Though it may be financial sacrilege to link the emergence of Bitcoin, the $10 billion online currency, with the Federal Reserve’s 300x larger $3 trillion QE program, we believe the two have more in common than their 2008 birthdates. In fact, we think each represents a further extension in our human understanding, use, and possibly abuse of “currency”, the lifeblood of our modern societies. Both Bitcoin and QE continue a process that began some 3000 years ago with the invention of coinage in the Greek Isles and, later, the invention of paper money in China.
If we consider that one of the primary goals of QE, laid straight out there by Bernanke himself, was to create a “wealth effect”, i.e. the perception of greater wealth inducing great spending, we think it is fair to ask if the system of belief behind Bitcoin is all that alien or outrageous a concept? Our answer is that it is a logical extension of the path we have been on for the past 80 years, ever since the abandonment of the gold standard in the 1930’s and the scrapping of Bretton Woods in 1971.
In brief, the concept of a Bitcoin came into existence in 2008 via an anonymous and still-unknown coder/hacker going by the web pseudonym of “Nakamoto”. The concept involves the creation of purely digital units of value (“bitcoins”) which are awarded to those who, using their computer, can solve 1 or more of a predefined (by “Nakamoto”) and strictly limited 21 million algorithms. If your computer solves the algorithm, 50 Bitcoins credited to your account. In theory, Bitcoins derive their value from the difficulty of solving any of the 21 million algorithms. A public, web-based register is maintained of all the Bitcoins awarded, much like the serial number on paper currency, so potential recipients can validate the payment.
Thus, like gold, you have to “mine” the solutions and, because that takes “work” (in the form of a processing time and power), there is value to be derived from the rarity of the solution, like the rarity of gold. After all, what gives gold value in an age when very few of us actually use gold either as a medium of exchange or in some industrial capacity other than its rarity?1 As things now stand, there are currently $10 billion worth of Bitcoins have been issued (at today’s Bitcoin prices) and even the Bank of Canada, the Government of South Korea, and JP Morgan are funding studies and promoting pilot programs revolving around digital currency, so this idea is no longer in the basement with the nerds.
At first, this idea of digital currency, unassociated with any government to back it, struck us as outrageous: so what if a math problem got solved? Unless the solution provided society with, say, a better way to shape turbines, treat cancer, time stoplights, or plant crops, the fact that someone figured out the answer is “2” to a complex math problem, seems of very little value to us in our everyday lives. Certainly, a math solution without a practical use seems less valuable than gold, which does not corrode, is infinitely malleable, has practical applications, and is pretty to look at. Why anyone would trust the storage or transfer of their wealth via such a volatile, ephemeral, unregulated method of exchange?
In terms of Bitcoin, part of the answer lies in the fact that Bitcoin is being used as an anonymous medium of exchange on the notorious “Silk Road” website, where illegal drugs, pornography, and prostitution were on offer until last October. And, until December, the other large constituency of Bitcoin users were Chinese nationals “off-shoring” their wealth. It should be noted that perfectly legitimate businesses are beginning to accept Bitcoin as a form of payment: Virgin Galactic, Overstock.com, OK Cupid (dating website) and the NBA’s Sacramento Kings all now accept Bitcoins, though they are exceptions, and not the rule. Nonetheless, the march of technological adoption over the past half-century has often started in alleyways before heading down Main Street.
Of course, people have found ways to use traditional currency, coin, and electronic payments to do nefarious things for literally thousands of years, so digital currency has not introduced us to anything new in that regard. The fact that Bitcoin, the poster child for digital currency at this point in time, is tarnished with the stain of impropriety does not make it unique: the concept of business on the internet is itself tarnished with the fact that for the first 2 or 3 years of widespread internet usage, the only web businesses making profits were porn sites. So it should not surprise us that despite the arrest of its webhost and the ban by the Chinese, the price of Bitcoins remains at record levels, thanks to “Silk Road 2.0” and rate of innovation in the virtual world.
All that aside, however, what we think is most interesting about Bitcoin is not the technology, its history, or what it tells us about Bitcoin users, but ultimately what it tells us about the current state of the global “fiat” money paradigm and a burgeoning number of law-abiding people willing to trust a currency created and controlled by everyone and no one at the same time, in preference to their august, democratically-elected representatives.
After all, prior innovations and experiments in currency must all have been met with similar skepticism: people tend to take very seriously the means for gaining their daily bread, literally or figuratively. Imagine moving from bartering with chickens and grains to one involving lifeless, mostly useless plugs of metal, or going from solid, imprinted coinage to flimsy paper money, or, nearer to our own time, moving from impressively and beautifully printed currency explicitly backed by gleaming gold reserves to one vouchsafed with nothing more than a government’s decree and its will to print, a concept which remains controversial even today. Certainly, none of these changes in the methods and means of exchange was greeted by society with open arms, just as it is with Bitcoin today, rightly or wrongly.
Does this truly represent an evolution in our concept of currency? Whether digital currency is a harmless fad, a step forward, or the next economy-crushing “Tulip Mania”, we do not know (though we have our suspicions). We do believe part of the reason for the rise of digital currencies in general is due to the diminution of our collective trust in government, whether on grounds of incompetence in its role as keeper of the currency or on grounds of straight up bad intent.
With the U.S., the E.U., and the Japanese all embarked upon QE programs of one kind or another combined with general public confusion or ignorance of the machinations of monetary policy and fiat money, we suspect that the concept of digital currency is here to stay. Some might even conclude that the concept of digital currency is nothing more than a “disintermediated” version of the global fiat currency system, no more or less credible than the currencies issued by national governments.
We do not think that Bitcoin will be the means for digital currency to gain wider public acceptance given its “seedy” roots and its extremely volatile fluctuations in value. After all, stability is key to currency credibility: we must believe that the standardized unit of value, i.e. money, we receive today will be roughly worth the same amount tomorrow, let alone in the next few hours, when we pass it along as payment for another good or service. But, as central banks continue to stretch the concept of fiat currency, so it will be harder for the public at large to tell the difference between one form of “funny money” and another.
1 If you’d like to delve further into Bitcoin, we direct you to these web links and their graphical explanations:
© Neosho Capital