Sunday, April 17, 2016

When Bitcoin Grows Up

It’s impossible to discuss new developments in money without thinking for a moment about what money is. The best place to start thinking about that is with money itself. Consider the UK’s most common paper money, the English five or ten or twenty quid note. On one side we have a famous dead person: Elizabeth Fry or Charles Dickens or Adam Smith, depending on whether it’s a five or ten or twenty. On the other we have a picture of the queen, and just above that the words ‘I promise to pay the bearer on demand the sum of’, and then the value of the note, and the signature of the cashier of the Bank of England.

It’s worth thinking about that promise to ‘pay the bearer on demand the sum of ten pounds’. When we parse it, it’s not clear what it means. Ten pounds of what? We’ve already got ten pounds. That’s exactly what we’re holding in our hand. It doesn’t mean, pay the bearer on demand ten pounds’ worth of gold: the link between currency and gold was ended in 1971, and anyway, Gordon Brown sold off the Bank of England’s gold reserves in the 1990s.

The fact is, there’s no answer to the question, ten pounds of what? The ten pound note is worth what it claims it is because the state, in the form of the Bank of England, says so, and we choose to believe it. This is what students of currency call ‘fiat’ money, money whose value has been willed into being by the state. The value of fiat money is an act of faith. There are quirks to this. In the case of the pound coin, if we ask how much it’s worth, the answer is obvious: a pound is worth a pound. It shouldn’t be, though. According to the Royal Mint, which actually makes the stuff, 3 per cent of all pound coins in circulation are fake. Allowing for that, we should discount the price of our pound coin, and mathematically assign it a value of 97p.

In real life, there’s no need to do that, because the overwhelming probability is that you won’t have any difficulty spending your fake pound for its full nominal value. (That’s unless you’re caught out by a coin slot which rejects your money. Most people attribute the annoying frequency with which this happens to a problem with coin slots; mostly, though, it’s a problem with the currency. The other time you’ll have trouble with your fake coin is when you get one of the mutant squishy ones which look like partially chewed fruit pastilles and are so badly forged they verge on the endearing.) They’re worth what they claim because we choose to believe in them. Your mathematically determined 97p of coin is worth a quid because we believe it’s worth a quid. We trust it. That’s the first main point about money. Its value rests on our belief in its value, underwritten by the authority of the state.

For the second main point about the nature of money, we need to travel to the Pacific Ocean. In Micronesia, about 1800 miles north of the eastern corner of Australia, there’s a group of islands called Yap. It has a population of 11,000 and is largely unvisited except by divers, but it’s a very popular place with economists talking about the nature of money, starting with a fascinating paper by Milton Friedman, ‘The Island of Stone Money’, published in 1991. There’s a particularly good retelling of the story by Felix Martin in his 2013 book Money: The Unauthorised Biography.

Yap has no metal. There’s nothing to make into coins. What the Yapese do instead is sail 250 miles to an island called Palau, where there’s a particular kind of limestone not available on their home island. They quarry the limestone, and then shape it into circular wheel-like forms with a hole in the middle, called fei. Some of these fei stones are absolutely huge, fully 12 feet across. Then they sail the fei back to Yap, where they’re used as money.

The great advantage of the fei being made from this particular stone is that they’re impossible to counterfeit, because there’s none of the limestone on Yap. The fei are rare and difficult to get by definition, so they hold their value well. You can’t fake a fei. Just as you have to work to get money in a developed economy – so the money constitutes a record of labour – the fei are an unfakeable record of the labour that went into their creation. In addition, the big ones have the advantage that they’re impossible to steal. By the same token, though, they’re impossible to move, so what happens is that if you want to spend some of the money, you just agree that somebody else now owns the coin. A coin sitting outside somebody’s house can be transferred backwards and forwards as part of a series of transactions, and all that actually happens is that people change their minds about who now owns it. Everyone agrees that the money has been transferred. The real money isn’t the fei, but the idea of who owns the fei. The register of ownership, held in the community memory, is the money.

It has sometimes happened to the Yapese that their boats are hit by stormy weather on the way back from Palau, and to save their own lives, the men have to chuck the big stones overboard. But when they get back to Palau they report what happened, and everyone accepts it, and the ownership of the stone is assigned to whoever quarried it, and the stone can still be used as a valid form of money because ownership can be exchanged even though the actual stone is five miles down at the bottom of the Pacific.

That example seems bizarre, because the details are so vivid and exotic, but our money functions in the same way. The register is the money. This is the second main point about the nature of money. We think of money as being the stuff in our wallets and purses; but most money isn’t that. It’s not notes and coins. In 2006, for instance, the total amount of money in the world in terms of value was $473 trillion. That’s a number so big it’s very difficult to get your head round: about £45,000 per head for all seven billion people on the planet. Of that $473 trillion, less than a tenth, about $46 trillion, was cash in the form of banknotes and coins. More than 90 per cent of money isn’t money in a physical sense. That number is even bigger in the UK, where only about 4 per cent of money is in the form of cash. What it is instead is entries on a ledger. It’s numbers on your bank balance, the electronic records of debits and credits that are created every time we spend money.

When we say we spend money, what we’re mainly doing is making entries on registers. Your work results in a weekly or monthly credit from your employer’s account to your account, maybe with another transfer of PAYE tax to the government, also your pension contribution if you make one, any forms of insurance, then a chunk automatically going off to your landlord or mortgage provider – all heading to different parts of the financial system, all of them nothing other than movement between and among all these various ledgers and registers. This is what almost all of what we call money mainly is: numbers moving on registers. It’s the same system they have on Yap. (...)

Bitcoin is a new form of electronic money, launched in a paper published on 31 October 2008 by a pseudonymous person or persons calling himself, herself or themselves Satoshi Nakamoto. Note the date: this was shortly after the collapse of Lehman Brothers on 15 September, and the near death of the global financial system. Just as the Civil War was the prompt for the United States to end private money, and the crisis of Kenyan democracy led to the explosive growth of M-Pesa, the global financial crisis seems to have been a crucial spur, if not to the development of bitcoin, then certainly to the timing of its launch.

Bitcoin’s central and most exciting piece of technology is something called the blockchain. This is a register of all the bitcoin transactions that have ever happened. Every time something is bought or sold using bitcoin – remember, that means every time something moves from one place in the register to somewhere else – the new transaction is added to the blockchain and authenticated by a network of computers. The techniques are cryptographic. It’s impossible to fake a new addition to the chain, but it’s relatively easy (by relatively easy, I mean relatively easy for a huge assembled array of computing power) to verify a legitimate transaction. So: impossible to fake but simple to verify. The entities transferring the money are anonymous, and at the same time completely transparent: anyone can see the bitcoin addresses involved, but nobody necessarily knows to whom they belong.

This combination of features has extraordinary power. It means that you can trust the blockchain, while knowing nothing about anyone else attached to it. Bitcoin is in effect a register like the one kept in people’s memory on Yap, but it’s a register that anyone can see and to which everyone assents. For the first time in human history, we have a register that does not need to be underwritten by some form of authority or state power, other than itself – and, as I’ve argued, that register isn’t some glossy add-on to the nature of money, it actually is how money works. A decentralised, anonymous, self-verifying and completely reliable register of this sort is the biggest potential change to the money system since the Medici. It’s banking without banks, and money without money.

by John Lanchester, LRB | Read more:
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