Archive | September, 2010

Seigniorage

13 Sep

US Government Deficit - Historical

President Barack Obama released a budget plan that expects the federal deficit for 2010 to be a record $1.56tn, surpassing last year’s record of $1.4tn. That translates to a fiscal deficit of 10 per cent to the GDP. The US debt-to-GDP ratio already stands at 93 per cent.

How will this debt be financed? Lets delve deeper into this.

First the basics. Suppose the US government budgets for an expenditure of USD 100, but its revenues (through taxation and other sundry revenue sources) are only USD 90. This entails a budget deficit of USD 10, which is financed through borrowings. The Treasury issues bonds of face value USD 10, and makes good the deficit.

The buyers of the US government bonds can be classified under three heads- private investors, foreign central banks and the Federal Reserve. Private investors include private retail investors (this forms a very small proportion) and private institutional buyers (like banks, insurance companies and trusts). Foreign central banks are also important buyers of US government bonds. Countries like China and India run a huge trade surplus with the US, and the dollars they have accumulated through such trade are invested back in US securities (see previous post). Then there is the Federal Reserve. And this is where things get a little murky.

Federal Reserve, for all practical purposes, is simply an extension of the US Government. So, the Fed buying US government bonds is simply a transfer of debt from one part of the government to another. As for where does the Fed get the dollars to buy the bonds? It prints them. The Federal Reserve does not have the power of taxation to raise money, so it simply prints money to finance government debt.  This is referred to as monetization of debt or deficit financing.

The way this works is as follows. Suppose the US Treasury wants to spend USD 10 bn, but it only has USD 9 bn as tax revenues. It issues bonds for USD 1 bn in the market. The Fed comes in now to conduct its open market operations. It prints USD 1 bn and buys the bonds. Assume the interest payment on the bonds amounts to USD 10 mn. The Treasury pays this interest to the holder of the bonds, which is now the Federal Reserve. The Fed uses part of this money, say USD 1 mn, to pay for its day to day running expenses (like staff salary, premises, printing cost, etc) and holds USD 9 mn as surplus, which is returned back to the Treasury. And this completes the cycle.

So, when debt monetization takes places, what is the cost to the Treasury of financing the USD 1 bn deficit? It is simply the cost of printing that amount of money, i.e., USD 1 mn, which is 0.1 per cent of the deficit. This power to print money, and finance any deficit simply out of thin air, is referred to as ‘Seigniorage’ and is a sovereign prerogative of the government.

This is how Wiki defines the term ‘Seigniorage’,

“Seigniorage can be seen as a form of tax levied on the holders of a currency…. The expansion of the money supply causes inflation in the long run. This means that the real wealth of people who hold cash or deposits decreases and the wealth of the issuer of the money increases. This is a redistribution of wealth from the people to the issuers of newly-created money (the central bank) very similar to a tax.”

The above definition does a wonderful job of explaining the economic impact of seigniorage.  And the term assumes special significance in today’s economic scenario as going forward, the US governments is slyly going to rely on this form of taxation to get their fiscal house in order. In fact, given the scale of fiscal stimulus undertaken, it is in fact impossible to cover up for all that spending without significantly relying on seigniorage at some point of time.

The brunt of this will be borne by the people who hold dollars – the US citizen and foreign central banks who have dollar holdings. How all this will unwind in the future, will be very interesting to see. More on this in a subsequent post.

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