Gresham's Law in Nineteenth-Century America
Greenfield, Robert L., Rockoff, Hugh, Journal of Money, Credit & Banking
For almost as long as money has been the object of systematic study, Gresham's law--bad money drives out good--has been recognized as one of money's governing principles. Now, however, doubts have arisen concerning the validity of this venerable principle. In their provocative, theoretical reappraisal of Gresham's law, Rolnick and Weber (1986) maintain that bad money and good money will typically circulate together, bad money at its face value and good money at a price exceeding its face value. Bad money, they say, rather than driving good money out, drives it to a premium.
This paper examines the leading cases in nineteenth-century U.S. monetary history, looking for evidence of cocirculation. No such evidence appears. Money circulated by tale, not weight.
1. GRESHAM'S LAW AND ITS RIVAL
What, according to Gresham's law, makes a money "bad"? What enables it to "drive out good money"? A bad coin contains less bullion than does another coin carrying the same denomination. The mint, for example, might begin paying a better price for bullion. Naturally, people will take advantage of an opportunity to have bullion struck as coin more valuable than the bullion itself. Access to the mint thus makes bad money cheap money, too, and its supply grows. Prices rise, including the price of bullion. It becomes more valuable than the heavier coin, which people remove from circulation. Cheapness, not badness per se, then, enables bad money to drive out good.(1)
Gresham's law embodies two distinct propositions: (1) two intrinsically distinct moneys will not both circulate at once, except when, because the quantity of one money is limited, that one remains a subsidiary money, and (2) of the two moneys, only the bad money will circulate. We will mainly concern ourselves with demonstrating that (1) held in nineteenth-century America. Such a demonstration, though it does not itself constitute empirical verification of Gresham's law, suffices to reject its rival.
Gresham's law assumes that a coin circulates, as long as it does, at face value. Rolnick and Weber question this assumption. Despite legal-tender laws, people would supposedly continue using good coin as money, but at its bullion value. Consider a creditor, for example, with a $100 claim. If the debtor offered bad money denominated $100, then its legal-tender status would force the creditor to accept the offer; the creditor could not win a suit for nonpayment. But suppose that the debtor offered good money denominated $95 but, as bullion, worth $100. The legal-tender law would not stop the creditor from accepting the offer, and neither party would have reason to seek legal redress.(2) Rolnick and Weber thus focus on price, not quantity, as the magnitude that adjusts to keep the good coin worth no less as coin than as bullion. They do allow for quantity adjustment, but "only when the costs of using good money at a premium are significant" (pp. 195-96).
What costs are these? When do they become significant? The costs are the costs of rounding, and they become significant when applied to small-denomination coins. A 25 percent premium on a nickel, for example, is 1.25 cents. If people round 1.25 cents to a penny, then in a small transaction, a customer using nickels would lose part of the premium. People would therefore bundle nickels for use in a large transaction or else melt nickels for sale as bullion.
Actually, rounding would not be the main cost of using the good money at a premium. The value of the nonpar coin would fluctuate constantly, forcing people to monitor its value and then negotiate in every transaction.(3) Perhaps today, we can imagine that, at virtually every transaction site, a computer network would make a quotation on the nonpar money available instantaneously and inexpensively. Under nineteenth-century conditions, however, using the nonpar coin would have required negotiating its value despite considerable uncertainty about its value in central markets. …