What Is Bitcoin, Anyway?

Bitcoin has been much in the news recently, particularly because of the meteoric increase in the price of a bitcoin — from less than a dollar in 2009 to (at this moment as I type on 10 December 2017) about $15,440, up from $10,012 as I typed the first draft on 30 November 2017. This has, not unreasonably, gotten a lot of attention in the financial markets, with mixed opinions among financial pundits. Jamie Dimon of JPMorgan-Chase Bank says it’s a fraud; others aren’t so sure. But while it seems everyone in the financial world is talking about it, the rest of the world is looking puzzled and saying: “What is a ‘Bitcoin’, anyway?”

To answer that question, let’s start with a more basic question: What is “money”?

Economists say money has three attributes:

  • it’s a medium of exchange: you can use it to buy things
  • it’s a unit of accounting: you can use it to keep your books
  • it’s a store of value: you can hold on to it in place of other goods or services of value.

The obvious historical meaning of money has been specie: physical coins, gold, silver, copper, along with less common physical objects like cowrie shells and wampum — beads made from quahog shells. Of course, exchanging specie in large amounts is difficult, so other representations came into use, largely paper notes that originally were supposed to represent a fixed amount of some valuable item like gold and silver, but — governments being what they are — those are usually replaced by fiat money, notes that are given their value simply by the issuing government announcing their value, and the willingness of people to exchange real goods or services for that stated value. Sometimes this works, sometimes it doesn’t, as for example the hyperinflation of the Weimar Republic in the 1930s or in Venezuela right now.

There’s a whole ECON 101 course to explain all the ramifications of how this works, but Milton Friedman and others restated a clean, simple model called the quantity theory of money. The super-simplified version of this theory says that money represents the value of the real economic assets available to the entity who issues the money.

As a model for this, let’s say that all our stuff, the whole gross domestic product (GDP), is bundled up in a basket (a very large basket) and balanced under an equally ridiculously large helium balloon. Next to the balloon in a yardstick. If the balloon is perfectly balancing the weight, the basket floats steadily at the exact same level on the yardstick.

The thing is, we keep making new stuff — ideally, the GDP is growing. So we need to keep adding helium to the balloon to keep it balanced.

Now, this is all a setup for a metaphorical pun, so stick with it a bit longer. In this model, we have the GDP in the basket, and the amount of helium in the balloon is the amount of money. The yardstick is showing us the price level — so as long as the helium and the stuff in the basket is balanced, the basket stays at the same price level: price stability.

Now, let’s say whoever is adjusting the helium lets in a little too much. Then the balloon has a little too much lift, and the basket starts to rise. In other words, we see inflation. Let out a little too much, and the balloon shrinks and we have deflation.

Okay, sort of an extended metaphor but if you think about the balloon, the notion of inflation and deflation will stick.

Now, in the (relatively) real world, we replace our helium with actual money, represented by something a little more convenient than helium. (Imagine your helium “coins” floating away on the wind.) We use some kind of token that has three properties:

  • it has to be hard to get, or hard to make — essentially hard to counterfeit.
  • it has to be convenient to store.
  • it has to be limited in supply.

Gold, silver, wampum, cowrie shells, salt, rice — all of these things have these properties in varying degrees, and they all have been used for money.

The more common modern approach is to base money only on the announcement by some government somewhere that hey, these pieces of paper are money because they have the secretary of the Treasury’s signature and an official-looking seal and serial number on them. This is called fiat money, because “fiat” is the Latin for “let there be.” (In the Latin Bible, God’s first words are “fiat lux.”) The piece of paper is hard to make or to counterfeit (although that’s a constant race with counterfeiters)  and it’s easy to store. But the serial number is the important part of the piece of paper: it identifies the bill as part of a limited supply.

So, now to bitcoin. (You wondered when that was coming, didn’t you?) Someone or some people going by the name Satoshi Nakamoto had an idea: what if the bill could be eliminated, keeping only the serial number? Numbers in a computer are certainly easy to store. Could they be made hard to get? Hard to counterfeit? Could they be made in a way that gave a limited supply?

Bitcoin was the answer, in two parts. The first part is that bitcoins are constructed, or “mined,” using a very computationally hard process. It takes many hours of computer time to generate a new bitcoin, and the nature of mining is that it gets harder every time someone creates a new bitcoin, until sometime in the future it will no longer be possible at all. The supply of bitcoins is limited.

These numbers are still just numbers, however. Once you make one, no matter how hard it is, you could just copy it, except for one thing, and that one thing is the key. It’s called the blockchain.

The blockchain is a distributed ledger: it’s a record of transactions that is distributed to many places around the net. When a bitcoin is created, it is entered into the blockchain ledger, which contains the bitcoin itself along with another cryptographically protected field that identifies the owner. When the owner sells the bitcoin, the transaction is recorded in the blockchain ledger: bitcoin 42 is now owned by chasrmartin, not harrythebitcoinminer. That transaction is passed along to all the distributed records of the ledger. It’s complicated in practice, but simple in concept: what the blockchain does is to let you prove that you own the “dollar bill” with serial number G 60394016 H — which you don’t, that one is on my desk right now — without presenting the physical bill, and to transfer it to someone else in a way that they – and only they – can prove they own it, without having to give them the piece of paper.

Technically, the blockchain is the most important part of the whole bitcoin phenomenon, but describing the many ways blockchain is being used would make a whole article in itself.

There’s one more part of bitcoin that explains why it’s so popular: bitcoin is not controlled by any government and in fact is (nearly) impossible to subject to any centralized control. The code to mine bitcoins and to support the blockchain is open source and easily available. The blockchain ledger is not in any one place — it’s distributed to everyone who maintains a copy, worldwide.

It a paradox. It’s fiat currency that’s not offered by any government, but it’s a hard currency that is harder to mine than gold or silver. It’s an electronic record that lets anyone find out who owns it, but it is almost as anonymous as cash — which is why ransomware demands payment in bitcoins. It’s a challenge to government control over banking and money supply, which is why people in Russia and China and Venezuela want to buy them, and why countries like China are trying hard to control them.

That paradox — money but not government money — is what makes bitcoins so desirable that people will pay more than $10,000 to buy just one.