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Gresham\'s law is commonly stated: "Bad money drives out good." Or, more precisely: "When there is a legal-tender currency, bad money drives good money out of circulation." Or, more accurately: "Money overvalued by the State will drive money undervalued by the State out of circulation."
Gresham\'s law applies specifically when there are two forms of commodity 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.
Gresham\'s law is named after Sir Thomas Gresham (1519 – 1579), an English financier in Tudor times.
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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 is money that shows little difference between its exchange value and its commodity value. In the original discussions of Gresham\'s law, money was conceived of entirely as metallic coins, so the commodity value was the market value of the coined bullion of which the coins were made.
An example is the US dollar, which through 1934 was equal to 1/20.67 ounce (1.5048 g) of gold — and carried an exchange value (at those fixed rates) roughly equal to its coined-gold market value. Subsequently, from the 1934 devaluation by Roosevelt (Executive Order 6102) through late 1971 (the Nixon Shock), the US dollar was equal to 1/35 ounce (0.887 g) of gold.
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 Krugerrand (South Africa) and the American Gold Eagle (United States). Coined money is of a known purity, and in a convenient form to handle. People prefer trading in coins than in anonymous hunks of bullion, so they attribute more value to the coins. There is also a certain demand from coin collectors. Thus, coining is frequently profitable.
Bad money is money that has a substantial difference between its commodity value and its market value, where market value is lower than exchange value, or the actual value is lower than the market value.
In Gresham\'s day, bad money included any coin that had been "debased." Debasement was often done by members of the public, cutting or scraping off some of the metal. Coinage could also be debased by the issuing body, whereby less than the officially mandated amount of precious metal is contained in an issue of coinage, usually by alloying it with base metal. Other examples of "bad" money include counterfeit coins made from base metal. In all of these examples, the market value was the supposed value of the coin in the market.
In the case of clipped, scraped or counterfeit coins, the market value has been reduced by fraud, while the exchange value remains at the higher value. On the other hand, with coinage debased by a government issuer the market value of the coinage was often reduced quite openly, but the exchange 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. The ubiquity of fiat money could indeed be taken as evidence for the truth of Gresham\'s law.
Gresham\'s law says that any circulating currency consisting of both "good" and "bad" money (both forms required to be accepted at equal value under legal tender law) quickly becomes dominated by the "bad" money. This is because people spending money will hand over the "bad" coins rather than the "good" ones, keeping the "good" ones for themselves.
Consider a customer purchasing an item which costs five pence, who has in their possession several silver sixpence coins. Some of these coins are more debased, while others are less so — but legally, they are all mandated to be of equal value. The customer would prefer to retain the better coins, and so offers the shopkeeper the most debased one. In turn, the shopkeeper must give one penny in change — and has every reason to give the most debased penny. Thus, the coins that circulate in the transaction will tend to be of the most debased sort available to the parties.
If "good" coins have a face value below that of their metallic content, individuals may be motivated to melt them down and sell the metal for its higher bullion value, even if such defacement is illegal. For an example of this, consider 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 half, 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 quickly disappeared from circulation, and the debased money was allowed to circulate in its stead. As the price of bullion silver rose above the face value of the coins, many of those old half-dollars were melted down. With the 1971 issue the government gave up on including any silver in the half dollars. A similar situation is currently (2007) occurring with the rising price of zinc and copper, and has led the U.S. government to ban the melting or mass exportation of one and five cent coins, respectively.
In addition to being melted down for its bullion value, money that is considered to be "good" tends to leave an economy through international trade. International traders are not bound by legal tender laws the way citizens of the country are, so they will offer higher value for good coins than bad ones, and thus higher value than can be obtained within the country. The good coins may leave their country of origin to become part of international trade. Thus, the good money is driven out of the country of issue, escaping that country\'s legal tender laws and leaving the "bad" money behind. This occurred in Britain during the period of the Gold Exchange Standard.
According to George Selgin in his paper "Gresham\'s Law":
Gresham made his observations of good and bad money while in the service of Queen Elizabeth, with respect only to the observed poor quality of the British coinage. The previous monarchs, Henry VIII and Edward VI, had forced the people to accept debased coinage by means of their legal tender laws. Gresham also made his comparison of good and bad money where the precious metal in the money was the same. He did not compare silver to gold, or gold to paper.
An early form of Gresham\'s Law was described by Nicolaus Copernicus in the treatise Monetae cudendae ratio, first drawn up in the year (1519) that Thomas Gresham was born. Copernicus wrote that "bad (debased) coinage drives good (un-debased) coinage out of circulation."Copernicus was aware of the practice of exchanging bad coins for good and melting down the latter or sending them abroad. Copernicus seems to have drawn up some notes on these lines while he was at Olsztyn (Allenstein) in 1519. He made them the basis of a report on the matter, written in German, which he presented to the Prussian Diet held in 1522 at GrudziÄ…dz (Graudenz), whither he had traveled with his friend Tiedemann Giese to represent the Chapter. He drew up an enlarged, Latin-language version (Monetae cudendae ratio) of his treatise, setting forth a general theory of money, for the 1528 diet. - Angus Armitage, The World of Copernicus, pp. 89-91 (chapter 24: The Diseases of Money).[1]
George Selgin in his paper "Gresham\'s Law" offers the following comments:
The passage from The Frogs referred to is as follows; it is usually dated at 405 B.C.:
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. However their research did not take into account the context in which Gresham made his observation. Rolnick and Weber ignored the influence of legal tender legislation which requires people to accept both good and bad money as if they were of equal value. They also focused mainly on the interaction between different metallic moneys, comparing the relative "goodness" of silver to that of gold, which is not what Gresham was speaking of.
The experiences of dollarization in countries with weak economies and currencies (for example Israel in the 1980s, Eastern Europe and countries in the period immediately after the collapse of the Soviet bloc, or South American countries throughout the late twentieth and early twenty-first century) may 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.
These examples show that in the absence of legal tender laws, Gresham\'s law works in reverse. If given the choice of what money to accept, people will transact with money they believe to be of highest long-term value. However, if not given the choice, and required to accept all money, good and bad, they will tend to keep the money of greater perceived value in their possession, and pass on the bad money to someone else. Said in another way, in the absence of legal tender laws, the seller will not accept anything but money of real worth (good money), while the existence of legal tender laws will force the seller to accept money with no commodity value (bad money). Thus, the buyer will always try to spend his bad money first, but in the absence of legal tender laws, the seller will not accept money with no real worth.
The principles of Gresham\'s Law can sometimes be applied to different fields of study. Gresham\'s Law generally speaks to any circumstance in which the "true" value of something is markedly different from the value people must accept, due to factors such as lack of information or governmental decree.
In the market for second hand cars, lemon automobiles (analogous to bad currency) will drive out the good cars. The problem is one of asymmetry of information. Sellers have a strong financial incentive to pass all cars off as "good" cars, especially lemons. This makes it chancy to buy a good car at a fair price, as the buyer risks overpaying for a lemon. The result is that buyers will only pay the fair price of a lemon, so at least they won\'t be ripped off. High quality cars tend to be pushed out of the market, because there is no good way to establish that they really are worth more. The Market for Lemons is a work that examines this problem in more detail.
Gresham\'s Law poses a similar trap in education.[1]Dochy, F. (2001). A new assessment era: Different needs, new challenges. Research Dialogue in Learning and Instruction 2, 11-20. For instance, The Economist, writing on the No Child Left Behind act\'s effect on U.S. schools, said:
Schools that respond to these incentives (and focus all their attention on those at the cusp of passing) in locations which allow easy switching of schools will tend to drive away the ignored students for whom the value of their education is not adequately captured by the Pass/Fail grade, as Gresham\'s Law predicts.
A case in education where Gresham\'s Law generally does not apply is with "diploma mills," schools that offer diplomas even to those with very low qualifications for a price. It may seem that according to Gresham\'s law these "bad" diplomas ought to drive out the "good" diplomas. However, unlike money, most countries have no law requiring employers to accept all diplomas as being of equal value. Each employer is free to assess the value of qualifications as they see fit. In those nations or governmental organizations where the law does require blindness, this effect does occur[citation needed].
Gresham Law was famously used by the current portuguese president Cavaco Silva to depict the mediocrity in political recruitment, clearly hinting that the at the time prime-minister Santana Lopes (a conservative populist who replaced Durão Barroso, nominated president of the EU Commission) was "bad money", driving away the high-profile credible politicians (the "good money"). After months of protests and instability, Santana Lopes was exonerated by president Jorge Sampaio, who called for a parliamentary election. Santana\'s party, the PSD eventually lost to Jose Socrates\'s socialist party. Cavaco Silva was elected President a year later.
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