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Gresham's law

From Wikipedia, the free encyclopedia

Gresham's law is commonly stated: "Bad money drives out good", but more accurately stated: "Bad money drives out good under legal tender laws".

This law applies specifically when there are two forms of commodity money in circulation which are required by legal-tender laws to be accepted as having similar face values for economic transactions.

Gresham's law is named after Sir Thomas Gresham (1519 – 1579), an English financier during the Tudor dynasty. However, it had been stated forty years before by Nicolaus Copernicus, so in parts of central and eastern Europe is known as the Copernicus Law. The phenomenon had been noted even earlier, in the fourteenth century, by Nicole Oresme. The fact of bad money being used in preference to good money is also noted by Aristophanes in his play The Frogs, which dates from around the end of the 5th century BC

Definitions

The terms "good" and "bad" money are used in a technical, non-literal sense, and with regard to exchange values imposed by legal-tender legislation, as follows:

"Good" money

"Good" money is money that shows little difference between its nominal value (the face value of the coin) and its commodity value (the value of the metal of which it is made, often precious metals, nickel, or copper.)

In the absence of legal-tender laws, metal coin money will freely exchange at somewhat above bullion market value. This is not a purely theoretical result, but rather may be observed today in bullion coins such as the South African Krugerrand, the American Gold Eagle or even the silver Maria Theresa thaler (Austria). Coins of this type are of a known purity and are in a convenient form to handle. People prefer trading in coins than in anonymous hunks of precious metal, so they attribute more value to the coins. As there is also demand from coin collectors, coining is frequently profitable.

As an example, silver coins were widely circulated in Canada (until 1968) and in the United States (until 1965 and 1971). However, these countries debased their coins by switching to cheaper metals as the market value of silver rose above that of the face value. The silver coins disappeared from circulation as citizens retained them to capture the higher current or perceived future intrinsic value of the metal content over face value, and used the newer coins in daily transactions.

The same process occurs today with the copper content of coins such as the pre-1997 Canadian penny and the U.S. one-cent coin, and even with coins made of less-expensive metals such as steel in India.[1]

Even different forms of banknotes can be subject to Gresham's law, for example, the recent change from paper to polymer bills in Nicaragua.[2]

"Bad" money

"Bad" money is money that has a commodity value considerably less than its face value, is in circulation along with money with a higher commodity value, and with both forms required to be accepted at equal value as legal tender.

In Gresham's day, bad money included any coin that had been debased. Debasement was often done by the issuing body, where less than the officially specified amount of precious metal was contained in an issue of coinage, usually by alloying it with a base metal. The public could also debase coins, usually by clipping or scraping off small portions of the precious metal. Other examples of "bad" money include counterfeit coins made from base metal.

In the case of clipped, scraped or counterfeit coins, the commodity value was reduced by fraud, as the face value remains at the previous higher level. On the other hand, with a coinage debased by a government issuer the commodity value of the coinage was often reduced quite openly, but the face value of the debased coins was held at the higher level by legal tender laws.

All modern money is "bad money" in this sense, since fiat money has entirely replaced the commodity money to which Gresham's law applies. This money is not redeemable for any kind of valuable commodity, relying entirely on the government's decree for its legitimacy, and valued purely in terms of the quantity of money in circulation relative to available goods. The ubiquity of fiat money could indeed be taken as evidence for the truth of Gresham's law.

Theory

Gresham's law states that any circulating currency consisting of both "good" and "bad" money (both forms required to be accepted at equal value under legal tender law) quickly becomes dominated by the "bad" money. This is because people spending money will hand over the "bad" coins rather than the "good" ones, keeping the "good" ones for themselves. Legal tender laws act as a form of price control. In such a case, the artificially overvalued money is preferred in exchange, because people prefer to save rather than exchange the artificially demoted one (which they actually value higher).

Consider a customer purchasing an item which costs five pence, who possesses several silver sixpence coins. Some of these coins are more debased, while others are less so - but legally, they are all mandated to be of equal value. The customer would prefer to retain the better coins, and so offers the shopkeeper the most debased one. In turn, the shopkeeper must give one penny in change - and has every reason to give the most debased penny. Thus, the coins that circulate in the transaction will tend to be of the most debased sort available to the parties.

If "good" coins have a face value below that of their metallic content, individuals may be motivated to melt them down and sell the metal for its higher intrinsic value, even if such destruction is illegal. As an example, consider the 1965 United States half dollar coins, which contained 40% silver. In previous years, these coins were 90% silver. With the release of the 1965 half dollar, which was legally required to be accepted at the same value as the earlier 90% halves, the older 90% silver coinage quickly disappeared from circulation, while the newer debased coins remained in use. As the price of bullion silver continued to rise above the face value of the coins, many of the older half dollars were melted down. Beginning in 1971, the U.S. government gave up on including any silver in the half dollars, as even the metal value of the 40% silver coins began to exceed their face value.

A similar situation occurred in 2007 in the United States with the rising price of copper and zinc, which led the U.S. government to ban the melting or mass exportation of one-cent and five-cent coins, respectively.

In addition to being melted down for its bullion value, money that is considered to be "good" tends to leave an economy through international trade. International traders are not bound by legal tender laws as citizens of the issuing country are, so they will offer higher value for good coins than bad ones. The good coins may leave their country of origin to become part of international trade, escaping that country's legal tender laws and leaving the "bad" money behind. This occurred in Britain during the period of the gold standard.

History of the concept

Gresham was not the first to state the law which took his name. The phenomenon had been noted much earlier, in the fourteenth century, by Nicole Oresme. In the year that Gresham was born, 1519, it was described by Nicolaus Copernicus in a treatise called Monetae cudendae ratio, as "bad (debased) coinage drives good (un-debased) coinage out of circulation." Copernicus was aware of the practice of exchanging bad coins for good and melting down the latter or sending them abroad, and he seems to have drawn up some notes on this subject while he was at Allenstein in 1519. He made them the basis of a report in German which he presented to the Prussian Diet held in 1522 at Graudenz, attending the session with his friend Tiedemann Giese to represent his Chapter. Copernicus's Monetae cudendae ratio was an enlarged, Latin version of that report, setting forth a general theory of money for the 1528 diet. He also formulated a version of quantity theory of money.[3]

According to the economist George Selgin in his paper "Gresham's Law":

As for Gresham himself, he observed "that good and bad coin cannot circulate together" in a letter written to Queen Elizabeth on the occasion of her accession in 1558. The statement was part of Gresham's explanation for the "unexampled state of badness" England's coinage had been left in following the "Great Debasements" of Henry VIII and Edward VI, which reduced the metallic value of English silver coins to a small fraction of what it had been at the time of Henry VII. It was owing to these debasements, Gresham observed to the Queen, that "all your fine gold was convayed out of this your realm."[4]

Gresham made his observations of good and bad money while in the service of Queen Elizabeth, with respect only to the observed poor quality of the British coinage. The earlier monarchs, Henry VIII and Edward VI, had forced the people to accept debased coinage by means of their legal tender laws. Gresham also made his comparison of good and bad money where the precious metal in the money was the same. He did not compare silver to gold, or gold to paper.

Origin of the name

In his "Gresham's Law" article, Selgin also offers the following comments regarding the origin of the name:

The expression "Gresham's Law" dates back only to 1858, when British economist Henry Dunning Macleod (1858, p. 476–8) decided to name the tendency for bad money to drive good money out of circulation after Sir Thomas Gresham (1519–1579). However, references to such a tendency, sometimes accompanied by discussion of conditions promoting it, occur in various medieval writings, most notably Nicholas Oresme's (c. 1357) Treatise on money. The concept can be traced to ancient works, including Aristophanes' The Frogs, where the prevalence of bad politicians is attributed to forces similar to those favoring bad money over good.[5]

The referenced passage from The Frogs is as follows (usually dated at 405 B.C.):

The course our city runs is the same towards men and money.

She has true and worthy sons.

She has fine new gold and ancient silver,

Coins untouched with alloys, gold or silver,

Each well minted, tested each and ringing clear.

Yet we never use them!

Others pass from hand to hand,

Sorry brass just struck last week and branded with a wretched brand.

So with men we know for upright, blameless lives and noble names.

These we spurn for men of brass...

Ibn Taymiyyah

Ibn Taimiyyah (1263–1328) described the phenomenon as follows:

If the ruler cancels the use of a certain coin and mints another kind of money for the people, he will spoil the riches (amwal) which they possess, by decreasing their value as the old coins will now become merely a commodity. He will do injustice to them by depriving them of the higher values originally owned by them. Moreover, if the intrinsic value of coins are different it will become a source of profit for the wicked to collect the small (bad) coins and exchange them (for good money) and then they will take them to another country and shift the small (bad) money of that country (to this country). So (the value of) people's goods will be damaged.

Notably this passage mentions only the flight of good money abroad and says nothing of its disappearance due to hoarding or melting.[6]

Reverse

In an influential theoretical article, Rolnick and Weber (1986) argued that bad money would drive good money to a premium rather than driving it out of circulation. However their research did not take into account the context in which Gresham made his observation. Rolnick and Weber ignored the influence of legal tender legislation which requires people to accept both good and bad money as if they were of equal value. They also focused mainly on the interaction between different metallic moneys, comparing the relative "goodness" of silver to that of gold, which is not what Gresham was speaking of.

The experiences of dollarization in countries with weak economies and currencies (for example Israel in the 1980s, Eastern Europe and countries in the period immediately after the collapse of the Soviet bloc, or South American countries throughout the late twentieth and early twenty-first century) may be seen as Gresham's Law operating in its reverse form (Guidotti & Rodriguez, 1992), since in general the dollar has not been legal tender in such situations, and in some cases its use has been illegal.

Adam Fergusson pointed out that in 1923 during the great Inflation in the Weimar Republic Gresham's Law began to work in reverse, since the official money became so worthless that virtually nobody would take it. This was particularly serious since farmers began to hoard food. Accordingly, any currencies backed by any sorts of value became the circulating mediums of exchange.[7] In 2009 Hyperinflation in Zimbabwe began to show similar characteristics.

These examples show that in the absence of effective legal tender laws, Gresham's Law works in reverse. If given the choice of what money to accept, people will transact with money they believe to be of highest long-term value. However, if not given the choice, and required to accept all money, good and bad, they will tend to keep the money of greater perceived value in their possession, and pass on the bad money to someone else. In short, in the absence of legal tender laws, the seller will not accept anything but money of certain value (good money), while the existence of legal tender laws will cause the buyer to offer only money with the lowest commodity value (bad money) as the creditor must accept such money at face value.[8]

The Nobel prize-winner Robert Mundell believes that Gresham's Law could be more accurately rendered, taking care of the reverse, if it were expressed as, "Bad money drives out good if they exchange for the same price."[9]

Application

The principles of Gresham's law can sometimes be applied to different fields of study. Gresham's law may be generally applied to any circ**stance in which the "true" value of something is markedly different from the value people are required to accept, due to factors such as lack of information or governmental decree.

In the market for used cars, lemon automobiles (analogous to bad currency) will drive out the good cars.[10] The problem is one of asymmetry of information. Sellers have a strong financial incentive to pass all used cars off as "good" cars, especially lemons. This makes it difficult to buy a good car at a fair price, as the buyer risks overpaying for a lemon. The result is that buyers will only pay the fair price of a lemon, so at least they reduce the risk of overpaying. High-quality cars tend to be pushed out of the market, because there is no good way to establish that they really are worth more. "The Market for Lemons" is a work that examines this problem in more detail. Some also use an explanation of Gresham's Law as "The more efficient you become, the less effective you get"; i.e. "when you try to go on the cheap, you will stop selling" or "the less you invest in your non-tangible services, the less sales you will get".

And there you are - you now know a little bit more economics...:o) I'm interested in reading all the alternatives, I find this mission one of the most creative so far.....so read this and I'll look forward to reading all your ideas.:o)

Views: 238

Comment by Rob Oliver on April 1, 2010 at 1:32pm
I will be very interested to see if our central bankers around the world avoid the consequences of Gresham's law as we all respond to the GFC. Will they be politically able to cut back primary currency supply as credit begins to expand once more and transactional speed and volume again picks up? If not, their countries (at least their central bank issued currencies) will be in big trouble.

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