Crypto Currency

So you think that money is the root of all evil? Have you ever asked what is the root of money? 

Ayn Rand

Yes, [we will not find a solution to political problems in cryptography,] but we can win a major battle in the arms race and gain a new territory of freedom for several years. Governments are good at cutting off the heads of a centrally controlled networks like Napster, but pure P2P networks like Gnutella and Tor seem to be holding their own. It's very attractive to the libertarian viewpoint if we can explain it properly. I'm better with code than with words though.

"Satoshi Nakamoto"

Computer software is an abstract concept for many. People generally have no idea how Facebook works, how emails get routed or how smartphones perform all their tricks. Developers do an exceptional job of abstracting away from all the low level details that underpin such software. What has software got to do with money though? Enterprising software developers have been at it again, creating a new money known as BitCoin (a dedicated wiki can be found here with further details). This article will not only attempt to explain this new concept that has the potential to revolutionise society, but along the way we will explore how the marketplace free of any Government interference, functions, and how this makes all of our lives better. Its an article of some length, so please ensure you have a large hot beverage at hand, take a breath; let us begin.

Let me start and re-hash what my previous articles have said; I am a firm believer in the fact that Governments should not be in the money business, such a task should be left to the free market. I've also discussed that consumers should select good money, be that commodity backed, in good faith or some clever new innovation that could only occur spontaneously from the free market. Individuals have attempted to challenge the State held monopoly of money by creating their own, a notable case is Bernard von NotHaus with his Liberty Dollar, however such activities have caused Governments to clamp down on challenges to their power. Governments don't like free money, shaking down individuals who challenge their 'wisdom'. Currencies issued from a central organisation will always be an easy target for the Government to shut down. 

Step forward a Cryptographic Currency known as Bitcoin, with the potential to revolutionise e-commerce and challenge the governments monopoly of money. It uses modern day Cryptography (Mathematics) to solve the conundrum of having a currency that is devoid of central control. The protocol functions in a peer-to-peer network. Rather than having a central third party checking the transactions to be correct, many users who are scattered all over the world perform such checks (known technically as miners). Think of it as the accounting ledger being public to all and distributed in such a way that everyone has access to it and works together to ensure its integrity. Integrity is also enforced by the difficulty of the Cryptographic problems. Anyone can then make anonymous transactions with the need for no financial intermediary, there is no third party. The buyer transfers the money direct to the seller. The coins themselves are cryptographic hash codes which are unique identifiers. With the use of public-private key pair technology these are then signed by the relevant parties. Miners then process transactions, validating that they are correct adding them to BlockChains (the accounting ledger). Each coin is unique and can not be double spent which is one of the key concepts that makes Bitcoin so unique. Up until that point digital currency systems were always susceptible to double spending and required a central third party to validate all transactions. Not with Bitcoin.

Want to know more. Here are some of the advantages:

Open Source Code
The code is open along with its theory, meaning it has been critiqued by a number of security experts around the world. It has no known flaws. It uses the same Cryptographic algorithms as your e-banking. The only flaws in e-banking are generally end users, or developers implementing the banking systems incorrectly. Therefore Bitcoin can be considered very secure.

Free from Inflation
Currently the currency grows at a predetermined mathematical rate, an algorithm that was purposely chosen to track the rate at which commodities, such as Gold, are mined. Eventually this will in all practicality stop with the supply never exceeding 21 million bitcoins. There is no corporation or political control over it therefore it can not be inflated. In this aspect it is even sounder than Gold. The Mathematics ensures it future scarcity.

People can now actually hold a currency that has the potential to not only retain its value but will appreciate over time. No need to worry about which is the best negative interest rate at your bank. Just keep your Bitcoins saved up and they will appreciate on their own, due to free markets increasing everyones purchasing power over time. I'm sure one day someone will create lending services, where users can lend their Bitcoins for a rate of return (legal property aspect would need to be explored) in a similar fashion to a Bank. Regular banks could take your Bitcoins, give you a rate of interest, lend this out to business for a slight profit. No doubt these areas will be gaps in the market that will be explored by the entrepreneurs as the money matures.

Peer to Peer Network
There is no central server for the network. Transactions are actually validated by the thousands of distributed servers, known as miners. This proof of work (the accounting ledger) is spread out among the miners who are rewarded with new coins created at a pre-determined mathematical rate. This proof of work, which is computationally expensive, makes it incredibly hard for someone to change the past or to double spend and corrupt the money. This distributed nature has great advantages. The Government can not physically shut it down (without shutting down the Internet). If they shut down one cluster of miners then others would join the network.

"No" (Low) Transaction Fees

Bitcoin cuts banks out all together. Its like dealing in cash but with all the benefits of electronic commerce. Banks no longer need hefty cuts for dealing with admin, bank managers, Government red tape and regulations. The third party is the mathematics. I'll cover the concept of low transaction fees later, suffice to say, its lower then any existing market offering.

No Double Spending
Coins can not be created out of thin air (excludes mining, which works on a pre-determined mathematical algorithm). Once a payment has been made it can not be reversed, nor can the coin or a wallet be copied and spent again. This keeps the system honest.

Cross Country E-Commerce
At present there can be boundaries from conducting trade between nations. As soon as you cross international boundaries fees can start to rise quite sharply. Bitcoin has no such limits, it doesn't matter if the person is half way round the world living in some totalitarian state. This is beneficial to nations who have been blocked from paypal or other credit card companies; the recent example of Wordpress now accepting Bitcoins shows how the currency can support free speech. No one on the network can tell you who not to pay, not even your Government. The currency itself is the ultimate liquid asset. Payment happens in seconds and becomes fully verified in minutes. I could pay someone in a country with strict capital controls or a nation that been blacklisted by paypal with no problem. Its just like Cash only with all the benefits of being digital.

Removes Political Censorship
Wikileaks is a recent example of where even Western Governments didn't like free speech and pressured payment companies to no longer process donations. Bitcoin allows free speech to prevail and Wikileaks now take Bitcoins as a form of donation. 

True Monetary Freedom
The most important feature of this new currency is the freedom is gives to people. Freedom to trade, free from inflation, free from currency or capital controls, inheritance tax (along with other forms of tax), free to manage your own assets completely free from a third party. Over time the money will no doubt be of wonderful value to society, however its the freedom of the currency that most appeals to me and is the most revolutionary concept it has created.

How it Began
The creator possessed the rare combination of being a Cryptography expert with Libertarian values. Known under the alias of Satoshi Nakamoto (a Japanese name, however people believe him to be British as he made references to the UK banking system) he built upon various ideas of others and created the first truly distributed free money. He created the protocol which others now maintain and the first thick client (a desktop application to create your own wallet containing coins). He did this because he wanted to. Not for money or fame, just because he believed it was the right thing to do. Individuals have other motives than money, despite what the left will tell you.

Since he gave his creation to the world he hasn't been seen since. However this is where others pick up and run with the system as it was all made open for other to contribute towards. 

So how do these Bitcoins work? How do I get hold of some? How can I store them? As detailed the coins themselves are in effect digital signatures that have been signed and verified by a network in a way that keeps everyone honest. These coins are stored in wallets. Wallets come in a number of forms and you can think of them just like your regular wallet that contains your cards and any cash you may be carrying. There are no limits to the number of wallets you can own, nor any limit on the size of your wallet (a wallet could contain an amount that is a fraction of a penny all the way up to millions of pounds). There are a number of options to store such coins.

Local Wallet
Local Wallets are created and stored on your local computer. This is how it started, the original client was written in such a manner (Bitcoin qt as it is known can be found here). Your wallet once it has some coins can be encrypted, meaning if someone does "steal" your wallet, they can't actually spend the coins without the password. This is the ultimate form of monetary freedom. You have complete control of your finances. If you want to spend money, it takes a matter of seconds to send to a seller. Likewise if you wish to receive funds then you can create an anonymous address and allow someone to credit your account.

However with great freedom comes great responsibility. If you forget your password, you can't access your coins, they are in effect lost. If your hard drive crashes and you didn't backup your wallet, tough, you've lost your coins. If your local machine becomes compromised by certain virus software, such as a key logger, and that person is able to log your password and ultimately have enough access to your system (and wallet), then again they could spend those coins (to their own account).

Then theres the problem of the client software, the original one for example took two days on my desktop to download the whole block chain (and when running in the background will considerably consume resources periodically as more transactions cross the network). Other clients are currently being released to solve such issues (Multibit is an example, I presume pruning the merkle tree) however then you find that Multibit doesn't support encryption yet (soon to be released I believe). Theres also the fact that you can't use these on Smartphones, or though a nice to use Web Interface. I can comprehend all the technicalities, so can others, but your average Joe will have a hard time. In order for the network to work, it needs to be made easier from a usability perspective (in fact this is just as important as the security, without usability the network will never gain mass appeal). This is where e-wallets step into the breach.

E-Wallet

Step forward the entrepreneurs amongst us. They could see all the issues above so set about solving them by taking away all the management involved, in effect assisting the end users in storing the coins securely and allowing non technical people to get started. E-Wallets have a number of advantages. You can access your money anywhere, anytime. You don't have to worry about backups, viruses or your personal computer being compromised. A third party will take care of such worries, for free. They generate their income based on either margins from buying and selling Bitcoins to their customers, advertising or some other source of income yet to be conceived. E-Wallets allow customers to access their coins on any computer system through an easy to use web interface, similar to your e-banking. They also supply applications for your Smartphone (due to its recent state predominately only for Android and iOS platforms). They take care of the all the intricate plumbing.

There is however a catch. E-Wallets were a first generation attempt to allow the majority of us to use bitcoins. Currently the bitcoin network has never had any weakness. Like I've said security weaknesses are the end users or the implementation of a system. There have been a number of notable cases where e-wallets have been hacked, the thief managed to gain access to the servers data which stored the wallet along with the private key and steal peoples coins. 

A Governments solution if they were aware of the Bitcoin platform, would be to condemn the service, stating more regulation was required in effect raising prices for consumers and stifling innovation. This is what always happens when Governments, Technocrats, Politicians and Commentators get involved. Thank God we have entrepreneurs, the people who do, as opposed to the people who talk. Enter the next solution.

Hybrid E-Wallet
One of the problems with e-wallets was that they stored all the data on the server, including the wallets private key (which could be used to gain access to someone's wallet - think of it like the key to your safe). If the central server was compromised then everyone's wallets were compromised. Another problem would be if the server went down, or even if someone attempted to shut it down, say the Government. All your coins would be tied up to that supplier with no way to get them back. New e-wallets, known as hybrids began to spring up. The concept was simple, try to solve the security issues of conventional e-wallets but maintain usability. Still not convinced?

A common attack was to gain access to the private keys in the central database. The solution therefore was to not store the private keys on the central server, instead run javascript on the client computer (your local machine) to generate the correct private key to open your wallet (hence the term "hybrid", you have in effect your wallet locally, but the server has all the APIs used to access your wallet). The server only stores the encrypted copy of your wallet, not the key to access it. Such third party systems in fact can not access your wallet, or your transactions and balance like a Bank or Government can. An overview can be found here. You own your wallet, all they do is provide a system that is far easier to use then a desktop client and store an encrypted version of your wallet. The disadvantage of course is if you forget your password, they can't help. In my view this isn't even a disadvantage. We all deal with passwords. If its important, write it down on paper and put it in a safe, share it with a loved one and so forth. I'm sure services will pop up that will store peoples passwords safely with ingenious security techniques that haven't been developed yet.

A popular hybrid e-wallet in the UK is BlockChain. The video below shows how ridiculously easy it is to create an account and pay someone. No paper work, proof of id, or admin - just trust in mathematics.

Before detailing the other superb security features of hybrid wallets I'd like to detail an example of why entrepreneurs are so important to economic development. BlockChain is a start-up conceived by someone called Ben Reeves. It is funded by the famous ycombinator start-up fund, that has made many a great company. He has done what many of us lack, realised the potential of a particular technology and begun to make this a usable for consumers. This is what Entrepreneurs do. They take future ideas, and turn them into accessible services. As great as Bitcoin is in theory, that's all it was a couple of years ago. You had to use desktop applications and manage all the security yourself, in that state no one was going to use it. It takes entrepreneurs (many others exist, similar to what Ben is doing with BlockChain) to take those services to the masses.

Steve Jobs was a great example of this in action. He was no engineer, but had an eye for value. He was the first to spot the value in Graphical User Interfaces and bring them to consumers, it was all stolen from Xerox. The iPod was just a copy of existing MP3 players that hadn't gained traction in the consumer market. Smartphones existed well before the iPhone, Bill Gates was trying to push tablets a decade before the iPad but Job's timing was impeccable. To achieve this Jobs stood on the shoulders of giants. OS-X which currently runs Apples computers exists because of Unix, a platform developed by engineers for engineers but not for consumers. No one can take away Steve Jobs brilliant talent for spotting value and making products accessible to consumers. That isn't to say he got everything right. He once famously remarked when Amazon brought out the Kindle that no one reads any more so they won't sell, and seven inch tablets would never sell - like all entrepreneurs its all trial and error. Bitcoin will be similar. All sorts of innovations created by entrepreneurs who spot gaps in the market will create new products to fill consumers needs. Lend/Borrow systems, Brain Wallets, send coins direct on Facebook further use of NFC swipe to pay with Bitcoins anywhere in the world seamlessly.

Back to the security, so what if it doesn't store the private key I still don't trust a third party with my money, you may say. BlockChain understands this. It doesn't want to lock you in. Young entrepreneurs are smart and realise the value they create is not in payment for their services, but for getting traffic to their servers, making money once they have the user base, similar to a Google business model. With a Hybrid wallet you can backup your wallet locally whenever you want. Alternatively you can send it to some other cloud storage solution, Dropbox, Google Drive your email account. You can have the backup copied automatically for every single transaction you perform, ensuring you always have the latest copy of your wallet (encrypted of course) at hand should the third party service disappear/go bankrupt.

The service also allows you to create a second password. This would then be requested whenever transactions are performed, ensuring in the unlikely case if someone gained access to your logon password and could look at your wallet they would not be able to transfer any coins. The coins are double encrypted with another private key a feature someone may wish to use with a savings account.

Two factor authentication is another security feature that is supported to further secure a wallet. When you login you would also be asked for a recent code that was sent to you. This can be either be through SMS, Email or Google Android Authenticator that runs on your mobile phone (meaning someone would need a physical device). It also supports Yubikey, similar to a physical key drive that provides a code to enter to your account. Again a physical device that is outside a hackers sphere. They only have access to data over cyber-space, not physical objects you possess. The service will only allow four password attempts if two factor authentication is enabled. If four failed attempts are made they will temporarily lock your account for a couple of hours and notify you that this has happened ensuring rough guess attacks are not attempted.

If you have a static IP address, you can lock your account to it (meaning a hacker would need to gain physical access to your actual computer).

You can create a physical paper wallet whereby your private key is printed as a QR code on a piece of paper. This means if your local computer is compromised with a virus or key logger software they couldn't see your password as your private key is stored at your house. You use your webcam to scan it in. Useful for long term savings accounts that you don't want to access or spend but wish to lock down. 

You can split your funds among multiple wallets, as there is no limit to the number of wallets you can own (I created around 3 to test - zero balances are fine). For small change you may wish to have little or no security, just a simple login password (similar to carrying cash) and for large savings wallets have many types of authentication detailed above - Bitcoin allows for many choices all down the consumer.

BlockChain also holds the majority of its code open source held in github meaning people can check for flaws and find bugs in it. All the code deployed to the servers is verified against known checksums to minimise malicious third parties changing the code. BlockChain provides local browser plugins that verify the local javascript that is run on your computer when generating your private key for login that I mentioned earlier.

In my opinion all Internet banking should be done on a secure system, preferably a non Windows device. I'd buy a Chromebook (if your tech savvy a recent Linux Distro will do). They run on Linux, a rock solid Operating System kernel that has been around for 20 years and is open source. Chromebooks give users minimal permissions meaning picking up malicious software is very hard. Verified bootup ensures any difference between boots are detected and a previous good copy of the Operating System is installed (the only way to hack this is to actually get physical access to the device and change the hardware - meaning its pretty safe). It runs the latest version of the Chrome Web browser, a very secure browser which is open source (constantly under the eyes of security experts with Google giving regular bounties to people who discover issues). Far more secure than closed source browsers such as Microsoft's Internet Explorer. The system is seamlessly kept up-to-date in the background. Why do a mention Chromebooks? Because consumer devices will continue getting thinner (not size, but in admin rights to the user). When people use computers, they don't want to update their OS, get anti-virus applications and check their firewall is up up-to-date. They want to turn on a machine and go. The Mozilla foundation have been working on a slimline smartphone OS, Firefox OS (based again on Linux), with the aim of making the phone a lightweight platform. No doubt Google will wish to eventually take Android (based again on Linux) in this direction, merging with Chrome OS, the operating system on Chromebooks.

All the above sounds complicated however Bitcoin is a platform and can be as complicated or simple as consumers want. Just as I have chronologically detailed how the platform for consumers has evolved within the short space of 3 years, in another several it will be even simpler and safer to use, the next generation of Bitcoin banks will emerge making payments effortless and efficient.

Bitcoin started with thick clients. Users had to keep this software up-to-date, download the complete BlockChain, ensure their computer was secure (Chromebooks were not around back then), deal with plaintext wallets, use third party software to encrypt them (in many cases use of a command line), back them up manually and so forth. You had to be a computer pro to do all this. As I have shown this state of affairs has now evolved into the fact you can login to a web interface, signup in a matter of seconds and you have a fairly secure wallet. As innovation improves so will usability along with security. 

Many have compared Bitcoin to the Internet when it first began and quite rightly for a number of reasons. Back when the Internet was in its infancy it was obscenely hard to use. No web browsers, graphical user interfaces, auto connect broadband wireless - it was just plain awful. However the basics were there a global interconnected network where people could share ideas and information. It took a decade later to gain mass public support and usability, now many rely on it as a service. The Internet was once dismissed as a toy for Geeks. Why do I need email, thats what the postal service is for? Why do I want to read something on a computer, thats what books are for? I think this quote best sums up how long it takes for new ideas to become mature enough for mass adoption,

"I predict that Bitcoin will reach usability sometime around 2019. I base that prediction on earlier disruption technologies, where blogging started appearing in 1994 and reached mainstream adoption in 2004; file sharing started in 1989 over the net and Napster hit in 1999. You had streaming video 1995, mainly porn sites streaming animated gifs, what was then tip of the spear technology; Youtube was founded 2005 and just swept the floor with everyone else just because they were usable. This is not something bad; it is just an observation that it takes ten years to get a disruptive technology from inception to becoming so easy to use that it reaches mainline adoption."
Rick Falkvinge

I'm sure there are other security options for e-wallets that I have missed but it gives you an idea as to the thought that has gone towards security. I bet many of you use internet banking, Paypal or whatever. How secure do you think your conventional banking is compared to all this detailed above (did I mention BlockChain also uses conventional TLS HTTP encryption on top of all the rest)? Sure, the Government protects your money but in the same breath they are secretly confiscating your funds through inflation and negative interest rates. You can make bitcoins as secure or in-secure as you wish. Some of the above may seem complicated to a non technical user however tutorials exist to show you how to do all this. Creating an online account takes seconds. To experiment with the above you don't even need to get any bitcoins, you can test by just continually logging in and out of the application, changing passwords levels etc. There will no doubt be many further security innovations to come.

Bitcoin is still in Beta. Many of the e-wallets are still very immature, its a high risk venture as non of this has been done before. All its users agree on one point, only put in what you can afford to loose. However many can still see the potential for the currency, how it could transfer the banking landscape forever. Due to its low user base it is still very much out of the public eye. Many users are either computer geeks (myself included), finance speculators who have spotted the potential, anarchists and libertarians. I'm sure mass use will come one day, but we are still in murky waters with a lot more to learn about the system.

Austrian view
Bitcoin aims to be a free, hard money. Mathematically its harder than Gold as it has a precise finite limit. Still many in the libertarian movement actually oppose such a system or have prematurely predicted its downfall. This would seem counter-intuitive. Investors who ascribe to the Austrian view, such as Peter Schiff and James Turk are also sceptical believing it to offer no advantages over Gold. I hold Gold. Gold has held value for thousands of years. Bitcoin can not compete with that historical record. However Bitcoin can compete in terms of technological superiority with its modern mathematics. I believe there is some vested interest within the libertarian community. Many make money from selling commodity based financial products. Bitcoin does away with the need for financial advice, fancy money managers. People can just hold the coins and take care of their own finances without the usual worry of inflation eating their life savings away. 

Bitcoin will be the spark that ignites the debate over regulation in finance - there is no bailout for a Bitcoin bank. In practice we will see the old banking system swamped under heavy regulation and a new finance sector, using true free market currencies to trade with. Governments will have a tough time trying to regulate such a decentralised system. Bitcoin won't be the last crypto currency, there will be others (there already are), weeding out the uncompetitive based on consumer demand.

It will also assist in debunking Socialist and Keynesian economic theory that is current conventional thinking, but as I and others have laboured, is plain wrong. 

Deflation
Bitcoin has appreciation built in. Inflation is not allowed. According to the State worshipers of all creeds without Inflation trade will ground to a halt. People will hoard their money, they won't buy food as an appreciating currency is far more important. Of course people will spend just as they had before. Genuine capital and savings will be able to form more naturally and spur economic growth to new levels. Prices adjust. People on the lowest incomes will benefit the most as all prices fall at a common rate. Inflation benefits the rich, not the majority. 

Credit Bubbles
There is no such concept in Bitcoin, but this is contary to the prevailing economic wisdom that of we need to fine tune this, or inject some "credit" here. Bitcoin will put that case to rest as bad businesses go bust, releasing scarce economic resources faster. Prices and production lines will not be distorted by massive credit bubbles engineered by central authorities. No more boom and bust on a nationwide (worldwide) scale. Liquidation of unprofitable lines will occur in small pockets in a continuous nature.

Central Planners and Regulation
We don't need them or their innovation stifling policies. Stop treating people like idiots and get out of the way. It will be a great challenge on the establishment.

With all of the above I'm still puzzled why many existing Austrian economic thinkers are still uneasy with Bitcoin. Busily reading their Mises or Rothbard texts for some clues, problem being that both economic giants had no idea how human imagination would create such an abstract currency.

People will be able to see all these concepts for themselves, not from some textbook. To see concepts can never be understated and is why a free market always wins out eventually. Actions speak louder than words. Socialism has a lot to say for itself but a miserable historical record for action. Socialists perversely usually manipulates the benefits that free markets have given to people, claiming such progress for its unjust causes. Markets need little words or political representation. It makes itself heard by its actions.

Counter Arguments
Bitcoin has been in the public domain for a few years now and therefore has been under widespread academic scrutiny. So far there have been no found compromises or issues with the protocol. That still hasn't meant there have been no concerns, many of which are popular myths.

Hard Limit on Money Supply
With a hard limit of 21 million coins many have said this will not be enough to expand to the needs of commerce and will not scale. The designers thought of this and ensured a bitcoin could have 8 decimal places to it. Meaning you can pay with 0.00000001 bitcoin. The whole currency has 2 Quadrillion units (a 2 with 15 zeros, compared with the World which has a population of 6 with 9 zeros), meaning it is more than sufficient to pass the divisibility test for years to come. Other currencies will no doubt come along if required.

Nothing Backs Bitcoin
The Dollar is backed by nothing but is still accepted as a medium of exchange. Gold is backed by nothing. The Software you are using now is backed by nothing, however it still has intrinsic value to us all. The internet is just a series of electrical pulses. Its the advanced Mathematics that backs bitcoin. It ensures it has a finite supply. It is backed by all the connected nodes who stay honest, its in their interests to do this as their income is derived by it being of value to the consumer. The very fact that it is not "backed" by a central authority is the very thing that gives it such value. Its no ones liability, only your own.

Its a Ponzi Scheme
In a Ponzi scheme you will always find someone at the base. In Bitcoin there is no central point, its decentralised. 

What if miner nodes are not Honest?
This is a published and known weakness. However it would cost millions of dollars to mount such an attack and as the network grows it would get more expensive, to the point that no single organisation could do this. If an attack was made the attacker would only be able undo what they have recently spent. They could not create money or steal from others. Compared with the millions of dollars it would take to mount the attack the gains would not add up, even if a collection of miners would form a cooperative. Currently miners get more financial gain from mining the network (transaction fees and bitcoins) then they would from bothering with an attack. Miners want it to remain honest as many hold and use Bitcoins themselves. The attack would also have to be run continuously as the network would resume normal operation as soon as the dishonest nodes stopped colluding.

Its a similar weakness to modern cryptographic algorithms which are considered secure but can still theoretically be broken. Brute force is always an attackers option. However in order to break a simple 8 digit alpha-numeric password using modern encryption may take 1000 years to do even with state of the art equipment, many of us won't care by then so we can live with that risk (in reality no one would attempt this as its a waste of resources and their lives). Its similar to the the honest node attack, theoretically its possible, in practice it won't be an issue.

Miners help keep the network secure and honest. To support the network during its first steps they were vital to ensure block chains (the accounting ledgers) were correct. To give incentives as gatekeepers of the network they were given Bitcoins. Anyone could participate, there were no rules or privilege. Money creation will slow over time, eventually to nothing so a question has to be asked why will people still mine and keep the network secure then? The plan is transaction fees will cover the costs. In its early years there is simply not the traffic to generate enough transaction fees to pay for the miners, hence the developers solved this by issuing money at a predetermined mathematical rate during the currencies growing pains. As the network grows and more people use it, more transactions will occur and fees will be a part of this. So why use this as opposed to Paypal? Because the fees should be so low as to be negligible. If the network gets really efficient then fractions of pennies will be all that is required. The incentive to pay fees for the users is their payments get processed quicker. If someone has a time preference for a quick payment, then they pay a larger fee. Many e-wallets set the optimal fee for a transaction so that it gets processed in a timely manner (when I say processed, I mean verified, it goes from wallet to wallet instantly).

The Biggest Risk is Government
This is what I perceive to be the biggest risk. Even if another crypto currency takes over from Bitcoin, the Government will fight tooth and nail to stop any monetary competition as whatever market money will exist it will be infinitely better than the Governments fiat. They will never be able to truly shutdown the network, but they will make it hard for the public to trade with it. No doubt we will see controls on trading houses on legimate companies providing services. They will use scare stories to bamboozle the public into their way of thinking, that can be assured its a common tactic. 

Governments will misinform people that it is for all our good to use our nations currency, with guilt trips a plenty. "Competitive Currencies damage the welfare system", "It will mean higher costs for goods and services", "it will be wasted effort when we already have a currency", "It encourages black markets and illegal activity". I can see it all already. 

The currency will however be the complete opposite. It will encourage the welfare state to shrink leading to more innovation, lower prices due to market competition and increased purchasing power for everyone. The Government will have to compete by not allowing arbitrary inflation as people will flock to other currencies.

Buying Bitcoins
If you live in the US you should have no problem buying Bitcoins. I think most places in the World it is fairly easy to buy. In the UK its a different matter and a real pain. It may be due to the heavy regulation or tight Government control but its not that simple. I had to follow this tutorial to exchange some money (as of writing there was a £10 limit per 7 days, previously this was £500. I suspect most people in the UK now have to use this service - its that bad!). It involves getting a smartphone app from Barclays called Pingit, a mobile payment platform (Pingit allows you to pay people if they have the application by just entering their mobile number). So you need either an Andoid or iPhone. Then once you have created an account follow the instructions. It worked fine for me and was simple enough, however its not for the average person. Bitcoin still has a lot of maturing to do.

I also setup a local wallet on my computer. Its just a case of downloading the software, waiting for the whole blockchain to download (took me around 2 days!), then creating a wallet and an address. This is what I used to transfer a penny from my e-wallet. Again, there is no way non-technical people are going to find the current thick clients very usable. E-wallets will be the way forward for mass adoption.

Fees are also an issue when converting domestic money into Bitcoins (not an issue in the US, but it is here in the UK). The fees using Pingit and BlockChain.info are around 6% - so for trading on a daily basis, its not worth it (in the US its around 1% for fees). The eventual ideal will be that your incomings and outgoings will be both denominated in Bitcoins, meaning no transfer fees. Governments will fight this.

A lot of people are speculating on Bitcoin and with good reason. If this is going to be a useful Global currency then if someone buys a Bitcoin now, imagine how much it will be worth in 10 or 20 years time? Current market valuation for the currency is around $120 million dollars. That is insignificant compared to global trade. As more people use it, then a Bitcoin will be worth more. Couple this with the fact its a deflationary currency and its value will go up over time. These two factors mean it potentially could be a very wise investment. Like all new concepts, just like a startup, you could loose it all due to its unproven model (although it has been going for a few years now). Its win or loose.

The Future

Bitcoin can exist alongside Gold and existing fiat money we use today. There is space for all. Whether Government fiat money can stand up to the competition remains to be seen, as history has shown with Government services against market services, they never do. Bitcoin was the creation of individuals who pursued their own goals under the influence of no central committee or planners. Their ideas happened spontaneously, the bottom up approach. We should all be thankful we live in such times to witness not just the creation of the greatest tool humankind has ever created, the Internet, but at a time when the Governments days are slowly numbered and there are genuine solutions to break the hypnotic grip it has held over the public. With revolutionary concepts such as Bitcoin there will be real examples of how markets make peoples lives better. You won't need to read a textbook or understand economic theory to see why money should not be controlled by the State. The actions of such products will speak louder than words. Bitcoin; if it fails or succeeds is not important. Its already made the playing field better for all of us.

The root problem with conventional currency is all the trust thats required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts. Their massive overhead costs make micropayments impossible. A generation ago, multi-user time-sharing computer systems had a similar problem. Before strong encryption, users had to rely on password protection to secure their files, placing trust in the system administrator to keep their information private. Privacy could always be overridden by the admin based on his judgment call weighing the principle of privacy against other concerns, or at the behest of his superiors. Then strong encryption became available to the masses, and trust was no longer required. Data could be secured in a way that was physically impossible for others to access, no matter for what reason, no matter how good the excuse, no matter what. Its time we had the same thing for money. With e-currency based on cryptographic proof, without the need to trust a third party middleman, money can be secure and transactions effortless.
"Satoshi Nakamoto"

Japan a Deflation Death? - Nope Stagflation

Gordon Brown this week announced what can only be described as a car boot sale of UK PLC's bric-a-brac goods, an attempt to sooth markets regarding the budget deficit. Many of the items have been for sale before, but I'm sure the government in their current desperation will be willing to accept lower offers this time around. I agree with privatisation in getting the state out of our lives, but a student loan book and a crossing in Kent are hardly big ticket items, never mind the fact that they are assets that generate money. Thatcher sold the majority of the family silver during the eighties privatisation bonanza however contrary to common belief there's plenty more the state could sell. Institutions such as the NHS, education the road infrastructure and so forth could all be sold, but these are not politically palatable areas that the public can swallow, meaning they are off limits for any politician that doesn't want to ruin their career. The Prime Minister once more began another Keynesian rant stating that the Conservatives proposals would lead to the same problems experienced by Japan for the past two decades. The title 'Prudent Chancellor' seems ever more absurd as time goes on, his emphasis on yet more needless spending in an attempt to bankrupt the nation. It doesn't matter if its Americas Great Depression or the lost decade in Japan, economists, politicians and journalists all seem to draw the wrong conclusions. What Gordon Brown in fact proposes are the very same policies that were pursued during both periods above and resulted in stagnation. Japan didn't get ravaged by the 'dangers of deflation', it was instead a good old classic stagflation.

Many Keynesian economists are still baffled by Japan. Over the years, policy after policy has been proposed by their school of thought, all of which involve some form of government action, but time and time again they all seem to fail. The classic Keynesian rebuttal whenever these policies fail is "Well, the authorities didn't do enough". Just like they apparently didn't do enough during the Great Depression. Yet put forward the question regarding Americas 1920-21 Depression and all Keynesian theory goes out of the window. Here Warren Harding, Americas president at the time, cut government spending, cut taxes and in fact did very little during a time when the economy was contracting at an alarming rate with the measure of unemployment rising faster than during the subsequent Great Depression. Yet the economy with market forces in full control, liquidated unprofitable lines of production and subsequently America during the 1920's experienced one of the greatest economic booms in history. The unemployment rate came dramatically down in no time at all, without government spending to alleviate this process as we are now all told. Herbert Hoover, who was later to become Americas President during the next depression, unsurprisingly didn't agree with Harding's polices, a pre-cursor of what was to come. Don't mention any of this to the Keynesian's though, it will give them a real headache.

What did Japan do when their bubble burst? Cut taxes? Cut Government spending? Liquidate? They of course carried out the exact opposite. Their Government debt used to be as low as the UK's before its recent exponential trajectory however Japans now stands at 200% plus and keeps growing. They propped up their infamous zombie banks, crippling the pricing mechanism that is so vital for an economy to prosper. Increases in taxes will choke the economy as rising social costs increase. In order to assess what really happened we need to deal with the aspect of deflation, or what is currently assumed as the bogeyman to economic growth. Japan never entered a downward death spiral of prices, that consistently fell year on year, in fact the lowest their CPI hit during this time was -1%. During the mid-nineties it spiked back up to 2%. There was only around 6 years of official deflation during the two decades using the Governments metrics. What gave the impression of price deflation was in fact asset price deflation. Both real estate and stock prices completely collapsed and have not returned since, instead stagnating for years. The reason why they never recovered to their previous highs was exactly what the Government did, they took over and tried the command economy approach. Roads to nowhere, propping up banks that were insolvent, not allowing private enterprise to take over the means of production. Rather than money going into the private sector, Japanese savings that were accrued during their economic miracle were funneled into Government bonds, wasteful Government consumption. It was quite simply a classic stagflation, that is still ongoing.

The UK are now pursuing similar policies and will go into a long period of stagnation unless the current direction is reversed. However it is useful to try and make further sense of Japans situation during that time, compared with our own. When the crunch came for Japan they ran budget surpluses, had high domestic saving rates for years and were a creditor nation. The UK on the other hand has the complete opposite and relies heavily on overseas investors to buy our Government bonds. Japan only began to run double digit Government deficits eight years later. They were able to sell their bonds to domestic citizens. They were still obtaining plenty of foreign currency as they exported more than they imported. The UK has already printed in excess of 10% GDP to pay for the debts, is running a huge budget deficit only two years after the current financial crunch and for the past decade its citizens have had low savings rates.

So what does all the above mean? Quite simply the UK is in a much more highly inflationary situation that Japan was. Japan's government couldn't really print money until over 10 years later as a last resort due to there being ample savings to pay for the Government debt. Japans government created their budget deficit, the UK has a structural one in which politicians are notorious for not tackling the shortfall. While Japans significant industries, electronics and car manufacture, continued to grow with global demand, the UK's key revenue streams, finance and North Sea, are in decline.

Another key factor is if the Government Bond market is in a bull or bear market. During Japan's economic disaster the bond market was in a bull market. Interest rates kept falling, people still had faith in many paper financial assets. Since 1981/82 Government Bonds have been in a bull market however these things always move in cycles, typically we should be seeing the end to this trend at some point. 25 years plus is a good run and in the near future this will turn into a long, grinding bear market, we may have already crossed that point. In a bear market, interest rates on bonds rise, which means Governments have to increasingly spend more on interest payments, diverting money away from spending such as health or education. Recently the CEBR said interest rates will stay low for the foreseeable future during the first half of the next decade, however that would mean the bond bull market lasting for over three decades, a highly improbable situation.

History is always an important guide to future trends, however it is crucial to compare given contexts in their current time frame. I have seen articles recently stating that Britain had debts in excess of 200% of GDP after the Napoleonic wars, indeed I have mentioned it myself before, however this didn't count for much when the UK went broke in 1976 with debts as meager as 48% of GDP. In the prior scenario the UK was the global superpower but a much bigger factor was that the UK didn't have a Welfare State. There was little government expenditure, with the majority of taxes just going to pay off the debt as alternative expenses didn't exist. Contrast that with current Government spending in which the interest payments are now comparatively small along with a rainbow of other Governmental expenditure, we see how context is key. Somehow, within the time frame of 150 years, Britain had transformed itself from one of the leaders of laissez faire, into a nation that was almost turning Communist in 1976. An ever expansive state, a declining currency, an economy with little productive purpose, meant investors wouldn't lend the UK any more money, despite the debt being around a quarter the level than that of the early nineteenth century.

Japan recently has around the same debt as the UK did 200 years ago and is still able to pay for it. It's dangerous to compare Britain with Japan, as Britain will not be able to sustain a public debt level that high. Japan built this debt up during a bull market in Government bonds and had savings to pay for it. The UK doesn't have either of those luxuries. It's one of the key concepts that many forecasters and economic commentators overlook, the fact that interest rates can rise over time and enter bear and bull markets. Payments for the interest are already predicted to soar as the debt increases based on the current low rates, but what about if those rates double 10 years from now? The government admits the earliest they can balance the books is around then therefore debt is almost certain to keep going up.

Do not believe predictions regarding long term interest rates and the level of debt a country can absorb, no one can forecast precise figures in these areas. Instead look at the fundamentals. Are the government balancing the books? Has the printing press been shut down? Has liquidation occurred? Until fundamentals return then stagflation looks the most likely outcome here in the UK. Just like Japan, only I fear much worse.

The Fallacies of Deflation

It seems every authoritative figure has begun warning about the dangers of deflation. With Britain's Monetary committee making a case for printing money, we are told that this is to ward off the 'dangers' of a falling money supply, and we need to inject more cash into the system to get the economy moving again. The Keynesian's, the governments economic cheerleaders, are proposing that inflation is needed in order to combat deflation and the new money can ensure increased consumption in order to drive the economy forward. Deflation is one of the most misconceived economic terms, used as a scapegoat by the above institutions portrayed that it can somehow cripple an economy. Yet Deflation should always be embraced as it is a sign of a healthy free market economy. If our economic system was truly free, we would never get inflation. We would always have deflation in the modern sense of falling prices. However Banks and Governments always prosper with inflation. Throughout history this has been demonstrated with the costs borne by the rest of us. I felt this post was needed as I have become weary of these statements that deflation is some how a terrible event that should be avoided at all costs, used to try and justify printing money. Nothing can ever justify printing money or inflation and this post attempts to tackle these common misconceptions that have been indoctrinated onto the public, either by officials and economists that prosper from such policies or are incompetent to see what is happening.

Credit Expansion, Banks and Governments

Governments worship inflation. It funds their expensive welfare programs. It funds their wasteful consumption. It funds their political ideologies, their Utopian society they promise the public who elect them. Permanent inflation, like the one we have in our monetary system would never occur in a stable and free market monetary system. It can only occur by the continual expansion of our money supply. Markets always reduce the costs of goods ensuring greater productivity efficiencies as capital is used to enhance the way we make products. The debasement occurs with the co-operation between the banks and the state, similar to what we are seeing now. There is no conspiracy behind this as there is a long history of governments encouraging reckless credit expansion from the banks. A credit boom, like the one we have just come out of, creates huge amounts of credit which is spent during the boom. Most of this money does not exist as fractional reserve lending allows banks to lend far more money than they hold on deposit (money that actually exists). The government allows this privilege to banks as it inflates the currency, expanding the amount of money in the system. Despite the huge deflation we have had over the past 10 years in, computers, mobile phones, holidays, with all these items coming down in price, we have still had continual inflation. That inflation was a credit boom created by the private banks orchestrated by the central banks who prop up this credit expansion process, ensuring it goes on for far longer then would occur in a free market system.

At some point this process breaks down (a credit crunch), usually by previous investments turning bad (sub prime was the trigger recently) thus wiping out what little reserves the banks have. The banks reach a point where they can no longer inflate and central banks become the lender of last resort propping up these banks, and essentially printing money to replace the credit being destroyed. This is the current time frame we find ourselves in. Deflation, as in a contracting money supply is happening, thus the government and institutions step in to inflate. Since the credit crunch began true deflation has not actually occurred. Instead the money supply (Broad Money, M3, M4) is still growing as the governments resort to running huge budget deficits, that will be paid by printing money. We are told that this is necessary, as our economy needs the credit in order for it to operate. This however is not the case.

It doesn't matter how much money you have in the economy, so long as it is stable and divisible enough to price goods and services. Zimbabwe has huge amounts of money, yet they are no better off than traditional hard money countries such as Switzerland. In other words our prosperity does not depend on how much money there is, only that it be a commodity that can retain its value. If we allowed our money supply to drop, as markets are currently indicating, prices would just fall to a new equilibrium. If our money supply fell 50% then prices would generally fall 50%. This is the way to get out of the economic hardship we find ourselves in. This ensures a healthy liquidation process runs its course and cleans out these excessive speculative debts, those of the wasteful businesses and individuals. It would also stop government spending, and these unpayable deficits that we now see. It would be painful, depending on your circumstances, but it was brought about by the excessive credit expansion of the previous boom. The market is simply trying to get rid of these excesses. The worst thing we can do is try to re-inflate like we are currently doing. History has always shown this, and economic theory proves it.

Deflation is Compatible with Economic Growth

The recent credit bubble has now morphed into a violent contraction as the credit expansion process has turned into a credit contraction. This is not to be confused with normal market deflation (constantly falling prices), rather a by product of the elasticity of our money. In a free market that did not permit excess credit creation (ideally none), used sound money and removed the monopoly our governments hold on our money, deflation would be a normal occurrence. As history has shown, economies that have undergone deflation, have performed better than economies that have experienced inflation. Milton Friedman, who in fact believed in price stability therefore inflation, concluded that America during the period from 1865 to 1879 experienced huge economic growth despite having no inflation. On the contrary the U.S. was experiencing deflation.

"[T]he price level fell to half its initial level in the course of less than fifteen years and, at the same time, economic growth proceeded at a rapid rate. . . . [T]heir coincidence casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible."
Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867–1960

Around this time Germany also experienced rapid price declines, yet had the best economic growth in the whole of Europe as they became a world superpower that challenged Britain's status at the start of the twentieth century.

These false justifications to create more credit will ruin market forces for years to come. Credit merely channels societies resources. If we have less credit then prices drop to their new equilibrium. Just because credit contracts, doesn't mean we suddenly loose all our infrastructure, our skills, our resources? They are still there, and will just be re-priced accordingly. The competent, people and businesses who did not overextend themselves during the credit boom, did not make wasteful purchases, will take over from the people who were overextended and have been liquidated, who could not manage societies scarce resources.

'Price Stability'

So why do we have this catastrophic credit expansion that creates all the issues we now have? Governments and Central banks use a concept of price stability. Many of you would have heard of it before. In the UK for example we have a composite index that represents typical consumer goods, called the CPI (Consumer Prices Index). The government (Central Bank) try to keep this target in a range of 2-3%. Around the turn of the Twentieth Century a proponent of this concept was an economist called Irving Fischer (an early day monetarist). The concept goes that this will somehow ensure greater economic productivity and planning. Another economist at the time, Friedrich Hayek, indicated that this proposal was doomed from the start. In order to stabilise prices in a free market where prices were continually falling, the stabilisation would inevitably take the form of a credit expansion, which would provoke a boom. This boom would be unsustainable and would result in these artificial credit distortions eventually unwinding with a bust.

These polices were used during the 1920's in America, with the Federal Chairman Benjamin Strong, ensuring 'price stability' by crediting a huge credit bubble in the stock market. Irving Fischer, who supported such polices said in 1929;

"Stocks have reached what looks like a permanently high plateau."

He also made statements for the continuing years that stock prices seem to have stabilised, even as they continued to decline until 1933. Meanwhile in 1928/1929 Friedrich Hayek, had wrote that a great depression was coming. Price Stability was a form of central planning, targeting fixed metrics that were incompatible with market forces. It was central planning intervention, interference with markets just like Communist Russia. At the time he was laughed at, people were saying it could never happen, this was the "Global Economy", the "New Economy". However the disaster was always on the cards, it was just a matter of time. Governments and Central Banks subsequently use 'Price Stability' to legitimise this expansion of the money supply that always brings about the boom and bust process we are currently seeing.

Price Indexes

Then we come to the point of the price index (CPI, RPI etc). How do we determine the algorithm to use? In a free society how do we decide what people spend their money on? Well one cost would be living costs, as we all have to live somewhere. Not in CPI. CPI, the preferred measure the government uses doesn't even include typically peoples biggest cost, their roof over their head. So how can they target 'price stability' when we don't include house costs. Quite simply they can't and its all an illusion. All the inflation went into houses - trillions of it, now its all spilling out as the governments try and replace the bad loans that were lent on these assets. It's a similar story with stock markets, they are also not included in any measure. The indexes they use from the start are flawed. Its all deliberate, to give people the illusion of prosperity i.e. rising asset prices to ensure continual inflation, debasement of our money. These are the justifications they now use for printing money, flawed centrally planned metrics which is just the same as any Communist centrally planned ethos. All monopolies are doomed to fail and impoverish the people. This is no different.

The amusing thing with CPI in the UK, is it hasn't even fallen in it's targeted range and yet the government are already wanting to print money, even before true falling prices have actually met their bounds that they use.

Arguments against deflation

There are many common horror stories with deflation, a fear is installed in people with various doomsday scenarios that will occur, and all of them incorrect.

The first one, is no one will buy anything. People will stop consuming and we will all have no jobs. So when mobile phones, computers, televisions, holidays, cars etc have all been falling, did people prospone their consumption? Of course they didn't, people have a time preference to enjoy their life now. Everyone knew these goods would most probably fall in price over the past 10 years yet everyone kept buying them at record levels for the enjoyment of these products now. People buy mobile phones every year, despite them continually falling in value. Common sense says people always spend money. We always need goods. People use these justifications for houses, if prices keep falling then no one will buy them. People will always buy houses regardless, as its a home, and people will always pay for the enjoyment of 'their' home. If peoples past expectation during the housing bubble was rising appreciation, then these attitudes need to change. A house is a home and historically has been a poor investment. When the credit crunch began people stopped buying homes not because they thought they would fall, but because the banks stopped reckless lending. Now people are not even sure if they will have a job, so buying a home suddenly seems like a liability.

Second, it would be harder to service our debts. Sure, if you have a million pound house with an income on minimum wage and a 125% mortgage. This only occurs in the extreme case we find ourselves in now, that is caused not by deflation, but the excessive credit expansion of the preceding years, all in the name of 'price stability'. Even in our current situation, people who have over extended themselves get liquidated. The people who have been prudent and competent take over these assets. Governments cut their wasteful spending, and don't rob the people through inflation allowing the competent private sector companies to take over - not the government like we are seeing now. An attempt to re-inflate will only result in further struggles to pay debts as the new money ends up in food, energy etc meanwhile production is distorted and hampered by these re-inflationary tactics.

Third, we will get a deflationary collapse like Japan in the nineties. It wasn't the deflation that killed Japan, as in a monetary trap, it was the government, a structural trap. It continued with further inflation. The government expanded its involvement, tried to prop up prices and didn't allow liquidation. The funny thing is U.S. Treasury Secretary Timothy Geithner now states that Japan did not inflate enough and that's why their economy never recovered. Talk about clown school economics. I couldn't believe what I was hearing. It was like Robert Mugabe stating that Zimbabwe's economy is in such a bad state, because he didn't print enough money.

Deflation allows all sections of society to prosper. It distributes lower priced goods and services to all income groups, regardless of social standing or what assets they hold. Inflation enriches the wealthy at the expense of the poor. It puts a break on social mobility. Banks and Governments are always the winners as they receive the money first. As the money moves out, prices rise and the last to get it suffer. As long as the government holds a monopoly on our money they will always inflate, regardless of the consequences. Regardless of robbing the very people they are elected to represent. The only way to prevent this is by giving production of money back to the people - to the market. Just like any other good, Chicken, Shoes, Phones, all are provided by the market and money is no different. It is merely a convenient commodity to exchange our more cumbersome goods. Britain had free market money around the turn of the nineteenth century, as it rose to become the economic superpower of the world. Government intervention outlawed it, as there was no benefit for them subsequently creating the modern money monopoly they still hold. One day, I hope we will look back at inflation as an ancient cult, extinct, with deflation a permanent feature in our economic landscape, discriminating against no social group and ensuring everyone can enjoy the fruits of a true free market.

"Today everybody is prepared to consider a rise in his nominal or monetary income as an improvement to his material well being. People’s attention is directed more toward the rise in nominal wage rates and the money equivalent of wealth than to the increase in the supply of commodities. In a world of rising purchasing power for the monetary unit they would concern themselves more with the fall in living costs. This would bring into clearer relief the fact that economic progress consists primarily in making the amenities of life more easily accessible."
Ludwig Von Mises, Human Action

The Descent of Niall Ferguson?

We came close to financial collapse, Wall Streets big Investment banks went bankrupt or were merged into other banks, the IMF bailed out various countries from monetary implosion, Sterling plunged, Governments turned to Socialist solutions, the myth of houses being a 'safe investment' was derailed. In all the turmoil with every asset in sight heading south, historian Niall Ferguson was on our screens again, this time with a series titled "The Ascent of Money" to promote his new book. A six part series that looked at the historical impact of finance within human society and how it has evolved, into the modern system we now use in our economies. I personally enjoy reading Niall Ferguson's books and there are some interesting titles to his name, my favourite being Empire: How Britain Made the Modern World. After the last episode there was an open web chat in which he answered peoples questions, which can be found here. Like the television series, Prof Ferguson seemed to have flawed analysis of economic matters, such as deflation and inflation which I wish to explain briefly here. Inflation and deflation is strictly a monetary phenomenon, it is caused by an increase in paper money compared with the goods and services in an economy. This shows up as rising prices, however the goods do not rise in price from market forces, but from monetary expansion. For the sake of this article, I may refer to deflation as falling prices, but technically it is a falling money supply. However I will use this definition to elaborate on Prof Ferguson points in question. I have selected some of the quotes he made in the online discussion that I found interesting.


"Well, right now Ben Bernanke is more worried about deflation than about inflation. But if he's successful we can soon revert to worrying about inflation. As I said in an earlier post, central banks today do not want 0% inflation (i.e. price stability). It limits the room for monetary policy too much. Are we going to see a big surge in inflation after this crisis is over? I frankly doubt it. The Fed can mop up a lot of this excess liquidity quite easily, as the Bank of Japan did after the end of quantitative easing."

The above analysis is flawed, in many aspects. First of all, that we are suddenly worried about deflation. This is a myth, as the past couple of decades have been deflationary. As I've said before market forces are always deflationary, people reinvest capital to increase productive capacity, thus reducing the cost of goods and services. Prof. Ferguson confuses general deflation, with the aspect of deflation that Ben Bernanke is worried about, that is asset price deflation - houses and stocks. As the US and UK have consumption debt based economies, where the 'wealth' is based on the price of the above assets, when these are falling in value then the economy contracts. This is what the Western Central Banks are worried about, as our whole economy revolves around these assets. They will inflate these assets at all costs, hence why they want to print money. History has always shown governments will do this as people want the government to take action. Prof. Ferguson does not mention any of this which is a big omission. He also doesn't mention it in the television series.

Apart from the first episode there is no great mention about inflation. Inflation is a purely monetary phenomenon, which amazingly he doesn't seem to explain in great depth. In order to obtain the 'price stability' he references above, central banks must constantly inflate the currency as the prices of goods and services continue to fall. Achieving price stability is a path to periodic financial crisis. Price stability helped cause the Great Depression, as the FED had to inflate during the 1920's in order to ensure inflation was ticking along, fighting against the deflationary forces of industialisation. Then when the bust came in, they tried to inflate to keep inflation up (i.e. keep wages, agriculture and stock market prices high), however they were beaten in the end by the gold convertibility so deflation won in the end. Rather than the economy resuming normal operation it stagnated for years due to the huge inflation in the proceeding years, accompanied by the draconian measures that were introduced as the government constantly interfered during the bust. It wasn't deflation that made the great depression, it was the inflation in the stock market. Then there was the stagflationary seventies. All currencies were off gold, therefore governments this time could inflate so inflation reached as high as 25% in Britain. Again the result was the same - economic hardship for years. It was inflation again in the 50's and 60's into asset prices that caused this as central banks looked for 'price stability'. Yet again, we are following the same foolhardy decisions, as price stability causes financial instability.

When Dr Ferguson mentions this price stability he says it limits the room for monetary policy. Does he really understand what he is saying here? The only thing it limits is the economies ability to re-deploy its resources efficiently and effectively. It has helped cause the stock market bubbles and the housing bubbles with the recent one, being one of the prime reasons we find ourselves in this mess as Greenspan and Co decided we had to pump cheap money in the system to ensure 'Price Stability' to combat these deflationary forces. They expanded the money supply so much that the West quite simply misallocated its resources in the wrong areas, hence the major correction we are now going into. Capital should always be scarce despite what people say, as it tries to direct a scarce amount of resources in the real economy into the required productive channels.

Then we come onto his other comment regarding if we going to see a big surge in inflation, in which he doubts we will. His reasoning is that we will be able to mop up any excesses like Japan. Like Japan did? As I have mentioned before, and unfortunately our governments have begun implementing this policy, Japan cut interest rates to 0% and tried to inflate to cure their downturn in the 90's but all it did was kill the economy. They also tried the new buzz word in the media "Quantitative Easing" which is effectively printing money, as I have earlier warned about. The reason Japan didn't experience inflation domestically, was that they exported this excess money to the world. Japan exported inflation to the world. You have probably heard of the Yen Carry trade well this is what it was in effect, people buying up huge amounts of Yen at cheap rates and putting the money to use in other countries where the returns were higher. It was also the reason for the Yens surge this year, and the deleveraging we saw in the autumn and winter of 2008 as these returns evaporated and the Yen increased in value against all currencies - people had to sell to cover these loses. This is also one of the causes of our asset booms in the stock market and housing. If it wasn't for this and the fact Japan is a huge creditor nation who have a trade surplus, they would have experienced huge inflation. So then we ask the question, how will the West mop up this excess money if the majority of the worlds economies are doing it? Quite simply, they can't, once this money is in the system along with less goods and services (which is what is happening at the moment as businesses won't invest) inflation is inevitable. The only way to stop it is by raising interest rates to double digits, a policy politicians don't particularly like, as Margaret Thatcher found when she became a demonised figure. Our economy is based around debt, so they are not going to be doing this for some time.


"Don't know the book. But people are always writing things like that. My favourite is William Rees Mogg's Great Depression of the 1990s, which never materialized (rather the reverse). Usually the predicted event doesn't happen. Sometimes it does -- though by 2010 I suspect we'll be out of this hole and Harrison's book will be out of print."

The comments above are in regards to Fred Harrison's book, Boom Bust: House Prices, Banking and the Depression of 2010, this is also a book I have read. Yet if Prof. Ferguson had done sufficient research and indeed read the book before passing judgement, he would have discovered that there is a very set pattern for the gap between each housing boom, specifically 18 years which Fred Harrison shows in his book. The book was also written in 2005, just as the housing market was slowing down and many thought it would collapse, however Fred stated that it would carry on for another two years, the period he terms as the "winners curse". He also said it would carry on with double digit rises, when everyone said it would slow to more moderate growth, as he claimed hysteria would grip the market once more. He also wrote a book back in the early eighties, The Power in the Land, in which he predicted the recession of the early nineties, so this is not a one off.

The assumption that we will be over the worst by 2010 is wrong and sounds like he has been listening to the Labour Government. This stagnation will go on for years in the West. 2009 will be even worse, with more bank failures, huge unemployment, and rising debt. Government finances will be in a hideous state and 2010 will be a grim year too, with in all probability the beginning of what will be years of inflation, as 2009 winds down.

"No, we are in a very different situation from the world in 1929, although the potential was certainly there for a Great Depression 2.0. The key difference is that the Federal Reserve System and the U.S. Treasury are doing everything in their power to combat the collapse of the banking system. And so far they've done a pretty good job. I find it hard to believe that this time next year will be so worried about deflation and depression. The conversation may even have switched to inflation and the need to reverse some of the stimulus that was injected."

The final sentence of the above comment concurs with the first statement in this article, however it is his comments regarding the authorities' interventions that I wish to tackle, as he quite clearly has a incorrect interpretation of history. As I have shown in a previous post the Great Depression was caused by government intervention, the Federal Reserve slashed interest rates from 6% to 1.2% and took all sorts of financial instruments from the banks to prop them up. Prof Ferguson seems to place a belief that they have done a good job, however President Hoover was saying exactly the same at the end of 1930. It wasn't until the second half of 1931 when things really were desperate, and the previous measures had quite clearly had no effect. Governments make the situation worse, which I will dedicate a post at a later date to fully explain why free markets should never be interfered with, even during a bust. He's right in once aspect that later in 2009 we shouldn't be worried about deflation, the monetary expansion along with the depletion of goods should ensure a resurgence in inflation again. We are facing a depression, even if the authorities never admit it, but it will be an inflationary depression.


These were just three of the comments he made in the web chat, I didn't feel the need to choose anymore comments as the post would have been too long. There were some good points regarding the Socialist Chilean President Salvador Allende from various posters and from Prof. Ferguson himself. His successor, General Pinochet was a tyrant and an oppressor of personal liberty, but Allende would not have been the Socialist Utopian alternative, as so many among the left like to believe. Before the coup, Chile was already showing signs of Totalitarianism, along with the classic hallmark of Socialist overspend resulting in the escalation in inflation. There was quite an extensive debate on this subject matter, with some emotions running high.

One of the terms coined in the series is that of "Chimerica", or the union of China and America in recent times. Ferguson paints a rosy picture of this relationship, although he does mention the possibility of a Third World War between the two without the mention of possible alliances. In one of his books "Colossus: The Rise and Fall of the American Empire", he evidently can see that America is on its way out as the worlds superpower, displaying signs of overstretch and faltering economic growth, similar to Britain's decline, decline that I suspect we will see over the coming decades (as empires always decline in over a long period of time). In the book he doesn't use the term Chimerica but acknowledges the China effect and the deficits that America is running with the rest of the world. This is one point he doesn't make an issue of in the series, which in my view is a major point. Britain, when it began its decline, was a large creditor nation with assets all over the world. America, on the other hand, is a huge debtor nation the largest in history with very little in terms of overseas assets. America, is in a far worse state than Britain was during its decline. Yet Ferguson seems to believe that America will be the main economic powerhouse for years to come. I disagree, and think he has overlooked this fact, or forgot to mention this historic parallel. The globalisation of today is far different to the one before the first world war. He mentions British trade with China, however the Chinese were very restrictive back then, only allowing European merchants to trade at key ports. They had no access to mainland China, and shifted their goods through the local merchants. In this recent revisit of Globalisation, the situation is very different. China now produces and exports huge amounts of goods to the West, and have modern economic capabilities. They are becoming self sufficient, while the West now relies on their productive facilities to make goods. This is why this time it is more experimental, as the West slowly loses its status as the economic center of the world.

In the final series Prof. Ferguson detailed the various financial events of the past two decades, from the Savings and Loans Crisis, the Asian financial crisis, the Russian Government Default, LTCM collapse, the dot com bubble, Enron then finally the housing bubble. Yet he didn't link into what caused these events, and how they kept reoccurring. Again the Federal Reserve has fostered these, and persistently distorted the market causing the major downturn we are now seeing today. All the above is created by Greenspan and Co who kept bailing the markets out. People were amazed that Lehman Brothers went bust last year, but half of those US investment banks should have gone bust 10 years ago, along with LTCM at the time. He instead pins the mistakes on human behaviour and markets. This is not true, as the market would have corrected these excesses long ago, instead the Central Banks kept bailing out everyone. In other words they took the risk out of the free market. The free market therefore did not price risk, which is a reason why the banks have so many issues we see today. This omission was fatal, as it explains the bust we are going into is not a product of the true free market, or the product of Capitalism (as many anti-capitalists have begun prophesying its downfall) but the product of Central Bank intervention. The market would have corrected all the above long before, thus we would have never had house values escalate as high as they did and an economy orientated so heavily towards these asset prices. These banks would have gone bust long before and along with it more sensible lending standards, with a more balanced economy.

After viewing the series I don't think I will be buying the book, and will probably wait until it becomes available at my local library. I was also disappointed that the series did not go into the details of fractional reserve banking, Central Banks and the artificial market forces that China have been exerting in recent years in order to grow their economy quicker. There was also a lack of history towards recent financial events, which would explain more clearly the predicament we find ourselves in. However, Prof. Ferguson is an academic, not an economist. His book Cash Nexus, another book that I have read, he declares gold as an old relic with comments such as "Gold has a future, of course, but mainly as jewelry". This was in 1999, around the bottom in Golds price, since which Gold has increased around 400%-500% in Sterling a decade since these comments. Other recent comments such as "Money is trust, not metal", is true with our modern fiat currency, however only metal ever keeps its value over history. Another historical point Prof. Ferguson misses.

Alan Greenspan, who helped cause the current issues we see, understood the damage central banks and a fiat monetary system can cause. Back in 2002 Ron Paul asked him about Gold and Economic Freedom, an essay he wrote (in which I have taken an extract from), and if he still believed it to be true and valid for today. He responded with "I wouldn't change a single word". It's a shame many mainstream commentators such as Prof. Ferguson can't see the flaws in our current system. Greenspan could.

"But prior to World War I, the banking system in the United States (and in most of the world) was based on gold and even though governments intervened occasionally, banking was more free than controlled. Periodically, as a result of overly rapid credit expansion, banks became loaned up to the limit of their gold reserves, interest rates rose sharply, new credit was cut off, and the economy went into a sharp, but short-lived recession. (Compared with the depressions of 1920 and 1932, the pre-World War I business declines were mild indeed.) It was limited gold reserves that stopped the unbalanced expansions of business activity, before they could develop into the post-World War I type of disaster. The readjustment periods were short and the economies quickly reestablished a sound basis to resume expansion ... In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value."
Alan Greenspan, Gold and Economic Freedom, 1967
Note: The Federal Reserve was established in 1913