What is Gresham's Law?
Gresham's law is a monetary principle stating that "bad money drives out good." It is primarily used for consideration and application in currency markets. Gresham’s law was originally based on the composition of minted coins and the value of the precious metals used in them. However, application of the theory has moved beyond basic metal valuation to include more comprehensive considerations in the currency markets globally.
Understanding Good Money vs. Bad Money
At the core of Gresham’s law is the concept of good money versus bad money. The law holds that bad money drives out good money in circulation. Bad money is then the currency that is considered to have equal or less value compared to its face value. Meanwhile, good money is currency that is believed to have greater value or more potential for greater value than its face value. One basic assumption for the concept is that both currencies are equally liquid and available for use simultaneously. Logically, consumers will choose to use bad money over good money because good money has the potential to be worth more than its face value.
Origins of Gresham’s Law
The minting of coins provides the most basic example of Gresham’s law applied. In fact, Gresham’s law itself was built around the minting of coins and Gresham’s service to Queen Elizabeth I of England. Sir Thomas Gresham lived from 1519 to 1579, working as a financier serving the Queen and later founding the Royal Exchange of the City of London. Henry VIII had changed the composition of the English shilling, replacing a substantial portion of the silver with base metals. Gresham’s consultations with the Queen explained that consumers were aware of the change and began separating the English shilling coins based on their production dates to hoard the coins with more silver which, when melted down, were worth more than their face value. Gresham observed that the bad money was driving out the good money from circulation. The theory was not given the formal name Gresham's law until the middle of the 19th century when Scottish economist Henry Dunning Macleod attributed the monetary phenomenon to Gresham.
Throughout history, coins have been made from gold, silver, and other precious metals, which has supported their value. Over time, the amount of precious metals used to make coins has steadily decreased. Despite this, new coins are given the same face value as older coins with more precious metal content. Because the value of the metal in old coins is higher than the coin's face value, people can melt the coins down and sell the metal, or they may simply hoard the coins as a greater stored value. New coins with less precious metal content are considered to have less value while the old coins are presumably greater in value—hence, the hoarding effect, driving out the "good money" from circulation.
Gresham’s law plays out in the modern day economy for the same reasons that it was developed in the first place. In 1982, the U.S. government changed the composition of the penny to contain 97.5% zinc. This change made pre-1982 pennies worth more than their post-1982 counterparts while the face value remained the same. To mitigate the effects of Gresham’s law however, the U.S. imposed a penalty in 2006 for melting coins. The legislation leads to a $10,000 fine and/or five years in prison if convicted of this offense.
Gresham’s Law and the Currency Market
While most governments have mitigated the effects of Gresham’s law through legislation and regulations banning the melting of coins, the concept can still be expanded. Gresham’s law can be considered across the global currency markets and with cryptocurrencies as well. In general, Gresham’s law involves basic investment theory which can help investors to choose certain currency investments over others.
As the law states, when two currencies can be used, investors will use the currency trading at its face value and hold a currency which is worth more than its face value. In this application, when one currency is rising versus another, investors may choose to hold the rising currency. For example, if the dollar is rising against the pound, then spending the pound and hoarding the dollar would follow Gresham’s law. The same theory holds in cryptocurrencies when investors choose to hoard a cryptocurrency that is rising and use the dollar instead because it is at face value.