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The Three Economic Eras Of Bitcoin

Courtesy of ZeroHedge. View original post here.

Authored by Randy Russell via Medium.com,

The way the bitcoin ecosystem will play out is written in the mathematics of its consensus rules; we should all know the three phases it will go through.

First Era: Satoshi’s Free Offer (2009–2014)

In the early years of bitcoin, it was obscure and unvaluable. Demand was so tiny you could send any amount for free. There was no real congestion, so software didn’t handle it, nor did business plans: gambling service Satoshidice famously sent a 1-satoshi payment to losing bets, using the infinite-capacity blockchain as a signaling layer. It was all free money.

Bitcoin was a new, barely-understood technology. It was hard enough to comprehend the interactions of its constituent parts, let alone extrapolate to what this would mean in future. Several factors made this worse:

  1. The pseudonymity and lack of central authority was deeply attractive to scammers, who became pervasive enough to make the permeation of real information extremely difficult and also lead to widespread distrust.

  2. The success of the system brought others who tried to replicate it (often with the main goal of simply generating money) and almost always with minimal understanding of the system.[1]

  3. The early adopters had not only the normal tribalism of an emerging clique, but a concrete financial self-interest in adoption. The resulting boosterism meant it was extremely difficult for any awkward facts to permeate the wider ecosystem.

The result there was surprisingly low awareness that this phase of “free money” was not the natural state of bitcoin. The developers were aware, so added some configurable settings in the reference client to minimize the worst abuses. These rules did not change bitcoin, just the default behavior: they added a minimum fee[2], stopped relaying tiny payments[3], and enhanced the scripting language to reduce the size taken up by unspent outputs[4].

Second Era: Satoshi’s Subsidy (We Are Here)

“Bitcoin is shifting to a new economic policy, with possibly higher fees.”

 - Jeff Garzik https://medium.com/@jgarzik/bitcoin-is-being-hot-wired-for-settlement-a5beb1df223a

The bursty statistical nature of block production, combined with the volatile market of bitcoin, began to produce intermittent capacity issues. These had been previously dealt with by code optimizations and tweaking settings by miners; now they became more regular and significant, causing rising awareness that the First Era was at risk.

Inevitably, many people wanted to prolong the free ride. This pressure was exacerbated by software and services unprepared for dynamic fee conditions, and the difficult nature of such fee conditions themselves: reliably guessing what fee would allow a transaction into the next block turned out to be difficult at best, and extremely difficult to present to users[5].

The developers’ general reluctance to support a naive increase stemmed from several factors:

  1. Previous increases on the network had driven significant centralization pressure, including a period where over half the network was under control of a single pool.[6]

  2. This would be the first backwards-incompatible change since Bitcoin’s introduction.

  3. Providing a “one-off” bump risks moral hazard, as lobbying for expansion is seen as cheaper and easier than engineering improvements.

  4. Despite being expected, neither software nor services were preparing for the transition. This may have been because they didn’t really believe the transition would occur.[7]

  5. The developers generally want to follow the community, not lead. Changes which are economically significant or contentious feed a narrative of developer reliance.[8]

  6. Transitions in a large, complex system need to be as gradual as possible to avoid unintended side effects. As the Third Era approaches, the Second Era provides that gradual transition, with time for software and services to gain experience with bitcoin as it will eventually be.

The developers implemented several improvements to address congestion. First among them was wide-ranging and significant optimizations[9] designed to handle the network now running at capacity. Block propagation was improved by a global network of node relays[11] and new strategies for better propagation[12]. Fee estimation algorithms became more sophisticated[13], along with restoring the ability to replace transactions (by increasing the fee)[14] and having the recipient boost transactions[15].

Despite centralization fears of larger blocks, an opt-in block expansion[16] was added which will eventually double the network throughput as software is updated to use it. Work is ongoing on packing more transactions into blocks[17], which increases throughput without the centralization risks of block expansion.

It is not surprising that such efforts were seen for what they were: insufficient to maintain the First Era. Bitcoin’s use as a payment network, always awkward due to block time variance, became even harder: a whole class of payments below $20 were no longer viable. Businesses and users established in the First Era began looking longingly at alternate coins still in their own First Era, and also lobbied for relief. A significant mining monopoly had formed at this stage, and it joined these efforts.[18]

Though these efforts failed, it’s important to note that while some who wanted the First Era to continue considered the Third Era avoidable[19], many just felt it shouldn’t happen now. The most convincing argument was that it would harm adoption, which is a major factor for both usefulness and regulatory resistance. Unfortunately this argument never becomes less compelling, and carries all the hazards enumerated above.

It is undeniable that an increase in transaction capacity reduces the eventual burden of fees, and is the main motivation for the growth plans which were implemented in this era.[20]

Third Era: Self Sufficiency (2028? onwards)

“Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.”

- Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System

Once the “free money” bootstrap phases of bitcoin are complete the system enters the phase of self-sufficiency, where users bear the cost of securing the network against double-spending (currently billions of USD each year[21]). This is phased in by halving the block subsidy every four years.[22]

Current levels suggest fees will be comparable with the subsidy at the 2024 halving, and consistently dominate from 2028 onwards.[23]

User-facing businesses established in the First Era who flourished into the Second Era will find the Third Era extremely difficult. One large business claims to be responsible for 25% of the bitcoin transactions: in 10 years they would be paying $700M per year to secure the network at current levels[24]. Yet no business is telling their investors about this impending cost, nor that they plan on reducing their on-chain percentage[25] nor suggesting that they are depending on significant bitcoin appreciation to offset these costs[26].

Miners will find the Third Era equally difficult. Directly supported by users, they will be in constant tension with them over fee levels, and in danger of having their income squeezed by large businesses or cliques of users. This may lead to further centralization, as miners consolidate under revenue pressure. This centralization may be offset by businesses choosing to invest directly in mining, however.[27]

The Third Era Will Start With Civil War

The mathematics of this situation seem inevitable: The miners and businesses with large transaction volume will both decide to (re)introduce inflation. For the large-volume businesses this will externalize their costs, and for miners it’s simply “free money”. The battle lines will be similar to the early Second Era New York Agreement, but this effort will be more nuanced and far broader, with mainstream arguments such as:

  1. The founder was not an economist; Economists recommend inflation around 1% to encourage spending.[28]

  2. The support burden of the network should be shared by the wealthy bitcoin holders, not just those actually using their bitcoin.

The counter-arguments are:

  1. The 21 million bitcoin limit was a key reason for bitcoin’s success,

  2. The system’s founder made a conscious and deliberate choice for bitcoin to be a store-of-value over subsidizing payments, by eschewing inflation, and

  3. Changing the rules now is stealing from early adopters (notably, but not mainly, the anonymous founder).

The main resistance to this change would come from the developers themselves (who feel this limit is non-negotiable[30]) and long-term bitcoin holders.

Businesses will be divided: those which cater to the latter (insurers, vaults) will be against the change, and those with high onchain volume (exchanges, wallet providers) will be for it.

Although this crisis is entirely predictable from first principles, and laid in the bedrock of bitcoin, it may yield surprising results. And even if bitcoin’s supply remains capped[31], the drama it can produce is limitless[32].


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