Bitcoin in International Monetary Relations. New Innovation or Old Imperialism?


Diploma Thesis, 2014

43 Pages, Grade: Merit


Excerpt

Contents

Abbreviations

1. Introduction

2. Bitcoin – an Anticipated Evolution of the Currency Space
2.1 Hayek’s Vision of Currency Competition and Bitcoin’s Technology
2.2 Evolution of Currency Space: from Deterritorialisation to Denationalisation
2.3 Anticipated Prerequisites for the Evolution of Digital Alternative Currencies

3. Bitcoin – a New Technological Innovation
3.1 Centralisation as the Failure of Historic Digital Alternative Currencies
3.2 Bitcoin’s Innovation: Cryptography, Open Source, and Decentralisation
3.2.1 Security
3.2.2 Anonymity
3.2.3 Portability
3.2.4 Reliability
3.2.5 Trust
3.2.6 Value
3.2.7 Transactors
3.3 Bitcoin as Largest Digital Currency and Growing Number of Transactors
3.4 Disruptive Market Potential vs. Notions of Ponzi Scheme and Fraud

4. Bitcoin – an Old Imperialist Dynamic of Capital Expansion
4.1 Capital’s Need for Worldwide Expansion
4.2 Bitcoin and Imperialist Capital Flows
4.3 U.S. as a Hegemon for Capital Expansion Technology

5. Conclusion

Bibliography

Abbreviations

ACU Artificial Currency Units

ARPANET Advanced Research Projects Agency Network

CI Currency Internationalisation

CIA Central Intelligence Agency

CPU Central Processing Unit

CS Currency Substitution

ECB European Central Bank

IPE International Political Economy

KYC Know Your Customer

LSE London School of Economics and Political Science

NSA National Security Agency

SHA Secure Hash Algorithm

TOR The Onion Router

1 Introduction

This thesis explores bitcoin, an emerging digital alternative currency and transaction technology, in international monetary relations. Three arguments are made:

Firstly, it is claimed that the evolution of the currency space towards the emergence of digital alternative currencies was a well anticipated phenomenon by the academic literature of International Political Economy. The thesis traces the evolution of international monetary relations back to Friedrich von Hayek’s vision of competing private currencies, and particularly to contributions by IPE scholar Benjamin Cohen. It is argued that Cohen has anticipated the evolution of the currency space from deterritorialisation to denationalisation as fundamentally driven by an ongoing currency competition. Additionally, it is argued that the literature also anticipated the necessary prerequisites for a successful emergence of a digital currency.

Secondly, centralisation is claimed to be the main reason for failures of previous digital currencies while bitcoin’s decentralised technology is seen as fulfilling all those long anticipated but never accomplished prerequisites. It is argued that bitcoin is a new innovative transaction technology providing an economic utility for businesses and consumers by reducing transaction costs. The predominantly negative media coverage of bitcoin as a Ponzi scheme or fraud is addressed as a misunderstanding of the necessary prerequisites anticipated in the literature for the evolution of digital currencies.

Finally, bitcoin’s transaction technology is looked at from a critical geography perspective emphasising how it enables capital to flow in currently impenetrable spaces. This dynamic is understood as a continuation of the old imperialist expansion of capital by innovative technological means. In supporting this process, the United States is seen as acting as a hegemon providing a public good by facilitating capital flows.

2 Bitcoin – an Anticipated Evolution of the Currency Space

This chapter argues that the emergence of digital alternative currencies such as bitcoin was an anticipated phenomenon in the academic literature of International Political Economy (IPE). Three aspects are specifically addressed:

Firstly, Hayek’s idea of introducing competing private monies in the currency space is presented as a cornerstone in the IPE literature pointing the way towards further monetary innovation.

Secondly, it is shown how IPE scholars have conceptualised the evolution of the international currency space as driven by accelerating currency competition preparing the emergence of digital alternative currencies.

Finally, the chapter outlines which specific necessary prerequisites have been identified by scholars for any digital alternative currency to evolve successfully.

2.1 Hayek’s Vision of Currency Competition and Bitcoin’s Technology

Denationalization of Money” (1978) by Austrian-British economist and LSE Professor Friedrich von Hayek is an important work in preparation of the emergence of digital alternative currencies, while still mainly focusing on tangible alternative currencies at the time. Hayek argues that instead of relying on government issued fiat currencies, private monies should be created by financial institutions. Based on principles of market competition the most successful currencies will succeed even independently from central banks or other government interference.

Bitcoin, along with a variety of other competing digital alternative currencies known as “altcoins”, follow exactly this competitive market-oriented maxim by emphasising their independence from any central authority.

Interestingly, while proponents of Hayek’s idea failed intellectually to convince governments to allow and encourage private monies, eventually, new innovative technology fulfilled these principles with or without governments’ support.

This very dynamic was anticipated by an IPE scholar eight years before bitcoin’s introduction: with “the arrival of electronic money, money creation will become increasingly privatized” and, therefore, “Hayek’s vision of a world of unrestricted currency competition could, for better or for worse, soon become reality” (Cohen 2001, 221).

2.2 Evolution of Currency Space: from Deterritorialisation to Denationalisation

The most comprehensive anticipation of bitcoin’s emergence can be found in the scholarly work by Professor Benjamin Cohen from UC Santa Barbara. In his trilogy starting with “Organizing the World’s Money” (1977), followed by “Geography of Money” (1998), and especially “Future of Money” (2004) he outlined the currency dynamics leading to the foreseeable emergence of private and decentralised digital currencies.

Cohen developed his analysis from a mainly state-centric focus of international monetary relations in the historical context of still significantly regulated financial markets (1977), to a situation where financial markets are becoming the driving factor in the configuration of the currency space (1998) eventually leading to the technological innovation of digital currencies (2004).

In Cohen’s understanding this change of the international currency space is generally driven by a “rapid acceleration of cross-border competition among currencies – a spreading market-driven phenomenon” (2000, 10). Accordingly, this ongoing competition leads to two fundamentally important monetary developments: firstly, the “deterritorialisation of money” – the usage of government money beyond national borders – and, secondly, and more importantly for bitcoin’s role, the “denationalisation of money” where private monies emerge in the competitive currency space (ibid., 27).

The empirical observation behind deterritorialisation of monies is that currencies are not only used within a particular country’s borders but also in other countries. Cohen clearly dismisses the “One Nation/One Money myth” (1998, 1). Instead, two general monetary phenomena are distinguished: “international currency use” also known as “currency internationalisation (CI)”, and “foreign-domestic use” also referred to as “currency substitution (CS)” (2000, 11).

Cohen identifies a particular pattern in the arrangement of the global currency space best described as a hierarchical “Currency Pyramid” (ibid., 10). The pyramid is dominated at the top by a limited number of strong currencies such as the U.S. dollar, the euro, and, the yen – known as the “Big Three” while the Chinese yuan is also recognised by Cohen for its potential future role (ibid., 15). The currencies at the top of the pyramid are widely accepted globally in the sense of currency internationalisation. At the bottom of the pyramid, however, there is a broad number of weaker less accepted currencies.

Cohen’s important contribution is to emphasise, that this hierarchical currency pyramid is far from fixed. Instead there is an ongoing capitalist competitive process of “survival of the fittest” in the global currency space (ibid., 10). He highlights three key factors driving this competition towards a more and more changed geography of money in the future: “logic of market competition, the strategic preferences of national governments, and prospective technological developments” (ibid., 9).

The most disruptive factor of these three has been identified by Cohen as the technological developments in form of digital alternative currencies. He describes these “new rivals to today’s top currencies” as being able of “transforming the geography of money virtually beyond recognition” (ibid., 10). This is a view shared and even further sharpened by Mervyn King, a former LSE professor and Deputy Governor of the Bank of England at the time who said: “the successors to Bill Gates” will “put the successors to Alan Greenspan out of business” (The Economist 1999).

Cohen stresses the fundamental difference between the phenomenon of tangible alternative currencies “rooted in a single community or subnational region”, and the new monetary aspect of digital alternative currencies whose “horizons are in principle limitless, potentially encompassing the whole universe of cyberspace”. He concludes, that “their impact on the worldwide competition among currencies will be especially profound” (Cohen 2004, 186). Accordingly, Cohen clearly anticipated the emergence as well as the qualitative difference of digital currencies in the age of the internet compared to previous local tangible alternative currencies.

He goes as far as suggesting the classic Big Three currencies could eventually be marginalised by competition with the digital currencies and become “little more than a sideshow” once the phenomenon fully evolves (2000, 28). This particular situation when “network money” could become the “threat of denationalisation” occurs once these new created artificial currency units (ACUs) can “circulate freely from user to user, without debiting or crediting third-party accounts, and thus substitute fully for existing national monies” (ibid.). Cohen anticipated the emergence not only of digital currencies, but more importantly, of decentralised digital currencies – exactly the “new” innovative technological design of bitcoin today.

However, at the time of his writing in the early 2000s many years before bitcoin’s introduction in 2009, Cohen argued there were still substantial technical issues to be solved before any of these digital ACUs would be successful. These particular challenges are addressed as follows.

2.3 Anticipated Prerequisites for the Evolution of Digital Alternative Currencies

The specific design and implementation of a digital alternative currency was long regarded as extremely challenging to engineer as several critical obstacles had to be overcome on both a technical programming level, as well as on an economic incentive level. As Cohen argues in his 2000 article “Life at the Top: International Currencies in the 21st Century” there are three crucial aspects for a digital currency to evolve successfully:

Firstly, three basic technical issues need to be solved: “adequate provisions for security (protection against theft or fraud), anonymity [or in later works called confidentiality] (assurance of privacy), and portability (independence of physical location)” (2000, 29). In his later work Cohen also added “reliability” in terms of “low probability of failure” as a fourth technical condition (2004, 189).

Secondly, he argues, trust is even more critical for a digital currency to work. The fundamental problem for a long time was how to create trust in a new digital alternative currency. Cohen clearly anticipated that the “conservative bias of the marketplace” would eventually be overcome once “volume of economic commerce” increases (ibid.). Some bitcoin enthusiasts argue the same today, claiming high price volatility, will settle once mass adoption occurs. However, in order to establish that high volume it is first necessary to design an intelligent economic incentive structure ensuring that trust can be created and also maintained over time. In that sense, Cohen connects trust in a digital currency with its value ultimately resulting from its particular money creation process or seigniorage.

Thirdly, the most crucial aspect of all is the “question of value: how to safely preserve the purchasing power of electronic money balances over time” (ibid.). Considering again that Cohen wrote his work many years before bitcoin’s introduction it is remarkable to see how clearly he anticipated the way to conceptualise the economic incentive process for digital currencies when he argued:

“The stimulus for innovation lies not just in the hope of reducing transactions costs but, even more critically, in the alluring promise of seigniorage: the profit that can be gained from the difference between the cost of creating money and the value of what that money can buy. […] That motive along should ensure that all types of enterprises and institutions–nonbanks as well as banks–will do everything they can to promote new forms of e-currency wherever and whenever they can”. (2004, 188)

Accordingly, the crucial aspect for a successful incentive design of a digital currency is outlined as the profit structure around its seigniorage. The process of creating new digital money must be so attractive and profitable that people and institutions actually engage in the procedure. In short, Cohen’s approach stresses: “money can be made by making money” (ibid.). Likewise, the historian Jack Weatherford also comes to the same conclusion – even before Cohen – when he identifies that “electronic seigniorage will be a key to accumulating wealth and power in the twenty-first century” (1997, 245-46).

Interestingly, instead of seeing this procedure as a necessary economic incentive for the emergence of digital currencies, even reputable economists have widely criticised bitcoin for many years now as a plain fraud, Ponzi scheme, or as a soon-to-burst bubble because of the profitable process of seigniorage. All of these negative notions are addressed in the next chapter.

In any case, it becomes clear, that the evolution of the currency space from deterritorialisation to denationalisation in form of the emergence of digital alternative currencies was a very well anticipated phenomenon in the IPE literature long before bitcoin’s actual introduction. More specifically, even the key dynamic for a successful digital currency was identified by Cohen and others in terms of the necessity of a profitable money creation process.

The next chapter focuses further on how bitcoin has solved all of the discussed obstacles by creating trust in a new digital alternative currency through a decentralised public ledger fully based on open source implementation of cryptography.

3 Bitcoin – a New Technological Innovation

In this chapter the thesis argues that bitcoin is truly a new technological innovation significantly advancing previously existing digital alternative currencies. Bitcoin is presented as the actual realisation of the long anticipated evolution of the international currency space as discussed by Cohen in the last chapter. Four critical issues will be addressed in particular:

Firstly, the chapter looks at failed historical digital alternative currencies, and identifies the aspect of centralisation as their main hindrance in establishing a successful alternative currency. Even partially peer-to-peer based currencies are discussed as failures due to their still too centralistic design structure of private profit limiting technological opportunity and contrasted with Cohen’s anticipated prerequisites for a success of a digital currency.

Secondly, the thesis presents bitcoin’s true technological innovation in terms of its decentralised public ledger, its open source architecture, implementation of cryptography, and how and to what extent those characteristics fulfil Cohen’s prerequisites.

Thirdly, it is claimed that bitcoin is by far the largest digital currency by a variety of indicators such as market capitalisation, computational network size, as well as accepting merchants. Further it is argued that all available quantitative data suggests a continuation of that growing trend of transactors – Cohen’s last condition for a successful digital currency.

Finally, the disruptive market potential by bitcoin’s transaction technology is contrasted with the predominantly negative notions of Ponzi scheme, fraud, or bubble as discussed in media publications and also by respected academics and institutions.

3.1 Centralisation as the Failure of Historic Digital Alternative Currencies

Bitcoin was the first decentralised open source implementation of cryptography applied on digital currencies – it is both a decentralised technical transaction protocol and a digital currency. This particular combination is unique to bitcoin – among the now emerging altcoins modelled after bitcoin – as historical attempts in the digital alternative currency space were based on a central trusted third-party institution such as a particular private company.

For example, two open but centralised digital payment projects were Beenz.com and Flooz.com in the late 1990s (Hileman 2014) representing the infamous dotcom bubble. Even already in the 1980-90s a larger number of similar U.S. companies emerged, such as CheckFree (’81) or CyberCash (’94), which all tried to establish new kinds of “digital money architectures” focusing on enabling basic internet commerce in form of bill payments or bank transactions online (Lynch and Lundquist 1996, 23).

While these forms of digital currencies were all clearly centralised in design, one company called DigiCash, founded in 1990 by U.S. cryptologist David Chaum based on his scholarly work, tried to market a more decentralised system of cryptographically based anonymous peer-to-peer transactions for the consumer, similar to bitcoin in its technical features emphasising anonymous transactions. In contrast, however, DigiCash still operated a centralised private company structure around it organising the exchange of fiat currency through bank transfers into their digital currency (Levy 1994). Seigniorage in that sense was based on a centralised company ultimately aiming for private profit while user-to-user transactions were already decentralised.

The aim here is to show that Cohen’s three prerequisites for a successful evolution of digital currencies – overcoming the four technical issues, establishing trust, and maintaining value – cannot be met within the framework of a corporate structure as the main aspect of such a centralised enterprise is to keep the source code closed and ultimately control the money creation as the company is in competition with other companies, and aims for private profit. Even if Cohen’s four technical issues – security, anonymity, reliability, and portability – were met, which is impossible to assess as the source code would be closed, the remaining two prerequisites – trust and value – can simply not be ensured. This is the case as long as a third-party such as a private company is in control of a closed source form of money creation since the company could manipulate the value of the currency at all times.

Furthermore, especially today after the NSA revelations by Edward Snowden, it is also highly unlikely that users would consider advertised anonymity in closed source products trustworthy as all U.S. companies are obliged under the law to work with the NSA – going so far as to even implement backdoors in supposedly secure technology such as the RSA cryptosystem (Menn 2014). Consequently, every U.S., but also in general every nation’s corporations trying to establish a digital form of cash would be essentially understood as directly submitting all financial transactions into the NSA’s or other services’ databases. Therefore, digital currencies operated by companies would effectively de-anonymise all previously anonymous cash transactions which would heavily violate Cohen’s prerequisites and would therefore probably not reach a successful mass adoption level in competition with the established fiat currencies.

Another reason why a centralised corporate structure cannot be successful in creating a digital currency is the limitation imposed by private profit: for both too high setup costs as well as too high transaction costs. In that sense centralised rather than decentralised private profit goes against the very advantages of digital currencies, namely to compete and outperform the established Big Three or fiat currencies generally. That includes avoiding costs since established fiat cash does not involve high setup or transaction costs. Therefore, DigiCash’s idea to charge, even a low fee such as a penny per transaction (Lynch and Lundquist 1996, 30), is simply not as efficient as charging no fees or fractions of a penny under decentralised market conditions. In any case, a competitive global market pricing for transactions will most likely be lower than any form of centralised company aiming for a maximum of private profit.

Additionally, the setup costs for the DigiCash currency were as high as $75 million in 1996 and were supposed to be paid by private financial institutions (Next 1999). Again, this high amount of setup costs violates Cohen’s prerequisites of “money can be made by making money” (2004, 188). It was clear to the banks that keeping their less innovative credit card technology and being able to charge consumers higher fees was certainly more profitable for them than paying such high setup costs and losing large parts of the credit card revenues.

In short, as DigiCash and Chaum tried to make the most profit in setting up the alternative system, no financial institution was willing to bear these high costs to begin with. Bitcoin overcame this entrance barrier as there were initially no setup costs and only incentives to engage in the setup process as it will be discussed in the next paragraph.

Nevertheless, there is no doubt, that cryptographer Chaum has heavily contributed to the technical emergence of digital currencies through various scholarly work such as developing “blind signatures” an early method to prevent double spending (Chaum 1983), or his implementation concept for anonymous payment transactions (Chaum, Fiat, and Naor 1990). Based on his significant contributions in the field of cryptography and entrepreneurial projects, combined with his work for intelligence agencies (Next 1999), it is possible that Chaum could be credited as a contributor to the creation of bitcoin. However, the U.S. cryptographer and legal expert Nick Szabo has been recently identified based on linguistic analysis (Grieve 2014) of his work as the most likely author of the bitcoin paper published by the most likely pseudonym “Satoshi Nakamoto” (2008). Szabo also seems to be a very likely candidate for having intellectually conceptualised bitcoin by developing a bitcoin predecessor called “bit gold”. Nevertheless Chaum’s cryptographic scholarly work has certainly been studied in the process of creating bitcoin even though he is surprisingly not referenced in the original paper (ibid., 9). Interestingly, after the failure of DigiCash, Chaum focused his work partially back on trustworthy voting systems (Chaum, Ryan and Schneider 2005) as he did earlier in his career – a field that has been discussed as compatible with bitcoin’s protocol as well (Zerlan 2014).

In any case, the crucial aspect for the emergence of digital alternative currencies is the replacement of a central trusted third party with a decentralised open source based cryptographic implementation which bitcoin finally accomplished.

3.2 Bitcoin’s Innovation: Cryptography, Open Source, and Decentralisation

The key technological innovation of bitcoin lies in its decentralised peer-to-peer network design of a public ledger called “block chain” based on an open source implementation of cryptography to ensure security and prevention of double spending. More specifically, instead of relying on a central authority such as a central bank or a private company like DigiCash administering the system, bitcoin relies on an open source protocol detailing the exact number of maximum bitcoins – a total of 21 million till 2140 is created while around 13 million already exist – as well as the creation formula, a process called “mining” – specifying how many coins are created or “mined” over time. Further, all transactions within the bitcoin system are public in the block chain, and are used to verify ownership of coins. Enforced is the system through all participating nodes running the same bitcoin protocol and verifying transactions based on consensus of hash values – the more computers take part the more secure is the overall network.

Currently there are around 7,000 notes part of the bitcoin network while 42% are in the U.S. (Heng 2014). The economic incentive to provide CPU power for the bitcoin network is based on the seigniorage formula: new bitcoins are distributed to the network in proportion to the provided CPU power. The more speed a user provides the higher the probability to receive new created bitcoins. So called “mining pools” help to bundle CPU power to distribute a more continuous flow of new bitcoins to participating miners (CoinDesk 2014a).

It is argued here, that these features fulfil the three prerequisites addressed in the IPE literature by Benjamin Cohen: (1) “adequate provisions for security (protection against theft or fraud), anonymity (assurance of privacy), and portability (independence of physical location)” together with reliability (low probability of failure) as well as (2) trust, based on money’s (3) value creation (2000, 29). The different aspects are addressed as follows:

3.2.1 Security

Firstly, adequate security is provided through digital signatures and cryptographic hashes enforced through the network based on the transparent open source algorithm. Actual fraud is then prevented through the automatic comparison of hashes through the network. For example, if a user modifies the open source code and creates fraudulent bitcoins himself and tries to introduce these coins into the block chain, the network will check the new coins based on the transaction history shown in the block chain and an additional hidden private key expressed through a digital signature: as the fraudulent coins can only match the public key but not the private key, the hashes will not match, and thus the introduction in the block chain will be denied. Therefore, cryptography together with the CPU power of the network prevent fraud.

However, as transactions are irrevocable, accidental transactions and theft remain issues since every user has to protect their bitcoins individually in terms of securely storing them from hacker attacks on their operating system or actual physical theft for mobile phones or laptops. In the best case, storing is done on devices not connected to the internet, a procedure known as “cold storage”. An extreme example of bitcoin theft was the $460 million dollar theft from the Japanese MtGox exchange which had particular weak security implemented in the exchange’s software (McMillan 2014) – not the bitcoin protocol as it was sometimes claimed in media reports. However, the theft is also rumoured as a potential inside job while the investigations are still running (McLannahan 2014).

More importantly, bitcoins are generally stored in “digital wallets” which can easily be password protected. Thus it depends, firstly, on the user’s storage behaviour, and, secondly, on the chosen password strength how secure bitcoin is. The design itself can be seen as adequately secure.

3.2.2 Anonymity

Secondly, anonymity demands more user engagement as all bitcoin transactions are public and, therefore, are not in the strictest sense anonymous unlike the DigiCash system as critics have pointed out (King 2014). However, a bitcoin address has 26-34 digit alphanumeric characters that are anonymous in itself meaning personal information are not included. The problem arises once users exchange fiat currency into bitcoins on regulated exchanges where they, then, have to identify themselves under Know Your Customer (KYC) policies. In that sense, even though the bitcoin addresses are anonymous, once a user is identified through an exchange all his transactions can be traced back to him – at least until other addresses that have not been identified are used to hide the true identity. For that purpose, there are so called “mixing services” that allow to obscure the origin of coins after purchasing them on an exchange requiring KYC. Also bitcoins can be bought at ATMs anonymously, or from person to person, and ultimately there are several decentralised bitcoin exchanges about to start allowing to bypass KYC regulation all together (Higgins 2014).

As a result, anonymity is ensured as long as some user engagement is involved.

3.2.3 Portability

Thirdly, portability is clearly ensured through the internet. Wherever a direct connection to the internet exists, and, thus, to the block chain, bitcoins can be transferred. New transaction models also include indirect connections through the mobile phone network, for instance, in Africa to enable the “unbanked” to use bitcoin transactions through SMS services (Asare 2014). In general, bitcoins are not geographically bound as mathematics is a universally understood principle and the computer network can be expanded to every part of the earth and beyond as there are even projects to setup bitcoin satellites (McMillan 2013).

3.2.4 Reliability

Fourthly, reliability in terms of low probability of failure is ensured through its decentralised design. Even if one particular country on a policy level bans bitcoin, such as Russia (Tyler 2014), it will not affect the overall network. Furthermore, through its decentralised design it is also quite unlikely in general that a policy ban can be successfully implemented, as the ECB stated (2012, 43): “there is no server that could be shut down if the authorities deemed it necessary“. Even if authorities tried to block bitcoin, a variety of technical tools are available to bypass those censorship mechanisms such as TOR. So it can be argued that as long as a country allows some access to the internet bitcoin will be available. Connected with that element of decentralisation is the specific technical matter of strong encryption as well as economic incentives to sustain the network ensuring reliability.

[...]

Excerpt out of 43 pages

Details

Title
Bitcoin in International Monetary Relations. New Innovation or Old Imperialism?
College
London School of Economics
Grade
Merit
Author
Year
2014
Pages
43
Catalog Number
V899632
ISBN (eBook)
9783346217851
ISBN (Book)
9783346217868
Language
English
Tags
Bitcoin, International Monetary Relations
Quote paper
Carl Philipp Trump (Author), 2014, Bitcoin in International Monetary Relations. New Innovation or Old Imperialism?, Munich, GRIN Verlag, https://www.grin.com/document/899632

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