September 26, 2021 — El Salvador this month became the first country to adopt a cryptocurrency, Bitcoin, as legal tender. One says “the first” as if there will be others. But the idea is highly dubious.
I will admit, like many economists, that I fail to see what problem cryptocurrencies solve. They aren’t well designed to fulfill any of the classic functions of money — unit of account, store of value, or means of payment – in part because they are so extraordinarily volatile in price. This volatility is not surprising, since they are backed neither by reserves nor by the reputation of a well-established institution, such as a government or even a private bank or other trusted corporation.
The adoption of Bitcoin makes little sense for El Salvador in particular. Bitcoin and its fellow cryptocurrencies were born out of a semi-anarchistic distrust of central banks. It is true that many central banks, especially in developing countries, have a history of debasing their currencies. But El Salvador adopted the US dollar as legal tender in 2001, precisely to assure the monetary stability that had been missing from the predecessor currency, the colón. The country’s inflation rate had substantially exceeded 10 % during 1977-1995. The reform worked: Inflation has been much lower since the adoption of the dollar: below 2 % since 2012, and close to 0 since 2015 – a rarity in Latin America.
There are costs to giving up the monetary independence that having one’s own currency affords: particularly, the loss of the ability to adjust monetary policy in response to local economic conditions. The Central American country already accepted those costs when it adopted the dollar. The costs would be even greater if a currency as unstable as Bitcoin were the sole national currency. But President Nayib Bukele somehow decided to designate two competing legal tenders at once: Bitcoin alongside the dollar. The Salvadoran logic is surreal.
The interloper currency has not been well-received by domestic residents, who don’t want to be obligated to accept it in their daily life (as they must, technically, since Bitcoin is now legal tender). Nor has it been well-received by international financial markets. Moody’s downgraded El Salvador’s debt in July. S&P could follow. The interest rate that the government has to pay on its debt has risen sharply since the plan to Bitcoinize was first announced in June.
There is one function that cryptocurrencies do appear to serve; that is facilitating illegal transactions. Needless to say, this is not a function that should be encouraged. And, to make things worse from the vantage point of the general welfare, the mining (production) of cryptocurrencies like Bitcoin requires unbelievably large amounts of energy, thereby hurting the environment (as Elon Musk discovered, belatedly).
By the way, even if one accepts a role for one or two cryptocurrencies, the number that have been created is baffling: 6,000 or 11,000 (or as many as 70,000 tokens), depending what source one consults. The entire notion of the usefulness of money is that people choose to use the currency that others use, thereby minimizing transactions costs. They can’t evaluate and keep track of the creditworthiness of dozens of issuers. Money is a sort of natural monopoly, which is why governments long ago took over its provision.
In mid-19th-century United States, private banks and other institutions issued an estimated 8,000 competing private currencies. As Fed Governor Lael Brainard has noted, that period “is now notorious for inefficiency, fraud and instability in the payments system.” This is essentially why central banks were created.
The logic that works against having a large number of currencies at the national level, applies at the international level as well. This is why the dollar remains by far the leading international currency. The world does not have room for 11 international currencies, let alone 11,000!
If the United States’ chronic budget deficits and current account deficits had resulted in a strong long-run downward trend in the value of the dollar, one could imagine people shifting away from it and seeking alternatives. But this has not happened, particularly not during the period of the rise of cryptocurrencies. International investors continue to treat the dollar and US treasury bills as safe havens. And US inflation was remarkably low during this period (though lately it has risen in tandem with the economic recovery).
Some, including President Bukele, claim that cryptocurrencies will help promote financial inclusion, giving “unbanked” citizens access to banking services and lowering the transactions costs for small cross-border payments, such as emigrants’ remittances. Remittances are particularly important to El Salvador, amounting to a fifth of national income. But it is unlikely that Bitcoin is the solution. (Other ways of bringing down such transactions costs appear more promising.)
Holding or transacting in such an unstable asset is a particularly bad idea for low-income residents. They can ill afford to sustain price swings as large as 30% in a single day. Over a five-month period in 2011, the price fell 90 %, from $32 in June to $2 in November. It has quadrupled over the last year — bitcoin are selling at around $44,000 as of mid-September – which accounts for much of its current popularity. But what has gone up, will come down.
Another disadvantage is that even the digitally savvy run the risk of forgetting passwords and thereby losing their Bitcoin. Moreover, at least half of the residents of El Salvador do not have access to the internet to begin with.
Many aspects of cryptocurrencies are baffling, including the success of some joke coins like Dogecoin. But the official Salvadoran adoption of Bitcoin is perhaps the most surreal example of all.
[An earlier version appeared at Project Syndicate (and at the Guardian). Comments can be posted there or at the Econbrowser site.]