Gresham's Law

Gresham's Law is the principle that when two forms of money must by law be accepted at the same nominal value, but one is worth more than the other as a commodity or in the market, the more valuable form will be withdrawn from circulation and the less valuable form will remain in use. It is usually summed up in the phrase "bad money drives out good". The overvalued money, the "bad" money, is spent; the undervalued "good" money is hoarded, melted down or sent abroad, where it can be used at its true worth.

The law describes a reaction to price controls on money. It depends on a fixed official exchange ratio, typically enforced by legal tender laws, between monies whose market values differ.

The principle is named after Sir Thomas Gresham (1519–1579), an English merchant and financial agent to the Tudor crown, who advised Elizabeth I about the effects of earlier currency debasement. The name was attached to the idea in 1858 by the Scottish economist Henry Dunning Macleod. The observation itself is much older: the fourteenth-century scholar Nicole Oresme and Nicolaus Copernicus, in a treatise on coinage written in the 1520s, both described it, and a passage in Aristophanes' play The Frogs is often cited as an early allusion.

Suppose a government issues silver coins of full weight and later issues coins of the same face value containing half as much silver. Both must be accepted in payment of debts at face value. A rational holder will pay bills with the light coins and keep the heavy ones, because a heavy coin can be melted and sold as metal for more than its face value. Over time the full-weight coins vanish from everyday transactions, and the money in circulation consists of the debased coins.

The same logic applies under bimetallism. When the official ratio between gold and silver differs from the market ratio, the metal that the mint overvalues is brought in for coinage and the undervalued metal is exported or hoarded.

• The Great Debasement under Henry VIII and Edward VI in the 1540s reduced the silver content of English coins, and older, better coins disappeared from circulation until the recoinage of 1560–61.
• United States bimetallism: the Coinage Act of 1834 changed the mint ratio to roughly 16 to 1, which overvalued gold; silver coins were then worth more as metal and largely left circulation in the following decades.
• Silver coins after 1965: the Coinage Act of 1965 removed silver from US dimes and quarters. Older 90 percent silver coins, which had to be accepted at the same face value as the new clad coins, were quickly hoarded and withdrawn from use.

Gresham's Law holds only where the law fixes the exchange ratio and forces acceptance. When people are free to choose which money to accept, the reverse often happens: sellers refuse the bad money or accept it only at a discount, and good money drives out bad. This opposite tendency is known as Thiers' Law.

Episodes of hyperinflation show the two laws side by side. Domestic currency, which must legally be accepted, is spent as fast as possible, while foreign hard currency is held as savings. Once the domestic currency becomes worthless enough, traders begin quoting prices in dollars or euros and refuse the local money, and the economy moves toward dollarization.

Under fiat money, coins and notes have no meaningful metal value, so the classic melting effect is rare. The principle remains useful wherever an official rate overvalues one form of money. Under capital controls, for example, holders of foreign currency avoid selling it at an official rate that undervalues it and instead trade at the parallel market rate or keep it abroad, contributing to capital flight.

The phrase is also used loosely outside money, for example to describe low-quality products or practices crowding out better ones in markets where buyers cannot tell them apart. Economists generally treat those uses as analogies, since they lack the legal tender requirement that drives the original effect.