Of Bitcoin & the State

Bitcoin is very much in ascendancy. While it has for over three years existed as a decentralised and anonymous electronics payments system and medium of exchange for online black markets and gambling, more attempts to integrate Bitcoin into the wider economic system — most notably the integration of Bitpay with Amazon.com — have brought Bitcoin to the attention of a wider segment of the population. Alongside this, the egregious spectacle of depositor haircuts in Cyprus, and the spectre that depositor haircuts might happen elsewhere seems to have spurred a great new interest in alternatives to bank deposits in particular and state fiat currency in general. Consequently, the price is soaring — pushing up above $140 per bitcoin at the time of writing. Of course, this is still far less than a single ounce of gold currently priced at $1572.

There are many similarities between Bitcoin and gold. Gold is cooked up in the heart of supernovae, and is therefore exceedingly rare on Earth. It has a distinctive colouring, is non-perishable, fungible, portable, hard-to-counterfeit, and even today so expensive to synthesise that the supply is naturally limited. That made it a leading medium-of-exchange and store of purchasing power. Even today, in an age where it has been eclipsed in practice as a medium-of-exchange and as a unit-of-account for debts by state-backed fiat monies, it remains an enduring store of purchasing power.

Bitcoin is an even more limited currency — limited by the algorithms that control its mining. The maximum number of Bitcoins permitted by the code is 21 million (and in practice will gradually fall lower than this due to lost coins). Gold has been mined for over 5000 years, yet there is still gold in the ground today. Bitcoin’s mining will be (in theory) complete in a little over ten years — all the Bitcoins that there will ever be are projected to exist by 2025. True, there are already additional new currencies like Namecoin based on the Bitcoin technology but these do not trade at par with Bitcoin. This implies that Bitcoin will have a deflationary bias, as opposed to modern fiat currencies which tend toward inflation.

Many people have been attracted to the Bitcoin project by the notion of moving exchange outside of the scope of the state. Bitcoin has already begun to facilitate many activities that the state prohibits. More importantly, Bitcoin transactions are anonymous, and denominated outside of state fiat currency, so the state’s power to tax this economic activity is limited. As the range of Bitcoin-denominated merchants grows, it may become increasingly plausible to leave state  fiat currency behind altogether, and lead an anonymous economic life online fuelled by Bitcoins.

So is Bitcoin really a challenge to state power? And if it is, is it inevitable that the state will try to destroy Bitcoin? Some believe there can only be one survivor — the expansive modern state, with fiat currency, central banking, taxation and redistribution, or Bitcoin, the decentralised cryptographic currency.

The 21st Century is looking increasingly likely to be defined by decentralisation. In energy markets, homes are becoming able to generate their own (increasingly cheap!) decentralised energy through solar panels and other alternative and renewable energy sources. 3-D printing is looking to do the same thing for manufacturing. The internet has already decentralised information, learning and communication. Bitcoin is looking to do the same thing for money and savings.

But I don’t think that conflict is inevitable, and I certainly don’t foresee Bitcoin destroying the state. The state will have to change and adapt, but these changes will be gradual. Bitcoin today is not a competitor to state fiat money, but a complement. It would be very difficult today to convert all your state fiat currency into Bitcoins, and live a purely Bitcoin-oriented life, just as it would be very difficult to convert into gold or silver and life a gold or silver-oriented life. This is a manifestation of Gresham’s law — the idea that depreciating money drives out the appreciating money as a medium of exchange. Certainly, with Bitcoin rampaging upward in price — (a trend that Bitcoin’s deflationary nature encourages — holders will want to hold onto it rather than trade it for goods and services. If I had $1000 of Bitcoin, and $1000 of Federal reserve notes, I’d be far more likely to spend my FRNs on food and fuel and shelter than my Bitcoin, which might be worth $1001 of goods and services (or at current rates of increase, $1500 of goods and services) next week.

Bitcoin, then, is emerging as a savings instrument, an alternative to the ultra-low interest rates in the dollar-denominated world, the risks of equities, and a recent slump in the prices of gold and silver which have in the past decade acted in a similar role to that which Bitcoin is emerging into. (This does not mean that Bitcoin is a threat to gold and silver, as there are some fundamental differences, not least that the metals are tangibles and Bitcoin is not).

This means that the state is far more likely to attempt to regulate Bitcoin rather than destroy it. The key is to make Bitcoin-denominated income taxable. This means regulating and taxing the entry-and-exit points — the points where people convert from state fiat currency into Bitcoin.

This is so-far the approach that the US Federal government has chosen to take:

The federal agency charged with enforcing the nation’s laws against money laundering has issued new guidelines suggesting that several parties in the Bitcoin economy qualify as Money Services Businesses under US law. Money Services Businesses (MSBs) must register with the federal government, collect information about their customers, and take steps to combat money laundering by their customers.

The new guidelines do not mention Bitcoin by name, but there’s little doubt which “de-centralized virtual currency” the Financial Crimes Enforcement Network (FinCEN) had in mind when it drafted the new guidelines. A FinCEN spokesman told Bank Technology News last year that “we are aware of Bitcoin and other similar operations, and we are studying the mechanism behind Bitcoin.”

America’s anti-money-laundering laws require financial institutions to collect information on potentially suspicious transactions by their customers and report these to the federal government. Among the institutions subject to these regulatory requirements are “money services businesses,” including “money transmitters.” Until now, it wasn’t clear who in the Bitcoin network qualified as a money transmitter under the law.

For a centralized virtual currency like Facebook credits, the issuer of the currency (in this case, Facebook) must register as an MSB, because the act of buying the virtual currency transfers value from one location (the user’s conventional bank account) to another (the user’s virtual currency account). The same logic would apply to Bitcoin exchanges such as Mt. Gox. Allowing people to buy and sell bitcoins for dollars constitutes money transmission and therefore makes these businesses subject to federal regulation.

Of course, the Bitcoin network is fully decentralized. No single party has the power to issue new Bitcoins or approve Bitcoin transactions. Rather, the nodes in the Bitcoin network maintain a shared transaction register called the blockchain. Nodes called “miners” race to solve a cryptographic puzzle; the winner of each race is allowed to create the next entry in the blockchain. As a reward for its effort, the winning miner gets to credit itself a standard amount, currently 25 Bitcoins. Given that Bitcoins are now worth more than $50 and a new block is created every 10 minutes, Bitcoin mining has emerged as a significant business.

If a lot of economic activity were to move totally into Bitcoin, then the state might react more aggressively, seeking to tax transactions within the Bitcoin network (which may or may not be technically possible given Bitcoin’s anonymous nature) rather than just at the entry and exit points. There are, of course, risks for those wishing to move their entire economic life into Bitcoin — not just Gresham’s law, but transaction risks (Bitcoin has no clearing house, so all transactions are uninsured), and the risk that Bitcoin will be superseded (perhaps via the cryptography being rendered obsolete by some black swan advance in processing power, mathematics or cryptography?)

This current boom, where awareness of Bitcoin is growing considerably and many more individuals are joining the network, may soon be over. It is inevitable that at some stage the number of profit-takers seeking to cash out of Bitcoin into a currency where they can spend their profits will exceed the number of new investors trying to buy Bitcoin. At that stage, the price will fall. Just how much it falls will impact to what extent Bitcoin establishes itself as a decentralised and trusted store of purchasing power.

The last consolidation phase in Bitcoin’s price — between 2011 and 2013 — was not overwhelmingly encouraging, as prices remained far below the 2011 peak for a long while:

bitcoin

Yet they remained far above the pre-2011 levels. And while the 2011 boom was marked by curious scepticism, this boom seems to be marked by the notion of decentralised virtual currency going viral. Due to this increased awareness, it is highly probable that Bitcoin will end 2013 above whether it started it, even if the present prices do not prove sustainable. Ultimately, Bitcoin has no fundamentals (P/E, EBITDA, cash flow, etc) and so is worth what people will pay for it. And as Max Keiser, an early champion of Bitcoin put it:

In my view, Bitcoin has a much better chance of being part of the future of money than Groupon ever did of being part of the future of commerce.

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57 thoughts on “Of Bitcoin & the State

  1. BitCoins are the ultimate in FIAT, not a new gold.
    As I frequently point out, the bitcoin is worthless.

    It may have required a defined amount of processing power to create, but that power is gone, the bitcoin cant be broken back down into CPU cycles, the bitcoin created has no more “fundamental value” than the s**t I had this morning, created by steak I ate last night.

    Gold, for all its flaws as currency, is eternal, Fiat, for all its flaws, remains a way to pay taxation and avoid jail, Rice, Wheat, Salt, Tea for all their flaws, remain food.

    A limited supply is only relevant if any supply has a value.
    You might not believe the US government (or the Cypriot Government) when it stands up and says I will accept this in lieu of taxes, but bitcoin doesnt have anything better, it jst has nothing in its place.

  2. By the way, bitcoin is obviously in a bubble. When the price collapses to about $30, most people will dismiss bitcoin as a virtual beanie baby. Shaking off the fair weather investors isn’t always a bad thing either.

        • Haha. Yes. I wasn’t buying in January. That was a joke. I wish I had been buying in January, but I had too many uncertainties and too many interests in other things.

          I think the thing that has changed is that the idea has begun to go viral. Bitcoin is an idea. If people know about it, it can be a success. If it remains hidden in the murky corners of the internet (just as if the internet had remained within the murky corners of academia) it can never be a success. But it has broken into the wider consciousness, just as it began to to a much lesser degree in 2011. Right now the price is in a bubble, but sooner or later sellers will outnumber buyers and prices will fall again, creating a buying opportunity.

  3. Where ever there is perceived value there is going to be thievery, that’s a simple fact. Bitcoin is going through a reality check. Many will not have the stomach for the risk or will become disillusioned as schemes play out.

  4. The common misconception about Bitcoin is that it is ‘anonymous’. Every BTC transaction ever made is available to everyone to see, this is the cornerstone of BTC – you can’t spend same BTC twice. In this sense BTC is a lot more transparent then any other payment system.

    • If schemes like last years pirate40 reappear you won’t know who they are and if you find out, is it technically a crime and who would prosecute. Time for BitLaw and BitCourt?

    • Too true AlexB. For instance, when the Japanese government (with the prodding of the FBI) hands Mt. Gox a warrant and politely asks to know who their clients area, they will get (eventually) a list of all the Mt. Gox users and what bitcoin addresses they have used.

      With this information, and with the publicly accessible blockchain, all Mt. Gox users who have deposited money to Mt. Gox via a bank account will no longer be anonymous. No amount of encryption and buying bitcoin in cash is going to change that fact.

      On the other hand, if you were to ONLY exchange bank funds via a Swiss, Hong Kong, or Singaporean exchange, you will be able to keep your anonymity longer.

  5. Reality suggests that all value is linked to human labor, so no matter how you wish to abstract it, what you are left with is something other than human labor, a “something” which can be mercilessly manipulated [no doubt for fun and profit].

    The problem lies in the abstraction of labor-value to money, not necessarily is the integrity of the money itself. The fact money is probably not going anywhere anytime soon, it will be interesting to see what money-alternatives the mathematical magicians come up with up until the time when nation-states decide to put away the printing presses and return to fiscal sanity.

    • personal IOU’s? Like doing a job for friends, then expecting them to help you move house. Only works in small closed communities such as the Amish.

  6. Price being supported by fleeing Citizens of Russia

    http://www.boston.com/news/world/europe/2013/04/02/putin-russian-officials-close-foreign-accounts/YAs2CBB4CC0XpXysASnXeI/story.html

    Note Putin has pushed this earlier but was hamstrung by lower has politics.

    I give Russian President one thing. His nations appears to have a higher moral fibre, and business conditions conducive to capitalism, than the West. It is well placed to supply the future economies of the world. Not only do they have vast resources, but they have high tech engineering and computer science.

  7. Excellent analysis, Aziz. I hope you get a chance to exchange in at $30/BTC

    A couple responses to comments: Bitcoin is as fiat as gold, perhaps less. Fiat simply means the currency is declared a currency by the state and the value is set by the state. Bitcoin is anti-fiat.
    ==
    A “collapse” to $30 would be completely fine. After the last spike in 2011 it “collapsed” to $2. Excellent time to get rid of your fiat if you were paying attention. If it goes back to $30 and hibernates for a couple years or even several years, so be it. I discovered Bitcoin when it was $8 in May 2011. An exchange rate of $30 today would still be way better performance than any other vehicle. For all of 2012, the S&P returned 12%, sleepy old Bitcoin returned 1,200%
    ==
    BitCourt sounds like an excellent idea – see Judge.me
    ==
    Is someone really arguing the labor theory of value???
    ==
    Again, this is a great piece, Aziz!

    • My twelve year old grandson discovered BitCoin last year while playing an online video game. He wanted to know if BitCoin was money or like Chucky Cheese tokens.

    • Thanks!

      By “fiat” I generally just mean non-commodity money. When it is state fiat I use those words instead.

      I received my total supply of Bitcoins last August as a gift, so I have never bought any myself. Big drawback I have noticed is it takes an eternity to synchronise with the network, but presumably this problem will be reduced.

      • The gift that keeps on giving until it does not. Did Max Kaiser give it to you? He must have got on the ride early on.

      • bitstamp.net is an easy place to liquidate. I’m surprised that the outage/hacking didn’t burst this bubble. This makes me think it’s not done yet.

  8. I think it would be a marvellous history lesson to see the rats of the economy store all their ill gotten wealth and watch it evaporate over night. The irony is that Russia’s patriot IT scientists discover a way to seize these “safety” deposit boxes.

  9. I still don’t really know exactly what is Bitcoin. Is it a new concept of money? Or new concept of payment system like Visa/Master card? How can I trust it when none is insurring it’s trustworthy? Is it FDICed?

    When things go wrong, where’s my money? In the cyberspace? I can’t touch it, feel it, nor to see it.

  10. Damn our stupid Australian Prime Minister wanted to meet Obama, so signed an agreement to allow US troops, and the Pine Gap facility in the north of Australia, is the eyes and ears of the US defence system. Easily in range of North Koreas missiles. Forget about Hawaii or Alaska, or San Francisco, Pine Gap is the US archiles heal, and the Port of Darwin, backed by Australia’s supply lines is a crucial launching point for the US millitary. Lets hope my speculation is not China’s strategy to dominate the region using their proxy dog of war.

  11. Pingback: Of Bitcoin & the State ← gold is money

  12. One doesn’t synthesise gold (as you stated, its created in stars, in particular, supernovae); one refines it.

    • Technically you can synthesise gold in a particle accelerator at very, very high cost. At some point, this cost may fall and gold may become cheap, but that could be 50 years, or 1 or 2 or more centuries away.

  13. Bitcoin has fairly limited utility, as suggested above g, it may be a convenient and cheap way to move money around the world, but as far as consumer payments go it has drawbacks… why would I buy something online with Bitcoins when I can use my credit card or PayPal which automatically protects me from fraud? Transactions are anonymous, but only if no one can ever link your wallet to you person and with a majority of Bitcoin transactions through Mt Gox I would be concerned about (another) site hack which results in user details being publicised. Another concern regarding the concentration of transactions around a single exchange arise when we have outages like during the last 24 hours… you wouldn’t want to have any serious money in Bitcoin when the primary exchange is up and down like a yoyo.

    Anyway good article. Another one I enjoyed here:

    https://medium.com/money-banking/2b5ef79482cb

  14. Pingback: Of Bitcoin & the State | Fifth Estate

  15. This is one of the advantages of Bitcoin

    http://www.zerohedge.com/news/2013-04-04/ton-gold-bricks-what-capital-flight-looks-italy

    The only problem is if the timing results in a depreciation. Since bullion gold sellers in different jurisdictions would have to record transactions, smuggling is not possible

    With governments cracking down on transfer pricing and tax havens, the wealthy WILL be taxed, and will have no safe haven from democracy and EBT voters. perhaps residency in North Korea, Iran?

    • The irony here is that with bitcoin instead of bullion the money would have easily been transferred. This incident typifies the advantages of bitcoin over hard and soft physical money.

  16. Aziz,

    Have you heard about Ripple?

    “Its mission is to provide a non-banking payments alternative by decentralizing the process of creating and circulating highly liquid IOUs. Put differently, Ripple offers an environment in which individuals can be their own credit-issuing and credit-accepting banks.”

    Ripple + Bitcoin seems like it has the potential to really democratize and decentralize the financial industry.

  17. Pingback: Is Bitcoin A Bubble? | azizonomics

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