The Bitcoin scaling debate goes on and on. The argument is not over whether Bitcoin should scale up: clearly, if it is to become a serious challenger to mainstream payments providers such as Visa and central bank RTGS systems such as Fedwire, it must be able to handle daily transaction volumes in the billions. No, the question is how it should scale up.
There are basically two camps: those who follow the original thinking of Bitcoin’s creator, Satoshi Nakamoto, that all transactions should be on-chain and democratically validated, and those who think that the way forward is to take most transactions off-chain, leaving only large transactions (perhaps made up of thousands of netted small transactions) on the main blockchain.
There is little doubt that the network could scale up to handle Fedwire volumes. Technology is not the problem. The problem is price – and in particular, the price of transactions.
Satoshi relies heavily on Moore’s Law to justify his argument that the system will be able to scale up to handle billions of transactions at very low cost:
Visa processed 37 billion transactions in FY2008, or an average of 100 million transactions per day. That many transactions would take 100GB of bandwidth, or the size of 12 DVD or 2 HD quality movies, or about $18 worth of bandwidth at current prices. If the network were to get that big, it would take several years, and by then, sending 2 HD movies over the Internet would probably not seem like a big deal.
It is unclear whether Moore’s Law will continue to apply forever. If it does, then at some point in the future computing power will effectively be free, so the only cost for Bitcoin users will be the reward required by miners for validating their transactions. If it doesn’t, then at some point in the future the price of computing power will stabilise at a level somewhere above zero. Under this scenario, transaction fees would need to be higher – possibly significantly so. The eventual stable cost of computing power will determine the long-run price of Bitcoin transactions. If it is too high, it will effectively set a limit to the scalability of Bitcoin.
However, even if computing power is effectively free, transaction fees could still be high enough to prevent Bitcoin becoming a mainstream payment service provider. James Donald, in a discussion with Satoshi, pointed out that, particularly for micropayments, transaction fees need to be very low:
File sharing requires extremely cheap transactions, several transactions per second per client, day in and day out, with monthly transaction costs being very small per client.
He argued for a layered approach, with most transactions taking place off the main chain using anonymous tokens rather than bitcoin:
So to support file sharing on bitcoins, we will need a layer of account money on top of the bitcoins, supporting transactions of a hundred thousandth the size of the smallest coin, and to support anonymity, chaumian money on top of the account money.
Donald has proposed the same solution to the store-of-value versus medium-of-exchange conundrum that humans have adopted for millennia. He envisages a base store of value which is intrinsically scarce and expensive – let’s call it “gold” - and on top of that, some form of “token” which is intrinsically worthless and can be produced in very large quantities – let’s call it “paper”. Those who want a store of value will hang on to gold: those who want a medium of exchange will use paper. As long as paper never becomes a store of value in its own right, everyone is happy, since sufficient token money can easily be produced to keep transaction costs low, while base money continues to hold its value. But of course, as all flows of money result in changes in stocks of money, paper must at some point be exchanged for gold, or it will inevitably become a store of value, undermining what we might term the “separation of powers”. Therefore, the paper must have a value expressed in terms of gold. This is how a gold standard currency works. It is also how Donald’s idea would work for Bitcoin.
Who would issue the token money? Why, banks, of course. They may not be called banks – they might be called “nodes”, or “exchanges”, or “intermediaries”, or “trusted third parties”. But that is what they are. Indeed, Donald recognises them as such, calling them “bitcoin banks”, or “binks”. Their job is to transfer bitcoins from Alice to Bob. They do so by using a token money which they create themselves and which is exchangeable at an agreed rate for bitcoins at either end of the transaction – or, since we are talking about micropayments here, a series of transactions.
The rate at which tokens are exchanged for bitcoin matters. Gold standard systems work best when the exchange rate between “paper” and “gold” is fixed: if it is not, then the aggregate value of a stream of transactions could change in gold terms between its start and its finish, to everyone’s consternation. But if it is fixed, then the market price of Bitcoin affects the value of tokens, and therefore their purchasing power. If Bitcoin is increasing in value in tandem with the amount of token money created, increasing the supply of token money doesn’t make any difference to its real value in bitcoin terms. But if the price of Bitcoin is stable, then increasing the supply of token money represents a real fall in value.
At this point, hard-money enthusiasts start extolling the virtues of deflation. But if Bitcoin is ever to be a serious challenger to mainstream payments systems, it must be able to create enough liquidity to support very high – and variable – volumes of transactions at low cost. The desire to preserve wealth cannot take priority over the need to support economic activity. Poverty and inequality due to scarcity of money and high transaction costs are surely worse evils than (mild) inflation.
The conundrum faced by Bitcoin at this juncture is not unlike the famous argument over gold and silver coinage that took place in late 19th century America. The elites in the cities favored a strict gold standard, because that preserved their wealth. But impoverished farmers wanted silver coins to be issued at a ratio of 16:1 to gold, because that would give them much needed liquidity. The famous “Cross of Gold” speech of William Jennings Bryan in 1896 was effectively an impassioned appeal for Donald’s solution:
If they dare to come out in the open field and defend the gold standard as a good thing, we shall fight them to the uttermost, having behind us the producing masses of the nation and the world. Having behind us the commercial interests and the laboring interests and all the toiling masses, we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold.
While Bitcoin remains primarily of interest to investors looking for a safe store of value, Satoshi’s approach is undoubtedly right. But if it is ever to facilitate the financial transactions that support real economic activity – the billions of payments made by people and businesses every day, everywhere in the world – it must transform itself into something much more akin to our present-day banking system. For, unlike the farmers for whom Bryan fought, today’s businesses and households can choose which means of exchange to use for their transactions. They do not have to crucify themselves upon a cross of Bitcoin.
