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The Penny Problem

Rising metal prices have caused pennies and nickels to be worth more as scrap metal than their face value. Therefore, the US Mint has banned melting of pennies and nickels. And now, Fed Economist Fran├žois Velde is recommending that the penny be "re-based" to become a 5-cent piece. You can read the original 4-page document here (PDF, and worth the read). While this sounds crazy, it's actually pretty much the only choice that the government has. History has proved this time and time again.

I happened to have Mr. Velde as a professor in college. He taught a course on monetary history (I got a B+). It was my favorite Econ class. His book The Big Problem of Small Change is both well-written and informative. It goes in some depth through the history of money, mostly focusing on the problems of medieval currency and into the modern day notion of fiat money (money with no inherent value... which is the source of the penny problem, since coins always have some inherent value). If it sounds crazy to you to simply decree that pennies are now worth 5 cents, you need to read this book. The same thing happened numerous times in various European countries from the 1500's forward.

Spain (actually, Castile) was especially good at this. The problem with using gold and silver coins is that both gold and silver are commodities with their own values that fluctuate according to market forces. This was a problem in 17th Century Europe, and especially Spain, due to the huge fluctuations in value as a result of precious metal discoveries in the New World. If I recall correctly (I wish I had the book in front of me), gold and silver were originally relatively similar in value (compared to today). With the huge amounts of silver found in Central and South America (note: Argentina gets its name from "argentum," the Latin word for silver), silver began to fall in value relative to gold.

The Spanish government was forced to revalue its coins. It basically ran a campaign to turn 10-unit coins into 20-unit coins. Citizens would bring in two 10-unit coins, the government gave them a "new" 20-unit coin (really just a restamped 10-unit coin) and kept the 2 old 10-unit coins. So the government would get 1 coin for free, while the citizens would keep the same amount of "money."

It sounds kind of stupid, but the amazing thing is that it worked. The Spanish government did this many times in the early 1600's. Most other European governments had to do the same thing during this general time period. I wish that I could give more detail (and hopefully I'm right on the detail that I did provide) -- the book is packed away somewhere, and there's no way I could find it right now. It has been years since I've read the book, and more years since I was in his class. So my memory is fuzzy, but I'm pretty sure I'm right. The book also goes into the theory of the whole topic, putting everything into equations, so we could figure out in our scenario above exactly how low silver could sink relative to gold before people started melting their gold coins. If you want to get into the nitty-gritty, have a look at Mr. Velde's working paper selections. The most historically-minded (and least mathematically dense) paper is The Evolution of Small Change, where you can find a discussion of the Spanish "experiments" (in which the government of Castile came very close to implementing a virtual fiat money policy) on pages 40-45.

If you still think this whole thing is stupid and would never work in real life, just think about the current situation. What if the US Government announced tomorrow that it was doing away with the penny? The program would be very similar to what the Spaniards did. You would bring 5 pennies in to a bank, and the bank would give you a 5-cent piece back. This new 5-cent piece would be about the same size and metal content of a current penny; current nickels would also be traded in for the new 5-cent pieces. Given the high transaction rates of our currency, it would not take long for pennies to disappear completely; some would be hoarded, but most would be traded in. Banks would collect them just like they collect worn-out dollar bills to send to the government to be destroyed. The old nickels and pennies would be collected, melted down, and minted into the new 5-cent pieces.

My bet is that most of the American public would welcome the change (no pun intended!). I have friends who have groused about pennies for years now. Yes, there are a few who would hoard the old coinage, but most people would be happy about the convenience of one less coin to deal with. Mr. Velde's suggestion is similar to this, but it saves the cost of having to re-mint everything and take the old pennies and nickels out of circulation. While this would be basically the equivalent of what I outlined above, I think there would be quite a bit more resistance. After all, a penny says "One Cent" on its reverse. Decreeing all pennies to be worth 5 cents would be a bit too much cognitive dissonance, I think.

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