What is Gresham’s Law and how does it relate to cryptocurrencies?

Gresham's Law, explained

Gresham's Law has influenced historical currency circulation and continues to influence economic behavior by telling how individuals prioritize different types of money.

Gresham's Law is a principle in economics that states that when two different types of money are exchanged, individuals will typically spend or trade the one they believe is more valuable when they store or use the one they believe is more valuable.

A common way to sum this up is “bad money pays for good.” Here, “good money” is defined as a currency that has a higher intrinsic value and is held, while “bad money” is defined as a currency that has a lower intrinsic value and people are eager to get rid of it.

Although he did not invent the concept, Gresham's Law is named after Sir Thomas Gresham for his role in introducing the idea of ​​how bad money drives out good money in financial systems. He was a 16th-century English financier and advisor to Queen Elizabeth I.

Gresham's Law has historically been observed in many fiat currency systems, where defaced or counterfeit coins drive more valuable legal coins out of circulation as individuals hold the higher value currency and spend the lower value currency. This idea is still relevant today when debating the use of cryptocurrencies and their varying levels of stability and utility.

How Gresham's law applies to cryptocurrencies

Regarding the use of cryptocurrencies, Gresham's Law reflects the principle of “bad money” and “good money” that more volatile digital currencies are used for speculative investments and stable and well-established digital currencies are preferred for daily transactions.

When it comes to choosing which laptop to use for business transactions, individuals tend to choose the one they believe is less expensive due to its stability and cost savings. Gresham's Law shows that individuals tend to use less volatile and well-established cryptocurrencies for daily transactions, saving the more speculative and volatile investments or assets. The principle remains relevant to cryptocurrency adoption and usage patterns.

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

Just as individuals own precious metals, users are more likely to hoard these cryptocurrencies to hedge against inflation or financial volatility. In contrast, more volatile cryptocurrencies are frequently employed in speculative trading, reflecting Gresham's Law concept of good money and bad money.

In the crypto world, stablecoins — cryptocurrencies tied to common assets like fiat money or commodities — are heavily influenced by Gresham's Law. Because of their stable value, these secure digital assets are popular for daily transactions and serve as the current equivalent of fiat money.

In addition, the increasing acceptance of cryptocurrencies with financial institutions is influencing people's use and prioritization of various digital assets, which is consistent with the propositions of Gresham's Law.

How does Gresham's Law affect the competition between cryptocurrencies and traditional currencies?

Gresham's Law highlights the importance of money quality, savings incentives, volatility risks, and legal and regulatory issues, all of which can affect the competition between cryptocurrencies and fiat money.

Gresham's Law explains the dynamic in the ongoing competition between cryptocurrencies and fiat money. The tendency for people to exchange or accumulate more desirable forms of money while liking and using money that they believe to be superior attracts attention. When people use traditional money for daily transactions, they tend to hoard cryptocurrencies because they perceive cryptocurrencies as investment assets with the potential to add value.

To understand, consider an individual who holds both US dollars and Bitcoin. The individual prefers to use US dollars for daily purchases knowing that the US dollar will probably depreciate over time due to inflation. On the other hand, they may decide not to spend their Bitcoin because they are missing out on future growth in value.

Furthermore, Gresham's Law shows that people shy away from cryptocurrencies for fear of volatility and instead favor the stability of fiat money for daily transactions. Because of this risk of volatility, cryptocurrencies can be used primarily in certain high-value transactions or only as a store of value.

Businesses generally accept common currencies for business transactions as they are recognized as legal tender in their respective countries. On the other hand, the legal environment surrounding cryptocurrency is uncertain and unclear.

As a result, people may choose to use traditional currency when regulations come into effect. China's cryptocurrency ban serves as a prime example of how regulations influence currency selection. Gresham's Law applies as the ban forces people to use the traditional currency, the yuan, due to the legal requirements and penalties associated with cryptocurrencies.

Gresham's law limits

Gresham's Law, while an important concept in currency volatility, faces limitations, including the volatility of cryptocurrencies and the evolving global financial landscape.

An important concept in currency volatility, Gresham's Law has limitations that extend to cryptocurrencies. The assumption of a stable exchange rate is one of its main limitations.

In reality, exchange rates are volatile, and enforcing the law becomes even more complicated in a global economy where digital currencies have floating values. Also, contrary to Gresham's prediction, government interventions such as currency limits and pegs can artificially keep bad money circulating.

Psychological factors also play a significant role. Gresham's expectations may not be consistent with people's (especially older generations') relationship with traditional currencies because of cultural influences, familiarity, and trust. Additionally, the pure volatility of cryptocurrency presents a special case.

Many people are reluctant to spend on them because they can experience sudden fluctuations in value, but some stock up in hopes of appreciation. This blurs the line between good and bad money and calls into question the application of the law.

Finally, the evolving payment system and fintech innovations further complicate the traditional application of Gresham's Law, requiring a more sophisticated understanding of modern currency dynamics.