What's the Big Deal with Bitcoins?

            Bitcoins…bitcoins...bitcoins!  It seems like the world has all of the sudden, or at least as of early this year, become entirely enamored with bitcoins as evidenced by the overwhelming press coverage they have been getting recently.  I don’t know how I managed to get this far in the year without writing about it because it has been a fascinating phenomenon to watch unfold.

            Recall from the end of my last post that bitcoins are an open-source fiat money that is backed by no government or bank, but rather the citizens of the internet.  It is the most fiat of money for that very reason.  Bitcoins have been around for several years, beginning in 2009 and growing slowly in popularity since then.  The exchange rate of dollars to bitcoins began 2013 at around $13 and rose to an all-time high of $230 by April and then dramatically crashed before leveling off around the hundred dollar mark where it sits now, several months later.  What happened in those months that caused the sudden bubble and bust?  I have a theory: an educated guess, if you will based on a little reading and some mental puzzle-solving.

            Bitcoins have been used primarily for ecommerce transactions of illegal goods because they are, by design, international and anonymous (or at least very difficult to track).  Drugs, firearms, fake IDs, and rather significantly more unsavory goods are dealt through illicit marketplaces with bitcoins being used as the medium of exchange, internationally and anonymously like the buyers and sellers themselves.  Hold that thought in the back of your mind.

            What was going on in the world in early 2013, culminating in March?  The European financial crisis had hit Cyprus pretty hard.  I even wrote a post about the whole incident when it was happening.  Cyprus is a tax haven for Russian business magnates and so one of the things that was suggested by the ECB/IMF/European Commission during the early weeks of March (March 16^th to be exact) was to confiscate 40% of the bank deposits of uninsured accounts with a value over 100,000 Euros: essentially targeting the Russian businessmen.  This idea was eventually dropped on March 25^th, but during the days between the 16^th and 25^th, the fate of those deposits were up in the air.  

            Before looking at the exchange rate graph below, take a wild guess as to when the bitcoin boom started, recalling that bitcoins are the de facto underground market currency and that a substantial portion of Russia’s economy is built on the dealings in such markets…and that Cyprus was a tax haven.

            If you guessed that the dramatic boom started in the third week of March, you’d be correct!  Bitcoins had been increasingly in the public eye since the beginning of the year but the major step up began when the deposits were threatened by seizure.  I suspect that the rest of the world noticed the inflation and speculators carried the bitcoin’s value to its highest point even after the deposits’ threat had gone away.  Examine the graph for a while and see if you can’t extract more insight from it.  The events of the past few months on the web and in the rest of the world are more interesting than ever and I suspect we can learn about how humans deal with booms and busts by seeing the bitcoin crisis as a microcosm of what has happened, and maybe will again, for other securities and currencies in the rest of the world.

By the way, the exchange rate chart can be made here where you can manipulate the time frame as well as several technical indicators.

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The Story of Money Part 2

            As promised, I am back with a sequel to the last piece about the story of money.  I mentioned that the main features of money are durability, divisibility, and wide acceptance as having value.  I also mentioned that these have not always been the case and that there is at least one notable exception that comes to mind, in the area of divisibility.  But this story in turn will take us to the more valuable insight about the nature of money in modern times, the concept of fiat money.    

"I'll need some help with getting this to the grocery store."

              There is an island in the South Pacific called Yap which until recent times has used large round blocks of stone as their currency, called Rai.  The origin of this money is unknown but essentially the scarcity of these stones (quarried and milled on another island), the difficulty associated with transportation (20+ men were required to move the largest ones), and the propensity for the movers to die with stones in tow when storms struck on the open sea made them sufficiently valuable to use as currency.

              While not all stone money items were gargantuan, it does not take much imagination to realize that having stone money of any size is not conducive to easy commerce between citizens.  This is where the story becomes even more interesting.  Once people realized that moving the Rai around was not practical, they started writing promissory notes that entitled the bearer to a particular stone stored in some location on the island.  Tangentially, the parallel between this kind of money and gold or silver certificates is easily seen.  This allowed easy transactions between people since a stone could be retrieved by anyone bearing the certificate.  Theft was out of the question because of the level of trust on the island and the fact that stealing boulders is no mean feat.

               On one fateful voyage, a very large and accordingly valuable stone was lost to the sea.  But as the inhabitants had grown accustomed to dealing in paper that represented stones, and the representative paper was still in existence, the populace agreed that the stone was out there somewhere and that its document was still valid money.  Thus fiat money was born for the island of Yap.

                “Fiat” is the Latin word for “it shall be” or “let it be done” and fiat money is money whose value is not derived from an underlying asset like gold, silver, or stone.  Rather its legitimacy comes entirely from the faith of the people who use it and, more often that not, the government that decrees it as the legitimate currency of the land.

                In modern times, the rise of Bitcoins has been an endlessly fascinating form of currency because it is backed by no government at all.  I recommend reading up on it because it is much too involved to deal with sufficiently here.  Yet even though there is no ruling authority that mandates it as having value, the faith and trust of those who deal in it online has elevated it to the status of money that is widely accepted in many stores (mostly online) across the globe.  But what makes it even more spectacular is the fact that it does not even have a physical presence.  In truth, it is the most fiat of money of all. 

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The Story of Money

What is money and why do we need it?  How did it come about in the first place?  This is a question that I addressed in conversation recently with a friend after visiting the Hong Kong Monetary Authority, its equivalent of the Federal Reserve.

Everyone knows intuitively what money is: a medium of exchange and permanent store of value.  In other words, one person has coins and bills and another person has coffee beans, guitars, or microscopes.  They trade one for the other and everyone goes on his way.  The permanence of money is also an important characteristic.  It would not do to have currency that decays over the course of time!

Where did money come from and why do people use it rather than just bartering like our ancestors used to, and why do we use paper or metal which have no intrinsic value rather than something that does have value?

The need for money is shown in the following story, as related to our class by my first economics professor.  Imagine that you are a maker of guitars and that you want to get coffee.  So you take your guitar to a coffee farmer and try to work out an agreement on a trade.  The problem arises: what if the coffee farmer does not want a guitar?  Or what if he does not have enough beans on hand to pay you for that guitar?  In modern terms, for example, 45.4 pounds of Starbucks coffee costs the same as a Fender Stratocaster, (if our ancestors had the benefit of price shopping on Amazon.com)! The problem with a pure bartering system is that not everyone wants what you have or perhaps they do but cannot accommodate your requirements for the trade. 

This is where money comes in: a society agrees on something that will be used to facilitate exchange whether it is coins, stones, shells, salt, metal ingots, or any number of other items used by civilizations in the past.  Besides society-wide acceptance of their value, money possesses at least one other advantage over trading goods for goods: it is easily divisible.  You will notice that half of a guitar, a third of a cart, and the base of a microscope are no good to anyone.  In other words, if our farmer from above didn’t have 45.4 pounds of coffee on hand, the trade would not go through.  But with money, the trade can happen between anyone who has money and anyone who is selling something. To recap, these features can be seen in money all over the world: easy divisibility, society-wide or universal acceptance in a country, and usually permanence in the material used to make it.  There are few exceptions but one or two of the most prominent ones deserve to be the subject of the next post. 

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China Seminar Post 3: The Real Wealth of Nations

            During one of our several university visits the lecturing professor gave us a particularly unique and memorable talk.  The typical speech we’d receive in these lectures tended to involve an economic lesson about some area that was growing such as how the city was planning to develop their infrastructure in this or that industry, or how 300 million people had migrated from rural areas to the cities, or how income has risen dramatically in the past several decades since the late 1970s.  This one, in particular, took a much more philosophical slant. 

            Professor Zhang Yu from Shanghai University spoke to us his philosophy about the reason that a country develops or does not develop.  Having grown up and been educated in an overtly Communist state, he learned that there was strength in unity of thought and belief.  He learned that the government was the benevolent institution to pass down those thoughts and beliefs for the good of the people.  But as he grew older and began to read independently (philosophers like David Hume), he came to a different conclusion.  He began to realize, as he told us, that the government cannot be the entity to oversee all aspects of life.  He told us that if the government controls thought and belief, then creativity and dynamism of the populace will be squelched, and a nation will be cursed with an inability to move forward.  As he said progress cannot be legislated, so he said that the power to transform a nation lies in the minds of its people.  Free thought emanating from the minds of free people is how society can evolve and change for the better.  So this brought him to his terminal point.  These days, those in governance over China’s cities and provinces put so much emphasis on how much is being exported, or how big the country’s GDP is from year to year.  This results in a measure of success being confused for success itself.  In reality, however, the true wealth of a nation is its people.  That country is rich which is blessed with free thinkers, tinkerers, and an environment conducive to the germination and sharing of ideas. 

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China Seminar Post 2: IBM

            In my last post, I recalled a visit to Baosteel, a symbol of the massive manufacturing capacity China has.  The following day, we visited IBM’s flagship office in Shanghai.  Not coincidentally, IBM ought to be taken as a symbol of China’s massive service-industry capacity.  For those who are unfamiliar, as I was to a large extent, International Business Machines provides custom programming services to business in need of software solutions, among many other things.  It is also a major player in the Big Data revolution, which I have written about before, competing with the likes of EMC and Google to meet the world’s growing data needs.  IBM has many branches beyond data processing and programming which makes it a major player and competitor in separate but complimentary industries such as financial management services and business operation planning.

            IBM is aware that the world is changing, sometimes for the better and sometimes for the worse.  But their overall mandate, as we learned in a lecture and saw on public service announcement posters hung around the office, is to build a smarter planet.  By “smarter”, they mean more connected, more responsive, and more efficient.  As we see, the world is a system of systems which exist not in isolation of each other, but rather as an ecosystem of its inhabitants.  In the broadest sense, IBM tries to measure the heartbeat of a city: its traffic, utilities usage, weather, and anything else one could possibly be imagine are all compiled and used to make a city run better.  Traffic is regulated more efficiently depending on the time of day, electricity is conserved in times of low demand, etc.  Weather readings are used to model climate patterns and make predictions for the future.  Even the pharmaceutical and medical research industries are being transformed as huge amounts of information is created from the processing of data at an The value of this kind of data compilation and processing can be seen at the individual user’s level as well when smart alarm clocks know poor weather conditions will exacerbate traffic and wake up their owners earlier.  The applications for this kind of technology are endless and as a doctor accesses and make decisions for his patient by measuring vital signs, so humanity can build a better world.

            IBM has been a particular boon to a developing nation like China because it is able to bring high technology to rural areas that are just beginning to modernize.  Without infrastructure like sewage systems, running water, power grids, public transportation, and the like, small towns are able to adopt the bleeding edge technology of city planning with the benefit of hindsight that is just one piece of the expertise IBM brings to its municipal clients.  By using IBM’s services, and the services of companies that offer the cutting edge of technology immediately, a town can make decades of regular development in one swoop of upgrade and join the 21^st century efficiently and quickly.  This means dramatic increases in the living standards for the populace touched by these improvements.  

  

                                                                                                                         IBM Logo

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China Seminar Post 1: Baosteel

I was in Shanghai recently with a school fieldtrip and we had a visit to one of the manufacturing facilities of China’s largest state-owned steel manufacturing company, Baosteel.  It is the second largest steel producing in the world after a Luxemburg company called ArcelorMittal.  With an area larger than the city of Macau (itself 11.39 square miles), the whole complex was an astonishing and breathtaking sight to behold.  One of my initial impressions was the fact that despite being a massive manufacturing area, the place did not give off the odor of pollution one would expect in a place where heavy machinery and metal smelting is in operation.  It turns out, and quite contrary to the popular culture belief of Western nations, China is quite environmentally conscious and has taken steps to offset the pollution created by Baosteel by covering 45% of the factory grounds with trees and foliage.  In reality, we learned that Baosteel is a small city with a zoo, pool, and other amenities that serve the employees and their families who live on-site.  I could not imagine an American company doing so much to take care of their people, and remember that this plant is in a country that often has a reputation for being a “pollution haven” by its detractors in the rest of the world.  Personally, I did not smell much pollution in the area and regardless of how effective their efforts are, one ought to give them credit for trying.

We witnessed the miracle of steel processing from the safety of a catwalk above the fray of the factory floor.  As we stepped into the room, it seemed as though we had been transported to a scene in Atlas Shrugged.  The heaviest of heavy industry came together in a shower of sparks emanating from fiery red steel ingots and measuring initially about three feet wide, by 50 feet long, and a few inches tall.  Over the course of a quarter mile of machinery, rollers pressed it down until it was much thinner and several times as long.  Before the metal was completely cooled, it was rolled into a coil.  Having finished, it was shipped off as the raw material for the next producer to use in his manufacturing.  Not only does the product from Baosteel go around the world but is used in a wide variety of applications from weapons to automotive, marine components to soda cans, and many more.  As a matter of fact, the 1 Yuan coin is stamped from their alloy.

As we drove around the city-factory, I was struck by many things.  The scale of the machinery was beyond anything I had seen before.  The blast furnace was actually several buildings because one could not contain it, for example.  Baosteel has three port harbors.  One is for receiving iron ore from Australia and Brazil.  A second is for shipping the finished product all over the world.  A final one is for the removal of slag, the impurities taken out of the ore in the smelting process.  It is common practice to recycle this slag and our tour guide was proud to inform us that many buildings are constructed of concrete made from Baosteel’s unusable materials. 

Despite the rather sun-shiny view we were given by the Baosteel executive/tour guide, I did hear from other sources that it is plagued with some large, but not unsurprising in light of the fact that it is a government-owned institution, problems.  First and foremost, and as one might expect, it is a highly corrupt institution.  It turns out that the monsters of patronage politics and its twin crony capitalism are alive and well all over the world when business and government are mixed. 

Overall, however, the tour was an eye-opening experience by any account and I came away with a more complete appreciation of the Far East’s progress.  So often in economics classes we will hear that the Chinese are building towers and buildings at unprecedented rates.  But this comes alive when we are greeted by a forest of cranes upon arrival in Shanghai.  In the same way, we hear that manufacturing is booming.  But I can say with some confidence that one starts to leave the realm of knowing and enter that of understanding while walking through in a room heated and illuminated by glowing steel. 

I didn't take this picture, but this is the room we saw. The line of fire is a steel ingot being rolled.

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