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Bitcoin and the Magic Money Tree

Posted 18 October 2017 Bitcoin and the Magic Money Tree
Written by Jon Gulson
This has been an eventful year in the short life of bitcoin. We have seen fear, forks, attacks, fallings out and the price increasing five-fold against the dollar. Not a stable store of value, some say.  It’s a bubble, say others.

One such headline making attack was JP Morgan CEO Jamie Dimon calling bitcoin a ‘fraud’. This ruffled a few feathers amongst bitcoiners, making many wonder if the traditional world of finance views the new world of cryptocurrency through Scotch mist?

So here is a potted version of where money comes from and what makes bitcoin real.

The Magic Money Tree

Contrary to the beliefs of children and bankers who receive bail-outs, money is a human construct. It doesn’t just magically appear without a cost.

It is created by banks, almost out of thin air and is essentially a ledger. The fractional reserve banking system means only a fraction of money in circulation is kept in reserve (by banks), so money relies on public trust to maintain its value and usefulness. 

The process of creating money is called seigniorage. This is the difference between the value of money and the cost to produce it. To create a dollar costs something like a couple of cents. The creation of physical money - such as a coin - to be used as currency is known as minting.

Seigniorage, minting and the ledger work well most of the time. Problems occur however where trust breaks down or where fraud and inflation become systemic – the last time this happened was the financial crisis of 2008. 

The irony of Jamie Dimon calling bitcoin a fraud is JP Morgan has been fined many times for breaking fiduciary responsibilities.

Mining Coins

When money is created by banks, it is creating debt - with most of the value extracted at birth. As more money is created, its purchasing power gradually reduces. 

Mining Bitcoin

In 2009 when Satoshi made his world changing announcement, he introduced an alternative to money creation. Instead of banks creating money on an inflationary basis, the bitcoin blockchain would create units of value or digital cash through a cryptographic consensus of mining

The benefit of the mining process (in contrast to the seigniorage and minting of bank created money) is an energy proofed ledger without single points of failure, resistant to fraud or manipulation. As John McAfee explained here, this process is known as proof of work and costs c.$1,000 to produce a single bitcoin – of which there is a fixed and determined total supply of 21 million.

So this is where Jamie Dimon got it wrong. The whole point of the bitcoin mining process and the blockchain is a distributed and trustless ledger which disintermediates the process from where fraud originates. Dimon probably called bitcoin a fraud to deter people from believing in it. In other words, trust me I’m a banker.
Written by Jon Gulson
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