Gresham’s Law: Then, Now & Speculations about the Future

Gresham’s law states that ‘bad money drives out good‘. However, as Murray N. Rothbard pointed out in ‘A History of Money and Banking in the United States: The Colonial Era to World War II‘, the ‘triumph’ of ‘bad money’ is not a perverse feature of the free market, but a direct outcome of government intervention:


…when government compulsorily overvalues one money and undervalues another, the undervalued money will leave the country or disappear into hoards, while the overvalued money will flood into circulation.


In this article, I’ll consider the implications and manifestations of Gresham’s law for traditional commodity monies as well as present-day fiat currencies.


Gresham’s Law in the Context of Commodity Monies:


Historically, Gresham’s law has typically operated in the following scenarios:


  1. Where a portion of the supply of gold, silver or copper coin was debased. Implying that the money supply could have been split up into – broadly – new (debased) coins and old (‘full-bodied’) coins.
  2. Where the exchange ratio between two different commodity monies was fixed at a government-decreed rate.


New Vs Old Coins:


If – say – a monarch debases a portion of the supply of coin, the entire stock can be divided into new (debased) coins and old (‘full-bodied’) coins. That is, there would be a new stock of coin consisting of diluted metal, and an old stock of coin consisting of unadulterated precious metal. If, via Legal Tender laws, these two classes of coin are set equal to one another, then Gresham’s law has the platform to take hold.


The reason is simple. Legal tender laws are used to determine what ‘counts’ when repaying debts. So, if the government decrees that both old and new coins ‘count the same’, it should be clear that people will tend to use the coin that they deem to be least desirable. Thus, as the new (debased) coins are less valuable than the old (‘full-bodied’) coins, they would tend to get thrown around in circulation. Indeed, the older, better coins would inevitably be hoarded or exported; for why give away the good stuff when you can give away the bad stuff?


Thus, by this operation, en masse, people would use the new (debased) coin in trade while hoarding or exporting the older (‘full-bodied’) coin. The “Great Debasement” of England (from 1542-1551) is an excellent example of the above in operation. The English Crown relentlessly debased silver coin while nevertheless granting them ‘legal tender’ status. The process described by Sir Thomas Gresham – and, incidentally, several thinkers before him – came into operation.


[To elucidate that Gresham wasn’t the first to notice this law, see an excerpt from Nicholas Oresme’s (1380-1382) Treatise on money (De Moneta):


. . . such alterations and debasements diminish the amount of gold and silver in the realm, since these metals, despite any embargo, are carried abroad, where they command a higher value. For men try to take their money to the places where they believe it to be worth most. And this reduces the material for money in the realm.


Bimetallism – Silver Vs Gold Coins:


Bimetallism was the policy of enforcing legal tender laws with two different metals at a particular (fixed) rate.


If – say – a government decrees the exchange ratio between gold and silver coins, then – sooner or later – the natural market exchange ratio between the two metals will reveal that decreed rate to be inappropriate. For example, consider what might happen if a government were to decree an exchange ratio of twenty to one (i.e. one gold ounce to twenty silver ounces), with a market rate of ten to one. With this government declaration, people could either pay off their debts with gold or silver at that rate. Which one might they choose? Well, with gold heavily overvalued with respect to silver, people, en masse would use gold in circulation while hoarding or exporting silver.


Gresham’s Law in the Context of Modern-Day Fiat Currencies:


If we seek Gresham’s law in the modern-day fiat currency system, we should think about components of the money supply whose exchange ratios are compulsorily decreed by government. As far as I can tell, (strictly) there is one type of (minor) exchange ratio in place today. However, arguably, there are some Gresham’s law-style undertones playing a significant role in the monetary system and there is potential for (significant) applications of Gresham’s law in the future.


Small Coin made with base metals:


I imagine that this point is rather embarrassing for governments, as it demonstrates their inevitable propensity to debase currency. Small coins are compulsorily decreed to be equal to central bank notes at a certain rate. Initially, governments made small coins with such a small amount of base metal that they thought they’d never exceed their face value, but – alas, after years of relentless debasement – they have. More and more, we’re seeing that the metal content in small change is rising above the face value of that change. Meaning, that numerous small coins have become (or are becoming) undervalued with respect to central bank notes.


It must be said that – apart from the embarrassment – these manifestations of Gresham’s law are fairly benign. Unlike historical operations of Gresham’s law, the implications do not affect the money supply in a significant way. Previously, a sudden scarcity of gold or silver could bankrupt a broad range of businesses due to the deflationary effects (as described by Oresme). Today, due to the tiny supply of small coin relative to the total money supply, this manifestation merely creates a (fairly unnoticed) scarcity of (a particular) coin.


Examples of this operation can be seen in the disappearance of the 1 Rupee coin, the recent change in the consisitency of 5 and 10 pence coins in the UK, and the progressive disappearence of US nickels.


Potential for Gresham’s Law to Operate in the Future:


As I have mentioned elsewhere on, we seem to be in a trend of private sector deleveraging. That is, an environment where the burden of dollar liabilities is on the rise. For the first time in decades, the viability of government-run deposit insurance schemes are coming into question. Furthermore, in recent years, we’ve rediscovered the meaning of the term ‘bank-run’.


Thus, it is conceivable that – as the private sector continues to de-leverage – the burden of central bank note liabilities will rise to intolerable proportions again. If this happens (on a large scale), then – similar to 1933 – you could find that you can’t exchange your demand claims on central bank notes for central bank notes (i.e. you can’t withdraw your deposits). This might take the form of a universal (and extended) ‘bank holiday’. In this scenario, if non-redemption were backed by government-decree, then commercial bank deposits could become de facto legal tender. In this case, we’d have an appropriate platform for Gresham’s law to take hold: Central bank notes would be undervalued relative to commercial bank deposits – thus commercial bank deposits would be flung around in circulation whereas central bank notes would be hoarded.


A note on Government confiscation:


Incidentally, this – for me  - highlights the greatest danger for future (obvious) confiscation of wealth. Roosevelt notoriously confiscated private holdings of gold during the 1930s, and this has exacerbated fear about future confiscation of gold. However, to understand the context, Roosevelt enacted that confiscation with the social legitimacy of ‘saving the people from evil hoarders and speculators in gold coin & bullion’. It was deemed to be unpatriotic to do the devilish deed of owning private holdings of gold. Such ‘hoarding’ was exclusively blamed for the inevitable unwinding of the levered fractional-reserve banking system.


Today, in a similar fashion, blame could be attributed to ‘hoarders’ of central bank notes i.e. hoarders of sterling notes, federal reserve notes etc. If the burden of central bank notes were to rise sufficiently, they could be confiscated altogether (i.e. forcibly exchanged at par with commercial bank deposits), and commercial bank deposits could achieve a de facto legal tender status.


See here for our collection of rare historical economic data.

Posted Apr 6, 2011