Gresham’s Law

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Gresham’s law is often stated in a simplistic and aphoristic form as “bad money drives out good money.” It means in practice that if two coins are in circulation, perhaps one silver and one gold, the public always wants to hoard the coin that has a face value equal to or less than the market value of the coin’s precious metal value. In turn, the public will use coins with a face value greater than their market value as precious metal to pay off debts and pay for goods and services. Coins with a face value less than the market value as precious metal can always be melted down and sold for a profit, causing these coins to disappear. The “bad money,” sometimes called debased money, is the money with a face value greater than the market value of its precious metal content, and it becomes the medium of circulation. The “good money” is the money whose face value is comparable to the market value of its precious metal content, and holders of good money are reluctant to give it up. In a country with debased money circulating alongside good money, the latter tends to flow into the hands of foreigners, domestic hoards, or goldsmiths’ melting pots, leaving only bad money in circulation, thus the phrase “bad money drives out good money.”

Gresham’s law owes its name to Sir Thomas Gresham, the foremost financial wizard of the Elizabethan era, who acted as a councilor to Elizabeth I and as the royal agent in European financial markets. England was on the silver standard and during the mid-sixteenth century, the silver value of England’s silver coinage had dropped from 75 percent of face value to 25 percent. Only 3 ounces of silver was in a coin that had a face value equivalent to 12 ounces of silver. Elizabeth I inherited the confusion and monetary disorder of the debasement policies of her predecessors, who had practiced debasement to build up England’s military defenses. Sir Thomas Gresham formulated Gresham’s law to explain the difficulty of introducing good money in a monetary environment dominated by bad money, explaining how bad money would drive out the good money. Gresham explained that the government ran the risk of coining full-valued money that would only end up in the hands of foreigners and the goldsmiths while the bad money remained in circulation. Gresham devised a policy based on a quick recall, revaluation, and recoinage of debased money combined with severe legal penalties for melting down or exporting the new coinage.

Although Gresham received the credit for formulating a law still discussed in modern economic textbooks, he was not the first to put the law into words. Aristophanes, the great comedic playwright of ancient Greece, writing in 405 b.c., remarked concerning Athens, “In our Republic bad citizens are preferred to good, just as bad money circulates while good money disappears” (Angell, 1929). A French theologian, Nicholas Oresme (c.1320–1382) wrote a book, A Treatise on the Origin, Nature, Law, and Alterations of Money, in which he explained the operation of Gresham’s law as one of the consequences of debasement.

In the modern world inflation of paper money has replaced debasement of coinage as a means of extracting more revenue for financially strapped governments. Gresham’s law can sometimes be seen in operation in countries where domestic currencies are depreciating from inflation, and United States dollars are hoarded as a preferred currency.