Gresham’s Law and Coin Clipping

Champions of the government’s coinage monopoly have claimed that money is different from all other commodities, because “Gresham’s Law” proves that “bad money drives out good” from circulation. Hence, the free market cannot be trusted to serve the public in supplying good money. But this formulation rests on a misinterpretation of Gresham’s famous law. The law really says that “money overvalued artificially by government will drive out of circulation artificially undervalued money.” – Murray N. Rothbard, What Has the Government Done to Our Money?, p. 24

Rothbard goes on to give an example of this occurring, which I’ll state in my own words here (I was annoyed earlier because I couldn’t explain this myself). Centuries ago, before the rise of fiat (paper) currencies and money substitutes, governments had to find alternative ways of inflating their money supplies and profiting. Since coins were often in use, governments would try to establish monopolies on the supply of money and “clip” the coins, removing some amount out of their base value. For example, if one ounce gold coins were the norm, the government, after getting some of the supply in its hands, would clip 1/10 of the gold off of the coins. The coins would then have 9/10 of its previous value, and governments could use the extra metal to create new coins. Through this method, they could achieve profits.

What does this have to do with Gresham’s Law? If the government mandated that all coins were equal, that the 9/10 ounce gold coins must be treated the same as the full ounce gold coins, Gresham’s law would come into effect. People, realizing that the 9/10 ounce gold coins could be used in exchange the same way as the full ounce coins, would exchange all of the former coins away domestically. As for the latter, they would either hoard these (A) because they might perceive some chance of government removing this artificial price control in the future, in which case their full ounce coins would be worth more, or B) because they could attempt to use these metals to their full value in some other respect rather than exchange, such as melting them down) or trade these overseas (because other countries would not be so accepting of the “illegitimate” coins). Thus the “good coins” would be driven out of circulation, not because of the free market, but because of the government.

I’ll post examples of Gresham’s Law occurring with gold/silver coins and fiat currencies later.


Posted on March 27, 2013, in Economics and tagged , , , , , . Bookmark the permalink. Leave a comment.

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