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

by Robert Mundell
Nobel Prize for Economics, 1999

 

2. Faulty Renderings

Gresham's Law has been frequently misinterpreted even by high authorities. In an article in the authoritative Palgrave's Dictionary of Political Economy, Harris (1927) starts off well but ends with a bad mistake:

[Gresham's Law] denotes that well-ascertained principle of currency which is forcibly though not quite adequately expressed in the dictum--"bad money drives out good." It has also not infrequently been explained by the statement that where two media of exchange come into circulation together, the more valuable will tend to disappear. The principle in its broadest form may be stated as follows: --Where by legal enactment a government assigns the same nominal value to two or more forms of circulatory medium whose intrinsic values differ, payment will always, as far as possible, be made in that medium of which the cost of production is least, and the more valuable medium will tend to disappear from circulation; in the case where the combined amount in circulation is not sufficient to satisfy the demand for currency, the more valuable medium will simply run to a premium."

Leaving aside the confusion between "intrinsic value" and "cost of production," the main error here is the view that where both currencies are needed to circulate, "the more valuable will simply run to a premium." This is merely a variant of Macleod's mistake that "good and bad money cannot circulate together."

In his History of Economic Analysis, Schumpeter made two rather derogatory assertions about the 'law.' The first is that "The so-called 'law' can be found in many earlier writings." The second--and this is an odd statement--is that it does not matter: "Considering its trivial nature, the question of priority is, however, without interest."

Schumpeter's comment points up a paradox: the law is trivially easy to understand, but then why does everybody get it wrong?

It must be conceded that one aspect of Gresham's Law seems trivial. People are motivated by the law of economy:(19) "Choose the most useful among goods with the same cost; and its "dual," choose the cheapest from among goods that give the same benefit." The application to money is straightforward: of two types of payment, pay with that which involves the least sacrifice. If one type of money is "good" and the other "bad," pay with the bad and keep the good.

There is no end to illustrations of this aspect of the principle. To make a payment of, say, $100, you might choose from among any valid combination of denominations of 100s, 50s, 20s, and so on not excluding coinage. Portfolio preferences--no pun intended--would determine which notes and coins you want to keep rather than spend. A key element in the law is that all payments must be acceptable to the seller as payment, either by force of law or convenience. Coins, for example, might not be legal tender beyond a certain limit, but might nevertheless be acceptable to the buyer. On the other hand, a buyer might prefer to retain coins needed, say, for parking meters, telephones or laundromats.

Every thinking individual makes such choices all the time as a matter of course. The idea has virtually ubiquitous applications. In the economics of charity, a donor will choose the cheapest from among potential gifts that yield the same utility to the donee. The theorem has a dual. It is that from among gifts costing the same, the donor will choose that which will produce the most utility to the donee. All these ideas are straightforward applications of the theory of rational behavior.

It is in the sense that the motivation behind Gresham's law is the theory of rational behavior that makes Schumpeter think the law is "trivial." But another word is "fundamental!" Leaving aside the choice of words, the law of economy even in its application to payments is not Gresham's Law. Gresham's Law is a theorem about the composition of money in an economy, not a theory of motivation. Schumpeter's error is in mixing up the motivating principle of microeconomics with one of its macroeconomic consequences.

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