Are Cryptocurrencies a Scam? | Psychology Today

When the history of cryptocurrencies is written, either they will be lauded as a key technological advance in finance, or they will go down as just another investment scam.

Economist Paul Krugman had no trouble saying that Bitcoin and its ilk are Ponzi schemes. A Ponzi scheme follows the “greater fool” theory of investing. Even though the investment may not be really worth what it is selling for currently, one invests because someone else is going to pay even more for it tomorrow.

The psychology of investment manias

All investment manias have common features. Even the brightest people can succumb to the lure of quick gains with minimal effort. This was apparent in the Madoff Ponzi scheme that mostly targeted wealthy elite investors.

Like the cryptocurrencies of today, buyers had little knowledge of the true value of the investment and were guided mainly by the fact that the market price was rising.

That sort of irrationality leads to some bizarre equivalences. At the height of the tulip mania in Holland from 1636 to 1637, a rare type of bulb was used to purchase a home. In the dot-com boom of 1999, companies with revenues smaller than a corner store had market valuations of billions of dollars.

Such improbable valuations reflect the intense euphoria that inflates all investment bubbles.

Pie in the sky

Investment manias are called that for a reason. They resemble the mindset of a person who is experiencing the manic phase of bipolar disorder.

Investment optimism has two key features. The first is the certainty of success. The favored investment can only go up. The second is an unrealistic expectation about how valuable the favored investment can become.

When Bitcoin was trading at $20,000, boosters were claiming that it could easily exceed $200,000 and that this lofty goal could be reached within a year. Why might something of questionable value suddenly be worth ten times as much?

All investment scams offer unrealistic profits or other improbable features. The Madoff scheme guaranteed returns of 15 percent with no risk. If something looks too good to be true, it probably is not true.

The Madoff swindle was a Ponzi scheme where the money of new investors (or victims) was used to pay off 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 raises the issue of whether cryptocurrencies actually store inherent value or become valuable purely due to an investment frenzy after the manner of tulip bulbs.

Do cryptocurrencies have inherent value?

There are at least two reasons that Bitcoin and other cryptocurrencies have intrinsic value.

The first is the electricity cost of mining it using Blockchain technology. (The term “mining” offers an analogy with precious metals, such as gold and platinum, that are valuable because they are scarce, hard to find, and expensive to produce.) Second is the fact that cryptocurrency functions when government-backed currencies fail, as is happening in Russia and Ukraine with the Russian invasion.

The electricity required to mine a single Bitcoin varies from place to place. If we assume that the electricity cost is around $10,000, then this gives a floor value of $10,000 because a bitcoin cannot be produced for less. If the price falls below this threshold, most Bitcoin miners will go out of business, just as gold miners stop digging whenever the value of gold falls below the cost of extracting it.

So, Bitcoin is not like an intrinsically worthless tulip bulb. However, if investors get caught up in a speculative mania that drives prices skywards, the market value may diverge widely from any estimate of intrinsic value.

Bitcoin and other cryptocurrencies may belong with the dot-com boom and much earlier manias, such as the South Sea bubble and tulip mania.

Blockchain is an important new technology that opens the path to decentralized finance and offers a novel method for establishing reliable and permanent records of transactions. This means that artists can sell their work as NFTs that also rely on Blockchain technology and cryptocurrency.

Conclusion

Bitcoin is not a currency and not a reliable store of value, but it is not entirely worthless. The price increases of cryptocurrencies, and their periodic price crashes, are a little different from other investment manias. They are not pure Ponzi schemes but constitute an investment mania nevertheless.

The fatal flaw in cryptocurrencies is that they are a colossal waste of electricity in a critical era of climate change, and investors are just waking up to this reality. Indeed, a single bitcoin transaction is estimated to have the carbon footprint of a person taking a trans-Atlantic flight.