Today's Tidbit: Why Minting Small Change Is Bad for the Economy

Economists have long since known that people want to be rewarded for taking on risk. Investments are thus judged by their risk-adjusted returns (Sharpe ratios). A typical hedge fund has a Sharpe ratio of around 0.5. This means that its excess annual return over the risk-free rate is about half its annual standard deviation.

During the past seven years, the S&P 500 has had a Sharpe ratio of around 0.1.

Often, when we make cash transactions, we have to screw around with pennies, and that takes time. Sebastian Mallaby estimates the cost of that screwing round to be around $3.65 per U.S. citizen per year. However, if we got rid of pennies and rounded all prices to nickels, then there would be a sort of random element to consumer transactions (depending on whether the price was rounded up or down). That random element would result in uncertainty, or risk.

Assuming an average of one transaction per day, the annual standard deviation of that risk would be around 27 cents.

So the Sharpe ratio of getting rid of pennies is roughly 365/27, or 13. That's 26 times that of a typical hedge fund.

So, purely on economic grounds, pennies need to go. Similar calculations show that it is also time to ditch nickels and dimes.

On May 4th, Canada minted its last penny. In the U.S. it costs 2.4 cents to produce a penny and 11.2 cents to produce a nickel, but according to The Economist, "tradition, and a public suspicion of such government initiatives, have saved the penny so far."

References:

• "Making no cents", The Economist, May 12, 2012
• "The Penny Stops Here" by Sebastian Mallaby, Washington Post 2006