Bitcoin and Gresham's Law

Economics Economics Questions
21

“Granted the conclusion follows from the assumption…”

Assumptions:

  1. Merchant will accept either bitcoins or dollars at their current exchange value.

  2. Buyer believes the future exchange value of dollars will be lower and the future exchange value of bitcoins will be higher.

Then in trade, the buyer will tend to relinquish (pay with) dollars and keep his bitcoins.

Even if the buyer believes Bitcoin is superior to and more desirable than fiat currency in terms of economics and political philosophy, he may wish to use fiat currency for purchases in cases when the merchant will accept both. In making a purchase, the buyer gives to the seller the objects he believes are decreasing in exchange value and keeps for himself the objects he believes are increasing in exchange value. If this thought process were widespread, then while these conditions remain (merchants willing to accept both currencies at current exchange rates: buyers believe that the future exchange rate between the two currencies will be markedly different) the “bad” money would be driving out the “good” money in the sense that dollars would remain in circulation as the general medium of exchange while bitcoins would remain in the cash holdings of market participants.

22

Potentially missing step 1.5: Buyer, knowing bitcoins appreciate, will seek to trade all his dollars for bitcoin before conducting any purchase at all and thus has no fiat left to buy with. When confronted with the need to buy something, reasoning he would’ve spent fiat for it anyway, he spends the bitcoin he’d been saving, knowing that it’s deflated partially since he got it, so the bought item is already ‘cheaper’ and the business-owner is also offering better price/terms if paid in bitcoin due to lower transaction costs, so it’s a double-win.

If the buyer believed that, chances are he would’ve already traded all his fiat for bitcoin up-front. In fact that’s the only way we can be certain the buyer does believe that. An iffy bitcoin user is the one that hedges by keeping some fiat on hand, just in case.

Agreed, but he does this at the point of exchanging dollars for bitcoin, not at some later purchase.

Eh, if everyone tries to exchange fiat for bitcoin, the value of fiat plummets, bitcoin increases dramatically, and suddenly everyone both wants bitcoin and deprecates dollars. At that point, dollars are essentially delegitimated and people make a rapid switch to bitcoin as the unit of account.

Thier’s law holds: “good money drives out bad money whenever the bad money becomes nearly worthless.”

23

Gresham’s Law is valid only when currencies are legally pegged, which is not the case for bitcoin.

Like worn and tear gold coins being legally equal to their original weight, or banana republic dollars that trade at fixed exchange rates against US dollars.

24

A. “Potentially missing step 1.5: Buyer, knowing bitcoins appreciate, will seek to trade MOST OF his dollars for bitcoin…”

B. "If the buyer believed that, chances are he would’ve already traded MOST OF his fiat for bitcoin up-front. In fact that’s the only way we can be certain the buyer does believe that."

C. In making a purchase, the buyer gives to the seller the objects he believes are decreasing in exchange value and keeps for himself the objects he believes are increasing in exchange value.

“Agreed, but he does this at the point of exchanging dollars for bitcoin, not at some later purchase.”

And he does that when deciding whether to give up bitcoins or dollars in exchange for product or service X.

D. “Eh, if everyone tries to exchange fiat for bitcoin, the value of fiat plummets, bitcoin increases dramatically, and suddenly everyone both wants bitcoin and deprecates dollars.”

Eh. This was part of the original assumption of what the buyer believes: that the value of fiat will go lower and the value of bitcoins will go higher.

Two comments:

  1. Today most people receive their income in fiat currency. The buyer who hoards bitcoins still receives increments of fiat currency as his customary stream of income.

  2. The Gresham’s Law effect suggested is a tendency and not intended as a statement about what every actor must necessarily do in every concrete instance. In a given individual case, an individual may spend a bitcoin instead of a dollar even if he believes dollars are depreciating and bitcoins appreciating.

25

“The narrow interpretation of Gresham’s Law is valid only when currencies are legally pegged, which is not the case for bitcoin.”

However:

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. Due to “lack of information” (about the future exchange value of bitcoins and dollars) another person may decide to sell me bitcoins for $20. In turn, if I believe the future exchange value of bitcoins and dollars is “markedly different” than their present exchange value (bitcoins will be worth much more; dollars will be worth much less), I may decide to keep bitcoins in my cash holdings and use dollars as a medium of exchange.

26

What you described is not Gresham’s law, it’s just a difference in expectations.

It’s what motivate somebody buy some FX futures for example.

Gresham Law applies only when you have fixed prices and two different moneys.

If one of these is being debased or somehow becomes less valuable than the other, it will be generally used in transactions (given away), as long as the counter parts are forced to accept it as a means of payment.

That’s not the case with bitcoin, which has a perfectly floating exchange rate.

27

“What you described is not Gresham’s law, it’s just a difference in expectations.”

It is a theory about why market participants who may believe Bitcoin is superior to and more desirable than fiat currency may nevertheless choose to use fiat currency for purchases instead of bitcoins, and in doing so, effecting a tendency for the “good” money to be withdrawn from circulation leaving the “bad” money in circulation. The difference in expectations is part of the theory.

“If one of these is being debased or somehow becomes less valuable than the other, it will be generally used in transactions (given away), as long as the counter parts are forced to accept it as a means of payment.”

I’m not referring to Gresham’s Law narrowly interpreted, but rather the general principle or general phenomenon of Gresham’s Law: A person is able to pay with a “good” object or a “bad” object, and chooses to pay with the “bad” object. If many market participants act similarly, then the “bad” objects (tend to) flow into circulation while the “good objects” are withheld from circulation.

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.”

28

Clarification / Correction:

My intended focus is on an actor who possesses both bitcoins and dollars and who is able to pay for good or service X with either dollars or bitcoins.

(not on an actor who is assumed to relinquish bitcoins in an exchange)

29

If exchange rates are free to adjust to offer and demand for a given currency, it reaches an indifference level where market participants are willing to trade in both units of money.

Gresham’s law, and the notion of “good” and “bad” money applies only when you have multiple currencies and a fixed exchange rate between them.

The scarcer currencies will have more demand than offer, and that’s why people will hoard them, because they cannot be legally exchanged at the market price where people are indifferent.

And generally the “good money” becomes scarcer because the “bad money” is being debased, either deliberately through inflationary methods or due to wear and tear of old metal coins.

Gresham’s law can apply to bitcoin only to the extent that bitcoin operators are not able to unpeg bitcoin prices to other prices.

Gresham’s law is something that happens when prices are constrained. In a way, it’s similar to shortages, waiting lines and surplus production that cannot be transported.

But even in a market free of official regulations pegging currencies, there’s some level of “gresham effects”, because of the general transaction costs involved in currency conversion and price monitoring. It could locally and momentarilly better to withold transactions in a given currency due to these expected costs, but these market inefficiencies would soon be corrected by the action of currency arbitrageurs.

30

Gresham’s law, and the notion of “good” and “bad” money applies only when you have multiple currencies and a fixed exchange rate between them.

But even in a market free of official regulations pegging currencies, there’s some level of “gresham effects”…

Again, I’m not talking about Gresham’s Law narrowly interpreted, but what you refer to as “Gresham Effects.” The exchange rate is “fixed” not permanently by government, but temporarily by the exchanges such as Mt. Gox. Meanwhile, the buyer who holds both bitcoins and dollars believes that the value of bitcoins will appreciate significantly relative to the dollar.

Example: Let’s say I have an art gallery and I sell paintings online. On my website I announce that I accept payment in bitcoins as well as dollars. My customer possesses both bitcoins and dollars and is deciding which to use for payment. He sees that bitcoins have appreciated in exchange value from around $20 in early February, to around $160 presently. Individual bitcoins have appreciated significantly in terms of dollars in a short amount of time, and this could possibly continue in the near future with no end in sight. His bitcoins might be worth $400 each by September he believes. In this case, it is likely that he will decide to pay with dollars and keep the bitcoins for himself. If many market participants act similarly, I’m arguing this would constitute the Gresham Effects you refer to. The exchange rate between bitcoins and dollars is “fixed” temporarily by the exchange. The buyer prefers to pay with the “bad” money rather than the “good” money which would effect a tendency for the bad money to remain in circulation while the good money remained in the cash holding of market participants.

This could be why Mundell proposed a more general and less narrow formulation of Gresham’s Law:

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.”

31

The exchange facility does not have the power to “fix” the exchange rate.

It is just a venue where people post their own bid-ask quotes.

The value right now in the exchange is the market value of a currency-pair exchange rate and it aggregates all expectations from all traders on both currencies.

If everyone thought that bitcoin would sharply appreciate against the dollar soon, they would react right now, by dumping dollars and acquiring bitcoins.

That would quickly bring the dollar value of the bitcoin to the level where as many people felt as predisposed to buy or to sell, that is, the market value.

But of course, if you have private expectations about the future, you can act on it too.

Maybe you think dollar will eventually depreciate more and more, even if the market right now doesn’t feel like it’s going to happen.

In that case you should keep hoarding your bitcoins, regardless.

But that’s your personal bet, that might or not payoff. It has little to do with Gresham’s law.

About the “gresham’s effects”, they might occur due to transaction costs in dealing with several currencies, but they would not hold for a long time in an unhindered market, because sooner rather than later the arbitrageurs would find a way to profit from price disparities in the currencies.

In environments of high inflation, people hold hard money (which in many cases in 3rd world countries, are dollars), but this can only go on as long as there’s still a market for the debased local currency.

After a while, when high inflation becomes hyperinflation, people only accept to sell in dollars or gold, and loans, jobs and business contracts are fixed in dollar value.

When I was a kid in Brazil, I remember that people only talked about real estate in terms of dollar, because the country was suffering from more than 400% inflation (and that was the official figure, the real one might have been more).

32

You’re simply saying you reject any notion of a general phenomenon of Gresham’s Law and only accept a particular, narrow, and concrete version of it. That is your personal opinion. However, the Wikipedia page on Gresham’s Law is not constrained by your personal preference, and provides several variations and interpretations of Gresham’s Law, which if read and understood, paints a picture of a more general economic law of which the narrow version is only one instance.

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.

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.

33

What I’m calling ‘gresham effects’ might be very common things, like when we select coins of small denominations to put inside vending machines.

10 coins of a dime are less valuable then 2 coins of 50 cents, because they are so small and dificult to find inside pockets, and then count and handle, and they never ammount to useful amounts, so we generally don’t want to hold them.

That’s why we dump them on vending machines. Gresham’s law.