What is Gresham’s Law and what does it mean? In this article, we’ll explain what Gresham’s Law is, the history behind it, modern examples of it in practice and how it can work in reverse.
Gresham’s Law is the monetary principle that “good money drives out bad money” when both forms circulate at the same time.
The reasoning behind Gresham’s Law
The theory comes from the time when mints created money using high-value metals like gold and silver. Sometimes, mints would mix high-value metals with lower-value metals to cut production costs. Despite this “debasement”, the coins created would theoretically have the same value as the high-value coins.
However, in practice, people knew the difference, which had a knock-on effect on their behaviour. They would choose to spend the poor quality money and keep the higher purity coins for themselves because they were more likely to have a worth greater than their face value in the future.
This is Gresham’s Law and it explains why debased coins (or bad money) drive good money (like pure gold coins) out of circulation. Sometimes, people even used debased coins at a discount to their face value.
How does Gresham’s Law work?
For Gresham’s Law to take effect, there must be a disequilibrium situation. Sir Thomas Gresham observed that, if the demand for money falls, the supply of coins in circulation must fall equally.
When this occurs, the best coins have a higher opportunity cost because of the higher value of their metal or their sales value abroad. Over time, the average quality of coins circulating gets worse. Conversely, if the demand for money increases, dishoarding occurs. The coins re-enter circulation and the average quality of the coins will improve.
At the very end of the process comes the debasement of the currency. The purchasing power of money falls and that leads to inflation. To combat it, governments resort to tactics such as precious metal confiscation and currency controls.
The essential condition for Gresham’s Law to operate is there must be two or more types of money. They must have equivalent value for some uses and a different value for others.
Gresham’s Law – then
One of the first to observe the effect of Gresham’s Law was Aristophanes in the 5th century BC. There are even stories of currency devaluation in the Bible.
Gresham himself was a sixteenth-century financial aid of the English Crown, known for explaining the law to Queen Elizabeth I during a crisis with devalued shillings. Her predecessors, Henry VIII and Edward VI, swapped out silver in shilling coins with basic metals, with the intention to inflate the government’s income without increasing taxes.
In a letter to the Queen, he explained that “good and bad coin cannot circulate together”. Author George Selgin noted that:
“The metallic value of English silver coins to a small fraction of what it had been … Gresham observed to the Queen that ‘all your fine gold left your realm’ because of these debasements.”
A more recent example of how bad money drives out good money occurred in the U.S. in 1982. In that year, the composition of the one-cent penny coin changed so that it now contained 97.5% zinc.
The previous coins contained copper. The price of copper rose significantly from an average of $0.6662 in 1982 to $3.0597 per pound in 2006. As a result, people began to harvest old pennies, the good coins, to melt down and sell.
This resulted in the U.S. introducing fines and even prison sentences for melting coins.
Gresham’s Law – now
The metal nickel is very in demand currently as a result of thanks particularly to its role in the manufacture of car batteries. In March 2022, if you melted one U.S. nickel coin (5 cents), the nickel metal in it would be worth approximately $0.079, almost 60% more than the face value of the coin.
Publication Market Business News covered this story as part of a wider write-up on Gresham’s law. They concluded that the U.S. Mint would likely begin to start using cheaper metals to make nickel coins.
In 2013, the Mint started to seek out a way of reducing costs when manufacturing nickel coins. They asked the National Institute of Standards and Technology (NIST) to design new coinage alloys. They wanted to find a cheaper way to produce nickel coins en masse.
At the time, it cost nine cents to make a five-cent nickel coin. The NIST formulated a new alloy composed of less nickel metal that would cost only 5.9 cents to make.
In 2015, the Government Accountability Office (GAO) reported on the matter. They claimed that the government could save $8-39m per year by changing the metal composition of the nickel, dime, and quarter coins.
In 2016, former President Barack Obama signed into law a provision that would make it possible for the U.S. Mint to switch to a cheaper metal for nickel coins. This change could take quite some time, but the chances of it happening are fairly high.
Gresham’s Law and crypto
In 2021, Kraken strategist Pierre Rochard predicted that more than half of all S&P 500 firms would hold Bitcoin on their balance sheets.
He forecasted a scenario where companies would spend a devaluing U.S. dollar before their Bitcoin or crypto holdings. CFOs would purchase crypto to sit on it and wait for its value to appreciate. This would create a feedback loop that would further inflate the value of cryptocurrencies.
His forecast was optimistic. As of January 2024, 28 public companies hold $11bn in Bitcoin according to CoinGecko.
Although he may have jumped the gun a little with his prediction, there is little doubt that it makes logical and financial sense in many ways. When widespread adoption of crypto happens, this is a feasible scenario.
How Gresham’s Law can also work in reverse
In cases of hyperinflation or severe inflation, you see an application of Gresham’s Law in reverse. The cause behind this is legal tender laws that mandate currency units to have an identical face value for transactions. That’s regardless of their intrinsic value.
In 2008, Zimbabwe suffered hyperinflation. The rapidly devaluing Zimbabwe dollar was the legal currency. In response to inflation, people use more stable foreign currencies for everyday transactions.
This led to a de facto dollarisation of the economy because the government couldn’t force people to use the country’s currency. Zimbabwe’s paper money suffered a great debasement from which it would never recover.
Venezuela is an example of dollarisation and Gresham’s Law. According to Zubair Bukhari, Kinesis operations executive:
“Under former president Hugo Chávez and current President Maduro, corruption, mismanagement and high levels of debt have resulted in the country’s economic collapse.
Venezuela’s economy is in shambles and the country was plunged into political chaos as a result of poor government decisions. This caused one of the most devastating circumstances of hyperinflation in recent times.”
Historically, bad money drives out good money. If you want to read more on Gresham’s Law in reverse, seek out the works of economist Robert Mundell.
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