Gresham’s Law

On page 364 of Basic Economics, Thomas Sowell makes a few remarks about cigarettes circulating as money in P.O.W. camps. He writes, ” […] cigarettes from Red Cross care packages were used as money among prisoners, producing economic phenomena long associated with money, such as interest rates and Gresham’s Law.”

A footnote reads, “Gresham’s Law is that bad money drives good money out of circulation. In the P.O.W. camp, the least popular brands of cigarettes circulated as money, while the most popular brands were smoked.” This isn’t exactly right.

For Gresham’s Law to be in force, legal tender laws need to be in place, which fix an exchange rate between two monies. If the law designates 1 ounce of silver to exchange for 1 ounce of gold, but the market exchange rate is 20 ounces of silver for 1 ounce of gold, a man will hold his gold—which is undervalued by the law—and spend only silver, which is overvalued by the law. Gold will be pushed out of the market, not because silver is a bad money, but because of laws that overvalue silver and undervalue gold.

As far as the P.O.W. camp goes, we’re talking about 2 different goods when comparing the high-quality cigarettes with the low-quality cigarettes. Remembering from yesterday’s post that a desirable money is fungible (i.e., mutually interchangeable), one unpopular brand of cigarette is just as good as another is, but is not as good as a popular cigarette. While either a high-end or a low-end cigarette may circulate separately as money under P.O.W. conditions, they may also circulate simultaneously such as gold and silver have done on the global market in the past.

I speculate the reason the market chose one grade of cigarettes over another to circulate had more to do with the ease of divisibility. For example, a pair of socks might exchange for 3 low-grade cigarettes or 1.5 high-end cigarettes as a matter of pure convenience. At the end of the day, it’s just plain easier to pass around 3 cigarettes than 1.5 cigarettes.

If you want to delve into this more, see Hulsmann’s  “The Ethics of Money Production”.