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“Gresham’s Law” – the tendency for bad money to drive good money out of circulation – is one of the most well-known propositions of economics. Although it is far from universally valid, provided it is appropriately qualified, by noting the particular conditions that can make it operate, it helps to account for many important episodes in the history of money. This chapter reviews early statements of Gresham’s Law and the circumstances that informed them. It then considers the determinants of currency selection in different market settings, starting with the case of unhindered market, so as to arrive at a more precise understanding of the factors that can cause Gresham’s Law to operate. Next it shows how Gresham’s Law can account for some past episodes involving irredeemable paper money and bimetallism, and why it cannot predict the consequences of private coinage, or explain the replacement of coins by redeemable paper money. The chapter ends by critically assessing Arthur Rolnick and Warren Weber’s claim that Gresham’s Law, even in its more carefully stated versions, is a “fallacy.”
KeywordsGresham’s Law Debasement Bimetallism Legal tender
Among the better-known propositions of economics, “Gresham’s Law” is often put bluntly as “bad money drives good money out of circulation.” Stated so it is, like many sweeping assertion, as likely to be at odds with experience as consistent with it. Indeed, as Robert Mundell (1998) has observed, were there nothing more than this to Gresham’s Law, instead of having a “claim to our attention as a serious proposition of economics,” it would be just one more “completely false generalization.”
Yet Gresham’s Law does deserve our attention, for provided it is stated carefully, with due attention to the special – but historically far from uncommon – circumstances to which it applies, it can account for, and shed light upon many important episodes in the history of money.
In this chapter I plan, first of all, to briefly review early statements of Gresham’s Law in order to consider the circumstances that informed them. I’ll then review the determinants of currency selection in different market settings, starting with the case of unhindered market, so as to arrive at a more precise understanding of the factors that may cause Gresham’s Law to operate. Next I’ll discuss how the law can be properly appealed to shed light on certain episodes involving irredeemable paper money and bimetallism, and how it has been improperly invoked to describe the likely outcome of private coinage and to explain the supplanting of coins by redeemable paper money. Finally I’ll respond to Arthur Rolnick and Warren Weber’s (1986) claim that Gresham’s Law, even in its more carefully stated versions, is a “fallacy.”
Early Statements of Gresham’s Law
Sir Thomas Gresham
To gain a proper understanding of Gresham’s Law, it is essential to consider just what its original exponents meant by it.
The expression “Gresham’s Law” itself dates back only to 1858, when British economist Henry Dunning Macleod (1858, pp. 476–478) decided to name the frequent tendency for bad money to drive good money out of circulation after Sir Thomas Gresham (1519–1579), the English merchant and financier who founded the Royal Exchange and served as advisor to four British monarchs, beginning with Henry VIII and ending with Elizabeth I.
Writing to Queen Elizabeth on the occasion of her accession, Gresham observed “that good and bad coin cannot circulate together,” and that this fact accounted for the “unexampled state of badness” to which England’s coinage had fallen in consequence of the “Great Debasements” of Henry VIII and Edward VI. Those debasements reduced the silver content of English silver coins to a small fraction of the standard that had prevailed during the reign of Henry VII; and it was thanks to them, Gresham told the Queen, that “all your ffine goold was convayd ought of this your realm.”
Copernicus and Oresme
In his brief remarks, Gresham, rather than explicitly appealing to a general principle, refers to a single episode only. Nicole (or Nicolas) Oresme and Nicolaus Copernicus had, as Macleod himself (1896, p. 38) eventually discovered, “fully explained the matter [of Gresham’s Law] 160 and 32 years respectively previous to Gresham.”
In his 1526 tract De monetae cudendae ratio (“On the principle of coining money”), Copernicus, in advising Poland’s King Sigismund I of the steps needed to rehabilitate Prussia’s debased currency, observed that previous debasements had driven away the better coins “so to speak, by main force,” and that to restore the old standard the debased coins would themselves have to be cried down. Otherwise, he explained, introducing new, full-bodied coins would prove futile, for then the better coins would either be diminished themselves or would disappear.
whenever the public currency was altered or tampered with in such a way as to bring into circulation two moneys, bearing the same designation but in reality having two different values, the money of lower value inevitably drove the money of higher value out of circulation. For the merchants found it to their advantage either to melt down the pieces of money that contained the higher amount of metal and to sell the bullion by weight or else to export the high weight coins to other lands. (Balch 1908, p. 23)
Although the main passage upon which the above summary rests has since been shown to have been written, not by Oresme himself, but by his French translator (Bridrey 1906, pp. 264–296), Oresme still came closer to explicitly stating Gresham’s law than Gresham himself did. In one indisputably authentic passage of his treatise he notes, for example, how “in spite of all vigilance and prohibition that may be taken,” mutations of the currency end up inspiring merchants and others to convey precious metal to “the places where they know these have a greater value” (quoted in Balch 1908, p. 23). It is, surely, but a small step from that observation to the conclusion that full-bodied coins will disappear from circulation, leaving their reduced substitutes behind.
Oftentimes have we reflected on a similar abuse
In the choice of men for office, and of coins for common use;
For your old and standard pieces, valued and approved and tried
Here among the Grecian nations, and in all the world beside,
Recognized in every realm for trusty stamp and pure assay,
Are rejected and abandoned for the trash of yesterday;
For vile, adulterate issue, drossy, counterfeit and base,
Which the traffic of the city passes current in their place. (Frere’s translation, as quoted in Balch 1908, p. 18)
The Context of Gresham’s Law
Each of these early references to what we now call Gresham’s Law took place against the background of deliberate reductions, through debasement or otherwise, of the metallic, though not the declared, value of official coins. Aristophanes’ play, for example, was written in 405 B.C., or just before the end of the Peloponnesian War. When that war began, Athenian silver coins had, thanks to their high and consistent quality, become the standard currency of the Ancient world. However, when, in 413 B.C., the Spartans seized Decelia, depriving Athens of access to its Laurion silver mines, the Athenian government was eventually compelled to strike copper (“brass”) coins for the first time, in 406 B.C. These “were made legally, for the time being, equivalent to their counterparts in silver” (Head 1888, p. xxviii). Oresme’s De Moneta was, according to Charles Johnson (1956, p. x), similarly “provoked by the successive debasements of the coinage by Philip VI and John II”: between 1351 and 1360, Balch (1908, pp. 22–23) tells us, the metallic content of the livre tournois changed “no less than seventy-one times.” As we have seen, Copernicus was also concerned with problems connected with debasement, and the difficulties involved in restoring “good” coin. Gresham’s remarks, finally, were inspired by Tudor England’s Great Debasement.
In each of these episodes, “Gresham’s Law” referred to the tendency of coins possessing a relatively low metallic content (“bad” money) to be employed in routine payments, while coins made of the same metal, but to a higher standard (“good money”) disappeared into hoards, or melting pots, or were themselves reduced through clipping or sweating to an intrinsic value no greater than that possessed by their inferior counterparts.
Currency Selection in Hindered and Unhindered Markets
An Unhindered Currency Market
To gain a more complete understanding of the conditions needed to put Gresham’s Law in motion, it is helpful to first consider the case of a free domestic currency market, meaning one in which there is neither government interference with the free selection and pricing of alternative currencies nor imperfect information regarding the different currencies’ qualities, as well as a world market for precious metals. It is easy to show that, in such an environment, Gresham’s Law does not apply.
Suppose, then, that there are no legal tender laws to compel the acceptance of coins by tale, that is, according to their officially declared value. Suppose as well that everyone possesses complete information regarding coins’ metallic composition. Finally, suppose that it is no more costly for coins to pass by weight, that is, according to their metallic values, than by tale. In such a setting, it should make no difference to merchants and their customers which coins they accept or proffer in exchange; coins would command values reflecting their metallic worth, and there is no reason why some would be preferred to others. Instead, better and worse coins of any given nominal value might co-circulate as “parallel” currencies. Goods might be priced in terms of both sorts of money, or one sort alone might serve as the medium of account, with the other trading at a discount (if “bad”) or a premium (if “good”).
Costly Nonpar Exchange
Evidently, to put Gresham’s Law in motion we must relax one or more of the assumptions made above. Let’s start by allowing it to be far more convenient for merchants to set prices and keep accounts in terms of a single medium of account only, and also for coins to pass by tale than by weight. Suppose as well that both “good” and “bad” coins are made available, where both have a face value of “one dollar,” but “good” coins contain substantially more precious metal. Which coins will be favored?
The intuitive answer is that market forces will favor the coins that are merchants’ chosen medium of account, and that therefore trade at par. But which coins will play this role? The answer is not clear: under laissez-faire, sellers might post prices in terms of either sort of coin. If they post prices in terms of “good” coins, those will trade at par, and “bad” coins, if they circulate at all, will do so at a discount, reflecting their lower metal content as well as the extra transactions costs merchants bear in dealing with them. If, on the other hand, sellers post prices in terms of “bad” coins, those will circulate at par, while “good” coins, if they circulate, will command a premium, albeit one that is less than proportional to their superior metallic worth. If nonpar exchange is sufficiently costly to merchants, nonpar money will not circulate. In that case, par money may be said to drive nonpar money out of circulation.
This last-mentioned outcome I dub “Rolnick and Weber’s Law,” after Rolnick and Weber (1986), who propose it as a possible alternative to Gresham’s Law, which they hold to be fallacious. I address their dismissal of Gresham’s law later in this essay. For now it will suffice to note that Rolnick and Weber’s Law is distinct from Gresham’s, because it suggests that either “good” or “bad” coins might disappear from circulation, depending on the type that trades at par, or, put differently, the type that serves as the “medium of account.”
A pure-coordination monetary selection game
Offer “Good” MoE
Offer “Bad” MoE
Employ “Good” MoA
Employ “Bad” MofA
An Asymmetrical Monetary Selection Game
To arrive at the Gresham’s Law outcome, we must move beyond the pure coordination game to one in which circumstances “nudge” players’ payoffs so as to favor a particular equilibrium. It is not difficult to imagine such circumstances. Suppose, for example, that one kind of money is more prominent than the other. Sellers may then expect to minimize transactions costs by posting prices in terms of that money (White 1984, pp. 177–178). Returning to the previous example, if the nominal outstanding quantity of “good” coins is known to be twice that of “bad”coins, sellers are likely to post prices in terms of “good” coins, openly signaling a preference for them. Buyers and sellers could then be expected to converge upon the “good” money equilibrium. Alternatively, suppose that, although they contain more metal, “good” coins are considered cumbersomely large, and therefore awkward to carry. In that case, sellers may anticipate having more customers arrive with “bad” coins and will post prices accordingly. In these instances the monetary selection game has a unique equilibrium. However, because the equilibrium in these cases may still favor either “good” or “bad” money, the conditions considered so far still do not suffice to give effect to Gresham’s Law.
Legal Tender Laws
To account for a systematic tendency for “bad” money to displace “good” money, it is necessary to appeal to other currency market imperfections. According to Richard Dutu (2004), two distinct sorts of market imperfections served the purpose in premodern currency markets. These were (1) legal tender laws and (2) imperfect information.
Mediaeval princes conceived that it was part of their inalienable Divine Right to alter the weight and name, and debase the purity of their Coin as much as they pleased, and to compel their subjects to receive the diminished and degraded and debased Coin at the same value as good, full-weighted Coin. This was termed Morbus numericus.
freedom of contract and of commerce did not exist in the sense in which we understand these terms. Government monopolized the function of coinage and enforced its monopoly by imposing penalties for the offense of refusing the king’s coins at the values set upon them by the king, and by prohibiting the currency of coins whose circulation would interfere with the coins issued from the king’s mints.
Legal tender laws might, of course, be more or less strictly enforced, and it was only relatively strict laws that served to give effect to Gresham’s Law. Yet such laws were not uncommon in premodern times; and they have occasionally been resorted to more recently.
Although they aspire to enforce the equal treatment of intrinsically distinct monies, legal tender laws influence currency selection, not (as some writings on Gresham’s Law suggest) by actually establishing an operational, fixed exchange rate between distinct currencies, but by making it costly for persons to openly assign distinct values to them, A legal-tender law might, for example, punish sellers who refuse or place a discount on “bad” money, while rewarding buyers who report such discrimination.
During the reign of Henry VII, for example, Parliament declared (19 Henry VII, c. 5) that all coins bearing the King’s stamp “should go and be current in payment through all this his realm for the sum that they were coined for,” and that all silver pence “having the print of the king’s coin, shall have course and be current for payment, as well to him in all his receipts, as to all his receivers, and to all other lords spiritual and temporal and their receivers, and to all other within this his realm, without any manner refusal or contradiction… Any person refusing to take coins in payment for the values aforesaid, to be liable to punishment at the decision of a justice.” Penalties for disobeying the law included fines and imprisonment as well as the forfeiting of any unlawfully exchanged sums.
From Pure Coordination to Prisoner’s Dilemma
In the presence of legal tender laws, a seller posting prices in terms of “good” coins would risk being penalized for refusing to accept “bad” ones at their face value. Such laws can therefore put Gresham’s Law in motion by turning the pure monetary coordination game described previously into a Prisoner’s Dilemma game.
Suppose, for example, that instead of receiving the payoffs shown in the above pure-coordination game, sellers who set prices in terms of “good” money, but are offered “bad” coins, receive a reduced net payoff of 1, because they must either accept such coins at their face value or risk being penalized. Buyers who offer “bad” money in turn earn an increased payoff of 5. If, on the other hand, buyers offer “good” money to sellers who set prices in terms of “bad” money, the payoffs are reversed. The exchange game now has a unique, “bad” coin equilibrium. Observe that this outcome does not depend on laws explicitly favoring “bad” money or making “good” money illegal.
The Gresham’s Law game
Offer “Good” MoE
Offer “Bad” MoE
Employ “Good” MoA
Employ “Bad” MofA
What becomes of “good” coins in the presence of strict legal-tender laws? If they are not to be traded at par for goods priced in terms of “bad” money, “good” coins may either be hoarded (in anticipation, perhaps, of a future change in the law) or exported: even strict legal-tender laws are difficult to enforce outside of domestic political boundaries (Miskimin 1989, p. 149). Alternatively holders of “good” coins may be encouraged to surrender them to the mint in return for a nominal profit to the mint: in order to supply “bad” coins, and thereby gain seignorage, a mint must secure a ready supply of precious metal, which it can do by sharing some of its nominal coining profits with those who supply it with needed raw material (Hicks 1969, pp. 90–91; Breckinridge 1903, pp. 34–36; compare Rolnick et al. 1996, who claim that “debasements provide no additional inducements to bring coins to the mint.”).
a citizen bringing a pound of silver to the mint would receive 584 good quality pennies. After that date he would have received 629 slightly lighter ones. If he assumed that the quality of silver was unchanged there was little real change in the deal he was being offered. In fact the silver content had been reduced from 0.925 to 0.75 fine. The mint equivalent was 768 pence. 139 pence, about 22 per cent, had been kept by the mint. This was nearly all profit, but a modest skim compared to what was to come. (ibid.)
Besides allowing their citizens to profit, if only in nominal terms, by bringing precious metal to the mint, medieval governments generally prohibited them from either retaining or dealing in bullion, meaning precious metal considered as a commodity. According to John Munro (2012, p. 317), “almost everywhere it was illegal to trade or to make transactions in bullion. For the law in most medieval countries or principalities stipulated that all precious metals deemed to be bullion (billon) – excluding metals for licensed goldsmiths – had to be surrendered to the prince’s mint for coinage.”
The great variety of coins, the imperfect coinage technique, frequent mutations, wear, the poor communication network, all these factors made it difficult for one type of coin to have a single price and a stable intrinsic content. Our thesis is that this imperfect information on coins was the source of large profits for people who invested in gathering knowledge on money – the moneychangers – and that their activity most of the time led to the driving out of the undervalued currencies.
those specialized in precious metals…sort out ancient coins, melt them again and then sell them to the silverer always receiving from inexperienced persons more money with the same amount of money. When older coins have almost disappeared, they choose the best from the rest and just leave the worst currencies. (quoted in ibid, p. 563)
Thus the inability of ordinary persons to afford to trouble themselves with determining the true metallic worth of different equally rated coins, particularly when relatively small amounts are involved, combined with the fact that others can profit by specializing in making just such a determination, may lead to be systematic disappearance of better coins even were strict legal tender laws are lacking.
Nor need the “specialists” responsible for this outcome be ones who deal in money and bullion exclusively: ordinary merchants might also find it worthwhile to start weighing or otherwise assessing coins, “putting aside those worth the most, melting them down and getting profit from them” (Dutu 2004, p. 564). But note that, whether merchants or other specialists do the culling, it must be the case both that coins pass by tale and that lighter coins serve as the de facto medium of account. Otherwise moneychangers and merchants would suffer losses to the extent that they received bad coins at par. To take advantage of the general public’s imperfect information, they must price their merchandise, whether it consists of other coins or of goods, as if they expected to be paid mainly in “bad” money.
the touchstone test – the common technology used to identify the fineness of coins in the early modern period – was accurate at best only to within two or three percentage points and required a great deal of specialized knowledge and instrument [sic]. This implies that for many consumers, the transaction costs of determining the intrinsic value of coins must have been prohibitive. Therefore, the general public likely handled coins by tale. On the other hand, merchants involved with large transactions especially in international trade and the government valued coins on their intrinsic value. (that is, by weight)
Munro (2012, pp. 317–318) likewise observes that in medieval times “even if it had been legal to make transactions in bullion, doing so would not have been economically feasible in terms of the required transaction costs: the cost of weighing the bullion, assaying it for fineness, and determining its market or exchange value.” Legal sanctions against nonpar exchange and the transactions costs of valuing coins according to their bullion content thus tended to reinforce one another in driving “good” coin, first into the hands of expert money changers, thence into melting posts, and finally (as bullion) either to foreign markets or back to the domestic mint in return for a nominal profit.
Extensions of Gresham’s Law
Although Gresham’s Law originally referred mainly to circumstances in which people were confronted with both “good” and “bad” coins bearing identical face values but containing different quantities of the same precious metal, the law, as William Stanley Jevons observed (1875, p. 84), may also be applicable to “the relations of all kinds of money, in the same circulation. Gold compared with silver, or silver with copper, or paper compared with gold.”
Irredeemable Paper Money
Just as a monetary authority might declare debased coins legally equivalent to full-bodied ones, so might it attempt to make irredeemable paper notes legally equivalent to coin. It seems only reasonable, then, to assume that Gresham’s Law might in this case cause coins to disappear from circulation.
There is, however, an important difference, to wit: that there’s no question of even less – sophisticated market participants being unable to appreciate the difference between paper money and coins, and of their tending for that reason to tender or receive either sort of money indiscriminately on that account. Strict legal tender laws are therefore likely to be of particular importance in causing “good” coins to be driven out of circulation, not by “bad” coins, but by irredeemable paper notes.
shall refuse to take Continental Currency in payment of any Debt or Contract whatsoever, or for any Goods, Merchandize or Commodity offered for sale, or shall ask a greater Price for any such Commodity in Continental Currency than in any other kind of money or specie….shall for the first offense be considered a dangerous Member of Society, and forfeit the Goods offered for sale or Bargained for, or debt Contracted, to the person to whom the Goods were offered for Sale or by whom they were bargained for, or for whom such Debt is due, and shall moreover pay a fine of five pounds to the State…; and every person so offending, shall for the second offence be subject to the aforementioned penalties, and be banished from this State, to such a place and in such manner, as this Council shall direct. (State of Pennsylvania 1852, pp. 70–71)
Evidently it is not always true, as Arthur Rolnick and Warren Weber (1986, p. 193) claim, that placing a premium on “good” money “would not be in violation of … legal-tender laws.”
According to Pelatiah Webster (1791, p. 129), resolutions like Pennsylvania’s were “executed with a relentless severity,” leading to the ruin of “Many thousand families of full and easy fortune.” Yet as the value of Continentals became increasingly doubtful, still harsher penalties were imposed on those who discriminated against them. By December 1780, Webster says, the penalty for refusing a dollar of Continental currency was greater than that for stealing ten times that amount (ibid., p. 137). William Graham Sumner (1892, pp. 48–52) refers to many specific prosecutions of persons accused of violating the laws in question.
Their severity notwithstanding, such laws were of course unable to make Continentals command the same value as their precious-metal counterparts. But they did achieve the unintended, Gresham’s Law outcome of driving specie out of open circulation. In fact, specie was seldom seen after its initial disbursement by newly arrived English and French troops, except among certain merchants who engaged in a regular, though clandestine, trade in it (Bezanson 1951, p. 320). Specie came out of hiding only after March 16, 1781, when Congress officially recognized its free-market value relative to paper money (ibid.). Although Charles Calomiris (1988, p. 697, n. 6) has called the subsequent re-emergence of specie, and concurrent disappearance of Continentals, “a clear contradiction of Gresham’s law,” it is hardly surprising that Gresham’s Law ceased to operate once Continentals were no longer assigned official specie values enforceable by law.
decreed any person selling gold or silver coin, or making any difference in any transaction between paper and specie, should be imprisoned in irons for 6 years: – that any one who refused to accept a payment in assignats, or accepted assignats at a discount, should pay a fine of 3,000 francs; and that any one committing this crime a second time should pay a fine of 6,000 francs and suffer imprisonment 20 years in irons. Later, on the 8th of September, 1793, the penalty for such offences was made death, with confiscation of the criminal’s property, and a reward was offered to any person informing the authorities regarding any such criminal transaction. To reach the climax of ferocity, the Convention decreed, in May, 1794, that the death penalty should be inflicted on any person convicted of “having asked, before a bargain was concluded, in what money payment was to be made.”
Nor were the government’s threats empty. A dozen men were in fact sent to the guillotine for the crime of hoarding specie (Harris 1930, p. 183). Small wonder that, under these circumstances, paper money alone circulated openly!
Although Robert Giffen (1891, pp. 304–305) has said that Thomas Gresham was “only responsible for the suggestion that bad coins … drive good ones of the same metal out of circulation,” and that he made no mention of either “the analogous case of inconvertible paper” or bimetallism, we have seen that in his famous letter to Elizabeth Gresham clearly alludes to bimetallism in attributing the disappearance of gold coins to the debasement of silver. It was, nevertheless, only in modern times, when debasement had largely become a thing of the past, that Gresham’s Law first gained prominence, no longer as an argument against princely abuses of the coinage prerogative, but as one against bimetallism.
When bimetallic legislation allows for both silver and gold coins representing a common monetary unit, the “mint equivalents” of the two metals (that is, the nominal value of coins struck from a given weight of either metal) imply a corresponding “mint ratio,” meaning the ratio of the metals’ official values. If coinage is gratuitous, or if coining charges are proportionally the same for both metals, the mint ratio is the same as the ratio of the metals’ “mint prices,” that is, the value of coins returned to those who surrender bullion to the mint for coining.
So long as the mint ratio coincides with the ratio of prices the metals command in the world bullion market, dealers in both metals will be willing to deliver them to the mint for coining, and full-bodied coins made of either metal can circulate simultaneously. If, however, the two ratios diverge substantially, one metal will be overvalued by the mint, while the other is undervalued by it. The undervalued metal will then cease to be coined, while extant coins made from it will tend to be treated as bullion rather than as money. If we then regard coins made from the overrated metal as “bad,” and those made from the undervalued metal as “good,” the tendency of de jure bimetallism to give way to de facto monometallism can be considered an instance of Gresham’s Law.
The tendency in question will, however, be limited by the fact that coins of different metals are unlikely to be equally useful in different transactions. In particular, gold coins will generally be of larger denominations, so that they cannot themselves satisfy the need for smaller change (cf. Sargent and Velde 2002). Consequently, even if gold is legally overvalued, and silver is no longer brought to the mint for coining, silver coins may not altogether disappear. Instead, they may circulate at a premium or (if that is too inconvenient) they may be clipped or sweated by private agents until their metallic values no longer exceeds their face value in gold, as happened in Britain during the eighteenth century. In the latter case, Gresham’s Law may still be said to hold in the strict sense that full-bodied coins of the undervalued metal cease to circulate.
England’s Switch to Gold
A famous instance of Gresham’s Law’s operating in a bimetallic setting is the one that led to Great Britain’s inadvertent shift from a de facto silver standard to a de facto gold standard. Although the English pound sterling had, as its name suggests, traditionally been a silver unit, when gold guineas were introduced in 1663, they were officially rated at one pound sterling, or 20 (silver) shillings. Bimetallism was thus formally established. However, because the implied mint ratio undervalued silver, which was then in great demand in the Far East, instead of bringing silver to the mint merchants would exchange it for gold, for which they could obtain a greater nominal quantity of guineas. The inevitable result was that full-bodied silver coins, instead of remaining in circulation, were clipped or melted down. Although in 1717 guineas were rated at 21 shillings, at that price gold was still overvalued. Consequently although it did not officially embrace gold monometallism until 1816, England had stumbled into a gold standard, without realizing it, more than a century before.
Bimetallism in the Antebellum United States
In 1792, the United States’ first Coinage Act provided for the free and gratuitous coinage of dollar coins, containing 371.25 grains of pure silver, as well as 10-dollar “eagles” containing 247.5 grains of pure gold, thereby establishing a mint ratio of 15 to 1, which at the time roughly corresponded to the ratio of the two metals’ market prices. But within a few years, the relative price of gold rose substantially, making it more profitable to exchange gold for silver in the open market than to deliver it to the US Mint for coining. The situation was, in other words, precisely opposite that which England first encountered several decades earlier. Consequently, although the United States remained officially committed to bimetallism, in practice it found itself on a silver standard.
Following the Appalachian gold discoveries, the market price of gold declined, though not enough to keep it from being legally undervalued. The new gold mining interests, however, pressured Congress to reduce the gold content of the eagle to 232 grains (with corresponding reductions in the content of other gold coins), establishing a new mint ratio of 16 to 1, which was almost as far above the market ratio as the old mint ratio had been below it. The result was a switch from de facto silver monometallism to de facto gold monometallism, which was to be further reinforced by a quadrupling of gold output in consequence of the Californian and Australian finds of 1848 and 1851.
Whether bimetallism need never fall victim to Gresham’s Law provided that enough governments subscribe to identical bimetallic ratios, has been a subject of considerable debate. The details cannot occupy us here; but those interested in them should consult the writings on this topic by Milton Friedman (1992), Marc Flandreau (2004), and Christopher Meissner (2015). For a thoroughgoing general survey of bimetallism, see Angela Redish (2000).
Misapplications of Gresham’s Law
Although Gresham’s Law has many historical applications, it is far from being universally valid. On the contrary, history is also well-supplied with instances in which “good” currencies, instead of being driven out by “bad” ones, have prevailed over them.
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.
Nor is it surprising that Gresham’s Law fails to predict the outcome, even in ancient times, of competition among alternative international monies. As we have seen, the law, properly understood, depends on the presence of strictly enforced tender laws, imperfectly informed agents, or both. In the realm of international exchange, where sophisticated traders are able to price “foreign” coins without regard to their official values, these conditions are absent.
But Gresham’s Law is also incapable of accounting for many instances of currency selection within domestic markets. For reasons we have already considered, it does not predict currency selection outcomes in cases in which different currencies are readily distinguishable from one another and in which people remain free to value those currencies as they please, or to refuse them altogether.
Yet Gresham’s Law is sometimes improperly invoked to explain or predict currency selection outcomes in unhindered market settings. For example, Mundell himself (ibid., p. 10) appeals to it to account for the gradual, voluntary substitution, during the eighteenth and nineteenth centuries, of commercial banknotes for gold and silver coin.
Mundell begins by quoting David Hume and Adam Smith on the advantages Great Britain enjoyed relative to France thanks to its having allowed “paper credit” to take the place of gold and silver coin. “The substitution of paper in the room of gold and silver money,” Smith observed, “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” (ibid.)
According to Mundell, this substitution of redeemable banknotes for coin was just another instance of Gresham’s Law at work, for what that law really implies, in his view, is that “cheap money drives out dear, if they exchange for the same price.” Irving Fisher (1894, p. 527n2) took a similar view, identifying Gresham’s law with the proposition that, when different kinds of money are available, “the cheaper will be substituted for the dearer.”
Important as it has been historically, the tendency for less efficient monies to give way to more efficient ones is hardly what concerned Gresham, Oresme, Copernicus, or Aristophanes! Those writers were addressing, not monetary selection outcomes in competitive and otherwise unhampered markets, but the peculiar selection processes at work in markets characterized by state coinage monopolies, legal tender laws, and such. In those markets, monetary selection favored, not more “efficient” monies but genuinely “bad” ones, meaning ones which, though officially just as valuable as others, were held by the public to be less valuable in fact.
The commercial banknotes to which Hume and Smith refer were, in contrast, regarded by their users to be, not only as “good” as, but better than, the coins they replaced; and that opinion rested, not on the presence of legal tender laws but on the combination of banknotes’ relative convenience and their issuers’ readiness to redeem them in specie on demand. In fact, commercial banknotes generally were not legal tender: although the notes of some state-favored banks were sometimes legal tender (Bank of England notes, for example, were made legal tender in 1833), the notes issued by ordinary commercial banks, including the Scottish banks to which Hume and Smith’s remarks directly refer, were not.
As Charles Kindleberger (1989, pp. 43) quite correctly observes in his Raffaele Mattioli lecture on Gresham’s Law, “Convertibility of one money into another…is the touchstone. When such convertibility is maintained, Gresham’s Law is held at bay.” More generally, to treat any “good” currency-selection outcome as an instance of Gresham’s Law is to strip that law of the paradoxical quality that is its very essence.
Another example of an inappropriate appeal to Gresham’s Law occurs in Money and the Mechanism of Exchange (1875), William Stanley Jevons’s popular textbook on money. Here Jevons appealed to Gresham, not to explain why certain products of the same official mint prevail over others but to counter Herbert Spencer’s defense, in Social Statics (1851, pp. 396–402), of private coining.
People who want furniture, or books, or clothes, may be trusted to select the best which they can afford, because they are going to keep and use these articles; but with money it is just the opposite. Money is made to go. They want coin, not to keep it in their own pockets, but to pass it off into their neighbour’s pockets; and the worse the money which they can get their neighbours to accept, the greater the profit to themselves. Thus there is a natural tendency to the depreciation of the metallic currency, which can only be prevented by the constant supervision of the state.
Although Jevons was an outstanding economist, and Spencer was not, Spencer’s controversial view was in fact more consistent both with a proper understanding of Gresham’s Law and with the results of actual private coinage episodes. Thus when, during Great Britain’s Industrial Revolution, the Royal Mint stopped producing small change, a score of private firms began striking custom-made private coins, called “tradesman’s tokens,” to take official coins’ place. Instead of being shoddy, many of these tokens were of higher quality than their official (poorly engraved, badly worn, and easily counterfeited) counterparts. For that reason the tokens quickly became Great Britain’s preferred currency for wage payments and retail sales, remaining so until 1821, when the government suppressed them (Selgin 2008).
California’s gold rush supplies further proof of the inapplicability of Gresham’s law to a private and competitive coinage system. Apart from its headquarters in Philadelphia, the US Mint at the time had only one branch, in Charlotte North Carolina. So California gold miners who wished to avoid the delay and risk involved in sending gold east for coining patronized local, private mints instead. Between 1849 and 1855, no fewer than 15 such mints catered to them; and while a few of these firms produced “bad” coins, meaning ones with bullion contents that fell short of their declared values, their products quickly fell out of favor with local merchants, while those of several more reputable mints, which had as much, if not more, gold in them than their US Mint counterparts, rapidly gained market share (Summers 1976).
Why did gold miners not patronize mints that made the worst, rather than the best, coins, so as to be able to pass those coins “off into their neighbour’s pockets” and thereby profit more themselves? The simple answer is, first, that no legal tender laws were present to prop-up demand for “bad” coins, and, second, that while imperfect information may for a time have encouraged the circulation of inferior coins (thereby allowing some bad mints to at least get off the ground), over time, thanks to the publication of assay results, the quality of different mints’ products became more widely known. The threat of failure on one hand and the prospect of success on the other supplied a powerful motive for competitive mints to look after their reputations – a motive that official mints generally lacked, except to the extent that they supplied coins for international use. Merchants’ eventual refusal to accept coins from less reputable mints in turn encouraged gold miners to deal only with the more reputable ones.
Rolnick and Weber’s Challenge
no evidence that such a fixed rate of exchange ever existed, and that is not surprising since it is hard to believe it ever could exist. If such a rate ever were managed-through a mint policy or a legal tender law, for example – it would imply potentially unbounded profits for currency traders at the expense of a very ephemeral mint or a very naive public. (ibid, p. 186)
Having on these grounds declared Gresham’s Law a “fallacy,” Rolnick and Weber propose in its place two alternative propositions. The first of these holds that “bad” and “good” money may in fact circulate together, with one type circulating at par, and the other at premium (if “good”) or a discount (if “bad”). The other, which becomes relevant in the presence of substantial market-based costs of nonpar exchange, is that par money – that is, whichever money serves as the medium of account – will drive nonpar money out of circulation. The second possibility is the one previously referred to as “Rolnick and Weber’s Law.”
In a reply to Rolnick and Weber, Robert Greenfield and Hugh Rockoff (1995) focus their attention on the first proposition, which they claim is contradicted by nineteenth-century US experience. But even if correct, that finding falls short of vindicating Gresham’s Law, for it leaves open the possibility that US experience supports, not the Gresham’s Law prediction that “bad money drives good money from circulation” but “Rolnick and Weber’s Law” that par money drives nonpar money from circulation.
Indeed, as Greenfield and Rockoff themselves recognize, one of the cases they consider – California’s continued adherence to the gold standard during the Greenback era – appears consistent with Rolnick and Weber’s Law rather than Gresham’s: although greenbacks were legal tender, Californians refused to accept them in lieu of gold. Since greenbacks depreciated considerably relative to gold, in California (and also in Oregon), in contrast to the rest of the United States, it was “good” gold that drove away “bad” greenbacks. Commenting on this outcome, Greenfield and Rockoff (1995) wonder whether it lies “outside the scope of Gresham’s law because Californians considered the greenback foreign exchange, not money.” But if Californians were able to take this view, it was because Washington either would not or could not force them to obey its laws. In other words, it meant that at least one of the two sufficient conditions for having Gresham’s Law take effect was lacking.
The fundamental problem with Rolnick and Weber’s criticism of Gresham’s Law is not that their alternatives, or at least the one I have dubbed “Rolnick and Weber’s Law,” are never valid, but that they simply cannot account for the frequent (though far from universal) tendency, in premodern times especially, for “bad” rather than “good” money to became nations’ de facto medium of account (Selgin 1996). Rolnick and Weber succeed in downplaying that frequent outcome, and with it the empirical relevance of Gresham’s Law, in part by simply not considering those early episodes of debasement that were the law’s original inspiration. Instead, they refer only to instances of bimetallism or the introduction of paper substitutes for coin; yet more often than not, even in those episodes, as Greenfield and Rockoff’s appraisal makes clear, “bad” money tended to prevail.
And what about Rolnick and Weber’s claim that Gresham’s Law “relies on the existence of a fixed rate of exchange” that would have bankrupted any mint that attempted to maintain it? It is true that Gresham’s Law is often said to rely on the presence of a “fixed exchange rate.” Friedman and Schwartz (1963, p. 27n16), for example, observe that it “applies only where there is a fixed rate of exchange” between two distinct monies; F. A. Hayek (1978 p. 43) likewise claims that Gresham’s law “applies only if a fixed rate of exchange between different forms of money is enforced.” The literature is full of similar statements.
But statements to the effect that Gresham’s Law depends on “fixed exchange rates” need not and should not be understood as implying that it depends on the presence of an operational fixed rate, as opposed to a declared legal equivalence, as when coins containing different amounts of metal, or made of two different metals, or coins on one hand and irredeemable paper on the other are officially deemed to represent identical sums. Certainly no one familiar with bimetallic coining arrangements ever supposed that the mints involved offered to exchange gold for silver and vice versa at their implied mint ratios! Rather than depending on mint officials’ risking bankruptcy by actually offering to exchange “good” money for its face value equivalent in “bad” money, Gresham’s Law refers to the quite unintended consequence of governments’ futile attempts to force their citizens to treat moneys they consider unequal equally.
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