In 2008, a person (or persons) named Satoshi Nakamoto, posted a paper that may prove to be one of the greatest technological developments in history. Nakamoto introduced the world to Bitcoin, an attempt to circumvent central-bank controlled fiat currency using a digital currency created, validated, and protected through cryptographic means. Since then, Bitcoin has grown to a market cap of over 4 billion dollars as of this writing. However, it’s value has dropped significantly from its peak of roughly $1200 per coin in 2013 to about $320 per coin today.
In my opinion (and most metrics bear out), Bitcoin is not very effective as a currency, particularly because of its fixed limit at 21 million total units. This artificial scarcity has two main outcomes:
- the positive is that Bitcoin is able to retain value better than most fiat currencies;
- the negative is that economic inequality is baked into Bitcoin; high demand for a fixed limit crypto-currency advantages those who are able to accumulate it in large quantity, particularly early on when it is least expensive.
Over time, I’ve come to appreciate both the elegance and flaws of Nakamoto’s Bitcoin. To illustrate, here are some excerpts from a few recent email exchanges I’ve had regarding the development of a new crypto-currency:
“So, here’s where the conundrum kicks in… how do you ensure supply/demand equilibrium while incentivizing miners to mine? Is it possible to gain the deflationary benefits of a fixed limit currency with the expansive capabilities of a non-fixed limit?
The way Bitcoin handles this is through divisibility. The problem with this is that it creates an inflationary effect… as long as its scarcity increases its value in exchanged currency, the same amount of exchanged currency purchases smaller and smaller amounts of Bitcoin while simultaneously massively inflating the Bitcoin worth of those who have accumulated a lot of them.
I conceptualized the chron to address this problem. The way supply/demand equilibrium is met is simply that people create their own money through time/effort. In essence, people simply print the money they want/need through their own productive effort.
As I stated, the validation process likely cannot be duplicated in a digital decentralized sense. The chron was designed for governments to adopt.
So that leaves these criteria:
Fixed limit – for high exchange rate
Non-fixed limit – for supply/demand equilibrium
In two articles, The Post Where I Fix Bitcoin and Fixing Bitcoin Part II: Pricing with Bitcoin Units, I attempted to solve the distortions in Bitcoin by creating a scheme that automatically divides the current pool of Bitcoin into lower fractional units when demand increases by implementing a fixed exchange rate.
This process confirmed that Bitcoin divisibility, without the benefit of exchange with other currencies, is, by nature, an inflationary process. Utilizing a fixed exchange rate was also inflationary. Bitcoin is only deflationary when in relation to another resource or currency with which it is exchanged that is itself increasing. In theory, that could be any natural resource but it is currently fiat currency.
Satoshi Nakamoto figured out that divisibility allowed a currency to be both scarce and expandable but there is simply no free lunch.”
“… a digital currency is worthless because its natural marginal costs are near zero. Again, Satoshi Nakamoto did an interesting job of addressing this issue with the proof of work system, which facilitates the creation of a digital file at substantial marginal cost. In other words, Nakamoto found a way to make generating a digital file very expensive. He made the creation of Bitcoin worthwhile by attaching it to a problem, the Two General’s Problem. By finding a way to eliminate third party trust using algorithms, he found a way to legitimize using copious amounts of energy to increase the marginal costs of creating a digital file.”
In my personal research, I’ve come to understand that the ideal currency is, by nature, paradoxical: it must be scarce enough to retain value and abundant enough to sufficiently meet demand for its use. In other words, the ideal currency must strive to achieve the supply/demand equilibrium that allows it to retain relevant value yet be common enough to use for daily transactions. I explain this more thoroughly in the following excerpt:
“Satoshi Nakamoto figured out that divisibility allowed a currency to be both scarce and expandable but there is simply no free lunch.
So the key is to try to create a free lunch: a currency that doesn’t lose value to inflation yet is abundant enough to freely spend.
What it boils down to is a currency must be both:
Scare and abundant
Indefinite and finite (as a store of value, you should be able to hold it forever yet, to prevent an overabundance, it should also be consumable)
In my personal explorations, I have only identified two things that naturally fit these criteria:
The first is time, hence the chron. It is the one essential that everyone shares that is both limitless and limited (through lifespan), has unquestionable intrinsic value, is a perfect store of value (through the concept of “history”) yet is “consumed” over a lifespan;
The second is ethyl alchohol. It is the one physical commodity that has very high practical utility in an emergency circumstance and high desirability in general. In theory, an indefinite amount can be made but there is always only a finite supply. It can pretty much be stored forever but there is a strong motivation to consume it as fuel, medically, or for enjoyment.
The challenge is in attempting to meet those criteria with a digital currency, which is the only practical means of creating a universal currency today. However, by its very nature, a digital currency is worthless because its natural marginal costs are near zero…
A question was asked whether lending should be part of a new economic paradigm. Here’s the thing: lending is what allows fiat currency to be both relatively scarce yet abundant. Our money is constantly in the state of being both created and destroyed through lending. This is what has made fiat currency so resilient conceptually… it is able to exist in a paradoxical state. However, in order to make it work, it requires monopolization of force. That is the only way the money itself has any value, the people with the guns say it does.”
Indeed, the ideal currency must be both scarce and abundant, finite and indefinite. I’ve decided to call this problem “The Riddle of Scarce Abundance.”
Bitcoin handles the “scarce abundance” problem with divisibility. However, as previously stated, severe economic inequality is the natural result.
If I was going to design a crypto-currency, the first thing I would do is enable it to produce unlimited coins. This would guarantee that everyone who wanted them could get them in quantity. Their abundance would encourage their use for everyday transactions. However, particularly for a currency produced digitally, this is naturally hyper-inflationary. Though “proof-of-work” and fixed limitation discourages reckless currency production, they don’t eliminate the problem. So how do you ensure the ideal supply/demand equilibrium of a currency such that it is both abundant enough yet retains its value over the long-term?
The answer is that the currency must be in a constant state of both creation and destruction. In other words, there needs to be a mechanism in a crypto-currency that eliminates the currency as well as creates it. Done properly, an ideal rate of coin destruction acts as a counterbalance to unlimited coin creation, allowing a currency to be both abundant and scarce. The key is to balance both processes to reach the currency’s ideal supply/demand equilibrium of maximum retention of value with enough abundance to encourage general purpose use.
However, if coin destruction is done improperly, the coin’s ability to store value will be destroyed. One of the advantages of the fiat currency system is that banks act specifically as mechanisms for both creating and destroying money. When a bank loan is paid off, the bank uses the received money simply to cancel the liability it created, rendering the credit/debit transaction to zero. However, in the world of crypto-currencies, all coins are held personally. So any mechanism to destroy coins has to respect the fact that all coins in a crypto-currency represent someone’s personally-held value. No one wants to hold coins that could “self-destruct” for fear of having their personally-held value destroyed.
The answer that I came up with is “taxation.” What I determined is that a percentage-based “transaction tax” could be implemented directly into a crypto-currency scheme so that, every time it was used for a transaction, coins were destroyed. The process would act as a “consumption” mechanism; as long as the coins were held, they would retain value, and, when they were used, they would be consumed in such a fashion as to not affect their ability to store value.
As is the case with most good ideas, I figured someone had already figured this out, so I decided to research the more popular altcoins to see if such a “taxation” process was already in use. Surely enough, I discovered a coin that had implemented the idea: Peercoin. However, the fashion in which it is implemented is fairly crude and not adaptive. If I’m not mistaken, its “taxation” process is also regressive by nature.
The alteration I would implement would be a variable transaction tax, one that increases or decreases relative to the amount being transacted. To be more specific, the lower the number of coins transacted, the lower the transaction tax and vice versa. Though not a perfect way to achieve a progressive tax style outcome, the reasoning is that richer people will generally transact in larger coin amounts.
This strategy goes a long way to ensuring supply/demand equilibrium but another flaw that should be addressed as it relates to Peercoin is its fixed rate of inflation, which is set at 1%. Implementing a method for increasing coin production when demand increases is essential or price distortions will likely result. Tying the rate of coin production to transactional velocity may be the solution. Changes in the transactional velocity rate should strongly correlate to demand for the currency; adjusting the rate of coin production as transactional velocity accelerates or decelerates should, in theory, allow for a highly balanced supply of the currency relative to demand.
So this is my idea for a better crypto-currency… one that is both abundant and scarce. The alterations I’m suggesting should allow it to achieve true supply/demand equilibrium thus achieving maximum stability. Many people think that scarcity is a desirable quality in a currency but what is more essential for its ability to store value is its stability.
As I’ve stated before, I don’t hate Bitcoin, I just don’t like it. I think I understand why Satoshi Nakamoto designed it in the way that he(?) did and the scarcity of the currency definitely works to his advantage as his coins are worth significantly more now than when they were initially mined. However, if he got that far in the process, I doubt he couldn’t have gone just a few steps further. He was SO close to creating the ideal replacement for fiat currency.
The good news is that he leaves a lot of work on which to build. The dream of a stable crypto-currency truly superior to fiat currency that can be made available to almost everyone everywhere is within reach. While I do not think such a crypto-currency would be superior by any means to the innovation presented in The Currency Paradox, I think it would be a great intermediate step. Ending currency wars would go a long way toward reducing economic inequality and increasing economic equitability.