Gresham's law is an economic principle that states, "when a government overvalues one type of money and undervalues another, the undervalued money will leave the country or disappear from circulation into hoards, while the overvalued money will flood into circulation." It is commonly stated as: "Bad money drives out good" - Gresham's Law.
Doesn't that sound like the situation in the United States and globally? Paper money is being printed by the trillions and the recent price takedown of gold/silver unleashed an unexpected frenzied scramble for physical gold and silver that the buyers will tuck away, out of the sight and from the grips of any government.
In the context of the current precious metals price correction, Gresham's Law in action tells us that gold/silver are significantly undervalued in relation to the dollar and other fiat currencies and that's why there are countless reports of global physical gold and silver shortages developing.
Thomas Gresham was a financial representative of the English Crown during the 16th Century. Henry the 8th had replaced 40% of the silver content in the English shilling with base metals, effectively devaluing the shilling by 40%. Merchants were hoarding the old shillings and using the new devalued shillings for commerce. "Bad money crowds out good money." The old shilling had far more value than the new shilling and the masses began to hoard the old ones.
Similarly today in the U.S., any shred of silver was removed from U.S. minted "currency" coins in 1964 (Kennedy 1/2 dollars had 40% silver until 1970). The pre-1964 silver coins trade for their weight value in silver. One pre-1964 quarter will buy a gallon of gasoline right now. It takes about 15 post-1964 quarters to buy a gallon of 91 octane gasoline in Denver. But it's hard to find pre-1964 coins (dimes/quarters/half-dollars) unless one is willing to pay a price that is the equivalent weights of those coins in silver. I doubt you would use one to buy a newspaper.
When you think about it, Gresham's Law is quite intuitive. Extending the pre-1964 coin example, let's say the value of a 90% silver quarter is roughly $3.50. If I have one each of a pre- and post-1964 quarter in my pocket, and I need to spend one of them, which one will I spend? Pretty obvious there.
Here's some examples of Gresham's Law in action since the recent price hit to the metals:
1) The Arizona Senate on Tuesday approved a measure to make gold and silver legal currency in the state, in a response to what backers said was a lack of confidence in the international monetary system - Arizona Makes Gold/Silver Legal Tender.
I believe 11 other states currently are legislating similar laws.
2) This is an interview with the President of the CME, the entity that owns the Comex, where paper gold and silver futures trade:
What's interesting about gold, when we had that big break two weeks ago we saw all the gold stocks trade down significantly, we saw all the gold products trade down significantly, but one thing that did not trade down, was gold coins, tangible real gold. That's going to show you, people don't want certificates, they don't want anything else. They want the real product...I think that is the value of gold...I think the coins are of more value than anything else.
People don't want paper money - they want real gold. I sourced the interview here from LibertyBlitzkrieg.com.
3) The U.S. Mint sold a record monthly number of silver eagles for the month April. In fact, for the first four months of 2013, the U.S. Mint has sold 18.3 million silver eagles vs. 11.7 million for the first four months of 2012 - U.S. Mint Coin Sales. That's a 36% increase year-over-year.
All three of these examples are Gresham's Law incarnate. It's the public - both retail, high net worth and institutional investors - responding to a lower price of gold/silver in relation to the value of the dollar. When entities buy physical gold and silver, the tendency is to put it away safely in some form of storage and continue using the fiat paper currency du jour for everyday use. The precious metal is used for wealth preservation.
The only conclusion we can make from the response to lower prices by the buyers of physical gold and silver is that "bad" money is being converted into "good" money because the perception is that gold and silver as good money are significantly undervalued in relation to paper dollars issued by the government and currently printed by the Fed at the rate of $85 billion per month, or a little over $1 trillion for all of 2013.
The question is, at what price for gold and silver would investors stop converting fiat paper currency into physical metal? If we could somehow figure out the answer to that question, we could benchmark what kind of returns can be made from investing in gold and silver right now.
One way to do this would be to measure the intrinsic value of 1 oz. of gold in relation to the ongoing devaluation of the U.S. dollar. At its price peak in 1980, gold hit $875. If we use just the Government measure of CPI over that time period of 3% - unarguably a conservative method of measuring the amount the dollar has been devalued since then - the current implied price of gold in relation to that measured rate of inflation would be $2350/oz. The gold/silver ratio in 1980 at the peak was 17.5. Using that ratio to derive an implied price of silver yields $134/oz for silver.
In other words, currently the price of gold is undervalued by $900, or 62%, and silver is undervalued by 570%. Perhaps the relative undervaluation of silver in relation to gold explains why there has been an incredible rush by the general public to buy silver eagles and other forms of silver bullion. Not only is it perceived that the price of silver is cheap relative to gold - and of course the dollar - but currently silver buyers are paying premiums to the spot price of silver of anywhere from 25-35%, depending on the silver product.
There are several other metrics by which to generate implied fair market valuations for the price of gold. Some of them which imply a much higher intrinsic value for gold actually have merit, like using a derivation of the amount of gold required to back U.S. Treasury debt by the Bretton Woods treaty. But regardless of how you want to base an argument for the ultimate price of gold/silver, based on the response by buyers globally, the current price is too low.
If you want to assume my numerical example above is realistic, it means that investors with any kind of patience can achieve pretty high returns by investing just in physical gold and silver at current prices. Since I already own a core amount of physical, I like to reach for higher returns using leveraged forms of gold/silver speculation. Call options on GLD and SLV are one alternative. I also like to use AGQ - which is 2x the return on spot silver - or UGL - which is 3x the return on spot gold.
Additional disclosure: The fund I co-manage is long physical gold, silver, AGQ and call options on AGQ