Gresham's Law and the Indian coin shortage

Gresham's Law is popularly known as, "Bad money drives out good money". In effect, people will hoard valuable money but will spend (and thus get rid of) money that is relatively more worthless. The case in point that JMR Ben thoughtfully provided was a link to the news.bbc.co.uk report titled "Sharp Practice of Melting Coins". It seems that inflation in prices in India (due to the Indian central bank creating so damned much money and credit every freaking day, just like all the other stupid central banks of the stupid world) has made the rupee almost valueless, but the little bit of metal in the coins is so valuable that "Millions of Indian coins are being smuggled into neighbouring Bangladesh and turned into razor blades".

How much more valuable is the metal in the coin? The conversion ratio is a one-rupee coin can be made into seven razor blades, worth 35 rupees! The natural result of Gresham's law in action is "an acute shortage of coins in many parts of India". The most surprising, astonishing and terrifying thing was the actual, in-your-face admission of further government debasement of the money! My eyes pop from my head in disbelief as I read that "The mints took corrective action - scaling down the metal content of the coins - but that has not stopped the shortages".

If the Indian mints wanted to take "corrective action" against the inflation that is rendering the coins worthless as money, they would storm the central bank of India and stop them from creating so much money and credit! And it is not just Indians, but according to a fax of a Globe and Mail article from Junior Mogambo Ranger (JMR) Andrew G., inflation in Canada is making them think of ditching the penny. The metal in the Canadian penny is worth so much more than the one-cent face value of the coin that pennies are, just like in India, being hoarded.

This phenomenon of disappearing coins must be happening almost everywhere, too, as all currencies are being debased by their central banks, and coins with a low, fixed denomination on them are doomed as the buying power of the coin falls below the melt value of the metal in the coins. And sure enough, the article notes that "Australia [stopped] making one-and two-cent coins in 1990. New Zealand stopped making them three years before that. France, Norway and Britain are among the other countries that have eliminated low-denomination coins." So inflation is hitting everywhere, literally rendering money increasingly valueless, and yet the governments allow the banks to just keep printing more and more of it! This is insane!

- They have stopped making the Singapore 1-cent coin years ago too. The official reason is that "the 1-cent coin is not actively used by the public". But why are the 1-cent coins not actively used by the public? Because they are effectively worthless. Why are they effectively worthless? Because of the relentless growth in money supply, which leads to monetary inflation, which makes every dollar yesterday worth less than a dollar today, and every cent yesterday worth less than a cent today.

At least, 5 years ago, gov.sg took action long before the people themselves did. You know, hoarding the coins to melt them down for their scrap value, for a tidy profit, like the Indians seem to be doing nowadays. That would have been quite embarrassing, wouldn't it?

1. Metal content and weight of Singapore 1-cent coin : 1.24g copper-plated zinc (singaporemint.com)
2. Ratio of zinc to copper content : zinc 97.5%, copper 2.5% (cmd-chart.blogspot.com) (assuming we use a similar ratio)
3. Price of zinc as of 24 Jul 2007 : US$3820 per metric ton (metalprices.com)
4. Price of copper as of 24 Jul 2007 : US$8160 per metric ton (metalprices.com)
5. USD to SGD spot exchange rate : 1.5076 (my.yahoo.com) (my customized page)
6. Value of metal content in 1-cent coin : (3820x0.975 + 8160x0.025) / 1000 / 1000 x 1.24 x 1.5076 x 100 = 0.734 cents

Well, as you can see, we're not yet at parity but it's probably a matter of time and inflation. Now that you have the formula you can re-calculate it any time you like.

Comments:

In the US, the expanded money supply has been almost completely limited to the amounts of credit created by banks and other lending agencies. The proportion of real currency has been dropping for decades, and its absolute amount has also been stagnant for the last few years.

What this means is, that the ongoing inflationary trend is not "real". It could suddenly reverse itself into a very aggressive deflation. If the cycle of credit is broken, the credit-based part of the money supply could contract very suddenly.

A large amount of defaults can propagate upwards in the chain of lending, decimating the bank accounts of each link without actually reducing a single dollar from the monetary base. We could be witnessing the first steps in such a collapse right now. First it's the home owners, then the hedge funds that own Mortgage Based Securities, then the banks that provide the leverage to those hedge funds.

One can think of it this way: The total amount of US currency in circulation is about the same as the current account deficit (ca. $800 bn). If foreigners stop lending their dollars back to the US economy and start to hold them as cash, they could very soon cause an actual shortage of cash in the US. Holding dollars in cash would suddenly be a very tempting idea, if a massive deflationary trend would show up. This could be started by the ongoing housing deflation. A deflation expectation would make people even more prone to holding cash, and the cycle would rapidly accelerate out of control.

If the FED responds to this by rapidly printing more cash, an even greater inflationary wave of liquidity would follow when the credit starts to expand again.

The markets are also full of derivatives that are supposed to handle all risks. What happens if major sellers of credit derivatives start to default on their obligations? Does anybody control the amount of risk that these companies can buy? What happens, when investors have sold their credit risks to a company that has bought more than it can deliver?

The current proportion of credit to currencies worldwide is very high. This means, that the money supply is not stable. All central banks should start to work towards a steady correction to the excess amounts of credit worldwide, perhaps by steadily increasing the reserve requirement ratios. If credit is allowed to grow without limits, it could suddenly explode by itself, bring ing the whole worldwide banking industry to a collapse.

Posted by Reino Ruusu on July 30, 2007 at 09:27 PM SGT #