Tuesday, March 11, 2014

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:

  1. Only the early investors who get out in time make a profit
  2. Their profit comes at the expense of those who invested later and didn't get out in time
  3. This is an unsustainable scheme because it requires ever more new investors while at some point the reservoir of potential new investors cannot but run dry, at which point the whole system necessarily collapses (which it will likely do much earlier already as people start to realize how the scheme actually works).

As I explain below, all three features apply to Ponzi schemes, but none of them applies to Bitcoin.
What happens in a Ponzi scheme?
Let's start with how Ponzi schemes work: The person who operates the Ponzi scheme tells prospective investors that he will invest their money in such a way that the risk is low while the returns are consistently high. But in reality he doesn't actually invest their money or he invests it but doesn't achieve the success that he tells his investors he achieved. The result is that he doesn't have enough money to pay the returns that he promised. After all, because he promises returns he promises more than is coming in. The way he fills that gap is by attracting new investors whose money he can use to pay the earlier investors if these decide to take their money out. 
Charles Ponzi
This process cannot but result in a collapse because at some point the Ponzi schemer will run out of new people whose investments he can use to pay earlier investors. Only if nobody were to ever decide to take their money out would he be able to avoid a collapse even in the absence of new investors because in that case he never would have to pay out any money. But of course people's time preferences are not zero and the whole point of investing money is to be able to have (more) money to spend later, so of course people are going to want to take out their investments at some point. Ponzi schemes, then, are doomed to fail.

But this is very different in the case of Bitcoin. To demonstrate this let me first show what it would look like for Bitcoin to become successful. By sketching this scenario I demonstrate why a Bitcoin collapse, unlike in the case of Ponzi schemes, is not unavoidable, and I show in what ways the other two features of a Ponzi scheme don't apply to Bitcoin either.

How Bitcoin could succeed
Bitcoin started from zero. At its creation 1 bitcoin was literally worth $0.00 and nobody or barely anybody would accept it as payment for anything. At the same time US dollars were almost universally accepted as payment. Then over time people began to mine bitcoins and/or to purchase them and use them as media of exchange. Demand for bitcoins grew and the price kept climbing, from one cent to a dollar to ten to a hundred to a thousand and higher.

Let's now imagine a future in which the demand for bitcoins has grown so much that it has come to completely replace the US dollar. During this process the purchasing power of bitcoins increases while that of dollars decreases. At the end point dollars will have become worthless while Bitcoin will have become money. Nobody will want to hold US dollars anymore, except perhaps as a collector's item, and everybody holds bitcoins as their medium of exchange. Bitcoin has become monetized and the dollar bills and coins demonetized.

Complete monetization of Bitcoin means that the growth in its user base ends, but it wouldn't be the end of Bitcoin! If anything, it would be the opposite: Bitcoin will never have been as alive and actively used as it is at that point. And this is a crucial difference with a Ponzi scheme: Bitcoin can survive an end to the growth in its user base while a Ponzi scheme cannot. A Ponzi scheme needs new investors in order to pay earlier investors, Bitcoin does not. While the speculative use of Bitcoin levels off and ultimately ends as no new users enter the market, its value as a money becomes primary.

What is crucial to keep in mind here is that during this entire process of monetization the price of bitcoins in dollars will continue to go up until dollars will have become entirely worthless so that the dollar will worth 0 bitcoins, and a bitcoin worth an infinite amount of dollars. This means that anybody who buys bitcoins at any point during this process will see the dollar value of their bitcoins increase and gains in that respect.

Moreover, unlike in the case of a Ponzi scheme if the early investors get out and sell their bitcoins they will miss out on the appreciation in the price of bitcoins that occurs after they've sold theirs and they will be stuck holding dollars that become worth less and less. So while in a Ponzi scheme it only pays if you get in early and get out early, in the case of bitcoin it pays to get in at any point and it never pays to get out,* and the strategy that pays least of all is to never get in at all! If you follow that strategy you'll be left with a wallet full of worthless dollars. 
Bernie Madoff
So two of the features (only those who invest early and get out in time win & the system will inevitably collapse) that critics see as common to both Bitcoin and Ponzi schemes don't in fact apply to Bitcoin while they do apply to Ponzi schemes. But what about the third feature, that the profits of early investors come at the expense of latecomers? Doesn't that apply to Bitcoin? Where else do the early investors gain their enormous ROI from if not from latecomers?

Who gains?
At first blush it may seem as if I've already dealt with this issue when I said that anybody who buys bitcoins at any point during this process will see the dollar value of their bitcoins increase. This may make it seem as if everybody wins while in fact this is not the case. The thing to keep in mind is that during this process of Bitcoin monetization and dollar demonetization is that as bitcoins gain in purchasing power, dollars lose purchasing power.** So the longer anybody holds US dollars the more purchasing power he loses, and their losses are bitcoin holders' gains.

What takes place during a process of Bitcoin monetization and dollar demonetization is a massive transfer in purchasing power from dollars to bitcoins. The earlier you switch to bitcoins the more you gain / the less you lose. At some point during this process no newcomer can be a net winner anymore. Switching to bitcoins will still be their best choice they can make at that moment but compared to their situation before the process of monetization and demonetization started they will have lost purchasing power.

So then is this then not in fact similar to a Ponzi scheme? Early investors gaining at the expense of latecomers? In a fundamental way, yes, but in the case of a Ponzi scheme you win if you get out in time while in Bitcoin you only start losing from the moment you get out, and unlike in the case of a Ponzi scheme those who never got in in the first place are the ones who lose the most!

In sum then, not only is Bitcoin different from a Ponzi scheme with regards to the more superficial features of the form they take respectively, but also with regards to the underlying sinister logic that allegedly governs both processes: unlike Ponzi schemes the process whereby Bitcoin increases in price need not end in a collapse, and unlike in the case of Ponzi schemes with Bitcoin your best strategy at any given point in the process of monetization and demonetization is to get in and never to get out.

But what if Bitcoin doesn't succeed?
Now even if critics were to accept all that I've written thus far, they still have one big argument left. Throughout this article I have assumed that Bitcoin will succeed. I did this first of all to show that unlike Ponzi schemes there is no reason that Bitcoin will inevitably collapse, and secondly to make clear what the process of Bitcoin's monetization would look like and how the other two features of a Ponzi scheme would not apply to Bitcoin in that case.

But of course in reality the successful monetization of Bitcoin is far from certain and still exceedingly unlikely. So what happens to my arguments if instead we assume that Bitcoin will fail at some point or only reach modest monetary success, not displacing the US dollar but finding some niche use for example?

Well, I could generalize my point by rephrasing it as follows: To the extent that Bitcoin succeeds all of the above holds. To the extent that Bitcoin fails it may very well be the case that only those who got in early and got out in time won, and that their gains come at the expense of those who came in later. But as such and without any fraud involved these features are hardly unique to a Ponzi scheme. If you invest in a company whose stock price first rises and then collapses, then you will have won if you got in early and sold for more, while everybody who bought before the stock started crashing will have lost. And nobody would accuse the owners of the company of running a Ponzi scheme on that basis. The same holds for Bitcoin.

So whether in the end Bitcoin will succeed or fail or only find a niche use, it simply makes no sense to accuse Bitcoin of being a Ponzi scheme. Both its more superficial features and its underlying logic are fundamentally different from those of a Ponzi scheme.

* Of course early investors may sell their bitcoins because they want to buy some goods or services that they want to consume, and because their time preference is not zero either, they will profit if they use their bitcoins to buy goods even if those bitcoins would have gained even more in value later.

** I explain this issue in more detail and in a somewhat different context in my post Why your bitcoins won't make you as rich as you think they will.

Further Reading
- John Mather - Ponzi Logic: Debunking Gary North
- Peter Surda - Gary North is clueless about Bitcoin
- Erik Voorhees - Open letter to Peter Schiff
Ponzi schemes

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