Many people who question Bitcoin focus on its so-called “deflationary” character: because the total supply of bitcoins is limited and tends to appreciate, people are inclined to hoard them rather than spend them, so liquidity is poor and Bitcoin cannot become a mainstream currency.
There are also two dimensions to this issue: one is temporal, the other spatial. First, considering the prospect of future appreciation, we may use money as conservatively as possible and engage less in speculation and investment. In this sense, the weakening of so-called “liquidity” by Bitcoin is inevitable, but that is not necessarily a bad thing. In a series of earlier articles of mine (such as Bitcoin and the Environment), I have already noted that Bitcoin may curb the blind expansion of capital and excessive investment. Of course, human beings are still greedy, and people will still invest; they will simply tend to be more restrained and more cautious.
But let us set that issue aside for the moment. Many people also question Bitcoin’s liquidity from another angle, namely by invoking the so-called Gresham’s law of “bad money drives out good,” arguing that when someone holds both Bitcoin and another, more inferior currency, they will be more inclined to spend the bad money, while Bitcoin, because of its many advantages, becomes something people are reluctant to spend and thus ultimately cannot circulate in the market.
Because this argument invokes the supposedly profound and impressive principle of Gresham’s law, it sounds rather authoritative, but in fact it is extremely forced. As a matter of fact, Gresham’s law has nothing to do with Bitcoin at all.
What is called Gresham’s law arose in the age of metallic coinage, and was used to explain the circulation patterns of gold and silver coins. It works through the following two principles:
1. The distinction between face value and market value:
Gold and silver coins are minted by the state, which stipulates a legal “face value,” for example, 1 gold coin being equivalent to 15 silver coins. However, gold and silver themselves also have market prices, and the market exchange ratio is not fixed; it fluctuates, and at many times it systematically deviates from the legal ratio. For example, although 1 gold coin is legally equal to 15 silver coins, the value of the gold contained in 1 gold coin may be equal to the value of the silver contained in 20 silver coins. In other words, you need 20 silver coins to buy 1 unit of gold on the market, but 15 silver coins can be exchanged for 1 gold coin. At this point, if I am holding gold coins, why should I use them as legal currency? If I want to spend gold coins as money, then according to the law they are worth only 15 silver coins, but if I melt them down and sell the gold, I can get 20 silver coins. Only a fool would spend gold coins as money. Thus, in such a situation, the liquidity of gold coins as circulating money will decline, and people will tend to hoard them rather than use them.
2. The difference between better and worse fineness:
Another case can also occur where there is only one legal coin, because ancient coinage varied in fineness: some coins might have a chipped edge, yet could still be counted at their face value; indeed, many people would even deliberately cut off a corner of a gold coin and keep it before spending it. A more typical situation is that the state, in its heyday, issued coins of the best quality and fineness, while later on the coins minted gradually became adulterated with impurities and the craftsmanship was no longer exacting, though the face value remained the same. In short, among the currencies circulating in the market, some are underweight or deficient, while others are full-bodied and sound; when I spend money, I will naturally choose to spend the inferior money as quickly as possible and keep the good money.
As we can see, these two principles ultimately amount to this: the “face value” of a coin does not match its “real” value.
Of course, it is possible to extend Gresham’s law and use it to explain some phenomena in contemporary markets. For example, the value of the aluminum in the old 1-jiao coin may be higher than 1 jiao, so it will surely be replaced by the new 1-jiao coin. Or, when the government forcibly pegs the exchange rate between the local currency and a foreign currency, but this ratio does not match market reality, people may hoard large amounts of foreign currency. But if one completely departs from the basic principle by which the law works, then one should no longer invoke so-called Gresham’s law to make one’s point.
And Bitcoin and the circumstances to which Gresham’s law applies are simply not in the same ballpark; indeed, Bitcoin’s very characteristics from the outset eliminate the possibility of Gresham’s law taking effect.
First, Bitcoin is not legal tender, so it has no externally imposed “legal face value.” Second, it also has no intrinsic material value based on its substance, and there is no issue of fineness. Its value comes solely from free exchange behavior in the market.
Bitcoin has broken away from the central bank issuance system and no longer depends on the government or authoritative institutions to promulgate coinage standards. To many skeptics, this seems like a lack of “government backing.” But that is precisely the key point: what, exactly, is the government supposedly backing? The government has never guaranteed that money will not depreciate, never guaranteed that one yuan can forever pay for a bus ride, and never guaranteed that ten yuan will forever be worth a lunch. What guarantees those things is the bus company or the restaurant owner, not whatever the government is supposedly backing.
So what does the government guarantee? The crux of the matter is this: the government backs bad money, and thus guarantees the occurrence of bad money driving out good.
When, in the actual market, one silver coin is worth only one-twentieth of one gold coin, the silver coin’s face value can still, because of the government’s “backing,” remain at one-tenth of one gold coin. This means that if a merchant prefers gold coins and is willing to price goods in gold coins, then a product marked at 1 gold coin must also be payable at a cost of 10 silver coins. Government backing guarantees the purchasing power of bad money; merchants who accept only gold coins and refuse silver coins will be subject to legal sanctions. Therefore, if a merchant wants to obtain the value of 1 gold coin in exchange for goods, he has no choice but to price it at 2 gold coins, that is, 20 silver coins. Naturally, customers will also be unwilling to pay 2 gold coins and will instead bring out silver coins to transact.
So let us consider what would happen if there were no government backing: the exchange ratio between gold and silver coins would lack an authoritative standard; their exchange rate would fluctuate according to the market. If today’s market quotation is 1 gold coin for 20 silver coins, then 1 gold coin can be exchanged for 20 silver coins, and 20 silver coins can also be exchanged for 1 gold coin, because the market quotation is produced by free transactions among equal traders. It is the exchange that can actually occur, not anyone’s arbitrary decree.
In such an environment, some merchants may prefer gold coins, while others may prefer silver coins. But whether prices are quoted in gold coins or in silver coins, the situation is much the same. When I quote 1 gold coin for a certain product, the customer can first exchange the 20 silver coins in hand for 1 gold coin in the market and then pay, or I can first receive 20 silver coins and then go exchange them for gold coins myself.
Because there is no government backing, the concept of bad money will no longer exist; gold and silver coins will stand on equal footing in the market.
However, some critics may immediately point out the special nature of the Bitcoin problem. Unlike the relation between gold and silver coins, the asymmetry between Bitcoin and legal tender is even more pronounced. The key point is that the total supply of Bitcoin is fixed; it is so-called deflationary money, whereas fiat money generally keeps depreciating.
But does that really matter? That fiat money can drive out other competing currencies because it keeps depreciating? That already sounds rather absurd.
Suppose I have 1 bitcoin and 10,000 yuan in hand, and suppose that according to the current market exchange rate, they are roughly equivalent—that is, I can go to an exchange at any time and swap 1 bitcoin for 10,000 yuan, or vice versa, paying only a very small spread and transaction fee.
Now I am going to the market to buy something. Am I more willing to spend 1 bitcoin, or 10,000 yuan? Since I am more optimistic about Bitcoin and more willing to hoard bitcoins, the answer seems obvious: I would rather spend the 10,000 yuan and keep the bitcoin in hand.
But the problem is: if that is so, why wouldn’t I have exchanged those yuan for bitcoin earlier? If I have been holding those yuan for a long time, and I prefer bitcoin more, then I might already have exchanged them for bitcoin. Why must I wait until today to make the choice?
Moreover, because transactions are so convenient, I can exchange yuan for bitcoin at any time, even right in front of the cashier, through my smartphone. So which currency I am more willing to spend does not depend on my expectations about the future of the two currencies, but only on the current market quote—for example, the price the merchant offers. If the merchant is willing to grant even a slight discount for bitcoin payments, enough to offset the extra fee I would pay when exchanging yuan for bitcoin at any time, then I have no reason to refuse that discount. For instance, if the market rate is 1 bitcoin for 10,000 yuan, but the merchant’s listed price is 0.99 bitcoin or 10,000 yuan, then instead of spending 10,000 yuan, I might as well convert them to bitcoin first, and after paying I will even have gained 0.01 bitcoin.
So could merchants offer such a discount? Of course they could. In fact, many merchants that currently accept Bitcoin payments often set the exchange rate at a level higher than the market rate rather than offering a discount, because they still prefer fiat money and ultimately have to settle in fiat. But imagine if the situation were reversed and they preferred Bitcoin more: of course they could then offer a more favorable price for Bitcoin payments.
In the traditional model of bad money driving out good, merchants would of course rather receive good money, but in the game between merchants and customers, the law suppresses the merchants’ claims and prevents them from pricing freely. But now merchants can more easily express their preferences. As a customer, it does not matter much if I can exchange yuan and bitcoin at any time, but for merchants the exchange is relatively troublesome. For example, if they receive banknotes, they cannot freely convert them into bitcoin before depositing those notes in the bank; or if they receive yuan through a credit card terminal or electronic platforms like Alipay, they often need to pay another transaction fee. In the end, when converting to bitcoin, merchants also have to pay a fee. So if customers can spare merchants who like to hoard bitcoin from these intermediate steps, then merchants will of course be happy to offer discounts. And if, in the market, merchants generally prefer bitcoin and customers also prefer bitcoin, then customers have no reason to cling to yuan until the moment they need to shop instead of converting it into bitcoin early and settling the matter.
At that point, the only advantage of the yuan may be credit consumption. Because of Bitcoin’s trend toward appreciation and the yuan’s trend toward depreciation, it may be difficult for people to borrow bitcoin but easy to borrow yuan, so customers may prefer to use credit card overdrafts rather than Bitcoin, even if the latter offers a certain discount and the former requires additional interest. But once Bitcoin has become mainstream to the extent that it can stand toe-to-toe with fiat currency, the existing credit system of fiat money will inevitably be shaken. For example, if I lend you money, and the principal plus interest I eventually receive does not exceed Bitcoin’s appreciation, why should I lend you money instead of converting it into bitcoin? As Bitcoin develops, once more and more investors begin to denominate value in bitcoin, not only will using bitcoin for overdrafts become difficult, but all investment will become more cautious and all overdrafts will become more difficult. Moreover, even if fiat currency still retains an advantage in overdraft consumption, Bitcoin will not be driven out of circulation as cash. Unless there comes a day when people no longer have cash at all, when everyone’s account is in the red, when no one can produce money to buy bitcoin, and can only overdraw in the government-designated way to purchase designated goods, only then might the driving force of bad money still have some effect. But that would at most be a final burst of light before the collapse of the fiat system.
In short, so-called bad money driving out good is not something that happens naturally in the market; it is merely shorthand for “the government using bad money to drive out good money.” Once control by the government can be escaped, this bad-money law will cease to work, and Bitcoin is precisely intended to free money from government control and let good money return to the market.
Translated from the Chinese original with AI assistance. The original text is authoritative.
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