Gresham’s Law & Financial Speculation

Gresham’s law is the (formerly popular) insight that states: ‘Bad money drives out good’. It occurred (and still occurs in a way) when governments compulsorily overvalued one component of the money supply with respect to the other(s). A sound understanding of this has brought fortunes to alert speculators in the past; it is my contention that it may bring fortunes to them in the future.

During the height of this law’s popularity, the money supply was made up of mostly gold and silver. The government policies of bimetallism would often ‘decree’ an exchange ratio between the two metals that overvalued one and undervalued the other. Gresham’s law describes the inevitable consequence: the overvalued money would rush into circulation whereas the undervalued money would disappear into hoards and be traded abroad.

 

(Why? Suppose that you have to pay off a debt in the near future, and that the law allows you to pay it back with either gold or silver. In an environment of (say) overvalued gold and undervalued silver, which do you choose? Do you pay off the debt with a quantity of silver worth comparatively more, or a quantity of gold worth comparatively less? Of course, you give away the stuff of least value; a quantity of gold. For why pay more when you can pay less?)

 

But why is this of interest to the investor/speculator/trader?

 

It is my contention that an adjusted form of Gresham’s law is in operation today; ‘Bad money drives out good [insofar as it remains unextinguished]‘. I will explain exactly what I mean by this in future posts.

 

Money is on one side of every transaction in an economy. Money is to goods as the sea is to fish. A scarcity of money is associated with a rise in the ‘price’ of money, whereas an abundance of money is associated with a fall in that price. In other words, money prices fall when money is scarce, and money prices rise when money is abundant. Gresham’s law can help us figure out when drastic changes in the money supply may be on the cards. If people have strong views of the future that oppose the monetary trends (as described by Gresham’s law), then we can find opportunities on the the other sides of their trades. These trades will likely have the golden property of asymmetry: You don’t lose much if you’re wrong (or rather if they’re right), but you could gain significantly if you’re right (or rather if they’re wrong).

 

In a very basic sense, all businessmen are engaged in swapping money for things, and then swapping things for money. Their hope is that their efforts will result in profits. My questions are; what if the money supply halves in the mean time? Or what if it doubles? Are people positioned for these prospects?

 

 

Conquer the Crash: You Can Survive and Prosper in a Deflationary Depression

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Posted Feb 26, 2011