Wednesday, July 23, 2014

Technology is Liberty, Part III: Bitcoin

In Part I of this series we discussed the need to increase our choices in order to have more liberty. In Part II we went over historical examples of liberty-enhancing technologies. This third part will focus on what I believe is the most significant technology for anyone who wants to have more liberty: Bitcoin. I submit that the best way to truly understand the implications of Bitcoin is to first understand money and the history behind it.

The History of Money*



Money was invented to facilitate trade. It's difficult to have a lot of trade (and therefore, increased wealth) without money. An economy without money is called a barter economy. The difficulty involved with a barter economy can be illustrated with an example: Imagine that you have an apple orchard. Obviously you can't just live on apples forever so you use your apples to trade for other goods. Let's say that you want wheat. Here's where the problem comes in. You need to find someone who has wheat and who also wants to trade it for apples. You might never find that person. And even if you did, for the trade to work, the apples and the wheat both have to be picked/harvested and available at the same time and at the same place. These are difficult barriers to overcome without the tool that we call money.



Money allows people to sell their goods and services without having to instantly exchange it for another good or service. The value of the good or service that was sold becomes stored in the money for a time. At a later time and place the person who sold the good or service can use the value that is stored in their money and exchange it for another good or service that they choose. Money is a medium of exchange.

What can be used as money? Potentially anything. That may surprise you, but literally anything can be used. Of course, some things make better money than other things. If you take a look at all of recorded history you will find that there has been a general consensus of what makes the best money. That would be precious metals, especially gold and silver. Gold, along with other precious metals, has properties that make it useful as money. Pure gold is the same everywhere you go, a particular amount of it will weigh the same no matter where you are on Earth, you can divide it or combine it into any size (e.g. coins or bars), you can't create it out of something else, and there is a limited amount of it so that its value is relatively stable. All these qualities make gold, and other precious metals, desirable as money. This led to communities and societies throughout history adopting precious metals, especially gold and silver, as money, or a medium of exchange.


So why don't we all carry around a bunch of gold and use it as money today? Excellent question. It's actually for the same reason you don't store your entire life savings in your wallet or at your house. People discovered that it's not exactly safe to carry all their gold around with them all the time, or even store it all at their house. Additionally, it can be inconvenient to haul gold everywhere to purchase things. That's where banks entered the picture. Banks offered the service of storing people's gold for a small fee and guarding it with more security than most individuals could afford. When someone stored their gold at a bank, the bank gave that person a certificate to represent their gold with which they could later redeem their gold. It's much easier to keep paper safe than it is to keep a bunch of gold safe. This led to people using their gold certificates as a money substitute instead of the actual money - their gold! People could safely and conveniently exchange gold certificates for goods and services and the new owner of any particular certificate could either trade it in the same way or redeem it for the gold. This is how paper money, or currencies, started.




At some point the banks realized something. They realized that, with all their gold deposits sitting around in a vault, they had money to loan out to people and charge interest on. But, since people felt comfortable with paper currency that represented the gold, the banks actually loaned out currency instead of loaning out the gold. Why let gold out of your sight when you can just give out paper instead? This created a phenomenon that affects everyone, including you, in more ways than you can imagine. Additionally, it would be very unlikely for all the bank's clients to all need their gold at the same time, so the banks started scheming. The banks figured out that they could loan out a lot of currency - so much, in fact, that the combined total of all the gold represented by the currency was often more than the actual gold that existed in the vault! They were printing out the equivalent of gold, using just paper and ink, and they were charging interest on it! Thus was born the greatest fraud in human history.

Governments have been aware of the currency printing done by the banks for a long time. In fact, governments have been using it to their advantage, probably as long as the banks have been doing it. Many times throughout history, governments have effectively nationalized the banks, encouraged or mandated the use of paper currencies over actual money (i.e. gold), and outlawed the redemption of currencies for gold. Currencies in this situation are called fiat currencies and are typically issued by a central bank that has a charter from the government. A fiat currency allows a government to have an overwhelming amount of control over the economy. It enables a government to manipulate the supply and value of the currency in order to transfer wealth to itself (and its cronies) to accomplish its objectives. Those objectives usually include consolidating power and making war. This leads to insane amounts of public debt and, therefore, the currency printing game cannot be played forever. Fiat currencies have a long history of failing and losing all their value. This is mostly due to governments overprinting, devaluing, and otherwise manipulating those currencies into extinction. Today we are in a unique situation where all the world's fiat currencies are primarily backed by the US Dollar, another fiat currency. What happens when the value of the US Dollar falls to zero? A lot of people encourage everyone to buy gold as a hedge against inflation and as a store of value to prepare for the collapse of the world's monetary system. I don't necessarily have a problem with that, but, since using gold as money started this mess in the first place, buying up a bunch of gold doesn't exactly solve the problems of traditional banking practices and economically manipulative governments. So how do we solve the underlying problems? Enter Bitcoin†.




What is Bitcoin?

When it comes to Bitcoin, there is always more to learn. I urge you to read as much as you can from various sources, but I will attempt to make a brief description here. Bitcoin is the world's first and foremost decentralized digital currency. It is decentralized as there is no single organization that distributes the currency, makes it possible, or backs it up in any way. It is based on the peer-to-peer networking that we discussed in the previous post. In this way, the Bitcoin protocol runs on thousands of computers all over the world. Bitcoin is completely digital as it does not exist in any physical form. You can't hold a bitcoin‡ in your hand and you actually can't even identify a computer file as a bitcoin. When you own bitcoins, you actually control a Bitcoin address that has a positive balance in it. Bitcoins only exist as these balances, and all the amounts in all the addresses are recorded in a public ledger called the block chain. Each computer running the Bitcoin protocol has this block chain available to it in order to know which addresses have balances in them. When an owner of any amount of bitcoins wants to make a transaction, that owner, using the private key to his address known only to him, broadcasts the transaction information to the network and eventually the entire network verifies that the transaction took place. In this fashion the block chain is a continuous record of all Bitcoin transactions. Bitcoin is used as a currency because people attach value to it as a useful payment system. It truly does not matter that it's not backed by any physical commodity. Nothing has intrinsic value in and of itself. Things have value only because people agree that they do. And thus, we have a commodity that can be used as money without having to trust anyone or anything.


Freedom from Third Parties

Since Bitcoin gives you the ability to control your own money, without the need for trust in a third party, banks and other financial institutions are not really necessary, at least not in their current forms. You don't need a savings account with a bank if you can keep your bitcoins safe on your own. You don't need a checking account or a debit card with a bank if you can send bitcoins to whoever you want in an instant, using your computer or phone. You don't need money transfer services like Western Union for the same reason. You don't need financial middle men for you to invest or borrow bitcoins if there are services that directly connect lenders and borrowers. The elimination of so many extra steps that get in the way of economic exchange creates a nearly frictionless economy. This frees up an enormous amount of wealth that allows individuals to do more of whatever they want to do. More choices equate to more liberty.

Additionally, think of the 2.5 billion people who still do not have access to traditional banking services due to the difficulty in satisfying the (sometimes arbitrary) requirements of banks. Such people can hardly participate in the market beyond their immediate communities. They have much to offer but little ability to connect to the worldwide economy. And I am not just talking about people in third-world countries. According to the World Bank, 11% of people in high-income economies do not have an account at a financial institution. I believe that Bitcoin will make the biggest difference for these "un-banked" people. With Bitcoin it is suddenly possible for virtually everyone, in every place with an internet connection, to fully engage with the global marketplace. I want as many people as possible to do so because, the more economic actors there are, the more everybody wins!

Remember how banks tend to loan out more money than they actually have in deposits? That is called fractional reserve banking and it happens even without any government interference. The most significant effect of fractional reserve banking is an increase in the currency supply, causing inflation and diminishing your wealth. Since, in most cases, people are comfortable with paper currency as a substitute for actual money, they don't question the currency. This can lead to big problems. Let's use an example. Let's say a bank has a reserve requirement of 10%. That means the bank has to keep at least 10% of its deposits "in the vault", so to speak, in case some people want to withdraw their deposits. If one person deposits $100 into that bank, the bank can loan out $90, even though the depositor's account will still say "$100". This seemingly magical process can be repeated until that $100 turns into $1,000. Reserve requirements vary, but sometimes they can be as low as 3%, or even 0%. As you can see, when banks act as a third party to handle your money, they can drastically expand the currency supply, diluting the wealth you thought you had. 


Source


Bitcoin changes everything. The original reasons that people desired paper currency instead of real money were safety and convenience. With Bitcoin, those reasons mostly go away. With the proper tools, you can safely and conveniently store and spend your bitcoins without having to use a third party. Essentially you could say that, with Bitcoin, the demand for money substitutes (i.e. currency) will probably drop a substantial amount. Without fractional reserve banking, your bitcoins will most likely be a good store of value over the long-term, free from the deleterious effects of an inflating currency supply.

Freedom from Central Banks





You will remember that a central bank has a charter from the government and has the authority to issue the "official" fiat currency of that government. A central bank can potentially use its power to inflate the currency supply to an unhealthy amount, in addition to what the banks already do by themselves. This has been happening on an unprecedented scale here in the United States as the Federal Reserve has been printing trillions of new dollars. Just like fractional reserve banking, this has the unfortunate effect of lowering the value of all the dollars already in existence. That means that the bank accounts of people like you and me decrease in value, even though the actual amounts of dollars in our bank accounts remain unchanged. This phenomenon is called inflation. Not only does inflation raise prices, but it destroys wealth by transferring it to the politically well-connected, and it even has the potential to destroy the economy.





Not only does currency printing lower the value of our dollars, but it also creates mayhem in the economy. When a central bank creates more currency out of thin air, it becomes much cheaper to borrow that currency (interest rates are lowered). With so much cheap currency available, businesses invest in the higher order stages of production, or rather, processes that are not projected to create a return on investment for a very long time. Those investments by themselves are just fine, but in cases of central bank intervention, the borrowing that takes place to fund those investments is not matched by the real savings of people in the economy. This situation creates an unsustainable market where businesses and consumers are competing to use the same resources. The businesses want the resources to finish their projects. The consumers want the resources to satisfy their demand for goods and services because they're choosing to spend instead of save (that's why the central bank felt the need to increase the currency supply in the first place)§. Such a competition raises prices for everyone and eventually the result is an abundance of failed business investments and an economic recession. This is where general booms and busts come from. For any economic nerds out there, I have just described the Austrian business cycle theory.

Now imagine a world where most people have adopted Bitcoin as money and most transactions are in bitcoins instead of dollars or other fiat currencies. Can a central bank simply print bitcoins so that the government can offer free stuff to the masses or transfer wealth to its cronies? No! Bitcoins are a finite resource that cannot be counterfeited. No central bank will ever be able to inflate the number of bitcoins in order to transfer your wealth. A government-chartered central bank could always print "official" government currency if it wanted to, but if people don't value that currency, it won't do a government any good at all. 

Freedom from Government





Where does the government get its funding? Taxation, which I view as nothing more than theft. That is a problem that limits our liberty. How does the government manage to compel payment from most people and businesses?  By using banks and other financial institutions. The government can easily identify and target financial institutions within its borders. The government constantly demands all sorts of documents from these institutions so it can always know how much currency and assets everyone has. This makes it very difficult to avoid paying taxes because all the organizations who we let handle our financial affairs are constantly selling us out.


Bitcoin allows people to have complete control over their money. No financial institutions are required in order for someone to execute a transaction, take out or make a loan, or fund a business venture. You can think of it as password-protected cash that you can send anywhere in the world instantly. If Bitcoin usage continues to expand (and I suspect that it will), the government will have an increasingly difficult time tracking down everyone's money in order to extort them. It is true that Bitcoin, by itself, is not anonymous. Remember that all transactions are constantly being broadcast to the entire Bitcoin network. However, because of the decentralized nature of Bitcoin, a unique investigation would be required to track down just one person's money. That is extremely more difficult than simply grabbing all the records from all the licensed financial institutions and instantly finding the assets of millions of individuals.

Even though Bitcoin itself is only pseudonymous, there are tools currently being developed that can completely anonymize all transactions. Dark Wallet is such a tool. Dark Wallet utilizes things like stealth addresses and coinjoin processes in order to make it basically impossible to track where bitcoins are sent. I'm not a programmer, so I can't completely explain what's involved, but ultimately, Bitcoin is programmable money, and people can program faster than government agencies can react. What will happen when a critical mass of individuals realize that they can safely hide their money from the IRS? Only time will tell. When dollars become worthless and the Federal Reserve can't print currency to transfer wealth anymore, there is absolutely nothing the government will be able to do to fund its operations without either producing themselves or directly and physically threatening its victims. The former is laughable (whoever heard of a government that actually produced anything?) but the latter is certainly possible. But, even if the government resorts to such violent behavior, it will only reveal itself to be the illegitimate and coercive organization that it actually is.

More Choices

With Bitcoin, we can make more choices that bypass unnecessary steps, and we can make more choices that avoid violent interference from others. In this way, it liberates people. Digital money that can be transferred instantly and anonymously, and the block chain technology behind it, creates the groundwork for countless new possibilities that deserve to be explored. 

Next: What can Bitcoin do for Me?


*To educate yourself further on money, what it is, and how it works, I highly recommend the YouTube series, "Hidden Secrets of Money". 

†Bitcoin is the world's first cryptocurrency but there are others that exist that could potentially supplant Bitcoin as the leading cryptocurrency and help people in all the same ways that I believe Bitcoin can help people.

‡You might notice that I sometimes capitalize "Bitcoin" and sometimes I don't. The Bitcoin protocol, or the general idea of Bitcoin, is always capitalized. The actual units of money, called bitcoins, are not capitalized, except for at the beginning of a sentence.

§It is important to note that, in an inflationary environment, people have a strong incentive to spend their currency quickly in order to utilize it before it loses its value.

Other Parts in the "Technology is Liberty" series:
Part I: The Formula
Part II: History
Part IV: What can Bitcoin do for Me?
Part V: A Decentralized World
Part VI: What Comes Next?

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