Can the War on Drugs Bootstrap Bitcoin?

A few weeks after my last post on Bitcoin, the cryptocurrency was featured on EconTalk. From there it captured the imaginations of libertarian geeks everywhere. When I last wrote about it on March 12, one Bitcoin was worth 88 cents; today one is worth $17.14. There are now numerous startups dedicated to serving as Bitcoin exchanges, banks, e-wallets, etc. Notably, there are not yet any futures markets, which has led many commentators to quite reasonably cry bubble.

There is a sense in which all fiat currencies are based on bubbles. After all, by definition fiat currencies have no intrinsic value; they are valuable because they are liquid, and they are liquid because they are valuable. This circular reasoning is not far from the information cascades that economists discuss in the context of bubbles.

Let’s call the process by which a currency comes to circulate as a widely-accepted medium of exchange “bootstrapping.” For fiat currencies, bootstrapping typically involves some coercion: the government demands that taxes be paid in its fiat currency, which creates demand for the currency. If the currency has other properties that make it useful as money—it’s divisible, transportable, and a reasonably good store of value—then this coercion is enough to make the currency widely-accepted for non-tax payments as well.

Bitcoin does not have a sponsoring government that demands Bitcoin-denominated tax payments. But it has something close: the black market. This week Gawker ran a piece describing Silk Road, an online black market where you can buy everything from marijuana to heroin, plus drug lab supplies and small weapons (no WMDs—yet).

Silk Road is only accessible through the encrypted and decentralized Tor network, so I did what any anarcho-curious geek would do. I downloaded and configured Tor and merrily browsed the Silk Road website (link only works if you have Tor running). I can confirm that it is like a candy store for drug users. According to the merchant reviews, the drugs are shipped in vacuum-sealed packages that emit no odor to be detected by the drug-sniffing dogs. Furthermore, each merchant lists the country from which he ships; pick a merchant based in your country and your package won’t have to go through customs, further decreasing the likelihood of detection. Most customers seem very happy with the care taken in shipping as well as the quality of the products they have received.

Nearly all payments on Silk Road are made using Bitcoin. Bitcoin is an excellent fit for the black market because it is pseudonymous—every payment is made from and accepted at a public 33-character address, but users can generate as many addresses as they want to preserve anonymity.

The question remains of whether the quasi-anonymity of Bitcoin is enough to keep the Feds from being able to shut down Silk Road or to make it unsafe to use the site. As Jerry Brito points out, we are now observing a natural experiment on the anonymity of Bitcoin. The hacker group LulzSec has recently undertaken some activities that make it a prime FBI target and solicited donations at a publicly-listed Bitcoin address. Assuming that the address is a real one and not devised to throw the FBI off the scent, we’ll soon know whether the government is able to identify people on the basis of their Bitcoin transactions.

Assume that it turns out to be safe and convenient to use Bitcoin in the black market. This fact may then turn out to be enough to bootstrap Bitcoin. As I wrote above, bootstrapping a fiat currency involves coercion. In this case, that coercion is supplied by governments who enforce the illegality of black market activities. They are coercively creating demand for the currency that is most convenient to use in the black market. Once there is enough demand for Bitcoin for black market purposes, Bitcoin may become more widely-accepted for legitimate transactions, just as the demand for fiat currency that governments create through taxation spills over to non-tax payments.

In the short run, Bitcoin will likely become more widely associated with the black market and therefore demonized. If you want Bitcoin to succeed, you should be OK with this, since it’s pretty much inevitable. Read up on Agorism and counter-economics. The demonization of Bitcoin may make some legitimate users hesitant to adopt the currency. In my view, this is silly. I will happily accept your Bitcoin-denominated tips and donations at 1FMxbQLh2hEoWXgM4GggbSAMoR61iL7zdp.

I am by no means certain that Bitcoin will succeed. The rapid rise in value that it has experienced may in fact be because there is a Bitcoin bubble. This guy is evidence of that. But it’s hard a priori to differentiate between a bubble and the successful bootstrapping of a currency (this is one reason we need Bitcoin futures). However, I am confident that if Bitcoin succeeds, it will be because of the War on Drugs and other policies that increase demand for a quasi-anonymous, internet-transportable currency to engage in online black market activities.

13 replies to “Can the War on Drugs Bootstrap Bitcoin?

  1. Alex Beal

    Interesting post! It’s similar to something I’ve been thinking for a while. For the average person, the risks of bitcoin substantially outweigh the benefits. The currency is volatile and possibly/probably a bubble. To the average Joe who just wants to cash his paycheck and buy groceries, bitcoin doesn’t make sense. It does make sense, however, to those in illicit trades, where the risks of using bitcoin, while still substantial, are less than those of using USD, etc (or at least they perceive them to be less).

    Which leads me to my next point: As some others have been pointing out, bitcoin isn’t really anonymous. It’s certainly more anonymous than a credit card, but it’s still not quite ready for trades like the black market that require strong anonymity. Here’s an example: You can actually view all of the activity going on in LulzSec’s account here: Although most of them have been deposits from other addresses, the owner of the account has made some payments from the address. Here’s an account that has received a payment from LulzSec’s address: The payment is the first transaction, and, as you can see, that transaction is a deposit from *two* addresses. One is the address published by LulzSec and the other, because it’s part of the same transaction, is probably also owned by LulzSec. This is a result of how the bitcoin client spreads your coins out across multiple addresses. This is supposed to bolster your anonymity, but it really just obfuscates it a step further. If you make a payment larger than the balance in any one of your addresses, the client has to use multiple addresses to fulfill the transaction, thus tying your multiple addresses together. If your identity is tied to any one of those addresses, it’s now tied to all the addresses bundled together in that transaction. As you can see, the other address implicated in that transaction is quite active: I wouldn’t be surprised if LulzSec’s identity has previously been tied to one of those. Of course, if LulzSec is using an e-wallet service, this analysis would be totally wrong, but I wouldn’t be surprised if someone smarter than me came up with some sort of statistical attack against these e-wallet services (someone like the CIA).

    That being said, I’m totally rooting for Bitcoin, but I’m afraid that someone who doesn’t really understand the protocol is going to get an unpleasant surprise in the night in the form of tear gas grenades through the window (delivered courtesy of the FBI).

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  3. Hector

    First, thanks for the fantastic analysis on bitcoin.

    Second, I’m interested in what you think the futures market you mention would do for bit coin. I understand a little bit about the theory of futures markets, how the futures market is supposed to send signals to producers to produce more or less.

    It seems to me though that the reality of futures markets is very different than the theory. Futures markets, instead of sending clear, useful signals to producers, can instead do just the opposite by encouraging wild speculation that then contributes to bubbles. Matt Taiibi wrote a piece recently about how in 2008 oil was above 140$/barrel, largely propelled by the futures market. Presumably this would send a signal to oil producers to produce more. But, contrary to this signal, Saudi Arabia was having difficulty finding buyers for their oil and did not imagine they could possibly find buyers were even more oil to be produced.

    So, assuming I didn’t butcher Taiibi’s example too badly, my question is whether you think a bitcoin futures market would act against the formation of a bitcoin bubble, or do you think it’s possible that a bitcoin futures market could contribute toward a bitcoin bubble?

  4. Eli Post author

    Hector, it’s true that the mere existence of a futures market does not preclude a bubble from forming. However I have in mind two effects of futures markets.

    First, contra some commentators, futures markets make prices less volatile. This fact clashes with many people’s intuitions, but the best way to test the prediction is to compare prices of similar commodities that do and don’t have futures markets. For example, in the US, onion futures are banned. Onion prices are much more volatile than other agricultural commodities that do have futures markets, such as corn.

    Second, right now there is no easy way for speculators to bet against Bitcoin. So you have all the speculators who think Bitcoin is going to appreciate entering the market, and all the speculators who think it will depreciate sitting on their hands. These latter speculators are an important force in taming bubbles.

    So I think on the whole futures markets are a force for non-bubbly asset markets. I simply don’t know enough about the oil market to address the example you cite, but it doesn’t strike me as contradicting my arguments. People might bid up the price of oil futures as a form of insurance against the risk of an even larger increase in the future. Just because the higher price didn’t materialize doesn’t mean that it was a bad ex ante hedge or that over the distribution of possible price paths futures don’t reduce volatility.

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