How Will Credit Work in a Bitcoin Economy?

Most people in the Bitcoin community agree that the digital currency has the ability to render fractional reserve banking impossible, but not everyone agrees on whether or not this development would be a good thing. The skeptics worry that without fractional reserve banking, it will somehow be impossible for banks to make loans.
Taking this ability from the banks would make it much harder for entrepreneurs and consumers to take out loans, which can greatly slow the rate of economic growth. If people cannot get loans, they would have to save their own resources in order to undergo time-intensive production projects. Directly saving resources takes up much more time than simply taking out a loan. Therefore, without bank credit, it would take a much longer time for material living standards to rise.

However, the idea that banks will not be able to issue credit without running fractional reserves does not hold water. It is very possible for banks to profitably make loans under a full-reserve system. Although the banking system would look much different in a fully Bitcoin-powered economy, the issuance of credit would not cease to exist — nor would it be required to undergo any dramatic changes.

It is true, because of the blockchain, it would be impossible for Bitcoin banks to run fractional reserves (unless the banks have convinced the public to use off-chain banking services). With the blockchain, banks patrons would be able to monitor their balances in real time, and would immediately see if the bank tried to use their savings without their permission. Patrons could then withdraw their funds, leaving the bank with no demand deposits to use in issuing loans.

Thus, in a Bitcoin economy without fractional reserve banking, it follows that there would be less credit available then there is at present. But this in no way means that banks will become totally incapable of providing credit to the market. In fact, under a Bitcoin monetary system — in which individuals are capable of “being their own banks” — banks will primarily serve as credit intermediaries.

In a Bitcoin world where people do not use banks for simple hoarding and safekeeping, banks’ main source of business would be the management of time deposits. These types of deposits are contracts where the depositor gives up control over a set amount of money for an agreed-upon period of time. During this period, the bank uses those funds to make loans that earn interest. At the end of the contract, the depositor receives the funds originally given up at the beginning of the time period, plus an additional sum of earned interest. Banks profit from time deposit contracts through the differences in the interest rates the banks pay to depositors and the interest rates they charge to debtors.

Banking in a Bitcoin economy would most likely look like the scenario described above, in which banks served primarily as time deposit managers rather than money warehouses. So, contrary to what many people fear, a Bitcoin economy would not kill the credit system by any means.

However, the skeptics do have valid concerns regarding the amount of credit available in a banking system without fractional reserves. There will indeed be less funds available to loan out, which means interest rates will be higher. Because of the high interest rates, entrepreneurs will not be able to finance as many projects, and economic growth will definitely slow down.

This decline in the average rate of growth may not be so problematic, though, if we consider the amount of capital squandered or left idle by recessions. During a recession, much of the growth that was achieved in the growth phase disappears, because many of the new projects were the result of malinvested capital. Therefore, the real growth rate, correcting for the losses of recessions, may very well be the growth that would occur without fractional reserves.

In a Bitcoin economy free of fractional reserve banking, there will be no business cycles — which means no periods of rapid growth or periods of painful contraction. (Assuming, of course, that Austrian Business Cycle Theory is correct.) If there really is not any extra growth under fractional reserve banking, and eliminating the practice solves the business cycle, then the decreased amount of credit on the market under the Bitcoin economy is something that should be celebrated.

In summary, a Bitcoin-dominated banking system would not look terribly different from what we have right now. In the worst-case scenario, there is less credit available and growth occurs slower than what would be achieved with credit expansion. In the best-case scenario, Bitcoin banking could solve the business cycle and foster steady, sustainable growth — finally putting an end to recurring recessions and the suffering they cause.

Will a Bitcoin-powered credit system be better or worse than the current system? Let us know in the comments below!

Images: Pixabay

This author’s views do not necessarily reflect those of Bitcoin.com.

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Evan Faggart

Evan is the Senior Editor of Bitcoin.com. He has a bachelor's degree in History with minors in Economics and Political Science. When he's not acting like he knows what he's doing in the newsroom, Evan is most likely playing video games. Follow Evan on Twitter @EvanFaggart.