The digital currency Bitcoin has not only attracted a lot of interest from investors, but it has raised some intriguing economic and financial questions. Economists and other theorists have long grappled with problems such as inflation, counterfeiting or money laundering. When we are talking about money in a digital world, however, we may have specific problems like scarcity and trust issues.
Bitcoin is based on the underlying block chain technology (see this explainer). Each time a user discovers a new block, a Bitcoin is created and an algorithm defines how currency will be created and at what rate. The number of Bitcoins in existence will not fall under 21 million, and the monetary base of bitcoins cannot be expanded If not limited in this way, the currency may become subject to severe deflation.
According to the Austrian School, deflation occurs in all of stages of production. Although Austrian economists may differ in their understanding, one view holds that deflation may be beneficial because profit ratios tend to stay the same and only their magnitude changes. And this may encourage entrepreneurs to invest in long-term projects.
Double spending is a problem unique to digital currencies The risk is that the owner of the currency could spend the same digital coins more than once.
This problem was solved in the following way: Each unit of Bitcoin is unique, that is, when a Bitcoin is transferred, the person that sent it no longer possesses the currency and does not retain any copy of it. The one who receives the coin becomes the possessor of that unit. Bitcoin uses a process called “proof of work,” which does not use a central authority to maintain transaction history. The various nodes of the network follow the same protocol to validate the transactions and work in consensus. After this process the data are stored in a public database that is also called a blockchain. Anyone can look at the online ledger to verify who owns any particular Bitcoin.
Scarcity in the digital world
To solve the problem of double-spending, in the digital environment, we wind up with a condition that already existed in the physical monetary system — scarcity. In the digital world scarcity is the ability to create something that cannot be duplicated.
The Byzantine Generals
The problem of the Byzantine Generals was proposed by Lamport, Robert and Pease (1982) who demonstrated a hypothetical situation where several divisions of the historical Byzantine army were camped outside an enemy city and each division is commanded by its own general, who can only communicate with each other through a messenger. They need to decide on a common plan of action, but some of the generals may be traitors trying to prevent loyal generals from reaching agreement. To succeed, generals must have an algorithm to ensure that all who are loyal take the same decision. At the same time, they must prevent traitor generals from influencing loyalists to make a bad decision, since the search for trust is the main issue. This problem with Bitcoin has been solved by mining because the process validates transactions and therefore creates a solid network of trust.
This problem was resolved also with the algorithm of the Byzantine generals. That’s because if the someone makes fake coins, they will not be accepted by anyone in the network. Bitcoins are entries in a ledger that everyone may inspect, so if anyone tries create a new coin, the network will know it.
This is not a problem of technology, but of human character.
In digital currencies, technologies exist to minimize money laundering including ChainAnalysis. Another way is to monitor how owners of digital currencies convert their assets in cash at banks.
Ultimately, the process of creating money in Bitcoin means you have created a blockchain, and with this you must establish the authenticity of this currency with the network. Your proof of work will check to see if the value you compute matches with predetermined pattern. Without this process you do not have the proof of finishing and your block is invalid. Without a valid block you cannot create a new Bitcoin, and this will be ignored by the entire network.