Gresham’s Law is a rule of monetary economics that says bad money crowds out good money.
The idea was first used in the context of the Gold Specie Standard to describe the tendency for overvalued currencies to circulate instead of undervalued currencies.
Overvaluation could result from the dilution of gold to make coins, or from a fixed exchange rate between gold and silver coins gradually moving away from market prices, but the principle still applies.
The reasoning is pretty simple – no one wants to hold overvalued currencies when the market is correcting to reflect the true exchange rates of the currencies involved. Therefore, there will be a preference to pay others in overvalued currency, while everyone keeps undervalued currency in anticipation of the market correction.
How do we apply Gresham’s Law today?
Now let’s turn to the new currencies being circulated and traded in the modern day cryptocurrencies.
The digital infrastructure for cryptocurrency payments is also currently being developed by many large companies. Uber just announced that they will be accepting cryptocurrency payments in the future, and they are hardly the only ones getting on the cryptocurrency bandwagon.
Microsoft, Starbucks, and many other companies are already accepting cryptocurrency payments, and the technology is clearly here to stay.
But is it really worth accepting cryptocurrency payments and developing such a digital infrastructure?
If we remember Gresham’s law, bad money crowds out good. If cryptocurrencies like bitcoin are undervalued and therefore likely to increase in value in the future, why would any sane individual or company use bitcoin or any other cryptocurrency to fund their own expenses?
Nevertheless, cryptocurrencies are becoming increasingly popular as a means of payment. Visual Capitalist reports that Bitcoin, Ethereum and Litecoin daily transactions have increased from 250,000 to more than 1.5 million per day.
What seems to be the problem here? There seems to be a calculation error somewhere.
When consumers miscalculate, they pay for goods and services with an undervalued currency and forego future dividends from holding cryptocurrencies.
However, the opposite could also be the case. Some cryptocurrencies may actually be overvalued, and consumers are simply throwing those cryptocurrencies at companies foolish enough to accept them as payment.
So who miscalculated? Apparently neither…
There is one caveat to Gresham’s Law, however.
One of the requirements of the rule is that there is a legal enforcement that both good and bad money must be accepted at face value. When this isn’t the case, Gresham’s law works in reverse – good money drives out bad.
Since people are not forced to accept both good and bad money equally, good money will be the preferred currency for transactions as it is more credible and less suspicious.
This happened especially in times of hyperinflation and the dollarization of entire economies. Vietnam, Cambodia and Zimbabwe are just a few examples where this has happened.
In all cases, the US dollar—considered more stable and less prone to inflation than domestically issued currency—was accepted as a means of payment for transactions, and the “good” US dollar began to crowd out the “bad” domestic currency.
Nowadays there is no legal obligation to accept cryptocurrencies. However, cryptocurrencies are increasingly being accepted as a valid payment method, either directly or through digital payment gateways. This could be interpreted as a sign that these cryptocurrencies are actually good money.
There are also good reasons to believe this. Cryptocurrency also meets the basic requirements that make it viable as a currency. It can be used as a reliable store of value, it can fill a need and it can be traded like any other commodity.
In fact, it arguably does this better than paper money. Cryptocurrency is less prone to counterfeiting attempts as it needs to be mined using cryptographic hash functions; Bitcoin is much easier to break down into smaller units compared to fiat fiat money, which means it’s also much more convenient.
While it has not yet achieved the most important qualification as a universally accepted commodity that will always meet a contingency of needs, neither does fiat currency fiat currency, with the only possible exception being the US dollar.
However, the increasing acceptance of cryptocurrencies like bitcoin seems to indicate that this could soon change. Bitcoin’s natural supply limit limits inflationary pressures to some extent, and the lack of exchange rate uncertainty when all parties are trading the same cryptocurrency makes it much less risky.
On the contrary, concerns about the US dollar’s viability have increased given the worrying policy of unlimited quantitative easing implemented since the start of the Covid-19 pandemic.
There is also significant competition from other widely used currencies to be the reserve currency of choice: the euro, Japanese yen and increasingly Chinese yuan have begun to threaten the US dollar’s long-held hegemony.
So what’s in store for the future?
The truth could be much more complicated and would require further research, and such research would be extremely helpful.
But for now, cryptocurrency seems like a good investment. In short, it’s good money that’s expected to rise over the long term.
We live in a time where global production is increasing every year. More is produced and more consumed. According to the quantity theory of money, each individual unit of currency has greater purchasing power when the production of goods and services grows faster than the money supply.
Therefore, the logical conclusion would be that it is a good idea to hold cryptocurrencies, which are becoming more and more popular. Even if they were temporarily overvalued, their increased use would mean that the balance would soon be restored or even surpassed.
Therefore, cryptocurrency digital payments and the technology that supports such payments as commonly demanded commodities would also be a good investment.
While the traditional form of Gresham’s Law suggests that people hoard good money and therefore payment gateways for such good money are underused, the opposite is now the case – good money drives out bad and will continue to do so.
I’ll end this piece with a caveat: not all cryptocurrencies are created equal; some are in fact a better investment than others. What matters is how well they serve the purpose of money, particularly as a store of value and as a medium of exchange.
But what seems to be the case right now is that cryptocurrencies in general are reaching a tipping point where they will overshadow traditional fiat currency paper money, both as a medium of exchange and a store of value.
Credit for selected images: Zipmex
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