Rules regarding money and finance can be difficult to remember. Sometimes, a catchphrase is needed to stick the point home in people’s memories. For instance, “don’t put all your eggs in one basket” is the go-to metaphor when discussing diversification, which makes the concept easy to remember and apply in our investments.
Here’s one from the world of currency trading: “bad money drives out good money.” That’s the primary principle behind Gresham’s Law. This financial theory surmises that money itself has intrinsic value, and when changes are made, attitudes towards currencies change as well. Below, we’ll discuss more about Gresham’s law and its relationship to money.
If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.
History of Good Money vs Bad Money
Thomas Gresham was born in England in the early 1500s. He was the son of a trusted businessman and eventually became a financial advisor for the queen. During this timeframe, most commerce was done via the exchange of coins made from precious metals like gold or silver. Not only did these currencies have the backing of the Crown, but they also had intrinsic value due to the metals they were composed of.
During the reign of King Henry VIII, it was decided that the shilling would have much of its silver removed and replaced with common base metals. The coins containing silver were kept in circulation, but the newer coins were deemed to be of equal value for all commerce.
However, just because the King said two differently-composed coins were of equal value, it didn’t make it so. Gresham discovered that the older coins containing real silver were used less and less in transactions. On the other hand, the newer, base-metal coins were frequently flipped back and forth as payment between citizens.
The older currency had more intrinsic value due to its silver composition. Silver shilling coins could be melted down and sold for a far greater price than their newer counterparts. So what happened?
Gresham told Queen Elizabeth that the “bad money”—the newer coins—had driven the older, silver-containing “good money” coins out of circulation. When encountering “good money,” merchants and shoppers were far more likely to keep it hidden and make transactions using the newer coins.
Government’s Role in Gresham’s Law
Gresham’s realization wasn’t exactly groundbreaking. The idea that more valuable currency would be hoarded while cheaper variants would get spent goes back to the days of the Bible. But one important concept that must be present for Gresham’s Law to be meaningful is another type of law—the type enforced by the government issuing the currency:
For Gresham’s Law to take effect, the concept of “legal tender” must be applied to both types of currency. Only the government can mandate legal tender, which is a regulated currency that can be exchanged for goods and services. Without a government mandating equal value, the idea of “bad money drives out good” will prove to be false.
Think about it like this: you have a gold coin and an aluminum coin. The gold coin clearly has more intrinsic value than the aluminum one, and merchants often refuse to accept the aluminum coin.
But now the government (or sovereign currency issuer, if you want to be specific) says that both the gold and aluminum coins are worth one unit each, regardless of composition. If you want to buy an apple that costs one unit, you can pay with one gold coin or one aluminum coin. When this is the case, of course you’ll pay with the aluminum coin first! In the absence of a government-enforced “legal tender” law, merchants could refuse the aluminum coins and accept only gold ones.
Gresham’s Law in Practice Today
Currency debasement is the end result when bad money drives out good money. Since all the original, valuable currency is hoarded, the newer, cheaper currency becomes all that remains, and purchasing power declines. Currency debasement leads to inflation, which is why economists still mention theories like Gresham’s Law.
Gresham’s Law may seem like an outdated prophecy since metal coins are hardly used at all today. However, the debasement of the penny in the 1980s did have some shockwaves—copper prices skyrocketed as the coin moved to nearly 98% zinc.
However, it’s key to note the importance of legal tender laws. Gresham’s Law takes hold only when two currencies are deemed of equal value by the government. If the penny wasn’t legal tender, merchants could turn it down and choose only to interact with those carrying older pennies. In the absence of a central authority to enforce legal tender, Gresham’s Law will actually work backward. Without a government referee, weak, less-valuable currency will be refused in transactions while the stronger currency is accepted and circulated.
Contact Good Life Financial Advisors of Mt. Pleasant
We hope you now understand Gresham’s law and its relationship to money. If you have questions as to how this theory applies to your finances and portfolio, reach out to a team member from Good Life Financial Advisors of Mount Pleasant today.