Gresham’s Law is a centuries-old economic principle that is often defined quite simply as “bad money drives out good money.”
Because gold is more valuable on the open market than copper, for example, copper coins with the same nominal value as gold coins would quickly drive the gold coins out of circulation; the gold coins would be hoarded or melted down, to extract every last bit of value from them.
There’s more to Gresham’s Law than that, though, and Tyler Cowen says it helps to explain some of the problems in the euro zone.
In the Economic View column in Sunday Business and in a conversation in the new Weekend Business podcast, Professor Cowen, who is based at George Mason University, says that many bank depositors in Ireland have begun to doubt that country’s commitment to the euro.
As a result, depositors have begun moving money from Ireland to banks elsewhere within the euro zone. In effect, euros held in a bank in, say, Germany, are being perceived as being more valuable than euros held in Ireland.
Gresham’s law is relevant in this case because it holds that if two assets — in this case, euros held inside and outside Ireland — are deemed by traders to have different values, sooner or later the legally fixed price parity will break down. This breakdown is already occurring, Professor Cowen says, and it is causing enormous problems within the euro zone. The various patches being applied won’t be enough to cure this problem, in his opinion.
The financial problems in Europe are part of the “wall of worry” that investors have been climbing in the long rally under way in many stock markets around the world since March 2009. Calamities abound, as I write in the Strategies column in Sunday Business, but markets have been rising anyway. Read more…