Is the US dollar backed by more than Bitcoin?

Bitcoin is getting to be a frequent topic here at AWildDuck.* Regular readers know that I am bullish on the exchange medium. Not just as an investment, but as an emerging world currency. And, as the story continues to unfold, the fundamentals just keep getting better and better.

Bitcoin has been around since late 2010. Less than 3 years. As an immature exchange medium, its wild swings make it too volatile to be recommended in any portfolio with short term objectives. But with bungling at the largest and earliest exchange and a perceived tie to the criminal bazzar, Silk Road, events have muddied the inevitable path toward legitimacy. They amplify the small risk and delay widespread adoption.

I’m cool with that, because with widespread misunderstanding comes opportunity for those that see the long term picture—especially when it comes to a tectonic paradigm shift. As a long term investment, Bitcoin is a slam dunk. It can’t go down, any more than an original Rembrandt can lose value in the long run.

But, what surprises me, is that three years on, we are still faced with pundits who fail to appreciate the dramatic tipping point that is looming just down the road. They point to volatility rather than fundamentals. Perhaps, most frustrating, they point to the lack of government backing or a central bank as a deficit rather than a bonus and—in fact—the Raison d’être.

Bitcoins are backed by something even better than US dollars

Backing that beats US dollars

Here is a new article from a credible source that ought to understand the intersection of technology with economics:

When armchair analysts dig into the risk or folly of Bitcoin as a currency or investment, I bite my tongue. (Well, not this time!).

Let’s talk about item #2, If Bitcoin fails, it has no safety net. The argument is built around a premise that Bitcoin is backed by the “expectation of acceptance by others” while the US dollar is backed up by something more tangible (e.g. a government that can “step in”). That premise is wholly ludicrous. Both the dollar and Bitcoin have value that is backed by nothing tangible. And Bitcoin wins handily on the intangibles.

Background

In 1933, Teddy Roosevelt ordered Americans to redeem all private reserves of gold for printed notes. Americans were no longer allowed to own gold coins, bullion or certificates. (That left only the gold content of industrial products, jewelry and ornaments). For the next 40 years, the US insisted that it was still on a “gold standard”, because it amassed a stockpile of gold bullion in Fort Knox, Kentucky. With this as collateral, the government guaranteed the value of printed currency and it pegged the dollar value of what it printed. Of course, it was a guarantor only in theory, because it was illegal for US citizens to redeem their gold. They weren’t even allowed to own gold overseas.

From 1934 until the early 1970s, the value of a dollar was fixed at 1/35 oz of gold. In other words, the US government was effectively promising foreign treasuries the foreign trade settlement was bound by the transfer of gold at a value of $35 for each oz.

The dollar’s relative stability throughout the post war era was a result of the Bretton Woods agreement in which a large number of nations pegged their own currencies to the US dollar.* In fact, the value of the dollar increased, even though it was still worth 1/35 oz of gold. Everyone trusted the USA to maintain the value of its own currency with something. Most hoped that it was the gold at Fort Knox, but some economists say that it didn’t really matter, because the US was such a dynamic and growing economy, with a history of predictable inflation. And therefore, it had a high degree of trust.

But as we approach the ’70s, trust probably accounted for more dollar purchasing power than gold. In 1971, under Richard Nixon, the US terminated convertibility of the dollar to gold, even for foreign banks. By 1973, the US decoupled its currency from gold altogether, and in 1974, Americans could, once again, legally buy gold in any form.

So, what backs the dollar today? In academic jargon, it is a fiat currency.* To economists, it is backed by the full faith and credit of the US government. But in reality, this just means that the US can print or borrow more money to pay past debts. In truth, it is backed by something, but that something is no more than what backs a Bitcoin: It’s value is based on the confidence of the person accepting or saving the coin that it will be accepted in the future by someone else—and at a rate they can believe in today.

But wait! Though both the US dollar and Bitcoin are fiat money—backed only by the perception of buyers and sellers, in fact, Bitcoin has the distinct edge…

Why Bitcoin?

Why is the long term value of a Rembrandt painting unlikely to tank? To retain value, any asset must meet two criteria: Limited availability and precious to behold (I use art as a metaphor—preciousness can be anything valued by a pool of perspective owners). Bitcoin is a limited commodity by pedigree and it is precious because of a vast trust-matrix built on a foundation of mathematics. When a two-sided market develops around something with a provably limited supply, trust becomes more durable than decree.

Bitcoin is the future of currency because it has the edge in all areas: it can be more certainly trusted, it offers an advantage to saving, it is a stateless exchange medium and requires no backing. This isn’t to say it is not backed… In fact, it is backed by solid mathematical principles that are open to peer review.

In the long run, the dollar is a weaker and more risky currency than Bitcoin. It has no natural cap and is subject to counterfeiters and manipulation by the people who authorize its printing. A wallet or bank cannot easily be provably “backed up” and its value inflates rather than deflates with adoption. Although armchair economists who focus on protectionism, exceptionalism, or short term objectives may see some of these things as benefits, they are all serious deficiencies.

Advantage: Bitcoin

Ellery Davies is editor of awildduck.com. He is a frequent contributor
to The Wall Street Journal, Yahoo News, CNet and PC World.

Past Posts about Bitcoin

* Resources

Bitcoin continues to gain trust & respect

In 2011, we discussed Bitcoin, a pure and decentralized digital currency. Introduced in 2009 as a mathematical treatise from a still-mysterious source, Bitcoins already had their own exchange and some retailers were beginning to accept it as payment. Bitcoins are decentralized. That is, they are not issued or backed by any government or bank, and they can be exchanged between buyers and sellers without either party having an account at a financial institution. Yet the supply of Bitcoins are provably limited, the growth in supply is mathematically constrained, spending is untraceable, and the validity of ownership is instantly provable. For these reasons, AWildDuck predicted that Bitcoin would gain steady traction and eventually be trusted as a mainstream form of payment and investment.

A “flash crash” is nothing more than a buying opportunity.

A “flash crash” is nothing more than a buying opportunity.

Of course, as with a new security or exchange medium, the road to maturity is bumpy. Bitcoins have endured wild swings in value, even very recently. These so called “flash crashes” are caused by pre-programmed trading or simply rumors on a day of thin trading. Despite swings in the exchange value, Bitcoin is gradually gaining legitimacy as a vehicle for payment, investment and even as a hedge against regional conflict. Here some things that cause a sudden change to Bitcoin’s exchange value:

  • Programmed trades: These affect any immature or thinly traded security. In fact, they present opportunity for long term investors or anyone less prone to panic.
  • Banking Crisis: Contemporary examples include Cyprus and Greece
  • IRS decision: Recognizing Bitcoin accumulation as a tax reporting obligation
  • Hacker attacks: Bitcoin is safe. These are temporary DDOS attacks
  • Reports or investigations: Anything concerning illegal trade (e.g. Silk Road)

Regional events also drive the Bitcoin exchange value higher, but only because of problems with another currency:

  • Excessive Government Borrowing & Printing: (Japan and USA come to mind)
  • Hyperinflation: South Sudan is currently at 79% while Belarus is at 70%
  • Trade embargo or regional instability: (Iran and North Korea). Citizens seek a safe haven that requires no physical transport and no cash exchange agent.

Are governments along for the ride? Of course not! They try hard to suppress pure, decentralized currency that is impossible to counterfeit, trace or tax. But Bitcoin is gradually becoming legitimized through wider retail acceptance, international currency exchanges, and a broader public understanding of the very positive privacy & security implications. Bitcoin is here to stay.

While it may seem bold to add another radical prediction to our 1-for-1 record, we believe that governments will eventually embrace Bitcoin—or some other pure and decentralized digital currency. In fact, they will halt the minting of their own regional paper and coin currencies—perhaps in our lifetimes. Even governments will one day see advantages of a currency that cannot be forged or directly manipulated.

Bitcoin-2Here is an interesting development: An entrepreneur in Sandy UT has begun minting brass and silver tokens that offer a physical representation of a Bitcoin. They sure look like currency and they come in various denominations. Each coin includes a hidden code covered by a tamper-evident hologram. The code is a hash that helps an owner to verify that the value represented by the minted token has not been used by others.

Of course, this seems to thrash the whole concept of Bitcoins. It raises a litany of contradictions. For example, if it is in your pocket, then it is not truly anonymous. And although you can test the hash to ensure that the coin is valid for the moment, you must trust Mike Caldwell in Utah every day that you carry it. If he were unethical, he could circulate a copy. In fact, he is no different than a central bank, which of course is what Bitcoins render irrelevant. So what’s the point, Mike? …

It would occur to few who understand the decentralized and mathematical nature of Bitcoins to bother with a physical token. It goes against everything that they stand for. Yet, Mike’s mint, casascius.com, offers non-Geeks a reasonable off-line, portable and still somewhat anonymous exchange medium. Most importantly, as long as he can avoid attracting high-tech counterfeiters, his coins offer a medium for those who don’t fully understand how to trust, test or move digital Bitcoins, a “pure” digital currency.

Read more about Mike Caldwell and physical Bitcoins:

Update:
Did Ted Nelson deduce Satoshi’s identity?

Readers who follow Bitcoin or have read about it’s 2008 roots know that it was the embodiment of a paper dropped onto the internet by a mysterious mathematician using the pseudonym Satoshi Nakamoto.

Shinichi Mochizuki

          Shinichi Mochizuki

In May, Ted Nelson, the man who coined the term “Hypertext” (way back in 1963) donned a Sherlock Holmes hat, grabbed a pipe and magnifying glass and did some very clever deducing. Of course, Nelson also reads technical papers by like minded thinkers around the world and this gives him a lot of raw data from which to deduce! He thinks that he has discovered the true identity of Bitcoin’s creator and has made a very convincing video. It ends with a plea for the genius’ next big invention.

I have an alternate theory based on a 1999 visit with cryptographer and DigiCash founder, David Chaum, over a period of 10 days in Palo Alto, CA. But Nelson’s video is compelling. Now I am not so sure which way to lean.

Bitcoin: Can cash have value if it isn’t real?

The Bitcoin discussion, below, offers a solid introduction to
digital currency. After reading it, check out
our 2013 update

It’s likely that early man had no widely accepted currency. They dealt in the food they hunted or gathered, and the clothes they fashioned from whatever materials were available. Perhaps some individuals offered services, such as labor, transportation or healing. But without currency, they weren’t buying and selling these things. Instead, each transaction was a gift or a trade.

Trading is good, but it is difficult for a trade to involve more than 2 parties. Also, It’s difficult to save for a rainy day. Food spoils quickly when there is no refrigeration.

Economies built on private trades

  • Limited to private transactions.
  • No exchange/settlement: An Inefficient market
  • Difficult to accumulate wealth
  • Doesn’t facilitate governments or public works projects

Eventually various forms of cash began to emerge. According to the comic strip, B.C., caveman traded clams for goods and services. That’s not far from what historians tell us. Beginning at around 1200 BCE, the Chinese exchanged the shiny shells from a Pacific sea snail for goods and services. For centuries Cowry shells were accepted as a portable “coin” because they were both rare and impossible to counterfeit. Historians think that it may have been the first medium of exchange.

“Medium”is a good word for money, because it is an intermediate layer between things of value — the thing that you sold today and the thing that you will buy tomorrow.

Was the Cowry shell really the first form of currency? It’s difficult to look further into the past, especially into events that occurred before written language. But we can be certain that with the rise of central governments, currencies were coined by banks and by nations. But this gives rise to two classes of currency. Things like gold and Cowry shells which have inherent value because of their limited supply—and things that are valuable because of someone says that they are valuable (dollars or other national currencies).

Cowry shells are like gold. They are portable and honored everywhere, just like a coin. And yet they are not minted by a central authority. Instead, they have value, as long as the new supply is limited by natural law, and as long as individual traders believe that their suppliers will continue to desire them. With all monies – clams, gold or government-issued cash – when a majority of productive individuals agree that coins have value, it becomes possible to save and to time shift assets. For example, if you produce clothes – but you aren’t immediately hungry – you can sell your clothes and accumulate wealth. Unlike asparagus or shoes, currency is fungible and it doesn’t spoil. Of course, it is also easier to tax.

Let’s jump forward several millennia. Today, people buy and sell with dollars, euros, pounds, shekels, Zlotys and Yuan. Each currency is minted by a government and backed by either a precious asset (typically Gold) or by the promise of a central bank or government. But wait! Few currencies in circulation today are backed by the recent behavior of a transient government. And most governments are saddled in debt. They have no ability to make good on their promise. The only reason that money in your pocket or bank has value today, is because you feel reasonably certain that vendors will treat it with value tomorrow. But for how long? Given the dearth of underlying assets, the value of money is about as far from “real” as one can imagine.

Putting your faith in money is terribly risky especially in the 21st century. It is rapidly eroded by inflation and debt. It is easily taxed. It is manipulated by day traders and emerging nations, and it’s value is dramatically influenced by energy, and political/social policy.

Before we move on to virtual currency, let me point out that the “virtual” part is nothing new. We already trust computers to keep track of our savings and we prefer bank statements over folded paper in our wallet or mattress. Very little of the money you spend is traded in the form of paper or coins handed from one individual to another. Credit cards, checks and automatic debits bypass the cash stage. Few people use cash to pay taxes, purchase a home or car, or even to buy groceries. Instead, credit cards and mobile payments are accepted everywhere, even at McDonald’s and at the post office.

And investing has become even more virtual than buying. When you purchase stocks or bonds, the entire transaction is virtual. You digital cash (computer bits) is converted into a new row on a spreadsheet. This row of characters and numbers reassures you that you own a tiny sliver of a mutual fund in Omaha. This fund, in turn, owns a fraction of 1400 companies or is the beneficiary of municipal debt (more computer bits). It can’t get more virtual than that. Can it? Well, yes. In fact, it can!

Even though money you spend today is virtual, it is still minted by a government (or in the case of Hong Kong, by a bank). You have no idea how much of the stuff they print and how it is distributed from the printer. The value you perceive in your pockets and all of your accounts is based on trust. So who are you trusting? Is it your own banker or business partner. Not on your life. You are placing your trust in the same entity that taxes you and the entity that can’t balance its own checkbook.

Bitcoin is different. First, it is totally decentralized. No bank or government is required to validate the coin, record a transfer, or to determine if a virtual coin was spent twice by the same party. And get this: New coins can be “minted” by any user, but the process is inherently limited and trustworthy. Moreover the more that is minted, the more difficult it becomes to mint additional currency. Eventually, the total amount in circulation will level off to a known and verifiable number of coins.

Confused? Of course, you are confused. But, believe it or not, there are already currency exchanges for Bitcoins. They are even bought and sold on eBay. Why? Because Bitcoin circumvents government manipulation. It also deters taxation, tracking, inflation and… Well, you get it. Bitcoin comes pretty close to a perfect currency.

Bitcoin: A virtual, decentralized, trustworthy currency

In my dreams, I fancy myself as a futurist. I like to think that I could hold my own with Ray Kurzweil, Esther Dyson, Bill Joy or Alvin Toffler. Putting myself into that mold right now, I would speculate that Bitcoin or something built much the same way will quickly subsume the world’s economies—perhaps even in the next 15 years. The fallout will be seismic, because governments will need to base taxes on real estate and transaction fees rather than income, property or savings. After all, it’s difficult to hide land or a home, and it’s pretty easy to issue a speeding ticket or charge for a marriage license.

See our April 2013 Update

 

After years of buying from China, time to pay the bill

I wrote this in April 2011 as feedback to this article in PC World.
__________________________________________________________

After decades of buying from China, it’s time we paid the bill.

Step back from rhetoric & ideology. What, exactly, do we expect the Chinese to buy with all the dollars that they’ve amassed? What happens if we try to dictate their options? –Making available just a few items at the bazaar?

Most Americans want balanced trade. Trade is balanced by encouraging foreigners to return dollars to America. That means purchasing goods & services or investing (purchasing equity or debt). But purchasing debt isn’t real balance. It postpones and magnifies a trade imbalance.

The Chinese have built vast quantities of products that we consumed for more than 30 years. For whatever reasons, they have built them cheaper and responded quickly to consumer demand, and with sufficient quality and style that we loved acquiring them.

Now China has pockets stuffed with dollars. There are so few places that want those dollars, the logical recourse it to spend before it depreciates. That’s logical. Getting them to use those dollars is what we want.

The US exports movies, airplanes, weapons & software, and we charge foreigners to attend our Universities. On the international stage, that about sums our brag sheet. But when we consume trillions from foreigners, do the promissory notes that we issue (“dollars”) limit them to these few commodities? What else can the Chinese purchase that isn’t manufactured closer to home, better, and in larger quantities? They export the really big ticket items themselves–like skyscraper contracting, oil drilling, nuclear technology!

When a foreign corporation or government wants to purchase something significant from the US, suddenly we stop yelling “Buy American” and we start yelling “Security Threat!”. Poppycock! If we create such enormous red tape that international telecom players cannot acquire or invest in one another, we reduce liquidity and further weaken our dollar. Face it: Our start up companies are commodities as certainly as a retail copy of Windows, a Boeing jet or a patent portfolio. When we turn up our nose at healthy interest in intellectual trade or infrastructure acquisition, we are not protecting our interests. We are simply informing trading partners that they were fools to trust us, and that the dollars they stockpiled can be redeemed only in Hollywood films.

It’s natural to be skeptical. China is controlled by an authoritarian dictatorship. Citizens lack social & political freedom. But don’t be misguided about their economy – both within and abroad. It is lubricated by capitalism and is more adaptive and free-wheeling than our own. Whatever their shortcomings, we accepted these when they were selling. We must also allow them to buy. Our technology plays are the only thing on our menu.

Conclusions:

  • A) If we refuse to allow the Chinese to repatriate dollars or offer them only the local goods of our choosing – typical of a Banana Republic – then they will dump our dollars and also stop buying our debt. It would crush our economy in a heartbeat.
  • B) If we allow those with large stockpiles of our dollars to use them as they see fit, the dollars will return to build factories, create jobs, and produce good, old fashioned innovation. But this won’t happen with newly printed dollars. It doesn’t work that way, because that weakens both parties and makes our factories unattractive. It must be the dollars that we willingly handed over for TVs, computers, shoes, toys and even building materials. We must accept that we owe China—big time! For decades, we passed off pictures of George & Ben in exchange for tangible goods. We knew the Chinese crafted high tech goods for less and that the political system was repressive. But we looked the other way. We really wanted those things! Whether you like their government or not, we promised to expend future time and resources supplying their children with commensurate goods.


Why does China say “America works for us”
Click image to learn why (video = 1min)

This video was commissioned in an effort to defeat Obama’s 2010 universal health care bill. It has terrific shock value. It depicts what China believes to be our economic weakness. I won’t comment here about health care or stimulus economics. It’s unrelated to my point. But the video also depicts what Chinese believe to be their imminent destiny, perhaps at America’s expense.

They deserve all of the positive things they have earned. Although it’s natural to whine and complain about an uneven playing field, and our past glory (Automobile assembly, television, the moon landing and the Internet), China is winning in the global economy and any trade in which we engage is, by definition, fair. In fact, the only uneveness in the playing field of international trade is just the opposite of popular perception: It has been tipped in our favor for the entire 20th century!

We must get it through our heads that capitalism is not a contest! This simple truth is often overlooked. The emergence of China as an economic superpower is a good thing. Not just for the Chinese, but for every American. If we keep our own ship in order, the result will be an abundance of goods and services from both sides because we will have affluent trading partners, broader access to labor and markets, and eventually, democratic trading partners.

– Ellery Davies|
Ellery clarifies law and public policy. He is a frequent columnist and TV commentator.