presently, the main activity of marketplace guarantor is to implement a transactions escrow system and a process for resolving disputes between buyers and sellers. This kind of escrow system hasn’t worked out well, because there have been numerous instances in which the anonymous guarantor has run off with both the buyer’s and seller’s Bitcoins. So the challenge now is to develop a decentralised mechanism that facilitates transactions between anonymous buyers and sellers. I can think of a number of simple mechanisms arising from game theory, whereby buyers and sellers are kept honest at the unique subgame perfect equilibrium. However, I doubt that these contrived three step examples are useful in either practice or theory.
*EDIT: I haven’t fully understood the inbuilt relationship between computational difficulty and miner competition. The computational difficulty of mining has jumped recently, and I’m now trying to model this in a formal Bitcoin pricing model. Interesting!