This is a guest post by Robert McCauley, a non-resident senior fellow at Boston University’s Center for Global Development Policy and an associate member of the Oxford University School of History. In this post, McCauley argues that comparing Bitcoin to a Ponzi scheme is unfair to Ponzi schemes.
Bitcoin retreated from an all-time high of $69,000 on November 9, 2021. It suffered a sudden, painful crash of $12,000 over the first weekend in December, amid closing accounts for leveraged positions. However, even at the current price of $49,000, guests at the financial TV news continue to tout it as the best performing asset in the past N years, where N can be any number from one to ten. They are also increasingly judging it as a credible investment in its own right.
This contrasts with the long-skeptical view by many economists and others that what Bitcoin is, in fact, is a Ponzi scheme. Brazilian computer scientist Jorge Stolfi is one voice to confirm this. His opinion was expressed in the following observations:
Investors buy in anticipation of profits.
This expectation is maintained by the profits of those who spend the money.
But there is no external source for those profits. They come entirely from new investments.
And operators take a big chunk of the money.
All of this appears to be true. But when calling Bitcoin a Ponzi scheme, critics are arguably very nice on two counts. First, Bitcoin does not have the same end game as a Ponzi scheme. Second, it constitutes a very negative sum game from a broad social perspective.
On the one hand, it is worth evaluating how it compares to the original scheme devised by Charles Ponzi. In 1920, Ponzi promised 50 percent on an investment for 45 days and was able to pay that amount back to a number of investors. It struggled and survived the investors’ operations, until the scheme eventually collapsed less than a year after it.
In the largest and perhaps the longest-running Ponzi scheme in history, Bernie Madoff paid returns of about one percent per month. He offered to exchange the money of the participants in his plan, both the original amount “invested” and “return” on it. As a result, the scheme could have already been exposed to operation; The Great Financial Crisis of 2008 led to a series of redemptions by participants and the collapse of the scheme.
But the dissolution of Madoff’s scheme extended beyond the collapse due to impressive and ongoing legal action. These things have outlived Madoff himself, who died in early 2021.
Not many realize that the bankruptcy trustee, Irving H. Pickard, has persistently and successfully chased after those who took more money from the scheme than they put into it. He was even able to trace the money into offshore dollar accounts, which led to litigation over the controversial extraterritorial access of US law all the way to the US Supreme Court. Of the $20 billion in original investment recognized in the scheme (which victims were told was worth more than three times that amount), about $14 billion was recovered and distributed, a staggering 70 percent. Claims up to $1.6 million to be paid in full.
In contrast to investments with Madoff, Bitcoin is not purchased as an income-generating asset but rather as a permanent zero-coupon. In other words, it promises nothing as a continuous return and never matures with the final payment required. It follows that he cannot suffer from running. The only way a bitcoin holder can cash out is by selling to someone else.
A Bitcoin crash would look very different from a Ponzi or Madoff scheme crash. One possible trigger could be the collapse of the so-called stablecoin, that is, artificial United States dollars created to provide a cash leg for cryptocurrency transactions. These “unregulated money market funds” were sold as dollar reserve units with safe assets in proportion to their outstanding liabilities. Given the lack of regulation and disclosure, it’s not hard to imagine large stablecoins “breaking the responsibility,” as happened with the regulated money market fund that held the Lehman paper in 2008. This could disrupt the entire crypto environment so that there could not be Bidding for Bitcoin. The market may close indefinitely.
In this case, there would be no long-term legal effort to hunt down those who cashed their bitcoins early in order to redistribute their profits to those who left bitcoins. Bitcoin owners will have no claim on those who bought and sold early.
In terms of cash flow, bitcoin is more like a small-stock pump and dump scheme than a Ponzi scheme. In a pump-and-dump scheme, traders acquire essentially worthless stocks, talk about them and possibly trade them among themselves at high prices before offloading them to those attracted by gossip and price action. Like a pump-and-dump scheme, Bitcoin exploits pure desire for capital gains. Buyers can’t stand the sight of friends getting richer overnight: they suffer from an acute fear of missing out (FOMO). In any case, Bitcoin makes no promises and cannot end with the end of the Ponzi scheme.
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On the second statistic, another major difference between the Bitcoin system and the Ponzi system is that the former is, from an aggregate or social point of view, a negative sum game. To the extent that real resources are used to run bitcoin, it is costly in a way that Madoff’s two- or three-man operation wasn’t. From a social point of view, what Madoff took out of his scheme and finally consumed it was redistribution in a zero-sum game (the trustee sold his shed). Stolfi’s fourth note above that “operators take a big part of the money” brings Madoff’s earnings and bitcoin miners’ earnings together, but they are economically very different.
Using bitcoin and other cryptocurrencies, the game is to name the country whose electricity consumption is equal to the consumption of everyone who solves puzzles (miners) who carry out transactions and get bitcoin as a reward. Even if electricity is priced to include its contribution to global warming (“environmental externalities”) – which it is often assumed it is not – this represents a real cost.
How big is the cost? At the beginning of 2021, Stolfi estimated the cumulative payment to bitcoin miners since 2009 at $15 billion. At the price of bitcoin at the time, he estimated the increase in that amount was about $30 million per day, which is mostly paid for in electricity.
With today’s high bitcoin prices, the hole is growing even faster. About 900 new bitcoins per day require most of the $45 million per day electricity. Thus, the negative amount in the Bitcoin game is in the tens of billions of dollars and increases by more than a billion dollars per month. If the price of bitcoin collapses to zero, the gains of those who sold will be less than the losses of the holders through this increased amount. The analogy of Bitcoin to a Ponzi system or a pump-and-dump scheme, both of which are essentially redistribution, is to flatter the cryptocurrency system.
In conclusion, the economic analysis of Bitcoin must acknowledge its uniqueness in the history of mania. As a subject of speculation, Bitcoin is unprecedented in the degree to which it does not exist. This postmodern obsession features exorbitant prices for entries in nobody’s spreadsheet. We’ve always come up with a zero coupon not as a joke but as a trillion dollar asset. Unlike the Ponzi scheme, Bitcoin cannot end in a single round.
In the event of an accident, bitcoin holders will collectively lose what they paid the miners for their bitcoins. That amount may not be far from the amount originally invested with Madoff, after accounting for inflation. But the owners of Bitcoin would have no one to go after him to get that amount back: it would simply be smoke, and a social loss. Then only Bitcoin owners wish it was a Ponzi scheme.
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The world of cryptocurrency is confusing, but don’t ignore it / From Nathan Thompson, lead technical writer, Bybit, Vientiane, Laos