In today's society, people often take out loans from banks. In an economy that was run on bitcoins, how would someone go about getting a loan? I do not understand how this would work with Bitcoin's deflationary model. It seems a loan would be creating a short on bitcoins which could be very harmful with the value of bitcoins increasing.
Loans are possible in a deflationary environment. Currently bitcoins is too volatile (which has nothing to do with deflation) to make lending viable. For the purpose of answering the question I will assume that in the future volatility is either low or easily hedges.
The interest in a loan comes from 4 components:
Opportunity Cost. Instead of giving you a loan I could do something else productive with the money. If I could get a 10% ROI on my money by installing a new air-conditioner that will factor into the interest I change. It would be a loss to loan money to you at less than 10% (after adjusting for the other risks) as I would "earn" more by taking the 10% ROI.
Inflation risk. If money is worth 5% less in one year I will want to be paid 5% more even on a no risk no profit loan. Thus inflation contributes to the overall interest charged. Deflation would subtract from the overall interest charged.
Default risk. If you don't pay me I lose money. In the long run I need to collect interest equivalent to % of amount loaned that is lost due to defaults. If I project I will lose on average 10% of amount loaned and charge 11% interest then I would break even. Note: real world calculations are more complex because one may collect some revenue even from loans that default and may receive collateral, or sell defaulted loan for some recovery. Still default risk needs to be included in the price of the loan.
Delayed Consumption. By giving you a loan (even if priced to exactly break even) I am delaying my ability to use my money today. I can't use it until repaid thus I will charge a premium for the time I lose waiting for repayment (sometimes called time value). Thus even if all other costs/risks are 0% there will be some interest charged otherwise I might as well just keep the money in a can.
Interest is the "cost" of money. Of the four components that contribute to that cost only one of them is related to inflation/deflation. If in the long term all other factor were equal (which is unlikely), the USD had 3% inflation rate, and BTC had a 2% deflation rate one would be expect interest rates in BTC to be ~5% lower.
If you take a loan out on a currency that is not stable, you are asking for trouble.
If the deflation rate was stable, one would have to take that into consideration when calculating the interest rate, similarly as one would in inflatory economy.
In an economy based on Bitcoins, they wouldn't actually be deflationary. An economy based on Bitcoins would be just like an economy based on dollars, except the Fed couldn't print any more dollars. But think about it, what fraction of the money in the economy is physical, printed dollar bills anyway?
If a deflationary currency doesn't work, people simply won't use it. They'll create substitutes for the currency so that the currency doesn't deflate.
I don't see why (In theory) a bank couldn't issue a loan in bitcoins just like they do in Dollars, Euros or Pounds.
Lets say I wish to borrow 100 Bit coins, I go to a BitCoin Bank and ask for a loan, they check me for credit risk and assuming that everything is ok they give me the money. I pay it back over some period of time with interest.
On the flip side if I have savings of 100 bitcoin I can deposit it with the bank, they keep some chunk as a reserve and loan out the rest.
As long as most of the depositors don't want their money back at the same time the whole thing works just fine.
The problem is that with BitCoin there is no central bank which can provide cash for short term liquidity like with most currencies.
Bitcoin is peer-to-peer decentralized cash.
If you want to talk about peer-to-peer decentralized credit, check out Ripple. http://ripple-project.org/
Peer lending has many differences compared to bank lending. There are often social and emotional relationships between the peers, and this has a strong impact on the underlying incentives. Friends and family are likely to make loans to each other with little or no interest. But then again, they're also likely to ask "well what are you going to use it for?" If you can't pay back a bank, you simply 'go bankrupt' and they can't touch you. If you don't pay back your friends, it's possible they'll hate you forever, or beat you up (illegally, of course, since that would be assault). So the cold professionalism of bank lending can swing both ways. But peer-to-peer lending is an alternative, and it's more viable than most people think.
There are some very good blog posts about peer-to-peer credit and related topics like reputation systems here: http://www.webisteme.com/blog/
#bitcoin-otc ( http://bitcoin-otc.com ) maintains a 'reputation' system that could be considered analogous to a credit score. It's a measure of your 'trustworthiness' in the context of bitcoin transactions. If you have very high ratings on #bitcoin-otc, it's likely you'll find someone willing to make you a bitcoin loan.
Bitcoin lending intermediaries could perform this function by paying interest on 3-month, 6-month and 1-year deposits; and then making loans for the same maturities. The lending intermediary would make the spread and they would also be assuming the credit risk of the borrower. These lending intermediaries would compete on reputation, overall financial soundness, rates paid for deposits, and flexibility of deposit durations.
There would be no lender of least resort and it would function very much like the free banking era where banks competed on the faith and soundness of their institution. The fittest will survive and prosper. Depositors beware.
I believe there is a point of view from which things as loans, mortgages, etc. are impossible in a Bitcoin economy: and that is anonymity.
If two peers know each other in person, they could choose to agree on a mortgage contract if the currency was stable enough, or if there was a real Bitcoin economy.
Suppose subject A has lots of coins, subject B wants to buy a house from C who accepts 1000 coins (probably he is able to make profit from selling a house for coins). B could request A to send him 1000 coins with promise of returning them plus interests.
A is surely interested in making such profit, but must deal with the risk of B being unable to pay back. In current economy, a mortgage agreement is made with a contract that allows A to take property over the house in case B doesn't pay, with a court order.
So if we suppose that a Bitcoin economy exist (there is lot of discussion about it) certainly these practices are possible, because instead of writing a check you could ask your destination's Bitcoin address, send the money and expect monthly payments.
But Bitcoin is based on distribution, anonymity and absence of control. Since transactions are final and not revokable, no authority in the Bitcoin's virtual world has the power of seizing property.
Lending Bitcoins is like lending a bike in exchange of it and some accessories, and Bitcoin can just be a currency like others when buying a house in a real-world economy with real-world regulations.