The Mechanics of Cryptocurrency

By Peter Bofinger, Professor for Monetary and International Economics at Würzburg University and a member of the German Council of Economic Experts. Originally published at the Institute for New Economic Thinking website.

Hayek’s Model of Currency Competition

More than forty years ago, Nobel laureate Friedrich von Hayek published a small book in which he called for the “denationalization of money.” For him, high inflation rates in all countries were proof that states were abusing their monopoly on issuing banknotes, and that only private money in competition could guarantee stable money. Hayek was more concerned with the regulatory principle of competition than with the question of how a competitive monetary system could be concretely shaped.

The success of Bitcoin and other cryptocurrencies today shows that there is indeed a market for such a private issue of money. It is however more than questionable whether a system with private currencies can actually replace the state-organized monetary systems and whether in the end a stable monetary system will emerge.

Mr. Smith Issues His Own Currency

The mechanisms of private money production, which at first glance are very complex, will be illustrated by a simple example. Mr. Smith decides to participate in the currency competition. He prints 1 million notes bearing “100 Valuecoin.” On the back it is expressly pointed out that the holder of such a note has no legal claim against Mr. Smith.

Now Mr. Smith can try to sell his notes against the euro. He starts with an exchange rate of 1: 1. But why would anyone come up with the idea of spending 100 euros on a piece of paper that has no intrinsic value and promises nothing? Mr. Smith refers to the example of Bitcoin, in which the quantity is also limited. By comparison, there is no upper limit on government currencies. The Valuecoin could thus have the advantage to gain value against the state money like Bitcoin. Soon 100 Valuecoin could be worth much more than 100 Euro.

Now, one could wonder, why only Mr. Smith should have the privilege to make money out of nothing. Again, it is geared to the model of Bitcoin. He decides not to put all the notes into circulation himself and to establish a mechanism for the issuance of Valuecoin, which ensures that the Valuecoin money supply can only increase gradually.

Thus, he organizes a dice game with friends once a week. Whenever a participant rolls a one on 4 dice simultaneously, he receives 100 bills. In order to prevent the bills from circulating too fast, over time, the number of bills received on successful dice rolls is reduced. So after the first year, participants only receive 50 bills for a successful throw. After that, the amount reduces further. In addition, as the number of participants in the dice rounds fluctuates, the level of difficulty is increased when a particularly large number of visitors are present. Then, no longer four but five dices are used and “five one´s” must be rolled. As more and more interested parties are expected to attend the dice game over time, this mechanism also makes it increasingly difficult for those involved to create new Valuecoins.

Mr. Smith assumes that the knowledge of such a mechanism, which ensures a gradual expansion of Valuecoins, in addition to the fixed ceiling, also helps to make his private currency attractive.

Overall, this mechanism ensures that the benefit of being able to exchange worthless bills for government money is not left to Mr. Smith alone. Rather, it is given to the participants of the dice game, who must acquire the Valuecoin notes by strenuous dicing. This coincides with the Bitcoin model, where miners have to solve highly complex computational tasks, which requires huge computing power and enormous power consumption. Since you get to the notes faster in the beginning, those who are participating from the beginning are favored. This, of course, especially benefits Mr. Smith as the initiator of the whole scheme.

Mr. Smith’s Currency Becomes Digital

Nothing fundamentally changes in the mechanisms described so far, when Mr. Smith does not organize his money issuing via printed bills, but digitally via accounts. He sets up a centralized Valuecoin settlement system, where all holders of Valuecoins keep an account. For a successful throw, they will then receive no bills, but the Valuecoins will be credited to the participants account in the clearing system of Mr. Smith. By buying Valuecoins against the euro from the dicer, outsiders can also open an account on the Valuecoin billing system. This makes the private money system perfect. Digital transfers can now be made between account holders.

With the digitalization of the whole scheme, also the dice game evenings are abolished. Now, anyone can build up Valuecoin balances by participating in the online game.

The Accounting System of the “Distributed Ledger”

What distinguishes Mr. Smith´s Valuecoin from Bitcoin so far is the central accounting system he manages. Instead, Bitcoin uses a decentralized system, the “distributed ledger.” In such a system, there is no central accountant anymore. Rather, in principle, each participant can make bookings in the ledger. However, those participants with higher computational power have an advantage, as they might be able to perform more throws (“proof-of-work”). In this way, the organizer of the whole thing disappears behind the scheme he has created. Thus, for outsiders, it is no longer clear that Mr. Smith is the creator of Valuecoin.

A special feature of this system is that it is completely transparent not only to the participants but also to outsiders. With a “distributed ledger” all participants can now see the e.g. that Mr. Roberts has made a transfer of Valuecoins to Ms. King. But that’s not all. You can also see that Mr. Roberts, has received 100 Valuecoin from Ms. Gordon, who has earned them on a dice evening. Thus, in principle for every Bitcoin its entire history can be determined from the transactions recorded in the “distributed ledger.” In principle, an encryption (“public key”) ensures that the anonymity of the parties to outsiders remains guaranteed. In addition, each participant also has a “private key,” which is similar to a PIN-code required to trigger payment transactions.

For its participants, however, the “distributed ledger” can be more of a curse than a blessing. Since all transactions can be viewed by all participants, with the knowledge of the “wallet address” of a participant one can track all his transactions. This is similar to when you as a customer of a savings bank with the knowledge of the account number of another customer could get insight into all his account transactions. The “wallet address” can be computed using another person’s “public key.”2 The “wallet address” of a Bitcoin participant can already be obtained by receiving a Bitcoin transfer from him.

Mr. Smith’s New Clothes

The complexity of the “distributed ledger” and the dice game (“mining”) process has the great advantage for Mr. Smith that the basic mechanism of the whole scheme is pushed completely into the background. Mr. Smith has managed to find buyers for his worthless bills and—in the digital version—his literally created Valuecoin balance holders, who are prepared to spend good government money to get even more Valuecoin. The Valuecoins have no intrinsic value, but as long as no one notices, they can rise enormously in price. But as with the fairy tale of the “Emperor’s New Clothes,” it only takes a small moment of realization and the whole system collapses.

Of course, there is also no promise of redemption from central banks for national banknotes. However, they have the distinct advantage over private currencies that sellers cannot deny them as “legal tender” and that they can be used at any time to pay taxes.

But what about the advantage of the fixed upper limit for the issue of Valuecoins and Bitcoins, which limits the circulation of individual crypto currencies? Since the model of monetary competition inherently provides for a large number of private currencies, there is no limit to the total circulation of money issued by all cryptocurrencies. And unlike government-issued currencies, there is no guarantee that this collective issuance process will generally follow a macroeconomic rationality.

From this perspective, a monetary system with national currencies issued under a sovereign monopoly should end up being more stable than a system of currency competition with a large number of currencies issued by private actors. And in terms of data protection and banking secrecy, the “distributed ledger,” which forgets nothing and at least makes everything transparent for professionals, proves to be highly questionable anyway.

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