El Salvador’s Bitcoin Madness EJINSIGHT

0


El Salvador this month became the first country to adopt a cryptocurrency – in this case, Bitcoin – as legal tender. I say the first, because others might follow. But they should think twice, because the idea is highly dubious – and likely to be economically dangerous for developing countries in particular.

I have to admit that I don’t understand the need for cryptocurrencies at all. Like many economists, I don’t see what problem they solve. They are not well designed to perform one of the classic functions of money – a unit of account, a store of value or a means of payment – because their prices are extremely volatile. This volatility is not surprising, as cryptocurrencies are not backed by reserves or the reputation of a well-established institution, such as a government or even a private bank or other trusted company.

In fact, Bitcoin and its fellow cryptocurrencies were born out of anarcho-libertarian mistrust of central banks. Certainly, many central banks, especially in developing countries, have a habit of depreciating their currencies. But adopting Bitcoin as legal tender does not make sense for El Salvador.

In 2001, El Salvador adopted the US dollar as legal tender to provide monetary stability that the country’s national currency, the colón, had not historically provided. The reform worked: the country’s annual inflation rate, which had greatly exceeded 10% between 1977 and 1995, has fallen sharply since the adoption of the dollar. It has been below 2% since 2012 and close to zero since 2015, a rarity in Latin America.

Giving up the monetary independence offered by issuing one’s own currency comes with costs – in particular, the loss of the ability to adjust monetary policy in response to local economic conditions. El Salvador already accepted this when it adopted the dollar. The costs would be even greater if a currency as unstable as Bitcoin was the only national currency. But President Nayib Bukele has instead decided to designate both Bitcoin and the dollar as legal tender. The logic behind this decision is surreal.

Bitcoin has not been well received in El Salvador. National residents don’t want to be forced to accept it. International markets are also reluctant. Moody’s downgraded El Salvador’s debt in July, and S&P could follow suit. The spread between the interest rate the government has to pay on its debt and the U.S. Treasury rate has grown sharply since the bitcoinization plan was announced in June.

There is one function that cryptocurrencies seem to perform: to facilitate illegal transactions. Needless to say, this is not a use that should be encouraged. Worse still in terms of general well-being, the “mining” of cryptocurrencies like Bitcoin – which relies on so-called blockchain technology to verify transactions – requires incredibly large amounts of energy and therefore harms the economy. environment.

Moreover, even if one accepts a role for one or two cryptocurrencies, the number that has been created is incredibly large: from 6,000 to 11,000 (or up to 70,000 digital tokens). The whole notion of the usefulness of money is that people choose to use the same currency as everyone else, thus minimizing transaction costs. They cannot assess and monitor the creditworthiness of dozens of issuers. Money is a kind of natural monopoly, which is why governments have long taken responsibility for its provision.

In the mid-19th century in the United States, for example, private banks and other institutions issued about 8,000 competing private currencies. As noted by US Federal Reserve Governor Lael Brainard, this period “is now notorious for the inefficiency, fraud and instability of the payments system.” This is essentially the reason why central banks were created.

The logic that works against a large number of currencies at the national level also applies at the international level. This is one of the reasons why the dollar remains by far the main world currency. The world has no room for 11 international currencies, let alone 11,000.

If the chronic US budget and current account deficits had caused a strong long-term downward trend in the value of the dollar, one would imagine people moving away from the greenback and looking for alternatives. But that didn’t happen, and especially not during the time when cryptocurrencies were on the rise. And US inflation was remarkably low during this period (although it has recently increased in line with the economic recovery).

Some, including Bukele, claim that cryptocurrencies will strengthen financial inclusion by giving unbanked people access to financial services and reducing transaction costs for small cross-border payments such as emigrant remittances. The latter are particularly important for El Salvador, having averaged around 20% of GDP per year over the past two decades.

But Bitcoin is unlikely to be the answer. Other means of reducing these transaction costs seem more promising. And holding or trading such an unstable asset is a particularly bad idea for low-income people, who can hardly afford to endure price fluctuations of up to 30% in a single day. The price of Bitcoin has quadrupled over the past year, which is part of the pull. But what goes up also goes down.

Another downside is that even digital connoisseurs run the risk of forgetting their passwords and losing their Bitcoin. And at least half of El Salvador’s population doesn’t have internet access in the first place.

There are many aspects of cryptocurrency that are baffling, including the success of a joke like Dogecoin. But El Salvador’s adoption of Bitcoin as legal tender is perhaps the strangest and potentially the most disturbing example of all.

Copyright: Project Syndicate
– Contact us at [email protected]

Jeffrey Frankel

Professor of Capital Formation and Growth at Harvard University


Share.

Comments are closed.