Bitcoin Loans and Lending; The Weakness in The Bitcoin Economy

[makomk]

We pretty much know for a fact that the USD is inflationary, with a long-term inflation rate of 3%. So, why isn't USD worth 0 now? (answer is because we don't calculate the value of money to infinity; only to the time we actually need to use it/invest is/repay it)

Exactly. This argument doesn't work for inflation because you can invest the money now in something that will hopefully give you good returns, so it doesn't matter that it would eventually be worth nothing if you just sat on it. The problem with deflation is that just sitting on your money is actually a realistic scenario.

As for next year, the $100 IS a discount on the $120 from the following year. This is how the time value of money works.

Except that the problem is that if we had price deflation, no one will be able to charge $120 to buy the product in a year's time, because the money would be worth more by then and that'll force prices down, not up.

But they are not buying money, they are buying product. If I carve something out of wood, and the cost is just the wood and a knife, I won't care if you pay me less for it a few months from now, if the amount I get has the same value as it did two months ago. That's why my price would decrease.

Ironically, the thing you're not quite grasping here is the time value of money. Receiving 995 BTC now is worth more than receiving 995 BTC in two months time, because having it now encompasses both the possibility of having it in two months' time and the possibility of spending it in the meantime. This is still true if deflation means that 995 BTC is worth more in two months' time, because you can take advantage of this even if you're paid it now. So if you're willing to sell delivery of some good now in return for 995 BTC later, you should be even more happy to do it for 995 BTC right now.

I agree. The assumption that predictable deflation is not built into the price leads to the conclusion that the price is too low, regardless of how high it is. Therefore, the assumption is false. Predictable deflation is built into the price. That's kind of my point.

No. My point is that predictable deflation cannot be built into the price, because the only rational price would be infinite (at least in this oversimplified scenario). More interestingly, look at what happens when everyone's only mostly certain about future deflation: the effects of predictable deflation on the price cancel out and price deflation occurs at exactly the same rate as it would have anyway. (This is again slightly oversimplified: in practice future expectations should help smooth out the rate of price deflation, but over the long term it has no effect.)

[1713946669]

1713946669

[1713946669]

1713946669

[1713946669]

1713946669

[1713946669]

1713946669

[1713946669]

1713946669

[JoelKatz]

My point is that predictable deflation cannot be built into the price, because the only rational price would be infinite (at least in this oversimplified scenario).

This is self-evidently false. The value of deflation can be built into the price and it's obviously finite.

The problem is, you're starting with the assumption that deflation is not built into the price and then showing that it cannot be built into the price. Of course if it is not built into the price, it cannot be built into the price. You do this by saying "The value is X today, but it also has additional value because it will deflate. Let us calculate that additional value." The X already includes the deflation value, just as the future X's also include the predicted future deflation value past that point. There is nothing else to add.

If you want to say "The value is X today, but it has additional value because it will deflate", your X must be the current value less the deflation value. And the future values you calculate the present value of must also be exclusive of the deflation value. If the deflation value is actually infinite, then the present value less the deflation value is infinitesimal, and the future values less their deflation values that you are adding to the present value are also infinitesimal, so you have a sum of an infinite number of infinitesimals which can be, and in this case must be, finite. This is especially so because a time frame of over, say, 1,000 years is self-evidently absurd. Nobody can be confident something will deflate for that long. Heck, we may not have physical bodies in 1,000 years.

[BBanzai]

Competition is for dogs.  If you produce what you need, you need no other.  If you produce more than you need yourself, you are in business.

[Synaptic]

My point is that predictable deflation cannot be built into the price, because the only rational price would be infinite (at least in this oversimplified scenario).

This is self-evidently false. The value of deflation can be built into the price and it's obviously finite.

The problem is, you're starting with the assumption that deflation is not built into the price and then showing that it cannot be built into the price. Of course if it is not built into the price, it cannot be built into the price. You do this by saying "The value is X today, but it also has additional value because it will deflate. Let us calculate that additional value." The X already includes the deflation value, just as the future X's also include the predicted future deflation value past that point. There is nothing else to add.

If you want to say "The value is X today, but it has additional value because it will deflate", your X must be the current value less the deflation value. And the future values you calculate the present value of must also be exclusive of the deflation value. If the deflation value is actually infinite, then the present value less the deflation value is infinitesimal, and the future values less their deflation values that you are adding to the present value are also infinitesimal, so you have a sum of an infinite number of infinitesimals which can be, and in this case must be, finite. This is especially so because a time frame of over, say, 1,000 years is self-evidently absurd. Nobody can be confident something will deflate for that long. Heck, we may not have physical bodies in 1,000 years.

So, deflation has been built into the value of bitcoin as it's fluctuated from $0.00 to $30.00 and back down to...$10?

I think you're missing some appreciable percentage of your parietal lobe...

[Rassah]

My point is that predictable deflation cannot be built into the price, because the only rational price would be infinite (at least in this oversimplified scenario).

This is self-evidently false. The value of deflation can be built into the price and it's obviously finite.

The problem is, you're starting with the assumption that deflation is not built into the price and then showing that it cannot be built into the price. Of course if it is not built into the price, it cannot be built into the price. You do this by saying "The value is X today, but it also has additional value because it will deflate. Let us calculate that additional value." The X already includes the deflation value, just as the future X's also include the predicted future deflation value past that point. There is nothing else to add.

If you want to say "The value is X today, but it has additional value because it will deflate", your X must be the current value less the deflation value. And the future values you calculate the present value of must also be exclusive of the deflation value. If the deflation value is actually infinite, then the present value less the deflation value is infinitesimal, and the future values less their deflation values that you are adding to the present value are also infinitesimal, so you have a sum of an infinite number of infinitesimals which can be, and in this case must be, finite. This is especially so because a time frame of over, say, 1,000 years is self-evidently absurd. Nobody can be confident something will deflate for that long. Heck, we may not have physical bodies in 1,000 years.

So, deflation has been built into the value of bitcoin as it's fluctuated from $0.00 to $30.00 and back down to...$10?

I think you're missing some appreciable percentage of your parietal lobe...

I think you're trying to argue this from a "wtf is this?" layman's point of view, while others are trying to argue this from a "standard business practices" point of view, and as a result, the two discussions are on completely different wavelengths.
Yes, if I was running this business, I would have deflation expectations built into my prices, just as I have inflation built into my USD prices. Currency fluctuation is just something completely different I have to deal with, having nothing to do with deflation, which is something I already deal with when dealing with USD/EUR

[makomk]

You do this by saying "The value is X today, but it also has additional value because it will deflate. Let us calculate that additional value." The X already includes the deflation value, just as the future X's also include the predicted future deflation value past that point. There is nothing else to add.

Aha! I have a feeling there's a problem with one of your assumptions, and I suspect may be the process by which the value of X takes deflation into account. There's already something driving the value of X - it's the prices of goods that can be purchased for X - and I don't think that in general the value of X can be such that it both matches the prices of goods that can be purchased for X and takes deflation into account. This is quite tricky to think through, though, because that's a fairly fundamental assumption of economics and I've never been that good at it at the best of times.

(Edit: Ah, that's interesting but not it, I think. However: changes to the value of X due to anticipated future deflation affect the rate of price deflation themselves, and that may be an issue.)

If you want to say "The value is X today, but it has additional value because it will deflate", your X must be the current value less the deflation value. And the future values you calculate the present value of must also be exclusive of the deflation value. If the deflation value is actually infinite, then the present value less the deflation value is infinitesimal, and the future values less their deflation values that you are adding to the present value are also infinitesimal, so you have a sum of an infinite number of infinitesimals which can be, and in this case must be, finite. This is especially so because a time frame of over, say, 1,000 years is self-evidently absurd. Nobody can be confident something will deflate for that long. Heck, we may not have physical bodies in 1,000 years.

You can't actually add up infinities like that. In any case, if we're not entirely certain about the future, then it's a lot simpler: over time we acquire new knowledge about future deflation, and unless there's suddenly some reason to consider it less likely this extra information will drive the value of X up over time. (Except for that one small outstanding issue...)

[BBanzai]

A symbol of value does not hold value.  It points to it.  The value of a sandwich, the value of a house, the value of gold....they do not change much.  You want some of the above everyday.  The 'value" of Cabbage Patch Kids or Magic the Gathering cards or comicbooks or stamps or modern currencies change all the time, and drastically, because they have no intrinsic value.  You can't eat them, you can only gloat about having them.  For a time.

[jtimon]

A symbol of value does not hold value.  It points to it.  The value of a sandwich, the value of a house, the value of gold....they do not change much.  You want some of the above everyday.  The 'value" of Cabbage Patch Kids or Magic the Gathering cards or comicbooks or stamps or modern currencies change all the time, and drastically, because they have no intrinsic value.  You can't eat them, you can only gloat about having them.  For a time.

You can't eat gold neither.
A symbol of value can hold value. For example an IOU, a dollar, a bitcoin or an ounce of gold.
The monetary value of gold has nothing to do with its industrial value.
There's no such thing as intrinsic value, value is always external to the object being valued, maybe how one values himself is intrinsic value, but nothing else.
If you mean that an object is valued similarly for many people then, yes, gold has been historically valued as a currency, as money, but its monetary value could drop to zero just like with fiat currencies. Because "gold is money" is like an agreement that could be canceled.

[johnyj]

value comes from desire, and the desire changes from time to time. Some desire seldom changes and is predictable, like the desire for food and housing etc... 300 years ago no one want petroleum, now... and 300 years later no one want petroleum

[JoelKatz]

So, deflation has been built into the value of bitcoin as it's fluctuated from $0.00 to $30.00 and back down to...$10?

Yes. Many factors affected its value, but deflation wasn't a significant one of them.

I think you're missing some appreciable percentage of your parietal lobe...

How do you figure?

[Grinder]

A symbol of value does not hold value.  It points to it.  The value of a sandwich, the value of a house, the value of gold....they do not change much.

That depends on your definition of "much". http://www.sharelynx.com/chartstemp/USHLSPOG.php

[JoelKatz]

What do I mean, let's say you take out a loan for 200 BTC in 2050, for the year prior there is a 10% deflationary rate, the bank wants an annual 7% profit so for the first year on your loan you have a NEGATIVE interest rate of 3% (This is probably mathematically not quite right, I'm just trying to prove a point),

It cannot work that way. 10 bitcoins today includes the right to have 10 bitcoins at any point in the future one desires. So 10 bitcoins will never be valued at less than the net present value of the expected future value of those 10 bitcoins at any point in the future.

You are thinking that bitcoins have a certain market value and then they have some extra value due to deflation. But this is not true. The market value includes the deflation value. There is nothing extra to use to offset the interest rate. The value from the deflation of the borrowed coins was part of what was borrowed from the bank and must be paid back to the bank in addition to the bank's interest.

Say an ounce of gold is generally expected to be worth $3,000 next year. Regardless of the present value of an ounce of gold, if you borrow an ounce of gold from me, you are borrowing at least the right to have $3,000 next year and I would insist that you pay me back at least the value of that right plus interest.

[JoelKatz]

Hmm... I never thought of it that way... makes sense and understandable because I switched shoes, if I loaned someone 10 bitcoins and next year 7 bitcoins has the same buying power would I be ok with them just paying me 9 BTC back... well no...  So, ya a negative interest would not work with a currency like this.  Causing receiving a loan in BTC even less desirable (which I actually think is a good thing), making a loan would be highly desirable because you get interest on top of the deflationary effects over time but borrowing hurts more getting the double whammy of interest + deflation...  I think I understand the mechanics of this a little better now....

You're close. But you are incorrect that borrowing takes a double whammy. Yes, of course you pay interest when you borrow. But the deflation cancels out. You benefit from the deflation on the borrowing end, because the bitcoins you borrowed are worth more to people today because they are expected to deflate. This cancels out most of the whammy on the deflation when you go to pay the money back.

To put it another way, expected deflation will make people want to hoard bitcoins so they can spend them later when they are more valuable. But they will also make people want to pry bitcoins out of other people's hands today so that they can hoard them. You will be borrowing these highly desirable deflating bitcoins that others will work very hard to get from you so they can sit on them. This partially cancels out the higher value of the bitcoins when you have to pay them back.

[Rassah]

Hmm... I never thought of it that way... makes sense and understandable because I switched shoes, if I loaned someone 10 bitcoins and next year 7 bitcoins has the same buying power would I be ok with them just paying me 9 BTC back... well no...  So, ya a negative interest would not work with a currency like this.  Causing receiving a loan in BTC even less desirable (which I actually think is a good thing), making a loan would be highly desirable because you get interest on top of the deflationary effects over time but borrowing hurts more getting the double whammy of interest + deflation...  I think I understand the mechanics of this a little better now....

A few of us on another thread have calculated out a loan repayment system that may work ok in a deflationary system. Basically, your first few payment will be higher than normal, with each consecutive payment decreasing until the last payment is fairly small compared to where you started. The loan is similar to an inflationary currency loan, where although each payment is the same amount, the value decreases over time, and it manages to pay back both bank's interest and compensate for deflation. One major assumption of it though is that deflation stays constant. The deflation amount may be adjustable on the fly, but I haven't played with that yet.

[jtimon]

Although it may decrease interest rates (negative inflation premium), deflation can never take them below zero.

I still think deflation makes borrowing to invest less desirable.
Say we have a potential secure investment that yields 5% of its value annually and interest rates are at 5%.
Our baker starts his bakery (and discounting its own wage and other costs) profits a 5% of the investment that goes to pay interest. After twenty years, the baker sells his bakery at the same price and pays back the full loan.
With stable prices, the investment covers its financial costs and therefore is economically viable.
With deflation, you also have to cover the gains of money from deflation to get the loan.
Say we have 5% annual deflation.
That same investment won't get the loan.
Producing exactly the same and selling the products at lower price each day, the baker can lower his wage to compensate deflation and will buy its supplies at a lower price, but he cannot lower the interest. Even if the loan is made in a way that the monthly payment of interest for the whole period takes deflation into account, the borrower will not be able to pay the loan after that period.
We have assumed a constant revenue of 5% and assuming there's no changes in the competition, there's no reason to expect it to go down.
But the nominal revenue has decreased. What has happened is that the capital (the bakery) has devalued. In our case to 0.95^20 = 0.358485922 % of its original price.

The business should have grown at a 5% rate too to compensate deflation. The interest paid monthly could be nominally constant in this case. Only the very best investments will get funded with deflation.

Edit: this example is also discussed here.

[JoelKatz]

The business should have grown at a 5% rate too to compensate deflation. The interest paid monthly could be nominally constant in this case. Only the very best investments will get funded with deflation.

All other things being equal, the benefit of investing over hoarding should be currency-neutral. That is, if an inflationary currency would lose 3% due to inflation if hoarded but gains 2% due to interest, a deflationary currency should also perform roughly 5% better if loaned rather than held.

There are two fallacies that lead people to the opposite conclusion:

1) Thinking that a deflationary currency is extra valuable to hold and forgetting that this means it has greater spending value too because the person you spend it with gets to hold it if they want. The value of the deflation comes from the lender and is carried through the transaction to the end.

2) Forgetting that the cost of inflation comes from the expansion of the money supply. This expansion acts as a tax on all wealth since the newly-printed money can claim any wealth in the economy. The cost of the inflation acts as a claim against the lender's wealth and is also carried through the transaction to the end.

The benefit to the borrower is from being able to consume earlier than he could otherwise. This value is currency-neutral and it is this surplus that is split between the lender and the borrower.

[makomk]

You're close. But you are incorrect that borrowing takes a double whammy. Yes, of course you pay interest when you borrow. But the deflation cancels out. You benefit from the deflation on the borrowing end, because the bitcoins you borrowed are worth more to people today because they are expected to deflate. This cancels out most of the whammy on the deflation when you go to pay the money back.

To put it another way, expected deflation will make people want to hoard bitcoins so they can spend them later when they are more valuable. But they will also make people want to pry bitcoins out of other people's hands today so that they can hoard them. You will be borrowing these highly desirable deflating bitcoins that others will work very hard to get from you so they can sit on them. This partially cancels out the higher value of the bitcoins when you have to pay them back.

I'm afraid the effect that you're hoping will cancel out the effects of deflation will mostly just cancel itself out. As a borrower you'll need to get hold of bitcoins to pay back the loan, but those bitcoins will again be worth more to the people you're trying to get them off because they're still expected to deflate, and you'll then be competing with all the people looking to get hold of those "highly desirable deflating bitcoins" to sit on. So even if you can get more for your loan because of expected future deflation, your income from which to repay it with will be less by roughly the same amount.

[JoelKatz]

I'm afraid the effect that you're hoping will cancel out the effects of deflation will mostly just cancel itself out. As a borrower you'll need to get hold of bitcoins to pay back the loan, but those bitcoins will again be worth more to the people you're trying to get them off because they're still expected to deflate, and you'll then be competing with all the people looking to get hold of those "highly desirable deflating bitcoins" to sit on. So even if you can get more for your loan because of expected future deflation, your income from which to repay it with will be less by roughly the same amount.

This is essentially what I'm saying. The deflation value is present both at the beginning and the end of the loan, so it cancels itself out.

When you have the ten bitcoins you borrowed to spend, you are also spending the value of their deflation. When you have to buy back ten bitcoins to pay back the principle, you also have to buy the value of their expected future deflation. It cancels out and has no effect on the loan.

The same is true with inflation. To the extent people are willing to part with dollars rather than hold them, your dollars are worth less today when you borrow them. But that also means they are worth less when you need to acquire them to pay them back.

[jtimon]

The business should have grown at a 5% rate too to compensate deflation. The interest paid monthly could be nominally constant in this case. Only the very best investments will get funded with deflation.

All other things being equal, the benefit of investing over hoarding should be currency-neutral. That is, if an inflationary currency would lose 3% due to inflation if hoarded but gains 2% due to interest, a deflationary currency should also perform roughly 5% better if loaned rather than held.

I'm assuming 5% nominal interest for both cases in my example.

There are two fallacies that lead people to the opposite conclusion:

1) Thinking that a deflationary currency is extra valuable to hold and forgetting that this means it has greater spending value too because the person you spend it with gets to hold it if they want. The value of the deflation comes from the lender and is carried through the transaction to the end.

In my example, the baker spends the money to buy real capital, he doesn't hold the money.

2) Forgetting that the cost of inflation comes from the expansion of the money supply. This expansion acts as a tax on all wealth since the newly-printed money can claim any wealth in the economy. The cost of the inflation acts as a claim against the lender's wealth and is also carried through the transaction to the end.

Yes, monetary inflation acts like a tax over any wealth and (if unexpected) damages in a special way to lenders.
If expected, it is just added to the nominal interest to maintain the real interest.

The benefit to the borrower is from being able to consume earlier than he could otherwise. This value is currency-neutral and it is this surplus that is split between the lender and the borrower.

But with deflation, money has an advantage over other capitals. When you buy capital, you expect its yield to be at least as good as basic interest (real interest less risk premium), thus the price of given capital can be calculated at any time from the basic interest rate in the market and the revenue you obtain with that capital. Deflation decreases the revenue, devalues real capital and therefore discourages its accumulation.
With deflation more than ever, money becomes the better of the capitals.

Do you see something wrong with my example?

[JoelKatz]

But with deflation, money has an advantage over other capitals. When you buy capital, you expect its yield to be at least as good as basic interest (real interest less risk premium), thus the price of given capital can be calculated at any time from the basic interest rate in the market and the revenue you obtain with that capital. Deflation decreases the revenue, devalues real capital and therefore discourages its accumulation.
With deflation more than ever, money becomes the better of the capitals.

Do you see something wrong with my example?

I think you're reasoning that whoever holds the money is paying the inflation tax and thus by loaning the money to someone else they have to pay the inflation tax. But if that were true, that would just make the money worth less today because taking the money would mean assuming the tax burden of inflation. It all cancels out however you figure it.

The cost of inflation is borne by the lender. The benefits of deflation are reaped by the lender. Otherwise, they have no effect on the mechanics of the loan except to offset the interest rate. All other things being equal, the benefit of lending over hoarding is the same.

If you hoard, you get whatever the money would do naturally. If you lend, you get whatever the money would do naturally (because you still bring that to the table in the first place) plus your share of the surplus created by the borrower being able to timeshift his consumption.