By Sebastian Mallaby
Monday, September 25, 2006
Two months ago, in an Olympian act of statesmanship, Rep. Jim Kolbe (R-Ariz.) took aim at the true menace in our nation. He introduced a bill that would get rid of the penny. In the first half of this year alone, the U.S. government minted 4.8 billion of these useless coins, and since it costs 1.4 cents to make each one and maybe two more cents each to distribute them, that robbed taxpayers of $115 million. The Wall Street Journal's editorial page denounced Kolbe's capitulation to the sinister forces of inflation, as though recognizing reality were the same as creating it. But in truth the noble statesman should go further. He should abolish nickels and dimes.
To see why this is so, start with the time wasted on pennies. In this great country, not even the most obscure subject escapes scrutiny, so I am able to report that the National Association of Convenience Stores and the Walgreens drugstore chain have estimated that handling pennies adds 2 to 2.5 seconds per cash transaction. Assume that the average citizen makes one such transaction every day, and so wastes (to be conservative) 730 seconds a year. The median worker earns just over $36,000 a year, or about 0.5 cents per second, so futzing with pennies costs him $3.65 annually.
If pennies were abolished, stores would have to round prices to the nearest nickel, and penny lovers suggest that consumers would suffer. I'm pleased to report that Robert M. Whaples of Wake Forest University has analyzed 200,000 transactions across seven states, and he concluded that consumers would not actually suffer. Purchases at gas stations and convenience stores are just as likely to come to $7.02 as $6.98, so the rounding up and rounding down would cancel themselves out. On average, shoppers would lose nothing.
That doesn't quite settle things, however. For although the average shopper would do fine, each individual shopper would run the risk of losing out from all this rounding. Hence the last-ditch question from determined penny partisans: Doesn't this risk undermine the case for abolishing pennies?
Thanks to the Nobel Prize winner William Sharpe, we know how to answer this question. The Sharpe ratio measures the reward you get for taking a risk divided by the size of that risk. For example, if you put your money into Vanguard's 500 Index Fund you would have earned 7.8 percent per year more than the risk-free Treasury bond rate over the past three years. But the Standard & Poor's 500 index's standard deviation, a measure of its volatility, was also 7.8 percent; dividing the reward over the risk, you get a Sharpe ratio of 1.0. If you do the same calculation for the Vanguard Total Bond Market Index , you get a Sharpe ratio of 0.3 over this period.
How does abolishing the penny compare to that? For each transaction, the rounding effect could cost the shopper either two cents or one cent or zero; or it could save the shopper two cents or one cent. If the shopper carries out 365 transactions per year, the standard deviation of all the possibilities is 27 cents per year. A benefit of $3.65 divided over a standard deviation of $0.27 gives you a Sharpe ratio of 13.5. In other words, abolishing the penny is 13 times better, on a reward-to-risk measure, than putting money in the S&P 500 over the past three years. It's 45 times more attractive than the bond index over that period.
Now what about those dimes and nickels? Assume that abolishing the nickel saves an extra second per transaction and that abolishing the dime would save another one. Each abolition would save the median worker time worth $1.83 per year, but each would also increase the risk of losing out from the rounding of prices. Yet on a risk-reward basis, both abolitions would be attractive. The Sharpe ratio for abolishing nickels after pennies works out at 2.7. The Sharpe ratio for finishing off the dime is 1.2 -- not quite so compelling, but still a lot better than stashing your savings in equities or bonds.
The great thing about America is that we have smart people to analyze every conceivable problem, so we know what we should do. But the less great thing about America is that politicians don't always care what's smartest, because they face other pressures. Kolbe is up against something called Americans for Common Cents, a pro-penny lobby funded partly by the zinc industry. The zinc guys have already secured a quiet victory. In 2009, the bicentennial of Abraham Lincoln's birth, the U.S. Mint will issue four commemorative zinc-filled pennies.