Sunday, 10 December 2017

Re-framing fake news and Bitcoin madness

Alternative currencies like Bitcoin continue to zoom as confidence in the stability of the global system declines.

Of course, I could be wrong and this daily drumbeat of suicidal rage is simply the new normal. Since I don't see any solid countervailing cultural, sociological and economic forces emerging, this crisis will continue to worsen. My gut tells me there's an existential crisis underway in the West, far deeper and scarier than Trump (he's just a symptom) or Bitcoin. And boy oh boy, is Bitcoin a polarising subject.

Hold onto your hats people, I'm jumping in.

I

First, it’s slow. The blockchain is nowhere near where it needs to be in regards to transactions. It should be hitting <10 per second. Right now, it completes approximately seven transactions per second. By comparison, Visa does 47,000 transactions per second. And because of this sluggishness, they're already charging extra fees so people can jump to the front of the line. That's not a good precedent to set so early on.

Second, if the price declines so much that mining isn't worth the price of electricity, the entire network could collapse and it's back to the gutter for all the "investors." If you think Bitcoin is a good investment at this point, I have some virtual bridges to sell you.

Third, it is doubtful Bitcoin will replace paper currency, but it could co-exist. It’s a $175 billion asset right now and it will be more difficult to ban when it becomes $1 trillion. It could become a store of value if more participants join and it increases its liquidity. My only concern is people could lose faith in the concept if the price drops severely.

Hopefully, Bitcoin hoarders start to behave like liquidity providers instead of trying to make a quick buck. Because at present almost everyone who is buying and holding Bitcoin is doing so purely because they expect to be able to sell it later at a higher price. That's not good if it's supposed to replace money.

II

But the big thing for me is the particularly annoying internet subculture.

You know them. They're like the (mostly) guys at a party who start spouting off about "The Fed" and "fractional reserve banking" as if they stayed awake for half the economics 101 lecture. At some point, they drop the word "fiat" when referencing money, like a codeword for other "woke" pseudo-adults.

These Bitcoin types are often conspiracy theorists in every other area of life too. When Bitcoin got to $700, people wondered what was happening (and I kept hearing “Venezuela!!”). Now that it’s at $17,000, these types refuse to even discuss the strangeness. The idea that the US Federal Reserve is out to get you but some unknowable group of dark web hackers is looking out for your best interests seems a little hypocritical to me. It smacks of my team/your team, which I thought the libertarian, digital socialists wanted to fix.

It's even more hypocritical because Bitcoin and offshore bank accounts have a lot in common in terms of the evasion of laws. They're at once concerned about offshore bank accounts being used to evade taxes while defending those very offshore bank accounts because they allow them to store their billions out of the reach of the countries from which they acquired their billions.

It’s also suspicious that the person who founded Bitcoin, ‘Satoshi Nakamoto,’ reportedly has a stash of 1 million inactive bitcoins (worth over $10 billion by today's prices) and that no one knows who that person is, or if it is a group.

III

Plus, there’s a finite supply of Bitcoins (21 million) and the supply is running out. Currently, about 80% have been mined. What happens when the last one is mined? Does the value go to infinity (= cost of mining new ones) or zero?

It seems unlikely the price will go up forever. There aren’t many fundamentals to drive it up. You can point to the value of gold, but gold actually has uses outside of money (jewellery, electronics, etc) and more importantly, it’s been a store of wealth for ages. It’s imminently tradeable anywhere and at any time.

Everyone knows what gold is and why it has a place in our world of the perceived value of relatively useless non-income producing assets. But 99% of people playing with Bitcoin know nothing about cryptography or the scaling issues. Gold is a fully-informed price. Bitcoin is a just people passing along a buzzword.

Bitcoin is a financial tool and has value only when it’s useful for that purpose. The sign of a bubble is when the ratio of use to speculative appreciation gets out of whack. That ratio certainly varies for different types of goods, but it seems extreme in the case of Bitcoins. So now that Bitcoin is worth $20k, does it still serve the purpose of being a financial tool? Doubtful. And what about all the other cryptocurrencies? A stable long-run value for Bitcoin cannot coexist with an infinitely elastic supply of Bitcoin-like assets, and there are hundreds of these things. Does anything limit the supply of Bitcoin-like assets?

At least gold is the only gold-like substance (silver is a pale imitator). And art is considered a store of value as well because you can display it and accrue prestige. So unless the super-rich start having gaudy displays of Bitcoin (how would this even work?), I don’t see how people will just “agree” that it’s a store of value.

In one sense art collecting is a bit like Bitcoin. In art collecting, you have to ‘mine’ value by attending auctions or shows to buy unknown artists at low prices in the hopes you’ll get a ‘coin’ - which is the equivalent of an artist turning out to be very collectable. Those established ‘coins’ go up in price as people opt to use the specific art as a store of wealth. Maybe Bitcoin is just a type of ‘number art’ where your artwork is a string of digits. The advantage is that Bitcoin has a chain of custody so it’s almost impossible to pass off forgeries.

The principle of gold is that you buy it, you put it in a vault somewhere and when you take it out again, it has roughly the same value as when you put it in. That’s not true in practice, but it’s kind of true, and historically there were very few competitors to gold. Nowadays, gold is less appealing because there are other competitors to being a risk-free long-term value storage. For instance, US Treasuries.

IV

It's also fairly well-known that a large percentage of Bitcoin mining efforts happen within China - between 70-80%, apparently. Has anybody asked if the Chinese are mining the cryptocurrency on government electricity and selling it to each other to inflate the price?

The three largest miners in China make up more than half of the mining power, which leads to the possibility of a Sybil attack. However, that has nothing to do with the price, because the amount of Bitcoin “minted” by miners is pre-determined, and it’s just a matter of which miners get it: Therefore, the ownership of the miners shouldn’t affect the price by itself. But it's still pretty weird.

Bitcoin mining in China
What if Bitcoin’s core “activity” is to convert cheap Chinese coal into US dollars outside of China? That’s not such a good thing to bet on, as a market/asset/whatever. And if the Chinese are doing this much mining, at which point do we consider Bitcoin to be an extension of the Chinese government? Bitcoin looks to be a shadow of the shadow banking in China. I also wonder how much North Korea is involved in all this.

Bitcoin is subject to a 51% attack by the Chinese government when it nationalises/confiscates the mines. This is inevitable. They couldn't “steal” Bitcoin because executing the attack makes Bitcoin worthless. But it can say, “we’re filling a vault with huge amounts of cash. Then we’re going to set the contents on fire to punish the people who put the money in the vault, or cause some general havoc from which we can benefit.”

It certainly has the incentives. Beijing wants to destroy the wealth gained by people who sneaked the coal out of the country? Check. Beijing wants to impose an exogenous financial catastrophe on the rest of the world? Check. Beijing is racing to build quantum computers, which it could use to empty people's e-wallets? Check. And does anyone think Bitcoin will retain its value when the CCCP starts shooting money launderers? After all, it isn't very anonymous.

(It could be Chinese government employees using Bitcoin to move their ill-gotten assets overseas. The anti-corruption purge by President Xi Jinping certainly spooked a lot of people, so if that's part of what's happening, then the clamp-down might not be so inevitable. But that's a big if.)

Throwing people into jail works very well on technological problems. So if Bitcoin’s price is just a reflection of the tight funnel applied to Chinese and Russian millionaires who want to get their money out of their respective countries, when they figure out a different avenue, Bitcoin's price will collapse back to $200.

V

Then again, cryptocurrencies started at zero and will probably end up with a price greater than zero in the long run. There is no way for the journey from point A to point B to not look a lot like a bubble.

Someday they’ll invent a term to describe this sort of situation. For those interested in history, 'Extraordinary Popular Delusions and the Madness of Crowds’ by Charles Mackay is considered pretty much the definitive historical overview.

Just think how many tulip bulbs or South Sea Company certificates you can buy with just a fraction of a Bitcoin! You can buy even more next week, next month, next year or next decade! Buy Bitcoin now, before the price becomes unaffordable, and you miss out on the biggest opportunity since the Mississippi Company!

One big difference between tulip mania and Bitcoin is how wealthy the uneducated class is in 2017. The West has never been dumber and wealthier. At least in Holland, only a few percent of people even had any wealth, and they tended to be quite educated.

Speaking of educated people, Isaac Newton probably would have bought Bitcoin too, so don't feel dumb. In the spring of 1720, he owned shares in the South Sea Company, the hottest stock in England. Sensing the market was getting out of hand, the physicist muttered that he ‘could calculate the motions of the heavenly bodies, but not the madness of the people.’

Sir Isaac dumped his South Sea shares, pocketing a 100% profit totalling £7,000. But just months later, swept up in the wild enthusiasm of the market, he dipped back in at a much higher price and lost £20,000 (the equivalent of £2,743,000 today). For the rest of his life, he forbade anyone to speak the words ‘South Sea’ in his presence.

But tulips aside, I don't think Bitcoin isn’t a bubble. It doesn’t rise to that high of a standard. Assets – things that have value – have value for a reason. A currency has government backing which needs to maintain financial credibility. Homes have usage value. Corporate goodwill promises future earnings growth and dividends. Bitcoin has nothing behind it and only a shadow of value in front of it: the hope that someone else might need an underground currency more than you do and will pay for the privilege.

It’s a currency supported by the needs of marginally and not-so-marginally illegal market participants. Not much else there.

VI

Some people are also pointing out the appaling environmental impact of Bitcoin.

The electricity required to process transactions must constantly grow to offset technology gains in mining. At current rates of electricity consumption, the projection is that mining will consume the entire planet’s electricity supply in five years. Obviously, that’s not gonna happen.

And it's a little unfair anyway. Has anyone done a comparative study of the energy use of Bitcoin versus "traditional" currencies, specifically ones used globally such as the US dollar? The energy consumption of Bitcoin only seems unusually large because it is intrinsically tied to a growing network of physical computers. Plus, it's the "bad guy" in this power play.

While Bitcoin's usage is obvious, we tend not to think about the energy costs of digital currency in general. But traditional currencies are just as much dependent upon the use of computers around the world for record keeping and financial transactions, and also have the added consumption of paper money and coinage - which use exceptional material resources.

Bitcoin, at the present time, does not have a widely used printed mechanism for exchange. I wouldn't be surprised if the global distribution of dollars, both in paper and global financial record-keeping, uses just as much if not more energy as the blockchain.

That's to say nothing about the storage capacity needed. Bitcoin's technology, called “distributed ledger,” is an ever-expanding computer code. This technology is based on a hope that computer technology will keep up with a pace of growth of the distributed ledger.

Unlike ordinary software, where developers can keep it small in case hardware doesn’t advance fast enough, the growth of a distributed ledger is uncontrollable. It balloons with every transaction. It's like a rocket scientist using an unknown material and saying: “Let’s hope it will last.” In fact, Mr Nakamoto wrote in his famous white paper: “storage should not be a problem.” Really? Are you sure about that? We're quickly reaching the limits of microchip miniaturisation, to say the least.

VII

You can make reproductions of paintings easily and inexpensively, but the reproduction will never be the original, even if the difference exists only as an awareness by the owner.

Bitcoin has the legacies of being the first, the crazy history of Satoshi Nakamoto, the stories of the lost hard drives worth millions and the billion dollar pizza. You can clone Bitcoin, but the clone isn’t Bitcoin. Humans are hard-wired storytellers. A centuries-old gold ring owned by a queen is a story worth more than the sum of metal, gems and workmanship. Bitcoin’s story is the lion’s share of its value, and it’s one hell of a story. If you have the means, you can own a piece of that story. That's pretty fun.

Bitcoin seems no different from any other speculative investment, and may well be the premier speculative investment. It is a new asset class that will eventually reach an equilibrium with other stores of wealth. Bullion and the paper cash of reserve currencies seem to be the most appropriate assets to compare it to – scarce, global, fungible, divisible, counterfeit-resistant, etc.

But it's not quite a form of money yet. All money is not alike. A million Zimbabwe dollars are not equivalent to a million US dollars, whereas commodities like gold, copper, and hardwood lumber are fungible. Money seems to derive value from the fact that enough people accept it in trade over time. But that seems kind of superficial and circular, so we have to check the fundamentals: a stable civil order, high productivity, large, liquid market and relative scarcity. What are the underlying fundamentals of Bitcoin?

*crickets*

People say the Bitcoin bubble inevitably will burst. Defenders say, so what, even if there is a correction, the correction will be followed by new highs. Defenders have the better case. Economists tend to focus on classical theories of investing, while the real money is made in speculation. The pending tax bills in the US Congress are a cornucopia of opportunity for this kind of speculative investing.

We are all speculators now. Me? I’m in the tulip market. If the market bursts, at least I can use them to decorate my backyard.

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