Seigniorage
Seigniorage during the era of commodity money is simple conceptually. The monetary base consisted mainly of precious metal coins minted by the State. The State spent the money into circulation as it acquired goods and services. Seigniorage was the difference between the value of the money and the cost of producing it, effectively a tax on the public.
The Monetary Base Today
In a modern fiat money system, seigniorage benefits arise in a different way. The monetary base consists mainly of the liabilities of the central bank. In the US the Fed issues its liabilities as Federal Reserve notes and credits held on deposit for banks. Those notes and deposits are simply different forms of the same liability, and are interchangeable on demand. Since the State accepts only Fed liabilities in payment of taxes, those liabilities are in effect tax credits with no tangible backing. Their wide acceptance as a medium of exchange is based on the power of the State to enforce tax collection.
The cost of producing Fed liabilities is very small, which means that seigniorage from issuing them is potentially quite large. However the total amount issued is a function of demand by the public, and not at the discretion of the Fed itself. Banks need Fed liabilities, known as reserves, to back their demand deposits. The more banks lend, the more reserves they must hold. The public desires notes for use as street money and for assured liquidity. There is also a large demand for notes in foreign countries. In fact over half of the total issued is believed to be held overseas.
Coins comprise only about 1% of the monetary base, and are of minor significance. They are a special case which will be discussed later. Our focus will be mainly on seigniorage from notes, which is quite different from the case of commodity money.
The Production and Distribution of Notes
The Bureau of Engraving and Printing in the Treasury produces all Federal Reserve Notes. The Fed buys notes at cost, and credits the Treasury's account at the Fed in payment. The Fed offers notes on demand to banks at face value, debiting their accounts at the Fed in payment. Banks offer notes on demand to depositors, debiting their individual accounts in payment. Banks can return notes to the Fed and regain credits in their Fed accounts. Likewise the public can return notes to their banks and gain credits in their accounts.
Seigniorage from Notes
Since the Fed buys notes at cost from the Treasury, it would appear that the Fed gains the seigniorage benefits when it sells them at face value to banks. However as a matter of accounting, the Fed simply swaps liabilities on its balance sheet between note obligations and deposit obligations as it sells and redeems notes with banks. Thus the Fed's capital is not affected, and it gains nothing from exchanges with banks.
Now consider what happens when the public increases its cash holdings by withdrawals from banks. Since a bank's vault cash is part of its reserves, the net withdrawal of cash reduces aggregate banking system reserves. In order to maintain control of the Fed funds rate, the Fed must replenish those reserves. It does so by buying Treasury securities in the open market, a process known as monetizing the debt. In effect, the public acquires cash by selling Treasury securities to the Fed. Conversely it buys Treasury securities from the Fed to reduce cash holdings.
The total value of the notes held by the public is backed by an equal value of Treasury securities held by the Fed. Interest earned on those securities is the main source of income for the Fed. However the Fed is not a profit-seeking operation. It rebates almost all of its income after expenses to the Treasury. As a result, the Treasury gains nearly interest-free loans in proportion to the cash held by the public.
In summary, the seigniorage benefit for the Treasury from notes in circulation is equal to the total interest paid on the Treasury securities in the Fed's portfolio, less the cost of producing the notes and the Fed's cost of distribution. The seigniorage benefit on notes accrues incrementally.
Seigniorage from Coins
The US Mint, a bureau of the Treasury, produces all circulating coins, and sells them at face value to the Fed. In other respects, the distribution of coins to the public is the same as for notes. However seigniorage for the Treasury occurs at the time of sale. It is equal to the difference between in the face value of the coins and the cost of their production, basically the same as it would have been in the era of commodity money.
Aggregate banking system reserves would increase as the seigniorage profit is spent. However in order to maintain control of the Fed funds rate, the Fed must recapture the excess reserves created by that spending. It does so by selling Treasury securities from its own portfolio, a process known as sterilization. That reduces the interest-earning securities in the Fed's portfolio, which has opposite effect from the case of note seigniorage. However coin seigniorage is very small in comparison, and can be safely ignored in the larger picture.
Who is the Real Beneficiary of Seigniorage?
Seigniorage from notes reduces the net interest paid by the Treasury on its debt securities. But the notion that the Treasury itself benefits from the reduction in interest payments on the debt is misleading. It implies the Treasury is a profit-seeking agent competing with the public for a piece of the financial pie. That would result in a drain on bank deposits and reserves of the banking system, and ultimately create a liquidity crisis. The government cannot avoid returning the apparent seigniorage benefit to the private sector in the form of lower taxes, increased spending, or reduced borrowing.
Seigniorage from Foreign Holding of Notes
What about Federal Reserve notes that are bought by foreign interests for use overseas? They too reduce the net interest paid on Treasury debt. Moreover if they never return to the US, they can be viewed as a very large gift of seigniorage to the US economy. Whether those notes are purchased in exchange for a foreign currency or acquired by exporting goods to the US, the public as a whole is the beneficiary.
