Can Bitcoin Solve Our Debt Addiction?

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Margarita Groisman graduated from the Georgia Institute of Technology with a degree in industrial engineering and analytics.

Since modern capitalism’s emergence in the early 19th century, many societies have seen a meteoric rise in wealth and access to cheap goods — with the party coming to an end years later with some sort of major restructuring triggered by a major world event, such as a pandemic or a war. This pattern is repeated over and over: a cycle that includes borrowing, debt, high-growth financial systems, and then what we now call “a market correction” in America. Ray Dalio’s How the Economic Machine Works explains these cycles. ” This article examines whether a new monetary system that is backed by bitcoin could address the systematic debt problems built into the monetary systems. There are many examples of financial crises that have been solved by money printing and debt. Japan’s inflation following World War II due to printing monetization of fiscal debt, the eurozone debt crisis, and what seems to be starting in China, beginning with the Evergrande crisis and real estate market collapse in prices and unfortunately, many, many more cases.

Understanding Banking’s Reliance On Credit

The fundamental problem is credit — using money you don’t have yet to buy something you can’t afford in cash. We’ll all eventually take on large amounts of debt, whether it be a mortgage to buy a house or for other purchases such as cars and college experiences. Businesses also tend to use large amounts of debt in order to run their day-today operations.

A bank will give you a loan to pay for any of these purposes if it considers you “credit-worthy.” This means that the bank will loan you the remaining money to purchase the item at a mutually agreed-upon interest rate and repayment arrangement.

Where did the bank get the cash to finance your large purchase or business activities? The bank doesn’t produce products or goods and therefore is not generating extra cash from these productive activities. They borrowed the cash from their lenders, who put their savings and extra cash in to the bank. These lenders may feel that this money is available to them at any time. The truth is that the bank borrowed it long ago and charged interest fees much higher than the interest they pay on cash deposits. This allows them to make a profit. The bank actually borrowed more than the lenders promised them, in exchange for future profits that they could use to repay their lenders. To ensure that you can pay for your purchase immediately, the bank simply moves around another saver’s cash deposit. This is a gross accounting oversimplification but it is basically what happens.

Fractional Reserve Banking: The World’s Biggest Ponzi Scheme?

Many cryptocurrency lending schemes are eerily similar to banks’ abilities to loan out money and create debt through fractional reserve banking.

“Madoff and Pyramid Schemes” (Source)

Welcome to fractional reserve banking. The reality of the money multiplier system is that on average, banks loan out ten times more cash than they actually have deposited, and every loan effectively creates money out of thin air on what is simply a promise to pay it back. These private loans are what create new money, but it is often overlooked. This new money is called “credit” because it assumes that only a small percentage of depositors will ever withdraw cash at once. The bank will then receive all their loans back with interest. If just more than 10% of the depositors try to withdraw their money at once –for example, something driving consumer fear and withdrawal or a recession causing those who have loans not being able to repay them — then the bank fails or needs to be bailed out. These scenarios have happened many times in societies that rely heavily on credit-based systems. However, it might be helpful to examine some specific examples and their outcomes. These systems have a built in failure. There is a point where there is a deflationary cycle that must be stopped.

Society Pays For The Bank’s Risky Loans

There is a lot to discuss in terms of how the central bank attempts to stop these deflationary cycles by decreasing the cost for businesses to borrow money and adding newly-printed money into the system. These short-term solutions are not sustainable because money cannot be printed without losing value. The fundamental result of adding new money to the system is that we transfer the wealth of all individuals in that society to the bleeding banks by decreasing the purchasing power of the whole society. This is what happens when inflation occurs: Everyone, even those not involved in credit transactions, becomes poorer and must repay all existing credit.

The more fundamental problem is the built-in growth assumption. This system must have more students willing and able to pay the rising college costs, more people who are looking to borrow money, more home buyers, and more asset creation. These growth schemes don’t work as the money stops coming eventually and the individuals don’t have the power to transfer the spending power of their population to pay these loans like banks. The system of credit has brought prosperity to many individuals and societies. But, every society that has experienced long-term wealth has found that it is possible to create innovative products, tools, technologies, and services. This is the only way you can create long-term wealth and grow your business. We all become more wealthy when we create products that people love and use because they improve their lives. We become collectively more wealthy when new companies find cheaper ways to make the goods we love. We all become more wealthy when companies create amazing services and experiences that make financial transactions quick and easy. Society becomes stagnant or on a downward trajectory if we try to create wealth through massive industries that rely heavily on credit to make market trades, bet on risky assets, and make large-scale purchases.

Is it possible to shift towards a system that is more long-term-oriented and has slower but steady growth, without suffering from extreme deflationary cycles. First, excessive and risky credit must be eliminated. This would result in slower and shorter-term growth. Our never-ending cash printer must be stopped. This would cause severe economic pain in certain areas.

Can Bitcoin Address These Issues?

Some say that bitcoin is the solution to these problems. This transition to a bitcoin-based world could offer an opportunity to rebuild our financial systems and end our addiction of easy credit.

Bitcoin is limited to 21 million coins. Once the maximum amount of bitcoin is in circulation, there will be no more. The creation of new bitcoin is not a way for bitcoin owners to take their wealth. The lending and credit practices of other cryptos and protocols seem to be similar to ours, but with greater risk. We must limit the use of fractional reserves and high-leverage loans in a decentralized monetary system and integrate these new protocols into the exchange protocol. If we don’t, the credit and deflationary cycles will continue to be as they are.

Cryptocurrency Is Following The Same Path As Traditional Banking

It is simply really good business to loan out money and guarantee returns, and there are numerous companies in the cryptocurrency ecosystem making their own products around highly risky credit.

Brendan Greeley writes a convincing argument that loans cannot be stopped just by switching to cryptocurrencies in his essay “Bitcoin Cannot Replace The Banks:”

“Creating new credit money is a good business, which is why, century after century, people have found new ways to make loans. Rebecca Spang, a U.S. historian, points out in her book “Stuff and Money in France’ that the pre-revolutionary French monarchy took lump-sum payments to investors and repaid them in lifetime rentals. In 21st-century America, shadow banks pretend they are not banks to avoid regulations. Lending is a normal part of life. You can’t stop lending. Distributed computing or a stake in the company can’t stop lending. The profits are just too good.”

We saw this happen just recently with Celsius as well, which was a high-yielding lending product that did essentially what banks do but to a more extreme degree by lending out significantly more cryptocurrency than it actually had with the assumptions that there would not be a large amount of withdrawals at once. Celsius had to stop large withdrawals because it did not have enough money for its depositors.

While creating a limited supply currency is an important first step it doesn’t solve the deeper problems. It just removes the current anesthetics. Standardizing and regulating credit purchases is the next step in building a system that supports long-term, stable growth.

Sander van der Hoog provides an incredibly useful breakdown around this in his work “The Limits to Credit Growth: Mitigation Policies And Macroprudential Regulations To Foster Macrofinancial Stability And Sustainable Debt?” In it, he describes the difference between two waves of credit: “a ‘primary wave’ of credit to finance innovations and a ‘secondary wave’ of credit to finance consumption, overinvestment and speculation.”

“The reason for this somewhat counter-intuitive result is that in the absence of strict liquidity requirements there will be repeated episodes of credit bubbles. Therefore, a generic result of our analysis seems to be that a more restrictive regulation on the supply of liquidity to firms that are already highly leveraged is a necessary requirement for preventing credit bubbles from occurring again and again.”

The clear boundaries and specific credit rules that should be put in place are outside of the scope of this work, but there must be credit regulations put into place if there is any hope of sustained growth. While van der Hoog’s research is a good starting point for more stringent credit regulation, normal credit is still an important part and can have positive effects if it is managed correctly. However, abnormal credit must be severely limited with exceptions in a world dominated by bitcoin.

As we are slowly moving to a new currency system we need to make sure we don’t adopt unhealthy habits and convert them into a new one. It is essential that the system has stabilizing credit rules. Otherwise, it will be too difficult to get out of dependence on easy cash. These rules should be either built into the technology or added as a layer of regulation. This topic deserves to be discussed more.

It seems that we have accepted that economic crises and recessions will happen. Although we won’t have a perfect system, bitcoin may be a step closer to a more efficient system that promotes long term sustainable growth. If we create better and more robust credit systems in this new system, the suffering of those who can’t afford to buy necessary goods and those who lose their life savings and work during crises that are predictable and built into existing systems does not have to happen. We must not allow our bad habits to continue to cause extreme pain long-term and incorporate them into future technologies.

This is a guest post by Margarita Groisman. Opinions expressed by Margarita Groisman are their own and do NOT necessarily reflect those of Bitcoin Magazine or BTC Inc.

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