09 Dec 2014

Understanding Bitcoin

Bitcoin 39 Comments

[UPDATE: The link below now goes to version 1.1, which fixes a slight mistake in a footnote and some typos.]

You guys think I spend my time at the karaoke bar and trolling Scott Sumner. Well, I do spend my time doing those things, but I also co-authored this guide to Bitcoin with Silas Barta. Joking aside, I really worked with Silas to make sure you can read this thing with no prior knowledge of cryptography, and can walk away knowing enough to really see how it works.

Understanding Bitcoin

39 Responses to “Understanding Bitcoin”

  1. Transformer says:

    I really think you should offer Silas a guest post on how he “built a liquid-­‐cooled mining rig from off-­‐the-­‐shelf graphics cards”.

  2. Major.Freedom says:

    I disagree that Bitcoins have “overcome the roadblock” of Mises’ regression theorem.

    Bitcoins were initially exchanged for dollars. Dollars were initially exchanged for gold and silver.

    The regression theorem applies to new money replacing old money as well.

    • Keshav Srinivasan says:

      Major_Freedom, how do you think the initial exchange rate between dollars and bitcoin was established? Isn’t Mises’ regression theorem about how a new medium of exchange acquires its initial exchange rate with a previous medium of exchange by people being able to refer to the new medium of exchange’s previous use value?

      If something like bitcoin is possible, then why isn’t it equally possible for people to go directly from barter with no medium of exchange to a non-commodity medium of exchange?

      • Major.Freedom says:

        Keshav,

        “Major_Freedom, how do you think the initial exchange rate between dollars and bitcoin was established?”

        For the very first Bitcoin for dollars exchange, it was by the previous valuation of dollars.

        “Isn’t Mises’ regression theorem about how a new medium of exchange acquires its initial exchange rate with a previous medium of exchange by people being able to refer to the new medium of exchange’s previous use value?”

        Bitcoins were not a medium of exchange when the initial exchange with dollars took place.

        “If something like bitcoin is possible, then why isn’t it equally possible for people to go directly from barter with no medium of exchange to a non-commodity medium of exchange?”

        Bitcoins were not instantly a medium of exchange.

        • Transformer says:

          Is it possible that the initial value of bitcoin was established by market intervention by its creators ?

          They want to get bitcoins established so they participate in the market as buyers to maintain a non-zero value.

          Seeing this, people develop the confidence to do anonymous electronic trades in bitcoin. These special kinds of anonymous trades give bitcoin a use value over and above normal currency where these kinds of trades can’t be done.

          After a certain point market interventions can stop as bitcoin has both an established use-value . and a history of holding value – so the regression theory applies to it..

          • Major.Freedom says:

            Transformer,

            Agreed. But I would not use the term “intervention” to describe what you are talking about. I would call it actual market behavior. Nobody is intervening in the process of the market by buying and selling Bitcoins, regardless of their psychological motivations. Mises has a good explanation on the difference between catallactics and psychological motivations.

            An exchange implies a non-zero value, even if the motivation is nefarious, political, benevolent, philanthropic, anything. It is the choice to exchange that constitutes the creation of (exchange) value, and markets.

            All value is the creation of individuals.

          • guest says:

            “Seeing this, people develop the confidence to do anonymous electronic trades in bitcoin. These special kinds of anonymous trades give bitcoin a use value …”

            You’re not describing the use-value of bitcoins, here, but rather the use-value of the technology which can permit anonymous trades.

            The bitcoins themselves still have no use-value, and the trades that happen in the attempt to use bitcoins as money are based on “the next sucker” accepting nothing in exchange for something.

            No matter how willing people are to accept a fraudulent transaction, fraud doesn’t create mutual value. We say this about paper money all the time; Just because you have more units of FRN doesn’t mean you’re better off – it could mean you’re worse off without knowing it.

            Let me try a different angle:

            If you pay me to ship a box of expensive X to you, and I slap a label on a box of nothing and ship it to you, does the fact that the empty box makes it to you mean that you will now accept boxes at the value you paid for something that was supposed to be in the box?

            The point is that just because you can convince people that something is valuable in trade doesn’t mean that it is.

            Should Austrians stop poo-poo’ing the FED because people willingly accept their paper in trade?

            From where does the business cycle come, since no one is apparently being mislead? You freely accepted the paper, so why blame the FED?

            In what way is paper money supposed to distort prices in the bitcoin adherent’s worldview?

            Without an understanding that money prices reflect perceived link to use-value to someone in the economy, you can’t speak of distorted prices. If you do nothing more with prices than what can be done by picking numbers out of hats (which is what happened when the first bitcoin was traded for pizza), then there’s nothing to distort.

            “Distorted prices” implies that the prices “should have been X” in some sense.

            Yes, prices change, and no one should expect anything to always hold a particular value, but there’s a difference between:

            1) “I think X has such and such use-value to someone, therefore I think it would be profitable to trade it for Y”

            and

            2) “I was told I have X”, but he actually doesn’t

            The 2nd example is where the distortions in paper AND bitcoins come from.

            Go back to basics. The purpose of all trade is to increase profit by lowering the costs of acquiring wealth. Money can only be money when it does this. Money can only enable subjective-valuation of the good that is bought with it, if there is a link between money and use-value.

            [I know, TLDR; I wouldn’t blame anyone.]

            • Tel says:

              Bitcoin is a method of making anonymous transactions, and a method of keeping a ledger, what else did you think it was?

              2) “I was told I have X”, but he actually doesn’t
              The 2nd example is where the distortions in paper AND bitcoins come from.

              Who told you that owning a bitcoin is actually anything other than owning a bitcoin? The value of a bitcoin is the market value that someone is willing to exchange for it, what do you think the mysterious X is here?

              The purpose of all trade is to increase profit by lowering the costs of acquiring wealth.

              I would have thought division of labour was the key issue… although if several competing transaction methods are available then low cost would be one consideration, and high security, and stability of prices (none of which can be perfect).

              • guest says:

                “Bitcoin is a method of making anonymous transactions, and a method of keeping a ledger …”

                The computers which enable such ledger-keeping has value, but so-called crypto-currencies aren’t the only things that can be put in such ledgers.

                I’ve always said that the service that the computers can provide is what can be valuable, rather than the bitcoins.

                Higher-order goods cannot make lower order goods valuable, since valuation happens the other way around [Menger’s Theory of Imputation]; Therefore the Bitcoin service cannot make bitcoins [the “currency”] valuable.

                “Who told you that owning a bitcoin is actually anything other than owning a bitcoin? The value of a bitcoin is the market value that someone is willing to exchange for it …”

                So, if I can get someone to accept a handful of dirt in exchange for something, you will then use that value going forward when accepting handfuls of dirt from me in payment?

                If not, then you are exemplifying my point that you do, in fact, attempt to link dirt to use-value, just as you should be doing with bitcoins, but aren’t.

                “I would have thought division of labour was the key issue… although if several competing transaction methods are available then low cost would be one consideration …”

                The only reason you trade is because it would be more costly for you to acquire the same good on your own.

                There’s no reason to trade if you can get it, yourself, at the same cost.

                Therefore all trades occur due to the lower costs involved.

                This is the value in the division of labor.

                It doesn’t ADD value; rather it lowers costs.

          • Transformer says:

            MF,

            I agree that market intervention in the wrong phrase – its more like a marketing strategy where firms give stuff away to get market share.

      • guest says:

        “If something like bitcoin is possible, then why isn’t it equally possible for people to go directly from barter with no medium of exchange to a non-commodity medium of exchange?”

        As an opponent of bitcoins, I can tell you that you’re asking exactly the right question.

        In what sense does money have to hold to the Regression Theorem, if, at a certain point, money doesn’t have to mean anything?

        Why the unnecessary intermediary step?

        This is why I say that the bitcoin Austrians are going to make Austrian Economics look bad.

        If they’re going to accept that bitcoins can be money, they might as well be Keynesians, in my view.

        • Tel says:

          I’m pretty sure several thousand years went past during which people found ways to trade despite not having Internet shopping.

          Why isn’t it possible for people to go directly from walking to driving cars? Why the unnecessary intermediary step of riding on horseback?

          • guest says:

            I’m going to say the technology wasn’t there to enable car-driving at the time.

            You’re going to respond, “Same with bitcoins.”

            And I will reply that there are plenty of things to which one may arbitrarily assign value – such as handfuls of dirt; and therefore a lack of technology cannot be an adequate response to my objection.

            [Aside: There’s no LOGICAL reason why someone couldn’t go directly from walking to driving cars. In fact, many people, today, make precisely this transition, not having ever been on a horse.

            Similarly, there’s no LOGICAL reason why there would need to be an intermediary step between barter and non-commodity money IF you believe that non-commodities could be used as money, at all.]

            • Anonymous says:

              There’s no logical reason why people brought up to use Bitcoin (in a society where the others around them use Bitcoin) would ever need to worry about barter.

            • Harold says:

              I am not sure what you are saying here. Is it that paper can not be money, as it has effectively no commodity value?

              Dirt has value – topsoil is about $100 / tonne.

              “So, if I can get someone to accept a handful of dirt in exchange for something, you will then use that value going forward when accepting handfuls of dirt from me in payment?” Maybe not a handful, but I can quite conceive that a soil supplier could accept a few cans of fuel for a tonne of topsoil. He may then trade on the fuel for something else.

              Topsoil is not generally used as a medium of exchange for reasons that have nothing to do with regression. Keeping a tonne of it around is inconvenient. It does not have the properties that would make it a good medium of exchange. The properties that are needed for a medium of exchange are also likely to give some commodity value – such as durability, portability, scarcity etc. Soil has none of these. Things that are tough often have some use. This means that things that have historically been used for money would tend to have had commodity value. It does not mean that everything used as money must have commodity value.

              “In what sense does money have to hold to the Regression Theorem, if, at a certain point, money doesn’t have to mean anything?” What do you mean here? Do you mean that the thing used for money at some point does not have to have any value?

              • guest says:

                ” Is it that paper can not be money, as it has effectively no commodity value?

                Dirt has value – topsoil is about $100 / tonne.”

                Don’t you see that you’re referencing dirt’s use-value to make your point?

                Why not arbitrarily value dirt at one house per handful, just like someone arbitrarily valued a certain number of easily copied pattern (bitcions) more than a pizza he gave up for them?

                I can copy/paste bitcoins ad nauseum. I think I just drank your milkshake.

                You’ll say that copied bitcoins can’t be used in the Bitcoin system.

                To which I’ll reply that that proves that bitcoins, themselves, have no use-value.

        • Keshav Srinivasan says:

          How would you respond to the Bob Murphy’s claim that the same argument that shows that bitcoin can never become a money would also show that it cannot be a medium of exchange, even though it is?

          • guest says:

            Because you can trick people into accepting anything in trade, through fraud.

            Just because someone accepts it in trade does not make it valuable.

            [Aside: Bob’s meaning that he pours into the phrase “medium of exchange” is one I would like to get away from, at some point, in favor of what I think the original meaning was: a conduit of subjective-value. This is the only meaningful sense in which money can communicate information, in my view. But I digress.]

            I do not accept that the wide use of an intermediary “something” is sufficient to make a thing “money”.

            Ponzi schemes can go on for a long time. Does that mean that the willing investors were actually gaining wealth the whole time, for all of their “willingness to invest”?

            Voluntary use of a medium of exchange is neccessary for something to be money, but not sufficient.

  3. Major.Freedom says:

    “The  protocol  actually  allows  the  blockchain  to  divide  ownership  down  to  eight  decimal  places,  meaning  that  the  original  protocol  and  related  software  can  handle  purchases  as  small  as  0.00000001  BTC.  Therefore,  rather  than  imagining  the  world  eventually  being  saturated  with  21  million  bitcoins,  it’s  more  appropriate  to  think  of  humanity  ultimately  holding  2.1  quadrillion  units  of  bitcoin  currency.  Just  as  Americans  use  dollars,  but  quote  cheaper  items  in  terms  of  cents,  so  too  could  merchants  quote  items  with  a  different  unit  of  measurement  (not  “bitcoins”)  to  denote  fractional  amounts  of  the  currency.  For  example,  a  merchant  might  simply  write  “45  mBTC”  on  a  price  tag,  to  indicate  that  the  item  cost  45  milli-‐bitcoins,  or  45  one-‐thousandths  of  one  bitcoin.  This  could  also  be  written  as  “4.5  cBTC,”  denoting  four-‐and-‐a-‐half  centi-‐bitcoins.  (Note  that  this  is  similar  to  1  millimeter  being  one-thousandth  of  a  meter,  and  one  centimeter  being  one-‐hundredth.)  Furthermore,  with  consensus  of  the  userbase,  the  protocol  can  be  updated  without  disruption  to  allow  even  greater  divisibility.<The  protocol  actually  allows  the  blockchain  to  divide  ownership  down  to  eight  decimal  places,  meaning  that  the  original  protocol  and  related  software  can  handle  purchases  as  small  as  0.00000001  BTC.  Therefore,  rather  than  imagining  the  world  eventually  being  saturated  with  21  million  bitcoins,  it’s  more  appropriate  to  think  of  humanity  ultimately  holding  2.1  quadrillion  units  of  bitcoin  currency.  Just  as  Americans  use  dollars,  but  quote  cheaper  items  in  terms  of  cents,  so  too  could  merchants  quote  items  with  a  different  unit  of  measurement  (not  “bitcoins”)  to  denote  fractional  amounts  of  the  currency.  For  example,  a  merchant  might  simply  write  “45  mBTC”  on  a  price  tag,  to  indicate  that  the  item  cost  45  milli-‐bitcoins,  or  45  one-‐thousandths  of  one  bitcoin.  This  could  also  be  written  as  “4.5  cBTC,”  denoting  four-‐and-‐a-‐half  centi-‐bitcoins.  (Note  that  this  is  similar  to  1  millimeter  being  one-thousandth  of  a  meter,  and  one  centimeter  being  one-‐hundredth.)  Furthermore,  with  consensus  of  the  userbase,  the  protocol  can  be  updated  without  disruption  to  allow  even  greater  divisibility.

    I love this. THIS is how a hard “digital” free market currency can facilitate unlimited real economic growth. Through unlimited division of the currency units.

    • LK says:

      Divisibility of money does not provide the same benefits as elastic supply.

      • Tel says:

        As it turns out, Bitcoin happens to also provide elastic supply. This is because anyone can start a new blockchain at any time (typically under a different name to avoid confusion).

        • Major.Freedom says:

          If after the year 2100, the year Bitcoins are estimated to peak in supply, if elasticity is desired by people, then subsequent to this, I see no reason why they cannot introduce a different crypto currency that is elastic, again for a hundred years say, that is “backed” by Bitcoins. Or perhaps it will replace Bitcoins altogether. I don’t know. I can only know what people find benefit with by observing their unhampered actions with their property.

          • Tel says:

            New blockchains, and new algorithms can happen any year, indeed several have already happened.

      • Major.Freedom says:

        I was making a technical point.

        Bitcoins have both unlimited divisibility and an elastic supply.

        Talking about “benefits” is a different argument. Benefits to the individual are subjectively determined. I cannot know what other individuals consider a benefit unless I observe them making unhampered choices with their person and property. The same is true for you. Property is required because without it, individuals are not unhampered in their ability to acquire benefits, given there are other individuals also seeking to acquire benefits.

        Clearly many people are finding a benefit with using the “hard” Bitcoins, compared to the alternative, and Bitcoins have gained in value relative to dollars and real goods since its inception. Divisibility is being considered a benefit by those people.

        If you don’t consider benefits in using Bitcoins because there is no privileged government enforced monopoly in creating them, then you don’t have to use them. You don’t have to use it as a medium of exchange that tends to divide over time for the average goods exchange.

        As it turns out though, Bitcoins supply is in fact “elastic” (up until the year 2100 it is estimated), and any individual, not just a central banker, can create them using their own computer.

        So I don’t see the relevance of your point. You also did not explain how an elastic supply of a currency benefits you.

        • LK says:

          “Bitcoins supply is in fact “elastic” (up until the year 2100 it is estimated), and any individual, not just a central banker, can create them using their own computer.”

          Just a few minutes of googling seems to show that Bitcoin supply will be a fixed at 21 million bitcoins and estimates of when supply will stop growing put it as early as about 2040:

          https://hbr.org/2013/04/building-a-better-bitcoin/

          Should have done some better research there, M_F.

          • Ag Economist says:

            So what keeps another currency from replacing it and providing elasticity?

            • Major.Freedom says:

              Bitcoins will always be elastic.

          • Major.Freedom says:

            LK,

            I was going by the guide written by Murphy and Barta, and they cite this:

            https://en.bitcoin.it/wiki/Controlled_supply#Projected_Bitcoins_Long_Term

            As their source.

            Barta mentions that 2030 is the projected year, according to the same source, that 99% of all Bitcoins will be mined and held by the public. Perhaps the source you cited treats 99% as an estimate of when Bitcoin mining effectively levels off.

            Please note that Barta and Murphy also mention in the guide that the Bitcoin supply will technically never reach exactly 21 million. It will asymptotically move towards 21 million, forever. That is how the architecture was designed.

            So interetsingly that suffices for Bitcoins to be forever elastic. Remember, elastic supply does not mean “greater than the minimum X”. It only means non-fixed. It would be flawed to argue that the incrementally small increases are NOT an elasticity, because it is would be reasonable to assume that in the year 2100, each Bitcoin will be worth so much relative to real goods, that what today would be a relatively low valued incremental increase, would be quite substantial when there are that many more real goods being exchanged.

            Ultimately, the crucial point is that Bitcoin architecture is structred in such a way that in principle the supply will never become fixed. 21 million is the theoretical max, but in terms of changes over time, there will never be 21 million Bitcoins. There will always be opportunity to increase the supply. And the estimates, credible estimates, are very highly foreseeable and investors and consumers would be able to make extremely long term plans. There would be very little opportunity for short term minded politicians and other looters to introduce uncertainty in the system due to human greed and avarice. Bitcoins help minimize that, and thus is superior to state monopoly of paper money.

            Paper is a barberous relic. Hahaha

            • Bob Murphy says:

              “It will asymptotically move towards 21 million, forever.”

              I used to think that, but I don’t think that’s right. The rewards to mining a new block go to literally zero in the 34th generation. Is that in our Guide, MF, or is that your language? If it’s in the Guide we need to change it.

              • Major.Freedom says:

                Oh, I read your point about “rounding down to literally zero” in the guide to mean not actually zero, but thought of as zero because the values are so small. When I hear or read “The value is rounded to be 2.000” to me that means something like “Pi rounded to 2 decimal places is 3.14”, which isn’t to say Pi is literally that number, but thought of that number.

                Is it impossible in the Bitcoin architecture to mine a fraction of a Bitcoin that is less than the current 8 decimal places, forever and ever? Or can there be an update to move the decimal over every now and then?

                I would think that with enough time, and the incredibly high value of a single Bitcoin, that people might find a way to produce and trade fractions of Bitcoins smaller than 8 decimal places. Perhaps other crypto currencies based on Bitcoins can do this?

                Sorry, hope I didn’t make it appear to be putting words into your mouth!

              • Harold says:

                Again we must remember that literally doesn’t mean what it used to. We need a new word that means what literally used to mean to avoid this sort of confusion.

  4. Phillip McManus says:

    Hello, today Bitcoin is 6 years old and the work of Satoshi Nakamoto remains unfathomable! Here is some amazing math behind the 21 million Bitcoins:

    6 blocks per hour
    24 hours per day
    365 days per year
    4 years per cycle
    = 210,240
    ~= 210,000

    Now consider the block reward size
    50 + 25 + 12.5 + 6.25 + 3.125 + 1.5625 + 0.7812 + (etc) = 100

    210,000 * 100 = 21 million

    (210,000 * 50) / 0.01 = 42

    0.01 was Satoshi’s recommended transaction fee and 42 is the answer to the ultimate question of life, the universe and everything.

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