This October, Ecuador will become the first sovereign nation to convert their physical currency to digital currency.
Beset by political and economic instability, Ecuador abandoned their sovereign currency, the sucre, and adopted the U.S. dollar in 2000. All sucres were exchanged for physical dollars, both bills and coin.
The benefits have been many. Given instability of the sucre, dollarizing the nation's currency stabilized the currency and headed off rapid inflation. The change, in turn, stabilized their economy. And with a stable economy, large oil deposits could be developed and the economy began to grow.
However, there have been disadvantages. Ecuador has lost control of its monetary policy and ceded it to the Federal Reserve. Without the ability to devalue their currency, their exports' appeal is dependent on American monetary policy.
Counterfeit dollars have also been a problem. Humid conditions and few wallets meant that dollar bills lasted only two to three months instead of the usual 14 to 18 months. By the way, it is exactly for this reason that U.S. dollar coins have been very popular in Ecuador. With the process for retiring the worn bills for new bills being expensive and time consuming, criminals took advantage of the opportunity to flood the economy with counterfeit U.S. dollar bills.
Finally, and most importantly, Ecuador's dollarization did not address systemic economic issues like corruption, lack of political stability and the government's huge spending problem. And it is Ecuador's spending problem that has caused them to seek a digital currency solution.
With limited physical dollars and the government's insatiable appetite to spend them, they have declared default twice and have run up a $4.5 billion budget gap this year. They have already used half of their gold reserves as collateral for a $400 million loan in May. In the same month, they sold future oil production to China for $2 billion amidst dwindling oil reserves. And they got a loan from the Latin American Reserve Fund for $618 million. All told, Ecuador's Finance Ministry projects $35 billion of loans needed to cover spending through 2017.
With limited U.S. dollars to pay for all this spending, Ecuador's government has decided the best way to fund their government is to create a new digital currency. Basing this currency on newly developed software, the government would in essence "mint" new currency in cyberspace and pay its obligations with it. It would also be cheaper and more durable.
On the surface, Ecuador should be praised for the bold experiment to convert their country's current monetary system to all digital currency. But scratching beneath the surface, several critical problems arise.
First, instead of creating a limited amount of currency and letting the market determine its value (like bitcoin), the government intends to create unlimited currency and will determine its value by fiat. To emphasize the point, Ecuador's Congress defeated efforts to back the new currency with an equal amount of U.S. dollars. Ultimately, this is an effort to create fiat currency cheaply.
Second, instead of decentralized open-source software, this is centralized closed-source software controlled by the Ecuadorian government. Digital currencies like bitcoin were created apart from government to prevent central bank manipulation and political influence on currency, which is primarily used for economic transactions. Having the license to digitally print unlimited currency with little accountability and an insatiable hunger to spend is a recipe for manipulation and political pressure.
And third, it is unclear how sophisticated the Ecuadorian programmers and technologists are. Are they using asymmetric encryption coupled with hashing, and building a public ledger that cannot be hacked and all transactions can be verified? Created by some of the world's best programmers over a longer time, bitcoin's software had some early issues and growing pains. It's hard for me to imagine any country creating a better mousetrap in three months (legislation passed in July with implementation planned for October).
While I think Ecuador is innovative and moving in the right direction, it is doing so for the wrong reasons and in the wrong way. The end result of "cryptocurrency-lite" will probably not be very pretty.
But expect that this pioneering effort will be copied and improved upon by sovereign nations seeking to decrease the cost of manufacturing physical currency while increasing the useful data from their monetary system and improving transparency. This co-opting of the principles of cryptocurrencies like bitcoin, right or wrong, will have a potentially profound impact on our ideas of money and payment systems.
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