When the idea of bitcoin was being put to paper, its author – Satoshi Nakamoto – wanted the mining of this cryptocurrency to simulate the mining of precious metals like gold. This is done by giving a reward of a certain amount of bitcoins to the miner who confirms a block. If this terminology sounds confusing, please see our intro to blockchain post.
In the beginning, the reward was 50 BTC. Every 210,000 blocks, the reward would become half the previous amount. This event is called the halving. After 64 halvings, the reward is programmed to be zero. If a block is mined every 10 minutes, it is calculable that the last of the 21 million bitcoins will be mined in 2140.
Comparison to Gold
Back in the 1800s, the gold rush started very rapidly. The mining was happening through generations and generations, however. This prevented the accumulation of enormous amounts of gold with certain individuals, and stopped a too early or too quick rise in price. This resulted in less HODL mentality (the mentality of not spending and waiting for the value to rise). In fact, most of the gold diggers from the early days immediately spent their gold – they needed land, tools for more digging, food, horses, gambled, drank a lot, etc. Gold was not a currency in and of itself. The real currency were the bonds, the IOUs that banks gave out to individuals in exchange for keeping their gold safe, as we've already mentioned in the cryptocurrency intro post.
As more and more gold was dug out and more and more governments started to stockpile it as a national reserve, less and less gold was available in the open market, thus increasing the price with the rising demand. A new gold vein find is incredibly rare these days and the amounts being mined are trivial compared to those from the early days – a situation comparable to how the bitcoin landscape could look in 2100.
The “work” that's a parallel to the hard work of mining the gold from an underground cave or filtering it out of a river is the “proof of work” concept we explained in the blockchain post – the process of performing thousands upon thousands of calculations by spending enormous amounts of electricity in order to seal a block. This is how Satoshi intended to inherently compare the two systems (gold and bitcoin):
- finite amount (new gold is not being created, only found, and the amount we'll ever find is limited)
- harder and harder to mine (calculations becoming ever more complex, and more computing power is required)
- increasingly smaller rewards
- increasingly more valuable rewards
Simulating precious metals as a means of preventing inflation in this new system of digital currency was a fundamentally good idea. However, the explosive initial growth (a theoretical maximum of 21 million coins and simply giving away thousands in the beginning) was an elementary mistake. The first miners didn't find minted gold bars in an open meadow, ripe for just picking them up and taking them to a bank. They still needed to work for them. The exponential growth of the financial complexity involved in obtaining bitcoin (increase in price, electricity demands, special chips called ASIC without which mining makes no sense these days, etc.) practically guaranteed the forming of a new 1% class. Those who now have even just one bitcoin already have more than the vast majority of people in the world will ever have, once the technology reaches the undeveloped third world countries. Why? Not because of bitcoin's rarity or its price increase, but because it's not finite in the true sense of the word.
“What do you mean?”, you may be thinking. “What about the 21 million mark?”
Every bitcoin in existence is currently split into 100 million parts. Think of them like cents to the dollar, only going into 100 million, not just 100 parts. One such part is called a Satoshi, after bitcoin's creator. But, just like the halving itself, this fragmentation is programmed into the code of bitcoin. The miners – the programs running the bitcoin blockchain and confirming transactions – are those in charge of enforcing those code rules. The amount of bitcoin in the world will soon start decreasing. People will lose their private keys and lose access to their wallets forever, they'll send money to the wrong address that doesn't belong to anyone, governments and corporations will stockpile it instead of spending, etc. Because of this deflationary nature (among other factors), the value of bitcoin is going up over time and will eventually reach the level at which even a single Satoshi will be too valuable to transact with. What then?
All we need to do to switch bitcoin from a deflationary into an inflationary currency or to move in the other direction and just split Satoshis further into even smaller parts is change the source code. If enough miners (the 51% majority) agree to activate this new software instead of the old one, this can happen. There is no central authority to veto the decision, there is no one to say “no, that's not bitcoin's original vision”, other than the miners. This is when a so called hard fork happens: the splitting of bitcoin into two branches.
One branch will keep mining with the old, original software, but the other will adopt the new rules and claim that these controversial changes are needed in order for the currency to continue working. A similar thing happened recently – perhaps you've heard of two types of bitcoin existing now: Bitcoin Cash and Bitcoin Core. We'll talk about this split in another post.
But a majority (51%) is a huge number, isn't it? Surely it's not possible? Well, yes, 51% is more computing power and electricity than a single person can imagine. But if we take into account that China currently has over 70% of the bitcoin mining power and that Russia is handing out surplus electricity for state sponsored mining, the danger of them joining forces and just deciding that no more bitcoin halvings will happen is very, very real.
What we're basically saying here is that anything that can be split into an infinite number of smaller parts is not finite. “But gold can also be split into smaller flakes, and a gram of gold is now worth as much as a kilogram used to be!”, sceptics of this theory will often claim. That's true, but the splitting of gold stops at an atom. Even if we reach the point at which an atom of gold is worth as much as a gram is today, we can't go smaller than that. Gold really is finite, because the amount of splitting we can do is finite. Don't you think governments would split gold into infinitely smaller parts to inflate the value and make their stockpile seem more valuable if this were possible? Those who hold even a miniscule amount of gold would, in such a case, become richer by a factor of X, if X is the difference in value between the newest smallest part and the oldest smallest part's value.
Anything that can be split into an infinite number of smaller parts, the value of which can then be inflated, is not finite.
The situation in which a currency keeps increasing in relative value when compared to the goods one can purchase for it is called a deflationary spiral.
When this happens, all the users of said currency are inherently encouraged to save and stockpile it because the chances of the currency doubling in value in a short timespan are great. If there's a chance for you to get a car for 1 bitcoin today, or two cars for one bitcoin next week, you certainly won't spend the bitcoin, will you? The Austrian school of thought is an economic opinion which states that a deflationary spiral cannot happen or won't have a major effect because as the value of a currency starts rising uncontrollably, the cost of production for goods will proportionately drop, keeping profit margins the same across time. A followup theory states that due to this system implicitly causing lower interest rates due to encouraged saving, savers will instead be encouraged to invest into businesses and ventures, keeping the economy healthy. Bitcoin maximalists (bitcoin users who refuse to accept the downsides of bitcoin) will often list these arguments in defense of the currency. Here's why it's folly.
When the value of a currency rises relative to the price of goods we can buy for it, the users of that currency are inherently encouraged to only stockpile it and spend only the bare minimum they need to survive or invest. Furthermore, claiming that costs of production will drop proportionately to the rise of the value of a digital currency with a limit of 21 million on a planet of 8 billion is nonsense. There is no conceivable scenario in which the production of, for example, food will drop as much as bitcoin is rising, even with full automation of production.
And finally, it's worth realizing the biggest problem of all: in its attempt to bring us a decentralized currency, bitcoin caused an unbalance the likes of which we've never seen before. Let's re-iterate:
Those who currently own even 1 BTC have more than 99% of humanity will ever have when (and if) this technology reaches the most undeveloped of countries.
How do we solve this? Do you think this is a problem? If so, how do we proceed and make the best of it? Let us know in the comments!