Sunday, December 26, 2010

Gresham's Law

Gresham's law is the idea often summarized as "bad money drives good money out of circulation". The expression Gresham's law was first coined by British economist Henry Dunning in 1858 when he decided to name the principle after Sir Thomas Gresham (1519-1579). In 1558, Gresham had written a letter to Queen Elizabeth attempting to explain the poor state of the economy. In it he explained "that good and bad coin cannot circulate together". This was in refference to the debasing of the currency conducted by Queen Elizabeth's predecessors Henry VIII and Edward VI historically known as "The Great Debasement". During this period, the amount of gold and silver found in the country's coins were significantly reduced and replaced with base metals such as copper. Even though the face value of the coins were the same, this debasing significantly reduced their commodity value. Since the old "good coins" (higher metal value content) were still in circulation at the time the newly minted "bad coins" (lower metal value) were added, people began hording the older coins and only spent the new ones.

A modern example of Gresham's law can be found when in 1965 the United States changed the composition of its dime, quarter, half dollar and dollar coins from 90% silver 10% copper to a blend of 91.67% copper 8.33% nickel (some brief exceptions for half dollar and dollar coins. Also, current dollar coins have a different blend of base metals). It didn't take long for the silver coins to be pulled from circulation as individuals held onto them hoping that their commodity value would go up. As of todays date, the metal value of pre 1965 coins are; $2.11 for dimes, $5.28 quarters, $10.56 half dollars, $22.60 for dollars.

The metal value of currently minted coins are well bellow their face vallue....except for one, the nickel. The composition of the nickel is 75% copper 25% nickel and its current metal value is $0.065. Of course base metal prices are volitile but I have noticed that the commodity value has held over 5 cents for sometime. It seems as if its only a matter of time before the composition of the nickel will be changed to something less expensive, probably to zinc. Once this happens I am sure we will once again see Gresham's law in effect. Maybe I should get ahead of the curve and save those nickels now.