Bitcoin and Interest Rates

Unlike gold which has been mined for thousands of years and there is no indication of it running out anytime soon, Bitcoin’s supply will all but halt in about 20 years. That would have implications on lending and interest rates in an economy using Bitcoin as money.
In an economy based on gold, miners are integral part of the market. They exchange their product – the gold – for goods, services and labor provided by their suppliers and employees. They are effectively creating monetary inflation – they inject new units of media of exchange to the economy. This way, they are putting an upward pressure on prices because there’s more money chasing goods and services. That is compensated by the increasing productivity of the economy, which leads to more goods and services being created with the same amount of labor and material.
If miners tried to pour gold in the economy at a faster pace than the increase of productivity, their suppliers would increase prices and at some point would make it uneconomical for miners to mine more gold. On the other hand when the increased productivity of the economy is reflected in the productivity of mining suppliers and employees, they will be able to provide more goods and services and more productive labor to mining companies and receive more gold for it without increase in prices of their output.
This is very different with Bitcoin. Bitcoin monetary base growth is predetermined in the protocol. It doesn’t respond to demand the same way as gold supply does and it will halt altogether. If money supply is S and being fixed, economic output is O and price of money is P, than (in our back-of-a-napkin calculation) P = O / S. That means all other things being equal, value of money in Bitcoin economy would grow by the same pace as the productivity since more goods and services chase equal amount of money.
It is then almost certain that the money one borrows in such economy would be appraised higher when he is supposed to return it. That means he needs to increase his own productivity more than the interest rate and growth of price of money combined. At the same time the one who lends out knows the money will grow in appraisal over time, which means she can as well hold on to them and spend them later when they can buy more without being exposed to a risk of default by the borrower.
Entrepreneurs borrow funds to increase their productivity and their profit. The same driving force that makes price of money grow is what allows entrepreneurs to return the same amount of money at a higher value. If we assume all capital investments in the economy come from borrowed money (i.e. not one’s own savings) and all entrepreneurs increase their productivity at an equal rate, all other things being equal their profit would remain flat in nominal terms, but grow in real terms at the same pace as the price of money. That would allow them to repay the debt without an interest.
That alone isn’t sufficient because lenders need an incentive to lend out appreciating money, which is what interest is for. Borrowers (entrepreneurs) express their time preference by paying lenders (capitalists) a premium on money in their hands compared to money they could save themselves in the future. To make up for that difference, they would try to come up with ways to increase their productivity and profit above economy’s average to make sure they can repay that interest. The rate of interest would then represent an equilibrium between time preference of entrepreneurs and risk of their default as calculated by capitalists.
Interest rates would vary sector-by-sector based on expected potential of productivity increase and returns on investment driven by demand and availability of capital. At some point, market would come to realize the increased productivity of a certain sector is catching up with the demand thereof or that the planned investments are reaching expected future availability of the capital. Interest rates would rise accordingly making some new planned projects unprofitable. As always with prices, also the interest rate (i.e. price of money in time) would send signals to the market, that there is shortage of supply of capital to the demand for it and those projects would not be realized.
As a result, investments would flow to sectors with more realistic future demand and available real capital. Investments with unrealistic return expectations would not be realized at all, which would prevent capital to be wasted upon their failure. That is in stark contrast compared to current state of affairs when interest rates pushed down below their ordinary levels by central banks create an illusion of long-term profitability of projects such as housing before 2007 (and tech, higher education, cars and pretty much everything that can be financed by debt today).
Join me for discussion about Bitcoin and role of money in society and the state with Erik Voorhees, founder of Shapeshift.io
Join The Discussion
5 CommentsThoughts? Comments?
Please login or register to post a comment.
Mike Reid March 19, 2015 , 11:36 am Vote1
Is this a difference in kind or merely a difference in degree between Bitcoin, gold, and fiat?
That is, is Bitcoin just further along the scale of pro-responsible-investment money from gold, or is it a radically different animal?
Tomas Forgac March 19, 2015 , 11:44 am
@mikereid Good question. There is obviously massive difference between fiat on one side and gold and Bitcoin on the other. Between gold and Bitcoin not so much. I had a couple of paragraphs in the article explaining further price mechanism in gold economy that would explain it, but eventually I removed them.
Gold mining is “older” economy , so productivity in that sector increases at smaller pace than the average, which means general price level is declining in gold economy as well. That’s exactly what was observed during gold standard. So in this sense, it is not so much different to Bitcoin.
Martin Brock March 20, 2015 , 4:14 pm Vote2
What is the Bitcoin interest rate now? What is the rate at which people accept Bitcoin promising to return the same volume of Bitcoin plus additional Bitcoin after a given interval? What is the volume of additional Bitcoin per unit of borrowed Bitcoin per unit of time?
The answer is: There is no such market, so there is no such market rate. “Bitcoin interest rate” is meaningless.
This answer will not change (unless the nature of Bitcoin itself changes), because the price of capital denominated in Bitcoin will never be stable enough to encourage entrepreneurs to rent Bitcoin only to exchange the Bitcoin for capital.
Entrepreneurs will not respond to Bitcoin appreciation by offering less to rent Bitcoin in order to exchange the Bitcoin for capital, because using something else as a standard of value in their credit agreements is less costly.
Your theory assumes that entrepreneurs use Bitcoin as a standard of value for extending credit while Bitcoin appreciates, even if this appreciation is very difficult to predict. Why would entrepreneurs use Bitcoin this way?
Capital is a means of production like land. A capitalist is an owner of means of production, not someone with a positive cash balance. Money itself is not capital. A capitalist need not have any money. A capitalist exchanges capital for money only to consume or to exchange his capital for other capital by spending the money on other capital.
An entrepreneur may borrow capital from its owners, and money can be an outcome of this borrowing rather than the thing borrowed. What we commonly call an “interest rate” in these transactions reflects the scarcity of the capital borrowed, not the scarcity of a medium of exchange.
http://archipelago.liberty.me/2015/03/10/money-credit-and-usury/
Mongo March 20, 2015 , 4:55 pm
Even knowing there is a limit on how many bitcoin can exist,which I find more value than the fiat system. The fiat system can keep on printing without checks and balances. That is whole point on why bitcoin can only produce so much; however, bitcoin is mot a bank and can not offer interest. You half to try other digital currency such as VeriCoin and hold a personal wallet. We need a digital bank to offer interest, and that I why I look at bitcoin like gold; however, I’m no expert, but digital currency is going to replace the fiat system. UK is already looking into it and getting rid of the tax forms.
Martin Brock March 21, 2015 , 4:04 pm Vote0
You assume here that Bitcoin is the only medium of exchange, that increasingly productive people using nothing else as money. If people may choose an exchange media freely, why would they pay a monopoly rent to Bitcoin holders?