Bitcoin’s Bold Experiment: A Goldmine for Economic Researchers

For academic economists meeting in San Francisco this week, digital currencies offer rich new research opportunities. Photo credit:

By Michael J. Casey

Outsiders are understandably baffled by the bitcoin community’s civil war.

The long-running dispute among the cryptocurrency’s top software developers hinges on a seemingly arcane issue: whether or not to increase the 1MB limit for each block of transactions in bitcoin’s blockchain ledger. How could such a trifling software fix cause so much angst?

But while bitcoin’s critics flag the impasse as proof the digital currency isn’t ready for Prime Time, I’d suggest an alternative perspective: it represents all that makes this open-source project fascinating. It’s a reminder of how big and bold the bitcoin experiment is, and of why social scientists should be studying it.

At MIT’s Digital Currency Initiative we see digital currencies as a goldmine for scholars — especially economists. If they can focus less on bitcoin the currency — and the dismissive assertions many often make about its unworthiness as a challenger to the dollar — and more on the many potential applications and social implications of bitcoin the technology, a world of intriguing research opens up.

Bitcoin is much more than a computer science development; it’s also a unique, self-regulating incentive system for achieving a notoriously difficult social objective: getting human beings to act in ways that serve both their self-interest and the common good. Bitcoin is a governance project, an attempt to overcome the Tragedy of the Commons.

Contrary to how it is often described, bitcoin-to-bitcoin transactions are not “unregulated.” It’s just that the regulations are enforced by software. The bitcoin protocol is the rule set that governs its economy.

Outgrowing the Rule Set

Efforts to govern economies always tend reach limits at which the original rules no longer fit because circumstances have outgrown them. At that moment, laws become tools of influence and privilege rather than protectors of a common interest. It’s also the moment at which the most aggressive lobbying begins. As per the “capture” theory of economic regulation, special interests can and will shape the regulatory reform push, often more so than the public interest. We saw this with the unseemly horse-trading that accompanied Congress’s drafting of the Dodd-Frank Act to overhaul U.S. financial regulations after the 2008 financial crisis.

This is precisely where bitcoin is now — albeit without Wall Street’s extreme “money politics.” Transactions in the bitcoin economy have grown to a point where a rule intended for the common good — one that discouraged distributed denial of service (DDOS) attacks by malevolent hackers — is now creating imbalances between economic interests. Those interests are jockeying to either forestall an impending rule change or to shape it in their favor.

The 1MB limit is no longer large enough to include all the transactions occurring within the roughly 10 minutes in which a new block is added to the blockchain. Thus the rule artificially creates scarcity for a certain resource — data space — for bitcoin users. They must now compete to get their transactions included in the ledger, which, as per the law of demand and supply, means the price for that resource must rise or the rule must change.

And so bitcoin has been thrust into a battle of interests.

One group includes the bitcoin “miners” — the computer owners that validate transactions and update the blockchain ledger for bitcoin rewards. Many don’t want any change in the block size because they’ve sunk money into expensive “hashing” equipment in anticipation that the 1MB limit would create a lucrative transaction fee market in which anyone making a bitcoin payment must bid for it to be included in a block. On the other hand, there are bigger miners who may welcome a block size increase as way to increase market share, since smaller competitors might not be able to afford to the storage upgrade to process more data

The 1MB limit is now also dividing regular bitcoin enthusiasts and consumer-facing businesses. Many worry that the fees caused by not raising the block size would make bitcoin unfeasible for everyday, low-value transactions, as well as for a promising future of high-tech micropayments and various new non-currency applications. Yet others fear that a block size increase would overly favor bigger miners, fostering centralization in the vital transaction-validation industry, thus risking collusion and undermining the security the all-important blockchain ledger.

Unable to negotiate a consensus around the trade-offs demanded by various proposals, these interests are now trying to sway bitcoin’s “legislators” — the core developers empowered to change the protocol once consensus is reached. This competition is showing up as a bitter war of words on Reddit and Twitter.

Last week, two of those core developers, Gavin Andresen and Jeff Garzik, described the situation this way:

As average block size approaches the 1M limit, the game theory picture changes. The accidental, artificial 1M limit becomes a Visible Hand in the market. Competition occurs not only for block space, but for developer consensus — because in this new economic system, the ability to freeze or move the 1M limit produces a system where humans — not the free market directly — wield oversize power.

In citing Andresen and Garzik, I’m not, per se, signaling support for the two computer scientists’ argument in favor of an immediate block size increase. I merely wish to point out a great piece of analysis on the economic forces at play in bitcoin’s power struggle — and note that it’s the kind of insight that professional economists could and should be making.

For Economists of all Persuasions

When it comes to research questions, bitcoin offers something for everyone in the economics fraternity, no matter which Nobel Prize winner’s approach one follows:

— Elinor Ostrom’s work on the governance of public goods could be applied to the self-regulatory mechanisms aimed at securing the integrity of the blockchain ledger.

— For behavioralists like Robert Shiller, there’s research to be done on the herd-like behavior of bitcoin’s uber-volatile currency markets.

— Anonymous bitcoin miners’ ability to reach consensus without knowing whether the group contains rogue actors is begging for John Nash-style game theory work.

— Bitcoin’s open-source code also offers researchers a chance to build their own mockup currencies and run simulations that test hypotheses about market behavior — a new approach for Vernon Smith’s experiments, perhaps.

— There’s even material for those steeped in Milton Friedman or Robert Mundell’s monetary policy ideas. Bitcoin’s algorithm — its leaderless “central bank” — issues a fixed amount of currency over time. But an alternative digital currency might automatically vary supply according to digitally ascertained factors such as the velocity of money. It’s something for the Bank of England’s digital currency lab to explore.

Most of all, bitcoin is a treasure trove of measurable data. Whereas researchers of the traditional economy depend on error-prone, time-lagged surveys, here they’d find up-to-date, economy-wide numbers published openly in real time.

Paradigm Shift

Far from being a mere fad for techies or a tool for drug dealers, the technology behind bitcoin has already made an historic achievement. It has shown that a decentralized network can be governed in a way that strangers can, for the first time ever, remotely exchange items of value without transacting through centralized “trusted” go-betweens. That has profound economic implications.

Many leading financial thinkers are predicting that this distributed model for sharing and managing valuable information will become the backbone of our financial system. Whether it’s bitcoin, another algorithmically regulated cryptocurrency, or some hybrid blockchain technology managed by banks, regulators or some other corporate structure, this disintermediating technology promises to render obsolete our existing time-consuming, expensive approach for moving money around.

The biggest companies are voting with their checkbooks. Almost $1 billion in venture capital has been invested in digital currency startups. Forty-two of the world’s biggest banks have joined the R3CEV consortium to develop blockchain technology and many have their own internal “blockchain labs.” IBM, Intel, Cisco, the Linux Foundation and other key players have formed the Open Ledger Project to explore standards encouraging innovation and wider, more secure deployment of this technology. Every major consulting firm is pouring resources into advising firms how to extract efficiencies from distributed ledger technology.

This innovative energy will change how we do commerce. What’s now needed is serious academic research into its economic impact. Key research questions include: What are the financial systemic risks associated with different blockchain governance structures? How do we apply contract law in this environment? How should it be regulated?

It’s fitting that San Francisco is this week hosting the joint annual meeting of the American Finance Association, the American Economic Association and various other academic bodies. The event brings 20,000 social scientists to a region that’s leading the biggest change in our financial system since the Medici of Florence invented modern banking 500 years ago. Let’s hope some of the attendees leave inspired to work in this vital new field of inquiry.


Michael Casey is a senior advisor for the MIT Digital Currency Initiative.