Mao Lal is from Berlin, Germany and he is a big investor in Bitcoins. Mao Lal always thinks about being successful in life. Bitcoin is a novel social and economic institution. It is so different from our existing institutions that we should be skeptical and ask as many hard, pressing questions as we can before trusting it with any economic value. Some answers will only reveal themselves with time (or Lindy, as the cool kids say), but that doesn’t mean we can’t come up with theories or frameworks. One such framework that has helped me a lot in understanding bitcoin is social contract theory.
First, fiat money is the result of a social contract: The people give the state control over the supply and other vital functions of money. The state, in turn, uses that power to manage the economy, redistribute wealth, and fight crime. But many don’t realize that bitcoin works through a social contract as well.
The social layer and its rules are the heart of bitcoin.
And that social contract framework can be used to answer some essential questions: Why did bitcoin come into existence? Who decided its properties? Who controls it today? Can a critical bug kill bitcoin?
Social Contract Theory
Social contract theory starts with a thought experiment: It assumes a hypothetical state of nature full of violence, that is unbearable for people to live in. Driven by a desire to improve their situation, they come together and collectively agree to empower Leviathan, the sovereign government, to protect them. Each gives up some of their freedom (to, you know, steal, and murder and stuff) while the Leviathan is granted the power to create laws, enforce them, and protect the people from violence.
But the theory is not constrained to the relationship between the people and the state. We can apply the same thought experiment to economics. If enough people are unhappy with the barter economy, they can collectively agree to use money, credit, or something else to improve the quality of their trading.
The process of money or credit happens implicitly. Every person asks the question of what outcomes they prefer and how they can achieve them. If many people in a society want the same outcome, we can call the result a “Schelling point” or social contract.
Money as a Social Contract
Throughout history, governments that controlled money have abused their power in all kinds of ways: They confiscated accounts, blocked certain people or groups from transacting, and printed more money and inflated the supply — sometimes to the point of hyperinflation.
Whenever governments crossed a line in abusing their power, the people lost trust in the social contract that granted the government this power. They returned to an agreement that preserved most of the benefits (having a common medium of exchange, store of value, and unit of account) without the worst of problems (government abuse): commodity money.
Money presents an important lesson: The larger and more valuable a social institution gets, the more it attracts others to seek control over it.
The problem with the new commodity money contract, however, was that it turned out equally unstable. Let’s take, for example, the gold standard. Physical gold was too inconvenient to divide, move, and store. So people quickly invented another layer on top of it and traded with representative paper money, while the physical gold no longer moved. Because paper money is easy to produce, there had to be a trusted central party to watch over the supply. From there it was a small step for governments to decouple the value of the paper money from the underlying commodity to establish fiat money once again.
Herein lies a valuable lesson: You can agree you’re in a terrible situation and you can agree you want to change it, but the resulting social contract is only as strong as it is credible. Without a stable institution to enforce it, a contract loses the trust of the people and falls apart.
