Some people say that you can't trust the free market with your money, but that's not true at all. The government is the one who makes money troubles.
When I was looking through my wallet the other day, I found a folded and scrunched-up bill. If you are over 20, you probably know what I mean. It was clear that it had been passed from person to person many times. Someone must have stuffed it quickly into their wallet at some point, giving it folds that are still there today. Since then, whoever has it has had a hard time with it because it is old, broken, and awkward.
When I saw this bill, my first thought was the same as everyone else's who has ever been in this situation: I need to find a reason to spend this. I thought to myself, "If I could just spend it, I could get rid of it without losing anything."
When I saw the reward, the economist in me began to think about what it meant.
I found out that I'm not the only one with this problem. Everyone does. So, sellers must get a lot of different kinds of crumpled, folded, and torn bills every day.
But neither the sellers nor I want to hold on to these bills. They probably also want to get rid of them by putting them in the bank or buying something else with them.
Of course, this money will slowly be replaced by new money as time goes on. But we have a bit of a problem until then. When everyone is trying to get rid of their crumpled bills, there are more crumpled bills in circulation than there should be. At any given time, they might only make up 5% of the bills, but they might be used in 15% of deals because everyone is always trying to get rid of them.
In theory, if there are enough of them, they could even take over deals. Crisp, new bills would be almost impossible to find. With all of this "bad" money, people would always be making trades. One could almost say that "bad money drives out good money."
This is the standard way to explain Gresham's law, and a smart reader will know it. In fact, it looks like scrunched bills are an example of Gresham's law in motion. We'll find out soon if this is true or not.
A Flaw in the Free Market?
Some people might say that bad money driving out good money is a problem with the free market. People say that this shows that the market can't handle money well. But that's not what's true. The government is in charge of money right now! This shows that the government doesn't know how to handle money well. As happens so often, the free market is blamed for a problem that was directly caused by market limits. The trouble is not the free market. It's the answer.
Get me a coin, Jesus might say. I want to see a dollar bill. Whose name does it have? Whose name is written? It says, "Federal Reserve Note: The United States of America." Okay, then let the government be in charge of government money and let the free market be in charge of free market money (gold, bitcoin, etc.).
In his book What Has Government Done to Our Money?, economist Murray Rothbard clears up what Gresham's law really means.
“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.’ Suppose, for example, there are one-ounce gold coins in circulation. After a few years of wear and tear, let us say that some coins weigh only .9 ounces. Obviously, on the free market, the worn coins would circulate at only 90 percent of the value of the full-bodied coins, and the nominal face-value of the former would have to be repudiated. If anything, it will be the ‘bad’ coins that will be driven from the market.
But suppose the government decrees that everyone must treat the worn coins as equal to new, fresh coins, and must accept them equally in payment of debts. What has the government really done? It has imposed price control by coercion on the ‘exchange rate’ between the two types of coin. By insisting on the par-ratio when the worn coins should exchange at 10 percent discount, it artificially overvalues the worn coins and undervalues new coins. Consequently, everyone will circulate the worn coins, and hoard or export the new. ‘Bad money drives out good money,’ then, not on the free market, but as the direct result of governmental intervention in the market.”
The decree Rothbard is talking about is called a "legal tender law." It gives a certain currency the legal standing of being a good way to pay off any monetary debt. Federal Reserve bills and coins are legal tender in the US, which is why they all say, "This note is legal tender for all debts, public and private." Since the law says that two coins that aren't actually worth the same amount are worth the same, there is a good reason to pay for things with the worn coin that is artificially worth more.
Later in the book, Rothbard talks more about how legal tender rules affect people.
“How was the government able to enforce its price controls on monetary exchange rates? By a device known as legal tender laws… The government may declare as legal tender a lower-quality currency side-by-side with the original. Thus, the government may decree worn coins as good as new ones in paying off debt, or silver and gold equivalent to each other in the fixed ratio. The legal tender laws then bring Gresham’s Law into being.”
Just as worn coins are less valuable and are thus overrepresented in exchanges in a world of legal tender laws, so too scrunched and ripped bills are less valuable than their new counterparts and thus are likewise overrepresented in exchanges thanks to the government.
Answering Objections
There are two things that could be said against this claim. First, some people might point out that legal tender must be accepted for debts, but it is not needed by law for day-to-day retail transactions. That's right. "There is no federal law that says a private business, person, or organization must accept cash or coins as payment for goods or services," says the Federal Reserve. Unless a state law says otherwise, private companies are free to make their own rules about whether or not to accept cash.
A private company could refuse to take a crumpled bill, just like they sometimes refuse to take $50 or $100 bills. But in real life, people rarely say no. This is likely because it would be more work than it's worth. If the store really only thinks the $1 bill is worth, say, $0.95, it's not worth the trouble to ask for something else. But keep in mind that this doesn't mean that the store "really" thinks the crumpled bill is worth the same as any other bill. Still, it doesn't make sense to accept a crumpled bill. Accepting the crumpled bill just shows that they don't think the extra $0.05 is worth the trouble at that time. But just because it's more trouble than it's worth to have a nicer bill doesn't mean it's not worth it. The person who gets rid of the bill takes advantage of the store's situation, so bad money keeps going around. And, of course, you can't refuse bad money when a bill is paid in cash.
If we want to be technical, Gresham's law only really applies in this second case or in the first case when individual states require the use of legal tender for retail deals. Bad money is also more common in places where legal tender rules don't apply (because it's hard to turn it down), which is a different thing that has the same effect. We could just make up a name for it, like "Carroll's law." Even in places where there are no legal tender laws, bad money will still tend to drive out good money to the point where the cost to sellers of haggling over an exchange is greater than the increase in satisfaction they will get from receiving good money.
The second possible argument is: How do we know that the crumpled bills are really worth less than new ones? When a coin is worn, you can tell because there is less metal in it. But if a crumpled bill can be used as money just as well and there's no metal value to worry about, how can we say that it's bad money?
The base is what people do. Austrian economists teach us that value is relative and that it is shown by what people do. If people spent both new and crumpled bills without caring which one they were using, then we could say that they were both the same. But the fact that people do different things with different bills shows that some bills are worth more to them than others. If a person treats two things as replaceable, they are the same good. If they don't, they are different goods. People don't seem to think that a brand-new bill and an old, crumpled one are the same thing. So, these people have different ideas about what the two bills are worth. For the person who spends the crumpled bill first on purpose, they are not two of the same thing, but two different things. Even though we can never know for sure what the difference in value is (because utility is ordinal, not cardinal), we do know that at the time of the exchange, the bill that was kept was worth more than the bill that was given up.
The Free Market Alternative
So how would this problem be solved by the free market? Gresham's law wouldn't be a problem because there wouldn't be any legal tender rules. Rothbard also says, "To deal with the problem of wear and tear, private coiners could either put a time limit on their stamped weight promises or agree to make new coins, either at the original weight or at a lower weight. We should note that in a free economy, coins won't have to be the same size, like they do when the government has a monopoly on currencies.
But in a free market for money, even the question of whether bills and coins get old may soon be irrelevant, since innovations like bitcoin could change the whole industry. Anyone can guess what money would look like in a free market. We can say for sure, though, that it would be much more useful, easy, and hassle-free than the pieces of paper we carry around in our pockets right now.
