Seigniorage (2)

28 June 2016, translated from Dutch by the author

Introduction

This article and the previous one were written while preparing my planned critical article that should follow the praising one, these latter two (both in Dutch) in reaction to an article (also in Dutch) dated May 2015, by Wim Boonstra, Chief Economist at Rabobank in the Netherlands.

In short, he stated that commercial banks, when creating money of account, do not earn a seigniorage benefit, but that governments or central banks do when they create base money.

I think he is wrong about that. In an attempt to find out if he might nevertheless be true, I suspected it might make a difference whether in the modern fashion, the central bank is at a distance from the state (or states, as in the case of the euro), while the central bank is not charged with funding the state; or that, in the old-fashioned way, like in the early days of the Dutch central bank, De Nederlandsche Bank, the King founded that bank with the express purpose of funding his policies.

In order to see whether that makes a difference, I elaborated an example – inspired by Modern Money Mechanics, MMM – in which a central bank creates base money. Each time I looked at state and central bank separately, but also after consolidating: combining the balance sheets, adding the numbers of like-named accounts, striking what is exactly compensated by the other balance sheet.

Situations

Government intends to issue government bonds.
Government has sold government bonds to a non-bank investor.
Government has spent the money received from the issue.
Central bank has purchased the government bonds.
Miscellaneous.

1. Government intends to issue government bonds

The government intends to issue bonds worth one 1000 (euros, dollars, millions of euros, it doesn’t matter as long as it’s consistent). The bonds will be bought by a party that is not a bank and not part of the government. For example, it could be a pension fund. Hereafter to be called: investor.

1A. Balance sheet of the government

For simplicity we assume this is all zeroes.

1B. Balance sheet of central bank

Description	Debit (assets)	Credit (liabilities)
Miscellaneous assets	100,000
Bank reserves of commercial banks		10,000
Shareholders’ equity		90,000

1C. Consolidated balance sheet of state and central bank

Description	Debit (assets)	Credit (liabilities)
Miscellaneous assets	100,000
Bank reserves of commercial banks		10,000
Shareholders’ equity		90,000

1D. Balance sheet of the investor’s bank

Again for simplicity’s sake, the only client the bank has is the investor. Later on there will also be a teacher with an account.

Description	Debit (assets)	Credit (liabilities)
Reserves with central bank	10,000
Investor’s bank account.		1,000
Shareholders’ equity		9,000

1E. Balance sheet of the investor

The investor only has an amount in the bank, and nothing else.

Description	Debit (assets)	Credit (liabilities)
Bank account	1000
Shareholders’ equity		1000

2. The government has sold government bonds to the investor

2A. Balance sheet of the government

Description	Debit (assets)	Credit (liabilities)
Treasury account at the central bank	1000
Government bonds		1000

2B. Balance sheet of central bank

Description	Debit (assets)	Credit (liabilities)
Miscellaneous assets	100,000
Treasury account at the central bank		1,000
Bank reserves of commercial banks		9,000
Shareholders’ equity		90,000

2C. Consolidated balance sheet of state and central bank

Description	Debit (assets)	Credit (liabilities)
Miscellaneous assets	100,000
Government bonds		1,000
Bank reserves of commercial banks		9,000
Shareholders’ equity		90,000

2D. Balance sheet of the investor’s bank

On behalf of the investor, the bank paid for the purchased government bonds. That was at the expense of its reserves with the central bank. Therefore these went from 10,000 to 9,000.

Description	Debit (assets)	Credit (liabilities)
Reserves with central bank	9000
Investor’s bank account.		0
Shareholders’ equity		9000

2E. Balance sheet of the investor

The investor now owns only those bonds, instead of its former bank balance.

Description	Debit (assets)	Credit (liabilities)
Government bonds	1000
Bank account	0
Shareholders’ equity		1000

2F. Effects on the money supply

M1: the investor (a member of the public) had money in the bank, but now no longer. So money destruction has taken place.

Bank reserves: they were 10,000, now are 9000. Here too there has been money destruction.

M0 (bank reserves + cash in the hands of the public): ditto.

Did the government and/or the central bank suffer a loss as a result of this transaction? No, because part of the bank reserves (= loans from banks to the central bank) in effect has been transformed to a government loan (a loan by the public, via banks, to the state).

The government does have more funds available (as a result of money destruction, mind you, not by money creation). By the way, the same happens when taxes are paid.

3. The government has spent the money it received

This is departing from the situation that the investor has just bought the government bonds, paying for it with its bank balance.

3A. Balance sheet of the government

The borrowed money is used for buying something, to pay contractors (expenses which will eventually result in a valuable asset, so it’s a debit item), or for example for paying teachers’ salaries (costs of education, also debit).

So part of the treasury changes into some other asset, or to costs. In the example they are costs of education. What I’m showing here is in fact the balance sheet including the profit and loss statement (a.k.a. income statement).

Description	Debit (assets)	Credit (liabilities)
Costs of education	1000
Treasury account at the central bank	0
Government bonds		1000

3B. Balance sheet of central bank

Description	Debit (assets)	Credit (liabilities)
Miscellaneous assets	100,000
Treasury account at the central bank		0
Bank reserves of commercial banks		10,000
Shareholders’ equity		90,000

3C. Consolidated balance sheet of state and central bank

Description	Debit (assets)	Credit (liabilities)
Costs of education	1,000
Miscellaneous assets	100,000
Government bonds		1,000
Bank reserves of commercial banks		10,000
Shareholders’ equity		90,000

3D. Balance sheet of the investor’s bank

The investor is not involved in this. The bank reserves do change, because the teachers receiving their salaries are also bank clients.

Description	Debit (assets)	Credit (liabilities)
Reserves with central bank	10,000
Investor’s bank account.		0
Teacher’s account		1,000
Shareholders’ equity		9,000

3E. Balance sheet of the investor

No difference, the investor is not involved in this.

Description	Debit (assets)	Credit (liabilities)
Government bonds	1000
Bank account	0
Shareholders’ equity		1000

3F. Effects on the money supply

M1: the teacher (also a member of the public) did not have money in the bank, now has 1000. So money creation has occurred – which compensates the earlier money destruction that resulted from getting paid for the government bonds.

Bank reserves: was 9,000, now is 10,000. Here too there has been money creation.

M0 (bank reserves + cash in the hands of the public): ditto.

Did the government and/or the central bank benefit from the transaction or suffer a loss? Yes, a loss, because part of the state’s assets (the treasury account) was transformed into costs (meaning a decrease of equity). Well, but that’s why they borrowed money, so they could afford this expenditure.

Note that the state does not benefit from this money creation, but suffers a loss. Had the scenario been different, like when buying something of lasting value, or having that built, part of a financial asset would have changed into physical assets. Then there would be no loss. But no benefit either.

So we see no money creation benefit or seigniorage benefit, although there was money creation.

Central bank has purchased the government bonds

4A. Balance sheet of the government

This is QE, quantitative easing.

Nothing changes for the state. The government bonds change owners, but that makes no difference.

Description	Debit (assets)	Credit (liabilities)
Costs of education	1000
Treasury account at the central bank	0
Government bonds		1000

4B. Balance sheet of central bank

The central bank obtains the government bonds on its balance sheet. Bank reserves increase as a result of the payment being made to the investor.

Description	Debit (assets)	Credit (liabilities)
Miscellaneous assets	100,000
Treasury account at the central bank		0
Government bonds	1,000
Bank reserves of commercial banks		11,000
Shareholders’ equity		90,000

4C. Consolidated balance sheet of state and central bank

In the consolidated balance sheet, the government bonds are both an asset and a liability, so they might as well be eliminated altogether. Bank reserves have increased.

Description	Debit (assets)	Credit (liabilities)
Costs of education	1,000
Miscellaneous assets	100,000
Bank reserves of commercial banks		11,000
Shareholders’ equity		90,000

4D. Balance sheet of the investor’s bank

The investor no longer owns the bonds, because they were sold to the central bank. A bank balance takes its place. The bank is compensated for that by an increase of bank reserves.

Description	Debit (assets)	Credit (liabilities)
Reserves with central bank	11,000
Investor’s bank account.		1,000
Teacher’s account		1,000
Shareholders’ equity		9,000

4E. Balance sheet of the investor

The investor no longer has the government bonds. A bank balance takes its place.

Description	Debit (assets)	Credit (liabilities)
Government bonds	0
Bank account	1000
Shareholders’ equity		1000

4F. Effects on the money supply

M1: the investor lost the bonds but has the money back. So there has been money creation.

Bank reserves were 10,000, are now 11,000. Here too there has been money creation.

M0 (bank reserves + cash in the hands of the public): ditto.

Did the government and/or the central bank benefit from the transaction or suffer a loss? For the state it makes no difference. The debt remains, except that it is now a liability to the central bank instead of to the investor.

After consolidation (considering that central banks are often (although not in the USA) wholly state-owned): the debt is eliminated on balance, because it appears equally at both sides of the balance sheet. However, the government was able to make its expenditure. So is this the paradise of monetary financing? No, because the combination of state and central bank is now also liable for bank reserves. Those have increased by one thousand.

So in fact the state again borrowed the money (as in the original situation when the investor owned the government bonds), from the investor, with its bank and the central bank as intermediaries. I came to that conclusion before.

So the transaction involves money creation, but it makes nobody any richer nor poorer. Monetary financing is an illusion, because sooner or later, taxes will have to be paid anyhow. State loans, whether via the central bank or on the capital market, are nothing but postponed taxes.

Assignment to the reader

Work out for yourself what happens if:

the CB (central bank) buys government bonds already before the money is spent;
then the expenditure; the effect must be the same as when they happen in reverse order.
if the purchase of government bonds by the investor is skipped, but the CB immediately provides the loan to the state (which is prohibited in the eurozone); the effect should be the same, both before and after the actual expenditure of the money the state obtains.

Conclusion

Money creation makes nobody richer. There is no benefit from money creation. The only way to earn anything by money creation, is indirectly: through returns on covering assets.

This applies to non-central banks that create money by granting credit to the public. It equally applies to a central bank that provides banks with base money (‘on demand’ funds, and banknotes), or that provides the public with banknotes.

Whether the central bank is separate from the state or integrated with it, is immaterial for this.

Direct seigniorage does not exist. Indirect seigniorage does.