Bitcoins, the Winklevoss twins, and financial foolery

In this April 3, 2013 photo, Mike Caldwell, a 35-year-old software engineer, holds a 25 Bitcoin token at his shop in Sandy, Utah. Caldwell mints physical versions of bitcoins, cranking out homemade tokens with codes protected by tamper-proof holographic seals, a retro-futuristic kind of prepaid cash. With up to 70,000 transactions each day over the past month, bitcoins have been propelled from the world of Internet oddities to the cusp of mainstream use, a remarkable breakthrough for a currency which made its online debut only four years ago. (AP Photo/Rick Bowmer)

Though they're better-known as Harvard's Facebook-lawsuit gazillionaires, the Winklevoss twins have likely already made a killing on the digital currency called bitcoin. But the Winklevii sure say some silly things - such as suggesting that they're doing something more than speculating. 

"People say it’s a Ponzi scheme, it’s a bubble,” Cameron Winklevoss said, according to this New York Times story. “People really don’t want to take it seriously. At some point that narrative will shift to ‘virtual currencies are here to stay.’ We’re in the early days.”

Cameron and Tyler Winklevoss apparently lay laim to more than 1 percent of the bitcoin digitally "mined" since the currency's invention in 2009.  It's tricky to assign a U.S. dollar value to their holdings, since the currency's value has swung wildly in recent days and weeks, as I noted here yesterday in a blog post on bitcoin's sinister role in fueling computer malware . The Times said their holdings were worth "at least $11 million as of Thursday morning — when trading was temporarily suspended after the latest and largest flash crash left a single bitcoin worth about $120 and the whole market worth $1.3 billion."

What's most striking about the bitcoin story is the conflation of bitcoin and "virtual currencies" - as if there is no other kind than bitcoin. But well before bitcoin's invention, vast sums of what goldbugs and bitcoin-bugs like to deride as "fiat currencies" were routinely changing hands in virtual form - and they have been, one way or another, for decades. Virtual currency is what the "cashless society" is all about.

It's no surprise that bitcoin was dreamt up during the fever of the post-2008 financial crisis, when industrialized countries were amassing large deficits, because of automatic stabilizers and intentional countercyclical spending, that helped stir fears of inflation - often, as Paul Krugman points out today, for political purposes. One of bitcoin's key features is its predictably stable growth in money supply.

Does that make it superior to a "fiat currency"? No, it just makes it another kind - and one with nothing other than shared claims of value to support its value. 

Blogger Joe Weisenthal elegantly skewered all the bitcoin foolery in a Business Insider piece yesterday. Weisenthal notes that the Winklevii are far from alone, and that bitcoin's boosters include venture investor Chris Dixon, who declared last month that math-based bitcoin represented the third great era of currency - after commodity based currencies, such as gold coinage, and fiat currency, such as Federal Reserve notes.

Weisenthal writes:

Here's the problem: Fiat currency has intrinsic value. Bitcoin doesn't.

There's a popular meme going around that fiat currencies (like the dollar, the British pound, the euro, and the yen) have no intrinsic value, and that they're only accepted because they're accepted, and that at some point, people will see through the "illusion" of the value of paper money, and realize that wealth lies somewhere else. Usually this argument is made by gold bugs.

But fiat currencies have tremendous intrinsic value because governments say they do. That's why they're called fiat currencies. They have value by government fiat.

This truth might be annoying, but the fact of the matter is that we live in a world of laws, where governments have armies, and can imprison you if you don't pay taxes. And every transaction that you do is taxed in some way, meaning that to operate in any practical matter in this world means transacting in U.S. dollars.

So the U.S. dollar isn't just important because other people think it is. The U.S. dollar is important, because the world's strongest entity, with the full force of the U.S. army, the FBI, the CIA, the NSA, and various local authorities with guns demands that you pay them in U.S. dollars. That's not faith. That's the law. Sorry.

Even outside of the requirement to pay taxes in U.S. dollars, the Federal Reserve system has established the dollar as the unit of currency for banking in the United States. So if you want to be plugged into the banking system at all — which is a requirement for virtually all individuals — you have to use U.S. dollars.

So instantly, anyone who says the U.S. dollar is backed by "faith" or an "illusion" has no concept of the sheer force behind the currency.

This isn't true of Bitcoins at all.

It's true that there's a scarcity to them — there's only a finite amount and there's a limit to how many there will ever be — but scarcity alone does not give something lasting value.

After all, I could create JoeCoins, and say that I will only issue 100. But it's unlikely that anybody would give me even a penny for one. And I can't force anyone to use them, because I don't have my own army or police force or my own set of laws.

JoeCoins could have value, if he or others could persuade people like Dixon and the Winklevii to exchange something of value for them. The real question is why so many people have been willing to do so for bitcoin, and how long it will take for a bubble based largely on foolery - on the hope that, as Weisenthal puts it, "you can sell them to a greater fool tomorrow" - will finally burst.