Bitcoin: The Ultimate Guerrilla Guide

 

Bitcoin symbol

Bitcoin…

There’s a good chance you’ve heard of it by now. Maybe one of your friends has been calling it “the most revolutionary technology since the Internet.” Or “buttcoin.” Or just a fad. Or a horrible thing used to do illegal stuff.

I’d like to clarify what Bitcoin is, why people believe it is a big friggin deal, and how to get started using it.

In this post you’ll learn:

  • How Bitcoin works
  • Why Bitcoin is the coolest thing since the Internet
  • Bitcoin myths
  • How to get your first bitcoin

Before diving into the meat of this post, it will be helpful to have an understanding of what Bitcoin is and how it works.

 

What Is Bitcoin?

Put simply, Bitcoin is a payment system, or a means of transferring value. The technology was proposed by an individual or group of developers under the pseudonym Satoshi Nakamoto in 2008 (read the white paper that originally described Bitcoin here), and implemented in 2009

Question: We already have payment systems – credit card processors, PayPal, the ACH system, the SWIFT system, and newcomers like Apple Pay, Venmo, and so on. Why and how is bitcoin special??

To answer this question, it helps to know how Bitcoin works. The Bitcoin protocol is a peer-to-peer network of nodes where transactions are verified by “miners” and then recorded in a distributed ledger called the “blockchain”. Yes, I know this sounds complicated, but in practice it’s simple.

As a peer to peer network, Bitcoin does not rely on a central authority to work properly. If I want to pay you with a credit card, there must be an entity that will actually process that transaction. With Bitcoin, there is no one corporation, government, bank, or server that must process it. That means there is no entity or “gatekeeper” that can cheat you or screw up when you are trying to hold or transfer value.

If there is no central authority that processes transactions on the Bitcoin network, then who or what does? This is where the miners come in. The non-technical explanation is that these miners compete with each other to solve very difficult math problems. The solution to these math problems supplies the “proof-of-work” necessary to say that a transaction has been verified. This adds a new “block” of transactions to the blockchain. For supplying this computing power, the miner is rewarded with newly created bitcoins. This is the cryptographic equivalent of mining gold or any other resource. Instead of using machines to dig into the ground, separate the resource from the useless stuff around it, and bring it to surface, bitcoin miners use machines to solve these math problems.

The blockchain is a ledger of all transactions that have ever happened on the Bitcoin network. Transaction details are stored in a block, and each block connected to the previous one in a chain that stretches back to the creation of the first bitcoin. But unlike your average ledger, the blockchain is distributed over, copied to, and maintained by thousands of nodes (instances of the software that are downloaded and running) that are operated independently. If you destroy my copy of it, the blockchain will continue to exist. If you try to change it, you will need to muster more computer power than the rest of the network, which is not easy.

Because of the way Bitcoin works, it has many unique advantages as a currency and payment system. Here are four main ones::

  • Low fees. Credit cards charge 2-3% per transaction, and remittance services like Western Union often charge 10% or more to move money around. Many Bitcoin transactions are free, and nearly all of them cost under 40 cents.
  • Irreversible transactions. Once you send bitcoin to somebody else, the transaction cannot be undone. This eliminates a lot of fraud and chargeback risks, which cost merchants almost $200 billion in 2009.
  • Limited supply. There will only ever be 21 million bitcoin, and they are being created on a set schedule known in advance. This means that the value of bitcoin compared to fiat (government created, unbacked) currencies is inclined to increase over time. It also means that you need not worry about inflation, which is endemic to fiat currencies.
  • Pseudonymity. Bitcoin is the most transparent payment system in existence. All relevant information is stored on the blockchain and can’t be tampered with, so it is easier to create more accountable systems off of it. But because it is pseudonymous, it also offers privacy benefits that legacy payment systems don’t have. If you use a credit card to pay for something, you surrender information that can easily be used to identify you (and possibly steal your identity or money). If you send bitcoin, you do not run this risk.

 

Why Bitcoin Technology Will Change Everything

what people think about bitcoin

Many people will compare Bitcoin to the Internet in the early 1990s. Early adopters considered the internet revolutionary, but most people didn’t have an adequate answer to that most important question: so what?

My dad recently told me that in the early days of computers the most vocal defenders of the technology predicted they would be used to store recipes and manage checkbooks. Perhaps the applications of Bitcoin may far surpass even what its proponents claim.

And as with the Internet, there is a ridiculous amount of venture capital being thrown into Bitcoin and blockchain startups. A whopping $314.7 million was invested in Bitcoin startups in 2014, which is three times more than the previous year. In 2015, we’ve already seen Coinbase rake in $75 million, and 21 Inc get $116 million (see this for a list of VC funding rounds).

This money is going towards building a maturer Bitcoin ecosystem. These companies are creating services that make Bitcoin easier to use, more secure, and more awesome. They are creating some of the applications that will enable us to do spectacular things on top of the blockchain.

Note: Not everything described in this section is happening specifically with Bitcoin, but all of this was made possible by technological advances initiated by Bitcoin.

The Underbanked and the Overbanked

Before getting into the revolutionary applications of this new technology, I’d like to give another reason why you should fully expect (and root for!) Bitcoin to keep growing.

Over half of the world’s adult population, or 2.5 billion people, do not have a bank account. These are primarily poor people in poor countries. Mobile phones, however, are far more widespread. This is how the innovative payment system, M-Pesa, has taken off in Kenya in just a couple years: it basically turns your phone into a wallet. Bitcoin should appeal to the same underbanked demographic, but is both cheaper and not dependent on a single entity that must be trusted. It also isn’t liable to the delays, fraud, and chargeback risks that M-Pesa is subject to.

While people in the third world may benefit the most from Bitcoin, millennials are another large group that seems poised to adopt and use it. According to a recent survey by Goldman Sachs, 33% of millennials don’t expect to need a bank in five years, and only half said they expect to use cash on a weekly basis by 2020. Another GS survey had 22% of millennials saying they already use bitcoin and would use it again, plus an additional 22% that hasn’t used it but intends to. There is a deep distrust of traditional banking and financial institutions, and using bitcoin lets people “be their own bank.” It is transparent, with no hidden fees, doesn’t require giving up tons of personal info, and doesn’t come with the limitations and capital controls of standard banking.

Remittances And International Payments

Probably the most obvious sector that Bitcoin is poised to disrupt is remittances, or migrant workers sending money back to people in their home country. According to the World Bank, global remittances topped $580 billion in 2014, so this is big money.

The average remittance fee paid is over 8%, and can be as high as 20%! Contrast this with the cost of sending bitcoin, which is generally somewhere between free or practically free. In fact, someone moved $150 million in bitcoin, and didn’t pay a transaction fee at all!

As a related benefit, the ease of sending money across state borders makes bitcoin ideal for charity aid work in emergencies, such as the recent earthquake in Nepal.

Identity Management and Trust

The blockchain is effectively immutable. As a result, it completely changes the dynamic of trust in society. Instead of trusting governments, corporations, and other third party entities, we can trust the mathematics that powers the blockchain. Distributed ledgers like the Bitcoin blockchain allow us to record things and know for sure that they are correct.

You can already have your identity verified on the blockchain and use it to gain access to websites, and soon enough you’ll be able to use that identity to unlock the doors of your house. You can think of this as essentially an impossible to forge key to the things you want to keep secured. Username and password combinations can be hacked or stolen, and keys can be spoofed and copied, but a blockchain ID cannot be faked.

This might not sound super exciting, but things change when you consider how many of the things we do that rely on trusting others, and how the blockchain can make that friction disappear. All the websites you log into, all the traveling you do, all the property you own, all the domain names you register or visit, all the bars you enter – all of these things could be handled instantaneously, cheaply, and with no risk of identity theft.

Honduras, a nation plagued with costly land disputes, is already beginning to experiment with managing their land registry on the Bitcoin blockchain. This could have massive ramifications for reducing corruption (officials could easily change the land registry and give themselves some prime beachfront property) and its effects on the poor by giving them recourse in land disputes.

There are all sorts of other services that the blockchain’s enhanced identity management can provide, including better medical record management for increased privacy and transparency on product supply chains.

Micropayments

What I find most exciting about bitcoin is that it allows for micropayments. Because bitcoin transactions involve trivial fees (and because a bitcoin is divided into 10 million units, called “Satoshis”), it is suddenly possible to transfer tiny amounts of money efficiently.

This may not sound all that impressive, but the implications are enormous. What if social networks and email systems wouldn’t accept incoming messages unless a tiny amount of bitcoin was included with it? The price would be trivial to the sender, but would deter spammers who can send a gazillion messages today for free.

Something that is already catching on is tipping. If you thought someone made a brilliant post on Reddit, you could send them $5, or $1, or a few cents’ worth of bitcoin. Or you can tip a particularly nice customer service rep, the guy who let you turn at that tough intersection, or anyone else you’d like to thank.

Micropayments could also change the way content monetization works, making it much easier for content producers to make money without relying on large advertisers. Marc Andreessen, a major figure in the Bitcoin community, writes:

One reason media businesses such as newspapers struggle to charge for content is because they need to charge either all (pay the entire subscription fee for all the content) or nothing (which then results in all those terrible banner ads everywhere on the web). All of a sudden, with Bitcoin, there is an economically viable way to charge arbitrarily small amounts of money per article, or per section, or per hour, or per video play, or per archive access, or per news alert.

This may help make the media more objective by reducing the influence of large advertisers.

Another  area where bitcoin micropayments could be revolutionary is in integrating with the Internet of Things, or the trend where all sorts of electronics and appliances are being connected to the Internet. What if you could use a smart meter that gave you real-time access to the sensor that measures energy usage and allowed you to only pay for exactly what you use? What if you could connect to a Wi-Fi network for just the few minutes you need and pay for that miniscule amount?

Startup 21 Inc is working on making that a reality. They have developed a bitcoin mining chip that can be included in most devices, which will turn spare power from wall sockets into bitcoin, which can then be spent on things like extra bandwidth and ad-free access to things.

Smart Contracts

Things start getting really wild once you consider the ramifications of smart contracts: programmable contracts that automatically execute when their conditions are met. In other words, smart contracts are like any other computer program – except that they can interact with real-world assets.

How might this look? Let me borrow an example from Jay Cassano’s great article on smart contracts:

Imagine if allocating your assets after your death was as simple as moving an adjustable slider that determines who gets how much…once the smart contract can verify the triggering condition—in this case, your death—the contract goes into effect and your assets are divvied up.

When combined with the Internet of Things, smart contracts look even more interesting.

Let’s say all the locks are Internet-enabled and they’ve all got network connections. When you make a bitcoin transaction for the rent, the smart contract you and I agreed to automatically unlocks the house for you. You just go in using keys stored on your smartphone.

In this way, smart contracts could help poor people get better access to legal services. For those who cannot afford lawyers, smart contracts could be a great boon.

There are an infinite number of applications for this. Almost anything where a lawyer or accountant would be necessary can be done automatically on the blockchain.

Smart contracts can also allow you to “be your own Kickstarter” and run a decentralized crowdfunding campaign. Backers can send their bitcoin into escrow, and they will be released to you when you hit your goal, or returned if you do not. This practically nullifies the idea of public goods – goods where nonpayers cannot be excluded from its benefits – via technology!

Finally, the blockchain allows for decentralized governance and voting. This could allow for provably fair democratic elections (political or otherwise). Different rules could be written in a fully transparent way (certain people get a higher stake, for instance), and the result of the election can be automatically enforced via smart contract.

Polling and surveys can easily be done and the data won’t get fudged. Corporate governance can be done transparently (shareholders electing the board of directors, for instance). Stakeholders in any given decision can vote on how to proceed, with the decision executing automatically with no funny business. An example of this is the Dash cryptocurrency, where large stakeholders get to vote on what new features should be developed, and funding is automatically released to the developers to work on them.

The political, social, and economic ramifications are enormous.

The Libertarian/Political Angle

There is a perception that bitcoin is a toy for white male libertarians. There are strong reasons why a libertarian would support bitcoin, but some on the left also favor bitcoin for its political implications.

Before diving into how bitcoin may radically alter political relations, I’d like to emphasize that there is nothing inherently political about bitcoin.

Nevertheless, bitcoin is a cypherpunk or crypto-anarchist’s wet dream. It has the potential to disrupt modern power structures in ways that are difficult for most to even comprehend.

The most obvious thing Bitcoin does is take power away from the elite central bankers by returning control of the money supply to the people. The Federal Reserve and other central banks have monopoly powers that grant them the privilege of debasing currencies at will, which is done to promote warfare and militarism, leading to inflation. Bitcoin can destroy this most important lever of control.

Similarly, bitcoin and other cryptocurrencies are resistant to capital controls, a feature that has been giving bitcoin some attention recently because of events in Greece, where the government is defaulting on its loans. The Greek government’s heavy-handed response included closing the banks for several weeks, making it illegal to move money out of the country, and imposing a 60 euro daily limit on ATM withdrawals. Bitcoin makes it harder for law enforcement and the tax man to steal people’s money, prevent transactions (think Silk Road), or apply sanctions against other states or individuals.

It also creates new and immutable ways of preventing censorship. Decentralized, peer-to-peer communication technologies are already being built on the blockchain. For instance, there is Twister, which is basically Twitter – except that third parties can’t access the data, you can communicate in a private and encrypted way, and it cannot be shut down by governments or other malicious actors. A similar project worth following is Synereo, which provides vastly more privacy than Facebook. These are just two of several applications making communication “NSA-proof”. Bitcoin may even enable efficient “homomorphic encryption,” which would let people share data on the cloud without it ever being unencrypted and vulnerable.

The blockchain can benefit free speech in other ways; it can be used to create a historical record that cannot be manipulated by the powers that be. And it can be used to fund dissident organizations – it was bitcoin donations that kept WikiLeaks alive when all other payment processors boycotted them.

By now, it should be obvious that Bitcoin is an incredible boon for women, minorities, the poor, and the persecuted, and yet it is still popular to view bitcoin as a plaything for white patriarchy. This view is dangerously misguided. Bitcoin has yet to catch on with much of the black community, but it would help marginalized African-Americans secure easier access to loans, microloans, and financial services in general, allowing black neighborhoods to better support themselves. Bitcoin has already empowered tens of thousands of women in the developing world, where women are often excluded from the financial system entirely. And soon enough, smart contracts will improve legal access for those who wouldn’t normally have much recourse to the justice system. Without central control, everyone has equal access, so people won’t be able to be excluded due to racism, sexism, ageism, or any other –ism.

The best part is that this process is nearly unstoppable. Soon there will be trusted, decentralized cryptocurrency exchanges built on the blockchain, which will make it impossible to prevent people from buying into bitcoin and other cryptocurrencies. A small example of this already exists with Multigateway.

Banning Bitcoin

There will also be decentralized markets, where individuals can meet in a secure, peer-to-peer environment to buy and sell whatever they wish – and unlike the Silk Road, the infamous online drug market taken down by the FBI in 2013, a decentralized market can’t be shut down. Well known projects in this space include OpenBazaar and the NXT FreeMarket, but there are several others.

Once decentralized exchanges and markets begin to take off, it will be literally impossible to stop the spread of crypto-anarchy short of a nuclear war or worldwide EMP blast.

As these technologies expand, it will become increasingly obvious to a growing segment of the population that there is no need for governments or traditional nation-states; society can be organized in a more voluntary, peaceful manner. In my opinion, this could lead to a rapid decline in the state as an institution, leaving behind a decentralized, voluntaryist world. As Nozomi Hayase wrote:

Bitcoin is the world’s first stateless currency that transcends borders in a similar way as the Internet. Its unmediated flow delivers more power to the periphery. As a result it could dissolve the hegemony of U.S. empire and end the monarchy of the petrodollar that controls flows of oil, finance and global geopolitics. This could potentially shrink the wealth gap between the Global South and the North. For the first time in history, humanity has the option to really heal the wound of long history of brutal colonization; to end major wars, transform poverty and inequality and move toward a more humane world. Humanity has a chance to embark on a new path, where technology of Western society is used to serve for the wisdom of indigenous cultures and together create a new civilization.

 

Doesn’t Bitcoin Get Hacked All The Time?

A common concern when dealing with bitcoin is that of security. If I had a Satoshi for every time I’ve heard that “Bitcoin has been hacked!!!1!1!” I would probably have a bit by now (sorry, bitcoin humor).

This is understandable, given the high-profile thefts from places like Mt. Gox and Bitstamp. But what is important is that these are third party services that have been hacked, NOT Bitcoin itself. In fact, in the six years that Bitcoin has existed, it has never been hacked. For anyone who works with software at all, this is ridiculously impressive. With each passing day, it becomes less and less likely that there is some “fatal flaw” in the Bitcoin protocol. By comparison, at least 527 banks have failed since 2008.

And when exchanges and other services become more decentralized, much of the issue of security becomes moot – without a centralized exchange, there is no target for hackers.

That said,, there are potential weaknesses in the Bitcoin protocol. Most are not serious, but one in particular, the 51% attack, deserves mention. If an attacker controls the majority of the network’s computing power, he will gain the ability to potentially double-spend transactions and deny other transactions from being confirmed by the network. While technically possible, this attack is highly unlikely, and does not give the attacker that much power. It would be a bad thing, but it is not an existential threat to Bitcoin.

Another empty critique of note is that, Bitcoin is bad for the environment and unsustainable. On the contrary, emissions from Bitcoin network are a miniscule fraction of current payment systems.

And finally, there are hundreds of other cryptocurrencies (“altcoins”) that work in different ways or rely on different codebases to Bitcoin. If there does happen to be some kind of “fatal flaw” with Bitcoin, one or many of these altcoins could be used instead.

In a nutshell: cryptocurrency is secure and here to stay.

Securing Your Bitcoin: Best Practices

All Bitcoin users should be conscious of how to keep their own bitcoin secure. If your bitcoin are stolen, I don’t think you’ll feel any better knowing that it was due to your ignorance rather than the Bitcoin protocol itself.

The bitcoin you own is stored in what is called a wallet, and is defined by a secret number called the private key. Whoever controls this key controls your bitcoin. The aim of securing your bitcoin is to make it as difficult as possible for a malicious actor to access to this private key.

There are different wallets you can have, each with unique security ramifications. In a moment, I will recommend an online wallet, but the bulk of your bitcoin should be stored offline. Numerous exchanges have been hacked, so leaving your bitcoin there is risky. Online wallets are convenient, but leave the control of your private key in a third party’s hands – that means a hacker, malicious employee, or government subpoena could get access to it. If you use an online wallet, make sure you use a strong password (ideally 20+ randomly generated characters) and 2-factor authentication.

For privacy and security, you’ll also want a local wallet on your phone or computer. If they are stolen, your house burns down, or your hard drive crashes, you’ll want to have backups of your local wallets. Have extra backups on USB keys, CDs, or hard drives. You should encrypt your wallet with a strong passphrase, and keep all your software up to date.

Here are a few more ways to keep your bitcoin secure:

  • Keep your coins in cold storage. You can keep your “savings account” that you don’t plan to use offline, away from the malware and hackers of the Internet. See guides on how to do this here and here.
  • Hardware wallets will cost you some money ($30-$200), but they turn your wallets into bitcoin fortresses. Malware can’t be installed on them, and some have their own keypads for you to enter your passphrases in case there are keyloggers or screen reading malware on your computer.
  • A “brainwallet” essentially lets you secure your bitcoin in your mind. You have to memorize a (strong!) passphrase, and this passphrase can generate your public and private keys via strong cryptographic protocols. Use a method such as Diceware to create your passphrase – DO NOT come up with it yourself. Seriously, I can’t emphasize this enough: if you create your passphrase yourself, it will be terrible, and your bitcoin WILL be stolen. If you set up your brainwallet properly, the only attack vector that could succeed is if someone put a gun to your head and forced you to reveal the passphrase. To counter this, create a decoy brainwallet with a smaller bitcoin balance that you are willing to give up in this situation. Instructions on how to create a brainwallet are here. This method is only recommended for advanced users.
  • A paper wallet stores bitcoin offline as a physical document, safe from hackers. It’s like a brainwallet, but instead of protecting a passphrase, you protect a document. Here are instructions on how to create a secure a paper wallet, and this page contains more paper wallet security tips and offers a way to do so.
  • Multi-signature transactions are a more “advanced” security feature. These can require more than one person to sign off on a transaction before it begins. For instance, you could specify that both the husband and wife must sign off on the transaction, but neither party can disburse funds individually. A little more technical info on multi-signature can be found in this article.

 

Bitcoin and Anonymity

Bitcoin is NOT anonymous. It is pseudonymous – the activity of a particular Bitcoin address can be tracked precisely on the blockchain, but finding the real identity corresponding to that address is complex but can be done fairly easily if you know how.

For general identity protection, I strongly suggest you use a different bitcoin address for every transaction (your wallet should let you do this). In addition, it’s a good idea to use different wallets for different purposes. You can have a more anonymous wallet to hide from your soon-to-be-ex-wife’s divorce lawyer, and then a less anonymous one for everyday transactions.

If you want to anonymize some bitcoin, you can use a service called a “mixer” which will hold deposits from you and others, and then send you different coins than the ones you put in. It’s basically cryptographic money laundering. Even better, by avoiding exchanges and using certain other services, you can acquire bitcoin anonymously in the first place, usually for a premium. If you really want to remain anonymous while using bitcoin, read through this guide.

 

Getting Started With Bitcoin

There are so many ways to get started with Bitcoin, and I think this leads to “analysis paralysis” for potential new bitcoiners. There are dozens of different wallets out there with different features, and numerous exchanges off of which you can buy bitcoin.

It is worth your time to educate yourself on these matters. My recommendation is to get started using the easiest method possible, and then begin incorporating other wallets, exchanges, and even other cryptocurrencies into your portfolio. The quickest way to get bitcoin securely is via a web wallet, such as Coinbase.

(Disclaimer: I am a former Coinbase employee.)

You should think of your Coinbase account as your “on ramp” to the Bitcoin universe. You can use them both as a wallet (send, receive, and store bitcoin) as well as an exchange (buy and sell bitcoin). Here’s how:

  1. To get started, go here. As of the date of publication of this post, Coinbase is running a referral program such that if you sign up for an account from the link I provided and then convert $100 into bitcoin, we each receive a $10 bonus in bitcoin.
  2. You will need to verify an email address, a phone number, and link a bank account before you can buy or sell bitcoin. If you have difficulty verifying your bank account, check out this guide.
  3. Once your bank account is verified, you’ll be able to place your first purchase at this page. It normally takes 4 business days for the buy order to complete, but you can verify a credit card to enable instant purchases.

If you have any troubles with this process, check the support page to see if your question has been answered.

It really is that simple to get started. At this point, you should start exploring the more “advanced” things you can do. For instance, if you are particularly security conscious, Coinbase offers a multisig vault so that you don’t need to trust anyone else to control your bitcoin. If Coinbase is ever offline or goes out of business, you can use this open-source tool to recover your bitcoin from the multisig vault. In addition, ALL users should have 2-factor authentication enabled to secure their account further.

I’ve focused on Coinbase, but there are plenty of other wallet providers and exchange services. You should learn about these alternatives as well, and ultimately split your bitcoin balance up into multiple wallets. I suggest reading this guide for more basic information on getting started with Bitcoin, and bitcoin.org has many trusted resources.

Not sure what to do with your new bitcoin? Go create an account with Purse, and then get 20% discounts on anything you buy off of Amazon when you use bitcoin. I’ve saved hundreds of dollars this way.

 

Where Can You Learn More?

The world of Bitcoin is massive and growing. Although this post was long, it was only just an introduction.

If this article has intrigued you, I recommend you do some research on your own. Besides the mountains of information on the Internet, there are a few books I would recommend for learning more:

Given the likelihood of Bitcoin radically changing the world as we know it, you would be doing yourself a favor by educating yourself about it and by getting involved.

Cigarettes and the Emergence of Commodity Money

Money bag

Money is a concept that most people have a solid intuitive grasp of. For example, the majority of people understand that they use money to exchange for goods and services, and that the utility they gain from money is derived from its use in trade.

This common sense no longer seems to apply when people think about monetary systems. People assume that without government-controlled and provided money, trade could never happen. They think that, despite free and open competition in other industries leading to better products at lower prices, this doesn’t hold true for money.

My intention in this post is not to make a complete argument for free banking and a free-market in money production. Far more modestly, I would like to show by way of example that money evolves out of a desire for indirect exchange on the market, not solely through government fiat.

Anything can take on the role of money in a group of people, but there are qualities of commodities that make some more suitable as money than others. A potential money will fare better if it is easily divisible, has a long shelf-life without losing value, is of limited supply, etc. Competition determines what becomes money in a given society. Historically, gold and silver have been the most widespread monies, but things like salt, cocoa, beads, shells, and many others have taken on a monetary role; that is, fostering indirect exchange of goods and services.

Since money evolves out of a desire for trade, people will tend to stock commodities that are generally valued or generally accepted in their society. A valuable microcosm of a society would be inside the walls of a prison or POW camp, where cigarettes have outcompeted monetary alternatives such as candy bars, toilettes, and food.

 

The Economic Organization of a POW Camp

In a paper written by R.A. Radford in 1945, just months after being liberated from a Nazi POW camp, the spontaneous adoption of cigarettes as currency is explored.

A camp like this provides us with an interesting case study in the evolution of money and indirect exchange. While hardly a natural, free-market environment, it does show us how people economically adjust to certain conditions. So, what are the economic conditions/assumptions of this environment?

First off, it is an isolated, closed economy. People in this POW camp aren’t engaging in trade with the outside world. While this is obviously a significant condition with regards to the lives of these prisoners, it doesn’t have much of a bearing on our economic analysis. If you zoom out far enough, any economic system is “closed”. For example, the Earth’s economy is closed, at least until we begin trading with other planets.

In addition, dollars and other official currencies aren’t allowed. Prisoners aren’t trading in dollars or francs. This condition actually makes the model more realistic, not less. There are no artificial fiat currencies, so the inmate economy grows organically without a preexisting bias towards currencies that already exist.

Finally, this is an economy without production, where initial resources are equal and provided by a central authority:

“Everyone receives a roughly equal share of essentials; it is by trade that individual preferences are given expression and comfort increased. All at some time, and most people regularly, make exchanges of one sort or another.”

This constraint does limit what we can glean from this case study. We can’t learn much about the very important subject of production. However, we are most interested right now in studying exchange, and the POW camp provides a perfect example of how humans will engage in trade in order to fulfill their various wants.

Price System

Very quickly, a price system formed in this camp. The assorted goods that came in peoples’ rations each found a price on the market. Early on, these prices were imperfect; the market required some time for peoples’ preferences to become adequately incorporated into prices.

“Stories circulated of a padre who started off round the camp with a tin of cheese and five cigarettes and returned to his bed with a complete parcel in addition to his original cheese and cigarettes; the market was not yet perfect. Within a week or two, as the volume of trade grew, rough scales of exchange values came into existence. Sikhs, who had at first exchanged tinned beef for practically any other foodstuff, began to insist on jam and margarine. It was realized that a tin of jam was worth l/2 lb. of margarine plus something else; that a cigarette issue was worth several chocolate issues, and a tin of diced carrots was worth practically nothing.”

Note how at this stage, trade was primarily done directly; that is, through bartering. While this is certainly better than having no trade at all, exchange still required a “double coincidence of wants”. In other words, you want what I have and I want what you have. Barter, of course, is quite inefficient, because it is not particularly common to experience this double coincidence of wants.

This is one area where the lack of production in the economy does impact the analysis. Bartering rations that were provided for you in advance is far easier than having a division of labor where everyone produces something different and then needs to trade with someone who wants what you’ve produced. As we will see later, this weakness in the example does not take any force away from our conclusions.

In any case, it only took a short while before the prisoner economy evolved past bartering and developed indirect exchange.

“By the end of a month, when we reached our permanent camp, there was a lively trade in all commodities and their relative values were well known, and expressed not in terms of one another – one didn’t quote bully in terms of sugar – but in terms of cigarettes.”

If I had extra butter and wanted some chocolate, I no longer needed to find someone who had chocolate and wanted butter. I could “sell” my butter to someone in exchange for cigarettes, and then “buy” the chocolate from a third party with those cigarettes. In other words, cigarettes became money.

“The public and semi permanent records of transactions led to cigarette prices being well known and thus tending to equality throughout the camp, although there were always opportunities for an astute trader to make a profit from arbitrage. With this development everyone, including non-smokers, was willing to sell for cigarettes, using them to buy at another time and place. Cigarettes became the normal currency, though, of course, barter was never extinguished.”

This cigarette-based economy became fairly well-developed. It was generally known throughout the camp how many cigarettes it would take to buy any given item. At this point, cigarettes were in high demand, because they could be used to purchase anything the prisoner wanted (well…anything that was provided in their given rations). Therefore, if you didn’t want your applesauce, you could just exchange it for cigarettes with someone else who did.

Money Helped Foster Entrepreneurship

The existence of indirect exchange fostered the creation of a real labor economy and some entrepreneurship.

Without money, you would need to trade your labor directly for whatever it is that you want to consume. Of course, this is highly inefficient, since we tend to enjoy consuming a variety of different goods. Some people might work for popcorn (as Bart Simpson was made to do), but certainly not everyone.

If you can sell your labor in exchange for money, however, you can now use that money to procure anything else that you want.

“Even when cigarettes were not scarce, there was usually some unlucky person willing to perform services for them. Laundrymen advertised at two cigarettes a garment. Battle-dress was scrubbed and pressed and a pair of trousers lent for the interim period for twelve. A good pastel portrait cost thirty or a tin of “Kam.” Odd tailoring and other jobs similarly had their prices.

There were also entrepreneurial services. There was a coffee stall owner who sold tea, coffee or cocoa at two cigarettes a cup, buying his raw materials at market prices and hiring labor to gather fuel and to stoke; he actually enjoyed the services of a chartered accountant at one stage.”

With cigarettes as money, prisoners found ways to increase the social good by performing services or starting small businesses. It’s highly unlikely that a prisoner would do someone else’s laundry for a specific item (rather than money) on more than rare occasions. But with money, someone could regularly offer a laundry service.

Prisoners who didn’t want to do this chore could give up two cigarettes (and therefore whatever else they could exchange those cigarettes for) to avoid it, while prisoners who wanted extra consumption goods had a means of getting money to exchange for them. Everybody wins!

Time Preference

Money is also used to coordinate consumption decisions over time. If you wanted to save some of your fruit now in order to eat more in a month, it would go bad in the process. Money doesn’t “go bad” (unless you count inflation), so it can be saved in order to buy fresh fruit later on.

There are many lessons we can learn about economics with regards to time and money. Naturally, a POW camp has a very simple economy, so we can’t explore all the implications of this relationship through this example. Despite its simplicity, however, the POW camp still developed a fairly advanced futures market.

“Bread was issued on Thursday and Monday, four and three days’ rations respectively, and by Wednesday and Sunday night it had risen at least one cigarette per ration, from seven to eight, by supper time. One man always saved a ration to sell then at the peak price: his offer of “bread now” stood out on the board among a number of “bread Monday’s” fetching one or two less, or not selling at all – and he always smoked on Sunday night.”

People prefer goods now to goods in the future, so there was a premium for “bread now”. Through planning and the use of these futures markets, an individual could smooth out his consumption over time to optimally match his preferences.

Markets like this that trade across time make it important that money retain its value over that time period. This is why apples are very unlikely to become a currency. After a week, they have lost most of their value. Cigarettes tend to stay good for a bit longer. And before they go stale, they are likely to have been smoked and replaced by fresher ones.

A currency also benefits from uniformity. The amount of tobacco in a cigarette was the primary variable that people wanted to be uniform. Therefore, hand rolled cigarettes were not as “good” of a money as normal cigarettes. Because they were not of a consistent size, prices could not be quoted in terms of cigarettes as easily. Never the less, people could verify how much tobacco was in a handroll, and adjust the price accordingly.

“Certain brands were more popular than others as smokes, but for currency purposes a cigarette was a cigarette. Consequently buyers used the poorer qualities and the Shop rarely saw the more popular brands: cigarettes such as Churchman’s No. I were rarely used for trading. At one time cigarettes hand-rolled from pipe tobacco began to circulate. Pipe tobacco was issued in lieu of cigarettes by the Red Cross at a rate of 25 cigarettes to the ounce and this rate was standard in exchanges, but an ounce would produce 30 home-made cigarettes. Naturally people with machine-made cigarettes broke them down and re-rolled the tobacco, and the real cigarette virtually disappeared from the market. Hand-rolled cigarettes were not homogeneous and prices could no longer be quoted in them with safety: each cigarette was examined before it was accepted and thin ones were rejected, or extra demanded as a make-weight. For a time we suffered all the inconveniences of a debased currency.”

While Radford rightly considers this an instance of currency debasement, the consequences in the POW camp are far more modest than they are in a more complex, free economy. It is far easier to judge how much tobacco is in a cigarette and make a rough comparison than it is to determine what percentage of gold or silver is in a coin, or how rapidly a paper currency loses value as more and more is printed.

Price Fixing

When people believe they can secure some advantage through cheating or manipulation, they often will try. That is one reason why it is critically important to have institutions that minimize the ability to do so.

Luckily, the “invisible hand” of the market process is a very effective means for curbing this tendency. Despite attempts at price fixing as well as fairly widespread sentiment in favor of “just prices”, the market price inevitably won out.

 “Curious arguments were advanced to justify price fixing. The recommended prices were in some way related to the calorific values of the foods offered: hence some were overvalued and never sold at these prices. One argument ran as follows: not everyone has private cigarette parcels: thus, when prices were high and trade good in the summer of 1944, only the lucky rich could buy. This was unfair to the man with few cigarettes. When prices fell in the following winter, prices should be pegged high so that the rich, who had enjoyed life in the summer, should put many cigarettes into circulation. The fact that those who sold to the rich in the summer had also enjoyed life then, and the fact that in the winter there was always someone willing to sell at low prices were ignored. Such arguments were hotly debated each night after the approach of Allied Aircraft extinguished all lights at 8 p.m. But prices moved with the supply of cigarettes, and refused to stay fixed in accordance with a theory of ethics.”

This is all the more impressive given the relatively small size of a POW camp. With at most a couple thousand people, the conditions for forming a cartel are about as good as they get (on a free market, at least. Given the power of government coercion, forming cartels is far easier).

And people still engaged in mutually beneficial trading despite whatever ethical theories or Marxist sentiments people had. In fact, the spontaneous formation of the market was in direct contradiction to some of these theories.

“It is thus to be seen that a market came into existence without labor or production. The B.R.C.S. may be considered as “Nature” of the text-book, and the articles of trade – food, clothing and cigarettes – as free gifts – land or manna. Despite this, and despite a roughly equal distribution of resources, a market came into spontaneous operation, and prices were fixed by the operation of supply and demand. It is difficult to reconcile this fact with the labor theory of value.”

 

Is A POW Camp A Realistic Model?

Some would argue that I have mischaracterized this instance of the development of commodity money as what would happen on a free market, despite the fact that POW camps are hardly a paragon of freedom of economic association.

In fact, it’s hard to think of a more centralized and coercive environment. Consider this argument from Matthew Berg:

“Far from being a stateless society or a paradise of market individualism, Radford’s POW camp was in fact… a POW camp. And that is not something we should allow ourselves to easily forget. There was a “state,” and for that matter the “state” (the German guards) was all-powerful. It was possible for the “market economy” to emerge because and only because the guards and the Red Cross established and preserved the conditions to enable it to emerge. Cigarettes and other commodities were – because of decisions by the Red Cross and the Germans which lay entirely outside of the control of the prisoners – delivered from a distant and utterly disconnected external world.”

There is much truth to this statement. A POW camp is not a free market, and the nature of the market that evolved in that camp was surely a product of the so-called “state”. Chances are, things would have turned out wildly differently were it not for the artificialities of the camp.

Prison

Berg uses this to claim that commodity money would not naturally emerge like this, but that it only exists because of “the state”. Were it not for the guards and administration of the POW camp and the fact that prisoners were provided rations automatically, cigarettes would not have become currency.

Berg is probably right; were it not for these state-like circumstances, cigarettes likely would not have become currency. In a free market, a different currency would have likely emerged (say, gold or silver). There are disadvantages of cigarettes as money, and surely preferable alternatives would have been discovered if given the opportunity. And thousands of years of monetary history have shown that, typically, gold and silver are the best currencies. Many have been tried, including salt, chocolate, shells, and beaver pelts.

What Berg ignores is that we aren’t so much concerned with the specifics of what happened in Radford’s camp (cigarettes becoming money) as we are with the process in general (something becoming money). The interventions that make a POW camp less of a free market may change the result of the market process, but they have not qualitatively changed the market process in a way that would make the example any less instructive.

If anything, the limits imposed on the POW camp economy makes the emergence of money even more impressive. The problems with the use of cigarettes as currency came from the lack of free market ability to import or bring in additional cigarettes to meet the monetary demand.

“While the Red Cross issue of 50 or 25 cigarettes per man per week came in regularly and while there were fair stocks held, the cigarette currency suited its purpose admirably. But when the issue was interrupted, stocks soon ran out, prices fell, trading declined in volume and became increasingly a matter of barter. This deflationary tendency was periodically offset by the sudden injection of new currency. Private cigarette parcels arrived in a trickle throughout the year, but the big numbers came in quarterly when the Red Cross received its allocation of transport. Several hundred thousand cigarettes might arrive in the space of a fortnight. Prices soared, and then began to fall, slowly at first but with increasing rapidity as stocks ran out, until the next big delivery. Most of our economic troubles could be attributed to this fundamental instability.”

Due to consumption of cigarettes (through smoking) and an inconsistency in supply (no free market in production/distribution of cigarettes), there was significant currency instability. None the less, it is clearly documented that they did use cigarettes as currency despite these problems. In other words, commodity money emerged in spite of the interventions in the market, not because of them.

There are many instances of the emergence of commodity money throughout history, and this is just one of them. Criticizing the theory of how money evolves based on (incorrect) views on a single one of those examples is a weak point to be arguing from. It is made especially weak given how cigarettes became money in post-World War II Germany, in a circumstance without the limitations of a POW camp.

 

Cigarettes as Money in Post-World War II Germany (1945-48)

German monetary history during the 20th century is fascinating. The time period that is talked about the most, and rightly so, is the hyperinflation in the Weimar Republic between 1921 and 1924. Much of the characteristically German suspicion of fiat paper money can be at least partially explained by sentiments dating back to this hyperinflation.

The period immediately following World War II in Germany is an obscure yet illuminating example of this. Bignon (2004) provides a description of how cigarettes came to be used as money throughout Germany between 1945 and 1948. As we explore this historical episode a bit more, we’ll see that the alleged weaknesses of the prior analysis of the emergence of commodity money vanish.

After the war, the Reichsmark lost its trust as a currency among the German population, and was only accepted in transactions about half the time. Despite not being a hyperinflationary environment, the lack of value of the Reichsmark led to a breakdown of the price system. As such, Germany devolved into what was largely a barter economy, with black market trades being responsible for the other half of German trade.

The end of the war resulted in a massive breakdown in production in Germany. Since war rationing was over, there were considerable changes in food production specifically, which motivated a change to direct exchange or bartering. Food was diverted from normal market channels as people went and traded for food directly from farms.

Workers began to be paid, at least in part, by their factory’s product, which they would then take to the farmers to exchange for food. Once this change in firm behavior began to take place, it drastically increased the need for a useful medium of exchange.

Very quickly, a handful of commodities emerged as widely accepted goods far barter: cigarettes, chocolate, and alcohol were accepted and traded more frequently than most other goods.

While chocolate and alcohol had fairly high trading volumes, cigarettes became the de facto currency in Germany. The existence of a population of smokers provided some immediate demand for cigarettes in the barter economy. The existence of smokers led to non-smokers accepting cigarettes as middlemen with a bid-ask spread for trading purposes.

The utility gain of smoking helps explain the acceptance of cigarettes as money by the whole population. Because cigarettes are not necessary for survival, the utility gain that smoking provides is often less than that of their use in trade. This led to smokers deliberately abstaining from smoking to gain an even greater utility by acquiring other goods in exchange.

This historical episode is clear proof that commodity monies can and do emerge organically. Even without the influence of the “authorities” that are present in a POW camp, cigarettes became widely used to facilitate indirect exchange in post-war Germany.

 

Cigarette Policies in US Prisons

For a long time, cigarettes were used as currency among inmates of prisons in the US. However, since the mid-1980s, cigarette smoking policies have become significantly more restrictive in prisons across the US. This allows us to observe a social experiment where we can compare how different cigarette policies in prisons affect their use as currency. If you are interested in a great ethnography of prison economies under varying cigarette policy regimes, you’ll find that previous link fascinating.

Because US currency is prohibited in prisons, a new kind of currency must evolve to facilitate indirect exchange and the various “hustles” going on in the prison economy. Cigarettes are a decent option for several reasons, including some discussed above.

Cigarettes are smoked, and thus are often replaced by new packs before old cigarettes have a chance to get worn out from too much trade. This is truer of the prison economy than the POW camp, because access to cigarettes is far less controlled (that is, in prisons where cigarettes were not banned). An inmate could always get more from the commissary, assuming they could afford it.

In addition, cigarettes have convenient denominations. In other words, they can be traded as individual cigarettes, whole packs, or entire cartons. This makes it easy to trade cigarettes in exchange for both cheaper and more expensive goods.

However, the benefits of inmates using cigarettes as currency are wiped out when they are banned from the inside of prisons. Of course, this intervention causes far more harm than just making indirect exchange more challenging – all the negatives of black market industries begin to emerge as well.

As long as there is a demand for cigarettes, people will come up with clever ways to sneak tobacco into prisons. Usually, this leads to serious institutional corruption. For example, “mules” will often pay officers $20 “gate fees” to avoid getting a patdown on their way into the prison. In fact, prison officials in these prisons play a crucial role in the black market for cigarettes.

As the supply of cigarettes is drastically curtailed when they are banned, their price skyrockets. As with most goods that are made illegal, they become a huge money maker for gangs, and the prison officials who work with them.

In fact, prison guards charge between $20-50 for a single pack of cigarettes, and can often make more than an entire week’s wages in a single transaction. The profits on tobacco, even when bought at these outrageous prices, are so high that some inmates request that family members do send-ins of tobacco (pay money to officers who then deliver tobacco to the inmate) instead of directly depositing money into their account. After all, a single carton could fetch a street value of $200-500 dollars with little effort.

Despite a ban on cigarettes, the desire to exchange doesn’t go away. Inmates will find a new way to transact – for example, books of stamps have become a replacement currency in some of these prisons.

The point of this all isn’t that outlawing certain goods is a bad thing (although that is certainly the case). Rather, the point is that people will find a way to get what they want through trade. People adapt, and they will come up with creative solutions that allow them to engage in mutually beneficial exchange.

 

Conclusion

So, what was the point of this whole discussion?

Money Hand

Many people just assume that money is something that government creates, and it cannot be done any other way. But this is simply not the case.

There is a human impulse to exchange; we act to satisfy our desires, and this involves engaging in trade with others. Direct exchange (trade without money, or barter) is highly inefficient, because two people would need to have the specific item that the other person desires (a double coincidence of wants). This creates a demand for some type of special good, aka money, to facilitate indirect exchange.

As the most efficient way of satisfying our desires is to trade for things that we want, it makes sense to trade for things that other people want as well. If I have things that other people want, I can more easily get what I want. These uncoordinated actions of all the individuals within an economy lead to certain goods becoming more widely accepted, because people know that other people will take them in exchange. Hence, money is born.

In this post, we’ve explored the use of cigarettes as money in various circumstances. In our day to day lives, we think of “dollars” as money, and cigarettes as a thing that some people smoke. But it isn’t quite that simple and categorical. If, say, the monetary system in the US were to break down completely (as it has in Zimbabwe recently, the Weimar Republic, and nearly all fiat money regimes throughout history), it’s quite possible that cigarettes will be facilitating trade, and dollars will be getting burned.

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