Why bitcoin is a compelling speculative diversifier and how it has been a better store of value than both the U.S. dollar and gold.
In this episode you’ll learn:
- How U.S. Notes or greenbacks became the first fiat currency.
- How large is the U.S. money supply and how much has it increased relative to gold and bitcoin.
- What is bitcoin and what is the controversy regarding transaction limits.
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Today, we’re discussing Bitcoin. I’ve not covered this topic on the podcast in over two years. It was episode 53, “Should You Invest In Bitcoin?”. The better question is: should you speculate in Bitcoin? Holding Bitcoin, or other cryptocurrencies, is a speculation, because there is disagreement on whether the currency will appreciate or depreciate in value.
Another Radical Currency
We’re going to discuss Bitcoin, but first let me share another radical currency that came out many years ago right around the time the U.S. Civil War. Prior to the 1860s the U.S. government only issued gold and silver coins and they were considered legal tender.
Legal tender means they are recognized by the legal system as valid for meeting financial obligations. Paper money was issued, but it was issued by private banks and you could take that paper money and redeem it for gold. Assuming the bank had the gold. If the bank failed, your money was gone.
However, during the U.S. Civil War, the U.S. needed funds to support the war efforts and they didn’t have enough gold. They went to the President, Abraham Lincoln, who then went to the New York banks. They wanted 24% to 36% interest to lend money for the war effort.
A businessman from Illinois named Colonel “Dick” Taylor went to Lincoln in January 1862 and suggested issuing this radical new currency, a currency that was not backed by gold. Taylor said, and this is from the Wikipedia article, “Just get Congress to pass a bill authorizing the printing of full legal tender treasury notes . . . and pay your soldiers with them and go ahead and win your war with them also. If you make them full legal tender . . . they will have the full sanction of the government and be just as good as any money; as Congress is given the Express right by the Constitution”.
On February 25th, 1862, Congress passed the first Legal Tender Act. It authorized the issuance of a hundred and fifty million dollars of United States notes. They became known as “greenbacks”, because they were printed with green ink on the back side. But they were also very volatile. They weren’t backed by anything. This was the first fiat currency.
By the spring of 1863, the greenback had declined to where it was worth $152 per $100 of U.S. coins that were backed by gold. So, they definitely had depreciated. As different battles took place and after the victory at Gettysburg, the greenback recovered to $131 to $100 in gold. I think the worst was in July of 1864; It was worth 258 greenbacks per $100 of gold. And then, after the war ended, it was $150 per $100 of gold. So, it was very volatile, as volatile as Bitcoin, because it was a new currency not backed by anything.
By the mid 1870s there was about $350 million worth of these greenbacks, or U.S. notes, in circulation, and in January 1875 Congress passed the Specie Payment Resumption Act, which authorized the reduction of circulation of greenbacks to $300 million worth and required the government to redeem the greenbacks for gold and this was going to be implemented by 1879. Essentially, the greenback strengthened, because it was going to be at parity with gold and eventually was.
So, you had U.S. coins backed by gold and then you had U.S. notes backed by gold and then, even after the Federal Reserve started issuing dollars, they were backed by gold up until 1933, when the government banned private ownership in gold, meaning you could no longer redeem Federal Reserve or U.S. notes for gold, but you could still redeem them for silver. That is, until 1968 when all currency became fiat currency, not backed by anything, Federal Reserve Notes and United States notes.
These greenbacks were issued up until 1971 and then they were no longer distributed into public circulation. The U.S. went off the gold standard and it was at that point that money, U.S. dollars, became digital. It could be created at will by banks by simply lending, and I discussed that in episode 94, “How Money is Created and Destroyed”, and in episode 157.
Money. What is money? I talked about it in episode 59, “Is Gold Money”, and there are some standard definitions. One of them is that it’s a store of value. Second, it’s a unit of account. Third, it’s a medium of exchange. And we are going to look at Bitcoin and see how it compares on that. But first, the store of value.
How has the dollar done as a store of value? Not so well. The annual inflation rate as measured by the Consumer Price Index has increased at 4% annually since 1971. That means you would need $600 today to buy $100 worth of 1971 goods. And how fast is this money supply increasing?
Well M2 is a broader measure of money supply, it includes U.S. dollars, coins, as well as digital bank savings and money market accounts. In August 1971, there was $685 billion of this measure of U.S. money. Today, it’s $13.2 trillion. That is how much the money supply has expanded and that is what leads, and has led, to inflation.
Last year, over the past three years, this M2, the money supply, increased by 6.4% per year, on average. Now let’s compare that to gold. So, there’s $13.5 trillion of U.S. money, dollars. There are approximately 200,000 tons of gold that has been mined and is available around the world. That is about 6.4 million ounces, worth roughly $8 trillion. Each year, there is about 3000 new tons of gold mined, which means the rate of increase in the gold supply is about 1.5% per year.
So, it’s increasing at a much slower rate than the money supply, which is why over time gold should do better, basically appreciate, in the U.S. dollars, because the supply of gold is not increasing as fast as U.S. dollars. Except it’s also very volatile, because it depends. All currencies depend on trust. Do people want to use dollars? Do they want to hold gold? The level of trust in wanting to hold those assets influences their price.
The Increase of Bitcoin
Now, let’s compare that to Bitcoin. There are 16.5 million bitcoins, essentially, in circulation, that’s the number of coins–and we’re going to talk in a minute and I’m going to show that Bitcoin is not really a coin–but about 16.5 million, total value $47 million. That’s the total value of Bitcoin and that’s at a price of roughly $2600 per bitcoin. That’s very small when you compare that to $1 trillion of gold and $13.5 trillion in terms of the U.S. money supply.
Bitcoin is really tiny and the algorithm that runs Bitcoin, that sets how much bitcoin is created per year, in the last year the number of new bitcoin increased 4.4%, but from a much smaller base. So, 4.4% of $47 million would be the amount of new bitcoin created in the next year, compared to 1.5% increase of gold that has a base of $1 trillion, and the 6% increase in U.S. money supply, which is at $13.5 trillion.
So, we look at the price of Bitcoin. I started getting involved in Bitcoin and researching it pretty extensively in the summer of 2012 and I talked about this back in episode 53. Then, it was priced at $11 per bitcoin. In 2015, when I did the episode J.D. sent me a bitcoin, or some bitcoin. He sent me .0078 bitcoin, it was worth $1.75. Today, that bitcoin, which I still have, is worth over $20.
So, that is storing value. The value is going up, because more people are trusting and using bitcoin despite its flaws, its growing pains, which we’ll discuss. But, as more people trust it and want to use it, because there’s a limited supply, a set supply, and because the amount of Bitcoin is not growing as fast as either gold or U.S. dollars, its price relative to those currencies is going up.
Can We Value What We Don’t Know?
Money is also a medium of exchange. And in Episode 84, “Money is Trust”, I said, “Money facilitates exchanges that would not have occurred in a bartering economy, because money acts as a symbol or token of value. Money requires cooperation and trust for it to function properly and facilitate transactions.
Trust is required, because money has no intrinsic value. It has only symbolic value. Money cannot be used in its physical form to make something productive. You can’t eat it. You can’t build shelter out of it. You can’t use paper money for heat by burning it in your fireplace. Money has value because we, and others, believe it is worth something, in that it can be exchanged for something of value”. People believe Bitcoin has value and as a result the price is going up.
But what is Bitcoin? The first bitcoin was issued in January 2009. The developer was a man named Satoshi Nakamoto. But, Bitcoin is not a physical coin. It’s not even really a digital coin. Bitcoin is a digital record of previous transactions between various Bitcoin addresses that is stored in a digital universal ledger, which is called ‘the block chain’.
J.D. sent me .0078 bitcoin and I held it. I downloaded an app on my phone, called Hive, and that’s where that bitcoin was sent to, because that had an address. So, then there was a record of this transaction, but before I could spend that Bitcoin again, it had to be verified again. Bitcoin is just this record in the cloud of Bitcoin transactions.
The entities that verify the transaction that J.D. sent a bitcoin to my wallet are called ‘miners’. They do, all these transactions six times an hour; about every 10 minutes the transactions are lumped together and then they’re put in what’s known as a block. Then the miners work on, basically, a mathematical algorithm that is trying to solve a particularly difficult math problem using that data from those transactions that are part of the blocks, verifying that transactions are legitimate.
At the same time, they’re trying to solve a mathematical problem, computers around the world are competing to see who can solve and verify these transactions the fastest. Whoever is able to do that gets a reward of new bitcoin, 12.5 bitcoins, for achieving that and verifying it.
Again, these are verified around the world on computer networks. And then, as I mentioned there is a limited supply of bitcoin. Every 10 minutes, 12.5 new bitcoin are created and every four years the amount of new bitcoin rewarded is going to be cut in half.
But there are also transaction fees. So, when J.D. sent me that bitcoin, he paid a transaction fee, a small transaction fee. The miners also get the transaction fees and that’s what’s amazing. A system that isn’t dependent on a central bank, but it definitely is dependent on trust.
Misplacing My Bitcoin
Do others trust and want to use Bitcoin? Now I had a slight problem because I forgot that J.D. sent me some bitcoin. I went to my phone and I looked for my wallet and my app there, but it wasn’t there. I went to the Hive web site and I saw this big sign that said, “Hive is closed. Thanks for your support”. They basically stopped development on Hive and I thought, “Did I lose my bitcoin?”.
It turns out that I was able to get my bitcoin back, but not from Hive. I’ll show you in a minute how I did that. But there is an important component to Bitcoin you need to understand. This is from “Mastering Bitcoin”, a book by Andreas Antonopoulos, who also wrote “The Internet of Money”. This guy knows a ton about Bitcoin and has been very helpful in my education on the topic.
He writes, “In Bitcoin, we use public key cryptography to create a key pair to control access to Bitcoin. The key pair consists of a private key and–derived from it–a unique public key. The public key is used to receive bitcoins and the private key is used to sign transactions to spend Bitcoin. There is a mathematical relationship between the public and private keys that allows the private key to be used to generate signatures on messages. This signature can be validated against the public key.
“When spending Bitcoin, the current Bitcoin owner presents her public key and a signature (different each time, but created from the same private key) in a transaction to spend those bitcoins. Through the presentation of the public key signature, everyone in the bitcoin network [all the miners] can verify and accept the transaction as valid, confirming the person transferring the bitcoins owned them at the time of the transfer”.
The key then, pun intended, is this private key and public key. So, what I did was I searched online. I went to a website called ‘coin.space’ and I opened that existing wallet, because Hive was open architecture, in that they had mentioned that all of their development code was put in get GitHub. It was the full source code and so other developers took it and are basically running virtual Hive wallets.
I opened an existing wallet and I had my 12-word passphrase which unlocked my private key–adding my four-digit PIN– and I was able to access my bitcoin, because of this security that’s built into it. So, then I sent it to a new wallet that I downloaded on my smartphone phone, called JAX.
Now, what’s interesting about that is that in order to do that, I had to pay a transaction fee. My transaction fee to move it from the virtual Hive to my new wallet was .00468 bitcoins, about $1.05 (at the time). And then I had to wait.
It immediately showed up in my wallet, but then it took 12 hours for that transaction to be confirmed, to be recognized on the block chain as part of a block and be confirmed, so then I could spend that bitcoin again. But it’s all out there with these miners.
The Waiting Game
Now the fact that it took 12 hours gets to the center of a current controversy that’s going on with bitcoins. There are six blocks per hour, one every ten minutes, and the size of the blocks, the data storage, is 1 megabyte, which means only about 3000 transactions can fit in a block. That works out to about 7 transactions per second. You compare that to Visa and Visa has 2000 transactions per second. Bitcoin is a much smaller processing rate, in terms of transaction, and it took a long time.
Now, I could have had it verified faster by paying a higher transaction fee, because there’s a priority in terms of which transactions get verified first. Whoever pays the most in the fee gets priority, as well as the longer it has been since a transaction showed up. So even if your fee was really low, after time has passed, eventually it’s going to get put in a block. Even those transactions that might not have any transaction fee.
So, it took 12 hours and that’s been a huge controversy with bitcoin. There has sort of been this civil war among different developers and those that are running mining software about expanding the size of the blocks so that they can hold more memory, so more transactions can be processed per hour. Now, there is some disagreement because no one controls Bitcoin; it’s just this network of computers that run the software.
This is from an article in the U.K. Telegraph. It says, “Last week key miners and developers of Bitcoin agreed to adopt a new way of operating the cryptocurrency: since the technology is open source, changes are made to its underlying code if agreed by a consensus of users”.
Now, this new technology is called Segwit2x. Segwit2x proposes moving some of bitcoins transaction data outside of the block and on a parallel track, to allow more transactions to take place, and then the block size would be doubled some time in November. Now the competing proposal is something called ‘Bitcoin Cash’ and they propose that the block size just be increased to 8 megabits.
A Fork in the Road
Today, August 1st, they never could agree and so there has been a hard split in the block chain, which means now there is Bitcoin and Bitcoin Cash, this rival currency. It’s a chain split. Now, what this means is because Bitcoin is just a record of all prior transactions, Bitcoin Cash and Bitcoin will share their block chain, the public ledger of all the transactions in the past, but not going forward.
Now I had that Bitcoin I owned. I now can have the regular Bitcoin and the Bitcoin Cash; I own the same amount. I could spend it as Bitcoin Cash or I could spend it as regular Bitcoin. But, there has been a fork and this has never happened and it potentially will increase volatility even more, because this is a young technology and, again, it depends on trust.
You’ve maybe seen some news regarding that. That’s what it’s about. It’s two versions of the software now running, all in attempt to increase the size of the blocks so that more transactions could be processed.
Now one reason there was perhaps some reason not to do is that the transaction fees were going up. So, people were making money. The miners could make up to five dollars per transaction sometimes; there was an incentive to not necessarily to increase the block size. But, it looks like it’s going to work out. We’ll see. There’s a hard fork and that just happened today.
Security is Trust
Now, in order for people to trust a currency and to use it–and to use it for exchanges–it needs to be secure. There has been a lot of stories about Bitcoin not being secure. My friend that introduced me to Bitcoin back in 2012 when he spent a lot of time dealing with it, they lost all their Bitcoin. Somebody got a hold of their private key, because they stored it on their laptop, which is not a very secure place.
Hackers, if they can get the private key, then they can control the transactions, they can access the public record and they, essentially, can then control the Bitcoin. One of the major exchanges Mt. Gox, where I tried to buy Bitcoin and was never able to do it, lost a huge amount of their bitcoin because somebody accessed the private keys.
That’s the thing about Bitcoin. If you store it on an exchange then you don’t control both aspects, the public key and the private key; you lose control. Now that’s not to say that you can’t lose money with regular currency.
A local news report in Denver reported how a Colorado couple lost their life savings while they were trying to buy their retirement dream home. They have filed a lawsuit with Wells Fargo Bank, the land title company, Land Title Guarantee Co., Envoy Mortgage Ltd., which was their mortgage broker, as well as the realtor and the real estate agency.
They lost their payment. They sold their house in Longmont and they were using $272,000 as a down payment. The mortgage broker said that in the morning you’ll get an email from the title company about where to wire the funds.
The next morning, they got an e-mail. It matched the amount that the mortgage broker had said and so they wired it. It turns out that the title company email servers had been hacked and it was a fake email; they wired it to the wrong account and they couldn’t get their money back. This is becoming more and more common. It was gone.
So, there are ways to lose money with regular currency. I was in New York a couple of years ago and I used an ATM in Brooklyn. I used my card, I took my money out and within days there were fraudulent transactions on my account because they had basically captured my ATM data, my debit card data, in that ATM.
When you use a credit or debit card and that data is captured you’re sending the card number and the card verification code is often asked for, as well as your address and all types of information.
Andreas Antonopoulos writes, “Bitcoin is fundamentally different. What I am transmitting is not the key, but a simple signed message. It is an authorization. That authorization has two external references: 1) to where the money’s coming from by referencing an unspent output on the block chain, and 2) a reference to where I want to send the money, by creating a new encumbrance, a new limitation on who can spend the money, usually a public key or Bitcoin address.
“The transaction contains no sensitive data. If you steal that information in the transaction, all you know is which address that money came from, which address the money is going to and how much. You didn’t transmit your secret key; it was just a signed message that can be verified that the transaction is legitimate”. But you can’t lose the money unless you send it to the wrong address.
A New Way to Hold Money
That’s what I find so fascinating about cryptocurrency and Bitcoin: here’s a way to hold money that has value, because people trust it, but hold it in a way in which you’re not dependent on the financial system to hold it. If I want to hold a, let’s say a foreign currency, digitally, how do I do that?
I get e-mails all the time from members of Money for the Rest of Us Plus saying, “I want to open up an investment account”. They live outside of the U.S., they’re not U.S. citizens and they want to open an account in U.S., which is very difficult to do, if not impossible. It’s hard to hold digital money, in a way, outside of your home currency.
But with Bitcoin and other cryptocurrencies, you can. You can hold it in an exchange. But again, by holding it in an exchange, you’re exposing yourself to that exchange potentially being compromised. So, when I buy Bitcoin–and I will be buying more cryptocurrency as a speculation–I buy it on a website, I think it’s called Coinbase, and it’s linked to my bank account.
Once I buy the cryptocurrency, I send it to either my wallet on my iPhone, where I have the private keys stored, or you can get an external USB wallet–I actually just bought one by Trezor–and you can store it there and that USB basically just has your private key and then interacts with the Bitcoin or other cryptocurrency network.
An Unknown Future with Wide Possibilities
But it’s absolutely fascinating and I have no idea where the price is going. We don’t know how this hard fork will turn out. In a future episode, maybe next week, we’ll talk about other developments in cryptocurrency, such as Ethereum and talk about initial coin offerings and some of the shenanigans going on there.
There was a book written, I think a couple of decades ago, by Clayton Christensen, called “The Innovator’s Dilemma” and it was talking about disruptive technology and about all the challenges with disruptive technology. It’s not perfect. It’s good enough.
If you see the path of Bitcoin, it has just been good enough. There have been problems: there have been exchanges hacked, there has been fraud and there has been controversy in terms of increasing the block size, but all this time it has been gaining trust.
There are countries around the world where there are limits to being able to use currency and people are using Bitcoin because it’s anonymous and secure, because it’s not dependent on having to interact with the traditional financial system. It does require trust. All currency requires trust.
But here is a way to have a currency that’s held outside of the traditional financial system. This is a way to diversify. This is the additional diversification, but it’s also speculative. It’s speculative like holding gold, because you’re not sure if it will be positive or negative. But, I certainly am in a process of increasing my holdings of Bitcoin and other cryptocurrencies, because I feel little regret.
After that 2015 episode, I bought Bitcoin, about $5000 worth of Bitcoin, and it would be worth $50,000 today, except I sold most of it in January 2016, after reading a number of articles by people that had been involved in the Bitcoin network early on. They declared that Bitcoin was dead, because of this block change size issue and because so many of the currency miners are concentrated in China.
Why are they in China? Because China has cheap power. The cheaper you can run the mining computers, in terms of the power to run electricity then, and the faster the processor you can get, then you’re more likely to win this competition that’s going on globally to verify transactions and solve the algorithms. So, a lot of computing power has gone to China and that causes some concern, and also this whole block change size.
These are bumps in the road. We’ll see if Bitcoin continues. Maybe the price will crash by half. But, this is a way of diversifying and if the price crashes it is because it lost trust, but everything I’ve seen is that trust is continuing to gain in Bitcoin. Maybe it’s there in other cryptocurrencies, it is something we’ll still have to explore.