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Professional Credentials: The reports that I write are my personal research and opinions. They are not associated with any firm or organization, and are not intended to be taken as investment recommendations or advice. They combine my passions in economics, finance, writing and education, and... More
  • Bitcoin; A Currency Not Even A Drug Dealer Can Love 2 comments
    Apr 17, 2013 12:13 PM | about stocks: GLD

    Ever since I took my first macroeconomics course almost 30 years ago I have been fascinated by our modern banking system. What I find most fascinating about it are the myths and misunderstandings that surround it. The Bitcoin is the logical outcome of people believing in many of those modern monetary myths. I recently wrote an article analyzing the Bitcoin and got the kinds of comments and e-mails that I expected I would get. Many if not most of them restating the myths portraying them as virtues of the Bitcoin, and of course claiming that I don't have a clue as to the truth about the Bitcoin. I would argue back that no one has a clue, that is the whole purpose of having the thing shrouded in secrecy. The whole purpose is to shield the user from the ever watchful eyes of the authority. The one thing the commenters were able to convince me of is that the real value on the Bitcoin is for use in illicit trade. If you want to trade in drugs and avoid detection by the authorities, the Bitcoin is for you...or is it?

    Even Drug Dealers Won't Want This Currency:

    Even this drug dealer theory is flawed, and the reason is very simple. The Bitcoin is deliberately designed a "perfectly inelastic" currency after some end date in the future. What that means is that after the end date, no more Bitcoins will be "minted" and the supply will be permanently fixed for all time. It will be like a gold standard when the last ounce of gold has been discovered, and there is no more left in the world to dig up.

    The appeal of Bitcoin and its advantages over paper money are instantly apparent. Bitcoin is inelastic money and as such closer to gold.

    This is one of the great myths, that gold is better than paper money. Anyone that makes that claim has never lived under a gold standard. If the objective is to subject your economy to wild and uncontrollable business cycles, all for the benefit of protecting the value of your currency, then the gold standard is great. Most people however would be willing to tolerate a mild amount of inflation to avoid the catastrophic depressions and viscous business cycles that frequently occur under a gold standard.

    Don't believe me?

    Don't believe me? Well here is an example demonstrating why a gold standard (inelastic currency) is so destructive; so destructive that even drug dealers will eventually abandon the Bitcoin.

    First you have to start with the basics. The theory behind modern monetary policy is called the "Quantity Theory of Money," and it defines the relationship between money supply, real output, velocity of money and prices. It essentially is the model Ben Bernanke uses when he runs the monetary policy of the US. For more information on this topic read "Why Deflation is Bad and Inflation is Good; Monetary Policy 101" .

    Basic monetary theory boils down to a simple formula MV=PQ, where P is the price level, Q is the real output level, M is the money supply and V is the velocity of money, or how often a dollar changes hands. A simple example would be if there was a money supply of $100, velocity was 4 transactions per year, price level was 0% inflation (1.00 deflator), then the Q or real GDP would be $400, ($100x4)/1.00=$400.

    To apply this formula everything is changed to %changes, so MV=PQ becomes %Change M x %Change V = %Change P x %Change Q, or %dM% x %dV = %dP x %dQ, the d stands for delta or change.

    Now just what is it about %dMx%dV=%dPx%dQ that a drug dealer won't like?

    Imagine you are a drug dealer and you transact in Bitcoins. Two years ago you transacted in Bitcoins when they were trading at $0.05. You sold a kilo of cocaine for 20,000 Bitcoins or the equivalent of $1,000 (I apologize if I am not pricing 1 kilo of cocaine incorrectly, I have no idea what a kilo of cocaine sells for). You convert your Bitcoins to US Dollars and head to Miami to party. After having so much fun you accidentally forgot to pay the drug lord that provided you the kilo of cocaine, and two year later he shows up on your doorstep asking for payment. You immediately grab your wallet and hand over $1,000. The drug lord reminds you that the contract was to be paid in Bitcoins. No problem you think, and you run over and check the conversion rate of a Bitcoin. After discovering that a Bitcoin now trades for about $225, the inevitable occurs. Absolute horror sets in as you rub your eyes in disbelief. What used to be worth $0.05 is now worth $225? You can't believe it. You hit refresh on your browser, again and again and again and the quote stays at $225. There must be some mistake you think. You call your drug dealer buddy down the hall to see what a Bitcoin goes for and he yells back, $225. You get out your calculator and do the math. $4,500,000 flashes in little red LED lights, you do the math again, $4,500,000. That can't be right, I can't own $4.5 million for a $1,000 kilo of cocaine you think to yourself. It is then and only then that you remember reading an article on Seeking Alpha by some guy warning people about the horrors of an inelastic currency, and the email you sent him telling him how wrong he was. The last thing you remember is pressure against the back of your head, a bright flash of light and then sudden darkness. Over time Q increased, V increased and P fell. Fixing M, without fixing V, P or Q can be deadly.

    That is only one example. An inelastic currency is also subject to hording. People can corner the market in Bitcoins. A large drug dealer who transacts billions and billions of dollars in Bitcoins could easily gobble up the entire estimated $1 billion supply of Bitcoins in existence today. For awhile he really thinks Bitcoins are great. Every Bitcoin he takes off the market simply sends the value of his stash of Bitcoins higher. He thinks he is a modern day Fisk and Gould. For a brief and shinning moment he thinks to himself, "I can make more money manipulating Bitcoins than I can selling drugs." "I can go legit" he thinks, and visions of ruling Wall Street flash through his mind. Then the bottom drops out of the Bitcoin market. It turns out than when you corner the market in Bitcoins, people can't get Bitcoins to use to buy drugs. Drug dealers across the world saw their Bitcom based economy collapse. A $1 million bounty is put of the head of the person that cornered the Bitcoin market. But that wasn't the worst of it, some enterprising young drug dealer rushed to solve the problem and releases Bitcoin 2.0, and provides an ample supply to unfreeze the market for drugs world wide. Drugs start flowing freely again, balance is restored to the drug market and the Bitcoin 2.0 currency immediately becomes the only trusted currency in the drug trade. The horded stash of Bitcoin 1.0 is suddenly worth less than a Zimbabwe $1 Trillion note. The only thing that remains of the Bitcoin 1.0 after the effort to corner the market is the bounty of the drug dealer's head that attempted it. Shrinking M to 0 in MV=PQ is a death sentence for a currency.

    Still not convinced?

    Consider the situation a drug deal faces today. 2 years ago it took 100 Bitcoins to buy a nickel bag of Mary Jane (once again I have no idea what a nickel bag is, or what it costs, this if for demonstration purposes only). Today, it only takes 0.022 of a Bitcoin. What used to bring in 100 Bitcoins, now only brings in less than 1. This is extreme hyperdeflation for the drug dealers. Why would anyone want to support a deflationary monetary system? Drug dealers aren't currency speculators, they are drug dealers. They want to sell drugs, and sell drugs for more and more money, not less and less. Just a few weeks ago a Bitcoin was trading for less than $50. Today it trades at $225, or 450% higher. A few weeks ago a kilo of cocaine cost $1,000 or 20 Bitcoins and today it costs $1,000 or 4.44 Bitcoins (once again the $1,000 quote is for demonstration purposes, I have no idea what a kilo of cocaine sells for). If you were a drug dealer, would you rather have your product sell for $1,000 a few weeks ago and $1,000 today, or have it sell for 20 Bitcoins a few weeks ago and 4.44 Bitcoins today? What is the drug dealer going to do when it took him 10 Bitcoins to make the 20 Bitcoins worth of cocaine a few weeks ago, and when it finally makes it to market, it only sells for 4.44 Bitcoins? I don't know how long it takes to ship cocaine from Columbia to New York City, but if it takes a few weeks, that seemingly comical and absurd scenario becomes reality. Once again fixing M without considering V, P and Q can be catastrophic.

    In conclusion, no matter how people choose to portray the Bitcoin, in its most basic form, it is simply an inelastic currency, or at least claims to be. Inelastic currencies are disastrous when economies are based upon them. The laws of economics and common sense don't cease to exist just because a new fad sweeps the internet. The old rules stay the same. No matter how much lipstick you put on a pig, it is still a pig. I remember the claims of the "new metrics" analysts would apply to dot com stocks, proving that the old rules simply did not apply. Well, we all remember how that turned out. I don't see any of those "new metrics" being taught in finance text books today, and for good reason...THEY DIDN'T WORK!!! I'm sure traders had metrics justifying the price of tulips back in the late 1600's. They were nothing more than nonsense where people attempted to make the illogical seem logical. The results were catastrophic. In my opinion, Bitcom is nothing more than the most recent in a long chain of bubbles, and it will almost certainly end the same way. Unlike other bubbles however this one doesn't even have hopes and dreams of a brighter future of limitless profits. The Bitcoin is designed to deliver deflation to anyone that dares use it, and is replicating a monetary system that has failed countless times throughout history. The Bitcoin isn't the result of people studying history and fixing their ways, the Bitcoin is the result of people attempting to repeat the mistakes of the past.

    Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Stocks: GLD
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