On Crypto-Currencies and Coal Mines

I’ll start this post with a confession: Until yesterday I’d not paid a great deal of attention to precisely what Bitcoin is or how it works. I ran across a link on Instapundit, however, to a Colorado representative’s tongue-in-cheek response to Sen. Joe Manchin’s call to ban Bitcoin because it’s hard to track and is widely used in certain criminal enterprises. The Colorado fellow’s response was to call for a ban on dollar bills, because they’re hard to track and are widely associated with criminal activity. I shared the post to my Facebook page and got a comment from a very good old friend of mine who now lives in Colorado and – let’s just say it politely – isn’t bowled over with admiration for this congresscritter. He’s also forgot more between breakfast and lunch about the details of how computers work and talk with each other than I’ll ever hear, let alone understand with any reliability.

I’ve seen for several years now references here and there to Bitcoin, and to the consternation it’s causing among those who are in the business of buggering us around watching out for our health, safety, and welfare. Since I’m not in a position to invest in a new set of brake pads for my Chrysler minivan with 269,700+ miles on it, I’ve never taken the trouble to learn how it works or why it’s so nefarious or wonderful (according to who’s in your ear at the moment). Thanks to the miracle of Google I’ve now patched, somewhat, my Ignorance Gap on that subject. 

For the uninitiated, Bitcoin is a “crypto-currency,” meaning: (i) It’s not issued, backed, or regulated by any constituted government or any agency or instrumentality of any such, but rather was cobbled together out of thin air (much like the Fed’s “quantitative easing,” when you get down to it) by some fellow who until literally the last couple of days had successfully preserved his anonymity (or not? according to this report in the FAZ, the Dorian Satoshi Nakamoto whom Newsweek outed as the inventor now denies any involvement at all . . . although given his previous statements I’m going with Newsweek on this one); and, (ii) Its individual units are created (in the slang, “mined”) by applying fairly substantial computing power to the solution of very difficult mathematical problems and protocols. Every time your computer (or more frequently, group of computers, as the computational power now required has long exceeded what’s available on single machines, at least desktops) solves one of these problems, it’s rewarded with the issue of a number of bitcoins. Each bitcoin, which is divisible up to eight decimal places, has a lengthy numeric key associated with it, and possession of that key, along with possession of the private key of the current possessor, allows the bitcoin to be transferred. Now, here’s the part that makes the whole system tick (and how it ticks is what generates a great part of the controversy): The mathematical problems required successfully to “mine” new bitcoins are intentionally made increasingly – exponentially so – more difficult, and on top of that, the number of bitcoins you’re issued with each successful “mining” is reduced. The system is set up so that a total of 21 million bitcoins can be issued . . . or at least that’s what is claimed. Is there anything out there to prevent jiggery-pokery to dump bazillions of bitcoins into the system? Nope. There’s nothing out there to prevent the powers that be behind Bitcoin from doing what the Fed has been doing for years now, namely just making the stuff up. 

So are bitcoins backed by anything at all? Nope. They’re backed by precisely what the federal reserve notes in your wallet are backed by: thin air. Seriously. Try going to a federal reserve bank and demanding anything for that C-note on your hip other than a spanking brand-new C-note, and see far you get. Likewise with Bitcoin. There’s nothing there; there are no assets at all; no collateral; no enterprise; no brand name; no goodwill. A bitcoin is “worth” only (i) what it costs you to acquire one, or (ii) what you can acquire with bitcoins. 

Whenever anyone anywhere completes any transaction involving bitcoins, there is supposedly updated a master, public database showing where every bitcoin has been traded thus far. This list is alleged to be run on multiple, decentralized servers, none of which is beholden to any governmental authority. So theoretically, if I’m understanding this correctly, everyone and his cousin can track precisely who’s got how many bitcoins. 

How much is a bitcoin worth? Well, that’s pretty flexible. The schoolhouse answer is that it’s worth whatever people are presently willing to pay to acquire one. Recently the price has been north of $1,100 per; it’s also within the past month or so crashed to below $300, and it’s been everywhere in between. The problem is that, as the computing power required to “mine” each issue of bitcoins gets more demanding, and therefore more expensive, the effective “purchase price” of each new bitcoin increases massively relative to all the previously “mined” bitcoins. Now, if you’re someone who’s looking to acquire additional bitcoins, you can either attempt to “mine” them yourself, or you can buy them off someone who’s already “mined” some (or that person’s assignee). Why would you pay more money to “mine” than you could pay to buy? And if you’re selling bitcoins, why would you sell at a price much less than what your putative seller would have to spend to “mine” his own? Thus all else being equal there ought to be some convergence between what the trading price is and the “mining” cost. 

Bitcoins are traded and warehoused, for want of a better expression, on exchanges dedicated to the purpose. They’re unregulated, uninsured, and (as recently demonstrated by the implosion of Mt Gox, one of the largest), not terribly secure. I’m not too sure about the mechanics of the trading/cash-out procedure, but there are – politely stated, again – some issues there as well. If you have your bitcoins housed at an exchange that goes belly-up . . . well, you’ve lost pretty much everything you have. Sort of like if you have more on deposit at an FDIC-insured bank that goes bust than the FDIC will cover. These exchanges, by the way, aren’t set up on Main Street in your friendly mid-American home town. They’re run out of places like Bulgaria and Rumania, notorious for having very fuzzy notions of the distinctions between meum and tuum, and also widely known for spawning armies of computer hackers. Just the winning recipe for the security of your investment in Bitcoin, in other words, right? More to the point, the entire system is no more secure against massive theft than the security mechanisms at these places. I’m not sufficiently computer-savvy to understand the precise sequence, but once the hackers get at the bitcoins’ keys and the private keys of the current owners, it’s only a matter of a few keystrokes to clean the place out. As in fact happened, it seems, at Mt Gox to the tune of many millions of dollars. 

What can you buy with Bitcoin? Well, pretty much anything that’s for sale by people who are willing to accept payment in Bitcoin. The concern arises from the fact that prominent on that list are things like international shipments of illegal drugs and weapons. This makes Bitcoin a burr under government’s saddle. 

Bitcoin is nearly ideal for things like “money laundering” and other “financial crimes.”  In pondering those, it’s helpful to bear in mind that those don’t necessarily mean “theft,” “wire fraud,” or other activities in which an innocent private party is separated from his hard-earned through force or trick.  In fact, “money laundering” is nothing more than making illegal proceeds ape in appearance those of lawful commerce.  The proceeds are not evidence of the crime itself, and if you look, for example, at the definitions of drug-smuggling crimes you won’t see that “possession of a boat-load of cash” is an element of any of them.  If you’re caught with $23,000,000 in $20s and $100s, and the man’s got nothing more on you, you’re not getting convicted of anything.  Rather, most of what falls under those concepts relates to doing the government out of what it has decided it’s entitled to . . . from you.  Viewed that way, government’s objection to crypto-currencies comes down to tax evasion. Government’s real dog in the hunt is tax revenue.

Demonstrating the truth of my last assertion above, consider how vanishingly small is the scale of money that needs to be, and is susceptible of, the kind of large-scale “laundering” that allegedly has governments all a-twitter.  Folks, the U.S. economy is cooking along at something like $14 trillion annually.  Even if every last dime made in an illegal operation of any sort, anywhere, by any person were successfully “laundered” that would still be a grain of sand in a very large ocean.  Add in the economies of all other Western countries and you rapidly figure out just how unimportant the supposedly monkey-shines in Bitcoin actually are to the proper functioning of the world. The trumpeted fear of “money laundering” and paying for coke and RPGs in bitcoins is a red herring.

So those are the results of my afternoon’s rambling through the Google results on “how does bitcoin work”. Here’s a description that seems pretty up-beat about the whole deal, and here’s a write-up that describes it as a “scam” and a “ponzi scheme.” All things considered, I think the stronger argument is the scam and ponzi scheme take, at least for the time being. So long as Bitcoin is not widely accepted and therefore not readily convertible into either “hard” currency (you have to try not to blow a snot bubble while describing the Fed’s funny-money as “hard” currency) or other tangible or intangible property, you as the owner of a bitcoin are sort of trapped in the system, and the later you got in the less likely anyone is to be willing to pay you a price for your bitcoin that gets you out whole. Your only likely market is the ever-fewer owners of later-mined bitcoins. And in fact that’s one of the defining characteristics of the classic ponzi scheme.  Adding to that aura of hucksterism is the fact that most of the early-mined bitcoins are not being actively traded.  So the price is being manipulated by hoarding as well, and a good deal of that hoarding appears to be by the inventor himself (his “worth” in bitcoins is estimated at anywhere up to $400 million).

But what if one day you really can take a card, or a flash drive, or some other storage mechanism out of your pocket, and swipe it, plug it in, or scan it down at the hardware store? And get ten bags of mortar mix for some decimal fraction of your bitcoin? At that point you’re not trapped in the system and what you have is a non-regulated medium of exchange. Government hates that notion. Very simply put, the modern income tax system cannot abide the existence of a competing medium of exchange. If Bitcoin outlasts its ponzi-scheme phase (and the writer at Market Sage does not think it will; I’m willing to accept that he may well be right) then the Internal Revenue Code blows up. 

So what, other than its structural flaws, can keep Bitcoin, or any other exchange medium, from achieving that result? Well, the answer starts with two little words printed on that C-note in your pocket. Remember that it’s worth more than the paper it’s printed on only because someone says it is – that is, after all, the reason it’s called “fiat” money. The two little words that make that C-note “worth” what the Fed says are “legal tender.” As in, tender of that C-note is a legally sufficient tender of performance of a monetary obligation up to $100. And no one is legally permitted to dispute that. If I assert that you owe me $100, and you toddle along and shove your C-note across the table at me, I am no longer entitled to deny that you performed your obligation. Your handing me that scrap of paper extinguishes $100 of your duties to me. Period. Bitcoin and its like will never enjoy the same status as “legal tender.” 

A further advantage that “government money” enjoys over the Bitcoins of the world is that they have the coercive resources of government behind them, theoretically to stabilize their values. Of course, anyone with any more than a fourth-grader’s understanding of history knows good and well that the stability function is not at all an inherent attribute of government money, or a necessary outcome of its being “government backed.” In fact currencies have been intentionally debased since ancient times, and they’re at it to this day. One of the perennial knocks on Red China is that they intentionally manipulate the “value” (meaning the exchange rates) of their own currency to make their products artificially “cheaper” to foreigners and domestic markets alike. Closer to home, since 2008 the U.S. economy has been about as anemic as it could be without actually collapsing. It’s “grown,” but it’s barely grown enough to keep up with population increase . . . which means it’s not really grown at all. During all this time the Fed has been dumping trillions of dollars of “money” into the economy in the form of buying Treasury debt. At one point the Fed was buying 91% of all new long-term debt issued by the Treasury. To borrow a line from Mitt Romney during the 2012 election, “At that point you’re just making it up.” He was right. How many trillion dollars can you dump into an economy that’s effectively not growing at all without destroying the value of each individual unit of it? 

A third advantage that government money enjoys over a Bitcoin is that the government is able, willing, and in fact diligent about deploying its coercive power to punish the kinds of monkey-shines that scuppered Mt Gox. I’m not aware that the computer security at the First Bank of BLANK is any tighter than at Mt Gox. What I do know is that if you hack your way into that bank and make off with several million dollars, Uncle Sugar will spend an enormous amount of resources to lock your country ass up for a very long time. That effort will never be expended to preserve the integrity of Bitcoin. 

So if the Bitcoins of the world are subject to wild fluctuation in value, and are not legal tender, and you’re pretty much on your own in protecting the integrity of the system, why would anyone with any large amount of skin in the game choose to do business in Bitcoin? The answer has already been mentioned, up above: taxes. As government grows ever larger, ever more expensive, ever more intrusive, it has to siphon an ever-increasing share of its population’s wealth to fund itself (just by way of example, since Dear Leader took office, U.S. federal spending as a percentage of GDP has been at levels not seen since 1946, when we’d just finished fighting and bankrolling a world war). In plain English that means the taxation system must become ever more burdensome and, in the dynamic of modern larcenous politics, ever more exploitative of precisely those actors who will have the greatest ability to choose the medium in which they conduct business. I mean, some Joe on the swing shift is probably never going to find it worth his time to plop down $500+ for a bitcoin. He’s already just barely taxed at all (at least to his knowledge; his actual indirect tax burden is pretty massive, but he’ll never realize it which is the entire purpose of making it an indirect burden, right?), his income covers his living expenses, just barely, so he’d be significantly exposed to a major slump in his bitcoin’s value (in the submarine service they call it an “uncontrolled depth excursion”), and he probably is not going to be doing business with third parties who are going to accept payment in bitcoins. So Joe’s got very little incentive not to support a tax system that loads ever more onerous burdens on “the rich,” “the 1%,” or whatever the demagogues of the day label them. A lumber supply house dealing with a French mill for several hundred thousand board feet of red oak? That’s a different story entirely. Congress is constitutionally prohibited from taxing the exports themselves. But it can tax the proceeds. But how do you document what the proceeds were, or are, if they’re paid in bitcoins?  The same attributes that make Bitcoin an ideal medium to “launder” the proceeds of your 250 kilos of smack also make it a really neat way to disappear the proceeds of that lumber.

And this, ultimately, is the core of government’s objection to Bitcoin: The existence of a viable medium of exchange over which it has no control is the final check on its ability to plunder its population. 

All of which suggests the question of why the government ought to have a monopoly on the medium of exchange. It’s not as if that’s always been the case. In colonial Virginia the standard medium was tobacco. On the frontier it was (among other things) whiskey. In post-World War II Germany cigarettes served the same function. Until 1913 there wasn’t such an animal as a federal reserve note. There was gold and silver coinage (and by the way, Bryan’s “Cross of Gold” speech was in favor of the free coinage of silver, which would have had the effect of devaluing the currency), and there were rafts and rafts of private bank notes, all trading at greater or lesser discounts from face value. A great deal of where you banked depended on how current your bank’s paper was. In all those cases the informal exchange media existed even though the respective governments of the time and place had “hard” currencies established. 

What is interesting is that existence of these private (that is, non-governmental) media was largely a function of the lack of adequate levels of hard currency. In some instances that was very much a consciously pursued policy goal. The British government intentionally starved its colonies of specie. In other cases it was a result of the government’s inability to keep up. Once the War of 1812 was over there was nothing to bar the American population from exploding, both numerically and geographically. And so it did. There just wasn’t any way to coin enough currency to satisfy demand. My, how times have changed. Now government is flooding the world with fiat money so fast that only the economically destructive policies being pursued by the same administrations can destroy wealth fast enough to avoid hyperinflation. In other words, people resorted to things like paper issued by the Second Bank of Nerts because they couldn’t do otherwise (the SBUS jerked down the house, sparking the Panic of 1837, by suddenly demanding payment in specie only . . . which then drove its corresponding banks to do likewise, which then drove their debtors under because they didn’t have it and couldn’t get it). Given the choice people would take hard currency in a flash. 

So why would human behavior change so drastically? Why would people nowadays willfully abandon what they so eagerly sought for generations? Once more I suggest the answer is in how government taxes its population now versus how it used to. Until the rise of what we can call the Ideal Gas State (that is, a state which expands to fill every crevice in human existence), there was little or no penalty to participation in the government’s exchange medium. Sure, you had taxes, but they were typically low and were mostly excises and imposts on identifiable things which, within very broad limits, you could choose to possess or not, at your pleasure. For example, at one point a popular way to impose property taxes was on the number of panes of window glass in a structure. One of the reasons that you see in old mansions a large number of tiny panes of glass is what Thorstein Veblen described as “conspicuous consumption.” On the other hand, you were also frequently taxed based on the number of rooms you had in the house, so those very same mansions typically had no built-in closets (and thus fewer rooms). Cynical, isn’t it? Show off how much you can afford to pay in taxes with hundreds 5×7 window panes, but clutter your living quarters with a forest of free-standing cabinets. All those things were, however, not taxes on the exchange of money itself. The income tax changed all that. Suddenly your tax burden was being driven not by what you had or did not have, but on your receipt of compensation for your economic activities. Add in the voracious appetite for spoil of the modern kleptocratic state and you have exactly reversed the incentives of 200 years ago.

I will humbly offer a few predictions: Bitcoin and those like it will prove to be most widely adopted in those countries which have the most larcenous tax regimes and the most corrupt governments. And in those places where such media are most widely adopted, we will see rapid spirals into something resembling anarchy. It is, after all, a characteristic of government plunder that the more people it drives out of the above-board economy, the more it must exact from those remaining. And no one will stand there and endure indefinite robbery. Modern governments can build things like the Berlin Wall and the sundry apparatus of the Iron Curtain, but all that does is ensure that when things do break loose, the result is catastrophic collapse. 

For us here in the U.S., Bitcoin and its cousins are going to prove canaries in the American coal mine. I am interested, and not a little alarmed, to see how it all works out.

 

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