Cryptocurrencies are interesting. An understanding of cryptocurrencies, and the underlying blockchain technology, can give you a wider understanding of economics, politics, technology, and even history. It is important to understand the fundamentals of what might prove to be an important technology. 

In late 2008 the person(s) known as Satoshi Nakamoto announced a ‘peer-to-peer version of electronic cash’. The software uses a combination of peer-to-peer networking, asymmetric (public-key) cryptography, consensus algorithms and game theory to create a new type of private currency. Prior to the innovations of Bitcoin, digital currencies suffered from a trust issue. How can users be sure that a unit of digital currency has not been spent, simultaneously, in more than one transaction? 

The big problem Bitcoin solved was the ‘double spend’ problem; preventing users from spending a unit of digital currency twice. By placing all transactions on a public ledger, users can see that any bitcoin sent has not been already spent. In addition, Bitcoin uses a mix of incentives to align the self-interest of its users. Bitcoin rewards users for maintaining the validity of the public ledger upon which all transactions are visible; ‘miners’ are rewarded with a ‘coinbase’ transaction. It is not worthwhile for users to compromise the network; any benefit they gain from doing so is outweighed by the value of the bitcoin they would have to give up to do so.

The system of incentives just described is an application of game theory, a mathematical framework that has many economic applications. Game theory examines rational actors in their strategic interactions. It examines how rational individuals will react in situations when all players in a ‘game’ are constantly evaluating each other’s strategies, and constantly responding to them. Game theory leads to sometimes terrifying insights. During the Cold War, a theory of deterrence – Mutually Assured Destruction (MAD) – helped convince the USA and USSR to develop increasingly large nuclear arsenals. According to this deterrence theory, rational actors want to avoid nuclear war. To avoid nuclear war they will continue to deploy a bigger nuclear arsenal. Game theory told them the bigger their stockpile of civilization-ending weapons, the less likely their opponent will risk an all-out conflict that will result in their own annihilation.

Bitcoin also allows us to examine fundamental questions about the nature of money. As students of economics know, money itself is not a valuable resource. Money is not wealth, but a measure of wealth. The nature of money has seen it issued and controlled by governments for at least the last century. The rationale for this includes the need to maintain the value of the currency (price stability) and to conduct monetary policy. For instance having a monopoly in money issuance allows a nation’s central bank to increase the money supply – decreasing interest rates – and stabilising levels of economic growth and employment during a downturn. However critics of this monopoly of the issue of money have argued private currencies might replace government currencies. Advocates of cryptocurrencies maintain they might soon take the place of fiat currencies.

Yet a fiat currency might make more sense if we consider ‘transaction costs’. These include costs not included in the sale price of a good. If I purchase a used car, I will pay the dollar cost of that purchase. Yet I also incur costs associated with searching for a suitable used car, evaluating its quality, negotiating the price, as well as resolving any disputes that might arise. Depending on the nature of the transaction, these transaction costs can be substantial. A big advantage of a fiat currency is that I am not constantly seeking out trading partners who accept Bergcoin. If my preferred currency is one of many in the economy, I am limited to trading with those who accept that coin. This might significantly limit economic activity. What the many cryptocurrencies available today demonstrate are the ‘network effects’ associated with a currency; the more people who use a currency, the more useful it is for me. The problem with Bitcoin currently is that very few people accept it in trade. Thus limiting its usefulness as a currency because the transaction costs are too high.

Cryptocurrencies and their underlying technology have far more potential applications than those I have alluded to here. Innovators in finance, logistics, gaming, and other industries are developing exciting new applications. Yet the interesting lessons they can teach us are those related to economics, politics, technology, and history.