When the history of cryptocurrencies is written, they will either be hailed as a key technological advancement in finance or they will be seen as a mere investment scam.
Economist Paul Krugmann had no trouble saying Bitcoin and the like are Ponzi schemes. A Ponzi scheme follows the “biggest fool” theory of investing. Even if the investment isn’t really worth what it’s selling for now, you’re investing because someone else is going to pay even more for it tomorrow.
The psychology of investment fads
All investment fads have common characteristics. Even the brightest people can succumb to the lure of quick wins with minimal effort. This was evident in the Madoff Ponzi scheme which primarily targeted wealthy elite investors.
Like today’s cryptocurrencies, buyers had little knowledge of the true value of the investment and were mostly guided by the fact that the market price was rising.
This kind of irrationality leads to bizarre equivalences. During the height of the tulip craze in Holland from 1636 to 1637, a rare type of bulb was used to buy a house. During the dot-com boom of 1999, companies with less revenue than a convenience store had market valuations in the billions of dollars.
These unlikely valuations reflect the intense euphoria that inflates all investment bubbles.
pie in the sky
Investment fads are called that for a reason. They resemble the state of mind of a person experiencing the manic phase of bipolar disorder.
Investment optimism has two main characteristics. The first is the certainty of success. The privileged investment can only go up. The second is an unrealistic expectation of what value the preferred investment can become.
When Bitcoin was trading at $20,000, boosters claimed that it could easily top $200,000 and that lofty goal could be achieved within a year. Why could something of dubious value suddenly be worth ten times as much?
All investment scams offer unrealistic profits or other unlikely characteristics. The Madoff plan guaranteed 15% risk-free returns. If something sounds too good to be true, it probably isn’t.
The Madoff scam was a Ponzi scheme where money from new investors (or victims) was used to pay anyone who wanted to withdraw their funds to maintain the sham. Their accounts became worthless when the Ponzi scheme collapsed after withdrawal requests exceeded incoming funds.
This begs the question of whether cryptocurrencies actually store inherent value or only become valuable due to a tulip bulb-style investment frenzy.
Do cryptocurrencies have intrinsic value?
There are at least two reasons why Bitcoin and other cryptocurrencies have intrinsic value.
The first is the cost of electricity to mine it using Blockchain technology. (The term “mining” offers an analogy to precious metals, such as gold and platinum, which are valuable because they are rare, hard to find, and expensive to produce.) Second, the fact that cryptocurrency works when government-backed currencies fail, as is happening in Russia and Ukraine with the Russian invasion.
The electricity needed to mine a single bitcoin varies from place to place. If we assume that the cost of electricity is around $10,000, this gives a floor value of $10,000 because one bitcoin cannot be produced for less. If the price falls below this threshold, most Bitcoin miners will stop trading, just like gold miners stop digging whenever the value of gold falls below the cost of mining it.
Thus, Bitcoin is not like an inherently worthless tulip bulb. However, if investors are caught up in a speculative frenzy that sends prices skyrocketing, market value can deviate widely from any estimate of intrinsic value.
Bitcoin and other cryptocurrencies may belong to the dot-com boom and much older fads, such as the South Seas Bubble and the Tulip.
Blockchain is an important new technology that paves the way for decentralized finance and offers a new method for establishing reliable and permanent records of transactions. This means that artists can sell their work as NFTs which also rely on Blockchain technology and cryptocurrency.
Bitcoin is not a currency or a reliable store of value, but it is not entirely worthless. Cryptocurrency price increases and their periodic price drops are a bit different from other investment manias. These are not pure Ponzi schemes but nevertheless constitute investment madness.
The fatal flaw of cryptocurrencies is that they are a colossal waste of electricity in a critical time of climate change, and investors are only now waking up to this reality. Indeed, it is estimated that a single bitcoin transaction has the carbon footprint of a person taking a transatlantic flight.