Why Proof of Work is Necessary

How Bitcoin solves the problems of human nature.

Imagine that you had a printer that was able to legally create US dollars of any denomination. With the push of a button, you could print as much of the currency as you needed or wanted. Would you use it? For most people, that’s a silly question. Of course they would.

For some, the answer to that question is “No” because they understand that to use it would amount to stealing from other people who hold dollars. Each dollar printed into existence without any asset backing it reduces the value of every other dollar already in circulation. Money is simply a representation of people’s time and energy – their work. Since printing new dollars doesn’t create more work, the amount of work each dollar represents decreases as the number of dollars increases. Your newly printed dollars essentially transfers some of the buying power everyone else received for the work they did into your hands without their permission. Taking something that doesn’t belong to you without permission is theft. When the government does it they call it “inflation”. It’s a simple truth, but not one that’s taught in public schools.

If you rightfully answered “No” to the question of using the money printer, stop and consider how tempting it would be to use it if some unforeseen disaster occurred that put you in a tight financial spot. How bad would the pain have to get before you start eyeing that printer in temptation? If you feel you would continue to stick to your convictions no matter how much financial pain you were caused, what if the trouble wasn’t your own, but one of your children’s (or relative’s, or close friend’s)? What if they made a mistake so bad that their financial troubles were going to land them in court – maybe even in prison? Would you bail them out? As the saying goes, “everybody’s got a price.”

It doesn’t matter how much we intellectually understand the need to be principled. Our human nature and emotional makeup play a large role in the actual decisions we make, whatever our ethics. And if you, a principled individual, could be tempted into stealing from others to protect yourself or someone you care about, imagine how far a person with little or no ethics would go if they possessed the printer.

Digging Holes

Let’s modify our personal money printer scenario. What if for every dollar you printed, you had to go dig a hole in your backyard. Not a huge hole, but fairly big, maybe half a dozen shovels full. That wouldn’t be so bad if you only needed twenty dollars, but what if you wanted a thousand dollars? Or ten thousand? While it might be possible to do it, it wouldn’t be worth it. You could earn more money with less time and energy by just getting a job. The work required removes the temptation to use the printer.

When the US dollar was on the gold standard, literal holes had to be dug for every dollar printed because gold had to be mined to back that dollar. Since gold is very difficult to mine and cumbersome to transport, store and secure, the government needed to have a good reason to get more gold so it could print more dollars. In most cases it would be easier to just raise taxes, except that people don’t like their taxes being raised, which again is why the government would need to present a convincing reason why the tax was necessary. If the people didn’t feel the reason was good enough, it could cause unrest. If the government enacted the tax anyway, it might cause rebellion (e.g., the Boston Tea Party).

Couldn’t you just lie about the holes you dug though? It would be a real chore for merchants to check your backyard each time you wanted to spend the dollars from your personal money printer. They would require some form of proof, maybe a photograph, but that would be easy to get around. Dig twenty holes, take a picture, and only print twenty-dollar bills, using them one at a time. How would anyone know that you’re reusing the picture of the holes as evidence for the new bills?

On the other hand, if no proof was required, merchants would have to rely on your honesty when accepting your newly printed dollars. You might be a generally honest person, but let me remind you that everyone has a price. How bad would things have to get before you would fudge a bit on your honesty?

In the past, you could go into a bank and demand proof of their reserves because they were required by law to give you the gold each dollar you held represented at your request. This system was okay, but not perfect. It only proved that the bank had enough gold for the dollars you wanted exchanged at that time. It didn’t prove they could cover your entire account balance.

You could withdraw all your dollars in gold, go through the tedious process of verifying the gold is pure and of the proper weight, and then redepositing it again, but that’s obviously cumbersome and unrealistic, and it also doesn’t prove that the bank would be able to cover the gold represented by everyone’s account balances, just yours. You had to trust the bank because there was no practical way to verify their total gold reserves.

However, on June 5th, 1933, the United States Congress removed the right of creditors to demand payment in gold for their dollars. The system went from “show me a picture of the holes in your backyard” to “trust me, bro!” This was done because bank failures during the Great Depression caused a loss of trust that motivated people to hoard gold instead of dollars. Think about that for a moment. Because banks couldn’t be trusted, the government removed people’s right to verify that the banks could be trusted. Does that sound like an honest, functioning system to you?

The Birth of US Fiat

In 1971 Richard Nixon signed an executive order that jettisoned even the myth that the United States had enough gold to back its dollars. Under that order, the dollar would no longer be backed by gold even in theory. It became fiat currency. Dollars were now backed, not by some hard asset, but by State violence. Try and use any other form of currency and you’d find yourself in trouble with the Law. Only US dollars and coins were legal tender.

This is the situation we are in today. Under a fiat currency system, the government can (and often does) print money any time it wants to fund an endeavor that people wouldn’t want their taxes raised for. Rather than asking your permission by voting on a tax, it simply removes some of the purchasing power of your money and transfers it to itself, creating inflation that lessens the value of each dollar you hold.

It’s not that money unbacked by a hard asset couldn’t work in theory. If the State set a fixed value of a dollar and that value remained unchanged, it could work just fine. As the amount of work the collective nation did increased or decreased, the number of dollars in circulation could be modified to keep its value relatively stable against the total work the nation was performing.

The problem is that human nature doesn’t allow the fiat system to work long term. Even principled people would be tempted to use the money printer, and politicians aren’t exactly known as the most ethical individuals. The reasons for that also go back to human nature, but that’s outside the scope of this discussion.

Golden Problems

For money to be effective in practice, it must be backed by work. Gold fits the bill in some ways, which is why it was used in the past, but gold has problems. First, it’s not easy to divide up for smaller payments. If you wanted to buy an item that only cost 50 cents, measuring out the right amount of gold would be near impossible.

As stated earlier, gold is also difficult to transport, store and secure because of its weight. That makes it expensive to maintain, which required individuals to put their trust in banks for the storage of their personal wealth, sometimes with disastrous consequences. Gold is also difficult to transact with over long distances, particularly for international trade. Even for local transactions, though, it’s cumbersome because the merchant has to go through an expensive process of verification to make sure the gold is pure and of the proper weight.

Because of these shortcomings, paper money came into use as IOUs for fixed amounts of gold. Paper was easily transported and exchanged, solving that problem, but it created the verification problem illustrated by the picture of the holes in the backyard. It was difficult to verify that the person handing you the IOU actually had access to the promised gold. Even if the IOU did represent gold in a bank that had enough to cover it, if economic circumstances caused the bank to fail your IOU would be worthless. This is what happened in the Great Depression. Thousands of banks collapsed as people and institutions defaulted on loans made by those banks.

Bitcoin Fixes This

Bitcoin has all of gold’s strengths and none of its weaknesses. Like gold, Bitcoin is mined, only on computers using a process called “Proof of Work”. The mining process is difficult and expensive, which keeps the growth of supply slow and steady. This is important because it makes supply inflation predictable and prevents any person, group or country from suddenly creating a huge number of additional coins.

Even if a government threw massive resources into mining Bitcoin, the inflation rate would remain relatively the same. This is because Bitcoin automatically adjusts how difficult it is to mine based on how much people are trying to mine at any given time (the “hashrate”). A government suddenly using thousands of computers to mine would cause the network to raise the difficulty of mining to keep its inflation rate constant.

Bitcoin also has a fixed maximum supply of 21 million coins. Once the 21 millionth coin is mined, no more will ever come into existence. At that point Bitcoin becomes deflationary rather than inflationary, at least if the world population is still growing at that time. The United Nations predicts that world population will peak around 2080 and then plateau or decline by 2100, and the last Bitcoin will be mined in 2140, so how that plays out remains to be seen.

However, Bitcoin is deflationary in the sense that it allows people to see the deflationary benefits of technology. As supply chains get more efficient through the use of new technology, prices should naturally come down. They usually don’t because of inflation of the fiat money supply. Only supply chains whose efficiency can outpace inflation, such as televisions and computers, will reflect a price decline.

Bitcoin also solves the problem with gold not being easily divisible. Each Bitcoin can be divided into 100 million satoshis (or “sats”). This is like a dollar being divisible into 100 cents, only Bitcoin can create much smaller denominations. The transactional issues of gold are also solved, since Bitcoin is digital money and can easily be sent over the Internet to any destination in the world.

Bitcoin is superior to gold in its security as well. Verifying that gold is pure and of the proper weight is costly and time consuming. Bitcoin uses cryptographic hashes that are easily verified by other computers (called “nodes”). The verification is fast and inexpensive. Storage of your Bitcoin is also secure, since the record of your holdings exists on many thousands of nodes all over the world. No individual or group can freeze your funds, and you don’t have to trust a bank to keep your money safe. Using a small device called a “hardware wallet” you can access your money on the Bitcoin network any time you want. There are no “bankers hours” with Bitcoin.

None of that would matter, though, if Bitcoin’s code was in the hands of one group or country. If it was, the temptation to just modify the code would eventually cause Bitcoin to have the same fate as the US dollar. The dollar used to be sound, but changes in the laws eventually turned it into unsound fiat.

Bitcoin solves this last problem by being decentralized. Because nodes are spread all over the world, if one person or group tries to change the code, the rest of the nodes will reject any transactions they try to make. It’s in each node operator’s self-interest to reject those transactions because they benefit someone else at the operator’s expense.

The only way to control the code would be to take control of the majority of nodes. This is an expensive proposition that gets even more so as Bitcoin grows in popularity and more nodes come online. This is one of the reasons Bitcoiners encourage everyone who holds any Bitcoin (known as “hodling”) to run a node, which is not difficult or expensive to do. The software is easy to install and runs fine on your average computer with a broadband Internet connection.

Unfounded Criticism of Proof of Work

One of the most common criticisms of Bitcoin is that the Proof of Work process requires too much energy and is bad for the environment due to climate change. First of all, despite its power consumption, Bitcoin is not a problem for climate change. Researching into the source of Bitcoin’s mining makes it clear that such claims are false, with 52% of the electricity currently coming from zero-emission sources. As Bitcoin miners search for cheaper sources of off-grid power, that percentage will continue to rise as it has been. No other industry, country or currency in the world can make that claim. Bitcoin power use also pales in comparison to gold mining and the current fiat banking system.

Even if it’s not an environmental problem, however, other cryptocurrency networks do use far less power, such as Ethereum’s Proof of Stake and the XRP Ledger’s Consensus mechanism. Why not just switch Bitcoin to one of those and keep it decentralized so it doesn’t require so much power?

The reason is that Bitcoin’s energy requirements are what make it so secure. As stated, a group that wanted to take over Bitcoin’s network would have to be in control of a majority of the hashrate. This would be very expensive, not just in monetary terms but also in physical ones. The hardware, expertise and electricity required to take over the Bitcoin network is extremely difficult to reproduce even now, and as the network grows it only gets harder.

Proof of Stake, however, only requires buying up most of the current supply and staking it to take control. That’s monetarily expensive, but not physically difficult. Governments could run the money printers as much as they like to buy up the necessary supply.

The XRP Ledger’s Consensus protocol cannot be controlled by owning most of the supply, but it also lacks the physical difficulty of reproducing. The number of XRPL nodes is only about 150, with the standard “trusted” list only having 35 nodes. Compare that to Bitcoin’s current node count of over 14,500. Which would be more difficult to influence?

Proof of Work Satisfies Human Psychology

Physical security is not the only reason Proof of Work is required, however. Money must also win over human psychology if people are going to put trust in its value. Gold illustrates this fact. In addition to the physical attributes that make gold scarce and long lasting, it also became the default money for most nations because of its weight and physical beauty. Gold’s attributes cause it to be perceived as valuable by humans even though it has very limited real world use outside of jewelry and a modest amount of use in certain electronics.

Humans don’t just admire beauty, though. They also admire power. People have been willing to use fiat currency despite it being printed out of thin air because it’s backed by the power of the State. With a powerful nation behind the US dollar, it was (and still widely is) seen as being backed by something strong, something difficult to conquer. The US dollar may just be a flimsy piece of paper or digits on a screen, but many people trust it because they respect the power behind it.

Bitcoin isn’t backed by any State, nor can it rely on any State’s power, which would defeat the purpose of its being decentralized. It is, however, backed by massive amounts of power in the form of the electricity it took to mine it. This gives Bitcoin both the physical difficulty of reproduction and the perception of value. This perception matters, just like it matters with gold and the US dollar.

Humans don’t value things that are easy to produce, and they value the currencies of powerful nations more than that of weaker ones. Unlike other cryptocurrencies whose supplies were literally created out of thin air, the current supply of Bitcoin was not at all easy to produce. In order for a currency to be respected as global money, it has to pass these important physical and psychological bars. Bitcoin does, the others don’t.

The Return to Sound Money

All of these attributes make Bitcoin the perfect form of sound money because they remove the temptation of our imperfect human nature. Whatever our ethics, or lack thereof, no individual or group is capable of rigging the system to their own advantage. It’s in everyone’s self-interest to follow the rules, and being unable to change the rules keeps the network secure and fair. Unlike fiat, Bitcoin doesn’t just work in theory, it works in practice.

Because of human nature, all fiat currency is doomed to fail. Many have collapsed in the past, and all current fiat will also meet its end for the same reasons – even the US dollar. In fact, all the world’s major economies are now in a fiat debt spiral from which there is no escape. Bitcoin was built to solve this problem, and the time is fast approaching where the world will rely on it to do so.