Posted by: chandniburman on Jul 20, 2011
A good bitchy conversation was at hand, when I met my friend Ruma.
“So why did you dump that Russian boyfriend of yours?” I asked.
“Oh. He was no good. Lost his job on Wall Street, and then expected me to support all his expensive habits,” she replied, sipping on her “Russian” vodka, which she liked to carry around.
“Ah. How things change. The last time you made him sound like God’s gift to mankind.”
“Well, in certain aspects he still is.”
“Now, let’s not get into that,” I said, before she could get into the details.
“And, you know I met this new guy, who happens to be tall, dark, handsome and cute. And of course, with a great job, which has nothing to do with the Wall Street.”
“Oh. So the good money drove out the bad money?”
“Well, that’s the opposite of Gresham’s Law, which says that bad money drives out the good money.”
“Gresham’s Law, of how to dump your boyfriend in seven days?”
“Not really! But it could even be applied in that context, now that you put it that way.”
“But what is this Gresham’s Law? This new toy-boy of mine likes to make these intellectual conversations. So I need to keep brushing up on interesting things that I can talk to him about. The normal Bollywood gossip won’t work with him.”
“I mean, if Ranbir keeps changing girlfriends every week, it’s rather difficult to keep track. I don’t blame your boyfriend in not being interested in Bollywood gossip,” I interrupted.
“So, getting back to the point. What is Gresham’s Law?”
“Gresham’s Law essentially states that the bad money drives out the good money.”
“Of course, that much you already said.”
“Patience Ruma ji. Patience. As you would know that for a very long period of time, gold and silver coins were used as money.”
“Yes I do.”
“As the great economist Murray Rothbard explains in What Has Government Done to Our Money, in 1200 AD, the French livre tournois (a kind of coin) was defined at 98 grams of fine silver...A striking case is the dinar, a coin of the Saracens in Spain. The dinar originally consisted of 65 gold grains, when first coined at the end of the seventh century.”
“So what you are effectively saying is that each metallic coin was worth a certain weight of gold or silver.”
“Yes, you are right. But once in a while, the kings and queens of the land had this simple idea of enriching themselves. They resorted to debasement.”
“They would call back for the existing coins and melt them. The gold or the silver they thus got was mixed with a base alloy and the coins were put back into the economy. These newer coins were of a lighter weight. As Rothbard explains, ‘Sometimes, the government committed simple fraud, secretly diluting gold with a base alloy, making shortweight coins. More characteristically, the mint melted and recoined all the coins of the realm, giving the subjects back the same number of “pounds” or “marks,” but of a lighter weight. The leftover ounces of gold or silver were pocketed by the king and used to pay his expenses.’”
“So, the French livre tournois, which in 1200 AD signified 98 grams of fine silver, by 1600 AD only signified 11 grams. The difference of 87 grams was simply debased away. The Spanish dinar originally consisted of 65 gold grains when it was first coined at the end of the seventh century. “The Saracens were notably sound in monetary matters, and by the middle of the 12th century, the dinar was still 60 grains. At that point, the Christian kings conquered Spain, and by the early 13th century, the dinar (now called maravedi) was reduced to 14 grains. Soon the gold coin was too light to circulate, and it was converted into a silver coin weighing 26 grains of silver. This, too, was debased, and by the mid-15th century, the maravedi was only 1.5 silver grains, and again too small to circulate,” points out Rothbard.”
“Oh. Such robbers these kings were.”
“Yeah. They were, but the public wasn’t so easily fooled. As John Mauldin, a hedge fund manager wrote in a recent column, ‘Under the Greeks and Romans, when gold coins were debased, few people were dumb enough to want to exchange their old coins that had high gold content for newer ones that had low gold content, so older good coins disappeared as people hid them.’ This is called Gresham’s law: Bad money drives out good money.”
“Okay. This part I understood. But what is the relevance in the current day and age?” asked Ruma.
“Well, what goes as money in this day and age is simply paper. It is not backed up by anything: no gold, no silver, except a fiat from the government stating that this paper is money.”
“Yup. That is the case.”
“Also, with paper currency, it is very easy for governments to debase. They can simply print more money. This happens particularly in cases where the government isdeep in debt. There is a tendency among governments to simply print money to repay their debts. This has happened time and again. As Mauldin points out, “Let’s look at the example of Brazil. In the late 1980s and 1990s, itsuccessfully got rid of most of its debt. Today, Brazil has very little debt, as it has all been inflated away (by printing money). Its economy is booming, people trust the central bank, and the country is a success story.” Other South American companies have successfully done this.”
“What are you hinting at?”
“What if the US, which currently has a debt of $13 trillion, does the same thing that Brazil did, simply print its way out of indebtedness. As Mauldin writes: ‘Imagine if the United States increased its money supply, which is currently $900 billion, by a factor of 10,000 times, as Brazil did between 1991 and 1996. We would have $9 quadrillion on the Fed’s balance sheet. That is a lot of zeros. It would also mean that our current debt of 13 trillion would be chump change.’”
“But is that really going to happen?”
“I don’t know. But what I do know is that currently the US government is financing its fiscal deficit by printing more money rather than borrowing. The same is true about the UK and Japan, to a large extent. What this tells us is that they are open to the idea to some extent, though they may not go all the way with it to get rid of all their accumulated debt.”
“But where does Gresham’s Law fit into all this?”
“When a government resorts to printing more of its currency, it leads to a situation where the currency really loses its value, and people do not like to use it. There have been many cases in South America were people have used the US dollar as a preferred currency for extended periods of time after they lost faith in their own currencies.”
“So, basically people replaced “bad” money with what they thought was “good” money,” she said.
“Or good money drove out the bad money. As Mauldin puts it: ‘The good foreign money drives out the bad, and the inflating currency becomes totally worthless.’”
“Now what will people do when they lose faith in the US dollar, the British pound or the Japanese yen? And some of them already are losing faith in these currencies, as more of it are being printed.”
“I get the point. The South Americans resorted to using the dollar, which was perceived as a strong currency, back then, when they lost faith in their “own” currencies. The way out now would be to buy what has always been perceived as money — gold and silver. As Mauldin puts it, “when no one wants to hold paper money...it leads to...the hoarding of real assets.””
“So what is the moral of the story?”
“The Gresham’s Law will now be reversed. Earlier, when currencies were debased people hid their gold and silver coins. Now when currencies are being debased, people ought to and will buy gold and silver.”
The writer can be reached at email@example.com.