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Why Bitcoin is worse than a Madoff-style Ponzi scheme

This is a guest post by Robert McCauley, a resident senior fellow at Boston University’s Global Development Policy Center and an associate member of the Faculty of History at the University of Oxford. In this post, McCauley argues that comparing Bitcoin to a Ponzi scheme versus Ponzi schemes is unfair.

Bitcoin surpassed its all-time high of $ 69,000 on November 9, 2021. On the first weekend of December, Bitcoin suffered a violent $ 12,000 flash crash when accounts were closed via leveraged positions. And yet, even at its current price of $ 49,000, it continues to be touted by financial news guests as the top performing asset in N years, where N can be any number from one to ten. They are also increasingly judging it as a stand-alone credible investment.

This contradicts the long-standing skeptical view of many economists and others that Bitcoin is, in fact, a Ponzi scheme. The Brazilian computer scientist Jorge Stolfi is one voice who claims this. His view is based on the following observations:

  1. Investors buy in anticipation of profits.

  2. That expectation is sustained by the profits of those who cash out.

  3. But there is no external source for these gains; they come exclusively from new investments.

  4. And the operators take a large part of the money with them.

All of this sounds true. But when they call Bitcoin a Ponzi scheme, critics are arguably too friendly in two ways. First, Bitcoin doesn’t have the same endgame as a Ponzi scheme. Second, from a broad societal perspective, it is a deeply negative sum game.

At first glance, it’s worth assessing how it compares with Charles Ponzi’s original scheme. In 1920, Ponzi promised 50 percent for a 45-day investment and managed to cash that out to a number of investors. He suffered and managed to survive investment attempts until the plan finally collapsed after less than a year.

In the largest and probably longest-running Ponzi program in history, Bernie Madoff paid around one percent a month. He offered to pay the participants of his system both the originally “invested” sum and the “return” from it. As a result, the system could and did take a run; The Great Financial Crisis of 2008 resulted in a cascade of repayments by participants and the collapse of the system.

But the resolution of Madoff’s plan has stretched beyond its collapse due to the notable and ongoing legal proceedings. These survived Madoff himself, who died in early 2021.

Little do not know that a bankruptcy administrator, Irving H. Picard, has doggedly and successfully prosecuted those who took more money out of the system than put into US law to the US Supreme Court. Of the $ 20 billion recognized original investment in that System (which victims were told was worth more than three times that amount), roughly $ 14 billion, an impressive 70 percent, has been recovered and redistributed. Claims of up to $ 1.6 million will be repaid in full.

In contrast to investments at Madoff, Bitcoin is not bought as a high-income asset, but as an eternal zero coupon. In other words, it promises nothing but ongoing returns and never matures with a required terminal payment. It follows from this that it cannot suffer a run. The only way a Bitcoin owner can cash out is by selling it to another person.

Bitcoin’s collapse would look very different from Ponzi or Madoff’s. A possible trigger could be the collapse of a large so-called Stablecoin, i.e. replacement US dollars raised to provide a leg of cash for cryptocurrency transactions. These “unregulated money market funds” were sold as dollar proxy with secure assets to match their outstanding liabilities. Given the lack of regulation and disclosure, it’s not hard to imagine a large stablecoin “breaking the money”, as was the case in 2008 with a regulated money market fund that held Lehman securities. This could mess up the entire ecology of crypto in such a way that it doesn’t bid on Bitcoin. The market could close indefinitely.

If so, there wouldn’t be a lengthy legal effort to prosecute those who redeemed their bitcoins early in order to redistribute their winnings to those who still own bitcoins. Bitcoin owners would not be entitled to those who bought and sold early.

In its cash flow, Bitcoin is more like a penny stock pump and dump scheme than a Ponzi scheme. In a pump-and-dump scheme, traders basically purchase worthless stocks, talk them up, and possibly trade them among each other at rising prices before passing them on to those who are drawn to the chatter and price movement. Like the pump-and-dump scheme, Bitcoin taps into the sheer desire for capital gains. Buyers can’t stand the sight of friends getting rich overnight: they suffer from acute fear of missing out (FOMO). In any case, Bitcoin makes no promises and cannot end when a Ponzi scheme ends.

Secondly, another big difference between Bitcoin and a Ponzi scheme is that the former is a game of negative sums from an aggregate or social point of view. To the extent that real resources are used to get Bitcoin up and running, it’s as costly as Madoff’s two- or three-man operation wasn’t. What Madoff took out of his plan from a social perspective and eventually consumed it is a reallocation in a zero-sum game (the trustee sold his penthouse). Stolfi’s fourth observation, that “the operators take away a lot of the money,” sums up Madoff’s income and the income of bitcoin miners, but these are very different economically.

Bitcoin and other cryptocurrencies are about naming the country whose electricity consumption corresponds to that of all puzzle solvers (miners) who carry out transactions and receive Bitcoin as a reward. Even if the price of electricity includes its contribution to global warming (its “environmental externality”) – which is probably mostly not the case – this represents a real cost factor.

How high are the costs? At the beginning of 2021, Stolfi put the cumulative payments to the Bitcoin miners since 2009 at 15 billion dollars. With the Bitcoin price at the time, he put the increase in this amount to around 30 million dollars per day, which is mainly used to pay for electricity.

With Bitcoin prices higher today, the hole is growing faster. About 900 new bitcoins per day require the majority of $ 45 million per day in electricity. Thus, the negative sum in the Bitcoin game is tens of billions of dollars and rises to over a billion dollars per month. If Bitcoin price collapsed to zero, the profits of those who sold would lag behind the losses of the holders by that growing sum. Comparing Bitcoin to a Ponzi scheme or a pump-and-dump scheme, both of which are essentially redistributive, is to flatter the cryptocurrency system.

In conclusion, an economic analysis of Bitcoin must acknowledge its uniqueness in the history of manias. As an object of speculation, Bitcoin is unprecedented to the extent that there is nothing there. This postmodern mania offers high prices for entries in anyone’s spreadsheet. An eternal zero voucher was not created as a joke, but as a trillion dollar investment. Unlike a Ponzi scheme, Bitcoin cannot end in a run.

In a crash, Bitcoin holders collectively lost what they paid miners for their Bitcoins. This amount, after taking inflation into account, may not be far from the amount originally invested with Madoff. But Bitcoin holders will have no one to reclaim that amount: it will simply have gone up in smoke, a social loss. Bitcoin owners would then only wish it had been a Ponzi scheme.

Source: Crypto News Austria

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