Response to Calacanis’ Post on BC [first written in 2011]

I haven’t posted here for a while, as I’ve been focused on other business, but thought I’d make a pass now at a comprehensive look at issues I see with bitcoin in light of Jason Calacanis’ recent, strongly positive, statements. I’m not an economist, but I do have a fair amount of experience in implementation of a wide variety of alternative transaction scenarios and business models, in scale, and tend to be on the bleeding edge of these things, so my perspective may have some practical use, whether on not you agree with me:

1. “Bitcoin is a technologically sound project.”

It depends how you interpret this statement. There are two respects in which it is probably not true:

a. Fragility. If Bitcoin is ever illegitimately manipulated, even a little, it likely ends up with no value whatsoever, as there’s nothing behind it. -No full faith of the government, no productive community. The entire value lies in its complete imperviousness to attack and its fixed quantities, which seems irrational to expect. If it is hacked in such a way that a few more bitcoins are produced, faith in the system will perish, as it has no recourse to external cross-checks or substantive value. If it is hacked in a way that a few less bitcoins are available, that will only accelerate the inevitable deflation issues of the system. Something that’s very important to remember is that while with most technologies (even with something like PGP, on a message by message basis) it’s not worthwhile to put a huge amount of effort into hacking a system, and one can safely say “that would take too much effort to be worthwhile;” this is absolutely not the case with large scale currency. Both criminals and governments will find it to be well worth such extensive efforts were scale ever actually achieved. Significantly, if you scan the internet for discussions of PGP hackability, the exception always given is that “you’re absolutely secure unless the NSA decides it’s interested.” -As I describe below, I think they eventually would be interested here.

b. Appropriateness. Bitcoin is an attempt to create a structure of value without human influence. There are a fixed number of units that can ever be generated. It can only be an inflexible and stagnant economy; if you look at the history of those who followed these sorts of strategies (ie: Andrew Jackson ), you’ll see that it leads to something worse than the economic downturn we’re seeing now. Dogmatic belief in the evil of debt or of human intervention leads to very bad things. -The fractional reserve system for increasing available US currency has a lot of detractors at the moment, but it’s part of a clever and dynamic true fiat system.

In deflecting claims that BC value is derived from a synthetic fiat system that actually mirrors a commodity system in functionality, or is even a truly commodity-based system (derived from use of power and cycles in mining coins), there’s a proposition put forward by some BC supporters that the only thing behind BC is the community of users. In saying this, though, they are simply adopting the language of complementary currency (such as LETS and Ithaca Hours), without taking on its structure or character. The reason that these other currencies can truthfully claim to have value from their communities is that they are structured to grow in ways that reflect such active participation: more users means more currency in play, as each individual joining the system is eventually reflected in quantity of currency units. More users of Bitcoin simply means more deflation. Hence, it has an inherently pyramidal structure, with early adopters effectively paying less per unit.

I’d throw in here that I’ve read a few postings by BC supporters that BC isn’t actually subject to deflation as conventional currency is, because it can be split into infinitely smaller pieces. For these folks, I’d just suggest that chopping up bitcoins has nothing to do with deflation:

Moderate inflation means that a unit of my money will probably be worth a little less tomorrow than it is today, which inclines me toward actively investing it in growth.┬áBut, why, you may ask, is rampant deflation a bad thing? I’d suggest that it’s bad because it’s anti-dynamic; however I chop up a bitcoin, if I am holding a bitcoin and think it will be worth a lot more tomorrow, I’m unlikely to invest it. Why should I invest it? It grows in my wallet. The wealthy holding onto their money is one of the biggest problems the US faces at this moment; why in God’s name would anyone actively attempt to replicate that situation in an alternative currency? For a currency to help its users it should be moderately inflationary and incredibly liquid. Deflation isn’t just another way of measuring the same growth effect in an economy as inflation; it’s absolutely entirely different, both in what it means and the action it drives.

2. “Bitcoin is unstoppable without end-user prosecution.”

Untrue, it’s very easily stoppable. Bitcoin, in scale, is entirely dependent upon the existence of entities that will allow conversion of Bitcoins to dollars. -There will never be retailers (and by this I mean professional retailers, with something to lose) participating in Bitcoin transactions. What will happen if Bitcoin ever gets scale is that banks, PayPal, Visa, etc., will shut these conversion sites down. Why would they shut it down? The problems with Bitcoin will largely derive from tax reporting issues, and the impossibility of an integrated relationship with the United States’ national taxation authority (IRS). A core element of Bitcoin is that there is no central tracking of transactions (or rules for usage); unfortunately for BC, though, for transactions involving sales of commercial services or physical goods with value of a dollar or more executed via a virtual currency, the IRS specifically requires reporting from the transaction-authorizing entity, via form 1099b. Since there are no controls on usage of Bitcoins, all transactions would need to be considered commercial (commercial will contaminate non-commercial if they’re in the same system), and subject to a $15 per transaction fine, in addition to taxes. There are other alternatives for integrating physical currency (like community currencies) into the overall economy, and bypassing this issue, but I don’t see how they could do it online.

If bitcoins cannot be used with conventional retailers or converted to dollars they will certainly not be liquid enough to scale and compete with dollars. I would suggest that alternative currencies can do incredible things for all sorts of communities, but that believing that a currency can or should compete with dollars is often, and certainly in the case of BC, taking a leap away from the useful and dynamic, and into the bitter and non-viable.

So, you start with this piece (that it will inherently be out of compliance with regulations) and then you add to it that, as with egold, even if you start out with great intentions, these sorts of anti-fiat-currency initiatives aren’t really interesting to citizens outside of a committed core group, you can see that usage will veer toward those for whom the negatives of inconvenience and a lack of liquidity are less important than is secrecy. And while a lot of the best people could fall into this category (Richard Stallman, etc.), there are a lot more of the worst sort of people, with a lot more reasons to participate in the system. And this latter piece is where they will come into most direct conflict with authorities, especially in this era.

Aside from these issues, there’s a structural difference between bitcoin and online credit card transactions that implies additional risk. Credit card transactions are representative of the transfer of money, while Bitcoin is built on the actual transfer of currency through the network. If Bitcoins are lost, it’s the same as cash being lost, but it lacks the tangible benefits of cash. If Bitcoins are lost or stolen (either literally or via non-performance), there is no recourse. Credit card transactions have significant recourse built in to the model, as several entities are responsible for tracking and confirming the transfer, and if one breaks, there are redundancies built into the system.

3. “Bitcoin is the most dangerous open-source project ever created.”

It’s basically toothless. Remember when Assange needed money and there was a cry to raise funds via Bitcoin? The project leader told them not to do it. Why? Because it’s inherently fragile and easily shut down. When you know that you really need cash, that currency needs to be liquid in the way that cash is. This is a structural problem with BC; that it wants to be cash, but it can never be liquid enough to fulfill that function well:

a. Its deflationary aspects and inherent instability in value need not be problems in other contexts, but being reliable enough as a transaction vehicle for external communities is a major issue here.

b. Governments don’t fear Bitcoin as a threat to national currencies. Truly they don’t, there’s no way it could scale to be a threat, either technically, or in desirability (are folks on the street crying out for new currencies to replace the $?) However, hidden transactions convertible to cash will be extremely concerning to them because of fears of terrorism, crime, and tax evasion. –At the very least, they will be inclined to shut down the system for the first reason.

4. “Bitcoin may be the most dangerous technological project since the internet itself.”

Dangerous in the sense that it could blow up and make a hideous mess?

5. “Bitcoin is a political statement by technotarians (technological libertarians).*”

Well, sort of. In a way it’s the modern version of the gold standard that Ron Paul adores. It’s mined and of fixed limited quantities. Hence it appeals to those who see the fractional reserve system as vile and corrupt.

6. “Bitcoins will change the world unless governments ban them with harsh penalties.”

As I mention above, conversion to dollars is an easy choke point, and, in addition,┬ánobody is saying that you can’t track who’s transacting via Bitcoins. Hence, while it could conceptually work for unaffiliated individuals to participate; an entity with anything to lose wouldn’t be likely to participate if any sort of legal rulings went against Bitcoin users and transactions.