Gresham’s Law is an economic principle that essentially states, “bad money drives out good”. The principle is named after Sir Thomas Gresham, a financial advisor to Queen Elizabeth I of England. It’s an essential concept in economics and monetary theory, shedding light on the behavior of holders of currency when different types of money are in circulation.
Conceptualizing Gresham’s Law
Gresham’s Law primarily applies when two forms of commodity money are in circulation, one of which is intrinsically more valuable than the other. According to this principle, people tend to hoard the “good” (more valuable) money and spend the “bad” (less valuable) one. As a result, the good money disappears from circulation, and the bad money becomes the standard.
To provide a practical example, let’s consider a situation where there are two types of coins in circulation: gold coins and copper coins. Assuming both have the same face value, but gold (being more valuable as a metal) is the ‘good’ money, and copper is the ‘bad’ money. According to Gresham’s law, people would tend to save the gold coins for their intrinsic value and spend the copper coins. As a result, over time, the copper coins would become more common in circulation, and the gold coins would disappear – the bad money drives out the good.
This phenomenon was described by Sir Thomas Gresham in a letter to Queen Elizabeth I, where he observed that where legally overvalued currency (bad money) and legally undervalued currency (good money) are in circulation together, the undervalued money will disappear from circulation. This observation is often quoted as, “When a coin of the realm is underweight, it will not pass, but if it is full weight, it will.”
Gresham’s Law in Practice: Case Studies
The Great Recoinage of England, 1696
One of the most famous instances of Gresham’s Law in action was the Great Recoinage in England in 1696. Due to years of clipping (shaving off small amounts) and coin deterioration, the silver coins in circulation became severely debased. As a result, people started hoarding the full-bodied coins, leaving only the degraded coins in circulation. This led to a shortage of good coins and economic instability.
In response, the British government initiated a recoinage. Old coins were recalled and melted down to be minted into new ones. This initiative helped to restore the credibility of the coinage and stabilize the economy.
Zimbabwe Hyperinflation, 2007-2009
In a modern example, we can look to Zimbabwe, where a period of hyperinflation led to Gresham’s Law in action. From 2007 to 2009, Zimbabwe experienced severe hyperinflation, with the inflation rate reaching an astronomical 89.7 sextillion percent per month at its peak.
During this period, both Zimbabwean dollars (ZWD) and foreign currencies like the US dollar and South African rand were in circulation. As the value of ZWD plummeted, people started hoarding foreign currencies for their relatively stable value (good money) and attempted to get rid of ZWD as fast as possible (bad money). As a result, ZWD rapidly disappeared from circulation, replaced by more stable foreign currencies.
References from Books and Literature
Gresham’s Law has been a significant theme in economic literature. In his book “The Wealth of Nations,” Adam Smith references the principle, stating, “The degraded state of gold coin would, in this case, increase the demand for silver coin, and thus push silver out of the country.”
John Kenneth Galbraith, in “Money: Whence it came, where it went,” observes, “When there are legally fixed exchange rates between currencies or forms of money and the market rates diverge from these, the overvalued money will drive the undervalued out of existence. This is Gresham’s law.”
Role of the mental model “Gresham’s Law” in equity investing
Gresham’s Law, while primarily a principle of economic theory relating to currency, can be applied metaphorically to the realm of equity investing. The translation of the concept to the stock market isn’t perfect, but there are interesting parallels that can be drawn.
- Quality of Companies: Analogous to the ‘good’ and ‘bad’ money, in equity markets, we have high-quality and low-quality companies. High-quality companies typically have solid fundamentals, sound business models, and strong management teams. Meanwhile, low-quality companies may lack these characteristics and possess higher levels of risk. During times of economic boom, speculative, and often overvalued ‘bad’ stocks (i.e., those of low-quality companies) might outperform and attract more attention from investors due to short-term hype or trends. As a result, these ‘bad’ stocks can sometimes drive out the ‘good’ stocks, which are often steady, high-quality companies with slower but more consistent growth rates. This can be seen as an example of Gresham’s Law at play in equity investing.
- Information Quality: Gresham’s Law can also apply to the type of information investors use to make decisions. ‘Good’ information refers to reliable, factual, and relevant data that can help investors make well-informed decisions. ‘Bad’ information, on the other hand, includes rumors, misinformation, or irrelevant data that can mislead investors. Similar to the original Gresham’s Law, when both ‘good’ and ‘bad’ information is available, there’s a risk that ‘bad’ information may dominate, particularly in the age of social media where misinformation can spread rapidly.
- Short-Term vs Long-Term Investing: In the investing world, there’s a constant tug-of-war between short-term and long-term investment strategies. Gresham’s law might be interpreted to suggest that in periods of market euphoria, the ‘bad’ money (short-term speculative trading) might drive out ‘good’ money (long-term investing) as the dominant market behavior. This is because short-term trading can seem more attractive due to potential quick profits, despite its higher risk and less consistent returns.
While Gresham’s Law in equity investing can provide valuable insights, it is also important to remember that the financial markets are influenced by a complex array of factors and can’t always be accurately represented by a single economic law. Gresham’s Law is just one of many mental models that investors can use to help shape their understanding of the market. The most successful investors often use a combination of various mental models, economic theories, and market analysis to guide their investment decisions.
Conclusion
Gresham’s Law continues to be a relevant principle in economic theory, serving as a guide to understanding currency circulation dynamics, particularly in situations of economic turbulence. As countries increasingly consider the implications of introducing digital currencies alongside traditional ones, the lessons from Gresham’s Law may prove pivotal. While this model primarily applies in cases of bimetallic standards or hyperinflation scenarios, its implications can extend to other aspects of economic life, highlighting the importance of maintaining strong and reliable monetary policy.