Seigniorage - Difference Between the Cost to Make Money and the Face Value of the Coin

A financial term which most people do not know the definition of is seigniorage. Seigniorage is the difference between the cost of making a coin (or other money) and the face value of the coin. In other words, when a government mints coins and then issues them to the public, any revenue in excess of the cost of making the coins is a profit taken by that government. The word stems from Old French in the Middle Ages, when the sovereign (king or nobleman) had the power to make and issue money whenever he liked. In fact, when directly translated, the root word "seignior" literally means a man of rank, for example a feudal lord. The idea was that the sovereign held the exclusive right to create money and thus profited from minting coins that cost him less to produce than their face value. In the feudal example, he himself spent the coins into circulation.

Seigniorage is not a term that only applies to studies of the Middle Ages, however. It is still widely used today, as all governments around the world earn some profit on the money they issue. This report will mostly discuss seigniorage in the United States.

To Abolish the Penny or Not?

During the last decade, there has been growing sentiment among United States citizens for the discontinuation of the penny as currency. Complaints ranging from the penny's appearance to its relative worthlessness have led many to take up this cause. However, below please find a few facts that support the continuation of penny use in the U.S.:

In 1994, the U.S. Mint produced over 13 billion pennies to meet broad public demand. The penny costs only .7 cents to make, so the Treasury makes .3 cents on each penny minted. In 1994, production of the penny generated over $40 million in revenue for the Treasury, which the government posts as a profit. In the last 15 years, seigniorage from the penny has earned the Treasury over $500 million. Eliminating the penny would increase government borrowing to finance the deficit and increase the deficit by almost $4 million a year; there would not be budget savings. With its substantial manufacturing volume, the Mint's penny production supports metals, mining and related industries. Tax payments from these supporting industries to the government would be lost if the cent was not produced

Seigniorage from Federal Reserve Notes

Federal Reserve notes are the paper currency in the United States. Based on its sovereignty, the U.S. government has the exclusive right to issue Federal Reserve notes. As of November 2000, the total value of notes outstanding was $575 billion (Federal Reserve Bank of NY). These outstanding notes had an annual replacement cost of about $450 million. This is to issue new notes, replace those which have been destroyed, and other related costs. The present value of those costs, a number that represents this $450 million annual cost continued indefinitely and discounted at 5%, is about $9 billion. Therefore, the seigniorage resulting from the monopoly on note issue in the United States is worth about $575 billion - $9 billion = $566 billion. Is this a true windfall for the U.S. government? Not really. That number does not relate a monthly or even yearly gain for the government, but more of a total gain. In order to understand this, we need to look first at the details.

How Banks Acquire the Notes

The Federal Reserve buys the notes from the Bureau of Engraving and Printing at the Treasury (another government agency) at a cost of about 4 cents each. Meaning a $1 bill costs the government 4 cents, and a $20 bill costs the government 4 cents. Now it is becoming easier to understand exactly why seigniorage is so important, as is shown in the chart below. For each and every bill issued by the Federal Reserve, there is a profit.

The Fed sells them at face value to banks on demand. These banks basically "trade" old notes with the Fed. How does this result in a gain for the government? Any time money comes out of circulation and into the Federal Reserve, the government gains. When a bank buys Federal Reserve notes from the Fed, its deposit at the Fed is debited accordingly. However the Fed's reduced liability to the bank is balanced by an equal increase in its note obligations. The sale of notes is a reversible transaction. Banks can sell notes back to the Fed and regain deposits at any time. The Fed simply swaps two liabilities on its balance sheet as it buys or sells notes to banks. So there is no actual exchange of "money," but there is a distinct benefit for the Federal Reserve.

Seigniorage in a Fiat Money System

The concept of seigniorage originated in the days when precious metals, such as silver and gold, comprised the monetary base. Coins of precious metal were widely viewed as having real value; that is, even if the government from which they were issued collapsed, the coins would still have worth because they were made of something valuable. The government minted the coins, but private enterprise could profit by producing the metal. Coins were an asset without a corresponding liability. Therefore the government as well as individuals could gain financial wealth by acquiring coins. The value of the coins in exchange for goods and services depended on their relative scarcity.

Today, fiat money comprises the monetary base. Fiat money is money that is made of a material with no real value. For example, U.S. Currency is made of cotton and linen, a fabric that is worth nowhere near what the money is worth. Since money in this country is no longer backed by gold or silver, if the economy were to collapse and the currency was worthless, owners would not be able to get fair value for it. It can be issued in any desired amount and is of necessity a monopoly of the government. Fiat money represents a balance sheet relation. It is an asset of the holder and an equal liability of the government. Since it has no intrinsic value, the exchange value of fiat money depends on the proper management of its scarcity. Thus seigniorage in a fiat money system is quite different from the classic example. It cannot properly be viewed as a means of gaining financial wealth. Indeed financial wealth of the government is a meaningless concept since it has unlimited spending power in its own fiat money.

Seigniorage now occurs as a result of the public drawing on its bank deposits to acquire cash. In this process the central bank plays a key, though passive, role. When the public chooses to hold more cash, in effect it swaps some of its interest-bearing Treasury securities for non-interest-bearing Federal Reserve notes. Other things equal, this reduces the interest payments owed by the government. However the benefits are fully refluxed to the public in the form of lower taxes, reduced borrowing, or additional spending. The government cannot avoid doing so without draining the reserves of the banking system and endangering the liquidity of the system itself.

A Case of Real Seigniorage

A present-day case of real seigniorage occurs when a foreign entity swaps its own currency for Federal Reserve notes and then removes the notes from the US economy. This would happen for example when a country uses the US dollar as an official currency. At the cost of a few cents each, the notes will effectively buy foreign goods and services at face value. As long as the notes remain overseas, those purchases are virtually cost-free. The government becomes the beneficiary of this situation, because those foreign notes rarely affect the domestic economy as long as they are kept overseas.

Works Cited

Federal Reserve Bank of New York Website http://www.ny.frb.org/pihome/fedpoint/fed01.html

"Seigniorage in a Cross-Section of Countries," Journal of Money, Credit and Banking v. 30 no. 2 (May 98) p.158

"Seigniorage, Taxation, and Weak Government," Journal of Money, Credit and Banking v.29 (February 97) p.113