The Satoshi Revolution – Chapter 1: What is a Trustless System? (Part 1)

The Satoshi Revolution: A Revolution of Rising Expectations
Section One: The Trusted Third Party Problem
Chapter 1: Listening to the Past
by Wendy McElroy

What is a Trustless System? (Chapter 1, Part 1)

“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.”
—Satoshi Nakamoto

A trustless system is one that does not depend upon the intentions of its participants, who may be honorable or malicious. The system functions in the same manner regardless of intentions. The blockchain, with a peer-to-peer protocol that is also transparent and immutable, is trustless. Intentions become important only when there is an intermediary who must be trusted. The third party’s good or bad motives become a determining aspect of the transaction and place the other parties at the mercy of his honesty. This is the trusted third party problem.

On a small scale, the problem will always exist because there are times when a middleman is useful or necessary. The ideal third party is trusted, trustworthy and competent. Some people are dishonest, however. They steal, overcharge, lie or otherwise betray their customers’ confidence in order to make profit over a fee. If the swindling is a one-time event and other third parties are available, the damage is limited. The two people take their business elsewhere, consider suing, report the swindler to business watchdogs and warn others.

An occasional dishonest third party is not the problem Satoshi Nakamoto addressed when he used Bitcoin as a lever to upend the world. It is the institutionalized and constant corruption of governments and central banks from which the average person cannot escape. Almost everyone who worked over-the-table, ran a business, bought goods from stores, accepted government benefits or paid taxes had to accept a fiat that constantly plunges in value due to inflation. Almost everyone who used credit, accepted checks, took out loans, conducted commerce or did business abroad needed to use banks that stole like drunken muggers.

To the average person, the situation looked hopeless. Competing with the government-banking cartel was illegal and severely punished. No speedy, safe and private alternative existed for transferring funds across borders…or across town. Attempts to reform or remove the system seemed doomed. Reform was impossible because monetary policy had rotted to its core and needed to be uprooted, not improved; removal was inconceivable because the monopoly was deeply entrenched and all-powerful. People’s need for money became a straitjacket.

And, then, Satoshi Nakamoto. And, then, the blockchain and bitcoin. Not just a new currency but a new concept of money was created, and in a form that cannot be inflated because it is fixed at 21 million units. The supply of bitcoin can only decrease as some coins are inevitably lost, for example, by people who forget a password. Satoshi noted, “Lost coins only make everyone else’s coins worth slightly more. Think of it as a donation to everyone.”

Peer-to-peer transactions go through a middleman called a miner but no trust is required as the transaction is released only when “proof of work” is rendered; this consists of a miner solving complicated math. The solution is costly in computer power and time-consuming to produce but easy for others to verify. Satoshi commented, “With e-currency based on cryptographic proof, without the need to trust a third party middleman, money can be secure and transactions effortless.” The soundness and propriety of the blockchain’s protocol itself is assured by the use of an open source that is visible and verifiable to all. Satoshi’s private currency snaps the monopoly of governments and central banking.

There is precedent for this in theory and in practice.

Precedent in Theory
Friedrich A. Hayek is the most respected Austrian economist of the late 20th century. In The Denationalisation of Money: An Analysis of the Theory and Practice of Concurrent Currencies (1976), he argued vigorously for private and competitive currencies to displace government issued ones. Hayek asked a key question. “When one studies the history of money one cannot help wondering why people should have put up for so long with governments exercising an exclusive power over two thousand years that was regularly used to exploit and defraud them. This can be explained only by the myth” of the necessity of government money “becoming so firmly established that it did not occur even to the professional students of these matters…ever to question it. But once the validity of the established doctrine is doubted its foundation is rapidly seen to be fragile.” (A slightly revised edition entitled Denationalization of Money: The Argument Refined was published in 1978.)

Governments know it is hugely profitable to debase the currency as long as people have no alternative but to accept it and they put the full weight of bureaucracy behind currency manipulation. But the system is fragile because it relies on people not understanding that debasement is theft and not having a choice. Otherwise, the status quo crumbles. The 1974 Nobel laureate pondered why public understanding was so elusive. “[W]hy [is] a government monopoly of the provision of money…universally regarded as indispensable” and what would happen “if the provision of money were thrown open to the competition of private concerns supplying different currencies.” (Hayek’s specific proposal for private currency is explored elsewhere in this book.)

With eerie prescience, Hayek argued for currencies to be developed by entrepreneurs who could innovate new forms of money just as they innovated in other areas. One of the drawbacks of governments’ monopoly on money was that it imposed a freeze on the sort of invention now running free in cryptocurrencies.

The voluntaryist historian Carl Watner observed, “No one can tell in advance what form these monies might take because no one can know for sure what choices individuals would make or what new technologies might be discovered. Laws forcing people to use the Federal Reserve System money have frozen monetary developments at a certain stage….Just imagine if Congress had protected the Post Office by passing laws that would have prevented people from communicating via the internet. We would never have experienced the marvels of e-mail.”

Along with Hayek, the Austrian economist Murray Rothbard wrestled with the question of “why do people so vigorously resist private currencies?” His book, For a New Liberty: The Libertarian Manifesto offered an explanation. “If the government and only the government had had a monopoly of the shoe manufacturing and retailing business, how would most of the public treat the libertarian who now came along to advocate that the government get out of the shoe business and throw it open to private enterprise?” Rothbard predicted they would attack the libertarian with outrage for depriving them of the only possible source of shoes. People were thoroughly indoctrinated to believe that government was necessary and daily life could not function without it.

Hayek and Rothbard are unusual among economists in that they embrace private money. Even free market zealots rarely champion free market currencies and private banking. Instead, they debate marginal issues such as fractional reserve banking which amounts to a trivial reform. Or they argue for the need to restore a gold standard. But if the gold standard is applied to existing fiat, then it means trusting governments and banks to be transparent; it means trusting them to act directly against their own interests, which they have historically refused to do. The trusted third party problem remains untouched and it is the root of all other corruption, including currency manipulation. An inherently corrupt institution cannot be reformed; it must be swept away or totally avoided.

What could convince the public and economists that private currencies work as well or better than government issued ones? One way is to point out that they already have worked better by providing real examples from the past and drawing parallels to cryptocurrencies.

America is Born into Private Currency
Early America offers powerful lessons about private currencies.

The British colonies naturally used British currency, but the homeland’s monetary policies created an appetite for alternative monies. Rothbard explained in A History of Money and Banking in the United States: The Colonial Era to World War, II (2002), “Great Britain was officially on a silver standard….However, Britain also coined gold and maintained a bimetallic standard,,,,In 17th- and 18th-century Britain, the government maintained a mint ratio between gold and silver that consistently overvalued gold and undervalued silver in relation to world market prices.” Great Britain’s policies created a robust market in substitutes for its own money.

Gresham’s law ruled colonial money as it rules all currencies. The law states: if two types of money are valued the same by law even though the market values of one is higher than the other, then the more valuable money will disappear from general circulation and be used for other purposes like hoarding or foreign trade. That is the meaning of the phrase “bad money drives out good.” Full-bodied silver coins began to disappear from circulation within the colonies, which turned to lighter silver, commodity-based money such as cotton or foreign and privately minted coins. These monies were parallel currencies with Spanish pieces of eight being particularly popular.

The first privately-minted American coin was the Granby or Higley Token that was struck by Dr. Samuel Higley of Connecticut in 1737. Samuel died shortly thereafter and his brother, John Higley, produced the copper coins from 1737 to 1739 inclusive. Valuing the tokens at three pence each, John is said to have spent most of them at the local bar until the barkeep refused to accept any more. Then he cast coins with one side reading “Value Me as You Please” and the other side stating “I Am Good Copper.” No value was stamped on the coin, which was common practice in those days. The coins circulated widely for many years even after John ceased minting largely because goldsmiths used them as a reliable alloy with which to make gold jewelry. Later metallurgical analysis of the Granby found the coins to be 98-99% pure copper.

The Granby benefited from what the Austrian economics icon Ludwig von Mises (1881-1973) called the Regression Theorem. In The Theory of Money and Credit, Mises wrote, “The theory of the value of money as such can trace back the objective exchange value of money only to that point where it ceases to be the value of money and becomes merely the value of a commodity.”

Economics Professor Jeffrey Rogers unpacked the concept. Today’s purchasing power of money “draws on yesterday’s, and yesterday’s…and so on….How far back does the regression…go?….[L]ogically, Mises explained, for a commodity money it goes back to the day before the commodity first started being used as a medium of exchange. On that day it had an exchange value or purchasing power due only… as an ordinary commodity (for consumption or for use as a productive input) and not for use as a medium of exchange. For…the U.S. dollar that became a fiat money by terminating the redeemability of what had been a claim to a commodity money…the historical chain goes back to the day before termination, and thence back to the day before that commodity became a medium of exchange. Application of the logic to a new fiat money,” is with reference to the official rate of redemption for an established fiat money.

In short, the value of a money is a composite of the demand for it as a medium of exchange and the demand for it as a commodity.

Bitcoin’s relationship to the Regression Theorem is important since critics often dismiss cryptocurrencies as money or currency because they violate the theorem. Most bitcoin enthusiasts react in one of three ways: they don’t care; they claim the theorem does not apply to the digital age; they insist it does apply to bitcoin, but in a misunderstood manner.

The economist Robert P. Murphy explained how bitcoin emerged as a medium of exchange without being tied to a commodity or redeemable in a fixed amount to an established fiat. The article “Why Misesians Need to Tread Cautiously When Disparaging Bitcoin” argued, “[T]he very first people to trade for it did so because it provided them with direct utility because they knew there was at least a chance that it would serve to chafe the governments of the world….[T]he early adopters of Bitcoin were doing it for ideological reasons, not for pecuniary reasons.” The ideology and the freedom it provided were the ‘commodity’ value of bitcoin‘.

Bitcoin enthusiast Jeffrey A. Tucker took a different tack. In a Foundation for Economic Education article entitled “What Gave Bitcoin Its Value?,” he pointed to the purpose Mises’s theorem served; it helped answer the question of why certain commodities emerged as currencies while others did not. Tucker ascribed the emergence of salt rather than gravel, as a currency to a widespread desire for salt and its direct utility.

Tucker then linked bitcoin not to a hard good but to a hard service which fills a deep need and has direct utility: the blockchain as a payment system. “Bitcoin is both a payment system and a money. The payment system is the source of [non-monetary] value, while the accounting unit merely expresses that value in terms of price. The unity of money and payment is its most unusual feature, and the one that most commentators have had trouble wrapping their heads around….This wedge between money and payment has always been with us, except for the case of physical proximity. If I give you a dollar for your pizza slice, there is no third party. But payment systems, third parties, and trust relationships become necessary once you leave geographic proximity. That’s when companies like Visa and institutions like banks become indispensable.”

The non-monetary worth of bitcoin resides in its payment system that does not require a trusted third party and, yet, has no geographical limitations. Otherwise stated, for Tucker the blockchain is the independent root with intrinsic value from which bitcoin as a medium of exchange emerged. The Regression Theorem applies to bitcoin, but it needs to be expanded to include services in order for the theorem to fit the digital age.

The private currencies of early America offer many such lessons. The history of the NYC goldsmith and silversmith Ephraim Brasher (1744-1828), for example, demonstrates a means by which privately-minted coins circulated widely through the colonies without being restrained by doubts about their purity and weight. Many private minters had reputations within their own communities but circulation was often limited to those communities. Brasher offered a solution. He became renowned for testing coins upon which he stamped “EB” if they were sound. Backed by his reputation, coins migrated far and wide.

The need for minters to be of good reputation highlights an advantage bitcoin has as a currency. It sidesteps the entire issue of the verification of purity or weight. Unlike physical coins, bitcoins cannot be shaved down, counterfeited, diluted by alloys or negated by the reputation of miners who release them or of users who exchange them. A bitcoin is a bitcoin is a bitcoin and no one can alter that fact. But cryptocurrencies do compete with each other for acceptance. Reputation is important to the competition and it is established largely by feedback from the Internet-connected community.

[To be continued next day]