Swapping bonds for cash

Seigniorage

During the era of metal-based money, the monetary base consisted of precious metals produced by the public and converted into coins by the State. The difference between the face value of the coins versus the cost of acquiring the metals and minting them generated a financial benefit for the State treasury, known as seigniorage.

The Monetary Base Today

In the U.S. today the monetary base is created by the Fed when it buys Treasury securities from the public and simply credits the sellers' banks with reserve deposits at the Fed. The Fed must supply reserves as needed to balance supply and demand at its target Fed funds rate.

Cash withdrawals from banks are a drain on their reserves, which the Fed must replenish or lose control of the Fed funds rate. A net withdrawal of cash from banks causes a continuing demand for additional base money from the Fed. Uner normal conditions, that is the principal reason for the growth of Treasury securities in the Fed's portfolio.

Seigniorage in a Fiat Money System

The Fed thus acquires Treasury securities equal to the amount of base money it creates. The interest paid by the Treasury on those securities is the main source of income for the Fed.  The Fed keeps enough to cover its expenses, and refunds the balance to the Treasury.  On average, over 90 percent of the interest paid by the Treasury on those securities is refunded by the Fed. Thus for all practical purposes, the Treasury securities held by the Fed are retired.

Retiring outstanding Treasury securities in that way eliminates a cost to the Treasury. That is the way in which seigniorage in a fiat money system differs from the classical view of seigniorage. The value of the seigniorage is approximately equal to the face value of the securities held by the Fed, which in turn is equal to the monetary base created through open market operations. The monetary base can also be increased through lending by the Fed, but that has no seigniorage benefit for the Treasury.

How the Issue of Notes Affect Seigniorage

The Bureau of Engraving and Printing in the Treasury produces all notes for the Fed. The Fed buys the notes at cost, and pays by crediting the Treasury's account at the Fed. The Fed provides notes on demand to banks at face value, debiting their accounts at the Fed in payment. Banks provide notes on demand to depositors, debiting their individual accounts in payment. Conversely depositors can return notes to their banks and regain credits in their accounts. Likewise banks can return notes to the Fed and regain credits in their Fed accounts.

Since the Fed buys notes at cost and sells them to banks at face value, it would seem that seigniorage from notes accrues to the Fed. However until the notes are sold to banks, they are not a part of the monetary base, but only engraved pieces of paper stored in the vaults of the Fed. As the Fed sells and redeems notes, it simply swaps liabilities on its balance sheet. The asset side of the balance sheet remains unchanged, and the Fed gains nothing from the “sale” of notes to banks. The more notes withdrawn, the greater the seigniorage benefit to the Treasury.

How the Issue of Coins Affects Seigniorage

The U.S. Mint, a bureau of the Treasury, produces all coins. It sells them to the Fed at face value for credit in its account at the Fed. The difference between the face value of the coins and the cost of their production is seigniorage for Treasury, which accrues at the time of sale to the Fed. 

Coins held by the Fed are carried on its balance sheet as assets. Those assets vanish when sold to the private sector. The Fed sells the coins to banks at face value, who in turn sell them to the public at face value. This peculiar distinction between coins and notes is a hold-over from the days when the monetary base was precious metal

Who Really Benefits from Seigniorage?

The notion that the Treasury is a beneficiary of seigniorage is an illusion. As the late economist Herb Stein observed, "The government is no one, there is nobody here but us people." Rather it is a temporary assemblage of citizens who determine how the government should spend and tax. However the government must spend at least as much as it acquires from taxes and the sale of securities. Otherwise it would drain the monetary base and stifle the economy.

In a modern fiat money system, the Treasury has no need for balances in excess of its near term obligations. If its balances increase due to seigniorage, it will have to be returned to the private sector, either through reduced taxes or increased spending. Thus the private sector is the ultimate beneficiary.

What about Federal Reserve notes that are bought by foreign interests for use overseas? If the notes never return, they represent a large gift of seigniorage to the U.S. Again the beneficary is the U.S. private sector as a whole.

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