In Fiat Standard lending creates money. Whenever the debt is fully paid the monetary supply increases.

What happens under bitcoin standard? Assume all the bitcoin has been mined and BTC has become the world reserve currency.

If some lending bank lends it's borrowers X BTC at some Y% interest rate, how can borrowers pay back the interest in BTC but not increase the money supply!

How this situation is handled in a deflationary Bitcoin Standard!?

Cross posted in bitcoin.stackexchange.com

  • $\begingroup$ (-1) This question relies on several false/impossible assumptions. $\endgroup$
    – Giskard
    Nov 27 '21 at 9:10
  • $\begingroup$ @Giskard: I don't see any false assumptions. Can you name one? $\endgroup$
    – Mick
    Nov 27 '21 at 11:04
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    $\begingroup$ @Mick let me answer that for Giskard. The question assumes that repaying loan increases money supply which is absurd. $\endgroup$
    – 1muflon1
    Nov 27 '21 at 12:45
  • $\begingroup$ Also, AFAIK bitcoin mines will never be completely exhausted. $\endgroup$
    – Giskard
    Nov 27 '21 at 12:53
  • $\begingroup$ @muflon1: I assumed that was just some bad English... it is very common for people to learn about loans creating money but they don't know that repayments destroy it. I surmised that was the case with this questioner. $\endgroup$
    – Mick
    Nov 27 '21 at 14:28

Correction of Some Misconceptions

You say:

Whenever the debt is fully paid the monetary supply increases

This is incorrect. Bank lending expands money supply and loan repayment contracts money supply. You can learn about how the current monetary system works by looking at Blanchard et al Macroeconomics: The European Perspective (the newest edition) or McLeay et al (2014) (McLeay et al. is slightly outdated because it was written before the reserves requirements were abolished, but new capital requirements have similar effect).

Lending creates money because bank can lend more money than people invested in it or than they get from central bank. For example, if you would put your \$100 in a bank, bank would have to set portion of that \$100 aside as mandated by the various new rules that replaced the old reserve requirement. For example, bank might be required to set aside \$10. Rest of that money can be used to make loans, so for example that bank could now issue up to \$90 worth of additional loans (exact amount will depend on demand for loans, regulations etc see the discussion McLeay et al). Now let's suppose the bank issues \$90 loan. This expands money supply because people still have \$100 dollars on an deposit account, but now people in the economy have \$90 thanks to the loan. So while originally money supply $M$=\$100 after the loan $M$=\$190.

When the loan is repaid money supply contracts (decreases). It does not increase, since repaying the loan destroys the addition to the money supply.

In addition, to the above private banks do not really need deposits to make loan (even though they still allow them to make even more loans so they like them) because they can draw on central bank reserves. A mechanism there is similar, but as explained later not necessary for your answer so I won't discuss it here, have a look at McLeay et al if you are interested in knowing the details of that.

Answer to Main Question

How interest payment work in lending under bitcoin standard?

It would work exactly the same way except bitcoin cannot be created by central banks, so it would operate only with intermediation of deposits (this is why understanding central bank reserves is not important for answering your question).

Even though the number of bitcoins is fixed, if you would deposit your bitcoins into some bank account (bank might provide better protection from some hackers getting into your wallet etc), bank would be then able to take portion of the bitcoins on your account and lend it. This is always possible because all people do not need all of their money at all time so bank does not need to keep 1BTC reserve for every 1BTC you deposited into your bank account. So if you deposit 100BTC they could just again keep 10BTC as some sort of reserve and lend rest of the bitcoins you deposited.

This would literally expand money supply even though the number of bitcoins that can be mined is fixed. Even under fiat standard there is a monetary base that is created by government not private banks (we call this often high powered money (see Brunner 2016) - since this is money that can create more money). Under bitcoin the only difference is that the high powered money is not created by governments (central banks etc) but by miners, and also that under fiat there is no maximum cap on amount of high powered money, whereas when it comes to bitcoin there is maximum cap on high powered BTC that can be created.

If some lending bank lends it's borrowers X BTC at some Y% interest rate, how can borrowers pay back the interest in BTC but not increase the money supply!

This is painfully common misconception. Fixed money supply and interest does not mean that more money has to be created to pay back interest. This is fundamentally wrong, but for some reason very wide-spread belief. I have even written an dedicated answer to that here.

In short, the reason why repaying interest rate does not require more money is that money flows through economy. The same \$ 10 dollar buck can be used for million different purchases.

For example, suppose that government decides to fix money supply at \$200 so private banks cannot get extra money by borrowing central bank reserves. Moreover, assume full reserve system where banks cannot create more money from high powered money. Banks have to actually lend you money of their owners.

Now suppose bank owners start \$100, you start with 0 dollars, and other people (consumers/workers etc all other actors) start with \$100. You will see that the money supply is fixed at 200.

Now since you have no money but you want to open a restaurant you might ask bank for \$100 loan for one year. They might be only willing to give you that loan at 10% interest p.a. and also here the loan does not increase money supply because we assumed full reserve system where private banks are sterile in process of money creation.

Now you get your \$100 dollars and you spend it on workers & suppliers etc so you can build your restaurant. Let us suppose you spend full \$100 on workers. Hence now workers/consumers have all \$200. But the workers need to eat, they will spend money in your restaurant. If you made smart business decisions you profits should be sufficient to cover all your costs, depending on market structure you might even get economic profit. So let us suppose your restaurant business yields you \$120 after one year. The money supply is still the same (you have 120 workers/consumers have 80). Now you will pay back to the bank \$100 plus interest \$10. So now bank has \$110 you have \$10 and workers have \$80.

Now what do you think you will do with your profit and bank will do with its profit? Burry it under ground like a pirate? Use it to decorate your home as some sort of postmodern art installation? No both you or the bank will spend their profits. Bankers might buy yacht or plane, and you might spend your profits to buy something nice for yourself, but eventually that money will be spent on some goods and services. After banks would spend their profits and you yours we would be back in the initial conditions where bank has \$100 workers have \$100 and you have zero (although we all have more goods and services to enjoy - workers got food, bankers their yacht, you got whatever you wanted).

So you can see that even with completely fixed money loans can be easily replayed even with positive interest rate. Fractional reserve system where money supply actually expands when people take out loans makes it even easier, but I choose to use full reserve system as an example to emphasize that fixed amount of money and interest does not mean economy needs more money supply.

Factoring in Deflation

How this situation is handled in a deflationary Bitcoin Standard!?

I already explained how it would work with bitcoin, but I assumed price level would stay constant there. Assuming there is deflation does not change the story much but deflation would affect interest rate so I want to cover that here.

If there is deflation in the economy that would actually affect the interest rate. Nominal interest rates, by the Fisher equation can be expressed as:

$$i \approx r+\pi_e$$

where $i$ is the nominal interest rate, $r$ the real interest rate and $\pi_e$ inflation expectations (where negative $\pi$ would imply deflation).

Hence if bitcoin would be undergoing large deflation this would lower interest rates (perhaps even make them negative). For example, if real interest rate is $5\%$ and there is $10\%$ deflation in the economy the nominal interest rate would be:

$$i \approx 0.05 - 0.1 \approx -0.05 \text{ or } -5\%$$

The point is that nominal interest rates will adjust for any expected deflation/inflation in the economy. After nominal interest rates adjust for inflation/deflation, the system will still work without additional money as described in the previous section.

However, note just because economy can operate without additional money that does not necessarily mean that is best way for it to most efficiently operate. Most economists would prefer gradual increase in money supply over time. Nonetheless, economy can function without this additional money. No laws of physics or logic or mathematics are violated by having economy with constant money supply and interest rate.

  • $\begingroup$ Given that we're talking about a hypothetical scenario, I would not rush to assume that bitcoin would be the basis of a new fractional reserve system - especially given that the very foundation of bitcoin had its roots in anti-fractional reserve thinking. $\endgroup$
    – Mick
    Nov 27 '21 at 17:01
  • $\begingroup$ @Mick 1. Bitcoin is not controlled by central authority. If it would ever get adopted by society en masse people depositing it into financial institutions would essentially settle on fractional reserve. Even gold commodity money worked with fractional reserves during periods of time where it was not as heavy regulated as later gold standard (eg. even old goldsmiths usually lent some of the deposited gold). 2. I am not sure if you read the full answer. Later in the answer I assume full reserve system $\endgroup$
    – 1muflon1
    Nov 27 '21 at 17:11
  • $\begingroup$ "Lending creates money because bank can lend more money than people invested in it" - absolutely false. "Lending" creates money because the new demand deposits created in the borrowers account never existed before. I put the word lending in quotes because banks scarcely lend at all. They create credit instead. $\endgroup$
    – Mick
    Nov 27 '21 at 17:11
  • $\begingroup$ @Mick it is not false. Please read McLeay et al (2014). If banks would be required to maintain 100% full reserves they would become sterile in process of money creation. $\endgroup$
    – 1muflon1
    Nov 27 '21 at 17:12
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    $\begingroup$ @Mick also do you actually understand what you are even talking about? lending= credit. Creating credit is literally synonymous for bank lending. Banks cannot create credit without lending. $\endgroup$
    – 1muflon1
    Nov 27 '21 at 17:14

Yes indeed in our current monetary system bank loans do create money. Sadly many descriptions of our monetary system omit to mention that the repayment of loans destroys money. (Here's a good explanation of the monetary system) So if the rate at which new loans were being taken out were constant (and when I say "rate", I mean dollars borrowed per day, not the "interest rate") then the money supply would not grow at all. So the problem of how does anyone get the money to pay interest exists both within our current system as well as in any potential bitcoin-based full reserve banking system. The answer is that interest is indeed repayable even with a fixed money supply.

  • 1
    $\begingroup$ "So if the rate at which new loans were being taken out were constant then the money supply would not grow at all." - this is false. Money can grow even without more bank lending. $\endgroup$
    – WilliamT
    Nov 27 '21 at 12:20
  • $\begingroup$ @WilliamT: OK, so the money supply can grow with some QE - but other than that it won't. If you say it can please explain how. $\endgroup$
    – Mick
    Nov 27 '21 at 14:30
  • $\begingroup$ a) treasury issuing more coins and notes, b) OMOs (technically not QE), c) helicopter money. That's 3 more ways off the bat that do not require more loan growth. $\endgroup$
    – WilliamT
    Nov 27 '21 at 17:32
  • $\begingroup$ I could argue about some of those but it's slightly beside the point because what I really wanted to convey in my answer was that a steady stream of lending does not in and of itself lead to monetary growth (or contraction). $\endgroup$
    – Mick
    Nov 27 '21 at 17:48

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