Bitcoin major fail - doesn't allow credit creation (aka deflationary currency)

[MoonShadow]

What we have nowadays, though, is a bit different, right? Fiat currency isn't backed by gold and can be created at commercial banks by a magical process called credit creation (or "credit expansion"?): the bank puts a new loan into its books as an asset and at the same time increases the balance of the customers account who took the loan by the amount of the loan. New money has been created. The bank cannot do this indefinitely, though, it need some "other assets" to back up the loans. Is that correct? How exactly does this work?

A bit over simple, but yes.

Simple is good, as long as it allows to draw correct conclusions ;>.

What kind of assets are required for a bank to have as reserves for the credit creation?

In our current system?  Banks are supposed to keep a 1:9 reserve to lending ratio, in other words banks are permitted to lend out nine times as much as they have on their books.  However, this includes not only the CD's and savings account balances, but also the marked-to-market value of all the collateral used in all of the loans.  I.E. the resale value of the cars and homes themselves that the bank would 'repossess' should the borrower fail to honor the terms of the loans.  So the ratio of cash on deposit to debt outstanding can be much higher, and when Lehman Brothers failed their real reserve ratio was pushing 1:50.  Reserves can be anything with an established market value; gold, foreign currencies, even raw land.

[MoonShadow]

A couple of comments on the IOUs, warehouse receipts, customer deposits and loans in a BTC economy.

First. With the current system, the IOU that you get from the bank is indistinguishable from the currency. Say you deposit 100 USD in BoA account, the bank will show that you have 100 USD, not 100 BoAD that are redeemable 1 on 1 with USD. So, that's a big difference because that will mean we need another form of currency to make BTC currency work, right? Name it banks' IOUs, vouchers, litecoins, etc.

No we wouldn't need such an alternative currency, but one could exist. 

Second. There is no such thing as customer deposits and loans with BTC because BTC is built for transactions; you cannot "deposit" in a BTC bank because it's not like you will share the private key of your account with them or they will share it with you and you can check your BTC account from time to time. You will "buy" an IOU from the bank that says you can get 1 on 1 BTCs for it (like the current system). So we go back to the first point.

No, you're getting confused.  We already have rudimentary banks, in the form of online wallet services.  Imagine if one particular service, let's call it BitcoinPal, were to grow large enough that it had thousands of consumers & retail websites with accounts.  Whenever a consumer used his web portal or smartphone app to import the address of a member's retail website, the computer doing the action could recognize that address to belong to a member, and simply credit that member's account.  This would require group storage of bitcoins, like a bank does with cash, and thus there would be some currently unmet need that the bank can provide that is costly to an individual consumer.  Most likely this would be transaction fee reduction, as thousands of members could operate in this way (so long as the banking institution was trusted) and only produce a blockchain bound transaction. Such transactions are cheap now, but they are subject to market forces too.  When Bitcoin is seving as many transactions per second as Visa, we can't expect a transaction fee to still be a nickel.

I still don't understand how a loans with interest system will work in a BTC based economy. Knowing that BTC can not be created by banks via "credit expansion" and that there is a limited number of them in existence, how will the interest be paid back? With what BTCs?

Ah, I see the block. You belive that successful banks would eventually own all the bitcoins, correct?  Well the free market doesn't work that way, those bitcoins, including the interest, is always in motion.  Banks pay employees, employees buy services, businesses pay their loans; and when they don't, loans default and banks lose both the principal and interest on that loan, and the interest on a couple others to balance out the loss of reserves.  Interest rates would naturally trend down toward a point that is close to the default rate plus the dispersion rate.  Very unlike our current system of fixed rates.

[DannyHamilton]

A couple of comments on the IOUs, warehouse receipts, customer deposits and loans in a BTC economy.

First. With the current system, the IOU that you get from the bank is indistinguishable from the currency. Say you deposit 100 USD in BoA account, the bank will show that you have 100 USD, not 100 BoAD that are redeemable 1 on 1 with USD. So, that's a big difference because that will mean we need another form of currency to make BTC currency work, right? Name it banks' IOUs, vouchers, litecoins, etc.

I realize you like to refer to bank accounts as IOUs, but as far as I can tell, the bank doesn't issue me a voucher.  They store a number in a database (or prior to computers, on a ledger) that indicates how much of my USD they are holding for me.  When I engage in a transaction, it is the value of that USD that is transferred.  Where it is transferred depends on the transaction.  If I transact with someone who uses the same bank, all they have to do is transfer the value from my database entry to the other customer's database entry within the bank.  None of the originally deposited USD needs to be moved.  On the other hand, if I choose to withdraw some of the USD that I have on deposit, then they give me USD, not BoAD.  This comes out of the total USD they have on deposit. I don't see how this requires another form of currency to make BTC work.  It should work pretty much the same way.

Second. There is no such thing as customer deposits and loans with BTC because BTC is built for transactions; you cannot "deposit" in a BTC bank because it's not like you will share the private key of your account with them or they will share it with you and you can check your BTC account from time to time. You will "buy" an IOU from the bank that says you can get 1 on 1 BTCs for it (like the current system). So we go back to the first point.

It is difficult to predict how an industry that doesn't even exist yet will operate, but my assumption is that you will transfer control of the BTC value to the bank just like you transfer control of the USD to them when you deposit them.  Nobody needs to share private keys.  You will transfer your bitcoin to an address the bank owns, and they will place an entry into their database indicating that they are holding a certain amount of your bitcoin for you.  When you engage in a transaction with another customer of the same bank, they won't move the bitcoin at all, they will just update the two database records in their computer system (just like with USD).  When you choose to withdraw some BTC, you will provide the bank with a Bitcoin Address, and they will transfer the amount you wish to withdraw over the blockchain to you updating their own database to reflect the reduced balance they are holding for you.  This too seems to work the same way as the current personal banking system.

I still don't understand how a loans with interest system will work in a BTC based economy. Knowing that BTC can not be created by banks via "credit expansion" and that there is a limited number of them in existence, how will the interest be paid back? With what BTCs?

I'm not sure what confuses you about the process.  You receive a loan, you make payments on it out of your income until you've paid the balance off.  You've reduced your purchasing power a bit, but made your purchase sooner gaining the benefits that come with earlier ownership of whatever it is you chose to purchase.  The lender has lost use of their currency for a time, but now has more purchasing power.  Both parties are satisfied with the transaction.

[odolvlobo]

What we have nowadays, though, is a bit different, right? Fiat currency isn't backed by gold and can be created at commercial banks by a magical process called credit creation (or "credit expansion"?): the bank puts a new loan into its books as an asset and at the same time increases the balance of the customers account who took the loan by the amount of the loan. New money has been created. The bank cannot do this indefinitely, though, it need some "other assets" to back up the loans. Is that correct? How exactly does this work?

To answer your question, laws limit the amount of deposited money that a bank can loan. The limit depend on the quality and size of the deposits. It is called the "reserve requirement" and it is set by the Fed in the U.S.

Fractional reserve banking (FRB) works whether or not the currency is backed by anything. In a nutshell, it works like this: I deposit $100 cash in a bank. The bank loans $90 of that to someone else. I believe that I have $100 in the bank, and someone else has $90. The perceived amount of money is now $190, although the actual amount is still $100. That's how FRB works. There is no reason why bitcoin can't have fractional reserve banking.

[bobitza]

I still don't understand how a loans with interest system will work in a BTC based economy. Knowing that BTC can not be created by banks via "credit expansion" and that there is a limited number of them in existence, how will the interest be paid back? With what BTCs?

I'm not sure what confuses you about the process.  You receive a loan, you make payments on it out of your income until you've paid the balance off.  You've reduced your purchasing power a bit, but made your purchase sooner gaining the benefits that come with earlier ownership of whatever it is you chose to purchase.  The lender has lost use of their currency for a time, but now has more purchasing power.  Both parties are satisfied with the transaction.

What confuses me is that if I apply simple mathematics, there is no way for the system to work. You can't pay back $101 (principal + 1% interest) if there are only $100 in existence. With BTC this is obvious because there will only be a maximum 21 million in existence and no other way to create them. It's a zero sum game. For me to repay the extra $1 is for others to "lose" that $1.

I guess moon hinted already in his/her response. Any interest based loans system (currency being fiat, BTC, whatever) is built for or is based on defaults. For the system to work, someone has to default at some point.

Banks pay employees, employees buy services, businesses pay their loans; and when they don't, loans default and banks lose both the principal and interest on that loan, and the interest on a couple others to balance out the loss of reserves.  Interest rates would naturally trend down toward a point that is close to the default rate plus the dispersion rate.  Very unlike our current system of fixed rates.

[molecular]

I still don't understand how a loans with interest system will work in a BTC based economy. Knowing that BTC can not be created by banks via "credit expansion" and that there is a limited number of them in existence, how will the interest be paid back? With what BTCs?

You're forgetting the possiblity of defaults.

Another option: Loans can be rolled over.

[molecular]

What we have nowadays, though, is a bit different, right? Fiat currency isn't backed by gold and can be created at commercial banks by a magical process called credit creation (or "credit expansion"?): the bank puts a new loan into its books as an asset and at the same time increases the balance of the customers account who took the loan by the amount of the loan. New money has been created. The bank cannot do this indefinitely, though, it need some "other assets" to back up the loans. Is that correct? How exactly does this work?

A bit over simple, but yes.

Simple is good, as long as it allows to draw correct conclusions ;>.

What kind of assets are required for a bank to have as reserves for the credit creation?

In our current system?  Banks are supposed to keep a 1:9 reserve to lending ratio, in other words banks are permitted to lend out nine times as much as they have on their books.  However, this includes not only the CD's and savings account balances, but also the marked-to-market value of all the collateral used in all of the loans.  I.E. the resale value of the cars and homes themselves that the bank would 'repossess' should the borrower fail to honor the terms of the loans.  So the ratio of cash on deposit to debt outstanding can be much higher, and when Lehman Brothers failed their real reserve ratio was pushing 1:50.  Reserves can be anything with an established market value; gold, foreign currencies, even raw land.

What about bonds (securitized loans if I understand correctly)?

[odolvlobo]

What confuses me is that if I apply simple mathematics, there is no way for the system to work. You can't pay back $101 (principal + 1% interest) if there are only $100 in existence. With BTC this is obvious because there will only be a maximum 21 million in existence and no other way to create them. It's a zero sum game. For me to repay the extra $1 is for others to "lose" that $1.

You are correct for your particular scenario; however, just because your scenario can't work, it doesn't mean that no scenario can work. In fact, if you loaned me all the BTC in existence, I could still pay you back all that (plus more) over time as long as neither of us hoard all of our BTC.

Your zero sum game assumes that productivity is 0, but it isn't. To repay that extra $1, I could catch a fish and sell it to someone for $1 and nobody loses anything.

[MoonShadow]

What about bonds (securitized loans if I understand correctly)?

Bonds are just a form of private loan, wherein some company (or other institution, such as a city government) needs to raise their cash position.  Normally, bonds are a one-for-one exchange, no fraction involved.  Investment banks will often issue bonds to be sold, so that they can raise their reserve fund high enough to grant a huge construction loan without breaking the reserve ratio required by law.  This is what is supposed to happen, but it doesn't always.  Bonds are unsecured revolving credit for huge institutions in a similar fashion that credit cards are for consumers.  Bonds function much like an old fashioned bank CD,  in the sense that bonds don't pay out on demand unless you're willing to sell them for a discount on the secondary bond markets.  Utility bonds are some of the safest places to store fiat currency in any of the first world economies, but really all they are is storage.  You're lucky to keep up with inflation under normal circumstances and you certain won't right now.  But even utility bonds sometimes go bad.  Municipal bonds, IMHO, are riskier than utility bonds mostly because you have a group of polititians trying to make a sound judgement on whether or not they can repay the costs of constructing that new sewer system with the tax base.  So you have a group of people who salary is not dependent upon their economic prowess, deciding upon a debt to be paid back by taxes, the amount of which is not often related to the success of the project it's funding.  Whereas a utility bond is pretty straight forward, you're loaning money to a company that (for example) builds power plants with the expectation selling the power from those plants to the city and it's people. 

[DannyHamilton]

What confuses me is that if I apply simple mathematics, there is no way for the system to work. You can't pay back $101 (principal + 1% interest) if there are only $100 in existence.

Lets work with your VERY SIMPLIFIED example of only 100 units available and one person has all of them.

There are only 3 people in the world, Bobitza, Lisa, and Danny.  There are only 100 units of currency in the world, and somehow Bobitza has managed to acquire all of it. Bobitza has deposited this currency in a bank owned by Lisa.

Bobiza has no fishing skills at all, but loves to eat fish and owns a shop that sells fishing equipment.  Danny is an amazing fisherman, but his fishing equipment is now broken and since he has none of the currency, he is unable to purchase any of the fishing equipment from Bobitza. This means that neither Danny nor Bobitza will be able to eat and will therefore starve.

Danny goes to Lisa's bank and informs her that he'd like to borrow 100 units of currency so he can purchase some fishing equipment.  He will be paying her back 110 units over the next 11 weeks (10 units per week).  Lisa knows of Danny's fishing skills and judges him to have a low risk of default.  She also knows (for some reason) that Bobitza won't be withdrawing any units from the bank this week, and won't be withdrawing more than 10 units per week in any of the following weeks. She lends him the 100 units out of the bank.

Danny takes his 100 units of currency to Bobitza's fishing equipment business and purchases all the fishing equipment he needs.  Bobitza takes this 100 units and deposits them in Lisa'a bank.  He's a bit confused, because he thought that he already owned all the units in existence, but he is glad that he now owns twice as much as he did before. Lisa breath's a sigh of relief when Bobitza deposits the 100 units because she now has some currency on hand in case Bobitza decideds to withdraw some.  Bobitza's account at the bank indicates he has 200 units on deposit and Lisa has 100 units in reserve so she is engaging in fractional reserve lending.  

Danny then proceeds to catch fish to eat and sells the extra fish to Bobitza who loves fish so much.  Each week, Bobitza withdraws 10 units of currency from Lisa's bank to pay Danny for his fish.  Danny then heads straight to Lisa's bank and makes a 10 unit payment on the loan which Lisa adds back to the bank's reserves to cover any additional currency Bobitza might decide to withdraw. Lisa feels more and more comfortable about her reserve situation each week as the number of units reflected in Bobitza's account drops by another 10 units bringing it closer to the actual amount she has in reserve.  Meanwhile her reserve remains at 100 units since Danny keeps making his loan payments of 10 units.

So, in the tenth week, Bobitza has payed Danny 100 units of currency for the fish bringing his balance back to 100 units and Danny has paid Lisa back 100 units of currency so the bank still has 100 in reserve.  At this point Lisa is no longer engaging in fractional reserve banking since the 100 units she has fully account for the 100 units that Bobitza's account indicates.

Now the 11th week comes along and Danny sells another 10 currency units of fish to Bobitza which he uses to pay off his final loan payment to Lisa.  Bobitza's account now indicates that he has 90 units. Danny no longer owes anything, and Lisa's bank has 90 units in reserve for Bobitza as well as 10 units of profit from the loan.

Does this explain how it works, or am I missing something?

[MoonShadow]

Unfortunately, such a demonstration of fractional reserve seems contrived and lacks the flexibility of the incumbent banking system,

Not really, it's just flexible in another place.  Fiat currencies are 'flexible' in the sense that the absolute number of monetary units (the total monetary base) is not fixed, and therefore the issuing entity (in theory) can add or witdraw (ha, ha) currency as it sees fit to maintain "price stability".  This makes the assumtion that price stability is desirable, but there is no economic reason that this is so.  Hard currencies, like Bitcoin or gold, have a fixed monetary base so they are "flexible" at the price point; which is one reason that the market exchange rate of bitcoin moves so much relative to fiat currencies and can be expected to do so for some time.

While parrallel clones of the bitcoin system could lead to expansion of the monetary base in theory, I don't think that's what is going to happen in practice.  A competing cryptocurrecy has to offer an advantage over bitcoin in some fashion or another in order to establish a market value at all.  This could be done by a niche need, such as with Namecoin; or it could be done by the promises of a trusted entity, such as WalMartCoin or AmazonCoin; or it could simply be that a clone fixes an as-yet-unknown bitcoin flaw (that is otherwise unfixable within bitcoin itself).  But without some obvious advantage in a particular market or function, bitcoin clones will never do well if they have to compete alongside bitcoin, because bitcoin has the first-to-market advantage and new vendors will desire to use the most widely known cryptocurrency first while most new digital consumers are going to desire the most widely accepted cryptocurrency as well. 

[MoonShadow]

General agreement here too. Running up against limits in the number of transactions per block could be fun, but I guess a free market on transaction fees could prevent this from becoming an issue for a while.

Yes, it could; and the size limit on the bitcoin block is arbitrary and amendable.  It's generally assumed that the max-blocksize will be increased several orders of magnitude in the future; but never permitted to be unlimited.  This forces a premium on transactions that need to be processed quickly if there the network is close to the limit.  In prior threads on this very topic, a max-blocksize limit of 1 Gbyte is likely to be the high end in a distant future wherein Bitcoin is processing more transactions per second than Visa while remaining within the practial limits of bandwidth that a dedicated server can afford, assuming that the costs of bandwidth do not continue to drop, which is also unlikely.

[thirdchance57]

a normal functioning economy grows at 1.5% to 3% per year

[MoonShadow]

a normal functioning economy grows at 1.5% to 3% per year

By what logic to you come to such a conclusion?  Are you basing this off of population growth, or something else?

[bobitza]

Does this explain how it works, or am I missing something?

Yes, the example given does explain how loans and interest can work ... in that very scenario. Lol, couldn't help but notice that with multiple loans like that, Lisa's bank come to hold all currency and Bobitza and Danny will have 0.

Here's what you might be missing. Same scenario but Bobitza doesn't like fish and has a farm that provides enough food for him and his wife Lisa. Unless Lisa accepts 10 units worth of fish in the 11th week, Danny can't make the final payment. Sorry but I can't get over the fact that 101 != 100.

I understand that money will circulate and the borrower will sell products indirectly to the loaner thus making somehow the interest payments possible because people don't hoard the currency. And with a few loans, that is going to work. However the more loans are made, the more interest payments will become a bigger part of the whole money supply and for example, at some point in time, all the money in existence will become interest payments. I still think somebody has to default to erase some of that interests payments that are now banks profits.

And speaking of "the people don't hoard the currency" pre-requisite ... what was the percentage of Bitcoins being hoarded? 78%?

I stand by my earlier comments that multiple Bitcoin-like currencies can provide a healthy financial ecosystem with credit creation and deletion as necessary. Perhaps the reason why nobody has cared to respond so far, is that they are heavily invested in the idea that Bitcoin ought to be a natural monopoly whose growth rewards existing users with increases in the exchange rate? Suggesting things like multiple clone currencies, issuance of shares with guaranteed inflation rates and so on, must be anathema to some people. However, I contend that Bitcoin's clone-able nature makes it more robust and fairer since there is less envy towards early adopters, and it doesn't come across as a possible ponzi scam.

I do share the view that multiple currencies can be the solution. In fact I shared a link to the Digital coin video that touches upon this subject ... was hoping to get some comments from the people here.

But then, we acknowledge the fact that Bitcoin on its own can't be the solution for a new, international currency because it needs other currencies?

[odolvlobo]

I understand the fact that money will circulate and the borrower will sell products indirectly to the loaner thus making somehow the interest payments possible because people don't hoard the currency. And with a few loans, that is going to work. However the more loans are made, the more interest payments will become a bigger part of the whole money supply and for example, at some point in time, all the money in existence will become interest payments. I still think somebody has to default to erase some of that interests payments that are now banks profits.

You aren't making any sense. Why would this ever happen: "all the money in existence will become interest payments"? Ok, in this absurd scenario, we have fractional reserve banking, and the average interest rate is higher than the reserve requirement, and all the interest payments are all due at the same time. Can't you even come up with a plausible scenario to support your claiim?

And speaking of "the people don't hoard the currency" pre-requisite ... what was the percentage of Bitcoins being hoarded? 78%?

And yet people are doing the impossible right now: borrowing BTC and repaying with interest.

[bobitza]

I understand the fact that money will circulate and the borrower will sell products indirectly to the loaner thus making somehow the interest payments possible because people don't hoard the currency. And with a few loans, that is going to work. However the more loans are made, the more interest payments will become a bigger part of the whole money supply and for example, at some point in time, all the money in existence will become interest payments. I still think somebody has to default to erase some of that interests payments that are now banks profits.

You aren't making any sense. Why would this ever happen: "all the money in existence will become interest payments"? Ok, in this absurd scenario, we have fractional reserve banking, and the average interest rate is higher than the reserve requirement, and all the interest payments are all due at the same time. Can't you even come up with a plausible scenario to support your claiim?

If you read the Bobitza, Lisa and Danny example, just imagine Danny's fishing net broke again at the end and he had to buy a new one ... 10 times in a row. At the end, all money will belong to the bank as profits from interest payments. Next time Danny makes a loan, Bobitza will have no money to buy the fish thus Danny will have to default.

[myrkul]

At the end, all money will belong to the bank as profits from interest payments.

A bank is a business like any other. Its profits are not static. They flow out almost as fast as they flow in. Employees. Building maintenance. Rent. Water and Sewage. Security contracts. Banks are part of the economy they serve, not a drain upon it. The bank will not, and can not, ever own "all the money."

[molecular]

What about bonds (securitized loans if I understand correctly)?

Bonds are just a form of private loan, wherein some company (or other institution, such as a city government) needs to raise their cash position.  Normally, bonds are a one-for-one exchange, no fraction involved.  Investment banks will often issue bonds to be sold, so that they can raise their reserve fund high enough to grant a huge construction loan without breaking the reserve ratio required by law.  This is what is supposed to happen, but it doesn't always.  Bonds are unsecured revolving credit for huge institutions in a similar fashion that credit cards are for consumers.  Bonds function much like an old fashioned bank CD,  in the sense that bonds don't pay out on demand unless you're willing to sell them for a discount on the secondary bond markets.  Utility bonds are some of the safest places to store fiat currency in any of the first world economies, but really all they are is storage.  You're lucky to keep up with inflation under normal circumstances and you certain won't right now.  But even utility bonds sometimes go bad.  Municipal bonds, IMHO, are riskier than utility bonds mostly because you have a group of polititians trying to make a sound judgement on whether or not they can repay the costs of constructing that new sewer system with the tax base.  So you have a group of people who salary is not dependent upon their economic prowess, deciding upon a debt to be paid back by taxes, the amount of which is not often related to the success of the project it's funding.  Whereas a utility bond is pretty straight forward, you're loaning money to a company that (for example) builds power plants with the expectation selling the power from those plants to the city and it's people. 

From above I deduct that bonds themselves do not count as reserves. Thanks for your explanation of bonds.

[molecular]

a normal functioning economy grows at 1.5% to 3% per year

By what logic to you come to such a conclusion?  Are you basing this off of population growth, or something else?

This is of course a question right to the point. The economy might only grow "on paper". It'd not be the economy that grows, but the money supply. Measuring the "health" of an economy by calculating GDP is totally flawed if you have an elastic money supply.