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A blog on financial markets and their regulation
Gresham’s law states that if good money and bad money are circulating simultaneously, everybody would hoard the good money and spend the bad money thereby driving the good money out of circulation. Essentially, the good money becomes a store of value, and the bad money becomes the medium of exchange. I am beginning to think that an even more perverse outcome is possible – the good money having ceased to be money can suddenly become nearly worthless (because the store of value function of the previously good money depended on its being money). This strong form of Gresham’s law came to my mind after reading Wiegand’s recent paper presenting a “prisoners’ dilemma” model of Germany’s adoption of the gold standard in the 1870s.
The story as Wiegand describes it is as follows. In the mid 19th century, a large bloc of countries led by France was on a bimetallic standard with both gold and silver being used as money at a fixed exchange rate. New discoveries in California and Australia brought new supplies of gold in the 1850s, leading to relative shortage of silver whose output grew slowly. While in 1849, annual production (by value) of gold was less than that of silver, in the 1850s and 1860s, gold output was 2-3 times that of silver. Gresham’s law operated as expected to cause hoarding of silver in the bimetallic world: the share of gold in the French currency in circulation rose from below 30% in 1849 to over 80% in the 1860s. As the proportion of gold in France approached 100%, the possibility emerged of silver simply ceasing to be money. But if silver was no longer money, its price would decline to its value in cutlery or jewellery (the first photographic rolls using silver halide came only in the 1880s). We know from 40-year old first generation currency crisis models (Krugman, P. (1979). A model of balance-of-payments crises. Journal of money, credit and banking, 11(3), 311-325.), that the transition from France being 90% on gold to 100% on gold would not be smooth, but would happen in a sudden speculative attack that demonitizes silver. My reading of Wiegand is that Germany acted like a mega George Soros in executing this speculative attack by shifting to a gold standard and dumping all its silver on world markets; soon everybody abandoned silver and its price collapsed. (In the French bimetallic standard, it took only 15.5 ounces of silver to buy an ounce of gold; currently it takes more than five times that many ounces of silver to buy an ounce of gold.) Wiegand’s “prisoners’ dilemma” model is that Germany was forced to act pre-emptively to prevent France from launching a similar speculative attack on Germany’s silver standard.
This is what I am calling the strong Gresham’s Law: in a world of competing monies, the good money would be destroyed by a sudden speculative attack if it undergoes excessive deflation. All successful moneys have been mildly inflationary over sufficiently long periods (Triffin’s dilemma also leads to the same insight).
On the other hand, it is well known that the bad (inflationary) money could also become worthless if inflation accelerates beyond a point (Bernolz has labelled this reverse of Gresham’s law as Thiers’ law). The two laws together imply that all moneys are likely to die over multi-century time frames because of the low probability of staying on the razor’s edge between being demonitized by (a) deflation (the strong Gresham’s Law) and (b) inflation (Thiers’ law) for such long periods of time. This is consistent with the historical evidence: the ultimate fate of every fiat money in human history beginning with 11th Century China seems to be to become worthless. Near worthlessness has also been the ultimate fate of every commodity money except gold (and who knows how long gold’s luck will last?).
This has implications for crypto currency money supply rules as well. Seared by an abundance of hyper inflationary episodes in the 20th Century, crypto currencies have been designed with a deflationary bias. Many of them have inbuilt rules that freeze the money supply after an initial period of gradual monetary emission. In the wake of the collapse of crypto currency prices in recent months, some are making their systems more deflationary. Commentators are interpreting the reduced rate of monetary emission under tomorrow’s Constantinople Upgrade in Ethereum as a move to increase its market price. The weak and strong Gresham’s Laws suggests that all this might be misguided. It appears to me that after the rapid appreciation of crypto currencies in 2017, the weak Gresham’s Law kicked in and crypto currencies ceased to be medium of exchange; they became mere stores of value as exemplified by the hodl meme. It remains to be seen whether the 2018 price collapse in crypto currencies is the beginning of the effect of the strong Gresham’s Law that could destroy these currencies. Counter intuitively, an increased rate of monetary emission might actually be the way to salvage these currencies. Models with multiple equilibria are indeed quite messy.