In economics, Gresham's law is a monetary principle stating that "bad money drives out good". For example, if there are two forms of commodity money in circulation, which are accepted by law as having similar face value, the more valuable commodity will gradually disappear from circulation.
The law was named in 1860 by Henry Dunning Macleod, after Sir Thomas Gresham (1519-1579), who was an English financier during the Tudor dynasty. However, there are numerous predecessors. The law had been stated earlier by Nicolaus Copernicus; for this reason, it is occasionally known as the Copernicus Law. It was also stated in the 14th century, by Nicole Oresme c. 1350, in his treatise On the Origin, Nature, Law, and Alterations of Money, and by jurist and historian Al-Maqrizi (1364-1442) in the Mamluk Empire; and noted by Aristophanes in his play The Frogs, which dates from around the end of the 5th century BC.
Video Gresham's law
Good money and bad 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 may be observed in bullion coins such as the Canadian Gold Maple Leaf, 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 rather than in anonymous hunks of precious metal, so they attribute more value to the coins of equal weight. The price spread between face value and commodity value is called seigniorage. Because some coins do not circulate, remaining in the possession of coin collectors, this can increase demand for coinage.
On the other hand, bad money is money that has a commodity value considerably lower than its face value and is in circulation along with good money, where both forms are 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, also known as "stemming" (reeded edges on coins were intended to make clipping evident). Other examples of bad money include counterfeit coins made from base metal. Today all circulating coins are made from base metals, known as fiat money.
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, while the face value of the debased coins was held at the higher level by legal tender laws.
Maps Gresham's law
Examples
Silver coins were widely circulated in Canada (until 1968) and in the United States (until 1964 for dimes and quarters and 1970 for half-dollars) when the Coinage Act of 1965 was passed. These countries debased their coins by switching to cheaper metals thereby inflating the new debased currency in relation to the supply of the former silver coins. The silver coins disappeared from circulation as citizens retained them to capture the steady current and future intrinsic value of the metal content over the newly inflated and therefore devalued coins, using the newer coins in daily transactions. In the late 1970s, the Hunt brothers attempted to corner the worldwide silver market but failed, temporarily driving the price far above its historic levels and intensifying the extraction of silver coins from circulation. The same process occurs today with the copper content of coins such as the pre-1997 Canadian penny, the pre-1982 United States penny and the pre-1992 UK copper pennies and two pence. This also occurred even with coins made of less expensive metals such as steel in India.
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.
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 value of the dollar (Federal Reserve notes) continued to decline, resulting in the value of the silver content exceeding 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, zinc, and nickel, which led the U.S. government to ban the melting or mass exportation of one-cent and five-cent coins.
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
The law was named after Sir Thomas Gresham, a sixteenth-century financial agent of the English Crown in the city of Antwerp, to explain to Queen Elizabeth I what was happening to the English shilling. Her father, Henry VIII, had replaced 40 percent of the silver in the coin with base metals, to increase the government's income without raising taxes. Astute English merchants and even ordinary subjects would save the good shillings from pure silver and circulate the bad ones; hence, the bad money would be used whenever possible, and the good coinage would be saved and disappear from circulation.
Gresham was not the first to state the law which took his name. The phenomenon had been noted much earlier, in the 14th 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: "bad (debased) coinage drives good (un-debased) coinage out of circulation." Copernicus was aware of the practice of exchanging bad coins for good ones 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 Olsztyn in 1519. He made them the basis of a report which he presented to the Prussian Diet held in 1522, 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 the quantity theory of money.
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" that 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."
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 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 metal, but of different weight. 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, pp. 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.
The referenced passage from The Frogs is as follows (usually dated at 405 BC):
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...
Precursors
According to Ben Tamari, the currency devaluation phenomenon was already recognized in ancient sources. He brings some examples which include the Machpela Cave transaction and the building of the Temple from the Bible and the Mishna in tractate Bava Metzia (Bava Metzia 4:1) from the Talmud.
Precursors in the Islamic World
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 values 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. Palestinian economist Adel Zagha also attributes a similar concept to medieval Islamic thinker Al-Maqrizi, who offered, claims Zagha, a close approximation to what would become known as Gresham's law centuries later.
Reverse of Gresham's Law (Thiers' Law)
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 had 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 monies, 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 (such as Israel in the 1980s, Eastern Europe and countries in the period immediately after the collapse of the Soviet bloc, or South America throughout the late 20th and early 21st century) may be seen as Gresham's Law operating in its reverse form (Guidotti & Rodriguez, 1992) because 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, as the official money became so worthless that virtually nobody would take it. That was particularly serious because farmers began to hoard food. Accordingly, any currency backed by any sort of value became a circulating medium of exchange. In 2009, hyperinflation in Zimbabwe began to show similar characteristics.
Those 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 are required to accept all money, good and bad, they will tend to keep the money of greater perceived value in their possession and to 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), but 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.
The winner of the Nobel Prize 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."
The reverse of Gresham's Law, that good money drives out bad money whenever the bad money becomes nearly worthless, has been named "Thiers' Law" by economist Peter Bernholz in honor of French politician and historian Adolphe Thiers. "Thiers' Law will only operate later [in the inflation] when the increase of the new flexible exchange rate and of the rate of inflation lower the real demand for the inflating money."
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 circumstance 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. 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. Certified pre-owned programs are an attempt to mitigate this problem by providing a warranty and other guarantees of quality. "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 fewer sales you will get."
Vice President Spiro Agnew used Gresham's law in describing American news media, stating that "Bad news drives out good news," although his argument was closer to that of a race to the bottom for higher ratings rather than over and undervaluing certain kinds of news.
Gregory Bateson postulated an analogue to Gresham's Law operating in cultural evolution, in which "the oversimplified ideas will always displace the sophisticated and the vulgar and hateful will always displace the beautiful. And yet the beautiful persists."
Gresham's law has been cited as "Silver currency will inevitably force gold currency out of circulation" (L. Pyenson, Servants of Nature (W.W. Norton, 1999) p. 21); this suggests a fundamental misinterpretation, cf. Mundell (above).
See also
- Adages named after people
- Adverse selection
- Lemon socialism
- List of multiple discoveries
- Metal theft
- Penny debate in the United States
- Free silver
Notes
References
- Armitage, Angus, The World of Copernicus, New York, Mentor Books, 1951.
- Bernholz, Peter and Gersbach, Hans, "Gresham's Law: Theory." The New Palgrave Dictionary of Money and Finance, vol. 2. Macmillan: London and Basingstoke 1992, 286-288.
- Bush, Vannevar, (1950) Science, the Endless Frontier, Report from the Director of the OSRD to President H. Truman
- Guidotti, P. E., & Rodriguez, C. A. (1992). Dollarization in Latin America - Gresham law in reverse. International Monetary Fund Staff Papers, 39, 518-544.
- Rolnick, A. J.; Weber, W. E. (1986). "Gresham's Law or Gresham's Fallacy". Journal of Political Economy. 94 (1): 185-199. doi:10.1086/261368. JSTOR 1831965.
- Rothbard, M.N. (1980). What Has Government Done to Our Money? Gresham's Law and Coinage [2]. Auburn AL, Ludwig von Mises Institute.
- Selgin, G., University of Georgia (2003). Gresham's Law.
- Spiegel, Henry William (1991). The growth of economic thought (3rd ed.). Duke University Press [Durham & London]. ISBN 0-8223-0965-3.
- Stokes, D.E (1997). Pasteur's Quadrant: Basic Science and Technological Innovation. Washington D.C.: Brookings Institution Press. ISBN 0815781776.
External links
- Gresham's Law by George Selgin
- Multi-language translation of Nicolaus Copernicus, Monete Cudende Ratio
- Coinflation.com - illustrates Gresham's Law based upon the current metal value of coins in circulation.
Source of article : Wikipedia
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