Tag Archives: Exchange rate

Gresham’s Law and Bitcoin

14 Nov

“The course our city runs is the same towards men and money.
She has true and worthy sons.
She has fine new gold and ancient silver,
Coins untouched with alloys, gold or silver,
Each well minted, tested each and ringing clear.
Yet we never use them!
Others pass from hand to hand,
Sorry brass just struck last week and branded with a wretched brand.
So with men we know for upright, blameless lives and noble names.
These we spurn for men of brass…”

Aristophanes, “The Frogs”, circa 405 B.C.E.

Gresham’s Law states that “bad money drives out good”. When the price of a currency is artificially constrained, for example by a legal tender law, then the constrained price may be higher, the same, or lower, than what its price would be on a free market. If the currency’s constrained price is lower than it would be on a free market, it will tend to be exported to be resold where the constraint does not operate, and thus will disappear from circulation. If there are competing currencies in the constrained market, the currencies that are relatively undervalued will also disappear from circulation. This will be true, even if the constrained price of the most undervalued currency is still greater than or equal to its true free market price. If creditors are compelled under legal tender laws to accept one or more currencies at a fixed price, debtors will always tend to pay with the cheapest currency available, that is the currency whose constrained price has the greatest positive (or smallest negative) spread from the free market price. The currencies with a narrower spread, even if they cannot be resold on a foreign market at a profit, will tend to be retained as savings.

What does this have to do with Bitcoin? Bitcoin actually does trade on a truly free and global market. Thus its spread is, by definition, zero. No national fiat currency can make this claim, at least in its home country. Thus, by applying Gresham’s law, we can see that given a choice, debtors will tend to pay their debts with their national currency, and retain any Bitcoin that they acquire as savings. They will exchange their Bitcoins for other currencies only if they have no other means of paying a debt or purchasing a necessity.

This means that the adoption of Bitcoin for commerce directly will be slow, or in other words, even if Bitcoin becomes commonly used as a payment system by merchants, prices for consumer goods and interest rates on loans will continue to be denominated in the national currency, and will be quoted in Bitcoin at the prevailing free market exchange rate at the time of payment. During the current phase of Bitcoin’s adoption, as it becomes increasingly clear that demand continues to rise steadily, I would actually expect that Bitcoin prices will be quoted at a discount to the instantaneous exchange rate.

So, as a unit of account, Bitcoin will not become the standard anytime soon, although it probably will at some point in the future, when demand for Bitcoin reaches equilibrium with other currencies, and in particular, gold and silver bullion, which also trade globally on a fairly free market. However, as a store of value, I believe that it is already the standard.

In my next post I will explain at what price I expect that equilibrium to occur.