Blockchain Basics

By William J. Luther

How do we know who owns what? We could just take each other‘s word for it. If you say that you own something, I’ll believe you. And if I say that I own something, you’ll believe me. But some people will lie. And then we will have competing claims of ownership. That’s a problem.

Traditionally, we have dealt with this problem by entrusting some third party with keeping a ledger — that is, a single list of who owns what. If two people claim to own the same thing, we can just check the ledger to see who the rightful owner is. If you want to transfer property to me, you tell the ledger keeper to update the ledger. Then the ledger will reflect that I now own that property.

But there are problems with that approach too. For one, we have to trust the ledger keeper. Or we must incur some costs to audit the ledger to make sure the ledger keeper only makes authorized changes. Moreover, all our transfers must go through the ledger keeper. So we have to reveal potentially sensitive information to the ledger keeper, like who we are transferring our property to and how much property we are transferring. We might prefer to keep that information private. Finally, when we rely on a single ledger keeper, there is a single point of attack for hackers or other malicious users. If they can compromise the ledger keeper, they can compromise the ledger — and transfer our hard-earned property titles to themselves.

Blockchain technology allows us to keep and update a ledger without relying on a single ledger keeper. Who owns what is recorded on the blockchain. To transfer ownership, we sign over our claim using a private key. Our transfer is added to others in a block of transfers and, once that block is confirmed as legitimate, the blockchain, or ledger, is updated. Since the entire system processes the transfer, we don’t have to trust a single ledger keeper.  We don’t have to reveal potentially sensitive information to others. And, since the blockchain is stored on many computers, there is no single point of attack. So, in brief, blockchain is a huge advance in ledger-keeping technology.

Thinking about various ledger protocols — and, especially, their relative strengths and weaknesses — also suggests which applications will employ a particular protocol. Economists have a special word for this. We say that an item is essential if it enables us to achieve a superior outcome to what could be achieved without that item. When is blockchain technology essential?

In brief, blockchain technology is essential when trust is sufficiently weak, monitoring is sufficiently costly, privacy is sufficiently important, or security is of sufficient concern. After all, these are the areas in which blockchain technology outperforms other ledger protocols. In cases in which we don’t care much about these areas, we might rely on some other, cheaper mechanism, meaning the blockchain is inessential. But, when overcoming one or more of these problems is key, we might turn to the blockchain.

When considering blockchain technology, many fall prone to the all-or-nothing fallacy. Blockchain technology will either be ubiquitous, radically changing the world as we know it; or it will be nothing, and it is a fad that we will soon forget. The truth is probably somewhere in the middle. Blockchain technology will be adopted where it is essential. But it will not replace traditional ledger technologies entirely.

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William J. Luther

William J. Luther is the Director of AIER's Sound Money Project and an Assistant Professor of Economics at Florida Atlantic University. His research focuses primarily on questions of currency acceptance. He has published articles in leading scholarly journals, including Journal of Economic Behavior & Organization, Economic Inquiry, Journal of Institutional Economics, Public Choice, and Quarterly Review of Economics and Finance. His popular works have appeared in The Economist, Forbes, and U.S. News & World Report. He has been cited by major media outlets, including NPR, VICE News, Al Jazeera, The Christian Science Monitor, and New Scientist.

Luther earned his M.A. and Ph.D. in Economics at George Mason University and his B.A. in Economics at Capital University. He was an AIER Summer Fellowship Program participant in 2010 and 2011.

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