The ongoing saga of bitcoin continued this week as tiny El Salvador became the first country to officially recognize bitcoin as legal tender. Bitcoin celebrated its new official status by promptly plunging nearly 17 percent before settling into a 10 percent loss for the day.
Most Salvadorans greeted the adoption of bitcoin with skepticism. The Wall Street Journal reported that a poll released by El Salvador’s UCA university found that 80 percent of Salvadorans have “little or no confidence in bitcoin” and more than 65 percent said they don’t want tax-payer money spent on this venture. El Salvador’s president, Nayib Bukele, on the other hand, claims that adopting bitcoin will bring more Salvadorans into the formal economy and free El Salvador from its dependence on the traditional global financial system.
At this point, nobody knows how El Salvador’s experiment will play out. El Salvador’s success or failure will depend on how well bitcoin can perform as money, something that hasn’t been broadly attempted before. In order for bitcoin to be good money, economists tell us it will need to perform three distinct functions.
First, bitcoin will need to become a store of value. By store of value, economists mean bitcoin will need to lose its volatility. For example, if I sell you something today in exchange for 2 bitcoin, I need to have confidence that those 2 bitcoin will retain their value when I use them to buy something else tomorrow. A currency that routinely plummets and surges is a terrible store of value. It may be a currency, but it is not very good money.
This is a huge point of criticism against bitcoin. Bitcoin is simply too volatile. Speculators may have loved the volatility and may have made a lot of money trading bitcoin, but the volatility that traders love undermines bitcoin’s viability as a store of value and hence, its usefulness as money.
Second, bitcoin will need to become a unit of account. “Unit of account” is another way of saying it allows you to measure the value of a transaction. In its simplest form, it means that you can quote a price for a good or service in bitcoin across the economy. There is nothing that would prevent bitcoin from functioning as a unit of account, though volatility complicates this function also.
Third, bitcoin must become a medium of exchange, meaning it would need to be broadly accepted as a method of payment. On my bookshelf, I have a jar full of foreign currency notes that I collected in my travels over the years. In their home countries, these notes are accepted as money. However, in the United States they are just brightly colored pieces of paper. In a practical sense, as long as I stay in the United States, they are no longer money because no commercial establishment will accept them as payment.
This is roughly analogous to bitcoin. Though bitcoin is not yet broadly accepted in most areas, things are changing. The other day I saw a small grocery store in Oakland with a sign saying “Bitcoin accepted here.” They even had a bitcoin ATM in the store.
One final point about bitcoin and money: money has evolved over the centuries. Primitive economies used barter to set the terms of trade, but barter was cumbersome and inefficient. As economies grew more sophisticated, money also became more sophisticated and more abstract. For example, money was once coins literally minted out of precious metals like gold and silver. Then money became paper script that signified gold or silver held in a treasury. Then money became just paper backed by a central government. Today money is an almost pure abstraction—numbers in a computer—and that abstraction allows for massive amounts of money to move around the world every day at the speed of light. Advocates say cryptocurrencies are the next step in that evolution. Maybe El Salvador is on to something.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to: firstname.lastname@example.org