Chronicle of a Revolution Foretold
In November 2001, as the world was coming to terms with the after-effects of the 9/11 attacks, two economists — Nobuhiro Kiyotaki and John Moore, both taught at the London School of Economics — wrote a paper with a title “Evil Is the Root Of All Money” that inverted a popular bit of Biblical moralizing. In the paper, they sought to understand an old problem — why does money exist. This question that had met two sort of responses till then. Money exists because both sides of any transaction (the buyer and seller) sustain an infinite set of beliefs about the acceptability of this phenomenon. That is, the architect believes the mason will accept a Rupee note tomorrow because the mason believes his cement supplier will accept it as payment on the day after. Through an argument of infinite regress of mutually reinforcing beliefs, money acts as a lubricant, as an object that solves for situations wherein barter may fail. But this sort of tautological theory explains away what money is by simply relying on an old theological trick: money is that which is called money.
But Kiyotaki and Moore were after something deeper. They wanted to motivate an explanation wherein money is the emergent property — which we could recognize as performing the function of money — that burbled up rather than as an a priori assumption. At its simplest, they showed that in a world without money, individuals could simply write each other IOU (“i owe you”) notes for services rendered. But this doesn’t happen and often we end up with an intermediating institution that we call the bank. Thus, when I go to a florist to buy flowers for my wife and pay with my debit card, what really is happening is: I write an IOU to the bank and in turn the bank writes an IOU to the florist. The natural question is why can’t I simply write an IOU to the florist? Kiyotaki and Moore argue the reason is not just that florist may not trust my IOU, but more importantly, that even if the florist trusts me, the rest of the society with whom the florist transacts may not be ready to trust my IOU which she holds. In essence, the bank’s IOU then becomes an object that is trusted across the economy and helps facilitate economic interactions. The bank issued IOU paper, in effect, performs the role of money. What Kiyotaki and Moore show is that it is lack of trust, or the inability to ascertain the extent of or enforcement of commitments that produces money (or money equivalent objects) in a society. The “evil” they speak of in their paper’s title is distrust. Less dramatically, they could have titled their paper as “Distrust Is The Root of All Money”.
What is more important to notice in Kiyotaki and Moore’s formulation are the following: (a) the presence of an institution called the bank that everyone trusts (b) everybody values trust in the system similarly (c) the bank has the ability to track the production of IOUs via a ledger or a electronic database. What Kiyotaki and Moore don’t fully make explicate is what do they mean by “trust”. How does trust permeate an economy? Why do people “trust” the US Federal Reserve more than the Zimbabwean Central Bank? And the Swiss Monetary Authorities more than the US Federal Reserve?
All the while as financial theorists conjectured the origins of money and journalists sang panegyrics to banker-bureaucrats at global monetary institutions, two simultaneous events had begun to unfold at the periphery. One was the accelerated issuance of subprime mortgages which made its way into securitized asset backed securities which were sold world wide including to pension funds for widows and orphans. Eventually, when the house of cards began to collapse, one of the great casualties was the reputation of the banking industry, and more particularly central bankers who were till then touted in mainstream press for being omniscient. The purported stolidity of traditional financial institutions became a laughable, if unfortunate, victim as well. Suddenly, these decades old institutions found themselves scrambling to gain access to the asset backed commercial paper (ABCP) markets and short term funding to keep the lights on and operations humming was suddenly in peril. What followed is an immiseration that many Western societies had never thought possible. More fundamentally, there arose a recognition that while their institutions may have been designed to defeat the dragons of a collectivist Soviet empire, but the democratic West had no answers to counter the termites of financial corporatization who were cynical enough to socialize losses and privatize profits. If venerable institutions can’t be trusted, politicians and figures of authorities such as bankers and bureaucrats cant be trusted, what is one to do? If only there was a way to circumvent the institutions who control our money and avoid the caprice of politicians who can arbitrarily demonetize at will or orchestrate bailouts to protect their favorites in the name of systemic stability.
While these concerns roiled above, hidden from mainstream discussions, in the subterranean world of chat forums dedicated to cryptography, a handful of pioneers — names that deserve much wider reknown than today, which include the late Hal Finney, Nick Szabo, David Chaum, Adam Back, Wei Dai, Gavin Andresen among others — went about tinkering, conceptualizing, discussing, writing code, debugging, inventing new analytical techniques in hopes of arriving at a self-contained peer-to-peer electronic cash system. Such a system would have its own “money” supply rules, tackle questions of how to prevent double spending, and most importantly have to architect consensus among various actors about the state of the world (“the truth”) without a centralizing authority. Despite many stabs at various versions of digital money since the 1980s — called bcash, bitgold and so on — the hardest question that remained was one of how to ensure consensus about the state of the world. How do we all agree on who owns what if there is no centralizing figure with a universal ledger? The problem with generating consensus over a distributed network was, as one of the early participants in the chat group, James A. Donald, described was: “It is not sufficient that everyone knows X. We also need everyone to know that everyone knows X, and that everyone knows that everyone knows that everyone knows X…”. It is the solution to this problem — commonly referred to as The Byzantine General’s Problem — that allowed for the creation of a practicable decentralized currency wherein ownership was safeguarded by impregnable (thus far) cryptographic functions. This solution came about via the legendary pseudonymous Satoshi Nakamoto.
To understand what makes Bitcoin so revolutionary involves trying to understand what is the exact problem that is being solved. When one bitcoin is transferred from person A to person B, we need to ensure two key aspects: one, this particular coin was not used elsewhere (thus avoid double spending) and two, everyone in the network agrees that the ownership has rightfully transferred (thus the need for ‘consensus’). In absence of a centralizing authority (such as a bank), the answer lies in a form of radical honesty tempered by multilateral verification of any claim. The bitcoin protocol demands that every transaction (a transfer) is publicly announced to everybody else in the network. This of course poses the obvious problem: not every node in the network will receive the same information at the same time. The challenge is to identify the temporal order of transactions — what bitcoin transfer came before or after. Nakamoto’s solution was to ensure that every block of information would have three components (a) information about new transactions (b) the prior block of information with its own set of transactions (c) a timestamp of that block’s creation. Concatenating these blocks together — thus, the word “blockchain” — we have, in effect, a long list (a ledger) of transactions and their time stamps. The challenge is how do we get different computers to form a consensus. This consensus can only be produced if two principal criterions are met: (i) the rules must incentivize truth telling as far order of transactions are concerned (ii) every act of truth telling must however be costly. Nakamoto’s underlying conceit should be familiar: only those who bear the cost to tell the truth can be, on average, more trusted to describe it accurately.
The question then becomes how do we make verification “costly”. To address this, Nakamoto relied on an older attempt by the cryptographer Adam Back, the inventor of an earlier avatar of electronic money Hash Cash, to solve the same problem, wherein costly signaling in terms of computer processing power is called “proof of work”. In Nakamoto’s scheme, every node (a cluster of computers) tries to solve a difficult mathematical puzzle. The answer to that puzzle is a cryptographic transformation (“hash”) of all the data in the block (which contains the previous block, the new transaction, and the time stamp) which fulfills specific dynamically set conditions. Upon solving that puzzle, the computer broadcasts the solution to the rest of the network. The rest of the computers in the network check if the proposed solution is correct, and if it is correct they will use that latest block of information. It is important to recognize that a correct solution signals publicly that enough computing power has been expended (a proof of work) to arrive a solution that maintains the fidelity of the order of transactions thus far. What is important to note is that the rest of the computers update their knowledge of about the state of the world after having verified their peer computer’s solution without the help of any centralizing mechanism. The successful implementation of this idea is the revolutionary conceit of Bitcoin.
The question that follows is that follows is how does the system incentivize truth tellers? The answer is brilliantly simple: by distributing bitcoin programmatically, up to a maximum of 21 million Bitcoins, to whoever helps in verification of the order of transaction in the system. The more verification you do, the more Bitcoins you collect. It is this distribution mechanism that acts as a “money supply” in the Bitcoin economy. Per Nakamoto’s original design, the older and more popular the Bitcoin network gets, the less reward will be given out to those who validate the transactions (the “miners”). This is another way of saying, in the Bitcoin economy, money supply is deflationary. Bitcoin is designed to gain value relative to any other asset that is produced more freely. And few things have been produced more liberally than fiat money in the form of dollars, euros, or rupees.
Like with any other phenomenon that finds success, the more popular bitcoin has become the more dimensions of it have revealed and come under scrutiny. These questions range from the obvious (“is Bitcoin money?”) to the more technical (“how can the bitcoin network process more transactions?”) to geopolitics (“should Chinese computer servers control so much of the validation mechanism?”) to fundamental (“where does Bitcoin gain its value from?”) to financial (“is the 1731% price appreciation in 2017 an indication of a bubble?”) to performance based (“how has Bitcoin network performed 99.99% of the time without any downtime?”) to structural (“can Bitcoin replace, if not take a substantial piece of the gold market?”) to the radical (“can a country’s currency be pegged to Bitcoin, or be a form of Bitcoin”) to the world-historic (“is Bitcoin as profound a disruption in institutional design as the invention of a corporation in 16th century Netherlands?”). Answers to these questions evoke tremendous amount of heat and furies. In parts, the reason is different people with vested interest (financially and technologically) are at different levels of the learning curve.
What is evident, and entirely non-controversial, is that bitcoin’s design of decentralized consensus building is as radical a shift in how human institutions have thus far been built at least since the Hydraulic civilizations of Pharaonic Egypt and Confucian China, with centralization as the key aspect of efficient design. Bitcoin undermines that entirely. The result is a comedy of misunderstandings, exaggerations, and quixotic efforts to regulate bitcoin or cryptocurrencies that are components of blockchain technologies. Meanwhile many who want to seem to be in the know, but still don’t comprehend fully, have resorted to anodyne statements like: “we believe in blockchain technology but don’t think bitcoin has a future” revealing a kind of corporate doublespeak born out of ignorance. Never to be left behind when an opportunity to make rules come by, politicians have raised the specter of drug trade, terrorism, and criminality as the reason to ban bitcoin without introspecting that the very same is often done via fiat currencies. They might as well try to ban a human language. The genius of decentralization is that all it requires is one computer in the world, like some secret keeper on the run, to run a copy of the transactions on the blockchain. Politicians also have the raised the question of sovereignty of their currency and the legality of bitcoin as a possible competing currency. This is a more complex issue for such debates depend on the taxonomy used — is bitcoin a currency (as Ashwath Damodaran, Professor of Finance at NYU argues), a conventional asset (as Steve Forbes of The Forbes publication argues), a property (as the American taxation department currently sees it as), and entirely new asset class (as the researcher Chris Burniske views it).
All this said, there are numerous headwinds as well. Currently, neither Bitcoin or technologies that have emerged via its original vision (be it Ethereum, LISK, Ardor, Litecoin etc) are in any way positioned to disrupt any existing industry. This is because the ability to scale it from a userbase of 1 million to 1 billion involves numerous challenges — some technical and some all too human disagreements between various groups of developers. Currently we are, as the hedge fund manager Michael Novogratz argues, in the “story telling phase” of cryptocurrencies — wherein the average person is slowly coming to terms with the radical possibilities contained in the blockchain and bitcoin. This is no different than learning of transatlantic steamers in 1850s or even the internet in 1990s. We are only beginning to learn the consequences of decentralized consensus making via technology. What such technologies will do to our forms of political decision making apparatus, the use of institutions such as banks that have thrived by being intermediary agents is still unclear and potentially both liberating for the individual and destabilizing for social structures. Concurrently, our understanding of fiat money itself — as a government sanctioned means of indexing labor and value — which has been exploited by politicians to suit the exigencies of the political economy they face with, will increasingly be challenged by various forms of digital stores of value and mediums of exchange that are algorithmic by design. Money without the politics of money-creation runs the risk of creating a class of citizens who are no longer concerned with the economic decision making, for they have migrated to a world of value and exchange controlled, in parts, by automatons. The challenge politicians face, in the long run, is not that their powers will be questioned but rather the reasons for there being a political class that can control our lives will itself be questioned. For now, we watch the price of bitcoin and other cryptocurrencies gyrate, for what bitcoin has set in motion globally is something far more insidious and promising: an idea worm that burrows within and promises financial sovereignty to the individual, unassailable by government and untampered by political economy.
[an edited version of this piece appeared in the year end supplement of The Hindu]