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"I, Broken Pencil": An Economic Analysis of Bitcoins

Gary North - December 06, 2013
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Reality Check

In 1958, Leonard E. Read wrote an essay, "I, Pencil." He did not know it at the time, but this article soon became the most important description of the division of labor that has ever been written. It is not as famous as Adam Smith's description of the pin makers, but analytically, it is far superior. It is also a lot more fun to read.

The article begins with the narrative of a pencil. The pencil tells of his origin. He makes the crucial point that nobody knows how to make a pencil. This seems fantastic. Yet, as the narrative continues, it becomes obvious that the statement is true. There is so much that goes into a pencil. There is wood, carbon, rubber, metal, and paint. There is also all of the equipment to make these items into a single pencil.

But this is just the beginning. How is the metal made? How is the tree harvested? What about the chainsaws that cut down the tree? This goes on, and on, and on. That is the whole point of the article.

Read makes this point: all this is done without central planning. All of this is done by means of the division of labor.

But what Read doesn't mention, which is the heart of the matter, is the monetary system. It is only through a system of prices, meaning monetary prices, that all of this can be coordinated by the market process. It is the miracle of the market, as Read called it, but this miracle depends completely on one thing: a monetary system. Without a monetary system, the division of labor simply collapses.


Now let's talk about Bitcoins. Bitcoins exist as a means of payment only because there is not yet money in the general economy. Bitcoins are a spinoff of the fiat money systems of the world. Bitcoins could not exist if there were not an integrated system of digital currency.

You have to have digital currency in order to buy Bitcoins. This digital currency leaves a record. Every purchase you make with the digital currency leaves a record. You are then told that you can make purchases with Bitcoins. These will not leave a record. As long as you never have to reenter the monetary economy of the government's fiat money systems, there is no further trace of your purchases with respect to digital entries.

But this creates a problem for the person selling you something. If the item that he sells you is manufactured, then he has to rely on the division of labor. He has to re-enter the world of fiat money currencies, meaning government run and central bank run fiat money currencies. He must convert his Bitcoins to real money. That is because he must buy real goods.

Bitcoins are virtual money. Problem: virtual money buys very few real goods. For virtual money to buy anything, the virtual money must be converted back into real money, which is digital money, which is money that is an entry in a bank account. At this point, all of the supposed privacy of Bitcoins disappears. Now the government can trace whatever happens.

In order for Bitcoins' promise of privacy to work, the division of labor must be exclusively governed by Bitcoins. There must be no re-entry into the world of government fiat money. The moment there is a re-entry into the world of government fiat money, privacy disappears. Whatever the economy has adopted as its pricing system, this is what every market participant, meaning the seller of a particular good, must deal with. He deals with the real world of real prices in real time.

This creates the philosophical problem of Bitcoins. That problem is known as the regression theorem. This was coined initially by Carl Menger, but it was developed by Ludwig von Mises. There has to be an extension from an existing price system to a new price system in order for a new currency to replace the old.

The problem for the defender Bitcoins is this: we need a comprehensive system of prices. For Bitcoins to work, they must be autonomous from the fiat money pricing system of the various government currencies. In order to make a pencil, there has to be a comprehensive, universal, widely recognized Bitcoins network. It is not possible to run Bitcoins as a separate currency system unless it applies to every product, every transaction, every service that is presently priced in terms of government monetary systems. Why is this? Because the division of labor must be integrated by a single currency system.

In order to make the pencil, everything must be priced in terms of Bitcoins: paint, wood, carbon, rubber, metal, and every raw material and every piece of capital equipment that was used to make the pencil.


This is the whole point of Read's thesis. There has to be universal pricing. There has to be a profit-and-loss system governed by the universal pricing system in an integrated currency system. The only way for cross-currency transactions to take place is on the market. The most sophisticated futures market in the world is the market for currency futures. Every single transaction is recorded. Every single transaction is governed by written rules of the exchanges, as well as customary rules of exchange. The private property system and the entire legal system that undergirds the private property system come into play in order for the currency markets to operate.

Bitcoins' defenders do not openly say that there is no need for a private property system, no need for legal appeals, no need for any kind of arbitration system no need for contracts, no need for anything except algorithms. Yet they must assume this if they are to piggyback on the central banks' monetary system. Ours is not a world governed mainly by bits and bytes and algorithms. Bitcoin's is -- officially. In fact, the whole system is a piggyback system. Theoretically, there is no personality in it. There's no person in it. There are no property rights in it.

Bitcoins rests on a religious confession of faith. "The system will, without law or custom, and without enforceable property rights, autonomously evolve into a system with the same features and benefits as the present property rights order enjoys. It will do this without any intervention by the courts." This is faith in a unique god: the god known as algorithm. This god is known by his promise: "seamless transition."

Fact: there is no way to get the extraordinary division of labor that is necessary to make a pencil, unless the social and institutional framework, which is the foundation of all systems of real-world money, exists comprehensively.

A social framework is necessary -- a moral, intellectual, and legal framework -- to make possible the monetary systems of the world, which in turn make possible the modern division of labor. The advocates of Bitcoins do not discuss any of this. All they talk about is the vaunted privacy aspect of the system -- its independence from central banking.

There is more to free market exchanges than privacy. In fact, very few free market exchanges are private. Exchanges are based on contract and custom. There are court systems that enforce the contracts. There are methods of social pressure that enforce the customs. There are jury systems. All of this is foundational to the existence of the monetary unit, and the monetary unit is foundational to the entire division of labor economy.

Never in the history of libertarianism has there been any more utopian proposal that Bitcoins. They rest on an implicit denial of the private property system. They rest on an implicit denial of contracts and a denial of courts. They rest on an implicit denial of face-to-face resolution of disputes. They rest on an implicit denial of bargaining on a face-to-face basis. This is an implicit denial of virtually everything that exists in the free market society. The whole idea is delusional beyond anything I have ever seen.

Am I exaggerating? No. The Bitcoins system has no customs, courts, legally enforceable contracts, no resolution of disputes. All it has is algorithms. Yet its defenders say that the system is an extension of the free market's social order. It is in fact a denial of such an order. Its defenders think the Bitcoins markets can do without the social order that brought capitalism into existence a millennium ago. It is a classic free rider. Yet they insist that their system can replace the present capitalist order.

This is a programmers' fantasy.


Here is the problem in one sentence: a modern division of labor economy is very close to all or nothing. You cannot have a monetary system that does not apply across the board, yet still defend the concept of the division of labor through competitive pricing. You cannot have a currency that applies to illegal drugs, programming services, and almost nothing else, and expect that currency to replace the existing currency, which is a fiat money-based currency. There has to be a transition from the fiat-based currency, in which there are hundreds of billions of transactions a day worldwide, which in turn provides a comprehensive system of pricing and information feedback, in order for the present system of the division of labor to be maintained.

Any suggestion that Bitcoins can move from the modern system of integrated currencies, prices, and contracts, to get to an equally comprehensive system in which you could make a pencil, without the pricing system that is provided by the existing fiat money order, is simply utopian.

The utopians who are promoting Bitcoins are arguing that this virtual monetary system is going to replace the modern world's monetary system. But in order to do this, the Bitcoin system is completely dependent on the central banking monetary system. Bitcoins are a supposed haven from central banking. This is such utter nonsense that it is hard to believe that anyone can say it with a straight face.

No one can sell you a Bitcoins-produced pencil. A pencil takes real money to buy its component parts. If you can offer him only Bitcoins, he must convert these Bitcoins into real money -- fiat government money -- in order to buy the real goods. You cannot go from real money to virtual money, which buys only virtual goods, and then use this virtual money to manufacture real goods in the real world. You cannot make a pencil, because you do not have a comprehensive, integrated pricing system based on Bitcoins. Until almost everything is priced in terms of Bitcoins, and only Bitcoins, you get the modern division of labor only with the present monetary system. You cannot get to the system of 100% Bitcoins without being dependent on central bank money -- today, tomorrow, and for decades.

The mania will not last for decades. The bubble will pop.

All the talk of Bitcoins' privacy is nonsense. Real money is bank money. The initiating purchase of Bitcoins and their final conversion to real money are going to be recorded, because in order to get from Bitcoins to real money, in order to get from the virtual coinage to real coinage, in order to get from virtual purchases to real purchases, and in order to get from utopia to reality, you have to sell Bitcoins for digital dollars. But as soon as you do that, you lose privacy. The IRS can get you. The Federal Reserve has still got you.

In between, all you have is a bunch of Bitcoins exchanges. Silk Road was shut down by the government. Sheep Marketplace went down because of massive theft inside the system. A hundred million dollars disappeared. The investors lost it all.

When your virtual money is gone, there is no appeal to arbitrators. There is no way to trace who did it. The money has disappeared for good.

Lesson: a fool and his virtual money are soon parted.

Rule: all digits are not created equal.


Mises argued in 1922 that socialism produces chaos. It has no pricing system.

The fundamental objection advanced against the practicability of socialism refers to the impossibility of economic calculation. It has been demonstrated in an irrefutable way that a socialist commonwealth would not be in a position to apply economic calculation. Where there are no market prices for the factors of production because they are neither bought nor sold, it is impossible to resort to calculation in planning future action and in determining the result of past action. A socialist management of production would simply not know whether or not what it plans and executes is the most appropriate means to attain the ends sought. It will operate in the dark, as it were. It will squander the scarce factors of production both material and human (labour). Chaos and poverty for all will unavoidably result.

Most of all, Mises argued, socialism has no means of pricing capital. There are no capital markets.

The same is true of the as-yet nonexistent Bitcoins economy. It cannot do without the pricing system provided by central banking. It cannot produce goods and services without converting Bitcoins' digital fiat money into the banking system's fiat money. You cannot produce real goods with virtual money.

You have no capital markets without the monetary system. Capital markets are all based on contract. Bitcoins are based on a rejection of contracts. Capital is based on responsible ownnership: public claims on assets, enforceable by law. Bitcoins are based on a rejection of enforcement by law.

Bitcoins relate only to consumer goods, and hardly any. Yet even these cannot be delivered by sellers without selling Bitcoins and buying dollars to fulfill contracts. Sellers cannot replace sold assets unless they have bank money to buy them in the real world economy. This economy operates in terms of real money, which today is central bank money.

Bitcoins represent zero threat to the central banks. Bitcoins are used by most owners as ways to make money: to buy more dollars than they paid. It is just another investment asset -- one based initially on a complete fantasy, namely, that Bitcoins will somehow remove people from central banking.

Bitcoins are valued in terms of dollars. The mania is fueled by their rising dollar-denominated price. They provide an investment medium for high-risk speculators. They are nothing more than a way to get into a tiny market, and then ride the wave up, as more people get into it. There is no payoff in terms of the economic value of autonomous Bitcoins that are held only because they will serve as an alternative currency. They are held as a way to make money by selling to the greater fools, who will pay real money -- dollars -- for them.

It's a tulip bulb market. It rests entirely on getting back into the dollar economy.

Bitcoins will have no impact at all on the monetary base. They will have no impact on the capita; markets.

Capital is valued in terms of central bank money. Bitcoins will not change this, for they cannot reduce the size of the monetary base. They do not pull money out of the fractional reserve banking system. The quantity of real money is in no way affected. The investors remain in the central bank economy, in which capital is priced. Capital is not priced in terms of Bitcoins.

This is why Bitcoins' economy today cannot produce even a broken pencil. It is giving Bitcoins far too much credit to say that they can produce a broken pencil. There is almost no division of labor based on stand-alone units of Bitcoins. To move to Bitcoins' realm of virtual money for real products, other than maybe programming services, is a fantasy. It isn't going to happen. We need pencils. We need computers. We therefore need today's division of labor. If we need those things, we have to sacrifice privacy to get them.

The privacy provided by Bitcoins doesn't do you a nickel's worth of good, and it's going to cost you $1,000 per Bitcoin to buy that less than nickel's value. You lose privacy as soon as you buy Bitcoins, because there is a record in your bank. The person who sells you something loses his privacy, because he has got a convert the Bitcoins back into a bank account. That leaves a record.

In the world of Bitcoins, there is no meaningful privacy, because you must surrender it to get back your dollars -- real money. There is no rule of law. There is no customary behavior. There is no pricing system. It is all a gigantic fantasy.


What went wrong with Bitcoins? Nothing. They started out wrong -- wrong conceptually (virtual money in a real world), wrong legally (no contracts and courts), and wrong with respect to their future market (tulip mania). They were from the beginning just another asset class, denominated in bank money. This has not changed. This will not change.

Bitcoins are the product of socially naive programmers' fantasies. They thought they could substitute algorithms for ethics, digits for legality, anonymity for custom, and dreams for responsibility. Ultimately, they thought they could substitute impersonalism for personalism. They were wrong. They merely launched a tulip mania.

If the advocates of crypoto-currency have a case for a free market social order, then they should advocate not buying Bitcoins until such an order exists. Money develops out of a social order. They have put the cart before the horse: a new monetary system before the institutional arrangements to support it. This was Mises' argument regarding the regression theorem. A comprehensive monetary order that will replace the existing one is not going to be designed by obscure programmers. It will be the product of human action within a prevailing social and legal order.

To imagine that people can invent new institutional arrangements as extensions of the prevailing social order is legitimate. Let's see these alternatives first. Then they can tell us about their algorithms.

Libertarian utopians, having failed to develop these institutions, now have adopted what they see as a shortcut. They predict that a supposedly non-central bank money (it isn't) to create their new social order (it won't).

A replacement social order will not be tacked onto a revolutionary new monetary system, which is based an appeal to a nonexistent privacy. The monetary order must flow out of existing social and legal arrangements. But the programmers think they can reverse the regression theorem. They think we must start with a new monetary order, and then we can design the appropriate legal institutions. F. A. Hayek had a phrase for this: constructivist rationalism. It was better described by his friend Karl Popper: piecemeal social engineering.

Include me out.

Mises had it right in 1920: the key factor in the free market's division of labor economy is capital pricing. Until Bitcoins' market has priced all capital, but without resorting to central bank money, they will remain just another libertarian utopian fantasy.

Until there are contracts and courts in the Bitcoins world, Bitcoins will remain a conceptual delusion -- one inherently opposed to Mises' conception of capitalism's pricing system.

Bitcoins are anti-Austrian to the core. The fact that libertarian utopians do not see this indicates that they have never understood Mises or Austrian capital theory. This is not surprising. They do not even understand Leonard Read's "I, Pencil."

(There will be a hundred angry online rebuttals by programmers, published on obscure websites. They will insist that I do not understand Mises. Make up your mind after you read at least one critical response by an Austrian school economist who has written at least one book. Meanwhile, read mine: Mises on Money.)




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