Central banks around the world have strived to co-opt digital currencies for their own purposes. El Salvador defeated them all by passing a law that makes bitcoin legal tender for all public and private debts.
Through this law, Salvadoran lawmakers essentially voted to initiate the process of outsourcing the country’s monetary policy to a decentralized network of computers governed by a set of fixed rules. It is an important step towards a world where money is healthy, not subject to the vagaries of politics.
Most digital currencies offered by central banks would be tightly controlled by governments. These currencies would strengthen the status quo, not revolutionize monetary systems. This is because the overwhelming majority of existing money issued and controlled by central banks is already digital – only a small portion of the world’s money supply exists in the form of paper money and coins. When most people talk about a digital coin issued by the Federal Reserve, they don’t have in mind a rules-based, censorship-resistant currency like bitcoin, but rather a mechanism for the Fed to directly control the money supply without the private banks acting as intermediaries.
One of the main concerns about giving the Fed so much power is the distinct possibility of arming the money supply. Parts of the country could be targeted with lower interest rates to selectively stimulate economic growth, creating opportunities for partisan conflict.
El Salvador, which does not have its own currency, avoids this risk by making bitcoin legal tender alongside the US dollar. The law provides that any economic actor technologically capable of accepting bitcoin is required to do so for payments for goods and services. It also allows bitcoin to be used to pay taxes and exempts the bitcoin transactions themselves from capital gains taxation.
To deal with wild fluctuations in bitcoin prices, legislation establishes a floating exchange rate determined by the market. If someone immediately transfers their bitcoins to dollars when they receive them, it doesn’t matter how volatile the exchange rate is because they will always have the dollar equivalent. Salvadorians are free to keep their savings in either currency; the legislation simply puts bitcoin on par with the US dollar and does not disadvantage cryptocurrency with higher transaction costs.
There are distinct advantages to this dual track system. In a recent National Bureau of Economic Research paper, David Yermack, Fahad Saleh and I use an economic model to show that the existence of non-state-controlled private digital currencies has important implications for emerging market countries. They discipline the government and encourage local investment. Throughout history, central banks have devalued their currencies or attempted to maintain unsustainable exchange rates to the detriment of investors.
This is not the first step that El Salvador has taken to overcome monetary uncertainty. In 2001, the country officially dollarized its economy. The colÃ³n was withdrawn from circulation and all prices, including taxes and wages, became denominated in US dollars. Among other effects, this move limited the discretion of the Central Reserve Bank of El Salvador to manage monetary policy, essentially outsourcing this function to the Fed.
El Salvador has the right idea here. In âThe Denationalization of Moneyâ (1976), FA Hayek questioned whether government control over the money supply was necessary and argued that monetary competition had the same advantages as competition in goods and services. It disciplines economic actors and encourages them to better serve consumers, in this case by acting as a brake on the tendency of governments to inflate and force innovation in payment systems.
Central banks want the benefits of digital currency, but they also want to control the system and not give up their monetary tools. This makes the concept of central bank digital currency inherently contradictory. Bitcoin was created to provide an alternative to a state-run currency.
Sound monetary policy is not a magic solution to all of a country’s economic woes. El Salvador must embrace the rule of law, private property and limited government. But having confidence in a healthy currency will become increasingly important as the inflationary costs of monetary stimulus become known.
Mr. Raskin is a research director at Qvidtvm Inc. and an assistant professor at the New York University School of Law.
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Published in the print edition of June 16, 2021.