Saturday, May 15, 2021

The overconsumption theory of bitcoin (and decentralization in general)

Bitcoin mining farm (via CoinDesk)

There are two extreme theories about cryptocurrency energy consumption, both of them bitterly opposed to each other. The first I'll call the big waste theory. Cryptocurrencies such as Bitcoin and Ethereum serve no useful purpose. Yet they are sucking up huge amounts of useful electricity. Let's ban them.

The second theory is the vital cog theory. Cryptocurrencies are a useful bit of global financial infrastructure. And so the huge amounts of energy that they are consuming is beneficial. Let's not impede them.

(This is an adaptation of an article I wrote for the Sound Money Project. Do head over to read it.)

In this post I'm going to trace a reasonable path between these two extremes with an overconsumptionist theory of bitcoin and decentralized technologies.


The vital cog theorists are right about one thing. Decentralized technologies like Bitcoin, Dogecoin, and Ethereum are useful.

But here's my modifier. These curious technologies are only inherently useful to a small group consisting of hobbyists, outsiders, and criminals. It's in the nature of a hobbyist to seek out complex and obscure things (such as decentralization, rare stamps, or ham radio) and consume it in abnormally large quantities. As for outsiders, they may get cut off from centralized service providers because they are engaged in legal but unfashionable activities. They need a decentralized alternative that can't censor them. Finally, criminals are drawn to places where they can operate unimpeded. Decentralized technologies are perfect for that.

For mainstream audiences, however, decentralized services are without value. Regular folks don't have a hobbyist's sensibilities for abstruseness, nor do they have the outsider's problem of being cut off from mainstream technologies, nor do they engage in criminal behavior. Introducing them to Bitcoin or Ethereum is like opening up a $5000 '67 Merlot for a friend who thinks all wines are the same – it's overkill.

Which gets us to the big waste theorists. They are right. Huge amounts of energy are being wasted by decentralized technology. Electricity thrown down the toilet.

But electricity isn't being wasted for the reasons that the big waste theorists typically put forth. Decentralized technologies are truly useful for passionate hobbyists and disconnected outsiders.

Rather, let's blame all the mainstream users who have decided to onboard themselves into these expensive energy-intensive technologies. Most mainstream users don't get any utility from decentralization. And so the huge amounts of electricity being devoted to their activities is wasteful.

More concisely, the problem isn't that bitcoin is wrong. The problem is that society is consuming too much bitcoin.

Next, I'm going to try and explain why mainstream users are over-consuming decentralization.

No doubt about it. Decentralization is EXPENSIVE. The process of securing a decentralized ledger requires thousands of competing computers, or miners, to perform redundant calculations. I’m not going to give a detailed description of how this mining process works. Suffice to say that it demands massive amounts of electricity. The miners who burn this energy don't work for free. They have to be paid significant amounts of money to cover their energy bills.

By contrast, centralized ledger technology, say an Excel spreadsheet, sips energy. That's because storing and updating a centralized ledger requires a single computer. Here is Matt Levine on ExcelCoin:

If decentralized ledgers are so pricey, why are mainstream users migrating over to them? Your neighbour owns Litecoin, your daughter holds Dogecoin, and your brother-in-law has some Bitcoin. Shouldn't these people be sticking to cheaper centralized options like ExcelCoin? After all, regular folks don't typically pay $6,000 for a '67 Merlot. They're perfectly happy buying a 2018 Pinot for $12.

I suspect that mainstream users are switching over because they don't directly experience the huge costs of decentralization. That is, they don't see the a line item called  "decentralization costs" in their monthly bills. There is no uncomfortable feeling of fees draining out of their wallets to pay electricity guzzling miners.

But these costs do exist. The problem is that they get paid in a very opaque way. Most of the costs of supporting decentralized networks come in the form of "inflation," or the issuance of new coins.

Below I've built a table showing how much it costs in inflation, or new coins, to support seven popular decentralized networks:

So for instance, every 13.2 seconds the Ethereum network creates two new Ether tokens out of nothing to pays to miners. At a price of $3,780 per token, this comes out to around $49 million per day, or $18 billion per year. Given that the value of the entire Ethereum network is $440 billion, this $18 billion in maintenance amounts to 4.1% per year.

4.1% is a lot. It's waaaay more costly than Matt Levine's ExcelCoin. My Vanguard ETF management fee comes out to just 0.1% or so.

But as I said, Ethereum users don't actually feel the pain of a yearly 4.1% fee. If you hold 10 Ether tokens, it's not as if 0.41 of that gets deducted from your personal stash each year.

The same goes for Bitcoin. Around $16 billion in new bitcoins gets paid to miners each year. That's 1.8% of the total value of the network. But bitcoiners don't actually see their balances being docked a 1.8% fee. Nor do Dogecoin holders have to foot Dogecoin's 4.1% maintenance, or Litecoin fans feel the pain of Litecoin's 3.9% mining costs.

Some of you are probably thinking: Ok JP, maybe you're right. Cryptocurrency users don't have to pay explicit fees. But surely mining costs are personally felt because they dilute the value of everyone's holdings? Doesn't this dissuade mainstream users from switching over to crypto?

Put differently, the point being made is that the $18 billion (or 4.1%) in new Ether push down everyone's Ether balances by a corresponding 4.1% each year. Likewise, Bitcoin's 1.8% inflation push everyone's bitcoin balances down by 1.8%.

Nope. There's no such thing as dilution.

That's because each networks' entire issuance schedule is already built into its price. Bitcoin's $50,000 price already includes the fact that Bitcoin miners must be paid 1.8% each year in new bitcoin.

I tried to explain how this works in my Sound Money article, but I'll repeat it here. Every two weeks Microsoft must pay its employees. But if I own Microsoft shares, the price of my shares doesn’t fall every time employee payday arrives. The price of Microsoft shares already includes the information that salary must be paid.

The same goes for Bitcoin. The fees paid to miners, like Microsoft’s salaries, are already factored into Bitcoin’s price.   

So people who hold cryptocurrencies don't feel any of the painful costs of decentralization. They neither endure explicit recurring fees nor regular price dilution. And so they are consuming expensive decentralization on the false sense that it is a free good.

Which gets us back to our two theories. The big waste theory says that all consumption of decentralization is wasteful. The vital cog theory says that none of it is wasteful. My middle of the road theory is that only the mistaken, accidental consumption of blissfully unaware mainstream users is wasteful.

Say that users actually had to pay an explicit 4.1% Dogecoin mining fee each year out of their own pocket, or a 1.9% Bitcoin mining fee. Our story would be very different.

Connoisseurs of decentralization would be happy to pay these fees. So would outsiders and criminals. But most people wouldn't. The moment Coinbase starts docking a fee every 10 minutes from Joe Regular's Coinbase account, Joe is going to move his $1000 back to the ExcelCoin alternative, say a centralized options & futures account. Or maybe to a sports betting website.*

And thus if the costs of decentralized technologies—Dogecoin, Ethereum, Bitcoin, Zcash, and whatnot—were transparent, they would never have gained such a widespread user base. And we wouldn't be in the midst of the energy consumption disaster we are in.

The big waste theory calls for a ban on cryptocurrency. The vital cog theory calls for acceptance. Splitting the difference, why not fix the mistake of overconsumption by levying a yearly tax on the value of cryptocurrency holdings? Like a carbon tax, it would force mainstream users to internalize the costs of consuming decentralization. But unlike a ban, it would allow outsiders and hobbyists to continue to use decentralized products.

* Even if we made the painful costs of decentralization explicit, would this actually stop people from playing? From the mainstream user's perspective, the attraction of buying Dogecoin is to make a 1000% return. Even if people have to pay a 4.1% decentralization fee out of their own pocket (rather than via opaque inflation), they may be willing to still play if only to get exposure to a potential jackpot.

Thursday, May 6, 2021

A nickel is worth more than a nickel

Having just emerged from the fiasco of last year's coin shortage (which I wrote about here and here), the U.S. Mint has a new problem on its hands. The melt value of the nickel, or five cent coin, has suddenly moved higher than the coin's face value.

The melt value of a nickel refers to the market value of the 3.25 grams of copper and 1.75 grams of nickel inherent in each five cent coin. In the chart below I've mapped out the melt value of a U.S. nickel going back to 2000, decomposed into its copper and nickel components.

As you can see, the last time that the intrinsic value of a coin exceeded its face value was ten years ago, back in 2011. Thanks to the huge rally in copper prices over the last twelve months, the metallic content of a nickel is currently worth 5.9 cents. In theory, anyone can buy nickels for five cents, melt them down, sell the copper and nickel for 5.9 cents, and earn 0.9 cent profit less costs.

But this trade isn't without its risks. Since 2006, the U.S. Mint has made it illegal to melt down U.S. one-cent and five-cent coins. Rule-breakers can get up to five years in jail. A would-be entrepreneur might try exporting U.S. nickels to Canada to melt them down. But the U.S. Mint anticipated this loophole and also made it illegal to export coins in amounts exceeding $5.

These sorts of punishments might reduce melting. But they are unlikely to stop melting altogether.

The price of copper has risen over the last year, but the price of nickel hasn't matched it. If nickel prices were to rise too and the melt value of a five-cent coin were to hit, say, 8 or 9 cents, then the financial incentive to break anti-melting laws would become quite strong. Cue the problem of coin shortages. If a coin is more valuable for its metal content than as money, it'll quickly disappear from circulation.

Shortages arising from illegal melting would be exacerbated by legal nickel hoarding by speculators. Kyle Bass, for instance, once made a $1 million nickel bet that I wrote about here. Expect many Kyle Basses to emerge out of the woodwork as commodity prices rise.

Careful readers will recognize this as an instance of Gresham's law. When a monetary instrument's value is fixed by the authority, but its intrinsic value is above the amount, then all of this "good" money will be withdrawn from circulation.

What's the solution? 

We've been fighting this problem for hundreds of years and have devised a pretty standard fix. The Mint needs to quickly reduce the metallic value of the nickel. For instance, the U.S. was plagued by shortages of silver quarters in the 1950 and '60s as people hoarded them for their silver content. The solution was to replace silver quarters with cheaper copper ones. (I wrote about these wise debasements here.)

Take another example. In 1982, the high price of copper forced the U.S. Mint to swap its 95% copper penny for a 97.5% zinc penny. Zinc is cheaper than copper. To this day, the melt value of a U.S. penny remains quite a bit below its face value, as the chart below illustrates. (The only exception is a few months in 2007 when high zinc prices pushed a penny up to 1.1¢.) If the U.S. Mint hadn't made the switch from copper to zinc in 1982, then the melt-value of pennies would currently be around 2.5¢, and everyone would be melting them down.

So moving back to 2021, one the U.S. Mint's option to combat hoarding and melting of nickels is a zinc nickel. A steel nickel is another possibility – back in 2000 we Canadians switched our five-cent coins from a nickel/copper mix over to 94.5% steel.

Sure, there would be some hassles. Vending machines often read a coin’s electromagnetic signature to determine its denomination. A move to steel coinage would require the vending machine industry to make significant changes to its coin-reading apparatuses.  

But compared to enduring constant shortages, a switch is a far better idea.

Or here's another option. Why not use the occasion of high commodity prices to get rid of both the one-cent and five-cent coins altogether? These coins are little more than monetary pollution. We don't need them anymore.