It is an excellent and fairly likely scenario that you describe. And there is a lot of BTC cheerleading in here so most responses are pretty useless as you can see above.
The scenario that you describe is likely to happen in many or some Western countries. The federal government probably has the power to do this and so does the European union. But the UN does not so each country would have to ban it if it were to be outlawed all over the world. Now imagine the scenario that it is illegal in every part of the world but it still has some kind of following since there are at least 100k people who currently holds Bitcoins and value them. If some ministate would then allow the exchange of Bitcoins to other currencies then this state/government would receive a huge revenue from this legalization since all the 100k users would need to trade through this country if they wanted to exchange Bitcoins for other assets. So a country would have a big incentive to remove this law if it was banned all over the world since it would bring revenue to that country. The exchange from BTCs to fiat currencies in just one country would increase the value of BTCs since one could trade goods for BTCs (privately) in a place were BTCs were banned and then, at some point travel to country were it was legalized and exchange to gov. fiat or other assets there.
So if BTCs are banned in USA and Europe but not i, say, Russia, the Carribeans and Australia, they would still be worth something and usefull in the US. And currently BTCs have found widespread use in these different countries which ensures that it is outside the grasp of a single legal entity to ban the use of BTCs.
Hey, thanks for the balanced response. I agree that a ban would most likely come from the US and the EU (who have the most to lose from Bitcoin gaining acceptance) but if Bitcoins would facilitate tax evasion then it could be a wider threat that any government would like to contain. If as we hypothesize, only a few handful countries like Russia don't ban it, then as you say that country would serve as the financial center of the bitcoin exchange...but I doubt it would be that lucrative because the size of the bitcoin market cap is just a fraction of a countries' GDP.
Not if it is a very small country like Iceland or a Carribean state. These countries could see a large rise in relative revenue from an acceptance of Bitcoins, i.e., they would have a large incentive to legalize it.
Also the scenario doesn't solve the case of how Americans or Europeans would be able to transfer money to these Russian exchanges because they would need the help of American banks or banks in America to achieve this (who are the exact enemies who don't want you to use Bitcoin).
The beauty is that most people would not have to. If just one person can go there once in a while, he can transfer money for other people or make some kind of black market currency exchange which already exists for government fiat currencies in countries that have exchange rate controls - e.g. there is a large black market for dollar exchange in socialist Venezuela.
Even if there was a way to keep taking part in the bitcoin economy - the whole negative stigma associated with something illegal, inconveniences relating to circumventing illegal activities, lack of big businesses accepting it - all would put a severe dampen on Bitcoin's overall potential and would reduce it to a niche online currency and not the world changing technology that we were all hoping for.
Like a government ban on drugs or online file sharing? It may reduce the usefullness and thus value of BTCs but not destroy it.
I think the main point here is that just having the currency system being decentralized is not enough - we also need decentralized corporations and exchange market places...and that seems to be beyond Bitcoin's technical limitations.
I think this is what they are trying to achieve with Ripple but I do not know that system very well yet.
I think the main difference between our views is that I see the things which you can avoid when using BTCs, like laws, capital controls, inflation, taxes, money seizures are more damaging than you seem to believe - to be able to avoid these things is more important than the dangers you list, I believe.