7/29/2019 Greshan Law

1/4

Greshams law,observation in economics that badmoneydrives out good. More exactly, if

coins containing metal of different value have the same value as legal tender, the coins composed

of the cheaper metal will be used for payment, while those made of more expensive metal will behoarded or exported and thus tend to disappear from circulation.Sir Thomas Gresham, financial

agent of Queen Elizabeth I, was not the first to recognize this monetary principle, but his

elucidation of it in 1558 prompted the economist H.D. Macleod to suggest the termGreshams

law in the 19th century.

Money functions in ways other than as a domestic medium ofexchange; it also may be used forforeign exchange, as a commodity, or as a store of value. If a particular kind of money is worth

more in one of these other functions, it will be used in foreign exchange or will be hoarded rather

than used for domestic transactions. For example, during the period from 1792 to 1834 the

United States maintained an exchange ratio between silver and gold of 15:1, while ratios inEurope ranged from 15.5:1 to 16.06:1. This made it profitable for owners of gold to sell their

gold in the European market and take their silver to the United States mint. The effect was that

gold was withdrawn from domestic American circulation; the inferior money had driven it out.

Bibliography

Table Of ContentsHelp us expand the resources for this topic. Click below to submit new publication for review

and accepted updates will be published to the site.

Gresham's Law

Posted Mon, 2010-02-01 18:21 by Anonymous

George Selgin, University of Georgia

Introduction

The proposition known as "Gresham's Law" is often stated baldly as "bad money drives goodmoney out of circulation." Ancient and medieval references to this tendency were informed by

circumstances in which lightened, debased, or worn coins had assigned to them the same official

value as coins containing greater quantities of precious metal. In this context the tendency, which

had yet to be elevated to the status of an economic "law," was one in which "bad" coins alone,that is, coins possessing a relatively low metallic content ("intrinsic value"), continued to be

offered in routine payments, while "good" coins were withdrawn into hoards, exported, or

reduced through clipping or "sweating" (that is, purposeful erosion by chemical or mechanicalmeans) to an intrinsic value no greater than that possessed by their "bad" counterparts.

Later writers, however, tended to stretch the meaning of Gresham's Law by invoking it as anargument against bimetallism and the competitive production of money and as the reason for the

historical substitution of paper for metallic moneys; and a recent work even goes so far as to treat

the law as being nothing more than an instance of the rule that rational agents prefer lessexpensive means of accomplishing their ends to dearer ones. As we shall see, although some

http://www.britannica.com/EBchecked/topic/389170/moneyhttp://www.britannica.com/EBchecked/topic/389170/moneyhttp://www.britannica.com/EBchecked/topic/389170/moneyhttp://www.britannica.com/EBchecked/topic/245848/Sir-Thomas-Greshamhttp://www.britannica.com/EBchecked/topic/245848/Sir-Thomas-Greshamhttp://www.britannica.com/EBchecked/topic/245848/Sir-Thomas-Greshamhttp://www.britannica.com/EBchecked/topic/197737/exchange-ratehttp://www.britannica.com/EBchecked/topic/197737/exchange-ratehttp://www.britannica.com/EBchecked/topic/197737/exchange-ratehttp://www.britannica.com/EBchecked/topic/197737/exchange-ratehttp://www.britannica.com/EBchecked/topic/245848/Sir-Thomas-Greshamhttp://www.britannica.com/EBchecked/topic/389170/money

7/29/2019 Greshan Law

2/4

modern interpretations of Gresham's Law can be regarded as legitimate extensions of the law's

original (and perfectly valid) meaning, others are entirely unwarranted. Indeed, inappropriate

applications of Gresham's Law have caused some economists to err in the opposite direction, byjumping to the conclusion that, because in these applications the law appears to be contradicted

by available empirical evidence, it must be altogether fallacious.

Attribution to Gresham and Ancient Status

The expression "Gresham's Law" dates back only to 1858, when British economist Henry

Dunning Macleod (1858, p. 476-8) decided to name the tendency for bad money to drive goodmoney out of circulation after Sir Thomas Gresham (1519-1579). However, references to such a

tendency, sometimes accompanied by discussion of conditions promoting it, occur in various

medieval writings, most notably Nicholas Oresme's (c. 1357) Treatise on money, and can even

be found in much earlier works, including Aristophanes' The Frogs, where the prevalence of badpoliticians is attributed to forces similar to those favoring bad money over good.

As for Gresham himself, he observed "that good and bad coin cannot circulate together" in aletter written to Queen Elizabeth on the occasion of her accession in 1558. The statement was

part of Gresham's explanation for the "unexampled state of badness" England's coinage had been

left in following the "Great Debasements" of Henry VIII and Edward VI, which reduced themetallic value of English silver coins to a small fraction of what that value had been at the time

of Henry VII. It was owing to these debasements, Gresham observed to the Queen, that "all your

ffine goold was convayd ought of this your realm."

Importantly, as Robert Giffen (1891, pp. 304-5) observed, Gresham made no direct reference to

bimetallism or to "the analogous case of inconvertible paper when the paper drives the metal outof circulation." However, Giffen (who appears here to have followed Jevons's lead) errs in

claiming that Gresham was "only responsible for the suggestion that bad coins ... drive goodones of thesame metalout of circulation," for Gresham's letter to Elizabeth clearly points to the

debasement ofsilvercoins as a factor leading to the disappearance of gold (Fetter 1932, pp. 490-1).It remains true nonetheless that the treatment of Gresham's Law as an argument against

bimetallism or resort to any sort of paper money are modern extensions of the law's original

meaning, the merits of (and implicit or explicit assumptions underlying which) must be assessedseparately from those of early versions.

Correct and Incorrect Interpretations

That bad coins have in fact often tended to drive better coins of the same metal out of circulation

is beyond dispute. Yet historical exceptions to this tendency have been observed. Thus even inits narrowest meaning Gresham's Law must be said to hold only under particular conditions.What are these conditions, and why are they crucial?

These questions may best be answered by first considering those exceptional cases in whichgood coins appear to have driven out bad ones rather than vice versa. The most notable of such

exceptions arose in the context of international trade, where, as Robert Mundell (1998) has

observed, "strong" currencies, meaning ones that tended to retain their precious metal value over

7/29/2019 Greshan Law

3/4

long periods of time, tended to dominate and drive-out "weak" (that is, less reputable) ones: "The

florins, ducats and sequins of the Italian city-states did not become dollars of the Middle Ages'

because they were bad coins; they were among the best coins ever made." Less well known butequally important exceptions to Gresham's Law involved relatively rare instances of competitive

coin production, one example of which was the competitive production of gold coins by private

mints in California in the wake of the gold rush. Here as well it was the higher-quality coins thatcaptured the market, allowing their makers to thrive while less reputable private mints failed(Summers 1976).

The main thing that distinguished these exceptions to Gresham's Law from other instances in

which the law appears to have applied was the lack of any rules or of any authority capable of

enforcing rules compelling people to accept particular coins in payment for goods or in the

settlement of debts at some officially designated nominal value. Thus while the Californiaprivate gold coins were, like those produced at the Philadelphia Mint, denominated in dollars,

none of them were legal tender, and people were free to value them as they pleased, or to refuse

them altogether. In practice only the better coins gained wide employment because others were

not considered to be reliable representatives of the pre-existing dollar unit, and because valuingthese inferior coins according to their actual gold content was inconvenient. In the market for

international exchange media a similar tendency for good coins to be favored over bad stemmedfrom the absence of government authorities capable of enforcing legal tender laws and otherrules compelling the acceptance of official coins "by tale" (that is, at par or face value, rather

than by weight) beyond national borders.

Gresham's Law can hold, on the other hand, where both good and bad coins enjoy similar legal-

tender status and where non-trivial sanctions can be applied to persons who insist upon

discriminating against bad coin and in favor of good coin. In such cases all coins must beaccepted by tale, and the employment of bad coin becomes a dominant strategy in what amounts

to a "Prisoners' Dilemma" game in which both sellers and buyers participate. Buyers, knowing

that sellers must accept either good and bad coins at their official face value, offer inferior coins,

while hoarding, exporting, or reducing better ones; sellers, anticipating buyers' dominantstrategy, price their wares accordingly (Selgin 1996). As Frank Fetter has observed in a classic

paper (Fetter 1932, pp. 494-5), the tendency for good coins (or metal made by melting metal

from good coins) to actually leave the country is the result, not of debasementper se, but of thetendency for prices, including the price of bullion, to increase in consequence of an overall

excess supply of coins. Debasement, including both official debasement and the unofficial

reduction of good coins, contributes to such an excess supply by allowing an increased nominalstock of money to be derived from any given quantity of metal.

Legal tender laws of varying degrees of severity have normally buttressed the "sovereign

prerogative" of coinage. In Gresham's England, for instance, the sovereign assumed the right toreinforce its monopoly of minting by "imposing penalties for the offense of refusing the king's

coins at the value set upon them by the king," and at least one act of Parliament (passed during

the course of the debasements) explicitly "forbade any person to receive or to utter any coin at aprice above the current value or proclamation rate." Penalties for disobeying such laws included

fines and imprisonment as well as the forfeiting of unlawfully exchanged sums. It is easy to

understand how such laws promoted the use of bad coin over good. On the other hand,

7/29/2019 Greshan Law

4/4

occasional changes to the legal status of bad coin, such as when Elizabeth elected (in response to

Gresham's advice) to "decry" (that is, to devalue) the bad shillings then in circulation, can serve

to bring good coin back into open circulation.

Failure to recognize the dependence of Gresham's Law upon laws interfering with the normal

course of voluntary exchange has been responsible for some of the cruder misapplications of thelaw, including the tendency to treat it as describing the inevitable outcome of any sort of

currency competition. A particularly egregious example occurs in William Stanley Jevons's

highly influentialMoney and the Mechanism of Exchange (1882 [1875], pp. 64 and 82), whereJevons argues that Gresham's Law supplies sufficient grounds for rejecting Herbert Spencer's

(1851, pp. 396-402) arguments for private coinage. Although Spencer was not an economist, his

arguments appear to have been more consistent with a proper understanding of Gresham's Law,

as well as with evidence from actual private coinage episodes in California and elsewhere.