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

by Robert Mundell
Nobel Prize for Economics, 1999

12. Conclusions

Gresham's Law, properly understood, can be a powerful tool in the hands of historians for the study of monetary history. The catchy phrase, "bad money drives out good," is not a correct statement of Gresham's Law nor is it a correct empirical assertion. Throughout history, the opposite has been the case. The laws of competition and efficiency ensure that "good money drives out bad." The great international currencies -- shekels, darics, drachmas, staters, solidi, dinars, ducats, deniers, livres, pounds, dollars -- have always been "good" not "bad" money.

Gresham's Law comes into play only if the "good" and "bad" exchange for the same price. "Good money drives out bad if they exchange for the same price" is an acceptable expression of Gresham's Law. But a better statement of it is that "Cheap money drives out dear, if they exchange for the same price." Put in this way, Gresham's Law becomes a theorem of the general law of economy, a consequence of the theory of rational economic behavior.

A common application of Gresham's Law arises when coins deteriorate after long usage. At any moment of time a stock of coins in circulation will consist of coins of different ages. The oldest coins in circulation may be much older than the newest coins, the former possibly in a considerably deteriorated condition. It is not true, however, that these coins cannot circulate side by side. Nor is it true that good coins will disappear on their own accord. If the demand for money is equal to the supply of money, no coins will be driven out. Gresham's Law is not a statement about static conditions; it is a statement about dynamic process.(67)

Bad coins will drive out good only if a change occurs to bring about an excess supply of money. An excess supply of money could result because of a decline in the demand for money. If this occurred in a closed economy, prices would start to rise and the value of the best coins as metal would be higher than their value as money, with the result that the best coins would be withdrawn from circulation until the excess supply of money had been eliminated. If, on the other hand, the economy were open to trade with the rest of the world, the good coins would be sent abroad until the money supply were reduced to its equilibrium level.

An excess supply of money could also arise because the government increases its supply. If the government issues new full-valued coins, they will be exported or withdrawn in hoards and the composition of the money supply will be unchanged. If, on the other hand, the government issues lighter or debased coins -- like Dionysius, Nero, John the Good, or Henry VIII -- the best of the coins already in circulation will be exported or otherwise withdrawn from circulation and the average quality of the coins in circulation will deteriorate.

The introduction of paper money is a more extreme case of debased or lightened coins in the sense that the value of the material of which money is made is almost nil. Paper notes or new bank credit would displace part of the coinage, and it would as always be the best part of the coinage. As we saw above that is exactly what occurred in the late 1690s in Britain when the issue of paper notes by the newly-created Bank of England displaced an equal quantity of the best coins. The authorities at that time could not understand why the best coins were being exported despite the cruel punishments of branding, hanging and burning at the stake. It shows also that the genius of Locke and Newton was no substitute for an idea whose time had not yet come.

Gresham's Law has powerful explanatory power in the world of free-coinage bimetallism that dominated the international monetary system for most of the two centuries between the 1660s and the 1870s. Given a world market price of gold in terms of silver -- the bimetallic ratio -- a country puts itself predominantly onto gold if it overvalues gold, and onto silver if it overvalues silver. Thus, when the United States established bimetallism at the Hamiltonian ratio of 15:1, it undervalued gold and overvalued silver relative to the international ratio around 15.12:1; thus the U.S. was de facto on a silver standard after 1792. But when the ratio was altered in 1834 to 16:1, it overvalued gold and the U.S. moved de facto to a gold standard. Similar stories can be told of other countries, most spectacular perhaps being the case of Britain when Newton's recommendations in 1717 overvalued gold relative to the European continent, at a time when Brazilian gold supplies were increasing, nudging Britain toward the gold standard.

Gresham's Law depends on two kinds of money being equivalent for some purposes but not for others. Two coins or notes might be equivalent in all respects except that one is legal tender and the other is not. In most countries, for example, central bank notes are legal tender whereas bank deposits are not, while coins usually have a limit on their legal tender feature. The power of a state to determine that which constitutes legal tender is an important aspect of monetary sovereignty. It is also a privilege that has been subject to great abuse by inflation-prone governments.

The study of coin hoards, in conjunction with an understanding of Gresham's Law, can yield important historical information.The existence of buried hoards often points to an era of insecurity. The frequencies of particular coins in hoards gives clues to monetary circulation in different times. Insofar as hoards are most likely to consist of "good" coins that have been driven out of circulation by "bad" coins, it is also possible to draw inferences about the monetary policies at the time the coins disappeared. A large concentration of heavy coins dated within a few years of one another would be prima facie evidence of an issue of overvalued coins.

Our discussion has been confined to the literal subject matter of Gresham's Law, i.e., its applications to the money sphere. It is of course a completely general law that holds whenever the isomorphism that constitutes its theoretical content applies. As Aristophanes knew as well as we, bad politicians drive out good, cheap conversation drives out dear, bad theory drives out good; cheap gifts drive out dear, bad food drives out good, and so on indefinitely. In each case the qualification must be made that from one standpoint (e.g., acceptability) good and bad have the same value.

It is, perhaps, fitting to close on an extension of Gresham's Law to the theory of money itself. The motivating force underlying Gresham's Law is economy: we settle a debt or transaction with the cheapest means of payment. But that is what money is! In the world of exchange, debts are settled in the cheapest medium possible. In the world of the gold standard, debts are not settled in wheat or oxen or fish, but gold, because gold is the cheapest means of settlement. Gold is the "bad" money that is "driven out" because it has the lowest costs of transport per unit of value. Silver, gold, paper, cheque money, and electronic transfers in succession become the means of settlement --the bad money that is driven out -- because they have been increasingly cheaper forms of payment. Thus it is that Gresham's Law can lead to insights into the very heart of monetary theory.

________________

For the past twenty five years, Robert Mundell has been Professor of Economics at Columbia University in New York . He studied at the University of British Columbia and the London School of Economics before receiving his Ph.D. from MIT. He taught at Stanford University and the Bologna (Italy) Center of the School of Advanced International Studies of the Johns Hopkins University before joining, in 1961, the staff of the International Monetary Fund. From 1966 to 1971 he was a Professor of Economics at the University of Chicago and Editor of the Journal of Political Economy; he was also summer Professor of International Economics at the Graduate Institute of International Studies in Geneva, Switzerland. In 1974 he came to Columbia University. He has written extensively on the history of the international monetary system and played a significant role in the founding of the euro. In 1983 he received the Jacques Rueff Medal and Prize in the French Senate; in 1997 he became a Distinguished Fellow of the American Economic Association; in 1998, he was made a fellow of the American Academy of Arts and Science; and in 1999, he received the Nobel Memorial Prize in Economic Science.

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