Gresham’s Law can be summed up this way: “Bad money drives out good.”
However, unless you’re already familiar with it, that’s not very clear. How can money be ‘good’ or ‘bad’? How do you ‘drive out’ money? Let’s clarify.
Who was Thomas Gresham?
Gresham was an English financier during the Tudor dynasty, in the 1500s. He founded the Royal Exchange and was present for, and instrumental in, the creation of the English central banking system. Gresham stated his Law, but wasn’t the first to point it out. And he never said ‘bad money drives out good’ — that was another economist, hundreds of years later, putting words in his mouth.
So much for Gresham. What about his Law?
Two types of money…
Gresham’s major achievements were to do with improving the value of the English pound which had become debased. His Law means that when people have two types of currency to choose from, they will choose in predictable ways.
Suppose that there are two types of pound coins in circulation: each bears the franking certifying it as a pound, but one is pure gold, the other mostly copper and brass. You have one of each, and wish to buy a pound’s worth of goods from me. Which will you give me?
…one predictable outcome
If you’re like most people, you’ll keep the gold and offer me the brass.
That’s Gresham’s Law. People will almost always circulate the ‘bad’ money — the kind more vulnerable to devaluation, inflation, collapse, or any other bad outcome — and hang on to the ‘good.’ In each person’s pocket, the gold drives out the brass, but in the marketplace, it’s the other way around.
Soon, an informal system of exchange rates between the two types of ‘pound’ springs up — three brass ones for a gold one, say — and the bad money increases in predominance: it’s worth less than before, and more of it is in circulation.
The nominal value is no longer believed, and a new exchange value has been assigned to the coins, based on their accepted value in terms of the coins that have commodity value (actually contain gold).
Eventually, the only ‘good’ money is stashed away by investors, HNWIs and states. Vaults are filled with gold; the market is filled with brass. Bad money has driven out good.
Gresham’s Law and the modern world
What bearing does this have for us? We don’t have to choose between gold and brass, but we do have to choose between various fiat currencies, and various digital assets, some of which were designed to be treated as currencies even if no nation considers them legal tender. How does Gresham’s Law operate now?
One example would be the status of Bitcoin. When Bitcoin was invented, its stated purpose was to serve as a decentralized currency that could not be controlled, manipulated, or surveilled. It would be ‘digital cash,’ with scarcity guaranteed by algorithm, security by cryptography and validity by consensus.
It worked; there’s no fake Bitcoin in circulation, the central Bitcoin blockchain has never been hacked or otherwise successfully attacked, and Bitcoin is perceived as valuable. In fact, that’s the problem.
Bitcoin is now almost never spent. There are two ‘top digital assets’ — the one with far and away the most transactions is BTS, while the one with far and away the most value being transacted is BTC (Bitcoin).
Bitcoin is an asset to invest in, not a cash alternative to buy pizza with. ‘Vaults’ (cold wallets, custodial storage) are full of BTC. The market is full of tokenized BTC, low-value digital coinage, ERC-20 tokens and more. It’s not that these things are of no value; it’s that their value is low compared to BTC. Many investors hold (‘HODL’) BTC and spend fiat currency; others hold BTC and transact in tokenized BTC. Whichever avenue is taken, the effect is the same: the most valuable ‘currency’ is hardly circulated. ‘Bad’ money has driven out ‘good.’