The Reserve Currency Fallacy
Speakers: Eric Voskuil
Transcript By: Bryan Bishop
The reserve currency fallacy
Thank you. Developers, developers, developers, developers. Alright, it wasn’t that bad. There’s a lot of content to explain this concept of the reserve currency fallacy. It’s hard to get through it in the amount of available time. I’ll be available at the party tonight. I want to go through four slides and talk about the history of this question of scaling, and then the first scaling proposal, second scaling proposal, and so on.
The first public discussion of bitcoin was this post on October 31, 2008 and the following post from James A. Donald from November 2, 2008. The first response to Satoshi was James talking about bitcoin and said the proposal does not seem to scale. The first problem was quickly identified. Satoshi’s response was the first scaling proposal: big blocks. We’ve been dealing with that for a while. This isn’t going to work; we can talk about how and why.
The second scaling proposal- this is Hal Finney. Sorry about the small text. Maybe too small for everyone to read, but it’s important.
“Actually there is a very good reason for Bitcoin-backed banks to exist, issuing their own digital cash currency, redeemable for bitcoins. Bitcoin itself cannot scale to have every single financial transaction in the world be broadcast to everyone and included in the block chain. There needs to be a secondary level of payment systems which is lighter weight and more efficient. Likewise, the time needed for Bitcoin transactions to finalize will be impractical for medium to large value purchases.”
“Bitcoin backed banks will solve these problems. They can work like banks did before nationalization of currency. Different banks can have different policies, some more aggressive, some more conservative. Some would be fractional reserve while others may be 100% Bitcoin backed. Interest rates may vary. Cash from some banks may trade at a discount to that from others.”
“George Selgin has worked out the theory of competitive free banking in detail, and he argues that such a system would be stable, inflation resistant and self-regulating.”
“I believe this will be the ultimate fate of Bitcoin, to be the “high-powered money” that serves as a reserve currency for banks that issue their own digital cash. Most Bitcoin transactions will occur between banks, to settle net transfers. Bitcoin transactions by private individuals will be as rare as… well, as Bitcoin based purchases are today.”
The modern scaling proposal are things like sidechains, drivechains, lightning network. I don’t work on these things, I work on libbitcoin. These are some modern scaling proposals. These implicitly reject early proposal flaws like hte need for large scale participation or reliance on systems subject to authority. You don’t need any authority to use lightning; but to participate in banking, you do.
So why are we still talking about reserve currency? Some people might say it’s a terminology issue. It’s not. I’ve debated this with other people. Lightning network is not a reserve system, it’s a layer. It’s just bitcoin. When we talk about a reserve currency, we’re more talking about what Hal was talking about in that quote.
I want to give a high-level overview of what bitcoin is. It’s not well understood or commonly agreed. Bitcoin is a class of cryptocurrencies. It’s a concept; the chain is the implementation. This is my terminology, you don’t have to like it, it’s for my consistency. Merchants want to get their confirmations, and miners want to sell those confirmations. It’s a confirmation market. The systems all share a common security model which was first outlined in Satoshi’s whitepaper. Bitcoin attempts to produce a free market where you can buy and sell confirmations at whatever price you want.
Why is bitcoin better than other moneys that have come before? The specific reason is that it gets the state out of the market to the best of its ability, although not entirely. It minimizes the money tax– monetary inflation, financial surveillance, foreign controls, bitcoin helps people avoid those things. That’s why it’s valuable. You might like it because you can program money, but that’s because of the lack of the money tax in the system. I’ve worked on paypal APIs and other things, and this stuff is a pain in the ass because of the law and chargebacks. Even if you’re only interested in the programmatic aspects of bitcoin, you won’t have it unless you keep the state out of the money. Bitcoin won’t eliminate taxes or banking, but it will enable better transparency on taxation.
You can have people buying and selling confirmations. The state usually takes a cut of the markets. Bitcoin intends to help people resist this.
Fedcoin objectives: only two factors make bitcoin unattractive to the state, loss of seignorage and transaction transparency. The state wants two changes (fedcoin) to retain these tax advantages. It wants to create new units (inflation) and authorize confirmations (censorship). Only merchants can reject inflation and only miners can reject censorship. Rejecting these will be considered criminal money laundering. Accepting these would eliminate the value proposition.
If it’s authorized, then it’s taxable, and it’s no longer opaque to the state. The state is also going to want to issue new units of the currency to itself, this is what we call monetary inflation. Or the state will call it monetary policy. They also want financial surveillance, which can come from the miner side of the market. If you can prevent the miner from mining the transaction unless it’s authorized by the state, then now you have financial surveillance. The state wants that. They have to get that from miners. Merchants have no say in that, miners can decide which payments are going to get confirmed.
The state also wants inflation or monetary policy. You get that from the merchants- you have to get the merchants to accept that rule; if they don’t accept the rule, then you don’t get to introduce your new coin. Fedcoin is referring to the abstract concept that they cause a merchant to accept a rule change, and they cause miners to accept censorship.
A market is buyers and sellers coming together for mutual benefit. Miners and merchants work together, despite what people say about the bitcoin security model it’s designed to protect the market from the state. Sometimes you might say the miners have no incentive to attack the market- of course not, they work together, it breaks the market. The security model is the market defending itself from the state, and these two sides of the market must do this independently. Bitcoiners want to protect the value proposition, and the state wants to eliminate it so that it can retain its monetary policy and censorship.
As bitcoin becomes more mature… right now, we’re at the honeymoon phase where bitcoin isn’t big enough to have a tax impact. Once we start having an impact and there’s less tax revenue, then people will care, and it will be called money laundering. I hear people say that bitcoin can’t be banned– but that’s nonsense. Think about the things that are banned, things that people like to do. Even gold for a long time was banned as a use of money. The state will do what it wants to. Failure of ban would result in a state-sponsored mining attack. They might make bitcoin a blackmarket money, if you accept it or use it then you are criminalized. It’s not rational to assume that this wont happen if we’re winning; it’s the easiest tool that the state has. Once that doesn’t work because people keep using blackmarket bitcoin because it’s worth them to do… I say you should start mining, because you can do that centrally, because unlike other black markets, bitcoin can be attacked from one place, more optimally from one place by just mining. So you get 51% attacks. So how does bitcoin secure itself from this? Transactions might get censored, not mined, giant state-sponsored mining and people might try to get their transactions confirmed and it doesn’t happen -what do you do when that happens? So you raise your fee, right? You’re unauthorized transactions aren’t getting confirmed and you don’t know why, so you raise your fees, and the state miner is not going to mine these transactions. There’s all this extra money and other premium to be made, by other miners. So more hashrate will come online to take that money, and suddenly the state doesn’t have 51%. So what does the state do? Does it start taking the unauthorized transactions, does it give up because it’s losing the 51% attack, or maybe it raises taxes to subsidize its mining operation. As soon as it stops taking higher-fee transactions, it starts losing money. Taxes have to be raised to offset the fee premium on black market transactions. That’s the bitcoin security model.
People will tell you that bitcoin is censorship resistant because the state can’t buy mining hardware. That’s ridiculous to think that the nation states can’t buy mining hardware. Mining is profitable. Bitcoin doesn’t have to go through the phases I listed above, but this is the design of bitcoin. It intends for this to happen.
So how is reserves different from savings? A reserve is the tax hoard of the state. Why does the state want a reserve? Hoarding its own money is unnecessary, the reserve is protected against inflation of its own money. Its own money is often insufficient for foreign exchange. How does it conflict with the reserve? Buys it with its own money, reduce the cost by imposition of law.
How do you resist this? Merchants.. All the businesses in town say no sorry I’m violating the law? They either accept it, or they hide. This is how blackmarket works. Being small allows you to hide, both on the mining side and merchant side. If there are merchants accepting bitcoin as payment, then they take bitcoin and bitcoin keeps working. They are the defense. This is the risk sharing. If the state is buying bitcoin from all of us, with paper, right, like Hal Finney suggested.. state prints paper, buys bitcoin, who is– it eventually becomes the global reserve. All these state-backed currencies are holding this bitcoin, they are receiving it, selling it amongst themselves like they used to do with gold. Who’s validating bitcoin in the trade- just the state. Everyone is moving paper around. People can get together and add inflation and they will- bitcoin will be the smaller blackmarket thing that we like; people will use the fake state version or something.
Maybe you could audit it, or you could somehow have the state prove its reserves. Say it did; I don’t know why it would.. But how do you prove how many dollars or euros are pledged agains tthem? They used to publish that. But you can’t audit something bound to bitcoin. You could do lightning, but that’s 1-to-1. The state can’t inflate that. So a reserve is this idea is that we go back to what the gold standard was— which wasn’t that people used gold, but rather the gold standard was fiat. The gold standard wasn’t about trading gold around. People say the gold standard worked until it didn’t, but the thing is that it didn’t- the state kept all the gold, and inflated the paper. The gold standard was a catastrophe. It took everyone’s gold. A bitcoin standard would be the same thing, except the state would try to control validation about what is actually valid bitcoin.