Tuesday, December 29, 2009

Gresham's Law Redux

 "Good Money"
 "Bad Money"
 Not Debased
 More Valuable
 Less Valuable
 More Expense
 Less Expense
 More Costly
Reviewing the previous post, one finds a number of ways to describe good and bad money. (See table at right.)

These days we associate fiat money with inflation. But the debasement of gold or silver coin also caused inflation. And sometimes the debasement was government action, the way printing money is government action. But sometimes it was not.

Sometimes the debasement was by the public. People did it, scraping a little gold off the edge of a coin before passing it on to the next guy. Today we worry about the government causing inflation. We forget that given the chance, people will also do things that cause inflation.

We forget that inflation may come from human nature.

If inflation is a natural result of human nature (and you can't change human nature) then the only way to avoid inflation is to put a device in the system to prevent it. That may be one reason many people support the gold standard. It's one reason that I do not totally reject the gold standard.

But that's not why I called this meeting.

Good and bad money. Good money is heavier or more valuable or contains more precious metal. Bad money is lighter or less valuable or contains less precious metal. (The word "valuable" as used here means "intrinsic value," the value of the gold or silver in the coin. Okay, I'll allow the word. But remember: Value is in the eye of the beholder. We may think a thing has intrinsic value, but it has value only because we think it.) "Good" money is more expensive, more costly to use. "Bad" money is less expensive, less costly to use.

With two gold coins in pocket you go to the store, grab some stuff, and go to the check-out. Time to pay. You reach into your pocket, pull out the two coins, and look at them.

You want to keep them both.

One is shiny and new. The other is smaller; nibbled at the edges. You want to keep them both, but you want to keep the shiny new one more. You spend the nibbled coin. You keep the new one. Gresham's Law in action.

Self-interest, Adam Smith said. People do what's best for themselves. If I have two coins but must give up one of them, I will give up the one that leaves me better-off. I will keep the coin that seems more valuable to me. The heavier coin. And I will spend the coin that seems less valuable to me.

It's human nature. It just seems less costly to spend the nibbled coin.

In the table above, some of the terms are technical, like "debased," but most of them are not. Some of the terms are tied to metal money -- "heavier" and "lighter" -- but most of them are not. Most of the terms are tied to our perceptions and our needs: more or less valuable, more or less expense, more or less costly.

Our perceptions and our needs. Wow... I'm having trouble getting to the point.

Gresham's Law is a statement about the expense involved in using money. We prefer to minimize the expense. We keep the more valuable coin. We spend the one it seems "less costly" to spend. That's gotta be clear and obvious by now, after all this beating around the bush.

We prefer to spend the less costly money. That's what Gresham's Law says.

So now I have a question: How come we use so much credit? It's more expensive to use credit than to use non-credit money. Gresham's Law would tend to drive credit out of circulation. Gresham's Law prevented the excessive reliance on credit for centuries after Gresham. And for centuries before Gresham as well. But not in our time. Why?

My answer: Our economic policies encourage the use of credit. Our policies encourage spending while restricting the quantity of money in circulation. And some of our policies -- the ones that encourage saving -- are specifically designed to create loanable funds. Specifically designed to facilitate the expansion of credit-use.

Gresham's Law is an observation of a natural phenomenon: the normal behavior of human beings in their natural economic environment. Economic policy is an attempt to override the natural order. It seems there are a lot of people these days who say it's wrong to try to override the natural order. I disagree.

Return to the cave? I think not.

But clearly, if you're going to impose policy on the economy, you ought to be aware of the side effects of that policy. After World War II, we had two economic goals: price stability, and economic growth. To achieve growth, policy did things that made our spending increase. To achieve price stability, policy removed money from circulation.

Policy made our spending increase, and policy removed money from circulation. Each policy fitted its purpose well. But put the two policies together, and you have an engine that drives credit-use up, and up, and up.

Economic policy, the combination of policies, is the reason we have all this debt. It is the reason we use all this credit. It's the reason we use so much of the kind of money that is more costly to use. It is the reason Gresham's Law no longer applies to our economy.

And the failure of Gresham's Law is proof of policy gone awry.

No comments: