Bitcoins, Tulips, and the Madness of Crowds

By Pam Martens: February 26, 2014

Coming off the greatest financial collapse in modern history because of unregulated derivatives backed by dodgy collateral, it is more than a little disconcerting that we are now forced to use our digital ink to explain the pitfalls of investing in a digital currency backed by air.

There seems to be a mass hypnosis at work. For example, last evening, at 6:47 p.m., the wire service Reuters explained Bitcoin to its readers as follows:

“Unlike traditional currencies, where a central bank decides how much money to print based on goals like controlling inflation, no central authority governs the supply of bitcoins. Like other commodities and currencies, its value depends on people’s confidence in it.”

The last sentence of the Reuters statement was likely penned by someone who has never traded commodities or registered with the Commodity Futures Trading Commission. Bitcoin is decidedly not like other traded commodities. Corn, sugar, gasoline are tangible things. You can readily check that their trading value is hinged to reality by checking their price in the grocery store each day or, in the case of gasoline, at the pump. A Bitcoin, on the other hand, has no tangible commodity backing it. Its value is whatever some self-created website says it is.

According to news agency AFP, just before the MtGox Bitcoin website shuttered its operations yesterday, a Bitcoin was trading for $130. On other Bitcoin websites it was trading for around $500.

As for the sustainability of confidence in a product based on nothing tangible, one need only look at the trading range of Bitcoin at MtGox since January. It has declined from $900 to $130 according to AFP. If that were a real commodity, a crash of 86 percent in a few months would strongly suggest a catastrophic event.

The business writers at Reuters are also dead wrong on Bitcoin being like other currencies whose “value depends on people’s confidence in it.” Let’s take the U.S. dollar. Backing the use of the U.S. dollar as a world currency is the following: a Congress made up of 435 Representatives in the House and 100 Senators in the Senate; 535 people elected from all over the United States who have the power to tax the income of every American receiving wage, dividend, interest or even Social Security income at whatever rate they see fit in order to pay the Nation’s bills and debt obligations to other countries.

There are two big mechanisms underlying the confidence in the U.S. dollar. Unlike many other countries which have a not-so-foolproof system of collecting taxes, in the United States Federal income tax is deducted from workers’ paychecks and sent off to the Federal government by the employer before the worker gets his hands on his paycheck. Every worker, therefore, becomes part of the store of value in the U.S. dollar.

Next comes the billions in taxes owed on interest and dividends. Those are reported to the Internal Revenue Service under the individual’s social security number by the financial institution or company declaring the interest or dividends, leaving no escape hatch for not reporting and paying the taxes owed.

When an individual or a financial institution tries to game the system to dodge paying their share of taxes to support the roads, schools, tunnels, bridges, national parks, and Federal law enforcement protections provided with those taxes, the government has both the ability and eager willingness to lock you up and/or make a public spectacle of you. Just yesterday, Credit Suisse was outed by Senators Carl Levin and John McCain and the U.S. Senate’s Permanent Subcommittee on Investigations for aiding and abetting tax cheats. In 2009, Swiss bank UBS was outed on similar charges and paid $780 million to settle the matter.

A digital currency that is backed with nothing tangible, that has no legislated power of taxation to support the currency, that has no Federal regulation over the people offering the currency, that has no independent, taxpayer-financed police to prevent counterfeiting of the currency, is not even a Tulip Bubble. A tulip is a tangible thing. This is just a bubble.

Bitcoin was launched in 2009 by an anonymous person or group calling itself Satoshi Nakamoto. The currency exists online with the promise that computers are keeping track of how many Bitcoins each individual owns. Investors can buy Bitcoins with dollars, euros and the currency of some other countries. In a standard transaction, an amount is transferred from the buyer’s online digital wallet to the seller’s online digital wallet. Because these websites are accepting deposits of hard cash from people around the world, they are effectively unregulated global banks.

When regulators can’t even control the global banks they already have on their radar screens with the legislative power to regulate, just what they need are unregulated banks where they have no oversight power.

Mainstream media has to some extent aided and abetted Bitcoin trading by referring to these unregulated Bitcoin websites as “exchanges,” giving them the imprimatur of a stock exchange or futures exchange – all of which are regulated in the United States. In London, not so much.

One entity which has been a big promoter of Bitcoin is the Mercatus Center at George Mason University which is heavily tied to billionaire Charles Koch and his money. Koch is a die-hard libertarian whose utopian ideal is the free-wheeling entrepreneur unfettered by the evil regulations of government.

In a paper published last year by Mercatus, researchers Jerry Brito and Andrea Castillo wrote:

“The current market capitalization of the bitcoin economy is estimated to be more than $1 billion. Businesses big and small have shown interest in integrating the Bitcoin platform into their operations and providing new services within the bitcoin economy. Venture capitalists, too, are eager to put their money behind this growing industry. The development of Bitcoin and its early successes are an exciting testament to the ingenuity of the modern entrepreneur.” (If Ayn Rand were alive today, she would no doubt be welling up with tears of pride.)

Signaling big plans for the future of Bitcoin websites, Brito of Mercatus wrote further in the December issue of Reason Magazine that Bitcoin “can serve as the backbone for any online transaction that relies on a ledger, such as property registration, futures swapping, and bonded contracts. Because Bitcoin is decentralized, these applications can exist largely outside regulators’ reach.”

A former director of the Mercatus Center’s regulatory program was Wendy Lee Gramm, the former chairperson of the Commodity Futures Trading Commission (CFTC) from 1988 to January 1993. Gramm’s deregulatory stance toward credit derivatives is widely regarded as a key element in the 2008 financial collapse of Wall Street.

According to Public Citizen, “In 1992, as the first step in its business plan to profit on the speculation of energy, Enron petitioned the CFTC to make regulatory changes that would limit the scope of the commission’s authority over certain kinds of futures contracts.  Immediately before leaving the CFTC, Gramm muscled through approval of an unusual draft regulation that would do just that – it narrowed the definition of futures contracts and excluded Enron’s energy future contracts and swaps from regulatory oversight.  Although her actions were criticized by government officials who feared the change would have severe negative consequences (as, in fact, it did), Gramm was rewarded five weeks after she left the CFTC with a lucrative appointment to Enron’s Board of Directors.  Between 1993 and 2001, when the company declared bankruptcy, Enron paid Gramm between $915,000 and $1.85 million in salary, attendance fees, stock option sales, and dividends.”


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