Bitcoin’s place in the long history of pyramid schemes
General Gregor MacGregor returned to Britain in 1821 an exotic war hero, dubbed a Cazique, or prince, of Poyais by the Latin American kingdom’s royal family. His stories of the democratic and fertile land prompted investors to snap up land certificates and £200,000 in Poyaisian sovereign bonds.
Unfortunately, Poyais did not exist. MacGregor had fashioned a tale to fit the obsessions of the age, democracy and settlement, along with a vogue for exotic investments such as Latin American bonds. Acquitted in an early example of failure to prosecute complex fraud, he then ran into competition from lesser scam artists imitating his hoax.
The latest incarnation of MacGregor, in a tradition that runs from Dutch tulip bulbs through the stamp scheme of Charles Ponzi, is MMM, a “social financial network” run by Sergey Mavrodi, a convicted fraudster and former Russian parliamentarian, powered by YouTube and the cryptocurrency bitcoin.
New members must purchase bitcoins to join MMM, and then receive a bonus for online testimonials describing their improbable profits. The fad helped to power an explosion in the bitcoin exchange rate, from less than $200 in September to more than $500 per bitcoin last week.
Yet the question prompted by the recent movement in bitcoin is whether it marks a resurgence for the cryptocurrency, or merely highlights its turn in the endless parade of get rich quick schemes, which prompted Walter Bagehot, founder of the Economist, to write “one thing is certain, that at a particular time a great deal of stupid people have a great deal of stupid money”.
The cryptocurrency was invented by an anonymous mathematician in 2008, and championed in the years that followed for its technology. At a time when many were unsettled by the actions of central banks after the financial crisis, bitcoin offered an alternative way to manage a currency, through mathematical rules rather than a metaphorical printing press.
It also fit the vogue for technological innovation. Bitcoins are created by computers solving mathematical problems, with the total number that can be calculated into existence over time limited. An open ledger allows the community to track the distribution of coins. At a time when small start-ups were earning multibillion-dollar valuations for their power to disrupt industries, anyone with a good idea and a neat bit of software could make a fortune.
As bitcoin attracted more attention, its price rose, attracting more money and attention. Early adopters got rich quick, or bemoaned how they would have done had their bitcoin hoard not gone in the bin aboard a discarded hard drive.
Bitcoins could be used to buy goods and services in the real world, although not usually without a third party intermediating. The attention and limited supply meant that by December 2013 bitcoins traded for more than $1,200 each.
However, in 2014 the cryptocurrency lost three quarters of its value after running into an old world problem, the failure of an overextended broker. Mt Gox, a prominent bitcoin exchange, collapsed.
Then the seizure of the Silk Road, a popular website for trading bitcoins for drugs and other frowned on goods and services, prompted a crash in the price to almost $100.
Such big swings in price undermine the case for bitcoin’s use as a currency. “It’s value is so volatile it’s not likely to serve as a medium of exchange”, says Eugene Fama, the Nobel Prize winning economist.
He pointed to examples such as Zimbabwe. “When a currency has a variable value, the people just switch to a different currency, or to barter.”
Bitcoin also lacks another feature of currencies: the balance sheet of a central bank standing behind it. They might be intangible, but a balance sheet has two sides to it, lists of assets and liabilities.
The bitcoin ledger, by comparison, is just a glorified list of liabilities, keeping track of where the bitcoins are located.
Furthermore, while the number of bitcoins is limited, the number of times the cryptocurrency can be replicated is not. There are a host of imitators, including Doge coin, started as a joke in 2013 at the height of alt-coin fever. Before Mr Mavrodi switched to bitcoins, MMM was operating with Mavros as the unit of exchange.
The inherent flaw of pyramid schemes is that they must always suck in new converts to avoid collapse, and the exponential growth in users is impossible to sustain. Bitcoin shares some of these features. It requires constant evangelism because its value derives from its use.
The limited supply of bitcoins then becomes a fatal constraint. The more people use it, the greater the price must rise, dissuading its use as a currency.
Bobby Lee, head of BTCC, the largest bitcoin exchange in China, argues its use for everyday transactions makes it a currency, and is frank about its price, saying: “The reason bitcoin has value today is scarcity, that is all.”
He also agrees bitcoin has the character of a pyramid scheme, but compares it with bubbles in housing markets, which might also appear pyramidical.
He adds: “It all comes down to what we think of a pyramid scheme. Is that a good thing, or a bad thing?”
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