Gresham's Law¶
Gresham's Law states that "bad money drives out good money" when two forms of currency are required to circulate at a fixed exchange rate set by legal tender laws. This principle describes a pattern that has recurred throughout monetary history: when debased currency circulates alongside sound currency at face value, people rationally spend the debased currency and hoard the sound one, causing the sound currency to disappear from circulation.
Historical Origins¶
The law is named after Sir Thomas Gresham, a 16th-century English merchant and financial advisor to Queen Elizabeth I, who explained the principle to the Queen. However, the observation predates Gresham by several decades. Copernicus, the Polish astronomer better known for his heliocentric model of the solar system, articulated the principle in his 1526 treatise on money.
Copernicus observed that when debased and sound coins circulate together at the same face value, people preferentially spend the debased coins (which contain less precious metal) and hoard or export the sound coins (which contain more). This behavior, though individually rational, compounds the monetary problem by removing good money from circulation, leaving only debased currency in everyday commerce.
Mechanism and Rationale¶
Gresham's Law operates through rational individual behavior in response to legal tender laws that force acceptance of both sound and debased currency at the same nominal value. When a gold coin containing one ounce of gold and another containing only half an ounce both must be accepted as "one gold piece," individuals face a choice: which coin to spend and which to save?
The answer is obvious: spend the debased coin (worth less as metal than its face value) and keep the sound coin (worth more as metal than its face value). This arbitrage opportunity exists because the fixed legal exchange rate differs from the market valuation based on metal content. Multiplied across thousands of economic actors, this individual rationality produces the systemic result: good money disappears.
Roman Example¶
The progressive debasement of the Roman denarius over centuries provides a clear example of Gresham's Law in operation. As emperors reduced the silver content of newly minted denarii to finance military campaigns and imperial administration, older denarii with higher silver content disappeared from circulation. Citizens hoarded them or melted them down for their metal value, while spending the newer, debased coins.
By the third century CE, the denarius contained less than 5% silver, having been progressively debased from nearly pure silver. Old, high-quality denarii became so scarce that they commanded a premium, effectively trading as a different currency than the debased coins that bore the same name.
Medieval and Early Modern Europe¶
Medieval and early modern European monarchs repeatedly debased their coinages, creating continuous opportunities for Gresham's Law to operate. When Henry VIII debased English coinage in the 1540s, older coins with higher silver content quickly disappeared from circulation. Merchants, rather than accepting the loss, began demanding more of the debased coins in payment, effectively repricing goods to reflect the lower metal content.
Throughout this period, international merchants developed sophisticated techniques to identify coin quality, weighing coins and testing their metal content. Good coins flowed across borders to where they commanded appropriate value, while debased coins remained in domestic circulation—another manifestation of Gresham's Law on a larger scale.
American Silver Coins¶
A modern example occurred in the United States during the 1960s. Prior to 1965, U.S. dimes, quarters, and half-dollars contained 90% silver. As inflation eroded the dollar's purchasing power and silver prices rose, the metal value of these coins approached and then exceeded their face value. In 1965, the U.S. Mint began producing coins from copper-nickel alloy with no precious metal content.
The response was immediate and predictable: pre-1965 silver coins rapidly disappeared from circulation as people hoarded them or sold them for their metal value. The debased, copper-nickel coins circulated freely, while silver coins became collectors' items or were melted for their bullion value. Within a few years, pre-1965 coins had effectively vanished from ordinary commerce—a perfect demonstration of Gresham's Law.
Bitcoin and Modern Applications¶
Bitcoin and other cryptocurrencies provide a contemporary example of Gresham's Law dynamics. Bitcoin holders, recognizing the fixed supply limit and comparing it to fiat currencies subject to continuous debasement, preferentially hold ("HODL" in Bitcoin vernacular) their Bitcoin while spending fiat currency. This behavior—hoarding the perceived sound money while spending the perceived bad money—mirrors the historical pattern.
Critics note an apparent paradox: if Bitcoin is "good money," why hasn't it driven out fiat currency? This objection misunderstands Gresham's Law, which requires legal tender laws enforcing a fixed exchange rate. Bitcoin and fiat currency float freely against each other, so Gresham's Law doesn't fully apply. However, the hoarding behavior remains: Bitcoin ownership is concentrated among long-term holders, while fiat currency circulates in daily commerce.
Reverse Gresham's Law¶
Some economists have proposed a "reverse Gresham's Law" or "Thiers' Law," suggesting that in the absence of legal tender restrictions, good money drives out bad money. When people are free to choose which currency to accept, they prefer the sound one, and the debased currency depreciates or disappears.
This is consistent with the broader principle: Gresham's Law operates when legal compulsion forces acceptance of both currencies at a fixed rate. Without such compulsion, market forces allow the good money to command its proper premium, and people shift away from bad money—as occurred with the French assignat despite its legal tender status, once confidence collapsed completely. This represents not a reversal but the ultimate conclusion of monetary debasement: the bad money becomes so bad it ceases to circulate.
Relationship to Seigniorage and Debasement¶
Gresham's Law illuminates why seigniorage-seeking through debasement ultimately proves self-defeating. As authorities debase the currency to capture seigniorage, they set in motion the Gresham's Law dynamic: good money disappears, leaving only debased money in circulation. This may appear successful initially—the government can spend the debased currency at face value—but it undermines long-term monetary stability.
As debasement continues, the disappearance of sound money removes the comparative benchmark that helps maintain confidence in the debased currency. Eventually, the debased currency stands alone, and its weakness becomes undeniable. Prices rise (inflation), trust erodes, and in extreme cases, the currency collapses into hyperinflation.
Implications for Monetary Policy¶
Gresham's Law demonstrates that monetary debasement cannot be hidden. Market participants recognize quality differences between currencies and act accordingly. Legal tender laws may force nominal acceptance, but cannot prevent hoarding, export, or melting of good money. The law demonstrates that attempts to circulate debased and sound money simultaneously fail, with the debased currency contaminating the monetary system.
This insight suggests that maintaining sound money requires consistency: authorities must resist the seigniorage temptation and avoid creating a two-tier system where new money is debased while old money retains higher quality. Once debasement begins, Gresham's Law ensures that only the worst currency remains in circulation, accelerating the erosion of monetary trust.