In the middle of 2021, with the COVID-19 pandemic raging, office-dwellers became home-dwellers, and high schoolers became home-schoolers.
What can one do from home? Trade Bitcoin.
But it is not so easy. High price volatility characterizes Bitcoin. That is, the value of one bitcoin can change significantly from day to day. For example, the price of a bitcoin rose $30,000 between February and April 2021, and fell by the same amount in two months.
Besides earning a reputation for extreme volatility, Bitcoin depends on a process called mining. To form a new bitcoin, a distributed network of computers must register transactions on the blockchain (essentially an account of all bitcoin transfers). For each successful register, that particular mining operator receives a bitcoin commission. As a result, every successful register also increases the number of bitcoins in circulation.
Instead of sticking with commodity production based on traditional currency, one country aims to reshape all transactions with this contemporary technology: El Salvador. For President Nayib Bukele, Bitcoin presents a new economic frontier. In September 2021, El Salvador emerged as the first country in the world to embrace Bitcoin as “unrestricted legal tender with liberating power.” In the United States, for example, the government relegates cryptocurrency to the status of property rather than a “real currency.” In contrast, Bukele elevated Bitcoin to the same level as traditional currency. Finally, the benefits of cryptocurrency can permeate the public policy sphere and not just private markets.
Liberating is right. Bitcoin is the future of El Salvador and the key to economic prosperity.
Before engaging in Bukele’s ambitious policy objectives, it is crucial to understand the background of El Salvador’s economy. For one, Salvadorans face a poverty crisis. Despite a 17% reduction from 2007, its poverty rate remained at 22.3% as of 2019. The bulk of that decline stems from the flight of agricultural workers to urban centers: the share of El Salvador’s urban population jumped from under 50% in 1990 to 73.4% in 2020. Improved wages and better access to health care facilities pull Salvadorans toward cities, but even these jobs tend to be in low-technology manufacturing and low-skilled services.
Another circumstance hinders El Salvador’s recovery: national debt. The country’s debt-to-GDP ratio is 91.8% with the fiscal deficit reaching 9.2% of GDP.
These two factors, make the provision of higher-earning jobs essential for social mobility. On the other hand, the government faces a policy dilemma: borrow even more and invest in future growth, or implement structural adjustment measures that could significantly impact Salvadorans. Trapped by loans issued by the IMF and partners such as the United States, structural adjustment forced Latin American debtor states to adopt a neoliberal model in the 1980s. This included devaluing their currencies, cutting public employment and spending, decreasing real wages, increasing interest rates, liberalizing foreign investment, and privatizing state enterprises. As a result, life became harder: people could barely afford basic needs, getting a job became hard, fewer public services were provided, and attaining a personal loan was out of the question. At the same time, the economy became even more volatile: investors pushed capital into Latin America and raised asset prices, such as homes, for the average person. As soon as loans cannot be paid back, the same investors rapidly retreat, cutting off funding for Latin America.
Luckily for El Salvador, the creation of a Bitcoin economy offers an alternative to the dire consequences of structural adjustment. To parse President Bukele’s logic, we can follow the money. A month after the authorization of Bitcoin as legal tender, the president announced a one billion dollar bitcoin bond. But this is no ordinary government investment project; it is an outright gamble. Half of the bond’s value will fund Bitcoin speculation. In fact, Bukele proudly tweeted, “We just bought the dip! 420 new #Bitcoin” in October 2021,” spending $25.6 million of the bond.
Government betting on the Bitcoin market raises questions. What actually drives the rise and fall of this digital currency? Is it reasonable for Bukele to seek speculative gains, or can we classify this as a political stunt? In a 2013 study, researchers investigated the market movements of Bitcoin in relation to Bitcoin-related internet search queries (a measure of interest from investors). For each 10% spike in Google search queries, the Bitcoin price shifted by 2%. In this way, there is a two-fold effect. First, more interest in Bitcoin creates higher demand and consequently higher prices. Second, the general public notices these prices and becomes more interested. This leads to additional demand and more price shifts in the market. But at the same time, increased interest due to negative price movements can push the price down even further. From this study, the researchers conclude Bitcoin movements are entirely different from traditional currencies, noting that “[s]peculation and trend chasing evidently dominate the Bitcoin price dynamics.”
If Bitcoin is entirely speculative, how can Bukele trust in the underlying currency itself? The answer is timing. The aforementioned study analyzed data from 2011 to 2013 and assumed Bitcoin does not possess any traditional macroeconomic determinants, such as supply and demand. In the 2016 study, researchers found demand-side drivers, including the Bitcoin economy’s size, strongly affect its price. Over time, Bitcoin became more well-known with a large number of Bitcoins in circulation, which increased the impact of supply and demand drivers. Completely overturning the previous study’s emphasis on search inquiries, the researchers found they had no long-term effect on Bitcoin prices, suggesting the very popularity of Bitcoin made online trends less impactful. They also found no long-term relationship between the Dow Jones Index, oil price, and exchange rate on Bitcoin prices. In other words, Bitcoin can be understood from a traditional economic perspective. To Bukele’s credit, it can even provide isolation from market risks like oil costs.
Imagine this: El Salvador invests in Bitcoin by issuing a bond. As El Salvador seeks more Bitcoin and more Salvadorans purchase Bitcoin, increased demand will shift Bitcoin prices higher. As Salvardorans accumulate more knowledge about Bitcoin, information queries will cause less price movement in the long run, hence more stability. At the same time, El Salvador can isolate itself from the threat of oil supply shocks, a timely concern given recent economic sanctions against Russia and shortages fueled by the COVID-19 pandemic. El Salvador would be on a path to repaying the bond and earning more revenue for social services and industrial policy.
This is only half of El Salvador’s bond. The other $500 million will go toward bitcoin mining infrastructure and energy production, two likely targets of industrial policy. What might this mean from a practical perspective? Volcanoes.
Endowed with plentiful access to geothermal electricity from volcanic activity, Salvadoran Bitcoin mining is in a position to achieve a competitive advantage; that is, the ability to mine cheaper and more efficiently than rival firms. Monthly electricity consumption from Bitcoin increased over ten-fold between December 2016 and February 2022. This increase in energy consumption will only grow as the Bitcoin network expands and more transactions require mining. The demand for cheap electricity is so high that one Bitcoin firm revived a coal-based power plant in Montana to power its data center. This points to one key advantage in El Salvador: clean power.
In today’s cryptocurrency economy, concern for environmental impact falls to the wayside. If one government attempts to impose climate mitigations, the footloose mining industry can easily shift production to less burdensome regulatory environments. This lack of regulation seriously threatens global well-being. Taking into account the fine particulate matter, carbon dioxide, sulfur dioxide, and nitrogen oxides released by fossil fuel combustion, researchers found that for every dollar of Bitcoin, miners also generated $0.49 of climate and health damage in the US. In China, this amounted to $0.37 in damage for every dollar. El Salvador’s access to geothermal electricity almost entirely eliminates the harmful effects of mining, while offering cheap electrical rates to lure investors. In fact, investors increasingly prioritize sustainable investing. A poll of institutional asset owners from the Asia Pacific region, North America, and Europe found that 45% of asset owners embrace sustainable investing across the board. At the same time, 57% plan to require sustainable investing from their investment managers. El Salvador is in an ideal position to profit from the transition to green investing, today and in the future. Clean Bitcoin mining is a long-term investment, giving El Salvador a viable path toward economic development.
Despite all the potential benefits of Bitcoin for El Salvador, its main opposition stems from a familiar entity: the International Monetary Fund. Its hesitation to endorse Bitcoin adoption arises from four major concerns. First is financial stability: given significant fluctuations in the price of cryptocurrency, the IMF recommends new liquidity and capital requirements to minimize exposure to Bitcoin. Secondly, the IMF fears cybercriminals could undermine the system and threaten El Salvador’s partnerships with foreign banks. Third, the IMF recommends additional regulation and education campaigns so that Salvadorans do not fall victim to theft or devastating loss of their savings. Fourth, the convertibility between US dollars and Bitcoin is guaranteed by a public trust fund, requiring additional borrowing if Bitcoin prices plummet and wipe out the fund’s value.
All the IMF’s concerns are reasonable. After all, Bitcoin is volatile and less scrutinized by existing regulatory frameworks. However, the IMF’s negotiation tactics are less advisory than iron-fisted. With $1.3 billion of IMF lending on the line, the IMF demanded a dismantling of the Bitcoin trust fund and the restriction of El Salvador’s digital payment system to dollars. If El Salvador complies with the IMF’s demands, it might receive a loan, but how might it pay off its debt without investing in an industry of the future? The very deployment of Bitcoin creates backward linkages throughout the economy, bolstering the domestic energy sector and creating new, high-paying jobs. If El Salvador wishes for high-income employment and aims to avoid the IMF’s austerity measures, the country must innovate.
To win in today’s global economy, competitive advantage is key. El Salvador found a technology whose benefits are largely unrealized. With a first-mover advantage to establish clean Bitcoin production, El Salvador can lead the world in green, efficient mining operations. If the IMF seriously values El Salvador’s future, it ought to remind itself that rewards entail risks.
Journal on World Affairs, UCLA 