Dear Nouriel Roubini, Here's Why Bitcoin Is Not A Ponzi Scheme

NYU professor Nouriel Roubini, famous for his prediction of the 2008 financial crisis, tweeted today that bitcoin is, among other bad things, a "Ponzi game." Roubini is not the first and won't be the last person to make this accusation, so it may be worthwhile to briefly explain why this belief is mistaken.

Briefly put: Bitcoin looks like a Ponzi scheme in the same way that a whale looks like a fish. In reality, though, they are two entirely different animals.
  

Do Early Bitcoin Adopters Deserve Their Wealth?

If bitcoin is successful as a currency it will take market share from other currencies. This means that its price will continue to go up while the price of other currencies such as the dollar will go down. What bitcoin gains in purchasing power comes roughly at the expense of the dollar and other national currencies.

In the extreme case, if bitcoin were to completely take the place of the dollar, the entire wealth in the economy would shift from holders of dollars to holders of bitcoins. The earlier people buy bitcoins the more they can profit from this price increase and the longer people hold on to dollars and other currencies, the more they will suffer from its depreciating value.

Bitcoin's success then implies a massive transfer of wealth from late adopters to early adopters.

Is such a redistribution of wealth and power fair, if it is based on nothing but the order in which people adopted bitcoin? Can it be justified?

Why start or invest in Bitcoin companies? Why not free ride Instead?

Most of the companies building or servicing the Bitcoin economy require significant investments. But why would you invest that money in a Bitcoin company if instead you could just use the money to buy bitcoins and wait for those to increase in value?

Individual companies vs. the whole industry
The remarkable thing about the Bitcoin industry is that it is possible to invest in the industry as a whole rather than (or in addition to) in specific companies in that industry.

This is very different in other industries: You can't make investments in 'the car industry' or 'the food industry', only in specific companies in these industries. Similarly, the current state of the Bitcoin industry is sometimes compared to the early internet: still very underdeveloped but with great potential. Now in the case of the early internet it was not possible to invest in TCP/IP, the general protocol underlying it, or even in the protocols built on top of that such as HTTP. If you were excited about the potential of the internet you couldn't invest in the protocols themselves, only in specific companies creating and/or using these protocols.

With Bitcoin on the other hand you can invest in the Bitcoin industry as a whole, in Bitcoin as a protocol for financial applications, namely by buying bitcoins. If Bitcoin as an industry and protocol succeeds, your bitcoins will go up in value and price.

Bitcorati's overview of existing Bitcoin companies

Understanding Krugman on Bitcoin

In his column 'Bitcoin is evil' Paul Krugman writes:

I have had and am continuing to have a dialogue with smart technologists who are very high on BitCoin [sic] — but when I try to get them to explain to me why BitCoin [sic] is a reliable store of value, they always seem to come back with explanations about how it’s a terrific medium of exchange. Even if I buy this (which I don’t, entirely), it doesn’t solve my problem. And I haven’t been able to get my correspondents to recognize that these are different questions.

Krugman is entirely correct in that

1) the medium of exchange function and the store of value function are two distinct issues,

2) even if we were to assume for the sake of the argument that bitcoin was a successful medium of exchange this in and of itself need not thereby also make bitcoin a reliable store of value, and hence

3) we would need an additional argument to demonstrate that bitcoin could also succeed as a store of value.

None of these points seems particularly controversial, which makes it all the more surprising that Krugman writes that none of the smart technologists and bitcoin enthusiasts he's been in dialogue with even seem to recognize or acknowledge them.

Never one to shy away from speculating about what psychological and/or moral defects may cause the people who disagree with him to behave in such an apparently irrational and/or dishonest manner, Krugman devotes much of the rest of his column to suggesting that it is really an evil libertarian agenda rather than intellectual understanding and conviction that is what drives many bitcoin enthusiasts.[1]

The problem, however, may lie with Krugman rather than with the bitcoin enthusiasts.

Why your bitcoins won't make you as rich as you may think they will

Suppose you have a bunch of bitcoins, let's say 50 of 'em. As you're leafing through your copy of Yachting Magazine, thinking about the day when 1 bitcoin will be worth 1 million dollars, you see an ad for a impressive $50,000,000 yacht and think to yourself: That's what I will buy once bitcoin hits a million! 

The problem here is that you are actually overestimating how wealthy you will be once bitcoin hits a million. Of course there's taxes and what not and these will take chunks from your wealth, but that's not what I have in mind here. My point is that once 1 bitcoin is worth 1 million dollars, 50 million dollars simply won't mean the same as it does now, in that it won't buy you as much as it does in 2013 dollars.

Bitcoin and Its Referents

The term 'Bitcoin' is used in different ways, which can cause confusion. For the sake of clarity below I list the six different types of things the term 'Bitcoin' refers to, and then describe how these relate to each other. 

Who benefits if Bitcoin succeeds?

To answer the question who will benefit if Bitcoin is successful it is important to distinguish between two different processes that take place during Bitcoin's road to success:

1. Bitcoin monetization
2. Growth of the bitcoin economy

As I will explain below, each of these developments results in different kinds of benefits for different groups of people.

Why Bitcoin Needs Neither 'Intrinsic Value' Nor Government Backing

One of the things that puzzles people most about Bitcoin, and what makes them most skeptical about its future, concerns the very nature of bitcoins and the source of their value. Put simply: Just what the hell are bitcoins exactly and why would anybody want them?

The most basic answers to these two questions are, respectively, that a bitcoin is a spot in a distributed ledger, and that what makes a bitcoin valuable is that it is a medium of exchange that at least some people are willing to accept as payment for other goods or services.

These answers, however, do little to take away the confusion and/or skepticism, because bitcoins are by nature so very different from other media of exchange that we are familiar with.

This becomes clear when we look at the different ways in which this type of confusion and/or skepticism is expressed by a wide variety of both experts and laypeople, including top economists like Paul Krugman, former central bankers like Alan Greenspan and Nout Wellink, Fed critics and hard money advocates like Peter Schiff, sympathetic Bitcoin observers like JP Koning, and many many more. Here are the most common points these critics make:

Why an end to Bitcoin's growth need not result in its collapse (unlike Ponzi schemes and bubbles)

Hardly a day goes by without somebody accusing Bitcoin of being a Ponzi scheme, or being like a Ponzi scheme.

At first sight this may seem like an odd charge: A Ponzi scheme is a fraudulent, secretive operation masquerading as an investment scheme while Bitcoin is an open-source currency and protocol.

Moreover, a Ponzi scheme is operated by one person or organization while Bitcoin is decentralized and not controlled or operated by any one person or organization.

Also, in a Ponzi scheme people are promised that their investment is low-risk while just about anybody in the world of Bitcoin will tell any prospective buyer that the risk is huge and that they should not invest more money than they can afford to lose.

Lastly, in a Ponzi scheme the (non-existent) returns are typically very steady while Bitcoin is notorious for its enormous volatility in price (and hence returns).

The same logic?
But while most critics would probably agree that Bitcoin is not a Ponzi scheme in these four respects, they would point to a more fundamental similarity, a basic logic that Bitcoin has in common not just with Ponzi schemes but also with manias and bubbles (e.g. here & here & here & here & here), a logic that goes a little something like this: