Bitcoin and Gresham's Law

Economics Economics Questions
1

A lot has been written about Bitcoin and the regression theorem, but I haven’t seen much written about Bitcoin and Gresham’s Law.

The thought occurs that if a person is faced with the choice of paying with a depreciating currency or an appreciating currency, he/she would likely pay with the depreciating currency and choose to keep the appreciating currency in his/her cash holdings.

If this were to happen, it would/could suppress or inhibit the widespread use of the appreciating currency in commerce. People would hold the appreciating currency as part of their cash holdings and trade with their stock of depreciating currency. Obviously, if given a choice, people would prefer to give away that which is declining in value and hold on to that which is increasing in value.

2

that makes a lot of sense.

3

Adam,

the underlying mechanism of the Gresham’s Law isn’t in appreciation/depreciation, but overvalueing/undervaluing through the state (i.e. price fixing). That results in two markets, one with a market price and one with a different price, and creates an arbitrage opportunity, which results in the artificially undervalued money flowing to the open market and the overvalued money flowing to the rigged market.

4

Only if the party receiving this depreciating currency is either (1) an idiot or (2) being coerced by law to accept it. Gresham’s Law is only valid under (2).

5

Just so you know some users can’t log in here and so they are posting at LibertyHQ:

http://libertyhq.freeforums.org/viewtopic.php?f=5&t=452

(And no, I had nothing to do with it :stuck_out_tongue: )

6

There was a conversation about this on another thread but no this is absolutely not true because you don’t take into account the merchant himself. In fact on the free market good money drives out bad money

Read the whole essay “A Free-Market Monetary System” by Frederick Hayek

http://mises.org/daily/3204

Here are some examples of good money winning out against bad. If bitcoin is superior to other currncies then bitcoin will win out over other currencies

The same happened with British India with silver coins

And with Sweeden on the gold standard

7

Peter:

From Wikipedia:

Reverse of Gresham’s Law (Thiers’ Law)

In an influential theoretical article, Rolnick and Weber (1986) argued that bad money would drive good money to a premium rather than driving it out of circulation. However, their research did not take into account the context in which Gresham made his observation. Rolnick and Weber ignored the influence of legal tender legislation which requires people to accept both good and bad money as if they were of equal value. They also focused mainly on the interaction between different metallic monies, comparing the relative “goodness” of silver to that of gold, which is not what Gresham was speaking of.

The experiences of dollarization in countries with weak economies and currencies (for example Israel in the 1980s, Eastern Europe and countries in the period immediately after the collapse of the Soviet bloc, or South American countries throughout the late 20th and early 21st century) may be seen as Gresham’s Law operating in its reverse form (Guidotti & Rodriguez, 1992), since in general the dollar has not been legal tender in such situations, and in some cases its use has been illegal.

Adam Fergusson pointed out that in 1923 during the great Inflation in the Weimar Republic Gresham’s Law began to work in reverse, since the official money became so worthless that virtually nobody would take it. This was particularly serious since farmers began to hoard food. Accordingly, any currencies backed by any sorts of value became the circulating mediums of exchange.[13] In 2009 Hyperinflation in Zimbabwe began to show similar characteristics.

These examples show that in the absence of effective legal tender laws, Gresham’s Law works in reverse. If given the choice of what money to accept, people will transact with [money they believe to be of highest long-term value]. However, if not given the choice, and required to accept all money, good and bad, they will tend to keep the money of greater perceived value in their possession, and pass on the bad money to someone else. In short, in the absence of legal tender laws, the seller will not accept anything but money of certain value (good money), while the existence of legal tender laws will cause the buyer to offer only money with the lowest commodity value (bad money) as the creditor must accept such money at face value.[14]

The Nobel prize-winner Robert Mundell believes that Gresham’s Law could be more accurately rendered, taking care of the reverse, if it were expressed as, “Bad money drives out good if they exchange for the same price.”[15]

The reverse of Gresham’s Law, that good money drives out bad money whenever the bad money becomes nearly worthless, has been named “Thiers’ Law” by economist Peter Bernholz, in honor of French politician and historian Adolphe Thiers.[16] “Thiers’ Law will only operate later [in the inflation] when the increase of the new flexible exchange rate and of the rate of inflation lower the real demand for the inflating money.”[17]

If I may pay a merchant in bitcoins or in dollars, and if I believe that bitcoins have a much greater long-term value, I will tend to pay the merchant in dollars and keep the bitcoins for myself.

Even if I believe Bitcoin is a desirable payment system and even if I believe Bitcoin will be much more widely used in the future, I may still choose to pay for things in dollars because I would prefer to pay with a declining asset and keep the appreciating asset in my holdings.

If many market participants do the same thing, this could suppress or inhibit the emergence of bitcoins as a general medium of exchange.

This situation could possibly hold as long as I am able to pay with either bitcoins or dollars, and as long as I believe bitcoins are appreciating and dollars depreciating.

Also from the same Wikipedia article:

The principles of Gresham’s law can sometimes be applied to different fields of study. Gresham’s law may be generally applied to any circumstance in which the “true” value of something is markedly different from the value people are required to accept, due to factors such as lack of information or governmental decree.

Thus, Gresham’s law can be understood as a more general phenomenon. If I believe the future value of bitcoins is “markedly different” than their present value, I may decide to keep bitcoins in my cash holdings, and not use them as a medium of exchange. Due to “lack of information” (about the future value of bitcoins) another person may decide to sell me bitcoins for $20. The bitcoins won’t go back into circulation if, due to the effects which Gresham’s law describes, I keep them in my cash holdings.

8

this is true, and lets remember the value investor’s maxim. because no one has perfect knowledge, all prices are imperfect. imperfect prices represent an opportunity for a profit.

9

“Only if the party receiving this depreciating currency is either (1) an idiot or (2) being coerced by law to accept it. Gresham’s Law is only valid under (2).”

From the article about Gresham’s law on Wikipedia:

The principles of Gresham’s law can sometimes be applied to different fields of study. Gresham’s law may be generally applied to any circumstance in which the “true” value of something is markedly different from the value people are required to accept, due to factors such as lack of information or governmental decree.

If the receiving party, due to lack of information, doesn’t understand the future value of individual bitcoins and/or the future value of dollars, he may accept dollars which are depreciating in place of bitcoins which are appreciating.

And thus:

The Nobel prize-winner Robert Mundell believes that Gresham’s Law could be more accurately rendered, taking care of the reverse, if it were expressed as, “Bad money drives out good if they exchange for the same price.”[15

If the seller is selling something and will accept 100 dollars or 1 bitcoin, I will pay with 100 dollars if I believe dollars are depreciating and bitcoins appreciating. If many people on the market do the same thing, the “bad” money drives out the “good” as dollars enter (or remain) in circulation while bitcoins remain in people’s cash balances.

10

“There was a conversation about this on another thread but no this is absolutely not true because you don’t take into account the merchant himself. In fact on the free market good money drives out bad money…”

My original post didn’t say anything about a “free market.” It assumes the market situation and political situation as they currently exist.

11

A lot of the stuff you quoted from wikipedia supports the idea of a reverse Gresham law situation happening which is the opposite of the thesis in your original post. For some reason you assume that the consumer has superior knowledge to the merchant. The buyer has a better understanding of the monetary situation than the seller. What if mister online merchant prefers bitcoins over dollars and because of the low transaction costs he is willing to accept bitcoins at a premium so it is cheaper for the consumer to go shopping with bitcoins than dollars. You just completely ignore the point of view of the merchant

You quoted this from wiki

[

You said this

Everything you said is based on the assumption that the merchant is an idiot and the consumer somehow has perfect knowledge of the situation or is at the very least smarter than the merchant. Sorry if I am repeating myself

Just answer this: What happens if the merchant prefers bitcoins over dollars

12

then he will do the same thing as the consumer, save bitcoins and spend dollars. gresham’s law is in effect regardless of producers and consumers because some people dont exhibit monetary preferences and will divest their less preferred money. the bitcoins will accumulate in the hands of the bitcoin collectors. what is missing here is the understanding that while “better” is necessarily subjective, the better entrepreneurs in any given field (including currency) will win out.

13

Then our merchant is playing the role as a consumer to other merchants. You are still looking at the situation solely from the point of view of the consumer.

You are an online merchant and you prefer to be paid in bitcoins rather than going through the hassle of accepting dollars and then trading dollars for bitcoins. Most likely you are going to offer better prices in terms of bitcoins than dollars in order to encourage your customers to buy your product with bitcoins. Anything in economics happens because of human action so I don’t know what you mean by “gresham’s law being in effect regardless of producers and consumers”. Then you say the better entrepreneurs will win out, this is exactly why the best money will win out in the free market

Edit: Bitcoin supporters always say that bitcoins lower transaction costs. This is an obvious reason why merchants will prefer bitcoins.

14

“A lot of the stuff you quoted from wikipedia supports the idea of a reverse Gresham law situation happening which is the opposite of the thesis in your original post. For some reason you assume that the consumer has superior knowledge to the merchant. The buyer has a better understanding of the monetary situation than the seller. What if mister online merchant prefers bitcoins over dollars and because of the low transaction costs he is willing to accept bitcoins at a premium so it is cheaper for the consumer to go shopping with bitcoins than dollars. You just completely ignore the point of view of the merchant.”

I assume that the seller is willing to accept dollars or bitcoins at their current exchange rate. Let’s assume that 1 bitcoin can be purchased for $100 on Mt. Gox. That’s what I meant in writing:

“If the seller is selling something and will accept 100 dollars or 1 bitcoin, I will pay with 100 dollars if I believe dollars are depreciating and bitcoins appreciating.”

What the seller believes or is willing to do is already covered in my original premise or assumption. Also here:

"If I believe the future value of bitcoins is “markedly different” than their present value, I may decide to keep bitcoins in my cash holdings, and not use them as a medium of exchange. Due to “lack of information” (about the future value of bitcoins) another person may decide to sell me bitcoins for $20. The bitcoins won’t go back into circulation if, due to the effects which Gresham’s law describes, I keep them in my cash holdings.

Here, I assumed that “another person” (the person willing to accept bitcoins or dollars at their current exchange rate) lacks information about the future value of bitcoins and the future value of dollars. For example, a person who doesn’t know or read economics or libertarian theory, and therefore doesn’t understand the Fed’s impact on the future value of the dollar, or Bitcoin’s impact on the future of commerce.

You’re saying I ignored the merchant (in my example, the “seller” or “other person”). However, my intention was to account for them in my original assumption.

“Everything you said is based on the assumption that the merchant is an idiot and the consumer somehow has perfect knowledge of the situation or is at the very least smarter than the merchant.”

No, not at all. The merchant (person A)need not be an idiot. He could be a person who doesn’t believe that the Fed’s policies will have any dramatic or significant effect on the exchange value of dollars in the near-term or long-term. And the same person could believe that Bitcoin is a cool system but not necessarily believe that Bitcoin will radically change the world or that individual bitcoins will be worth $400 or $1000 any time soon. This probably describes a lot of people.

On the other hand, the purchaser (person B) may believe that the Fed’s policies will dramatically lower the exchange value of the dollar, and this same person may believe that Bitcoin might radically change the world and that the exchange value of individual bitcoins may exceed $400 in the relatively near future. This probably describes a significant number of bitcoin holders.

Under these assumptions, it is reasonable to expect—I’m suggesting—that the “bad” money (dollars) will tend to remain in circulation, while the “good” money will tend not to pour into circulation, but will instead tend to remain in people’s cash holdings.

Thus, it would be fully consistent with the superiority or desirability of Bitcoin over dollars that dollars could remain the generally used medium of exchange, while bitcoins are withheld from circulation. (as long as the assumed conditions hold: that merchants are willing to accept bitcoins or dollars at the published exchange rate, while the buyer believes that the future exchange value of dollars will be much lower and that of bitcoins will be much higher)

“A lot of the stuff you quoted from wikipedia supports the idea of a reverse Gresham law situation happening which is the opposite of the thesis in your original post.”

Yes, I quoted the full passage, and not only the parts that support my argument. My point is not that every single particular version of Gresham’s Law applies neatly to Bitcoin. My point in the original post was that not much has been written about the general phenomenon of Gresham’s Law as it applies to Bitcoin. That is, the idea that if there are two allowable objects I may pay with (this is the original assumption), generally (though not absolutely always) I will pay with the object I view as less desirable, and keep the more desirable object for myself.

This was meant to provide an explanation for a future situation in which someone may be at a loss to understand why, on the one hand Bitcoin is arguably superior to fiat currency, and yet on the other hand, people continue to pay with fiat currency when they have the choice to pay with bitcoins.

15

seems like you got the point of my post without realizing it.

16

I just find it hard to fathom that people A (merchants) will be, as a whole, more ignorant on monetary matters than people B (consumers). Your scenario only applies if buyers are more informed than sellers. It is possible to have a thought experiment like this but I don’t see how it could apply to the real world

17

“Edit: Bitcoin supporters always say that bitcoins lower transaction costs. This is an obvious reason why merchants will prefer bitcoins.”

There are at least two distinct entities:

  1. The Bitcoin payment system as that was designed by Satoshi Nakamoto:

I will refer to this by writing “Bitcoin” with a capital B.

  1. The individual bitcoins that are a part or a component of the Bitcoin payment system.

I will refer to those as “bitcoins” with a small b.

The Bitcoin payment system eliminates, or potentially eliminates, the need for a third-party payment processor in Internet commerce (Visa, Mastercard, Amex. PayPal). Currently, for small merchants (excluding large merchants like Wal Mart or Amazon) third-party payment processing fees are 2.5% to 3.5% of revenue. If there are $10,000 in revenue processed in one month, then the processing fee the merchant must pay is around $250 to $350 per month or $3000 to $4200 per year. Obviously, many “small” merchants have much larger monthly revenues and their payment processing fees are much higher. Bitcoin has the potential to lower merchant payment processing fees from around 3% of revenue to close to zero.

This is one reason that a person engaged in Internet commerce may see value in Bitcoin. There are also other possible reasons besides this.

This factual situation is independent of the situation in which a merchant may obtain bitcoins (through his business or through other channels) and then face the choice whether to use them to purchase goods and services. In this case, the merchant becomes a “buyer.” And if this buyer is able to purchase what he wants with either dollars or bitcoins (at the current exchange rate), and if he believes the future value of dollars will be much lower while the future value of bitcoins will be much higher, the suggestion is that something analogous to Gresham’s Law may take place. The buyer may pay with dollars and withhold his bitcoins from circulation. If many buyers act similarly, this may constitute a general phenomenon which theory is called upon to explain.

18

“I just find it hard to fathom that people A (merchants) will be, as a whole, more ignorant on monetary matters than people B (consumers). Your scenario only applies if buyers are more informed than sellers. It is possible to have a thought experiment like this but I don’t see how it could apply to the real world.”

I’m not referring to an objective merchant or consumer. I’m referring to the actor in his role as either a merchant or consumer.

When the actor holds bitcoins and dollars and must decide whether to either relinquish bitcoins or relinquish dollars in making his purchase, I am referring to this actor as a “buyer” regardless whether this same person also owns a store and in this regard is a “merchant.”

When he buys something he is a buyer, when he sells something he is a seller or merchant.

I’m assuming the case where the merchant will accept bitcoins or dollars at their current exchange value, and where the buyer believes that the future exchange value of dollars will be much lower while the exchange value of bitcoins will be much higher.

When these assumed conditions are met, I’m suggesting that something like Gresham’s Law may apply. Individual bitcoins (the “good” money) may be withheld from circulation while dollars (the “bad” money) may continue in circulation.

19

That’s the difference between the real Gresham’s Law and this pretender law. The real one needs no assumptions, merely analyzing a situation that has existed many times, legal tender laws overvaluing one of two currencies. The law has apodictic certainty [to use a buzz word], and follows logically from first principles.

Contrast this with thie pretend law, where an arbitrary, unrealitic assumption is made, as Adam made clear. Granted the conclusion follows from the assumption, but no Nobel Prize for that lame thing, sorry.

As for Robert Mundell, he missed the boat, too. What he should have said is that bad money drives out good money, unless the bad money is fiat and rapidly losing all value. In that case, it’s not a question of the good money driving out the bad money. It’s the bad money being abandoned and left for dead. Even if there was no alternate money, the bad money would be abandoned. [I’ve already started a campaign to have William Vickrey’s Nobel Prize transferred to me. Robert Mundell. you’re next].

Nothing to see here for bitcoin. Don’t expect it to drive out the dollar anytime soon, or ever. It’s not money at all, Malachi’s esteemed opinion notwithstanding, and the regression theorem proves it never will be. A car with four flat tires will not drive anything.

20

Speaking of the nobel prize, click here if you need a good laugh!