The Mathematician’s Defense of Bitcoin: It’s Just Another Option

Making Sen$e recently examined Bitcoin and the rise of its mainstream appeal.

Paul Solman: A fascinating thread of critical comments in response to our Bitcoin story last week prompts this and a series of follow-up posts, including several interviews that didn’t make it into the broadcast.

We begin with the esteemed long-time finance expert on this page, Zvi Bodie, Norman and Adele Barron Professor of Management at Boston University, affectionately known around here as Bodie-Sattva for his profound pronouncements on everything from I-bonds to how to find a financial adviser.

Zvi has a finance professor’s problems with Bitcoin, which echo those of some of our commenters. I asked him to share them briefly with our readers.

Zvi Bodie: I think that there is something unique about Bitcoin that NYU economic historian Richard Sylla did not mention, at least not in the broadcast story. Paper money has value if a functioning government will honor it in payment for taxes. Thus U.S. dollars serve as currency, but Confederate dollars do not.

Credit cards are also accepted as money, but only when a third party verifies them and guarantees ultimate payment.

Then there is gold, whose physical properties give it value independent from its use in settling transactions.

But bitcoins seem to have no independent source of value other than that a group of digital experts have agreed to accept them. So far, it may be working. But the exchange rate between dollars and bitcoins has already proved far from stable, suggesting that there is only one reliable moral to the story: Caveat investor.

Paul Solman: As usual, we agree with Zvi. But the Bitcoin evangelists are a fascinating flock that we found well worth listening to. So we’re going to share some of their interviews with us in greater detail than we had time for on the broadcast.

As part of our Bitcoin interview series, here’s Charles Hoskinson, a Colorado-based technology entrepreneur and mathematician who attended the University of Colorado, Boulder, to study analytic number theory in graduate school before moving into cryptography and social network theory. He describes his current focus as “evangelism and education for Bitcoin and fully homomorphic encryption schemes.”

He is the director of the Bitcoin Education Project and chief executive officer of Invictus Innovations Incorporated (a Virginia based “peer-to-peer” technology company).

Paul Solman: Explain how Bitcoin works now. This is computers, hacking, encryption… why would this be more secure than gold?

Charles Hoskinson: You start with something that not even the National Security Agency or the federal government can break and deal with. Let’s build a money system on it. So we have this thing called a block and it contains a bunch of bitcoins and you mine that. A block contains all the transactions that have occurred up until that point. And every 10 minutes a new one is created. They stack on top of each other and they create what’s called a block chain.

And this is so incredible because for the first time in history, every transaction made with Bitcoin is known. The block chain is like a global ledger. If you buy something today with Bitcoin, for the rest of time, as long as the Bitcoin network is supported, that transaction is going to be known and archived. So whatever bitcoins you assert that you have, we can see where they were created in the block chain and all the way to your address. That record must exist and everybody in the network has a copy, not just a bank or some credit institution — everybody who has the client has the copy of the block chain.

Paul Solman: But you don’t know it’s me.

Charles Hoskinson: Exactly — that’s the beauty of the system.

Paul Solman: But how can you be sure that people won’t decrypt what you all can encrypt?

Charles Hoskinson: Well, if that were the case, we’d have bigger problems because all of our passwords would be vulnerable; people could break bank encryption; the secret communications the NSA uses and the government uses would all be decryptable. I’m a cryptographer and a mathematician. We and the U.S. government, and the world as a whole, has trust in the cryptography that’s used in Bitcoin. And it involves what’s called a public-key cryptosystem. So you have a public address that you can expose to the whole world but then you have this private address that only you know. You have to have the private address to spend your money. To receive money, you can just give out your public address, and that’s safe and secure. It’s the way key exchanges work between you and your bank or you and Amazon.

Paul Solman: But I’ve got a million passwords I have to keep…

Charles Hoskinson: You don’t have to know that; the software takes care of all of that for you. So the cryptography has been made very simple by modern-day software.

Paul Solman: But you could see how I would be scared, as a user, that somebody would be able to hack my Bitcoin account and just take them all away and I would never know.

Charles Hoskinson: Okay, well let’s do a compare and contrast with credit cards and Bitcoin. A credit card is really like a secret key into your financial life. If you hand somebody your credit card, they at any time can charge money to that account, right? With Bitcoin, it’s a one time access to an amount of money that you have decided. That’s kind of the difference. So you have the same ability to transact online as you do with credit cards, but the difference is that a credit card is unlimited; as long as they have your credit card they can use it, whereas Bitcoin is one time access and for as many funds as you’ve decided for that particular transaction.

Paul Solman: So why am I not safer to have, I don’t know, gold in a safety deposit box?

Charles Hoskinson: Within a few years, with a lot of the innovation that’s being done, just with your cell phone, with really strong Department-of-Defense style cryptography, you’ll be able to go anywhere in the world and spend your bitcoins. So you have basically the same store of value mechanism of gold, but the transactability of credit cards with even more security layered on top, and that’s why we really think Bitcoin is special.

Paul Solman: How much of this activity is an attempt to avoid taxes?

Charles Hoskinson: It’s up to the consumer and to the individual to decide whether to pay their taxes, and if people don’t want to pay their taxes, they’re not going to pay. They’re going to deal in a cash-only economy. The (difference between) Bitcoin (and) traditional payment foils is that there’s no middle man, so when you have middlemen like PayPal or banks and when you get above a certain point of money, that has to be reported to the government. And that’s set by the Patriot Act.

But with Bitcoin, what’s really unique is that it’s impossible for anybody to really understand how much money you’re making. So over time, if Bitcoin becomes very popular, what we’ll probably see happen is increasing consumption taxes and decreasing income taxes because it will become less feasible to actually understand how much money people are making, particularly because of the global nature of the money.

Paul Solman: Isn’t this a way of making money laundering a lot easier?

Charles Hoskinson: In terms of making it easier for financial crimes, yes, there’s some avenues that could be exploited; there’s avenues that can be exploited with cash. And just like the Internet can be used for bad things, like terrorist activity or child pornography, Bitcoin could be used for bad things — for example, funding rogue states like Iran or North Korea, but it also revolutionizes commerce. You kind of have to take the good with the bad, and the government has the ability and it is building great tools and good regulations to try to mitigate those money laundering concerns.

Remember, the key here is that if you’re a criminal network, you get paid initially in Bitcoin, but right now you can’t buy a lot of things, so at some point you want to offload that for your sovereign currency. So if you’re in Europe, you want to have Euros. If you’re in the United States, you want U.S. dollars. Well, how do you convert it? It’s very hard to convert it without using an exchange, and if they regulate the exchanges, they can make it very difficult for people to silently convert their money.

Paul Solman: So this is never going to completely replace government currencies?

Charles Hoskinson: You’re never going to be able to pay your taxes in Bitcoin. Think of Bitcoin as kind of like the money of the Internet, and it’s just another option — like PayPal or credit cards or Starbucks gift cards — to pay for things. But it probably won’t and never will replace sovereign currencies, as long as you have to pay your taxes in your sovereign currency, and I don’t think the government’s going to change that anytime soon.

Paul Solman: You wouldn’t mind if it did, though?

Charles Hoskinson: Of course, that would be nice if I could pay for my bills in Bitcoin, but then again the United States loses the competitive advantage, right?

In August, Germany recognized Bitcoin as a type of “private money,” meaning it could be used legally for both private and commercial transactions, subject to both capital gains and sales taxes. While the United States has not legally recognized Bitcoin, the government is taking steps toward making Bitcoin transactions taxable.

This summer, James White, director of tax issues at the Government Accountability Office, attended the Bitcoin conference in New York, where we did the bulk of our interviews, to tell attendees in no uncertain terms that “if it’s taxable in dollars,” it’s taxable, period. Here’s a very brief video of how he put it.

The Government Accountability Office’s James White explains to Paul Solman how Bitcoin is taxable.

This entry is cross-posted on the Rundown — NewsHour’s blog of news and insight.