You should not run your country on bitcoin

El Salvador made bitcoin legal tender in their country. While some bitcoin proponents would consider it to be a first step in global adoption of the currency I think it would be an extremely poor idea. 

None of the ideas in this piece are new or unknown to most mainstream economists. But I still think it's worth restating them because sometimes they're forgotten in the debates regarding bitcoin. 

Volatility 

Bitcoin's supply and demand characteristics make its price volatile. Bitcoin's supply is fixed by a complete algorithm and the demand for Bitcoin is variable. This means that the price of Bitcoin will be volatile. 

Around September 2019 the price of bitcoin was $5000 and by January 2020 it had doubled to almost $10000. Then it catapulted to over $30000 over the next year. After peaking at $60000 in April 2021 it fell back to $30000 in July. 

Such extreme price volatility in any currency would be hazardous to economic activity in that currency. Imagine signing a contract where you agreed to buy some amount of goods and services denominated in Bitcoin. The price swings would mean that it would be impossible for any planning to be done if bitcoin was the current of use. (Of course then it's value would fluctuate against all goods and services not the USD) 

Typically bitcoin proponents have an answer to this: as the currency becomes more adopted, the demand for it will become less volatile. Instead of speculators looking to flip the currency for a quick profit, the demand for Bitcoin will come from regular people looking to save their money. This is more stable than the current demand for Bitcoin and so the price volatility should reduce. 

This is at first glance at least a plausible argument and I'll accept it. But there is another serious problem in adopting Bitcoin for global use. 

Tradeoffs

It is virtually guaranteed that two things will happen with bitcoin:

  1. The supply of new bitcoin falls by roughly half every four years

  2.  The demand for Bitcoin will increase going forward from now

The first prediction is far more likely to happen than the second. It is algorithmically guaranteed, but the second one is dependent on institutions and the social status of bitcoin which is more  volatile than an algorithm. Regardless, I think both of them are very likely and so as the supply goes down and the demand goes up, the price of bitcoin is almost guaranteed to go up. This is great news if you want to buy it, and many people cite this as their investment case.

But here’s the problem: for a new currency there is a tradeoff between large price increases and widespread use. Obviously the owners of bitcoin want the price to go up. But such large price increases hurt anyone with a liability denominated in bitcoin.

In the hypothetical bitcoinized world, imagine a company which borrowed money. It would borrow 1 Bitcoin and promise to pay some amount in the future (probably at a negative interest rate given such a world would be deflationary). 

This world would still have a low but declining supply of Bitcoin, and an increasing demand for it. But this demand is volatile. Let’s say for whatever reason (earthquake, pandemic, financial crisis) that there is unexpected deflation. People save more and spend less, which reduces overall demand and leads to deflation.  That causes problems for people who have borrowed money. Their revenues go down when there is deflation, but their liabilities do not. The hypothetical company is far far worse off because its liabilities are fixed, but its assets are dependent on the economy. Many companies like this would go bankrupt because they would not be able to meet their liabilities, and this would reduce demand further and the whole process would repeat.

This is not a hypothetical. In countries with extremely tight money (like Bitcoin would be), this has caused bankruptcies and has led to a large fall in GDP. Unexpected deflation rewards lenders at the expense of borrowers and causes large falls in GDP. Given that usually those who are richer are the ones investing and saving more and it is low income households and less successful businesses that borrow more, this increases income inequality (and makes people worse off).

This phenomenon where unexpected deflation leads to bankruptcies and the cycle repeats is called debt deflation. In history this has happened before and the debt deflation of the 1890s in the US is a good example of it

Debt Deflation of the 1890s

For a variety of reasons, there was a global depression in the 1890s. There was a run on the US Dollar because of a failed coup in Argentina, the popping of the railroad bubble and a fall in international commodity prices. The fall in commodity prices (which corresponded with a global deflation) led to declining revenues for farmers. But their debt did not reduce and they had serious problems in paying off their debt. 

The farmers faced extremely high debt loads and falling commodity prices over the course of the depression. In an economy with fiat money, this could have been avoided by monetary stimulus that allowed them to refinance these loans at a lower rate and increased the general price level and got them out of such a situation. But it was impossible under gold, and culminated with William Jennings Bryan’s Cross of Gold speech. The period only ended when increases in gold availability increased the gold supply and the money supply in 

 Both of these solutions, the engineered one by cutting interest rates and the natural one with an increase in the gold supply, would be anathema to bitcoin proponents. I’m not sure what solution they have to this problem.

So in the end, bitcoin’s greatest asset as an investment - its fixed supply - will end up being its worst flaw for monetary policy