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Berentsen and Schär
tically to changes in the expectations of market participants and is reflected in extreme price
volatility. From monetary theory, we know that currencies with no intrinsic value have many
equilibrium prices. 5 One of them is always zero. If all market participants expect that Bitcoin
will have no value in the future, then no one is willing to pay anything for it today.
However, Bitcoin is not the only currency that has no intrinsic value. State monopoly
currencies, such as the U.S. dollar, the euro, and the Swiss franc, have no intrinsic value either.
They are fiat currencies created by government decree. The history of state monopoly curren-
cies is a history of wild price swings and failures. This is why decentralized cryptocurrencies
are a welcome addition to the existing currency system.
In the Bitcoin system, the path for the money supply is predetermined by the Bitcoin
protocol written in 2008 and early 2009. Since then, many changes have been applied to the
Bitcoin protocol. Most of these changes are not controversial and have improved the function-
ing of the Bitcoin system. However, in principle all aspects of the Bitcoin protocol can be
amended, including the money supply. Many Bitcoin critics see this as a major shortcoming.
Theoretically speaking, this is correct. Any network participant can decide to follow a new set
of rules and, for example, double the amount of newly created “Bitcoin” units in his or her
version of the ledger. Such a modification, however, is of no value because convincing all the
other network participants to follow this new set of rules will be almost impossible. If the
change of the protocol is not supported unanimously, there will be a so-called fork, a split in
the network, which results in two co-existing blockchains and essentially creates a new crypto­
asset. In this case, there would be Bitcoin (the original) and Bitcoin42 (a possible name for an
alternative implementation with an upper bound of 42 million Bitcoin42 units). The market
would price the original and the newly created Bitcoin42 assets according to the community’s
expectations and support. Therefore, even though in theory it is possible to increase the Bitcoin
supply, in practice, such a change is very unlikely because a large part of the Bitcoin commu-
nity would strongly oppose such an attempt.
Moreover, the same critique can be raised against any current government-operated fiat
currency system. For example, since the Second World War, many central banks have become
independent in order to shield them from political interference that yielded some undesirable
outcomes. This independence has been given to them by the respective parliaments or related
institutions and can be taken away if politicians decide accordingly. Political interference in
the fiat currency system can be interpreted as a change in the “fiat currency protocol.” Undesir­
able changes in fiat currency protocols are very common and many times have led to the com-
plete destruction of the value of the fiat currency at hand. It could be argued that, in some
ways, the Bitcoin protocol is more robust than many of the existing fiat currency protocols.
Only time will tell.
2 BITCOIN TRANSACTIONS
The complexity of the present material is due to interdisciplinarity. To understand the
Bitcoin system, it is necessary to combine elements from the three disciplines of economics,
cryptography, and computer science (Figure 7).
Federal Reserve Bank of St. Louis REVIEW
First Quarter 2018
9