Digital currencies won’t save you from inflation

As Rod Serling might have put it: submitted for your consideration: the value of BitCoin and Ethereum (actually Ether), two prominent digital currencies, over time since 2016, compared to the U.S. dollar:

Bitcoin and Ethereum value in dollars since 2016
Bitcoin and Ethereum value in dollars since 2016

The dollar of course hasn’t increased in value since 2016: inflation has eroded its value. Since 2016 though both BitCoin and Ether have returned astronomical returns: over 11,000% for BitCoin and nearly 22,000% for Ethereum.

So congratulations to you savvy speculators who bought both of these currencies back in 2016. Hopefully you were smart enough to buy them in large quantities because you knew they would be the winners in this space. I imagine you are independently wealthy now. Perhaps it was your enormous private yacht I saw in Barbados in December, though I heard it belonged to a Russian oligarch.

I’m betting though that, like me, you didn’t own either of them back then. Until last year I owned neither. Had a client not paid me in BitCoin, I’d likely still not be in that market. Anyhow, I was paid $86.14 in BitCoin in early July 2021. To sell it, I set up an account on BlockFi, deposited $100 and bought $100 worth of Ether on November 1, 2021. So I invested $184.14 and at the moment it’s worth $176.69. So I’m losing money.

Chances are if you invested in crypto you’ve lost money too. I’ve lost a whopping $7.45 and that’s after a lot of interest credited to my account by BlockFi. Obviously, if I invested a lot more, my losses would be greater.

These so-called digital currencies were supposedly created to save us from the ravages of inflation. I sometimes think crypto currencies were invented by nerdy libertarians. To libertarians, Ronald Reagan and much of the Republican Party, government is the problem. While waiting for glorious freedom via anarchy, they can at least move their money into these new digital currencies and beat inflation, which they largely attribute to wasteful government spending.

Except, at least so far, crypto doesn’t seem to be living up to its promise. The value of crypto currencies seems to have tanked along with stock markets in general. You might want to attribute it to Russia’s invasion of Ukraine, but even before Russian troops amassed outside its borders, both Ether and BitCoin were down with the equities markets. This happened both recently and in 2018 when markets were down. So apparently crypto is subject to the laws of supply and demand just like everything else. Who would have thought?

The good news is that when markets rose, BitCoin and Ether rose too, disproportionately so. If there’s an upside to these currencies it is that so far at least it is likely to appreciate faster than markets. The downside is that so far it appears to depreciate faster than the markets too.

From this I can infer that these two “coins” are more volatile than the market in general, which doesn’t surprise me because there’s nothing behind them. If I buy a share of Amazon stock, I own a piece of the company. If I buy some BitCoin, its value is irrelevant until I go to sell it, then it’s whatever someone else is willing to pay for it. In some sense I own some part of the value of creating the coin in the first place, which you can assume was done with a lot of dirty energy. But it’s not tangible. I can go to a local Amazon warehouse and imagine my stock in Amazon is worth the value of one of its loading docks. Should Amazon go under, at some point I will at least get a check for my portion of its value. With BitCoin though, its value is entirely virtual.

The case for digital currencies seems to be that if you invest enough in an emerging currency that takes off, you can become extremely wealthy. Also, if it’s a reasonably popular currency, if you buy low and sell when markets are going up, you’ll probably do very well, assuming you are fortunate enough to time the market well.

So it’s definitely a risky form of investment of something with absolutely no intrinsic value, no matter how much the huskers want you to believe otherwise. Like the U.S. dollar, it’s a fiat form of currency because its true value is based on supply and demand. Unlike the U.S. dollar though there is no Federal Reserve entity to prop up its value.

I can see if these get used enough that central banks may decide to prop up these currencies so their economies are impacted less. So maybe rather than being an escape from the tyranny of governments, it will eventually be governments that keep these things going.

In any event, governments are onto you. President Biden is likely to sign an executive order shortly directing the federal government to look into regulating crypto. Lots of other governments are doing the same, recognizing that these currencies have national security implications as they gain wider adoption.

If you are hoping to escape capital gains and interest on your crypto, you are likely to be disappointed. Apparently, there is no free lunch when it comes to crypto, particularly since you are likely to pay a fee to those who process blockchain transactions when you buy, sell or exchange crypto.

Crypto is also useless if you can’t buy stuff with it. Russia is now largely disconnected from the world’s financial networks due to its invasion of Ukraine. This makes it a herculean endeavor for ordinary Russians to buy anything made elsewhere. They can try to buy stuff with rubles, whose value has plummeted about fifty percent since the invasion. Maybe some vendor will accept their Ether to buy some electronics not made in Russia. It’s unclear if they can get it shipped to them in Russia.

It turns out money is pretty meaningless if you can’t get a physical product or a service from trading it. It’s likely that Russia’s control of the internet is pretty severe, probably making trading crypto not an option for most Russians. China has already figured out digital currencies are a threat, and simply disallows them.

So crypto isn’t now and is unlikely to be your hedge in our new inflationary times or for your distaste for government. If at some point it becomes that hedge, it’s likely to be because governments facilitate its use.

Who’s really profiting from crypto?

So I’m continuing to explore cryptocurrencies and specifically why anyone would want to buy them. One obvious reason is greed. While returns on most cryptocurrencies is marginal or negative, as pretty much anyone with a computer can make their own cryptocurrency, the big name cryptocurrencies tend to appreciate exceedingly well. They get a buzz, so that alone makes people want to buy them. It’s gotten to where I can buy Bitcoin at a kiosk at our local grocery store.

In the last five years, one BitCoin appreciated 4075%. You won’t get that return in an index fund. In 2017, Ethereum was virtually unknown and could be purchased at $9.59 each. It’s now worth $3232.61, so it’s up nearly 40,000%! (Technically, Ethereum is the platform, and Ether is the digital currency.)

There’s no way to know which of these coins will take off while the vast majority of them languish. It probably can’t hurt to buy at least some of these coins on the hopes that while most will languish a couple might take off and you could profit from those purchases. Even with established digital currencies though, there are major ups and downs. My BitCoin investment is worth a modest $140.59 at the moment, and my Ether is worth $90.89. A few months ago though my BitCoin was valued at closer to $200. I bought the Ether only recently, but at the moment I’m losing money on it as I spent the $100 in cash in my BlockFi account for it.

Obviously my investment is trivial, but it’s there mostly to get my head around this stuff. So far for me the return has been good but not great. Since it can all appreciate or depreciate very quickly, it doesn’t seem wise to invest too much. It’s clear in general though that digital currency millionaires are very few and that most of us who are late to the party will assume more of the risk because these coins cost more to buy.

I did watch a YouTube video on these currencies recently. It evolved into a discussion on what money is and talked about the gold standard. The U.S. dollar was once tied to the gold standard. What made the dollar valuable was that gold itself is time consuming to mine and process. The gold in our nation’s vaults was “proof of work”. The gold was valuable because it was hard to acquire, which made the dollar valuable because the number of dollars in circulation was (in theory anyhow) proportional to the amount of gold in our vaults.

Digital currencies are trying to create “proof of work”. “Mining” a BitCoin, for example, requires a lot of computing resources and energy use. The computers you use aren’t free and the electricity they use to create it is not free either. Maybe the algorithms used to create the currencies are free but if you manage to mine a new BitCoin (it’s becoming computationally prohibitive) you will sure expend a lot of treasure to do so. This in theory makes the coin worth money.

What makes it valuable though appears to be that buyers reward BitCoin sellers for the hassle it took them to create the coin. The energy and computer resources it took to make the coin can’t be recovered. Gold though is different. It’s a physical thing, although it is expensive to store because it has value and it’s not easy to use it to pay for things as it is, in effect, too precious to be used for routine financial transactions.

But inarguably the existence of these coins proves “proof of worth” because creating these coins is hard to do. If you don’t believe me, try creating one yourself with some spare PCs. For me the question then becomes, “Yeah, so what?” I can dig a hole ten feet deep in my backyard. The fact that I dug it indicates proof of work, but is it valuable? Maybe it would be if I turned it into a root cellar. Building a root cellar is probably cheaper than building an extension to my house for this purpose. With digital currencies though, the fact that you own some part of a virtual coin that was hard to create doesn’t mean much unless you can do something with the coin.

And with most of these coins, their primary value is not to buy stuff with them, at least not directly for most coins, but that they can be traded. Unlike U.S. currency, a digital coin is infinitely splitable. I own 0.00298038 of a BitCoin. I don’t prove ownership of it by pulling it out of my pocket, or from a piece of paper properly notarized saying I do. I own it because a record exists in multiple BitCoin blockchains stored on publicly accessible servers worldwide. I’m pretty sure it’s not directly tied to my name and address, but indirectly with my email address. I can verify my ownership if needed with the private key in my digital wallet or on the BlockFi digital exchange if I exchange it for something else, such as U.S. dollars.

It turns out though that there are other ways these coins generate “proof of work”: the hassle of creating records that show the transfer of these coins from one person to another. These blockchain servers don’t work for free: you have to compensate them for the hassle it takes to make these trades, generally in a percentage of the coin you are trading. If you have a digital coin broker, you compensate them, who probably become the entity to ultimately compensate those who place the transaction on multiple registers. For example, you can see the fees BlockFi charges here. You can think of these fees as similar to interest charges on your credit card or the fees that Visa or Mastercard charge businesses to manage credit card transactions, costs which are largely passed onto you in the form of higher prices.

So in effect these are like taxes, which means that digital coins aren’t quite coins and their price is a bit inflated to cover the cost of using them. If I use some coins to buy a pack of gum at the drug store I may pay a sales tax, but the store won’t have to pay Visa or Mastercard for the privilege of taking my real coins.

If your head is spinning, I’m not surprised. None of this is obvious to most people when they buy digital currencies, but you will be charged coming and going into this market. The profits go to those that “mine” the coin and the brokers that let you trade the coin. They also go to you if you exchange the coin for more than you paid for it after factoring in these fees. But the risk is on you. You will be charged to get into the market, and if you decide to cash in your chips, unlike the casino, you’ll be charged on the way out too.

I suspect except for a few lucky millionaires the real winners are the miners and the brokers managing all this technology, and it won’t be you.

Speculations on the future of digital “currencies”

So my $88.31 or so that I was paid in BitCoin on July 1st is now valued at $174.20, according to BlockFi, where it still sits because I’ve been too lazy to sell it and turn it into U.S. dollars. Looks like my natural lethargy worked in my favor as if I had sold it for on August 2nd, when I last blogged on this topic, it was worth $109.71. I’d be out the $64.49 in extra value it has accumulated since then. If the “currency” continues to rise as it has since I acquired it on July 1st, I’ll get a 666% return on investment and it will be worth $587.95 on July 1st, 2022.

The people who study this stuff think that maybe one BitCoin will hit $100,000 soon, perhaps because it looks like a BitCoin futures electronic trading fund (ETF) will soon be approved by regulators. Anyhow, the guys I follow on YouTube are still all agog on digital currencies. Graham Stephan is upping it to five percent of his portfolio.

Should I do the same? With our portfolio hovering close to $2M, that would be $100,000. No, I don’t think so. But since I have only $174 of digital currency at risk, I see no harm in keeping the BitCoin I have to see how it does as a speculative asset. It will be interesting to track it at yearly intervals.

These digital “currencies” are clearly becoming a new market, like it or not. Lots of people like me continue to feel largely baffled by these virtual currencies. It’s easier to get behind them though when you consider that most currencies are like BitCoin: virtual. That’s true of the U.S. dollar because it’s a fiat currency.

In my last post on this topic, I lamented that there were no assets behind these “currencies”, unless you count the value of the electricity that it took to “mine” one of these “coins”. The U.S. is now the largest miner of digital currencies, and most of it is occurring in Texas where electricity is cheap, at least until there is another winter storm that knocks out most of its power grid. Since most of this power comes from non-renewable sources, owning currencies that are energy intensive to mine, like BitCoin, should come with a carbon tax. Maybe that would deflate its surreal valuation.

Its value is based purely on supply and demand. Which makes me wonder if these currencies are the latest version of a Ponzi scheme and I now own a tiny fraction of an electronic tulip. If it’s a Ponzi scheme, you want to sell your crypto before the market collapses.

What perhaps can be said is that this new “market” is still getting established and time will tell if it’s got legs. But on the other hand, BitCoin has been around since 2009. It’s hard to see it collapsing altogether, if only because so many people have vested wealth in it, and won’t want to lose their investment in it. These “currencies” though are so easy to create that clearly not all them will survive.

I do think that these “currencies” that more closely imitate real currencies are likelier to survive. A lot of work is going into creating versions of these “currencies” that act as currencies. For example, you can buy so-called stable coins whose value is tied to currencies like the U.S. dollar.

These stable coins are generally underwritten by private insurers. Governments are thinking of putting banking-like regulations on companies offering these stable coins, emulating FDIC-like protections. It will be interesting and confidence building if governments but their good faith and credit behind these stable coins by essentially underwriting them. By doing so though they tend to undermine the foundation by which digital currencies were unleashed: to detach themselves from the shackles of traditional currencies. It’s unclear why these “currencies” based on stable coins should be preferred to currencies already in circulation.

I wonder if there will be a Black Tuesday for these currencies. Black Tuesday was the event that kicked off the Great Depression. One of the lessons from Black Tuesday was we needed to keep banks from collapsing, so we formed the FDIC. Because of their decentralized nature though, there’s nothing to prevent a Black Tuesday for crypto, and no organization to prevent it or from happening again.

What’s more likely in my mind is that the block-chain technology rather than these “currencies” will prove to be where its true value lies. Nonfungible tokens, for example, offer proof of ownership and transfer, and work on block-chain technology pioneered by “currencies” like BitCoin. If the goal is to do away with traditional banking, these miners may be onto something. I’m much more skeptical that they can succeed in creating currencies that will be as ubiquitous and fluid as traditional currencies like the dollar.

Sorry, digital currencies aren’t actual currencies

It’s hard to go a month now without a post from me on cryptocurrencies. I dabbled into this market on July 1st when a client paid me in BitCoin, which worked out to $88.31 at the time of the exchange. Since then its price has increased at a much greater rate than the market in general.

Yesterday I moved it from my digital wallet to BlockFi, a crypto exchange, and it was worth $109.47. So over just one month, I made a 24% return. If I could do this for a whole year, the return would be 288% and it would be worth $254.33. It’s safe to say that there is no other asset that I own that would reap that sort of return.

I can’t see eleven months into the future. You will get a million different opinions about where BitCoin’s value will be going. What I can say is that it fluctuates a lot. Since yesterday, its value dropped to $103.71. Volatility comes with the digital currencies territory.

What doesn’t change that much is the value of the U.S. dollar on a given day. Right now there are innumerable news stories because inflation in the last twelve months has been running in the 5-6 percent range. But if I had planned to spend my BitCoin today on something tangible, I’d be paying 5.26% more for it than yesterday. So in a way my BitCoin inflation rate was 5.26% and this occurred over just one day. Wow! But no one seems to be holding BitCoin to the same inflation standard as the U.S. dollar.

Why is this? To paraphrase The Grinch Who Stole Christmas, I puzzled over this until my puzzler was sore. Both are currencies, right? Well, no. BitCoin, Ethereum, Dogecoin and the rest are not actual currencies. Just because someone slaps a label to it, doesn’t make it an actual currency.

Okay, it is a currency in the sense that you can trade it for things of value, like until recently a Tesla. Right now at least though you can’t buy most things in these “currencies”. In my case, I buy them in U.S. dollars. Given that you can’t buy much with them, they are only currencies in a very limited sense. If you really want to buy something with your BitCoins, you are probably going to sell it to someone who will give you a local currency like the U.S. dollar in exchange for it. That’s what I aim to do with my BitCoin. It will feel real when its value in U.S. dollars hits one of my accounts denominated in U.S. dollars. Until then, it’s funny money. But actually, it’s not money.

So the fundamental premise behind “digital currencies” is false, as except in some very limited cases you can’t use these as money. That could and maybe will change over time, but right now for most practical purposes, they’re not currencies. They are not money.

So what are they? Some call them assets. For me, calling them assets fails the smoke test too. An asset is something you own, and it amounts to something tangible and real. These assets are often denominated in shares, so in that sense they are somewhat virtual. As an ex federal employee, I’m still in its Thrift Savings Plan (TSP), their fancy name for 401K/IRA. I have, for example, 2686.0352 shares in the TSP C Fund, which is a basket of funds. It’s likely that some part of its current value of approximately $203,000 is invested in IBM, so I own part of that company along with lots of others. I can claim my share its capital gains and dividends, at least when I sell them — it’s a tax-advantaged account. I own some part of the buildings that IBM owns and the computers and equipment inside them and in its warehouses.

What can I say about the assets behind my BitCoin? Well, I can say there are no assets. That’s not to say it doesn’t have value. If I can convince someone else to buy my BitCoin and give me U.S. dollars, I can take and spend those U.S. dollars pretty much universally. There is no BitCoin headquarters to go to if the currency goes bankrupt. If it does, I’ve lost the value of my BitCoin. Its value lies merely in its perception.

The same is true with U.S. dollars, of course. Dollars are perceived to have value because the U.S. government stands behind them. You aren’t entitled to your share of the gold in Fort Knox if the U.S. government collapses, but we do know there is an institution, a lot of smart people, and the full faith and credit of the government supporting it. If my bank account is FDIC insured and my bank goes belly up, the government will give me the value of my account in U.S dollars, up to $250,000.

If for some reason you have an incompetent government, then a currency can collapse too. Venezuela’s currency is just one of many recent examples. So I have plenty of incentive to keep the U.S. government functional. No wonder I obsess over whether certain radicals might succeed in doing away with our democracy and setting up an autocracy. If nothing else, the value of my U.S. dollars would get very iffy.

Those into “digital currencies” are placing faith in them too, mainly that they can’t be hacked or undermined. That’s pretty dubious to my way of thinking. One thing is clear is that they are subject to the laws of supply and demand. If demand ceases because they aren’t trusted, they become effectively worthless. Just like Venezuela’s currency.

These “digital currencies” are actually speculative assets where the asset is basically the successfully operation of an advanced computer algorithm (which spits out a “coin”) and the faith that blockchain-powered servers will be around to certify transactions in these assets. All of them share one fundamental weakness: they require the Internet. Some share another weakness: they depend on governments to allow their use. It’s hard to transact these “currencies” in China because for the most part its government won’t allow it.

Currencies facilitate the exchange of value. But they have one other important asset: they hold their value within a reasonable range of inflation over a long period of time. If they don’t, this money will move toward other currencies that do a better job of retaining their value. In short, they facilitate savings so that their value can be quickly and conveniently spent.

Digital currencies currently do not excel in either easily exchanging value or as a reliable source of savings. To my mind, this tells me they are not a currency.

So don’t treat them as such. With time, it’s likely the U.S. and other governments will create their own digital currencies. The blockchain technology that is the foundation of these “digital currencies” is something of value. It will be leveraged by other more stable entities like the U.S. government to more conveniently, securely, cheaply and transparently exchange value.

It’s hard for me to see a business case for “digital currencies” once governments start issuing their own.

Cryptocurrencies and true financial value

Until recently you could buy a Tesla with BitCoin. Elon Musk though recently changed his mind because it was an environmentally unfriendly currency, since newer mined BitCoins are mined using tons of servers, many of which use electricity generated by fossil fuels. So Musk is going toward more environmentally benign cryptocurrencies. There’s a lot of them out there and anyone with the right software and hardware can create their own. To use a cryptocurrency though you have to convince others to buy, use and accept them.

To say the least, cryptocurrencies are highly speculative. Coins most often mentioned in the media seem to do the best, and these include BitCoin, Ethereum and a literal joke currency, Dogecoin. With Elon Musk going all in for cryptocurrencies, the rest of us are left scratching our heads wondering if we’re missing something. Maybe we need to start buying cryptocurrencies too.

I had a customer recently who wanted to pay me in BitCoin. I told him no thanks, but he thought I was foolish because BitCoin’s price was likely to keep going higher. Maybe he’s right. All fiat currencies are speculative too. The U.S. dollar depends on the full faith and credit of the U.S. government and nothing else. Given how fragile our democracy is at the moment, maybe I should be trading dollars for BitCoin, Ethereum and Dogecoin.

Governments seem to be accepting the inevitable. I noticed on my tax return I had to answer some questions about cryptocurrencies, to make sure they were appropriately taxed. Cryptocurrencies seem to be settling in as a thing.

With the exception of real coins, all money is an abstraction and a shared delusion. It solved the messy problem of exchanging goods and services conveniently. BitCoin is not convenient, given the time and hassle it takes to exchange them, although it is getting easier. Others may be more convenient for transacting business where they are accepted, but the general market remains a long way from generally embracing cryptocurrencies.

The faith in most cryptocurrencies is that they are either hard to manufacture or that their block chain technology helps instill some sense of trust. Dogecoins are relatively easy to create, but they sure don’t look like a hedge against inflation. Five billion new Dogecoins are created annually, which means 2.7 million new Dogecoins go into circulation every day. It hardly looks like a precious asset, but where they are accepted at least they should be easy to spend. You shouldn’t have to worry about running out of them. The U.S. dollar is backed up by the U.S. government. The U.S. government at least has people overseeing the management and distribution of dollars. The same can’t be said about many cryptocurrencies.

I notice that those most into cryptocurrencies tend to be those who are libertarian, at least in spirit. They want the best of both worlds: a currency that retains its worth over time but also has the advantage that money provides: an easy exchange of value. It’s highly debatable though whether a cryptocurrency can hold its value. The run up in cryptocurrency prices seems due to supply and demand: more people are buying into the idea/hype of cryptocurrencies, which drives up their prices. Cryptocurrencies strike me as speculative investments without any firm moorings. Much like the Dutch tulip mania of 1637 demonstrated, these currencies hold value as long as we agree with the illusion/delusion that they have value.

I can see investing in cryptocurrencies as a highly speculative way of reaping short term profits. If I believe that there are many more enthusiasts of cryptocurrencies out there to be persuaded, buying some of these and hoping their prices go up, then selling them when they reap a handsome profit, makes a certain amount of sense. I would look at any money invested this way as money I could live without if the tables on cryptocurrencies I bought turned. I would not bet the house on cryptocurrencies appreciating. I would view it more like going to Las Vegas and gambling $1000, but no more than $1000, just for the fun of it. I strongly suspect though that having this approach does not make me a good candidate for investing in cryptocurrencies. I suspect most of these investors are looking to become millionaires through this sort of investing. People like me don’t rush in where angels fear to tread.

As an asset though, I consider these decentralized cryptocurrencies fool’s gold. In that sense I think Elon Musk is being foolish, but as the world’s richest person he can afford to be foolish on a grand scale. That said, over time it may be that we will have no choice. Cryptocurrencies may gain such traction that they can’t be ignored. There may come a time when going to a foreign country might require buying a cryptocurrency, because it and the local currency will be the only currencies accepted.

If that happens though we may be in for a world of trouble. The U.S. dollar’s value is based on the full faith and credit of its government. But nothing is forever. The U.S. is likely not forever as well, so having most cash parked in U.S. dollars could be foolish if our government ultimately collapses. It’s just a safer best than most other non-cryptocurrencies out there, and that it is the de-facto cryptocurrency of the world makes it a reasonably safe harbor … for now.

Real assets though is tangible stuff you own. You don’t own your savings account. It seems like we do, but its value is wholly dependent on the institutions that oversee it. With cryptocurrencies there are generally no people regulating it. If there are, it doesn’t amount to the investment in people and resources that countries give to managing their own currencies. Inflation may be the penalty we pay to make sure our currency doesn’t collapse altogether, because if the U.S. dollar weren’t overseen and regulated, it would probably collapse pretty quickly.

The deed to my house and cars, the portions of my portfolio that represent a percent of ownership in various stocks and funds, these are real assets because they have true value. All forms of money have some risk associated with them. I think many drawn to cryptocurrencies are suffering from a shared delusion that they can take the risk out of money through computer algorithms. I think they are likely to be disappointed in time. I’d rather own currencies that are managed by people because as flawed as we are I trust economists managing currencies more than I trust a computer algorithm.

Monetary policy and the danger of revolution

My recent post on quantum computing and its impact on cyber currencies like BitCoin have taken me exploring the world of money some more. This exploration took me to this video, which discusses who controls money and how it is created.

I think this video is meant to be shocking. Most of us are painfully aware of how important money is, because we cannot survive without it. While vital, money is also completely abstract. We like to think money is a form of permanent liquid value. This video points out the “shocking” fact that money is not this and that it is created almost universally by central banks, the Federal Reserve in the case of the United States.

As you get on in the video, you also learn that banks create money when they issue loans. If you were hoping to trade in your dollars for gold bullion, those days are gone. President Nixon turned the U.S. dollar into a fiat currency. This essentially means that the dollar has value because the government says it does. If it’s backed up by anything, it’s backed up by your faith that our government can manage money intelligently.

But really, the only ones managing money is the Federal Reserve, since they are the sole suppliers of money. The degree to which the Fed controls the spigot of money generally determines the health of the economy. Quantitative easing, which the Fed (and other central banks) have been doing since the Great Recession is basically the creation of lots of money which are then used to buy assets. Doing this helped pick up the economy and over many years took us out of recession.

So one might extrapolate that it’s not how much money that gets printed that is important, but how frequently it gets circulated. If circulated a lot, the production of goods and services continues apace. If it gets circulated too much, you end up with inflation, which means the same money buys fewer goods and services. If it’s not circulated enough, you may end up with deflation, which seems worse than inflation, in that the same money tomorrow buys more than it will today. In a deflationary environment, you would rather hold onto money than spend it, and that tends to stifle economic activity.

Lots of people like Ron Paul don’t like the way money actually works, which is why they would prefer the dollar be based on a gold standard, or some standard which equates a dollar to some amount of something precious. These people are probably economic Don Quixotes chasing electronic money windmills that may have existed at one time but which are probably gone for good. They look for impartial standards of value instead, which is why they turn dollars into BitCoin and similar electronic currencies.

The video says that central banks, being run by bankers, are a system that essentially pumps money from the lower classes to the upper classes. There’s a lot of recent evidence that they are right, as our middle class seems to be disappearing. Americans owe a lot more than they used to and in general earn a lot less in real wages than they used to. It used to be that wage increases followed productivity increases, but for decades that has not been the case. Today, the level of personal debt is staggering. Without meaningful raises, it gets harder and harder to pay off debt or do things we used to take for granted, like buy cars and homes. The Uber/Lyft phenomenon may be in part a reaction to these new facts of life.

Something ought to be done. In part, Donald Trump’s election was due to these economic anxieties. Trump was going to be our fixer to these various problems by bulldozing his way through all obstacles. Of course, he has done just the opposite. There is more than $1 trillion in outstanding student loan debt, but Trump’s education secretary Betsy DuBois is actually making it harder for people to pay off their student debts, and is promoting pricey private education at the expense of relatively affordable public education. So Trump is turning the screws even tighter on the working class.

Democratic presidential candidates have all sorts of ideas for addressing these problems. My senator, Elizabeth Warren, is distinguishing herself by having the most comprehensive set of policies for addressing these issues, including a lot of student loan debt forgiveness. All these policies though are basically ways of trying to solve the fundamental problem of more of our wealth going to the wealthiest and to put more money into those who need it the most. They all depend on redistribution of income from the wealthy toward the poor.

This “socialism” of course has the wealthy up in arms, since maintaining and increasing their wealth is all they seem to care about. So they are dead set against any of these ideas. Based on how our money supply works though, all this will do is keep pushing more of the wealth toward the wealthy.

It makes me wonder how all of this economic anxiety ends. And that gets me to figuring out what money really means. Money is essentially a social compact for the exchange of wealth, and whoever sets the rules controls the flow of wealth. The Fed is essentially accountable to no one. At best, all you can do is wait for someone’s term to expire. Trump’s inability to get people like Herman Cain on the Fed speaks to Republicans true values: they want the Fed to be populated with people that think like them, and that’s not Herman Cain. He’s too out of the mainstream.

To cut to the chase, the real threat to the wealthy is revolution. That’s exactly what happens if you screw the working class for too long. Revolution is upsetting the whole apple cart and starting over because the system is fundamentally broken and cannot be fixed. I believe this is the root of the partisan tensions we see these days. It’s not about value, or whether you are white or not; it’s about money and who gets to control it and how it should be distributed and used. Revolution though is very dangerous. It brings severe economic disruption, likely civil war, complete upheaval and a fundamental reordering of society. Hopefully when it is over the new system is more fare, but as we watch these things play out in places like Brazil it doesn’t look like that’s likely.

Ideally, rich Americans would understand that giving more back to society is in their interest. Sucking ever more wealth from the lower classes exacerbates tensions and increases the likelihood of revolution. They don’t seem to believe it though, and want to maintain control of the levers of power. If they succeed they will likely bring about the real revolution that will destroy their wealth, because wealth is predicated on connected economic systems that work. Unfortunately, the rich seem to be deliberately tone deaf, increasing the likelihood of the exact outcome they fear the most. Should it occur, BitCoin is not going to save them.

As billionaire Nick Hanauer puts it, the pitchforks are coming.

Quantum computers will kill cryptocurrencies, but that’s just the start of it

About five years ago I took my first gander at the BitCoin phenomenon. In that post I wrote:

In short, to trust a Bitcoin you must buy into its assumption that it can’t be hacked. Since the dawn of the computer age, hackers have demonstrated their ability to hack anything. They love the challenge. It’s reasonable to believe that Bitcoin is going to be hacked one of these days.

Five years later, BitCoin and similar cryptocurrencies are still safe, but they may not be much longer. This is because quantum computers, which are still-in-the-laboratory are going to fundamentally reinvent computing.

When I wrote this post on BitCoin, I was thinking some hacker would just figure out a very clever way to hack these coins that wasn’t so computationally prohibitive. Right now you can throw supercomputers for years at the problem and they won’t succeed.

Quantum computers though are leveraging actual quantum physics, and that looks like a game changer. If you follow my blog, you’ll realize I’ve been fascinated by quantum physics and its implications, most recently this post. Quantum physics is the study of the ultra tiny; it’s a realm so tiny it cannot be seen at all, but only inferred. The foundation of quantum physics seems ridiculous: it postulates that two things can be in two different states at the same time.

Quantum computers take advantage of this seemingly impossible fact of nature. By allowing a bit of storage in a quantum computer (an atom) to take on not just two values (0 or 1) but an extra value (both 0 and 1 at the same time), putting a quantum computer to a task that would challenge even a supercomputer becomes doable. As a practical matter, this puts the security of the Internet and most of our electronic trust-based systems in jeopardy. It looks like someone with the right quantum computer will be able to decode anything electronically encrypted without breaking much of a sweat!

One thing this will impact is digital currencies like BitCoin. Right now to “mine” a new BitCoin requires rooms full of servers. As most BitCoins have already been “mined”, creating new BitCoins gets prohibitively more expensive. With the right quantum computer though, creating new BitCoins won’t be a problem, even if there aren’t that many more that can be created.

But any digital currency that depends on this blockchain technology could be minted quite easily on a quantum computer. Effectively this means that the “preciousness” of digital currencies is going to go away. Quantum computers will be able to “mine” new digital currencies in whatever quantities will be desired. These currencies then move from being on something similar to a gold standard (a finite number of Bitcoins, for example) to a fiat currency.

But with fiat currencies like the U.S. dollar, some entity controls the creation of dollars (the Federal Reserve). With digital currencies, anyone with a correctly programmed quantum computer can create as many units as desired and the currency permits. In short, digital currencies will reach a point where they cannot be trusted and quantum computers should kill them.

Much scarier though is how easily these computers will crack passwords and encryption keys. Consider that electronic commerce is carried out over the Internet using pairs of public and private keys. The private key is retained by vendors like Amazon, and the public key is handed out, but you need both to make the transaction secure. If you can figure out the private key though you can certainly purport to be some entity that you are not, and once you have someone’s credit card or bank account number grabbing their money won’t take much effort. Of course, if you can easily figure out someone’s password with a quantum computer, not much remains private anymore, at least not in electronic form.

As bad as this is, it has much worse implications. Suppose North Korea or China get a leg up on us on quantum computers. Imagine the havoc they could create. Right now, China is leading on quantum computing. It’s not clear if the United States even has a strategy in this area. We have to hope the NSA is studying the problem and perhaps surreptitiously developing quantum computers too. Quantum computers will break the model of electronic trust that we take for granted. We will need something else that can’t be broken with quantum computers but which can still be done electronically. I can’t think of what can viably replace it. But moving whatever solution we come up with, we have to retrofit every system to use it instead.

The United States would be well advised to become the leaders in quantum computing, and quickly. Unfortunately, our tone-deaf Trump Administration is much more concerned about people seeking asylum on our border or getting rid of Obamacare than tackling a super-huge national security threat like quantum computing. Let’s hope that when the grownups are back in charge again, there is still time to gain the upper hand.

To get your head around this, watch this 3:44 video:

Bitcoin reevaluated

In December 2013 I looked at Bitcoin and called it libertarian bit nonsense. Like most pundits, I’m not good at admitting I was wrong. But I was wrong about Bitcoin. In December 2013 a Bitcoin was worth about $716. As of today one Bitcoin is worth about $3250. (See this index chart.) So if bought a Bitcoin in December 2013 and traded it today for U.S. dollars, your return on investment would be 354%. That’s an annual return of 96%. You are not going to get that sort of return from an S&P 500 index fund.

The dates I picked were random so coins bought at other times might have lost money. In truth if you had bought a Bitcoin in December 2013 you would have to have waited until November 2016 to see a positive return on your investment. For the last year or so though Bitcoin appears to be picking up real traction, taking the new currency to surreal highs.

One reason I was wrong in 2013 is that back then I did not anticipate its major use. Back then it was used for shady transactions but existed on the fringes of this world. Bitcoin seems to have found its niche as a method for facilitating ransomware. Illicit hackers are using it to get money from you when they do things like hijack your computer and won’t let you access key parts of it until you pay them sufficient Bitcoins. (Even then it works only about half the time.) If they asked for dollars or yen then hiding their tracks would be much harder. Making you go out and buy Bitcoins and then sending it to them though makes anonymous electronic thievery much more possible and practical. While each transaction is recorded in the Bitcoin itself, there is no mechanism in the transaction to positively identify the buyer and seller. Thus it’s much harder to catch electronic thieves at work.

I doubt these thieves hang onto their Bitcoins. Bitcoins are still a hassle to trade. Bitcoin exchanges are few and their trustworthiness not to mention solvency are problematic. Thieves probably don’t see the Bitcoins they collect as investment since they are hard to spend on real world goods and services. Most likely they are quickly converted into a local currency where they are then used to buy goods and services.

As a libertarian currency, Bitcoin is having some success. It is theoretically money that can be stored and used independent of taxation, although legitimate sellers that accept Bitcoins probably have to charge taxes on Bitcoin transactions. The percent of sellers that accept Bitcoins though is still tiny, which provides evidence that their value comes from being able to transmit value relatively free from prying eyes. This is one aspect of cash that allows it to endure into the 21st century.

So while Bitcoins may appeal to the libertarians among us, its primary usage is probably to facilitate crime, thus its value and surging price. The harder it becomes to trade illicit money with conventional currencies, the more valuable Bitcoins become, since there are a finite number of Bitcoins out there. Most governments are getting quite good at monitoring transactions of conventional currency. Transactions that are too large result in inquiries that may slow down or stop the transfer of money. With Bitcoins this is currently not much of an issue. Governments are getting better at regulating these transactions. At one time China blocked Bitcoin transactions altogether. They are accepted on certain Chinese exchanges now, but China is proposing to make Bitcoin exchanges subject to money laundering laws and to collect information verifying the identity of buyers and sellers exchanging Bitcoins.

As I noted in 2013, the more a Bitcoin is traded, the larger its digital fingerprint becomes. Some of these coins are becoming so digitally huge that they are inefficient to verify it is a legitimate coin. This is frustrating to many in this community, which is causing other more practical digital currencies to emerge like Ethereum. Currencies like Ethereum try to address issues like the huge blockchains in many Bitcoins and to build in features like identifying buyers and sellers and a limited blockchain ledger. If they gain traction then this undercuts Bitcoin’s ability to keep these transactions confidential.

Whether Bitcoin or some other form of digital currency, all such currencies that rely on blockchain technology are inherently risky, for the same reason that I noted in 2013: they are potentially hackable because they are encrypted. So far to our knowledge no one has successfully hacked into a Bitcoin. If it happens though that a hacking algorithm or a quantum leap in computing power reveals an easy way to mine new Bitcoins then the coin should drop in value precipitously and become essentially worthless. However, if a coin can be “minted” by a provable and legitimate source, say a country’s equivalent of a Federal Reserve, then such digital currency should hold value. This could be done by such organizations holding a registrar of coins it has “minted” that are publicly electronically available.

If that happens though then the onus for having a Bitcoin also goes away, as its value is in its surreptitiousness. Electronic coins that only go through legitimate exchanges and follow policies for tracking and handling illicit uses become essentially legitimate currencies because they are issued and accepted by trusted institutions.

So there are likely to be many more digital coins in our future. Bitcoin’s future as an electronic currency though is likely coming to an end as it becomes computationally inefficient to record transactions with Bitcoins and as advancements in computers, like potential quantum computing potentially render obsolete our current methods of encrypting data, making the encryption keys faster to crack.

Bitcoin’s time has arrived but with its success it is also likely quickly passing into obsolescence. What comes next is unknown but any permanent way of electronically storing untraceable electronic value was probably always myth.

Ashley Madison stupidly lets itself get pwned

So I have been streaming Mad Men on Netflix. It’s a strangely compelling series about the world of Madison Avenue in the 1960s. It’s a world of constant drinking, endless cigarettes and infidelity. The principle character is Don Draper (played by Jon Hamm), the creative director for the advertising firm Sterling & Cooper. As we quickly learn, Don was previously Dick, he is a deeply messed up man, and he also happens to be one hunk of a guy. Don’s a liberal drinker, a liberal smoker and a liberal bed hopper as well. He does this while somehow staying married to his ultra pretty and slinky wife Betty (January Jones).

It takes a few seasons but Betty eventually figures out Don’s infidelities. They divorce but Don keeps bedding the women, often inappropriately, including his secretary. Yet Don is hardly the only character in the series with his pants down. Most of the characters are involved in an illicit relationship or two. I have no idea how close any of this is to real life on Madison Avenue, but from what I’ve read it was not too far off the mark. Most of the men are caught between who they really are and the roles they are supposed to play. How they manage all this screwing around in these pre-Ashley Madison days is kind of mysterious, but likely all that booze helped reduce inhibitions.

Yesterday of course the infidelity website ashleymadison.com quickly went dark after hackers posted a dump of its database on a number of websites. While bad for cheaters out there, what it said about Ashley Madison was even worse. First, its security system was laughably bad. Second, even after the hack they could have taken down their site and saved their forty million members embarrassment, but they didn’t. They kept collecting fees right up until they went dark. In short, they gave the online infidelity business not only a moral stink but in an unexpected way: they were so busy chasing short term profits that they were willing to throw its forty million customers on mercy of their spouses. Doubtless the hackers provided samples to prove they had hacked the good stuff, including apparently seven years of credit card transactions. AM was hoping they would blink.

Doubtless too that marital counselors and divorce lawyers are going to get a sharp increase in business. It would not surprise me if their phones were ringing off the hooks. As for AM, I wouldn’t blame its customers if they arrived en masse to torch its offices. Cheaters of the world, unite! Anyhow, fifty years after Mad Men, there are still plenty of Don Drapers out there that are mostly hooking up online. Until a couple of days ago apparently Ashley Madison had the lion’s share and then some of this market.

What interests me is not that AM brokered infidelity. As disgusting as most people at least claim to view infidelity and those that aid them, there are far worse things on the Internet, with ISIS beheading videos coming immediately to mind. Some entities like AM are to be expected in our electronic age. What’s interesting and more than a little appalling is how bad a job they did in keeping their clients’ information confidential. As a software engineer, but also as a guy that is currently getting paid to ghostwrite articles about data security, AM gets an F.

Yes, AM kept a record of all its credit card transactions for the last seven years! It’s such a mind boggling, stupid and reckless thing to do, particularly given the profitability of the site. It would have made much more sense to give in to the hackers’ demands and quietly establish a new site under a new name, oh and fix those security problems too. Doubtless they had the money to do it. Forty million customers, figure 30 million of them men, figure each putting out at least $50 each, that’s at least $150 million in revenue. Since they’ve been in business fifteen years, it’s likely a lot more than that. Likely their overall revenue likely exceeded a billion dollars, not that we’ll know for sure. They aren’t publicly traded, although maybe their successor or whoever buys the brand (Vivid Entertainment?) will be publicly traded, and doubtless do a better job at security.

If I had fewer scruples and more money I might create the next AM site, one that its dubious clients could actually trust. Of course there are always risks in anything done over the Internet. AM’s clients now understand that. The next AM is bound to arise from its ashes, and probably sooner rather than later. Here are some actions items for whatever entrepreneur wants to sail in these turbulent waters in the future:

  • Do not keep records of credit card transactions. Just don’t. Purge these daily, if not more often, from any internal databases. Don’t journal them on backup somewhere.
  • Do not collect any privacy information from your customers, you know like their real names, address and phone numbers. Instead, let some third party act as your broker. Your client gives the broker some money and the broker provides some electronic token identifying the payee that doesn’t actually identify them to your company. The future AM should never collect anything that could identify their clients.
  • Accept more discreet ways of payment. There are lower tech and anonymous ways to pay fees confidentially: wire deposits and money orders, for example. I’d say accept BitCoins but BitCoins are hardly anonymous.
  • Don’t use cloud hosting. Use your own data centers that only you can access and control.
  • One person can’t do this in his basement. So find employees who have a history of being trustworthy, very talented, and discreet and pay them very well. Give them incentives to be discreet. Make their bonuses contingent upon their contributions to improving the business’s security.
  • Retain security experts. To get AM’s entire database required a whole lot of bandwidth. This can be monitored. The tools exist to cut off suspicious behavior already.
  • Do regular vulnerability testing of your website and applications. The tools are out there. Of course fix any vulnerabilities found quickly.
  • Hire a CISO, a Chief Information Security Officer with of course the right credentials.
  • Don’t store obviously sensitive information, like a client’s IP address. Passwords should be encrypted in a MD5 hash in the database.
  • Tell your customers what your security plan is. Get an annual (or more often) security audit from a trusted security auditor and publicize the results for your customers.
  • Provide your customers security tips, like clearing your browser history. I can think of another one. Figure out a way for clients to share pictures anonymously. I’m pretty sure it could be done with Instagram.

As for AM’s clients, those who are not on their way to marital counseling or divorce court, you might consider picking up strangers at bars again or just plastering them with lots of alcohol in the privacy of your office. It sounds cheaper and faster. It worked for Don Draper.

Mt. Gox: more evidence of why BitCoin is best avoided

Dorothy in The Wizard of Oz learned from Glinda that if she clicked her ruby slippers, closed her eyes and kept repeating “there’s no place like home” that she would magically return to Kansas. So simple! BitCoin adherents are a lot like Dorothy. Dorothy at least made it home from her fantastical journey. True believers in BitCoin, the libertarian currency, got a splash of cold water across their faces this week instead. Mt. Gox, the Tokyo-based BitCoin exchange, has gone belly up, along with about $300M in BitCoins. Most likely someone stole those BitCoins, either someone inside the firm or some shadowy hackers. By any standard, this was quite a heist. Looking at history, you’d have a hard time finding any instance of a similar theft inside what amounts to a bank.

In any case, sorry you BitCoin suckers. Real banks and exchanges still have vaults, but they don’t carry much of their assets in cash. Much of it is commercial paper, bonds, mortgage deeds, promissory notes and Federal Reserve Notes. Whether in paper, assets on an electronic register somewhere, or gold bars in a vault, these assets are quite tangible. Someone with a car loan who defaults on their payments is likely to find their car repossessed. Those who defaulted on home loans during the Great Recession found their houses foreclosed and if they had ready cash assets, they were put under legal assault. BitCoin owners with their BitCoins in Mt. Gox now have nothing and the police just aren’t interested in serving them justice.

This was not supposed to happen to this libertarian currency. Freed of its tie to governments, it was supposed to soar above inflation and always retain a finite empirical value. It was all secure and such through the power of math. After all, exchanging a BitCoin involves keeping a record of who its next owner is. Unless, of course, it just disappears. Undoubtedly these stolen BitCoins were converted into a real currency, just unbeknownst to its owners, and perhaps with the help of some money laundering exchange, perhaps Mt. Gox itself. BitCoin is after all the preferred currency of drug dealers, at least until their fingerprints have disappeared and they can convert the digital money into something more tangible and fungible, like U.S. dollars.

I keep my cash in a couple of credit unions and a bank. It’s unlikely that a credit union like Pentagon Federal, where I have a couple of accounts, is going to go under like Mt. Gox. In the unlikely event that it does, I’ll get my money back because it is backed up by what amounts to the full faith and credit of the United States. Mt. Gox was backed up by the full faith and credit of, well, Mt. Gox. It’s like asking the fox to guard the henhouse.

And there’s the rub with BitCoin exchanges. When you create a currency detached from a government that will assert and protect its value, there is no one to complain to when your BitCoin bank goes bust. The government of Japan is looking into the event, but it is mostly hands off. It never promised to underwrite Mt. Gox, and Mt. Gox never asked it to. In any event, Japan underwrites its Yen, not BitCoins. Japan has a vested interest in keeping its currency solvent. It has no such interest in keeping another currency, particularly one it cannot control, solvent.

An exchange like Mt. Gox could of course seek out local governments for underwriting of their exchanges. Those BitCoin exchanges and banks that want to remain viable are going to have to do something just like this. Good luck with that. In doing so though they are of course defeating the whole purpose of BitCoin. BitCoin is about a libertarian ideal; it’s about money having a value independent of government apron strings. Affiliate the BitCoin currency in a BitCoin exchange with a government, and you tacitly admit that BitCoin is not a libertarian currency after all. In short, you have to give up the notion that money can be decoupled from government control.

It’s unlikely that many governments will be willing to protect BitCoin exchanges. It is reasonable to protect assets that you can actually control: your national currency. For a government to protect a BitCoin currency, it is reasonable to expect that they would also be able to control the amount of BitCoins in circulation and set rules for their use and misuse. They can’t do that, which means that they would be asked to put the good faith and credit of their country against an erratic currency that could prove digitally worthless at any time. This strikes me as a foolish thing to do, but there may be entrepreneurial countries out there, say, the Cayman Islands, that will take the plunge. The risk might be worth the rewards.

I don’t think you have to worry about governments like Germany, England, Japan, China and the United States doing something this foolish. If there is any organization that might see profit in this, it will probably be the Mafia, or other criminal syndicates, many of who are already using BitCoins as a mechanism for money laundering.

Doubtless other BitCoin exchanges will work real hard to sell trust that is now deservedly absent from these exchanges. As I pointed out in an earlier post, it’s going to be a hard sell given that BitCoin’s value is essentially based on faith in its mathematics and algorithms.

Absent from the minds of BitCoin true believers is an understanding that money must be tied to a governmental entity to be real money. It’s tied to governments for many reasons, but primarily because governments are required to govern, and this includes having the ability to enforce its laws and to collect taxes. Money is based on the idea that entities can force everyone to play by the same rules, including using the same currency as a means of exchange within the country for lawful debts. The truth is, there are no rules with BitCoin other than its math. It is a lawless currency. That Mt. Gox’s treasury of BitCoins can be plundered with impunity proves it.

Libertarianism is built on the idea of caveat emptor: let the buyer beware. No warranties are expressed or implied, but even if they are expressed they depend on the trust of the seller. No one can force the seller to do squat. The best a buyer can hope for is to track the thief down and take justice with his fists or a gun. That’s no way to run an economy, which is why libertarianism is an ideology that simply does not work in the real world.

Again, a word to the wise: just say no to BitCoins.