What is sound money?

What is sound money?

  • 23 Novembre 2018
  • by Blogger

Bitcoin is essentially digits in a digital wallet. They are created as pieces of code and can be traded for goods and services with merchants who have agreed, and downloaded the software, to accept them. There are many angles to take on this story, but we will begin with the subject of trust. From the white paper that introduced Satoshi Nakamoto’s BTC to the world:

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. Completely non-reversible transactions (Ed. This means technically non-reversible, not contractually non-reversible; “reversing” in this case means making a payment and then rescinding the payment fraudulently, not “returning” as per a contractual guarantee.) are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for nonreversible services. With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party.

Nakamoto hits one of the key characteristics of money that is often overlooked. Generally when people describe what is necessary for something to be effectively used as money they include things like portability, divisibility, durability, sufficient scarcity, fungibility, but it is also important that the money be distinguishable and, by extension, that transactions with it can be trustworthy. When people accept money instead of goods in kind they are putting trust in their counterpart and the money system that they are working within. If you cannot easily identify the money as being legitimate then even one-to-one deals will be difficult, but when a market grows to the point that people must transact through intermediaries trust becomes a paramount concern. Nakamoto’s plan is to avoid the trust issue by bringing transactions back to a one-to-one basis:

What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers. In this paper, we propose a solution to the double spending problem using a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions.

The interesting part about this, aside from watching people try to “create” a natural market process, is how influenced by the economics of gold-as-money Bitcoin is. New money must be “mined” and a “miner” must be efficient in his money production.

In this aspect it resembles the gold coin: an issuer of gold coins cannot unfairly profit by minting extra gold coins because in a well-run gold-coin currency, obtaining the gold to make the extra coins has a cost approximately equal to the revenue or benefit to be gained by the minting of the coins. Moreover, this cost (i.e., the price of gold) is knowable or predictable by anyone. The steady addition of a constant of amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended.

Because mining BTC requires time and resources, and because they become harder to find as the number of coins and users increases, there are natural limitations to the speed and breadth of money creation; and the distribution of new money would be toward those contributing real effort to the system, not just to the most skilled manipulators. Different from the real gold mining scenario is the fact that “gold rushes” or “mother lodes” do not exist, and there won’t be any Spanish galleons sinking with tons of BTC either, so there won’t be big swings either way in the supply. The supply of Bitcoins is also predictable and finite (21 million).  Of course, there is also a finite amount of gold in and on the planet, but we may never know when we’ve found it all. But back to the trust problem, and how it encourages centralization:

The problem of course is the payee can't verify that one of the owners did not double-spend the coin. A common solution is to introduce a trusted central authority, or mint, that checks every transaction for double spending. After each transaction, the coin must be returned to the mint to issue a new coin, and only coins issued directly from the mint are trusted not to be double-spent. The problem with this solution is that the fate of the entire money system depends on the company running the mint, with every transaction having to go through them, just like a bank.

Why is it a problem if money is double-spent? This would just “spur economic activity” by effectively having more money in circulation, or so goes the mainstream thinking. But equally mainstream is condemnation of the counterfeiter. In fact, no one would describe double-spending a Bitcoin as anything other than fraud; yet this is what a government is doing every day when it issues additional unbacked legal tender fiat money. There is very little difference to double-spending an electronic credit and just adding, “out of thin-air,” new credits to an account by adding zeros to the balance – the effect would be functionally the same. Electronic double-spending would take products off of the market without any corresponding production and would thereby, by leaving a relatively higher amount of spendable money to buyable products, put upward pressure on prices if the market is to be brought back into balance; adding zeroes to bank accounts would give the same extra purchasing power to the initial recipient and would also leave the economy with a higher relative amount of money to products. Both would produce the same amount of price inflation relative to the money and production left in circulation, but the latter would do so by increasing the actual total supply of money. We have said that sound money requires decentralized authority and voluntary use, so it will be interesting to watch this experiment play out.

Francesco Simoncelli

This article does not constitute investment advice and is not a solicitation for investment. Auromoney does not render general or specific investment advice and the information on this article should not be considered a recommendation to buy or sell gold or precious metals. Each reader is encouraged to consult with his or her individual financial professional and any action a reader takes as a result of information presented here is his or her own responsibility.

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