On June 8, legislators in El Salvador voted 62 to 22 in favor of making Bitcoin (BTC -1.89%) legal tender -- the first country in the world to recognize a cryptocurrency in this way. According to local news source elsalvador.com, businesses need to accept Bitcoin as a method of payment and prices can now be set directly in bitcoins.

The "Bitcoin Law" goes into effect in 90 days. Here's why a country like El Salvador is doing this, what other countries could follow El Salvador's lead, and why this could be a game-changing development for the cryptocurrency long term.

The flag of El Salvador flies above the clock tower of a building in the city of Santa Ana, El Salvador.

Image source: Getty Images.

Can Bitcoin solve El Salvador's problems?

El Salvador President Nayib Bukele points out that 70% of the country's population doesn't have access to traditional financial services. By officially making Bitcoin legal tender, the government hopes to usher more of its citizens into a modern, global economy. But there's a lot more that could also be influencing the Bitcoin Law.

Consider that El Salvador's currency is the U.S. dollar. Yes, American greenbacks have been the only legal tender in El Salvador for 20 years. This isn't unique: Ecuador, Panama, and others have also dollarized their economies. Sometimes, countries chose to substitute foreign currency to avoid local currency inflation.

But the U.S. issued an incredible amount of fiscal stimulus in 2020. Looking at M2 money data, there was a big jump in money supply in 2020, which has some economists fearing inflation of the dollar.

US M2 Money Supply Chart

Data by YCharts.

Countries using foreign currency are subject to policy decisions outside their control. With Bitcoin, at least El Salvador can rest easy knowing the supply of new coins is fixed by established blockchain protocols -- not politicians abroad (for the record, Bitcoin and the dollar are both legal tender in El Salvador now).

However, Bitcoin may solve a far more practical problem for the country. Many of its citizens work abroad and send money back home. According to the Associated Press, $7 million is sent back to El Salvador annually -- a big number for an economy this size. Unfortunately for Salvadorans, some of this money is eaten up by international transfer fees, but some hope that Bitcoin can be a cheaper alternative to send funds.

That said, we should note that transaction fees on the Bitcoin network are historically high right now. However, the high fees are starting to mitigate now that many miners are increasing their computing power.

Bitcoin Average Transaction Fee Chart

Data by YCharts.

El Salvador's not alone

Certain politicians in Panama, Mexico, Brazil, and Argentina also want Bitcoin laws in their own countries. But one interesting country to consider is Paraguay -- a place I resided in for about 10 years. Legislator Carlos Rejala is proposing a bill to encourage cryptocurrency miners to set up shop there. Rejala is part of Partido Hagamos -- one of the smaller political parties in the country -- so the bill may struggle to gain traction. But it's still interesting considering Paraguay's vast amount of unused electrical energy.

Paraguay owns two of the world's biggest hydroelectric dams -- Itaipu and Yacyreta. Nearly all of the country's electricity comes from these clean energy sources and they generate more than Paraguay needs -- it exports most to its neighbors. But with a clean, cheap electricity surplus, it believes it could incentivize miners to operate in Paraguay.

Stacks of golden coins display a symbol representing Bitcoin.

Image source: Getty Images.

Why this matters for Bitcoin

When thinking about the price of Bitcoin, investors need to consider factors that increase long-term demand. Consider that there doesn't necessarily need to be an increase in Bitcoin transactions for there to be an increase in demand. If regular people and corporations start buying and holding Bitcoin as they have over the past year, that's a form of demand that can send prices higher. And now, countries may start holding Bitcoin as well.

One of the practical challenges of transacting in Bitcoin is its volatility. Merchants risk losing a lot of money on the exchange. El Salvador's government, however, will seek to mitigate this risk for its people. As reported by Medium, President Bukele said the government will set up a $150 million fund to hold Bitcoin for merchants, assuming the volatility risk. Therefore, as a side effect of its new law, El Salvador's government could become a net holder of Bitcoin.

El Salvador will still need to overcome a host of practical challenges to prove to the rest of the world that its Bitcoin Law is a good idea. But if more countries start legitimizing and holding Bitcoin as well, this could create a new wave of demand for the coins. It's far too early to speak in certainties, but demand like this could serve as a long-term catalyst to send the price of Bitcoin much higher than it is today.