LeoGlossary: Gresham's Law
This was named after Sir Thomas Gresham (1519-1579) who lived in the 1500s. He was a financier serving the queen. Later, he founded the Royal Exchange of the City of London.
It is a monetary principle cited in the field of economics where essentially bad money drives out good. Gresham's focus was obviously on specie or coinage. During his time, gold and silver coins were relevant to his writings.
Behind this theory is the idea that, if two coins have similar face value, the one with more value as a commodity will gradually disappear. This could come as a result of clipping which debases the currency or through the minting by the government. When the mint starts to alter the metallic composition of the newer coins it produces, this will affect the intrinsic value. We can see how the older coins will be held with the newer ones placed in circulation.
Since most economies moved away from specie, the law has been applied to other forms of currency and money.
Good And Bad Money
Under this concept, good money is that which is undervalued or more stable. Bad money is overvalued or will lose its value rapidly. It is now easy to see how bad money will drive good out of circulation.
For this assumption to work, we have to have two coins that have similar medium of exchange. It will not hold if the face value is different. The coinage must be the same in terms of the economic and transaction ability. It is the commodity that is different Individuals will prefer to conduct business in the bad money while hold in balance the good because could be worth more in the future than its face value.
Seigniorage is an important concept in this discussion since it is he price spread between face value and commodity value when it is minted. Even today, Gresham's Law is applicable since coin collectors prefer to hold those with higher commodity value, driving up demand.
This is obviously good money.
Dispute
Gresham's Law is not accepted as absolute. In fact, many content the validity of the theory, even when applying it to coinage.
There are numerous examples throughout history where a coin had greater metallic content yet saw demand less. We also saw numbers times when counterfeit money was circulated. Again, the commodity value was greater than that of the real currency but it was not in demand.
This starts to get into what makes a currency or money valuable.
Economic productivity is part of what stands behind a currency. When there is a powerful empire like the Romans, it is hard for another currency to step in. Many consider this to be the case of the US dollar. Since the economic output tied to the currency is so massive, even if fiat, it far outweighs anything else in history. Naturally, there is no intrinsic value in the USD or any other under our currency monetary system. In fact, since the digital age came about, money is actually resident on electronic ledgers.
Gresham's Law As A Tax
One way that seigniorage was used is a way for governments to pay their debts. This was effectively putting a tax on the citizens who were using the money.
The mint would create coins that typically would be made of an alloy. This would decrease the value of the newer coins, allowing debts to be paid off with debased currency. Since the coins fall under legal tender, the power to mandate the face value being the same is there.
Here we see the situation where the newer coins are overvalued especially against the commodity in them.
When the older coins are forced out of existence, pulled in by the banks and government, then we see how the impact can produce the same effect as a tax.
Gresham's Law In Reverse
At the center of Gresham's Law is the idea of legal tender. The only way bad money can drive out good is if they are exchanged at the same price. This is something that can be done by force.
When given an option, merchants will accept only the currency they believe has the greater long-term value. This doesn't exist if people are forced to accept both the good and bad money.
If money becomes totally worthless, there are time in history where people will stop accepting currency for goods. This happened during the inflation of the Weimer Republic in 1923.
Thus, any currency that is viewed to have a store of value will be utilized and accepted.
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