We learn from history that in 1558 a certain Sir Thomas Gresham gave Queen Elizabeth a maxim about money. Various writers have different versions of what he is supposed to have said. The following are examples:
- Bad money drives good money out of circulation.
- Inferior money tends to drive preferred money out of circulation.
- A less valuable money will drive a more valuable money out of circulation.
It is not important for us to know precisely what Sir Thomas Gresham said to Queen Elizabeth. But it is important that we understand why some money ceased to be used as currency.
If we use the word "coin" in place of the word "money," we may more easily understand what was meant because the word "money" meant coins to Sir Thomas, to Queen Elizabeth, and to almost everyone [p. 40] else until recent times. Terms such as "good" and "bad" when applied to coins are inappropriate. Coins are neither good nor bad. Some coins may have less exchange value than others, but that does not make them bad.
One coin will not and cannot drive another coin out of circulation. People will simply exchange their coins for the highest value they can get. People will use a coin as a medium of exchange so long as its exchange value for any other purpose is less than the government-set exchange value as legal tender or as a payment for taxes. No other coin will drive it out of circulation.
For example, if the price of copper should increase to $1.50 per pound, people would quickly sell (exchange) their copper coins because it takes only 147 cents to make a pound. The one-cent coins would no longer be used as currency but not because they were driven out of circulation by other coins. People would simply exchange them for a value which is higher than the government-set legal tender value.
If Sir Thomas Gresham had done his homework, he would have told Queen Elizabeth that when a coin is given a fixed legal tender value, it means that the coin has two exchange values. It has the market exchange value of the metal it contains and it has the legal tender exchange value set by the government; and people can be expected to exchange the coin for whichever value is higher. As long as its set legal tender value is higher than its exchange value for any other purpose, it will circulate as a currency. Its exchange value for any other purpose may drop to zero, but it will continue to circulate as a medium of exchange.
If at any time, however, the market exchange value of the metal in the coin became greater than the set legal tender value of the coin, the coin would no longer be used as currency. It would be hoarded or exchanged for the higher value. Thus, we can conclude the people will not use coins as currency if and when they have an exchange value for other purposes that are higher than their set value as legal tender. [p. 41]
We may conclude, too, that when a government sets a legal tender value on a coin, or on any other item used as a medium of exchange, it must set that legal tender value higher than, or at least equal to, its exchange value for any other purpose. Otherwise people will use such an item for purposes other than a medium of exchange.
It makes no sense for a government to place a legal tender value on gold or silver coins, if that legal tender value is higher or lower than the market value of the metal in the coins. If the legal tender value of the coins is higher than their exchange value as a commodity, then the coins need not be gold or silver. A cheaper metal would serve the same purpose. If the legal tender value of the coins is less than their exchange value as a commodity, the coins will be hoarded or exchanged for their higher value as a commodity. They will not be used as legal tender.
Gold and silver coins (900 fine) could be useful, though not necessary, as media of exchange so long as the government did not give them a set legal tender value or a fixed price at the time they were minted. People will determine for themselves the exchange value of the coins at the time of each transaction. That is what coin dealers and collectors do now. They have no need for the government to set an exchange value on the coins. The government should set the legal tender value, the market value, on the coins only when they are presented as payment to the government and when the government uses them as payment to others.
It is not only coins that cease to circulate as currency because of Gresham's Law. When paper currency has more than one exchange value, people will also exchange it for its highest value. For example, when we had silver certificates, the silver certificates had two exchange values:
- The government declared them to be legal tender at their face value.
- The government promised to redeem them at the [p. 42] rate of 371.25 grains of silver for each dollars worth of silver certificates.
For many years (from 1878 to 1964) the 371.25 grains of silver was worth less than one dollar, and at times it was worth less than fifty cents; the legal tender value, however, always remained at the face value of one dollar .The result was that the certificates were used as currency for those many years. People did not redeem the certificates for silver until the price of the 371.25 grains of silver was worth more than one dollar's worth of other currency. Then the silver certificates were no longer used as legal tender or as currency. It was not other coins or currency that drove the certificates out of circulation; people merely exchanged them for an item (silver) which had an exchange value that was greater than the legal tender value or face value of the certificates.
Perhaps an appropriate definition for Gresham's Law may be stated as follows: When an item which is used as currency acquires an exchange value that is greater than its government-set exchange value as legal tender, it will no longer be offered as legal tender or as a medium of exchange.