In the 16th century, European adventurers sailed to the Americas in the hope of discovering lost cities of gold. Recently the most popular political leader in the Americas, President Nayib Bukele of El Salvador, announced his country would soon begin building a metaphorical city of gold, unveiling stunning artwork and a golden scale model (pictured below) to show how the city is supposed to look when completed. The money for funding the construction of this extraordinary city will come from Bitcoin, one of the cryptocurrencies sometimes described as the digital equivalent of gold. Bitcoin City will be built alongside a volcano whose energy will be used to mine Bitcoins. Bukele consistently scores approval ratings of around 85 percent with Salvadorans but his plans routinely receive criticism from mainstream bankers and financial journalists in other countries. They accuse Bukele of gambling with his country’s money, not least when he announces on Twitter that El Salvador’s treasury has ‘bought the dip’ by increasing Bitcoin reserves in response to a fall in Bitcoin’s value. The problem with buying the dip, as most sensible cryptocurrency investors will admit, is that you can never be sure if you have reached the bottom of any current dip. Markets have not been kind to cryptocurrencies recently; the value of Bitcoin is less than half of what it was 6 months ago. So will we ever see the golden Bitcoin City promised by Bukele?
The building of Bitcoin City will not be cheap; the USD500mn budget will be covered by a ‘volcano bond’ issued by state-owned power company LaGeo. The plan is for the bond to raise USD1bn in total, with the other half being invested directly into cryptocurrency. In theory, the Bitcoins mined using the city’s geothermal energy will be used to service the debt. This plan is extremely ambitious. LaGeo’s annual revenue was just USD136mn per its 2021 financial statements, but the interest on the volcano bonds would be USD65mn a year. If no assumptions are made about the profitability of the Bitcoin City and its geothermal-powered mining operation then the cost of financing the additional debt would turn LaGeo’s 2021 profit of USD35mn into a loss of USD30mn. Investors may assume the debt will be backed by the state, but nothing guarantees that so far, and it is notable that the proposal is for the bond to be governed by El Salvador’s laws, and not by New York law, as is the norm for debt issued by El Salvador. Purchasers of the bonds may find they have little recourse if the ambitious Bitcoin City project turns sour, and this may mean El Salvador is being overoptimistic about the interest that the volcano bond will generate. The volcano bond was originally due to launch by March 20, but has been delayed because of the slide in the cryptocurrency’s value.
Bukele’s Bitcoin schemes will appear outlandish to some, but he would not be the first politician to calculate the best way for a small country to make money is to attract people who are unusually wealthy. He need not look far to identify several Caribbean neighbors who unashamedly appeal to foreigners that are definitely rich and possibly crooked. Whilst a lot of emphasis is placed on the novelty of building such a large investment on the mining of Bitcoin, most of the value proposition for Bitcoin City will be familiar to anyone who has ever considered sheltering their assets in places like Switzerland or the British Virgin Islands. Bukele has promised that Bitcoin City will be a tax haven, with no income tax or property tax, so the city’s income will only come from sales taxes. The rich will also have a route to obtain permanent residency and to convert that into citizenship over time. Anyone investing USD100,000 in the volcano bonds will qualify for residency. If we think of the pseudonymous nature of cryptocurrencies as the modern technological equivalent of banking laws that were designed to favor the privacy of the individual over the investigative powers of tax collectors then it becomes apparent that Bukele is using Bitcoin to repackage an old and familiar value proposition. This should not be surprising given that the President is a former marketing executive as well as a millennial.
Whilst it is easy to be cynical, it is worth remembering the genuine motives for inventing cryptocurrencies and hence the reason why some people were passionate about them before they became synonymous with speculation. Cryptocurrencies represent a key technological component of a potential revolution in how people use money. If you disagree, then I will point you at numerous financial services which have remained extraordinarily profitable over a prolonged period of time even though the movement of money from one place to another should be subject to competitive pressures that force down the prices which banks and other providers can levy. Some might argue that it only appears as if governments oversee bankers, when the reality is that bankers drive the adoption of laws designed to limit the degree of competition they can ever face. Those bankers and those laws have not done much to help the world’s poor play any economic role beyond that of servitude. Electronics, mobile communications and the internet have greatly expanded financial inclusion in recent decades. It should be just as easy to be cynical about the reasons why bankers and their representatives in government always seem to be obstructing this progress.
Cryptocurrencies can be an engine of change, but the problem with new technology is that you can never be sure how people will use it in practice until you observe how they use it. Unlike fiat currencies that are ultimately controlled by governments via the central bankers they appoint, cryptocurrencies like Bitcoin cannot lose value because of an arbitrary decision to create more. The rate at which new money is added to the supply is mathematically determined in advance, and is not subject to the whims of bankers or politicians. This led many to believe that cryptocurrencies would behave like a digital version of gold, serving as a hedge against inflation, just like gold can be a hedge against inflation because gold mines do not increase production in response to what is happening elsewhere in the global economy. If Bitcoin was an effective hedge then it would rise in value in response to the rising inflation that has beset major fiat currencies. The opposite has happened. It appears that most people who bought into Bitcoin now treat it more like a tech stock, dumping their holdings when they become pessimistic about the future. The New York Times recently observed the importance of research showing the correlation between Bitcoin and tech stocks.
Arcane Research assigned a numeric score between 1 and -1 to capture the pricing correlation between Bitcoin and the Nasdaq. A score of 1 indicated an exact correlation, meaning the prices moved in tandem, and a score of -1 represented an exact divergence.
Since Jan. 1, the 30-day average of the Bitcoin-Nasdaq score has approached 1, reaching 0.82 this week, the closest it had ever been to an exact, one-to-one correlation. At the same time, Bitcoin’s price movement has diverged from fluctuations in the price of gold, the asset to which it has been most often compared.
One explanation for this unexpected transition from digital gold to the handmaiden of tech stocks is that there has been an important change in the reasoning of the people buying Bitcoin and other cryptocurrencies. The true believers who adopted crypto early had an appreciation of the mathematics behind the technology and idealism about the cross-border, supra-governmental purposes that could be fulfilled by a digital currency that no government could tamper with. They believed they were buying the gold that would become the foundation of currencies that would overcome perennial human failings. Later adopters were attracted by the gold rush. They were less motivated by heady idealism and more impressed with charts which implied valuations would keep going up.
Irrespective of their motives, the newer investors in cryptocurrencies should have been helping the original advocates to achieve their goals because the scale of a market is also an expression of its maturity. Cryptocurrencies like Bitcoin should have become so large and so liquid, being supported by so many responsible businesses that serve as the on-ramps and off-ramps for ordinary people, that fluctuations in the value are less prone to the vagaries of big investors – known as ‘whales’ in cryptocurrency vernacular. This has proven to be wrong. We can now see that a shoal of a million small fish swimming together may collectively possess the same mass and energy as the largest whale. A single whale may have the brain to act selfishly but may still be rational in pursuing its own goals; how many fish in a shoal know why they are swimming in any given direction? The problem with cryptocurrency is that too much of its value remains divorced from normal economic activity. It is being used to store value in the hope that value will increase, when the normal way to understand the value of a currency begins with understanding the price that must be paid to acquire other things that people want, whether they are houses, handbags or pizzas.
If cryptocurrency is to gain mainstream acceptance as a medium for exchange then it will first be adopted by rich people. Gucci is the latest luxury brand to announce it will accept Bitcoin in its stores. Whilst it is nice to be rich in theory, individuals sitting on a fortune in cryptocurrency will eventually want to move beyond the theory by showing off their wealth. They can already exchange their Bitcoin for a fiat currency which is then used to make a conventional purchase, but that involves an additional step, and may also attract unwanted attention from tax collectors. There is some irony that the authorities who keep wanting to imply that cryptocurrencies are not real assets are also increasingly keen to levy capital gains taxes on anyone whose cryptocurrency holdings have risen in value. Tax authorities are focused on persuading exchanges to report transactions so the value of any gain can easily be calculated. The taxman’s life will be much harder if cryptocurrencies are used to make direct purchases; there is no easy way to calculate the value of gains crystallized by acquiring many different pairs of fashionable shoes. The greater the number of stores that accept cryptocurrency, the harder it would be to monitor them all. It seems like that Bukele will encourage many bling-bling stores to open in Bitcoin City, enhancing its golden luster.
The way the value of cryptocurrencies have correlated to tech stocks instead of gold has highlighted how little was understood about the way real people valued cryptocurrencies in practice. Socialist economics may offer some useful insight. You do not have to agree with socialists to understand their criticism of how capitalist markets determine the value of something. Socialists believe human intuition shows that the valuations given by capitalist markets are often terribly wrong: companies are overvalued, human labor is undervalued. However, any discussion of the irrationality or flaws of ‘the market’ is just a euphemism for criticizing the choices made by real people. Any poker player can explain how choices that seem rational when risking somebody else’s money suddenly seem a lot less rational when your own money is at stake. Critics who say markets behave irrationally are often right, but have never identified a reliable way to force people – whether dictators or the general public – to only make rational decisions. Critics of cryptocurrencies are right to highlight their volatility, but there are other assets that can suddenly change in value. Most of us are familiar with the idea that a new car loses 10 percent of its value as soon as it is purchased. This sudden change in value does not cause alarm because it is predictable, though a genuinely rational response in a perfect market would see the value of new cars fall as buyers become tempted by a prospective 10 percent saving. They would then wait to see if they can secure a bargain by waiting for nearly-new cars to be resold by recent purchasers, but that is not how people buy cars in practice.
The economist John Maynard Keynes observed that the value of an asset may not be determined by what the purchaser thinks about its fundamental value, or even the purchaser’s belief about the value that some other specific person would attach to that asset. He likened the valuation of an asset to a group of people voting in a beauty contest, but instead of each voter picking the face they liked most, they instead picked the face they think is most likely to win the contest. Each vote hence represents an estimation of how the voter expects the majority of other voters to vote, because the voter can only ‘win’ by making a selection that matches the choice that other voters also expect to win. If the first degree of valuation is paying a price based on your own estimation of something’s value, and the second degree involves paying a price because you believe you know the sales value when selling that thing to another specific individual, Keynes thought stock markets set a price determined by at least the third degree:
We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.
Although some liken Bitcoin to a Ponzi scheme, the unpredictable nature of Bitcoin’s value really shows the extent to which different people can struggle to determine the second, third, or fourth degree of valuation of an asset where there is insufficient history to tell investors how the value ‘should’ behave. Some thought the value should behave like gold. The actual behavior of many people means the value of Bitcoin has fallen in line with tech stocks. This reveals an underlying truth that many people only bought Bitcoin because they hoped to sell their holding for a profit at a later stage, which is also the reason they bought tech stocks. They did this without much thought as to why the value of their holding should otherwise increase. It is hence rational for a politician like Bukele to simply dismiss such behavior as irrelevant to his program. He is investing in a currency which is free from the control and oversight of foreign governments whose policies may not be helpful to El Salvador. If the transition to a Bitcoin-based economy is successful then he will dismiss the importance of any losses caused by buying Bitcoin with US dollars at one point in time, only to see the valuation of Bitcoin to later fall relative to US dollars. However, Bukele should still be mindful of Keynes’ famous maxim that markets can stay irrational longer than investors can stay solvent.
All of this should matter to communications businesses because it also provides an insight into how those businesses should be valued too. The total annual value of electronic communications is approximately USD1.6tn, but the cost of each form of communication is trending towards zero, which is why telcos are keen to diversify their sources of revenue. The value of a telecoms business is highly influenced by government policy, but we do not know whether the trend will be towards increasing competition (which will keep driving down profit margins) or there may be a return to a policy of promoting national champions, which would see telcos revert to the roles played by state-owned incumbents prior to market liberalization. These communication firms also have an interest in the communication of money, as most obviously apparent in those telcos that have enjoyed huge growth by supplying mobile money services. The role of public policy in deciding telco profitability is also evident when asking how much telcos need to carry a burden on behalf of the rest of society. That burden may involve investing in infrastructure without being allowed to impose charges on the businesses that profit most from exploiting that infrastructure (in other words, net neutrality) or it may mean determining the identity of a customer even though that customer is engaged in a transaction that does not directly involve the telco (as demonstrated by telephone numbers becoming central to the process by which many online customers are authenticated). Either way, there are serious questions about who pays telcos to underpin the rest of an economy that is increasingly dependent on network connectivity.
When we think of communication we tend to think of the way people speak and write, or the use of electronics to convey pictures, sounds and text, but there is another meaning which includes physical modes of transport such as trains and roads. The history of money has mostly involved the physical transportation and exchange of pieces of gold or other metals. There later came a realization that the value of the money need not reflect the value of the metal in a coin; it could be a piece of a paper with a number printed on it. Humans even evolved systems where millions of paper IOUs – otherwise known as checks – would be sent from place to place to exchange money. If you think it is bizarre to entirely abstract this process, so that no physical paper is involved, then please identify where the historic evolution of money should have stopped. Paper IOUs are not inherently more rational than sending money in the form of very long computable numbers, and many have criticized the notion that we must dig gold out of a hole in the ground just to store the gold in a bank vault, which is typically a different hole in the ground. Believers in the benefits of cryptocurrency can credibly argue that their goals are no less grounded or plausible than those of previous generations.
A rational analysis of Bitcoin may lead to the conclusion that the cryptocurrency only benefits the people at the top by taking from the people at the bottom. That argument also has some merit, but societies tend not to identify Ponzi schemes until they have already failed. We live in societies that have evolved many other mechanisms to take from the bottom to enrich those at the top. A reasonable person could ask why the Congolese miners who dig 70 percent of the world’s cobalt are so poor when that metal is so essential to modern electronics. We could also question why democratically-elected politicians tend to invest so much of their own wealth in housing and other buildings whilst never finding any solutions to the decades-long bull run on house prices. It is right to say the policies of El Salvador are a blatant gamble. If the gamble fails then there will be bad consequences for ordinary people. But there are also other examples of national leaders endangering the prosperity of their people. We have become inured to some of these failings because they have been so customary for so long.
Most of the criticism directed at El Salvador stems not from the degree of risk being taken, but because there is a chance they might significantly change the international pecking order by encouraging much more money to flow into their country. This would represent a major reversal. Much of the human wealth of Salvadorans currently flows to other countries where their brightest and best are expected to work for a pittance, and are then charged a premium just to send some money home again. President Bukele is taking a risk with his ambitious schemes, but change always involves a degree of risk. There is a need for more change in this world than most of El Salvador’s critics are willing to admit. That is the reason I do not blame Bukele for trying to do something different, whatever the market’s final verdict on his city of digital gold.