Bitcoin Crash February 2014 – Calling the Ponzi-Word

BitcoinsBitcoin Crash February 2014: NY Post author Jonathon M Trugman describes Bitcoin of being a 21st century Ponzi Scheme in this article. Despite all my reservations about the new crypto currency, I do not agree with this statement. First and foremost and Ponzi or Pyramid scheme involves a distinct element of fraud, there is no evidence of that to be seen anywhere. According to Trugman's definition, every non-income generating asset in a bull market can be a Ponzi scheme. A number of underlyings could fit such a definition when prices are going up:

  • Art
  • Wine
  • Antiques
  • Watches
  • Oldtimer Cars
  • Baseball cards
  • Non-dividend paying stocks etc.

The big difference is that the above items have a use besides being speculative objects. However, this does not tip the scale from bubble to Ponzi Scheme. Probably Mr Trugman wanted to add some drama by dropping the Ponzi word.

What we are seeing is more likely the repeated growing and bursting of bubbles. The article mentions Pump and Pump, which is possible, but hard to prove.  described Bitcoin as a speculative bubble back in December in his blog. The article shows how there are few transactions and a significant amount of hoarding. For now, it looks as if he was right about the bubble. Nevertheless, it would not be surprising if we continue to see very high volatility in the coming months. Also, the current level of around 600 (on 17Feb14) is still more than 3x higher than in late October 2013. If this is really a crash, then we may not have seen the end of it.

Bitcoin has had some very wild value swings before, in April 2013 the closing price fell from over USD214.86 on the 09Apr13 to below USD75.9 (source: Bitcoin Charts). On 10Apr13 it rebounded to 101.52, but nevertheless this is almost a 65% fall in value over a three day period.


On the graph above the latest turmoil looks even worse, but when looking at a logarithmic scale below, this is no longer the case (source of both graphs: Bitcoin Charts).


So Bitcoin has shown some resilience to shocks before. As long as people put a value on it, it will continue to be traded, even after the next shock. Unlike most Ponzi schemes, which have to balance a delicate system of cash flows and an untrue cover story, there is no such thing in the case of Bitcoin.

Despite all this, I have never been a big fan Bitcoin, in fact, I think it contains some flaws that a lot of the fans deliberately choose to ignore. This post will try to investigate them a bit further.

On the website there is the following definition:

Bitcoin uses peer-to-peer technology to operate with no central authority or banks; managing transactions and the issuing of bitcoins is carried out collectively by the network. Bitcoin is open-source; its design is public, nobody owns or controls Bitcoin and everyone can take part. [...]

The message certainly looks appealing at first glance. It sounds empowering, it promotes open source and there is no central bank or government that will inflate away your hard earned savings. However, is this enough to create a viable currency?
Before digging deeper, it makes sense to define some desirable features of a functioning currency for its users:
  1. An efficient means to pay for goods and services.
  2. A reliable measure of the value of goods and services.
  3. A store of value.

Earning interest may be another, but secondary feature. Depending on the mandate of a central bank the store of value goal may be sacrificed for the greater good, but the other 2 points are well met by any G10 currency. In the current state of affairs Bitcoin barely passes #1, although that may change. Given it's massive price volatility it fails on #2 and #3. Some people have made a lot of money with Bitcoin, but their success depends a lot on market timing.

So if Bitcoin looks less like a standard currency, then what does it look like? In many ways, Bitcoin resembles gold and maybe silver. They also have set of properties that are part currency and part commodity. Understanding those may help understanding Bitcoin a bit better.

  • They are non-perishable
  • Their supply is finite and growing.
  • The value of gold is predominantly driven by investment flows. There is industrial use as well, but the effect on the price tends to be minor.
  • In physical form they are bearer instruments and can be traded without audit trail.
  • In physical form it is the owner's responsibility to protect against theft.
  • Leaving the industrial uses aside, gold does not have a lot of inherent value. It is mainly valuable because people consider it so.

Gold and silver obviously have a phenomenally long track record as means of payment, stores of value and safe havens. They are surely here to stay, however, at which price is not obvious. Bitcoin is still in much earlier stages and it remains to be seen how it copes. One potential weakness is, that the complete lack of alternative use could become a problem. If there is ever a crisis of trust, there is no fallback activity which keeps Bitcoin in circulation. In currencies, ideally, the powers and actions of the government and the central bank help to mitigate such crises.

To further analyse the viability of Bitcoin it is useful to distinguish two cases. It remains a niche currency that facilitates international payments and promotes privacy among other things. Alternatively it becomes a widely used substitute for the currencies we use now, a bit like using actual gold coins.

If it remains a niche product, the massive price volatility has to come down for it to be a useful means of payment. Also, the technology has to become user friendly and secure enough, so that people with average computer literacy can easily handle transactions and do not need to worry about theft of their savings. At least the user friendliness aspect will likely be solved at some point. As long as there is the perception of rampant use of Bitcoin for illegal drugs and arms trade there is also the threat of government intervention. If exchanges are targeted by legal action and the possession is deemed illegal, then this will threaten a meaningful niche existence, even if government cannot directly attack Bitcoin.  

If, on the other hand, it becomes a widely used currency, then additionally to the above points, a whole new set of issues arises. It would also have some issues of the gold standard.

Pawel Morski describes some of those issues in his blog:

I have nothing to say about the Gold Standard other than it’s the obvious solution for those who feel the main problems with the euro are that it’s too flexible and covers too few countries.

This highlights the problem of having a global currency in different countries with different growth rates of the economy and of credit.
By far the biggest issue in my view is the limited supply of Bitcoin. The protocol is designed such that there will never be more than 21 million Bitcoins. To be fair, according to this Investopedia article, this limit will only be reached in 2140. In a world where Bitcoin has been widely adopted, the 21 million limit is reached and the economy keeps growing at a positive rate, there is bound to be deflation. Because there is no way to do monetary policy, this may lead to unfavourable outcomes.
Inflation and especially Hyperinflation can create a strong emotional response in people. Even in an environment of mild inflation we remember how much cheaper things used to be. Also, the thought of losing most of one's savings in a short term through hyperinflation is deeply worrying. The point is though that deflation can have similarly dire consequences. In this WSJ interview, John Normand from the investment bank J.P.Morgan describes the trade off between inflation and deflation:

With fixed supply, bitcoin’s deflationary bias should also be clear. That quality serves owners well when exchanging into foreign currency, but it would be onerous for any economy operating with it as legal tender. Indeed Weimar Germany was unpleasant, but so was the Great Depression.

Bitcoin is a very interesting experiment, both social and also monetary, the Bitcoin Crash February 2014 does not change that. Bitcoin and other crypto currencies will likely provide a ton of study material for monetary theory and may well help getting to a better understanding of money and improve monetary policy by a great bit. However, I am not so sure whether it is the future of currencies some make it out to be.

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2 thoughts on “Bitcoin Crash February 2014 – Calling the Ponzi-Word

  1. Ferdinand Tjombe

    Thanks for posting this interesting article. I find that the pros and cons of bitcoins as a future currency are neatly analysed for even a layman to uderstand. I will adopt a wait and see attitude before I trade in this currency.

    1. Carl Savant

      Post author

      Thanks for the comment. At this stage, I would consider Bitcoin highly speculative. Even people who believe in its success need to have a long time horizon, if they want to make money. If you are uncertain about the eventual success, then buying Bitcoins becomes outright gambling.


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