Crypto-currencies and the Fate of the Dollar

At various times in history, feathers have been money, shells have been money, dollars and euros are money. Gold and silver are certainly money. Bitcoin and other crypto-currencies can also be money.

People say some forms of money, such as Bitcoin or U.S. dollars, are not backed by anything.

But that’s not true. They are backed by one thing: confidence. If you and I have confidence that something is money and we agree that it’s money, then it’s money. I can call something money, but if nobody else in the world wants it, then it’s not money. The same applies to gold, dollars and crypto-currencies.

Governments have an edge here because they make you pay taxes in their money. Put another way, governments essentially create an artificial use case for their own forms of paper money by threatening people with punishment if they do not pay taxes denominated in the government’s own fiat currency. The dollar has a monopoly as legal tender for the payment of U.S. taxes.

According to John Maynard Keynes and many other economists, it is that ability of state power to coerce tax payments in a specified currency that gives a currency its intrinsic value. This theory of money boils down to saying we value dollars only because we must use them to pay our taxes — otherwise we go to jail.

So-called crypto-currencies such as Bitcoin have two main features in common. The first is that they are not issued or regulated by any central bank or single regulatory authority. They are created in accordance with certain computer algorithms and are issued and transferred through a distributed processing network using open source code.

Any particular computer server hosting a crypto-currency ledger or register could be destroyed, but the existence of the currency would continue to reside on other servers all over the world and could quickly be replicated. It is impossible to destroy a crypto-currency by attacking any single node or group of nodes.

The second feature in common is encryption, which gives rise to the “crypto” part of the name. It is possible to observe transactions taking place in the so-called block chain, which is a master register of all currency units and transactions. But, the identity of the transacting parties is hidden behind what is believed to be an unbreakable code. Only the transacting parties have the keys needed to decode the information in the block chain in such a way as to obtain use and possession of the currency.

This does not mean that crypto-currencies are fail-safe. Large amounts of crypto-currency units have been lost by those who entrusted them to certain unregulated Bitcoin “banks” and “exchanges.” Others have been lost to old-fashioned fraud. Some units have been lost because personal hardware holding encryption keys or “digital wallets” has been destroyed. But on the whole, the system works reasonably well and is growing rapidly for both legitimate and illegitimate transactions.

It’s worth pointing out that the U.S. dollar is also a digital crypto-currency for all intents and purposes. It’s just that dollars are issued by a central bank, the Federal Reserve, while Bitcoin is issued privately. While we may keep a few paper dollars in our wallets from time to time, the vast majority of dollar denominated transactions, whether in currency or securities form, are conducted digitally.

We pay bills online, pay for purchases via credit card, and receive direct deposits to our bank accounts all digitally. These transactions are all encrypted using the same coding techniques as Bitcoin.

The difference is that ownership of our digital dollars is known to certain trusted counterparties such as our banks, brokers and credit card companies, whereas ownership of Bitcoin is known only to the user and is hidden behind the block chain code.

Bitcoin and other crypto-currencies present certain challenges to the existing system. One problem is that the value of a Bitcoin is not constant in terms of U.S. dollars. In fact, that value has been quite volatile, fluctuating between $100 and $1,100 over the past few years. It’s currently around $575.

It’s true that dollars fluctuate in value relative to other currencies such as the euro. But those changes are typically measured in fractions of pennies, not jumps of $100 per day.

This gives rise to tax problems. For example, if you acquire a Bitcoin for $200 and later exchange it for $1000 of good or serveries, you have an $800 gain on the purchase and sale of the Bitcoin itself. From the perspective of the IRS, this gain is no different than if you had purchased a share of stock for $200 and later sold it for $1000. You have to report the $800 as a capital gain.

It seems unlikely that most Bitcoin users have been reporting these gains. Those who do not may be involved in tax evasion. The IRS has broad powers to investigate evasion, and may require counterparties to reveal information, including computer keys, which can lead to discovery of the transacting parties. Given the fact that the IRS has engaged in selective enforcement against Tea Party activists and other political opponents in recent years, this is a serious potential problem for libertarian users of Bitcoin.

One potential solution to the Bitcoin volatility problem I find interesting is to link bitcoin to gold at a fixed rate. This would require consensus in the bitcoin community and a sponsor willing to make a market in physical gold at the agreed value in bitcoin. This kind of gold-backed bitcoin might even give the dollar a run for its money as a reserve currency, especially if it were supported by gold powers such as Russia and China who are looking for ways out of the current system of dollar hegemony.

Another problem is that Bitcoin and the other crypto-currencies have not survived a complete business and credit cycle yet. Bitcoin, the first crypto-currency, was invented in 2009. The global economy has been in a weak expansion since then, but has not experienced a financial panic or technical recession.

Investors have some experience with how stocks, bonds, gold and other asset classes might perform in a downturn, but we have no experience with Bitcoin. Will liquidity dry up and prices plunge? Or will investors consider it a safe harbor, which will lead to price increases? We don’t know the answer.

I believe Bitcoin and its crypto cousins represent an opportunity. It is still too early for investors to hold in their portfolios due to excessive volatility and unresolved tax issues. But the time may come, sooner than later, when some Bitcoin technology companies might warrant investor interest based on their possible role in the future of payments and in other forms of wealth transfer. Companies such as Western Union and PayPal dominate the private payments systems space today. They may have company from crypto-currency start-ups soon.

One of the things I like about gold is it’s not digital, it doesn’t depend on the internet, it doesn’t depend on the power grid. It has intrinsic value independent of those things. Bitcoin does not.

If the power grid goes down, your Bitcoins are worthless. I’m not anti-Bitcoin, but physical gold does not have the disabilities of Bitcoin and digital currencies like the U.S. dollar.

Regards,

Jim Rickards
for The Daily Reckoning

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