Thursday, August 10, 2017

Why is a one pound coin worth more than four pennies?

The new 12-sided pound coin released earlier this year

The UK's recently-introduced one pound coin is made of 8.75 grams of metal, 76% of that copper and the remaining 24% a combination of zinc and nickel. At market prices, this amount of metal is worth around four pennies. So why do pounds trade for 100 pennies? Why are Brits passing these coins around as tokens—i.e. far above their metal content—rather than at their intrinsic melt value of four pennies each?

One answer is tradition. Brits accept that pound coins should trade at a 2000% premium to their metallic content because they've always done so. This isn't a very satisfactory answer. We need an explanation for why this tradition emerged in the first place.

It could be that the British government simply says that coins must be worth more than their metallic content, and Brits have fallen in line with this order. If they pass on these tokens at an illegal price, they'll be fined, or thrown in prison, or forced to drink tea without crumpets.

This too is an unsatisfactory explanation. Coin and banknote payments are highly decentralized—it's simply not possible to police against trades that deviate from the stipulated price. We have centuries of examples in which government proclamations about currency exchange rates have been ignored. Just today I can mention two. The Venezuelan government's official price for the bolivar is 2,870 to the dollar, but bolivars trade unofficially at 13,077, despite jail sentences to anyone caught trading in the black market. Zimbabwe's leaders say that their recently-printed issue of bond notes must trade at par to U.S. dollars, but in practice a 10-15% discount has emerged, one this will probably only widen over time.

So if governments can't will a monetary instrument like a coin to trade at a premium, where do these premia come from?

A bit of history about token coins—i.e. coins that carry a large premium—may help.

One strange feature about the world before the 1800s is that everyone—you, me, and our grandmas—had access to the mint. We could walk into the mint with a bag full of raw gold or silver and ask the mint master to have this material coined. Upon leaving we'd be provided with the same weight of metal (less a small fee for the mint), except that it had been transformed into coin form. This was called free minting: access was available to everyone.

Free minting meant that coins couldn't carry a premium over raw metal value, at least not for long. To see why, imagine a coin that contains one ounce of silver. When demand for that coin suddenly shoots up a shortage develops, the coin developing a 'fiat component'—it starts to trade at a large premium to its silver content, say one coin can buy two ounces of silver. At this point it has become a token. If I had one of these coins in my pocket, I'd sell it for two ounces of silver, take that silver to the mint, and get two coins in return. Voila, I've turned one coin into two coins! Because many people would conduct this same arbitrage, a slew of coins would enter into circulation. The shortage resolved, the market price of the coin would return to its intrinsic value. With the coin's fiat component gone, it has ceased to be a token.

If coins to are exist permanently as tokens, free minting needs to be halted. If people can't bring in silver to be minted, there is no way for the public to draw out a new supply of coins to remedy a shortage. It is then possible for a coin's value to have a permanent fiat component, or, put differently, for the coin's market price to forever above the intrinsic value of its metal content. 

As an economy grows, people need more coins to conduct transactions. With the mints being shut to the public, how would this supply be created? The answer is that government itself must introduce new coins into circulation by purchasing metal, bringing it to the mint to be coined, and issuing the coins into the economy. If it puts too many coins into circulation, the artificial scarcity that feeds the fiat component of a coin's value will cease to exist and the price of these tokens will fall to their intrinsic melt value. By carefully regulating this supply, coins should always contain a fiat component—their token nature continuing in perpetuity.

These were precisely the steps taken by the British authorities when they introduced their first official issue of silver token coins in 1817. In the centuries before, the British monetary authorities had always maintained a policy of free minting of silver, the Royal Mint—owned by the government—producing only full bodied silver coins, not mere tokens. In 1817, the era of free minting was suddenly brought to an end. The Mint would now only make new coins for the government's account, not for the public. At the same time a token coinage was introduced, the silver content of the new coins being set such that it was now significantly below the coin's face, or par, value. The crown in the picture below, which has the legend of Saint George and the Dragon engraved on it, is an example of one of these early tokens.

To maintain the premium on its tokens, the Mint began to carefully regulate the supply of new coins. Here is monetary historian Angela Redish:
The Mint bought silver at the prevailing market price in the quantity it thought necessary and believed that by limiting the quantity of silver coin supplied it could maintain the value of the coins above the value of their silver content; that is, the supply limitation would give value to the fiat component of the currency. (pdf)
While this worked at first, over the next decade the mechanism for maintaining an artificial shortage—and thus the fiat component of the government's new tokens—broke down. From Redish, we learn that throughout the 1820s the new tokens began to accumulate at the Bank of England, still then a private bank, which had a policy of accepting tokens at their official value from the public, providing gold in return. (The Mint itself had no conversion policy.) The Bank had effectively become the only redemption agent for government tokens. Without the Bank's sopping up the public's unwanted supply at par, the market value of silver tokens would have quickly become unhinged from the coin's face value, eventually falling in price to the market value of their metal content.

Having the Bank of England act as the lone redemption agent for the government's token coins wouldn't do, so in 1833 the government officially took on the task of maintaining the par value of tokens. The Bank of England still accepted all silver coins from the public at par, but now the Bank was allowed to return this stockpile to the Mint for redemption in gold at the coin's par value.

And that, ladies and gentleman, is why your new pound coins, despite containing just 4 pennies in metal content, are worth a full pound. Since 1833 the British Treasury has promised to act as a backstop for all its token coinage, buying them back at their full face value so as to prevent any decline in the fiat component of its coins. Put differently, your one pound coin is worth 2400% more then its metal content because the government promises to uphold that premium by using funds it has raised out of tax revenue.

Coins are thus very much a liability or IOU of the government. This IOU nature of coins tends to operate far in the background, but it becomes much more apparent when a denomination of coins is cancelled. Take for instance the 2013 termination of the Canadian cent, in which the Royal Canadian Mint began to withdraw the lowly penny, the nickel being given the duty of serving as our nation's smallest denomination coin. Ever since then Canadians have been dutifully bringing their hoard of pennies into the local bank in return for cash or a credit to their bank accounts, banks in return sending the coins onward to the government for redemption.

We know from its initial report that the government budgeted $53.3 million to pay the face value of pennies redeemed. Which means that it anticipated the return of 5.3 billion pennies. According to the Mint's 2016 Annual Report, some 6.3 billion pennies have been since brought in, a small amount compared to the roughly 35 billion produced since 1908 and presumably still languishing under mattresses and in dumps—but still above the budgeted amount. Which means a larger chunk of Canadian taxes will have to go to paying penny IOUs then originally expected.

So as you can see, it isn't by mere diktat or tradition that coins trade above their metal content. It's the government's promise to buy them back that provides coins with their fiat component. In the case of the UK's new one pound tokens, should Her Majesty's Treasury refuse to backstop them its quite probably they'd be worth, say, just 90 pence a few years from now; 50 pence a decade hence; and finally 4-5 pence much further down the road. The market value of the pound coins wouldn't fall below that. At 2 or 3 pence per coin, Brits would start withdrawing them from circulation and illegally melting them down for their metal value.

To write this post, I relied on these two fine sources:
1. Angela Redish, The Evolution of the Gold Standard in England, pdf
2. George Selgin, Good Money, link

I also got inspiration from the conversation with Dinero and Antti on this post