The Magic of Money, The Science of Bitcoin

The greatest barrier to bitcoin adoption today is the mysticism and magic that surrounds money and wealth. Due to this mystical perspective of money, many people do not understand the scientific functions of money as an economic mode of exchange. However, when we can come to understand bitcoin and money from a scientific perspective, we can pull back the curtain of Oz and see the little man for what he is.

The Mysticism of Money

I use the words magic and mysticism very specifically. When I say mysticism, I am not talking about true fairy-tale like mystical forces, but the human perception of the legitimacy of the unknown.  The unsaid agreements that run and dictate larger forces within our society that one does not understand, but one accepts at face value. It is here that we find the sacrifice of knowledge-sovereignty  in exchange for mystical comfort–there is strength to be found in ignorance.

Magic is the application of psychological obfuscation to obscure what the truth is. The application of ‘magic’ creates a mystical story around whatever the target does not understand. This creates the false reflection of truth through offering ‘what is’ as a justification for how it should be. This article in Time Magazine’s blog speaking about the dangers of bitcoin is an example of this.

This article speak of how the most recent report from the consumer financial protection bureau warns that bitcoin is, “Vulnerability to hackers, limited security, excessive costs and scams…Virtual currencies are not backed by any government or central bank, and at this point consumers are stepping into the Wild West when they engage in the market.” However, what Time fails to understand that this is the whole point of bitcoin.

Bitcoin seeks to ensure that West stays wild. It seeks to take money completely out of the hands of governments and regulators due to the fact they cannot be trusted with the economic prosperity of all. This propaganda piece from Time made to scare people into continuing to trust their governments with their money and economic prosperity, despite the mountain of evidence that we should not.

However it is not enough alone to simply use propaganda and lies to create a mysticism–violence, control, and intimidation must also be an implicit facts of how ‘The Story’ is forged. This is part of what creates the ideological paradigm that money must be control by governments, or terrible thing will happen! This story is perpetuated by making money into something that only ‘experts’ can understand, as it is just too complicated, risky, and difficult for the common man to understand.

The Science of Bitcoin

Bitcoin is a financial system that is based upon scientific logic. This logic is derived from the mathematical bases and protocol upon which bitcoin is built. Those who use bitcoin understand that the known, limited supply of bitcoin, is part of what creates the value of bitcoin in the first place. Bitcoiners don’t want backdoors built into the protocol, or allow for the suits in banking or government to have any kind of access to their money–that’s the whole point of bitcoin! There is substantial evidence that these bankers and regulators want to be good masters, but they seek to be our masters. There is ample evidence of the long train of abuses that clearly shows what they want to do with that power, and it is not to protect the average citizen.

The myth of money is animated behind the belief that the ruling establishment is pushing that people cannot, and should not have control of their own money. There is not a strong analytically case for this, but half-truths, fear-mongering, and an obscuring of what is true to attempt to herd people away from trying to achieve true economic independence for oneself. Whereas bitcoin and other digital currencies make the argument for why their are powerful modes of exchange and storage of wealth through strong, scientific whitepapers. The virtue of the value of digital currencies come from what they are, and what they are alone–not from the authoritarian systems that ask us to trust them without any reassurances.

The science of bitcoin comes from its mathematical bases, and that anyone can review the code that build it. Bitcoin creates an argument for itself; you can see and understand how it is ‘unhackable’ when stored and used correctly, and see how the cryptography behind bitcoin keeps everything private. You can see how much the fees are for using bitcoin with the knowledge that there no other sort of hidden fees, random fund seizures, or someone who will deny you access to your own money when you need it. Digital currencies can be used anywhere on the planet (and in space as well), and can cross boarders with no hassles or declaration forms to be filled out. Bitcoin is simply better money than fiat simply by what it is.

To Pull Back the Curtain

The con is up. The once ever-so-powerful wizardry that created and legitimized the banking, financial, and money systems can now be seen for the trickery that it is. The internet has given us the access to the information that lets us to tear down the curtain and see the wizard for who he is. As the false prophet flails and panics to put the curtain of obstruction and mysticism back up, we will find that his tale no longer holds the power it once did. We those behind the curtain for the criminal they are, and the way that they do it; now it is just a matter of time before people see these powerful institutions for the criminals that they are as well.

Next: Antifragile Bitcoin

Gresham’s Law and Bitcoin

Over the last few years there have been a number of papers and blog post on Gresham’s law and bitcoin. Most of these have rudely proclaimed that bitcoin will die because of Gresham’s law–ironically, it will be fiat currencies that will die because of that law, not bitcoin. This is because the real value of fiat money is always going to be lower than the real utility value of bitcoin. As the illusion of fiat money is exposed for what it is, the value of bitcoin compared to it will continue to go higher, and higher.

Gresham’s Law, Real and Nominal Values

Gresham’s law dictates that bad money will drive out the good due. This is due to the fact that ‘bad money’ is overvalued so you want to use it; while good money is undervalued, so you want to save it. Thus, consumers will get more bang for the buck using the inferior money, and will benefit from hoarding the superior money.

Let me elaborate in an example using a $100 bill and a 1oz Gold Double Eagle $20 coin. In terms of the recognition of value, the $100 has a higher nominal value than the $20 coin. However, one would be an idiot to spend the $20 gold coin on $20 worth of goods, as the gold coin’s commodity value worth well over $1000. This is why we don’t see $20 gold coins floating around–people have ‘horde’ them up so those coins are no longer in the money supply.

This is what is meant by the saying of Gresham’s law: bad money drives out the good. Please see difference my post The Legal Politics of Money for more details on the difference between nominal value (valor impositus) and real commodity value (bonitas intrinseca).

In contemporary society, we have a hard time understanding that ‘money’ is really just a catch-all term for ‘object of exchange value.’ Really anything can be money–gold, bushel of wheat, salt, seashells, etc.–what is important about money is that it is an equal and standard measure. Because governments have historically fix fiat money’s value to something (in the case of the 1oz gold coin, it was $20, as that was the rate that the FED honored from 1913 to 1933–1oz of gold was = $20) it creates two values: real and nominal.

This means ALL money has two values–a real commodity value, and a nominal value. The commodity value is the worth of the object that the money is made of; such as the gold the coin is made from, or the paper that a dollar bill is printed on, or the electrical energy that is spent on mining bitcoins. This commodity value will always be independent of the nominal money value of money.

Historically, governments always ‘pegged’ the nominal value of government money to the commodity value of gold or silver. Today however, because dollars are not pegged to anything and are free-floating, the value of dollars are decided by the market alone; just like bitcoin. Dollars today are only and explicitly nominal values–as the paper they are printed on is just that–paper that has no commodity value other than being legal tender. People can assess those two values (nominal vs. commodity) against one another and decide for themselves what is more advantageous. That which is seen as ‘bad money’ is spent, and the ‘good money’ is saved for a later date when its value has increased. The ‘demand’ for money is called liquidity preference, as the demand of each monetary unit and it total value is also affected by how liquid it is, and how willing people are to accept it.

double eagle gold coinIn short:

$20 double eagle gold coin; nominal value = $20

$100 bill; nominal value = $100

These are the values that these monies have because of the nominal, set values by the government.

$20 double eagle gold coin; real commodity value = around $1200 because of the 1oz of gold it contains

$100 bill; real commodity value = Around $0.13 per bill to produced because it is just fancy cotton.

Money has two independent values : the nominal value, or the set price that the government will value that money at; and the real commodity value–the price that money has because of its own intrinsic commodity value. This is why dimes made before 1964 have vanish from the supply–as the silver they are made out of is worth at least $1, thus it becomes a better option to spend zinc dimes (post-1964) that are worthless than $0.10 per coin, vs. spending dimes that are worth more than $0.10.

The Value of Fiat Money

peso-to-dollarFiat money by definition has no intrinsic value. The only the value that fiat money has is the threat of legal force if someone refuses it. This is why the value of fiat money is directly tied to the legitimacy of the governments that issue those currencies. Right now, we are seeing a collapse of the Argentina peso (again), which is due to the government’s refusal to pay it debts. This in turn has lead to a crisis in confidence of the monetary stability of the peso, which has caused for a self-fulfilling prophecy of people and investors fleeing the peso.

As people dump the peso for other options (mostly dollars due to exorbitant privilege), the value of the peso goes into free fall because there is far too much supply and not enough demand. This causes for the value of the peso to plummet, and people want to get rid of their peso as fast as possible for something that can hold value. This can be commodities, cars, property, foreign currency, or anything that can help them store value and not quickly evaporate under the 56% inflation they are currently facing.  As this process builds, one of two things happens:

1. The value of the peso collapse far enough for supply and demand to meet, and the value will start to stabilize, abated after losing a signification amount of it’s value.

2. The peso is continually dumped, the value will go into almost total free fall, and hyperinflation will ensue.

It is important to understand that hyperinflation is linked to a dramatic rise in the velocity of money, as people are trying to transact with that money almost immediately, as people want to get what their money is worth, and not lose 50% of their purchasing power. Furthermore, this problem then tends to be exacerbated by government printing more money to try to deal with price increases, which further expands the money supply of a market that is already oversupplied with a money no one wants.  For more details on how hyperinflation and velocity of money operate together, please see this page.

Working Towards the True Value of Bitcoin

When we look at bitcoin from the lens of Gresham’s Law it is rather impossible to determine if bitcoin is overvalued or undervalued; as by definition, whatever the market price is today is the real value. Due to bitcoin’s total elasticity, the value of bitcoin can theoretically fluctuate from millions of dollars in a matter of minutes, with little changing in the market other than perception. If we look closely, there are several indicators which we can use to see if bitcoin is undervalued or overvalued. Some of these indicators are the transaction volume, the cost of bitcoin mining, the number of market participants, and the bitcoin day’s destroyed metric.

The transaction volume can act as an indicator of the equilibrium of the bitcoin market. We can assume that generally if the value of bitcoin is overvalued, more people will spend their bitcoin than fiat; wheras if bitcoin is undervalued, people would rather spend fiat than bitcoin. However, both miners, and bitcoin based business both need to sell bitcoin for fiat to pay their bills–which in the case of the price dropping precipitously, these buisness would need to dump even more bitcoin, which would accelerate the drop in price. This can lead to dynamic disequilibrium, which is essentially when the market has lost its collective mind, and the euphoria or panic of the digital herd dictates the market and creates a self-fulfilling prophecy that is totally unrelated to the commodity value of bitcoin. What can be seen in any situation of disequilibrium is the velocity of bitcoin is much higher than the norm.

Velocity Adjustment of Bitcoin

If bitcoin is undervalued, than transaction volume will continue to drop, tightening the money supply until equilibrium price has been met. If bitcoin is overvalued, then the supply cannot meet the demand, and the price will rise until equilibrium is met.

The value of bitcoin pulled between the social value of the network at the current time (short-term), verses the total electrical expenditure that has been spent to create the bitcoin supply today (long-term). This creates a moving target for what the ‘true value’ of bitcoin is. The higher the velocity compared to the historic gross average velocity of bitcoin, the greater the chance of bitcoin’s price being in disequilibrium. The lower the velocity compared to the historic norm, greater the equilibrium there is.

The fixed supply of bitcoin ensures that the only way to adjust the monetary value of bitcoin is through exchange. When the price is undervalued or overvalued, the transaction ratio compared to the norm will be much greater.

Conclusion

When comparing digital currencies and fiat currencies directly against one another, it is quite clear that digital currencies are very undervalued at this time. There is a clear limit on the number of bitcoins that can be forged, they are backed by the real electrical energy that is expended on bitcoin mining, and there is a huge amounts of VC capital going into building the bitcoin ecosystem. This is no different from the expenditures that go into mining operations for gold, silver, platinum, or fossil fuels. Furthermore, bitcoin and other digital currencies are digital natives, living in the realm of the internet; which is the largest and fastest growing economy in the world. Goverments and their fiat money will always be interlopers in the transglobal internet. Chained to the states they are from, with the slow, inefficent, and backwards idea that state-based fiat money work will in a transglobal economy, they will succumb to the creative destruction of bitcoin. When looking back on 2015 from the vantage point of 2025, it will seem laughable that digital currencies didn’t immediately usurp fiat money. We simply need to look to the history of the failure of fiat currencies to understand that it is not a question of if they will fail, but when.

The issues of the financial crisis of 2008 were never addressed, which has made the entire financial economy today into one huge moral hazard. This empire of paper will topple soon, and it is refreshing to know that in that process, we will be able to take back our financial power, and strike at the very heart of state-capitalism.

Next: The Transaction Cost of Bitcoin

Bitcoin and The History of Money

To understand Bitcoin, we need to also understand the history of money. This is a long and complex topic that has changed dramatically over the last 400 years, and has a total history of more than 3000 years. In order to understand both money, and bitcoin, we need to understand that there are two distinct functions that money has, that are independent of each other, but both influences money’s value: the payment function of money, and its storage of value function.

Both of these features have important functions for money, but it is important to understand how each one of these affect money differently. I cover this in more detail in what is the intrinsic value of bitcoin, and bitcoin as commodity money.

The best way to think of it is that bitcoin is a threat to both common storage of value; such as precious metals like gold and silver, but it is also a threat to normal fiat money because of the bitcoin payment network. These two features of bitcoin create one type of money that is superior to both precious metals and fiat currencies. To understand why bitcoin works as money, we need to understand the history of money over the last century.

The History of Banking

To understand banking, we need to know what is a mode of exchange, how did it come about, and why it was needed in addition to a storage of value.

A mode of exchange is just that, a mode in which you can engage in the exchange of one good for another. Before modern money, this could be anything that was commonly exchanged, and the value was well understood by the general public. Throughout history, this has been everything including bushels of wheat, tobacco, land, etc. As long as both parties understood the value of what was being exchanged and chose to accept it, it could function as a mode of exchange.

As gold became the common standard for exchange during the mercantilism era, there became substantial risk in carrying large amounts of precious metals. Instead of carrying around a brick of gold, people could carry around notes that were redeemable at banks for the same amount of gold as the note. This is how banking has been practiced for most of its existence. It has only been in the last century that fiat paper money with no convertibility to a commodity has become the norm.

It is substantially important to understand that fiat money came about to represent an actual storage of value to make real payments. The only reason fiat money ever did come about is because it was a technological innovation that was fiat money. To be able to spend the value of gold, but carry it around in a lighter paper form what a huge technological development that fundamentally changed how exchange was preformed. This allowed for people to continue commerce in the same ways as before, but now with their wealth from the threat of theft.

Ironically, the creation of banking notes that can be redeemed for a storage of value also created the needed framework for the current system of fractional reserve banking that all states use today. This created a kind of banking system where banks no longer operated on how much money they have available, but they operate on only a fraction of the total they should have available. Banks use this system to cheat their profits by using the multiplier effect to multiply their profits–and their losses. These losses can become so substantial that it can destroy the entire banking system and economy. This is what happened during the Great Depression, and more recently during the 2008 meltdown.

The Bretton Woods Era

near the end of WWII, the allies came together in secret meeting in Bretton Woods to negotiate how the new global economy would be built. Keynes wanted an International Clearing Union which would use a fair international banking currency based off of trade deficits called the Bancor. This became the official position of the UK when negotiating at the BW conference.

Keynes’ idea was rejected (despite its popularity), and instead the dollar was to replace the international currency unit, which today gives the U.S. a special power in international finance call exorbitant privilege. To do this, $35 was set as the redeemable price for one ounce of gold (almost twice what it was worth when it was seized from U.S. Citizens back in 1933), and what would become the IMF was setup. Keynes understood the huge issues this would create in international monetary system, and offered incredible insight to how this would play out 20 years later.

This system would have worked, if the U.S. was not cheating on their balance of payments. From 1945 to 1971 more and more U.S. dollars started circulating around the globe because the U.S. was importing more than they were exporting–creating a negative balance of payments. In fact, so many dollars were exported like this that the U.S. could not cover all of the outstanding gold that the dollars represented. The French were suspicious of this in the 1960s and started to repatriate their gold, which led to Nixon shock. In 1969, Nixon announced that the dollar was no longer convertible to gold, and created a 10%  tariff to protect american industries from the shock of this. $35 was no longer worth an ounce of gold–it was worth nothing.

Nixon Shock

In order to make sure that the dollar did not enter into a death spiral of hyperinflation, Nixon as put in place tariffs, wage freezes, and a fixed exchange rate until he figured out what to do to give the dollar value. In 1973, Henry Kissinger struck a deal with the Saudi King. In exchange for arming and supporting the Saudis and their brutality domestically, they would agree to sell oil in only U.S. Dollars. This created the ‘petrodollar‘ which propped up the value of the dollar now that it was no longer exchangeable. So from 1973 on, the dollar was no longer worth gold, but oil.

Nearly thirty years later we can see the evidence of how decoupling the dollar from gold has shattered faith in the global monetary system and the dollar. This had huge consequences for the purchasing power of the dollar and everyone who used it. Below is a chart of the purchasing power of the dollar since 1970–today the dollar of 1970 can only purchase $0.18 of goods today–it lost more than 4/5th of its purchasing power in just 45 years.

 

The Theft of The World

Now that money was no longer tied to the actual value of commodities and is free-floating, it became possible for the theft of the productive capacity of not just entire nations, but the world itself through the monopolization of money by state governments. Slowly over decades, inflation simply caused for the slipping purchasing power of not only the dollar, but all fiat currencies. This was done so slowly and deliberately that few could understand what Keynes had warned people of so many years before:

“Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery. Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

–JMK, The Economic Consequences of the Peace (1919)

Today the inflation that we face is not due to new gold being introduced to the fractional-reserve banking system, but from the value of the dollar simply decreasing.  Today there are more dollars in the world today than yesterday due to quantitative easing (i.e. making more dollars). The decrease in the purchasing power of the dollar is a direct loss to you and everyone using the dollar; and a direct gain for the government and banks who benefit from the creation of new dollars. We have been told that these are good men, and that they will use monetary policy to create price stability and keeping unemployment low, but the facts show something much different and much more insidious. 

Failure of Gold as a Storage of Wealth

Gold has been used as a storage of wealth for millennia because of the total fungible nature of gold. However, what happened from the start of the 20th century, to the end of WWII, was a consolidation of gold in the hands of the State through legal confiscation and violence. By 1973, almost all gold was in the hands of the state through force and theft.

This was done in two distinct ways. There was state-to-state confiscation of gold and precious metals, such as the reparations from WWI and imperialism. This concentrated gold in the global north in the hands of a small number of elite bankers and business magnates. The other way was through the war that governments carried out against the private wealth of their own citizens.

This can be seen throughout the world with the restrictive legislation from states around the globe; such as Executive Order 6102, The Australian Banking Act 1959, and the Indian Gold (Control) Act 1968Instead of protecting citizens from the tyranny of wealth seizures, holding gold actually made people a target for the state. Through this violent seizure of wealth, governments essentially gained an oligopoly on gold. This allowed for governments and their allies in banking to manipulate the price of gold through holding or dumping; but more importunately, they have rendered gold meaningless as a source of payment and storage of value. Today, almost no one will take your gold or silver as payment, despite the fact it truly is worth more than paper money.

The Need for Protection From The State

It should be obvious that the greatest threat to ones personal wealth is not some foreign or personal aggressor, but the State itself. This puts us in a predicament because the State is the owner of the means of exchange, and the arbitrator of all legality. Through controlling the means of exchange, the State can manipulate the value of the dollar on a large scale for its own benefit (such as quantitative easing or unlimited funding for war), while also being the gatekeeper of the finance system. The greatest issue with this is that even if you find a suitable alternative means of exchange (like bitcoin), the state can still call it illegal, and bring violence to you and your family for not complying.

If one is to control a large portion of wealth, it can only be done with the explicit approval of the State. At any time they can choose to seized you wealth, and you can go to prison. The accumulation of large amounts of wealth becomes impossible without the approval of the State in modern society. If the State does not approve of it, they will call it ‘money laundering’ and treat you as a criminal. This means that it is impossible for someone to be against the state, while still being able to control their wealth. This helps explain why the state is so active in financial oppression against its own citizens, while allowing for out right crimes to be preformed by some of the largest banks in the world, and letting police execute its citizens.

This explicitly displays that the State has the power to stop these criminals today,  and yet they choose not to do so. This is because the government is in bed with these organizations. Politicians receive ‘donations‘ from these companies and former CEOs are given elite, secure jobs from the government later down the line in exchange for this. These companies have bought laws and protection for themselves at the direct expense of other citizens through the corruption of the legal, and political system. It should be clear and obvious for all to see: we cannot recover this system of government, economics, and finance, and we must reject the system as a whole.

Now that we have bitcoin, we can actual do that. Once we reject the money of the State, and their crony capitalist bankers, the value of their fiat money will collapse. The State will no longer be able to pay for their wars, bloated salaries, or mechanisms of fear and terrorism. There will be a great unwinding and no one will accept their shitty paper money anymore.

Conclusion

bit-freeThe State over the course of the last hundred years has pulled off one of the greatest stunts ever: getting people to believe that paper is worth more than real commodities. Through the slow theft of gold for paper, people have been robbed of their ability to have independent wealth. Wealth today can only be acquired at the good will of the State because the State monopolizes the legal authority for how you can get money. The State, and their banker allies siphon off as much value as they can from the productive capacity of normal, hard-working people through devaluing fiat money through quantitative easing and interest.

From the end of gold standard in 1933, to all of the usurpation that brought us to where we are today, it should be clear that governments cannot be trusted with our wealth. Bitcoin and digital currencies offers people a chance to have a financial system that does not empower the State, or elite banks, but protection us from them.

Bitcoin is a global payment system, and storage of wealth that allows for a new system of finance and economics to be built. One based upon the principals of mathematics, privacy, and provability. A new system where we are not punished for saving and protecting our wealth, but rewarded. A system that understands, respects, and protects people’s right to privacy, and their right to conduct commerce with anyone in the world, no matter what State has their bootheel on their back, demanding a portion of their wealth.

Change is coming, and it will be radical, and it will change the world for the better.

Next: The Absolute Value of  Crypto

Zombie GOX: The magical price increase

In recent months the fall out from the GOX fiasco has really weathered bitcoin. From seeing its highest price of around $1126 and a low of $394, the market has weathered some amazing news, mostly due to the fails of the largest, now defunct bitcoin exchange MtGox. MT. GOX (frequently called Mount Gox, is really an abbreviation of Magic: The Gathering Online eXchange) closed its doors and officially announced bankruptcy, stating that they had been robbed of most of their bitcoins. But since then there have been some rumblings of foul play from the like of The Idiot, and some concerns with coins that have tainted links to Mtgox. What I suspect is that Mark cut a deal.

In this deal in exchange for relinquishing control of the business (and hopefully facing criminal negligence charges as well) Peter Vessenes will drop the Coinlab lawsuit. Together, Peter and Jon will use the bitcoin collected for membership at the Bitcoin foundation to both inject funds into MTgox and give The Bitcoin Foundation a share of MTGox. They’ll rehabilitate the business and inject huge sums of money (both fiat and bitcoin) into the market to inflate themselves away from a fractional reserve bank.

This is a sweet deal for everyone because Mark will get off the hook lighter than if all of the coins were gone. Peter gets what he wanted from the Coinlab lawsuit. Jon gets the make the Bitcoin Foundation the Hero, and can show their role in helping create self-regulation. And Gox gets to become the largest exchange in the world again as the price per bitcoin pushes beyond $3000.

I know this is kinda dirty, and that is why the idiot is crying so much about it, but I also think this is what can propel bitcoin into the next big bubble. If GOX is bailed out by the foundation, it makes them look competent, shows that the foundation is more than a mouth piece, and can help legitimize The Bitcoin Foundation for these kind of crises. I also think to do this a ton of shade backdoor deals were made, and there is going to be a huge pump of capital all at the same time. This will both save GOX and push the price up several fold.

The coming days will be interesting…

The Economic Functions of Bitcoin

The economic functions of the bitcoin network causes it to behave like a central bank. This has a few effects: bitcoins (the payment unit) behave like stock due to the fixed, known supply of units being subject to open market operations. What happens when the market price of bitcoin changes is the velocity of bitcoin falls into disequilibrium until a new equilibrium is found. This is why the transaction volume of bitcoin its extraordinarily high during the bubble cycle, both on the way up, and on the way down. From this observation we can see the velocity of bitcoin also serves as the price finding mechanism for the immediate price of bitcoin. Before we dive in deeper, lets first take a look at how bitcoin acts as a private bank in the digital world.

Bitcoin: The Private Bank for The Digital World

If bitcoin was a private bank it would have the following maxim as its monetary policy:      

  • Whomever secures the Network shall be reward 50 bitcoin with each new block. This amount shall decrease by 1/2 every 210,000 blocks until it cannot be halved any longer.

This is the issuance of bit-coins, the currency unit, is made from the electrical energy spent mining bitcoins. We can see the monetary inflation schedule for bitcoin below. The supply of bitcoins is 100% totally fixed–the only way that new coins can be created is through solving a specific block, and the reward for that is drops every 4 years.  

bitcoin supply growth over time

bitcoin supply growth over time

In order to have a money system that needs no central authority, Satoshi made bitcoin based upon rules that are fixed and secured by the mining process. This allows for a system where all bitcoin units are known at all times, thus making the double spend problem solved.

trinityIf bitcoin is a central bank, it would have to solve the impossible trinity problem that all central banks face (except the U.S. but that is a different story). Bitcoin accomplished this by creating a computer program with an independent monetary policy that humans cannot interfere with. The block reward, how the competition for the block reward is done, and the fixed supply of units are all parts of the bitcoin program that cannot be changed.

Anyone with a bitcoin address can use bitcoin, and it is impossible to know who is controlling each address, so bitcoin must be freely exchangeable. This means that the ‘sacrifice’ that bitcoin has made in terms of the impossible trinity is that it has no fixed exchange rate–the market must find an exchange rate based upon bitcoin’s perceived value, and the number of units available to the market. This free flow of capital from any sources is what allows for bitcoin to have been worthless just a few years ago, and why it could be worth $10,000s per coin one day. The free flow of capital is what creates the total elasticity that bitcoin experiences. 

Bitcoin and Deflation

When economist have called bitcoin deflationary they are referring to its economic property of rising in value over time. This is due to the restricted supply of bitcoins while there is increasing demand for them. This is similar to how if you had bought Apple stock in 1980 during its IPO you would have paid $22 per share. Due to the restricted supply of Apple stock and the increase in demand, today it is valued at $520 per share–and that is after 3 splits.

apple price

You could say that Apple stock “deflated” in value.

This occurred while the supply of the stock (# of shares) of Apple increased–it inflated. On three different occasions Apple had their stock split increasing the total number of Apple stocks there were. Again, this is due to the dramatic increase in demand for the stock. This is the kind of deflation that Bitcoin is experiencing overall, despite the volatile ride bitcoin has had over the last few year.

Why Deflation Supposedly Bad

Deflation is bad according to modern monetary theorist who charade as economist because contemporary economies are based upon debt. Fractional reserve banking and debt cannot exist without one another, so when deflation happens, it happens to debt as well. This means the real value of debt becomes harder to service, which means defaults, and bankruptcy will increase. In 1931, Irving Fisher  presented his theory on debt-deflation, which explains this process in greater detail.

This kind of deflation does not happen with bitcoin. There is no need to service ‘debt-bitcoin’ with bitcoin, so debt deflation does not happen. If this were true, we would see a similar collapse in the velocity of bitcoin during deflationary episodes, but in fact we see the opposite. The velocity of bitcoin increases correlatively to the price change of bitcoin in the short-term.

The Price of bitcoin

The price of bitcoin is derived from the total utility of the bitcoin network. In otherwords, bitcoin’s value is specifically tied to how many people are in the network, how useful the network is, and what the perceived value of bitcoin is. This is similar to how Twitter and Facebook have created social value that has translated into real economic value; which is reflected in the stock price of both of these companies. Without their userbases, each one of these networks would be worthless. All networks have a hidden utility that translates into direct economic value. 

The value of bitcoin is based in part off of this network abstraction. In order for price discovery to happen individuals need to use their subjective preference to decide how much each bitcoin is worth, and how much the network itself is worth. This is how the general, long-term price levels for bitcoin are discovered.

The short-term price is discovered according to network externality, such as exchange failures, or political issues. An example would be how bitcoin is ‘more expensive’ in Argentina because of the high rate of inflation that the peso is experiencing. Another would be the dramatic drop in price, and then recovery after the Silk Road was shut down. These network externalities, unlike fiat money, causes for great volititly in the price because there is no goverment to fix the price of bitcoin; only the market. The price of bitcoin reponds to these events through change, which causes for the velocity of bitcoin to increase until a new equilibrium is found.

The Velocity of Bitcoin

Due to the fixed supply of bitcoin, the only way that the price can be adjusted is in one way: through exchange and transaction. This is why during the most volatile times of bitcoin, we see a higher transaction volume. This applies to both increases as well as decreases in the price. Due to the fixed supply of bitcoin, the only way someone can acquire bitcoins is to mine them, or to buy them. Thus if the price of bitcoin is to increase or decrease in ANY WAY, an exchange or transaction must take place for that value to be accounted into the market.

Conclusion

Bitcoin’s deflation is similar to a technology stock where individuals are making real gains though holding a risky asset while it grows. Because bitcoin has a fixed monetary supply that cannot be manipulated, the price of each bitcoin is determined through supply and demand mechanisms. This is reflected in the increase of the velocity of bitcoin. If bitcoin were facing true currency deflation, we would not see the velocity of money decrease.

Next: Gresham’s Law and Bitcoin

The Barbarians of Government

In a recent New York Times Op-ed “Bits and Barbarism,” Paul Krugman resumed his bashing of bitcoin, gold, and everything that is not government issued money. He presents an idea of how bitcoin and gold are ‘barbaric’ forms of money because of the resources that are expended to obtain them, while government ability to create money is good because it can spend that money to create positive economic output. The irony of Paul’s argument is he completely fails to see the barbarism of the United States, its imperial military, and the way that government money creation empowers such barbarism. Paul wants for the government to be our savior, but fails to see that governments created the economic situation we are in today. Bitcoin provide an exit from this tyranny that men like Paul cannot see because of their entrenched position within the interest of the wealthy from atop his ivory towers.

Paul thinks that the government has a serious vested interest in creating full employment and encouraging economic activity. However, when we look at the political-economic structure in this country, it is clear that something else is happening. In 2012 less than 32,000 people accounted for 28% of all political donations in 2012–that’s almost 0.01% of the population getting about 1/3 of the political voice of all the other voters combine. J.P. Morgan Chase, one of the richest companies in the world, has spent more than $100 million dollars on lobbying and political donations, and this has paid off for them handsomely. The International Monetary Fund estimates that J.P Morgan Chase receives about $14 billion dollars a year in subsidies–about 140x as much as they spent on political manipulation.

When we look at these figures we must understand that this is how the political system works. No amount of hope or objections will change that. Paul seems to think that creating positive economic change is simply about creating sufficient will power to create that change. He fails to see how the whole political system has been compromised by none other than the heroic government that he wants to see change it.

Now that we understand where Paul is coming from, we can address some of the points in his article.

Gold

Krugman opens his article with talking about the human rights violations that are occurs in gold mines, like the Porgera gold mine in Papua New Guinea. He then goes on to talk about how the desire for gold is to blame for such gross human rights violations, but fails to point out that this mine he mentioned is managed by the Canadian mining company Placer Dome. Paul seems to think that the western government of the world have some vested interest in preventing human rights violations. If that is so, than why would they not come down on companies that are facilitating it?  To most of us it is pretty obvious–governments get kickbacks in the form of lobbying and political donations, in exchange for allowing large corporations to violate human rights abroad. It is disingenuous to talk about human rights violations, and then turn around and defend the governments that allow for those violations to occur.

Bitcoin

Paul then moves on to talk about how bitcoin mining engages in a similar wasted expenditure of energy similar to gold mining. He actually sounds like he really doesn’t understand how the block reward is distributed, which could be part of the problem. Paul does not understand the value of a P2P digital payment system that is out of the control of governments. He does not even see how it could have value. To him, bitcoin is just another commodity money like gold, which also should not have value.

This is critically important to understanding the elitist world view that Paul presents. Paul writes for the NYT, went to Yale for his undergrad, and M.I.T. for his Ph.d, and is a professor at Princeton. I’m sure that he has never been on the wrong side of the law, nor would he ever understand why you would be. He believe in the goodness of this government because he has always gotten the goodness of this government because of the elite position he occupies in society. Trying to tell him that maybe we need financial privacy because the government is proven to be corrupt and thieving doesn’t make sense to him–to him, these are the good guys, so why would you ever want a way to defend yourself from them?

Fiat

Paul then move on to talk about fiat money, and how in theory burying money and allowing for companies to struggle to extract the money would be a way to create real economic output. He uses this analogy to display that the extraction process of gold creates real economic output, in the same way that burying money could. He does this to show that the government can use their power of seigniorage (creating money from nothing) to create real economic output.

As true as this theory is, it is not the way that the governments have used their power of seigniorage. Instead this power has been used to give free money to the wealthiest organizations in the world: banks.

In Paul’s fantasy world, this is providing banks with the capital that they can then pass on to the little guy to create economic activity. What is really happening is the banks are just fattening themselves with free money in order to have the highest stock returns in recent history.

Government Role

Paul then moves on to quote Adam Smith on how gold and silver are ‘dead stocks’ to animate how wealth gets tied up in precious metals and then sits around doing nothing. What is very odd about this is if you read “The Wealth of Nations” you’ll see that this idea of gold and silver being a ‘dead stock’ is because gold and silver are hard to circulate. Smith saw paper money as being a technology–an innovation that allowed for all of the value of gold or silver to move about through a paper medium.

In many ways, bitcoin is the fusion of the ‘dead stock’ of precious metals, and the circulatory power of fiat money. Smith knew that gold and silver were the bases of the mercantilist world that he lived in, but he saw how damaging the hoarding of gold and silver was to the wealth of the nation because it wasn’t doing anything. This is why he thought that paper money was a good–though imperfect–method of engaging the value of the gold and silver. Smith states,

“The judicious operations of banking, by substituting paper in the room of a great part of this gold and silver, enable the country to convert a great part of this dead stock into active and productive stock.”

Gold itself was not the problem, it was making gold into an active stock that could be used everyday that was the problem, and bitcoin solves this problem.

Near the end of the article Paul asks, “So why are we tearing up the highlands of Papua New Guinea to add to our dead stock of gold and, even more bizarrely, running powerful computers 24/7 to add to a dead stock of digits?” To me, this actually displays Paul’s lack of understand of how bitcoin works, because unlike gold, bitcoin is not a ‘dead stock.’ It is clearly used as a medium of exchange, while at the same time being storage of value, hence fusing the idea of how fiat money and gold have classically worked.

Paul concludes the article with this:

Talk to gold bugs and they’ll tell you that paper money comes from governments, which can’t be trusted not to debase their currencies. The odd thing, however, is that for all the talk of currency debasement, such debasement is getting very hard to find. It’s not just that after years of dire warnings about runaway inflation, inflation in advanced countries is clearly too low, not too high. Even if you take a global perspective, episodes of really high inflation have become rare. Still, hyperinflation hype springs eternal.

Bitcoin seems to derive its appeal from more or less the same sources, plus the added sense that it’s high-tech and algorithmic, so it must be the wave of the future.

But don’t let the fancy trappings fool you: What’s really happening is a determined march to the days when money meant stuff you could jingle in your purse. In tropics and tundra alike, we are for some reason digging our way back to the 17th century.

This is just a lie. $1000 today is equal to the purchasing power of $353 dollar in 1980–which I would say is a hell of a lot of debasement. Furthermore, how is an inflation rate of +10% in 28 countries ‘rare’? What men like Paul fail to understand is that the government is not our savior, but a tyrant.

All of the economic woes of today could be end with the stroke of a pen from our government. The government could build huge public works programs, nationalize the banks, and take homes from the banks and give them to homeless.

But they don’t.

They don’t because there is no economic incentive for them to care about the poor, about the slow death of the economy for the middle class, or of even acting like they want to help us. The average American’s net worth has dropped 8 percent during the past seven years, while members of Congress got, on average, 15 percent richer. The only explanation for congress members having on average about 10 time the average wealth of americans, is that their corruption offers them special privileges, at the expense of everyone else.

This is why people are choosing commodity moneys over fiat money. We see the criminals that these people are, and the way that they are destroying the true wealth and industriousness of this nation. We want a money they cannot control, because they have proven time and time again that they cannot be trusted to control the wealth of a nation. Don’t let the rambling of a foolish man in a professors clothing fool you–the governments of the world seek to be good masters, but they seek to be your master.

Bitcoin’s Creative Destruction

“The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U. S. Steel illustrate the same process of industrial mutation-if I may use that biological term-that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.”

–Joseph Schumpeter in Capitalism, Socialism and Democracy

The process of creative destruction can be thought of as the evolution of efficiency within the markets. This can take many, many different forms with the core premise being to create new profit through innovation–with innovation being the keyword. Creative destruction is the wedge that divides the entrepreneurs from the capitalist.

Creative destruction generally presents itself as a technologically achievement that creates a greater total utility from the new product or process over the old. It can also take place as non-technical innovation, such as the worker assembly line processes pioneered by Ford, or the development of the just-in-time production strategy. These new innovations ‘destroy’ the older models through direct competition, not through using any sort of oppressive apparatuses of the law or monopolism. Disruption tends to be the contemporary word for it.

Creative destruction causes for a total increase in the utility of what is being accomplished–it is making it better. This question of ‘better’ or ‘more efficient’ is decided by free and fair markets though the greater returns that one receives. Thus, the most efficient actor or technology within a market, if not suppressed, should take the largest market share over time due the the fact that it is more efficient that all other options within the market.

Bitcoin is More Efficient On a Micro, Macro, and International Level

The creative destruction that will come from bitcoin is nothing short of earth-shattering. Bitcoin is more efficient on a macroeconomic, microeconomic, and international level. In almost every way it is better money than money itself.

Macroeconomic

As I explained in The Transaction Cost of bitcoin, when you look at bitcoin as a whole monetary system, it is always going to be more efficient than fiat currencies. This is because of a number of mechanisms that bitcoin uses to automatically establish and manage its own monetary system. The needed laws, legislation, and regulation that are needed for any fiat monetary system are handled automatically by the bitcoin protocol itself–Bitcoin users do not need to pay for the legal support of the system itself. Whereas, because of the nature of fiat monetary system, the users of these systems must bear the cost of the legal and enforcement mechanism of that fiat money system, and that is very, very expensive.

How much do fiat money systems cost?

This is a difficult question to ask because the monetary system is implicitly part of the state, and the state is implicitly funded through taxation and seigniorage, which make is difficult to separate one from another. One cost that we can look at is counter-fitting, which costs between 200 to 250 billion dollars per year. The counter-fitting cost with bitcoin is $0.

These sort of savings are simply too dramatic to be ignored for long, and can help business dramatically reduce the cost they they incur from supporting a monetary system that is inefficient and subject to counter-fitting risks. This is not to include other indirect cost such as the actual printing, distributing, transporting, and securing of fiat money. When you compare the transaction cost between bitcoin and fiat money systems Bitcoin will always have a lower transaction cost because it does not need to pay for the legal and enforcement mechanisms that fiat systems must pay for in order for them to function.

Microeconomic

Once upon a time, storing your money within a bank to offer you the security of knowing that your money was safe and secure. In addition to helping one secure their money, banks also found the opportunity to make the use of money sitting in their vaults through allowing easier access to the funds through services like checks, debit cards, and credit cards. As these services evolved, the banking system started taking more and more ‘convenience fees’ for access your very own money! But what is one to do when all banks are part of the greater monopoly that makes up the various national money systems? Until now, nothing–but now because bitcoin challenges this monopoly, and it is much more efficient than this monopoly, it is going to break this monopoly. The fiat money system just cannot compete–it’s too slow, too prone to fraud, and there are too many fees. This is in addition to inflation that has proven itself time and time again to destroy the savings of all the general public. When one see all of the benefits that bitcoin offers and understands how it works, there simply is no good reason to keep using fiat–it’s just shitty money.

When you compare the amounts that one spends on banking fees, from either a consumer or a merchant perspective, to that of using bitcoin, we again see that using the fiat banking system is much, much more expensive because one is paying people to do what bitcoin does automatically. This is why services like CoinBase can offer 0% processing fee for the first $1,000,000 of transactions–because bitcoin is just that much more efficient. If any non-bitcoin services offered this kind of deal, they would be bankrupt within the month. They just cannot afford to do it because of how expensive it is to move around fiat money. Bitcoin will always have a lower transaction cost than using the banking system because it does not need to pay all of the mechanisms and fees to move around money–that is part of the bitcoin program.

Internationally gain-loss

The world is globalizing at an incredible rate, and is poised to continue to grow in that direction. Since 1995 there has been a dramatic growth in international trade by all countries except for industrialized one (who lost a portion of the international market to developing nations). This indicates that trade is starting to spread more evenly between all nations, instead of the industrialized nations taking up such a large potion of international trade. It is in the field of international trade that bitcoin offers some of its most powerful benefits.

Because bitcoin exist ‘in between’ national boundaries, it is not subject to many of the restrictions that fiat capital is subject to. This means that people and business that are working across boarders can choose to use bitcoin, and avoid national taxes, capital controls, and the intense oversight that is forced onto people and business from governments. Furthermore, when using bitcoin one does not need to deal with changing currencies consistently, and the associated fees and taxes that come with that.

Innovation vs. Crony Capitalism

Bitcoin is clearly a superior currency to its fiat counterparts. This is because Satoshi took all of the best features of both the internet and money and imbued them into one to create the first digital currency: Bitcoin. Bitcoin automates most of the processes that governments, laws, and the banks preform to maintain the money system. This means that the users of bitcoin do not have financially support the very large cost of maintaining a fiat monetary system. The innovative way that bitcoin secures money, protects identity, and allows for transfer to anyone with a internet connection is much more efficient than any monetary system today. With bitcoin, your money belongs to you, and you are the only one with control over it. Hands-down, this makes bitcoin win the economic argument by being more efficient, quicker, and secure.

But the economic argument has nothing to do with what we are talking about though…. because money is NOT about money.

It’s about politics.

Bitcoin is a massive threat to those that are already in political power  and the special interest groups that pay them. We are at this interesting crossroads where we all know that bitcoin cannot be stopped, yet it clearly threatens the current financial and governmental infrastructure. What fascinates me about this is that it forces states into a prisoner’s dilemma against one another that they cannot win.  The countries that have a clear, succinct, and friendly policy towards bitcoin first shall be the one to win the most economic benefits of bitcoin, and the ones that fail to do so shall lose the most. This is on top of the fact that bitcoin is superior to every country’s fiat money–there simply is no way fiat currencies can ever win over bitcoin. States will have to acknowledge and accept digital currencies as real legal tender, or they will have to suffer the consequences of using a money that is more expensive to use, subject to inflation, can be seized at any point in time, and is forced to pay taxes on it, and is subject to banking fees. At the end of the day, bitcoin is just better money, and it will take over the financial system because of that.

Next: The Creative Destruction of Bitcoin

 

Fraud, Chargebacks, and How Bitcoin Can Prevent Both

Online fraud is a growing phenomenon that is not only getting more sophisticated and advanced, but also much more costly as well. In 2012 alone fraud cost merchants more than $3.5 billion dollars, with a 0.9% average cost of total online revenue. For individuals  $525 million dollars was reported as being lost from fraud.  With each successive year, these numbers are growing, and there are no signs of slowing down. In a world where we need to be ever more vigilant with our information online, one solution to fight back is Bitcoin.

How bitcoin can protect one from personal identity fraud

Bitcoin, being the cash of the internet, can offer the same protection that cash can offer us when we use it in person. One of those features is that you do not need to disclose your identity. With more than 12 million people being effected by identity fraud in 2012, with an average cost of $2,000, and for a total loss of $21 billion dollars, it is clear that new technology needs to be implemented in helping people protect their identities online. Bitcoin offers a unique and easy way to make a payment without needing to disclose your personal information and make yourself susceptible to identity theft.

Bitcoin works as a ‘push’ currency, meaning that the only way that you can spend bitcoins is to ‘push’ them out of your wallet and to whomever you are sending money to.  So if Bob sends Alice 1 BTC, once the transaction has been sent and confirmed by the network, the 1 BTC Bob sent is gone. He cannot get it back, and it now is fully in control and owned by Alice–just like handing over cash. What is fantastic about this is that each transaction is its own autonomous spending unit that is not tied to other units. So although both Alice and Bob can see that Bob sent Alice 1 BTC, there is no information that revels their identities to one another or anyone else–again, just like handing over a $20 bill.  Through offering the same amount of pseudo-anonymity as cash, but on the internet, bitcoin can help eliminate the personal risk of identity theft.

 How Bitcoin can help merchants with fraud

LexisNexis offers a comprehensive annual report on the true cost of fraud for merchants, and the numbers are quite astounding. Merchants incur a $2.70 dollar lost for each dollar of fraud that occurs, and a total of about $3.4 billion in 2011 alone. For merchants that work in an international areas, the same area that bitcoin has some of the strongest advantages, the risks are even higher, with a 25% increase in fraud losses over domestic merchants, with 4 times as many fraudulent transactions completed (p. 39). It is clear that as we move into a more technologically advanced and increasingly mobile age, that there needs to be a better solution to fraud that is not having merchants part with nearly 1% of their total revenue.

Bitcoin offers a solution to these issues of fraud on a number of fronts. First and foremost, because there is no need for identity verification, there is no risk of compromising customer data. Furthermore, because bitcoin works internationally, there is no need for international merchants to accept all forms of currency, and thus expose themselves to a greater degree of fraud. Bitcoin offers an international solution for merchants that does not require the verification of customer identities, nor does it involve being responsible for customer information. Through reducing each transaction down to its own autonomous unit that is unrelated, and securely separated from other transactions, bitcoin offers an ideal solution to merchant fraud, and specifically merchant fraud for international merchants.

Bitcoin can prevent Chargebacks

Chargebacks, where consumers go through their bank or credit card provider to force a refund, can be very costly to businesses and can ultimately lead to the failure of one’s business. in 2011 alone, the cost of chargebacks to businesses was $11.8 billion dollars. If your chargeback rate drifts above 1% of transactions, you can be fined up to $5,000 for a ‘monitoring program’ to be put in place, and up to $10,000 if you do not comply. Perhaps the most shocking out of all statistics is that as a result of this entire dispute process 50% of online business fail due to chargeback requests. That is simply an impossible number to deal with, and any business person who wants to protect themselves, their business, and their livelihood cannot tolerate having so much of the success of their business completely out of their control.

Thank God for Bitcoin.

With bitcoin there is no risk of chargebacks. Because each transaction is pushed, there is no way for someone to ‘pull’ funds away from you. Unlike with a bank or credit card company, the money that is in your possession is yours, no one can forcibly take that money from you. Furthermore, if your business has their funds wrongfully seized like this Michigan grocery store owner, there is very little that you can do, even if you are innocent. Considering the overarching and generally illegal nature of such seizures, it is a breath of fresh air to know that if you are accepting bitcoins, it can be very difficult to forcibly take those funds from you.

Conclusion

In a world where identity theft, fraud, and all of the related cost that come with that are on the rise, and with scams becoming more sophisticated, bitcoin offers us a real and tangible solution to these issues. For consumers, one does not need to compromise their own identity and expose themselves to identity fraud. Furthermore, because of bitcoin’s push feature, you only are exposing the exact amount of funds that you are paying with–no more, no less. For merchants and the extraordinary cost that come from fraud, it is clear that payment processing is something that can make or break your business. Through using bitcoin, you can ensure that you have a 0% chargeback rate, and all of the associated cost as well. Bitcoin clearly offers a solution to many of the issues of online fraud and the associated cost. If you are a business owner, don’t you owe it to yourself to see what bitcoin can do for you business?

Bitcoin, Alt-coins, and Free Money Theory

Gavin with some BitBills

Gavin Andresen wrote this piece on his blog about alt-coins and several of the issues they create. As much as his concerns are valid, there is a different perspective where digital currencies of all kinds can compete in an open market to capture the most customers bases off of the greatest advantages they offer. This was presented in “The Denationalization of Money,”  the magnum opus of Fredrick Von Hayek, Nobel laureate in economics and close friend of John Maynard Keynes. Hayek’s primary argument in this work was that through allowing the private issuance of currencies, banks would be forced to compete on the open market to have the most competitive currency. Below I am going to explore some of the concerns that alt-coins present and how they can be understood from the perspective that Hayek offers in the Denationalization of Money.

Free money theory

Bitcoin has a significant advantage over other digital currencies with that it is the first digital currency, and no other digital currency is significantly different from bitcoin. With that being said, alt-coins not only help legitimize bitcoin as THE currency of the internet, but also help create a whole new digital currency economy, in which alt-coins can specialize, or succumb to market forces.

Gavin makes an excellent point that alt-coins don’t do too great of a job differentiating themselves:

“So what?  The free market at work, right? If they’re good they’ll survive, if not, then they’ll fail. If they’re better than Bitcoin somehow then maybe someday one or more of them will usurp Bitcoin as the biggest and best!”

He then goes on one to voice his concern that:

“Creating gazillions of alt-coins seems to me to just be a way of getting back to an “inflate on demand” world. Not enough genuine Bitcoin money for you? No problem! Create a new alt-coin to produce more!

As much as this concern is valid, I think we can see that his first point seems to be the direction we are heading. The value storage of the number of alt-coins in circulation vs. their price simply does not compare to bitcoin. There are more than 20 million litecoins today, with the total supply capping out at 84 million. LTC price in recent months has gone from  $2.75 per LTC, to under $2. You can see that despite there being a total cap on the supply of LTC at 84 million, it is still is valued 30 to 40 times less than bitcoin, despite being a pretty good copy of it. This is because bitcoin has the first-mover advantage behind it, and thus has had more time to establish a market for itself.

If bitcoin is doing such a good job, than why are alt-coins valued at all?

Each one has its own reason, so I’ll just use litecoin as an example for now. Litecoin has value most because of speculation, but it is also a good bitcoin catastrophe insurance, it has second-mover advantage, and it is the most liquid way to get out of bitcoin, but not back into another fiat currency.

Insurance

Let’s face it–bitcoin does not have a lot of friends, and it has a bad reputation

Personally I’m bullish enough on digital currencies to believe there will be a $10,000 bitcoin one day, and so are others like Max Keiser. Gavin hypothesized this may be part of the reason why alt-coins are around.

Maybe altcoins will be an important safety valve in some future crypto-currency-dominated world. Maybe if there is lots of economic growth and some technical reason prevents the velocity of money from accelerating to match the increased demand for transactions people will use alt-coins to fill the gap.

And I think what Gavin is saying about the velocity of money is true. I believe this is the behavior that we are seeing with litecoin being used as a shelter during turbulent bitcoin times.

Even if alt-coins were to become a threat to bitcoin, it would most likely be for a good reason. Perhaps mining centralization could lead to some issues down the line, or pump and dumps too frequent–who knows? Other than a faster block-time, and 4x the supply of coins, I don’t see any difference of advantage of using litecoin as a storage of wealth, or a mode of exchange.

I do however see how it is useful as a short-term hold of wealth for shelter during turbulent bitcoin market periods. There are members of the /r/bitcoinmarkets is an example of a community that utilizes this technique. There is also ample evidence that this is also done on the Russian exchange btc-e.com as well in order to do ‘pump n’ dumps–where one inflates the price through rapid buying, and then dumps to collapse the price and buy back at a lower value.

Litecoin may also become valuable as a mode of exchange. We can see that the recently closed online drug market place, Atlantis, accepted litecoin, in addition to bitcoin. Litecoin could very well bootstrap its way to become more valuable, similar to how bitcoin did with The Silk Road.

Other Altcoins

Namecoin, Peercoin, and Primecoin all have there own unique features that one day may make them very valuable, but today that is not the case. As Gavin pointed out, these developers could focus more on their alt-coins unique features (which I’ll discuss in a separate post), but to simply have it be another bitcoin copy is little more than inflationary flack. There are always 51% attacks, and people simply not accepting alt-coins to solve that. I believe from seeing where we are at in this very new economic paradigm we are see exactly what we need to see: A few unique and well-differentiated alt-coins seeing limited success, along with the death of dozens of other more useless coins.

When we look at bitcoin through the eyes of Hayek, none of this is surprising. Digital currencies represent Free Money, or money that has no monetary authority other than itself. This means that the value of digital currencies can only come from their intrinsic value which is established through the market. This is one of the reasons that bitcoin’s first-mover advantage is so important–it was the first digital currency to gain a wider following and create market legitimacy, thus it has the largest market cap of all digital currencies in circulation.

This also helps explain why alt-coins do have some limited success. Because they still have the same money function that bitcoin has, which is more efficient that fiat currency, that can be used to give them value. Yet, because there are fewer people accepting alt-coins today, nor do they differentiate from bitcoin greatly, many of them are still highly-speculative prospects that have gained little traction because of this lack of differentiation.

Conclusion

Hayek’s theory on free money found in the denationalization of money helps explain why digital currencies have value. This theory also helps explain the complex market relationships that allows for some currencies to keep and hold value, while limiting the success of others. It will remain to be seen how successful alt-coins will become, but it is most likely that because of bitcoin’s first-mover advantage that it will always remain the primary digital currency. With that being said, alt-coins will always be needed in the market for bitcoin catastrophic insurance, and to act as an alternative mode of exchange.