What is Gresham's Law? What is its relationship with cryptocurrency?

Author: Jagjit Singh, Cointelegraph

Translation: Song Xue, Golden Finance

1. Introduction to Gresham's Law

Gresham's Law has historically influenced the circulation of currency and continues to impact economic behavior by addressing how individuals prioritize different forms of currency.

Gresham's Law is a principle in economics that states when two different forms of currency are in circulation, individuals tend to spend or trade the currency they consider more valuable, while hoarding or using the currency they consider less valuable.

A common way to summarize this is "bad money drives out good." Here, "good money" is defined as currency with higher intrinsic value that is held, while "bad money" is defined as currency with lower intrinsic value that people are eager to get rid of.

Although Gresham was not the originator of this concept, it was named after Sir Thomas Gresham because of his significant role in popularizing the idea of bad money driving out good in the currency system. He was a 16th-century English financier and advisor to Queen Elizabeth I.

Historically, Gresham's Law has appeared in many fiat currency systems, where depreciated or counterfeit currency would drive more valuable fiat currency out of circulation, as individuals prefer to hold the higher-value currency and spend the lower-value currency. Today, this idea still holds practical significance when discussing the use of cryptocurrencies and their varying degrees of stability and utility.

2. How Gresham's Law Applies to Cryptocurrency

When using cryptocurrency, Gresham's Law suggests that highly volatile digital currencies are used for speculative investment, while stable and mature digital currencies are chosen for everyday transactions, reflecting the principle of "bad money" and "good money."

When choosing which cryptocurrency to use for transactions, individuals typically opt for the cryptocurrency they consider less valuable because of its stability and store of value function. Gresham's Law implies that individuals tend to use less volatile cryptocurrencies suitable for daily transactions, while using more speculative and volatile cryptocurrencies for investment or assets. This principle still holds relevance in the adoption and usage patterns of cryptocurrencies.

Gresham's Law is closely related to the function of cryptocurrency as a store of value. Some digital currencies, such as Bitcoin (BTC), are considered relatively stable and valuable due to their scarcity and widespread use as a digital asset similar to gold.

Similar to how individuals hold precious metals, users are more likely to hoard these cryptocurrencies as a hedge against inflation or financial turmoil. Conversely, highly volatile cryptocurrencies are often used for speculative trading, reflecting the concepts of good and bad money in Gresham's Law.

In the world of cryptocurrency, stablecoins—cryptocurrencies pegged to traditional assets like fiat currencies or commodities—have a significant impact on Gresham's Law. Due to their stable value, these reliable digital assets are favored for daily transactions and serve as equivalents to modern currencies.

Furthermore, the increasing acceptance and assimilation of cryptocurrencies by financial institutions are influencing people's usage and priority of different digital assets, aligning with the ideas proposed by Gresham's Law.

3. How Gresham's Law Affects the Competition Between Cryptocurrency and Traditional Currency

Gresham's Law emphasizes the importance of perceived currency quality, hoarding motives, volatility concerns, and legal and regulatory considerations, all of which may impact the competition between cryptocurrency and fiat currency.

Gresham's Law elucidates the ongoing dynamics of competition between cryptocurrency and fiat currency. It draws attention to people's tendency to trade or hoard less desirable types of currency while favoring and using what they perceive as superior currency. People tend to hoard cryptocurrency while using traditional currency for everyday transactions because they view cryptocurrency as an investment asset with appreciation potential.

To understand this, consider an individual who owns both US dollars and Bitcoin. This person may choose to use US dollars for daily shopping because they know that the value of US dollars often depreciates over time due to inflation. On the other hand, they may decide not to spend Bitcoin because they would miss out on the potential future value appreciation of Bitcoin.

Additionally, Gresham's Law suggests that due to concerns about value fluctuations, people may avoid cryptocurrency and prefer stable fiat currency for daily transactions. Because of this volatility risk, cryptocurrency may primarily be used for high-value transactions or as a store of value.

Businesses typically accept traditional currency for transactions because they are considered legal tender in their respective countries/regions. On the other hand, the legal environment surrounding cryptocurrency is uncertain and unclear.

Therefore, when regulations come into play, people may choose to use traditional currency. China's cryptocurrency ban is a typical example of how regulations affect currency choices. Gresham's Law applies because the ban, due to legal requirements and penalties associated with cryptocurrency, forces people to use traditional currency, the renminbi.

4. Limitations of Gresham's Law

While Gresham's Law is a valuable concept in the dynamics of currency, it also faces limitations, including the challenges posed by cryptocurrency volatility and the evolving global financial landscape.

Gresham's Law is a valuable concept in currency dynamics, but it does have limitations when extended to the realm of cryptocurrency. Its assumption of stable exchange rates is one of its primary limitations.

In reality, currency exchange rates fluctuate, and in the globally interconnected economy where digital currencies often have fluctuating values, the application of the law becomes more complex. Additionally, contrary to Gresham's predictions, government interventions such as currency restrictions and pegged exchange rates may artificially perpetuate the circulation of bad money.

Psychological factors also play a significant role. Due to cultural influences, familiarity, and trust, Gresham's expectations may not align with people's (especially the older generation's) association with traditional currency. Furthermore, the extreme volatility of cryptocurrency presents a unique challenge.

Most people are reluctant to spend it due to the risk of sudden value fluctuations, but some hoard it for appreciation. This blurs the line between good and bad money, raising questions about the applicability of the law.

Finally, the evolving landscape of payment systems and financial technology innovation further complicates the traditional application of Gresham's Law, requiring a deeper understanding of modern currency dynamics.

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