Economist Brian Easton says financial activity is too often gambling. Cryptocurrencies are the latest example

This is a re-post of an article originally published on pundit.co.nz. It is here with permission.

Gambling is a zero sum game: the proceeds of the winners are offset by the losses of the losers. That statement is not quite true because typically there is someone between taking a margin on each transaction. Patrons leave a casino with, on average, with less than they entered, the casino operator taking the difference to run the business.

Providing one understands that, no great harm is done. You go out for a night’s entertainment and whether it’s housie, the races or a casino, you go home with a little less (on average) but, hopefully, with good feelings.

Of course, whatever the entertainment, you should not spend more than you can afford. It is especially important that you don’t borrow (or steal) to finance your flutters. Some gamblers do not follow commonsense. The outcome can lead to personal and family tragedy and even the bankruptcy of a business if there is embezzlement.

This is all pretty obvious, unless you ignore that some financial investments are also zero sum or less. Less because somebody is taking a margin. It is in their interests to convince you that you can surely be a net winner, so there will be much mysticism to promote the scam.

The classic scam is the Ponzi scheme in which early investors are paid generously out of the deposits of later investors. The smart early investor takes the profits and runs but many unwisely reinvest their ‘winnings’ to lose them all when the scheme inevitably collapses.

Even so, in the interim they think of their reinvestment as a real asset, when it is there on the books. But it is not real, until it is turned into something more substantial. That is the trick; the investor/gambler believes the scribbles on a page or bits in hyperspace have a meaning other than symbols. But the meaning is only in the potential to turn the symbols into something tangible.

Thus it has been with cryptocurrencies. The promoters have to suggest that this time it will be different from the usual Ponzi scheme. The core of their gimmick has been the blockchain technology supplemented with terms like ‘coin’ and a mystical theory of gold. Whatever the uses of blockchains – there are some strengths – when it comes to the actual financial investment the blockchain is more like the roulette wheel than the actual gamble.

Sure, the price of your currency may rise – more zeros attached to the symbols – and you may believe you can convert it something more tangible. Perhaps you will be able to find a (usually anonymous) sucker with similar beliefs who will buy your symbols — exchange his cash for your symbols. But you may not, at which point they become near worthless.

Consider the recent collapse of FTX, a cryptocurrency exchange. While it owes about $US8b to depositors, its total assets have been valued below $2.5b. Depositors will be lucky to get 30 cents in the dollar.

On 8 November one investor/gambler had about $US85,000 of fiat currencies on the FTX exchange, plus three bitcoins worth about $55,000 and about $10k in other altcoins. Prompt action enabled him to withdraw $25,000 but the rest is gone. A few days later he described his position: ‘I have lost $60,000 and whatever my three bitcoins would be worth now.’ He went on ‘I and many others ... got caught up in a kind of intense euphoria last year, about the small guy’s chance of going from zero to hero, and this is now the morning after.’

Couple of things here. Observe that he thought that what he had was real money. It is like somebody who has a dunger in the garage they bought for $3000, who is told it is worth $30,000 and is distraught when they find they can only sell it for less than $3000, Second, he is upset by the collapse in the values but, surely, that should be no more surprising than the euphoria that occurred when they as arbitrarily rose.

One investor said ‘I don’t have this kind of money to lose’. Bloody hell! You don’t gamble money you cannot afford to lose.

I do not know whether the collapse of FTX, the second biggest crypto-exchange, will terminate the crypto-currency bubble. Ponzi schemes tend to collapse quite quickly but Dornbusch’s law reminds us that ‘crises take longer to arrive than you can imagine, but when they do come, they happen faster than you can possibly imagine’.

We’ve seen it before. Yes, the details will be different but the form will be the same. On the basis of such experiences, economists and financial advisers have warned it would happen, but many in their euphoria do not listen. (The assessment was buttressed by many advocates of cryptocurrencies having cranky theories about money.)

Once more it is happening in a poorly regulated market. The cryptocurrency industry has been resistant to regulation. As the disgraced previous chief executive of FTX twitted ‘Fuck regulators, they make everything worse.’ Which means those playing the casino don’t know what is going on.

What has been going on, is reported by John Ray III, who has just taken over as FTX’s chief executive. ‘Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. ... From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.’

Twenty years earlier Ray had overseen the collapsed energy company Enron after its fraud was revealed. Its corporate controls were sloppy enough. The already reported FTX lapses far exceed theirs. Remember, gambling is a negative sum game, because those in charge have been taking their margins. They include poorly documented property purchases for employees. Probably we shall never know it all; the digital assets were controlled through an unsecured group email account.

Drawing a line between gambling and investing makes regulation difficult. An earlier column pointed out that earthquake insurance has an element of gambling in it as property owners pay insurance companies to shift the risks from them. The share market also has elements of gambling but it is not zero sum if the proceeds are invested for a productive return.

The problem for public policy is to ensure necessary gambling is not overwhelmed by gambling destructive to serious investment. As Keynes said 85 years ago ‘when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.’

PS. You may, when investing in a fund, want its investments to be ethical. It might also be wise to check that it is not investing in cryptocurrencies.

*Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.