What is Bitcoin Part I: The Fundamental Problem It Solves

What is Bitcoin? What is it for? What problem does it solve? What is this “cryptocurrency” anyway? And why does humanity care about something like this? Thirteen years after its creation, Bitcoin (and along with it, other cryptocurrencies) remains a mystery to the average person. Even many specialists and experts in the fields of computer science, economics, and finance do not understand its meaning and function. In this and the next few materials from EKIP, we will try to fix this and explain what Bitcoin is and why humanity needs it.

The case of trust in economic relations

One of the fundamental problems in economics is that of trust. And it makes sense that it should be so. Economic relations are always and everywhere interpersonal relations. And in interpersonal relations, trust is always of utmost importance, even when economic considerations do not play any role. Each of us has at least one bitter experience from our personal lives that emphasizes the importance of trust and the “price” we can pay for misplaced trust. In economic relations, this “price” is not just a metaphor for emotional pain – it always has material dimensions.

Any exchange of goods and services requires trust on both sides of the transaction – the buyer and the seller. When Peter and Todor exchange two goods, say tomatoes for shoes, Peter trusts Todor that the shoes are not torn, and Todor trusts Peter that the tomatoes are not spoiled. This is a very simple example in which the quality of the goods being exchanged can be verified relatively easily. But this is not the case for many other goods and services.

With money (and more specifically, the goods that serve as money), trust has always been of utmost importance. Have you ever heard economists talk about the “trust” of the markets in a given currency? Have you ever read the writings of historians about any of the historical episodes in which a given population “lost trust” in the local currency and this caused hyperinflation? With money, trust is everything. Without trust, money has no exchange value. And without exchange value, there is no more money – complete devaluation, currency collapse, hyperinflation.

How to ensure trust in money? Historically, the most successful form of money has been gold, silver, and copper coins minted by certain private or government institutions. Banks, states, and artisans minted coins of standardized weights. This is what was called “currency.” A French “franc,” an English “pound,” or an American “dollar” is simply a coin that corresponds to a certain weight of gold of a certain purity of the metal.

People trusted these currencies because they were minted by respected institutions. That is, the trust that people have in the respective institutions is transferred to the currencies that they issue. Complete strangers from different nations, speaking different languages, practicing different religions, exchange goods and services with each other, using one of these currencies as a medium of exchange, i.e. for money. Not because they trust each other, but because they trust the institution that issued the currency they use.

At this point, the key role of currencies as standardized money with a clearly defined value, which historically has most often been expressed in a given amount of precious metal of a certain purity, is clear. Without the existence of such currencies, the value of which is guaranteed by the reputation of institutions known to all, trade outside the narrowest circles of acquaintance is at best extremely difficult, if not impossible. They are the “lubricant” of the wheels of the economic machine. They do not completely eliminate the need for trust between market agents trading with each other, but they transfer the burden of this trust to a third party – the issuer of the currency. And this greatly facilitates economic relations.

The fundamental problem of monetary systems

Such a monetary system works, and can even work very well, but it still suffers from some significant problems. The fundamental problem is that the need for trust is simply transferred to a third party, who becomes an implicit participant in every economic transaction. With the widespread use of currencies issued in such a centralized manner by a single institution – private or public – no exchange of economic value takes place entirely “peer-to-peer”, i.e. only between the relevant parties who wish to exchange something.

Even when you use cash, there is an implicit third party in the transaction – the institution that issued the cash. In the case of modern fiat currencies and their corresponding banknotes, this is the government’s central bank. In its role as issuer, the institution in question has an extremely centralized power. It can prohibit the use of the currency it issues for transactions involving certain goods, such as marijuana or some other drug. It can also prohibit its currency from being used in transactions with certain individuals.

It can also cheat those who use its currency by secretly devaluing it (the original meaning of the term “inflation”). Especially if the currency is in widespread use (as any government currency is), by issuing new units of it that it uses for its own purposes, the issuer can effectively transfer economic value from others to itself. The issuer creates a new quantity of the currency, uses it for its own purposes, and this increases demand in the economy and begins to cause inflation. First in terms of the goods and services that the issuer has purchased with the new quantity of currency, then in terms of the goods and services that are consumed by those who sold the original goods and services to the issuer.

This creates a chain process of inflation, with the prices of more and more goods and services rising at each step along the chain. Those who are last in this chain are the most damaged, because by the time the new money reaches them, inflation has already passed through almost the entire economy - without them. And so it has eroded their purchasing power - what is expressed in the value of the money we use. This is a hidden forced transfer of economic value - from the last in the inflation chain to the first. Tax inflation.

The risk of such an inflationary redistribution of value has reached its historic peak today. The standardization that historically dominated currencies is completely absent. Today, no currency in the world is standardized to a certain amount of precious metal or any commodity. The lack of such a standard means that there is no limit to the extent to which the issuer can devalue the currency through inflation. The mandates that are supposed to limit monetary excesses have proven to not work. It is enough to simply look at what is happening to the size of central bank balance sheets since 2008. At the same time, the issuance of money is completely monopolized in these centralized institutions, which means that there is no market competition, no alternative. Which means that there is no mechanism that could limit the depreciation of the currencies they issue.

Money in the digital age

Moreover, nowadays most economic transactions are electronic, especially when it comes to large amounts. In many ways, the electronic method of payment is more convenient. In other ways, however, it is also more dangerous. For the issuer, controlling electronic transactions is much easier than physical ones. When the issuer wants to impose restrictions on the use of cash currency, it encounters certain purely practical problems. Once the money is already in the pockets of the relevant parties who want to carry out a given transaction, even if it is completely illegal and prohibited by the issuer, it is very difficult to thwart it.

When transactions are electronic, however, they pass through systems that the issuer can monitor very easily by computer. The centralized institutions that offer electronic payment methods – banks and companies like PayPal and ePay – monitor and record every single transaction that goes through their systems. What is the value of the transaction? What is it for? By whom? These companies know all this. The state also requires and is given access to this information. And if either the state or the companies themselves that offer these services do not like who and how is using their payment systems – they can block it. In the era of mass electronic payments, the concentration of economic power in the hands of private and public state institutions is greater than ever.

Now imagine that all of this could be turned upside down. Imagine that the monopoly could be broken up. Imagine that the centralization of power could be fragmented, decentralized. Imagine that it was possible to have electronic transactions without them being under the control of a totalitarian state-finance-technological leviathan. Imagine that you could exchange economic value with anyone you wanted, anywhere in the world, at any time, electronically without the transaction having to be subject to the control of a third, centralized institution. Imagine that the need for “trust” in economic transactions was completely eliminated because there was a decentralized system in which it was guaranteed by definition, built into the very foundation of its functioning.

Such a system and currency already exist. The system is blockchain, and the currency is bitcoin. In this introduction, you were introduced to the fundamental problem that bitcoin solves. A problem that has plagued human civilization since its inception. There is nothing unusual in the explicitly technological approach to solving this economic problem. As it became clear, the fundamental problem – how to pay each other (especially at a distance) without the need for an (implicit) intermediary – is technological.

The production of money itself has always been a technological case. It is logical that today, at the dawn of the digital era of human civilization, digital money is invented, just as at the dawn of the Iron Age in the kingdom of Lydia in Asia Minor, the minting of coins with standardized purity and weight of the precious metal was invented. The invention of such coins solved the problem of the lack of standardization in the means of payment (money) and the difficult verification of their value. Later, in the 7th century AD, in China during the Tang dynasty, another technological problem appeared - payment in metal coins for very large transactions, especially in long-distance trade, turned out to be very impractical due to the weight and more difficult portability of the metal. Therefore, in response to the needs of the empire's vast trade network, the first paper banknotes were invented, which were more portable and more flexible in their denomination, thus significantly facilitating large transactions.

In the next parts of this series, we will move from the “big picture” of the problems that Bitcoin is trying to solve to the specific details of how it works. You will learn HOW exactly Bitcoin works and why it has any value and application at all. We will start by explaining what cryptography is and the key role it plays in cryptocurrencies.

Finally, I would like to congratulate you. You are fortunate to be living in one of the most important and I would say revolutionary moments in the history of human civilization. Bitcoin will forever change the way money works. In the future, historians will mark the years we are now living in as some of the most important in our economic history. And they will wonder if we were aware of the monumentality of what is happening around us.

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