Bitcoin miners are on a path to self-destruction

Meanwhile, Bitcoin's demand for computer chips has hogged the production lines at Taiwan Semiconductor Manufacturing Co. and Samsung Electronics Co., contributing to a global chip shortage that is costing automakers tens of billions of dollars and threatening the phone industry as well

Many of the complaints about Bitcoin over the years have been overhyped. But the cryptocurrency's increasing use of real physical resources - energy and computer chips - can no longer be ignored. If Bitcoin wants to avoid government crackdowns, it needs to shift to technologies that don't require constant massive resource consumption just to maintain the currency's price.

A real problem with addressing criticism of Bitcoin is that so many people have cried wolf about it in the past. Its initial enthusiasts believed - and many still do - that cryptocurrency is going to undermine central banks and take over from fiat currencies like the US dollar. That has led some to decry Bitcoin as a plot to bring down governments. That's a red herring. Bitcoin is not going to become the dominant currency as long as it remains highly volatile. And for it to become less volatile will probably require it to become inflationary - that is, for its price to go down over time.

But the price, though it bounces around and has plenty of bubbles, has kept on going up. That's great for the people who bought in early and for people in the crypto software industry. But Bitcoin's high price may now be leading to new problems for the cryptocurrency, because unlike other financial assets, Bitcoin uses more resources as its price goes up. (Disclosure: I own Bitcoin and other cryptocurrencies.)

For normal currencies such as dollars, transactions are logged and verified by a trusted entity like a bank. For Bitcoin, however, transactions are logged and verified by a decentralised network of people called 'miners.' Miners compete to be the one to verify each block of transactions by using computers to guess a number. The lucky miner who guesses the number first gets rewarded with a certain amount of new bitcoins.

The higher the price of Bitcoin, the more valuable winning each little lottery becomes. And like an increased jackpot in Powerball, that bigger reward draws more miners into the game, who spend more resources making guesses. Those resources include computer chips and electricity to run the computers.

The whole system creates decentralised trust. No evildoer can come in and change all the transactions so that they get all the Bitcoins - that would require spending enough on computer chips and electricity to outcompete all the other miners. In other words, it's the cost of the real resources that go into logging and verifying Bitcoin transactions that keeps the network honest and reliable.

So the more Bitcoin's price goes up, the more resources it consumes. In early 2017, when the price was only about $1,000, the website Digiconomist estimates that Bitcoin mining used about 10 Terawatt-hours per year in electricity. Four years later, the price has gone up by about a factor of 50, and the electricity consumption has risen by a factor of 8 or 9.

Power hog

This means Bitcoin mining now consumes electricity on par with the country of Finland and almost as much as the entire US federal government. Bitcoin supporters argue back and forth about how much carbon this emits. But it undoubtedly hogs local power resources, which makes other customers mad. China's Inner Mongolia recently banned Bitcoin mining, and some regions of the US have moved to limit it as well. Bitcoin miners are trying to fix this by making use of the excess solar and wind power produced during peak hours, but it remains to be seen how much of this extra energy is just lying around.

Meanwhile, Bitcoin's demand for computer chips has hogged the production lines at Taiwan Semiconductor Manufacturing Co. and Samsung Electronics Co., contributing to a global chip shortage that is costing automakers tens of billions of dollars and threatening the phone industry as well.

This spiralling resource consumption indicates a basic weakness in the technology that supports Bitcoin. For most financial assets, like gold, the cost of storage doesn't go up much as the price goes up; it's just about as easy to guard the world's gold at $2,000 an ounce as at $200 an ounce. And for most currencies, transactions are super cheap. Because people already trust banks and the government, these centralised institutions can handle massive amounts of transactions with near-costless efficiency. Bitcoin's decentralised trust, in contrast, keeps getting more expensive as Bitcoin gets more valuable.

That process can't go on forever. And as the economist Herbert Stein once astutely observed: "If something cannot go on forever, it will stop." Eventually, lots of places will follow Inner Mongolia's lead and ban Bitcoin mining, and the governments of South Korea and Taiwan will intervene to stop computer chips from being sold to miners. This will be bad for Bitcoin miners, as well as crypto investors and software developers. To avert that outcome, the developers who control Bitcoin's algorithm need to think about switching to a cheaper technology. One alternative is a proof-of-stake system, where mining can only be done by people who already own a lot of the cryptocurrency; this cuts down massively on resource use by limiting competition. Bitcoin enthusiasts might not like the fact that such a system is more centralised, but if the technology of decentralised trust is inherently expensive, libertarian ideals might have to give way to cold, hard economic necessity. (Bloomberg)