Over the past decade or so, one important way that the United States has protected our nation’s core interests, projected power, and exercised leadership on the world stage is through the increasing use of financial measures. Far from just focusing on terrorist financing and money laundering, my office in the Treasury Department is now regularly called upon to help advance a variety of U.S. national security and foreign policy goals. … financial measures have become far more powerful tools of statecraft, and their effects are multiplied in a world defined by economic interdependence. …Compare, for example, Jefferson’s failure to our ongoing efforts to use sanctions to prevent Iran from obtaining a nuclear weapon. Together with partners around the world, we have imposed what many believe is the most effective set of financial and economic sanctions in history. Carefully designed and customized to maximize pressure, they have impeded Iran’s ability to acquire material for its nuclear program, isolated it from the international financial system, drastically slashed its oil exports, and deprived it of access to a sizeable portion of its oil revenues and foreign reserves. Not surprisingly, the impact on Iran’s economy has been dramatic: its budget deficit and inflation have spiked, the value of its currency has sharply declined, foreign investment has all but dried up, and overall economic activity has stagnated.
The reason that the U.S. can do this is because it has a lot of effective control over financial networks. It can put pressure on banks (including foreign banks, which have been fined billions of dollars for not complying with the U.S. sanctions regime) to isolate Iran from the international system. In Cohen’s words:
Put simply, financial institutions everywhere need dollars to serve their customers, and thus require access to U.S. banks through correspondent accounts to settle their customers’ transactions. That means that foreign banks are especially attuned to our sanctions.
Because so many international transactions are (a) settled in dollars and (b) settled across payment systems run by banks and other financial intermediaries that are vulnerable to U.S. pressure, the U.S. can use these systems to exert political control. Now, imagine the likely response of the U.S. (and the E.U., and, for that matter, China) to a payment network which is designed from the ground up to be decentralized, so that it is impossible for any specific intermediaries to really control payment flows from one actor to another. Such a network would be impossible for states to control. The U.S. wouldn’t be able to use it, for example, to squeeze Iran out of the world financial system. If such a network ever showed signs of really becoming established (rather than being a relatively small-scale thought experiment, and money suck for libertarians with more ideology than good sense), the U.S. would ruthlessly act to isolate it from the international financial system.
And that is the story of Bitcoin. Up to this point, regulators have largely tolerated Bitcoin as a curiosity and experiment. While Bitcoin allows consumers to buy illegal drugs on Tor Hidden Services sites like Agora and Evolution, they don’t do so on a sufficiently large scale to really cause enormous alarm. Regulators still don’t know quite what to do with Bitcoin. But if Bitcoin were ever to threaten to become a truly decentralized payments network, owned by no one, and with no one e.g. capable of implementing Know Your Customer rules, regulators would know very well what to do with it. They’d introduce regulatory guidances and pass laws to freeze it off from the regular financial system. Very possibly, Bitcoin could still survive at the margins (as the Hawala system has survived). However, it would be isolated, and in no position to threaten Visa or Mastercard, let alone the underlying payment and messaging services that really underpin the world financial system.
If Tim Lee and other Bitcoin fans want to make the case that Bitcoin can become a major payment network, they need to do one of two things. First, they could show that the U.S. and other major states would not feel threatened by a well-established payment system that they couldn’t control. Second, they could show that a Bitcoin financial network would survive the opposition of hostile states that have enormous control over the actually-existing financial systems that Bitcoin needs to connect to, as well as regulators, police, etc. I don’t see any very plausible arguments that would support either claim. It’s perfectly possible that the underlying technologies of Bitcoin (which help solve some interesting problems of trust and exchange) can be deployed to other valuable uses. But Bitcoin is doomed as a payments network — the very point at which it looks as though it is likely to be widely deployed is the point at which governments, like that of the United States, will crack down on it.
Update: Tim responds here and on Twitter, arguing that it is too late to stop Bitcoin from taking off. However, he seems to me to underestimate the willingness of the US and other major states to pursue their strategic interests, even if it annoys business, and the vulnerability of any payments systems to regulatory actions. As the Cohen speech linked above indicates, the US understands the value of its influence over the global financial system, and is demonstrably willing to upset business in order to pursue its strategic aims. Moreover, much of this power comes from the fact that any individual payment system, if it is to be effective, needs to be interoperable with other payment systems which, by and large, rest on transactions in US dollars. This is why the US has such extraordinary leverage over the world financial system. The sorry recent history of financial flows to and from another stateless financial system, Somalia, provide some evidence of how difficult life can get for financial networks that have been targeted by the US state.