What is Gresham’s Law and what does it mean? The history behind Gresham’s Law, modern examples and its importance in terms of finance.
Gresham’s Law can be described as a monetary principle that states that, “bad money will drive out good money.” The law was originally based upon the composition of coins and the overall tangible value of the metals used to make them. Since metallic currency use has dropped almost to the point of abandonment, Gresham’s law as a theory is now applied to the stability of different currency values in the global context. Gresham’s law states that overvalued currency will push out undervalued currency from circulation.
What Does “Good Money” vs “Bad Money” Mean
Gresham’s Law states that bad money will drive out good money from circulation. Bad money then becomes a currency in the market that has equal or less value compared to its overall face value. From there, good money becomes a currency that has greater value or the potential for more value.
- The basis of Gresham’s law involves the concept of good money (currency that is undervalued or more stable when it comes to internal value) and the concept of bad money (money or currency that is overvalued or possibly loses value quickly.)
- It can be assumed for this principle that both of these currencies are equally acceptable in terms of exchange, can be easily liquid, and are available to be used at the same time. Individuals in the market will opt to transact business with bad money and maintain hold balance on good money, as the latter has more potential to be worth more than its face value in the future.
How does Gresham’s Law Work?
Throughout the history of currency, coins have been composed of precious metals, such as gold, which gave the coins their natural value. However, over time, coin issuers would reduce the amount or percentage of precious metals used in their composition and attempted to implement them as full-value currency. The new coins with fewer precious metals would have less market value and would be traded at a discount or, simply, not at all, while older coins that actually were full-value would retain more value. As government laws establish that new coins must have the same face value as old coins, then new coins are now overvalued while old coins are legally undervalued. Governments and similar coin issuers would do this to gain revenue via seigniorage and use that revenue to pay older debts back into new coins at par value.
Since the value of the metal in older coins are higher than metal found in new coins at face value, citizens have a very transparent incentive to prefer those old coins with higher precious metal content. As long as both types of coins must be treated as the same unit of currency, buyers will pass their less precious coins on as fast as they can and hold onto their older coins.
These coins could be melted down and sold for the metal they contain or be hoarded to increased stored value. Bad money will then circulate through the market and economy, and good money gets removed from market circulation.
The end of this process is known as currency debasing, in which there is a decline in the purchasing power of those currency units, leading to inflation. In order to combat Gresham’s law, governments will resort to messy tactics such as currency control and confiscations of precious metals.
Why is Gresham’s Law Important?
Gresham’s law is important because it continues to play out in the modern economy for the exact reasons it was applied in the first place. It all comes down to legal tender laws.
Without effectively enforced legal tender law, good money will drive out bad money because individuals can simply refuse to accept the less valuable currency as a way to pay for transactions. When currency units are mandated by law to be recognized at an identical face value.
When hyperinflation occurs, currencies from foreign sources will usually replace local currencies, which would be an example of Gresham’s law working in reverse. When a currency loses value quickly, people will stop using it quickly in favour of foreign currencies that are more stable, even if there are legal regulations in place.
One example of this could be the case of hyperinflation in the nation of Zimbabwe. In 2008, the inflation of the country’s currency annual rate was about 250,000,000%. While the Zimbabwe dollar still had to be legally recognized as the main currency, most people in the country started to stop using it in everyday transactions, which led to the government being forced to recognize de facto dollarization of the total economy. As the country faced a devastating economic crisis with an almost totally worthless currency, the nation’s government could not enforce its legal tender laws. As more stable (good) money pushed out the hyperinflated (bad) money, the country’s economy recovered.
In this context, Gresham’s law can just as well be considered across international currency markets and trade, since legal tender laws only really apply to domestic local currencies. In the global context, resilient currencies like the euro hold a lot more stability in terms of value over time and will often circulate as the international medium of exchange. That currency is then used as the global pricing reference for international commodities that are traded between countries. Currencies that are much weaker and a lot less stable, particularly currencies in less developed nations, will circulate rarely or not even at all outside of the currency’s local jurisdiction. With global competition between a variety of currencies, and without an individual global currency (universal currency), good money will continue to circulate and bad money will continue to be kept out of general circulation by the overall operation of the market.
The History Behind Gresham’s Law
However, a sixteenth-century financial aid of the English Crown named Sir Thomas Gresham was one proponent of the law that explained the phenomenon to Queen Elizabeth I during a crisis with devalued shillings. The king before her, Henry VIII, had replaced a significant amount of silver in shilling coins with basic metals in order to inflate the government’s income without increasing taxes. The bad money would be used when possible, while the good money would be saved and thus would disappear from circulation.
In his paper on the phenomenon, economist George Selgin broke down the interaction that eventually claimed Gresham’s name.
Gresham’s Law Modern Examples
One example of Gresham’s law can be found in the United States today. Coinflation implies that a nickel’s metal content is worth just a little over 20% more than the nominal face.
A writeup on Gresham’s law for Market Business News broke down how and why the U.S. Mint will likely use cheaper metal to make nickels.
Back in 2016, former President Barack Obama had signed into law a provision that would make it possible for the U.S. Mint to switch to a cheaper metal for nickels.
“When the change does happen, Gresham’s Law will definitely go into effect,” the article continues, “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 their metal content is not switched, each one will still be worth a nickel.”
This change could take quite some time, but the chances of it happening are fairly high.
“My boldest prediction is that if we take the S&P 500, the world’s largest corporations, I think that by the end of 2021, more than half of them will have Bitcoin on their balance sheet, and I think that will be driven by simple economics, which is that issuing shares to buy Bitcoin causes your stock price to go up more than the dilution,” said Rochard, “And so because that is the case – we have market data showing this – we’re going to see a huge amount of corporate adoption of Bitcoin, and we’ll even see like what [MicroStrategy CEO] Michael Saylor is doing, corporations issuing large quantities of bonds, fixed-income instruments – whether they’re convertible or whatever – in order to just bulk buy Bitcoin. So the way the sound money drives out bad money is what’s called Thiers’ law. And Thiers’ law is actually the inverse of Gresham’s law. And Thiers’ law, really the practical implication of it is that eventually, the recipient of the payment – not the sender, the recipient of it – is going to refuse fiat.”
It’s likely that USD is going to lose value quite fast, so corporations will be much more interested in bitcoin. In fact, many companies convert their USD funds into bitcoin already.
Bitcoin could be seen as the ultimate example of good money in action because it is impossible to debase it. There is a stable, fixed amount of bitcoin available right now, and the rate of new bitcoin is programmed to reduce over time. Eventually, the new supply will disappear entirely. In this case, Gresham’s law is stipulating that good money will be saved instead of spent. This is happening now with bitcoin, as forensic studies show that the majority of bitcoin is held instead of traded or spent, returning it to circulation. Investors tend to purchase bitcoin and sit on it. This tendency to hoard bitcoin instead of trading in or spending it has led to the reduction of circulated bitcoin. If a thousand dollars of bitcoin goes into storage and never comes out, the impact of the supply and demand balance is no different than reducing bitcoin supply by a thousand dollars forever.
The more investors realize that other investors are sitting on their bitcoin to escape the bad money (fiat currency), the more incentive they have to sit on bitcoin in the long-term instead of spending it or trading it. This creates a feedback loop that is powerful. As fiat currencies continue to be debased at a high rate, the more bitcoin people will hold instead of trading it. This reduces the bitcoin supply further and kicks up its price via large supply and demand imbalance.
The Reverse of Gresham’s Law – Theirs’ Law
There is also an opposite principle known as Theirs’ law. This principle was established and argued for by Rolnick and Weber (1986) in an influential theoretical essay. The two argued that bad money could drive good money to a premium, instead of simply driving it out of circulation.
However, the research they conducted did not take into account the market-based context in which Gresham made his initial observation for the law. The two did not take into account the influence of legal tender legislation, which will require people to accept both good and bad money as if they were of equal value.
They also focused a little too much on the interaction between different metallic currencies, comparing the overall “goodness” of silver gold, which is not what Gresham was describing in his original theory.
The experiences of dollarization in nations with not-so-strong market economies and currencies could be seen as Gresham’s law operating in its reverse form, because overall, the dollar has not been legal tender in these kinds of situations, and in a few cases has actually been illegal.
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