Word of the Day: Gresham’s Law

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Word of the Day: Gresham’s Law

Tuesday, July 28th, 2009 | Economics, Word of the Day |

Gresham’s law is commonly stated: “Bad money drives out good.” This law applies specifically when there are two forms of commodity money in circulation which are required by legal-tender laws to be accepted as having similar face values for economic transactions. The terms “good” and “bad” money are used in a technical, non-literal sense, and with regard to exchange values imposed by legal-tender legislation, as follows:

Good 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 is not a purely theoretical result, but rather may be observed today in bullion coins such as 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 than in anonymous hunks of precious metal, so they attribute more value to the coins. As there is also demand from coin collectors, coining is frequently profitable.

Bad money

“Bad” money is money that has a commodity value considerably less than its face value, is in circulation along with money with a relatively higher commodity value, and with both forms 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. Other examples of “bad” money include counterfeit coins made from base metal.

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, but the face value of the debased coins was held at the higher level by legal tender laws.

All modern money is “bad money” in this sense, since fiat money has entirely replaced the commodity money to which Gresham’s law applies. [Emphasis mine - LLJ] This money is not redeemable for any kind of valuable commodity, relying entirely on the government’s decree for its legitimacy, and valued purely in terms of the quantity of money in circulation relative to available goods. The ubiquity of fiat money could indeed be taken as evidence for the truth of Gresham’s law.

Hat tip to Kenneth Anderson.

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Tags: fiat currency, gold

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