By Jonathan McQuarrie
Lately, Bitcoins have received considerable attention from the media. The recent failure of the Tokyo-based Mt. Gox exchange, where users could exchange their Bitcoins for national currencies, sparked particular concern. The website managed to lose some 850,000 Bitcoins, which at the time were valued at approximately $400 million. For the last month, proponents of Bitcoins, such as Coinbase founder Fred Ehrasam, have been in damage control mode. Despite the recent bad headlines, they argue, the fundamental technological principles behind Bitcoins are sound. They are fond of noting that during the early days of the internet (back in the dimly remembered 1990s), start-ups and failures abounded. They scoff at naysayers like Warren Buffett, arguing that he does not understand the technology behind Bitcoins.
The system behind Bitcoins is indeed complex, but here is my simplified understanding. The origins go back to a 2008 article by ‘Satoshi Nakamoto’ (widely believed to be a pseudonym), where s/he outlined the development of a ‘peer-to-peer electronic cash system.’ The basic goal is to create a system of exchange where two users can spend Bitcoins with values determined and security protected by other users. When two people make an exchange using Bitcoins, their exchange generates a publicly recorded transaction, designed to ensure that a person does not try to spend the same Bitcoin twice. The public transaction has an associated hash (generated by the cryptographic hash function SHA-2), which presents a mathematical challenge. Users called miners verify the transaction by providing a proof for the mathematical challenge. The hash also provides a means for the miner to demonstrate that their computer resources solved the challenge. The miner adds the verified transaction, called a block, to a chain of blocks that extends back to the beginning of Bitcoins, and receives a portion of the fee charged to the people making the transaction in exchange for their work to create blocks. Miners are also able to create new Bitcoins as a reward for their work in extending the transaction block chains—as the chain is extended, more Bitcoins are issued, though the speed at which this occurs decreases as more Bitcoins enter the system. Decreasing speed is designed to ensure that they remain scarce, which is a fundamental element of almost any currency. Calling people who create transaction blocks ‘miners’ emphasizes the scarcity of currency – deliberately evoking connections to gold (that most recognizable of specie) and impressing that in order to get wealth, one must work.
As the ‘mining’ metaphor suggests, historical analogies have been used for explaining Bitcoin’s potentials and shortcomings. News articles have likened Bitcoins to the Gold Standard, the era of “Wildcat banking” of early to mid-19th century United States, and the stone discs used by the Yap people (today part of Micronesia). These references recall a wide-ranging historical trajectory that impresses how units of commercial exchange depend on the particularities of time and space. Tulips were at the base of an early futures market (and, in the opinion of some scholars, the first futures bubble) after certain variants of the flower became highly desired for fashion. The market boomed and declined in Amsterdam, the economic hub of the mid-17th century. In New France, Intendant Jacques Raudot issued playing cards as bills of exchange, in order to deal with the severe shortage of specie in the colony. In colonial Virginia, tobacco was not only a lucrative cash crop, but also it could even be used as a sort of cash. Given these examples, it seems less surprising that a digital currency, conceived of and traded on the internet, has emerged in our age.
Advocates of Bitcoins oppose centralized control of exchanges, including both state and bank interventions. Nakamoto’s original model emphasized that the new form of exchange would require only the transaction and the participating parties. A video posted on the Bitcoin website shows how an organic farmer in Argentina uses bitcoins as a means to reach customers directly. The farmer, Santiago Zaz, claims that “[p]erhaps this is the most important social tool that we have discovered, because it allows us to work and receive payments in a totally deregulated manner.” In a sense, this sentiment evokes the calls of American Populists during the late 19th century, who blamed both banks and state monetary policy for limiting credit and impeding their access to markets. The fact that Bitcoin chose to promote how they linked to farmers seems significant, as farm production is readily acknowledged to be of tangible value. It grounds the rather ephemeral Bitcoin concept in fruit and vegetables, and harkens back to informal markets of exchange that proliferated in rural areas.
One of the Bitcoin Foundation’s core missions is to create “non-political online money.” This ambition — decoupling currency from state — also has a long history. Most famously, the United States was long reticent about adopting a state-backed currency. Fears that centralized currency would centralize power ran deep in among people vested in Jeffersonian republicanism based in part on local state rights. This anxiety reached its most dramatic act during the ‘Bank War’ of the 1830s between President Andrew Jackson and the patrician head of the Second Bank of America, Nicholas Biddle. Part of Jackson’s success in winning this ‘war’ was his ability to evoke popular sentiment against large centralizing banks, as the Second Bank was becoming. Jackson supported regional banks and specie based currency, decrying the evils of paper money in his Specie Circular. Not until the Civil War did the American government begin issuing federally-backed currency, the greenback. And not until 1913 did they establish a Federal Reserve based on the gold standard and the ‘real bills’ doctrine (basically, the idea that bills should arise from production, inventory financing, and international trade). Persistent criticism of the Federal Reserve, including Milton Friedman’s call to replace the reserve with a mathematical model to oversee the money supply, speaks to the fact that there is nothing inevitable about state regulation of currency.
The Mt. Gox affair also reveals a core problem with any form of exchange: fraud. The media became briefly fascinated with Kolin Burges and Aaron (who never gave his last name), who stood outside the Tokyo headquarters with a direct message: “Mt. Gox Where Is Our Money.” As Stephen Mihm outlines in his brilliant book, A Nation of Counterfeiters: Capitalists, Con Men, and the Making of the United States (Harvard University Press, 2007), currency relies on confidence. The proliferation of counterfeit currency in 19th century America deeply shook that confidence to the point where capitalists and counterfeiters were intimately linked. For this reason, Nakamoto’s original article paid considerable attention to outlining how hash algorithms would prevent a malicious user from capturing the system. Videos that explain how Bitcoin works (like those on Khan Academy) give considerable attention to quelling fears about the fact that Bitcoin transactions are anonymous. For example, no central bank tracks how the money is spent. (The fact that the original inventor of the system remains anonymous likely also contributes to this concern). The cryptographic hash functions — the core means to prevent double spending — are certainly more sophisticated than the voluminous and frequently outdated counterfeiter detectors that 19th century merchants used to try to protect themselves. However, reports on the Mt. Gox collapse considered problems with ‘transaction malleability,’ which referred to people manipulating transaction blocks. Given that unreliable bills contributed to the collapse of a number of U.S. banks during the 19th century, historical examples of the consequences of counterfeiting should provide Bitcoin advocates with some important cautionary material.
A historical perspective on Bitcoins does not provide a particularly powerful guide for predicting the long-term viability of the venture. After all, historians are lousy prognosticators. What it does bring, however, is context, comfort, and caution. The story of counterfeiting and instability during the period following the Bank Wars impresses that Bitcoin advocates will have to make an impressive case for doing away with state oversight. However, there is nothing particularly new about developing a new form of exchange, and there are plenty of examples of means of exchange existing without significant third party oversight. It turns out Bitcoins may be new, but they aren’t radically new.
Jonathan McQuarrie is a PhD Candidate at the Department of History, University of Toronto. He tweets about things historical and not at @jrmcquarrie.