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Uses and Abuses of Gresham's Law
in the History of Money

by Robert Mundell
Nobel Prize for Economics, 1999

5. The Replacement of Gold by Credit and Paper Money

Several propositions that imply or are the companions of Gresham's Law were widely known and used correctly by economists long before the law acquired its name. One of those propositions relate to the relation between paper money or credit and the precious metals. David Hume, writing in 1752, went to great pains to demonstrate that the existence of paper credit would mean a correspondingly lower quantity of gold, and that an increase in paper credit would drive out an equal quantity of gold.

Starting off which what he assumes to be the current condition in Great Britain, he writes:

"Suppose that there are 12 millions of paper, which circulate in the kingdom as money. . . and suppose the real cash of the kingdom to be 18 millions: here is a state which is found by experience to be able to hold a stock [of money] of 30 millions. I say, if it be able to hold it, it must of necessity have acquired it in gold and silver, had we not obstructed the entrance of these metals by this new invention of paper. Whence would it have acquired that sum? From all the kingdoms of the world. But why? Because, if you remove these 12 millions, money in this state is below its level, compared with our neighbours; and we must immediately draw from all of them, till we be full and saturate, so to speak, and can hold no more. By our present politics, we are as careful to stuff the nation with this fine commodity of bank-bills and chequer notes, as if we were afraid of being overburthened with the precious metals."(24)

Hume goes on to explain why some countries have more gold -- in proportion to population and wealth -- than others; it is because there is no credit to displace gold:

"It is not to be doubted, but the great plenty of bullion in France is in a great measure, owing to the want of paper credit. The French have no banks; merchant bills do not there circulate as with us; and usury, or lending on interest, is not directly permitted; so that many have large sums in their coffers: great quantities of plate are used in private houses; and all the churches are full of it. . .What a pity Lycurgus did not think of paper-credit, when he wanted to banish gold and silver from Sparta! It would have served his purpose better than the lumps of iron he made use of as money; and would also have prevented more effectually all commerce with strangers, as being of so much less real and intrinsic value."(25)

Adam Smith would develop the same idea in The Wealth of Nations with the use of paper money and applaud its use in the nation:

"The substitution of paper in the room of gold and silver money, replaces a very expensive instrument of commerce with one much less costly, and sometimes equally convenient. Circulation comes to be carried on by a new wheel, which it costs less both to erect and to maintain than the old one. . ."(26)

Gresham's Law can also be seen in its application to paper money and gold in recent centuries. Suppose the unit of account in a country (Britain) is the pound, and that its money initially consists entirely of gold sovereigns (valued at one pound). Suppose now the government introduces into circulation a legal-tender paper currency denominated in pounds to pay for, say, £1 million of its expenses. The addition to the money supply will create an excess supply of money, raising expenditure above income, and generating a balance-of-payments deficit that will have to be settled with gold sovereigns--given that the paper pounds are not acceptable abroad. Provided the national demand for money is unchanged, the £1 million of paper money will exactly displace 1 million gold sovereigns. The "bad" money in this case is the paper money because, unlike the "good" sovereigns, it cannot be used for making international payments.

Gresham's Law has other applications. We have considered Hume's and Smith's examples of credit or paper money driving out specie. But the same analysis applies to debased or light-weight coins driving out full-bodied coins. Examples abound in the ancient literature of the consequences of coinage debasement. From the very beginning of coinage, generally assumed, on the authority of Herodotus, to originate with 7th century Lydia, coinage was overvalued. The earliest coins were made of electrum, a natural alloy of about 70 percent gold and 30 percent silver. But hoards of the earliest coins found in the Temple of Artemis at Ephesus in 1904 contained "artificial" electrum coins with much lower gold contents. The weights of the stater coins (or its fractions) were uniform but the gold contents were as low as 30 percent. The Lydians and Greeks had not only learned how to use ancient Egyptian techniques of metallurgy, but also how to overvalue coins by using less of the more expensive metal and exploit the monetary prerogative as a fiscal device.

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