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.