Dollars vs. Bitcoin: Which is the Better Deal?

Some countries, like El Salvador, are ready to put dollars and Bitcoin on equal footing and it's left to be seen which will most appeal to savers in real life.

In a late July blog post, The International Monetary Fund (IMF) compared the value of crypto assets, such as Bitcoin, with a reserve currency like the dollar. The Washington-based lender put forward one key differentiator: the evolution of the purchasing power of the two currencies. In theory, the stability of the inflation rate determines which is best as a store of wealth. In practice, we don't know...yet. As the IMF states, 'Bitcoin and its peers have mostly remained on the fringes of finance and payments'. Fortunately, some countries, like El Salvador, are ready to put dollars and Bitcoin on equal footing and it's left to be seen which will most appeal to savers in real life. In the meantime, let's unpack the whole story.

Are Inflation Worries Over-Inflated?

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Inflation

Inflation imposes direct costs on many segments of the economy. One of the most important drawbacks of the overall price increase is that it erodes the value of savings. When it becomes rapid enough, people begin acquiring non-perishable commodities and other durable goods as stores of value to counterbalance the declining purchasing power of money. This, in turn, creates shortages of hoarded goods.

Deflation

Although deflation increases the value of savings, it is a risky alternative. When prices fall, consumers have an incentive to delay making purchases until prices fall further, in turn reducing economic activity. Investments fall while bankruptcies increase, leading to further reductions in aggregate demand. This deflationary spiral puts bank savings at risk, which triggers a growing number of individuals to withdraw their bank deposits in order to hoard them under their mattresses.

What can be done?

The solution stems from interest rates. When inflation goes up, financial institutions charge higher interest rates on both sides of the balance sheet (the deposits/liabilities and the loans/assets). At the core, the interest reflects the default risks (uncertain repayment) and the time value of money (earning capacity). The latter is directly connected to perceived general price level fluctuations. Interest rates rise not only to compensate for inflation but also to account for the risks of high inflation. In theory, the Fisher effect postulates that the nominal interest rate tends to adjust to accommodate any changes in expected inflation, thereby preserving the value of savings. Unfortunately, nominal interest rates have often been disconnected from such inflation in practice. This repressive situation can ultimately result in savers earning less than what is required to preserve purchasing power.

In an attempt to channel funds from the private sector to themselves, governments are always on a quest for magical solutions to create growth without deepening sovereign debts. Analysts were cautious, given the volatility of cryptocurrency, while some said it could even put a pending IMF program at risk.

El Salvador's solution using Bitcoin

Two decades ago, in a moment of hubris, El Salvadoran officials envisioned a scenario in which a shift from the colón to dollars would marvelously decrease interest rates. They did come down, but only for a short while. Although some analysts argue that it could put a pending IMF program at risk, the president of El Salvador is trying to pull another rabbit out of its hat, with the same objective. The law recognizing the digital asset of Bitcoin as legal tender is motivated by the objective "to increase national wealth" and "economic growth".

Is the Dollar Definitively Popular?

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According to the IMF, the dollar is the world's most popular currency; about two-thirds of all dollar currency is held outside the United States. The US dollar represents over 60% of all known central bank foreign exchange reserves, making it the de facto global currency. It has also been at least partially adopted by more than twenty countries in a situation of currency substitution. It is also worth noting that dollarization is usually a response to hyperinflation or fiscal mismanagement leading to large and unsustainable government deficits.

However, switching to a foreign currency comes with its own challenges. By losing virtually all monetary power to combat hyperinflation or deflation, they became dependent on the money supply, which has grown faster than ever to reach about $800 billion, decided by the Federal Reserve.

The problems with USD

People become wary of dollars because both strong deflation and strong inflation are possible. Current inflation spikes stem from temporary supply shortages in the wake of the Covid crisis. At the same time, the exceptionally fast-growing supply of USD, in theory, should also lead to higher prices. This is not what we see in practice, as a big chunk of the money supply stems from the controversial QE program. In essence, the Fed bought financial assets from savings institutions which could only use the newly created liquidity to buy more savings assets. As the QE policy never truly reached the real economy (although it did drive financial assets prices up), it didn't spur inflation... yet. As a result, the interest rate level is opportunely kept below the rate of inflation, helping to resolve the high sovereign debt levels. In addition, the US government has begun to compel commercial banks to further accelerate the current money creation by guaranteeing private sector loans.

Governments hold power

Legislation and policies will certainly be passed to allow governments to allocate private sector savings through greater control over private banks. For instance, long-term government guarantees, particularly for green lending, are almost cast in stone. It's a type of magic money tree that creates politically directed growth, without increasing taxation or debt. This situation is called financial repression, as the whole point is to capture money from savers surreptitiously, through inflation.

However, while the US government and the Fed can control the supply of dollars, it cannot control what and how much people spend it on. Forecasting the velocity of money is an impossible mission. The lack of control over velocity is why inflation has failed to pick up in many countries beyond the USA - and even there, the Fed thinks it is only "transitory". In contrast, deflation could happen quite rapidly. If people lose faith in the dollar as a store of value, they would quickly buy goods and move their cash into alternative assets, such as stocks, bonds, or cryptocurrencies.

Will Bitcoin appeal turn bitter?

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Considering the limitations of traditional monetary systems, several countries are actively considering granting crypto assets legal tender status. El Salvador is even going ahead and authorizing Bitcoin for tax payments while exempting it from capital gains tax - as you obviously couldn't possibly make a gain on your legal tender, since it's your unit of account.

The nature of Bitcoin and the Bitcoin network

However, the country won't gain much more monetary power from that move. Bitcoin is a currency system that has a predetermined final monetary supply and the Bitcoin transactions are fully traceable on the blockchain. The number of Bitcoins on the Bitcoin network is limited to 21 million, and it should reach that number by about the year 2140. It will not be possible to mine more than that (and many have been lost, so the actual number will be far less). On the contrary, the amount of accessible Bitcoins on the Bitcoin network will decrease over time. And as they become increasingly rare, their perceived value will increase and the Bitcoin price will rise.

This increase in purchasing power means the bitcoin is a deflationary asset. There is an incentive for Bitcoin users to save their digital assets instead of spending them. Although hoarding a currency is theoretically bad for the overall economy, in practice, people would still need to spend money to meet their daily needs thereby allowing Bitcoin to find a settling point of steady deflation over time, as opposed to most fiat currency that finds its settling point of steady inflation over time. Most central banks actually target it at around 2%.

Decentralized finance and Bitcoin

Moreover, the concept of banking intermediation for Bitcoin is a bit more complex to fathom. On top of the challenge of offering interest rates on a deflationary currency, such intermediation clashes with Bitcoin's philosophy of being a decentralized cryptocurrency. Yields are part of a surprising turn in this context. Yet, with the rise of decentralized finance, DeFi applications use blockchain-based smart contracts to execute lending-borrowing transactions, offering to pay owners of Bitcoin annual percentage yields of 2% to 6% and sometimes more.

This is of course much higher than interest rates of about 0.5% on conventional bank deposits in USD. But the risk is somewhat higher as crypto lending functions without the Federal Deposit Insurance Corporation protections that come with a traditional bank account. However, most of the time, they work by collateralizing the loans - like a pawn shop - and the protocols have, thus far, been very good at managing risks. Even when it's MKR lending DAI for real estate in the US, which is essentially a mortgage.

Bitcoin price

In addition, Bitcoin market value can be extremely volatile. Bitcoin price reached a peak of $65,000 for one Bitcoin in April and crashed to less than half that value two months later. Some of the previous massive crypto market crashes were in the fall of 2014 when the Bitcoin price fell 67% of the market value of its last peak and in 2018 when Bitcoin had lost 82% of the last peak's market value. One Bitcoin today, may not be worth the same as the same Bitcoin of tomorrow. Bitcoin does come with a substantial advantage, however. You don't need to buy Bitcoin for tens of thousands of USDs. One bitcoin can be divided into up to eight decimal places, meaning you don't need to concern yourself with the large Bitcoin price. It's possible to buy Bitcoin in small fractions, which doesn't require a large investment.

Hard forks

There is also a risk of the Bitcoin blockchain forking again, as it happened twice already. Changes on the Bitcoin protocol did not reach consensus and as such the blockchain split. At first, it split into Bitcoin and Bitcoin Cash. Later on Bitcoin Cash blockchain split, and a Bitcoin Satoshi's Vision blockchain was created. This essentially means, that we now have three different cryptocurrencies that came from the original Bitcoin blockchain.

Bitcoin vs Dollar

The IMF argues that people would have "very little incentive" to save in Bitcoin as its "value is just too volatile and unrelated to the real economy". The blog post further adds: "even in relatively less stable economies, the use of a globally recognized reserve currency such as the USD or EUR would likely be more alluring than adopting a crypto asset". I disagree with the IMF's assumption that Bitcoin might merely succeed as a medium of exchange, but not as a store of value. Bitcoin is more like gold than it is like the USD or euros. Its code makes it a rare commodity that can be used for transactions and trading, whereas the dollar is a widespread payment instrument that can be used for savings.

What can we expect?

The most likely scenario is that Bitcoin will not become the sole global or San Salvadoran currency in the coming years. A promising option for lending is accepting Bitcoin deposits and then lending out fiat currency, like the USD in this case. Another is what the move to a truly digital currency enables: programmable money. So if people want to spend in USD-denominated terms, they can always convert their Bitcoin cryptocurrency to Maker DAI, Terra UST or some other on-chain stablecoin digital asset. But the fact that they can do so in crypto-crypto as opposed to fiat currency to crypto has a huge advantage in a country where not everyone has access to a bank account.

Bitcoin might not be the end-game for El Salvador. But even if it is the trojan horse that moves the whole Salvadorian financial system on-chain and banks the unbanked, it's not half-bad.

**The key incentive to save is simply to accumulate purchasing power by deferring your consumption in the future. There is still much debate between economists as to what will happen to the USD and Bitcoin price levels in the coming months. How will the battle of Bitcoin vs dollar end? Will the recent money-printing by the Fed and the Bitcoin price drop create inflation? Or will the current economic crisis (Covid's recession) and Bitcoin's limited supply generate deflation? **

As of September, the** El Salvadoran Bitcoin and dollar coexistence**, in the form of the Bitcoin legal tender, should provide some practical insights. It is likely we will continue to experience financial volatility, slower growth, and significant changes in how the financial and monetary system of the world works. Investors would do well to think about seeking protection by diversifying their investment portfolio during these uncertain times.

Written by Etienne Goffin

Senior economist from Brussels, Belgium. He has a 10+ year career in the financial sector both within the public sector (Central Bank of Malta) where he was an innovation consultant and economic advisor as well as the private sector where he has worked as a banking consultant (Needle Strategy) with expertise in corporate financing, monetary policy, and business innovation. He advised both governments and fintechs globally. Etienne is also Senior Economist and a member of the public affairs team at OSOM. You can find him @EtGOFFIN on Twitter or at goffin.eu