Saturday, 27 March 2021

Bitcoin and trust: how cryptocurrencies are "backed" by the government

If you ask most people what the £ is backed by, they will say "gold". There is a belief that somewhere, in the Bank of England, there is this huge vault of gold bars that you could exchange your hard-earned cash for. What gives money value, is not a question that most people really think about. That is until recently, with the advent of Bitcoin. 

The £, like the majority of global currencies, is a fiat currency, which means it is not backed by a commodity like gold but is government-issued. You could interpret this as being "backed" by the government, as people will accept £s as payment because you can always pay your taxes in it. What this effectively means, however, is that fiat rests on one important aspect: trust.

Many Bitcoins proponents will say that because it is backed by blockchain technology (a type of transparent ledger) it is backed by something immutable. As a result, we can trust Bitcoin more than any government. 

The problem is, for Bitcoin to actually work effectively, we still need to trust the government. Let's say you have some Bitcoin burning a hole in your virtual pocket and you decide to buy a Tesla. You send over your hard-mined, virtual cash and wait for delivery. But it never arrives. You send an angry e-mail to HR and no one gets back to you. You tweet at Elon Musk but he just tweets back: "lol n00b". At this point, you are understandably irritated and you decide to take Tesla to court. 

But wait a minute, what is forcing Tesla to make good on its promise? "Well, you will quite rightly say, "it's the law, it was a legal transaction that the seller failed to oblige by". But who is enforcing that law, what gives the law, value? Just because it is the law, doesn't mean it will necessarily be enforced.*

So in order for this transaction to go smoothly with Bitcoin, you need to have trust. Trust in the fact that the government will enforce your contract (this is technically what a purchase is) and also protect your property. Although some libertarians will argue that you can get around this in all sorts of ways, I am unsure if many people will be comfortable going down this route, even if hiring goons to beat-up Elon is an attractive prospect.**

Put simply, if you can't trust a government to behave responsibly with its currency, then it's unlikely you are going to be able to trust the government - in many other ways - in order for us to use a currency of any kind. This is why making governments trustworthy is so important and why we have mechanisms such as democracy to instil that trust. 

If we have that trust in fiat currency, it has the added bonus of central banks are able to have greater control over the booms and busts of the economy (I think this another aspect of monetary systems that most people are not really aware of). Also, Fiat currency doesn't have the issue of Bitcoin, which is that is inherently deflationary. As it gets harder and harder to mine Bitcoins it puts a limit on supply, as the value of Bitcoin increases people will want to hold on to them rather than use them to purchase stuff. What happens as a response is that sellers lower prices, which just makes Bitcoins more valuable and the spiral continues. This is one reason why a feature of a good currency is that it is stable over time. 

Bitcoin also has the feature that it is untraceable.*** If you are living under nefarious government, then this would be something we would think is desirable. But is it really a good feature if the government is somewhat trustworthy? I can understand in some countries this would be beneficial, perhaps if you were raising money for a protest against a corrupt government, for example. However, all this lets us do under a trustworthy government is things we as a society have deemed we don't want, like buying a bag of weed, tax evasion or hiring a hitman. 

If Bitcoin really became a serious candidate to replace fiat currency then you can see why governments would want to do something about it. However, even at the level it is operating at now, the amount of carbon it is producing (from all computational power needed to mine Bitcoin) is a serious cause for concern. This doesn't mean that certain types of research related to blockchain technology has to stop, but it would mean effectively having to ban cryptocurrencies (this is in fact what India have done).

So how would you ban Bitcoin? I am told from a legal expert friend that the high court in the UK has recently declared Bitcoin to be property, so in effect, you could ban owning it like we do with illegal substances. However, this has not yet been upheld by the Court of Appeal or UKSC.

Alternatively, you could make it illegal to mine bitcoins. This may be quite difficult to catch anyone doing it, but that's not the point. What it means is that if you buy something with bitcoin, and they don't fulfil your promise, you can't take them to court. The irony of all this is that if you were then to buy something with Bitcoin, you would have to trust the seller.


*The fancy Winnie the pooh terms here are De Jure and  De Facto

**Although you may have to hire more goons, in order to beat up the goons that were meant to beat up Elon, if they didn't fulfil their contract).

***As it is an open ledger system potentially a government could force people to register their private wallets, which would sort out some of these issues.

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