Bad money still driving good money out of market

Kilmore posted on Fri, Oct 10 2008 4:31 PM

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Few weeks ago I stumbled upon short article in some encyclopedia concerning Gresham's law. Those few sentences were ended by statement that there is little application of this law in modern time because we left metal standard. It seemed to me very peculiar. Either the law is valid in all times and at all places or it is not a law at all. So, is that finding of Mr. Gresham about bad monies driving out good ones really economic law or not? This is my attempt for an answer, sort of restating Austrian business cycle theory in another words to prove Gresham still riding high.

Contrary to opinion of many Austrians, even Rothbard himself for example, I believe there is nothing inherently wrong with fractional reserve banking as long as depositors are explicitly allowing banks to hold only such fractional reserves. It poses no problem because free market would price notes of this enterprising bank far below their nominal values. Therefore any such bank would be prevented from really creating new money out of thin air even though it could print as much notes as it would wish. This is not that obvious as it should be because we live in the world where fractional-reserve banks can do both at once, to "print" huge piles of notes and yet to hold their value intact and far above true market level. This is orchestrated by central bank promising to devaluate cash money (by creating any necessary amount of it) against non-cash money (demand deposits) every time market prices of cash and non-cash should differ. Thus artificial ratio 1:1 between cash and non-cash is quite firmly fixed. 

Of course market cannot be fooled forever. Demand-deposits mostly are no money at all, especially when banks lend frantically. Fixing of ratio above market level causes severe damage to economy because market participants are led to act against each other. Depositors think of their non-cash as of perfect money substitutes, they do not see very risky investments constituting their true value. On the contrary many enterpreneurs mistakenly believe in willingness of depositors to take high risks. In time when this mistake is revealed Mr. Gresham takes over. Everyone rushes to get good money (cash) into his pocket and to pay his debts by bad money (non-cash), therefore good money are drived out by bad money even though we have abandoned metal standard long ago.

Government tries to do exactly that what it tried so many times in history, i.e. to enforce its artificial fixed ratio 1:1. Since laws against hoarding are inefficient, another steps must be taken. Government can expropriate good money via taxes or via inflation. Hence bail-out plan and stream of liquidity flowing from Fed. Indeed it seems to me Mr. Gresham has still much to say.