Many people have asked me to respond to Gary North’s article on Bitcoin but I’m pretty much over giving detailed responses to people who haven’t done basic homework on the topic. Still, I was thrilled to receive this nice point-by-point rebuttal, which I publish here:Ponzi Logic: Debunking Gary North’s “Bitcoins: The Second Biggest Ponzi Scheme in History”
by John Mather
Gary North is no stranger to predictions. Perhaps his most famous one is his widely publicized prediction that Y2K would end civilization as we know it. In his Bitcoin article, North makes another technology related prediction: after Social Security, Bitcoin will go down as the biggest Ponzi scheme in history. North’s article is riddled with false premises and faulty logic demonstrating that he does not understand Bitcoin.
North is widely recognized as an expert on Austrian economics, and I make no claim to the contrary. North purports to base his critique of Bitcoin on Austrian economic theory. However, his arguments are so weak that he makes Austrian economics look bad, to the point that someone unfamiliar with Austrian theory could finish his article doubting the validity of Austrian theory. One reader who linked North’s article on a message board even commented that the article made him want to stop referring to himself as Austrian.
This article attempts to rectify this unfortunate situation by calling out the faults in North’s arguments and showing how his arguments diverge from Austrian economics.Is Bitcoin a Ponzi Scheme?
Given that the market of freely choosing individuals has placed a value on Bitcoin, the burden of proof is on North to show that Bitcoin is a Ponzi scheme. However, the Ponzi scheme Wikipedia entry shows that the very definition of a Ponzi scheme does not apply to Bitcoin.
There are several key differences between a Ponzi scheme and Bitcoin. First, Ponzi scheme vehicles are inherently fraudulent. When running a Ponzi scheme, the promoters lie to participants and conceal key information about the where their funds go. Bernie Madoff, who claimed his firm’s consistently high returns were based on investments which he in fact never made, is a prime example. The issuance by Allen Stanford of phony certificates of deposit to unwitting customers is another example. In contrast, Bitcoin is not based on fraud or deception. Bitcoin is an open book, literally. The open source model Bitcoin employs means that it cannot claim to be one thing while in fact being another. Anyone is free to inspect the Bitcoin code base to determine for himself what it is or is not. This difference alone starkly distinguishes Bitcoin from a Ponzi scheme.
The second key difference between Bitcoin and a Ponzi scheme is revealed in Wikipedia’s differentiation of a Ponzi scheme from a pyramid scheme. A Ponzi scheme requires an operator. “In a Ponzi scheme, the schemer acts as a ‘hub’ for the victims, interacting with all of them directly.” Bitcoin is not run by anyone. It is a decentralized system – in Hayekian terms, a spontaneous order. Anyone can mine, buy, or sell bitcoins. And unlike Charles Ponzi, Bitcoin has no promoter acting as a hub. The creator(s) of Bitcoin are anonymous. (Note: Bitcoin is capitalized when referring to the software and network as a whole, and uncapitalized when referring to individual currency units.)
The third difference is this: “A Ponzi scheme claims to rely on some esoteric investment approach and often attracts well-to-do investors….” Bitcoin is the opposite of esoteric. It is open source, and all are free to use it at their own chosen level of participation. Computer programmers can read and even modify the source code. Crytographers can study, and even try to crack, the mathematics of the system. And everyone, techie and non-techie alike, can buy and sell BTC (the abbreviation for bitcoins) without understanding Bitcoin’s inner workings.
There is a single trait that Bitcoin can be said to have in common with highly successful Ponzi schemes: a dramatic appreciation in price. But if that trait is all that’s required to make something a Ponzi scheme, then countless stocks which have soared from a penny per share at corporate founding to hundreds of dollars per share would be considered Ponzi schemes.North’s Ponzi Logic
Now that the fundamental premise of North’s article has been dispatched, let us address several statements North makes which contain faulty logic or false assumptions.
1) North says Bitcoin is made “out of nothing.” This is a specious argument. The fact is that the Bitcoin currency and payment network is comprised of computer code. Is the web browser you’re using to read this article made out of nothing? That Bitcoin is not a physical good doesn’t mean it is made out of nothing. Billions of people, including North, assign economic value to all sorts of things which have no physical form. The most obvious example aside from the computer code of companies like Google or Apple is the vast supply of US dollars, the majority of which exist only in digital form.
2) North writes, “Something that was valuable for its own sake, most likely gold or silver….” Nothing is valuable for its own sake. All value is assigned. This is Subjective Theory of Value 101. North doubtless knows this, but it appears he’s attempting to imply gold and silver possess some sort of intrinsic value. It may feel good to believe (especially if you own gold and silver), but it’s just not true. Gold and silver have many uses, for example in electronics or silver in water filtration. But most of the value of gold in particular is due to its marketability, meaning, the acceptability of gold by other market participants. This acceptability is a mutually reinforcing process by which people are more willing to accept gold because others are more willing to accept it. The existence of a mutually reinforcing cycle of demand is known as a network effect. Some examples of other network effect markets are cell phones, fax machines, web browsers and web servers, cars/roads/gas stations, and fiat money.
The difference between network effect goods and direct use goods is that, for example, the enjoyment of a steak dinner does not depend on its acceptability or adoption by others. A direct use good directly meets an individual’s needs, while a network effect good derives a significant part of its value from the network. Most goods we use today have some combination of both.
It should be clear from the arguments made above that network effects alone are not sufficient to identify a good as part of a Ponzi scheme. Most network effect goods are not based on fraud, and most of them do not have a central operator who extracts profit out of the system. Successful network effect goods achieve their success by market adoption based on consumer choice.
Anyone who wishes to show that a good is a Ponzi scheme must demonstrate how it differs from a market network effect good. As the Austrian economist Karl Menger argued, money itself replaced non-money as a market network effect good. Gold and silver emerged due to a combination of traits which are desirable to have in a money commodity, namely scarcity, portability, uniformity, divisibility, and durability. Other commodities which have historically served as money, such as salt or cigarettes in prisons, only possess a subset of these traits.
Network effects can come and go. An example is the adoption of fashion. A particular look can go in and out of style either very quickly or over a much longer time frame. During the time that a fashion is popular, many clothing and shoe retailers can increasingly profit by serving consumer tastes. When that look goes out of style, garment producers must shift to producing something else or go out of business. Is fashion a Ponzi scheme, or simply a market following shifting consumer tastes? Almost nothing is permanent in the market. Any time a once-popular good falls out of favor, does that mean it was a fraud?
3) North writes, “But Bitcoins are unique. The money was siphoned off from the beginning.” By calling it money, North is contradicting himself. And unique? With every fiat currency, the state siphons off a portion of the money it prints. It’s standard operating procedure.
With market money, early adopters have always profited from their foresight. The creator(s) of Bitcoin may be sitting on lots of them; I don’t know. But there’s nothing unique about that. Early adopters also take on a lot of risk. The founder of every multi-billion dollar company had mountains of stock at the company’s inception. That doesn’t mean money was siphoned off. What is unique about Bitcoin compared to all fiat currencies is that there is a hard limit on how many currency units can be created/mined. Fiat money can be replicated instantly without limit on central bank computers.
4) North observes, “Money develops out of market exchanges.” Yes, and that’s what is happening with Bitcoin. People began using it from the beginning knowing it was not money by the Austrian definition as the most widely demanded commodity. Yet they kept using it for market exchanges. They could do so because Bitcoin is also a payment system which allows secure peer-to-peer transactions with no third party fees. That feature in and of itself has great utility. If Bitcoin becomes money by the Austrian definition, it will be because it developed out of countless market exchanges.
5) When North proclaims, “Bitcoins cannot serve the consumer. There is nothing to consume,” he makes an absurd statement. As if a customer cannot be served without consumption! When was the last time North consumed a gold coin? Never, because gold is not consumed. Even if it’s made into jewelry, it can be refashioned into coins or any other form. A commodity doesn’t need to be consumable in order for it to be a useful currency. While it’s true that market forms of money in the pre-digital age originated from consumption goods, billions of people today have only known money in their lives as completely unbacked fiat.
6) North continues with more nonsensical statements: “But the fundamental characteristic of money is its relatively stable purchasing power.” Stable purchasing power is desirable in a money, but it is most certainly not the fundamental characteristic of money. Rather, the fundamental characteristic of money is that it is the most widely demanded commodity in a given economy.
North keeps pointing to the US dollar as money, yet even the US government’s inflation calculator (which statistically “adjusts” the real figures lower) shows that since 1988, the US dollar has lost half its purchasing power. In my grandmother’s lifetime, the US dollar has lost over 96% of its purchasing power. Several goods over those periods have had more stability in their exchange power for other goods than the US dollar. If stable purchasing power were the fundamental characteristic of money, then the US dollar would no longer be money.
North frequently in his writings points to gold and silver as the most desirable money commodities. Yet the price of gold went from $35 to $1,910/oz. Perhaps upside volatility is acceptable to North, with the exception of Bitcoin of course.
7) North goes on to set up a straw man argument, framing Bitcoin not as an open source international currency and payment system, but rather as a mania-driven, pump-and-dump investment. He writes, “Whenever somebody tries to sell you an investment that is based on the economic analysis of a market – an analysis that cannot possibly be true – do not buy the investment. “ Now that his monetary theory arguments regarding Bitcoin have failed, he points to the rapid price increase in Bitcoin as evidence that Bitcoin itself must therefore be fraudulent. Perhaps Bitcoin is in a bubble and the price will crash. Maybe it will be overtaken by another crypto-currency some day. Perhaps the rapid price increase is pointing at an acute worldwide demand for a secure, borderless, person-to-person, expense-free form of payment. The fact is nobody knows why the price of Bitcoin is what it is right now, or what it will be in the future. For North to claim he does, and importantly, for him to use Austrian economics as the basis for his claim, is unfounded and misleading.
As noted above, most of the valuation of money comes from its marketability, which is what makes it money, so there is a circular and network effect component inherent in money. When a good is adopted as money, its value goes up because it is adopted as money. And unlike yielding assets, there is no way to say that it is over-valued because you can’t calculate a yield. You don’t have to believe that Bitcoin is a good investment in order to use it for exchange. Many people use US dollars every day knowing that their purchasing power will very likely continue to dwindle.
8) A final piece of Northian Ponzi logic masquerading as sound argument: “The mania has destroyed Bitcoins’ use as money. Bitcoins are too volatile in price ever to serve as a currency. Which is money: dollars or Bitcoins? The answer is obvious: dollars.” So to follow his line of thinking, US dollars are money. Agreed. Yet every single fiat currency throughout history that has hyperinflated into oblivion was money by North’s standard before its hyperinflation. Going from money-status to worthlessness is the most extreme case of volatility – terminal volatility so to speak. Bitcoin has not done that – quite the opposite – making North’s argument contradictory. Once the US dollar has lost 99% of its purchasing power (rather than the 96+% my grandmother has suffered), will it still be money? Further, if one defines a currency as a medium of exchange, we see that Bitcoin is used many thousands of times per day in exchange for thousands of different products and services. So in that regard it already has been and continues to “serve as a currency.”
It is true that if the exchange rate of Bitcoin continues to be highly volatile indefinitely, bitcoins will be ill-suited as a currency over the long term. But Bitcoin is still in its infancy. During the adoption phase of any good as money, the purchasing power rapidly increases from its initial value as a non-monetary good as more and more people adopt it. If we are in the adoption phase of Bitcoin as money, it would be normal for its purchasing power to rapidly increase.
It is also true that in bubbles, the purchasing power of an asset rapidly increases, so increasing price alone does not tell us whether we are in the adoption phase or a bubble. Bubbles can be characterized by yielding assets, such as equities, stocks, bonds, and real estate, selling at very low yields and high valuations. But money inherently has no yield; the investment of money has a yield. Only time will tell if Bitcoin is currently in a bubble or undergoing adoption as money. If it were to, say, triple from here and then stabilize, clearly this period would not be viewed in retrospect as a bubble.Bitcoin vs Gold & Silver
Now that it’s obvious Bitcoin is not a Ponzi scheme, we can shift our focus to seeing that Bitcoin stacks up well against gold and silver as a network effect good. We return to the desirable traits of a money commodity: relative scarcity, portability, uniformity, divisibility, and durability.
Scarcity: Gold and silver are scarce. They have become increasingly difficult to find and extract. There are trace amounts of gold in all of the earth’s crust and in sea water, but there is no extant technology that can cost-effectively extract it. It may surprise some that aluminum used to be more highly valued than gold, but technological innovations in the 19th century made aluminum extraction more economic. Bitcoin is inherently scarce by virtue of the underlying cryptographic math which sets a hard limit of 21 million bitcoins. As the total already-mined supply increases toward the limit, additional bitcoins can only be mined with ever-increasing difficulty. In this respect, Bitcoin is different than gold and silver which, while difficult to produce, do not have a known cap on their production. There is no guarantee, for example, that large undiscovered deposits of the metals could not exist.
Portability: Compared to some other highly valued commodities, gold and silver are quite portable, but when viewed as a money commodity, they are very heavy to transport in any sizable sum. That makes them extremely inconvenient as currency, which is why commodity-backed paper money came into use. Bitcoin wins hands down of course, as the only weight a person must bear is to carry the device the bitcoins are stored on, such as a mobile phone. And, unlike metals, bitcoins can be transported over any computer network.
Uniformity: Bitcoin is superior to gold and silver because both metals are easily adulterated. One of the ways gold and silver coins were inflated in the past is by debasing them with more common metals. The Roman denarius initially was almost pure silver, but subsequent regimes continually debased the denarius until it only contained 2% silver. A metallurgist can for a fee tell you with a high degree of confidence if a coin or bar contains the purported concentration of gold or silver. A layperson cannot. In comparison bitcoins are completely uniform, and there is no mechanism by which they can be adulterated in the way precious metals can.
Divisibility: Gold and silver are both highly divisible, but only with specialized skills and equipment. You can’t readily lop off 1/3rd of a gold coin to pay for an airline ticket, or buy supper for 1.65 silver coins. Bitcoin wins again, hands down, as it is instantly and exactly divisible down to 0.00000001 of a bitcoin (called a “satoshi”).
Durability: It would seem at first glance that gold and silver would win hands down, but I submit that Bitcoin actually wins. It’s easy to dent and scratch gold, yet to its credit gold is practically indestructable. But if a gold coin gets badly banged up or bent, a vendor would likely hesitate to accept it. Sure an expert can assay the metal content of the damaged coin for a fee, so it is durable in that sense. But Bitcoin has a different, and arguably more practical, sort of durability. Namely, you can make any number of perfect backups of your bitcoins. While a USB thumb drive containing one’s Bitcoin wallet is susceptible to breakage, that wallet can be stored on any number of other digital storage devices. This provides for a kind of durability that gold and silver cannot offer. You can have your bitcoins with you on a mobile device, on a thumb drive in a secure spot at home, even perhaps stored in another state or country in case of local disaster.
Another trait provided by Bitcoin not typically addressed in traditional monetary theory is security. Bitcoin wallets are encrypted. If your storage device is stolen, as long as you have a backup of your wallet, you still have your bitcoins to spend. The same cannot be said of gold or silver. They are, unfortunately, easily stolen or confiscated. And if you’re not where your gold and silver are stored when you need them, you’re out of luck. To be fair, it’s worth mentioning that bitcoins are not categorically immune to digital theft, so depending on the situation, your money is always at some kind of risk.
I have focused on gold and silver because of their historical importance as money, because North focuses on them in his writings, and because the Austrian school has a lot to say about them. If I had to choose a commodity money, it certainly would be gold and silver for the reasons outlined above. My purpose was not to suggest that they are unsuitable as money, but rather to show that Bitcoin shares, and in some cases exceeds, the traits which make gold and silver good forms of money.
The big weakness with Bitcoin is also its strength: it requires electric power and a computer network in order to function. In a catastrophe such as a natural disaster, bitcoins would be of no use. This is an important consideration, and in an all-out crisis where power grids shut down indefinitely, paper money will likely rapidly become unusable as well. Having gold and silver on hand would clearly be the desirable choice in this scenario, but food, alcohol, medical supplies, and means of self-defense would probably be of equal or greater priority. In other words, in a dire catastrophic situation, barter is likely to take over, and since very few people have gold and silver coins on hand, they will not serve as money.Conclusion
If Bitcoin can never be money for the reasons North argues, how is it that the US dollar has been money for so long while violating North’s own self-imposed standards? Legal tender laws aren’t a valid answer because legal tender laws have not stopped other fiat currencies from becoming worthless.
The more people who transact with Bitcoin without any coercion or legal compulsion, the more it functions as a free market money. Because Bitcoin is not tied to any political region, it does not need to surpass the usage frequency of the US dollar to be considered money. This, too, is another straw man argument North foists on the reader. It is also a false dilemma. You can exchange Bitcoin for countless other fiat currencies. Perhaps North doesn’t consider the currencies of dozens of small countries to be money. When a greater number of international transactions happen per day in Bitcoin than, say, in Bolivian bolivianos or Bahraini dirhams or Bermudian dollars or Bhutanese ngultrums, will North continue to deny that Bitcoin is a legitimate currency, yet defend the monetary status of those?
North was spectacularly wrong about his technological prediction that Y2K would be the downfall of civilization. Nobody knows if his prediction that Bitcoin is destined for worthlessness will come to pass. But if it does, the cause of Bitcoin’s downfall won’t be because of the empty arguments North has made against it.