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Author Topic: Bitcoin Loans and Lending; The Weakness in The Bitcoin Economy  (Read 16557 times)
BitQuestr (BitCoinWorldMarket)
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July 12, 2011, 06:18:52 PM
 #1

I've been reading about bitcoin now for just over a month and am fascinated with the economic possibilities. Myself and my partner managed to launch the largest Bitcoin Market so far at www.BitCoinWorldMarket.com  Every day there seems to be new and exciting news regarding the growth and acceptance of bitcoin and I for one am so excited at the future and possibility of bitcoin becoming extremely widespread.

One of the very interesting things about bitcoin is that it is a deflationary currency. Normally economists list massive deflation as a bad thing. Bitcoin embraces that with its infinite divisibility.

The one weakness that I see in bitcoin is that the current model for loans and lending is incompatible with bitcoin.

Imagine Taking a loan out for 100 bitcoin at even 0% interest to keep it simple. At the end of the year you have to pay back that 100 bitcoin. If the point of your loan was to pay for something now so you can create more income in your business the volatility in the bitcoin market would make it infeasible to pay it back. If Bitcoin doubles for example in value it is like having to pay back 100% interest. If it drops in value by half the lender then is basically out half the money they lent out.

With the longterm likelihood of an overall gaining in value due to bitcoin being deflationary it just doesn't make sense to have any loans, interest, or even credit be issued in bitcoin. Fractional reserve banking in bitcoin is completely unlikely.

The only way i'd see loans or credit working is if you just get the loan in your national currency and exchange the money as needed and spend the bitcoin right at the moment.

As a business man this creates an interesting dilemma. Most small and medium business DEPEND on short term loans and credit. Suppliers accept Net 15 or Net 30 payment terms. Inventory costs are highly variable and often come all at once rather than at a rate related to income.

I see the future and complete acceptance of bitcoin as an alternative currency, however I don't see how we will ever separate it from daily exchange with a fiat currency.

Thoughts?
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July 12, 2011, 07:40:47 PM
 #2


I love it when bitcoiners finally look directly into the mirror and a brief moment of terror washes over their faces when they realize what they've done.  It's always much too brief, and then they look away and try to find re-assurance in the echo chamber.

You almost realized that promoting bitcoins as a currency doesn't make any sense at all.  You were soooo close.
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July 12, 2011, 07:53:57 PM
 #3

I think this is something that makes Bitcoin more suitable for equity, rather than debt investments. As the Bitcoin economy matures, it will also become easier to hedge against currency exchange fluctuations through the use of futures and such (this already exists for Bitcoins).
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July 13, 2011, 12:39:35 AM
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I love it when bitcoiners finally look directly into the mirror and a brief moment of terror washes over their faces when they realize what they've done.  It's always much too brief, and then they look away and try to find re-assurance in the echo chamber.

You almost realized that promoting bitcoins as a currency doesn't make any sense at all.  You were soooo close.

+5 :-D
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July 13, 2011, 12:47:08 AM
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Just like we were taught that deflation is bad, maybe we've just been brainwashed to think that loans are good.

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July 13, 2011, 12:54:33 AM
 #6

This is based on a misunderstanding of what predictable deflation does in a market. In fact, predictable deflation is already priced into the current price of a bitcoin. If a bitcoin is expected to be worth $25 next year, it cannot possibly be worth $10 right now because all the people who would rather have $25 next year than $10 now would bid the price up.

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patvarilly
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July 13, 2011, 02:06:19 AM
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One of the very interesting things about bitcoin is that it is a deflationary currency. Normally economists list massive deflation as a bad thing. Bitcoin embraces that with its infinite divisibility.

On a more serious note, lack of divisibility isn't (at all) the problem with a deflationary currency, so infinite divisibility is not a solution.  You hit on one of the much more serious problems.  The other big one is that deflation likely encourages hoarding at the expense of consumption, so as a businessman, you should also expect very few customers.  Here in Bitcoinland, saying such sensible things gets you labeled as an ignoramus / troll, etc. and you get pointed to threads where the issues have been "settled" (never mind that a large majority of professional economists think otherwise).

So instead of starting yet another flame war, I have a proposal.  Presumably, like most of us here, you regard Bitcoin as an interesting experiment, as opposed to the thing that you're mortgaging your future on.  Experiments need data.  So, in the spirit of openness, my proposal is:

Would you be so kind so as to regularly update us as to how much business you're doing every day?

It would help the discussion enormously to see if actual businesses are getting any significant volume or not.

Right now, it's not clear to me if Bitcoins are inflationary or deflationary: it depends on whether the rate of new coin creation does or does not exceed the rate at which new people are joining the experiment.  Certainly Bitcoins will tend to be deflationary as the rate of coin creation goes down and/or the user base explodes (assuming this happens).  So what would be most useful is to see a trend over time.  For instance, when the subsidy switches to 25 BTC instead of 50 BTC, or when a news article with wide visibility brings in a sudden spike of new users, I'd expect your business volume to go down.  But who cares what *I* expect, the data would speak for themselves.

What do you think?
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July 13, 2011, 02:13:21 AM
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The other big one is that deflation likely encourages hoarding at the expense of consumption, so as a businessman, you should also expect very few customers.
This is false. Deflation does not encourage hoarding. The argument that deflation encourages hoarding works just as well to argue the deflation encourages spending.

Say I hold some asset that's going to go up in value. The fact that the asset is going to go up in value means that the asset includes the right to hold that asset as it goes up in value. The more the asset is going to go up, the more the right to hold the asset as it goes up is worth today. So deflation encourages spending by increasing the present value of an asset, meaning that you can get more goods for it today than you could otherwise.

This is, of course, an invalid argument. But it's invalid for the same reason the argument that deflation will encourage hoarding is invalid. An asset that will be worth more in the future will be worth more today because the price today includes the present value of its expected future prices. Everyone who owns a bitcoin today also owns the right to have one bitcoin in five years. If we all agree a bitcoin will be worth X in 5 years, a bitcoin will never be worth than the present value of X in 5 years.

I am an employee of Ripple.
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July 13, 2011, 02:36:08 AM
 #9

Businesses depend on loans because they are artificially so cheap right now. It would be like if there was an enormous subsidy for blankets for a decade. Everyone would find all kinds of ways to blankets because they were practically free. Ending the subsidy and making people pay whatever the right cost is for blankets is clearly the right thing to do even if it shakes up business practices for a while.

There is nothing wrong and plenty of things right with people needing to earn before they spend. The flip side of expensive borrowing is that you get very high interest in real terms for working and saving a while before you spend.

Instead of grinding away at a job for decades and having your savings devalued you work harder and spend less up front and in a year you have plenty of capital to get started.

It should also be noted that the bitcoin economy is not in a steady state. Right now the best play by far is to convert old economy assets to bitcoin. Later when most are in the bitcoin economy this explosion will be over and the new profit will be picking things that appreciate faster than the general economy which means committing some coins to stuff.

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July 13, 2011, 05:49:48 AM
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The one weakness that I see in bitcoin is that the current model for loans and lending is incompatible with bitcoin.

As I said in my post on fractions, in a deflationary world, the way to treat shares and money may completely invert. Those with the least bargaining power may be given shares. Those with the most bargaining power may be given money and zero interest loans. This is a very long term scenario where bitcoin has stabilised.

Much more equity and much less debt in a bitcoin dominated future.

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As a business man this creates an interesting dilemma. Most small and medium business DEPEND on short term loans and credit. Suppliers accept Net 15 or Net 30 payment terms. Inventory costs are highly variable and often come all at once rather than at a rate related to income.

More businesses will move to shorter payment terms. This happens in any place where the money is valued highly.

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I see the future and complete acceptance of bitcoin as an alternative currency, however I don't see how we will ever separate it from daily exchange with a fiat currency.

Thoughts?
In a hyper inflationary endgame, I could see more and more people borrowing in the native currencies to buy bitcoin, which is a typical hyper inflationary scenario. Prices being more and more stable in bitcoin and varying crazily in native currencies. But this is an unlikely scenario, since interest rate rises will put a temporary halt to the same.


patvarilly
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July 13, 2011, 06:53:42 AM
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Wow, an intelligent post on the economics forum!  What a treat!  I had to think this through for a while, so thank you for making me think.  Here's my best effort at thinking through the consequences of what you're saying; I may have more to say tomorrow as I think this through a bit more.

The other big one is that deflation likely encourages hoarding at the expense of consumption, so as a businessman, you should also expect very few customers.
This is false. Deflation does not encourage hoarding. The argument that deflation encourages hoarding works just as well to argue the deflation encourages spending.

Say I hold some asset that's going to go up in value. The fact that the asset is going to go up in value means that the asset includes the right to hold that asset as it goes up in value. The more the asset is going to go up, the more the right to hold the asset as it goes up is worth today. So deflation encourages spending by increasing the present value of an asset, meaning that you can get more goods for it today than you could otherwise.

Well, first things first, this paragraph made no sense to me whatsoever, perhaps an example would help.

This is, of course, an invalid argument. But it's invalid for the same reason the argument that deflation will encourage hoarding is invalid. An asset that will be worth more in the future will be worth more today because the price today includes the present value of its expected future prices. Everyone who owns a bitcoin today also owns the right to have one bitcoin in five years. If we all agree a bitcoin will be worth X in 5 years, a bitcoin will never be worth than the present value of X in 5 years.

It's appealing to think this (and indeed, I've thought like this automatically when discounting things for inflation in the past), but here's how I think it goes wrong.  It's too simplistic for two reasons: (a) you haven't accounted for individual uncertainty in calculating the net-present-value of Bitcoins 5 years from now, and (b) you haven't thought through the consequences of people having different opinions on what a bitcoin will be worth in the future.

To not complicate the discussion, let's pretend the inflation rate for the dollar will be 0 for the next 5 years.  You could account for non-zero inflation, but it just muddles the larger point.

a.1) Even as an individual, I have no certainty of what the value of a Bitcoin will be 5 years from now.  All I have is a feeling for the probabilities of different outcomes.  For example, I may think there's a 50% chance that 1 BTC for $10 today will be worth $25 in 2016, or a 50% chance that it will be worth $0 (say, it never takes off as a currency, so people lose all interest).  You might think that I'd agree to pay $12.50 today for it, but since I'm taking a risk ($12.50 in my pocket has the same net present value), I'll only agree to pay $11.00 today for it (let's say that happens to be the market price).  Call the extra $1.50 compensation for sleepless nights worrying about a government on Bitcoin erasing my investment.  As time goes by, the probabilities of the different outcomes become sharper.  For the sake of argument, let's say that five years from now, it's clear that a Bitcoin is worth $12.50 with 100% certainty.  Again for the sake of argument, let's say that everyone else went through my same thought process.  Then it appears that the value of Bitcoins has gone up from $11.00 to $12.50 in the market over the five years 2011-2016, even though the net present value of a 2016 Bitcoin was constant throughout that period.  This should start popping up red flags about net-present-value arguments.  Uncertainty will create risk premiums for Bitcoins in the future, and right now, that uncertainty is quite high.  

a.2) Uncertainty also has the effect of reducing the amount of money in the market.  Say I have $1,000,000 to invest, and will need $250,000 for a minimal retirement five years from now, and $500,000 for a comfortable retirement.  Hence, assuming every other financial obligation is covered (again, sake of argument), I can *definitely* invest at least $500,000 and will invest *at most* $750,000.  If there is no uncertainty, I'll invest the $750,000.  If there's huge uncertainty, then I'll invest only marginally above $500,000.  Why does this matter?  In a market as small as the currency exchanges, there may not be enough money on the table to bid up the price to what you'd expect from net-present-value arguments (with or without accounting for a risk premium).  In other words, if you're a buyer, you may see an offer from someone to sell that's below what you'd be willing to pay, but you may not be certain enough of its value that you're willing to risk losing your money.  So you don't buy, and the market price is not pushed up.  That's a second mechanism, especially applicable for the small market size of the exchanges, by which uncertainty will weigh on the present price of a Bitcoin without changing its net present value, beyond just a risk premium.

b) Getting back to deflation, here's what goes wrong.  Deflation means that prices for things 40 years from now will be lower than they are today*.  We do agree on this, don't we?  Now, if you have all the time in the world, then you can calculate the net present value of your bitcoins today according to just how quickly you think they'll deflate.  Let's say that that's how you decide how much to save for retirement.  However, not everyone can wait that long.  A miner may need to sell some of his Bitcoins soon to pay his electricity bill, even though he knows that holding those coins, they'd buy more electricity in the future.  Or maybe Satoshi's medically uninsured sister has a heart attack and needs to pay for hospital attention tonight, not in 40 years.  To both people, Bitcoins in the future are worthless, they need to sell them now.  So the amount they'll be willing to sell them for will be less than what they (and everyone else) think they're worth if they could wait.  If the exchange markets were deep, the difference between the two quantities might be as small as the trade commission, but at their current shallow depth, it's probably more.  You buy them and since you have no reason to sell them, you keep them for a long long time: you're in no hurry to spend them, and at the price that you're demanding, nobody's buying anyway.  You might want to invest them somewhere, but as businessman BitQuestr points out, few businessmen want to take out loans and give you interest in a deflationary world, so your investment opportunities are few and far between.  You're certainly not going to give out negative-interest loans (why on earth would you do that?).  Maybe you're willing to take a risk on your own, but you don't have to: in a deflationary world, you're guaranteed not to lose purchasing power, and this is your retirement after all.  By taking those Bitcoins out of circulation, now there are fewer Bitcoins chasing the same goods, so prices go down.  Everyone's Bitcoins are suddenly a bit more valuable (to those who have them), so it's a bit more tempting than before to not spend these things if you can afford to wait.

Sooner or later, most bitcoins in quick circulation will end up being captured by someone who can sit on them as long as they need to.  Maybe not in the first transaction, maybe not in the second, but once they land in one of these people's wallets, they're gone for a *long* time.  In other words, from your point of view, you might see lots of Bitcoins flowing through your account, but from a Bitcoin's point of view, they zap and zap between a few accounts before landing on a retirement stash and staying put for 40 years.

In an inflationary setting, removing money from circulation like that, with the concomitant decrease in economic activity, is punished by eroding the value of that money.  If you want to stay ahead of inflation, you *have* to invest the money somewhere, which keeps it moving.  When money is flowing in one direction, work is flowing in the opposite direction, and that work is what we actually care about in the real world.  For better or for worse, most people are not entrepreneurial, and if you tell them that if they keep their money under the mattress, all will be well, that's exactly what they'll do.  If you want think of profit as the carrot for investing, inflation is the stick.

* Be creative: imagine what food will cost compared to now if 9 billion people have to eat every day, and everyone demands their wallet balance to always be at least a day's worth of expenses.  hint: that's 0.002 BTC / person under complete equality and assuming each and every Bitcoin changes hands daily.  For comparison, the equivalent measure for dollars is about half a year, and for BTC now [discounting the "volume" generated by change transactions], about two years the same [sorry about that glitch].
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July 13, 2011, 09:36:24 AM
 #12

I don't think bitcoin is incompatible with loans.

Once bitcoin matures reaches a stable user base, the rate of deflation will correspond roughly to the rate of global economic growth.

Say for the sake of argument that this is 5%. (There will be fluctuations above and below this mean, but lenders and borrowers can hedge against those).

Say for the sake of argument that the rate of inflation of fiat currency is 3%.

Say that a lender is prepared to lend at a real interest rate of 10%.  Then he could either offer a bitcoin loan at a nominal interest rate of 5% or of fiat loan at a nominal interest rate of 13%.  Competition will push towards a market equilibrium with this 7% points difference between fiat and bitcoin interest rates.  Then it makes no difference what currency you lend in, you are getting the same real interest rate for both.

The only thing that would not be viable would be lending bitcoins with a real interest rate below 5%, because you can make more money by just sitting on your bitcoins.  But that would not be viable with fiat money either.  Why would anyone lend for a real interest rate below 5%, if they can get 5% returns simply by investing in the  global economy?

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July 13, 2011, 09:59:49 AM
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This is based on a misunderstanding of what predictable deflation does in a market. In fact, predictable deflation is already priced into the current price of a bitcoin. If a bitcoin is expected to be worth $25 next year, it cannot possibly be worth $10 right now because all the people who would rather have $25 next year than $10 now would bid the price up.
Your refute is based on the misunderstanding that the deflation has to be predictable. It doesn't. There only has to be a reasonable chance of it happening, and there definitely is. This makes taking up a loan for a house or even something much cheaper denominated in bitcoins a much higher risk than any sensible person would take.
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July 13, 2011, 10:01:40 AM
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This is false. Deflation does not encourage hoarding. The argument that deflation encourages hoarding works just as well to argue the deflation encourages spending.
Reality does not agree with you, people are hoarding bitcoins like crazy.
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July 13, 2011, 10:08:23 AM
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Businesses depend on loans because they are artificially so cheap right now.
No, businesses depend on loans because you have to spend money to make money. Of course, if the value of the money increase faster than most businesses can earn them then doing business will be bad business for most people who already have money. I'm sure you think you have a really good explanation for why this is a good thing too.
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July 13, 2011, 01:22:55 PM
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Reality does not agree with you, people are hoarding bitcoins like crazy.
Not because they expect them to deflate due to scarcity, but because they expect the probability that the expected deflation will actually occur will increase. My argument only applies to expected (in the sense of generally agreed to be a near certainty) deflation.

Imagine if there was universal agreement that Bitcoins would be worth $1,000 each next year. The price would rapidly shoot up to near $1,000 now, nobody would sell for much less and nobody would buy for much more. Then there would no longer be any need to hold them to next year to get the deflated value.

The reason the price is going up is not because they will be worth $1,000 in ten years and it's getting closer to then. It's because people are becoming more convinced that the value might actually be $1,000 in ten years. That is, it's not deflation that's raising its value. It's that people are realizing they might actually deflate.

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July 13, 2011, 02:17:05 PM
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"Not because they expect them to deflate due to scarcity, because they expect the probability that the expected deflation will actually occur will increase"? Does this actually make sense to you? That's just desperate. Of course it's because they are scarce. We will seldom get closer to "expected deflation" in the real world than we have with bitcoins today, so the purely theoretical "expected inflation" you are arguing against is basically a straw man. There will never be a universal agreement about anything, and certainly not a bitcoin price, so why pretend that is what we are talking about? That does not stop people from hoarding bitcoins.
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July 13, 2011, 02:27:04 PM
 #18

"Not because they expect them to deflate due to scarcity, because they expect the probability that the expected deflation will actually occur will increase"? Does this actually make sense to you?
Yes. Many people believe Bitcoins will never depreciate but that bitcoins will be replaced by something else or cryptocurrency will fail long before that happens.

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That's just desperate. Of course it's because they are scarce.
Scarcity is only one component of price. My poop is scarce, but it's not valuable. What's happening is that people are become more convinced that bitcoins will actually hold value.

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We will seldom get closer to "expected deflation" in the real world than we have with bitcoins today, so the purely theoretical "expected inflation" you are arguing against is basically a straw man. There will never be a universal agreement about anything, and certainly not a bitcoin price, so why pretend that is what we are talking about? That does not stop people from hoarding bitcoins.
The expected deflation only happens if bitcoins are an established currency with solidly established value and declining supply. Otherwise, people would just switch to some other currency.

I am an employee of Ripple.
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July 13, 2011, 02:56:13 PM
 #19

The expected deflation only happens if bitcoins are an established currency with solidly established value and declining supply. Otherwise, people would just switch to some other currency.
At least you now seem to agree that bitcoin has what can be called expected deflation. Now you only need to realise the logical result of that. As Jalum said, "You are sooo close".
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July 13, 2011, 03:06:54 PM
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The expected deflation only happens if bitcoins are an established currency with solidly established value and declining supply. Otherwise, people would just switch to some other currency.
At least you now seem to agree that bitcoin has what can be called expected deflation. Now you only need to realise the logical result of that. As Jalum said, "You are sooo close".
The logical result is that once such deflation is generally accepted as inevitable, the present value will be the greatest of the net present value of all future price points.

If a Bitcoin is forecast to be worth $1,000 USD in 2015. The current value of a bitcoin will have a market lower bound of whatever the present value of $1,000 USD in 2015 is. If I said "how much would I have to pay you today to get $1,000 USD in 2015" and you said "oh, about $815", then the present value of a Bitcoin will be bid up to at least $815, since a bitcoin includes the ability to have $1,000 USD in 2015 and that alone is worth $815.

This requires a general agreement that the deflation will actually happen. Unpredictable deflation will not have this effect.

So predictable deflation gives no incentive to hoard unless you'd prefer the value in the future. You can sell the deflating asset to get equivalent value today.

I am an employee of Ripple.
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