Subject: On Seignorage Newsgroups: sci.econ Seignorage from the Issue of Federal Reserve Notes William F. Hummel December 15, 1997 Seignorage is the difference between the value of money and the cost of its production. In the classic example, the sovereign holds the exclusive right to create money and thus profits from minting coins that cost him less to produce than their face value. He himself spends the coins into circulation. How does this differ from seignorage in our fiat money system? The U.S. government has the exclusive right to create Federal Reserve Notes as part of its money supply. As of mid-1997, a total of $408 billion in notes were outstanding with an annual replacement cost of about $400 million. The present value of those costs (continued indefinitely and discounted at 5%) is $8 billion. So the "seignorage" resulting from the monopoly on note issue is worth about $400 billion. Is this a true windfall for the U.S. government? I think a close examination will show it to be an illusion, with one important exception to be explained later. First we need to distinguish between the assets of the Federal Reserve Bank and the U.S. Treasury. All government spending is paid out of the Treasury's account at the Fed. That account balance must somehow increase from the issuance of notes by the Fed if government spending power is to benefit from seignorage. What actually happens? The Fed buys the notes from the Bureau of Engraving and Printing at the Treasury at a cost of about 4 cents each. It sells them at face value to banks on demand. The Fed is required by law to pledge collateral at least equal to the amount of currency that it issues. The bulk of that collateral is in the form of Treasury securities owned by the Fed. However the requirement for collateral appears to have no significance other than symbolic. Treasury bonds do not represent a claim on the real assets of the government. They are merely interest-bearing IOUs that are guaranteed to be repaid at maturity in legal tender, more Federal Reserve notes. Consider what happens when a bank buys notes from the Fed. Its deposit at the Fed is debited accordingly, and the Fed's reduced liability to the bank is balanced by an increase in its note obligations. The sale of notes is a reversible transaction, i.e. banks can sell notes back to the Fed and regain deposits at any time. The Fed simply swaps two liabilities as it buys and sells notes to banks. Clearly, these transactions have no effect on Treasury balances. Now consider what happens when the public increases its cash holdings by withdrawals from banks. Since vault cash is a part of a bank's reserves, net withdrawals of cash reduce the aggregate banking system reserves. In order to support the Fed funds rate as set by the FOMC, the Fed must replenish those reserves. It does so by buying Treasury securities in the open market, thereby restoring deposits to the banking system. In effect, the public trades some of its Treasury bonds to the Fed for the additional cash. The public foregoes interest earnings on those bonds in proportion to the cash it holds. Note that the bonds become assets of the Fed, and remain as obligations of the Treasury. The Treasury must still pay to redeem the bonds when they mature. How does the Treasury cover the redemption of maturing bonds? For those owned by the public, it sells new issues to pay for the old. If the Fed owns the maturing bonds, the Fed simply debits the Treasury's account at the Fed. This is booked as a reduction in the Fed's assets (loss of the bond) and an equal reduction in the Fed's liability to the Treasury. Of course the Treasury must replenish its account, which It does by selling new bond issues to the public. The purchase of those issues would result in a loss of banking system reserves if the Fed did not replenish those reserves by buying more bonds. Thus the Fed is obliged to replace the bonds in its portfolio as fast as they mature simply to maintain its control over short term interest rates. Whether the public or the Fed owns the maturing bonds, the total supply of T-bonds outstanding remains unaffected by the redemptions. As the public increases its cash holdings, the Fed's portfolio of Treasury bonds increases while the public's ownership of T-bonds decreases. This reduces the interest cost on the government's debt since the Fed rebates most of the interest earned from its T-bond portfolio to the Treasury. Aside from this small and indirect benefit, the government gains nothing as a result of the Fed's issuing Federal Reserve notes to the public. The Fed's balance sheet simply shows an increase in its assets (the bonds) and an increase in its liabilities (the note obligations). In truth the concept of seignorage in a fiat money system through note issuance by the Fed is incongruous. The government has unlimited spending power, and can cover any shortage in tax revenues through the sale of bonds to the public. If the public refused to buy them, the Fed could be required to do so. Of course that would result in loss of control of the money supply. In effect deficit spending would then be funded from newly created money rather than recycled money, with obvious inflationary implications. Under normal conditions, the Fed is forbidden to buy -- except on a rollover basis -- other than small amounts of new Treasury debt directly from the Treasury. In any case, the Treasury's sale of bonds for deficit financing is unrelated to the issuance of currency, and thus does not qualify as seignorage in the normal meaning of the term. The exception noted earlier applies to Federal Reserve notes that have migrated overseas. Those do represent real seignorage for the U.S. economy. The Fed estimates that about two-thirds of the notes outstanding are in foreign hands. At a cost of a few cents each, those notes bought foreign goods and other assets at face value. As long as the notes remain overseas, those assets are virtually cost-free. An interesting question then is: who is the actual beneficiary of that seignorage? William F. Hummel December 15, 1997 From: scsr@airmail.net (Steve Conover, Sr.) Good post, well thought through. Your definition in the first sentence matches the Microsoft Bookshelf definition, but I think that one may be a little out of date, because the other two I found apply to fiat money. Here are the two other definitions I found for 'seigniorage': 1. The power of a country whose currency is held by other countries as a reserve asset. (Only the U.S. has real seigniorage powers today: it can pay for its imports with its own currency, whereas everybody else has to use foreigh exchange.) --The Economist 2. Technically, a piece of currency is simply a small-denomination, non-interest-bearing bearer bond of no fixed maturity that governments issue for just one reason -- it provides interest-free debt financing. --Bert Ely, _Electronic Money and Monetary Policy: Separating Fact from Fiction_ I personally think the second one says it best. --Steve --------------------------------------- William F. Hummel: >1. The power of a country whose currency is held by other >countries as a reserve asset. (Only the U.S. has real >seigniorage powers today: it can pay for its imports with its own >currency, whereas everybody else has to use foreigh exchange.) >--The Economist ----------- This is true. In fact, it is the only significant example of the role seignorage plays in a well-run fiat money system. > >2. Technically, a piece of currency is simply a >small-denomination, non-interest-bearing bearer bond of no fixed >maturity that governments issue for just one reason -- it >provides interest-free debt financing. >--Bert Ely, _Electronic Money and Monetary Policy: Separating >Fact from Fiction_ ----------- Governments do realize an interest-free return from the issue of paper currency, though there are significant costs to service that currency. In any case, the interest-free return has nothing to do with seignorage as defined in the dictionary. And it is by no means true that the "one reason" the government retains a monopoly on the issue of its currency is to profit as indicated. The need for a convenient form of money as a medium of exchange is obvious. Free banking with each bank issuing its own bank notes would not work in a modern economy. People traveling freely from one region of the country to another, as is so common nowadays, need a universally accepted currency. William F. Hummel From: eflahert@garnet1.acns.fsu.edu (Edward Flaherty) Organization: Florida State University A great post. I thought that the seignorage was generated by the difference between the Fed's selling price of the currency to the banks and the cost of the currency the Fed paid to the Treasury -- about $0.04 on a one dollar bill. But the accounting transactions clearly indicate when currency is sold to the banks the Fed is only swapping liabilities, not selling an asset out of inventory as I had previously thought. I sort of knew this, but it wasn't clear until you pointed it out. -- Edward Flaherty School of Business & Economics University of Charleston eflahert@garnet.acns.fsu.edu OR flahertye@cofc.edu A REPLY: From: gchand4059@aol.com (GChand4059) Organization: AOL http://www.aol.com >A great post. >when currency is sold to the banks the Fed is only swapping >liabilities, not selling an asset out of inventory as I had >previously thought. I sort of knew this, but it wasn't clear >until you pointed it out. I'm glad you understand this, now how about explaining this to others. Is this OK? Just another example of Fed hankypanky? george It's easy. When banks want currency they tell the Fed to send them $x, and the Fed deducts it from their reserve account. It's like this: FED Assets Liabilities --------------------------------------- | + FRNs outstanding | - bank reserves COMMERCIAL BANKS ---------------------------------------- + vault cash | - reserves at Fed | -- Edward Flaherty AND From: Gary Forbis An interesting thing about this is vault cash at the FED is not included in the money supply. I'm sure it must be counted as an asset somehow but at what value? could some one fill in the accounting for FRN printing and destruction: Treasury Assets Liabilities ------------------------------ | Fed ------------------------------ | -- --gary forbis@accessone.com http://www.accessone.com/~forbis AND THE ANSWER: >An interesting thing about this is vault cash at the FED is >not included in the money supply. I'm sure it must be counted >as an asset somehow but at what value? ----------- Vault cash is not counted as a part of the money aggregate M1 which comprises currency held by the public plus demand deposits, i.e. transaction money held by the public. However it is a part of the monetary base which comprises bank deposits at the Fed and all currency issued by the Fed. Vault cash and deposits at the Fed are what make up the reserves of the banking system. Vault cash is the major component of banking system reserves. > >could some one fill in the accounting for FRN printing and destruction: ------------ The Fed picks up the cost of the printing and destruction of FRNs in the price it pays to the Treasury to purchase those bills, about 4 cents each. That expense reduces the total earnings of the Fed which come mainly from interest on the bonds it holds. The Fed's earnings (less expenses for running the Federal Reserve System) are refunded to the Treasury. William F. Hummel Gary bonks the side of his head, muttering, "I knew that, really, I knew that," and wanders down the hall in shame. -- --gary forbis@accessone.com