Monetary Ramblings – Part 1 (Seignorage)

Conspiracies about money abound: there are crackpot theories about the international dominance of the dollar, the Chinese hoarding of Treasuries, the rate of inflation, or the gold standard that repeatedly make their way into the opinion sections of respectable magazines and newspapers. I think part of the explanation for the almost theological obsession of the public with all things related to money is, on the one hand, the association with deep philosophical concepts like value, time, authority and its omnipresence in human interactions, on the other hand, the fact that the monetary system is quite difficult to understand, which leaves much room for speculation.

I am no exception and so I constantly struggle to understand what it is exactly, that money does and how it can be influenced by policymakers. It seems that, where it comes to money even the simplest question are never silly and oftentimes have very complicated answers. As an illustration, consider the question “What is money?”. The answers can range from coins and note, to the entirety of assets like checking accounts, liquid stocks, jewels etc. that are available as stores of value and means of exchange. Consequently, any statement about monetary policy needs to contend with this complexity by clearly stating its definitions. Faillure to do so is often the reason for the seeming disconnect in public debates about the topic. Personally, I find that simple analogies help me to think through the chain of effects of a particular intervention. For personal reference and perhaps also as food for thought for the reader, I will try and think through some policy-relevant issues related to money in the next posts.

One question I have been wrestling with, is whether the central bank can help the government pay for its debt. Given that it can print an infinite amount of money to pay for all its obligations, it is trivially true that the central bank could pay for all the debt outstanding in the short run, at the non-trivial cost of destroying the US economy by hyperinflation. However, in the more meaningful sense of whether it can make sustainable profits without destroying the economy, and how large these profits can be and who has the offsetting loss, the question becomes more difficult to answer.

The profit that the central bank derives from being the monopoly producer of money in its area of operation is called seignorage. In order to find out how much that privilege is worth, there is two different ways we can measure this: the loss to citizens and the gain to the central bank. For the former, we can measure the opportunity cost of money. Remember that the central bank increases the money supply by buying interest-paying assets (bonds, stocks etc.) using a  zero interest asset (money) as payment.  Thus, citizens lose out on the interest and just get a bunch of green papers in return, which makes their loss equal the interest rate of whatever asset they would like to hold instead of zero interest money. This is obviously quite vague, as the best alternative to holding money is not the same for everyone and will actually change as monetary policy changes, which makes this is a hard measure to use in practice.

The gain to the central bank is easier to measure because it is not dispersed among many citizens: to the first approximation, in the short run its benefit from increasing the money supply is whatever it can buy with that money, that is, the real value of one dollar. In a way, it can print a dollar, go into a store and buy something. As the central bank does not really produce any real stuff, when it goes into the store and buys something real with the printed money, someone else must become poorer to make up for the fact that the central bank just got something for (green papery) nothing. This cost is in fact shared by all citizens, as the additional dollar introduced by the central bank increased the ratio of money to stuff in the economy, thereby making all the other money in circulation slightly less valuable. In effect, the increase in money supply is a tax on people who hold money.

In the long run however, this tax, like all taxes (as depicted in the Laffer curve), has a maximum level of revenue it can raise. The limitation to printing more and more money and buying more and more stuff with it is that if the amount of money created greatly exceeds the natural increase that is necessary to grease the wheels of an expanding economy, there will be inflation, which is just a different way of restating the fact that money loses value, if there is too much of the latter and not enough things to buy. This inflation (like all taxes) distorts the economic process by leading to frequent changes in pricing,  sub-optimal adjustment of relative price ratios and a tax on trying to accumulate wealth, which discourages effort. Thus, if inflation gets too high, the economy stops to function well, shrinks, and the money printed by the central bank will buy less real stuff, even as they print more money. Thus, if the central bank overdoes the seignorage trick, it will kill the golden goose. It’s as if you have a pub and you secretly dilute your beer with water. Initially, it is a gain for the pub owner (central bank) at the cost of the drinkers, but if you overdo it, people will stop coming to your pub all together and so, even if you would dilute the beer more and more to increase your profit, you would actually end up with less and less income, as business dries up.

  1. Monetary Ramblings – Part 2 (Seignorage in practice) « thewholegamutoflife

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