This simple economic principle could be huge for gold over the next few years

by Bengt Saelensminde, Money Week

There’s an economic principle called ‘Gresham’s law’ that can be summed up in one sentence: “Bad money drives out good”.

And, as I’ll show you in a moment, this simple principle could be absolutely imperative for the gold price over the coming years.

To demonstrate why, today I’m going to take Gresham’s law and apply it in a new way.

Hold onto your hats, because if I’m right, news from China suggests massive implications for gold in the years to come.

Gresham’s great idea

Gresham’s law dates from an era of metallic currency. In days of yore, it was common to have many competing currencies – and, indeed, hundreds of different coins in circulation.

Even though each pound issued was notionally equal, in reality some were more equal than others.

For instance, a pound issued by the Royal Bank of Scotland (run by a dour, thrifty Scot), may have historically been worth more than one issued by a flighty English bank. After all, if the issuer went bust, your money could become worthless. So with less downside risk, a pound issued by a well-capitalised, reputable institution was worth more than one which wasn’t.

Better even than a Scottish promissory note would be something like a gold sovereign, or bag of silver coins. Here you had something with intrinsic value.

And here’s the key point of Gresham’s law: in this world of ‘good’ and ‘bad’ currency, people would hoard the good stuff and spend the bad.

They’d put those gold coins or Scottish notes under the mattress, taking them out of circulation. The dodgy stuff, they’d spend. The ‘bad’ money drives out the ‘good’.

It’s a simple idea that can work with any sort of monetary construct. Take the euro.

Greek euros are being taken out of circulation

Euros have been shifting out of Greece for ages now.

The reason is quite simple: depositors fear that if Greece is ejected from the euro, their Greek euros may be converted to drachmas.

That could be quite a devaluation for the poor unsuspecting granny who wakes up to find her purchasing power decimated overnight.

So punters have been converting their ‘Greek euros’ into ‘northern European euros’ (a simple bank transfer will do) and hoarding them overseas.

Good money is thus driven away and out of circulation. Much of the investment capital Greece would normally count on is sitting in bank accounts well out of the way. Hardly great for business!

Gresham’s law is often used to argue for commodity-backed money. But as we’ve just seen, it can equally be used to explain the dire goings-on within a paper currency like the euro too.

Let’s not leave it there. We can use the exact same principle for entire markets.

Bad paper gold contracts are driving out good

Anyone with an interest in gold will be fully aware of the great transfer of gold from West to East over recent decades.

But the real story is that the entire market for trading gold is in the process of being driven out of Western hands.

For hundreds of years, the London Bullion Market (LBM) sat at the centre of gold trading. The exchange decreed what a gold bar should be, in terms of purity and weight, and provided (and still does) a trusted trading platform.

More recently, the Chicago Mercantile Exchange (CME), with all its paper contracts on gold, has left the LBM behind in terms of value traded. The CME’s paper promises are used to speculate on the gold price.

Rarely do the CME contracts end up with physical delivery. Instead, the contracts are mostly ‘rolled over’ to new contracts for future delivery (and so on).

But this setup could be all about to change.

For years, there have been rumours that either Singapore or China will set up a serious rival to the traditional exchanges. An international market for physical gold (not the dodgy paper-based contracts traded in Chicago) that can be trusted by participants.

After all, Asians are mostly buying the stuff. Why wouldn’t they want a market closer to home?

Reuters now confirms that it is the Shanghai Gold Exchange that looks set to capture this market: “China is set to launch a link between gold markets in Shanghai and Hong Kong this year following a landmark stock connect scheme, aiming to enhance its pricing power of gold contracts and ultimately challenge its competitors in the West.”

In time, this Eastern market will set the gold price

Though nobody’s saying it, the main reason these guys want their own exchange is that punters are increasingly wary of the traditional exchanges.

For one thing, buying a promise for future delivery of gold is not the same thing has having it in your hand. Moreover, just like Libor, currency and gawd-knows-what else, the megabanks stand accused of rigging the gold markets too.

Truth is, many of the key players (including the miners supplying the gold) want a more transparent and trustworthy exchange for physical gold.

Put another way, bad traders (megabanks) are driving out the good (gold miners and buyers of physical gold).

I suspect, given a bit of time, the newly-internationalised platform in the East will establish itself as the go-to platform for trading, and to set the gold price.

Trading physical gold (one-kilo bars, I understand) is much less open to the manipulation and skulduggery that many feel has been going on in Western exchanges for too long.

Xu Luode, Chairman of the Shanghai Gold Exchange, says: “For the purpose of such an arrangement, we have set up a 1,500-tonne gold vault in the Shanghai Free Trade Zone. This can serve as a delivery store for both gold imported into China and trans-shipped to other destinations”

He reckons the market should be functional by June this year.

The West will only have itself to blame when trade migrates East. Bad paper-based promises (and exchanges!) drive out the good.

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