– October 6, 2019
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Gresham's Law

In 1558, Sir Thomas Gresham wrote a letter to Queen Elizabeth of England that would forever preserve his name for those of us studying money. What became known as Gresham’s law is popularly invoked to describe monetary competition, frequently stated and remembered as “Bad money drives out good money” — and it’s entirely wrong.  

The namesake for the economic law is almost entirely innocent to its creation; in his letter, informing the newly ascended queen about the Crown’s foreign debt in Antwerp, he mentions that after Elizabeth’s father, Henry VIII, had debased the currency in the Great Debasement in the 1540s and 1550s, “all your fine goold was convayd ought of this your realme.” 

That’s it, the apocryphal basis for one of economics’ first and perhaps most sound laws. It does require, writes the British monetary economist Frank W. Fetter in the 1930s

considerable ingenuity to draw from Gresham’s modest statement about debasement and the exchanges, with its historical inaccuracies, a universal law that “bad money drives out good money.” Most certainly the passage gives no warrant for the assertion by many writers that Gresham expressed an economic law with great exactness.

Instead, the originator of what we call Gresham’s law was Henry Dunning MacLeod a mere three centuries later. Joseph Schumpeter, in his History of Economic Analysis, calls it both “trivial” and a “not quite correct phrase.” Robert Greenfield and Hugh Rockoff describe the law as “one of money’s governing principles.” Adding proper modifications, the Nobel laureate Robert Mundell describes it as “a theorem of the general law of economy, a consequence of the theory of rational economic behavior.” Now, why do we care about this seemingly commonsensical piece of obscure monetary economics?

In so many aspects of economics, there is a mismatch between what the economists are really saying and what the general public believes. The economic law to which Gresham has lent his name is a typical victim, as illustrated spectacularly this week by the Financial Times’ chief U.S. commentator, Edward Luce. In a piece titled “The Gresham’s Law of Our Democracies,” Luce invokes Gresham to explain Hayek’s famous point: in politics, the worst get on top.  

It’s about as strange as it sounds. 

A Run-Down of Gresham’s Law

The “venerable principle” that we know as Gresham’s law only had the first part of its true meaning conveyed to the public. The idea isn’t only that when two or more currencies circulate together, the money of superior quality (“good money”) will be hoarded while the money of inferior quality (“bad money”) will dominate trade. That would merely be the outcome of monetary competition where users preferred some of the available moneys’ attributes for different purposes.

Rather, Gresham’s law only causes inferior-quality money to dominate an economy’s transactions when there is some institutional rule (fixed mint price or legal tender laws) that forces market participants to accept two differing monies at a fixed ratio — and, importantly, this ratio must be different from current market prices. Mundell writes that “Gresham’s Law comes into play only if the ‘good’ and ‘bad’ exchange for the same price.” In this sense we can understand why Schumpeter called it “trivial.” This is nothing more than a special case of the law of one price — or the common sense notion that consumers, in most places at most times, will choose the cheaper version of two identical products offered to them. If one of the monies we hold is officially overvalued — that is, we get higher purchasing power for it than we should — it doesn’t take strict rationality postulates to figure out that consumers will spend their overvalued money. 

To make matters slightly more complicated, Arthur Rolnick and Warren Weber wrote a much-read article in the 1980s where they found historical instances that contradicted this “trivial” law. After all, we have many historical instances — the French Revolution or the American Civil War, for example — where the conditions for the law did not result in the undervalued money disappearing from circulation. They write that “both bad and good money appear to have been current” at the same time. Another is 18th-century Sweden, whose peculiar seven-currency monetary system looks rather chaotic to a modern-day observer. 

Rolnick and Weber’s version of the law specifies that bad money drives good money from circulation “only when use of the good money at its market (nonpar) price is too expensive.” Indeed, presuming — as Gresham’s law does — that the use of a competing money will simply cease is somewhat strange. Whenever two economically different goods circulate in the economy (Toyotas or BMWs, almond milk or cow milk), the “good” good doesn’t disappear from circulation; its price simply adjusts. Why couldn’t different officially mispriced monies (say gold and silver) fetch different prices in actual trade? Even if governments mandated legal tender laws, argued the authors, merchants could quote prices in the inferior money but provide discounts to consumers using the good money. In other words (barring limitless arbitrage profits until the mint runs out of resources), there is no way a government can fix two moneys’ prices in decentralized transactions. 

George Selgin objected to Rolnick and Weber’s version by showing that preventing actors from communicating their preference over currency traps individuals in a prisoner’s dilemma. By imposing sufficiently strict penalties on breaches of legal tender, actors incorporate those additional negative payoffs and ultimately favor the bad money. In general, legal tender laws are rarely that strict, but they are possible.  

Economists may quibble among themselves about the precise specification for a correct Gresham’s law and the conditions for “bad money” to drive out “good money.” What is clear is that some institutional feature must operate on market-established relative prices between good and bad money, restricting actors’ payoffs such that the economy centers on a “bad” money. It’s not enough that one money is — even universally — perceived to be better than another. 

The Audacious Adventures of Mr. Luce

With that in mind, let’s see how much sense it makes to think about “bad” politicians in a Gresham’s-law way. Luce writes: 

Where have all the good people gone? Gresham’s Law holds that the bad drives out the good. He was talking about debased currency. But it applies equally to the quality of public life. I have no doubt that there are just as many talented people, and individuals of high moral character, in our time as in earlier ones. Our average IQ apparently keeps rising. The intelligent ones obviously have enough sense to avoid politics.

The question itself has bugged political scientists and economists for centuries and is well worth pondering: is there something in the malicious field of politics that attracts particularly awful people? 

On a superficial level, it also makes sense for Luce to invoke Gresham here. Luce wants to make the reasonable case that politics recently has been an area where “bad” conquers “good,” and in the popular (and wrong) version of Gresham’s law, “bad money” similarly drives out “good money.” As we now know a lot more about Gresham’s law, we can now see how this makes very little sense. 

First, Gresham never talked about the law that carries his name. Second, for Gresham’s law to drive “good” out of circulation, there must be some institutional (non-price) rule that holds the relative prices of “good” and “bad” in place, preventing them from adjusting. We quibble over exactly which such feature (mint price, currency traders, legal tender laws) matters and how much is required, but there must be one.

Apparently, then, it’s too expensive for “good” politicians to circulate. I don’t know what that means. I can’t think of a legal restriction that makes us unable to trade “good” politicians at a premium price or that imposes official sanctions on us for doing so. I don’t even know what it means to say that a politician has a market price! 

Mr. Luce has made the reasonable observation that politics seems less sane than we would expect it to be. He need not invoke a mistaken version of Gresham’s law to make that case. 

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Joakim Book

joakim-book
Joakim Book is a writer, researcher and editor on all things money, finance and financial history. He holds a masters degree from the University of Oxford and has been a visiting scholar at the American Institute for Economic Research in 2018 and 2019. His writings have been featured on RealClearMarkets, ZeroHedge, FT Alphaville, WallStreetWindow and Capitalism Magazine, and he is a frequent writer at Notes On Liberty. His works can be found at www.joakimbook.com and on the blog Life of an Econ Student;
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