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Summary:

For all the talk of Bitcoin’s brilliance and disruptive potential, what will prevent it from ever being mainstream is that the disruptees – big banks and especially governments – will intervene.

Bitcoin
photo: Guardian/Guy Grandjean, James Ball

Every currency created since the advent of money 2,700 years ago has fit nicely into one of two classifications: Either it was a representative money system, deriving its worth from a link to some physical store of value like gold, silver or gemstones; or it was fiat, deriving its value from the fact that a government or central authority guaranteed it.

Bitcoin, the world’s most successful digital currency, defies this time-tested classification system: It is neither fiat nor representative. It is not fiat, because its supply is actually finite and, more importantly, it lacks any central backing authority. (Click here for a good primer on the tech behind Bitcoin). Nor is it representative, because it is not linked to anything physical. Thus the internet has (once again) spawned a phenomenon that is inexplicable via conventional economic frameworks.

As economists study the attributes of digital money, they are discovering that Bitcoin is, in many ways, a better currency: unlike paper money, it is unforgeable; unlike gold, its supply is perfectly verifiable. It is immune to the inflation that plagues all fiat currencies: governments cannot simply print Bitcoins to pay off their debts. It is perfectly secure: all transactions are monitored collectively by the Bitcoin network. Bitcoin payments can be made at any time, to anyone, with as little as zero fees and no dependence on financial intermediaries. Bitcoin transaction histories are distributed and decentralized, making the system robust and resilient. And Bitcoin minimizes the amount of personal information that users have to disclose when transacting.

For all of these traits, Bitcoin has potent disruptive potential to the world banking system, and thus the governments that are supported by it. Which is precisely why it is doomed.

Anonymity threatens control

Though novel today, the anonymity of transactions that Bitcoin provides is actually a very old trait of money, one that most currencies actually enjoyed for most of their history. If fact, it was only recently eradicated by virtue of the digital nature of modern banking, combined with legislative initiatives in the United States (and other countries).

Governments today enjoy unprecedented power of monetary observation, which they argue has resulted in a “safer” world with less money laundering, greater impediments to criminal activity, and reduced tax evasion. Industrialized nations are just beginning to maximize the benefits of this newfound transparency and so understandably have no interest in reverting to a more opaque banking system.

Monetary control is power

But beyond monitoring money flow, there is an even more fundamental reason why substantial Bitcoin success is undesirable for governments. For any government, ceding control of money supply is tantamount to an abdication; without control of money there is no control at all. For this reason, as Bitcoin continues to gain users, government indifference must gradually give way to bemusement and ultimately resistance.

However, well before governments attempt to curtail Bitcoin, there is another antagonist that might take action more rapidly: the financial services industry. Banks and their kin make tens of billions of dollars every year from providing the very basic task service of moving money from one place to another. And as a nearly foolproof revenue stream – zero risk, almost zero cost, and billions of dollars in profits – it’s also a pillar of their business model. In fact, banking as we know it today would have a far diminished role, if any, in a Bitcoin-denominated economy. Hence, you will see little support for digital money from any bank.

Thus, if Bitcoin can continue to gain in popularity, its users can look forward to an eventual confrontation with two extremely powerful antagonists. Unfortunately for Bitcoin, both parties, governments especially, can follow a simple strategy to ensure Bitcoin, or any other aspirational digital currency, never gains widespread use.

Governments hold nuclear option

The strategy, by the way, is not prohibition. A legislative attempt to curtail Bitcoin would be hampered by political agendas, court challenges, enforcement costs and, perhaps most importantly, the complications national boundaries create. Indeed, lawmaking is utterly clumsy compared to the much cleaner, cheaper and perfectly effective solution called “currency intervention.”

All major economic powers are experienced in the techniques of manipulating the value of monies whose price they care about. To affect a currency, one need simply to buy or sell enough of it that marginal supply or demand is affected. Price change then follows naturally. (For example, China and Japan have done this in the recent past to weaken the buying power of Renmimbi and Yen respectively, to reduce the cost of their exports in Western markets.)

Interventions are usually meant to do one of two things: change the value of a currency or moderate the volatility of a currency. But currency intervention can just as easily be used to increase the volatility of a currency. And, in the case of Bitcoin, it would be utterly simple to do because the total value of all Bitcoins, currently about $1 billion, is so minuscule compared to the buying power of any industrialized country.

This would remain the case if Bitcoin’s market cap increased 100-fold or even 1000-fold. The algorithm is simple: gradually purchase large sums of Bitcoins, a  hundred million dollars worth given the current market cap would be plenty. Then flash sell them to flood the market and drive the price down. Rinse, repeat.

A currency that quintuples in a month, and then loses two-thirds of its value in the following week, is not a currency that inspires confidence in users. And while features like security, verifiability, untamperablity and decentralization are attractive, they are all secondary to the main factor that controls adoption of any currency: stability of purchasing power.

Thus Bitcoin’s Achilles heel is its susceptibility to manipulation by the very people who need Bitcoin to fail. It seems not just possible, but likely, that the potential victims of Bitcoin would exploit this vulnerability if they needed to. And, ironically, they would be able to do this totally anonymously. It is this vulnerability that the Winklevosses and others who are “going long” Bitcoin should probably take a good look at sooner rather than later.

Tammer Kamel is founder and CEO of Quandl, a searchable database of numerical data, including a collection of Bitcoin statistics. Follow him on Twitter @TEKamel.

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  1. Mario Héctor Rovetto Saturday, July 13, 2013

    Es una lástima que los intereses de los grandes capitales se metan con Bitcoin. Es un buen proyecto, la posibilidad de una moneda virtual que brindaría acceso a muchos que no pueden entrar al mercado de otro modo. Habrá que ver si las nuevas tecnologías y la posibilidad de mancomunar esfuerzos a través de las redes sociales permite el crecimiento de este tipo de caminos económicos alternativos. Muy buen blog, un saludo !

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  2. Reblogueó esto en La mutación Neomuray comentado:
    Es una lástima que los intereses de los grandes capitales se metan con Bitcoin. Es un buen proyecto, la posibilidad de una moneda virtual que brindaría acceso a muchos que no pueden entrar al mercado de otro modo. Habrá que ver si las nuevas tecnologías y la posibilidad de mancomunar esfuerzos a través de las redes sociales permite el crecimiento de este tipo de caminos económicos alternativos.

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  3. Martin Bergstrom Saturday, July 13, 2013

    “It is immune to the inflation that plagues all fiat currencies: governments cannot simply print Bitcoins to pay off their debts.”

    Governments generally pursue low levels of inflation to maintain economic stability (pegged prices are subject to market volatility and currency runs while deflation is far more destructive and difficult to reign in than low inflation; see Japan) , with only rare and isolated incidences of high inflation being used to erase debt burdens (as the costs of such inflation are generally much higher than its benefits). Even assuming that the fed is completely controlled by either the commercial banking sector, free from any political or popular pressure or controlled by political considerations (in reality, it is subject to banking interest control but somewhat responsive to outside pressure), it is within the best interest of both the large banks, and political bodies and institutions to maintain a stable, balanced monetary system that inspires market confidence.

    Inflation is not some insidious plague inherent in fiat currencies, it is a desirable good that helps maintain price stability and market confidence against the threats of outside shocks or the animal spirits of the free marketplace. Has inflation been misused in the past? Yes, but those incidences are rare exceptions in isolated markets; hardly a reason to write off inflation as an inevitable ill of fiat currencies that should be feared and protected against. Bitcoin is an interesting project, and I do not mean to write it off, but trumpeting it as a cure an imagined ill is at best misguided, and at worst, dishonest.

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    1. The history of paper currency has been rife with hyper-inflation. It happens on a long time scale, so it doesn’t seem like it’s a common occurrence, but given the devastation caused by severe inflation, it’s frequent enough to be a major problem.

      “Inflation is not some insidious plague inherent in fiat currencies, it is a desirable good that helps maintain price stability and market confidence against the threats of outside shocks or the animal spirits of the free marketplace. ”

      World class investment teams with better tools than the Federal Reserve control most global capital flows, not mom and pop investors subject to animal spirits.

      Central bank intervention increases the information disparity between mom and pops and the elite, because the elite will undoubtedly always be able to get advance knowledge of central bank decisions.

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      1. Martin Bergstrom Tuesday, July 16, 2013

        I was responding to the claim that governments use inflation to inflate debt away, which is rare and often counter-productive (unstable monetary policy will raise credit risks and thus credit costs, causing greater debt problems than such inflation would solve). Moreover, believing that world class investment teams are not subject to animal spirits is ridiculous and completely unsupported by the historical record. It is not even a question over knowledge or rationality, it is a question of simple incentives. During a banking run, it makes perfect, rational sense for individuals (or individual investment entities) to pull their savings from the bank. You are right in the fact that private capital controls the vast majority of international capital flows (above both mom & pop investors, and central banks), and yet we see still see the wide fluctuations associated with the animal spirits. It is not that this private capital is being overridden, but that it too is prone to animal spirits. If low-level inflation were not present, future values and actions would be even less predictable. Who do you think would benefit in that situation, the mom & pop investors, or the large investment groups that have experts monitoring markets full-time? Stability and predictability (even at the cost of some loss of purchasing power) benefit the small time, everyday market participants far more than any large capital structures and entities; the big dogs would thrive in a world of chaos.

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    2. Nonsense. Inflation is THEFT by banks and government of the purchasing power of money. It is theft of the most insidious nature for at least two reasons: (1) from whom the theft is mainly perpetrated upon = the elderly, the infirm, the poor, and the uneducated and (2) by the method by which it is conducted = propaganda created by the State and propagated by the complicit main stream media to convince the foolish that it is good for all if a few (banks and government) impoverish the many to deliver unearned wealth to the few (banks and government). If you are simply ignorant, please read “Economics in One Lesson” by Henry Hazlitt and “What Has Government Done to our Money” by Murray Rothbard. If you are a troll who already understands the horrors of inflation and are simply doing the banks’ / governments’ job of spreading this propaganda, then GET LOST!

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      1. Martin Bergstrom Tuesday, July 16, 2013

        And the possibility that I’m neither ignorant nor a troll is simply unimaginable; I suppose I’d lean towards ignorant as economics is a relatively new field that asks impossibly large questions that are difficult to study in isolation. As with all things though, inflation comes with a cost and a benefit. The cost is that which you highlighted; the depreciation of the value of current monetary assets over time. The benefit is long term stability that promotes economic growth. Policy makers have decided that the cost of inflation (which is relatively low and can be mitigated) far outweighs the dangers of an unstable monetary system subject to fluctuation and instability.

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    3. If you see The Simpson, when the movie of Itchy&Scratchy is playing, you can see at the end of the movie the “benefits” of inflation.. “One senior citizen and one Chief Justice of the Supreme Court… The tickets cost $650.”.

      On the long run, inflation is always hyperinflation. Do your calculations (http://www.westegg.com/inflation/), if you saved 1000 USD 50 years ago, they is going to be equivalent to only 134 USD today. If you “like” that type of devaluation, then good for you!

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      1. Martin Bergstrom Tuesday, July 16, 2013

        If you like keeping your money in a sock under your bed, that is quite the unfortunate situation. If instead, you place it in a savings account, treasury bonds, or S&P 500 equity, you are actually doing quite well for yourself. Interest rates adjust according to both risk, and current/expected inflation rates.

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  4. I enjoyed your perspective, and felt it was well-informed. However, I think focusing on Bitcoin as a currency and/or asset, ignores that it is a backbone technology in it’s infancy. We still have no idea what developers (many funded by an active VC pool) will build upon this impressive, secure, distributed ledger system. It’s not at all hard to imagine that the Bitcoin platform will be built upon in useful ways that are specifically independent of the actual price of a Bitcoin. The technology itself is simply not reliant on Bitcoin having high or even stable exchange rates, so I don’t at all think you can be confident that government (or other) price manipulation will be able to crush Bitcoin.

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    1. Simon Edhouse Monday, July 15, 2013

      yes, good answer… seeing bitcoin through the lens of a pure monetary system, is to not see the BTC protocol clearly.

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    2. Martin Bergstrom Tuesday, July 16, 2013

      I agree wholeheartedly. My issue is only with those that trumpet it as a currency to cure the ills of current, government-backed currencies. From a currency based perspective, Bitcoin is sorely lacking (of the 3 uses of currency -a medium of exchange, a unit of account, and a store of value- Bitcoin is currently useful*ish as a store of value). From a technological perspective, it is a far more interesting and ambitious project.

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  5. My savings being worth less each year. Inflation is desirable? Keynesianism has surely poisoned many an otherwise sound mind.

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    1. inflation is desirable and important. it’s good for you that you have your savings, but it’s bad for the economy at large if money holds or increases in value, because then everybody starts saving all their money and nobody buys much of anything and, guess what, businesses go to hell. that’s why a dollar today buys less than a dollar in the 70s, that’s how it’s all designed

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      1. You must buy food, you must buy clothes, once your money has more value, is more probable that you are willing to buy expensive things like smartphones, and other gadgets…. It is false that when money increases its value people stop spending….

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        1. Martin Bergstrom Tuesday, July 16, 2013

          …and deflationary spirals do not exist.

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          1. “deflationary spirals do not exist” – um… True? Once you give someone the unrestricted ability to print money for themselves, there’s little hope they wouldn’t do that.

            Even if they did exist, that would simply mean that people do not need to buy more stuff. Which is perfectly fine, and good for environment.

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  6. John Ratcliff Saturday, July 13, 2013

    I agree, I’ve been saying that ‘they’ are going to shut it down for a while; once ‘they’ realize just how big of a threat it is. Forget about even the banks, bitcoin puts Western Union out of business almost out of the gate; like within a year this could happen.

    Bitcoin is very complicated because it can be thought of as a currency, a commodity, and a transaction system all at the same time!

    However, it’s most immediate disruptive power is as a transaction system. There are more and more businesses creating a model where they don’t even care about the value of bitcoin as a currency, they are just using it is a transaction system to wirelessly transfer money anywhere around the world instantaneously.

    As long as the value of the money is stable enough for the duration of the transfer (a few minutes??) it seems to work.

    I agree, that banks and wire-transfer services are the most immediately threatened by the power of cryptocurrency.

    But, it’s kind of hard to put that genie back in the bottle.

    So, they knock bitcoin down? Big deal, then twenty other cryptocurrencies pop right up again in its place.

    I think it’s easiest, and most likely, that it gets regulated out of existence or demonized and propagandized in the US.

    The weak point is where fiat goes in and fiat comes back out again. The real threat is when nobody even wants fiat at all any more. For that to happen, it really does need to become a universally accepted form of payment; as common as Mastercard and Visa who, by the way, cyrptocurrency would put out of business too.

    We are already hearing a number of anecdotal reports of people having their checking accounts closed because they are doing bitcoin transfers.

    It’s going to be an interesting ride for sure…

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  7. Governments might hold control over the button but they have no control of the winds and where the fallout will land.

    If a government today decides take some change and pump it into bitcoin, it will hike up the price immensely, but as an unintended consequence attract more attention to bitcoin. This will cause more buying than they intended. They can then cash out and do their evil laugh thing, but the price will settle higher than it started and leave many new entrants still in the system.

    Besides actually getting more people in bitcoin, they will also not be able to affect the use of bitcoin as a temporary medium of exchange for black market activities. Even during the spike, online gamblers will still use bitcoin because they have no other options. Online sellers of illicit goods will still use bitcoin during and after the spike, because they have no other options. Ironically government prohibition of activities lead to the guaranteed future of bitcoin or something like it.

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  8. Citation: “A currency that quintuples in a month, and then loses two-thirds of its value in the following week, is not a currency that inspires confidence in users. And while features like security, verifiability, untamperablity and decentralization are attractive, they are all secondary to the main factor that controls adoption of any currency: stability of purchasing power.

    Thus Bitcoin’s Achilles heel is its susceptibility to manipulation by the very people who need Bitcoin to fail.”

    My opinion: I don’t think that Governments and Central Banks will give the opportunity to speculators to became rich over their shoulders…

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    1. Look up Day trader and arbitrage. Some life forms derive their income from volatility. And if govt is persueing an obvious pattern…EZ money!

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  9. The very same hypothetical volatility which would make Bitcoin a poor choice as a currency would make it an attractive speculation.

    A lot of people _want_ to gamble in such an unpredictable boom/bust/boom market.

    And what if someone had inside knowledge of the moves the big banks were making before they made them?

    Bitcoin might well flourish in such a manipulated environment.

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    1. You beat me to it, thank you.

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  10. Bitcoin is not just a currency but it is freedom

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    1. Fresh freedom i should say

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