Are you aware that a Federal Reserve dollar bill is not a constitutional dollar? Perhaps you are, but if so, do you know what a constitutional dollar literally is? Is it gold? Is it silver? Is it both? What is actually meant by a metal standard? Can the United States or any country be on two standards at the same time? Can two metals circulate as coin if there is but one standard? Or does one metal have to drive the other out of circulation? How and why does Gresham's law work when a country uses metal coin for money? In what ways are certain statements of Gresham's law misleading?
Sooner or later, if and when the power of the Federal Reserve over money is revoked in a constitutional manner, and if and when constitutional coin comes back into use, these questions will need to be asked, answered, and understood. That is what this article does in a compact fashion.
In his meticulously researched two-volume work, Pieces of Eight, constitutional lawyer Edwin Vieira Jr. shows beyond any doubt that the constitutional dollar in the United States is an historically determinate, fixed weight of fine silver. The Coinage Act of 1792 is but one source among many that makes this evident, reading,
the money of account of the United States shall be expressed in dollars or units ... of the value [mass or weight] of a Spanish milled dollar as the same is now current, and to contain three hundred and seventy-one grains and four sixteenth parts of a grain of pure ... silver.
The United States has a legal and constitutional silver standard, although we would not know it today, since the government has illegally and unconstitutionally removed silver as currency and replaced it with the Federal Reserve notes that we know as dollar bills. The term dollar bills obscures the actual and tangible meaning of dollar as a specific weight of silver.
The United States has historically minted gold coins as well as silver coins, as the constitution instructed. It regulated their value, the weight of gold they contained, in order to bring the meaning of a gold dollar into conformity with the silver standard coin, which contains 371.25 grains of pure silver. This too was constitutionally mandated. The government did the same for foreign coins up until 1857.
The United States never was or could be constitutionally on a dual standard or a gold standard. It circulated silver and gold coins as media of exchange by adjusting the content of the gold dollar to a silver-standard dollar. For example, the Coinage Act of 1792 authorizes Eagles - each to be of the value of ten dollars or units [i.e., of ten silver dollars], and to contain two hundred and forty-seven grains, and four eighths of a grain of pure ... gold. Since the dollar contained 371.25 grains of silver, this brought into legal equivalence 3712.5 grains of silver and 247.5 grains of gold. The ratio was 1:15.
In the Coinage Act of 1834, Congress adjusted the gold eagle: Each eagle shall contain two-hundred and thirty-two grains of pure gold. This brought into legal equivalence 3712.5 grains of silver and 232 grains of gold. The ratio was 1:16. The reason for the change was that gold had appreciated in market value relative to silver.
If a dollar is made to be 1 oz of gold and also 16 oz of silver, what is a dollar when those metals no longer exchange at that ratio?
Old coins could be brought in and reminted for free (after waiting 40 days.) If old coins were not reminted, they were to be accepted as payments at the rate of ninety-four and eight-tenths of a cent per pennyweight. The weights of the earlier and later eagles were influenced by a change in the standard gold alloy. The rate of 94.8 cents per pennyweight took that change as well as the alteration in the pure gold content into account, so that payments made in either the old or the new coins became very nearly equivalent in terms of the amounts of pure gold being paid.
With this as an introduction, let us go on to an explanation of Gresham's law and the reason why Congress was constitutionally mandated to make such adjustments in the weight of gold in the gold-dollar coin.
Suppose that the dollar is defined as a unit that contains 371.25 grains of silver, and suppose that the unit is physically identified with a specific silver coin that contains that mass of silver. Since grains are unfamiliar units, let us use ounces. Let us note that There are 480 grains in one troy ounce. Hence, 371.25 grains weighs 0.7734375 oz. That is to say that if a silver-dollar standard is officially and constitutionally instituted, with each dollar having the mass of 371.25 grains of silver, this means that the dollar is defined as containing 0.7734375 troy ounces of silver.
In all nonfraudulent exchanges involving dollars, someone who pays or receives a dollar is supposed to pay or receive that mass (or loosely weight) of silver in coin or its equivalent in bullion (bars or ingots). The dollar sign, $, in such a regime means 1 silver dollar of the official weight of 0.7734375 troy ounces of pure silver. The word dollar means the silver coin of that specific mass.
A standard is something that is unchanging. A yard always has 36 inches. A pound always has 16 ounces. A standard, constitutional dollar always has the same amount of the metal that is chosen as its definition, until the constitution is amended to alter the standard, or unless the constitution allows the legislature to alter the standard.
Economically, there can only be a single such standard dollar at a time. One cannot simultaneously have the dollar mean a certain amount of silver and another amount of gold. An economy cannot have two concurrent and different standards of the dollar. The reason for this is that, as will now be discussed, the relative prices of any two metals fluctuate over time.
The exchange rates of gold for silver vary over time due to the changing supplies and demands for these metals in markets. At one time, 1 oz of gold may exchange for 16 oz of silver, while at another time it may exchange for 25 oz of silver. These fluctuations go on unceasingly.
If an attempt is made to define a dollar by two standards simultaneously, it will fail. If a dollar is made to be 1 oz of gold and also 16 oz of silver, what is a dollar when those metals no longer exchange at that ratio? What is a dollar when they exchange at 1 oz of gold to 25 oz of silver? There is no answer. There is no answer because the dollar cannot simultaneously be two different weights of two different metals whose rates of exchange vary over time. One or the other of the two metals has to be chosen as a standard.
Fluctuations occur in the market even if the government sets an official rate of exchange between the two metals, which is what was done in the various coinage acts. The government can attempt to force a given exchange rate, but this will not alter the fact that the market exchange rate departs from the forced exchange rate. The result of a discrepancy between legal and market rates of exchange will be that one of the metals will disappear from circulation. That result comes under the heading of Gresham's law in operation.
There are two ways that the government can, without the direct use of force, keep both silver and gold circulating as money even if only one of them is the standard. One way is to regulate the value of the official gold dollar as time passes, which means to change the official rate of exchange between gold and silver in order to bring it into accord with the market rate of exchange. That is what the coinage acts did.
The other way is to avoid using a gold dollar altogether and produce gold coins that have a known weight but no designation as a dollar. The gold coin can float or have a changing price against the silver-standard dollar. This method was not used but it could and should be used in the future if and when the constitutional silver dollar is restored as the unit of account.
Let us examine in more detail how a money standard, such as the silver standard, works; and then let us examine Gresham's law.
Gresham's law is an application of the idea that money machines do not exist in equilibrium, that there is no free lunch, and that risk-free arbitrage opportunities do not exist in equilibrium.
Suppose that there is a single silver standard: that of a dollar containing 0.7734375 oz of silver. Suppose also that at some specific time, the price of a troy ounce of gold in terms of silver is $16 in the market. This means that 1 oz of gold exchanges in the market for 16 silver dollars, each dollar containing 0.7734375 oz of silver. That is, 1 oz of gold exchanges for 12.375 oz of silver.
Now suppose that the government issues a gold coin. If an official gold coin is made that says it is a $16 gold coin, stamped literally 16 dollars, it will contain 1 troy ounce of gold, worth exactly $16, that is, worth 16 silver dollars. Suppose that the government goes one step further: it makes this exchange rate the official rate, such that in debt contracts one is permitted to pay either 16 silver dollars or 1 of these gold coins.
The official exchange rate is 1/16 oz of gold per silver dollar. The silver standard and accompanying law make silver a legal payment or legal tender in debt contracts, unless perhaps the private parties to the contract are allowed to specify otherwise. With gold's price officially fixed at 1 oz per 16 silver dollars, then gold at that price is also a legal tender in payment of debts. The government in this example is attempting to keep both gold and silver in circulation by making the official rate the same as the market rate.
In the unlikely case that the market price of gold remains at $16 indefinitely, this gold coin provides a substitute or equivalent to the silver standard, even though there is but a single standard. If this market ratio prevails through time, staying at the official rate, there is no real difference between gold and silver for payment purposes. In this situation, one can think in terms of either a silver or a gold standard, even though there is really only a single standard. There is no significant difference.
However, this situation never actually occurs. Market prices do change. A single standard then becomes essential in an economic sense if the dollar is to retain a clear definition as a standard. The silver standard fixes the dollar at 371.25 grains of silver, no matter what happens to the market price of gold in terms of silver. If the relative prices of silver and gold change, that shows up in a change solely in the price of gold. This will make the 16 dollar designation on the gold coin obsolete from a market point of view, but not from an official point of view.
This disparity will set in motion certain events that we now look into. These events are certain to occur because the discrepancy between the market and official rates will create a profit incentive.
Consider two examples in which the market prices deviate from the official exchange ratio. The first example occurs when gold rises in price relative to silver. Suppose that 1 oz of gold becomes able to buy 20 silver dollars in the market. The market exchange ratio becomes 0.05 oz of gold per silver dollar, while the official rate is still 0.0625 oz of gold per silver dollar. The gold piece becomes more valuable. An ounce of gold now exchanges for 15.46875 oz of silver, which is the amount of silver in 20 silver dollars. At the official rate, it exchanges for only 12.375 oz of silver.
Now we explore the profit opportunity that lies at the heart of Gresham's law: If someone owes 16 dollars and can pay in either silver or gold coins, which will they chose? Will it be silver or gold? Intuitively, one pays with the less expensive metal, which is silver. One holds gold off the market and instead uses silver for payments. The more expensive metal disappears from circulation as money or coin, although it will continue to be used for jewelry, teeth, and industrial applications.
The official contractual rate in debt contracts calls for either 16 silver dollars or 1 gold coin. But 1 gold coin now exchanges for 20 silver dollars in the market. If a person possesses 1 gold coin, he can buy 20 silver dollars in the market by ignoring the official rate of exchange. He can then pay the debt with 16 of these silver dollars and have 4 silver dollars left over. This is clearly preferable to paying out the entire gold coin to satisfy the debt, since he gets rid of the debt and still has 4 dollars left over. Hence, he will pay at the official rate in silver dollars, not in gold coins.
This situation contains a risk-free arbitrage (or profit) opportunity. Exploiting it drives gold out of circulation as money. For example, suppose a person starts by borrowing 1 gold coin. He then buys 20 silver dollars and keeps 4 of them. He then repays the loan of the gold coins with 16 silver dollars, since they are legal tender. He can repeat this operation again and again to augment his pile of free silver. This is a money machine - a risk-free arbitrage - in which one party gains and the other loses.
The lender of gold coins is obeying the law by honoring the official exchange rate, but he is losing on this deal since the 16 silver dollars that he is repaid cannot buy 1 gold coin in the market. He will stop lending gold coins. He will put an end to the money machine. This is why finance theories typically assume that assets are priced so as to preclude risk-free arbitrage opportunities.
One hears Gresham's law stated as 'bad money drives out good.' This is misleading, confusing, and erroneous. In the example of gold appreciating and disappearing, silver is by no means 'bad money,' nor is gold 'good money'.
Let us think of this in another way, which is in terms of exchange rates. An exchange rate when silver is the standard is expressed as a number of ounces of gold per silver dollar. When gold appreciates in price relative to silver, the exchange rate falls. That is, less gold is required to exchange for each silver dollar. In the example above, one can satisfy the debt at the official exchange rate of 0.0625 oz of gold per silver dollar, whereas the silver dollar fetches only 0.05 oz of gold in the market. Silver that is used to extinguish debt has a greater value than silver that is used to buy gold in the market as coin. Therefore, silver will be used for payments of debt and all other exchanges, not gold.
The result of gold having appreciated in price relative to silver and thus of the market rate of exchange of gold for silver having fallen below the official rate of exchange (0.05 oz of gold per silver dollar as opposed to 0.0625 oz of gold per silver dollar) is that gold will disappear from circulation as payments. This is an example of Gresham's law.
When two metals are legal tender at an official rate of exchange and one metal's market price increases, that metal (here gold) will disappear from circulation as money. Gresham's law is an application of the idea that money machines do not exist in equilibrium, that there is no free lunch, and that risk-free arbitrage opportunities do not exist in equilibrium.
There is another way of describing what happens when gold appreciates in price relative to silver, but the official rate is lower: One could say that the official exchange rate undervalues gold. The undervalued metal disappears from circulation.
This language is misleading and confusing, however. Is silver overvalued? It seems natural to conclude that silver is overvalued if gold is undervalued. However, silver is not overvalued. Silver cannot possibly be overvalued because it is the standard being used to define the dollar.
Despite the very great drawback introduced by the terms undervalued and overvalued in this context, they have been common in debates on bimetallism. These terms have contributed to confusion, erroneous analysis, and policy blunders with costly consequences, because they obscure the reality that one metal is always the standard. In the United States, that constitutional metal has always been silver.
One also hears Gresham's law stated as bad money drives out good. This too is misleading, confusing, and erroneous. In the example of gold appreciating and disappearing, silver is by no means bad money, nor is gold good money. There is no good and bad money at all. Silver is the metal being used as the standard. It has not driven gold or good money out of circulation. The fixed exchange rate of gold set at too high a level compared to the going market rate has driven gold out of exchange.
For completeness, we consider the opposite case in which gold depreciates relative to the silver standard. Suppose that the market exchange rate rises from 0.0625 oz to 0.076923 oz of gold per silver dollar, which means that one ounce of gold now trades for 13 silver dollars. Suppose that a debt of $16 is to be paid. A person can pay in either silver or gold dollars. This again requires 1 gold coin at the official rate. The cost of that coin in the market is 13 silver dollars. If one had 16 silver dollars, one could use 13 of them to buy 1 gold dollar in order to pay off the debt. One would then have 3 silver dollars left over. Therefore, it's less expensive to pay the debt with gold.
Gresham's law again goes to work. Silver disappears from circulation. When two metals are legal tender at an official rate of exchange and one metal's market price depreciates in terms of the metal used as a standard (silver), that depreciated metal (gold) will circulate, and the other metal (silver) will disappear from circulation as a medium of exchange while maintaining its role as a medium of account.
In practice, a rather small depreciation of gold (1-3 percent) is enough to cause silver coins to disappear from circulation. Suppose we start with an official and market ratio of silver to gold at which there is the equivalent of 0.05 oz of gold in one silver dollar. This means that 1 silver dollar buys exactly $1 worth of gold at the official and market rate, and that 20 silver-dollar coins buy 1 gold coin that weighs 1 oz and is worth 20 times as much as the silver in one silver dollar.
The solution to all this is straightforward. Choose one metal as a standard and allow the price of the other metal to fluctuate freely or float in the market.
Suppose now that the market price for gold declines such that 0.051 oz of gold buys 1 silver dollar. This is a 2-percent increase in the market exchange ratio. At the official exchange rate of 20 silver dollars per gold coin, the 0.051 oz of gold is worth 0.051 × 20 = $1.02 (i.e., 1.02 silver dollars.) If a person had to pay $1, it would be better to pay it in the less-expensive metal (here gold), at the official rate of 0.05 oz of gold per dollar. People will thus tend to use gold for exchanges and hold silver off the market.
If small changes drive one metal or the other out of circulation, the government has to adjust the official exchange rates frequently if both are to be kept in circulation. This is both costly and inconvenient. The solution to this is straightforward. Choose one metal as a standard and allow the price of the other metal to fluctuate freely or float in the market.
If silver is the standard, then gold coins can be minted with no dollar designation at all. They can be minted with the weight of pure gold shown. Then when they are used as payments or used as a basis for issuing e-credits or gold certificates, their weights can be used in conjunction with the changing price of gold to gauge appropriate payments and receipts.
Frequently Asked Questions
Q: What is a constitutional dollar literally (in the United States)?
A: It is a silver coin containing 371.25 grains (0.7734375 troy ounces) of pure silver.
Q: Is a gold standard constitutional?
A: No, not for the United States as the constitution is written. It should be noted, however, that individual states have a constitutional power to make specie (silver, gold, or both) legal tender.
Q: What is meant by a metal standard?
A: It means a monetary unit that contains a specific weight of metal.
Q: Can the United States or any country be on two metal standards at the same time?
A: No, this will be impracticable because of the continual changes in relative prices of any two metals.
Q: Can two metals circulate as coin if there is but one standard?
A: Yes. The metal that is not the standard can circulate as a coin of a given weight of that precious metal whose value at any given time is determined by reference to market prices. Such a coin need not carry any specific dollar designation. This obviates Gresham's law.
Q: Does one metal have to drive the other out of circulation?
A: No. As long as the metal that is not the standard is not legally made to exchange at a fixed ratio to the standard metal, both metals can circulate just as silver and gold both trade in today's markets. Gresham's law will not come into play.
Q: How and why does Gresham's law work when a country uses metal coin for money?
A: Gresham's law takes hold when the government fixes an exchange rate between two metals. When the market rate of exchange deviates from the fixed rate, arbitrage opportunities arise that make it profitable to use the less-expensive metal as means of payment at the official rate. Then the more-expensive metal disappears from circulation as a medium of exchange.
Q: What is an accurate rendition of Gresham's law?
A: When two metals are legal tender at an official rate of exchange and when one metal's market price appreciates in terms of the metal used as a standard, the appreciated metal will disappear from circulation as money and the metal used as a standard will circulate. Conversely, when two metals are legal tender at an official rate of exchange and one metal's market price depreciates in terms of the metal used as a standard, the depreciated metal will circulate; the metal used as a standard will disappear from circulation as a medium of exchange, although it is still the medium of account.
Put more simply, when two metals are legal tender at a fixed, official rate of exchange, the metal that is less expensive at the market rate of exchange will tend to circulate for payments while the more expensive metal will tend to disappear as a medium of exchange.
About the Author:
Michael S. Rozeff is the Louis M. Jacobs Professor of Finance at the University at Buffalo.