And why inflation will get worse from here.

There are a few axioms in economics our blundering political class should start paying attention to, and none more basic than Gresham’s Law, which states that “bad money drives out good.”

This deceptively simple concept – a direct consequence of supply & demand dynamics – is about to rear its ugly head with profound implications. How profound? How about $15 for a gallon of milk?

We’ll get there, unfortunately, and here’s why.

Understanding Gresham’s Law

Gresham’s Law is the idea that when two forms of money coexist, one perceived as inferior and the other superior, people hoard the superior money while spending the inferior one, thereby increasing the velocity of the bad money (and decreasing, through hoarding, the velocity of good money).

The reasoning behind this behavior is that individuals naturally want to save the money they believe will retain greater value, while they part first with the currency they consider to be of lesser worth.

Prices are a function of not only money supply, but money velocity. Hyperinflations happen when too much currency is created, but it’s not linear. There’s a tipping point that occurs with a change in psychology, when instead of wanting to save in the currency, people realize they need to spend it quickly.

Throughout history, Gresham’s Law has played a pivotal role in shaping monetary systems and the dynamics of currencies. Since at least 1944, the US Dollar largely benefited from this phenomenon, as people and countries saved in dollars and US Treasuries became the world’s neutral reserve asset.

I write this article from Nicaragua, where the locals will happily accept – prefer to receive – US Dollars to the Nicaraguan Cordoba. They stuff their USD under the mattress, and spend Cordoba’s first-

graph

The Cordoba is bad money, and the dollar a preferrable alternative to hoard.

Today, however, we are witnessing a blow-off top, an orgy of spending and borrowing by the twin monsters of (a) the US Treasury spending without abandon (for your own good, of course)-

ratings

And (b) a Central Bank who, after literally creating and enabling the problem for 15 years of near-zero interest rates and expansion of the monetary base by over 7x, finally thinks it found religion-

graph

Gresham’s law in history

1.            Ancient Rome:

One of the earlier instances of Gresham’s Law in action can be traced to ancient Rome. During the reign of Emperor Nero, the Roman currency underwent significant debasement. Coins were progressively minted with less precious metal, leading to a loss of trust in the currency’s intrinsic value. As a result, people started hoarding older, more valuable coins and using the debased ones for everyday transactions. This exacerbated the economic crisis and contributed to the downfall of the Roman Empire.

2.            America in the mid-1960s

A more recent example of Gresham’s Law was the removal of silver from dimes, quarters, and half-dollars, which took place in the 1960s. Prior to 1965, these coins were made with 90% silver content.

When silver was removed from newly issued US coinage, people recognized the intrinsic value of older coins with silver, and as a result, the new ones were spent first, and the old ones hoarded.

The transition from silver to base metal coins in circulation was relatively swift. As the new coins were introduced, people began pulling pre-1965 coins out to keep or melt for silver content. Banks accelerated the process, sorting and retaining silver coins, giving customers newly issued copper slugs.

The US Dollar’s fate

The dollar’s fate – like any currency – is a function of supply and demand. While the supply has ballooned, the dollar’s role as the best horse in the glue factory or the cleanest dirty shirt in the laundry has maintained sufficient demand, thereby limiting the velocity by which it changes hands.

All that’s needed, though, to push all those extra dollars from under the mattress and in sovereign reserves out into the wild is a better form of money. Gresham’s Law will do the rest.

No, I don’t expect that the Nicaraguan Cordoba, the Russian Ruble, the Euro, or the Chinese Yuan will take its place. All that’s needed, though, is for the world to wake up and rediscover gold. The reason the US Dollar even became the world’s reserve currency was because it was backed by gold.

And we’re seeing that happen now, as the BRICS countries, now inclusive of Saudi Arabia, who account for a significant and increasing percentage of GDP, population, and global resources, openly discuss a new gold-backed currency. Once that happens, which currency do you think will get spent first?

Where will the demand be for dollar-denominated debt instruments like treasures and mortgage-backed securities? Will the people in Asia want to continue financing our consumption by holding dollars?

While these people – in Asia, the Middle East, and the developing world – will prefer to hold a gold-backed currency, that may not be easy for them to do. But there’s a much better form of money to save in than US Dollars that’s now very easy to get. All you need is a smart phone. That, my friends, is Bitcoin.

As a holder of gold, silver and Bitcoin, do I use these forms of money to transact? Of course not, because I hoard those things – good money – while spending the bad money.

Conclusion

Gresham’s Law, a timeless economic principle, is beginning to exert its influence on the global monetary landscape. As the US dollar faces challenges to its stability and purchasing power, the search for “good money” by the rest of the world intensifies. They don’t need to look long or hard to find it in gold, silver and Bitcoin. When they do, all the bad money gets spent first, which will drive prices to the moon.

Got milk?