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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6 Responses to “Seigniorage”

  1. George September 14, 2010 at 4:28 am #

    Might be a silly question but can’t the FED reduce the inflation burden since it has a hand on the interest rate lever.. I’m sure interest rates are not fully market based?

  2. Ravi Saraogi September 14, 2010 at 4:45 am #

    Yes, it can reduce the inflation burden by increasing benchmark interest rates. However, higher interest rates will hurt aggregate demand and investments in the economy and there will eventually be an inflation-growth trade off…

    The US government has accumulated such high deficits to prop up demand in the economy. To then increase increase rates to cool down investments and aggregate demand will take care of inflation, but it will be self defeating to the entire purpose of running the debt in the first place..

  3. Arun Sathiya September 14, 2010 at 5:54 am #

    Good work Ravi.

    Expecting this kind of analysis on Indian Economy too.

  4. Ravi Saraogi September 16, 2010 at 3:37 am #

    @ Sathiya… Thank you very much… The process of money creation is same for all economies… So though I have taken the US example, the concepts are applicable to the Indian economy too…

  5. Gautam Sadana February 25, 2011 at 11:01 am #

    Yes, broadly this concept remains the same..with some exception to the US. With USD being the reserve currency (and therefore stashed by foreign central banks/escrow accounts), the inflationary impact of printing $ is not borne directly or immediately by its residents..rather it exports these concerns to economies whose monetary policies are closely linked to the Fed (eg. China,India, etc.). Ravi, how did US escape from the record deficits immediately after WWII.. probably debt monetization ? do you think it could be different this time around..given increasing pressures from creditors like China for an alternate methodology for reserve currency?

  6. Ravi Saraogi February 25, 2011 at 12:04 pm #

    Yes Gautam, with the US, the inflationary impact of printing currency is muted, as the US dollar has ‘demand’ in other countries also. And if these countries build up foreign currency reserves without sterilization, the inflationary impact is exported. Unless the economy is growing at an impressive pace, any rapid increase in debt levels eventually boils down to debt monetization. Not sure about WWII, but my guess would be that since the US was a growth engine during that time, part of the increase in debt levels would have been taken care of by growth in GDP and part through debt monetization.

    This time, US has massively resorted to debt monetization. The balance sheet of the Fed has ballooned since the sub prime mess. China (being the single largest holder of treasuries outside the US) has been complaining about this massive *glut*, but does not seem to be making much of a diffence to the US. So the question of ‘will this time be different’ does not arise as the process of monetization has already taken place. The only reason things have not gone topsy turvy is that is that much of this monetizaion is still ‘electronic’ and hard currency has not yet been released into the system. Now we just need to sit and watch how things unfold on that one day the world starts questioning the value of the dollar.

    Hope the above makes sense.

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