Friday, July 1, 2011

Why Bitcoin Will Be the Last Refuge of the Wealthy

Things are looking grim.  It seems as if these days, practically the whole world is drowning in a deluge of debt, brought on in large part by the excessively loose monetary policy of the United States' Federal Reserve System, the manager of the world's primary reserve currency, the US dollar.

The Euro is in trouble as well.  Bond market bookmakers are giving Greece about an 80% chance of default, with the solvency of other several other nations in Europe standing all lined up and ready to topple like dominoes if Greece's debt goes bad.  Even if these countries don't default right away, the problem will just recur in another year or two.

And what is especially frightening is that the United States itself, whose sovereign currency is supposedly the last bastion of safety, seems politically paralyzed and unable to resolve differences between raising revenue vs. decreasing spending.  Congress seems determined to play chicken with the debt ceiling until the last possible moment, and perhaps longer.  As a result, there seems to be a not-insignificant possibility the United States may actually default on its debt, in some sense, when the current round of 3-month Treasury bills matures in August - either by delaying interest payments, or perhaps (I wonder?) by firing up the presses for old-fashioned greenbacks (United States Notes, still legal tender!) to retire some of this debt at the cost of directly inflating the base money supply, thus debasing the currency.  Either one of these actions would probably be considered a technical default by international investors, and so the value of the dollar will collapse as a result, as they start fleeing from Treasuries in search of safer investments.  (Standard & Poors has threatened to cut the US credit rating to "D" if Congress doesn't raise the debt ceiling.)

The underlying cause of the problem can perhaps be traced back to an excessive power held by the Fed to inflate the money supply through fractional-reserve lending practices, which are no longer (since 1971) tied down to the gold standard.  As a result, in recent decades, vast amounts of liquidity were created willy-nilly and tossed around foolishly to make all kinds of sub-prime consumer loans (and other bad investments) that greatly enriched the financial industry with fees and bonuses.  By 2008, enough of the Fed's loans into the US financial system had gone bad that it was, itself, essentially bankrupt, which is why it then had to come running to Congress for a bailout.  Of course, through the magic of fractional-reserve lending, that little $700 billion loan from the taxpayers morphed, in the Fed's hands, into 10x as much ($7 trillion worth) of ability to spin new liquidity out of thin air.  This money promptly went out, hundreds of billions of dollars of it at a time, to the Fed's best buddies, the major US banks, to enable them to soak up Treasuries and sit on them, earning interest from the US taxpayers to help the banks lick their self-inflicted wounds.  This went beautifully as far as rescuing the banks was concerned, but it arguably did dick-all to jump-start the US's real economy.

Furthermore, the real economy itself (both US and global) is arguably nearing the end of a major long-term bubble caused by the excessively rapid industrial expansion of the last 50 or 60 years (fueled, again, by loose money from the Fed).  Global rates of "production" (i.e., development and harnessing) of many basic natural resources (oil, fresh water, arable land) is leveling off and is becoming unable to meet projected demand growth.  Meanwhile, the effects of pollution are beginning to destabilize the natural order of the oceans and atmosphere, with runoff from agricultural fertilizer creating offshore dead zones, CO2-acidified surface waters bleaching corals and interfering with the marine food chain, and, of course, the climate is increasingly becoming destabilized by an excess of greenhouse gases which, by basic physics, upset the radiation balance between the Sun and Earth's surface.

Due to the combination of all these effects and more, ecologists have estimated that in terms of global rates of consumption, we are already at least 50% above Earth's sustainable carrying capacity over the medium to long term (50-100+ years).  A major correction to the size of the global economy (and possibly also population) is therefore inevitable sooner or later, and probably sooner (possibly starting in as little as the next 5-10 years, or I'd guess at most 20-30) if the recent rate of acceleration of the severity of these various problems is any indication.  When the resource crisis hits in earnest, and people start to become truly desperate, the streets will fill with angry crowds, and governments all over the world will start dropping like flies, or else will take extreme measures to hold onto power.  The so-called "Arab spring" in the Mideast and Northern Africa is a sneak preview, due in part to the fact that these countries have been affected more than most by the inflation of food prices on the world market.

What happens when a major revolution and/or government crackdown begins in the US?  Even if we will have managed to avoid default and continue propping up our currency until then, the government eventually can be expected to start taking extreme measures to redirect resource allocation in a way that will help it stay in power (i.e. towards food assistance to starving people, and/or to crowd control by force).  High taxes and/or high inflation will siphon vast amounts of money away from the nation's wealthy to pay for such programs.  As the value of the dollar falls, or as assets are seized, most individuals' personal life savings (those who have managed to avoid bankruptcy) will get largely wiped out.

Many people will naturally try to protect their assets by converting their wealth to portable forms of "hard currency," such as gold.  But this is doomed to backfire.  During the last major economic crisis, the Great Depression, the US government (in 1933) simply seized all the gold being held by private individuals, and used it to replenish the government's reserves, which were (at that time) backing the dollar on international markets.  It remained illegal for individual Americans to own any gold (apart from a few exceptions such as jewelry or dental fillings) until 1974.  You might have a plan to flee the US if it looked like this was going to happen again, but the same thing could in principle occur in any country - or your gold could just be seized at the border.

As a result of these troubling risks, one of the reasons that many people find Bitcoin to be particularly attractive is that it provides a way that personal wealth can theoretically be totally protected from hyperinflation or seizure by any central authority.  Let's discuss how this works.

First, protection from hyperinflation:  Unlike existing fiat currencies, the base supply of Bitcoins (by the very nature of its peer-to-peer protocol) can never be inflated beyond a predetermined slow and decelerating rate of growth, which approaches a limit of 21 million BTC gradually over the coming decades.  New Bitcoins in excess of this predetermined growth schedule simply cannot be created.  Therefore, Bitcoin could serve as the most stable, reliable base currency for a global monetary reserve system that the world has ever seen - better than gold even, since the gold supply could increase unpredictably if large new deposits were discovered, and plus, gold is heavy and is difficult to transport and to appraise (especially from a distance).  In contrast, Bitcoins can be instantly transmitted over the Internet, and can be easily verified by anyone, anywhere.

Second, protection from seizure:  Perhaps the most secure way to protect one's Bitcoins is to stash your digital "wallet" (which contains your Bitcoin ownership credentials) into a file that is hidden undetectably within an encrypted volume, a file that only you know the passphrase to unlock.  This can be done using any of a variety of free open-source encryption tools, such as TrueCrypt.  (Even if you were tortured for your password, you could plausibly deny that the hidden file that contains the majority of your coins even exists.)

After creating this encrypted digital "safe" to hold your wallet, you can then, to prevent your Bitcoins from being lost or kept away from you, upload numerous backup copies of your safe into the "cloud," i.e., into various online backup services and/or anonymous file-sharing networks.  You can even put a few copies of your safe onto USB thumb drives that you bury in locations in the woods that only you know about.  No matter how chaotic things may get in the world, as long as you can find your way to some copy of your digital safe, and you still remember your passphrase, and the Bitcoin network itself is still operating, then you can access and spend your coins.

Even if the Internet itself is someday shut off by a government "kill switch" or a power outage, you could have a grassroots person-to-person network of Bitcoin users who personally meet face-to-face and exchange thumb drives containing transaction data, and in this way, the free flow of information that powers the Bitcoin peer-to-peer network could continue to take place - even in the total absence of the Internet!

In contrast, no other investment is as safe.  Land can be seized by governments.  Even if you stock up on weapons and ammo to protect your property, those too can be defeated and taken away by a superior force.  But, no amount of force can make you reveal the passphrase to your largest secret personal stash of Bitcoins, tucked away in a hidden, encrypted, backed-up wallet that only you are aware that you even own.

Therefore, as a result of the above points, I think there is a very compelling argument to be made that Bitcoin is in fact the safest place to store wealth long-term, and it holds the additional promise that as more and more people come to understand and appreciate this fact, and the popularity of Bitcoin grows, Bitcoins purchased today will continue to appreciate in value.  This is why I would advise everyone (especially those who have a lot to lose) to invest a significant fraction of their total liquid wealth in the form of raw Bitcoins, or at least in Bitcoin-denominated instruments.

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