April 10, 2013

Bitcoin vs. Big Government

Jerry Brito

Former Senior Research Fellow
Summary

Interest in Bitcoin has surged along with its valuation. Last week saw its exchange rate soar past $100 for the first time ever, landing the virtual currency on the front pages of The Washington Post and the Financial Times. Yet the media frenzy, which has focused on the rapidly rising valuation and its possible causes stemming from the bank crisis in Cyprus, is overlooking Bitcoin’s true radical significance—that it can’t be controlled by government.

Interest in Bitcoin has surged along with its valuation. Last week saw its exchange rate soar past $100 for the first time ever, landing the virtual currency on the front pages of The Washington Post and the Financial Times. Yet the media frenzy, which has focused on the rapidly rising valuation and its possible causes stemming from the bank crisis in Cyprus, is overlooking Bitcoin’s true radical significance—that it can’t be controlled by government.

In his new book, This Machine Kills Secrets, Andy Greenberg recounts the history of the 1990s cypherpunk movement that paved the way for WikiLeaks and Anonymous. The early Internet’s crypto-anarchists foresaw a future world in which widely available cryptography secured personal anonymity and privacy to such an extent that it threatened the authority of the state. Their key insight, Greenberg explains, is that anything that can be done cryptographically can be done without government oversight.

Before eBay or WikiLeaks, cypherpunks like Tim May imaginedonline markets for information in which buyers and sellers transacted anonymously using untraceable digital cash. Anything from state secrets to private credit reports would no doubt become available for the right price. These ideas were notoriously taken to the next level by the radical libertarian Jim Bell who proposed a system  for anonymously crowdfunding the assassination of corrupt government officials.

While almost all the technology necessary for such black markets was available when the cypherpunks were writing, there was one conspicuous exception: true digital cash.

Until Bitcoin, virtual currencies have in one way or another relied on a third party intermediary, such as a bank or a credit card company, to prevent “double spending.” In the physical world, if I give you a $20 bill, I will no longer have it. You can’t be as sure of that, however, when the cash is a digital file that can be easily copied. The solution has been to have a trusted intermediary keep a ledger of balances and deduct a transaction’s amount from the payer’s account, and add it to the payee’s.

Intermediaries, however, are the regulatory chokepoints at which government can apply pressure. For example, after WikiLeaks released its trove of State Department cables, payment processors such as Visa and MasterCard succumbed to political pressure and refused to transmit donations to the group. PayPal even froze its account so that the group couldn’t access funds it had already collected. As as a result, WikiLeaks has been driven to near bankruptcy.

Today, online gambling is illegal under federal law and the prohibition is enforced through payment processors, which are not allowed to send money to offshore casinos. The infamous Stop Online Piracy Act (SOPA) also targeted financial intermediaries and would have banned payments to suspected pirate websites.

Bitcoin is revolutionary because it solves the double-spending problem without employing an intermediary; there is only the payer and the payee. The system accomplishes this by distributing the ledger of transactions across a peer-to-peer network of users, much like BitTorrent. This allows a record to be kept of all transfers so that the same cash can’t be spent twice, but because it’s distributed, there’s no one central authority keeping the ledger. This makes bitcoins true digital cash. Like dollar bills or euro coins, if you hand them over to a payee, you will no longer have them. And because there is no third party running the ledger, there is no one for the government to pressure or regulate.

Much of the discussion around bitcoin today centers on whether it will work as money. Money has three functions: it serves as a medium of exchange, a unit of account, and a store of value. Because Bitcoin is distributed, there is no central banker that can decide to inflate the money supply. Some argue this makes it a good store of value, like gold or Picassos, while others counter that Bitcoin’s historic volatility make it a poor store of value and an unreliable unit of account to boot. Given the public’s fear of currency devaluation in Europe and the U.S., the question of whether you can stash your wealth in bitcoin to avoid capitol controls and inflation is what has been driving much of the media’s coverage of the currency.

Time will tell whether the gold bugs or the skeptics are right, but what’s being overlooked is that it doesn’t matter whether Bitcoin makes it as a store of value or a unit of account for it to work as a medium of exchange. Even if the Bitcoin market remains volatile and never pans out as a good store of value or unit of account, one can imagine users converting their dollars or euros to bitcoins for just long enough to make a transaction; perhaps just minutes. And as long as it works as a medium of exchange, it is the true digital cash that was missing from the cypherpunks’ predictions.

With a little bit of effort, today you can purchase bitcoins anonymously with physical cash. You could then do all sorts of things the government doesn’t want you to do. You could buy illegal drugs on the notorious Silk Road, an encrypted website that has been operating with impunity for the past two years facilitating annual sales estimated  at almost $15 million. You could gamble at various casinos or prediction markets, buy contraband Cuban cigars, or even give money to WikiLeaks. Dissidents in Iran or China can use Bitcoin to buy premium blogging services from WordPress, which now accepts payment in the currency. Perhaps more importantly, Bitcoin makes the cypherpunks predictions of markets for stolen secret information and even assassinations feasible.

Last month, the Treasury Department issued guidance on how it plans to regulate Bitcoin exchanges. This is good news for the currency since it implies the government is looking to regulate its use rather than prohibit it. Confronted with Bitcoin’s potential, it’s not reasonable to expect that Treasury’s money laundering cops would simply let it be. So it’s a sensible approach for them to take because Bitcoin, much like BitTorrent, can be used for both licit and illicit purposes and would in any event be difficult to shut down.

Today physical cash is anonymous, which helps keep one’s purchases private. Cash is also difficult to control: a $100 bill never gets “declined.” As we move to an all-digital world, we should ensure that we retain some type of digital cash that is not tied to a financial intermediary that can spy on or control transactions—even if, just like physical cash, it is put to nefarious uses. The real question facing Bitcoin today, then, is whether law enforcement and regulators will continue to show as much restraint as they have so far.