Every day we hear about contemporary, serious concepts (e.g., chained CPI) and new, silly fads (Vadering), but in the modern age it’s not always easy to tell which category a new idea falls into. Take, for instance, Bitcoin. As Jordan Ballor wrote yesterday,

bitcoinIt is certainly a phenomenon worth greater attention, and something of significant cultural, social and economic import. But I’m not buying Bitcoin, at least not yet.

My initial skepticism is in part due to my lack of familiarity with the details of the currency and its formation. I certainly need to learn more.

Many of us are in the same situation as Jordan. We recognize that Bitcoin is a significant phenomenon but need to become more familiar in order to develop an informed opinion and be able to “think Christianly” about it’s value and implications. While Bitcoin is not a topic every Christian should know something about (at least not yet), it does overlap with many subject areas of particular interest for Acton PowerBlog readers: business, technology, regulation, ethics, etc. For that reason, I thought it might be helpful to write a series on Bitcoin for Christians.

Over a series of three posts I’ll provide some background information on Bitcoin, explain how it works, and consider some of the reasons why Christians need to develop an informed opinion about the cryptocurrency. The purpose of these posts is not to tell you what to think about Bitcoin (though I have begun to form my own opinion) but merely to provide information that will help you to develop an informed opinion of your own.

We should start with the question “What is Bitcoin?” but before we can answer that we need to consider a more fundamental question, “What is money?” And that question brings us to the story of the rai of Yap.

What Yap Can Teach Us About Bitcoin

In the Caroline Islands of the western Pacific Ocean there is an island called Yap that can help answer the question, “What is money?” For centuries the island had neither paper currency, nor metals such as gold, silver, or copper to use for minting coins. Instead, the islanders used limestone, which they had discovered on another island four hundred miles away. Because this stone was the most beautiful and precious commodity in the area, they made it their money.

Laborers would travel to that distant island to carve thick stone wheels called rai which range in height from one to twelve feet. At their center a hole would be cut so that a pole could be inserted for transport. Even with this change, though, the stones were too big and bulky to be carried to the local market. Instead, when payment was made, everyone would simply acknowledge that the rai belonged to the new owner and the stone would remain on the former owner’s premises.

One time a work crew was transporting a giant stone coin back to Yap on a raft and was met by a violent storm. To save their own lives, the workers dumped the stone into the ocean. As anthropologist William Henry Furness III wrote in 1910:

rei-of-yapWhen they reached home, they all testified that the [rai] was of magnificent proportions and of extraordinary quality, and that it was lost through no fault of the owner. Thereupon it was universally conceded in their simple faith that the mere accident of its loss was too trifling to mention, and that a few hundred feet of water off shore ought not to affect its marketable value, since it was all chipped out in proper form. The purchasing power of that stone remains, therefore, as valid as if it were leaning visibly against the side of the owner’s house.

The concept of considering a stone on the bottom of the ocean—a stone that few people have ever seen—as a legitimate currency might seem absurd. But as the late economist Milton Friedman has noted, this story isn’t as unusual as it might sound. For instance, when the United States was on the gold standard, the Bank of France asked the Federal Reserve of New York to convert its dollar assets to gold.

Rather than ship the gold across the Atlantic Ocean, the Federal Reserve requested that the gold remain in the Bank of France’s accounts. The French bankers went into their gold vaults and changed the labels to mark the gold as the property of France. After the relabeling, everyone involved considered the U.S. currency owned by the French, to be sufficiently backed by gold.

Both the stones of Yap and the gold in France reveal, says Milton, how much unquestioned belief is necessary in monetary matters. Such unquestioned belief is also at the heart of one of the day’s most intriguing stories. It’s a tale of how thousands of hackers, druggies, entrepreneurs, libertarians, privacy-nuts, and techno-anarchists developed the world’s first online decentralized currency. It’s the story of Bitcoin.

What is Bitcoin? (The Short Version)

Bitcoin is network-based digital currency that is created and exchanged electronically. Although the currency exists entirely online, it can be used to purchase non-virtual goods and services. Because it is a purely peer-to-peer version of electronic cash, Bitcoin allows online payments to be sent directly from one party to another without going through a financial institution.

What is Bitcoin? (The Detailed Version)

The founder of the world’s most successful cryptocurrency has a name but no identity. In 2009, a computer programmer using the pseudonym Satoshi Nakamoto (Satoshi means “reason” in Japanese) self-published a nine-page paper explaining how a digital currency could be created that would eliminate the need for centralized third-party financial institutions.

In most forms of ecommerce, a third-party acts as a mediator between the buyer and the seller for the purpose of electronic funds transfer. This mediation not only increases the transaction costs but the ability to reverse the payments allows the financial institution to have the last word on any transaction. Although this function is necessary for the current trust-based system of online commerce, it conflicts with a core value of the super-secretive Nakamoto: absolute privacy. As Nakamoto explains:

With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party.

What is needed, according to Nakamoto, is an electronic payment system based not on trust but on cryptographic proof. Such a system would allow “any two willing parties to transact directly with each other without the need for a trusted third party.” Without a third-party mediator, the buyer and seller could remain completely anonymous, exchanging goods and services without having to disclose any private information about each other.

The problem with such an approach is that with most digital cash schemes, it is possible to spend a single digital token twice. Unlike physical token money such as coins, the act of spending a digital coin does not remove its data from the ownership of the original holder. Another means is needed to prevent double-spending. Nakamoto’s ingenious solution to the double-spending problem was to use a proof-of-work system as both an initial currency distribution mechanism and a measurement against double-spending.

Proof-of-work (POW) systems were originally designed by computer scientists as a means of preventing network service abuses, such as spam or denial-of-service attacks. The system requires evidence that some time-bound function has been completed (generally solving a computation that requires processing time by a computer) before access to the network will be granted. In 1999, computer scientist Hal Finney developed the concept of the “bread pudding protocol.” Just as stale bread can be repurposed to create a new foodstuff (e.g., bread pudding), a POW solution can be repurposed for other uses, including the creation of a digital token. Such repurposed POWs—or RPOWs—form the basis of cryptographic proof for Nakamoto’s Bitcoin system. Bread pudding isn’t the most inspiring metaphor for a currency, though, so the users of Bitcoin refer to the creation of new currency as “mining.”

In part 2 of this series we’ll look at how Bitcoin works, why they are valued, and their advantages. In part 3 we’ll consider the disadvantages of Bitcoin, it’s future, and why it should matter (to everyone, but specifically to Christians).