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Suppose Bitcoin lenders (banks, creditors, investors) issue loans with interest. As the total supply of Bitcoins approaches the 21M ceiling, the total amount owed in outstanding interest will exceed the money supply.

This is the same as existing banks: they actually hold only a fractional reserve of funds, and the economy as a whole owes itself more money than there is in existence.

The difference is that reserve banks can print more money (yes, with inflation). Bitcoin can't.

An economy can continue to operate, I assume as long as there is enough circulation for a debtor to pay back his interest. However, since interest is compounded, it grows at an exponential rate: over time, wouldn't the total debts eventually outstrip the coins in circulation available to repay them?

Would Bitcoin find itself in a situation similar to the current global economic crisis? How would it correct itself?

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It doesn't matter very much because the economy can trivially create substitutes for currency. Anything that has the same capabilities as currency (fungible, easily exchanged, limited supply) can also serve as currency.

A good example would be a Mt. Gox code. Mt. Gox may or may not have 100% reserves, but it doesn't matter. A Mt. Gox code for 100 Bitcoins is basically as good as 100 Bitcoins. If you don't fully trust Mt. Gox, maybe it's as good as 99.5 Bitcoins.

Also, you can "print money" without actually being able to produce currency. For example, say I want to buy a car today and need 2,500 Bitcoins to do so. If someone loans me 2,500 Bitcoins in exchange for an insured IOU to pay 2,600 Bitcoins in six months, the 2,500 Bitcoins I borrowed to buy the car are still in circulation. But there is also now an IOU in circulation that is also worth 2,500 Bitcoins. As that note comes closer to maturity, it's value will go up. So just by time passing, the effective number of Bitcoins in circulation will go up.

This is bad news to the people who don't like the way a modern economy works, oppose fractional reserve banking and currency controls, and think that Bitcoins will bring on a new economy where banks can't create money. But I think it's pretty obvious that the same kinds of things will happen.

The whole Bitcoin system itself is an example of creating money out of thin air.

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Good sir, I dare to disagree about the "bad news" in that those "Mt Gox promissary notes" and other IOUs can and will become a currency of their own, detaching from the Bitcoin value, simply because they will be clearly distinguishable. This is contrary to today where we can't differentiate where a dollar we hold comes from, leading to these inflation problems that we can hopefully leave behind in a Bitcoin world. –  herzmeister Sep 23 '11 at 11:28
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A check is clearly distinguishable from a dollar bill. A credit card or number in a bank account is clearly distinguishable from a check. The point is not that people can't tell, it's that so long as they work the same, people don't care. –  David Schwartz Sep 23 '11 at 11:34
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I don't see the difference. If I loan you 10 bitcoins in exchange for an IOU, the bitcoins are in circulation and so is the IOU and everyone can tell the difference but they trade the same. If a bank loans me $100,000 in exchange for a mortgage, the $100,000 is still in circulation and so is the mortgage and everyone can tell the difference but they trade the same. A bitcoin created by a loan would appear precisely the same. The loan would appear different, but nobody would care. –  David Schwartz Sep 23 '11 at 11:47
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@Chris: It's precisely the same. In both cases, the loaned funds are still available for someone's use, and the loan itself acts as additional funds as well. –  David Schwartz Sep 26 '11 at 16:01
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@DavidSchwartz: Consider banks which dealt in gold/gold receipts prior to central banking. They could issue more receipts than gold, even though it is essentially fraudulent. Bank runs happen when people find out about this. The threat of runs keeps their desire to commit fraud in check. Central banks "fixed" this by removing the gold from the equation, institutionalizing the fraud. However, this required the ability to essentially confiscate all the gold. That would be rather difficult to do with Bitcoins. –  Chris Rico Sep 26 '11 at 21:25
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The limited money supply isn't actually an inherent problem for payment of interest. As long as the people being paid the interest are spending it back into the economy (presumably the banks, creditors, and investors have expenses, right?), then there will be an opportunity for the person who owes the interest to earn or buy it back and use it to pay down their debt--with each cycle of this the debt gets further paid off, no matter how limited the total amount of currency. To understand how this works, imagine that the person who borrowed the money is working as a janitor at the bank. The interest they pay funds their wages, so the same coins can keep circulating in a loop as the debt is paid off.

Speaking more broadly, most people don't just borrow more and more and more all the time. During the course of operations a responsible business or individual tends to pay down their debt, so the total amount of debt wouldn't automatically grow simply due to compounding.

The larger problem for an economy with a limited total currency supply is that, given ongoing economic growth, the value of the currency itself will tend to rise. This makes any "reasonable" interest rate end up being negative, and in that case why would anyone lend money anyways? There are ways around this involving futures markets, etc. However, it's quite unlikely that someone would choose to denominate their debt in bitcoins in the first place because it would be so confusing. Remember, no reasonable person believes that bitcoins are going to replace all other currencies. So probably, you would just borrow money denominated in one of the many other possible currencies instead, and use it to buy bitcoins if you needed them.

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The inability or unwillingness of financial entities to return 100% of moneys taken as interest to the economy was the primary reason that usury was punishable by death for much of human history. Of course banks still don't return 100% of interest moneys to the economy so I'm not really sure why we stopped thinking it was a bad thing. In any case, it's not a core Bitcoin problem so much as a core economics problem that will apply to anything used as currency. –  David Perry Sep 22 '11 at 21:26
    
Re: "the total amount of debt wouldn't automatically grow simply due to compounding": it's true that an individual tends to repay their own debt but at the same time the money plus interest they pay back can be re-loaned to others. As long as there is outstanding debt in the totality of the system, the total amount owed will continue to grow even as individual loans are repaid. No? –  Andrew Vit Sep 22 '11 at 21:33
    
From the bank's perspective, yes. But from an economic perspective you will eventually saturate the number of people/businesses who want loans. –  eMansipater Sep 22 '11 at 21:39
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David is right that Bitcoin in itself does not prevent the practice of fractional reserve banking.

But the difference with Bitcoin is that unlike gold, you now have a digital, easily transferable, easily storable, easily secured currency. Banks would need to fight much harder for deposits now because there is alot less reason to trust a bank with your bitcoins when you can just store it in a encrypted wallet.

The core difference is that even if everyone in the world decides to trust their bitcoins with banks, the base money supply will not be inflated via a central bank in the event of a bank going bankrupt. This will inevitably cause banks to increase their reserves and reduce risk to appease depositers of the safety of their funds, possibly only accepting fixed-deposits. The end result is that the interest gap between savings and borrowing rates will have to shrink due to a competition for deposits.

And given bitcoin's properties, i can assure you that most people would demand payments in bitcoins instead of a banks IOU for large amounts.

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It cannot. Fractional reserve banking is an experiment. The premise of using a hyper-inflationary currency is tested to show if it can promote a healthy economy. Bitcoin is an experiment to see if a secure hyper-fluid deflationary currency can promote new forms of economies. They may exist together for a very long time, but the most successful experiment will eventually win out. I suspect multiple deflationary currencies will supersede the model of a single inflationary currency.

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