Bitcoins, coal exports, and the New Switzerland: a puzzle

Here is a puzzle for you: what is the theoretical link between bitcoins, Australian coal exports to China, and the US becoming a New Switzerland? It’s a bit of a convoluted link, so see at what stage in the story below you spot the answer.

Bitcoins are all the rage at the moment. With 11 million of them on the internet, each worth a 1000$ today (maybe more tomorrow!), it is a market of 11 billion dollars. This is peanuts in terms of world trade or even Internet trade, which measures volumes in the trillions of dollars rather than paltry billions, but still worth a chat.

Bitcoins have unusual properties as a currency: they are essentially a long string of numbers and characters that uniquely identify a ‘bitcoin wallet’. If you like, your possession of bitcoins stands and falls with a complicated password. Bitcoins can be sent to your wallet by anyone from their own wallets, but only the holder of your password can send from your wallet. So your password, your wallet and your bitcoins are one. For most purposes, there is a finite amount of bitcoins, but at the margin one can create a few more by doing lots of calculations that require a lot of electricity. (I hope you begin to see where coal might come in! )

Now, as a future internet currency, bitcoins are doomed. There are three reasons for that: their limited supply, the ‘greater fool’ principle, and governments.

The finite supply of them (there are 11 million of them now, and there will never be more than 21 million of them as they have been designed to get harder and harder to create) means that, if they are truly used as currency on a large scale in the presence of continuous growth in trade, that their value will continuously grow. This in turn would be its undoing because people would then hold onto them rather than spend them, anticipating that future value increase, meaning they are no longer used as means of exchange and their market collapses. It is a classic hoarding collapse of currencies seen before in money history.

The ‘greater fool principle’ will also kill off bitcoins: the fact that bitcoins really are no more than passwords means their value is entirely dictated by what the next person is willing to pay for them. This is true of all pyramid schemes, where one person buys into the scheme hoping future entrants will make it worthwhile. Often when a population is new to finance you see such pyramid schemes come in – they for instance caused havoc throughout Eastern Europe when the Eastern Europeans started to discover the joys of Western banking after the collapse of communism in the 1990s – and bitcoins is a pyramid scheme tailor-made to rip off a young and inexperienced internet generation. The early adopters in pyramid schemes make fortunes out of the scheme. The next entrants hope that there are even greater fools out there who are going to pay even more than they did, right up until the market runs out of greater fools.

But governments might well pull the plug before the internet has run out of greater fools or the inevitable hoarding kills it off. This is because of the potential for money laundering offered by bitcoins, which is where China comes in.

Consider how one can money-launder with bitcoins. There are really two ways. Like having anonymous bank accounts in Switzerland, buying bitcoins can be done simply by buying them off a previous owner without any identity swap necessary. All that needs to be swapped is real money. Hence a criminal, or merely a corrupt official, can launder his ill-begotten money by buying the bitcoins in his vicinity with cash. He can then smuggle them out of the country by simply going abroad with the password or sending the password to an associate abroad in some way, after which the bitcoins can be transferred into goods or dollars again. The ease with which one can dodge banking fees and capital export restrictions with bitcoins is such that they are ideal for criminal networks looking to launder. Which is of course why they were used by criminals and corrupt officials in the silkroad networks closed down recently. You should thus not be surprised to know that China is now second in the number of bitcoin dowloads in the world, with Russia also appearing in the top 5.

There is another way to launder money though and it involves electricity. Once one has bought up all the local bitcoins with cash, one cannot easily launder money by buying foreign bitcoins via sending money electronically in some other way to foreign bitcoin holders, simply because those online transactions risk being observed by the authorities. But one can create new bitcoins by ‘mining’, which is essentially a direct function of computations requiring sheer computing power, ie, electricity.

So the want-to-be money launderers in China, of which there will be many given the fairly embryonic state of its financial sector, its huge capital export restrictions, and the broad penetration of computer infrastructure and skills in China, might well start mining bitcoins once they have exhausted all the existing bitcoins locally. And this in turn will require vast amounts of energy generated by …… coal-fired powered stations. And where does a lot of that coal come from? You guessed it, Australia.

Consider how this might go: money launderers would convert, say, 200 billion dollars of surplus (merely 10% of China’s accumulated trade surplus of the last few years) into 200 billion dollars of bitcoins via spending 200 billion dollars on computations, ie Australian coal. They then take the passwords abroad and spend it on something else, hoping of course that the bitcoin market hasn’t collapsed whilst in transit!

So the trillions of dollars of surplus run by the Chinese over the years might possibly end up being laundered by means of bitcoins and Australian coal! Causing lots of additional greenhouse gas emissions, one might add.

The story should make it clear to you why governments cannot allow this to happen and the steps they might take to prevent this from happening, via banning bitcoin mining or closing the market down or coming up with an alternative regulated internet currency.

The international politics of this are interesting though, and that is where the New Switzerland comes in: since it might well be the Chinese and Russians doing a lot of the laundering by buying up the existing bitcoin reserves where they are now (mainly the US), one can imagine the US not being all too keen to shut its bitcoin markets down quite yet. The US too wants to enjoy the benefits of undermining the financial controls in other countries, like Switserland has done for ages!

On this point, I wonder if the price of diamonds and Swiss bank fees are reducing with the new competition for money laundering provided by bitcoin?

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David Walker
David Walker
8 years ago

Paul, you pick up on a point which I’m surprised is not raised more often. The Bitcoin crew are running a monetary system without any understanding of monetary policy. And while ever interest in Bitcoin grows, they will be running a policy which is not only inflexible but also extremely tight: their money supply is expanding much more slowly than long-term underlying demand for their currency. That has already made Bitcoins extremely volatile as a store of value, and will ultimately undermine its perceived reliability as both a store of value and a medium of exchange.

And of course this monetary policy is baked into the underlying rules of Bitcoin.

I suspect that virtual currencies have a big future, but an essential part of that future is credible monetary policies. Successful virtual currencies will probably have monetary policy boards composed of high-credibility experts.

(If I’m correct, this is very good news for any economist working at our high-credibility Reserve Bank.)

Mr Hencecake
Mr Hencecake
8 years ago
Reply to  David Walker

“The Bitcoin crew are running a monetary system without any understanding of monetary policy.” Actually, it’s not so much without any understanding of monetary policy so much as it is an espousal of an alternative system of monetary policy (ie, Austrian school of economics). Whether or not it will work in the real world, only time will tell. Regardless, there is most definitely a theoretical basis for it.

“Their money supply is expanding much more slowly than long-term underlying demand for their currency.” Remember, this is a digital currency – a Bitcoin is not indivisible, it can be divided up to 8 decimal places (0.00000001BTC = 1 Satoshi). Hence, while it is indeed volatile, it can be distributed more fluidly than you think, and will not be ravaged by the money shortages that were the bane of basing currency on gold.

“Successful virtual currencies will probably have monetary policy boards composed of high-credibility experts.” And they helped out so much in forseeing the GFC, no? High credibility experts? Boards? Part of the appeal of Bitcoin is that it is completely decentralised. I hope Bitcoin succeeds so that we don’t have to look forward to a future of boards and organisations controlling digital currency. Will it succeed? Who knows. The only reasonable objection in the article, I think, is that of hoarding. I don’t think governments will do squat (or if they do, they’ll be a few fringe governments who won’t have an affect on the Bitcoin economy), and I think applying the greater fool principle to Bitcoin is incredibly mistaken. In terms of hoarding, I think if people begin hoarding overly much, the exchange rate will slowly fall until people realise their stupidity and begin buying and selling, etc. Besides, so long as there is a decent sort of distribution by the time the Bitcoin market has expanded to more or less meet global demands, hoarding shouldn’t be enough of a problem to destroy the whole project.

Maybe I’m a dreamy idealist and Bitcoin will fail miserably. Or maybe there’s some tree out there tirelessly producing oxygen for your sorry cynical ass, and maybe you should appreciate that and stop being so skeptical.

Die.

Paul Frijters
Paul Frijters
8 years ago
Reply to  Mr Hencecake

A true idealist would be proud to put his real name behind his beliefs, so don’t worry about being an idealist: you’re not.
I would guess you’re probably just another student infatuated with the idea he can bypass the old guard by entering a world without financial institutions. A fairly harmless power-fantasy, and a quite normal one too that many of us also had when young and powerless. So happy dreams.

ps. [update Dec 5] Your reply was already a bit rude but one can view it as a bit tongue-in-cheek and so I allowed it. However, the subsequent ones (using a variety of false names) were clearly just personalised abuse, so I deleted them. You can make the same points in a civilised way. Preferably with your actual name.

Harry Faulkner
Harry Faulkner
8 years ago
Reply to  Paul Frijters

I apologise for any offensive content that I sent. I unreservedly retract all rude and silly comments.

Sincerely,
Harry Faulkner

Paul Frijters
Paul Frijters
8 years ago
Reply to  Paul Frijters

apology accepted.

conrad
conrad
8 years ago

At least supercomputers should become cheap when they reach 21 million.

It’s also worthwhile noting that not all things die as quickly as your observation on classic hoarding suggests. Things like artwork and stamps just go up in value the rarer they get, and stamps have essentially no intrinsic value apart from collecting (at least artwork provides enjoyment). Bitcoins, alternatively, have huge value for hoarding and transferring dirty money — even if each individual coin had a large price tag, it’s presumably only tiddlywinks for the amount of money people want to cleanse. So one can imagine them going on for a very long time.

Patrick
Patrick
8 years ago

Also I’m pretty sure you can deal in fractions of a bitcoin.

Paul frijters
Paul frijters
8 years ago
Reply to  Bruce Bradbury

With trade growth of a similar order as real interest rates, that value is going to get extremely high. Makes for an unstable market, like the silver market in China in the 19th century.
Sounds like forbes got hold of some silly theorist though: a known rate?

Bruce Bradbury
Bruce Bradbury
8 years ago
Reply to  Bruce Bradbury

On further reflection, I think this discussion of hoarding is beside the point. Deflationary monetary systems don’t work in the sense that they are bad for the overall economy. However, bitcoin is not a currency for an economy. As a parallel system to national currencies, I don’t see why expected increases in value should prevent it use as a medium of exchange (unless the algorithm leads to very fast increases which make timing of transactions difficult). The analogy with rare stamps by Conrad is a good one.

On the other hand, the fact that bitcoin is not a national currency, and is not linked to a government raising taxes and paying taxes with it will mean that it will continue to be highly unstable.

Paul frijters
Paul frijters
8 years ago
Reply to  Bruce Bradbury

I disagree, Bruce. Have you ever known a highly volatile item to be used as a mass means of exchange? Stamps and paintings might have some use as a means of investment, but it will be very limited. Also, volatility in prices matters. When prices can change many percentages per minute, it is hard to plan production and consumption. That is why hyperinflation is so bad for an economy.

These internet currencies might at the moment be merely a means for speculation and dodging national capital controls (ie, they are used as an intermediary between national currencies), but there is a clear demand for a true internet currency and the question is whether it could be bitcoin. You seem to agree it can’t.

David Walker
David Walker(@d-w-griffiths)
8 years ago
Reply to  Bruce Bradbury

“I don’t see why expected increases in value should prevent it use as a medium of exchange …”

Bruce, I can see where you’re coming from. The argument the other way is that in order to conduct trade, people have to hold currency for a substantial period. And in the case of bitcoins, we will be holding a highly volatile asset – which for many/most people is not desirable.

Of course, we could buy the bitcoins just before the trade and sell them again straight after. But that seems to defeat the purpose of the exercise.

(Timothy Lee’s argument works well so long as God keeps telling us what bitcoins will be worth at future dates. In the real world, though, future asset prices are harder to determine.)

john r walker
john r walker(@annesanders)
8 years ago

paul
What do you make of this article on Bitcoins, am particularly intrigued by this:

Now the block chain is being applied beyond the movement of money using a technique called “colouring” bitcoins. It has the potential to transform commerce. Take the buying and selling of real estate, for example. In a statement before the US Senate Committee on Banking, Housing and Urban Affairs on 19 November, Anthony Gallippi, CEO of Bitcoin payment firm BitPay, described how co-opting the block chain could do away with the gaggle of fees and legal manoeuvrings that usually accompany home sales.

“The biggest up­front costs for consumers trying to buy a home are the closing costs, which include fees for deeds, titles, stamps, title insurance, and other redundant tasks to record the sale in different record books,” Gallippi said. “Bitcoin can replace thousands of dollars in closing costs with a single transaction that costs 5 cents. By reporting deeds and titles on the block chain, the information would be public record forever, for pennies, and eliminate the need for title insurance.”

Paul frijters
Paul frijters
8 years ago
Reply to  john r walker

Hahahaha. He is basically making the point that the memory of all transactions can be useful as it could replace other memory systems, or be the basis for them. Sure, but …. in order for it to be useful, one would have to link payments (or wallets) to actual individuals! Also, there would need to be a verification system to ensure the payment was indeed authorised by the individual (to ward against theft). Both would effectively transform the bitcoin network from a collection of people who want to be anonymous to a regulated official institution of recognisable citizens. Did this guy mention that?

Whilst the future probably will see some regulated identity-linked internet currency, it is unlikely to be bitcoin. It’s process for generating more bitcoins makes it useless for monetary policy (as well as very wasteful).

john r walker
john r walker(@annesanders)
8 years ago
Reply to  Paul frijters

I think that Bitcoin is only one of a number of ‘vaguely’ similar systems around at the moment.( ‘Exactly’ what these systems are is a hard, not simple, question, no?)
As best as I understand each ‘wallet’ is a sort of Godel Number for all the Godel numbers of the system; in other words a currency who’s currency is its coded memory.

BTW
I think that the person quoted sees it as a way of doing ‘Land title’ exchanges much more cheaply , not as away of being anonymous .
And re
“link payments (or wallets) to actual individuals”, wouldn’t it be link to individual properties?

Paul Frijters
Paul Frijters
8 years ago
Reply to  john r walker

– sure, lots of copy-cat ‘itcoins’ around now. Hard to keep track of all the new ones.
– Land title exchanges need individual names. Anyone can add whatever information they want, but the verification has to be based on legal entities that can own things.
– No, in order to be useful as a kind of ‘legal memory’, the payments and rights flowing from those payments would have to be linked to entities that can own things, which is people and not properties.

However, the issue really is quite moot. Effectively what the guy is saying is that one can use the memory-upload system inherent in a couple of these ‘itcoins’. But its a highly inefficient system ill suited for it, quite apart from the identity issue: in stead of having to be uploaded once and then being available for all, the information would be dragged around ‘forever’ many times per day by many entities. That is an awful waste, which will only get worse if these itcoins are used more and more. Indeed, given the volume of transactions, we must already be talking about many gigabytes that are constantly streamed around, just to provide that ‘money memory’. Very wasteful. Hard to see how bandwidth could hope to keep up with the explosive increase in data that this would entail in the future if one of these currencies is mainstreamed. There are clear economies of scale in this sort of thing, whereby the far more efficient thing to do is for one central clearing house to record all the transactions and to have them open-access for anyone wanting to read them. It is the sort of thing governments and institutions are particularly good at. Like a central bank.

john r walker
john r walker(@annesanders)
8 years ago
Reply to  john r walker

I agree with your skepticism, but we could be wrong.

john r walker
john r walker(@annesanders)
8 years ago
Reply to  Paul frijters

Paul
come to think of it- given that many governments have been minting coins that are not really the full quid, maybe the bitcoin is a response to the operations of Gresham’s law?