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The overconsumption theory of bitcoin (and decentralization in general)

Summary:
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

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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.

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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:

The overconsumption theory of bitcoin (and decentralization in general)

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.

About Jp Koning
Jp Koning
Working in the bowels of the finance industry. Blogging about monetary phenomena is my side gig.

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