Sun | Sep 19, 2021

Walter Molano | The crypto-peso dynamic and currency monopolies

Published:Wednesday | June 16, 2021 | 12:08 AM
President of El Salvador Nayib Bukele.
President of El Salvador Nayib Bukele.
A worker at Hope House, an organisation that sponsors the use of cryptocurrencies in El Zonte beach, makes a purchase at a small store that accepts bitcoin, in Tamanique, El Salvador, on June 9, 2021.
A worker at Hope House, an organisation that sponsors the use of cryptocurrencies in El Zonte beach, makes a purchase at a small store that accepts bitcoin, in Tamanique, El Salvador, on June 9, 2021.

The tiny country of El Salvador made headline news when the government announced that it would allow bitcoin to be used as legal tender.

Always the master showman, Salvadorean President Nayib Bukele was heaped with praise immediately by cryptocurrency fanatics.

Some commentators saw this as the way of the future. However, this is probably not going to be the case.

Sovereigns have several innate monopolies, which they jealously guard. The first is the legitimate use of violence. Governments have the right to protect themselves and to enforce their laws. There are some limitations on the use of force. These are delineated in international protocols, such as the Geneva Convention. Limitations are also specified in constitutions and domestic legislation.

Nevertheless, attempts to subvert this monopoly usually results in a swift response. There are instances when governments have not been able to exercise their monopoly, and these are referred to as failed states. This occurs when criminal groups or paramilitary organisations are allowed to operate with impunity.

The other monopoly that governments guard jealously is their currencies.

The right to print currency endows governments with enormous political and economic powers. It gives them the power to spend and allocate resources. This was a concept that was learned early on, and it was the basis of seigniorage. This was the profit that governments made from the minting of coins.

Even before Roman times and in Ancient China, governments have minted coins. Usually, it is a mix of precious and base metals. In Colonial Spain and Portugal, miners were forced to bring their silver and gold to the royal mint, where the government stamped it into coins. And, it is the reason so much of the bullion that made its way out of the colonies was in the form of Spanish doubloons.

The organisation of the Spanish and Portuguese colonies were based on the location of the royal mints, which were run by vice-royals or captaincies. Today, the building that housed the royal mint in Santiago, Chile, is the place where the president resides.

The cost of minting or seigniorage was typically a fifth. In Spanish, a fifth translates to ‘quinta’, which is still used to refer to a mansion. There is even a hotel chain in the United States called La Quinta.

Of course, the practice of seigniorage was not relegated to the Latin world. As gold deposits were discovered in the United States, especially in California, Treasury officials were in hot pursuit. The San Francisco Mint is a vestige of those roaring days of more than 150 years ago.

Seigniorage was a major source of government revenue. It was also the source of a lot mischief. Governments would debase their currencies, by increasing the mix of base metals. They would shave off the edges or use other techniques to devalue it.

Nevertheless, the power of the purse and the power of the sword have always been the main sources of power for governments since the beginning of time. Therefore, why would anyone want to surrender their currency?

There have been instances when governments surrendered control over their currencies. This usually happens when societies lose faith in its value.

In Weimar, Germany, the government printed so much currency that it became meaningless, and the country collapsed into hyperinflation. The only solution was to introduce a new currency unit that was backed by government land holdings.

In the early 1990s, the Argentine government faced a similar situation. The way it escaped hyperinflation was by backing its currency with dollars.

Ecuador and El Salvador also decided to dollarise their economy when their societies lost confidence in their monetary units.

El Salvador is a dollarised economy. It surrendered its right to print its currency two decades ago. Therefore, the government is indifferent to whether another currency enters circulation. In fact, it would probably welcome it, because the more transactions are done in bitcoin, the more dollars are available for external obligations.

It would be an application of Gresham’s Law, which states that ‘bad money drives out good’. In other words, if two monetary units are in circulation, people will hoard the more valuable unit and transact with the less valuable one. I would bet that dollars would evaporate, and kept under mattresses, while bitcoin would become the unit for most transactions. This would create other problems and complications, which has already been noted by the International Monetary Fund.

The acceptance of bitcoin as legal tender may be an option for rare cases, such as El Salvador, but it would be too much of a limitation for most governments. It would make them surrender one of their most treasured powers – the power of the purse.

Dr Walter T. Molano is a managing partner and the head of research at BCP Securities