[This article is part of the Understanding Money Mechanics series, by Robert P. Murphy. The series will be published as a book in 2021.]
In a modern primer on money mechanics, it is necessary to provide at least an introduction to Bitcoin. 1 Consequently, in this final chapter we will first give a basic explanation of what Bitcoin is and how it works. Then we will place Bitcoin in the framework of money that we developed in chapter 2, seeking to answer the fundamental question: Is Bitcoin money? Finally, we will relate Bitcoin to an important component in the Austrian school’s discussion of money, namely Ludwig von Mises’s “regression theorem.”
Explaining Bitcoin with an Analogy 2
“Bitcoin” encompasses two related but distinct concepts. First, individual bitcoins (lowercase b) are units of (fiat) 3 digital currency. Second, the Bitcoin protocol (uppercase B) governs the decentralized network through which thousands of computers across the globe maintain a “public ledger”—known as the blockchain—that keeps a fully transparent record of every authenticated transfer of bitcoins from the moment the system became operational in early 2009. In short, Bitcoin encompasses both
(1) an unbacked digital currency and
(2) a decentralized online payment system.
According to its official website: “Bitcoin uses peer-to-peer technology to operate with no central authority; managing transactions and the issuing of bitcoins is carried out collectively by the network.” 4 Anyone who wants to participate can download the Bitcoin software to his or her computer and become part of the network, engaging in “mining” operations and helping to verify the history of transactions.
To fully understand how Bitcoin operates, one needs to learn the subtleties of public-key cryptography, which we briefly discuss in a later section. For now, we focus instead on an analogy that captures the economic essence of Bitcoin, while avoiding the need for new terminology.
Imagine a community where the money is based on the integers running from 1, 2, 3, … up through 21,000,000. At any given time, one person “owns” the number 8, while somebody else “owns” the number 349, and so on.
In this setting, suppose Bill wants to buy a car from Sally, and the price sticker on the car reads “Two numbers.” Bill happens to be in possession of the numbers 3 and 12. So Bill gives the two numbers to Sally, and Sally gives Bill the car. The community recognizes two facts: first, the title to the car has been transferred from Sally to Bill, and second, Sally is now the owner of the numbers 3 and 12.
Further suppose that in this fictitious community an industry of thousands of accountants maintains the record of ownership of the 21 million integers. Each accountant keeps an enormous ledger in an Excel file. The columns run across the top, from 1 to 21 million, while the rows record every transfer of a particular number. For example, when Bill bought the car from Sally, the accountants who were within earshot of the deal entered into their respective Excel files “Now in possession of Sally” in the next available row, in the columns for 3 and 12. In these ledgers, if we looked one row above, we would see “Now in the possession of Bill” for these two numbers, because Bill owned these two numbers before he transferred them to Sally.
Besides documenting any transactions that happen to be within earshot, the accountants also periodically check their own ledgers against those of their neighbors. If an accountant ever discovers that his neighbors have recorded transactions for other numbers (i.e., for deals for which the accountant in question was not within earshot), then the accountant fills in those missing row entries in the columns for those numbers. Therefore, at any given time, there are thousands of accountants, each of whom has a virtually complete history of all transactions involving all 21 million numbers.
Explaining the Analogy
We hope our analogy gives a decent first pass in explaining how Bitcoin works. In our hypothetical story, the people in the community kept track of which person “owned” an abstract, intangible number. Of course, you can’t physically hold the number 3, but because the people in the community had adopted a convention where the accountants’ Excel files kept track of which person was “matched” with the number 3, there was a sense in which the person owned it. And then, as our story showed, a person could transfer his claim to a number in order to buy real goods, such as a car.
To keep things simple, in our analogy, we assumed that the community had already reached the end state after all of the bitcoins have been “mined.” In the real world, this will occur at some point after the year 2100, when (virtually) all of the 21 million bitcoins will be in the hands of the public. 5 After that time, there will be no more “mining” operations; the total number of bitcoins will be fixed at 21 million, forever.
Just as in our story, when people in the real world want to buy something using Bitcoin, they transfer their ownership of a certain amount of bitcoins (or fractions of a bitcoin, for smaller purchases) to other people in exchange for goods and services. This transfer is effected by the network of computers performing computations, and changing the public key to which the “sold” bitcoins are assigned. (This is analogous to the accountants in our story entering a new person’s name in the column for a given integer.) Rather than physically handing over an object—such as a $20 bill or a gold coin—to the seller, the buyer who uses Bitcoin engages in the necessary electronic operations in order to command the network of computers to edit the blockchain to reflect the transfer of ownership/control of the relevant bitcoins to the seller.
Where Does Cryptography Come In? The Problem of Anonymous Owners
The present book deals with economics, not computer science, and consequently we will only provide a brief sketch of what’s going on during a Bitcoin transaction. (Interested readers can refer to the endnotes for a fuller explanation. 1 and thus...