Topic: Interest rates in a deflationary currency (Read 5553 times)

Until we manage to become immortal there will always be interest which is time preference, because things (money, goods, assets, btc) will always be worth more to you the day before you die then the day after.  Everything else is just the market that seeks equilibrium and until we become all knowing gods each one of us will have an imperfect view of such markets and we will therefore be able to make deals with each other because of differing veiws on time preferences.  Also notice how those who cry out that interest is evil usury want to replace the market with a system that benefits them personally even if indirectly much like government operators who draw enourmous salaries and benefits for administering such a system all the while claiming its for all of our benefit.  Therefore it doesn't matter if a currency is deflationary, inflationary or sea shells there will always be interest.

Wrong.
There is no incentive to loan money if the interest rate paid is not high enough.

If the interest rate is 10%/year and the return of keeping the money is 3% increase of purchasing power without risks, someone will loan money at 10% rate, if they had enough money to loan and take risks (if they are able to save). They will accept the risks and will take the gains a year later.

As saving increase the capital available, the utility of saving will reduce.
Then, instead of saving, people will start to loan.
First loans to be done will be the loans able to generate an higher rate of return.
If there is more capital available, other loans with a lower rate of return will be made.

Yes.
Money supply and inflation are linked but it is not a perfect link, there are other factors, namely demand (for both the money and for the goods).
If there is a scarcity in a particular good, its price will rise against the currency.  For example in a disaster, there may be a great deal of things which are scarce and so there can be external reasons for inflation, not just the rate of money creation.
You've heard the saying "save for a rainy day"?  Its never quoted corollary is "spend on rainy days".

Default risk provides a reason for interest on a loan even in a preemptively deflationary currency.

Correct, if you are rational.

and Economists argument for the current system because they argue market aren't rational

For those people who think a deflationary currency is impossible , let me ask you one question.

How do you think human society evolved?

Did governments evolve before humans? Was it like this: A government arrived on the planet, before any human beings, and dictated all the rules for society to function. It dictated how much money would be circulating every year, and every year set an interest rate in order to carefully control the money supply. And, thank God it did that, because if it had not set this interest rate and carefully controlled the money supply, there is no way people would have been able to trade. Because people need the government's help for everything. Human beings cannot function without government help. They cannot trade without the help of the government. They cannot use currencies without the government. People need to pay high taxes and have central bankers slowly removing the value they have carefully saved and accumulated during their working life.

Well, let's answer the question. No, it wasn't like this. What actually happened? Human beings evolved first before governments. They traded and did business with each other perfectly fine without ANY government interference for hundreds or thousands of years. Then, around the time of the 20th century, politics began to mix with greed and self-interest, and self-interested politicians began to expand the role of government ever more, into ever more areas of the lives of the citizens, without citizens realizing exactly what was happening - because it happened incrementally.

Eventually politicians , again for their own self-interest, decided to take control of the money supply, and suddenly we are convinced by them and their journalist friends that we need inflation, that society cannot function without governments constantly printing money every year, that the currency needs to be controlled because deflation is a danger.

This is exactly like in my opinion when, hundreds of years ago, the ruling elite convinced everybody that the world was flat, and refused to acknowledge that it could actually be round, despite the logical evidence.

So, human beings have survived fine for thousands of years without inflationary fiat currencies. There is really no need for them today any more than there was 2,000 years ago.

This post by DeathAndTaxes really, in my opinion, answers the questions about deflation. Loans can still be made, sure, because the rate of deflation will be small. Why would it be large? The only flation that is large is inflation, because of governments. Why is it necessary for economies to grow? GDP is defined as the total value of all transactions in an economy. Why is it assumed that GDP always grows year-on-year? Why should people transact more next year than this year?

There is no incentive to loan money in a deflationary currency where the economy is growing.  Why risk not being repaid when the potential lender can just sit on his or her pile of bitcoins and see their value rise (buy more goods per bitcoin) without lifting a single finger?

/\ This FTFY

No, basically interest is the price you have to pay if you want to consume (or invest) before you have earned, or the reward the saver gets for postponing his consumption. The interest rate is a market, which depends on the valuation of time on part of the market actors.

Nowadays the central banks tries to affect the interest rate with lending to lower rates (of money they don't have). So nowadays the time market is somewhat crippled.

There is also speculative borrowing.  Its not all consumption based, but the time element is always there in lending.
If I think that the price of a BTC is going to go down, against some other asset class, I can borrow BTC, convert it to the other asset class, and then reverse it in the future to repay the loan.

Folks that borrowed BTC at 120 and repay now may have done well (depending on the conversion asset).

This doesn't seem to follow: "bitcoin/fiat has (controlled) inflation => there should be no inflation"

Maybe if you discern "money supply inflation" and "price inflation" you'll get a clearer picture.

If bitcoin was the only money used in a certain growing economy (at a higher than the current bitcoin money supply inflation rate) prices would generally fall.

That's only a problem if everyone tries to pay back their debt. Also: you're forgetting the fact that some borrowers default.

It's not a problem.

Further to my last post - if you break it down into lots of people loaning other people BTC and charging interest there will be more BTC listed in loan books than there are in circulation and then we will end up in another financial crisis when someone does an audit and realises this.

Interest is charged on FIAT currencies because there is an unlimited supply of money.

Take this example - lets just say I have all 21 million bit coins - I then loan them to you at an interest rate of 1% - hey I am a generous guy.

Immediately you can see the problem - how are you going to pay back the additional 300,000 bit coins? They do not exist?

Interest rate is the added price you have to pay for the pleasure of buying something now, as opposed to later when you have earned it. Inversely, it is the premium you get for postponing consumption now, and then consume it later. It is basically a time market, where prices have a time dimension in addition to the value at present. Lets call this the basic interest rate.

I practice, when loaning, you also have to pay for the expected price inflation, insurance against default and the work spent by the lender.

The current high appreciation of bitcoin is not going to last forever. When bitcoin is implemented in the world, and all coins are created, the appreciation (reduced prices of goods) will come from more users (more people in the world) and lost coins. More users could be a small percent per year, but it could also stabilize, expand faster or even start to go down. Nobody knows. In the meantime, if you need a loan, get it in fiat.

Expected appreciation will have to be subtracted from the interest rate. So, if we have a basic interest rate of 3%pa, appreciation of 2%pa, the resulting nominal interest rate would be 1%pa. Obviously, if the basic interest is lower, or appreciation is higher, the resulting nominal rate could become negative. This would stop lending, because you don't get more than just keeping the bitcoins in the mattress.

A sound business traditionally could loan say half of its capital, representing the safe part, while the owners' equity represented the risky upper part. Loaning for business is not strictly necessary, for instead of loaning, you could summon up more people, and finance your business with only equity. But this does not really solve the problem, as any entrepeneurial effort should have an expected return of the nominal interest rate plus compensation for risk and effort. This means that investing could also stop, except for the ventures with high expected return.

I am not sure if this is healty. Anyway all the low return, high risk projects would have to stop, leaving only safer, high return projects.

At least, this would stop all the malinvestments. Malinvestment today is chinese unused cities, spanish unused airports and so on. May be capital could therefore build up more, giving higher productivity. Not sure here either.

I was under the impression inflation is caused by an increase in the money supply (Quantitative easing for example) and as the creation of money is controlled at a sustained rate by the Bitcoin network and has a set upper limit - there should be no inflation?

It is not the same if the measure of success is measured in the units of medium of exchange.

Obviously you have a simplified model in bold for making a business case, that simplified model is what I would call the Austrian model devoid of all human action and dependant on rational facts, so I propose we base the modeling on just rational facts and ignore human action.

The investment should be considered in terms of macro economics, given the scale of the investment and the size of the market.

Starting from the premise oil production is profitable and has been profitable up until the investment was considered, then during times of inflation (shrinking economic prosperity) the investment is more viable.

that is: Save your medium of exchange and you purchasing power decreases - by the inflation rate.  The rational reaction is invest now and get a higher return, that is inflation adjusted in the future and invest before your capital lose value.

V

Starting from the premise oil production is profitable and has been profitable up until the investment was considered, then during times of deflation (increasing economic prosperity) the investment is less viable.

that is: Save your medium of exchange and you purchasing power increase - by the deflation rate.  The rational reaction is save now for a higher rate of return in purchasing power, consider the capital investment will cost less in the future so save until you get the best value when investing.

If the inflation rate is targeted at between 2 and 5% investing is preferred to saving because saving will cost you between 2 and 5%. So the rational thing to do is invest.  
The deferred investing is a free market responding to hard money, and taking risks based on market feedback, the market self regulates in the absent of  the medium of exchange manipulators. It is argued by Keynesians that deferred investment is the cause of Boom Bust cycles and can be eliminated by having constant inflation - the prevailing wisdom by which our economy is organised today.
 
I don't see much point in arguing that fact, at the end of the day if you can manipulate the economy and steel wealth from the working class, and the political elite have no motivation to change, they won't.
For the first time an alternate option is available and reason and rationality can prove themselves independently of the entrenched system of economic and political structures. And fortunately I don't have to prove anything if our system is working there is no need for a hard currency and Bitcoin will fail, if the Austrians made any sense at all then all you have to do is use Bitcoin, every possible way you can think of. And the more efficient system will win in the long-term.  

A rational market wouldn't.

This changes in times of inflation (economic activity starts to shrink low supply and high demand) then the rational market would be willing to pay interest and borrow with interest.  
Until then, save your cryptos,

If you have a deflationary currency I am at a loss to why you would need to pay interest on a loan?

For example lets say today 1 BTC buys 1 pint of milk but as it deflates tomorrow it would 0.8 BTC for the pint of milk.(quite extreme deflation I realise  )  So therefore just by repaying the principle you have effectively earned 0.2 BTC because of the increased purchasing power.

Gold is effectively a deflationary currency as its value increases overtime - you give me 1 kilo of gold today I give it back to you in 10 years time and it is worth a great deal more so you have effectively made money.

So what you are saying? Investing in more efficient oil mining wouldn't be profitable with sound money? How so? You reduce your costs per barrel so you can keep prices and earn more for every one you sell. Or you lower price a bit and get greater share of market. Same in fiat and same in sound money system.

I would probably be able to sell my coinlenders account with existing CDs for something like 9x% of its value, so yes it is possible. I succesfully traded mtgox codes for bitcoin or services at it face value so it isn't impossible to use bitcoin IOU as money.

I am lending in bitcoins and will get bitcoins back so I am long bitcoin and if it falls to $1 I will loose 99% of value. $1000 would be good for me.


I am not thinking that IOU is sound money. It is money substitute and it affects value of other money. There is nothing wrong with it, because like anything in free market you have right to your property but don't have right to you property value. It''s up to market.

Yes it is about real saving or investment. What you miss is that no matter what is money saving money is just that - saving money. If money was bitcoin or gold it would still be only saving it and not real saving or investment.