Abstract



We look at common misconceptions with respect to how banks make loans and the implications this has on the ability of banks to expand the level of credit in the economy. We analyse the inherent properties of money which ensure that this is the case. We then consider why Bitcoin might have some unique combinations of characteristics, compared to traditional forms of money, namely the ability to transact electronically and avoid a third party financial intermediary, thereby avoiding the need for bank deposits, which fuel the credit cycle. We explain the implications this could have on the ability of banks to engage in credit expansion.

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Dynamics of Credit Expansion

The core characteristic of the traditional banking system and modern economies, is the ability of the large deposit taking institutions (banks) to expand the level of credit (debt) in the economy, without necessarily needing to finance this expansion with reserves.

An often poorly understood point in finance, is the belief that banks require reserves, liquidity or “cash”, in order to make new loans. After-all where do banks get the money from? It is true that smaller banks and some financial institutions do need to find sources of finance to make new loans. However, in general, this is not the case for the main deposit taking institutions within an economy.

If a main deposit taking institution, makes a new loan to one of their customers, in a sense this automatically creates a new deposit, such that no financing is required. This is because the customer, or whoever sold the item the loan customer purchased with the loan, puts the money back on deposit at the bank. Therefore the bank never needed any money at all. Indeed there is nothing else people can do, the deposits are “trapped” inside the banking system, unless they are withdrawn in the form of physical notes and coins, which rarely happens nowadays.

Please consider the following simplified example:

A large bank, JP Morgan, provides a mortgage loan to a customer, who is buying their first home, for $500,000 JP Morgan writes a check to the mortgage customer for $500,000 The mortgage customer deposits the check into his deposit account, at JP Morgan The mortgage customer writes a new check, for $500,000 and he hands it over to the seller of the property The seller is also a banking client of JP Morgan and as soon as she receives the check, she deposits it into her JP Morgan bank account

Illustrative diagram of a new home mortgage with one dominant bank in the economy

As one can see, the above process had no impact on the bank’s liquidity or reserves, the bank never had to spend any “cash” at any point in the above example. Of course, the seller of the property does not necessarily have to have an account with the same bank as the one which provided the loan. However large deposit taking institutions, such as JP Morgan, HSBC or Bank of America, have large market shares in the deposit taking business, in their local markets. Therefore, on average, these large banks expect more than their fair share of new loans to end up on deposit at their own bank. Actually, on average, new loans in the economy increases the available liquidity for these large banks, rather than decreasing it.

The accounting treatment of this mortgage, for the bank, is as follows:

Debit: Loan (asset): $500,000

Credit: Deposit (liability): $500,000

The bank has therefore increased its assets and liabilities, resulting in balance sheet expansion. Although from the point of view of the home seller, she has $500,000 of cash. The above transaction has increased the amount of loans and deposits in the economy. From the customer’s point of view, these deposits are seen as “cash”. In a sense, new money has been created from nothing, apart from perhaps the asset, which in this case is the property. In the above scenario, M0 or base money, the total value of physical notes and coins in the economy, as well as money on deposit at the central bank, remains unchanged. M1, which includes both M0 and money on deposit in bank accounts, has increased by $500,000. Although the precise definition of M1 varies by region.

Cash reserves from the point of view of a bank are physical notes and coins, as well as money on deposit at the central bank. The ratio between the level of deposits a bank can have and its reserves, is called the “reserve requirement”. This form of regulation, managing the reserve requirement, leads to the term “fractional reserve banking”, with banks owing more money to deposit customers than they have in reserve. However, contrary to conventional wisdom, in most significant western economies, there is no regulation directly limiting the bank’s ability to make these loans, with respect to its cash reserves. The reserve requirement ratio typically either does not exist, or it is so low that it has no significant impact. There is however a regulatory regime in place that does limit the expansionary process, these are called “capital ratios”. The capital ratio, is a ratio between the equity of the bank and the total assets (or more precisely risk weighted assets). The bank can therefore only create these new loans (new assets) and therefore new deposits (liabilities), if it has sufficient equity. Equity is the capital investment into the bank, as well as accumulated retained earnings. For example if a bank has $10 of equity, it may only be allowed $100 of assets, a capital ratio of 10%.

The credit cycle

To some extent, the dynamic described above allows banks to create new loans and expand the level of credit in the economy, almost at will, causing inflation. This credit cycle is often considered to be a core driver of modern economies and a key reason for financial regulation. Although the extent to which the credit cycle impacts the business cycle is hotly debated by economists. These dynamics are often said to result in expansionary credit bubbles and economic collapses. Or as Satoshi Nakamoto described it:

Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve

Ray Dalio, the founder of Bridgewater Associates (a leading investment firm), appears to agree that the credit cycle is a major driver of swings in economic growth, at least in the short term, as his video below explains:

The view that the credit cycle, caused by fractional reserve banking, is the dominant driver of modern economies, including the boom and bust cycle, is likely to be popular in the Bitcoin community. This theory is sometimes called Austrian business cycle theory, although many economists outside the Austrian school also appreciate the importance of the credit cycle.

The fundamental cause of the credit expansionary dynamic

The above dynamic of credit expansion and fractional reserve banking, is not understood by many. However, with the advent of the internet, often people on the far left politics, the far right of politics or conspiracy theorists, are becoming partially aware of this dynamic, perhaps in an incomplete way. With the “banks create money from nothing” or “fractional reserve banking” narratives gaining some traction. The question that arises, is why does the financial system work this way? The underlying reasons for this, are poorly understood, in our view.

Individuals with these fringe political and economic views, may think this is some kind of grand conspiracy by powerful elite bankers, to ensure their control over the economy. For example, perhaps the Rothschild family, JP Morgan, Goldman Sachs, the Bilderberg Group, the Federal Reserve or some other powerful secretive entity deliberately structured the financial system this way, so that they could gain some nefarious unfair advantage or influence? Actually, this is not at all the case.

The ability of deposit taking institutions to expand credit, without requiring reserves, is the result of inherent characteristics of the money we use and the fundamental nature of money. This is because people and businesses psychologically and for very logical practical reasons, treat bank deposits in the same way as “cash”, when they could alternatively be considered as loans to the bank. This enables banks to then expand the amount of deposits, knowing they are safe, as customers will never withdraw it, since they already think of it as cash.

Bank deposits are treated this way for perfectly reasonable and logical reasons, in fact bank deposits have some significant advantages over physical cash. Bank deposits are simply much better than physical cash. It is these inherent and genuine advantages that cause fractional reserve banking, not a malicious conspiracy, as some might think.

Advantages of bank deposits compared to physical notes and coins

Factor Bank deposit Physical cash Security Keeping money on deposits in financial institutions, increases security The money is protected by multiple advanced security mechanisms and insured in the unlikely event of theft Large physical cash balances at home could be vulnerable to theft or damage Physical cash cannot be insured and storage costs can be expensive Electronic transfers Using the banking system, it is possible to quickly send money effectively over the internet or by phone, across the world at low cost and at high speed If physical cash is used, then a slow, inefficient, insecure physical transfer must take place Convenience Using a banking system to manage your money, can result in a convenient set of tools. For example the ability to use money using your mobile phone or on your computer Precise amounts can be sent so there is no issue with receiving change Handling cash is often a difficult and cumbersome process. Precise amounts cannot be specified and one may need to calculate change amounts Auditability Traditional banks offer the ability to track, control and monitor all transactions, which can help prevent fraud. This improves reporting and accountability With physical cash, effective record keeping is less automated, increasing the probability of fraud

The main features of the different types of money

Despite the strong advantages of bank deposits mentioned in part 1 of this piece, namely the ability to use it electronically, physical notes and coins do have some significant benefits over electronic money. The following table aims to summarize the main features of the different types of money, bank deposits, physical cash and Electronic Cash (Bitcoin).

Features of electronic bank deposits, physical notes & coins and electronic cash

Feature Bank deposit Physical cash Electronic Cash Advantages of physical cash Funds are fully protected in the event the bank becomes insolvent or inaccessible* × ✔ ✔ It is difficult for the authorities to confiscate funds × ✔ ✔ Funds can be effectively hidden from the authorities × ✔ ✔ Transactions cannot easily be blocked × ✔ ✔ Transfers can be highly anonymous × ✔ ✔ Transfers can be irrevocable × ✔ ✔ Transfers can occur instantly ? ✔ ? Payments can occur 24×7 ? ✔ ✔ Transaction fees are zero ? ✔ × Payments work during power outages or when communication networks are unavailable × ✔ × Money can be used without purchasing or owning a device × ✔ × Anyone can use the system, without seeking permission × ✔ ✔ Advantages of electronic systems Payments can be made over the internet ✔ × ✔ Change does not need to be calculated ✔ × ✔ Payments can easily be recorded ✔ × ✔ Funds can easily be secured to prevent theft ✔ × ?

Note: * Physical cash still has a potential problem with respect to the solvency, related to the policy of the central bank which issues the currency

Due to the strengths mentioned in the above table, physical cash will always have its niche use cases. However, on balance, banking deposits are superior to physical cash, for the majority of users. The ability to use bank deposits electronically is particularly compelling, especially in the digital age. As we explained in part one of this piece, it is this ability to use the money electronically that ensures there is always high demand for bank deposits, giving banks the ability to freely expand the level of credit.

The unique properties of Bitcoin

Bitcoin shares many of the advantages of physical cash over electronic bank deposits. Although Bitcoin does not have the full set of advantages, as the table above demonstrates. However the key unique feature of Bitcoin, is that it has both some of the advantages of physical cash and the ability to be used electronically.

Bitcoin aims to replicate some of the properties of physical cash, but in an electronic form, an “electronic cash system”. Before Bitcoin, people had to make a binary choice, between physical cash or using a bank deposit.

Although technically physical cash is a kind of a bank deposit, a deposit at the central bank, physical cash still has unique bearer type properties which could not be replicated in an electronic form. For the first time ever, in 2009, Bitcoin provided the ability to use a bearer type asset, electronically. The simple table below illustrates this key unique feature of Bitcoin and blockchain based tokens.

The binary choice in legacy finance & the new option Bitcoin provides

Bearer type instrument Electronic type instrument Physical Cash (Notes & Coins) ✔ × Electronic money (Bank Deposit) × ✔ Electronic Cash (Bitcoin) ✔ ✔

Therefore Bitcoin can be thought of as a new hybrid form of money, with some of the advantages of physical cash, but also some of the advantages of bank deposits.

Bitcoin’s limitations

Although Bitcoin has inherited some of the strengths of both traditional electronic money systems and physical cash. Typically Bitcoin does not have all the advantages of either electronic money or physical cash, however it is uniquely positioned to be able to have a subset of the features of each. This provides a new middle ground option.

For example, Bitcoin may never have the throughput of traditional electronic payment systems or the ability to use without electricity such as with physical cash. Although as technology improves, Bitcoin may slowly develop more strengths and gradually improve its capabilities, to narrow the gap.

The implications of these characteristics on credit expansion

Understanding the dynamics of these characteristics, can be useful in evaluating the potential economic significance of Bitcoin, should the ecosystem grow. Bitcoin has at least six properties which provide some level of natural resilience against credit expansion, which traditional money does not have. This is because the advantages of keeping money on deposit at a bank are not always as pronounced in Bitcoin, compared to the alternatives. However, Bitcoin is certainly not immune to the same credit expansionary forces which exist in traditional systems, indeed people can keep Bitcoin on deposit at financial institutions just like they can with physical cash. Bitcoin may merely have greater resistance to the same credit expansionary forces.

At the core of our reasoning, is looking at the advantages of bank deposits compared to physical cash, which are the characteristics that enable large banks to freely expand credit and evaluating to what extent they apply in Bitcoin. As the table below shows, the advantages of keeping money on deposit at a bank are less significant in the Bitcoin world, therefore we think Bitcoin does have some unique resilience against the forces of credit expansion.

Physical cash vs bank deposits compared to Bitcoin vs Bitcoin deposits

Factor Physical cash compared to deposits Bitcoin compared to Bitcoin deposits 1. Security Keeping money on deposits in financial institutions, increases security relative to keeping large physical cash balances at home, where the cash is vulnerable to theft or damage Bitcoin can potentially allow a high level of security, without putting the funds on deposit at a bank For example Bitcoin can be concealed or encrypted 2. Electronic transfers Using the banking system, it is possible to send money effectively over the internet or by phone, across the world at low cost. If physical cash is used, then a slow, inefficient, insecure physical transfer must take place Bitcoin can allow users to efficiently transmit money over the internet, without using deposits at financial institutions 3. Convenience Using a banking system to manage your money, can result in a convenient set of tools. For example the ability to use money using your mobile phone or your computer. Precise amounts can be sent so there is no issue with receiving change Bitcoin can allow users to make payments on a mobile phone or without manually calculating change amounts. Deposits at financial institutions are not required 4. Ability to redeem deposits In the traditional banking system, withdrawing physical cash from a financial institution is a long administrative process which takes time. Banks therefore do not need to worry about keeping large quantities of physical cash in reserves Bitcoin can allow users to withdraw money from deposit taking institutions quickly, which may encourage banks to ensure they have adequate Bitcoin in reserve at all times 5. Auditability Banks offer the ability to track and monitor all transactions, which can help prevent fraud and improve accountability. Physical cash cannot offer this Bitcoin’s blockchain or other electronic databases can allow users to effectively audit and monitor transactions, without using third party financial intermediaries 6. “Hybrid banking” In traditional banking models there are only two fundamental choices: 1. Physical cash which provides full user control of the money 2. Money on deposit at a financial institution This is a binary choice with no middle ground options, forcing consumers to make a difficult choice with no compromise option available Bitcoin allows for a wider spectrum of deposit and security models, resulting in a more complex credit expansionary dynamic. For example: 1. 2 of 2 multi-signature wallet, where the bank holds one key and the user holds another key; or 2. 1 of 2 multi-signature wallet, where the bank holds one key and the user holds another key

The economic consequences of less credit expansion

The consequences of the lower level of credit expansion this analysis implies, does not really say much about whether this potentially new economic model will be more beneficial to society, nor does it say much about whether Bitcoin will be successful or not. The former is something that has been heavily debated by economists for decades and the latter is a separate topic, in our view. Although, despite decades of economic debate, perhaps Bitcoin is sufficiently different to the money which came before it, such that the debate is required again, with new very different information. For example inflation or deflation, caused by cycles of credit expansion, may have very different consequences in a Bitcoin based financial system, than on one based on bank deposits and debt. A key problem with deflation in a debt based money system, is that it increases the real value of debt, resulting in a downwards economic spiral. For non debt based money systems like Bitcoin, it is less clear what the implications of deflation are.

Although Bitcoin may not necessarily result in a superior economic model, we think this analysis may suggest that Bitcoin may have some properties that make the economic model somewhat unique or perhaps interesting, compared to the possible models that came before it. Therefore it does look like an area worth examining.

To many, the ultimate objective of Bitcoin is to become sufficiently dominant, such that there is a significant decrease in credit expansionary forces, which can neutralize the credit cycle and therefore the business cycle. Although, this should be considered as an extremely ambitious objective, which we consider as extremely unlikely. And even in the remarkable circumstance that Bitcoin grows to this scale, other unforeseen economic problems, particular to Bitcoin, may emerge.