Sunday, April 13, 2014

Gresham's law and credit cards

This is a follow up to my previous post on the monetary effects of credit cards. In this post I'll explore the idea that the use of credit cards in payments is driving a modern Gresham effect, the result of which is a displacement of cash and an inflationary race to the bottom of sorts. This downward spiral resembles the same dynamic set off by coin clippers in the medieval age, the era when Gresham's Law was first enunciated.

First, we need to revisit the idea of Gresham's law, or the idea that the bad money drives out the good. Imagine that it's 1592 and you're a fish monger in a busy market in London. Like everyone else, the unit of account that you use to price your wares is the pound unit of account, further subdividable into twelve shillings and 240 pennies. The actual medium that you and most other merchants have chosen to represent that unit (ie. the medium of account) is the English penny, coined by the Royal Mint from twenty-four grains of silver.

However, not all English pennies are the same! You've been selling fish for most of your career at 1d (d is the sign for the penny unit). But lately you've noticed that a growing number of the pennies you've been receiving have been altered. Small notches have been clipped from these coin's edges. The imprints on them look increasingly worn, and you hear stories about people who "sweat" coins. These ruffians are putting pennies into a sack, shaking them, and removing the small pieces of silver that have been scratched off.

Which means that in a growing minority of your transactions you are receiving the same amount of coin per fish but earning less silver. Clippers and sweaters are stealing the difference. To solve this problem, what you'd really like to do is weigh and assay each penny proffered and charge a unique price based on that coin's silver content. But you don't have the expertise to do this, and in any case, the chaos of the market doesn't offer enough time. Even if you could, accepting coins by weight rather than tale (their face value) is probably punishable by something grisly like getting your finger chopped off.

So instead you raise your prices a bit. By selling fish for 1¼d, you get more pennies than before, but roughly the same amount of silver. What you've done here is switch the medium you use to define the "d" unit of account, or your medium-of-account. You've adopted clipped and sweated shillings as your definition of the penny unit rather than full bodied shillings.

Here's where Gresham's law kicks in. Anyone who has undebased pennies (i.e. good pennies) in their pockets now has to pay 1¼d for your fish rather than 1d. But this is a bad deal for them. Our fish buyer can simply pay with with clipped and sweated pennies that contain less silver, say twenty-three grains of silver... and buy the same quantity of fish. Good pennies containing twenty-four grains of silver are being undervalued in the market place. Owners of these good pennies will choose to hoard them in their pockets and never use anything other than bad pennies to buy things or pay debts.

Where will all the good pennies go? They'll eventually be sent to wherever their silver is not being undervalued. In 1592, people would most likely have melted their good coin down into bullion and shipped this bullion across the Channel to France, only to have it re-minted into French coin and used to buy a larger quantity of fish (or more likely some durable good) than the London market allowed. That is Gresham's Law: when the price of various exchange media are fixed by law or custom, if the true market value of these media diverge, the market will tend to adopt the overvalued medium as their preferred payments option. In short, the bad English pennies drove out the good.

Now it's 2014 and you're a fish monger in a busy market in downtown Toronto. You use the dollar unit of account, the medium that represents this unit being Canadian banknotes.

However, not all dollars are the same! You've been selling fish for $10 for the past few years, but lately you've noticed that the use of credit cards has increased. Furthermore, the credit card networks are charging you ever higher transaction fees, say twenty cents rather than just two cents. This means that people are paying you the same amount of dollars per fish, but after fees you're earning the equivalent of just $9.80 worth of paper dollars in your account.

To solve this deficit, you'd like to charge the transactor a 20c fee, similar to how in 1592 you would have liked to assay each coin and charge a discount to face value based on the coin's actual silver content. By placing a 20c surcharge on credit card transactions, you'd end up with $10 per fish. However, the credit card companies stipulate in their contract with you that card payments can't be surcharged, the penalty being banishment from the card network. (Banishment certainly seems more humane than having your finger cut off.)

So instead you raise your prices a bit, just like you did in 1592. By selling fish for $10.20 you receive more in payment than before, but once the twenty-cent fee kicks in you end up with the same $10 quantity of paper dollars. Just like the medieval fish monger switched from full bodied pennies to clipped pennies, you've switched the medium you use to define the $ unit of account from paper money to credit card money. By doing so, you've preserved your margins.

As it did in 1592, Gresham's law kicks in. All things staying the same, anyone with paper money in their pocket now has to pay $10.20 for a fish rather than $10. But this is a bad deal for them since it undervalues their paper dollars. Better to pay $10.20 in credit card money and get all the associated rewards (air miles, cash back, etc) then pay $10.20 in cash and get no rewards. People will keep their paper dollars in their pockets and only make purchases by credit card.

Where will all the hoarded banknotes be exported? Well, people can't ship them down to the U.S. Americans aren't fond of Canadian dollars. But there will still be places in Canada that don't undervalue banknotes, namely all those retailers who only accept cash. Perhaps there's a competing fishmonger on the other side of town, say Scarborough, who won't accept credit cards and still charges $10 per fish. People will export undervalued banknotes to Scarborough where their dollars earn their full value. Or maybe they'll be exported to Toronto's drug market, or its prostitution market, or anywhere else where cash is still king. At the end of the line is the Bank of Canada, which will always offer to repurchase and shred all of the unwanted old notes that it has issued.

So the point of my little exercise has been to illustrate how 1592 is no different from 2014. Just substitute out the word "coin" with "credit cards" and the same Gresham effects are generated.

In both eras, one of the ways to remedy the displacement of good money by bad money would be to allow the price of the various exchange media to float. In the case of medieval coins, if merchants were allowed to charge varying prices based on the quality of coins proffered, then good coins would once again be properly valued and return into circulation. In the modern case of cash and credit cards, if retailers could charge surcharges on credit card payments, then cash would no longer be undervalued and would return to universal circulation.

In Australia and the U.S., authorities have adopted policies that should relieve these modern Gresham effects. Merchants in both nations are allowed to put surcharges on credit cards transactions. In Canada, surcharges are not allowed, despite efforts by the Competition Bureau to allow them. Gresham's law, it would seem, is still in effect up here.

Left unchecked, the Gresham effects kickstarted by both coin clippers and credit card networks contribute  a race to the bottom of sorts. In 1592, the incentives to clip coin would have been huge since the payor would be able to buy a greater real quantity of goods with a clipped coin than an unclipped coin. In reaction to the appearance of newly clipped coin, merchants would defensively raise their prices. The rest of the populace could only tag along and adopt the newly clipped coin as their standard payment medium. After all, using their good coin in local trade would be madness, since good coin was always and everywhere undervalued. The clippers would attack once more, prices would rise, and once again non-clippers would have to shift their cash holdings into inferior coin. Unless something was done to break out of this downward spiral, there was a tendency for the standard to be perpetually debased and prices to rise forever.

The same dynamic set off by clippers also emerges when credit card networks issue new premium cards that offer better rewards. Say that the networks introduce a "super" card that offers 5% cash back. Early-moving consumers will quickly adopt these cards—after all, they can buy the same quantity of goods at the same price... and get a large cash reward to boot. The higher the reward, the higher the fees a merchant must pay. They now find themselves ponying up 5% of the value of each transaction to the networks. In defense, merchants will belatedly raise their prices.

However, while early movers have adopted 5% cards, the general populace may still only be using cards that allow, say, a measly 1% cash back reward. Their existing cards are now undervalued, since merchants' prices are implicitly being marked up to a 5% card standard. What retailed for $100 now retails for $105. Anyone purchasing $105 worth of goods and getting only $1 cash back incurs a loss of $4. To avoid real losses, the population has no choice but to play catch up and apply for 5% cash back cards. By then, the card networks may be offering 6% cash back cards, which early movers will quickly adopt in order to enjoy the increased purchasing power that these cards afford. Once again merchants will raise prices to defend their margins, adopting a 6% card standard (in other words, their chosen medium-of-account is now 6% cards). But now the 5% cash back cards adopted earlier by the general populace will be undervalued, forcing them to transition to the use of 6% cash back cards. And on and on and on till we have a 100% cash back Visa card standard.

Empirically, we can see this effect over the last decade by the proliferation of premium credit cards, as well is the growing fees that merchants must pay to the card networks.  See this GAO report, especially Figure 3 which I've appended below.

In closing, here's a rare bit of practical advice from the Moneyness blog. If you live in a nation that doesn't allow credit card surcharges (like Canada), and you use cash to pay for most things, YOU ARE LOSING MONEY. Many merchants are implicitly setting prices based on the expectation that credit cards will be used and are pricing in a premium to cover the fees they must pay to the card networks. Either demand a 2-3% cash discount on everything you buy, or get yourself a credit card that yields decent rewards. Save your cash for buying stuff at your local farmer's market or any other cash-only venue where your cash isn't being undervalued. Put differently, if you aren't behaving according to the strictures of Gresham's law, you should be.


  1. However you should also consider that cash discount you may obtain may come from lower taxes being paid by the business which is the most prominent usage of cash in the first place and that discount may amount to a small fraction of taxes evaded. If the transaction is illegal then this is what you want. If not, you may end up paying much more to make up for the lost tax revenue and may be better off charging it.

    1. True, although a corporate retailer like McDonald's or Safeway doesn't engage in tax avoidance via cash payments, so if they offer a cash discount at all, that's because it wants to save on credit card fees.

  2. Great post. I'd also add that modern banking in sums greater than $10,000 cash currency has additional costs -- probably punishable by something grisly like getting your liberty chopped off.

  3. This Australian retailer marketing tag line is "pay less pay cash". Even with surcharging allowed in Australia many just have a credit card based price (as most pay that way) and you still need to ask for a cash discount.

    1. Bron, neat example. That's a good example of a company that has chosen to specialize in solving the modern Gresham problem of undervalued cash.

  4. I refuse to use my credit or debit card to buy my morning coffee - I want %100 if the money to go to the local cafe.

  5. but if cards are driving out the cash, what good is the 5% cash rebate?

    Sooner or later the lost marginal value of everyone holding an extra dollar will equal the value of the marginal discount at the window.

    this puts an upper bound to the inflation spiral...though we just haven't hit it yet.

  6. 1. The cost of a MC/Visa transaction in Australia is about 0.8%. However the tax benefit of not recording a sale is 30% of the profit. This is why shops refuse or surcharge card.

    2. Market-based fees/charges only work where there is free flowing information. The average consumer has no idea how much merchant fees are, so don't question surcharges of up to 10% (Australian taxis)

  7. JP, I'm fascinated by credit cards so I've read your recent thoughts on them with great interest (and hope you carry on!). I was surprised in this post that you put your emphasis entirely on transaction fees without looking at the main reason consumers actually use credit cards: namely, credit, and more specifically, the time shifting inherent in card mechanics.
    I've lately become a bit obssessed with said time shifting. All cards include a grace period, of typically over 30+ days, which you can time to buy something now and pay for it much later. For a lot of people, the convenience of this small, interest-free time-shift (and of not having to carry cash) is enough to justify owning a card. (In my country, Mexico, 43% of card users are "totaleros", total-ers, who pay every month their entire balance. )

    What's gotten me fascinated is the huge, recent rise here of much longer interest-free credit, initially in select shops and for special periods, but now starting to appear in certain cards in blanket terms. I have a card with HSBC that will ALWAYS allow me to defer ANY purchase denominated in a non-peso currency into 12-monthly INTEREST-FREE instalments. I have another one that will, again all year long, allow me a similar deferment of ANY peso-denominated purchase over 700mxn (~60cad). The added limit on both credit cards is about a year of my salary. On some special months the time shift can be of up to 24-months.

    (If I don't pay an installment I'm up for rapacious (!) interest & fees, but it just takes a bit of prudence and planning on my part to avoid those.)

    What I want to point out is that this is a new time-shiftable kind of money. To frame it in terms of Gresham's law, this deferred, time-shifted money soon starts to drive out the "real", immediate money, for who would pay now when they could pay much later? I'm being lax with what I mean by money, of course, and a pursuit of exactness on the concept is an appropriately recurrent theme in your blog. Let me just frame it in Ray Dalio's famous definition of money as "what you settle your payments with", while credit is merely "a promise to pay money." This emerging use --extremely convenient, widespread, third-party-enabled, blanket-termed-- starts to blur that way of looking at money.

    The way I've come to conceptualize credit cards and particularly this new modality is to consider them as personal-money issuers. My cards, for instance, enable me to "print" out of thin air "my money", backed by me, a full year's worth of it. It is, to be sure, a float I have to pay, but in theory, a float I can keep indefinitely recreating ("all money is a bubble"). In general, this is what credit cards do for everyone on the grace period, but for most people "printing" beyond that period is still outrageously expensive (even without stepping off the wagon). This is an axis for future financial developments that has me tremendously excited... could the blockchain be used for descentralized credit? Could there be billions of colors to tint our coins with?

    Your thoughts? :)

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