Why did I bet on bitcoin at the peak of the mania? (2) – Digital gold

Part 2: Digital gold

Satoshi Nakamoto, the anonymous inventor of Bitcoin originally hoped to create a payment system with radically cheap (even free) transactions, which therefore could also be used for micropayments. We can declare that bitcoin has not been fulfilling this promise for years: at times, a single transaction can cost multiple dollars. This is certainly not how I would buy my coffee.

Still, at the peak of the mania in December 2017, I made a bet that bitcoin would outperform gold on a five-year horizon. I did so despite clearly seeing that we were in the final phase of a bubble soon to pop. Moreover, it was doubtful whether bitcoin would ever be able to serve the purpose it was dedicated to by its creator. So what did I base my bet on?

Due to its decentralized operation, limited supply and permissionless usage, there is another role bitcoin may serve. Even if it fails to become a global transactional currency and the universal money of the internet, it may still become some sort of digital gold that meets the expectations of the 21st century (as opposed to the recently announced Libra project, which aims to create the global internet money).

So I based my bet on the following assumptions:

1. There is a need for digital gold, a role which is yet unfulfilled.
2. Bitcoin has a good chance of soon becoming the globally accepted digital gold.
3. State authorities cannot or do not want to prevent this from happening.

After presenting the background of my bet, in this article I will summarize my arguments for the first assumption.

The failure of central policy making

During his youth, the Argentinian Wences Casares was thrice a witness to his sheep rancher parents losing their life savings. The reasons varied: devaluation of the local currency, hyperinflation and the state expropriation of bank deposits. He saw the struggles, agony and ever-growing fear of his parents. The hardships affected their whole community, many became beggars, criminals or both. A small elite though, the truly wealthy, had access to foreign bank accounts where they could secure their savings in dollars. The young Wences was deeply traumatized by these events, leaving marks on him for a lifetime.

The history of humanity is full of similar periods of inflation or economic chaos that caused the suffering of millions. And they are not over. Just think of the total havoc in today’s Venezuela, the tailspin of Turkey or the default of Greece a few years ago. Not to mention the numerous dictatorships in Africa and Asia. But we need not look far for extreme examples: the currency of post-World War II Hungary holds the all-time world record for hyperinflation.

A shared feature of these rough periods is that they are typically brought about by deliberately destructive or simply incompetent decisions of the powerful. However, it is the elite that is the least affected by the crisis. The damage is mostly done to the poor.

The sympathetic crowd

The crimes of politicians made vast numbers of people distrustful of central policy makers. Yet, for long, these people have been helpless and exposed. They lacked the means even to protect their savings, the value of which was inseparable from the decisions of powerful leaders. Those decisions sometimes still had catastrophic consequences.

But developments in the past few decades, the emergence and global spread of the internet, and a series of discoveries in cryptography led to the creation of the first tool that brought hope to these people. With the birth of bitcoin, for the first time ever, they were able to secure their savings against central malintent and incompetence. Even without access to foreign banking or the US dollar, they can find refuge from devaluation, hyperinflation or the nationalization of bank deposits. It is especially ironic that they are protected by an asset as volatile as bitcoin. However, compared to the 10,000,000% inflation in Venezuela, bitcoin is a much better choice even with the unluckiest timing in buying.

The history of cryptocurrencies is full of characters whose immense motivation to develop the technology and spread its use stems from personal experiences. A key component to the quick progression and success of the decentralized world is the plenty of committed contributors.

Taking Wences Casares’ example, he currently serves as the CEO of the bitcoin wallet provider Xapo. Besides the business opportunity, his work is also driven by a strong sense of purpose. He wants to provide an escape from hyperinflation, devaluation and bank deposit seizures to young people with a similar fate. On a related note, through Xapo he is also a founding member of the Libra project, which aims to realize the freely accessible global internet money.

There is another proof that there are plenty of quiet-but-committed contributors. Lots of shops, big and small, have been accepting bitcoin for many years, long before the crypto bubble of 2017. But why would anyone take a currency that may be worth a fraction of it tomorrow, and is otherwise troublesome to handle? Leading economists, who typically argue for the pointlessness of bitcoin, usually do not understand this fact and rather just ignore it. Indeed, economical reasoning does not work here: they take it because too many people around the world have had too many bad experiences with central policy makers. They sympathize with the decentralized ways of bitcoin and accept it despite any economical consideration.

Dedicated geniuses

The advancement of cryptocurrencies is supported by determined people not only in adoption, but also in R&D. Although Vitalik Buterin, the father of Ethereum — a young parent, currently 25 — now lives in Canada, he was born in Russia. The country has a significant tradition of abusing central power and oppressing citizens. I do not think this is a coincidence. While I do not have exact numbers, so this is a highly subjective remark, it seems as though programmers from similar countries were overrepresented in the original Ethereum developer team. Hungarians certainly were.

Speaking of which, scientists of Hungarian descent made lasting contributions to the field of cryptocurrencies long before Ethereum, and even before bitcoin. Again, origin plays an enormous role in spurring dedication. Cryptographer Nick Szabo was born in the United States, but his father fought against tyranny in the Hungarian Revolution of 1956. After the defeat, he was forced to flee due to the following retaliation. Nick Szabo heard a lot from him about oppression, nationalization and the misuse of power. He became convinced that governments should be stripped of as many roles as possible, since they are inclined to use their power maliciously. Instead, important governance functions should be provided in a different way, through a different system. This should be designed such that abuse and arbitrary deviation from predefined, mutually agreed-upon rules is impossible. So it should be based on the least possible amount of trust, since that is typically abused by people put into power.

It was Nick Szabo who created and defined the notion of smart contracts in 1997. A year later he described the world’s first decentralized financial technology that seemed feasible, which he called Bit gold. Although Bit gold was never realized in practice, as it was never implemented, it is clearly the direct precursor to bitcoin. Satoshi Nakamoto transferred many ideas from it into his own invention.

And, since we mentioned the anonymous creator of bitcoin, it would be interesting to know Satoshi’s ancestry and roots as well. It is possible we already do, because Nick Szabo scores high on the list of people believed to be Satoshi. He borrowed numerous ideas from Szabo maybe because the two are in fact the same person. Unsurprisingly, Szabo denies this. Of course, Satoshi could be someone else with a different life story and different roots.

The birth of bitcoin and the credit crunch

Though we do not know Satoshi’s ancestry for certain, his opinions we roughly do. That is because he encoded a message into the first block of the Bitcoin blockchain, the so-called genesis block. This message is the headline of The Times from January 3, 2009: “Chancellor on brink of second bailout for banks.” By quoting the front page of a well-known newspaper in a block, Satoshi elegantly proved to posterity that he could not mine this block earlier — that he was playing fair. However, it is also a kind of statement about his motivations. For a better understanding, we should put his message into historical context.

The start of 2009 marked the darkest period of the credit crunch. Bank after bank was revealed to have accumulated incredible amounts of toxic assets on its balance sheet. These assets lost value quickly and consumed their capital. They practically went bankrupt. Since no one knew who else has skeletons in their closet, no one wanted to provide loans to no one else. Trust evaporated, the interbank market froze over, and channels of credit vital to the circulation of the economy dried up.

Governments and central banks around the world desperately tried to control the situation, but they failed to stop the crisis despite their best efforts — it kept striking again and again. The situation was critical in Great Britain as well. This made Chancellor Alistair Darling consider a bank rescue package to protect banks from collapsing and cover their losses from taxpayer money, not for the first time in a short period. This is what The Times headline is referring to. And two weeks later they indeed introduced the measures.

Of course, the practice highlights the contradictions of the financial system. We built a system where certain private companies can generate profits for their owners, but force taxpayers to cover their losses. If it is not the taxpayers, the system — in which these big banks are “too big to fail” — will collapse, doing enormous damage to the whole economy. With his message, Satoshi drew attention to this anomaly and the systemic risks built into the global financial system.

No one is safe

So far, we focused on how citizens of underdeveloped countries have been defenseless against the irresponsible or malicious decisions of their leaders. The dollar and foreign bank accounts could have given shelter to their savings, but were generally inaccessible. However, the credit crunch has shown that even residents of the most developed countries are not safe from fatal mistakes of central policy makers, politicians and bank governors. If economic policy directors build a vulnerable financial system and bank governors put the money given to them into risky investments, the seemingly safe bank deposits can easily turn into thin air too. Deposit insurance means no protection either, since the amounts in question far exceed the capital of any deposit insurance fund. Ultimately, banks and thus savings were rescued at the expense of taxpayers, spreading the damages even further out.

The generation of the digital age

The shock of the Recession defined the course of the world for quite long. In many ways, we are still suffering its consequences. It irrevocably became a part of our thinking. And the Great Recession was practically the first adult experience of millennials. They were also the most deeply affected by it.

They could experience its harsh consequences as they first entered the labor market. Huge numbers of people faced the fact that employment and an independent life is impossible for them. Youth unemployment skyrocketed, and in multiple countries — such as Spain and Greece — it stuck above 50% for years.

Research has shown that youth unemployment has long-term negative economic and mental health effects on individuals. This is not surprising: at a formative and vulnerable life period, young people are confirmed in their beliefs that they are worthless, useless and no one needs them. All this provides a long-term foundation for self-esteem issues, anxiety and depression. Add to this that they miss out on experiences from the early years of employment, and it becomes clear why it takes them 20 years to reach the earnings level of their luckier peers or of members of a luckier cohort.

In any event, it is safe to say that the ripples of the credit crunch probably caused masses of youth a trauma similar to that of the young Wences Casares. And it was not necessarily only those without a job at the time. The increased uncertainty and narrowing opportunities were felt by the employed as well. All of them learned a harsh lesson about the failure of central policy making and the systemic risks of their financial system.

Digital gold

This generation will slowly begin to create savings. And many of them, partly due to their personal experiences, will look for ways to also invest in assets independent of the financial system. Traditionally that meant buying gold, but they are far from doing that.

They grew up in front of screens, online, in a digitized world. Virtual space is very real to them. Half of their life has been spent with using gadgets. Bothering with gold bars and coins is out of style for them. These are difficult to transport, safeguard, sell or split up, and you cannot even order them on the internet. Millennials are not used to this. But they are open to new solutions.

They need digital gold. One that can be stored without a safe or a security guard. One that can be transferred without an armored car, instantly and cheaply, all across the world. One they can buy sitting in front of their computer. One they do not need to smelt and pour again if they need smaller units. One that cannot be forged or imitated. The trading and holding of which is much harder for state tyranny to control or block. One that even they can mine. And if they can pay with it here and there, and even accept it as a payment themselves, that is a nice plus.

New crimes

Cryptocurrencies were created for the generation growing up in the digital age. They are similar to gold in their independence from the current financial system, but unlike gold, they have the previously mentioned advantages. This is why the modern safe haven asset of economic turmoils, the new gold of the digital age, will be a cryptocurrency.

However, it took gold centuries to gain its status as the global safe haven asset. If it will take the same for digital gold, then writing this article is somewhat premature. But the world has accelerated since. Once there is demand, the corresponding supply now appears quickly. And there will certainly be a demand for a safe haven asset. That is because central policy makers are preparing to commit new crimes.

In fact, through rampant money printing and negative interest rates, the directors of monetary policy already committed these crimes in the past decade. Now they are just preparing to make it worse, following the course preset by past actions. Global debt-to-GDP ratios have been rising steadfastly even after the credit crunch. The enormous debt made the world economy addicted to zero interest rates. The Federal Reserve attempted an interest rate hiking period, but they have already stalled, and last time they were even forced to cut rates. [Since the original publication, two other cuts have taken place.] The European Central Bank recently decided to resume money printing and to lower rates further, even as they are already in the negative. Within its current framework, monetary policy is helpless. Ever-louder advocates of Modern Monetary Theory (MMT) are proposing new tools. These people would even allow financing state expenditures directly through printing money.

But that will sooner or later trigger inflation, which would be hard to control. Or, if that will not happen, then the consequences of zero interest — rising wealth inequality and skyrocketing real estate prices — will cause a social explosion. Either way, we are heading toward a chaotic period, so there will be no shortage of demand for safe haven assets. And younger generations with increasing savings will prefer digital gold to the traditional one.

One question remains. Out of the thousands of cryptocurrencies that already exist, which one will fulfill the global role of digital gold? Maybe it does not even exist yet? Given my bet, it may come as no surprise that I believe it already exists and it will be bitcoin. As for why, I will explain in the next article.