by Dave Kranzler, Investment Research Dynamics:

Thomas Gresham observed in the 1500’s that “bad money drives out good.”  The concept applied to gold and silver coins and the value of precious metals metals used in the coins relative to their face value.  Back then silver coins would be debased by replacing some of the silver content with base metals.  Of course, that practice of monetary debasement goes back to ancient Rome.

But the idea applies today in the sense that, as fiat currency continues to be devalued with money printing and artificially low interest rates, those paying attention will begin to convert cash savings into physical gold and silver and use the devalued fiat currency for transactions settlement. This is likely part of the reason the prices of gold and silver are at all-time highs in almost every fiat currency globally.

But I got to thinking about the further imposition of negative rates after absorbing Alasdair Macleod’s must-read essay, “Deeply negative nominal rates are on their way.” In this brilliantly written explanation of the problems with negative rates, Macleod references two working papers from the IMF which address the problem of hoarding cash if commercial banks impose a negative rate on cash balances by “taxing” cash withdrawals. This would be the implementation of negative rate on money held at banks. Money spent electronically would not be taxed like this.

As preposterous as that may seem, if the International Monetary Fund (“IMF”) is publishing working papers which discuss taxing those who attempt to remove cash from the banking system, it likely means implementation of this policy is being considered not only by the IMF but also the BIS.

The imposition of a negative rate policy in the form of a “tax” on cash withdrawals will likely lead eventually to a run on the banks by large depositors, who will “smell” this policy in advance. This cash – or “untaxed good money” – will be removed from the financial system. Currency needed for daily use would remain in the banks and used electronically – this would be the “bad money.”

In a sense, we’re already seeing Gresham’s Law in the sovereign bond market. Large pools of capital are flooding into sovereign bonds as the price of these bonds grinds inexorably higher. It would be absurd to pay a huge premium above face for a bond knowing that if you hold it to maturity you’ll be repaid substantially less than the price you paid for the bond (i.e. a negative return on these bonds held to maturity). So it’s rational to assume that savvy players will eventually sell before the price of the bond is below the price paid.

It’s performance-chasing that gives the investor a better return than simply holding cash if he sells at the right time. The alternative is holding the cash in short term money market type investments which guarantees a negative return. To visualize this dynamic, here’s the price chart of a 100yr Austrian sovereign bond:

As Bloomberg describes it: “this type of debt carries heavy risks. After all, it will only redeem at 100% of its face value (or par) so investors who have bought in at much higher prices would suffer if yields returned to levels seen as recently as the start of this year – and the price of the bond fell. Furthermore, while interest might not be the priority for many investors in ultra-long maturities, the Austrian paper is only yielding 60 basis points currently. That won’t butter many parsnips.”

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