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, known as seigniorage.

The Monetary Base Today

In the U.S. today the monetary base consists of cash (notes and coins) and bank-owned deposits at the Fed. Notes and Fed deposits are carried as liabilities on the Fed’s balance sheet. Coins are not, as will be explained. All three are fiat money, meaning they have little or no intrinsic value and are money by government fiat. To back that up, the government requires that all payments to it be made in its own fiat money.

The amount of cash issued is a function of demand and is not at the discretion of the Fed. Since cash earns no interest, the public normally holds only what it needs for current use. Likewise Fed deposits earn no interest so banks hold as little as needed. Banks need reserves to back the demand deposits they create through lending. Whether issued as Fed deposits or cash, the creation of the monetary base by the Fed generates significant seigniorage for the State. 

The Production and Distribution of Notes and Coins 

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. 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.

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 coins. 

Banks “buy” notes and coins as needed to meet the demand for them by their depositors. 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, which increases aggregate bank deposits at the Fed. In effect, the public acquires cash by selling Treasury securities to the Fed. Conversely it disposes of excess cash by buying Treasury securities from the Fed. 

Seigniorage from Notes and Fed Deposits

Since the Fed buys notes at cost and sells them to banks at face value, it would seem that the seigniorage from notes accrues to the Fed rather than the Treasury. 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, so the Fed gains nothing from the “sale” of notes to banks.

Interest earned on the Fed's portfolio of Treasury securities is income for the Fed. However the Fed retains only what it needs for operating expenses and refunds the remainder 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, those Treasury securities are retired.

The present value of the refunded interest payments about equals the face value of the Treasury securities in the Fed's portfolio. Seigniorage thus accrues to the Treasury and is about equal to the monetary base, less the cost of producing and servicing the notes and coins.

Who Really Benefits from Seigniorage?

In a democratic nation with a modern fiat money system, the view that  seigniorage benefits the government is misleading. As the economist Herb Stein observed, "The government is no one, there is nobody here but us people." Rather it is simply an assemblage of citizens who, while in office, determine how the government should spend in support of the economy. Indeed the government must spend at least as much as it acquires from taxes and bond sales. Otherwise it would drain the monetary base and stifle the economy. In effect, seigniorage is a measure of the net financial wealth of the private sector. Whether that wealth is distributed equitably depends upon the actions of its elected officials.

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. Whether the notes are purchased in exchange for a foreign currency or acquired by selling goods and services, the U.S. private sector as a whole is the beneficiary.

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