Let me start by saying that I’m not, at present, a long-term optimist on the alternative currency space. I’ll spell out my case for pessimism as clearly as I can here. My background is strong in economics and modest in the alternative currency space. I taught behavioral finance at Harvard for five years, game theory for one year, and international macroeconomics for three years. I once had the opportunity to buy the bitcoin poker site Seals with Clubs, in the summer of 2011, when bitcoin was $6. The price was not high, but I turned it down due to legal and regulatory risk. I bought $6k in bitcoin (now worth around $2.7 million) at that time, but lost all of it in a series of sports bets.

The reason I urge caution in bitcoin investing is very simple: the powers that be do not want it to succeed. They cannot have it succeed. Therefore, it will not succeed.

My view is really that simple. I’ll support it as best I can below.

A further part of my background with relevance: I was actively involved in shorting financial stocks in 2007-2008, and I was the primary research assistant for Michael Lewis’s The Big Short.
Our history of that era is littered with hindsight bias. The successful speculators we celebrate today had to have things go perfectly. They were betting on the failure of banks, and their counterparties were banks! As it happened, failure occurred at just the right measure; bank losses were astonishing, but small enough such that the economy survived (barely) and the government was willing to print money to cover the equity hole across the industry. The story is well known at this point; homeowners received no relief, but all counterparties were paid in full. Many of the people who bet huge on the financial system failing had a bet that looks like a negative freeroll: if the financial system had continued to do well, the bets would have suffered complete loss; if the financial system crashed, the counterparties couldn’t pay and no substantial gain would occur (or, worse, the crash would be so extreme that the meaning of financial wealth would change).

It’s my belief that a decision right now, to hold alternative currency rather than convert it to cash, shares similar aspects of a negative freeroll. For a decision to keep a substantial portion of your wealth in alternative currency or bitcoin to be right, a very particular course of events has to play out. What has to happen, essentially, is that governments as we know them fail over time and yet, as they fail, a decent portion of economic activity functions well, and alternative currency remains useful in this space. The likelihood of this, to me, seems very low.

Governments everywhere have what I call the “Sea of Red” problem. Imagine a talented analyst with a comprehensive spreadsheet that projects the future of US federal and state government finances. What is he sees at the moment is a sheet that has a lot of red in important places, but not a truly terrifying amount of red. The magnitudes of the red numbers are scary at present, but much scarier around 2025 and 2030, when Baby Boomers (the first of whom started to retire in 2008) are drawing heavily on Social Security and Medicare. They are so scary around 2025 and 2030 that the talented analyst concludes that the country might have to skate up to the very edge of disaster, even if the future plays out near perfectly.

Now, the reason I call this spreadsheet the “Sea of Red” is that, while it looks under the rosy scenario quite red, the real problem is that if you change almost any key variable, the spreadsheet becomes all red. If long-term growth and productivity rates are lower than generally anticipated, all the key numbers are red. If another financial crisis and accompanying bailout occur, all red. And, crucially, if interest rates rise from today’s insanely low, government-manipulated level, we have all red. So the only way we have a chance of things working is if the US government continues buying large quantities of its own debt, effectively funding its own operations, and does so in a way such that the debt-to-GDP ratio skirts up against disaster levels without going over. And, all the while, interest rates must stay low, lest the interest expense as a percentage of the budget balloon out of control.

So what we have is one hell of a problem. Effectively the government has to balance between absurdities and contradictions over a period of several decades. How does anyone fund retirement when the government funds itself through inflation, yet ensures that interest rates remain low? If the only protection against inflation is holding assets, and yet a small percentage of the population own all the assets, how does one prevent inequality from spiraling out of control? How can the high level of real economic growth that’s needed to prevented disaster in government finance be achieved in the face of the uncertainty created by extreme monetary policy?

What absolutely cannot happen, from the government’s perspective, during the management of this “Sea of Red” problem, is the government losing control of the currency. The government uses the currency to fund itself!! This cannot be lost. It simply cannot and will not be true that the government will watch bitcoin go from the current price of $2700 per coin, to a higher price of, say $8000 per coin, while other alternative currencies experience similar success, and have any reaction other than an intense desire to kill the space and limit alternative currencies’ use in transactions. It’s a battle the government can’t lose, and therefore they won’t lose it.

The problem for the alternative currency holder is that there are really only two long-term outcomes. The first case is that the government succeeds in knocking down the price of alternative currencies and their use in transactions, in which case you’d be better off selling now. If there’s true doubt about governments’ ability to do this, I’ll have to make that the subject of a later post, but to me there is no doubt. The other case is that is that government doesn’t succeed in curtailing activity in alternative currency and it continues to expand in importance. In this case you’re also fucked, as governments will not be able to fund and sustain themselves. There’s no alternative world where taxes will be paid and governments will function with bitcoin. That is not how governments work. Governments inflate. That is what they always have done. We live in an era where we will have to accept that they are going to inflate a bit more than the usual amount.

So, as noted, in the two key states of the world where you decide to hold bitcoin rather than convert to cash today, you’re fucked. The only scenario where things work out is a strange middle scenario where governments slowly fail, but it remains valuable for individuals to have alternative currency. I see this as a bit of a strange and unlikely special case.