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April 01, 2013, 05:35:05 AM |
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Thought Experiment: Banking and Debt in a Deflationary Currency
The drive back down south on the east cost I started thinking about the differences between our current banking and debt system versus a system that was done entirely in a deflationary currency. Forgive me for over simplifying this, but I want people to understand the basic concept.
1. How it is "Done" Now
In a system where inflation exists, the system is as the following. Central banks lend out money to the banks at an interest rate that mimics inflation. Why? Because if someone lends you money, you don't want the money back, you want the value of the money you lent to them originally to be worth the same amount as when they pay you back. If you expect a currency to be worth 2% less because of inflation after a year -- why lend money out for a year at 1%? You would be getting back less buying power then when you lent it out.
The banks borrow the money from the central bank at the rate of inflation. Then, in order for them to lend it out at a profit, they tack on additional percents to account for risk of default. So if the central banks lend to them at 2%, they lend it to the end borrower (with decent credit score ) at say, at 3%.
The end effect is the end borrower -- someone buying a house or a car with credit is a large APR. The good news is that in an inflationary economy as the dollar becomes less, so does the weight of any debt. For example, if you had borrowed a quarter from your great granddad (as he tells it), you could have spent all day at the movies with popcorn and soda. If you paid back a quarter today, it would be meaningless. If you paid back the "value' of a quarter today while taking inflation into account it would be well over fifty dollars. What am I trying to say? Inflation is bad for the saver, and excellent for the debtor.
2. How it Would "Work" in an End-to-End Deflationary Currency
In a deflationary currency -- one that say gained value of 2% a year. The central banks would not loan out money to banks at under 2%. Why? Because they could make 2% by doing absolutely nothing but sitting on the currency. Therefore, they would have to loan it out at the rate of deflation to get back the same amount of pricing power they lent. So the central bank lends money at 2% to banks.
Banks get these funds and now have the ability to loan out to companies and individuals. What are the risks? A bank has to worry about default risk. What if the borrower isn't very smart about computers? What if their hard drive crashes? What if they are scammed online? What if.. if.. if... The fact is, that dropping BTC into someone's anonymous wallet as a loan has a much higher consequences then dropping a number that represents dollars into a verified account. It would be like me mailing your a hundred dollar's worth of gold, vs putting one hundred dollars in your bank account where it could be "properly accounted for". To combat this, banks will necessarily not use BTC without verifying the accounts identity wallets will have to be tied to accounts. Would you loan someone money "anonymously"?
In addition, without a fractional reserve system, you don't get to "make up" bitcoins to loan. They actually have to be coins the bank owns.
3. The Big Difference in the Price of Debt
In an inflationary economy the value burden of debt decreases over time. You may have gotten "cost of living" raises at your job. Or switched jobs to maintain a competitive rate. However, in a deflationary currency the debt value grows and grows and grows. It punishes the debtor and rewards the saver. If you are trying to get a loan for starting a small business or buy a house you can see easily which system makes it safer for you to do so.
My example is this. Lets say you borrowed a bit coin from a co-worker to buy lunch two months ago when the value was ~15 dollars. You owe them one bit coin. However, now to pay them back, you have to buy one at ~90 dollars -- that's a lot o' lunches.
In a deflationary currency, you may get "cost of living" decreases as the value of the currency they are paying you goes up. Can you briefly imagine what this would do to a debt owed in a currency that grows in value over time?
4. Conclusion
Debt and leverage is almost always dangerous for the un-initiated to it's workings. If you do use debt, use it in dollars, not in bit coins. I believe this is one reason why BTC will be more like a commodity then a currency.
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