Unit 1 Lecture Notes

If my conclusion that a bitcoin financial system cannot develop fractional reserve banking sustainably, what would be a bitcoin financial system look like? How would credit and investment markets work? Would it be easy to borrow money? How would interest rates be determined? The detailed answer to these questions will come in a future edition of The Bitcoin Standard Research Bulletin, but for today, the broad features will be outlined.

A Bitcoin financial system would consist of financial institutions that engage only in maturity matched lending, in other words, for every quantity of bitcoin that a bank lends for a particular period of time, there would be a lender who has contractually agreed to lend that quantity for the exact period. With this rule, we can see that the two traditional functions of banking could survive and function normally and independently in a bitcoin economy: deposits and credit.

Both these models of banking are normal market services that have been demanded throughout human history, regardless of the form of money used. People will always like the convenience and safety of having their money stored in professionally-secured facilities, rather than have them on hand at all time risking loss theft, or extortion, and that business will likely continue in a digital economy. But without maturity mismatched lending, there can be no interest on demand deposits, since the bank will have to hold them all on reserve, and cannot earn returns on investing or lending them. Depositors will instead pay money to have their money handled by institutions that provide superior security and regular access to it.

In a world in which lending is maturity mismatched, the incentive for saving rises dramatically. Banks can no longer resort to rolling over short term assets to finance long-term liabilities, as that form of maturity mismatching can always collapse or be attacked. Given that the money on deposit is hard money, and that no fractional reserve is built on top of it, it would be expected to appreciate slightly over time. Having a sum of money saved as a financial safety net would in fact allow people to think more of the long-term, and plan for it with the rest of their money. People will find higher interest rates for longer savings, and having a financial bedrock of hard money would allow people to save for the long-term, and to take more and more risks.

The incentivizing of long-term savings would in turn lead to more capital accumulation and investments taking place, and in turn, that would act to bring down interest rates, naturally. The low interest rates that Keynesians attempt to mandate via central bank edict cannot work unless they are a true market signal of an abundance of capital caused by an abundance of savings. The process of human civilization, as the lowering of time preference, is driven by, and in turn drives, more savings and lower interest rates. Austrian economist Eugen Bohm-Bawerk said that cultural level of a nation is mirrored by its rate of interest, as explained by Schumpeter:

Historically, interest rates have been declining in the long-term, and by the end of the nineteenth century had begun approaching zero. The turn to government money and its destructive impact on human society has made them rise sharply in the twentieth century. They have been in decline since the 1970s, but this is after they have become purely government-mandated prices, and not a correct reflection of people's propensity to save and provide capital for investors. The following chart, taken from Andrew Haldane's Growing: Fast and Slow shows the historical relationship.

A world of hard money that resists inflationary credit creation would bring back the process of lowering time preference and lowering interest rates. The Austrian economists understand that the ultimate determinant of interest rate is time preference, and a hard money will likely lead to a progressive lowering of time preference and interest rates.

Credit markets would work only with fully-backed debt. Actual savings need to go into a bank for a pre-agreed duration for the bank to lend them out. This means that an actual saver must forgo consumption of real resources in order for someone else to borrow them. As the incentive to save rises, capital accumulation and technological progress increase productivity and living standards, interest rates would continue their decline, particularly if hard money saves humanity from the catastrophe that was twentieth century's easy money-fueled warfare states and the trail of destruction they leave behind.

One question I have considered for a while is just how low can interest rates go? I suspect that the end result of developing hard-to-confiscate strictly scarce hard money with very high capacity for decentralized fast global settlement is that interest rates would naturally go to zero, to the point that interest-based lending would seize to exist. Given that money would be expected to constantly appreciate, a zero percent rate of interest is a positive interest rate in real terms. And given that the holding of deposits would usually incur a cost, there is an opportunity cost to holding on to money rather than lending it, which effectively increases the real rate of return of a 0% nominal loan. Combined with increased savings and lower time preference, all this is likely to lead to there being a zero percent nominal rate on credit. Creditworthiness will be all that matters in these loans, and not an interest rate.

I also often consider whether in such a world we would likely transition from debt-based financing to equity-based financing. Given that banks cannot engage in fractional reserve banking, it is not possible for banks to make any guaranteed returns on any of their investments. With any investment, there is the possibility that it goes to zero, but in a fractional reserve banking system, central banks protect depositors against such an outcome, through generating new easy money. In a hard money monetary system, there is no amount of financial risk engineering that can protect savers from loss of their capital in a venture. Banks can diversify, but can never make a guarantee for a minimum return, or maximum loss. Without the ability to protect the downside of the saver, there is no reason why the saver should not prefer to be fully exposed on the upside as well. Why settle for a fixed return on their investment if it succeeds, but unlimited downside if it fails? The more attractive model for savers will be one in which they make the real return from the businesses in which the bank invests their money, sharing in the profit and loss. The role of the bank will be in matching maturities and risk profiles between borrowers and lenders, and identifying the correct projects in which to invest.

Outlining the working of the capital markets, and the role of interest rates in a bitcoin-based economy, is the topic of a forthcoming edition of The Bitcoin Standard Research Bulletin. I will continue researching this topic, and likely make it the topic of next month's bulletin. Another potential topic is the following.

Forthcoming Bulletin: A closer look at the impacts of continued Bitcoin growth.

Most discussions of Bitcoin assume that its rise can be catastrophic to the old economy and monetary system. But maybe it doesn't have to be that way. People generally tend to think of Bitcoin's rise as being akin to hyperinflation, focusing on the collapse of government money and the economic catastrophes that might unleash. But in hyperinflation, the collapse of the currency brings about the disappearance of a monetary system, leading to the collapse of economic trade, division of labor, and production across society, with a devastating effect on society. But the adoption of bitcoin will itself come through people moving to a new monetary standard that's relatively easily accessible globally. Perhaps a better comparison for the rise of Bitcoin would be the episodes of societies adopting harder monetary standards from easier ones. A forthcoming edition of The Bitcoin Standard Research Bulletin will look at several examples of dollarization - economies that moved from their local easy money to the harder dollar, analyzing how that transition came about, its effects on capital markets, government, and society in general, and what lessons it has for understanding the larger macroeconomic impacts of Bitcoin should it continue to grow in economic significance. A comparison will be made with hyperinflationary episodes and their impact and relevance.

These are preliminary thoughts, and I might end up significantly changing the topics of the forthcoming bulletins, particularly in response to your suggestions and feedback. Please feel free to email me at any time with your suggestions and questions.