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

by Robert Mundell
Nobel Prize for Economics, 1999

 

3. Good Money Drives Out Bad?

The usual expression of the law, "bad money drives out good" is a mistake. Schumpeter refers to this common definition as "not quite correct."(20) But as the statement stands, it is not just "not quite correct;" it is quite false. The opposite is true!

Standing by itself, the general statement, "good money drives out bad," is the more correct empirical proposition. Historically, it has been good, strong currencies that have driven out bad, weak currencies. Over the span of several millennia, strong currencies have dominated and driven out weak in international competition. The Persian daric, the Greek tetradrachma, the Macedonian stater, and the Roman denarius did not become dominant currencies of the ancient world because they were "bad" or "weak." The florins, ducats and sequins of the Italian city-states did not become the "dollars of the Middle Ages" because they were bad coins; they were among the best coins ever made. The pound sterling in the 19th century and the dollar in the 20th century did not become the dominant currencies of their time because they were weak. Consistency, stability and high quality have been the attributes of great currencies that have won the competition for use as international money.

The same proposition holds with respect to the use of materials for international money. The precious metals won out over other substances not because they were "cheap" or "bad" but because they were more efficient than other instruments in fulfilling the required functions of money. Among the precious metals, gold drove out others not because gold was bad but because it was more efficient from the standpoint of effecting transactions at the least cost. The dollar became the dominant international money in a world of paper currencies not because it was "bad" but because, among the alternatives, it best satisfied the characteristics of an international money.

If Gresham's Law could be rendered coherently as "bad money drives out good" it would have no claim to our attention as a serious proposition of economics. On the contrary, it is a completely false generalization, and an invalid rendering of Gresham's Law.

4. Cheap Drives Out Dear If They Exchange for the Same Price

A more correct (but not perfect!) rendering of Gresham's Law is that "Bad money drives out good if they exchange for the same price." If, for example, both monies are legal tender, and thus equally capable of paying a debt or making a purchase, the 'bad" money will drive out the "good" money.

It is further necessary, of course, to define the sense in which one money is "bad" and the other "good." The sense in which it is relevant to Gresham's Law is that "good" money has one or more alternative uses that do not apply to the "bad" money. The essential condition for Gresham's Law to operate is that there must be two (or more) kinds of money which are of equivalent value for some purposes and of different value for others.(21)

The most typical instance leading to the generalization was the circulation of a particular type of coin, say a silver drachma, in different conditions. Say one is new and the other, badly worn. If both coins are legal tender at their face value, they are equivalent from the standpoint of effecting an internal payment. But they have different values if they were melted down for their commodity values, and in international exchanges where the coins will be valued only (or mainly) for their silver contents. In short, in their roles as internal means of payment, they are equal in value, but otherwise the new coin is worth more than the old.

The fact that the two coins have different external values does not mean that they cannot circulate side by side in a state of equilibrium. As long as the worn coins are insufficient to satisfy the total demand for money, old and new coins can and will circulate together without any premium on the good coins being required or possible.

For Gresham's Law to be activated, there must be a disequilibrium situation. Suppose the demand for money falls. This means that the supply of coins in circulation must fall to an equal extent. Which coins will disappear? Certainly not the worn coins that have a low opportunity cost as metal or sales value abroad. The best coins will disappear abroad or be hoarded, and the average quality of the coinage will deteriorate. The opposite would happen if the demand for money increased: the good coins would be dishoarded or imported and the average quality of the coinage would improve.

Under ordinary circumstances, the old and new coins can circulate side by side as long as the balance of payments is in equilibrium. But should the occasion arise that the country develops a deficit, the difference between the coins will be apparent: the worn coins will have only their value as money at home but the new coins will have their value abroad without discount and will therefore be used to settle the deficit. Automatic forces would thus restore equilibrium. But if the deficit is perpetuated by sterilization operations or otherwise, the good coins will eventually disappear and the coinage will be increasingly composed of "bad" coins, leading eventually to depreciation and inflation.

The tendency for good coins to disappear would become pronounced if the government introduced debased or lightweight coins. The "cheap" money would drive out the dear money. As we shall see later, this is exactly what happened when Athens introduced debased coins during the Peloponnesian War. As Aristophanes noted, all the best coins of Athens were anywhere but Athens!

Gresham's Law does not, of course, apply only in an international economy. The same process would take place in an isolated economy, closed to the rest of the world. Suppose again there are new and worn drachmas in a closed economy, and that the demand for money falls. Which coins will be "exported" to the non-monetary sector? Of course the new coins. The old coins would be weighed and discounted for use in industry and jewelry or hoarded for future purposes.

Coins depreciate with wear and tear, clipping and counterfeiting. New coins are also periodically introduced. At any given time, the money supply is composed of new and worn, clipped and full-bodied coins, all of which, however, may be accepted at face value. In some situations coins separated in age by hundreds of years may circulate side by side. In vast numbers of hoards of coins found over the centuries issued in ancient Rome, coins from the Republic are included in the same hoards as those in the reign of Diocletian, a span of over three centuries. The coins are homogeneous with respect to their legal tender value at home but very heterogeneous as far as their metallic and international values are concerned.

It should be apparent from the foregoing that, contrary to MacLeod's statement, good and bad money can and do circulate side by side. As long as the "bad" money is insufficient to fulfil the total money demand, some of the "good" money will have to remain behind to help. In the same way we see machinery of different ages and people of different abilities working side by side often with the same salaries. Nor is it true, as Palgrave's Dictionary asserts, that the "good" money will command a premium.(22) No premium can or will be paid.

It is important to realize that the introduction of an overvalued coinage does not necessarily cause depreciation or inflation. The overvalued coinage will displace some of the high quality coins but as long as some of the latter remain in circulation, it will not change the total supply of money. The quality of the money supply is changed, but not the quantity. Depreciation and inflation set in, subject to a minor qualification,(23) only after the fully-valued coins have disappeared. The same holds for an issue of paper money. The new paper money will drive out an equivalent value of coins. But it will be the best coins that disappear first, and the average quality remaining will be lower.

The correct expression of Gresham's Law law is: "cheap money drives out dear, if they exchange for the same price." That proposition is neither trivial nor obvious.

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