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Bitcoins: Money of the Future, or Ponzi Scheme?

Bitcoins: The Second Biggest Ponzi Scheme in History

Gary North – November 29, 2013

I hereby make a prediction: Bitcoins will go down in history as the most spectacular private Ponzi scheme in history. It will dwarf anything dreamed of by Bernard Madoff. (It will never rival Social Security, however.)

To explain my position, I must do two things. First, I will describe the economics of every Ponzi scheme. Second, I will explain the Austrian school of economics’ theory of the origin of money. My analysis is strictly economic. As far as I know, it is a legal scheme — and should be.

PONZI ECONOMICS

First, someone who no one has ever heard of before announces that he has discovered a way to make money. In the case of Bitcoins, the claim is literal. The creator literally made what he says is money, or will be money. He made this money out of digits. He made it out of nothing. Think “Federal Reserve wanna-be.”

Second, the individual claims that a particular market provides unexploited arbitrage opportunities. Something is selling too low. If you buy into the program now, the person running the scheme will be able to sell it high on your behalf. So, you will take advantage of the arbitrage opportunity.

Today, with high-speed trading, arbitrage opportunities last only for a few milliseconds seconds in widely traded markets. Arbitrage opportunities in the commodity futures market last for very short periods. But in the most leveraged and sophisticated of all the futures markets, namely, the currency futures markets, arbitrage opportunities last for so brief a period of time that only high-speed computer programs can take advantage of them.

The individual who sells the Ponzi scheme makes money by siphoning off a large share of the money coming in. In other words, he does not make the investment. But Bitcoins are unique. The money was siphoned off from the beginning. Somebody owned a good percentage of the original digits. Then, by telling his story, this individual created demand for all of the digits. The dollar-value of his share of the Bitcoins appreciates with the other digits.

This strategy was described a generation ago by George Goodman, who wrote under the pseudonym of Adam Smith. You can find it in his book, Supermoney. This is done with financial corporations when individuals create a new business, retain a large share of the shares, and then sell the stock to the public. In this sense, Bitcoins is not a Ponzi scheme. It is simply a supermoney scheme.

The Ponzi aspect of it comes when we look at the justification for Bitcoins. They were sold on the basis that Bitcoins will be an alternative currency. In other words, this will be the money of the future.

The coins will never be the money of the future. This is my main argument.

THE AUSTRIAN SCHOOL’S THEORY OF MONEY’S ORIGINS

The best definition of money was first offered by Austrian economist Carl Menger in 1892. He said that money is the most marketable commodity. This definition was picked up by his disciple, Ludwig von Mises, who presented it in his book, The Theory of Money and Credit, published in 1912.

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Analysis continues. In sum, he thinks the buyers of bitcoins are in thrall of the Greater Fool Theory; but is Mr. North correct?

14 Comments

  1. John Galt says:

    I disagree with the characterisation, I don’t think bitcoin is like a Ponzi scheme, I think it’s more like Tulip Mania, the difference being that a Ponzi scheme is a river of income which eventually dries up when the pool of new suckers does, whereas bitcoins (and previously tulips) are an overvalued asset, if you can think of a bitcoin as an asset at all.

    Bitcoins are only worth what people are prepared to pay for them to exchange for other (mainly illicit) goods and services. They have no intrinsic value, they are just a string of bits on a hard disk somewhere.

    Unlike a dollar bill, you can’t even wipe your arse with it.

  2. Julie near Chicago says:

    LOL!! And I gots to say, JG, it’s getting more & more to be a good deal to use the dollar bills instead of TP for the purpose! TP after all is fungible when the going gets rough….

    But, seriously, if I understood his article correctly, he agrees with you.

  3. CountingCats says:

    Bitcoins are only worth what people are prepared to pay for them to exchange for other (mainly illicit) goods and services. They have no intrinsic value, they are just a string of bits on a hard disk somewhere.

    Which is true of nearly all currency these days. Bitcoins differ only in that they are not backed by confidence in governments – which is probably why they are long term appreciating…

  4. Longrider says:

    South Sea bubble?

    But the answer to the question? Yes.

  5. John Galt says:

    Cats, unlike dollars, pounds, the Flainian Pobble Bead and the Triganic Pu a Bitcoin is not recognized as legal tender by any government (e.g. for the settlement of taxes).

    This renders it useless for even the most basic of legitimate purposes, ergo its intrinsic value is the same as any other random collection of bits, the square root of farque-hall.

    The valuation of $1,000 per bitcoin merely goes to illustrate that this is indeed a bubble, just like so many before it, but don’t take my word for it, here’s what Timmy Worstall says about it…

    Bitcoin, Litecoin, we’re well into South Sea Bubble territory here

    As you’ve mentioned previously Cats, it might be worth a punt on bitcoins when this bubble has popped and they are worth pennies again, but that’s just my capitalist evil twin speaking.

    Despite my criticism, I still find that digital currencies are interesting as an example of capitalism red in tooth and claw, but suspect that we’re likely to see a lot of value being both created and destroyed as they find their feet.

    After all despite Tulip Mania, a tulip still has some value doesn’t it?

  6. Sam Duncan says:

    “… ergo its intrinsic value is …”

    Oh, come on, John. I know what you mean, but, well… come on. Intrinsic value? Really?

    “Despite my criticism, I still find that digital currencies are interesting as an example of capitalism red in tooth and claw, but suspect that we’re likely to see a lot of value being both created and destroyed as they find their feet.

    After all despite Tulip Mania, a tulip still has some value doesn’t it?”

    Yeah, okay, I’ll buy that. I’ve written and deleted several comments arguing with your previous ones and others’, but that seems fair enough. If people use Bitcoin as money, then it’s money. It’s really that simple in the end. Its price against other things is all over the place at the moment, but that’s to be expected (it was surprisingly stable against gold in the six months up to October, mind you, which is interesting). It’s going to take longer than the two or three years it’s been around before it settles down.

    Whatever happens, it’s definitely not a Ponzi scheme, though.

  7. John Galt says:

    “Oh, come on, John. I know what you mean, but, well… come on. Intrinsic value? Really?”

    What part of that do you take issue with? If bitcoin is attempting to claim that it is an asset class*, then saying “what is it’s intrinsic value?*” is a perfectly reasonable question. If it is meant to be a store of value*, then how does that actually work in the long run?

    It seems to me that bitcoin is neither of these things (except accidentally) and that manipulation by unregulated traders doing regular pump-and-dump’s of the value is making things worse. If virtual currencies are to have any real meaning they need to be stabilized so that prices can be set which reflect the real world capacity that they are offering.

    There is a lot of experimentation going on, but I don’t think we have any clear answers as to what bitcoin and other digital currencies are going to look like in the future. Remember, being first-to-market is not necessarily the key criteria for long-term success.

    The problem here is that if they go down the road of stabilising these digital currencies with either fixed exchange rates to other currencies (e.g. 1 BTC = 1 USD) or asset convertibility (e.g. 1 BTC = 1 Troy Oz AU) it has to be backed by something, which means somebody putting up capital. In either respect it means the end of digital mining.

    This was exactly what e-gold tried to do years ago and the US government declared their operations illegal and attempted to seize their assets, one of the few times that a seizure has been refused by a US federal judge.

    Regardless of apparent flexibility on their behalf in US senate hearing, the US government will come down like a ton of bricks on any digital currency which attempts to undermine the US Dollar.

    When bitcoin was low in value and limited in use then the US government could ignore it, but as either of these rise, then it becomes a threat.

    * = Each of these are specific finance terms, with specific meanings, collateral, value and risk assessments.

  8. Talwin says:

    Although I’ve heard of Bitcoin – sheesh, who hasn’t? – I still genuinely don’t understand it (although, truthfully, I’ve not tried to that hard).

    I intend to keep it that way.

  9. JohnW says:

    Bitcoin is not money – see Ayn Rand on the medium of exchange in Atlas Shrugged and Capitalism the Unknown Ideal:

    “Gold, having both artistic and functional uses and being relatively scarce, has always been considered a luxury good. It is durable, portable, homogeneous, divisible…” AG in Ayn Rand’s CUI.

  10. Sam Duncan says:

    I balked at “intrinsic value”, John. Okay, so it has a specific meaning in the finance industry, fair enough. But it’s a misnomer as far as I can make out.

    As I say, I tend to agree with your assessment; I’d just phrase it differently, being a layman who’s thought about this stuff a lot rather than a financial professional. I don’t know how it would work as a store of value either (although, again, I’m beginning to think that thinking of things in those terms – “storing value” – is actually looking at the situation in the wrong way, because I’m increasingly convinced that “value” isn’t – or shouldn’t be – a noun; there might be a post in this if I can marshall my thoughts about it sufficiently). And you’re absolutely right about the US reaction to a threat to the Dollar. That’s the real problem down the road. I don’t see how that one can be surmounted. Unless the Dollar collapses round our ears first.

  11. All money, any money, is simply a token of exchange. It has no intrinsic value. It’s a placemarker in the system of exchange. And with deference to goldbugs – so is gold. it’s a pretty metal, useful in electronics. You’d soon learn its intrinsic value if a gold asteroid softlanded in Hyde Park.
    So Bitcoin’s problem is getting it accepted as a medium of exchange. if it becomes so, it will be so. It’s that simple.
    It not being ‘legal tender’ is the feature not the bug. ‘Legal tender’ is money will be accepted by government for taxes owing. Why would you want a government having anything to do with your medium of exchange? They don’t exchange anything for it.

  12. Incidentally, the quasi ‘legal tender’ aspect of Bitcoin is really the stumbling block. Most of ‘money’ is just matching book entries. It doesn’t matter a jot what token those book entries are expressed in, as long as all the players acknowledge the same token. The value of the token is not the token itself but the underlying exchanges of value. X amount of work for X amount of food is still the same X whatever the name on the ‘coin’.

  13. John Galt says:

    …and as if by magic…

    “The tiny Channel Island of Alderney is launching an audacious bid to become the first jurisdiction to mint physical Bitcoins, amid a global race to capitalise on the booming virtual currency.

    The three-mile long British crown dependency has been working on plans to issue physical Bitcoins in partnership with the UK’s Royal Mint since the summer, according to documents seen by the Financial Times.

    It wants to launch itself as the first international centre for Bitcoin transactions by setting up a cluster of services that are compliant with anti-money laundering rules, including exchanges, payment services and a Bitcoin storage vault.

    The special Bitcoin would be part of the Royal Mint’s commemorative collection, which includes limited edition coins and stamps that are normally bought by collectors. It would have a gold content – a figure of £500-worth has been proposed – so that holders could conceivably melt and sell the metal if the exchange value of the currency were to collapse”

    Financial Times (Paywall Link)

    Tim Worstall @ Forbes

  14. Where ever I go in the world (I am just back from Gibraltar) I see signs saying “we buy gold” – people asking me to sell gold to them.

    But business enterprises just seem to interested in selling Bitcoin (not buying it) – this is troubling. They will “accept it in payment” but only a limited scale (and as way of getting people to buy Bitcoin – getting the LEGAL TENDER [even though it is fiat money] seems to be what these business enterprises are really about).

    Also I keep asking the same question – “what is a Bitcoin?” and just getting the answer that it is a number.

    How can a number be property?

    “Ah but it is a number protected by cryptography”.

    Bitcoin people tend to be really worried about the NSA (although, for some reason, they are quite relaxed about the Russian and Chinese intelligence services) and they are trusting their wealth to cryptography?

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