Category Archives: Economics

WTF is up with bitcoin?

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Since I wrote about Bitcoin a couple of years ago, I’ve had a few people ask me what’s going on with Bitcoin this week. There’s been some pretty hysterical-sounding pieces in the press about bitcoin’s nightmare scenario, and folks want to know what’s going on, and whether it’s real, or just a hyped up press thing.

It looks real to me. The technical problem is definitely solvable, but there’s a bunch of social/political stuff piled on top that’s making it hard for the technical solution to actually get implemented.

To understand what’s going on, we need a quick refresher on how bitcoin works.

The basic idea of bitcoin is pretty simple. There’s a thing called a ledger, which consists of a list of transactions. Each transaction is just a triple, (X, Y, Z), which means “X gave Y bitcoins to Z”. When you use a bitcoin to buy something, what’s really happening is that you’re adding a new entry to the ledger.

To make it all work, there’s a bunch of distributed computing going on to maintain the ledger. Every 10 minutes or so, a batch of transactions is added to the ledger by performing a very expensive computation. The set of transactions is called a block. The entire ledger is just a list of blocks – called the blockchain. In the current bitcoin protocol, a ledger block can only hold 1 MB of information.

That block size of 1MB is the problem. There are enough bitcoin transactions going on right now that at peak times, the amount of data needed to represent all of the transactions in a ten minute period is larger than 1MB.

That means that transactions start to back up. Imagine that there’s 1.5M of transactions occuring every 10 minutes. In the first period, you get 1M of them wrapped in a block, and the remaining 0.5MB gets delayed to the next period. The next period, you process the remaining half meg from the previous period, plus just 1/2MB from the current – leaving 1M to roll over to the next. That next period, you’re going to spend the entire block on transactions left from the previous time period – and the full 1.5MB gets deferred to later. Things have backed up to the point where on average, a new transaction doesn’t get added to a block for 45 minutes. There are confirmed reports of transactions taking 7 or 8 hours before they get added to the blockchain.

This is a problem on many levels. If you’re a store trying to sell things, and people want to pay with Bitcoin, this is a massive problem. Up until a transactions is confirmed by being part of a block accepted into the blockchain, the transaction can be rescinded. So you can’t give your customers their merchandise until you’re sure the transaction is in the blockchain. That was awkward when you had to wait 10 minutes. That’s completely unacceptable when you have no idea how long it might take.

Looking at this, you might think that the solution is just to say that you should create blocks more frequently. If there’s 1.5M of transactions every 10 minutes, why not just create a block every five minutes? The answer is: because it takes an average of around 10 minutes to perform the computation needed to add one block to the chain. So you can’t reduce the amount of time per block.

Alternatively, you could just increase the size of the block. In theory, that’s a great answer. Jump a block to 2M, and you’ve got enough space to handle the current volume. Jump it to 10M, and you’ve got enough buffer space to cover a couple of years.

But that’s where the social/political thing comes in. The work of performing the computation needed to add blocks to the chain (called mining) has become concentrated in the hands of a small group of people. And they don’t want to change the mining software that they’re running.

I don’t follow bitcoin closely, so I don’t know the details of the fights over the software. But as an outsider, it looks like a pretty typical thing: people prefer to stick with known profits today even if it kills the business tomorrow, rather than take a risk of losing todays profits. Changing the protocol might undermine their dominant mining position – so they’d rather see Bitcoin fall apart than risk losing todays profits.

To quickly address one stupid “answer” to this problem: I’ve seen lots of people say that you can make your transaction get added to the chain faster. There’s an option in the protocol to allow a transaction to say “I’ll pay X bitcoins to whoever adds this transaction to the chain”. Miners will grab those transactions and process them first, so all you need to do is be willing to pay.

That’s a partial solution, but it’s probably not a long term answer.

Think of it this way. There’s a range of different transactions performed with bitcoin. You can put them into buckets based on how time critical they are. At one end, you’ve got people walking into a store and buying something. The store needs to have that transaction processed while the customer waits – so it needs to be fast. You’ve got other transactions – like, say, paying your mortgage. If it takes 12 hours to go through, big deal! For simplicity, let’s just consider those two cases: there’s time critical transactions (fast), and non-time-critical ones (slow).

For slow transactions, you don’t need to increase the transaction fees. Just let the transaction get added to the blockchain whenever there’s room. For the fast ones, you need to pay.

The problem is, 1MB really isn’t that much space. Even if just 1/3 of the transactions are fast, you’re going to wind up with times when you can’t do all of the pending fast transactions in one block. So fast transactions need to increase their fees. But that can only go on for so long before the cost of using bitcoin starts to become a significant issue in the cost of doing business.

The ultimate problem is that bitcoin is being to successful as a medium of exchange for the current protocol. The blockchain can’t keep up with transactions. What adding transaction fees does is increase the cost of using bitcoin for fast transactions until it reaches the point where enough fast-transactors drop out of using bitcoin that all of the remaining fast-transactors no longer exceed the blocksize. In other words, transaction fees as a “solution” to the block-size problem only work by driving businesses away from accepting bitcoin. Which isn’t exactly in the best interest of people who want to use bitcoins. This is why I think that online wallets like paypal to western union are going to continue to be the mainstay.

Realistically, if you want to use bitcoin as a currency, you can’t solve its capacity problems without increasing its capacity. If there are more than 1MB of transactions happening every 10 minutes, then you need to do something to increase the number of transactions that can be part of a block. If not, then you can’t support the number of transactions that people want to make. If that’s the case, then you can’t rely on being able to use bitcoin to make a purchase – and that means that you don’t have a usable currency.

Bitcoin, MtGox, and Deflation

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This is the last bitcoin post. Here I’ll try to answer the questions that led me to start writing about it.

What is MtGox? What happened there?

MtGox was a company that maintained bitcoin wallets. The basic idea is that they acted like a bank/broker for bitcoins. If you want to get bitcoins, you can go to someone like MtGox, and give them some money. They create a public/private keypair for you, and use it to create a transaction giving you the bitcoins. When you want to make a purchase, you’d go to your MtGox account, and tell them to transfer the bitcoins, and they use your key to sign the transaction, and then broadcast it to the bitcoin network. It is through processes like this one that you can buy Bitcoin with PayPal.

By using MtGox, you don’t need to have a program that participates in the bitcoin network to do transactions. You don’t need to worry about keeping your keys safe. You don’t need to have software capable of generating and signing transactions. All you need is your web-browser, to log in to MtGox.

Here’s where the problems start: MtGox didn’t start off as a bitcoin bank. In fact, they started off about as far from banking as you can imagine. From the name, you might think that MtGox is named after a mountain. Nope! It’s an acronym, for “Magic: the Gathering Online Exchange”. MtGox started off as a trading card exchange market.

This continues to boggle my mind. I just can’t quite wrap my head around it. A hacked together trading card exchange site decides to start acting as a sort of electronic bank/currency broker. And people trusted them with hundreds of millions of dollars!.

What happened is completely predictable.

You have an online site that manages massive quantities of money. Criminals are going to try to steal from it. Hell, when I was administrating Scientopia, at least once a week, I’d get email from someone with some kind of scam to try to manipulate google ads with fake clickthroughs, offering to split the profit. Scientopia’s revenue was only in the hundred dollar a month range – but it was still enough to attract crooks and scammers. Imagine what happens when it’s not $10 to be made, but $100,000,000?!

Crooks tried to steal money from MtGox. From what we know (there’s still a lot about this that’s still being figured out), they succeeded. They found a weakness in the MtGox implementation of the bitcoin protocol, and they exploited it to steal a massive number of bitcoins.

The ridiculous thing about all of this is, as I said above, it was totally predictable. You should never just hack together cryptosystems. You should never just hack together anything that handles money. When you hack together a crpytosystem that handles money, it’s pretty much a given that money is going to get lost.

If you want to deal with money, you need to be really, really serious about security. That doesn’t just mean making sure you write code. It means having an entire staff of people who’s job it is to make sure that you don’t fuck up. It means having people working full time, trying to break your system – because if they can break it, so can someone else! It means having a strongly adverserial setup, where the people trying to break it really want to break it – they can’t be the same people who want it to not get broken. It means having a different team of people who’s full time job is auditing – constantly watching the system, checking transactions, verifying them, making sure that everything is working correctly, catching any potential problems the moment they start, instead of letting them continue until they become disasters.

MtGox had none of that. It was a hacked together site. To get a sense of the way it was built, just look at the CEO’s blog, where he talks about implementing SSH in PHP. I’m not saying that he used this SSH code in MtGox – but read it, and read the comments, and you’ll get a sense of how poorly he understands security issues.

What does it mean when people say that Bitcoin is deflationary?

When you read the hype around bitcoin, you also see a lot of criticisms from the skeptics. I am one of the skeptics, but I’m trying to be as fair as I can in these posts. One of the criticisms that you constantly see is that Bitcoin is deflationary.

As I mentioned in yesterdays post, the only source of new bitcoins is mining. Each time the ledger gets updated with a new block in the blockchain, the person who generated the solution for that block gets a bounty, in the form of newly created bitcoins. Today, the bounty for a block is 25 bitcoins. But the bitcoin protocol specifies that that bounty will gradually decline and eventually disappear. When that happens, the miners will receive a commision, in the form of a transaction fee for transactions in the new block, but they won’t get new bitcoins. When the system gets to that point, the supply of bitcoins will be fixed: no new bitcoins, ever.

Lots of people think that that’s a good thing. After all, inflation sucks, right? This will be a fixed supply of money, whose value can’t be manipulated by politicians.

The catch is that nothing is ever that simple.

First: the fact that new bitcoins will not be issued means that the total supply of bitcoins will decline. People die without giving their passwords to their heirs. Passwords get lost. People forget about bank accounts. All of those things are more mean that bitcoins fall out of circulation. So not only is the supply of bitcoins going to stop increasing, it’s going to start decreasing. In fact, the bitcoin folks are completely open about this:

Because of the law of supply and demand, when fewer bitcoins are available the ones that are left will be in higher demand, and therefore will have a higher value. So, as Bitcoins are lost, the remaining bitcoins will eventually increase in value to compensate. As the value of a bitcoin increases, the number of bitcoins required to purchase an item decreases. This is a deflationary economic model. As the average transaction size reduces, transactions will probably be denominated in sub-units of a bitcoin such as millibitcoins (“Millies”) or microbitcoins (“Mikes”).

Is it really a problem? Maybe. I don’t know enough about economics to have a strong opinion, but it’s certainly enough to be worrying. The argument runs as follows:

When the supply of money is decreasing, it means that there’s less money available for making purchases – which means that the value of the money needs to increase. A bitcoin will need to be able to purchase more today than it did yesterday. And that is a serious problem.

Economies work best when money is kept moving. In an ideal world, money isn’t an asset at all: it’s just a medium. You want people to make products, sell them to other people, and then use the money that they made. If they take their money and hide it in a mattress, there’s going to be less activity in the economy than if they used it. The whole idea of money is just to make it easier to match up producers and consumers; when money is taken out of the system, it means that there’s potential economic activity that can’t happen, because the money to make it happen has been withdrawn from the system.

This is why most governments try to run their economies so that there is a moderate amount of inflation. Inflation means that if you take your money and hide it in your mattress, its value will slowly decrease. It means that withdrawing your money from the system is a losing proposition! So a bit of inflation acts as a motivation to put your money to work producing something.

Deflation, on the other hand, does the opposite. Suppose that today, I’ve got 10 bitcoins and 100 dollars, and they’re worth the same amount of money. I’m going to go buy some bacon. I can spend $10 buying bacon, and keep $90 and 10 bitcoins; or I can spend 1 bitcoin, and key 9 bitcoins and $100. So overall, I’ve got the equivalent of $190 and some bacon.

Next week, the value of bitcoins has risen to $15/bitcoin. If I spent my dollars to buy bacon, then now I’ve got $150 worth of bitcoins, $90 worth of dollars, and some bacon – my total asserts are equal to $240 and some bacon. If I spent my bitcoin, then I’d have $135 worth of bitcoins, $100 worth of dollars, and some bacon – $235. If I used my bitcoin to buy stuff, I lost $5.

That means that I’m strongly motivated to not use my bitcoins. And that’s not a good thing. That kind of deflation is very harmful to an economy – for example, look at Japan during the 1990s and 2000s, and to some extent still today.

The Tech of Bitcoin

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Now we can get to the stuff about bitcoin that’s actually interesting. How does it work?

Before I start, one major caveat. I’m deliberately talking about this in vague terms – enough so that you an understand how and why it works, but not enough so that you could do something like implement it. Like anything else involving cryptography: if you’re thinking about implementing your own crpytosystem, don’t!

Cryptography is an area where even seasoned experts can easily make mistakes. A serious crpytosystem is built by a team of professionals, including people whose entire job is do everything in their power to break it. And even then, it’s all to easy to wind up with un-noticed bugs! When it comes to something like bitcoin, an inexperienced cryptographer trying to implement a new agent for the bitcoin network is insane: you’re dealing with money, and you’re risking losing a whole lot of it if you screw up. (That’s basically what appears to have happened to mtgox – and if the reports I’m reading are correct, they managed to lose hundreds of millions of dollars worth of bitcoins.

On to the fun part!

Basically, bitcoin is a protocol. That means that it’s really just a system that defines how to communicate information between a collection of computers. Everything about bitcoin is defined by that protocol.

At the heart of the protocol is the ledger. The ledger is a list of transactions that says, essentially A gave N bitcoins to B. The only way to get a bitcoin is by a transaction: there needs to be a transaction saying that someone or something gave you a bitcoin. Once you have one, you can transfer it to someone else, by adding a new transaction to the ledger.

That’s the basic idea of it. The beauty of bitcoin is that at the core, it’s incredibly simple – it’s just a list of transactions. What makes it interesting is the crpytographic magic that makes it work. In theory, the ledger could be simple text. Each line would contain a sender, a receiver, and a quantity. If you have that, it’s enough to manage transactions. But there are a bunch of problems with a simple ledger approach, which mostly involve making sure that transactions in the ledger are valid and that they can’t be changed.

In addition, there are problems that come about because of the fact that bitcoin wants to be completely decentralized. There is no authority in charge of bitcoin. That means that you need to have a consensus based system. Anyone can join the network of bitcoin managers at any time, and anyone in the network can drop out at any time – but the network as a whole must always have a consensus about what the current ledger is. There’s also the question of where the coins come from!

We’ll start with the question of authentication.

Suppose I own a bitcoin, and I want to use it to buy a loaf of bread from friendly baker, Barbera. I need to give Barbera my bitcoin. To do that, I need to add an entry to the ledger saying “MarkCC gave one bitcoin to Barbera”. The problem is, the ledger entry needs to contain something to prove that I’m really the owner of the bitcoin that I’m trying to transfer! If it doesn’t do that, then my arch-nemesis, Tony the thief, could just add a ledger entry saying “MarkCC gave one bitcoin to Tony”. Only I should be able to add a ledger entry transferring my bitcoin.

This one is simple: it’s a textbook use-case for public key crpytography. In a public key system, you have key-pairs. One member of the key pair is called the public key, and the other is the private key. Anything encrypted with the public key can only be decrypted using the private key; anything encrypted with the private key can only be decrypted with the public key. So you get a key pair, lock the private key away somewhere safe, and give away copies of the public key to anyone who wants it. Then if someone sees a message that can be decoded with your public key, it means that you must have been the one who sent it. No one else could encrypt a message using your private key!

In the bitcoin ledger, the lines are signed. Instead of directly saying “MarkCC gave one bitcoin to Barbera”, they say “One bitcoin was transferred from the owner of MarkCCs cryptokey to the owner of Barbera’s cryptokey”. The ledger entry for that transaction is signed using a signature generated from the ledger entry using MarkCC’s private key. Anyone can verify the validity of the transaction by checking the signature using MarkCC’s public key. Once that’s in the ledger, Barbera now own a bitcoin, and only Barbera (or whoever has access to Barbera’s private key) can do transfer that bitcoin to anyone else.

Now, on to the complicated part! There is no authoratative ledger in bitcoin. There are many copies – thousands of copies! – of the ledger, and they’re all equal. So how can you be sure that a transaction is real? Someone could write a transaction to a ledger, show you the ledger, and then you could find out that in every ledger except the one you looked at, the transaction doesn’t exist! If you there is no single place that you can check to be sure that a transaction is in the ledger, how can you be sure that a transaction is real?

The answer is a combination of a consensus protocol, and a bit of computational cleverness. When you want to add a ledger entry, you broadcast a message to the bitcoin network. Every 10 minutes or so, participants in the bitcoin network take whatever transactions were added to the current ledger, put them into a structure called a block, and perform a very difficult, semi-random computational task using the block. When they find a solution, they sign the block using the solution, and broadcast it to the network.

The first agent in the bitcoin network that completes a solution and broadcasts it to the network “wins” – their block becomes the new basis for the next block.

The blocks form a chain: block one contains some transactions; block 2 contains more transactions that happened after block1 was broadcast; block 3 contains transactions that happened after block 2 was broadcast, and so on.

At any time, the consensus ledger – that is the master, canonical ledger – is the one with the longest verifiable chain. So someone can broadcast a new solution to an old block, but it will be ignored, because there is already a longer chain in the consensus. You can be certain that your transaction can’t be revoked or lost once you see a new block issued that builds on the block containing your transaction.

This all relies on people finding solutions to computationally expensive problems. Why would anyone do it? That’s why this process of computing hashes for the blocks is called mining: because if you’re the first one who finds a solution for a block, then you get to add a transaction giving yourself 25 brand new bitcoins to yourself! Mining – the process of maintaining the ledger – becomes a sort of lottery, where the people doing the mining randomly get bonuses to motivate them to do it.

The computational side of it is clever in its simplicity. The bitcoiners want the problem to be hard enough to make it effectively impossible to cheat. But they also want to be sure that it’s easy enough that they get blocks frequently. If it takes an hour before anyone has a solution for a new block, that’s also a problem: if it takes that long to commit a transaction to the ledger, then people aren’t going to trust bitcoin for fast transactions. They can’t be sure that a bitcoin was transferred to them unless they know that the transaction was committed in an accepted block. But there’s a trick there: people want to get the mining rewards. That means that they’re constantly trying to push the limits of what they can get away with computationally. People started with bunches of PCs, and then discovered that the GPUs on their graphic cards could do it faster, and then started building custom PCs with tons of graphics cards to do bitcoin mining computations in parallel. And of course, there’s always Moore’s law: computers are constantly getting faster. That means that they can’t just pick a particular complexity for the problem and stick with it.

The solution is to make the problem variable. They start with a well known algorithm that’s a very good one-way problem (meaning that it’s relatively easy to compute a result given an input; but very, very hard to figure out the inverse – to get an input that produces a desired result. In slightly more mathematical terms, if y=f(x), then computing y is easy if you know x, but it’s very hard to compute x if you know y.

There are a bunch of well known one-way computations. They just picked one, called SHA-256 computation. Now the clever part: they make SHA-256 computation into a variable complexity problem by picking a threshold T, agreed on by consensus in the bitcoin ledger protocol. The solution for a block is a hashcode for the block plus a bit of extra data which is smaller than T: for a ledger block L, they need to find a value N called a Nonce where \textbf{SHA}(L + N) < T.

Because SHA-256 is a one-way function, there’s no good way to predict what value of N will give them a hashvalue that’s smaller than the threshold – the only way to do it is to just keep guessing new N-values, and hoping that one of them will produce an acceptable result. By reducing the value of T, you can make the problem harder; by increasing the value of T, you can make it easier. The bitcoin protocol specifies a regular interval and an algorithm for selecting a new T.

When a miner solves the problem, they publish the new ledger block to the bitcoin network, with the new ledger section and its (H, N) values. Once a new block is issued, all of the future ledger entries can only get added to the next unsolved block in the ledger.

The reason that this is safe is a matter of computation. You can go back in time, and find an old transaction, remove an entry from it, and recalculate the block. But it takes time, and other people are still moving on, computing new blocks. For your change to be accepted by the bitcoin network, you would need to issue new version of the altered block, plus new versions of any other blocks issued since the one you altered, and you’d have to do it before anyone else could issue a new block. The consensus is the longest block-chain, so issuing blocks that aren’t longer than the longest chain in the network is a waste of time. Because the computation is hard, even being one block behind is enough to make it effectively impossible to be able to change the ledger: to become the new largest chain when you’re just one block behind means you’d need to compute solutions for three blocks before anyone could find a solution for just one more block!

That last bit isn’t so clear when you read it, so let’s work through an example.

  1. Block B is issued
  2. Block C is issued
  3. You want to change block B.
  4. The current longest blockchain is […, B, C].
  5. To replace B with a new block B’, you need to issue a
    longer blockchain that the current consensus of […, B, C].
  6. That means that you need to issue B’, C’, and a new block D’ before anyone else can just issue D.
  7. By falling just one block behind, you need to issue 3 three new blocks before anyone else can issue just one.

And that, my friends, is effectively impossible.

Money and Bitcoins part 1: What is money?

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Bitcoin has been in the news a lot lately. I’ve been trying to ignore it, even though lots of people have sent me questions about it.

In the last couple of days, Bitcoin has been in the news even more. Mtgox, one of the major companies associated with bitcoin has gotten into serious trouble. It’s not entirely clear what exactly is going on, but it appears that mtgox lost a massive quantity of bitcoins. As a result, they’re almost certainly going bankrupt, and a whole lot of people are about to lose/have already lost a huge amount of money. This burst of news about mtgox has turned the trickle of questions into a flood.

In order to shut you all up, I’m going to try to answer the questions. I started off working on one post, but it’s gotten out of hand – over 5000 words, and not finished yet! Instead of just posting that monstrosity as one gigantic mega-post, I’m splitting it up into several posts.

To understand bitcoin, first you need to understand what money really is. That’s going to be the focus of this post: what is money? And how is bitcoin both similar to, and different from, other things that we call money?

Money is, ultimately, an elaborate shell game. Currency is a bunch of worthless tokens that we all agree to pretend are worth something, so that we have some way of exchanging valuable things in a reasonable, fair, and easy way.

To understand that, let’s start with a really simple scenario. We’ve got two farmers: Will grows wheat and turns it into flour, and Pam raises pigs and chickens. Will has lots of wheat, so he can grind it into flour and make bread – but he’d also like to be able to have some bacon with his toast for breakfast. Pam, meanwhile, has all the bacon she can eat (lucky lady!), but she’d like to have some bread, so that she can make a BLT for lunch.

There’s an easy solution. Will goes over to Pam’s place, and offers her some bread in exchange for some bacon. Between them, they figure out how much bread is worth how much bacon, and make the trade. And hurrah! both are happy. This is simple barter – no money needed.

Things become more complicated when we add more people to the story. We can add Mary the miller who gets wheat from Will and grinds it into flour, and Bob the Baker who gets flour from Mary and bakes it into bread. Now the process of making bread has gotten more elaborate: the person who grows the wheat is no longer the person who sells the final product to the pig-farmer!

Now if Will wants his bacon, it’s harder. He has wheat, but Pam doesn’t want wheat, she wants bread! As long as Mary and Bob both like bacon, this can be made to work. Bob can go to Pam, and trade bread for her bacon. Then he can take some of the bacon he got from Pam, and give it to Mary in exchange for flour. Mary can take part of the bacon he got from Bob, and give it to Will in exchange for wheat. Then Mary, Bob, and Will all have their bacon, and Pam has her bread, and everyone is happy. We’re still in the land of barter, without any money, but it’s getting difficult, because everything is stuck going through intermediaries.

This works, as long as everyone in the chain is happy with bread and bacon. But as things get more complicated, and you get more people involved, you get situations where you have people who want something that they can’t easily trade for what they have. We could add Phil the plowmaker to our scenario. Phil makes the best plows you’ve ever seen. If Phil wants to get some wheat, he’s in great shape: Will would love to get one of Phil’s plows to plow his fields. But Phil doesn’t want to deal with freshly harvested wheat – he wants bread and Bacon! That means he’s got a problem: Pam has no use for a plow, and neither does Bob. In order to get bread and bacon in exchange for his plows, he somehow needs to get something that Pam and Bob want. He’s not part of the chain from Will to Pam.

If you’re sticking with barter, then poor Phil has a very complicated problem. He needs to go to Pam, and figure out what she wants in exchange for bacon – she could say she needs a new butcher’s knife, and she’ll trade that for bacon. So now Phil needs to find someone who’ll trade a plow for a butcher’s knife. He can go to Kevin the knifemaker, and see if he’ll take a plow. If Kevin doesn’t want a plow, then he needs to find out what Kevin wants, and see if he can find someone who’ll trade a plow for that. He’s stuck running around, trying to find the sequence of exchanges that give him what he wants. If he can’t find a chain, he’s stuck, and he’ll just have to give up and not have any bacon, even though he’s got beautiful plows.

The solution to this mess is to create create a medium of exchange. You need to create something which has a symbolic value, which everyone is willing to trade for his or her stuff. Will his wheat for little green pieces of paper. Pam exchanges her bacon for little green pieces of paper. Phil exchanges his plows for little green pieces of paper. The little green pieces of paper are completely worthless themselves – they’re just green paper! But everyone recognizes that other people want them. Because the other people want them, they know that if they take some, they’ll be able to use them to get stuff from other people.

For Phil to get his bacon, there’s still got to be some chain: he exchanges his plow for some green paper; he goes to Pam, and gives her green paper in exchange for the bacon. Pam uses that green paper to get stuff she wants. The chain is still there: ultimately, what Phil did by giving Pam the green paper is give her something that she wanted. But instead of needing to find a concrete product or service that she wanted, he was able to give her symbolic tokens of value, which should could then exchange for whatever she wanted.

That’s what money is. It’s a symbolic medium, where we all agree that the symbolic tokens are worth something. The tokens only have value because we believe that other people will also take them in exchange for their stuff/their work. And because we believe that, we’ll take them in exchange for our work. When we do this, we’re simultaneously being perfectly rational and completely delusional. We’re trading the products of our work for something utterly worthless, because we’ve all agreed to pretend that the worthless stuff isn’t worthless.

Of course, when you’ve got valuable stuff moving around, governments get involved. In fact, governments exist largely to help make it safe for valuable stuff to move around! Money ends up getting tied to governments, because the governments exist in large part specifically to provide an enforceable legal system to manage the exchange of money.

In todays world, money is just a set of tokens. If you go back a hundred years, all over the world, people had what they believed what a different idea about money. Money was backed by gold. If you had a dollar, it wasn’t just a green piece of paper. It was a lightweight representation of about 1.67 grams of gold. You could go to the government with your dollars, and exchange them for that quantity of gold. According to many people, derogatorily called goldbugs, this was fundamentally different from todays money, which they call fiat currency, because it was backed by a tangible valuable asset.

The problem with that argument is: why is gold any more valuable than green paper?

Gold is valuable because it is a pretty yellow metal, incredibly malleable and easy to work with, non-corrosive, and useful for a wide variety of artistic and industrial purposes. It’s also relatively rare. In other words: it’s valuable because people want it. It’s not valuable because it’s tangible! No one would say that a currency backed by rocks is intrinsically more valuable than a so-called fiat currency, even though rocks are tangible. People don’t want a lot of rocks, so rocks aren’t worth much.

Now we can finally get around to just what bitcoin is.

Bitcoin is a currency which isn’t backed by any government. In fact, it’s not backed by anyone. It’s a fundamentally decentralized system of currency. There’s no central authority behind it. Instead, it works based on an interesting protocol of computation over communication networks. Everything about it is distributed all over the world. You could pick any individual computer or group of computers involved in bitcoin, blow them to bits, and bitcoin would be unaffected, because there would still be other people in the bitcoin network. It’s all driven by distributed computation. A bitcoin is an utterly intangible asset. There is no coin in a bitcoin.

I’ll go into more detail in my next post. But the basic idea of bitcoin is really, really simple. There are a bunch of computers on the network that are keeping track of bitcoin transactions. Between them, they maintain a ledger, which consists of a list of transactions. Each transaction says, effectively, “X gave N bitcoins to Y”. The only way that you can own a bitcoin is if, somewhere in the ledger, there is a transaction saying that someone gave a bitcoin to you. There is no coin. There is no identifying object that represents a bitcoin. There’s not even anything like the serial number printed on a banknote. There is no bitcoin: there is just a transaction recordin a ledger saying that someone gave you a bitcoin. There is absolutely no notion of traceability associated with a bitcoin: you can’t take a bitcoin that someone gave you, and ask where it came from. Bitcoins have no identity.

The point of it is specifically that intangibility. Bitcoin exists largely as a way to move valuable stuff around without the involvement of governments. Bitcoin is, really, just a way of making a computationally safe exchange of value, without transferring anything tangible, and without any single central authority in control of it. You know that someone gave you money, because there are thousands of computers around the world that have agreed on the fact that someone gave you money.

Obviously, there needs to be some technical muscle behind it to make people trust in those unknown entities managing the ledgers. We’ll talk about that in the next post.

What’s amusing about bitcoin is that in many ways, it’s no different from any other kind of money: it’s absolutely worthless, except when people agree to pretend that it isn’t. And yet, in bitcoin circles, you’ll constantly see people talking disdainfully about “fiat money”. But bitcoin is the ultimate in fiat: there’s nothing there except the ledger, and the only reason that anyone thinks it’s worth anything is because they’ve all agreed to pretend that it’s worth something.