How do economies grow?

At the end of the day, that is ultimately the question that the Bitcoin community is asking when it asks, “what is the non-currency ‘killer app’ for Bitcoin?”  And this could be akin to asking, “what is the ‘killer app’ for the Chinese economy?”

Why?

Because as described in a number of other posts, “Bitcoinland” — a “virtual-state” — probably has more in common with the economic dynamics of a “nation-state” than say, agnostic, inflationary computer protocols like TCP/IP/HTTP.

So what is the “killer app” for a meat space economy like China?  How, as measured in GDP, did China grow from 364 billion RMB ($58 billion USD) in 1978 to 58 trillion RMB ($9.4 trillion USD) in 2013?  Was it solely the result of Deng Xiaopeng efforts of “reform and opening up?”  The full answer to that involves surveying numerous books; the shorter answer involved a combination of liberalizing a nearly fully autarkic economy and improving the productivity levels of existing inputs.

In the physical world, one way to measure how an economy develops is by looking at something called total factor productivity (TFP).  An increase in TFP is largely a result of technological improvements, inventions and innovations.  That is to say, for the same quantity of inputs, more outputs are created.

We see this frequently occur in developing economies as subsistence farmers adopt mechanization to improve agricultural yields, sometimes by several orders of magnitude.   For instance, the 2011 harvest yields in Heilongjiang province China, broke nation-wide records, rising 11% over the previous year due to ‘bigger and better machinery for threshing and plowing’ (for more specifics see also: Wage Growth, Landholding, and Mechanization in Chinese Agriculture).

Historically, as an economy develops, the inputs (such as land and labor) become more productive and therefore produce more outputs.  Can the internal Bitcoin economy also see such productivity gains?

Maybe, but probably not securely.

Let’s rewind for a moment.  Because there is no land per se, let us instead look at the labor component of Bitcoinland.

Unlike the labor market in the real world, this virtual-state has a marginal productivity of labor of zero.  It is very unique in that manner.  That means irrespective of the amount of hashing power (or laborers) added or removed from the network, the virtual country will always (and only) produce a fixed amount of output (block rewards).  Both David Evans and Tadge Dryja independently discussed this observation last year.

Proportionalism

Simultaneously, this virtual country’s economic output is secured through proportionalism: ceteris paribus, in the long-run it should take a bitcoin to make a bitcoin.  Rational laborers (miners) will not spend more than a bitcoin to make one.  Thus if a coin is worth $250, miners as an aggregate will not spend more than $37,500 per hour to secure the ledger.

Recall that maintaining a distributed consensus network is different from consensus on a centralized ledger.  Bitcoin was purposefully designed so that it is artificially expensive for people to cast “votes” for a consensus.  The necessity was to make casting “votes” in the consensus artificially high since we cannot know who is participating in the “vote” (because it operates on an untrusted network).

What is another way to look at this?

I spoke with Jonathan Levin, formerly of Coinometrics.  In his view:

The security model of Bitcoin is how much it would cost a malicious attacker to gain a significant portion of the network. The security model of Bitcoin is therefore an anti-Sybil attack mechanism and not necessarily focused on securing financial transactions. This begs the question: Is any financial transaction secure if the cost of reversing it is less than the value of the transaction. Or would we need a system in which it would cost $1 million to undo $1 million of value?

This question is difficult to answer in the abstract. For different use cases, there might need less proof-of-work needed in order to secure the transaction. There could be a few reasons for this.  In many cases the issuer of the goods may be able to monitor the network for an attack waiting for sufficient work to be done before issuing the goods, e.g. Warehousing and physical delivery. For account balances, the victim could alter the balance of the attacker. There are very few $1 million transactions that are consumed instantly. However it does throw high value escrow services based in Bitcoin into question.

In the original white paper, Satoshi, albeit incorrectly calculated the probability of successful block reversals by an adversary. From this a magic number of 6 confirmations was often deemed as secure. I think this security model should be framed as burying a transaction under some dollar equivalent value of proof-of-work. This might give businesses more accurate view of the security of bitcoin transactions.

One unfortunate reality for assessing the security of bitcoin transactions is that we still need to factor in market concentration due to the possibility of bribes and corruption. Where some of these pools would actually find it profitable to attempt block reversals, a la selfish mining, it is difficult to think of an economic model for bribery and corruption in the Bitcoin network. Furthermore, we have seen the discussion take place on gated entry where you can make the entry into the validating nodes set super secure but someone may be able to bribe that entity to reverse / block transactions.

What does Levin mean by the cost of reversing a transaction?

To successfully disrupt the country (the network), the maximum cost to do so is roughly 0.5 x MC, where MC is the marginal cost of production.

In today’s terms to brute force the network — to attack it head on through its hypothetical ‘Maginot Line‘ it would in theory cost half of $37,500 per hour (or rather, half of the aggregate of 6 blocks as Levin suggested above) to obtain the magical “51%” of the hashrate needed to continuously double-spend.

In reality, the actual cost is significantly less due to out-of-band / side-channel / rubber hose attacks.  But that is a topic for another article.

A parasitic unit of account?

In May 2014, at the Bitcoin Foundation Amsterdam conference, Robert Sams brought up two interesting points that involve Bitcoin as a developing country, the first involved deflation:

There is a different reason for why we maybe should be concerned about the appreciation of the exchange rate because whenever you have an economy where the expected return on the medium of exchange is greater than the expected return of the underlying economy you get this scenario, kind of like what you have in Bitcoin.  Where there is underinvestment in the actual trade in goods and services.  For example, I don’t know exactly how much of bitcoin is being held as “savings” in cold storage wallets but the number is probably around $5 billion or more, many multiples greater than the amount of venture capital investment that has gone into the Bitcoin space.  Wouldn’t it be a lot better if we had an economy, where instead of people hoarding the bitcoin, were buying bitshares and bitbonds.  The savings were actually in investments that went into the economy to fund startups, to pay programmers, to build really cool stuff, instead of just sitting on coin.

I think one of the reasons why that organic endogenous growth and investment in the community isn’t there is because of this deflationary nature of bitcoin.  And instead what we get is our investment coming from the traditional analogue economy, of venture capitalists.  It’s like an economy where the investment is coming from some external country where Silicon Valley becomes like the Bitcoin equivalent of People’s Bank of China.  And I would much prefer to see more organic investment within the cryptocurrency space.  And I think the deflationary nature of bitcoin does discourage that.

As I noted in a previous article, the $500 million that VC’s have deployed to build Bitcoinland are effectively a foreign exchange currency play (because it is a virtual-only foreign country that can only be accessed with a pre-paid card, bitcoin).  This money is being paid to effectively leverage one economy, or rather one unit-of-account (namely USD, EUR, RMB) to build a virtual unit-of-account called BTC.

But because of a number of factors, including volatility and lack of native on-protocol financial services (such as credit facilities), bitcoins are not typically used to fund internal improvements (such as building the actual country of Bitcoinland).  Or as Sam aptly noted:

I think the issue if should you have more elastic supply or not it just really comes down to the fact that if you have a fixed supply of something, the only way that changes in demand can be expressed is through the change in price.  And people have expectations of increased demand so that means those expectations, expectations of future demand get translated into present day prices.

And the inelastic supply creates volatility in the exchange rate which kind of undermines the long term objective of something like cryptocurrency ever becoming a unit of account.  And forever it will be a medium of exchange that’s parasitic on the unit of account function of national currencies.  So I do think the issue does need to be addressed.

What does this have to do with “growing” the GDP of Bitcoinland?  And more to the point, how can Bitcoinland increase the amount of outputs?

If the labor force in Bitcoinland, miners, are continuously expanding and contracting the amount of capital they destroy to secure the network (in concert with the market price of the token), then the size of the Bitcoin economy is continuously shifting in size each hour, day, week and month.

Or in other words, as measured in terms of several foreign unit-of-accounts (because the physical land, electricity and hardware are paid for in foreign currency): the size of Bitcoinland is directly proportional to the amount of fixed outputs.  Denominated in BTC, the economy grows at an incrementally fixed rate.  It cannot, due to deterministic rules, be more productive in terms of outputs.  It can only grow larger and/or faster than this fixed amount through what amounts to ‘secondary issuance’ of watermarked metacoins such as Counterparty, Mastercoin and colored coins.

As described below, while this is not an issue today, these hacked-in under-secured metacoins are a double-edged sword.  Why?  Because these metacoins create a disproportional rewards vulnerability discussed last year.

Hacked-in value

Recall that metaprotocols (or sometimes referred to as ’embedded consensus mechanisms’) that utilize and sit on top of Bitcoin blockchain provide disproportional rewards.  For instance, while both Counterparty and Mastercoin require participants to pay some nominal transaction fee, the social value of the actual asset itself if effectively piggy backing and free-riding off seigniorage rewards (this also happens with colored coins and Dogeparty).  Aside from mining pools that use Luke-Jr.’s software, miners in general currently have no way to distinguish between a watermarked transaction from any other transaction.

Consequently, they have no incentive to destroy more capital to protect these metacoins in part because they receive no additional revenue to do so… because the network and coinbase itself has no knowledge of the social value placed on these metacoins and therefore cannot distribute rewards in proportion to the actual value being protected.  And the network then is effectively top-heavy.

For example, if for some reason Apple Inc. decided to issue all of its shares onto the Bitcoin network via a metacoin, this could create a top-heavy security vulnerability.  Recall that the total market cap of Apple’s shares is ~$750 billion USD but the labor force of Bitcoinland is only destroying enough capital to secure ~$3.46 billion in bitcoins (at the time of this writing $250 x 13.85 million mined coins).

Thus in the long run, miners are probably not destroying enough capital to ultimately secure metacoin assets, making the network less secure.

Or in other words, Bitcoinland — as it is encoded today — probably cannot securely increase its productivity levels (as would be measured by TFP) without opening itself up to some kind of vulnerability.

What about merged mining?

Last year I wrote a short working paper discussing the potential of merged mining as a way of productively reusing the existing capital base.  In theory it sounds like an easy home run but in practice, if it costs miners nothing to merge mine, then it also costs them nothing to attack the merged chain/coin.  Relying on and trusting in goodwill or altruism of a labor force is the direct antithesis of the game theory baked into Bitcoin itself: where it is assumed that all parties can and will be adversaries.

Empirically we have seen Bitcoin pools attack chains that have attempted to merge mine (see Coiled Coin).

We have also seen (above) how Namecoin’s hashrate has diverged over this past year and how it now consistently represents less than half of Bitcoin’s (note: Namecoin began merged mining with Bitcoin in October 2011).

This is due to at least 2 reasons:

1) not all Bitcoin pools support AuxPOW (merged mining) with Namecoin

2) also due to a block reward halving that took place in mid-December 2014 (notice that in contrast to the popular narrative, there was in fact no doubling in namecoin value because the market had already priced the future block halving into present day prices)

Or in other words, if it depends on the growth of an underlying unit-of-account hoping for an unseen Bitcoin GDP multiplier (or in this case a non-currency ‘killer app’) probably is similar to wanting something for nothing.

That doesn’t mean it shouldn’t be tried or that all the startups in this space are for naught. In fact, it looks like there are any number of useful innovations with practical applications (such as hierarchical deterministic, multisig, keyless wallets, etc.), including the experiments coming out of the altchain/ledger community.  Several investors and entrepreneurs willing to navigate the space could see a good return if some of these innovations become integrated within other industries (such as financial services).

Yet in practice, operating a distributed consensus network based on proof-of-work seems to require an always changing capital allocation structure that is fused to the market value of its internal unit-of-account relative to national currencies.  And based on the current version of the program, Bitcoinland itself (and not the ecosystem on the edges) may likely remain a laboratory model of a marginally subsistence nation that (often) violently moves between contractionary and expansionary cycles.

Other open questions

• Aside from currency conversion, can there be a stable, secure domestic economy within Bitcoin.  If so, what is or could be another identifiable, exportable good or service?
• As its labor force (miners) must continuously exchange the domestic currency (BTC) into a foreign currency (USD, EUR, RMB) to pay for bills — what is the recent historical precedence of economies that start off subsisting off of a foreign unit-of-account that later manage to move on to become an independent unit-of-account for economic calculation purposes?
• Can other Bitcoin-like cryptocurrency economies actually grow, or are they all faced with similar constraints with respect to proportionalism?
• Existing metacoins require their own consensus systems and as such, they don’t fully rely on Bitcoin.  Can this be further enhanced?

See also:

• A Marginal Economy Versus a Growth Economy
• Digital Economies: Markets, Money and Democratic Politics Revisited by Yanis Varoufakis