El Salvador recently became the first country to make Bitcoin legal tender. At about the same time, President Nayib Bukele declared himself “the world’s coolest dictator” in a tweet.
While embracing Bitcoin may sound cutting edge, it really is not a cool move for the government of El Salvador. On the contrary, switching to Bitcoin puts the savings and pensions of millions of Salvadorans at serious risk.
There are digital technologies that can curtail corruption and promote access to government and financial services, but Bitcoin does not do these things. The move is an ill-thought-out effort to introduce additional liquidity into the Salvadoran economy and escape the fiscal discipline that has characterized the country’s monetary policy since it adopted the U.S. dollar as its currency two decades ago.
Those 20 years for El Salvador have been a period of lower inflation and interest rates than its neighbors. However, dollarization has also constrained Salvadoran governments by preventing them from financing deficits by printing money.
Inflating the economy by printing more money can create the illusion of growth for a time. At least until people realize that the money in their pockets is worth less, so what seems like growing wealth is really growing poverty.
The hope is that Salvadorans will “mine” Bitcoin – injecting more of the Bitcoin crypto-token into circulation by running esoteric computerized calculations – and that Bitcoin owners around the world will buy Salvadoran real estate and invest in Salvadoran businesses.
The ultimate promise is a more rapidly expanding, technology-based Salvadoran economy that can leapfrog slower-growing, middle-income countries.
There’s a good bit of wishful thinking here, unfortunately.
First, mining Bitcoin requires enormous amounts of electricity. El Salvador’s electrical grid is stretched to the limit, and the country has some of the highest retail electricity rates in the Americas – five- or six-times U.S. levels.
Second, the problem isn’t that there’s not enough money to go around. Investors are avoiding El Salvador because the investment environment isn’t inviting.
Along with high power prices, regulatory procedures are opaque and slow, and taxes are high even as the authorities are consistently unable to ensure safe streets and educational and health systems capable of producing a 21st century workforce. Meanwhile, El Salvador’s underinvested transportation infrastructure inhibits trade and raises manufacturing costs.
Third, using Bitcoin when the country is dependent on trade and remittances denominated in dollars risks calamitous declines in purchasing power if Bitcoin goes out of favor. Small countries generally prefer fixing their exchange rate against the currencies of their major economic partners to hedge against these risks.
Finally, a great deal of Bitcoin is used to launder the corrupt profits of organized crime. By embracing Bitcoin, El Salvador risks becoming the gangsters’ banker. This could undermine the Salvadoran banking sector, raising interest rates, further inhibiting investment, and inviting closer scrutiny from U.S. authorities. Alarmingly, over 2,000 Salvadorans have been victims of identity theft through the government’s official Bitcoin wallet, “Chivo,” since its launch in September.
To promote public acceptance of Bitcoin, the government has promised to maintain a dollar fund equal in value to the Bitcoin circulating in the country so that anyone who wants to exchange Bitcoin for dollars can do so at any time.
But if the government doesn’t put enough dollars into its Bitcoin exchange fund, the stage would be set for a financial crisis.
If significant numbers of Salvadorans decide to “cash out” at once – in response to a natural disaster or a ripple in global Bitcoin markets, for example – it would trigger a run on the dollar fund, and the government could be forced to dip into pension or health care funds or curtail other expenditures to redeem Bitcoin.
This worst-case scenario would empty the treasury of dollars and leave it full of Bitcoin. Who would get dollars first? Don’t bet on the campesino or the shopkeeper.
Many Salvadorans don’t have the ability to manage or even understand these risks. In fact, they may not even know that they are taking those risks at all. Complaints are already rolling in about Salvadorans converting Bitcoin to dollars but receiving less than they converted – without knowing if the difference is due to a fee or price fluctuation.
In a small, underdeveloped country, the potential for disaster is high.
Matthew Rooney is the Managing Director of the George W. Bush Institute-SMU Economic Growth Initiative and Cullum Clark is a Director of the Bush Institute-SMU Economic Growth Initiative. The views expressed are the authors' own.
