Gresham's Law

Gresham's law is stated as, "Where legal tender laws exist, bad money drives out good money".

Gresham's law applies specifically when there are two forms of money in circulation which are forced, by the application of legal tender laws, to be respected as having the same face value in the marketplace.

Gresham's Law has found use in many fields other than finance or economics. It is named after Sir Thomas Gresham, an English financier in Tudor times.

Good Money: Money whose face value is equal to the intrinsic or historic value of the material it is made of. An example is the US dollar, which, prior to the 1900's was equal to 1/20.67 ounce of gold.

Bad Money: Money that has an intrinsic or historic value less than its face value. In Gresham's day, this was coins that had been "debased," usually by cutting or scraping some of the metal off. Other examples of "bad" money would be counterfeit coins and coins issued by the mint that are minted from metal with a lower market value than previously. In modern times bad money is recognised as, for example, the 1965 US Half-Dollars which were made from only 40% silver. The previous year the half-dollar was 90% silver. With the release of the 1965 dollar, which was legally required to be accepted at the same value as the previous year's 90% halves, the older 90% silver coinage of the US began to be hoarded while the debased money was allowed to circulate in its stead.

Gresham's law says that the money forced into circulation under legal tender law tends to be dominated by the "bad" money. This is because people will spend the "bad" coins rather than the "good" ones and hoard the "good" ones. If the good coins have a face value below the value of their metallic content they will even go as far as to melt them down and sell the metal for what it is worth. The "good" coins also tend to retain more lasting value for international traders, since overseas traders are not bound by legal tender laws. The coins then leave their country of origin. Thus the good money escapes legal tender laws, and leaves the "bad" money behind. This occurred in Britain during the period of the Gold Exchange Standard.

This shows that in absence of legal tender laws Greshams law works in reverse. When people are given the free choice between accepting good money or accepting bad money, the value of all money finds its intrinsic or historic value in the marketplace. In a free economy, bad money becomes less popular than good money, and is eventually driven back to the refineries. Thus, for bad money to drive out good, as stated in the first paragraph, legal tender laws are necessary.

The same principle has been applied to many different fields. Diploma mills exist to produce lower-value qualifications. According to Greshams law as it applies to money, these "bad" diplomas ought to drive out the "good diplomas". However, unlike with legal tender laws for money, there is no law forcing employers to accept all diplomas as being of equal value. Consequently, each employer is free to assess the value of qualifications on the free market based on where they came from, and to judge the value each diploma as they see fit.

The first recorded expression of Gresham's law is probably to be found in the play The Frogs written by Aristophanes and usually dated at 405 B.C.:

''The course our city runs is the same towards men and money.

''She has true and worthy sons.

''She has fine new gold and ancient silver,

''coins untouched with alloys, gold or silver,

''each well minted, tested each and ringing clear.

''Yet we never use them!

''Others pass from hand to hand,

''sorry brass just struck last week and branded with a wretched brand.

''So with men we know for upright, blameless lives and noble names.

These we spurn for men of brass....

[Compare Tragedy of the commons.]