December 04, 2011

Pick up that penny

If you found a penny on the ground, would you pick it up? Most people would not. In fact many believe they should be discontinued. They argue that pennies are not commonly accepted, that they are worth more for their metal content than for their monetary (fiat) value, that they are impractical to carry around, and that they are an inefficient store of value (breaking 2 out of 3 qualities money must have: medium of exchange, store of value and unit of account). In sum, the penny is a vestigial remnant of an era long gone that has no purpose anymore - much like the appendix or the wisdom teeth in the human body.

Does this mean that pennies are really worthless?

Fiat money is a very funny thing. It is worth something because we are told so by decree and because we expect (or believe) that someone else will also expect (or believe) it will be worth something when they take it from us in exchange for a good or a service. Enter the key word: "expectations". We hear often about "expectations" from Central Bankers when they manipulate the value of their currency. Inflation (the change in the level of prices) will happen to a great extent if people expect it will. It is the task of central bankers to gauge those expectations and adapt policy making decisions to the population psychological mindset.

But what determines inflation expectations? Some argue expectations are determined by inflation of past periods. Some other even argue that people form inflation expectations considering every piece of information in the economy to reach their expected inflation level (the "rational expectations" assumption).

What if people's expectations were heavily determined by the level of prices instead? What if, in forming future price expectations, it made a difference to have bread prices in the billions as opposed to a couple of dollars? People have a tendency to like stronger currencies. Germans in the 1920's were excited when they could buy a tin bread bin for 1 Rentenmark after paying trillions of Marks for it. The moment the Germans believed they had a strong currency (the new Rentenmark), hyperinflation disappeared. Their inflation expectations were reset because of the existence of fractional money (i.e. pennies).

If the price level was not important in setting inflation expectations, countries with hyperinflation problems would never "reform" their currencies (like China's 1948 3-million-to-1 re-denomination or Brazil's multiple attempts in the early 90's) in order to allow its citizens to pay unitary and fractional prices for basic necessities. Clearly, they sought to establish (with different degrees of success) a perception of currency strength in order to change inflation expectations. In the Brazilian case (see graph below: tip of the hat to Keith Houston/B. Malamud), each time a new currency entered the economy, inflation plunged.

Fractional money is worth something more than the metal it is made with. It is a psychological anchor that helps keep mass perception that cents are still needed and that a currency is strong. Without them (and considering the current insane level of money printing in these times of crisis) inflation could spiral out of control. So, the next time you find a penny in the ground, think about its more subtle value and give the little Lincoln some respect.

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