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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.

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    I think this question would be better answered on Economics SE: economics.stackexchange.com . – ThePiachu Nov 5 '11 at 13:12
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    @ThePiachu: I agree that this is a better fit for the Economics SE since the question is actually "How are loans possible in a deflationary economy?". I'll let the community decide if this one should be closed though. It's certainly of interest to the community and there are some good answers already. – D.H. - bitcoin.se Nov 5 '11 at 21:34
  • I think it should stay open here, because it is an excellent example of loan operations within the context of 100% reserve banking as opposed to fractional reserve banking. Bitcoin economists will have to deal with this issue as the economy matures. – matonis Feb 3 '12 at 19:03
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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:

  1. 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.

  2. 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.

  3. 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.

  4. 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.

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    "Opportunity Cost" and "Delayed Consumption" are more or less the same thing. – Meni Rosenfeld Nov 6 '11 at 9:30
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    Generally opportunity cost is refers to an alternative method of deploying capital. Delayed Consumption refers to the time value of the money. Simplistically even if I have nowhere productive to put my money I expect to be compensated for the time value of my money. If not ... I might as well bury it in a can in my backyard. However they are closely related. – DeathAndTaxes Nov 7 '11 at 4:57
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    You're confusing the two bargaining parties. Generally the Shapley value of a two-person bargain is such that both parties make the same profit from the deal. So even if the lending party has no current use whatsoever for the money, he will still expect to profit from a loan if the other party does. But what you've described is just a breakdown of the lender's costs. And again, #1 and #4 are the same - money has time value precisely because one has the opportunity to use it elsewhere (whether the use is investing in appreciating stock or buying a bag of Cheetos I want now rather than later). – Meni Rosenfeld Nov 7 '11 at 9:40
  • would be more helpful if it described what a deflationary loan looked like. Most of the answer describes 'cost' of money. – osmosis Nov 8 '11 at 5:25
  • @osmosis. Not sure what you mean. Interest IS the cost of money. A deflaitonary loan would work exactly like an inflationary loan except interest rates would account for expected deflation not inflation. The only other material change is that collateral is less effective method of reducing risk. Over time the collateral will be worth less and less relative to initial loan balance still that risk is factored into the cost of default. – DeathAndTaxes Nov 8 '11 at 16:54
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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.

One could also consider the concepts of Smart Property, as well as some concepts use by Islamic banking. But those are concepts that are probably best answered in the Economy SE.

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Futures and options can be used to eliminate the risks associated with price volatility. If you're borrowing and worried that the price will go way up, make an agreement with someone to trade at a reasonable price at some point in the future. Lenders can do the same on their side.

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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.

  • since some bitcoins are being lost, there would always be a slow deflation. – osmosis Nov 8 '11 at 5:26
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    why would a deflationary currency not work? this seems to be what you are proposing. – osmosis Nov 8 '11 at 5:27
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    A deflationary currency doesn't work because it creates value paradoxes. For example, would you rather have 10 bitcoins today or 10 bitcoins next month? Of course you'd rather have them today, because having them today includes everything you could do with them next month and more (value today = value next month + additional opportunity). But in a persistent deflation, the value of 10 bitcoins next month will be predictably and reliably more than the value of 10 bitcoins today. So you can only have a sustained, predictable deflation when people value more highly what is clearly worth less. – David Schwartz Nov 8 '11 at 7:10
  • You still need to eat right? You still want to play video games, go to movies, etc. The less inflationary a currency is the less it promotes consumption, even to the negative side. I think this is a good thing. The best way to reduce your (eco-)footprint is by consuming less. This might actually save the earth. Besides the deflation should drop very low once everyone uses the currency. – Lodewijk Feb 3 '12 at 23:07
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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.

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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.

  • there is one key difference between borrowing money from a bank and a family member, I don't invite my banker over for dinner. So If for some reason I borrow money from a bank and default I don't have to worry about strange family dinners for the next 25 years. – Zachary K Feb 4 '12 at 16:37
  • webisteme is a deadlink... – stiv Sep 28 '15 at 21:22
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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.

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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.

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