Gresham’s Law, Gold and Cryptocurrency (1 of 2)

The other day, I was thinking about a lesson my father gave me when I was a young boy. We had gotten into a conversation about the expression “good money after bad”. When I asked him to explain what the difference was between “bad” and “good” money, he defined them and went on to explain Gresham’s Law.

Firstly, he told me that the expression itself meant that one is overpaying for something first with their “bad” (debased or circulating) money and then with the “good” (higher valued or hoarded) money.

As with any commodity, the value is determined by many different market factors. With any metal, its weight and purity determine its base value. That value, after some authority does an assay and the metal is coined, has a face value recognized and accepted by the People as bona fide. If, as an example, the coin has been circulated for many years and wears out, its weight is reduced, but its face value remains the same as the day it was minted. The People, after determining that the weight is not the same as a freshly minted coin, will reduce its buying power by the percentage of the lost weight. The same would go for the physical removal of a section of a coin by someone, or some governmental agency, for fees, interests on loans or taxation.

(It was the practice of chiseling out wedges or “bits” of the coin to take fees. As an example, a Spanish Piece of Eight could be evenly divided into eight pieces. “Two Bits” of those eight pieces was one quarter of the total, which is why Americans refer to a quarter Dollar as “Two Bits”.)

The problem also arises if there are two or more metals used as media of exchanges within the same economy. Attempts to fix a ratio of equivalents, such as 5 grams of silver equals 1 gram of gold, may also lead to discrepancies in even exchange values over time, such as raising the reserves in one or reducing them in the other.

Additionally, if a government reduces the weight of a coin or substitutes another metal, (as in the “sandwich” coins that came out in the U.S. in the early 1960’s, reducing the silver content of dimes, quarters and half-dollars) the face value remains the same, but it’s true, market value (purchasing power) is reduced. Governments must then force the People to use the debased money by enacting “legal tender” laws.

Sir Thomas Gresham was a 16th century, English financier who re-iterated an observation that dates back at least 2,500 years ago to Aristophanes. When dealing with commodity money, such as in gold- and silver-based economies, bad money will drive good money out of circulation. As an example, if there are two forms of commodity money in circulation, which people are coerced to accept by law as having a similar face value, the more valuable commodity, as determined by the market, will disappear from circulation leaving the less valued currency to be used in daily commerce. The effect would be that prices for goods and services would go up because the market would de-value the currency from its face value. Again, to counter this, governments would pass “legal tender” laws, forcing the people to comply.

A perfect illustration of Gresham’s Law in action can be seen with the first appearance of paper money in America in 1690.

As was their custom, the English of the Massachusetts Colony would make a yearly raid on the French in Canada at the time of the year when their fishery and animal pelt stocks were full and ready to be sent to Europe. Their plunder was usually successful; this year was different.

The French were sick of being raided and decided to fortify, prepare and defend themselves. The English were pushed back and returned to their colony empty-handed. Under the terms of their agreement with their leaders, they were to be paid once the spoils were sold in the markets. Since there was nothing to sell, the authorities were facing a large group of angry, armed men who wanted their money, so they decided to print up 7,000 Pound notes to be redeemed at a later date with specie (hard currency). The authorities made a solemn promise that this was only to be done once, as an emergency measure, and suggested that anyone who didn’t voluntarily accept these scripts at full, face value was being foppish, uncivilized, disloyal and “unpatriotic”.

Initially, the plan seemed to work. The authorities saw no immediate ill effects, so, within two months, they forgot about their solemn promise and printed up another 40,000 Pound notes to pay off ALL of the colony’s debts.

The People, in response, did not trust the government to redeem these notes with specie – especially since those coins would have to come from England, which forbade the colonies from minting their own coinage. The market value for the paper notes fell to 40% of their face value, driving up the prices of goods and services. The hard currency, the English, Spanish and Austrian coins used in commerce, immediately disappeared from circulation and were hoarded.

Trade between the New England colonies was also effected. The other colonies, following Massachusetts’ lead, issued their own paper and, soon, money and trade wars broke out between them. The colonial government officials then complained to London that there was a “shortage” of specie.”

There were many examples of Gresham’s Law throughout human history and the Founding Fathers were well aware of this. It was from this knowledge that the U.S. Constitution forbade the federal government from “printing” and monopolizing the production of money through a central bank. They understood this to be one among many inflationary practices that would lead to a collapse of the economy.

Our federal government was to recognize only gold and silver as money and its only obligation was to standardize weights and measures and verify the purity of the metals from which the coins were to be made.

The Constitution demonstrates a relatively complete understanding of Gresham’ Law, in that only one of the metals should really have been considered legal tender.

Now, onto Gold

Everyone reading this post is probably familiar with the 5,000-year history of gold as a medium of exchange. Its physical characteristics make it a perfect commodity for such a role. It’s durable, impervious to water, rot, fire, oxidation and has many uses in industry, dentistry and making jewelry. It is also pleasing to feel, hold and is appealing to the eye. It is difficult to mine and extract and cannot be counterfeited. And, as long as the gold that leaves the reserves for industrial use are replaced by newly mined and processed gold, it isn’t subject to large swings in value or purchasing power over time. Hence, it is resistant to inflation.

Briefly, gold held the exact same purchasing power from the beginning of our republic all the way until 1933, when FDR wrote an Executive Order removing it from daily commerce and making it illegal to hoard. The People were ordered to turn in their gold at the accepted rate of $20.00 per ounce, or else they were subject to fines, confiscation and prison. The next year, the Roosevelt Administration increased the price of gold to $35.00 an ounce. 

I won’t go into the reasoning of those in government for doing this, but it had to do with paying off the War Bonds from World War I, which were coming to maturity.

Gold was still used for international accounting through the Bank for International Settlements (BIS), which, for all intents and purposes, was in International Central Bank of Central Banks formed in 1930. The participants fixed their national currencies to a specific number per ounce of gold, making it easy for transactions between countries. I won’t go into the mechanics of it all here, but Nazi Germany became the greatest beneficiary.

In any case, in 1944 while the Second World War was still going on, 730 delegates from all over the world, including Germany, Italy and Japan, met at the Mount Washington Hotel in Bretton Woods, New Hampshire. They came together to put some order to the international banking system for the purpose of post-war reconstruction. The objective was to fix a monetary exchange rate using the U.S. dollar and gold as the base instruments to determine variations in the exchange and force them to remain +/- 1%.

(Interestingly, out of this accord were born the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD). The IBRD became the kernel for the World Bank Group, after post-war reconstruction was over.)

The U.S. Dollar was still pegged to gold until the “Nixon Shock” in 1971, when the convertibility of the Dollar to gold was ended and it became a fiat “reserve currency” on a free-floating exchange. Most other world currencies followed.

A Look at Purchasing Power

As was mentioned above, from the founding of the Republic until 1933, one ounce of gold could be bought for $20.00. This means that if I inherited a dollar from my father in say, 1920, who inherited it from his great-grandfather from 1810, it still held the same buying power; that is to say, what my ancestor 110 years before me could have bought for a dollar, I could have bought at the same price – all things being equal.

Allow me to give a simple example of how this works.

Back in 1910, people went to their doctors when they were ill and paid a fee for the service. If one were to go to their Family Doctor, that fee was $3.00, if they went to the “Professor”, which is the term they used for a specialist, they would pay $5.00. This was justified because it was the “Professor” who taught the doctor.

With gold at $20.00 per ounce, the doctor’s visit was equivalent to 3/20th of an ounce and the Professor’s visit was equivalent to 5/20th of an ounce. Now, let’s examine how this would translate to prices in today's market to see if their prices have increased from 1910.

Today, gold is running at about $1,300.00 per ounce. If we multiply this figure by 3/20th and 5/20th, we will get to the fees of $195.00 for the doctor visit and $325.00 for the specialist. This doesn’t sound too far off from what we would actually pay today for a consultation.

What this shows is NOT that the price of office visits have gone up, but that the value or purchasing power of the dollar has GONE DOWN!

Let’s look at another example. In 1960, one could have purchased an Alfa-Romeo Spider in the U.S. for $1,300.00. In that year, gold was selling at $36.50 per ounce. If we divide $1,300 by $36.50, we come up with 35.61 ounces of gold. If we then multiply that figure by the present quote on an ounce of gold, we come up with $46,301.00. This, too, is not far off from the present price of an Alfa-Romeo sports car.

The lesson here is that you should NEVER try to determine the value of anything using a fiat currency as the standard. You must ALWAYS look at the gold value equivalent!

Now, you may be asking,” Okay, Doc; you’ve told us about Gresham’s Law and you’ve given us a little history of gold. How does this apply to cryptocurrencies?”.

Well; that’s for the next post …