27 Jan 2018

What's wrong with Bitcoin?

Bitcoin has been in the news a lot recently and I was mostly ignoring it because I already have a perfectly good medium of exchange called Sterling and don't feel the need for another one. Plus I don't have capital to invest.

The main idea seems to be that we cut govt out of the loop. But why on earth would we cut govt out of the loop? Govt, in the UK, provide us with free education, healthcare, policing, roads, etc. It's the "What did the Romans ever do for us?" argument (remembering that in the Life of Brian the Romans represent Government per se). Neoliberals have portrayed tax as an intolerable burden from which people must be relieved. In fact, tax is the way we contribute to society and keep the country functioning. If you want to know what small government with low taxation looks like, then read Charles Dickens! He very accurately portrays the social conditions that prevail under the Libertarian ideal.

But the real problem with Bitcoin is a design "feature" - there is a finite supply. With fiat currency there is literally no limit to how much money can be created. Bitcoin is finite. Let's simplify it to make it easier to see.

I launch my new crypto current the J. There are 100 J in the world, and I hype the shit out of it on the internet as the next big thing. The potential for the J is limitless and no one will ever have to pay tax on it, because it's run on a server on a ship in international waters. (This is by the way a theme from an excellent novel called The Cryptonomicon)  I open the bidding on J at £1 and I buy the first 50 myself. I invest £50. Demand is high for the J so people are willing to pay more that £1. They end up paying an average of £2. My £50 investment just became £100. All the J is now owned, but people start to buy stuff with it or cash it in. So small numbers of J become available at a time.

Word is out that you can double your money by investing in J. So speculators get interested and they buy up all the available J at £4. They think "the price can only go up". My £50 is now worth £200. With this net worth I start to talk to venture capitalists about my next project. This steep rise in value attracts more speculators willing to pay too much. They all want to get in on this *easy money* and are willing to risk more and more. The price hits £10 per J. I convert my J into £500 cash, put it in the bank in the Cayman Island: 1000% profit in just a year or two. My J are bought up at even higher prices, but it reaches a peak of £20 per J.

At the peak, people don't think the J is worth £20 so they stop buying. The price levels out. The early investors also start to sell. The price drops. The last people in realise they are losing money now, and they sell to minimise their losses. The value of the J plummets overnight, back down to £1. Everyone loses their money, except me. And I have already started a new cryptocurrency called the K. And the K is the next big thing...

There are currently about 2000 different cryptocurrencies. And if crypto loses it's savour then it will be some other get rich quick and bypass taxes scheme. 

This kind of financial instrument is a variety of Ponzi scheme. It's named after Mr Ponzi who took investors money and used to to pay dividends to himself and early investors. As long as he could attract new investors at an exponential rate, he was able to pay out high returns to earlier investors. But exponential growth is impossible so it collapsed and most people except Mr Ponzi lost their investment.

Ponzi schemes are dishonest and illegal. One of the benefits of govt is that they protect their citizens from such schemes.

The worst scenario happens when people borrow money to invest - this is what happened in the Tulip Bulb Bubble in the 17th Century and in USA Stock-market in the 1920s. You borrow at 10% interest, but the investment is paying 20% while the bubble is inflating. So the investment pays the interest and you still make a profit, without risking your own capital. The deflating of the bubble is more catastrophic because as soon as growth falls below the interest on the loans, those speculators are bankrupt. These were the guys jumping out of windows on Wall St in 1929.

But of course the Bitcoin bubble didn't deflate all the way to zero. A lot of people still believe. So we don't know what will happen next. It is entirely possible that the bubble will inflate again and that when it bursts a whole new cohort will lose their investment.

This boom and bust cycle, which UK Finance Minister Gordon Brown once declared to be at an end, is built into Capitalism. A guy called Hyman Minsky called it the Financial Instability Hypothesis. The New Yorker magazine ran a long-read story on Minsky and the sub-prime mortgage scam in Feb 2008. Lehman Brothers declared bankruptcy in September of that year, sparking the Global Financial Crisis.

The moral of the story is that government regulations can be effective in preventing con artists from running Ponzi schemes and in regulating financial institutions to prevent the worst excesses of irrational exuberance amongst investors. By subverting this and setting up as a de facto Ponzi scheme, Bitcoin is likely to produce more instability and chaos. And it doesn't solve an existing problem. Well no legitimate problem. It's used to circumvent laws - making it the ideal way for criminal gangs and kleptocracies to launder money while avoiding the regulations that now apply to banks (not that this has stopped them using banks at times - if you have billions to launder, then banks seem only too happy to help).

No comments:

Post a Comment

Keep is seemly & on-topic. Thanks.