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Gresham's law is stated as, "Where legal tender
laws exist, bad money drives out good money".
Gresham's law applies specifically when there are two forms of money in circulation which are forced, by the application of
legal tender laws, to be respected as having the same face value in the marketplace. The Law has been applied in many fields
other than finance or economics. It
is named after Sir Thomas Gresham, an English financier in Tudor times.
The terms "good" and "bad" money are used in a technical sense:
- Good Money: Money whose face value is equal to the intrinsic or historic value of the material it is made of. An example is
the US dollar, which, prior to the 1900s was equal to 1/20.67 ounce (1.5048 g) of gold.
- Bad Money: Money that has an intrinsic or historic value less than its face value. In Gresham's day, this was coins that had been "debased," usually by cutting or scraping some of the metal off. Other examples of "bad" money would be counterfeit coins and coins issued by the mint that are minted from metal with a lower market value than
previously. In modern times bad money is recognised as, for example, the 1965 US Half-Dollars which were made from only 40%
silver. The previous year the half-dollar was 90% silver. With the release of the 1965
dollar, which was legally required to be accepted at the same value as the previous year's 90% halves, the older 90% silver
coinage of the US began to be hoarded while the debased money was allowed to circulate in its stead.
Gresham's law says that the money forced into circulation under legal tender law tends to be dominated by the "bad" money.
This is because people will spend the "bad" coins rather than the "good" ones and hoard the "good" ones. If the good coins have a
face value below the value of their metallic content they will even go as far as to melt them down and sell the metal for what it
is worth. The "good" coins also tend to retain more lasting value for international traders, since overseas traders are not bound
by legal tender laws. The coins then leave their country of origin. Thus the good money escapes legal tender laws, and leaves the
"bad" money behind. This occurred in Britain during the period of the Gold Exchange Standard.
This shows that in the absence of legal tender laws Gresham's law works in reverse. When people are given the free choice
between accepting good money or accepting bad money, the value of all money finds its intrinsic or historic value in the
marketplace. In a free economy, bad money becomes less popular than good money, and is eventually driven back to the refineries.
Thus, for bad money to drive out good, as stated in the first paragraph, legal tender laws are necessary.
Like many other supposed laws in economics, Gresham's Law is founded on theoretical argument rather than empirical evidence -
as the above description demonstrates. The law is thus open to challenge by opposing theory. It is also open to challenge by the
collection of real data, as opposed to the "stylised facts" on which the theoretical argument depends. In recent decades,
Gresham's law has been challenged both theoretically and empirically. 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. On the empirical
front, the repeated experiences of dollarization in economies with weak
economies and currencies (for example Israel in the 1980s, the Eastern European countries in the period
immediately after the collapse of the Soviet block, or South American countries throughout the late twentieth and early twenty-first
century) can be seen as Gresham's Law operating in its reverse form (Guidotti & Rodriguez, 1992), since in general the
dollar has not been legal tender in such situations, and in some cases its use has been illegal.
The same principle has been applied to many different fields, to the point where the phrase "Gresham's Law", used outside
economics, is almost a cliché. For example, in higher education, "Diploma mills" have come into existence to produce lower-cost qualifications of
little or no inherent value. According to Gresham's law as it applies to money, these "bad" diplomas ought to drive out the "good
diplomas". However, unlike with legal tender laws for money, there is no law forcing employers to accept all diplomas as being of
equal value. Consequently, each employer is free to assess the value of qualifications on the free market based on where they
came from, and to judge the value each diploma as they see fit, and it is therefore optimistically believed that diploma mills
will be driven out of existence.
The first recorded expression of Gresham's law is probably to be found in the play The Frogs written by Aristophanes and usually dated at
405 B.C.:
- 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....
References
- 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 law or Gresham fallacy. Journal of Political Economy, 94,
185-199.
See also
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