Uncle Sam Takes a Bite Out of Bitcoin

Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of “The Up Side of Down: Why Failing Well Is the Key to Success.”
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News broke yesterday that the Federal Bureau of Investigation had arrested the proprietor of Silk Road, a Bitcoin-based market that seems to have been most widely used for the purchase of drugs and other contraband. The details are lurid and theatrical, including $150,000 that Silk Road's proprietor allegedly paid someone to murder a user who was blackmailing him:

DPR gave redandwhite the address of FriendlyChemist in British Columbia, and the indictment reports that redandwhite sent back photo evidence of the deed. But according to the indictment there is no indication the hit actually happened -- "Although I believe the foregoing exchange demonstrates DPR's intention to solicit a murder-for-hire," Tarbell wrote, "I have spoken with Canadian law enforcement authorities, who have no record of there being any Canadian resident with the name DPR passed to redandwhite as the target of the solicited murder-for-hire. Nor do they have any record of a homicide occurring in White Rock, British Columbia on or about March 31, 2013."

But that's not how the proprietor was caught; he was caught because he attached his e-mail address to the account that made the first mention of Silk Road online. It's a good lesson for folks on the Internet: Anonymity is really, really hard.

The question now is what happens to Bitcoin, the anonymous online currency that Silk Road relied on. It has been alleged that bitcoins are mostly useful for buying drugs on Silk Road (or presumably, similar successors), which raises the possibility that Silk Road's demise will spell doom for the digital currency. Jerry Brito of Mercatus, who has far and away the most useful primer on Bitcoin, has argued that Silk Road was too small a part of the Bitcoin economy to matter much. But he was relying on estimates that put Silk Road's revenues at around $24 million a year. The FBI's complaint says that the company actually posted $1.2 billion in sales between 2011 and 2013. Its revenues during that period totaled about 9.5 million bitcoins -- close to the number of the bitcoins in circulation (about 11.75 million).

Of course, that doesn't mean that Bitcoin has no other uses -- Wal-Mart's annual revenue of $440 billion is more than one-sixth of our money supply, but that doesn't mean that the dollar would collapse in value if Wal-Mart went out of business. What we need to know is what bitcoins are for -- why do users want to use them? If the answer is "to buy illicit goods, and otherwise evade the government," then yesterday's action dealt a serious blow to the currency. If users are mainly interested in other features, then this will be at most a temporary setback.

It probably helps first to ask "what are dollars for?" The monetary economist's answer is that they are a store of value, and a medium of exchange. Sometimes those functions are pretty closely tied -- a lump of gold was both a store of value and a medium of exchange in the 19th century, and so is a modern checking account with a debit card attached to it. Sometimes, they're pretty widely separated -- a physical bill is a very good medium of exchange, because it's easy to make and easy to carry, and a really lousy store of value, because it's easy to print too many, and easy to destroy the ones you've got. The rai stones of the Yap Islanders, by contrast, are great stores of value -- they're nearly impossible to destroy. But they're hard to carry around, and making change is a real chore.

In theory, Bitcoin could be a very good store of value and a very good medium of exchange. The number of bitcoins is limited -- eventually there will be 21 million bitcoins "mined," and then no more, ever, so the value can't be inflated away. And it's pretty easy to transfer bitcoins, or fractions of bitcoins, to other people without involving third-party payment networks that want to be paid for facilitating your transactions.

It's not clear how true these things will ever be in practice, however. The currency is easy to transfer, but not so easy to turn into real-world goods and services. And the value of bitcoins swings wildly against the government-backed currencies that most of us use every day, so you can turn your salary into bitcoins and then find out that it's suddenly lost as much as one-third of its value (as happened after the Silk Road bust was announced). Which in turn makes it harder to get businesses to accept it; most businesses try to hedge currency risk, not seek out more of it. If Bitcoin ever stabilizes, it may become an attractive alternative to Visa and Mastercard. But right now, most of the people who accept it seem to be doing so for quasi-ideological reasons, rather than because it makes business sense. Right now, this volatility is not a big problem for those people, because Bitcoin is not (usually) a big part of their sales. But if you have to pay your rent and taxes in dollars, you probably don't want a third of your sales coming in bitcoins.

So why would you choose bitcoins over one of the many other currencies that you could transact in? Here are the main ones that I've observed among Bitcoin fans:

Ideological and quasi-ideological reasons: People who like things that are quirky, offbeat and feel somehow "homemade." Folks who are highly committed to privacy. Or people who dislike anything controlled by the government on principle. For them, Bitcoin is the currency version of Esperanto. Problem: There are not enough of these people to make Bitcoin much more successful than Esperanto was. And they may lose interest when some other absorbing new project comes along.

Speculators: They think bitcoins will keep getting more valuable, so they buy them. There may well be enough of them to provide liquidity -- meaning that you can easily turn your bitcoins into some other currency, if nothing else. Problem: They cause the volatility that will make businesses reluctant to accept a lot of bitcoins.

Inflation hawks:They think that governments are going to inflate away the value of their savings in traditional currencies in order to finance big fiscal gaps. Because only a limited number of bitcoins can ever be created, they view it as a better store of value than dollar- or euro- or yen-denominated investments. Problem: These people also aren't that numerous. There are a lot of them in Internet chat rooms, but not so many compared with the masses who keep their money in banks. Also, they may get tired of an investment that doesn't lose money, but also can't be invested in much of anything that makes money.

Tax cheats, drug dealers and other people trying to hide from the government: We haven't talked much about Bitcoin's anonymity, but that is, of course, one of the main competitive advantages that Bitcoin has over a bank account. In the minds of many of Bitcoin's supporters, that made it a superior substitute for physical cash -- all the anonymity, without needing a gym bag to carry the stuff around. This is most useful for people who want to hide their transactions from the law.

Problem: Though I hesitate to disagree with Jerry Brito, who has spent a lot more time thinking about Bitcoin than I have, it does seem to me that this is the primary competitive advantage of the currency -- a supposition that seems to be backed up by the extraordinary volume of business being done by Silk Road. Earlier this year, I explained at length why I do not think that comparative advantage will prove very durable:

Remember how online gambling was finally going to let Americans evade the absurd US gambling laws? For a while it did. And then Congress sat on the banks and the credit card providers until they agreed not to process those transactions. You could still gamble online, but you couldn't get paid, which basically killed the US business. You could name half a dozen other examples of technologies which failed to provide a real alternative to currency.

Some of those "technologies" are pretty low tech. Bitcoins are essentially electronic bearer bonds. Readers of 1930s-era thrillers will remember that these often figured heavily in the plot: bonds which paid out to whoever happened to be physically holding the bond. These were very useful for refugees, tax dodgers, and criminals, and anyone else who wanted to keep the government's eyes off their finances.

But the usefulness of bearer bonds became a problem. If your bearer bond was destroyed, you had no recourse. They also turned out to be very useful to steal, since the original owner had no way to prove their property rights. And indeed, one source alleges that about 10 percent of Bitcoins have been stolen at some point.

Even worse, governments found a way to shut down the issuance. In fact, this proved surprisingly easy: the US government simply announced that interest payments on bearer bonds would no longer be tax deductible. And voila, no one in this country wanted to issue bearer bonds any more.

All of which is to say that the government can destroy much of the value of your Bitcoins simply by making it hard to exchange them in the real economy. For Bitcoins to be really useful, it must be possible for them to be exchanged for other currencies at a fairly stable exchange rate. For now this is impossible simply because the price of Bitcoins gyrates so wildly. But say that things settle down in the Bitcoin market; you've still got a big problem. Efficiently exchanging them for other currencies implies a physical nexus somewhere: a moneychanger, a central exchange. That physical nexus is vulnerable. Servers or piles of cash can be seized. If the local government turns a blind eye, shipments in and out of that country can be blocked.

Look at tax havens, which are starting to cave under pressure from countries with stricter banking laws. This has been a bit of a surprise, given that in many places, selling secret bank accounts is basically the entire economy. But under examination, it makes sense: bank secrecy laws don't do you much good if other countries have banded together to make it impossible to transfer money into or out of your country.
On net, the digital era has made it easier, not harder, for governments to control the finances of their citizens. Why don't we already have an easy, anonymous way to transfer cash? Is it that no one has tried to think of one? No. Is it that such a thing is technically impossible? God no: Bitcoin proves that. So do hawala networks.

The reason it hasn't happened is that governments can fairly easily prevent those transfers from entering the traditional banking and credit networks, which means that for most people, such a technology would be basically worthless. And the more we shift away from physical cash, the harder it gets to transform your Bitcoins into currency. If you start making sizeable deposits of cash, and you don't run a convenience store, a nice lawman will eventually show up at your door and ask you where all that money is coming from.

And voila, it turns out that the FBI found out where the Silk Road server was located, then got the government in that country to help it set up a server to mirror the one at Silk Road. This gave them access to all Silk Road's transactions ... at which point it turned out that the anonymity of Bitcoin had been oversold. Not by smart analysts like Brito, who pointed this out long ago, but by naïve users. The public record of Bitcoin transactions that allows their owners to bypass payment networks also makes it possible to track the activity of Bitcoin users as they buy and sell.

The FBI has exposed another weakness that no one, as far as I can tell, has been talking about; it seems to have seized all of the servers, which means that they have all of the bitcoins. Now, maybe they'll cash those bitcoins out and, I don't know, apply them to the budget deficit. But maybe they'll just sit on them. Which is basically the same as destroying them (something that can also happen to bitcoins, if you don't have a backup.)

For people who are using bitcoins as a store of value, that's great. But for a potential Bitcoin economy, that's a problem. If governments simply take the Bitcoin wallets and warehouse them (or destroy them) every time they bust an illegal Bitcoin site, they will essentially be running the monetary policy for the Bitcoin economy -- a dramatically contractionary monetary policy.

At first blush, this may seem great for folks who are using Bitcoins as a store of value; every time a bunch of bitcoins are destroyed, the remaining ones become more valuable. Whoever wrote the link above doesn't seem to think that this is a big deal; just redenominate into micro-bitcoins and move on.

But if you are trying to get your currency adopted as a medium of exchange, as well as a store of value, this is actually a big problem. It's no good if most of your users are simply sitting on their bitcoins, waiting for them to get more valuable; people who want to trade in bitcoins will find them harder to come by. And this, in turn, will retard their adoption by the legitimate merchants whom you need to make this an actually valuable currency, rather than a short-lived way to buy drugs and evade capital controls in your country.

Yes, I understand that not everyone who uses Bitcoin does so for illegal purposes. But if the illegal users are even a significant minority, governments will be looking for ways to curtail their use -- and given all the ways they have to make things difficult, I'm pretty sure they'll succeed. Most of the people who buy Sudafed are probably not looking to cook meth. But I still can't buy it without trekking down to the drugstore and presenting a driver's license.

Which is why, as I said before, I don't like the long-term prospects for Bitcoin. I certainly wish its supporters luck. But in the long run, I'm betting on Uncle Sam.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Megan McArdle at mmcardle3@bloomberg.net