Bitcoin Algorithm

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Part I

This talk is about the Role of Bitcoin as Money.

This talk is intended to give people a better understanding of money itself.

Because to understand Bitcoin, you must understand money.

For this talk, Forget the tech. Forget the mining. Forget the cryptography and the peer to peer networks and the open source code. All of these things are secondary to an understanding of money itself. The core of the Bitcoin experiment is not about tech at all, it’s about money.

Unfortunately, most people do not spend enough time pondering the nature of dollars and cents.

This is strange and somewhat tragic, because we spend our lives chasing it. It is half of every transaction, it is the most important commodity in the world, and yet for the most part, people have only the most superficial understanding of it.

But from an early age, we understand that money is good. We want it. We’re happy when we have it, and sad when we don’t. We learn that to obtain money, we must work for it, and as we leave childhood we go to school for many years, and work very hard, so that we may be paid in dollars.

And so, much of our lives is spent searching and grasping for something we don’t understand.

On the surface, the reason we seek money is simple: money lets us buy things. The utility of a new car, or the entertainment of an Xbox, or the taste of a nice steak dinner is apparent, and since we want those things, we seek money.

But what people don’t spend enough time considering is why the money we use actually enables us to obtain the car, the xbox, and the dinner. Why is the shoemaker willing to give us his shoes for our money?

You cannot answer this by saying that the shoemaker can in turn trade the money to someone else, for that begs the question, why does that person want the money?

If nobody actually wants the money, and they only want what the money can buy, how did this whole crazy system get started? Who was the first person tricked into accepting something so silly as money in return for something real?

Part II

This is what we want to examine. How we got to this point.

In school, we learn that before we had money, we had a bartering system. Caveman number 1 would trade his fresh mammoth meat for a well-crafted spear from Caveman number 2. Bartering in this way makes intuitive sense, and even as children we engage in it.

School then tells us there is something wrong with bartering. Something called a “Coincidence of wants.” If Caveman 1 wants the spear from Caveman 2, then great. But what if he has no need for a spear? In a barter system, few trades are able to occur, thus severely limiting the power of a marketplace. Again, this makes intuitive sense.

We then learn that to get around the Coincidence of Wants dilemma, money was invented. Money (dollars, yen, euros, pounds sterling) is the name for a common medium of exchange, whereby everyone agrees to trade for money instead of other objects.

We learn that things like wampum shells were early forms of money, and that eventually people used gold and silver, and ultimately people started using the flat paper bills we have today.

Since this narrative is presented as one of ongoing human progression, children tend to grow up assuming their dollars, or euros, or yen, are proper money and that things like gold and seashells are outdated relics.

Further, they come to perceive dollars as a very physical item, because they can hold physical bills in their wallet, and we all see movies with bank robbers stealing bags of physical cash. Even though nearly all your dollars are digital today, we still tend to understand them as something physical.

With this as our frame of reference, Bitcoin looks kind of absurd, doesn’t it. If one compares dollars to Bitcoin, Bitcoin looks like a joke. It’s purely digital? Not backed by any trusty Government? Unregulated? No presidential heads or latin incantations printed on it?! Clearly, it is nothing more than made up magic internet money. An absurd fad. A bubble. Tulip mania. Pets.com. A Ponzi scheme.

PART III

So why is it that some people believe in Bitcoin as money when it is so clearly different than dollars, which are the best form of money we could possibly have?

I think it’s because these people have a different understanding of money itself, one that isn’t really taught to us in school.

Consider that a crucial question may have been overlooked during our school education: why were seashells, or gold, chosen as money in the first place?

Was there a vote? Did people just wake up and start using it? Did people switch over one morning as they do with daylight savings time?

I believe that the question of why gold became money is in fact one of the most egregious lapses in modern education. Gold was the money of the world all the way up until 1971. Why was this the case? Why was it gold, and not rubies, or eggs, or feathers?

And if gold was chosen as money, and nobody ever seems to have enough money, then why wasn’t something more plentiful, like grass, chosen as money? Certainly if grass had been chosen, then we’d all have plenty of money! Poverty would’ve been eliminated long ago. So who’s bright idea was it to choose gold?

In absence of a proper education, most assume that society just arbitrarily decided to make gold money, and that any other commodity would have worked roughly as well.

They perceive money as an arbitrary token, but this is a mistake, and this is where the grand misunderstanding of Bitcoin begins, because if money is an arbitrary token, and we already have a great arbitrary token backed by the full faith and credit of the United States Government, why should we get distracted by some other arbitrary token?

Because… Money is not arbitrary; it is selected with very good reason through a very natural process.

Gold became money, gradually over time, not by mistake, but because it had specific attributes that made it highly useful in exchange. We can call this an attribute-based theory of money.

It is these attributes, these specific properties of gold, which led it to be used increasingly as a medium of exchange. Simply, it has better properties than basically everything else.

It is scarce (unlike grass)

It is fungible and uniform

It is transportable, because it has a high value-to-weight ratio

It is easily identifiable

It is highly durable

And its supply is relatively steady and predictable

If you understand that these attributes make gold a great means of exchange, you’ll understand why gold was increasingly sought in the natural marketplace.

And what this means is that a money-based system is not actually something separate from a barter system at all. It’s just a barter system that’s been running for a while. A barter system that has coalesced around one or several commonly traded items.

We’re still in a barter system, but the good most people prefer to barter for now is gold or dollars or bitcoin, and we called these most exchangeable of goods, money.

So money is thus nothing more than the natural outcome of barter. Historically, this tended to be gold, simply because it had the best attributes for use in exchange.

And if we see the genesis of gold’s monetary use – that it was nothing magical or arbitrary – gold simply had the best properties for exchange and was thus frequently bartered for, then it should not be a stretch to imagine that a commodity with even better properties might be an even better form of money.

This is what I found when I discovered Bitcoin.

Part IV

“But wait, Erik,” some of you might say. “We already have something better than gold, it’s called the United States Federal Reserve Note. (also known as the dollar)

“Certainly, the Federal Reserve Note is superior to gold, and that’s why we use it today,”

Well let’s examine the properties of the dollar.

Dollars are fungible and uniform, that’s good. They are transportable, perhaps even more easily then gold. They have a high value-to-weight ratio. They’re fairly easy to divide and recombine. Looking pretty good so far. But what else?

Well, they’ve lost 98% of their value since the Federal Reserve started creating them.

Really? Why is that?

Well, it’s because they are constantly created out of thin air. Every year vast new quantities of it are produced. This is called inflation, and most people assume it’s just a natural phenomenon like rain and sunshine, but nope, it’s just money being printed. It may be the greatest scam ever devised.

But a scam needs a victim, why would anyone accept a form of money that could be constantly created out of thin air and thus looses purchasing power every day. Because they’re forced to pay tribute to the government using this money through a scheme called taxation, and through legal tender laws.

In other words, dollars are not used over gold because the attributes of dollars are superior. A free market did not choose dollars based on the dollars’ merit. Dollars are used because people are forced to use them. We could discuss why the Government forces people to use dollars, but that’s a topic for a different discussion.

These are the concepts behind money that people need to understand. Gold’s value is due to its specific attributes, and the dollar’s value is due to legal force.

So how does this relate to Bitcoin?

Bitcoin’s value as money needs to be understood like gold, which comes not from legal force, but from its specific attributes. Bitcoin’s attributes make it an amazing form of money and it was engineered for just that purpose.

It is easy to divide and recombine

It cannot be counterfeited

It is highly durable, so long as certain precautions are taken

It can be sent anywhere, instantly, at near-zero cost

If you were going to make a super hero currency, this is one of the traits you would give it

Can’t do that with gold due to physical constraints, or dollars due to legal constraints

It is scarce, with a known supply and a known inflation schedule

And it cannot be manipulated, restricted, or seized by any central party (shares this property with gold). Nobody has special privileges. In this way, it is very democratic, and very egalitarian.

Just as mankind has engineered houses to be used as shelter and cars to be used as transportation, so too can we engineer something to be used as an ideal medium of exchange. But while the dollar is a poorly engineered money (so poor in fact that it relies on coercion for its value), Bitcoin is a brilliantly engineered money.

It might not be perfect, but it’s pretty damn good, and this is why people are using it as money, despite the fact that nobody is forced to.

And given that it is so useful as money, due to its attributes, it should not be a surprise to anyone that it commands a market price. Any good that is useful and scarce will have a price on the market.

Economists and journalists get very caught up around the question, why does Bitcoin have value? The answer is easy: because it’s useful and scarce.

The corollary here is that Bitcoin’s value can never reach zero unless it is no longer useful, or no longer scarce.

Part V

And this brings us to the more interesting topic. For if Bitcoin is so well-engineered as money, won’t it necessarily begin competing with other forms of money?

A fair question would be, “well if that were true Erik, why have people not tended toward gold over the dollar? Isn’t gold, as you claim, a superior form of money?”

The reason is that while gold works very well as a store of value (indeed the best the world has ever known), it doesn’t work so well as a means of exchange in our modern society.

And this should be obvious.

Transacting in physical gold is, unfortunately, quite a burden, and while services like e-gold had huge potential, they inevitably fail because they get beheaded by the government. If a digital gold company is too successful, the government destroys it. Anyone who tries to make it useful as a currency gets shut down – GoldMoney is another great example.

This is why gold remains safely in vaults, used for storing wealth, not so much as a currency.

So we see a physical bullion currency is too inconvenient, and a digital bullion currency is a fantasy (because it requires backing by a party that can be shut down).

This is also why anyone who suggests Bitcoin should be backed by something like gold is gravely misunderstanding the situation. Backing injects counter-party risk, because a specific person or entity must be obligated to fulfill the backing.

Bitcoin doesn’t need backing, because it is a digital commodity that is valuable itself, and valuable in large part because it carries no physical burdens or constraints. It is this lack of physical backing which enables it to move anywhere, instantly, at near-zero cost.

One can see then that Bitcoin is revolutionary in this regard. For the first time ever, a form of money, superior to all others due to its specific attributes, has been successfully decentralized and decoupled from the material world in such a way that nobody can turn the system off.

The world has never seen this before, and there is now a certain inevitability that markets around the world will gradually gravitate toward this superior money. Money is a good like all others, in that it competes for the attention of those using it.

Part VI: Conclusion

So I think it is fair to say that Bitcoin is a monumental invention that has finally been captured by mankind.

And if you understand the deep and central role that money plays in every aspect of our lives, then might Bitcoin not be as important as the printing press, the automobile, and the internet. In fact, not everyone is literate, not everyone has a car, and not everyone is online, but everyone uses money. (And for those who are wondering, you do not need internet access to use Bitcoin.)

All of you who are involved in this, right now, are making history.

And perhaps most exciting about all this, is that the only thing which can derail this invention is an even better invention. If you play through the various scenarios in your mind, you’ll realize that Bitcoin can only fail if a superior currency takes its place, in which case mankind is even better off, and the promise of Bitcoin will carry forward into its successor.

The genie is truly out of the bottle. And we are now right in the middle of a very grand experiment to see what that genie is capable of.

The point is this…

Bitcoin, like gold, has properties that make it an excellent form of money. However, unlike gold, Bitcoin can actually be used in our modern economy for day to day exchange.

Unlike gold, Bitcoin, as an asset with no counter-party risk, can be transferred to anyone on the planet in one second. It is super hero currency. And nobody’s permission is needed. There are no terms of service.

Further, Bitcoin’s decentralized nature means that it is not in danger of being shut off by the incumbent monetary monopolist. Thus Bitcoin can achieve critical mass.

Nothing has ever been able to claim these attributes before, and this is why it’s foolish to compare Bitcoin to any other digital currency from Facebook Credits to World of Warcraft Gold to our most favorite virtual currency, the United States Dollar itself.

Bitcoin’s attributes enable it to operate freely and grow within an increasingly larger sphere of activity.

Inevitably, this means it will start displacing monies with inferior attributes.

Bitcoin will grow like a benevolent hydra, with heads sprouting up in every country and community. It will gobble up commerce that has, until now, been shackled to the economic witchcraft of a decrepit fiat financial system, and will leave an expansive, frictionless marketplace in its wake. It is up to all of you, to capture and grow that new marketplace.

Someday, in school, the curriculum will be different. The children will be taught the true nature of money. They’ll learn the difference between a real asset, like Bitcoin, which is based on merit, and virtual currency, like the US dollar, which based on coercion.

They’ll learn how powerful a market can be, when its medium of exchange is honest. And they’ll learn how a small group of idealistic entrepreneurs saved the world from a monetary dark age.

I feel very excited for my children to grow up in such a world, and I am deeply honored to be here in San Jose, working on this project with so many great minds all over the world.

Thank you.