Bitcoin Loans and Lending; The Weakness in The Bitcoin Economy

[Rassah]

I don't think the argument about "deflation is not actually bad" or deflation is priced into bitcoin" is really relevant. It is what it is, and if bitcoin becomes dominant, we'll have to deal with it.

On that note, here's my answer to your original post: Currently loans are structured so that each consecutive repayment of the loan is actually worth less than the previous one. In nominal terms the amount is the same, but the value decreases due to deflation. So, a $1000 mortgage payment on your first month becomes the equivalent of a $411 mortgage payment on your 360th month at the end of the 30 year loan, assuming 3% annual inflation. Since we can't control the rate of inflation, can't control the amount of the loan, and can't, or shouldn't, change the interest rate earned on the money, since interest rate is basically the cost of holding or lending that money, our only real option is to change the principal (repayment) amounts. If we want to follow the established structure, we would need to figure out how to have the first payment be worth the equivalent of a $1000 payment, and the last payment be worth the equivalent of a $411 in real value amount (not nominal amount). My algebra skills have gotten EXTREMELY rusty, though, but here is the current level-payment annuity formula:

R = P / [ (1 - (1 + i)^-n) / i ]

R is the payment amount
P is principal amount
i is interest
n is number of terms
(If you wish to calculate monthly payments using an annual interest rate, say of 5%, you need to use i/12 for interest and n*12 for term)

Since we know that, in this formula, despite the nominal value of R remaining the same, the actual value of R is decreasing when using inflationary fiat, for a deflationary currency that formula has to be tweaked somehow to make sure that the value of R changes with every n term, decreasing in both nominal and real value as it approaches the maximum value of n, while still paying off the entire P principal and providing the entire i interest return to the lender. The end result will likely be a much higher than $1000 for the first payment though.
As I said, my algebra skills are really rusty, so if anyone feels like taking a stab at it, please do. Playing around in Excel got me nowhere, sadly.

[Rassah]

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.

Just want to say, brilliant point on this one. Thanks!

[Grinder]

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.

You keep repeating these trivial models, but the fact remains that your theoretical models are only good in theory. There is no universal agreement about anything, so in practice they have very little value. They only look convincing if you already believe or want to believe what they are saying.

[Rassah]

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.

You keep repeating these trivial models, but the fact remains that your theoretical models are only good in theory. There is no universal agreement about anything, so in practice they have very little value. They only look convincing if you already believe or want to believe what they are saying.

Thing is, what he is saying is basically how our finance world and business already operates. NPV (Net Present Value) and annuity formulas are used to figure these types of things out all the time when making business, lending, or investing decisions. He's just pointing out that the same thing will pretty much continue to happen, but from a different angle.

[JoelKatz]

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.

You keep repeating these trivial models, but the fact remains that your theoretical models are only good in theory. There is no universal agreement about anything, so in practice they have very little value. They only look convincing if you already believe or want to believe what they are saying.

What do you think the bond market is? Of course there isn't universal 100% agreement. But the closer you have to that, the more accurate the model is. Look, either we can know that bitcoins will deflate or we can't. If we can't, then you can't even say that deflation is a problem. And if we can, then you can't say deflation is a problem because my model applies.

It is, in fact, a perfect balance. Every bit of expected deflation is one pressure to hoard and one pressure not to. This is not some magic coincidence, it's the nature of markets. The extent to which the market is willing to bet on deflation is the extent that the market believes the currency will deflate.

The market will rationally take in all available information. If there's a 90% chance that a bitcoin will be worth $1,000 in 2015, then my argument will apply to 90% of the net present value of $1,000 in 2015. If there isn't, then bitcoins aren't deflating.

If your question is, "what happens if bitcoins deflate but nobody predicts it", I'd say, "what happens if dollars deflate but nobody predicts it?"  Every reason we have to think bitcoins will deflate is a reason to predict deflation. If you're outside of the realm of evidence, all claims are equally valid.

[CurbsideProphet]

Assuming this: http://forum.bitcoin.org/index.php?topic=27166.0 is the expected value of Bitcoin at the end of the year, over 50% of the community believes price will be in excess of $36.  Over 22% believe the price will be greater than $100.  Yet Bitcoin currently sits at $14, substantially lower than the general consensus.

While your theories, similar to the efficient-market hypothesis, seem nice on paper are impractical when applied to real life.     

[JoelKatz]

Assuming this: http://forum.bitcoin.org/index.php?topic=27166.0 is the expected value of Bitcoin at the end of the year, over 50% of the community believes price will be in excess of $36.  Over 22% believe the price will be greater than $100.  Yet Bitcoin currently sits at $14, substantially lower than the general consensus.

While your theories, similar to the efficient-market hypothesis, seem nice on paper are impractical when applied to real life.     

I agree that bitcoins cannot be reliably predicted now. They could become completely worthless if they're replaced by a superior cryptocurrency or if crytpocurrencies don't catch on. But the argument here is about what will happen if bitcoins are predictably deflationary. They aren't right now, so what's happening to them now isn't relevant.

The claim is that bitcoins will deflate, that people will know that they will deflate, and will therefore hoard them. I've argued that this isn't possible.

If you want to argue that people will not know that bitcoins will deflate, then you've found another way to refute the argument that deflation will lead to hoarding. If the deflation is a shock and surprise, people won't hoard in anticipation of it. People don't expect dollars to deflate, so they don't hoard them either.

[Grinder]

The claim is that bitcoins will deflate, that people will know that they will deflate, and will therefore hoard them. I've argued that this isn't possible.

Nobody can predict the future with 100% certainty and everybody knows it, so that's just another straw man. It's enough that people assume they will inflate, which a lot of people do, so they hoard them. The only reason to assume it will not inflate is if you don't think bitcoins will be a success. Apparently enough people currently thinks that to balance out those who think it will.

[JoelKatz]

The claim is that bitcoins will deflate, that people will know that they will deflate, and will therefore hoard them. I've argued that this isn't possible.

Nobody can predict the future with 100% certainty and everybody knows it, so that's just another straw man.

Then the argument that we can predict that bitcoins will deflate and cause hoarding is a straw man too. Your argument that we can't know anything for sure, therefore we can know that deflation will cause hoarding is self-refuting.

To the extent that we don't expect deflation, we don't expect hoarding. To the extent we do expect deflation, we can expect the price to be bid up to discourage hoarding. It's not coincidence that they cancel out, it's simple market mechanics.

To the extent we cannot predict what bitcoins will do, we cannot predict what will happen. I agree that an unpredictable currency is not as good as a predictable one. If bitcoins remain unpredictable over the long term, they will probably not be a viable currency.

In the short term, the advantages of bitcoins over other currencies are to some extent moderating the harm the unpredictability will do. Also, unpredictability brings volatility which brings speculators, which to some extent helps to balance out people driven away by volatility. Long term, bitcoins will have to become predictable to be useful as a real currency.

The market does even have ways to protect against unpredictability, but that's an awful lot of work to go through. Unpredictability functions like a tax on a currency because you have to pay to hedge it, and most people prefer not to gamble with the money they're trying to live on and run a business on.

[Grinder]

To the extent that we don't expect deflation, we don't expect hoarding. To the extent we do expect deflation, we can expect the price to be bid up to discourage hoarding. It's not coincidence that they cancel out, it's simple market mechanics.

Problem is, they can't cancel each other out in the long run unless you stop population and economy from growing. As long as the bitcoin economy gets larger the value of bitcoin will continue to inflate. As long as that happens it doesn't matter what price you put on bitcoin, the fact remains that it will be even more scarce in the future. That's why I said that the only reason to think the value of bitcoin will not continue to inflate is if you think it will fail.

[JoelKatz]

To the extent that we don't expect deflation, we don't expect hoarding. To the extent we do expect deflation, we can expect the price to be bid up to discourage hoarding. It's not coincidence that they cancel out, it's simple market mechanics.

Problem is, they can't cancel each other out in the long run unless you stop population and economy from growing. As long as the bitcoin economy gets larger the value of bitcoin will continue to inflate. As long as that happens it doesn't matter what price you put on bitcoin, the fact remains that it will be even more scarce in the future. That's why I said that the only reason to think the value of bitcoin will not continue to inflate is if you think it will fail.

They do cancel each other out. If the value change is predictable, it will be bid into the price, regardless of the source of the change in value.

If we all expect gold to be worth $5,000/oz next year, it will be bid up to very near the present value of $5,000 in one year. This is true regardless of why the price is expected to go up. In such a market, when you sell an ounce of gold, you are selling the right to have a $5,000 payment next year. So the value of an ounce of gold will be at least what the right is worth.

Population and economic growth are predictable.

People have to know it's going to increase in value to be incentivized to hoard. People don't hoard dollars, but they might go up in value. Why don't they? Because they don't expect them to go up in value.

You want to argue that we all know it will go up in value unpredictably. That's self-refuting.

[Rassah]

To the extent that we don't expect deflation, we don't expect hoarding. To the extent we do expect deflation, we can expect the price to be bid up to discourage hoarding. It's not coincidence that they cancel out, it's simple market mechanics.

Problem is, they can't cancel each other out in the long run unless you stop population and economy from growing. As long as the bitcoin economy gets larger the value of bitcoin will continue to inflate. As long as that happens it doesn't matter what price you put on bitcoin, the fact remains that it will be even more scarce in the future. That's why I said that the only reason to think the value of bitcoin will not continue to inflate is if you think it will fail.

Why do you hoard your $100 bitcoin if you know that it will be worth $120 in a year? Likely answer is so you can buy something in a year when your money is worth $120, meaning your money will have 20% buying power 1 year from now. What's to stop you from buying now if the merchant simply took the 20% deflation into account, and gave you a 20% discount on the item today? You'll have a choice of buying something for $80-equivalent today and have $20 left over, or $100-equivalent a year from now and have $20 left over a year from now.

[Grinder]

(snipped your beloved "proof")

People have to know it's going to increase in value to be incentivized to hoard. People don't hoard dollars, but they might go up in value. Why don't they? Because they don't expect them to go up in value.
You want to argue that we all know it will go up in value unpredictably. That's self-refuting.

So why do people hoard gold at ever-increasing prices? Your theory obviously doesn't correspond with reality.

[JoelKatz]

So why do people hoard gold at ever-increasing prices? Your theory obviously doesn't correspond with reality.

They hoard gold because they believe that gold will increase in value by more than everyone else does. That is, they hoard gold because they believe that it will unpredictably deflate. People who have expectations that differ from everyone else's do all kinds of things that seem irrational to everyone else. If their expectations are right and everyone else's is wrong, they'll profit. If not, they'll lose.

Another factor is that they believe their fiat currencies are crap. They hoard gold because they have no alternative investments denominated in anything other than fiat currency. This type of hoarding is good, assuming they're correct, it reflects rationally deferred consumption.

There will always be some irrational people with irrational beliefs who do irrational things for irrational reasons. It's hard to tell how much gold hoarding is rational and how much is irrational. But it's not because they agree with the consensus view about how much gold will go up in value. If they did, they'd hoard about as much gold as the average person does.

[Grinder]

There will always be some irrational people with irrational beliefs who do irrational things for irrational reasons. It's hard to tell how much gold hoarding is rational and how much is irrational. But it's not because they agree with the consensus view about how much gold will go up in value. If they did, they'd hoard about as much gold as the average person does.

Talking about rational or irrational gold hoarding is meaningless, and so is talking about a consensus. There is no consensus. If there were everybody would sell because it's no use in holding on to something that has reached it's maximum price and does not pay interest.

[LeonGeeste]

By my count, JoelKatz seems to have won this thread several times over by now.

There are people who understand the economics behind your points, they're just (mostly) staying out of this.

[BBanzai]

I must admit, I skipped a half page before replying.  Basic premise....modern businesses rely on loans to conduct their business. Lenders make tons of money on interest.  Historically, have the businesses benefited most from loans and lenders?  Or from financing their own growth with their own profits?  You need to start with savings, your own capital, no liens or mortgages, to start off that way.  Lenders serve a purpose, certainly, and should expect some reward for their service...but when most business models require outrageous debt, interest, and no self-sufficiency, what do we get?  Ummmm.  Greece.  Lehman Brothers.  The U.S. Italy. Et cet.  you cannot have an economy dominated by consumers and lenders, it eats itself and everything around it.  Lenders do not produce new value, consumers do not produce new value, eventually everyone reverts to cannibalism.  Because there is nothing left to eat.  I would add something about bureaucratic functionaries, perhaps another time.

[patvarilly]

I must admit, I skipped a half page before replying.  Basic premise....modern businesses rely on loans to conduct their business. Lenders make tons of money on interest.  Historically, have the businesses benefited most from loans and lenders?  Or from financing their own growth with their own profits?  You need to start with savings, your own capital, no liens or mortgages, to start off that way.  Lenders serve a purpose, certainly, and should expect some reward for their service...but when most business models require outrageous debt, interest, and no self-sufficiency, what do we get?  Ummmm.  Greece.  Lehman Brothers.  The U.S. Italy. Et cet.  you cannot have an economy dominated by consumers and lenders, it eats itself and everything around it.  Lenders do not produce new value, consumers do not produce new value, eventually everyone reverts to cannibalism.  Because there is nothing left to eat.  I would add something about bureaucratic functionaries, perhaps another time.

I think you may be sacrificing an important tool in the name of removing some of its misuses.  I will agree with you heartily that when someone uses a credit card to buy a $1000 plasma screen TV, or a $7000 luxury cruise in the Caribbean, but has no real savings to pay off the credit card, this is a terrible idea, and the economic "activity" that has taken place is unsustainable and undesirable.  As an individual, the only two assets for which I'm willing to go into to debt to are education and a home, and the latter only because, under most realistic scenarios of what the future has in stock for me, I won't be able to save for one before it's too late for me to reap the benefits of owning one (i.e., the timescale for saving for this is comparable to my lifetime, and I want to get to live in that home).

The education part is more interesting, and is connected to lending and credit serving a useful role.  If I educate myself, presumably my income will go up, and I can both pay back the loan and have enough left over to live a better life.  If I don't educate myself, presumably the amount that I can save per year might be so meager that I would die before I could finish saving for the cost of an education.  This logic is what goes on behind most business investment.  You borrow because the investment that you can make with that money will pay for itself much more quickly than you could save in order to make that same investment.  Since presumably that investment lastingly increases your capacity to receive income, the person who borrows and invests will be, *for the entire foreseeable future*, better off than the person that insists on never borrowing.  In other words, to answer your question, it's the businesses that borrow and invest, not the ones that grow with their own profits, that do best (this is why the OP was so concerned).  In this "good loan" scenario, *both* the lender and the business benefit, the lender because he gets interest for doing nothing but acknowledging that he doesn't need that money for a long time (so he can focus on other pursuits) and the business because the loan has paid for itself and grown the business much more quickly.  If you malinvest, as Greece, Leeman Brothers, etc. have done, then that's your problem that you haven't used loaning in a sensible way.  But it's not an argument against loaning per se.

The trouble with loans in a deflationary environment is that you have no incentive to make them unless the effective interest rate
you could get for them is at least as high as the deflation rate.  Hoarding your money is a zero-risk way of getting that effective interest rate.  On the other hand, in an inflationary environment, hoarding your money is *guaranteed* to make you poorer with time.  To avoid that, you either need to do something with that money yourself (which most people rarely, if ever, get to in their lives), or you need to lend it out to other people who can put it to work out there on your behalf.  The rate at which you lend it out for this to make sense doesn't even need to keep up with inflation (as happens with savings in a bank account, or lending to the US Treasury) because if you do this, the rate at which you become poorer is at least lower than if you keep your money.  *This* is the loaning logic that breaks down in a deflationary world.  You kill off all the low-cost (low-risk) financing, and only leave the high-cost financing behind, so the effective cost of financing anything goes way up, and you slow investment all around.  We are all worse off as a result.

[Denicen]

I have a question that might be stupid and might have already been asked before, but I am gonna ask anyways.

Why would you ever want to hold an inflationary currency versus a currency that isn't? If someone has the option between using an inflationary currency or a deflationary one, why would they ever choose the inflationary one? I mean you personally.

OK like this scenario: 40 years in the future the US dollar is still being inflated, while bitcoin is fairly stably deflating (and it is not subject to the large swings that it is having now). Would you want your paycheck in US dollar or in bitcoin?

[BBanzai]

If you educate yourself...you owe nothing, libraries are free.  The internet is free-ish.  Learning by doing has its costs, but they aren't loans as such.  Learning does not automatically make you an indentured servant to loans unless you think that colleges are the only stores of real information.  Anyone that mistakes money for value does not understand how the map differs from the territory.  Don't worry about money.  Worry about how to make more real value than you need yourself.  Sell it, save it, give it away, whatever you want.  But learn about self-sufficiency first.