Bitcoin's El Salvador Option

Saturday last, the president of El Salvador, Nayib Bukele, shook the bitcoin world when he announced he would make bitcoin legal tender in his country. The hype after that was unbelievable, as the hodlers went into overdrive. There were some more intelligent takes, as from Caitlin Long on Twitter and Peter St. Onge, but in general, the impression was that we were on the cusp of the brand-new world of bitcoinization.

Well, we now have the concrete law before us and can see exactly what Salvadoran bitcoinization means. To put it in the words of Horace: Parturient montes, nascetur ridiculus mus. The mountains labor—and give birth to a ridiculous mouse! Let’s examine the law and its implications.

Legal Tender—So What?

Front and center is the according of legal tender status to bitcoin. Not only can taxes be paid in bitcoin (article 4 of Ley Bitcoin [Bitcoin law]), but every economic agent must accept bitcoin as payment for goods and services (article 7), and all prior obligations expressed in US dollars may be paid in bitcoin (article 13). This is a massive infringement of property rights and freedom of contract, and any principled libertarian or supporter of free markets should oppose it on those grounds alone. Is bitcoin really so bad a currency that it has to be imposed at the point of a government gun?

However, the devil, as always, is in the details. The detail to consider here is the end of article 1: “What is mentioned in the previous paragraph [according legal tender to bitcoin] does not hinder the application of the Monetary Integration Law.” For those not up on Salvadoran monetary regulations, the Monetary Integration Law is the statute that accords legal tender status to the US dollar. So now (or three months from now, when the bitcoin law takes effect) both US dollars and bitcoin are legal tender in El Salvador. So what?

At this point, we need to reacquaint ourselves with one of the oldest insights in economics: Gresham’s law. As popularly stated, this law says that “bad money drives out good.” Or more correctly stated: artificially overvalued money drives out artificially undervalued money. If the government fixes an exchange rate between two moneys—gold and silver, classically—and this exchange rate diverges from the market rate of exchange, then people will hoard the undervalued money and only use the overvalued money in exchange. If the market rate of exchange between silver and gold is 16:1 but the official rate is 15:1, then people will only spend silver and hoard or export gold.

The application to the case of two legal tenders may not be evident. After all, the law makes clear that the market sets the rate of exchange between dollars and bitcoin. However, while there is no fixed exchange rate, you still have two currencies that are equally serviceable in canceling obligations. This fiat equivalence means that their legal power if only due to the intervention of the state, is the same. In this scenario, the lower-quality currency is bound to be preferred to the higher-quality one. If dollars are expected to depreciate and bitcoin is expected to appreciate, would you rather spend your high-quality bitcoin or your low-quality dollars? Virtually everyone will choose to spend dollars, and since this preference will be legally enforced, bitcoin will be driven from the market.

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