One of the most famous axioms in economics is "bad money drives out good." This rule has generally been attributed to Sir Thomas Gresham (1519–1579), an English financier who advised King Edward VI and Queen Elizabeth I with regard to financial matters, and it is popularly known as Gresham's Law.
The circumstances which give rise to Gresham's Law are quite simple, and they have occurred many times throughout recorded history. The key prerequisite is that there must be two forms of money or currency (with the same face value) in circulation simultaneously. The acceptance of both currencies at the same face value is required by legal tender laws enacted by the government. One of the currencies is artificially overvalued, and the other currency is artificially undervalued. In such situations, the bad money (the artificially overvalued one) tends to drive the good money (the artificially undervalued one) out of circulation. In other words, people spend the bad money and hoard the good money.
During the reigns of Henry VIII and Edward VI, the silver content of English coins had been significantly reduced (debased). As a result, people had hoarded the older English coins which had a higher silver content. The bad money had driven the good money from circulation. When Queen Elizabeth I ascended the throne in 1558, Gresham wrote her a letter wherein he discussed the debasement of the English coinage. In that letter, he made several observations: 1) that "good and bad coin cannot circulate together"; 2) that the English coinage was in an "unexampled state of badness"; and, 3) that, as a result of this, "all [of Queen Elizabeth's] fine gold was convayed out of this your realm."
In truth, Sir Thomas Gresham was not the first to say that bad money drives good money out of circulation. Nicolaus Copernicus (1473–1543) had made the same observation in a treatise written in 1519.
In about 405 B.C., Aristophanes (446 B.C.-386 B.C.), the great Greek playwright, had written the following in his play, "The Frogs":
"Often has it crossed my fancy, that the city loves to deal
With the very best and noblest members of her commonweal,
Just as with our ancient coinage, and the newly-minted gold.
Yea for these, our sterling pieces, all of pure Athenian mould,
All of perfect die and metal, all the fairest of the fair,
All of workmanship unequalled, proved and valued every-where
Both amongst our own Hellenes and Barbarians far away,
These we use not: but the worthless pinchbeck coins of yesterday,
Vilest die and basest metal, now we always use instead.
Even so, our sterling townsmen, nobly born and nobly bred,
Men of worth and rank and metal, men of honourable fame,
Trained in every liberal science, choral dance and manly game,
These we treat with scorn and insult, but the strangers newliest
Worthless sons of worthless fathers, pinchbeck townsmen, yellowy
Whom in earlier days the city hardly would have stooped to use
Even for her scapegoat victims, these for every task we choose.
O unwise and foolish people, yet to mend your ways begin;
Use again the good and useful: so hereafter, if ye win
'Twill be due to this your wisdom: if ye fall, at least 'twill be
Not a fall that brings dishonour, falling from a worthy tree."
A more recent example of the operation of Gresham's Law took place when I was a teenager back in the 1960s. Until 1964, all U.S. dimes, quarters, half dollars, and silver dollars were composed of 90% silver and 10% copper. I still remember going to the bank and being able to exchange a $1 paper silver certificate for a silver dollar. Although the U.S. had gone off the gold standard (except vis a vis other nations), the U.S. still backed its paper currency with silver.
All of that changed in 1965, when the U.S. Congress passed The Coinage Act of 1965. The new law eliminated the silver content from dimes and quarters. It reduced the silver content in half dollars from 90% to 40%. No new silver dollars were to be minted for five years from the date the bill was enacted into law. The law also allowed the Treasury Department to sell silver from its reserves "in excess of that required to be held against silver certificates." The law made both the new and old coins legal tender "for all debts, public and private, public charges, taxes, duties and dues."
Let us refresh our memories. The first prerequisite for the operation of Gresham's Law is that there must be two forms of money or currency (with the same face value) in circulation simultaneously. With the enactment of The Coinage Act of 1965, the U.S. now had two forms of currency with the same face value in simultaneous circulation. Congress had also made it mandatory that both currencies be accepted at the same face value. Most importantly, one of the currencies (the new coinage) was artificially overvalued, and the other currency (composed of 90% silver) was artificially undervalued. All of the elements of Gresham's Law were in place!
President Lyndon Johnson gave a speech on the date that he signed The Coinage Act of 1965. Here is a pertinent portion of that speech:
"All these new coins will be the same size and will bear the same designs as do their present counterparts. And they will fit all the parking meters and all the coin machines and will have the same monetary value as the present ones."
"Now, all of you know these changes are necessary for a very simple reason--silver is a scarce material. Our uses of silver are growing as our population and our economy grows. The hard fact is that silver consumption is now more than double new silver production each year. So, in the face of this worldwide shortage of silver, and our rapidly growing need for coins, the only really prudent course was to reduce our dependence upon silver for making our coins."
"If we had not done so, we would have risked chronic coin shortages in the very near future."
"There is no change in the penny and the nickel. There is no change in the silver dollar, although we have no present plans for silver dollar production."
"Some have asked whether our silver coins will disappear. The answer is very definitely-no."
"Our present silver coins won't disappear and they won't even become rarities. We estimate that there are now 12 billion--I repeat, more than 12 billion silver dimes and quarters and half dollars that are now outstanding. We will make another billion before we halt production. And they will be used side-by-side with our new coins."
"Since the life of a silver coin is about 25 years, we expect our traditional silver coins to be with us in large numbers for a long, long time."
"If anybody has any idea of hoarding our silver coins, let me say this. Treasury has a lot of silver on hand, and it can be, and it will be used to keep the price of silver in line with its value in our present silver coin. There will be no profit in holding them out of circulation for the value of their silver content."
"The new coins are not going to have a scarcity value either. The mint is geared to get into production quickly and to do it on a massive scale. We expect to produce not less than 3 1/2 billions of the new coins in the next year, and, if necessary, twice that amount in the following 12 months."
Well, what happened after LBJ signed the new law? Almost immediately, people began to pull silver coins from their pocket change and to hoard them. Within just a few years, it became unusual for people to find silver coins in their change. So much for LBJ's prediction that the coins would not disappear from circulation! These days, pre-1965 circulated silver coins trade as "junk silver." A full bag contains coins having a face value of $1,000. For instance, a full bag of silver quarters would contain a total of 4,000 coins, and it would contain about 715 ounces of silver. As of the end of 2010, the "melt value" of a bag of junk silver was about $22,000!I was only 13 years old in 1965, but I remember the time quite well. Like many other people, I started saving silver coins. As a matter of fact, I still look for them because they occasionally turn up in my pocket change. When I do find one, I immediately suspect that a child or a thief has raided someone's silver hoard. Not knowing the difference between real silver money and metal slug money, the child or thief has then spent the money. Needless to say, on the rare occasions when I find a real silver coin in my change, I keep it!
As we have seen, Gresham's Law operates when the public values one competing currency over another. However, I contend that there are times when Gresham's Law does not operate as originally described. To put it another way, Gresham's Law operates normally when the public hoards an artificially undervalued currency but continues to use an artificially overvalued currency. The key factor is that, in order for Gresham's Law to work, the public must still be willing (or required) to use the artificially overvalued currency. If and when a time comes when the public loses confidence in the artificially overvalued currency and stops using it, then the good money will drive the bad money out of circulation. In short, there are times when Gresham's Law can work in reverse.
Has good money ever driven out bad money? Most emphatically, yes! In the Weimar Republic, during the great hyperinflation of 1922-1923, German paper money became worthless. There is a famous story about someone who carried a pile of paper money to a store in a wheelbarrow. The person left the wheelbarrow and the paper money outside the store and went inside to shop. When the shopper went back outside to get the paper money, it was still there. However, someone had dumped it on the ground and stolen the wheelbarrow! In such a world, a wheelbarrow had more monetary value than the fiat currency issued by the government.
During the 2007-2009 hyperinflation in Zimbabwe, we saw a similar phenomenon. It has been estimated that, by the end of 2008, the government had debased the Zimbabwean dollar to such an extent that annual inflation was raging at the rate of 6.5 quindecillion novemdecillion percent. In other words, imagine 65 followed by 107 zeros!
By early 2009, there were videos posted on the internet showing desperate poor Zimbabweans panning for gold in alluvial streams. They were exchanging the gold for food and other necessities. As for the Zimbabwean dollar, there were reports that it was being used as wallpaper. The Mugabe government finally suspended the use of the Zimbabwean dollar in April, 2009. At that point, the South African rand and the U.S. dollar became the standard currencies in use in Zimbabwe.
There have been many hyperinflations throughout history. During hyperinflation, legal tender currency is rejected by the citizenry. During such times, people want things which have intrinsic value. Barter becomes an important means of exchange. People sometimes choose to use foreign currencies which are perceived to have greater value than the hyperinflated currency of the nation. However, there are two forms of money which have always reigned supreme during periods of hyperinflation: gold and silver.
We are now in an era when governments around the world are engaging in competitive currency debasement. The Federal Reserve has announced that it will engage in "QE2" to the tune of creating at least another $600 billion in new fiat currency. According to data published by the St. Louis Fed, since August, 2008, the adjusted monetary base of the United States (BASE) has gone from about $875 billion to over $2 TRILLION. Base money is the amount of money actually issued by the central bank of a nation. It is measured as currency plus deposits of banks and other institutions at the central bank.
A sudden and rapid expansion of base money is the tinder for hyperinflation. Standing alone, it does not mean that hyperinflation is inevitable or pre-ordained. More is required. Specifically, the public must also lose confidence in the nation's currency. As people hurry to exchange their debased currency for goods and services of more perceived value, money velocity accelerates. When money velocity reaches a critical point, hyperinflation begins.
Some economists believe that hyperinflation is purely a monetary phenomenon. I believe that hyperinflation involves both a monetary component and a psychological component. I think that it is when the public loses confidence in a currency that hyperinflations occur.
Will we see hyperinflation in the United States? No honest person can say for certain. Some well-respected economists such as John Williams believe that hyperinflation is very likely. Others, such as Robert Prechter, believe that a severe deflation lies ahead. Ben Bernanke has famously claimed that the Fed has the ability to shut off inflation "in 15 minutes if we have to." I am less convinced of the Fed's magical powers. If hyperinflation takes off, I think that it will be well nigh impossible to put the proverbial genie back into the proverbial bottle.
Where does that leave us? With a valuable lesson, I think. If we do see severe inflation, or hyperinflation, it is a good bet that many people will lose confidence in the enduring value of the U.S. dollar. If that happens, there is a strong probability that those same people will look for forms of money that have a good track record for preserving wealth. In hyperinflationary times when good money drives out bad money, gold and silver reign supreme. That is why everyone should own some gold and silver bullion...just in case!
A Postscript: When Gresham's Law operates, either with bad money driving out good money, or in reverse, it shows us what happens when a government debases its currency. Under an honest money system like the classical gold standard, good money protects people from bad money. An honest money system also stands as a guardian of individual liberty.