This month, El Salvador made history. It became the first country to adopt bitcoin as legal tender. But the legislation was rushed—it passed in a matter of hours—and this reform is not entirely good news.
The designation means that the cryptocurrency—one of several electronic currencies privately created in recent years and independent of any central bank—must be accepted as payment for a debt. The bitcoin law also requires businesses to take bitcoin in exchange for goods and services. This mandate is a great imposition on the liberty of Salvadorans, but at the same time we should celebrate bitcoin’s wider adoption as a competitor to government-issued currencies.
Some 70% of Salvadorans lack access to traditional financial services. By boosting the use of bitcoin, the new law, which takes effect Sept. 7, aims to give them an alternative to banks. The idea is the brainchild of President Nayib Bukele, an evangelist for bitcoin whose Twitter avatar boasts lasers superimposed over his eyes, something that’s popular with bitcoin enthusiasts.
El Salvador already has an unusual monetary history—it’s used the U.S. dollar as its official currency for 20 years—so it’s not entirely surprising that the country is breaking new ground with cryptocurrency. As civil war raged from the late 1970s through the early 1990s, El Salvador saw inflation sometimes exceed 20% a year. After the war, the government pegged its currency to the dollar to hammer down inflation, and it worked. By the late 1990s, the economy was generally sound. Nevertheless, the government went further: In 2001 it took the dramatic step of adopting the U.S. dollar as its official currency. It “dollarized” to increase its ties to the U.S., bring in more investment and spur economic growth.
El Salvador’s move was unusual because countries typically dollarize when they’re suffering from high inflation. Inflation-ravaged Ecuador officially adopted the dollar in 2000. Similarly, Venezuela, plagued by hyperinflation, appears to be moving toward official dollarization. Some economists say Argentina should dollarize. El Salvador’s decision was also unusual in that its plan was rushed and made in secret.
What the Law Gets Right
The law establishes clear rules that will increase the ability of entrepreneurs, producers and consumers to spend and invest by using bitcoin. It exempts bitcoin transactions from capital gains taxes and allows other taxes to be paid in bitcoin. And it commits the government to helping Salvadorans gain the ability to transact in either dollars or bitcoin. Merchants and customers are already getting acquainted with bitcoin in the Pacific coast village of El Zonte, where a project called Bitcoin Beach introduced a payments application two years ago. But spotty internet service and other technology issues there indicate that adoption around the country might be slow.
Most importantly, Salvadorans will have a choice of currencies, and thus enjoy more economic freedom, if bitcoin catches on around the country. Migrant workers abroad, for example, might prefer to send home remittances in bitcoin if their family and friends don’t have bank accounts. Remittances make up more than 20% of El Salvador’s gross domestic product.
Private money is not without precedent; at different times in some countries, commercial banks were free to issue their own currencies in a competitive market. People were free to accept them, or not. Such “free banking” regimes include Scotland’s in the early 18th through the mid-19th centuries and Canada’s in the early 19th through the early 20th centuries. These competitive monetary systems worked well in producing economic stability and prosperity.
Writing in 1976, the economist F.A. Hayek argued that privately issued currencies would be superior to government-issued fiat currencies in stemming the high inflation of the day. His work has inspired many cryptocurrency proponents today. They argue that bitcoin and other cryptocurrencies are desirable, in part because they are safe havens from inflation. Although inflation in the U.S. has been low for the past few decades, it is not out of the question that the recent rise in prices may reverse that trend. Higher U.S. inflation could spill over into El Salvador because it heavily relies on the dollar. But the value of many cryptocurrencies is volatile, so the jury is still out on whether they will be a good hedge against inflation.
What the Law Gets Wrong
The new bitcoin law may increase economic freedom in one way, but it also undermines it in other ways. Most egregiously, it stipulates “that every economic agent must accept bitcoin as payment when offered to him by whoever acquires a good or service.” Although another provision clarifies that this applies only to those with the technical ability to transact in bitcoin, the law also seeks to grant everyone that ability. Therefore, the requirement will eventually apply to everyone.
Such a requirement is draconian. While many countries have legal tender laws for payment of taxes and debt, they rarely extend to everyday transactions for goods and services. In the U.S., a grocery store is free to refuse cash payments from customers, and many did during the pandemic. The new law will force Salvadoran vendors to accept bitcoin even if they prefer dollars or another currency. Also problematic is a provision that “all obligations in money expressed in USD, existing before the effective date of this law, may be paid in bitcoin.”
Creditors and vendors may prefer dollars because of the volatility of the bitcoin-dollar exchange rate. This year, the rate has swung by an average of more than 3% a day, equivalent to 60% annually. Suppose a store is paid for groceries with the equivalent of $50 in bitcoin. A 60% drop in the exchange rate cuts the value of its bitcoin to $20. Dollars in the form of cash also afford even greater anonymity than bitcoin.
The government claims that under the law, people will have the ability to instantly convert bitcoin into dollars, if they wish, and it is working with digital-wallet company Strike to build the necessary financial infrastructure. However, this promise was thrown into question because Strike’s model has been to convert bitcoin only into tether, a cryptocurrency whose value is supposed to be pegged at $1. Tether would then need to be converted into dollars on a cryptocurrency exchange. On Monday, though, Strike said it is phasing out its use of tether. But switching bitcoin for dollars may still prove difficult for many people. Bitcoin could be exchanged at bitcoin ATMs, for example, but there are only two in the country and they charge hefty fees.
The bitcoin law grants Salvadorans more economic freedom with one hand, then takes away significant freedom with the other. The law is something of an experiment, so let’s hope that President Bukele soon realizes his mistake and allows people to accept bitcoin, or not. This would better serve the liberty and prosperity of the Salvadoran people.