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Of Money, Bad and Good: Gresham’s Law is Wrong

July 26th, 2008

Gresham’s Law (i.e., bad money drives out good money) is often and peculiarly cited by opponents of specie-backed currency. According to Gresham’s law, the existence of a competing yet inferior currency will ultimately result in widespread use of the inferior currency as people hoard the superior currency. The subtle point which is overlooked in this argument is the institutional framework of the economy under observation.

This is the framework they assume:

With the press of a button, a bolt of cloth (in the right hands) can become Federal Reserve Notes, which someone will then be able to use to buy things which already existed prior to the miraculous transmogrification. So long as you can get the new money before anyone else, you can spend it before prices rise, and expropriate real wealth from the rest of a productive society.

Turning simple cloth into greenbacks does not and cannot create wealth. This argument cannot be made about gold, since so long as people continue to desire it (for whatever purposes), the production of gold does constitute the production of real wealth, and the resources allocated towards its procurment are not malinvested.  On the contrary, paper money cannot conjure up the abundance of goods and services which indicate wealth, from nothingness.

Under a gold standard, the amount of credit that an economy can support is determined by the economy’s tangible assets, since every credit instrument is ultimately a claim on some tangible asset. But government bonds are not backed by tangible wealth, only by the government’s promise to pay out of future tax revenues…

Greenbacks are only accepted by people in exchange for real wealth (i.e., goods and services), because people are bound by the full force of the government, to accept them.

When a government, says that bad money = good money, and any refusal to accept this fiat will be met with violence, the results are predictable: bad money drives out good money.

Gresham’s law can only have its prophesied effect when governments distort the market for money, forbidding by one means or another, several currencies from being accurately valued in terms of one another.  In a free market, “bad money” would properly be discounted in proportion to its “badness,” so long as that quality could be reasonably ascertained (a risk that many people might not be willing to bear) and if allowed to trade at a discount relative to the good money, the “bad” money would not drive out the good money, because only an idiot would accept the bad money at face value.

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  • KipEsquire says on: July 26, 2008 at 8:37 pm

     

    “Turning simple cloth into greenbacks does not and cannot create wealth. This argument cannot be made about gold, since so long as people continue to desire it (for whatever purposes), the production of gold does constitute the production of real wealth[.]”

    This is a totally circular argument: Fiat currency has no “real” worth, because people MIGHT stop valuing it, but gold has “real” worth, because people MIGHT keep valuing it?

    Stated differently: The entire global economy should be linked exclusively to the demand for jewelry?

    (Incidentally, going back to Gresham’s Law: Seen many gold wedding bands — as opposed to platinum — on young newlywed men recently? Why not adopt a platinum standard instead?)

    The gold standard’s only claim to validity is that of dilution: the government can debase the currency. But the anti-gold argument is still valid: the government need not debase the currency. And as long as it doesn’t, then the gold standard is a canard.

    So, as always, the debate is only one of politics, not of economic theory per se.

  • Robert Evans says on: July 27, 2008 at 9:56 am

     

    In short, Gresham’s Law is only correct in the presence of legal tender laws.

  • Francois Tremblay says on: July 27, 2008 at 12:35 pm

     

    “the government need not debase the currency.”

    Are you serious?

  • Shaoyu Wang says on: September 29, 2008 at 8:34 am

     

    Robert,
    In addition, it also works in the presence of Bimetalism fixed exchange rate or face values (also enforced by governments).

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