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The Importance of Gresham's Money Law and Fed Bad Money

Economics / Fiat Currency Oct 17, 2009 - 01:57 PM GMT

By: Gary_North

Economics

Best Financial Markets Analysis Article"Bad money drives out good money." This aphorism has been known as Gresham's Law for almost 500 years. Sir Thomas Gresham never said it exactly like this. The statement is wrong in its familiar form.

Bad money does not drive out good money in a free market. The free market rewards producers of customer-satisfying products and services. Good money drives out bad money on a free market. The definition of bad money is money that the free market refuses to use. Gresham's law, as stated, is incorrect. The opposite is true.


A correct version of Gresham's Law is this:

"In an economy with a government-legislated fixed price between two currency units, the artificially overvalued currency drives out of circulation the artificially undervalued currency."

This does not have quite the same ring to it as the more familiar version.

ONE MORE ROTTEN PRICE CONTROL

Gresham's Law is simply an application of the economic analysis of price controls to monetary units. There is nothing complicated about it.

From the early days of the republic, the United States government legislated a price control between gold and silver. At the time the law was first passed, gold was worth 15 times as much as silver was. The ratio of 15 to 1 became law.

In 1848, there was a huge gold discovery in California. For discussion's sake, let us say that the price of gold in silver on the free market subsequently fell to 10 to 1. But the government's law still holds. Banks are required to pay 15 ounces of silver to anyone who brings in an ounce of gold and asks for silver.

Let us say that you were there. You get a bright idea. You go to the bank with two ounces of gold. You demand 30 ounces of silver. Then you take your 30 ounces of silver and buy three ounces of gold. Where? Across the border in Canada or Mexico. (OK, it was a long ride on horseback. Maybe there were banking trading ships just off San Francisco.) You then take your three ounces of gold to the bank and demand 45 ounces of silver. You repeat the procedure until the bank has no more silver to sell at the price of 15 to one.

Of course, you would do this with ten times as much gold. Your competitors, currency speculators, would buy a thousand times as much gold. We call this "economies of scale." Sorry, Charlie.

The artificially overvalued currency (gold) remains in circulation. "One ounce of gold is worth 15 ounces of silver. The government says so." The artificially undervalued currency (silver) disappears. "One ounce of gold is worth 10 ounces of silver. The free market says so." So, people start buying 15 ounces of silver with an ounce of gold in the government-rigged market in order to buy an ounce and a half of gold with silver in the free market.

Meanwhile, anyone in the know who receives a silver coin in exchange sets aside the coin. Silver coins go out of circulation. Mexico and Canada wind up with America's silver coins. The U.S.A. winds up with gold coins.

Trade between Canada and the U.S.A. then falls. So does trade with Mexico. The foreigners don't want to accept gold from Americans at the fixed rate of 15 to one, since it is worth only 10 to one. Signs go up: "For sale to Americans: for silver only." But Americans cannot get their hands on much silver; it has already been transferred to Canada and Mexico, or it is in coin hoards in Americans' homes. So, Americans cannot buy goods from Canada and Mexico.

Throughout American history, right up until gold was declared illegal in 1933, either gold coins or silver coins were driven out of circulation at any government-mandated price. The 15-to-one price was used for decades. This system was called bimetallism. It did not work. It was monometallism operationally.

This is another case of the economics of price controls. The process is not limited to money. If the government says it is illegal to sell gasoline above $4.00 a gallon in order to avoid a fine for price gouging in a time of crisis, and the free market price is $5.00 a gallon, expect to spend lots of time in gas lines.

This happened in Nashville and Atlanta in September of 2008. People could not buy gasoline. The pumps were dry. When a gasoline truck drove into town, it was soon followed by a line of cars, rather like a mother duck and her ducklings. Drivers did not know where the truck was heading. They followed it, so they could line up as soon as it unloaded its cargo.

FLOATING EXCHANGE RATES

Let us assume that Congress passes a new law. The exchange rate between gold and silver is no longer fixed by the government. People can buy and sell gold for whatever price they can get.

Nobody is sure what the gold/silver ratio will be after the law is passed. But speculators expect gold's price to fall toward ten ounces of silver – the free market's price.

As soon as speculators think that this new law will pass, they start selling gold – "Get rid of it; it's overvalued" – and start buying silver. They know that gold will not be artificially overvalued much longer. Better to start buying silver in Canada and Mexico and hold it across the border until the law passes. It will not take long for the new ratio to be established. At that time, gold and silver coins will circulate side by side in the United States. The government does not set a price. There is neither overvaluation by law – fiat valuation – nor undervaluation. Supply and demand jointly establish the exchange rate, moment by moment. No problem. No glut of gold coins. No shortage of silver coins.

If both gold and silver coins are called dollars, these dollars will buy varying quantities of goods and services, moment to moment. A gold dollar is not worth what a silver dollar is.

Back in the 1960s and 1970s, there was a debate between those who advocated fixed exchange rates for the currency market – the Bretton Woods system – and those who advocated floating exchange rates. Milton Friedman was the best-known advocate of floating rates, meaning market-established rates. Friedman always had the advantage conceptually. He stood for free-market pricing. The fixed-rate people were in favor of price controls. They never used that language, however. Had they been forthright in this regard, they would have lost the debate much earlier in free-market circles.

The debate ended after December 1973. That was a year and a half after Nixon took the country off the international gold-exchange standard, i.e., the Bretton Woods agreement. From late 1973 on, the dollar has floated. Defenders of the old fixed-rate system are few and far between.

The fixed-rate system was a Keynesian-like imitation of the international gold standard. It began in 1922. Prior to World War I, when a nation's currency was defined as a specific quantity and fineness of gold, and when the central bank or treasury redeemed gold on demand, there were fixed exchange rates between gold-backed currencies. The free market adjusted the rates. Because the exchange was in fact gold for gold, ounce for ounce, the currency exchange rates remained fixed. These rates were definitional. They were rates of exchange between quantities of gold.

It is 1875. A British citizen walks into an American store in New York City. He sees something for sale for an ounce of gold. He hands the store owner four British gold sovereigns. He walks out with the item. Some critic might exclaim: "But the sovereigns have a dead king's face on it. This face is not like the goddess of liberty, whose face is on a $20 gold piece." "His money's good in this store," declares the owner.

The money was good because it was gold. The pictures on the coins were irrelevant to the store owner. He did not honor any British king. He also did not worship a goddess. He just wanted the gold. Dollars. Pounds. Who cares? He wanted the gold.

The modern gold-exchange standard (1922–1971) was a statist imitation of the gold coin standard. The rates of currency exchange were set by governments and their agencies. The currencies were no longer redeemable in gold after World War I broke out in 1914. The Bretton Woods system of 1944 extended this system. The results were predictable: foreign currency shortages, then announced devaluations by governments, which in turn forced operational revaluations of the other currencies in relation to the devalued currency.

Price controls do not produce markets that balance supply and demand. Price controls are a government's assault on free-market pricing. They create gluts (overvalued item) and shortages (undervalued item). This does not change merely because the items are called national currency units.

The problem with floating exchange rates is not floating exchange rates. It is the lack of any fixed exchange rate between a nation's currency and gold.

The modern floating exchange rate system is comparable to floating exchanges between the currency units of two rival gangs of counterfeiters. By "comparable" I mean "identical." There are still a few defenders of fixed exchange rates who decry floating exchanges between currencies because the system leads to monetary inflation. The problem is not the floating exchange rate system. The problem is the counterfeiting.

Milton Friedman was not wrong for his defense of floating exchange rates and a system of free market currency speculation. He was wrong because he was a defender of government counterfeiting. He attacked the gold coin standard. So do his followers. He thought that a hypothetical system of automatic, fixed-rate monetary expansion was preferable to a gold standard. But there is only one way to get the central bank counterfeiters to pick a monetary expansion figure and stick to it. That way is called the full gold coin standard.

GOLD, PAPER, AND THE GUN

There were two gold standards: the gold coin standard and the gold exchange standard. To understand the two gold standard systems, think of paper money, gold coins, and a gun. The government holds the gun.

In a gold coin standard, a bank issues paper money: banknotes. A banknote is a legal IOU. Each piece of paper promises to deliver an ounce of gold upon presentation of the paper. Think of the paper as pre-1933. The paper says $20. It promises one ounce of gold.

The government holds the gun. It is pointed at the banker. "Fail to deliver an ounce of gold for each $20 warehouse receipt, and you go to jail."

This analysis also applies to checking deposits. But it easier to imagine when we talk about bank notes. They are IOUs.

In a free banking system, the government does not check to see if a bank has enough gold to meet all demands. In a 100% reserve system, it would. In a free banking system, rival banks and a bank's depositors serve as the executioners. Ludwig von Mises favored free banking. Murray Rothbard favored 100% reserves.

Step two: the issuing bank is the central bank. Does the government hold a gun on the central bankers? In theory, yes. In practice, it depends on how dependant the government is on loans from the central bank.

After World War I broke out, every European government except the Swiss holstered its gun. The commercial banks were allowed not to redeem gold on demand.

Then, within weeks, there was a new rule. The central banks demanded the gold held by commercial banks. Each government unholstered its gun. "Fork over the gold," they said.

In the gold exchange standard, central banks and governments held British and American debt certificates instead of gold. The British and the American governments promised to redeem their debts in gold on demand. The British went back on the gold standard in 1925, but at the pre-War rate of exchange. It had to shrink the money supply. This reversed the boom. Then they inflated. Gold began flowing out to the United States. The head of the Bank of England persuaded the head of the New York Federal Reserve Bank, Benjamin Strong, to inflate the dollar, in order to take pressure off the Bank of England's gold outflow. The NY FED did as Strong asked. This inflation was the origin of the U.S. stock market bubble. The FED reversed course in 1929, the year after Strong's death. That caused the crash.

In 1931, Great Britain went off the domestic gold coin standard. It continued to redeem gold for other central banks. The U.S.A. followed this lead in 1933.

Busby Berkeley unknowingly launched a fond farewell to the gold coin standard in "Gold Diggers of 1933." That was the first and last time any movie chorus line was decked out in Liberty head $20 gold pieces. Ginger Rogers sang "We're in the money!" (http://tinyurl.com/ylekr7e) That same year, Roosevelt pointed the gun at every American and every resident in the United States. "Turn in your gold." The next year, the government hiked the dollar-gold exchange rate of gold to $35 per ounce. It let the Federal Reserve System issue currency against this gold.

In 1971, Nixon took the nation off the gold-exchange standard. Not a shot was fired.

Conclusion: civil government points its gun at private citizens. It does not point it at itself. Cleavon Little's scene as the sheriff in "Blazing Saddles," where he points his gun at his own head, threatening violence, was good for laughs. It was not good political theory.

CONCLUSION

Gresham's Law, properly understood, is a real phenomenon. When a government threatens violence against currency traders for daring to make an exchange at a rate not mandated by the government, there will be a glut of the overpriced currency and a shortage of the underpriced currency in that jurisdiction. The result will be decreased trade across borders. There will be shortages of goods on both sides of the border. Most people's wealth will decline as a direct result of reduced trade.

Gresham's Law for centuries was observed in action, but it was not analyzed in terms of the economics of price controls. This was true in the pre-Nixon era. The discussion of fixed exchange rates by those favoring fixed rates was never discussed in terms of the controls' legal status as price controls, any more than a tariff is ever discussed by its proponents as a sales tax on imported goods and, necessarily, as an export restriction. The problem with people's incomplete understanding of Gresham's law is that they treat money as arising from government rather than from the free market. They imagine that there is a failure of the free market: "Bad money drives out good money." There is no failure of the free market. There is a failure of a government-imposed price control. People see government as sovereign over money. It is not. Here is why bad money drives out good money: a bad law forces people into capital-defense mode.

    Gary North [send him mail ] is the author of Mises on Money . Visit http://www.garynorth.com . He is also the author of a free 20-volume series, An Economic Commentary on the Bible .

    http://www.lewrockwell.com

    © 2009 Copyright Gary North / LewRockwell.com - All Rights Reserved
    Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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