One of the underlying traits of human behavior is the tendency of people to seek out true value. This applies to crowds staking out a department store on Black Friday, and it also applies to coin collectors. People know value when they see it, and they search it out. In economics the principle of Gresham’s Law describes how the perception of true value affects which coins remain in circulation.
What is Gresham’s Law?
Gresham’s Law is “a monetary principle stating that ‘bad money drives out good.’ For example, if there are two forms of commodity money in circulation, which are accepted by law as having similar face value, the more valuable commodity will gradually disappear from circulation.”
It is named for Sir Thomas Gresham, who was a financier and advisor to Queen Elizabeth I. In 1558 he persuaded Queen Elizabeth to restore England’s debased currency. He wrote “…good and bad coin cannot circulate together” as part of his argument. Elizabeth’s predecessors, Henry VIII and Edward VI, had forced legal tender laws on the English people that required them to accept debased coinage. Coins that had had their silver content reduced to a fraction of what coins had consisted of under Henry VIII’s father, Henry VII, were the only ones available as a result.
Silver has real value. There is always a market for it because people everywhere recognize this and are willing to trade goods and services for it. When Henry VIII had coins minted that had less silver content but the same face value, people knew they were getting a bad deal. They were forced to use the debased coinage, so they used it for commerce and hoarded the old coins with the higher silver content as a way of storing up savings. The bad money drove the good money out of circulation.
What Is Bad Money?
You might wonder what differentiates good money from bad. It’s how closely the actual value matches the face value of the money. The actual value, or the commodity value, is the current market price at which the metal that makes up the coin can be bought or sold for. This is otherwise known as the spot price.
The face value is stamped on the coin or printed on the currency itself. The issuing government assigns that value, creating legal tender. The face value likely has little to do with what the coin is worth. A $20 Saint-Gaudens double eagle has a face value of $20 and a real value of perhaps 1,500.00, depending on condition among other factors. In the United States and Canada silver coins widely circulated until the 1960s when the U.S. and Canada debased their coins by using cheaper metals to mint their coins. Before 1965 the U.S. half dollar coin was 90% silver. In comparison, silver comprised only 40% of the 1965 half dollar. By 1971, the government no longer included any silver in the half dollar. As in the days of Henry VIII, because the face value of the coins was so much less than the spot price of silver, people began to hoard them as method of saving and used the new coins in day-to-day transactions.
Silver and gold coins are good money because they have actual value that everyone acknowledges. Bad money is money that has a face value that is higher than its actual value. A U.S. $1 coin can be used to trade for $1 worth of goods, but if you melted down that coin, it’s metal would be worth 10 cents or less. In this sense all fiat currency, or modern money is bad money because it only has value because everyone agrees to transact using the face value as if it were its actual value.
The fact that all modern money is almost completely worthless actually proves Gresham’s Law. Bad money has chased out good money. Coin collectors hunt down and hoard the good money for themselves and we buy and sell using paper and coins with randomly assigned values primarily for the sake of convenience.