What is Gresham’s law? Definition and meaning
The definition and meaning of Gresham’s Law in economics is a monetary principle stating that when there are two forms of commodity money in circulation, which are accepted by law as legal tender and the same face values, the more valuable one – ‘good money’ – will be hoarded and will disappear from circulation, while the less valuable one – ‘bad money’ – will be passed on (used for transactions). The principle states that ‘bad money drives out good’.
Imagine you have two coins with the same legal tender face value – say one penny. However, one is made of silver and the other of copper. People will hold onto the silver coins and use just the copper ones for payment. The ‘good’ money (silver) will disappear from circulation, because everybody hoards it, leaving just the ‘bad money’ (copper) in circulation.
According to the Financial Times glossary of terms, by definition Gresham’s law is:
“Theory that if people are allowed to use an alternate currency that is of equal nominal value as their normal currency but of higher real value (because of higher metal content or stronger purchasing power abroad), they will continue to use the old currency and hoard the alternate one, thereby taking it out of circulation.”
Elizabeth I, Sir Thomas Gresham, and an Elizabethan shilling. To fund his expenditure, Henry VIII had replaced the precious-metal content of shillings with non-precious metals. Sir Thomas explained to Elizabeth I why there were no precious-metal shillings in circulation – people were hoarding them.
Gresham’s law named after Thomas Gresham
Gresham’s Law was named by Scottish economist Henry Dunning Macleod (1821-1902) in 1860, after Sir Thomas Gresham (1519-1579), an English merchant and financier who acted as financial adviser to King Edward VI, as well as Edward’s half-sisters Mary I and Elizabeth I.
Good money is the one where there is minimal difference between its face value (nominal value) and its commodity value (the value of the metal of which it is made, usually precious metals, nickel or copper).
Coins used to be made of silver, gold and other precious metals – the metal itself gave them their value. Eventually, the amount of precious metals used to produce the coins decreased because they had greater value on their own than when minted into the coin itself.
Historically, people have bitten coins for several reasons. Perhaps, in a Gresham’s law situation they were trying to determine whether the coin was ‘good’ or ‘bad’ money. Olympic medal winners today also bite their coin-like medals when they are posing in front of cameras.
If the metal was worth more than the coin’s face value, people would melt down the coins and sell the metal.
In the same way, if a product of inferior quality is passed off as a top-quality one, then the market will drive down prices because purchasers will not be able to determine its real value.
Money has many functions
Money is not only a domestic medium of exchange – it can also be used for foreign exchange, as a store of value, or as a commodity.
If one kind of money is worth more in foreign exchange, as a commodity, or as a store of value, it will not be used as a domestic medium of exchange – it will gradually go out of circulation.
From 1792 to 1834, the United States maintained an exchange ratio of 15-to-1 between silver and gold, compared to between 15.5-to-1 and 16.06-to-1 in Europe. Owners of gold found it profitable to sell their gold in the European market and take their silver to the USA mint. Gold was effectively withdrawn from domestic US circulation – it had been driven out by the ‘bad’ money.
In Canada, silver coins were widely circulated until 1968, while in the United States dimes and quarters were made of silver until the Coinage Act of 1965.
Canada and the US debased their coins by switching to non-precious metals, thereby inflating the new debased currency in relation to the former silver coins’ supply. US and Canadian citizens hoarded the silver coins – they effectively disappeared from circulation – and just used the non-precious metal coins for transactions.
The same happens today with the copper content of coins, such as the pre-1992 British copper pennies and two pence coins, the pre-1982 US penny, and the pre-1997 Canadian penny. The same happened in India with coins made of less expensive metals such as steel.
Gresham’s law – Queen Elizabeth I
In the 16th century, Sir Thomas Gresham explained to Queen Elizabeth I – Queen of England and Ireland – what was happening to the English shilling.
Elizabeth’s father, Henry VIII, had replaced forty percent of the silver in the coin with non-precious metals, as a source of income for the government without having to raise taxes. Astute merchants and many ordinary subjects would hold onto their ‘good’ shillings – made from pure silver – and use the ‘bad’ ones for buying things. The pure silver coins disappeared from circulation.
According to American economist George Selgin, Director of the Cato Institute’s Center for Monetary and Financial Alternatives, 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’ 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.'”
Although Gresham’s law was named after Sir Robert, the phenomenon had been around for a very long time. In 1519, Nicolas Copernicus described the phenomenon in a treatise called Monetae cudendae ratio: ‘bad coinage drives good coinage out of circulation.’
There are some references to Gresham’s law situations in the Bible.
Is Gresham’s law revelant today?
It can only be relevant if we still have ‘good money’ – and we do! The nickels that are still being produced by the US Mint are worth more than one nickel (5 cents). Coninflation says that a nickel’s current metal content is worth just over six cents, i.e. twenty percent more than the nominal face (face value).
It is highly likely that the US Mint will soon decide to use a cheaper metal to make nickels. It will not want to continue losing money to the tune of one cent for each nickel it produces. Many believe that its current composition – 75% copper and 25% nickel – will be switched to steel.
President Barack Obama has already signed into law a provision that would allow the US Mint to switch to a cheaper metal. When the change does happen, Gresham’s Law will definitely go into effect. The copper/nickel coins will be hoarded and disappear from circulation – the new ‘bad’ money made of steel will drive out the ‘good’.
Hoarding these nickels is risk-free. If the their metal content is not switched, each one will still be worth a nickel.
Video – What is Gresham’s Law?
This Capital Account video explains in easy-to-understand terms what Gresham’s Law is.