Bitcoin Explained

 

Over the last few days, I’ve been exchanging emails with Ricochet’s own Michael Stopa, asking Michael — one of the few people I know who truly understands both technology and the English language — to tell me about Bitcoin. (The background: During the Bitcoin craze with which last year concluded, I finally succumbed to temptation, buying a few hundred dollars’ worth. By the very next morning, I had lost a third of my money.)

Herewith, and with thanks, again, to Michael, the best succinct explanation of the blockchain phenomenon I have yet encountered. My own occasional comments appear [in brackets].

Let me say at the top that the one thing I can’t tell you (and probably the thing you want to know the most) is whether bitcoin value will go up or down and when. Sorry. [Michael knows—I’m sure he knows. He just won’t say.]

That said, the basic innovation of bitcoin is the public ledger of all transactions that allow everyone to see who (or what “wallets” anyway, not the actual human beings) has how many bitcoins and where, over history, have they been moved to; i.e., all the transactions that have ever existed. This is, of course, the blockchain. The blockchain is what is called a linked list. You could think of this like a book where instead of reading the pages sequentially, you find, at the bottom of each page, a line telling you what page to go to next. And when you get to the next page the first thing you find is an encoding (a so-called “hash”) of the page from which you have just come. Thus in some sense each page contains the information of the preceding page, which contains the preceding page, which…

The encoding machine (the hash function, in bitcoin this is called SHA-256) produces codes of the same length irrespective of how long the input is — specifically 256 bits. The technical details of this hash function are not really so difficult, but you do need a little mathematical savvy to work through it. One thing that might occur to you immediately is if we are encoding (or encrypting) a whole page of data into 256 bits (64 characters) then the encoding cannot be unique. It must be possible to find two pages of information that “hash” into the exact same string of 256 bits. This apparent paradox is solved by statistics (it is very unlikely to find two such pages). So far the best source I have found for details of this is on a site called blockgeeks.com.

So, this linked list blockchain can’t be quite that simple, of course. If all we need to do to add a new page to the book is take the previous page, hash it, and put that on the new page with the latest transactions, then anyone could willy-nilly be adding pages all day. So the encryption process also includes a number, called a “nonce,” which has to be “mined.” That number is such that (this is a little subtle) once it is concatenated with the hash of the most recent page and hashed again, then it results in a number with a lot of leading zeros (meaning it is less than some fairly arbitrary target). Just using a 10-digit decimal example, the hash of the hash+nonce would need to give a number less than, say, 0000025000. That result depends on both the nonce and the previous hash (plus other data) obviously. So each time the blockchain gets updated a new nonce has to be found. Once a nonce is found (and the technical details here are to me still somewhat opaque) the blockchain gets updated (and the finder gets some bitcoin for his trouble).

The reason for that is that I am planning to write this all up with copious references on our Harvard Lunch Club page. We will also change the name of the podcast to the Harvard Lunch Club Bitcoin podcast, a la the Ice Tea Company that did the same and saw their share prices skyrocket. (I am kidding a bit here). Maybe we could make it a page on Ricochet, too? [From your lips, Michael, to the Blue Yeti’s ears.]

Anyway, regarding the stability and prospects of bitcoin, what is needed is a genuine calculation of how it will fare in the market. The market, in this case, is the universe of other currencies. Only geeks will use it just because it is cool or democratic. Other folks will use it because it costs less to use it (or else its value is more stable). One thing that mystifies me is how a currency can be useful when its value changes by 30 percent in a day. Surely there must be an expectation that its value will flatten out eventually. [True enough, but in countries where Bitcoin is reportedly unusually popular, such as Venezuela, the native currency is even more unreliable, right?]

Regarding the marginal value of using bitcoins versus other currencies what you are competing against are, of course, the central banks. Transaction costs (e.g., for international transfers) are small but, of course, they add up. These costs are to some extent fixed because the bank has to keep a record of all of the transactions in whatever currency and keep all that information secure. So ultimately the competitive advantage of bitcoin is that they have worked out a system of securing transactions that is cheaper than the old methods. (As I am sure you know, bitcoin transactions are not free. They take computer power and mining costs, etc., that cost money … but they are arguably far cheaper than what the banks need to charge).

Then the question is how will banks compete? They’re not going to take this lying down. Possibly this will force them to innovate their transaction-recording technology (no doubt they are working on it all the time). But I am not sure how, other than becoming cryptocurrencies themselves, governments and banks can surpass bitcoin here.

Lots of other things here, like taxes, for instance. But let me stop there. I hope I haven’t just filled up your inbox with unusable dreck! [No, Mike, you’ve provided a lovely brief education. Thanks.]

Published in Economics, Technology
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  1. RufusRJones Member
    RufusRJones
    @RufusRJones

    Kozak (View Comment):

    Front Seat Cat (View Comment):
    It is the currency of choice for hackers and bad eggs holding peoples’ computers for ransom etc. since it cannot be traced. It’s a tool for terrorism to me. It allows thugs, criminals, terrorists across the world to hide their money.

    Exactly the arguments governments are making to ban currency. They would love it if every single financial transaction was traceable, and taxable.

    The other thing is they have to do this to force negative interest rates etc., too. The want more tools to force us to cooperate with their central planning madness.  They need to turn us into lab rats on a habit trial. They know the debt to GDP will never improve and they know their ideas caused this mess. Ken Rogoff, Larry Summers, Paul Krugman, Alan Greenspan, etc.

    You genuinely don’t have a republic or democracy or permeant, fair  prosperity under a discretionary central bank regime. Then the left takes over everything before it all collapses. A few in the House get this.

    This is excellent.

     

    • #61
  2. Instugator Thatcher
    Instugator
    @Instugator

    <disregard>

    • #62
  3. Instugator Thatcher
    Instugator
    @Instugator

    RufusRJones (View Comment):
    How are all of the Western entitlements going to get paid?

    Promises that can’t be repaid won’t be. See Greece.

    • #63
  4. Instugator Thatcher
    Instugator
    @Instugator

    Joseph Stanko (View Comment):
    But ultimately, isn’t the upper limit just an arbitrary number that Satoshi pulled out of a hat when he wrote the white paper?

    Something like that. It had to do with the rate at which he want to introduce and establish the currency.

     

    • #64
  5. RufusRJones Member
    RufusRJones
    @RufusRJones

    Instugator (View Comment):

    RufusRJones (View Comment):
    How are all of the Western entitlements going to get paid?

    Promises that can’t be repaid won’t be. See Greece.

    And then this forces the whole global monetary system to get overhauled the hard way, war included as one of the options.

    Central planning never works on a large scale. This has been proven over and over. The End.

     

    • #65
  6. RufusRJones Member
    RufusRJones
    @RufusRJones

    If Ricochet did one long, serious podcast on what the dynamics are of legal tender laws and why any fiat money is demanded today, it would be incredibly sobering and informative.

    I’d pick Francis Cianfrocca from the old Coffee and Markets podcast (Ben Domenech’s old podcast) and Robert Murphy of Texas Tech. Those guys are incredibly good at explaining stuff. And then of course, you have to have the obligatory Ruling Class apologist to explain why those guys are all wrong.

    • #66
  7. Skyler Coolidge
    Skyler
    @Skyler

    So bit coin is free money, except the cost of electricity?  Sign me up.  How do I start mining?  For virtually no investment, all I need is to start my computer hacking at the crypto that hides potential bitcoins.

    If it takes me a year to get one bit coin, that’s still virtually free money.  How much is one bit coin worth now?

    • #67
  8. RufusRJones Member
    RufusRJones
    @RufusRJones

    Skyler (View Comment):
    So bit coin is free money, except the cost of electricity?

    This is actually the situation in Austria where they have excess hydropower. This is also why dirty coal in third world you-know-whats is a popular source.

    Along these lines, whatever  is driving up the price of gold (I have my opinion: stupidity in Western governance) is very bad for the environment. Gold mining is a very, very, nasty business for both people and the environment in far too many countries.

    Keynesian leftists, statists and RINOs are bad for people and the environment. Then they pretend to solve it with government force. After that, the rubes vote in a crazy fascist-populist to…well, make them feel better and hopefully help them get a cut of the Keynesian graft. What a system.

    • #68
  9. J Climacus Member
    J Climacus
    @JClimacus

    Mike H (View Comment):
    By the way, it makes me really really happy that so many people are still expressing so much skepticism about Bitcoin. If everyone was a believer then there would be no upside (kind of like US stocks at the moment). The fact that so many people dismiss it and call it a bubble and the newest Tulip Mania means I may not have gotten in too late. I even hope it’s something of a bubble because I want to buy a ton for a cheap price, but every time it dips a lot of people want to call “the death of crypto,” and I take that as an extremely good contrarian indicator.

    When people like Peter Robinson, who admittedly knows virtually nothing about bitcoin (thus the OP), buy a few hundred dollars worth simply to follow along with the herd, it’s hard to think of a better bubble indicator. And simply because it is a bubble, doesn’t mean you can’t make a lot of money on it even now. The thing about bubbles is that they get bigger until they pop. This bubble might get much bigger before it pops, who knows? The key will be to get out before it does pop, because when it does, the value of it will plummet like a stone.

    The cryptos have already died in a theoretical sense. The original point of bitcoin was not to be a speculative asset, but to be an alternative currency that would substitute for depreciating fiat currencies like the dollar. But you and Peter aren’t buying bitcoin merely to use it as a medium of exchange.  I suspect Peter had no idea that that was what bitcoin was originally about. You’re hoping some other buyer out there will pay you a lot more for your bitcoin than you paid for it. And they might. Or they might not. Eventually someone is going to buy bitcoin and will find the next buyer in line has gone somewhere else, and he’s left holding the bag. The math is unforgiving in that there has to be as many losers as winners in bitcoin.

    If I’m looking for a speculative asset on which to make a killing, I know I’m already too late to the game when get-rich-quick stories about it are featured on the morning news. It’s time then to find another asset that isn’t yet on the mainstream radar and buy some of it up for cheap. Cashing out IRA money now to get in on the bitcoin mania might just workout for those who do, and I sincerely wish them luck and hope they have the wisdom to cash out before it crashes. It’s not a game I’m interested in playing.

    • #69
  10. RufusRJones Member
    RufusRJones
    @RufusRJones

    I’ll say this one more time. If you want to hear a balanced, comprehensive, and fundamental explanation of bitcoin, listen to this.

    ***EDIT***

    What I’m trying to say is that this guy is very smart and informed and he makes a good case that crypto can’t be ruled out as money just yet even though it’s literally just heat solving an equation. Robert Murphy is an Austrian economist, professor and consultant. Texas Tech.

    • #70
  11. RufusRJones Member
    RufusRJones
    @RufusRJones

    The ultimate problem is Western governments won’t / can’t let crypto and precious metals gain too much power over the economy, which is what is going to happen if the debt to GDP trajectory and growth doesn’t improve. We will have bank bail-ins at gunpoint and everyone will be forced to buy treasuries. Something like that.

    • #71
  12. J Climacus Member
    J Climacus
    @JClimacus

    Skyler (View Comment):
    So bit coin is free money, except the cost of electricity? Sign me up. How do I start mining? For virtually no investment, all I need is to start my computer hacking at the crypto that hides potential bitcoins.

    If it takes me a year to get one bit coin, that’s still virtually free money. How much is one bit coin worth now?

    That’s like saying driving your car across the country is free travel, except for the gas. Gas just is the cost of travel, and electricity just is the cost of mining a bitcoin. I read an estimate recently that it takes about $3500 worth of electricity to mine a bitcoin. Given that bitcoin is now trading at something like $13500, that certainly does look like a good investment, and is probably a better way to acquire bitcoin than buying it at prices that are grossly overvalued in terms of cost of production. But since bitcoin has no intrinsic value, and there are many other and even better crypto alternatives available, there is a not an ainsignificant chance that your bitcoin will sell for less than $3500 by the time you’ve spent all that money on electricity and successfully mined one.

    • #72
  13. Instugator Thatcher
    Instugator
    @Instugator

    J Climacus (View Comment):
    there is a not an ainsignificant chance that your bitcoin will sell for less than $3500 by the time you’ve spent all that money on electricity and successfully mined one.

    Well, that and the computer to do the actual, you know, mining. What is really being consumed is processing speed and electricity is a proxy measurement.

    • #73
  14. Instugator Thatcher
    Instugator
    @Instugator

    RufusRJones (View Comment):
    and everyone will be forced to buy treasuries. Something like that.

    Buy it with what?

    Just kidding, this line of thought is nonsense. When currency becomes worthless, barter takes its place.

     

    • #74
  15. RufusRJones Member
    RufusRJones
    @RufusRJones

    Instugator (View Comment):

    RufusRJones (View Comment):
    and everyone will be forced to buy treasuries. Something like that.

    Buy it with what?

    Just kidding, this line of thought is nonsense. When currency becomes worthless, barter takes its place.

    There are many steps before the currency gets worthless.

    • #75
  16. Kozak Member
    Kozak
    @Kozak

    Joseph Stanko (View Comment):

    Kozak (View Comment):
    The guy who lost the hard drive was a miner. His girlfriend hated the noise his mining rig made and he shut it down and dismantled it. Put the hard drive in a desk and forgot about it, BTC was worth a couple of pennies each at the time….

    I wonder if they’re still together…

    • #76
  17. Kozak Member
    Kozak
    @Kozak

    Instugator (View Comment):

    RufusRJones (View Comment):
    How are all of the Western entitlements going to get paid?

    Promises that can’t be repaid won’t be. See Greece.

    See Cyprus regarding how safe your bank account is..

    • #77
  18. RufusRJones Member
    RufusRJones
    @RufusRJones

    The simple way to think about it is, the “the system” works on inflation (both CPI and asset inflation), debt growth no matter what the cost, entitlements, welfare and taxation. The shorthand for that is “force”. Bitcoin and gold or whatever are “choice” or “freedom” except they tax the crap out of you when you trade it etc. etc.

    This quit working due to robots, NAFTA, China opening up, computers, in other words the natural deflation man has created through progress. Better living though purchasing power. They can’t tax purchasing power, only inflationist growth.

    If this system breaks, they will have to try to hold it together with government force. They well start with CPI inflation and go from there.

    ***EDIT***

    You also have to sort of have to have sort of excess population growth in an inflationist system, either from procreating FICA slaves (otherwise known as “good citizens”)  or importing them.

    (To be clear, I’m not that smart or anything, I’m just obsessed with this stuff.)

    • #78
  19. J Climacus Member
    J Climacus
    @JClimacus

    Instugator (View Comment):

    RufusRJones (View Comment):
    and everyone will be forced to buy treasuries. Something like that.

    Buy it with what?

    Just kidding, this line of thought is nonsense. When currency becomes worthless, barter takes its place.

    When the stock market crashes again, pension funds start to collapse, and interest rates on U.S. govt debt starts to rise steeply, crashing the value of bonds and threatening the entire system, the government will take extraordinary measures. Very tempting will be the trillions of dollars held in 401k’s and IRAs.  The gov’t could say that, in the interests of protecting citizen’s retirements, which are threatened by the volatile stock market, it will require that 80% of the wealth in retirement accounts be converted to U.S. Treasuries, since bonds are (allegedly) a stable store of value. What will really be happening is that the govt, banks and busted pension funds will be bailed out by savers. I think something like this is what @rufusrjones was getting at.

    • #79
  20. Front Seat Cat Member
    Front Seat Cat
    @FrontSeatCat

    Joseph Stanko (View Comment):

    Front Seat Cat (View Comment):
    I know the people at my bank – they know me – I trust them with my money.

    My bank charges me a fee if I visit a real teller — but ATM transactions are free, and their ATMs are everywhere and open 24/7. Consequently it’s been at least a decade since I set foot inside a bank branch. I don’t know them and I’m sure they don’t know me.

    So the people handling your money through Bitcoin is better to you?

    • #80
  21. RufusRJones Member
    RufusRJones
    @RufusRJones

    What @jclimacus said. There are different versions of this stuff and way smarter people than me that are very worried about it. My favorite versions of this is, France tracks antiques so people can’t hide or move money that way. Insane.

     

     

    • #81
  22. Henry Racette Member
    Henry Racette
    @HenryRacette

    J Climacus (View Comment):

    Skyler (View Comment):
    So bit coin is free money, except the cost of electricity? Sign me up. How do I start mining? For virtually no investment, all I need is to start my computer hacking at the crypto that hides potential bitcoins.

    If it takes me a year to get one bit coin, that’s still virtually free money. How much is one bit coin worth now?

    That’s like saying driving your car across the country is free travel, except for the gas. Gas just is the cost of travel, and electricity just is the cost of mining a bitcoin. I read an estimate recently that it takes about $3500 worth of electricity to mine a bitcoin. Given that bitcoin is now trading at something like $13500, that certainly does look like a good investment, and is probably a better way to acquire bitcoin than buying it at prices that are grossly overvalued in terms of cost of production. But since bitcoin has no intrinsic value, and there are many other and even better crypto alternatives available, there is a not an ainsignificant chance that your bitcoin will sell for less than $3500 by the time you’ve spent all that money on electricity and successfully mined one.

    Yes.

    Another factor is that mining is still a gamble: if someone else successfully encrypts the transaction block before you do, your effort is lost. So maybe it takes $3,500, on average, to mine a bitcoin. (I haven’t looked at the numbers.) But here’s what I wonder: how many people spent $500, $1000, $2000, trying to encrypt that same block, and lost their energy investment?

    Obviously, the more people who are mining, the more likely this is to happen. And bitcoin-mining hardware continues to grow more sophisticated: guys sitting at home with a hot off-the-shelf PC are increasingly at a disadvantage against people with purpose-built computing cards designed for cranking out hash codes.

    Now I wonder what the total energy investment per bitcoin actually is, when you include the miners who lost….

    • #82
  23. Aaron Miller Inactive
    Aaron Miller
    @AaronMiller

    It is not possible to place any useful possessions beyond the influence of powerful men, be they government officials or tech administrators. If blockchain currencies become common or important enough, transactions and savings will be interfered with and managed by self-imposed authorities.

    • #83
  24. Henry Racette Member
    Henry Racette
    @HenryRacette

    A little more about the energy cost of bitcoin.

    First, it looks like bitcoins are profitable in terms of total dollar value earned versus total miner investment (including the miners who lose the race to encrypt the next block). However, it’s a safe bet that the miners who are showing a profit are usually — probably overwhelmingly — those running hardware designed specifically to generate bitcoins.

    (This is a great time to be manufacturing custom GPU-based hash crunching hardware. There must be a bitrush hardware boom going on in the tech sector.)

    So just how much energy is going into bitcoin generation, and how fast is it increasing?

    Six months ago, as of July 14, 2017, the energy invested in bitcoin generation (according to Digiconomist.net, which maintains a bitcoin energy tracking index) was just under 15 terawatt hours.

    In the past six months, bitcoin energy consumption has almost tripled (182% increase), to 41 terawatt hours. The rate of increase is accelerating.

    Just for reference, the annual energy electricity production of Hoover Dam is about four terawatts; the total U.S. nuclear energy electricity production is about 800 terawatts.

    Bitcoin generation today consumes about as much energy electricity as New Zealand, or more than ten percent of what either the UK or Italy consume. It is now consuming a measurable fraction — about 0.2% — of total global energy electricity production. Almost four million U.S. homes could be powered with the energy electricity invested in bitcoin; perhaps 50 million homes in a relatively advanced developing country.

    These numbers are for bitcoin only. Bitcoin is one of at least a thousand crypto-currencies.

    [ Updated to replace “energy” with “electricity.” ]

    • #84
  25. RufusRJones Member
    RufusRJones
    @RufusRJones

    The other thing is the whole concept of the government calculating one measure of inflation that has so much stuff is dependent on it is criminally absurd. This would be true even if they were being honest about it, which they aren’t.

    • #85
  26. Instugator Thatcher
    Instugator
    @Instugator

    J Climacus (View Comment):
    When the stock market crashes again, pension funds start to collapse, and interest rates on U.S. govt debt starts to rise steeply, crashing the value of bonds and threatening the entire system, the government will take extraordinary measures.

    Really?

    J Climacus (View Comment):
    Very tempting will be the trillions of dollars held in 401k’s and IRAs.

    Well, with a stock market crash they won’t be worth trillions anymore, would they?

    J Climacus (View Comment):
    The gov’t could say that, in the interests of protecting citizen’s retirements, which are threatened by the volatile stock market, it will require that 80% of the wealth in retirement accounts be converted to U.S. Treasuries, since bonds are (allegedly) a stable store of value.

    When the stock market crashes, don’t people already do this?

    I don’t think it works like you said it will work.

     

    • #86
  27. RufusRJones Member
    RufusRJones
    @RufusRJones

    @instugator It is a process. The smart guys can see this stuff with how tax receipts go up and down now.  Some say this stuff will stay inflated on it’s own for a bunch of reasons (not good ones). Maybe there will be dramatic interventions like Japan or Switzerland is doing. Who knows.

    • #87
  28. Instugator Thatcher
    Instugator
    @Instugator

    RufusRJones (View Comment):
    The smart guys can see this stuff with how tax receipts go up and down now.

    Tax receipts have been going up steadily for a while now.

    Seriously – one fundamental difference between bitcoin and our current banking system is that bitcoin actually hews to the Austrian economics school and does away with fractional reserve banking.

    Our current economic system would collapse if we tried to implement the Austrian economics preferred solution. If there had to be an actual dollar in existence for every dollar on paper with a 1 :1 obligation to serial number ratio the fed would have to print about 100x the current currency supply. Talk about inflation!

    • #88
  29. RufusRJones Member
    RufusRJones
    @RufusRJones

    Instugator (View Comment):
    Tax receipts have been going up steadily for a while now.

    Um, yes. That’s the point.

    • #89
  30. Jules PA Inactive
    Jules PA
    @JulesPA

    I’d guess the Anonymous creator of bitcoin is associated very high up in the electricity chain…and the tech chain…

    Follow. The. Money.

    • #90
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