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:


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.

The Platinum Coin


Is this how the debt ceiling issue will be resolved?

Last year, Republicans in Congress resisted lifting the debt ceiling until the last minute — and then only in exchange for spending cuts. Panic ensued. So what happens if there’s another showdown this year?

Enter the platinum coins. Thanks to an odd loophole in current law, the U.S. Treasury is technically allowed to mint as many coins made of platinum as it wants and can assign them whatever value it pleases.

Under this scenario, the U.S. Mint would produce (say) a pair of trillion-dollar platinum coins. The president orders the coins to be deposited at the Federal Reserve. The Fed then moves this money into Treasury’s accounts. And just like that, Treasury suddenly has an extra $2 trillion to pay off its obligations for the next two years — without needing to issue new debt. The ceiling is no longer an issue.

It seems to be entirely in accordance with the letter (if not the spirit) of the law. So while it is more likely that Boehner and Obama (the Boner-Droner connection) will work something out (as they did on the “fiscal cliff”, and in 2011 on the debt ceiling), the Platinum Coin Option is the ace up Obama’s sleeve if negotiations break down.

I don’t think it would have any real immediate effects different to just raising the debt ceiling through an Act of Congress. It is just opening a loophole to continue doing what America has been doing for the last four years (and Japan for the last twenty) — aggressively offsetting the private debt deleveraging with public debt.

The American government is a strange, multi-headed creature. One of its (partially private) heads — the Federal Reserve — retains the exclusive right (delegated from the Treasury by an Act of Congress) to create money. The rest of the American government pretends to be revenue-constrained, and subject to a debt ceiling.

This is obviously a charade. If one part of the government is not subject to a debt ceiling, then none of the government is subject to a debt ceiling. Loopholes — whether they are platinum coins, or something else — can be found.

The key component of any fiat system is trust. What the Platinum Coin Option would demonstrate is a lack of coherency and a state of fiscal disarray, which could easily in the longer term lead to a loss of trust, and further moves — beyond those already initiated by the BRIC nations — away from the dollar as a reserve currency.

Where Gold is Going

Many will argue that — more or less — this reflects the U.S. government’s attempts to deal with broad and deep social and financial problems through monetary policy. The higher the price of gold goes, the more the market believes that monetary policy just isn’t working, and that the big problems in American and Western society — oil dependency, deindustrialisation, unemployment, regulatory capture and debt saturation — are just not being effectively addressed.

As I wrote last month:

Getting out of a depression requires debt erasure, and new organic activity, and there is absolutely no guarantee that monetary easing will do the trick on either count. Most often, depressions and liquidity traps are a reflection of underlying structural and sociological problems, and broken economic and trade systems. Easing kicks the can down the road a little, and gives some time and breathing room for those problems to be fixed, but very often that just doesn’t happen. Ultimately, societies only take the steps necessary (e.g. a debt jubilee) when their very existence seems threatened.

The simple expansionary recipe for getting out of depressions is a sad smile, a false promise of an easy route out of complex and multi-dimensional problems.

If these problems are fixed, then the correlation between the debt ceiling and the price of gold will go away. Gold is not necessarily going to the moon, and the gold speculators will be forced to give up the ghost as real broad-based economic growth returns. The trouble is, I don’t see any evidence that these problems are going away. Japan is still — more or less — in the same place it was twenty years ago. Now the whole world may be moving to the Japanese model. Readers are welcome to try and convince me otherwise.

Paper vs Gold

Last month I explained why gold is not an asset to hold in every kind of market. But here’s an even more extreme piece of evidence.

During the last 200 years — an era of unprecedented growth and development — paper investments have trounced gold:

Now there are two perspectives on this:

  1. Gold is so far behind because it has no inherent value, it creates no product or new income, or innovation. It just sits.
  2. Gold is so far behind because stocks, bonds and dollars in a humungous, history-shattering bubble.

We shall see which case is correct.

Investors need to remember that the reasons for gold’s present strength — above all else mismanagement of the global economy and international financial system by governments and large financial corporations which has resulted in a low-growth, high unemployment, negative real rate environment — although historically abnormal, will eventually subside, and we will return to the historical norm where gold significantly under-performs paper. That’s because gold just sits, whereas other assets either produce a net return, or are a net liability.

As I explained last month:

I believe that in order to restore growth, what the system needs, and what it is driving toward is restructuring. This can either be accomplished intentionally through explicit haircuts or defaults, through high inflation, through a slow painful private deleveraging process or through strong organic growth.

I don’t know how debt reduction will take place. It could be three months or years away, or it could be another grinding, unemployed and depressed ten years, full of false dawns. Certainly that is what has happened to Japan since its stock market and real estate bubbles burst twenty years ago. Maybe the West will perform better than Japan in the deleveraging trap — maybe new technological innovations like cheap decentralised solar energy will provide the necessary organic growth to overcome the debt problem. Or maybe not.

Until the private debt load is significantly reduced, it will act as a huge weight tying down economic growth, tying down employment, and structurally weakening both the financial system and society. High debt loads require low interest rates to sustain — which with a little inflation means negative real interest rates. Gold has traditionally done very well in low real rate environments.

Once the deleveraging trap has been left behind, it will be the time to ditch gold and plough all of that purchasing power into productive assets: industrial stocks, real estate, farm land, inventory, and labour force.

And gold will once again settle into significantly under-performing stocks.

Is it Always a Good Time to Own Gold?

Is it always a good time to own gold?

Absolutely not. A portfolio in the S&P 500 or Treasuries in 1973 has returned a much higher rate than gold bought that year — even if gold raced ahead up ’til 1980, and is racing ahead again now. We know that throughout history gold has sustained its purchasing power, and fiat currency has lost its purchasing power. But we also know that stocks have grown their purchasing power.

But gold continues to rise — so what makes gold different right now? Well, from a technical perspective, America and the West are in a secular bear market:

But a technical perspective doesn’t really give enough political and economic background to explain why we are where we are.

Continue reading

Economy Tanking, Precious Metals in Liquidation

Silver is getting pummelled:

So is gold:

What does this mean?

Hedge funds and speculators who were long gold are trying to get a buffer of cash to soak up hits from the coming default cascade.

What does that mean for gold’s long term fundamentals?

Continue reading

The Great Gold Squeeze

So what’s next for gold? The weekend is over, and the week is about to begin — and that means gold, equities and debt trading in Asia will shortly be under way. Gold has been in a meteoric move upwards, spurred to even greater heights by Hugo Chavez’s announcement that Venezuela would repatriate its gold holdings from foreign banks — specifically those in London and New York.

From Things That Make You Go Hmmm (an absolute must-read):

Chavez’s move this week could set in motion a chain of events whereby Central banks who store the bulk of their gold overseas in ‘safe’ locations scramble to repossess their country’s true ‘wealth’. If that happens,the most high-stakes game of musical chairs the world hasever seen will have begun.One would imagine that a country’s gold would be storedonshore in their own vaults rather than be entrusted to a foreign power – after all, if tensions were to rise between the two sovereigns, amongst the first casualties would be said gold.

In trading since Chavez’s announcement, gold has shot up further. Of course there are other reasons for gold to rise — fiat debasement, sovereign debt concerns, equity weakness, concerns with overall trading conditions. But — ever since Gordon Brown offloaded Britain’s gold reserves for less than $300 an ounce at the millennium — coinciding with the peak of the fiat bubble — gold has shot up in value over 500%, and finally central banks are shifting holdings back into gold — especially the central banks of developing nations like China, Brazil and Russia, whose gold holdings have shot up 900%:

But the real problem may be that the vast growth in paper gold trading has been built on the backs of a very, very small physical base. Will the paper house of cards come tumbling down if part of the physical base is removed and sent to Venezuela? From Zero Hedge:

What could well be a gamechanger is that according to an update from Bloomberg, Venezuela has gold with, you guessed it, JP Morgan, Barclays, and Bank Of Nova Scotia. As most know, JPM is one of the 5 vault banks. The fun begins if Chavez demands physical delivery of more than 10.6 tons of physical because as today’s CME update of metal depository statistics, JPM only has 338,303 ounces of registered gold in storage. Or roughly 10.6 tons. A modest deposit of this size would cause some serious white hair at JPM as the bank scrambles to find the replacement gold, which has already been pledged about 100 times across the various paper markets.Keep an eye on gold in the illiquid after hour market. The overdue scramble for delivery may be about to begin.

The real question is whether any such scramble would cause more panics, more scrambles — to get out of cash, treasuries and equities and into gold and silver bullion — causing a deeper and harsher crash. Current data suggests that this is unlikely — but the deep worries over sovereign liquidity, fiat debasement, and food and fuel scarcity suggest that a panicked scramble out of cash is not entirely out of the question. Here’s a fantasy re-enactment of one not-entirely-improbable scenario:

$2000 gold ain’t far away:

Why Cash Is Not King

This is a strange and beautiful crisis. For the last century, at times of change and instability, nervous investors have traditionally piled their money in two directions, into Treasury Bonds, and into cash. This time, the fortifications underlying the entire financial system are straining beneath the weight of change, the weight of systemic debt, and the rise of China, Brazil, India and Russia. From The Economist’s resident cartoonist, KAL:

And the most common response to these wild and whirling winds of change is money flowing into the asset class that has just been downgraded, the US Treasury, slashing yields by half a percent. Why? Because it is the most widely traded and the most liquid asset in the world. Put money in Treasuries — goes the common logic — and you will get your money back. The United States Treasury cannot, will not default. Why? The answer has been spoken explicitly in the past few days, most prominently by former Federal Reserve Chairman Alan Greenspan:

The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default

Sadly, Chairman Greenspan is sorrily wrong. There are others kinds of defaults, and currently one is ongoing as a policy choice. With rates low, it is only necessary to have a small rate of inflation for real rates to be negative.

So are real interest rates really negative? It depends how we measure inflation. A huge aspect of my economic case is that — really — there is no such thing as a uniform inflation (or uniform inflation expectations), because there are different rates for different people, different communities and different strata of society. For welfare-recipients on a fixed income, food and fuel make up a much higher proportion of their income, leading to a much higher inflationary rate. For large corporations importing vast quantities of goods from China, inflation is undoubtedly lower. But no matter who you are, the rate of inflation is high enough to yield a negative real rate on cash.  On Treasuries, this is not necessarily true. But real rates on Treasuries are undoubtedly close to zero, if they are not negative.

Of course as I noted above that is the point of the zero interest rate policy: it is designed to spur holders of cash and Treasuries out of merely holding onto wealth, and instead into more productive ventures. The ostensible goal of the Federal Reserve’s policy, at this stage is to gradually increase productivity, output and unemployment and kick the can down the road for long enough to be able to get the burden under control. This is why Bernanke has called for further fiscal stimulus, as well as continuing monetary stimulus. In this environment, cash and Treasuries cannot be king, because cash and Treasuries are being deliberately throttled (even as the market deludes itself by pushing them to ever-greater heights).

What is king? Returns above the rate of inflation, at least. Right now that includes gold, silver, stocks from various countries and continents, and corporate bonds — so long as they are not in default. But in the long run, the winner will be quality productive assets built around solid companies, solid entrepreneurs, solid products and solid ideas. Value investors have known this for an eternity. But in tempestuous markets, getting in at the right price and at the time is difficult. That is why so many investors are waiting on the sidelines in cash and treasuries.

Is Silver Money?

Yesterday — following on from my post on gold — I was asked for my thoughts on silver:

Let’s have  a look at the return shown by gold and silver against the S&P500 over the last 10 years:

Continue reading

Why Does Gold Keep Going Up & Up?

Gold, born only in dying moments in the hearts of stars, and blasted out across the universe in supernovae, just keeps going up & up & up, rising today to a meteoric peak of $1684.70:

Continue reading