ECON430-Topic #4: Bitcoin, Politics, and Devaluation

Bitcoin is the recent online-only addition to the world’s currencies. One of the main reasons there appears to be so much buzz about the virtual currency is that there is a definitive limited amount of the currency. Like gold, Bitcoin has a limited amount of currency ever available meaning prices of all goods are expected to fall over time. Unlike fiat currencies which have had increased in quantity over time and prices have risen.

As many countries attempt to devalue their currencies at once, we may be experiencing a race to the bottom. Countries trying to ease credit terms have increased their money supplies at relatively more rapid rates than before the financial crisis. While this might be inflationary in the long term, it hasn’t created inflation to date, nor has it raised inflation expectations among the general public. Is this general easing of credit conditions expected to stabilize markets which have suffered large price declines (e.g., housing) and allow for more labor market and credit market flexibility? Would this flexibility open up the economy to a more rapid recovery? Or should we simply allow the economy to take the necessary time to return to a healthy state? What role should fiscal policy play in this economic reconstruction if any?

Regulators in the U.S. are interested in understanding the transactions that take place using Bitcoin for a number of reasons. The “Silk Road” online marketplace was shut down and Bitcoin was the currency of choice for many otherwise illegal transactions. Iranians who have been unable to access dollars for international transactions in dollars have turned to Bitcoin to get access to otherwise embargoed goods. It is probably unlikely that Bitcoin is banned, since the transactions are private, but how much does this undermine government activities? Is it more likely than not that the government finds a way to regulate and tax transactions that take place in Bitcoin?

Finally, while Bitcoin is itself a currency that is limited in quantity, does this mean that someone couldn’t create a Bitcoin2? Or perhaps a Nioctib (Bitcoin spelled backwards)? As long as these alternative currencies were accepted couldn’t there be an infinite number of them? Would this undermine the ability to declare Bitcoin the end of government control of currency? Does this eliminate the credit created by banks, or do people demand credit in a way that Bitcoin cannot foreseeably provide?

There are a lot of questions I posed above, so pick one and go with it.

12 thoughts on “ECON430-Topic #4: Bitcoin, Politics, and Devaluation”

  1. Economist agree that Federal Reserve isolation from domestic politics is essential. Independence from political parties allows for less biases in decision making. In lieu of the recent recession monetary authorities are experimenting with unprecedented policies to stimulate growth in the economy. Although the Fed has pumped enormous amounts of liquidity into the market and have kept borrowing cost near zero, the economy has yet to pick up steam. It can be said that fiscal authorities are responsible for the lag in the economy’s performance. Washington’s inability to effectively govern and provide legislation, have altered and stalled fed policy making. Fiscal authorities are tasked with creating reforms and regulations to foster growth within the economy and the Fed is there to assuage any shocks. If the Fed cannot rely on successful governance then it cannot effectively conduct monetary policy. When central authorities are not decisive in their strategies they begin to lose credibility, drastically reducing the effectiveness of policies they enact. Loss of faith in the central banks’ ability to conduct policy, strips them of their capability to shape economic conditions. As fiscal authorities, their prime responsibility is to function efficiently and in harmony. Tensions between political factions and their inability to compromise makes central banking far more difficult.

  2. Bitcoin is constantly referred to as a decentralized currency. The developer, Satoshi Nakamoto, states that it, “allows payments from one party to another without going through a financial institution” [Nakamoto]. The idea of a decentralized currency is loosely defined and Bitcoin has mechanisms and elements that are very centralized and others that are discretionary in nature.
    At the surface, this seems to be true: Bitcoin is a finite peer to peer electronic currency that is governed by a set of mathematical algorithmic rules written into the software and all this functions without the intermediation of any central authority. The supply is capped at 210,000,000 Bitcoins (BTC) and BTC can be divisible 100,000,000 times into a unit known as a Satoshi. The rate at which new BTC are created is set to a benchmark algorithm: 10,5000,000 BTC were created in the first four years; every four years the amount introduced is reduced by one-half until the year 2140 when the cap is met. The BTC introduced are “mined”, or created, by verifying other Bitcoin transactions. The software algorithm changes the difficulty of mining Bitcoins to ensure the benchmark rate is met [Nakamoto].
    Upon closer inspection, there are centralized and discretionary mechanisms including:
    -The protocol of the software was introduced by a single pseudonymous developer
    -The transactions occur in an online ledger
    -Miners have the opportunity to gain market power through collusive behavior [Eyal and Sirer]
    -Verification proof-of-work disputes are settled by miners
    -The 5 key developers alone have the authority to determine if Bitcoin is broken and if action is necessary, giving them discretionary authority [Velde]
    Further, the identity of the nodes, or miners, can be anonymous, which leaves the possibility that the original developers can influence the market through this mechanism. All of this means that there is an inherent logical fallacies of the decentralized aspect of bitcoin.

  3. Sources:
    Bitcoin: A Peer-to-Peer Electronic Cash System. Satoshi Nakamoto. http://www.bitcoin.org.
    Bitcoinwiki
    Chicago Fed Letter. Bitcoin: A primer. Francois R. Velde, senior economist.
    Bitcoin is Broken. Posted on Monday November 04, 2013 at 10:30 AM by Ittay Eyal and Emin Gün Sirer.

  4. While Bitcoin is continuing to gain popularity, the digital currency seems unlikely to establish itself as a legitimate international currency. Silk Road, the online drug marketplace that only accepted payment in Bitcoin, was shut down by the FBI in October and its creator was arrested. On the day of his arrest, the value of Bitcoin fell 20 percent. Since October, a new Silk Road has been launched, in addition to numerous other black market sites. However, given the FBI’s focus on the original Silk Road, it seems probable that the federal government will continue to pursue action against these sites, which poses a threat to Bitcoin’s future.

    The federal government also has an interest in regulating Bitcoin due to its recent rise in popularity in Iran. The U.S. has placed sanctions on Iran aimed at crippling the country’s economy. Should Bitcoin prove to be an effective means of bypassing sanctions and allow terrorists to funnel resources into Iran, the U.S. and its allies are likely to pursue means to restrict and regulate the use of Bitcoin.

    There is also precedent for the government to shut down digital currencies. The U.S. Justice Department shutdown E-Gold, a digital currency based on gold, in relation to money-laundering activities in 2007. It appears that Bitcoin is currently and has the potential to continue being used for money-laundering. Regulators are likely to keep a watchful eye on Bitcoin and shut it down if it undermines national or international safety.

    Sources:
    http://www.bloomberg.com/news/2013-10-02/bitcoin-bets-feed-twitter-dreams-as-regulators-circle.html
    http://money.cnn.com/2013/11/06/technology/new-silk-road/
    http://money.cnn.com/2013/10/02/technology/silk-road-shut-down/index.html?iid=EL
    http://www.businessweek.com/articles/2012-11-29/dollar-less-iranians-discover-virtual-currency
    http://www.businessweek.com/articles/2013-10-02/silk-roads-demise-sinks-bitcoin-value-and-saves-bitcoins-reputation

  5. The case involving the “Silk Road” online marketplace is an interesting topic regarding Bitcoin’s potential future success. It has been proven after the fact that Bitcoin was the currency of choice in many illegal transactions whether it be drug or terrorist related. Although it is not likely that Bitcoin will be banned, the question arises if the currency can undermine government activities and regulations.

    Former Bitcoin core developer Alex Waters, successful “Bitcoin miner” Yifu Guo and former chairman for the New York Republican Party’s Finance Committee Matt Mellon are launching Coin Validation, a service for Bitcoin that is supposed to add regulation and ease government nerves. They plan on creating a database that allows Coin Validation to be the one-stop evaluation for law enforcement to determine the legitimacy of transactions. Mellon is quoted saying “Cash and credit cards are doomed. The future of payment is international and on the smartphone. I want to break this myth that Bitcoin is only associated with drug dealers and money launderers.” By easing government officials and potential Bitcoin users, the trio and other Bitcoin representatives hope to improve the overall image of Bitcoin.

    In a recent Forbes Article about Dread Pirate Roberts, the man behind Silk Road estimates about $30-45million in annual revenue. About 0.5% of Bitcoin’s total transactions were used to buy drugs. “Wikipedia claims that the illegal drug trade constitutes 1% of world GDP. Bitcoin seems to underindex to other payment mechanisms for buying drugs” (Liew 2013).

    I don’t believe Bitcoin is harmful or that it would lead to the undermining of government activities. If you compare it to normal international currency it still comes up as a lower percentage of total transactions. People are skeptical about the unknown and the term Bitcoin as an online currency scares uninformed citizens. Virtual money seems a lot easier to use for illegal activities but the numbers prove otherwise. The addition of regulations will ease the minds of government regulators as the slowly gain more incite to how the currency works. This increase attention to illegal activities via Bitcoin will deter potential harmful users that would have otherwise entered the system.

    Sources:
    http://lsvp.com/2013/08/15/about-half-a-percent-of-bitcoin-transactions-are-to-buy-drugs/
    http://www.forbes.com/sites/kashmirhill/2013/11/13/sanitizing-bitcoin-coin-validation/

  6. Bitcoin is a very interesting proposed solution to the supposed issues with the current monetary system. It does, however, share some similarities with the gold standard – a system that most economists agree is not a good idea. As was mentioned earlier in the thread and in the Bloomberg article, “The system Nakamoto designed caps the number of Bitcoins at 21 million.” (Bloomberg.com – Baker). The supply of bitcoins increases as nodes mine for the online currency. However, the system was designed so that all bitcoins will have been mined by 2140. There is a definite issue with this type of system. The most powerful part of the current monetary system is that institutions have the ability to manipulate liquidity if necessary. This was the major issue with the gold standard. When market conditions necessitated an increase in the money supply (as was the case with the Great Depression of the 1930s and the depression of the late nineteenth century), authorities did not have the power, or refused to use the power, to increase liquidity. They chose, rather, to preserve the gold standard. Changes in the money supply instead stemmed from changes in the supply of gold, which has no correlation to the systems need for liquidity. The same issue can be seen with bitcoin as current increases in the money supply is not tied to the markets need for liquidity at all. Not to mention that eventually there will be no further increases in the supply of bitcoin only leading to deflation of the currency as demand for it increases.

    Also, a large source of government funding is seigniorage or profits from printing money. According to the Federal Reserve, it costs about 5 cents to print one dollar bill. Thus, the government earns about $0.95 per dollar increase in the money supply. The US benefits most from seigniorage, as the dollar is currently the worlds reserve currency and accounts for 85% of forex transactions worldwide. This being said, the US is benefiting greatly from this seigniorage and would do whatever it could to ensure that this source of income does not disappear. If bitcoin emerges as a serious threat to the validity of the dollar, the US government would be quick to enact policy to hinder the use of bitcoin (much like it did to stop online gambling through poker sites – threatening legal action against credit card companies and banks involved in transactions with the gambling websites).

    http://www.princeton.edu/~achaney/tmve/wiki100k/docs/Cross_of_Gold_speech.html
    http://www.federalreserve.gov/boardDocs/speeches/2004/200403022/default.htm
    http://historymatters.gmu.edu/d/5354/
    http://www.federalreserve.gov/faqs/currency_12771.htm
    http://articles.economictimes.indiatimes.com/2013-10-16/news/43107179_1_reserve-currency-treasury-bonds-debt-ceiling
    http://online.wsj.com/news/articles/SB10001424052748703313304576132170181013248
    http://www.bloomberg.com/news/2013-10-02/bitcoin-bets-feed-twitter-dreams-as-regulators-circle.html

  7. While devaluing the nation’s currency should help exports and through that channel revitalize some sectors of the economy, the relative value of the currency matters. Thus, when all or many major countries are devaluing their currency, it really has little effect to help the economy. In some ways, it seems much like a prisoner’s dilemma. When you devalue your currency, you are not changing any real variables, just altering the exchange value of money, which induces more people to buy from you. Therefore, it might be better if all countries agreed not to influence their exchange rates and let them come to equilibrium naturally. This might actually lead to real recoveries in respective economies. The problem with this is that each country has an incentive to cheat. If they believe the other person is not going to alter the value of their currency, it is in their interest to devalue for some short terms gains. Unfortunately, this leads to the race to the bottom as was described in the Bloomberg article and seems to be playing out currently as “the G-20 participants agreed to ‘refrain from competitive devaluation’”. If they actually maintain that agreement will be another story.
    At this point, continuing LSAP’s in the US seems to pose more risks than benefits. It may be time to taper off and let the economy experience more real recoveries. If anything, one of the biggest hindrances to economic recovery is fiscal headwind. Uncertainty from fiscal legislation hurts the economy on both the producer and consumer side. Firms may not be willing to hire because they are unsure of the future costs of their employees due to uncertainty with healthcare legislation, while consumers are content to subsist on increased unemployment benefits. These situations create negative feedback loops where firms do not hire and consumers do not have the confidence to buy or vice versa. The best thing fiscal policy makers can do is set out a more certain policy path and allow the economy to adjust accordingly.

  8. The digital currency Bitcoin reached a fresh all-time high on Nov. 18, 2013 as it rose to $750, up 107 percent from the previous week (CNBC, 2013). These earnings coincide with uncertainty concerning possible government regulations on Bitcoin transactions. “Although the Fed monitors developments in virtual currencies, it does not have authority to directly regulate these innovations of the entities that provide them to the market” says Ben Bernanke. This may actually be a worrisome statement to those in favor of Bitcoin. Bobby Lee, CEO of the world’s largest Bitcoin exchange, states that the “industry is actually in support of government regulation”. Lee proposes that the government could help in clarifying necessary components of Bitcoin, such as licensing information, which would allow the virtual currency to become better known to the public.
    On August 12, the New York Department of Financial Services issued 22 subpoenas to Bitcoin businesses asking questions about their policies to prevent money laundering and their ability to provide consumer protection. It has been proposed by many that a system of public-private partnerships would need to be established in order to detect financial crimes and offer protection. The Bitcoin community and economy stands to gain if Senate regulation leads to clearer rules. Forecasters expect (if regulations are enforced) more jobs to be created, more tax money to be collect, customer funds will be protected, and the “public will benefit from a highly sophisticated and efficient value transfer system (USA Today, 2013)”.

  9. While there could theoretically be an infinite number of digital currencies comparable to Bitcoin so long as they are publicly accepted, the odds that an imitator comes along and experiences the same success and notoriety that Bitcoin has achieved over its short tenure of existence is unlikely until government regulations in regards to digital currencies are more strictly enumerated. The primary justification for this is the fact that Bitcoin is starting to face scrutiny from the private banking sector. Over the past few months, an increasing number of Bitcoin entrepreneurs are being declined bank accounts by several notable commercial banks including: Chase, Wells Fargo, Citibank, and US Bank (Forbes, 2013). While further growth and expansion with digital currencies could lead to the point where bank accounts with US dollars are unnecessary, today’s Bitcoin venture capitalists are having a more difficult time operating as banks continue to refuse their business. The biggest reason associated with Bitcoin’s refusal from banks is the risk that they associate with it. Despite the fact that Bitcoin is perceived by many of its investors to be very stable, outsiders see it differently as Kinnard Hockenhull (founder of Bitbox) stated that “saying Bitcoin in a bank is like yelling fire in a theater” (Forbes, 2013). Steve Kenneally, a VP at the American Bankers Association maintains that until policy makers establish rules for how to handle digital currencies, banks will avoid them in order to mitigate risk. So, until this occurs, the likelihood of a Bitcoin 2 is low as investors would have an equally difficult time getting started.
    Source: http://www.forbes.com/sites/kashmirhill/2013/11/15/bitcoin-companies-and-entrepreneurs-cant-get-bank-accounts/

  10. Although Bitcoin encompasses a few values in line with current society (virtual, high-speed, etc.) I highly doubt Bitcoin will be a successful currency. IF it does prove to be successful, I would disagree with Ryan and argue that it does have the potential ability to undermine both government and central bank. Not only can it be used for illegal transactions, such as the ones on Silk Road, it can also decrease the Central Bank’s credibility. “In October 2012, the European Central Bank released a report saying that central banks could become less influential if the public starts to doubt whether they control enough of the money supply to be effective (Bloomberg).” Bernanke acknowledged that the Federal Reserve does not have the authority to regulate Bitcoin (Bernanke). If enough people begin to use Bitcoin, it can seriously affect the Central Bank’s ability to affect the economy through monetary policy. Many economists agree that altering the money supply can create change in the economy in the short run. However, interest rates become unimportant if individuals begin utilizing Bitcoin as oppose to the dollar.

    Bitcoin also makes it significantly more feasible for firms who accept Bitcoin to escape taxes. As long as Bitcoin is not considered a form of currency, it is not subject to taxes. Thus Bitcoin makes avoiding taxes much more practical. Not only would this break on taxes significantly affect the United States current deficit, it would also force the U.S. to decrease spending. Regardless of an individuals political beliefs, it is understandable as to how the decrease in taxes would have negative affects on military spending and thus our performance in the current war. Tax evasion is not the only illegal problem that arises with Bitcoin. Due to it’s anonymity, individuals can also purchase illegal goods, such as drugs (previously available on Silk Road).

    Sources:
    Bernanke http://www.businessinsider.com/ben-bernanke-on-bitcoin-2013-11
    Bloomsberg http://www.bloomberg.com/quicktake/bitcoins/

  11. Bitcoin is an interesting revaluation over the past year or so. Overall due to the idea of currency only having power if their is belief behind it, Bitcoin has been able to obtain a following. This has allowed it to become a worldwide currency. The idea presented that bitcoin2 or some other or multiple other currencies could pop up is hard to fathom it working. Bitcoin is the first , although unofficial, international currency. If multiple currencies started popping up some would obviously fail, causing population belief to not fall in line with new currencies or existing ones. This would overall push people away from Bitcoin or other currencies of similar nature and back towards their local currency. If there is not an influx of other international currencies, it would seem that local government would lose control of transaction regulations and such , especially that not all Bitcoin has to be purchased it can also be produced by a person desiring to consume it. The possibility of creation of Bitcoin like alchemy and the it being used over the internet in private transactions, nations worldwide would have to come together to have any chance of putting regulations on such a commodity. Although most governments realize how high risk the new experimental currency is for consumers at this point. Along with that treasures have officially recognized it as a viable option currently being valued at $650 dollars per bit coin, but knows that if Bitcoin wants to stay a viable currency in larger economies like the United States it will need to find a way to follow some of the currency regulations involving anti-laundering and transaction records. The future outcome of Bitcoins effect on the economy is completely unknown, although some economists feel that it will help developing countries and speed up their development by being able to transfer funds , store money, and purchase goods when banks are just unavailable in the area. Bitcoin although with a very unsure future seems that it would be a great step forward towards the idea of a worldwide economy.

    http://www.usatoday.com/story/news/nation/2013/11/18/senate-holds-first-bitcoin-hearing/3628523/

  12. There is absolutely no reason that Bitcoin cannot be replace by some new form of currency. It is a mathematical algorithm that randomly awards 50 bitcoin to computers logged into its network for at certain specified time intervals. This is called “mining” for bitcoin. In effect computers are simply solving a complicated math problem. Another mathematically minded individual could develop another form of code that could is limited in quantity the same way that Bitcoin currently is. As long as people are willing to trade this new currency with a specific value attached to it then this alternative will be just as much currency as bitcoin. In fact China already has experience with a similar program called Q coin. Similarly, this online currency became a standard of trade in the Chinese black-market. The Chinese government quickly shut down the user-to-user payment transfer. This suggests that government can still exert control over the currency.
    http://www.policymic.com/articles/41349/bitcoin-price-2013-could-bitcoin-destroy-government-control-of-currency
    http://www.youtube.com/watch?v=yYTqvYqXRbY

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