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