16 highlights
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And yet, even at the current price of $49,000, guests on financial TV news continue to tout it as the best-performing asset of the last N years, where N can be just about any number from one to ten.
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This contradicts the longstanding sceptical view by many economists and others that what bitcoin really is, in effect, is a Ponzi scheme.
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But in calling bitcoin a Ponzi scheme, critics are arguably being too kind on two counts. First, bitcoin doesn’t have the same endgame as a Ponzi scheme. Second, it constitutes a deeply negative sum game from a broad social perspective.
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In the largest and probably the longest running Ponzi scheme in history, Bernie Madoff paid returns of around one per cent a month. He offered to cash out his scheme’s participants, both the original sum “invested” and the “return” thereon. As a result, the scheme could and did suffer a run; the Great Financial Crisis of 2008 led to a cascade of redemptions by participants and the scheme’s collapse.
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Of the $20bn in recognised original investments in the scheme (which the victims had been told had reached a value more than three times that sum), some $14bn, a striking 70 per cent, has been recovered and distributed. Claims of up to $1.6m are being fully repaid.
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By contrast to investments with Madoff, Bitcoin is bought not as an income-earning asset but rather as a zero-coupon perpetual. In other words, it promises nothing as a running yield and never matures with a required terminal payment. It follows that it cannot suffer a run. The only way a holder of bitcoin can cash out is by a sale to someone else.
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Bitcoin’s collapse would look very different to that of Ponzi’s or Madoff’s scheme. One possible trigger could be the collapse of a big so-called stablecoin, that is, ersatz US dollars that have sprung up to provide a cash leg for cryptocurrency transactions.
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Given the lack of regulation and disclosure, it is not hard to imagine a big stablecoin “breaking the buck”, as occurred with a regulated money market fund that held Lehman paper in 2008.
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In this event, there would be no long-running legal effort to chase down those who cashed in their bitcoin early in order to redistribute their profits to those left holding bitcoins. Holders of bitcoin would have no claim on those who bought early and sold.
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In its cashflow, bitcoin resembles a penny-stock pump-and-dump scheme more than a Ponzi scheme.
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Like the pump-and-dump scheme, bitcoin taps into the pure desire for capital gains. Buyers cannot stand the sight of friends getting rich overnight: they suffer an acute fear of missing out (FOMO). In any case, bitcoin makes no promises and cannot end as a Ponzi scheme ends.1
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On the second count, another big difference between bitcoin and a Ponzi scheme is that the former is, from an aggregate or social standpoint, a negative sum game.
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From the social standpoint, what Madoff took out of his scheme and finally consumed is a redistribution in a zero-sum game (the trustee sold his penthouse).
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With bitcoin and other cryptocurrencies, the game is to name the country whose electricity consumption equals that of all the puzzle-solvers (miners) who get to effect transactions and receive bitcoin in reward. Even if the electricity were priced to include its contribution to global warming (its “environmental externality”)—which presumably it mostly is not—this represents a real cost.
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About 900 new bitcoin a day require most of $45m a day in electricity. Thus, the negative sum in the bitcoin game is in tens of billions of dollars and rising at over a billion dollars per month. If the price of bitcoin collapses to zero, the gains of those who sold would fall short of the losses of holders by this growing sum.
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In a crash, the holders of bitcoin will collectively have lost what they have paid the miners for their bitcoin. This sum may be not far from the sum originally invested with Madoff, after accounting for inflation. But bitcoin holders will have no one to pursue to recover this sum: it will simply have gone up in smoke, a social loss.
Footnotes
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This comparison seems a bit unfair. It’s not like people who invest in the traditional market setup do so without any “pure desire for capital gains”. The idea of FOMO is true for the stock market in general and not just pump-and-dump penny stocks. ↩