No, your theory is incorrect. If anything, the green address makes it easier to trace.

If I see a transaction from an Instawallet green address, I subpoena Instawallet and ask them who commanded them to make that transaction. Boom, they found me.

If I don't use a green address, how can they tell the coins came from Instalwallet at all? How would they even know who to subpoena?

If I send the coins directly from my wallet, the merchant could likely trace the coins back to the exchange where I originally purchased them, and possibly issue a subpoena to the exchange (which likely knows my identity).

So what? If some dollar bills were used to buy drugs that I withdrew from an ATM machine, what does that tell you? And how would they trace the coins to the exchange exactly?

Whereas, if I send the coins via a Green Address, the merchant could not trace the coins upstream at all - even if they issued a subpoena to InstaWallet, there should be no way to determine the original source of the coins.

I don't follow your reasoning. They subpoena Instawallet and ask them which user commanded that transaction through their green address. They identify you. They're just saved the hard work of trying to trace the coins to an exchange.

It's pretty much academic anyway. There's no good way to tell a sham transaction (where the sender and recipient accounts are controlled by the same party) from a real one.

No

I also thought your way but under the false assumption that Instawallet maintains many small wallets unless you ask them to pipe your money through a green address:

If you use Bitcoin Spinner only, each trading partner will see exactly when you send and receive bitcoins as you will have one address only.

If you use the Satoshi client, your trading partner can guesstimate which addresses belong to your wallet. If one output is worth some round $$ value, the other output is the return address. If there are several inputs, these also belong to your wallet (true for 99.9999% of all transactions), etc.

If you use Instawallet with green addresses, a trading partner will not know much about your wallet but may ask at Instawallet to find the input to do the Satoshi client analysis once he has this info + he might get your IP address (ok, you use tor, but for other readers this point is relevant).

If you use Instawallet without green address, a trading partner might find evidence that links your transaction to Instawallet but again he would have to ask Instawallet to find out details as your charging address is not what you pay from later. Instawallet uses old coins to pay, so when you receive coins and send them on, this is not done from the same address, regardless of your choice to use a green or not green address.

If you are not worried about subpoena, hosted wallets without registration like Instawallet provide more privacy than your own wallet as they are much busier and don't connect inputs from one person with the outputs of the same person. This connection is the book-keeping done on the hosted wallet in privacy.

DISCLAIMER: Never ever trust a hosted wallet that has your private keys with your money. They will run with your money or get hacked.

The transaction in The Bitcoin Network are public, but the addresses are what enables you your privacy. If youy pay from a bitcoin address the receiver will know that address but your other private infos are not needed.

The only thing is that if you reuse that address (which is most likely if you received bitcoins on that address) it may be able to track what you spend, but to know to who you spend would be munch more difficult.

And as you can create address as you wish you can render the task of identifying munch more difficult.

The green addresses are third parties so your privacy will rely on them and in fact it does not rely protect your privacy because one could check what have been spent or transfer to that address anyway.