Mind Of Mav
The Case For Bitcoin: Why It Won’t Stop Here
As we approach $20,000, there is one question that seems to permeate all mediums and discussions: why does Bitcoin have value?
Looking beyond the price of the digital asset, the question also evokes a profound second question: why Bitcoin?
After 12 years, what is the driving force behind this digital coin? Why did it succeed and why does it continue to do so? Why hasn’t it be superseded, died, or been hijacked as pundits have often fortold?
This week, in light of these questions, I want to make a solid and substantiated claim that lays out the case for Bitcoin.
Let’s first explore how the Information Age gave rise to Bitcoin, a novel economic institution designed to challenge legacy financial systems. Then, let’s delve into how legacy financial institutions, which have evolved through a trust-based model, appear to have fallen short of the four economic assurances necessary for a predictable financial system. Finally, we’ll go deep into looking at Bitcoin’s behavior in relation to these four economic assurances and explain why it is designed uniquely to satisfy them.
Buckle up, this should be fun.
The Evolution of Economic Organization
Advancements in civilization have led to increasingly complex modes of economic organization. In hunter-gatherer society, humans lived in small groups and relied predominantly on face to face interactions. They established communities in rural areas, with economic production limited to manual human labor. In the transition to agriculture, humans began interacting in larger groups and adopting new forms of social organization to scale interactions. They formed towns and cities, with resource-rich regions the centers of trade and commerce. As manufacturing processes advanced, an era of industrialization emerged. Productivity increased as workers flocked to factories, and tasks that previously required months could be completed in days. Today, the focus of the economy has shifted from traditional industries developed through industrialization, to industries enabled by information technology. Economic activity has migrated from the physical to the digital world, with power granted to those in charge of storing and distributing information.
As groups grow and become more complex, institutions evolve to scale interactions, governing the behavior with a system of rules intended to facilitate coordination. Marriage, markets, governments, banking, laws, and firms are examples of institutions that have emerged over the course of human history.
The advancement of technology during The Information Age has given rise to novel institutions. Digital logic, transistors, and integrated circuit chips have created powerful tools, from computers and microprocessors to cell phones and the Internet, enabling participation in institutions at unprecedented scale. Social media networks have transformed the way we communicate and interact. Online marketplaces have led to widespread, instant commercial matchmaking. Digital media platforms allow the streaming of content libraries consumed on-demand.
Perhaps the most notable institution to rise from the creation of these tools, Bitcoin has called into question the very basis of economic organization. In 2009, the Internet birthed Bitcoin, a novel economic institution giving individuals the ability to participate in a politically neutral realm of economic activity. Its coordination transcends borders, locations and jurisdiction.
Instead of relying on centralized intermediaries to enforce its rules, Bitcoin relies on a distributed network of computers. This architecture enables it not only to function outside the purview of legacy systems, but also to challenge them. While the full ramifications of Bitcoin’s creation are not well understood, we believe that it will contribute more dramatically and profoundly to the evolution of monetary and financial systems than any other breakthrough in history.
The Financial System Has Evolved to Rely On “Trust-Based” Institutions
“Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust-based model.” – Satoshi Nakamoto, Bitcoin whitepaper
The promise of Bitcoin is best understood in relation to traditional financial systems, which rely on centrally controlled institutions that enforce the rules, record-keeping, and adjudication of the system. These institutions were created to standardize the exchange of value, manage wealth, and facilitate economic activity. Central banks, for example, govern monetary policy, while commercial banks custody and manage assets, and centralized payment processors mediate consumer transactions.
Under a “trust-based” model, the integrity of an institution is a function of those controlling the institution. Rules enforced from the top down are guaranteed if those in control are trustworthy.
Institutional decision-making typically is opaque and unpredictable. Rule changes are at the discretion of those in control, sometimes creating a misalignment of incentives between the institution and its participants. As institutions grow in importance, the entities controlling them accumulate more power, potentially exposing participants to harmful behavior.
As we will explore, financial systems founded on a trust-based model fail to provide predictable economic assurances.
Specifically, under a financial system:
- Value should be exchanged globally and freely.
- Wealth should be owned wholly and protected.
- Rules should be enforced reliably and predictably.
- Integrity of the system should be verifiable.
In the next section, I’ll detail how trust-based institutions fall short of satisfying these economic assurances.
The Trust-Based Model Falls Short
Assurance 1: Value should be exchanged globally and freely.
Why trust-based model fails to meet Assurance 1: Centralized parties determine the eligibility of participants and control the flow of capital.
Today, financial institutions rely on centralized authorities to control the flow of transactions and determine the eligibility of participants. While controlling flows of capital can protect the financial system from malicious activity, who defines malicious activity? If one transaction can be censored and controlled, can’t all transactions be censored and controlled? Can’t the powers-that-be deprive participants of the ability to exchange value globally and freely?
At both the private and nation-state levels, financial institutions exert varying degrees of control. At the private level, payment processors like PayPal can and do censor users, often throwing them off their platforms without explanation.4 In some cases, governments pressure private companies to do so.5 Because these companies must abide by local laws, they can face limits to serving users on a global basis, leading to a highly fragmented global financial infrastructure.
At the nation-state level, governments sometimes impose restrictions on the free movement of capital. Specifically, a monetary authority choosing to fix exchange rates and control the money supply cannot accommodate the free flow of capital. Such restrictions not only limit a citizen’s ability to move anything of value freely and globally, but also create economic distortions.
Instead of subjecting local banks and markets to competitive pressures, governments can force their citizens to misallocate capital, curbing productivity, investment efficiency, and economic growth. In the long run, institutions risk making decisions favoring those in control at the expense of customers, users, or citizens. During the last 10 to 15 years, countries have been increasing capital controls rather than decreasing them. Since 2007, the share of countries increasing capital controls has soared 300% to 15%, while the share of countries reducing them has dropped 60% to 5%, as shown below.
Assurance 2: Wealth should be protected and owned wholly.
Why the trust-based model fails to meet Assurance 2: Participants rely on a local enforcer to grant property rights and protect property.
An important indicator of economic prosperity is the protection of property rights.7
A well-established private property system gives individuals exclusive control over their wealth and the right to use their resources as they see fit.8 Incentives to work, save, and invest lead to a more efficient allocation of resources and greater economic output.
In a trust-based model, the protection of assets depends largely on the existence and reliability of local protection, typically the government. In the absence of reliable local protection, individuals often have been unable to protect their wealth. In 1933, for example, the United States banned the private ownership of gold, including coins, bullion, and gold certificates,9 a ban that persisted for more than 40 years. In 2016, the Government of India announced the demonetization of all ₹500 and ₹1,000 banknotes, which many critics considered confiscation of property without due process.10
Then, in late 2019, the Hong Kong and Shanghai Banking Corporation (HSBC) seized the funds of individuals affiliated with the Hong Kong protests,11 highlighting once again that centrally controlled wealth is guaranteed only if institutions are willing to protect it.
Subject to weak and unpredictable property rights, citizens must rely on the protection inherent in the properties themselves. Assets protected in the absence of authority are “deep”, while those protected by authorities are “shallow”,12 as shown below.
Today, institutions controlled centrally typically protect assets but present various tradeoffs. Immovable and impossible to hide, physical assets like real estate are vulnerable to weak local enforcement because they can be seized more easily than cash.
Unlike cash, however, real estate cannot be demonetized. Likewise, local bank managers can freeze bank accounts but cannot seize gold bars stored under mattresses. Conversely, criminals can break into houses and steal gold bars but cannot freeze bank accounts.
Tomorrow we’ll cover the other two assurances, how the trust-based model fails to satisfy them, and how Bitcoin eliminates the need for a trust-based system by providing a distributed trust model.
1 Currie, Thomas, et al. Evolution of Institutions and Organizations. University of Michigan, www-personal.umich.edu/~jbednar/WIP/ Strungmann.joint.pdf.
2 Currie, Thomas, et al. Evolution of Institutions and Organizations. University of Michigan, www-personal.umich.edu/~jbednar/WIP/ Strungmann.joint.pdf.
3 Nakamoto, Satoshi. Bitcoin: A Peer-to-Peer Electronic Cash System https://bitcoin.org/bitcoin.pdf.
4 Sollazzo, Giuseppe. “PayPal Closed My Account with No Explanation. It Could Happen to You.” Medium, Medium, 6 May 2019, medium.com/@ puntofisso/paypal-closed-my-account-with-no-explanation-it-could-happen-to-you-6ff0ba4ea95f.
5 Poulsen, Kevin. “PayPal Freezes WikiLeaks Account.” Wired, Conde Nast, 4 June 2017, www.wired.com/2010/12/paypal-wikileaks/.
6 “Ex-Chinese Central Bank Adviser Denied US Dollar Exchange Due to Age.” South China Morning Post, 31 May 2019, www.scmp.com/economy/ china-economy/article/3012312/chinas-capital-outflow-controls-have-gone-extreme-former
7 O’Driscoll, Gerald P., and Lee Hoskins. “Property Rights: The Key to Economic Development.” Policy Analysis, 7 Aug. 2003, www.cato.org/sites/ cato.org/files/pubs/pdf/pa482.pdf. medium.com/@hasufly/bitcoin-and-the-promise-of-independent-property-rights-8f10e5c7efa8.
8 Hasu. “Bitcoin and the Promise of Independent Property Rights.” Medium, Medium, 9 Jan. 2019, medium.com/@hasufly/bitcoin-and-thepromise-of-independent-property-rights-8f10e5c7efa8.
9 “CY19 May Journal.” Crypto Words, 31 May 2019, cryptowords.github.io/cy19m5.
10 “India’s History with Demonetisation: From 1946 to 2016.” Free Press Journal, www.freepressjournal.in/cmcm/indias-history-withdemonetisation-from-1946-to-2016.
11 France-Presse, Agence. “Hong Kong Police Seize $10m in Donations Intended for Protesters.” The Guardian, Guardian News and Media, 20 Dec. 2019, www.theguardian.com/world/2019/dec/20/hong-kong-police-seize-10m-in-donations-intended-for-protesters.
12 Nick Szabo. “Shallow Safety vs. Deep Safety.” Twitter, Twitter, 17 Aug. 2019, twitter.com/nickszabo4/status/1162743096821469184?lang=en.
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