If you stop off at McDonald’s for lunch, would you rather hand the cashier a crumbled up piece of paper with the number “5” printed on each corner, or a beautiful and shining silver coin worth $5? Odds are you’d be more willing to give up the deteriorating piece of paper and hold on to the silver coin.
That was Gresham’s Law in a nutshell…
The popular phrase to describe Gresham’s Law is that “Bad money drives out good.” A more formal definition is given by Murray Rothbard in his book, A History of Money and Banking in the United States:
When government compulsorily overvalues one money and undervalues another, the undervalued money will leave the country or disappear into hoards, while the overvalued money will flood into circulation.
In the example above, since the silver coin is better than the worn-out piece of paper, people are more likely to hoard the silver and circulate the paper.
An Historical Example…
Near the end of the 17th century, Massachusetts began to print paper money to pay off its outstanding debt. However, lots of people—especially farmers—were skeptical of accepting the paper money because they weren’t confident in the government’s promise to redeem the notes for silver or gold. Problems escalated when the expanding money supply led to major price increases—i.e. each unit of money was worth less. “Indeed,” writes Rothbard, “within a year after the initial issue, the new paper pound had depreciated on the market by 40 percent against specie.”
By 1692 the government dealt with any existing dissent by making paper money compulsory legal tender for all debts at par with specie. It also granted “a premium of 5 percent on all payment of debts to the government made in paper notes.”
Effectively, the Massachusetts government was overvaluing the paper money and undervaluing silver coins. According to Rothbard,
This legal tender law had the unwanted effect of Gresham’s Law: the disappearance of specie circulation in the colony. In addition, the expanding paper issues drove up prices and hampered exports from the colony…Thus, in 1690, before the orgy of paper issues began, £200,000 of silver money was available in New England; by 1711 however, with Connecticut and Rhode Island having followed suit in paper money issue, £240,000 of paper money had been issued in New England but the silver had almost disappeared from circulation.
In June 2014 the price of crude oil was $105.12 per barrel. Through the past 11 months it has fallen by 44 percent to $59.23.
Many rigs cannot remain profitable during this price decline, resulting in the steep cut in the number of oil rigs you see in the graph below. Interestingly, oil output remains near all-time high levels.
This segment with Peter Robinson is an interesting discussion about current events from the perspective of Thomas Sowell, author of Basic Economics.
Around 22 minutes in, Robinson asks:
Robinson: “Should Obamacare be fixed, or repealed outright?”
Sowell: “Repealed outright, that would fix it.”
The discussion gets very interesting at 22:05 when they turn their attention to the Federal Reserve Bank.
Robinson asks Sowell, “Since the financial crisis of 2008, how has the Fed served us?”
Badly. By keeping the interest rates low, they’re depriving a whole generation of a decent return on money that they save, which would normally go into the marketplace and earn them a decent rate of interest. But now, the Federal Reserve is keeping the interest rate low and so they won’t get it.
Then Sowell comes eerily close to laying out a condensed framework of the Austrian Theory of the Business Cycle, which roughly argues that Central Banks ignite the boom/bust cycle by holding interest rates below the market level.
It’s more than unfair, it’s a bad allocation of resources. If someone wants to set up a business, and is willing to pay 5 percent for money to do that, and the government comes in and follows a policy that brings it down virtually to zero, then the investments will not go where they would have gone ordinarily in a free market.
Unfortunately they don’t expand on how the Fed’s role of causing the misallocation of resources ultimately leads to a boom-bust cycle. To the extent of my knowledge Sowell has never commented on the Austrian theory.
Robinson then plays devil’s advocate, and counters that the financial crisis decimated the lives of Americans so badly that the Fed had to do something. Failure to act would have been cruel and made the crisis even worse.
To show the absurdity of this claim, Sowell brings up James Grant’s book, The Forgotten Depression.
There’s a book out called “The Forgotten Depression.”… When Warren Harding takes the office of President in 1921, unemployment was something like 12 percent. Harding did absolutely nothing, except cut back government spending…
Now obviously the Keynesian would say ‘Oh my God, what is wrong with the man!’ But the following year the unemployment rate was around 6 percent, and the year after that it was around four. And Harding did absolutely nothing again!
That is, the Depression of 1920 was not met with fiscal stimulus or monetary expansion. It was handled largely by the processes of the free market, and ended so quickly that we aren’t even taught about it in schools!
So when people say things like ‘The government has to do something,’ I say, ‘Have you ever studied what happens when the government does something, compared to what happens when they don’t do anything?’
For 150 years, the government of the United States did nothing when there was a depression. No depression during all those 150 years was ever as bad as the Great Depression of the 1930s, in which the government did more than it had ever done before in its entire history.
We may never even have had the Great Depression of the 1930s if Calvin Coolidge had chosen to run for a third term. Contrary to the common view of Herbert Hoover as a laissez-faire president who stayed true to his “do-nothing” philosophy of government while the Depression became Great, Hoover was actually a big spender and implemented major public works projects to stimulate the economy.
For example, Franklin Roosevelt wasn’t attacking Hoover on the campaign trail for being a cold-hearted “do-nothing” president. Instead, Roosevelt described the Hoover administration’s time in office as*
the most reckless and extravagant past that I have been able to discover in the statistical record of any peacetime government anywhere, any time.
Hoover did indeed use his administration to increase federal spending and tax revenue. And whereas Coolidge never ran a budget deficit, Hoover never ran a budget surplus.
It is possible, then, that if Herbert Hoover had never been president (and Coolidge won a third term), we may not ever have had the Great Depression of the 1930s. According to Sowell,
The stock market crash occurred in October 1929. Two months later, unemployment peaked at 9 percent, and then it started declining. By June of 1930 it was down to 6.3 percent–that was when the first government intervention took place, and within six months it was in double digits. And it stayed in double digits for the entire decade of the 1930s.
If Coolidge had run for a third term and won, Sowell believes “he would never have done what Hoover did.”
Fascinating thoughts from Thomas Sowell. Also, did you know he used to be a Marxist!?
*Source: Robert P. Murphy, The Politically Incorrect Guide to the Great Depression and the New Deal, page 55