Over the weekend, the value of one bitcoin dropped from a little more than $1,200 down to $990 (at the time of this writing). Bitcoins have been capturing business headlines because of its volatility and immense fluctuations – in January, a price of one bitcoin was trading at around $10.
With many proponents arguing that bitcoin will revolutionize alternative currencies and become a globally-recognized form of money, there have been some critics, mostly who have been making the case that the cryptocurrency is nothing more than a bubble that is filled with speculation.
Gary North, an economist from the Austrian persuasion, published an in-depth piece late last week in which he definitively states that “Bitcoins will go down in history as the most spectacular private Ponzi scheme in history. It will dwarf anything dreamed of by Bernard Madoff. (It will never rival Social Security, however.)”
He uses two primary elements to denounce bitcoins: the economics of Ponzi schemes and the Austrian School’s Theory of money’s origins.
According to North, the publisher of Specific Answers, starts off his article by explaining that the first step in a Ponzi scheme is to have an unknown person announce that they have found a method of making money, which is similar to bitcoins because he “literally made what he says is money, or will be money. He made this money out of digits. He made it out of nothing. Think ‘Federal Reserve wanna-be.’”
The second aspect, says North, is the individual running the Ponzi scheme claims a particular segment of the market can offer unexploited arbitrage opportunities, which lasts for very brief moments, a la commodity futures and currency futures markets.
“The individual who sells the Ponzi scheme makes money by siphoning off a large share of the money coming in. In other words, he does not make the investment,” wrote North. “But Bitcoins are unique. The money was siphoned off from the beginning. Somebody owned a good percentage of the original digits. Then, by telling his story, this individual created demand for all of the digits. The dollar-value of his share of the Bitcoins appreciates with the other digits.”
In the end, the Ponzi element of bitcoins is the fact that they were sold off on the premise that they will be a legitimate alternative currency, “money of the future,” according to North. He concludes that it will never be the money of the future.
North’s next point comes from the Austrian School of Economics. The fathers of Austrian Economics, such as Carl Menger and Ludwig von Mises, say money is originated from market exchanges or transactions. Essentially, it means that something that did not work as money before, like gold and silver, will now become a currency of exchange.
As the transition from barter to money continues, the division of labor is established and increases thus producing enhanced productivity. Money cannot just be created out of thin air. Therefore, it is warned by North that once a new system of money is introduced be sure to hold on to your old form of money.
“Here is the central fact of money. Money is the product of the market process. It arises out of an unplanned, decentralized process. This takes time. It takes a lot of time. It spreads slowly, as new people discover it as a tool of production, because it increases the size of the market for all goods and services. No one says, ‘I think I’ll invent a new form of money,’” stated North.
“Money is not accumulated for its own sake. It is accumulated to buy future goods and services. It is useful in the facilitation of exchange precisely because its market value varies little over time. It is the predictability of money’s market exchange rate that makes it money.
Investors that got into bitcoins as early as this year have garnered tremendous returns, unless they panicked and started selling off after the burst of a bubble in spring of this year. However, North makes the case that since it jumped from $2 to $1,000 bitcoins are not money – even since it hit $1,000, bitcoiners aren’t selling in the hopes of it hitting $2,000, which is considered the psychology of all Ponzi schemes.
Austrian theory: individuals purchase money because it has not fallen nor increased in price.
“Here is an economic fact: the number of fools is limited. They are a scarce economic resource. As the price of bitcoins rises, more fools will be lured into the market. But this is a finite market,” said North.
“In other words, bitcoins cannot possibly fulfill their supposed purpose: to serve as an unregulated currency unit. Bitcoins are not an alternative currency. They are something you buy in the midst of a mania, and you will sell at some point in order to get back your money. You are thinking of buying Bitcoins, not because Bitcoins will serve as a means of exchange, as originally argued, but because you want to get back lots more money than you paid for them. In other words, Bitcoins are not money; dollars are money. There has been no challenge from Bitcoins to the reign of the dollar.”
The mania in itself – Peter Schiff refers to the bitcoin bonanza as “tulipmania” – has already obliterated the concept that bitcoins could be used as money because now they are too unstable to carry out the purpose of a currency.
It is inevitable, writes North, that bitcoins will decrease in value. Of course, the early investors, which were mostly computer experts, got rich or will get rich if they sell early enough. Unfortunately, it’s the latecomers who are going to experience the most pain because they will have spent thousands of dollars to get their hands on bitcoins in the hopes it will shoot up to $2,000, $3,000 or $4,000.
“Any time you buy an investment, you had better have an exit strategy. There is no exit strategy for Bitcoins,” warned North.
“You must get out at the top, or you lose your shirt.”
North concludes that bitcoins are not illegal nor should they be, but “they should be merely avoided.”
Note: Oh, look: bitcoin just shot up to $1,050.