Bitcoin, the Brilliant Ponzi Scheme

Ponzi schemes are an unfortunate fact of modern life.

Named after Charles Ponzi, an Italian immigrant who ran a famous scam in the 1920s, a Ponzi scheme is a fraudulent investment scam where returns to earlier investors are paid using funds from new investors, rather than from legitimate profits generated by any underlying business activity or asset appreciation.

These schemes rely on a constant flow of fresh money to keep going. Eventually, when new investors dry up or too many people try to withdraw funds, the scheme collapses, leaving most participants with heavy losses. (See grok for more.)

Like many others, I am convinced that bitcoin is the greatest Ponzi scheme of the 21st century CE. It has no underlying productive activity and it needs a constant flow of fresh money from “bigger fools” to keep going.

Bitcoin depends on a decentralized ledger which is maintained by blockchain technology. It’s complicated stuff that fascinates techies. The average user need not bother with understanding cryptocurrency technology any more than the user of a smartphone needs to know about the internal workings of the darned thing.

Bitcoin is a very nice name for a cryptocurrency. It sounds modern and it is definitely so. The coin suggests that it is money and bit that it is digital. Everything digital is cool and money is cool and crypto is awesome. So crypto digital money is the bestest. Its legendary inventor, Satoshi Nakamoto, was a pretty smart cookie, whatever else he is or was.

Mr Nakamoto (or a group that used that pseudonym) invented the ingenious scheme out of whole cloth. I won’t bother with the technical details because my knowledge is at best shallow in that area. Broadly each bitcoin has to be “mined” using computing power. As the pile of mined bitcoins grows, it becomes increasingly harder to mine the next bitcoin. That means that the amount of energy required for the marginal bitcoin mined keeps climbing exponentially.

Computation is also required to maintain the public ledger that keeps track of all bitcoin transactions. The more transactions, the more costly it becomes to maintain the ledger. The mining and the maintenance of the ledger requires high powered GPUs. The ginormous amount of energy expended in doing that is essentially worthless except that it enables untold wealth transfer from the more deluded fools to those lucky enough to buy into the Ponzi scheme earlier in the game.

Who made the most out of this Ponzi scheme? Like in all Ponzi schemes, the person (or persons) who came up with the scam make out like a bandit. In this case, Mr Satoshi. It is believed that he holds a significant share of the existing bitcoins.

The bottom line is that bitcoins are conjured out of thin air — but the conjuring trick requires humongous gigawatts of energy. Exactly how much energy is wasted in this is left as an exercise for grok or Claude or Perplexity.

That waste of perfectly good energy is one of the greatest strikes against bitcoin. Nakamoto is very technically smart but is a cretin when it comes to energy efficient design. Perhaps he didn’t care. If one is conjuring up money out of thin air, one should make it costless. Any competent economist (and I claim that I am one) can do a much better job, as I will show later (perhaps in a separate piece.)

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Bitcoin can definitely be used as money — and some people have even used it as money. Most people have then regretted using it for payment. One time a guy bought a pizza and paid for it with bitcoins when the price of bitcoin was a fraction of a penny. He paid with a few hundred bitcoins. As it turned out, if he had waited just a few years, he could have used those bitcoins to buy the whole friggin’ pizza chain instead of buying just one pizza.

The main reason that people “invest” in bitcoin is the expectation that its price will go up. Therefore, using bitcoins to buy something doesn’t make logical sense at any point. So it fails as a medium of exchange.

Another story. One guy had been mining bitcoins using his PC at home. He had mined a few thousand bitcoins. His girlfriend said that the hard drive was too noisy. So he threw it out in the garbage. Had he kept the drive, he could have made a few hundred million dollars. C’est la vie.

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If only, lord, if only. Bitcoin is like that only (as they say in India.) More about that later. For now, let’s talk about money.

What is money? Functions generally associated with money are: a store of value, a unit of account, a medium of exchange, and a standard of deferred payment. Money comes in two forms:

• • • specie money (also called “specie” or “hard money”): metallic coins made of precious metals, typically gold or silver, that serve as money, and
    • fiat money: government-issued currency (paper notes, base-metal coins, or digital entries) that has value by government decree and is declared legal tender. It is not backed by any physical commodity.

Bitcoin is not specie money. Sometimes called “liquid gold”, unlike gold which has other important industrial and social uses, you cannot use bitcoin for anything other than exchange. Most of the time that exchange involves the buying and selling of bitcoin using fiat money. How that is an improvement on fiat money is unclear.

The promoters of bitcoin look down on fiat money but bitcoin depends on fiat money. They say that fiat money is inflationary. That much is true: fiat money is indeed inflationary because most governments merrily run the printing presses to churn out money thus imposing an inflation tax on the people. (In these days of the new-fangled digital economy, there’s no need even for actual printing of currency.)

Inflation is always and everywhere a monetary phenomenon, as Milton Friedman tirelessly pointed out. Loose monetary policies lead to inflation. But most of the inflation in developed economies is broadly predictable. The value of the currency is therefore predictable in the short and medium term. That predictability is important because it allows people and institutions to respond rationally.

The trouble with bitcoin is its value (its price in US$, for instance) is an unpredictable crapshoot. People hold bitcoins not for use as currency but purely as a speculative asset. They buy bitcoins with the expectation that its price will appreciate. Buy low and sell high — that’s the amazing strategy that no one has ever figured out until now.

Other than that minor thing about the unconscionable misuse of precious energy which has valuable alternative uses in producing goods and services that people can actually consume, bitcoin has the additional property of being the most volatile asset (if you can call it an asset) known to man. It began as being worth a fraction of a penny but climbed to over $125,000, with many intermediate peaks and troughs.

The pure transfer of money from those who bought at a local maxima transferred money to those who sold at the local maxima. Bitcoin, in game theory terms, is a zero-sum game considered from the point of view of the bitcoin market participants. The winners’ gains are exactly the losers’ losses.

From a social point of view, it is a total waste because that pure transfer of money among the winners and losers involves the aforementioned waste of energy. Therefore from a social point of view, it’s a negative-sum game.

I confess that I have a hard time wrapping my head around the entire concept of money. Certainly, I do understand that money has valuable functions in any economy that’s more sophisticated than a purely barter economy, and I understand better than the average person how it works. But I also know that I don’t quite fully understand money. Greater minds than mine — Hayek and Friedman, to mention just two of the greatest economists of the 20th century CE — have studied money for decades. Perhaps they understood money. But I don’t.

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Brilliant investors such as Messrs Buffett and Munger have been explicit about their total disdain of bitcoin. Surely they know what they’re talking about more than the average Joe Blow does.

Munger recognized that the intrinsic value of bitcoin was zero. He said in an interview that “I don’t think that buying a percentage of nothing is a good investment, even though it’s hard to create more nothing.”

Munger did not hold his tongue. He called crypto a “scumball activity” and those who engaged in it delusional, and the technology not as a store of wealth, but as a “store of delusion.” Munger was hugely entertaining. Here’s a bit from Business Insider (Dec 2023):

Munger has railed against crypto on many occasions, calling it “rat poison,” a “venereal disease,” an “open sewer,” and an “absolute horror.” He also said he wouldn’t want anyone involved with crypto to marry into his family.

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I have been arguing against bitcoin for years with true believers of crypto in general and bitcoin in particular. It was an exercise in futility. Maybe it was not entirely futile because it forced me to understand how I would engineer a better system of money.

One of the biggest features that bitcoin true believers point to is the fact that the number of bitcoins is capped at 21 million. That appears to me to be one of its major bugs, not a feature. The world economy is growing exponentially (where I use the word advisedly.) The money supply must also grow to keep pace with that. My solution lies at the intersection of the social sciences and philosophy. More about that later.

This piece is a response that I’d promised a friend, SC, who had asked me to elaborate on my take on bitcoin. I believe that the value of bitcoin is a random draw, a purely stochastic process with an attractor that is anchored at zero. When will it go to its final value is unpredictable, as random walks are by definition.

For now, I think that bitcoin (and other crypto currencies) is an ingenious Ponzi scheme that has transferred huge amounts of wealth to the crafty winners (who frequently follow the “pump and dump” strategy) from the stupid dupes who buy into the scammers’ promise of unearned wealth.

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Music time.

Thank you, good night and may your god go with you.