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, since the abandonment of metallic currency standards, the theory has been applied to the relative stability of different currencies' value in global markets.
- Gresham’s law says that legally overvalued currency will tend to drive legally undervalued currency out of circulation.
- Gresham’s law originated as an observation of the effects of metallic currency debasement, but also applies in today’s world of paper and electronic moneys.
- In the absence of effectively enforced legal tender laws, such as in hyperinflationary crises or international commodity and currency markets, Gresham’s law operates in reverse.
Understanding Good Money vs. Bad Money
At the core of Gresham’s law is the concept of good money (money which is undervalued or money that is more stable in value) versus bad money (money which is overvalued or loses value rapidly). 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 intrinsic value compared to its face value. Meanwhile, good money is currency that is believed to have greater intrinsic value or more potential for greater value than its face value. One basic assumption for the concept is that both currencies are treated as generally acceptable media of exchange, are easily liquid, and available for use simultaneously. Logically, people will choose to transact business using bad money and hold balances of 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, the law’s namesake, Sir Thomas Gresham, was referring to gold and silver coins in his relevant writing. 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 people 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.
This phenomenon had been previously noticed and written about in ancient Greece and medieval Europe. The observation was not given the formal name "Gresham's law" until the middle of the 19th century, when Scottish economist Henry Dunning Macleod attributed the it to Gresham.
How Gresham's Law Works
Throughout history, mints have made coins from gold, silver, and other precious metals, which originally give the coins their value. Over time, issuers of coins sometimes reduced the amount of precious metals used to make coins and tried to pass them off as full value coins. Ordinarily, new coins with less precious metal content would have less market value and trade at a discount, or not at all, and the old coins would retain greater value. However, with government involvement such as legal tender laws, the new coins would typically be mandated to have the same face value as older coins. This means that the new coins would be legally overvalued, and the old coins legally undervalued. Governments, rulers, and other coin issuers would engage in this in order to obtain revenue in the form of seigniorage and pay their old debts (which they borrowed in old coins) back in the new coins (which have less intrinsic value) at par value.
Because the value of the metal in old coins (good money) is higher than the new coins (bad money) at face value, people have a clear incentive to prefer the old coins with higher intrinsic precious metal content. As long as they are legally compelled to treat both types of coins as the same monetary unit, buyers will want to pass along their less precious coins as quickly as possible and hold on to the old coins. They can either melt the old coins down and sell the metal, or they may simply hoard the coins as a greater stored value. The bad money circulates through the economy, and the good money gets removed from circulation, to be stashed away or melted down for sale as raw metal.
The end result of this process, known as debasing the currency, is a fall in the purchasing power of the currency units, or a rise in general prices: in other words, inflation. In order to fight Gresham’s law, governments often blame speculators and resort to tactics like currency controls, prohibitions on removing coins from circulation, or confiscation of privately owned precious metal supplies held for monetary use.
In a modern example of this process, 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. Over time, due to the debasement of the currency and resulting inflation, copper prices rose from an average of $0.6662 in 1982 to $3.0597 in 2006 when the U.S. imposed stiff new penalties for melting coins. This means that the face value of the penny lost 78% of it's purchasing power, and people were eagerly melting down old pennies, which were worth almost five times the value of the post-1982 pennies by that point. The legislation leads to a $10,000 fine and/or five years in prison if convicted of this offense.
Legalities, Gresham's Law, and the Currency Market
Gresham's law plays out in the modern day economy for the same reasons that it was observed in the first place: legal tender laws. In the absence of effectively enforced legal tender laws, Gresham's law tends to operate in reverse; good money drives bad money out of circulation because people can decline to accept the less valuable money as a means of payment in transactions. But when all currency units are legally mandated to be recognized at the same face value, the traditional version of Gresham's law operates.
In modern times, the legal links between currencies and precious metals have become more tenuous and eventually been cut entirely. With the adoption of paper money as legal tender (and accounting entry money through fractional reserve banking), this means that the issuers of money are able to obtain seigniorage by printing or loaning money into existence at will as opposed to minting new coins. This ongoing debasement has led to a persistent trend of inflation as the norm in most economies, most of the time. In extreme cases, this process can even lead to hyperinflation, where then money is literally not worth the paper it is printed on.
In cases of hyperinflation, foreign currencies often come to replace local, hyperinflated currencies; this is an example of Gresham's law operating in reverse. Once a currency loses value rapidly enough, people tend to stop using it in favor of more stable foreign currencies, sometimes even in the face of repressive legal penalties. For example, during the hyperinflation in Zimbabwe, inflation reached an annual rate estimated at 250 million percent in July 2008. Though still legally required to recognize the Zimbabwe dollar as legal currency, many people in the country began to abandon its use in transactions, eventually forcing the government to recognize de facto and subsequent de jure dollarization of the economy. In the chaos of an economic crisis with a near worthless currency, the government was unable to effectively enforce its legal tender laws. Good (more stable) money drove bad (hyperinflated) money out of circulation first in the black market, then in general use, and eventually with official government support.
In this sense, Gresham’s law can also be considered across global currency markets and international trade, since legal tender laws almost by definition only apply to domestic currencies. In global markets, strong currencies, such as the U.S. dollar or the euro, which hold relatively more stable value over time (good money) tend to circulate as international media of exchange and are used as international pricing references for globally traded commodities. Weaker, less stable currencies (bad money) of less developed nations tend to circulate very little or not at all outside the boundaries and jurisdiction of their respective issuers to enforce their use as legal tender. With international competition in currencies, and no single global legal tender, good money circulates and bad money is kept out of general circulation by the operation of the market.