It is one thing to adopt a bimetallic standard and quite another to maintain it. The problem is that the relative values of gold and silver fluctuate. Thus, even though a mint ratio of 15 to 1 closely approximated the prevailing market ratio in 1792, world supplies of and demands for gold and silver were such that the ratio in the market rose gradually during the 1790s to about 15.5 to 1; by 1808, it was 16 to 1. A market ratio of 16 to 1 and a mint ratio of 15 to 1, technically, is a relationship in which gold is “undervalued” at the mint. Under such circumstances, it paid to export gold coins, exchange them for silver in Europe, import the silver, and convert it into new coins at the mint.
For centuries, observers had noted this tendency for undervalued coins to be hoarded for export. One naturally paid out debased coins whenever it was possible to pass them off at their nominal value and held on to the undervalued coins. Popular sayings to the effect that “bad money drives out good money” or “cheap money will replace dear” thus came into use in various languages. Sir Thomas Gresham, Elizabeth I’s master of the mint, is credited with analyzing this phenomenon, which has become known as Gresham’s law. For our purposes, we may best state the law as follows: Money overvalued at the mint tends to drive out of circulation money undervalued at the mint, providing that the two monies circulate at fixed ratio.
In a well-known paper titled “Gresham's Law or Gresham's Fallacy?” Arthur Rolnick and Warren Weber (1986) pointed out that if people were willing to use coins at their market values, there would be no reason for one coin to drive another out of circulation. For example, if people were willing to value one gold dollar at, say, $1.05 in silver coins, reflecting the market values of the metallic contents of the coins, both gold and silver could circulate side by side, even though gold was undervalued at the mint. But as Robert Greenfield and Hugh Rockoff (1995) and George Selgin (1996) show, legal tender laws, custom, and convenience are powerful forces that tend to force the exchange of coins at their face (mint) values. In early nineteenth-century America, it was easier for holders of gold coins to hoard them for export rather than to try to use them in everyday transactions at more than their face values. Recall Economic Reasoning Propositions 3, incentives matter; and 4, laws and rules matter in Economic Insight 1.1 on page 9.
BAGEHOT'S RULE
While the United States had no central bank, Britain had the venerable Bank of England, the “Old Lady of Threadneedle Street.” The Bank of England had begun life, and was still, partly, a private bank. It was not always clear that it could or should act as a lender of last resort. Ideas about central banking, however, were evolving. A major landmark was the famous book by Walter Bagehot: Lombard Street published in 1873.53 Here Bagehot argued that it was crucial for the stability of the banking system that the Bank of England build up an adequate reserve of gold and announce its willingness to use that reserve during panics to lend to financial intermediaries who were in desperate need of funds. In times of panic, Bagehot wrote, “it [the Bank of England] must advance freely and vigorously to the public out of the reserve.” Bagehot saw the need for some restrictions on emergency lending—it should be at a high interest rate to encourage prompt repayment and should be backed by assets that normally would be valuable—but above all the Bank had to stop the panic. Sixty years later during the banking panic of the 1930s the Federal Reserve had yet to learn this lesson.
THE QUANTITY THEORY OF MONEY
The quantity theory of money can be expressed by the following equation:
M = kPy
M stands for money (silver or gold coins, bank notes, bank deposits, and so on); k for the proportion of income held as money (a decision made by money holders), P for the price level, and y for real output. The equation is a tautology, made true by the way k is defined. But it still can provide important insights into how the economy works. An increase in M, for example, because the government printed paper money or because new gold or silver mines were discovered, must produce an increase in one of the variables on the other side of the equation. If k and y are relatively stable, the main impact will be on P: “Inflation is the result of too much money chasing too few goods.” Or, to take another example, if M and k are stable, and y is growing rapidly, then P must fall: Inadequate monetary growth could produce deflation.
Courses because an A in an easy course counts just as much toward their grade point average as an A in a hard course: “Bad Courses Drive out Good.” Gresham’s law applies to college courses because of the difference between the way students and colleges value courses, just as it applies to coins when there is a difference between the way the market and the mint values the metal in the coins.
In June 1834, two acts that changed the mint ratio to just a fraction over 16 to 1 were passed. Gold was then overvalued at the mint, and gold slowly began to replace silver, which was either hoarded or exported. The discovery of gold in California in 1848 accelerated the trend toward a pure gold circulation.
The international flows of metal under the bimetallic standard were a nuisance. Often coins in convenient denominations could not be had, and the coins that were available were badly worn. But the bimetallic standard also provided a major, if often overlooked, benefit. A change in the market ratio could reflect the slow growth of one metal, say, gold, relative to demand. If the country were tied solely to that metal, the general price level would fall. But under a bimetallic standard, the cheaper metal can replace the dear metal, thus helping to maintain the stock of money and the price level.
World History
