The Satoshi Revolution – Chapter 2: Cautionary Tales From Earlier Digital Cash (Part 3)

The Satoshi Revolution: A Revolution of Rising Expectations.

Section 1: The Trusted Third Party Problem
Chapter 2: Monetary Theory
by Wendy McElroy

Cautionary Tales From Earlier Digital Cash (Chapter 2, Part 3)

There are 3 eras of currency: commodity based, politically based, and now, math based. — Chris Dixon

Cautionary Tales From Earlier Digital Cash

Versions of digital cash and online transfer systems existed before Bitcoin. DigiCash and e-gold are among the better-known ones, but neither could shake the dogged trusted third party problem. Both lacked the essential vehicle of privacy and self-banking created by Satoshi Nakamoto: the blockchain. The early systems are useful as cautionary tales, however, and they spotlight the elegance of Bitcoin.


In 1983, the renowned cryptographer David Chaum introduced the idea of digital cash in a path-breaking research paper. In 1989, he founded an electronic money corporation named DigiCash, Inc. which in turn established the electronic payment system e-cash; the actual currency or “coin” was DigiCash. E-cash has been called “technically perfect.” It built upon an earlier system designed by Chaum: Blind Signature. This is a digital signature in which the content of a message from one person is disguised and so it is not seen by a second person who signs off on the message as authentic.

The process is often illustrated by an analogy. A voter wants his ballot to remain secret but, to be counted, it must be signed by an election official who verifies the voter’s eligibility. The solution: the voter writes his credentials on the outside of an envelope, wraps the marked ballot in carbon paper and places it inside the envelope. The official verifies the credentials and signs the envelope, thereby transferring his signature to the ballot inside; he verifies the ballot without knowing its contents. The voter puts the now-authorized ballot into a new unmarked envelope which is slipped into a box of ballots waiting to be counted. The vote counter verifies the validity of the signature and the vote is recorded. But the vote counter has no idea who cast that particular ballot. Neither the content of the vote nor the ballot itself can be linked back to the individual voter. This is the essence of a blind signature and its unlinkability.

In simplistic terms, the Chaumian e-cash uses blind signatures as follows: At a bank that handles e-cash, you have an account with $20 to which a password offers access. To withdraw e-cash in sums of $1 each, you use software to generate 20 unique, random numbers of sufficient length that makes it unlikely anyone else will also produce them. The problem: you need the bank to verify that each serial number is worth $1, but you don’t want the bank to know which $1 “coin” is which because then the coins could be tracked. If nothing else, the bank could match outgoing and incoming data. This would provide the bank with information about where you shop, what you buy, your lifestyle and other aspects of life that you wish to remain private.

You “blind” each request and serial number with a special kind of encryption. The bank then receives a scrambled request on which it signs off with a private key for $1 – which affirms both the value and the authenticity of each coin. (The bank has different keys for different amounts.) The addition of the bank’s stamp converts the serial number into a $1 coin that can be used only by you. It is anonymous; the bank knows how many $1 units it stamped for you, but it cannot distinguish between those units, nor can it recognize them from any other $1 coin it has ever authenticated.

You “unblind” or decrypt the serial number with the bank’s signature, which results in a valid signed message that can be verified by the bank’s public key. The $1 coins are stored on your computer, waiting to be sent to anyone who accepts e-cash. To do so, you send someone a decrypted, signed serial number and they take it to the bank. The signature is verified, the serial number is recorded, and the amount is redeemed. Recording the number allows the bank to reject any attempt at double-spending. The bank cannot connect the transaction to your account; the recipient of a $1 coin has no idea who you are unless you choose to reveal that information.

This process is as anonymous as cash. It stands in stark contrast to online credit-card use, which involves telling a credit-card company and a recipient who you are, where you are and what you are purchasing. DigiCash is also safe from malicious people who like to steal identities.

DigiCash had an extra advantage. Because it was highly divisible, it accommodated micro-payments – payments under $10 – for which transaction costs made credit cards impractical. E-cash was perfect for transferring e-quarters and e-nickels over the Internet.

DigiCash Inc. made quite an impact on the financial community. The first bank to implement e-cash was the Mark Twain Bank in St. Louis, Missouri, but others soon followed. By 1998, e-cash was available through Deutsche Bank in Germany, Credit Suisse in Switzerland, and several other powerful outlets. But in 1998, DigiCash Inc. filed for Chapter 11 bankruptcy and subsequently sold its assets, including patents.

What happened? Explanations vary, and all may be partially true.

In a 1999 interview, Chaum claimed DigiCash was an idea before its time because e-commerce had not been firmly established. Forbes (11/01/1999) offered another explanation: “A brave new currency for a brave new world, with only one problem: No one wanted it–not banks, not merchants and, most important, not consumers. Electronic commerce is flourishing, but it turns out Visa and MasterCard–not digital cash–are the currency of choice.” Governments are in the list of those who did not like the untraceable money. It could be used to avoid taxes and commit other “crimes” – victimless or not.

A fascinating anonymous article in Next! magazine advanced an entirely different theory. Cryptographers, it explained, are generally paranoid. And Chaum was a GREAT cryptographer. The inside workings of DigiCash Inc. depicted in the article sound like a psychiatric ward rather than a tech company. Apparently, Chaum was also an abysmal businessman. One example of the article’s many stories of commercial self-sabotage: “A little later ING Investment Management was interested. This deal was about twenty million guilders [$10 million US at the time]. The plans were all laid out. ING Barings together with Goldman Sachs would also bring DigiCash to the stockmarket [sic] within two years. ‘The day we were all set to sign, David didn’t want to’, tells Stofberg [the man responsible for DigiCash’s financial affairs until August 1996]. ‘He was so paranoid, that he always thought something was wrong. There were 8 people from ING, including the CEO, and David simply refused to sign‘!”

A more interesting approach than psychologizing is to look at flaws in the e-cash and DigiCash system which contributed to its failure, and then to contrast them with the success of bitcoin and blockchain.

• Chaum believed in patent and copyright – both of which he applied to his designs. This restricted access and co-operative development by a global community of brilliant minds. Putting a price-tag on the product hindered broad public acceptance. By contrast, Bitcoin is patent-free and open-source, which gives unrestricted access and allows development to sprint forward. There is no charge for its use.
• E-cash could not get around the trusted third party problem because it needed an authorizing blind signature from a financial institution. Peer-to-peer bitcoin eliminates trusted third parties because acceptance by the blockchain is the authorization and each participant is a self-banker.
• E-cash required a centralized issuer, such as a bank. Bitcoin is decentralized down to the individual level.
• E-cash preserved the existing banking system and currency. Peer-to-peer bitcoin renders the current system irrelevant, and it menaces the existing currency.
• E-cash was vulnerable to the personality flaws of one man. Bitcoin is haunted by internal conflicts, to be sure, but no one personality can rule or wreck it because no one owns it.
• E-cash was not designed for financial freedom. The essay, “Untraceable Electronic Cash,” co-authored by Chaum, stated, “Generating an electronic cash should be difficult for anyone, unless it is done in cooperation with the bank.” The anarchists and idealists who sculpted Bitcoin wanted to empower the individual against the state and needed no one’s permission to do so.

No wonder corporations showed immediate interest in e-cash, but only recently showed interest in Bitcoin, which they now hope to patent, dominate and tame for their own purposes.

Lessons Taught By Earlier Digital Cash: E-gold

E-gold was a digital gold currency that was operated between 1996 and 2009 by Gold & Silver Reserve, Inc. In 2000, G&SR restructured and a new company, e-gold Ltd., assumed the administration of e-metal issuance and transfers. The digital currency was linked to gold – with the typical unit of account being grams or troy ounces. Like early U.S. gold certificates, e-gold represented the units of gold for which it could be redeemed on demand from stored metal. Customers with accounts on the e-gold website could make instant transfers of precious metals to other accounts. It was one of the first payment systems to allow complex global exchanges outside the traditional banking system. A critic of fiat currency and conventional banking, co-founder and libertarian Douglas Jackson had a mission: he was determined to forge a private alternative to the financial mire caused by governments. In the book “A History of Digital Currency in the United States: New Technology in an Unregulated Market” (2016), the publisher of Digital Gold magazine, P. Carl Mullan, quoted Jackson as saying that such a “task required large-scale computational capacity, data storage and secure global means of communication.” The costs were prohibitive except for national governments. That is, they were until the Internet.

With the Internet, e-gold pioneered several breakthroughs. In 1999, for example, the company introduced wireless mobile payments using a web-enabled cellphone. This was seven years before PayPal offered a similar service. A less laudable innovation came in 2000 when the company required customers who wished to add value to their accounts to have a trusted and independent third party who would exchange e-gold for national fiat currencies and vice versa. Within a year, several dozen businesses and individuals filled that niche; a new industry was born.

According to e-gold Ltd., the number of accounts grew from 1 million in 2003 to 5 million in 2008. E-gold users had a variety of motives. Some were gold bugs who devoutly believed e-gold was superior to fiat. Others were economic anarchists who thought government had no proper role to play in money. Still others wanted to evade taxes or participate in other victimless crimes.

Many more were attracted by the emergence of High Yield Investment Programs, some of which used e-gold as a payment platform. These programs offered unrealistically high returns that could be maintained only by redirecting the wealth of new investors; these Ponzi schemes led to an e-gold rush on an international level. Fraud artists took advantage of e-gold features such as the fact that all transactions were final and never charged back, with no exceptions. The scammers opened e-gold accounts and urged prospective investors to do the same. Then they milked investors and buyers for all they could.

By this time, e-gold offered a wide range of services from online casinos and auctions to metals trading and donations to non-profits. The company was rife with possibilities for scams. Unfortunately, defrauded customers often made no distinction between e-gold itself and the individual scammers who ripped them off with faux investments or non-existent goods. Some disillusioned users complained to government authorities.

In 2007, the U.S. Federal Government accused e-gold of money laundering and of violating 18 U.S. Code § 1960, which prohibits businesses from transmitting money without a license. Several exchanges attached to e-gold were closed down. The publicity and disrupted exchanges caused a steep drop in the number of e-gold customers; the difficulty of exchanging e-gold for fiat caused potential recipients of e-gold to shy away. Many customers were trapped with accounts they could not liquidate.

E-gold vigorously fought the charges, to no avail. In April 2008, the judge in United States of America v. E-gold, Ltd. ruled against e-gold and, in doing so, dramatically increased the Treasury Department’s range of authority. The law now defined a “money transmitter” as a business that transferred any stored value from one person to another, whether or not the transfer involved cash or a national currency. The definition gave the Treasury Department a de facto blank check on future prosecutions.

The company’s three directors pled guilty and entered into an agreement by which e-gold would come into compliance with the legal requirements for a money-transmitting business, including obtaining a license. Jackson received 300 hours of community service, 3 years of supervision and a $200 fine. He could have received 20 years in prison and a $500,000 fine. The two other directors received the same sentence, with heavier fines.

Then came a bitter irony. The guilty pleas precluded the directors from acquiring a license anywhere in the U.S. This put all of e-gold in lock-down because returning money to customers would involve transmitting money without a license and violating the plea agreement. In 2010, the government finally allowed e-gold to return the monetized value of their accounts to customers.

The Treasury Department’s expanded and vague definition of “money transmitter” has clear implications for bitcoin. The success of e-gold, and the court case that quashed it, changed the way government handled online payment systems. And, now, it had the legal precedent to act against cryptocurrencies.

The parallels between Bitcoin and e-gold are also clear. E-gold was highly divisible and allowed micropayments as tiny as one ten-thousandth of a gram. It maintained an open ledger in which daily transactions were published live and in transparent form. Like bitcoin, e-gold was not a complementary currency – at least not to begin with. A complementary currency is one that supplements a national currency without competing with it; an example would be private “money” issued by a business to customers as a promotion. E-gold was intended as a replacement for fiat and for the banking system, with the added advantage of hedging against inflation.

The differences between bitcoin and e-gold are as important as the parallels:

• E-gold embodied the trusted third party problem, as the customers stranded by legal proceedings found out. It is difficult to blame e-gold for the circumstances, of course, but dishonesty or inefficiency are not the only risks of trusting others with your money. Again, Bitcoin eliminates this problem.
• Arguably, e-gold introduced a trusted-fourth-party problem when it insisted customers use exchanges to convert into and out of fiat.
• E-gold and the exchanges were points of centralization that were easy targets for regulation or prohibition. They were also choke points at which to gather customer information. When e-gold restructured in 2000, OmniPay was formed as the company’s exchange system. In his previously mentioned book, Mullan explained, “OmniPay quickly became the largest e-gold exchange in the world. It served as the primary dealer exclusively working between the issuer, e-gold Ltd., and all other third-party independent exchange agents around the world.” OmniPay used three methods to verify the identities of customers: universal postal verification; payment by bank wire only; and, safeguards to detect incoming third-party payments. In e-gold’s plea agreement years later, the government almost certainly gained access to that information. Peer-to-peer bitcoin is pseudonymous.
• E-gold’s insistence on “membership for use” restricted the spread of its services. Bitcoin is open to all.

The riskiness of a trusted-third-party exchange like OmniPay is a warning bell in the night to bitcoin users. A centralized exchange is usually the first target of government regulation because it is visible and vulnerable, and because it comprises a cache of valuable data on individual users who are otherwise elusive. Exchange owners are likely to comply with government demands because non-compliance means being closed down, imprisoned, or both. In short, centralization encourages third parties to obey laws and regulations, such as I.D. verification – which harm customers.

At every financial turn, the trusted third party problem works for government control and against personal freedom. It would still be that way, only worse, if lightbulbs had not gone off in Satoshi Nakamoto’s brain.

The Satoshi Revolution – Chapter 2: Technology Meets Anarchy. Both Profit (Part 2)

The Satoshi Revolution: A Revolution of Rising Expectations.

Section 1: The Trusted Third Party Problem
Chapter 2: Monetary Theory
by Wendy McElroy

Technology Meets Anarchy. Both Profit (Chapter 2, Part 2)

Bitcoin is the catalyst for peaceful anarchy and freedom. It was built as a reaction against corrupt governments and financial institutions. It was not solely created for the sake of improving financial technology. But some people adulterate this truth. In reality, Bitcoin was meant to function as a monetary weapon, as a cryptocurrency poised to undermine authority. Now it is whitewashed. It is seen as a polite and unassuming technology in order to appease politicians, banksters, and soccer moms. Its purpose is sometimes concealed in order to make the tech palatable to the unwashed masses and power elite. However, no one should forget or deny why the protocol was written.–Sterlin Lujan


Technology Meets Anarchy. Both Profit.

Cryptocurrency was not created to make money; the blockchain was not forged to render banking more efficient. The core developers did not use open source or eschew patents because they were proprietary or wanted to reap a fortune. They wanted privacy and freedom to be available without cost to all. Anyone who believes Bitcoin was designed for financial gain knows nothing about its history or the idealism built into its algorithms. Profiting from cryptocurrency and using blockchains to economic advantage are laudable by-products, but Bitcoin was conceived as a vehicle for creating political and social change by empowering individuals and weakening government. The developers were revolutionaries. Bitcoin was a blast of rebellion.

It came not a moment too soon. The galloping growth of the Internet gave government an incredible weapon against which individuals would have had scant protection without cryptography, the art of secret communication.


The Radical History of Bitcoin

Before Satoshi, there was the engineer and scientist Timothy C. May to whom Bitcoin is sometimes traced. May’s “Crypto Anarchist Manifesto” (1988) first appeared when it was distributed to a few techno-anarchists at the Crypto ’88 conference. The six-paragraph manifesto called for a computer technology based on cryptographic protocols which would “alter completely the nature of government regulation, the ability to tax and control economic interactions, the ability to keep information secret, and will even alter the nature of trust and reputation….The technology for this revolution–and it surely will be both a social and economic revolution–has existed in theory for the past decade….But only recently have computer networks and personal computers attained sufficient speed to make the ideas practically realizable.”

The manifesto ended with a cry to arms, “Arise, you have nothing to lose but your barbed wire fences!” The “barbed wire” reference is quintessentially American. It evokes images of land out West being sectioned off by sharp fences that were snipped apart by cowboys who demanded an open landscape.

Even in 1988, May could draw upon crypto-history. In the mid-1970s, cryptography ceased to be the nearly-exclusive domain of military and intelligence agencies who operated in secrecy. The academic research that surged forward was openly shared. One event in particular broke government’s grip on the field. In 1975, computer guru Whitfield Diffie and electrical engineering professor Martin Hellman invented public-key encryption and published their results the next year in the essay “New Directions in Cryptography.” (Arguably, the public key was a re-invention as the British had developed “nonsecret encryption” in 1973 but chose to be silent on the subject, as governments generally do.) In 1977, cryptographers Ron Rivest, Adi Shamir and Leonard Adleman created the RSA encryption algorithm, which was one of the first practical public-key systems.

Public-key encryption hit the computer community like an explosion. It is brilliant in its simplicity. Every user has two keys – a public and a private one – both of which are unique. The public key scrambles the text of a message which can be unscrambled only by the private key. The public key can be thrown to the wind but the private one is closely guarded. The result is close to impenetrable privacy.

Diffie had been inspired by the trusted third party problem. The book “High Noon on the Electronic Frontier: Conceptual Issues in Cyberspace” (1996) quoted him as saying, “You may have protected files, but if a subpoena was served to the system manager, it wouldn’t do you any good. The administrators would sell you out, because they’d have no interest in going to jail.” His solution: a decentralized network with each individual possessing the mathematical key to his own privacy – the right most threatened by a digital society.  It obliterated the problem by removing any need for trust. At the same time, public-key encryption also removed the contradiction of sending secure information over insecure channels. It excluded “Eve” – the name cryptographers called unwanted eavesdroppers. And, importantly, public-key encryption was free to all because revolution required participation.

Government was displeased. The National Security Agency (NSA) could no longer eavesdrop at will and its domestic monopoly on encryption was suddenly thrown open to all comers. The journalist Steven Levy commented in a Wired article, “In 1979, Inman [then-head of the NSA] gave an address that came to be known as ‘the sky is falling‘ speech, warning that ‘non- governmental cryptologic activity and publication. . .poses clear risks to the national security’.”

The Cypherpunk response was captured by a later statement by cryptographer John Gilmore. “Show us. Show the public how your ability to violate the privacy of any citizen has prevented a major disaster. They’re abridging the freedom and privacy of all citizens – to defend us against a bogeyman that they will not explain. The decision to literally trade away our privacy is one that must be made by the whole society, not made unilaterally by a military spy agency.”

The first crypto war erupted with the NSA strenuously trying to curtail the circulation of Diffie’s and Hellman’s ideas. The agency went so far as to inform publishers that the two rebels and whoever published them could face jail time for violating laws restricting the export of military weapons. The Institute of Electrical and Electronics Engineers, one of Hellman’s outlets, received a letter that read, in part, “I have noticed in the past months that various IEEE Groups have been publishing and exporting technical articles on encryption and cryptology—a technical field which is covered by Federal Regulations, viz: ITAR (International Traffic in Arms Regulations, 22 CFR 121-128).” Gag orders were issued. Legislation was proposed. The NSA attempted to control funding to crypto research. Inman gave the agency’s first public interview to Science magazine in order to explain his position. NSA also considered requiring people to “escrow” their private keys with a third party who would be vulnerable to a judge’s order or to the police; of course, this would have returned the trusted third party problem which public key encryption was intended to solve. In response, Electronic Frontier Foundation co-founder John Perry Barlow declared, “You can have my encryption algorithm…when you pry my cold dead fingers from my private key.”

The NSA’s efforts failed. Powerful crypto was now a public good.


Arise Cypherpunks!

In the late 1980s, “Cypherpunks” emerged as something akin to a movement. The deliberately humorous label was coined by hacker Judith Milhon who blended “cipher” with “cyberpunk.” The Cypherpunks wanted to use cryptography to defend against surveillance and censorship by the state. They were also determined to build a counter-economic society that offered an alternative to existing bank and financial systems.

Their vision was inspired by the pioneering work of computer scientist David Chaum, nicknamed the “Houdini of crypto.”  Three of his papers were particularly influential.

  • Untraceable Electronic Mail, Return Addresses, and Digital Pseudonyms” (1981) laid the groundwork for research into and the development of anonymous communications based on public-key cryptography.
  • Blind Signatures for Untraceable Payments” (1983) stated, “Automation of the way we pay for goods and services is already underway….The ultimate structure of the new electronic payments system may have a substantial impact on personal privacy as well as on the nature and extent of criminal use of payments. Ideally a new payments system should address both of these seemingly conflicting sets of concerns.” The essay called for digital cash.
  • “Security without Identification: Transaction Systems to Make Big Brother Obsolete” (1985) further described anonymous digital cash and pseudonymous reputation systems.

A typical cypherpunk distrusted and disliked government, especially the federal variety; the NSA’s near-hysteria over unclassified encryption only heightened this response. Most cypherpunks embraced the counterculture with its stress on free speech, sexual liberation and freedom to use drugs. In short, they were civil libertarians. One of the earliest portraits of the coding radicals was Levy’s Wired article, mentioned above, which appeared in the magazine’s second issue (May 1993).  Levy called them “techie-cum-civil libertarians.” They were idealists who “hope for a world where an individual’s informational footprints – everything from an opinion on abortion to the medical record of an actual abortion – can be traced only if the individual involved chooses to reveal them; a world where coherent messages shoot around the globe by network and microwave, but intruders and feds trying to pluck them out of the vapor find only gibberish; a world where the tools of prying are transformed into the instruments of privacy.”

Levy understood the stakes. “The outcome of this struggle may determine the amount of freedom our society will grant us in the 21st century.” The spread of personal computers, the rise of the modern Internet and the titillating label of “outlaw” were an irresistible combination.

Then, in 1991, Phil Zimmermann developed PGP, or Pretty Good Privacy, the world’s most popular email encryption software. He viewed it as a human rights tool and believed in it so deeply that he missed five mortgage payments and almost lost his house while designing it. The first version was called “a web of trust” which described the protocol by which the authenticity of the link between a public key and its owner was established.  Zimmermann described the protocol in the manual for PGP version 2.0:

“As time goes on, you will accumulate keys from other people that you may want to designate as trusted introducers. Everyone else will each choose their own trusted introducers. And everyone will gradually accumulate and distribute with their key a collection of certifying signatures from other people, with the expectation that anyone receiving it will trust at least one or two of the signatures. This will cause the emergence of a decentralized fault-tolerant web of confidence for all public keys.”

PGP was initially given away by being posted on computer bulletin boards. Zimmermann commented, “[l]ike thousands of dandelion seeds blowing in the wind” PGP spread around the globe. Government noticed. Zimmermann was targeted in a three-year criminal investigation based on the possible violation of US export restrictions for cryptographic software.

Fast forward to 1992. May, Milhon, Gilmore and Eric Hughes formed a small group of coding zealots who met every Saturday in a small office in San Francisco. A Christian Science Monitor article described the group as “all united by that unique Bay Area blend: passionate about technology, steeped in counterculture, and unswervingly libertarian.”

The group’s size grew rapidly. The List, an electronic posting forum, became the most active aspect with the “people’s algorithms” drawing staunch support from the likes of Julian Assange and Zimmermann. The Christian Science Monitor article commented, “Radical libertarians dominated the list, along with ‘some anarcho-capitalists and even a few socialists’. Many had a technical background from working with computers; some were political scientists, classical scholars, or lawyers.” Eric Hughes contributed another manifesto: “A Cypherpunk’s Manifesto” that opened, “Privacy is necessary for an open society in the electronic age.” But , it continued, “[f]or privacy to be widespread it must be part of a social contract. People must come and together deploy these systems for the common good. Privacy only extends so far as the cooperation of one’s fellows in society.”

The group quickly encountered an objection that later became a dominant thrust of government’s attack on private encryption: “bad actors” would use anonymity to get away with crimes. During a 1992 interview, a skeptic confronted May. “Seems like the perfect thing for ransom notes, extortion threats, bribes, blackmail, insider trading and terrorism,” he challenged. May calmly replied, “Well, what about selling information that isn’t viewed as legal, say about pot-growing, do-it-yourself abortion? What about the anonymity wanted for whistleblowers, confessionals, and dating personals?”

Cypherpunks believed public-key encryption made society less dangerous because it removed the two major sources of violence. First, anonymity neutralized governments, which consisted of “men with guns.” Shutting governments out removed those guns from exchanges. If financial exchanges were invisible, for example, the violence of taxation would be impossible. Second, public-key encryption reduced the risks associated with victim-less crimes, such as drug use. Ordering drugs online, for example, was safer than buying them in a back alley of a shoddy neighborhood. Admittedly, public-key encryption could shield activities that violated rights. A common Cypherpunk response was to view the prospect as irrelevant. Encryption was a reality and it would spread in spite of unpleasant side effects. Perhaps cypherpunks believed a technological or community solution to real online crimes would evolve.


The Crypto Wars Continue

One incident captures the core of crypto wars between the Cypherpunks and government, especially the NSA. Gilmore was determined to rescue the information from documents that the NSA was attempting to suppress. His first major victory was to distribute a paper by a cryptographer employed by Xerox, which the NSA had persuaded Xerox to suppress. Gilmore posted it on the Internet and it went viral.

Then, in 1992, Gilmore further enraged the NSA. He filed a Freedom of Information Act (FOIA) request to acquire the declassified parts of a four-volume work by William Friedman who is often called the father of American cryptography; the manuals were decades old. Gilmore also requested the declassification of Friedman’s other books.

While the NSA dragged out its response before refusing Gilmore, he heard from a Cypherpunk friend. Friedman’s personal papers had been donated to a library after his death, and they included the annotated manuscript of one still-classified book Gilmore sought. The friend simply took it off the shelf and Xeroxed it. Then, another of Friedman’s still-classified books was found on microfilm at Boston University; a copy of it was also turned over to Gilmore. He notified the judge, who was hearing what had turned into a FOIA appeal, that the “classified” documents were publicly available in libraries. Before he did so, however, Gilmore made several copies and hid them in obscure places, including an abandoned building.

The NSA reacted with extreme prejudice. They raided libraries and reclassified documents that used to be publicly available. The Justice Department called  Gilmore’s lawyer to say that his client was close to violating the Espionage Act, which could bring a prison term of ten years. The violation: he showed people a library book. Gilmore informed the judge of the latest development, but he also contacted technology reporters in the press.

NSA feared publicity, and the Cypherpunks knew it. Articles began to flow, including one in the San Francisco Examiner. Two days later, the New York Times stated, “The National Security Agency, the nation’s secretive electronic spy agency, has abruptly retreated from a confrontation with an independent researcher over secret technical manuals he found in a public library several weeks ago….[I]t said that the manuals were no longer secret and that the researcher could keep them.” The Aegean Park Press, a California publisher, quickly printed the books in question.

The early Cypherpunks were prototypes who set the attitude, technology and political context in which the next generation of cryptocurrency zealots operated. The goals were disobedience, disruption of the system through cryptography, personal freedom, and counter-economics. They set and lit the stage for Satoshi Nakamoto.



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The Satoshi Revolution- Chapter 2: Currency Creates Freedom and Civilization…Or Oppression (Part 1)

The Satoshi Revolution: A Revolution of Rising Expectations.

Section 1: The Trusted Third Party Problem
Chapter 2: Monetary Theory
by Wendy McElroy

Currency Creates Freedom and Civilization…Or Oppression (Chapter 2, part 1)

“Historically, money was one of the first things controlled by government, and the free-market ‘revolution’ of the eighteenth and nineteenth centuries made very little dent in the monetary sphere. So it is high time that we turn fundamental attention to the life-blood of our economy—money.”
–Murray Rothbard, What Has Government Done to Our Money?

Currency Creates Freedom and Civilization…Or Oppression

I was seven years old when I realized my parents did not understand some of the most important dynamics of life. I was riding in the back seat of the car with a bag of candy purchased from a roadside store which was supposed to keep me quiet. It didn’t work. A thought tumbled out of my mouth. “Why do we pay for anything?” I asked. “Why don’t people just go into stores and take what they need?”

My mother replied, “It is wrong to steal.”

I explained, “I don’t mean stealing. I mean why do we give people money instead of sharing everything?” My parents fell silent.

When I asked again, my mother shot back over her shoulder, “Don’t ask stupid questions!”

They didn’t know the answer; I recognized this immediately. And their inability to explain why we needed money disturbed me because they discussed money constantly. How to make more, was there enough to repair the car, could they afford to replace the roof, someone needed dental work, what was the spending cap on Christmas? Concern about money ran through every aspect of their lives and, yet, my parents didn’t know how to answer the basic question of why we need it.

“Money is simply how the world works,” they finally explained, “because it lets people buy the things they need to live.” This was a non-answer because it returned me to the question of why we buy the things in the first place instead of sharing. Why do we trade paper for stuff, and why do people give us stuff for paper? At a childish level, I was trying to understand monetary theory and I’ve been struggling with it ever since.

Nothing has been more valuable in that quest than the short book “What Has Government Done to Our Money?” by Murray Rothbard. He does not use the term “trusted third party” or its equivalent in the book nor did he use such a term elsewhere in writing or conversation, as far as I know. Murray was a friend and mentor; I suspect he would have viewed the need to trust a financial intermediary as not being a problem at all, because private banks could offer guarantees such as reputation, redemption in gold and audits. To him, the dilemma of modern money began with government and ended with the free-market that allowed individuals to issue money; Murray named his own hypothetical currency “the Rothbard.”

These were the pre-Bitcoin decades. Money radicals solved the trusted-third-party problem by demanding free-market money and banking; they did this because the only third party on which they focused was government. The solution did not go far enough because free-market alternatives also rested on trust and, any time trust is required, betrayals will occur. But privatization was the best solution possible at the time; the blockchain had not surfaced to allow people to become self-bankers.

“What Has Government Done to Our Money?” belongs to the pre-Bitcoin years but it has significant contributions to offer the cryptocurrency world. There, Rothbard explains the origins of money as well as its pivotal importance to freedom and civilization. Free-market money is rooted deep within the needs of human nature, which makes a lie of the argument that regulating bitcoin is no big deal or even beneficial. If freedom and civilization depend on a free-market money, then unregulated cryptocurrency is essential to human welfare. Rothbard next sketches the catastrophic impact of government on money; namely, it destroys freedom and reverses the progress of civilization. These are the stakes of the game. Rothbard provides a context in which to appreciate the immense liberation that is the blockchain and the immense oppression that is modern monetary policy.

The book is a deceptively simple exposition of the world’s greatest swindle: inflation. The scam was possible because people needed a trusted third party in currency and government legally usurped that role, especially through central banking systems. The scam is no longer inevitable, however, because an intermediary is no longer necessary.

To understand the devastation of inflation, it is necessary to grasp the nature and power of money. Monetary theory needs to be laid out in simplistic terms because an intentional haze of complexity has ensured that people like my parents are left speechless and puzzled when confronted by easy questions. The confusion is intentional because it could be easily avoided. Schools could teach commonsense economics; government and financial institutions could be transparent rather than presenting a brick wall, as the Federal Reserve does about being audited; fiscal policy could be presented in English rather than bureaucratized with impenetrable statistics. It won’t happen. The lack of public awareness benefits government in tightening its grip on money.

A Brief Tour of the Basics

(Note: “money” here is used as a synonym for “currency” because that is money’s most important function. The other functions — acting as a store of value or a unit of account — are consequences of its primary role as currency.)

Goods and services are exchanged within every society because exchange is a human need. It is the engine of economic life. It is a wellspring of prosperity because exchange is not a zero-sum game, as some economists argue. That is to say, if a person trades a fish for a loaf of bread, it is not because the value of a fish is one loaf of bread with each trader’s gain and loss equaly balancing the other’s. The exchange occurs because one person values the bread more than the fish and vice versa; each profits from the exchange or it would not occur. As a by-product of trading, the parties also establish cooperation and perhaps a level of good will, which means exchange may be the basis of civil society as well.

Human beings are so diverse that the skills within even a small set of individuals can vary dramatically; trading these skills, and the resulting goods, increases the odds of survival both for the group and for each member. But direct exchange or barter is severely flawed, as Rothbard explains. “The two basic problems are ‘indivisibility’ and ‘lack of coincidence of wants’.” Indivisibility means it is difficult or impossible to divide many barter items, like a plow, in order to trade for several different things with multiple people. So no trade occurs. A lack of coincidence of wants means Smith has eggs and Jones has shoes but Smith wants to trade for butter. So no trade occurs.

Indirect exchange solves the barter problem…to a degree. Smith trades with Jones for a marketable good he doesn’t want but which can be traded to a third person for something he does want. A remarkable by-product spontaneously emerges: money. Indirect trading naturally encourages a medium of exchange to appear. Why? Those who buy a good to trade it will favor a highly marketable one that exchanges widely, easily and well. Highly marketable goods tend to share characteristics such as divisibility, durability, fungibility and transportability; it is no coincidence that these same characteristics are often used to describe good money.

In the beginning, the marketable good is generally desired due to its use value. Rothbard lists some goods that went on to become currencies: “tobacco in colonial Virginia, sugar in the West Indies, salt in Abyssinia, cattle in ancient Greece, nails in Scotland, copper in ancient Egypt, and grain, beads, tea, cowrie shells, and fishhooks.” The demand for the good soon generates a “reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media–in almost all exchanges—and these are called money.” On this basis, Rothbard would have rejected bitcoin as currency, insisting it did not originate in or constitute a “useful commodity.” A rebuttal of this position occurs earlier in this chapter.

Commonly-accepted currencies eliminate the need for indirect exchanges that can be clumsy, time consuming and geographically limited. Eventually, currency created a complex free-market that allowed millions of people to consume products from around the world. Prosperity ensued. In short, money catapulted human beings from survival and into circumstances with time to think, to be artistic, to pursue relationships, to invent, to waste time. In other words, money permitted civilization. Mark Twain was correct in revising the old expression to read, “the lack of money is the root of all evil.”

Enter government. Currency had played a defining role in freeing and civilizing human beings but now it would be used to enslave and debase them.

Inflation, the Greatest Theft of All

Unlike individuals, government does not trade goods and services for money in a voluntary exchange. Instead, government expropriates wealth from productive people by forcing them to pay for its ‘goods’ and ‘services’ whether or not they want to or benefit from them. Taxation is the most visible form of theft but a myriad of others exist, from monopolizing goods like postage stamps to licensing cars.

The most powerful tool of expropriation is the government’s monopoly on issuing money or fiat. Rothbard explains, “The emergence of money, while a boon to the human race, also opened a more subtle route for governmental expropriation of resources….[I]f government can find ways to engage in counterfeiting—the creation of new money out of thin air—it can quickly produce its own money without taking the trouble to sell services or mine gold. It can then appropriate resources slyly and almost unnoticed, without rousing the hostility touched off by taxation.”

Everyone understands taxation because it comes with forms to fill out, a need to write checks or to pay a visible premium at the checkout. No wonder tax resistance and rebellions have been common themes through U.S. history since the American Revolution. But inflation is too subtle and complex to create enraged mobs…that is, until it goes badly out of control and then it is too late. If taxation is a gun, then inflation is like a cat burglar. This makes it all the more important to understand.

Inflation is an increase in the supply of money and credit. It is usually associated with government, and with good cause, but it can occur with free-market money as well. For example, the supply of gold could increase for various reasons. But a crucial difference exists between government and free-market inflation. Gold fulfills many non-monetary uses and those employments would increase as the cost of gold fell. This means an inflation in gold is a social good for the other uses even if the inflation temporarily reduces its monetary value. The increased demand for non-monetary uses both absorbs the “excess” supply and drives the monetary value back up. In short, the inflation tends to be self-adjusting, temporary and is accompanied by a social benefit. Moreover, a fall in gold will drive up the value of competing currencies, such as silver.

By contrast, government fiat’s only use value is as currency which means there is no self-adjusting mechanism. World markets may react negatively and devalue the egregious fiat – that is, if their fiats are not as bad or worse. If so, the offending government can crank up the printing press and create a vicious circle of further increasing the money supply. The average person has little choice but to live with the inflation because legal-tender laws forbid competing currencies. In short, fiat inflation has no social benefit or escape route, only social devastation and entrapment.

The word “inflation” is often used as a synonym for “a rise in prices” but the rise is a consequence of inflation, not its cause. The cause is an increase in the supply of money and credit. The difference between these two usages is more than semantic. Viewing inflation as rising prices misses much of the great harm it inflicts. For example, inflation redistributes wealth from average people upward to the ruling classes. This happens because freshly-printed fiat is initially valued at the same rate as all other units of it in existence. Doubling the money supply overnight eventually collapses the buying power of each unit, but the first users enjoy the pre-inflation value because the increase has not trickled through the economy. The first users are typically government, banks, financial institutions or businesses that are offered favorable loans. The end user receives fiat that has gradually diluted in buying power as it has spread throughout the economy. This user is the average person who bears the full brunt of inflation by having the value of his income sink while prices around him soar.

With legal-tender laws and the elimination of the gold standard, there is little to check government from pumping up money and credit at will, using interest rates for fine tuning. The incentives are all on the side of inflation. It is hugely profitable to government and mostly invisible to the average person, especially in its early stages. The economic villain of free-market advocates, John Maynard Keynes, knew this well. His pivotal book “The Economic Consequences of Peace” (1919) states, “By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

The harms of inflation scroll on and on. Rothbard highlights a less-discussed one. “It distorts that keystone of our economy: business calculation. Since prices do not all change uniformly and at the same speed, it becomes very difficult for business to separate the lasting from the transitional, and gauge truly the demands of consumers or the cost of their operations. For example, accounting practice enters the ‘cost’ of an asset at the amount the business has paid for it. But if inflation intervenes, the cost of replacing the asset when it wears out will be far greater than that recorded on the books. As a result, business accounting will seriously overstate their profits during inflation—and may even consume capital while presumably increasing their investments.”

The Central Bank bears massive blame for the theft and market distortion of inflation. In the United States, the Federal Reserve System is sometimes called “private.” For one thing, the regional Reserve Banks are private corporations that are owned by their member banks. The label is illusory. The Federal Reserve was established by an act of Congress (1913) and derives its core power from a government-granted monopoly to issue money. The system may mimic a private agency in some ways but, as Rothbard explains, the system of banks are “always directed by government-appointed officials, and serve as arms of the government.”

The Federal Reserve consistently acts in a manner that enables inflation. It does so in two ways: removing checks on inflation and directing inflation itself. Rothbard offers an example of the first tactic. “[T]he Federal Reserve Act compels the banks to keep the minimum ratio of reserves to deposits and, since 1917, these reserves could only consist of deposits at the Federal Reserve Bank. Gold could no longer be part of a bank’s legal reserves; it had to be deposited in the Federal Reserve Bank.” He illustrates the second: “By controlling the banks’ ‘reserves’—their deposit accounts at the Central Bank. Banks tend to keep a certain ratio of reserves to their total deposit liabilities, and in the United States government control is made easier by imposing a legal minimum ratio on the bank. The Central Bank can stimulate inflation, then, by pouring reserves into the banking system, and also by lowering the reserve ratio, thus permitting a nationwide bank credit-expansion.”

Fiat inflation destroys the free-market which is its antithesis. The extent to which government tightens its grip on money is the extent to which the free exchange upon which liberty and civilization rests is weakened. Traditional private money confronts the government in an admirable David-Goliath fashion but it does not remove the statist loophole that allows inflation – the need for a trusted third party. Not until the blockchain sidesteps government and obviates trust does currency regain its status as a vehicle for freedom and civilization.

The Satoshi Revolution – Chapter 1: Politics Versus Ideology (Part 3)

The Satoshi Revolution: A Revolution of Rising Expectations.

Section 1: The Trusted Third Party Problem
Chapter 1: Listening to the Past
by Wendy McElroy

Politics Versus Ideology (Chapter 1, Part 3)

A lot of people automatically dismiss e-currency as a lost cause because of all the companies that failed since the 1990’s. I hope it’s obvious it was only the centrally controlled nature of those systems that doomed them. I think this is the first time we’re trying a decentralized, non-trust-based system.
Satoshi Nakamoto

Bitcoin Avoids the Lethal Problems of Earlier Private Currencies

(Caveat: I do not mean to credit Satoshi Nakamoto for all good things within cryptocurrency, as I may seem to be doing. Visionaries came before him and forged new paths. For example, Timothy C. May’s “Crypto Anarchist Manifesto” was published in 1988 and opened with the remarkable sentence, “A specter is haunting the modern world, the specter of crypto anarchy.” The genius of Nakamoto was twofold. He produced an elegant, original technology that rivals the Gutenberg printing press and allows the implementation of economic crypto anarchy; and he saw clearly its broad political, revolutionary significance. As much as anything, Nakamoto is a symbol and an aegis for others who have done or are doing fine work.)

Part of the Satoshi Revolution’s brilliance lies in the fact that it is profoundly political without being ideological. Most people see little difference between the political and the ideological or, if they do make a distinction, they believe ideology is the set of beliefs that determine the specific political positions a person takes. In many cases, they are correct. But not in all cases. Sometimes politics and ideology are distinct.

Bitcoin is political in the same sense as the Gutenberg printing press (1448).
Although his press was not the first one, Johannes Gutenberg (c.1400-1468) pioneered innovations that were almost as creative as those of Nakamoto. For example, he used a durable oil-based ink rather than water-based ones that did not last well. He used a strong alloy to create close to 300 separate type bits that could be quickly assembled into uniform templates; prior printers used fragile wooden bits or carved the letters of each page into a wooden block to be inked. Then Gutenberg. Opened a world of information and ideas to the average person who no longer needed to rely on authorities for ‘truth’. The printing press decentralized knowledge from the hands of authorities to those of the common man, and knowledge is power. This made it not only a technical marvel, but also an agent of social change and revolution.

Those who ruled would have prevented the shift in power by plugging the flood of opinions and ideas, if they could have, because an illiterate, uninformed public is easier to control. A literate, informed public serves the goals of populists and reformers who threaten the status quo which is the main reason state censorship existed then and now. Unfortunately for the ruling class, literacy increased and more people judged for themselves which religious and political beliefs resonated inside of them as real.

One example of social upheaval: without Gutenberg’s printing press, the Protestant Reformation is difficult to imagine. When Martin Luther launched the Reformation in 1517 by nailing his Ninety-Five Theses to the door of a German church, the document was rapidly translated from Latin into German, copied and reprinted. Luther, the man, could reach only those within the range of his voice. Luther, the mass-produced author, spread ideas across Europe in months. Within three years, hundreds of thousands of copies of his Theses had been cranked off hundreds of printing presses. The Catholic Church responded by excommunicating Luther and prompting him to flee into hiding. But ideas do not respond to hellfire, nor do they flee.

The Gutenberg printing press was a powerful, political tool which sparked movements and revolutions. But the printing press itself was not ideological because any idea could be assembled in templates and printed en masse for people to read: Catholicism or Protestantism, individualism or socialism, Karl Marx or Ayn Rand. The machine itself was neutral. The printing press had strong ideological implications, it could be argued, because it did empower the individual and the masses. In other words, it was a populist force. But authorities also used the new technology to their own statist advantage. As magnificent as the printing press was, it was a tool to produce good or ill, depending on the purpose of the user.

Bitcoin is similar. It empowers the individual which is a profoundly political act. But that empowerment makes everyone freer to choose whatever ideology they wish. Bitcoin itself has no settled ideological slant. That’s why individualists, anarchists and socialists alike can use it as a way to pursue their own goals, whatever those goals may be. Amir Taaki, a developer of the Darkmarket/Openbazaar and Dark Wallet, is an aggressive left-anarchist. He spent time in Rojava [Syrian Kurdistan] helping to found a People’s Republic through the introduction of Bitcoin. Rojava was “under embargo, so there’s no way to move money in or out,” he explained. “So we have to actually create our own bitcoin economies. Now we have a technological tool for people to freely organise outside [the] state system. Because it is a currency not controlled by central banks.”

Bitcoin is a mechanism that can achieve a galloping diversity of goals. This is a great strength.


The answer lies in history and requires a bit of background.

A key difference between the radical, individualist movements of the 19th and 20th centuries is that the earlier one focused intensely on the importance of private money and private banking to achieve personal freedom. The radicals placed a primal emphasis on the right of every individual to create their own currency and to function as their own bank. It was a natural right every bit as important as freedom of speech or freedom of religion.

Some 20th-century advocates of private money, such as Rothbard or Hayek, took a similar approach. Rothbard wrote, “Let us first ask ourselves the question: Can money be organized under the freedom principle? Can we have a free market in money as well as in other goods and services? What would be the shape of such a market? And what are the effects of various governmental controls? If we favor the free market in other directions, if we wish to eliminate government invasion of person and property, we have no more important task than to explore the ways and means of a free market in money.” Most modern advocates, however, argue in utilitarian or public-policy terms instead of civil liberties.

Their 19th-century counterparts were more consistently accurate in placing monetary theory at the core of all freedoms. The pivotal individualist-anarchist Benjamin Tucker believed the right to issue private currency was so important that it could destroy the State all by itself. The money monopoly was the means by which the State sustained itself and robbed the average person not merely of money but also of economic opportunity by controlling credit. Nothing was more important than to destroy the money monopoly.

Two specific events sculpted the approach of individualist anarchists to the banking monopoly and private currency. James J. Martin commented on one of them:

“Few instances in American history have created as much curiosity concerning economic and financial matters among amateurs and members of the general citizenry as the panic of 1837…Banking abuses came under concentrated scrutiny and gave rise to many proposed radical remedies.”

The other event was the Civil War in which the North used the Legal Tender Acts and the National Banking Act of 1863 to finance its side of the conflict. Through these measures, Congress guaranteed the notes of authorized bankers and legally protected them from liability for debt. The act also established a national tax of 10 percent for all money not authorized by Congress.

Fresh with a knowledge that private currency not only could work but had been working well for well over a century, the 19th-century radicals responded. They did not merely theorize; they vigorously issued private currency and experimented with new economic models. Their efforts are fascinating to review but they are also cautionary tales as to some pitfalls that private money should avoid.

A major problem for 19th century individualist anarchism in America was the movement’s determination to link private money to the labor theory of value. The theory states that the economic value of a good or service is based upon the amount of labor required to produce it rather than upon what a capitalist wants to charge or what a purchaser is willing to pay. Radical individualists back then generally rejected profit from the capital because it constituted value in excess of the labor invested in a good or service. They rejected excess profit in three forms: interest on money, rent, and profit in exchange – all of which were called “usury.” If the main political goal of 19th century radical individuals was the abolition of the State, then their main economic goal was the abolition of the “money monopoly.” By the term “money monopoly,” they referred to three different but interacting forms of monopoly: banking, the charging of interest, and the privileged issuance of currency. In short, unlike Gutenberg’s printing press and Bitcoin, their private monies were grounded in ideology and a badly flawed ideology, to boot. This greatly reduced the social value of their currencies as a tool. For one thing, when the labor theory of value became less popular, the currencies seemed to be discredited.

Josiah Warren provides a real-world example of the problem of attaching an ideology to money. Warren, who is credited with being the first American anarchist, based his political thought on two concepts, both which were common within the 19th-century radical individualist movement. The first was “Sovereignty of the Individual,” which meant every human being was a self-owner with jurisdiction over his or her peaceful actions. The second was “Cost is the Limit of Price” or the labor theory of value.

Warren tested his specific solution to the money monopoly and to the “inequity” of interest through a Time Store from which he issued Labor Notes. In 1827, the business opened with $300 worth of groceries and dry goods that were offered at a 7 percent markup from Warren’s own cost in order to cover expenses such as overhead. This was before groceries were pre-packaged, pre-weighed and it was common for buyers to bargain with the shopkeeper rather than pay a posted price. One of Warren’s innovations was to post prices for goods which drove prices even lower because transactions consumed less of his time. The customer paid in traditional money for the good and, then, compensated Warren for his time through a Labor Note which obliged the customer to provide Warren with an equivalent amount of the buyer’s time. If the buyer were a plumber, for example, the Labor Note committed him to render his services to Warren for “X” units of time in plumbing work. The Labor Notes were circulated and traded. Warren’s goal was to establish an economy in which profit was based solely on the exchange of time and labor.

To some degree, he succeeded. People travelled from a hundred miles away to avail themselves of Warren’s low prices. After a few years, Warren declared the experiment to be a success and closed the store’s doors. Whether the store was a success is questionable, however. And, if it was a success, it was probably due more to low prices than to the Notes that came close to being a barter system. Whichever is true, it is difficult to see how this novel currency could have functioned in dense populations where people were not acquainted with each other, or for commerce on a grander scale. And exchangers still had to trust other people.

Some might state the lesson of attaching an ideology to an instrument for political liberation as “get the damned ideology correct this time.” I believe this is the wrong lesson. The point of empowering people is to give them the tools to decide on ideas and life for themselves, not to deliver a predigested message. That’s the lesson of Gutenberg and Bitcoin.

It is also a reason to stand hard behind the original vision of Bitcoin, because the power Nakamoto produced can be used well or badly depending on the intentions of the user.

And, now, Satoshi?

To paraphrase George Bernard Shaw, I hear the future knocking on my door. And as I throw it open, I see Satoshi Nakamoto standing at my threshold with a grin on his face, asking to come in. Just as I begin to wave him through, however, Murray Rothbard appears and shoves him aside with the words “Not so fast there, Saschik, I have something to say to her first!” And, if for nothing more than the fact that he infused the modern freedom movement with Austrian economics, my old friend and mentor deserves to take the next step.

The Satoshi Revolution – Chapter 1: What is a Trustless System? (Part 1)

The Satoshi Revolution: A Revolution of Rising Expectations

Section One: The Trusted Third Party Problem
Chapter 1: Listening to the Past
by Wendy McElroy

What is a Trustless System? (Chapter 1, Part 1)

“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.”
Satoshi Nakamoto

A trustless system is one that does not depend upon the intentions of its participants, who may be honorable or malicious. The system functions in the same manner regardless of intentions. The blockchain, with a peer-to-peer protocol that is also transparent and immutable, is trustless. Intentions become important only when there is an intermediary who must be trusted. The third party’s good or bad motives become a determining aspect of the transaction and place the other parties at the mercy of his honesty. This is the trusted third party problem.

On a small scale, the problem will always exist because there are times when a middleman is useful or necessary. The ideal third party is trusted, trustworthy and competent. Some people are dishonest, however. They steal, overcharge, lie or otherwise betray their customers’ confidence in order to make profit over a fee. If the swindling is a one-time event and other third parties are available, the damage is limited. The two people take their business elsewhere, consider suing, report the swindler to business watchdogs and warn others.

An occasional dishonest third party is not the problem Satoshi Nakamoto addressed when he used Bitcoin as a lever to upend the world. It is the institutionalized and constant corruption of governments and central banks from which the average person cannot escape. Almost everyone who worked over-the-table, ran a business, bought goods from stores, accepted government benefits or paid taxes had to accept a fiat that constantly plunges in value due to inflation. Almost everyone who used credit, accepted checks, took out loans, conducted commerce or did business abroad needed to use banks that stole like drunken muggers.

To the average person, the situation looked hopeless. Competing with the government-banking cartel was illegal and severely punished. No speedy, safe and private alternative existed for transferring funds across borders…or across town. Attempts to reform or remove the system seemed doomed. Reform was impossible because monetary policy had rotted to its core and needed to be uprooted, not improved; removal was inconceivable because the monopoly was deeply entrenched and all-powerful. People’s need for money became a straitjacket.

And, then, Satoshi Nakamoto. And, then, the blockchain and bitcoin. Not just a new currency but a new concept of money was created, and in a form that cannot be inflated because it is fixed at 21 million units. The supply of bitcoin can only decrease as some coins are inevitably lost, for example, by people who forget a password. Satoshi noted, “Lost coins only make everyone else’s coins worth slightly more. Think of it as a donation to everyone.”

Peer-to-peer transactions go through a middleman called a miner but no trust is required as the transaction is released only when “proof of work” is rendered; this consists of a miner solving complicated math. The solution is costly in computer power and time-consuming to produce but easy for others to verify. Satoshi commented, “With e-currency based on cryptographic proof, without the need to trust a third party middleman, money can be secure and transactions effortless.” The soundness and propriety of the blockchain’s protocol itself is assured by the use of an open source that is visible and verifiable to all. Satoshi’s private currency snaps the monopoly of governments and central banking.

There is precedent for this in theory and in practice.

Precedent in Theory

Friedrich A. Hayek is the most respected Austrian economist of the late 20th century. In The Denationalisation of Money: An Analysis of the Theory and Practice of Concurrent Currencies (1976), he argued vigorously for private and competitive currencies to displace government issued ones. Hayek asked a key question. “When one studies the history of money one cannot help wondering why people should have put up for so long with governments exercising an exclusive power over two thousand years that was regularly used to exploit and defraud them. This can be explained only by the myth” of the necessity of government money “becoming so firmly established that it did not occur even to the professional students of these matters…ever to question it. But once the validity of the established doctrine is doubted its foundation is rapidly seen to be fragile.” (A slightly revised edition entitled Denationalization of Money: The Argument Refined was published in 1978.)

Governments know it is hugely profitable to debase the currency as long as people have no alternative but to accept it and they put the full weight of bureaucracy behind currency manipulation. But the system is fragile because it relies on people not understanding that debasement is theft and not having a choice. Otherwise, the status quo crumbles. The 1974 Nobel laureate pondered why public understanding was so elusive. “[W]hy [is] a government monopoly of the provision of money…universally regarded as indispensable” and what would happen “if the provision of money were thrown open to the competition of private concerns supplying different currencies.” (Hayek’s specific proposal for private currency is explored elsewhere in this book.)

With eerie prescience, Hayek argued for currencies to be developed by entrepreneurs who could innovate new forms of money just as they innovated in other areas. One of the drawbacks of governments’ monopoly on money was that it imposed a freeze on the sort of invention now running free in cryptocurrencies.

The voluntaryist historian Carl Watner observed, “No one can tell in advance what form these monies might take because no one can know for sure what choices individuals would make or what new technologies might be discovered. Laws forcing people to use the Federal Reserve System money have frozen monetary developments at a certain stage….Just imagine if Congress had protected the Post Office by passing laws that would have prevented people from communicating via the internet. We would never have experienced the marvels of e-mail.”

Along with Hayek, the Austrian economist Murray Rothbard wrestled with the question of “why do people so vigorously resist private currencies?” His book, For a New Liberty: The Libertarian Manifesto offered an explanation. “If the government and only the government had had a monopoly of the shoe manufacturing and retailing business, how would most of the public treat the libertarian who now came along to advocate that the government get out of the shoe business and throw it open to private enterprise?” Rothbard predicted they would attack the libertarian with outrage for depriving them of the only possible source of shoes. People were thoroughly indoctrinated to believe that government was necessary and daily life could not function without it.

Hayek and Rothbard are unusual among economists in that they embrace private money. Even free market zealots rarely champion free market currencies and private banking. Instead, they debate marginal issues such as fractional reserve banking which amounts to a trivial reform. Or they argue for the need to restore a gold standard. But if the gold standard is applied to existing fiat, then it means trusting governments and banks to be transparent; it means trusting them to act directly against their own interests, which they have historically refused to do. The trusted third party problem remains untouched and it is the root of all other corruption, including currency manipulation. An inherently corrupt institution cannot be reformed; it must be swept away or totally avoided.

What could convince the public and economists that private currencies work as well or better than government issued ones? One way is to point out that they already have worked better by providing real examples from the past and drawing parallels to cryptocurrencies.

America is Born into Private Currency

Early America offers powerful lessons about private currencies.

The British colonies naturally used British currency, but the homeland’s monetary policies created an appetite for alternative monies. Rothbard explained in A History of Money and Banking in the United States: The Colonial Era to World War, II (2002), “Great Britain was officially on a silver standard….However, Britain also coined gold and maintained a bimetallic standard,,,,In 17th- and 18th-century Britain, the government maintained a mint ratio between gold and silver that consistently overvalued gold and undervalued silver in relation to world market prices.” Great Britain’s policies created a robust market in substitutes for its own money.

Gresham’s law ruled colonial money as it rules all currencies. The law states: if two types of money are valued the same by law even though the market values of one is higher than the other, then the more valuable money will disappear from general circulation and be used for other purposes like hoarding or foreign trade. That is the meaning of the phrase “bad money drives out good.” Full-bodied silver coins began to disappear from circulation within the colonies, which turned to lighter silver, commodity-based money such as cotton or foreign and privately minted coins. These monies were parallel currencies with Spanish pieces of eight being particularly popular.

The first privately-minted American coin was the Granby or Higley Token that was struck by Dr. Samuel Higley of Connecticut in 1737. Samuel died shortly thereafter and his brother, John Higley, produced the copper coins from 1737 to 1739 inclusive. Valuing the tokens at three pence each, John is said to have spent most of them at the local bar until the barkeep refused to accept any more. Then he cast coins with one side reading “Value Me as You Please” and the other side stating “I Am Good Copper.” No value was stamped on the coin, which was common practice in those days. The coins circulated widely for many years even after John ceased minting largely because goldsmiths used them as a reliable alloy with which to make gold jewelry. Later metallurgical analysis of the Granby found the coins to be 98-99% pure copper.

The Granby benefited from what the Austrian economics icon Ludwig von Mises (1881-1973) called the Regression Theorem. In The Theory of Money and Credit, Mises wrote, “The theory of the value of money as such can trace back the objective exchange value of money only to that point where it ceases to be the value of money and becomes merely the value of a commodity.”

Economics Professor Jeffrey Rogers unpacked the concept. Today’s purchasing power of money “draws on yesterday’s, and yesterday’s…and so on….How far back does the regression…go?….[L]ogically, Mises explained, for a commodity money it goes back to the day before the commodity first started being used as a medium of exchange. On that day it had an exchange value or purchasing power due only… as an ordinary commodity (for consumption or for use as a productive input) and not for use as a medium of exchange. For…the U.S. dollar that became a fiat money by terminating the redeemability of what had been a claim to a commodity money…the historical chain goes back to the day before termination, and thence back to the day before that commodity became a medium of exchange. Application of the logic to a new fiat money,” is with reference to the official rate of redemption for an established fiat money.

In short, the value of a money is a composite of the demand for it as a medium of exchange and the demand for it as a commodity.

Bitcoin’s relationship to the Regression Theorem is important since critics often dismiss cryptocurrencies as money or currency because they violate the theorem. Most bitcoin enthusiasts react in one of three ways: they don’t care; they claim the theorem does not apply to the digital age; they insist it does apply to bitcoin, but in a misunderstood manner.

The economist Robert P. Murphy explained how bitcoin emerged as a medium of exchange without being tied to a commodity or redeemable in a fixed amount to an established fiat. The article “Why Misesians Need to Tread Cautiously When Disparaging Bitcoin” argued, “[T]he very first people to trade for it did so because it provided them with direct utility because they knew there was at least a chance that it would serve to chafe the governments of the world….[T]he early adopters of Bitcoin were doing it for ideological reasons, not for pecuniary reasons.” The ideology and the freedom it provided were the ‘commodity’ value of bitcoin‘.

Bitcoin enthusiast Jeffrey A. Tucker took a different tack. In a Foundation for Economic Education article entitled “What Gave Bitcoin Its Value?,” he pointed to the purpose Mises’s theorem served; it helped answer the question of why certain commodities emerged as currencies while others did not. Tucker ascribed the emergence of salt rather than gravel, as a currency to a widespread desire for salt and its direct utility.

Tucker then linked bitcoin not to a hard good but to a hard service which fills a deep need and has direct utility: the blockchain as a payment system. “Bitcoin is both a payment system and a money. The payment system is the source of [non-monetary] value, while the accounting unit merely expresses that value in terms of price. The unity of money and payment is its most unusual feature, and the one that most commentators have had trouble wrapping their heads around….This wedge between money and payment has always been with us, except for the case of physical proximity. If I give you a dollar for your pizza slice, there is no third party. But payment systems, third parties, and trust relationships become necessary once you leave geographic proximity. That’s when companies like Visa and institutions like banks become indispensable.”

The non-monetary worth of bitcoin resides in its payment system that does not require a trusted third party and, yet, has no geographical limitations. Otherwise stated, for Tucker the blockchain is the independent root with intrinsic value from which bitcoin as a medium of exchange emerged. The Regression Theorem applies to bitcoin, but it needs to be expanded to include services in order for the theorem to fit the digital age.

The private currencies of early America offer many such lessons. The history of the NYC goldsmith and silversmith Ephraim Brasher (1744-1828), for example, demonstrates a means by which privately-minted coins circulated widely through the colonies without being restrained by doubts about their purity and weight. Many private minters had reputations within their own communities but circulation was often limited to those communities. Brasher offered a solution. He became renowned for testing coins upon which he stamped “EB” if they were sound. Backed by his reputation, coins migrated far and wide.

The need for minters to be of good reputation highlights an advantage bitcoin has as a currency. It sidesteps the entire issue of the verification of purity or weight. Unlike physical coins, bitcoins cannot be shaved down, counterfeited, diluted by alloys or negated by the reputation of miners who release them or of users who exchange them. A bitcoin is a bitcoin is a bitcoin and no one can alter that fact. But cryptocurrencies do compete with each other for acceptance. Reputation is important to the competition and it is established largely by feedback from the Internet-connected community.