May 31, 2022

What the IMF forgot to mention about El Salvador’s adoption of Bitcoin

El Salvador

5 min read

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Many commentators are debating whether El Salvador’s commitment to making Bitcoin a legal currency and creating bonds backed by Bitcoin is sound economic policy. Less often discussed, and perhaps more important, is why El Salvador is pursuing this innovative and risky path. El Salvador is trying to reassert a degree of economic sovereignty that has been lost to dollarization and the problematic history of IMF economic policy intervention. Reasserting economic sovereignty also provides an opportunity to address long-standing economic inequality that is nearly impossible to fix within the current system. Reviewing just a few basic aspects of El Salvador’s economy makes it clear why they feel the potential benefits outweigh the risks.

El Salvador’s national currency is the US Dollar. After years of having a fixed peg against the dollar, El Salvador made the US Dollar an official currency in 2001. The impacts of dollarization are widely debated but, whatever the potential benefits, it means that El Salvador does not control its monetary policy. When the financial and political powers in the United States debate and set monetary policy it is quite clear that the health of El Salvador’s economy is not taken into account. El Salvador operates with an absurdly strong currency relative to its local economy and hence cannot benefit from the opportunity to be a low cost exporter. For instance, China has a per capita GDP that is more the double El Salvador’s but has a currency, the Yuan, that trades at a significant discount against the dollar. Unsurprisingly, El Salvador consistently runs a negative current account balance as their relatively expensive exports cannot keep pace with imports. This is a significant challenge to economic growth.

El Salvador has increased spending on social programs and infrastructure but at the cost of increased public sector borrowing. As the cost of borrowing increases, El Salvador will have to undertake some combination of increased taxes and reduced spending. A monetarily sovereign nation, like the US, could print more currency, as it has been doing quite aggressively of late. While this risks inflation, imported goods would become more expensive, it might also help exports by making them relatively cheaper. However, this option is denied to El Salvador.

Exacerbating this problem is El Salvador’s vexed relationship with the IMF. The IMF was central in dollarizing their economy and is a prime lender. They also promote policies of reducing social spending and infrastructure investment to reduce public sector borrowing. Therefore, the IMF helped coordinate the dollarization of El Salvador’s economy which has greatly constrained the ability of the government to make large public sector investments in social programs and infrastructure that could help redress systemic poverty and social inequality.

Further, the IMF’s long history in El Salvador does not help. In 1982, during El Salvador’s civil war, the IMF approved an $84 million loan. Very controversial at the time, it was supposed to be used to help the economy, but much of the money was used to fund the war or embezzled. When the Efemelenistas defeated the government, they discovered they were obligated to pay back a huge loan that had been used to fund the war against them or was stolen by their enemies.

The IMF also remains tone deaf to the many deep-seated structural problems El Salvador faces. Twenty percent of El Salvadorans work overseas and send money home in the form of remittances. This accounts for a shocking 24% of El Salvador’s GDP. Without remittances, the economy would collapse because of the trade imbalance and consistent capital outflows from the country. Rather than seeing this structure as a problem — having to support your country’s dollar dependence by sending 20% of your population to other countries, often illegally — the IMF refers to this as “Robust Remittances” and sees “resilient remittances” as a driver of economic growth: Not something to fix, but something to cheer.

Legalizing Bitcoin and offering Bitcoin bonds attempts to partially redress these problems. If El Salvador can successfully mine Bitcoin, they are in essence printing their own money. This gives them extra flexibility in spending without increasing taxes or reducing public investment. The IMF is very much opposed to these ideas. What is curious about the IMF’s stance is that it would not be particularly controversial if El Salvador announced a large find of lithium which they were going to mine. They could sell stakes in the mines, borrow against proven reserves and earned royalties and use the revenue to spend on whatever programs seemed appropriate. Chile has been attempting to do precisely this with their lithium mines with no complaints from the IMF. However, the IMF argues that Bitcoin is too risky. Lithium prices in the last several years have fallen from $160,000 to $40,000 and risen to nearly $500,000. Further, the discovery of a lithium substitute, many are in development, would reduce the value of lithium dramatically. So volatility does not seem to be the core issue. Rather, the IMF seems committed to dollarization regardless of the long-term cost to El Salvador.

Given the costs of dollarization and the power it gives to outside entities like the US government and the IMF, it is little wonder El Salvador’s leaders are willing to run an experiment with Bitcoin. They are trying to escape from an economic bind that hinders them from redressing structural inequality in their country. Reasserting some measure of monetary sovereignty might give them the ability to invest more robustly into social programs and infrastructure projects without relying on excessive borrowing or unsustainable levels of remittances. One can understand why other countries like Honduras, Guatemala and Mexico are seriously considering the Bitcoin experiment…

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